Reinsurance operations are conducted through EMC Reinsurance Company and accounted for 23 percent of consolidated premiums earned in 2018. The Company’s reinsurance subsidiary is party to a quota share agreement and an inter-company reinsurance program 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. The inter-company reinsurance program in place with Employers Mutual covers both business assumed from Employers Mutual through the quota share agreement, as well as business obtained outside the quota share agreement, and consists of two treaties. The first is a per occurrence catastrophe excess of loss treaty with a retention of $10.0 million, a limit of $10.0 million, 20 percent co-participation, and no reinstatement. The total cost of this treaty was approximately $1.6 million, $1.7 million and $2.0 million in 2018, 2017 and 2016, respectively. The second is an annual aggregate catastrophe excess of loss treaty with a retention of $20.0 million, a limit of $100.0 million, and 20 percent co-participation. The total cost of this treaty was approximately $3.6 million, $3.2 million and $3.2 million in 2018, 2017 and 2016, respectively. Any losses recovered under the per occurrence treaty inure to the benefit of the aggregate treaty, and only catastrophic events with total losses greater than $500,000 are subject to the terms of the aggregate treaty. With the exception of the costs, the terms of the program were the same in all three years presented. Losses and settlement expenses ceded to Employers Mutual under the inter-company reinsurance program totaled $(4.6) million in 2018, $16.8 million in 2017 and $(467,000) in 2016. Much of the negative amount for 2018 is attributed to the reinsurance subsidiary recovering losses under external reinsurance purchased in 2017 to provide additional protection in peak exposure territories (see following paragraph). In accordance with the co-participation provision of the inter-company reinsurance program, the reinsurance subsidiary retained 20 percent of this recovery, with the balance ceded to Employers Mutual.
Employers Mutual’s actuarial department annually reviews the Mutual Re reserves for reasonableness. These analyses use a variety of actuarial techniques, which are applied at a line-of-business level. Mutual Re staff supplies the reserve analysis data, which is verified for accuracy by Employers Mutual’s actuaries. This review process is replicated by certain other Mutual Re member companies, using actuarial techniques they deem appropriate. Based on these reviews, Employers Mutual and the other Mutual Re member companies have consistently found the Mutual Re reserves to be adequate.
Disputes with ceding companies do not occur often. Employers Mutual performs claims audits and encourages prompt reporting of reinsurance claims. Employers Mutual also reviews claim reports for accuracy, completeness and adequate reserving. Most reinsurance contracts contain arbitration clauses to resolve disputes, but such disputes are generally resolved without arbitration due to the long-term and ongoing relationships that exist with those companies. There were no matters in dispute at December 31, 2018.
Following is a summary of the claim activity associated with asbestos, environmental and products liability exposures for 2018, 2017 and 2016:
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, 2018 and 2017, the Company had no securities priced solely from broker quotes.
In accordance with GAAP, actuarial gains/losses contained in the valuations that result from (1) actual experience that differs from that assumed, or (2) a change in actuarial assumptions, is accumulated and, if in excess of a specified corridor, amortized to expense over future periods. As of December 31, 2018, all of the benefit plans had accumulated actuarial losses in excess of the corridor that will be partially amortized into expense in 2019. The Company’s share of the accumulated actuarial losses that will be amortized into expense during 2019 amounts to $998,000. Prior service credits for plan amendments are also contained in the valuations, and are amortized into income over the future service periods of the participants. As of December 31, 2018, the postretirement benefit plans have prior service credits that are being amortized into income in future periods. The Company's share of the prior service credit being amortized into income during 2019 is $2.6 million.
2 During the third quarter of 2016, management implemented a new reserving methodology for the determination of direct bulk reserves in the property and casualty insurance segment. The new methodology, which is referred to as the accident year ultimate estimate approach, better conforms to industry practices and provides increased transparency of the drivers of the property and casualty insurance segment's performance. In connection with this change in reserving methodology, there was a reallocation of IBNR loss reserves and allocated settlement expense reserves from prior accident years to the current accident year in multiple lines of business. This resulted in the movement of approximately $5.6 million of reserves from prior accident years to the current accident year that was technically reportable as favorable development; however, this development was "mechanical in nature" and did not have an impact on earnings because the total amount of carried reserves did not change. This "mechanical" development amount was excluded from the favorable development amount presented for 2016 to improve comparability.
