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 slightly after increasing consistently during the last three years. The market hardening of the last few years was driven by a persistent decline in investment income and an increase in severe weather events, not a reduction in capital adequacy. The outlook for 2014 is that overall premium rate levels will continue to rise for most lines of business, but at a slower rate than the last few years.
The FASB issued an exposure draft on accounting for insurance contracts on June 27, 2013 that would have had a significant impact on insurance companies that issue short-duration contracts, which would include most property and casualty insurance contracts. On February 20, 2014, the FASB announced that it was scaling back the scope of its insurance contracts project in response to feedback from constituents that the costs of implementation would outweigh any benefits to be achieved from applying the proposed guidance to all contracts that met a new definition of an insurance contract. The FASB also noted that insurers and users of the financial statements indicated the current accounting model for short-duration contracts provides reasonable measurement and recognition guidance. As a result, the FASB indicated that it will focus on improving disclosures for short-duration contracts. However, it should be noted that any change to the definition of insurance that the FASB makes for long-duration contracts could affect an entity's ability to use the current short-duration accounting model.
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 two former policyholders. One of those former policyholders, a broker of various products, including asbestos, settled a claim for approximately $450 (the Company’s share) in 2008. Prior to 2008, the asbestos exposure associated with this former policyholder had been thought to be relatively small. At December 31, 2013, nine additional claims associated with this former policyholder remain open, though similar exposure on these claims is not anticipated. The other former policyholder, a furnace manufacturer, had multiple claims settle for a total of approximately $2,176 (the Company’s share) during the period 2009 through 2013. 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 the primary 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 646 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.
The discount rate utilized in the valuations is based on an analysis of the total rate of return that could be generated by a hypothetical portfolio of high-quality bonds created to generate cash flows that match the plans’ expected benefit payments. No callable bonds are used in this analysis and the discount rate produced by this analysis is compared to interest rates of applicable published indices for reasonableness. The discount rates used in the pension benefit obligation valuations at December 31, 2013, 2012 and 2011 were 4.17 percent, 3.24 percent and 4.13 percent, respectively. The discount rates used in the postretirement benefit obligation valuations at December 31, 2013, 2012 and 2011 were 4.71 percent, 4.03 percent and 4.59 percent, respectively. The discount rates used in the pension and postretirement benefit obligation valuations are also used in the calculation of the net periodic benefit costs for the subsequent year. A 0.25 percentage point decrease in the discount rates used in the 2013 valuations would decrease the Company’s net periodic pension and postretirement benefit costs for 2014 by approximately $57. Conversely, a 0.25 percentage point increase in the 2013 discount rates would increase the Company’s net periodic pension and postretirement benefit costs for 2014 by approximately $56.
The Company held $2,392 and $863 in minority ownership interests in limited partnerships and limited liability companies at December 31, 2013 and 2012, respectively. The Company does not hold any other unregistered securities.
The following table reflects the Company's contractual obligations as of December 31, 2013. 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 2014. Employers Mutual has entered into various leases for branch and service office facilities with lease terms expiring through 2023. 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.
Prepayment risk refers to changes in prepayment patterns that can shorten or lengthen the expected timing of principal repayments and thus the average life and the effective yield of a security. Such risk exists primarily within the portfolio of mortgage-backed securities. Prepayment risk is monitored regularly through the analysis of interest rate simulations. At December 31, 2013, the effective duration of the mortgage-backed securities, excluding interest-only securities, is 3.9 with an average life of 4.6 years and a yield to worst of 3.0 percent. At December 31, 2012, the effective duration of the mortgage-backed securities was 2.6, with an average life of 3.3 years and a yield to worst of 1.4 percent.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of EMC Insurance Group Inc. and Subsidiaries as of December 31, 2013 and 2012, 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, 2013 of EMC Insurance Group Inc. and Subsidiaries and our report dated March 12, 2014 expressed an unqualified opinion thereon.
For the reinsurance segment, the December 31, 2013 estimate of loss and settlement expense reserves for accident years 2012 and prior decreased $5,504,476 from the estimate at December 31, 2012. This decrease represents 3.2 percent of the December 31, 2012 gross carried reserves and is largely attributed to reported losses that were below the December 2012 implicit projections for policy year 2012 in the Home Office Reinsurance Assumed Department (also known as “HORAD”) book of business.
At present, the pool participants are defending approximately 1,717 asbestos bodily injury lawsuits, some of which involve multiple plaintiffs. Five former policyholders and one current policyholder dominate the pool participants’ asbestos claims. Most of the lawsuits are subject to express reservation of rights based upon the lack of an injury within the applicable policy periods, because many asbestos lawsuits do not specifically allege dates of asbestos exposure or dates of injury. The pool participants are defending several hundred plaintiff lawsuits (primarily multi-plaintiff lawsuits) filed against three former policyholders related to exposure to asbestos or products containing asbestos. These claims are based upon nonspecific asbestos exposure and nonspecific injuries. As a result, management did not establish a significant amount of case loss reserves for these claims. As of December 31, 2013, approximately 2,000 of the claims remain open. The pool participants defended another former policyholder that was a named defendant in approximately 33,000 claims nationwide. The last of these claims were settled during 2012 for approximately $690,000 (the Company’s share).
The estimated fair value of the surplus notes is derived by discounting future expected cash flows at a rate deemed appropriate. The discount rate was set at the average of current yields-to-maturity on several insurance company surplus notes that are traded in observable markets, adjusted upward by 50 basis points to reflect illiquidity and perceived risk premium differences. Other assumptions include a 25-year term (the surplus notes have no stated maturity date) and an interest rate that continues at the current 1.35 percent interest rate (3.60 percent at December 31, 2012). The rate is typically adjusted every five years and is based upon the then-current Federal Home Loan Bank borrowing rate for 5-year funds available to Employers Mutual.
The amortized cost and estimated fair value of fixed maturity securities at December 31, 2013, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties.
The Company participates in other benefit plans sponsored by Employers Mutual, including its 401(k) Plan, Board and Executive Non-Qualified Excess Plans and Defined Contribution Supplemental Executive Retirement Plan. The Company’s share of expenses for these plans amounted to $1,457,211, $1,822,925 and $1,523,675 in 2013, 2012 and 2011, respectively.
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 on 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. Employers Mutual generally purchases common stock on the open market to fulfill its obligations under its employee stock purchase plan.