The estimation of settlement expense reserves assumes a consistent claims department philosophy regarding the defense of lawsuits. If the pool participants should in the future take a more aggressive defense posture, defense costs would increase and it is likely that the Company’s carried allocated settlement expense reserves would be deficient. However, such a change in philosophy would likely reduce losses, generating some offsetting redundancy in the loss reserves.
To ensure the accuracy and completeness of the information received from the ceding companies, Employers Mutual’s actuarial department reviews contract years 1988 and subsequent every quarter, and all policy years on an annual basis. Any significant unexplained departures from historical reporting patterns are brought to the attention of the reinsurance department’s staff, who contacts the ceding company or broker for clarification.
Since 1989, the pool participants have included an asbestos exclusion in liability policies issued for most lines of business. The exclusion prohibits liability coverage for “bodily injury”, “personal injury” or “property damage” (including any associated clean-up obligations) arising out of the installation, existence, removal or disposal of asbestos or any substance containing asbestos fibers. Therefore, the pool participants’ current asbestos exposures are primarily limited to commercial policies issued prior to 1989. At present, the pool participants are defending approximately 1,872 asbestos bodily injury lawsuits, some of which involve multiple plaintiffs. Claims activity associated with eight policyholders dominates the pool participants’ asbestos claims, representing an aggregate 1,798 lawsuits. Most of the lawsuits are subject to express reservation of rights based upon the lack of an injury within the applicable policy periods, because many asbestos lawsuits do not specifically allege dates of asbestos exposure or dates of injury. The pool participants’ policyholders named as defendants in these asbestos lawsuits are typically peripheral defendants who have little or no exposure and are often dismissed from asbestos litigation with nominal or no payment (i.e., small contractors, supply companies, and a furnace manufacturer).
The TCJA was signed into law on December 22, 2017. Among other provisions, the TCJA lowered the federal corporate tax rate from 35 percent to 21 percent effective January 1, 2018. Companies are required to calculate deferred income taxes using tax rates expected to be in effect when tax timing differences reverse, which, as of December 22, is now 21 percent rather than the previous 35 percent. The Company was in a net deferred tax liability position on the date of enactment, which means that the reduction in the tax rate resulted in a lower deferred tax liability. In accordance with GAAP, this reduction in the deferred tax liability, which is reflected as a deferred income tax benefit, was recognized in net income in the fourth quarter.
Net investment income decreased 4.2 percent to $45.5 million in 2017 from $47.5 million in 2016. The decrease primarily reflects a lower book yield in the fixed maturity portfolio and a decline in dividend income. 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, declined slightly over the past year, coming in at 3.7 percent at December 31, 2017 compared to 3.8 percent at December 31, 2016 and 3.9 percent at December 31, 2015. The effective duration of the fixed maturity portfolio, excluding interest-only securities, also declined slightly to 5.0 at December 31, 2017 from 5.2 at December 31, 2016. The Company’s equity portfolio produced dividend income of $6.0 million in 2017, compared to $6.9 million in 2016.
Premiums earned for the property and casualty insurance segment increased 2.1 percent to $456.5 million in 2016 from $447.2 million in 2015. The premium amount for 2016 reflects $7.8 million ceded to Employers Mutual for the cost of the new inter-company reinsurance program. Excluding this amount, premiums earned increased 3.8 percent, primarily due to growth in insured exposures, new business, and small rate level increases on renewal business. New business premium (representing 14 percent of the pool participants’ direct written premiums) was approximately ten percent higher than in 2015. Commercial lines accounted for most of the increase in new business premium; however, personal lines also reported an increase in new business premium after several years of declining premium. Commercial lines new business continued to be in the desired range of growth, and management was encouraged by the reversal in personal lines, which experienced an approximate 36 percent increase in new business premium. This large increase was based on a relatively small amount of new business premium in 2015; however, it did reflect agents' and policyholders' satisfaction with the new products that were rolled out during 2016. While management continued to seek growth in most territories, it was particularly focused on achieving the strongest growth outside of the core Midwest market, which would help 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. Renewal business premium increased approximately three percent during 2016. After factoring in the continued implementation of some mandatory rate reductions on workers' compensation business in a few states, the overall rate change on renewal business remained positive, but was less than one percent. Rates were expected to be mixed in 2017, with the largest rate increases expected in the troubled commercial auto line of business. Rate decreases were expected in the workers' compensation and general liability lines of business, and rates on most other lines of business were expected to be flat or increase slightly. During 2016, the overall policy retention rate remained strong at 86.8 percent (commercial lines at 87.0 percent and personal lines at 84.6 percent). These retention rates approximated those reported at the end of 2015.