On October 29, 2018, the Company and Employers Mutual, its parent company, announced that they had made a strategic decision to exit personal lines business so that more time and resources could be dedicated to the commercial and reinsurance business. At the time of the announcement, personal lines premiums written comprised approximately six percent of the Company's total premiums written. The companies stopped writing personal lines policies in the first quarter of 2019, and all personal lines business is expected to roll off the companies' books by the end of the first quarter of 2020. During 2019, premiums earned for personal lines business will decline significantly, but the companies will continue to process claims and incur expenses to support this business. In addition, approximately 80 employees who spent a portion of their time supporting the personal lines operation (equivalent to approximately 40 full time employees) will be retained after the exit from personal lines is completed. This will place additional pressure on the acquisition expense ratio during the next few years until growth in commercial lines business replaces the discontinued personal lines business. During the fourth quarter of 2018, the Company incurred approximately $967,000 of expense associated with severance costs and the write-off of personal lines software currently in development. During 2019, the Company expects to incur approximately $914,000 in additional severance costs. In addition, the amortization of personal lines software currently in use will be accelerated over the transition period, which is expected to be approximately 18 months.
The loss and settlement expense ratio for the reinsurance segment decreased to 83.0 percent in 2018 from 88.3 percent in 2017. This decrease is primarily attributed to a reduction in catastrophe and storm losses, despite a record $18.5 million incurred in the fourth quarter of 2018. Current accident year catastrophe and storm losses totaled $23.9 million in 2018 and accounted for 15.9 percentage points of the loss and settlement expense ratio, compared to $30.2 million and 22.4 percentage points in 2017. Nearly half of the record fourth quarter catastrophe and storm losses resulted from the California wildfires, with the majority of the remaining losses stemming from Hurricane Michael and Typhoon Jebi. Only catastrophic events with total losses greater than $500,000 are subject to the terms of the inter-company annual aggregate excess of loss treaty. In 2018, such losses did not exceed the $20 million retention amount. As a result, no recoveries were made under the treaty and all catastrophe and storm losses were retained. However, the reinsurance subsidiary did recover $5.2 million under external reinsurance protections purchased in 2017 to provide additional protection in peak exposure territories. The reinsurance subsidiary retained 20 percent of this recovery in accordance with the co-participation provision of the inter-company reinsurance program, with the remaining 80 percent ceded to Employers Mutual. In 2017, the reinsurance subsidiary incurred a significant amount of catastrophe and storm losses, primarily from Hurricanes Harvey, Irma and Maria, California wildfires and two Mexico earthquakes. The reinsurance subsidiary retained the first $20 million of qualifying losses and 20 percent of all qualifying losses above that amount, and ceded $16.8 million of catastrophe and storm losses to Employers Mutual under the inter-company reinsurance program. Taking the loss recoveries and the premiums paid to Employers Mutual into consideration, the inter-company reinsurance program increased the reinsurance segment's loss and settlement expense ratio by 5.8 percentage points in 2018, and reduced it by 9.0 percentage points in 2017. The inter-company reinsurance program has been renewed for 2019, with no change in terms. The reinsurance subsidiary reported favorable development on prior years' reserves totaling $3.4 million in 2018, compared to $3.9 million in 2017. For a detailed discussion of the development experienced on prior accident years’ reserves during 2018 and 2017, see the discussion entitled “Loss and Settlement Expense Reserves” under the “Narrative Description of Business” heading in the Business Section under Part I, Item 1 of this Form 10-K.
Acquisition and other expenses increased 7.8 percent to $213.8 million in 2018 from $198.4 million in 2017. The acquisition expense ratio increased to 33.1 percent in 2018 from 32.7 percent in 2017. The increase in the acquisition expense ratio is attributed to the property and casualty insurance segment.
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, 2018 and 2017, the Company had net unrealized holding gains, net of deferred taxes, on its fixed maturity securities available-for-sale of $7.7 million and $17.3 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.
