This discussion and analysis should be read in conjunction with our audited Consolidated Financial Statements and Notes thereto presented in Item 8 of this Form 10-K (“Consolidated Financial Statements”). You should also read our discussion of Critical Accounting Estimates beginning on page 57 for an explanation of those accounting estimates that we believe are most important to the portrayal of our financial condition and results of operations and that require our most difficult, subjective and complex judgments.
This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements, which involve risks and uncertainties. See “Item 1A - Risk Factors” and the “Cautionary Note Regarding Forward-Looking Statements” on page 65 for a list of factors that could cause our actual results to differ materially from those contained in any forward-looking statement.
Fronting premiums were $34.8 million in 2008, compared to $59.8 million in 2007 and $14.8 million in 2006. The decrease in fronting premiums in 2008, compared to 2007, was primarily the result of the termination of our agreement with Midwest in March 2008. The decline in the Midwest business was partially offset by new fronting business of $24.4 million produced under arrangements we entered into during 2008. The increase in fronting premiums in 2007, compared to 2006, was due to an increase in the Midwest business. Our agreement with Midwest became effective September 1, 2006 and terminated on March 2, 2008.
In the first quarter of 2006, we stopped writing integrated disability business. Effective August 1, 2007, we purchased reinsurance covering substantially all unpaid losses and LAE related to our integrated disability business. Under the agreement, the reinsurer also handles the servicing and benefit payments related to this business. Upon entering into this agreement, we ceded $25.7 million in carried loss and LAE reserves and paid $22.7 million in cash.
In a 2004 Order, the Pennsylvania Insurance Department prohibited PMACIC from declaring or paying any dividends, return of capital or other types of distributions to the holding company prior to 2006. Under the terms of the 2004 Order, PMACIC was permitted to request an “extraordinary” dividend, as defined under Pennsylvania law, in 2006 provided that immediately after giving effect to the dividend or return of capital, PMACIC’s risk-based capital equaled or exceeded 225% of Authorized Control Level Capital, as defined by the National Association of Insurance Commissioners. In 2006, the Department approved our request for an “extraordinary” dividend in the amount of $73.5 million from PMACIC. We used the proceeds to reduce our debt obligations and to maintain liquidity at the holding company. In 2007, the Department approved our request for an additional “extraordinary” dividend in the amount of $37.5 million from PMACIC. We used the proceeds to purchase Midlands, to repurchase shares of our Class A Common Stock and to maintain liquidity at the holding company. We did not receive any dividends from PMACIC in 2008, and given the pending sale of this operation in 2009, we do not expect to receive any dividends from PMACIC prior to the closing of the sale. As of December 31, 2008, the statutory surplus of PMACIC was $34.5 million, which included a $13.0 million capital contribution made by the holding company in the fourth quarter of 2008. The capital contribution included $5.0 million of cash and a promissory note of $8.0 million, $4.0 million payable in each of March 2009 and March 2010.
For all but three securities, which were carried at a fair value of $2.2 million at December 31, 2008, we determined the fair value of fixed income securities from prices obtained in the public markets. Prices obtained in the public market include quoted prices that are readily and regularly available in an active market, market values generated by external pricing models that vary by asset class and incorporate available trade, bid and other market information, as well as price quotes from other well-established independent market sources. For the three securities whose prices were not obtained from the public markets, which were privately placed 18-month construction bridge loans with no secondary market, we utilized a discounted cash flow valuation model to approximate their current fair value.
See “Item 1 - Business - Investments” and Notes 2B, 5 and 6 to our Consolidated Financial Statements for additional discussion about our investment portfolio.
