UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Quarterly Report Under Section 13 or 15(d) of the
Securities Exchange Act of 1934
(x) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended MARCH 31, 2003
-----------------------------------
OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________________to_________________
Commission File Number: 0-10956
EMC INSURANCE GROUP INC.
----------------------------------------------------
(Exact name of registrant as specified in its charter)
Iowa 42-6234555
- ------------------------------- ------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
717 Mulberry Street, Des Moines, Iowa 50309
- -------------------------------------- --------
(Address of principal executive office) (Zip Code)
(515) 280-2902
--------------------------------------------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. [X] Yes [ ] No
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). [ ] Yes [X] No
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
Class Outstanding at May 1, 2003
----- --------------------------
Common stock, $1.00 par value 11,436,872
Total pages 32
--
PART I. FINANCIAL INFORMATION
- ------- ---------------------
ITEM 1. FINANCIAL STATEMENTS
- ------- --------------------
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
March 31, December 31,
2003 2002
------------ ------------
(Unaudited)
ASSETS
Investments:
Fixed maturities:
Securities held-to-maturity, at amortized cost
(fair value $24,042,965 and $61,639,037) ... $ 21,476,624 $ 55,033,675
Securities available-for-sale, at fair value
(amortized cost $386,938,234 and
$459,844,928) .............................. 409,847,112 485,855,966
Fixed maturity securities on loan:
Securities held-to-maturity, at amortized cost
(fair value $34,037,584 and $0) ............ 30,493,983 -
Securities available-for-sale, at fair value
(amortized cost $60,640,191 and $0) ........ 61,466,503 -
Equity securities available-for-sale, at fair
value (cost $34,445,964 and $38,444,030) ..... 34,184,153 34,596,985
Other long-term investments, at cost ........... 3,533,273 3,057,000
Short-term investments, at cost ................ 44,259,595 29,650,230
------------ ------------
Total investments ..................... 605,261,243 608,193,856
Balances resulting from related party transactions
with Employers Mutual:
Reinsurance receivables ...................... 11,274,401 11,582,136
Prepaid reinsurance premiums ................. 3,641,568 2,442,899
Intangible asset, defined benefit
retirement plan ............................ 1,411,716 1,411,716
Other assets ................................. 4,226,720 1,331,816
Indebtedness of related party ................ 1,237,689 -
Cash ............................................. 1,460,420 (119,097)
Accrued investment income ........................ 7,350,209 9,179,555
Accounts receivable (net of allowance for
uncollectible accounts of $7,297 and $7,297) ... 328,928 772,944
Income taxes recoverable ......................... - 213,504
Deferred policy acquisition costs ................ 25,520,400 24,926,861
Deferred income taxes ............................ 12,417,271 13,986,172
Goodwill, at cost less accumulated amortization
of $2,616,234 and $2,616,234 ................... 941,586 941,586
Securities lending collateral .................... 98,037,048 -
------------ ------------
Total assets .......................... $773,109,199 $674,863,948
============ ============
See accompanying Notes to Interim Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
March 31, December 31,
2003 2002
------------ ------------
(Unaudited)
LIABILITIES
Balances resulting from related party transactions
with Employers Mutual:
Losses and settlement expenses ............... $330,659,539 $331,226,753
Unearned premiums ............................ 119,643,383 115,746,814
Other policyholders' funds ................... 873,577 1,035,622
Surplus notes payable ........................ 36,000,000 36,000,000
Indebtedness to related party ................ - 3,304,539
Employee retirement plans .................... 10,492,291 10,014,349
Other liabilities ............................ 12,800,676 19,767,507
Income taxes payable ............................. 1,273,666 -
Securities lending obligation .................... 98,037,048 -
------------ ------------
Total liabilities ......................... 609,780,180 517,095,584
------------ ------------
STOCKHOLDERS' EQUITY
Common stock, $1 par value, authorized 20,000,000
shares; issued and outstanding, 11,410,913
shares in 2003 and 11,399,050 shares in 2002 ... 11,410,913 11,399,050
Additional paid-in capital ....................... 67,470,088 67,270,591
Accumulated other comprehensive income ........... 15,069,430 14,218,330
Retained earnings ................................ 69,378,588 64,880,393
------------ ------------
Total stockholders' equity ................ 163,329,019 157,768,364
------------ ------------
Total liabilities and stockholders' equity $773,109,199 $674,863,948
============ ============
See accompanying Notes to Interim Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
All balances presented below, with the exception of investment income,
realized investment (losses) gains and income tax expense, are the result of
related party transactions with Employers Mutual.