The Company reported net realized investment gains of $4.1 million in 2016, compared to $6.2 million in 2015. Included in these amounts were losses of $6.3 million and $1.5 million in 2016 and 2015, respectively, from declines in the carrying value of a limited partnership that the Company had invested in since 2014 to help protect the equity portfolio from a sudden and significant decline in value (an equity tail-risk hedging strategy). Due to the sharp decline in the equity markets in August of 2015, the losses from this investment were much lower in 2015. The large amount of losses experienced in 2016 were more than offset by gains recognized during the fourth quarter from the sale of some equity securities in connection with a small re-balance of the investment portfolio. The Company recognized "other-than-temporary" impairment losses of $1.3 million and $1.5 million during 2016 and 2015, respectively. With the exception of a $209,000 impairment loss recorded in 2016 on a new investment that conveys investment tax credits (included in other long-term investments), these impairment losses were recognized on securities held in the Company's equity portfolio.
The Company 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 program. 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 2018 without prior regulatory approval is approximately $54.2 million. The Company received $5.7 million, $9.7 million and $9.2 million of dividends from its insurance subsidiaries and paid cash dividends to its stockholders totaling $18.0 million, $16.2 million and $14.2 million in 2017, 2016 and 2015, respectively.
The Company monitors interest rate risk through an analysis of interest rate simulations, and adjusts the average duration of its fixed maturity portfolio by investing in either longer or shorter term instruments given the results of interest rate simulations and judgments of cash flow needs. The effective duration of the Company’s fixed maturity portfolio, excluding interest-only securities, at December 31, 2017 was 5.0.
The valuation of the Company’s marketable equity portfolio is subject to equity price risk. In general, equities have more year-to-year price variability than bonds. However, returns from equity securities have been consistently higher over longer time frames. The Company invests in a diversified portfolio of readily marketable equity securities. A hypothetical 10 percent decrease in the S&P 500 index as of December 31, 2017 would result in a corresponding pre-tax decrease in the fair value of the Company’s equity portfolio of approximately $19.9 million. Management implemented an equity tail-risk hedging strategy during 2014 to protect the Company from significant monthly downside price volatility in the equity markets. The cost of this protection (recorded as a realized investment loss) totaled $6.3 million during 2017. This hedging strategy may be discontinued in the future depending on market conditions and/or the cost of the protection.
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. Management continues to research this guidance, which thus far has led management to a preliminary determination that lease costs allocated to the Company through the pooling and quota share agreements can not be attributed to a specified asset, and therefore do not meet the definition of a leased asset contained in the guidance. As a result, adoption of this guidance is not expected to have a material impact on the Company's consolidated financial condition or net income.
In June 2016, the FASB issued updated guidance in Financial Instruments-Credit Losses Topic 326 of the ASC. The objective of this update is to provide information about expected credit losses on financial instruments and other commitments to extend credit. Specifically, this updated guidance replaces the current incurred loss impairment methodology, which delays recognition of a loss until it is probable a loss has been incurred, with a methodology that reflects expected credit losses considering a broader range of reasonable and supportable information. This guidance covers financial assets that are not accounted for at fair value through net income, thus will not be applicable to the Company's equity investments upon implementation of the updated guidance described above for the Financial Instruments-Overall Subtopic 825-10. This guidance is effective for interim and annual periods beginning after December 15, 2019, and is to be applied with a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective (modified-retrospective approach). Early adoption is permitted, but only to fiscal years beginning after December 15, 2018. The Company will adopt this guidance during the first quarter of 2020. The Company is currently evaluating the impact this guidance will have on the Company's consolidated financial condition and net income.
The net foreign currency exchange gains (losses) assumed by the reinsurance subsidiary from Employers Mutual were $(978,000) in 2017, $367,000 in 2016 and $386,000 in 2015. The total amount of net foreign currency exchange gains (losses) assumed by the reinsurance subsidiary, including the business written on a direct basis outside the quota share agreement, were $(1.6) million in 2017, $356,000 in 2016 and $898,000 in 2015.
The parties to the pooling agreement cede insurance business to other insurers in the ordinary course of business for the purpose of limiting their maximum loss exposure through diversification of their risks. In its consolidated financial statements, the Company treats risks to the extent they are reinsured as though they were risks for which the Company is not liable. However, insurance ceded by the pool participants does not relieve their primary liability as the originating insurers. Employers Mutual evaluates the financial condition of the reinsurers of the parties to the pooling agreement and monitors concentrations of credit risk arising from similar geographic regions, activities or economic characteristics of the reinsurers to minimize exposure to significant losses from reinsurer insolvencies.
The Company’s insurance subsidiaries are required to file financial statements with state regulatory authorities. The accounting principles used to prepare these statutory financial statements follow prescribed or permitted accounting practices that differ from GAAP. Prescribed statutory accounting principles include state laws, regulations and general administrative rules issued by the state of domicile, as well as a variety of publications and manuals of the National Association of Insurance Commissioners (NAIC). Permitted accounting practices encompass all accounting practices not prescribed, but allowed by the state of domicile. The Company’s insurance subsidiaries had no permitted accounting practices during 2017, 2016 or 2015.