We have established a carried loss and LAE reserve for unpaid claims at December 31, 2008 that we believe is a reasonable and adequate provision based on the information then available to us and we believe such amounts are fairly stated at December 31, 2008. However, if significant assumptions that are components of our actuarial analysis, such as the frequency and severity of claims or the amount of medical cost inflation, develop differently than we anticipate, then our range of reserve estimates could vary. Based upon our actuarial analysis at December 31, 2008, we believe there is a reasonable probability that the range of reserve estimates for losses and LAE could vary, higher or lower, from our reserves at December 31, 2008 by approximately five percent (5%) at The PMA Insurance Group and by approximately seven percent (7%) at our discontinued operations. Because our carried reserves reflect management’s best estimate and are not determined by a formula that is automatically the direct product of the actuarial methods used to develop our range of reserves, we are unable to quantify in any meaningful way the effect of a change to any one of the significant assumptions underlying our actuarial process on our carried reserves. It is also possible that the amount required to settle all losses and
As part of determining the fair value for each specific investment that we hold, we evaluate each issuer’s ability to fully meet their obligation to pay all amounts, both interest and principal, due in the future. Because we have invested in fixed income obligations with an overall average credit quality of AA+, and all of our investments, excluding our Lehman Brothers senior debt and Fannie Mae preferred stock, are currently meeting their obligations with respect to scheduled interest income and principal payments, we believe that we will fully realize the value of our investments. However, future general economic conditions and/or specific company performance issues may cause a particular issuer, or group of issuers in the same industry segment, to become unable to meet their obligation to pay principal and interest as it comes due. If such events were to occur, then we would evaluate our ability to fully recover the recorded value of our investment. Ultimately, we may have to write down an investment to its then determined net realizable value and reflect that write-down in earnings in the period such determination is made.
G. Dividends to Policyholders - The Company sells certain workers’ compensation insurance policies with dividend payment features. These policyholders share in the underwriting results of their respective policies in the form of dividends. Dividends to policyholders are accrued during the period in which the related premiums are earned and are determined based on the terms of the individual policies.
Shareholder’s equity of the Run-off Operations as of December 31, 2007, prior to the impact of the impairment loss.
Condensed balance sheet information of the discontinued operations is included below:
At December 31, 2008, of the 34 securities that have been in an unrealized loss position for more than 12 months, 33 securities have a total fair value of 81% of their combined amortized cost basis at December 31, 2008, and the average unrealized loss per security is approximately $383,000. The other security that has been in an unrealized loss position for more than 12 months at December 31, 2008 has a fair value of $300,000 and an amortized cost of $1.4 million. This security, whose $1.4 million principal is backed and guaranteed at maturity by discounted government sponsored enterprise securities, matures in 2033 and is rated AAA. The Company has both the ability and intent to hold this security until it
matures. Of the remaining 33 securities, six were corporate debt securities issued by financial institutions that had a total fair value of 87% of their combined amortized cost basis at December 31, 2008.
During the vesting period, restricted shares issued are nontransferable and subject to forfeiture, but the shares are entitled to all of the other rights of the outstanding shares. Restricted shares are forfeited if employees terminate employment, or Directors resign from the Board, prior to the lapse of restrictions except upon death or permanent disability.
In March 2006 and 2007 and February 2008, the Compensation Committee approved the 2006, 2007 and 2008 Officer Long Term Incentive Plans, pursuant to which stock may be awarded to all officers in 2009, 2010 and 2011 if the after-tax return on equity (“ROE”) in 2008, 2009 and 2010 is within a specified range. Award amounts are calculated as a percentage of the participants’ base salaries. The 2006, 2007 and 2008 Officer Long Term Incentive Plans link compensation to performance under the Company’s three-year strategic plan and recognize the long-term nature of improvement in ROE and the value ROE growth creates for shareholders. The Company recognized expenses related to these plans of $1.9 million, $1.0 million and $500,000 in 2008, 2007 and 2006, respectively.
The Company’s Qualified Pension Plan assets are managed by outside investment managers and are rebalanced periodically. The Company’s investment strategy with respect to Qualified Pension Plan assets includes guidelines for asset quality standards, asset allocations among investment types and issuers, and other relevant criteria for the portfolio.