Three months ended
March 31,
------------------------
2003 2002
REVENUES ----------- -----------
Premiums earned .................................. $80,381,898 $68,509,392
Investment income, net ........................... 7,846,924 8,258,711
Realized investment (losses) gains ............... (1,749,785) 271,919
Other income ..................................... 167,830 117,112
----------- -----------
86,646,867 77,157,134
----------- -----------
LOSSES AND EXPENSES
Losses and settlement expenses ................... 50,227,072 48,551,008
Dividends to policyholders ....................... 390,234 969,233
Amortization of deferred policy acquisition costs 17,556,374 15,143,993
Other underwriting expenses ...................... 8,035,197 6,433,204
Interest expense ................................. 485,966 331,644
Other expenses ................................... 408,548 257,729
----------- -----------
77,103,391 71,686,811
----------- -----------
Income before income tax expense ........... 9,543,476 5,470,323
----------- -----------
INCOME TAX EXPENSE
Current .......................................... 1,987,181 810,585
Deferred ......................................... 1,110,617 969,861
----------- -----------
3,097,798 1,780,446
----------- -----------
Net income ................................. $ 6,445,678 $ 3,689,877
=========== ===========
Net income per common share - basic and diluted .... $ .57 $ .33
=========== ===========
Dividends per common share ......................... $ .15 $ .15
=========== ===========
Average number of shares outstanding - basic and
diluted .......................................... 11,403,353 11,341,184
=========== ===========
See accompanying Notes to Interim Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
Three months ended
March 31,
------------------------
2003 2002
----------- -----------
Net income ......................................... $ 6,445,678 $ 3,689,877
OTHER COMPREHENSIVE INCOME (LOSS)
Unrealized holding losses arising during
the period, before deferred income tax benefit.. (439,688) (6,555,682)
Deferred income tax benefit ...................... (153,890) (2,294,492)
----------- -----------
(285,798) (4,261,190)
----------- -----------
Reclassification adjustment for losses (gains)
included in net income, before income tax
(benefit) expense .............................. 1,749,074 (271,919)
Income tax (benefit) expense...................... (612,176) 95,172
----------- -----------
1,136,898 (176,747)
----------- -----------
Other comprehensive income (loss) .......... 851,100 (4,437,937)
----------- -----------
Total comprehensive income (loss) .......... $ 7,296,778 $ (748,060)
=========== ===========
See accompanying Notes to Interim Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Three months ended
March 31,
--------------------------
2003 2002
CASH FLOWS FROM OPERATING ACTIVITIES ------------ ------------
Net income .................................... $ 6,445,678 $ 3,689,877
------------ ------------
Adjustments to reconcile net income to net
cash provided by operating activities:
Balances resulting from related party
transactions with Employers Mutual:
Losses and settlement expenses ........ (567,214) 4,528,102
Unearned premiums ..................... 3,896,569 3,419,682
Other policyholders' funds ............ (162,045) 324,039
Indebtedness to related party ......... (4,542,228) (5,326,576)
Employee retirement plans ............. 477,942 156,963
Reinsurance receivables ............... 307,735 1,669,891
Prepaid reinsurance premiums .......... (1,198,669) (312,875)
Commissions payable ................... (2,316,471) (2,068,848)
Interest payable ...................... (1,649,771) 331,644
Prepaid assets ........................ (2,801,351) (935,781)
Deferred policy acquisition costs ......... (593,539) (683,497)
Accrued investment income ................. 1,829,346 1,434,899
Accrued income taxes:
Current ................................. 1,487,170 810,585
Deferred ................................ 1,110,617 969,861
Realized investment losses (gains) ........ 1,749,785 (271,919)
Other, net ................................ (586,885) (1,956,756)
------------ ------------
(3,559,009) 2,089,414
------------ ------------
Net cash provided by
operating activities .............. $ 2,886,669 $ 5,779,291
------------ ------------
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED
(Unaudited)
Three months ended
March 31,
--------------------------
2003 2002
CASH FLOWS FROM INVESTING ACTIVITIES ------------ ------------
Maturities of fixed maturity securities
held-to-maturity ............................ $ 3,069,823 $ 4,616,690
Purchases of fixed maturity securities
available-for-sale .......................... (130,352,209) (70,005,481)
Disposals of fixed maturity securities
available-for-sale .......................... 143,054,965 87,760,042
Purchases of equity securities
available-for-sale .......................... (7,507,562) (15,192,597)
Disposals of equity securities
available-for-sale .......................... 7,249,591 5,101,696
Purchase of other long-term investments ....... (750,000) -
Disposal of other long-term investments ....... 273,727 -
Net purchases of short-term investments ....... (14,609,364) (16,978,325)
------------ ------------
Net cash provided by (used in)
investing activities .................... 428,971 (4,697,975)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Balances resulting from related party
transactions with Employers Mutual:
Issuance of common stock .................. 211,360 419,183
Dividends paid to Employers Mutual ........ (1,602,870) (1,351,764)
Dividends paid to stockholders ................ (344,613) (350,616)
------------ ------------
Net cash used in financing activities ..... (1,736,123) (1,283,197)
------------ ------------
NET INCREASE (DECREASE) IN CASH ................. 1,579,517 (201,881)
Cash at beginning of year ....................... (119,097) 558,073
------------ ------------
Cash at end of quarter .......................... $ 1,460,420 $ 356,192
============ ============
See accompanying Notes to Interim Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
March 31, 2003
1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States (GAAP) for interim financial information and with the
instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they
do not include all of the information and notes required by GAAP for complete
financial statements. In the opinion of management, all adjustments
(consisting of normal recurring adjustments) considered necessary for a fair
presentation have been included. The results of operations for the interim
periods reported are not necessarily indicative of results to be expected for
the year.