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 consistently been 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, 2018 would result in a corresponding pre-tax decrease in the fair value of the Company’s equity portfolio of approximately $18.5 million. The Company has an equity tail-risk hedging strategy in place to protect it from significant monthly downside price volatility in the equity markets. The cost of this protection (recorded as a realized investment loss) totaled $2.7 million during 2018. This hedging strategy may be discontinued in the future depending on market conditions and/or the cost of the protection.
We have audited EMC Insurance Group Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, EMC Insurance Group Inc. and Subsidiaries (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on the COSO criteria.
Other long-term investments primarily consist of holdings in limited partnerships, and privately placed common and non-redeemable convertible preferred stock in start-up technology companies with ties to the insurance industry. The equity method of accounting is used for these investments, with changes in the carrying value recorded as realized investment gains (losses). Also included in other long-term investments are holdings in limited liability companies that convey renewable energy tax credits that are carried at amortized cost.
In February 2018, the FASB issued updated guidance in Income Statement-Comprehensive Income Topic 220 of the ASC. The objective of this update was to allow a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act of 2017 (TCJA), and requires certain disclosures about the stranded tax effects. The Company adopted this guidance for the 2017 reporting period, and elected to transfer the stranded tax effects in accumulated other comprehensive income to retained earnings as reflected in the consolidated statements of stockholders' equity. The Company releases the tax effects in accumulated other comprehensive income on an individual unit of account basis.
The Company’s basic and diluted net income per share is computed by dividing net income by the weighted average number of common shares outstanding during each period. As previously noted, the Company receives the current fair value for all shares issued under Employers Mutual’s stock plans. As a result, with the exception of the immaterial number of shares of outstanding non-vested restricted stock issued to the Company's non-employee directors, the Company had no potential common shares outstanding during 2018, 2017 or 2016 that would have been dilutive to the calculation of net income per share. The outstanding non-vested restricted stock issued to the Company's non-employee directors is not material enough to produce a diluted net income per share different from the basic net income per share; therefore, the Company does not disclose an amount for the diluted weighted average number of common shares outstanding.
In 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's research of this guidance led to the conclusion 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 will not have an impact on the Company's consolidated financial condition or net income.
Investment expenses are based on actual expenses incurred by the Company and its subsidiaries, 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 $1.8 million, $1.6 million and $1.4 million in 2018, 2017 and 2016, respectively.
The Company uses an independent pricing source to obtain the estimated fair values of a majority of its securities, subject to an internal validation. The fair values are based on quoted market prices, where available. This is typically the case for equity securities and money market funds, which are accordingly classified as Level 1 fair value measurements. 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. Fixed maturity securities, non-redeemable preferred stocks and various short-term investments in the Company’s portfolio may not trade on a daily basis; however, observable inputs are utilized in their valuations, and these securities are therefore classified as Level 2 fair value measurements. Following is a brief description of the various pricing techniques used by the independent pricing source for different asset classes.
Options granted under the 2007 Plan generally had a vesting period of five years, with options becoming exercisable in equal annual cumulative increments commencing on the first anniversary of the option grant. Option prices could not be less than the fair value of the common stock on the date of grant. Restricted stock awards granted under the 2007 Plan generally have a vesting period of four years, with shares vesting in equal annual cumulative increments commencing on the first anniversary of the grant. With the exception of death, permanent disability or a change in control, any unvested shares of restricted stock are forfeited on termination of employment, including retirement. Holders of unvested shares of restricted stock receive compensation income equal to the amount of any dividends declared on the common stock.
On March 14, 2013, the Company registered 300,000 shares of its common stock for issuance under the 2013 Employers Mutual Casualty Company Non-Employee Director Stock Purchase Plan. All non-employee directors of Employers Mutual and its subsidiaries, as well as non-employee directors of the Company, are eligible to participate in the plan, though this plan is currently suspended pending the outcome of Employers Mutual's non-binding indicative proposal to purchase all outstanding shares of the Company. When this plan is not suspended, each eligible director could 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 was authorized through the period of the 2023 annual meetings. The plan is administered by the Corporate Governance and Nominating Committee of the Board of Directors of Employers Mutual. The Board may amend or terminate the plan at any time; however, no such amendment or termination shall adversely affect the rights and privileges of the participants. Expenses allocated to the Company in connection with this plan totaled $53,000, $65,000 and $84,000 in 2018, 2017 and 2016, respectively.