The consolidated balance sheet at December 31, 2002 has been derived from
the audited financial statements at that date but does not include all of the
information and notes required by GAAP for complete financial statements.
Certain amounts previously reported in prior years' consolidated
financial statements have been reclassified to conform to current year
presentation.
In reading these financial statements, reference should be made to the
Company's 2002 Form 10-K or the 2002 Annual Report to Shareholders for more
detailed footnote information.
2. STOCK BASED COMPENSATION
Prior to the fourth quarter of 2002, the Company had concluded that it
was not subject to the accounting requirements of Accounting Principles Board
(APB) Opinion No. 25, "Accounting for Stock Issued to Employees", and related
interpretations, since it receives the current fair value for any common stock
issued under Employers Mutual Casualty Company's (Employers Mutual) stock
option plans. As a result, the Company was recognizing as compensation
expense its pool participation share of the stock option expense recorded by
Employers Mutual for these plans. During the fourth quarter of 2002, the
Company concluded that it is subject to the accounting requirements of APB 25
and, accordingly, should not be recognizing compensation expense from
Employers Mutual's stock option plans since the exercise price of the options
is equal to the fair value of the stock at the date of grant. The results for
the first quarter of 2002 reflect $186,840 ($121,446 after tax) of expense
associated with stock options. Since this amount is not material, the
financial statements for the first quarter of 2002 have not been restated.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(Unaudited)
March 31, 2003
The Company accounts for the stock option plans using the recognition and
measurement principles of the intrinsic value method (APB 25). The following
table illustrates the effect on net income and earnings per share if the
Company had applied the fair value recognition provisions of Statement of
Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation," to Employers Mutual's stock option plans:
Three months ended
March 31,
------------------------
2003 2002
---------- ----------
Net income, as reported .................. $6,445,678 $3,689,877
Add: Compensation expense recognized in
net income ......................... - 121,446
Deduct: Total stock-based employee
compensation expense determined
under fair value method for all
awards, net of related tax effects 6,346 4,748
---------- ----------
Pro forma net income ..................... $6,439,332 $3,806,575
========== ==========
Net income per share:
Basic and diluted - As reported ........ $0.57 $0.33
Basic and diluted - Pro forma .......... $0.56 $0.34
3. SEGMENT INFORMATION
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
environment in which they operate.
Property
Three months ended and casualty Parent
March 31, 2003 insurance Reinsurance company Consolidated
- ------------------ ------------ ------------ ------------ ------------
Premiums earned ...... $ 59,205,804 $ 21,176,094 $ 80,381,898
Underwriting gain
(loss) ............. 4,470,091 (297,070) 4,173,021
Net investment income 5,550,937 2,245,755 $ 50,232 7,846,924
Realized losses ...... (1,358,914) (390,871) - (1,749,785)
Other income ......... 167,830 - - 167,830
Interest expense ..... (339,987) (145,979) - (485,966)
Other expense ........ (277,184) - (131,364) (408,548)
------------ ------------ ------------ ------------
Income (loss) before
income tax expense
(benefit) .......... $ 8,212,773 $ 1,411,835 $ (81,132) $ 9,543,476
============ ============ ============ ============
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(Unaudited)
March 31, 2003
Property
Three months ended and casualty Parent
March 31, 2002 insurance Reinsurance company Consolidated
- ------------------ ------------ ------------ ------------ ------------
Premiums earned ...... $ 52,443,570 $ 16,065,822 $ 68,509,392
Underwriting loss .... (1,190,002) (1,398,044) (2,588,046)
Net investment income 6,007,617 2,219,379 $ 31,715 8,258,711
Realized gains ....... 248,960 22,959 - 271,919
Other income ......... 117,112 - - 117,112
Interest expense ..... (331,644) - - (331,644)
Other expense ........ (151,228) - (106,501) (257,729)
------------ ------------ ------------ ------------
Income (loss) before
income tax expense
(benefit) .......... $ 4,700,815 $ 844,294 $ (74,786) $ 5,470,323
============ ============ ============ ============
4. INCOME TAXES
The actual income tax expense for the three months ended March 31, 2003
and 2002 differed from the "expected" tax expense for those periods (computed
by applying the United States federal corporate tax rate of 35 percent to
income before income tax expense) as follows:
Three months ended
March 31,
------------------------
2003 2002
----------- -----------
Computed "expected" tax expense ................... $ 3,340 217 $ 1,914,613
Increases (decreases) in tax resulting from:
Tax-exempt interest income .................... (405,276) (364,454)
Proration of tax-exempt interest and dividends
received deduction .......................... 40,274 41,140
Other, net .................................... 122,583 189,147
----------- -----------
Income tax expense ........................ $ 3,097,798 $ 1,780,446
=========== ===========
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
- ------- -------------------------------------------------
CONDITION AND RESULTS OF OPERATIONS
-----------------------------------
(Unaudited)
OVERVIEW
EMC Insurance Group Inc., an 80.1 percent owned subsidiary of Employers
Mutual Casualty Company (Employers Mutual), is an insurance holding company
with operations in property and casualty insurance and reinsurance. Property
and casualty insurance is the most significant segment, representing 73.7
percent of consolidated premiums earned. For purposes of this discussion, the
term "Company" is used interchangeably to describe EMC Insurance Group Inc.
(Parent Company only) and EMC Insurance Group Inc. and its subsidiaries.
Employers Mutual and all of its subsidiaries (including the Company) and an
affiliate, are referred to as the "EMC Insurance Companies."
The Company's four property and casualty insurance subsidiaries and two
subsidiaries and an affiliate of Employers Mutual are parties to reinsurance
pooling agreements with Employers Mutual (collectively the "pooling
agreement"). Under the terms of the pooling agreement, each company cedes to
Employers Mutual all of its insurance business, with the exception of any
voluntary reinsurance business assumed from nonaffiliated insurance companies,
and assumes from Employers Mutual an amount equal to its participation in the
pool. All losses, settlement expenses and other underwriting and
administrative expenses, excluding the voluntary reinsurance business assumed
by Employers Mutual from nonaffiliated insurance companies, are prorated among
the parties on the basis of participation in the pool. The aggregate
participation of the Company's property and casualty insurance subsidiaries is
23.5 percent. Operations of the pool give rise to inter-company balances with
Employers Mutual, which are settled on a quarterly basis. The investment and
income tax activities of the pool participants are not subject to the pooling
agreement.
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
assets, and from the wide range of policy forms, lines of insurance written,
rate filings and commission plans offered by each of the companies. A single
set of reinsurance treaties is maintained for the protection of all companies
in the pool.
The Company's reinsurance subsidiary assumes a 100 percent quota share
portion of Employers Mutual's assumed reinsurance business, exclusive of
certain reinsurance contracts. This includes all premiums and related losses
and settlement expenses of this business, subject to a maximum loss of
$1,500,000 per event. The reinsurance subsidiary does not reinsure any of
Employers Mutual's direct insurance business, nor any "involuntary" facility
or pool business that Employers Mutual assumes pursuant to state law. In
addition, the reinsurance subsidiary is not liable for credit risk in
connection with the insolvency of any reinsurers of Employers Mutual.
Operations of the quota share agreement give rise to inter-company balances
with Employers Mutual, which are settled on a quarterly basis. The investment
and income tax activities of the reinsurance subsidiary are not subject to the
quota share agreement.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
- ------- -------------------------------------------------
CONDITION AND RESULTS OF OPERATIONS, CONTINUED
----------------------------------------------
(Unaudited)
The reinsurance subsidiary pays an annual override commission to
Employers Mutual in connection with the $1,500,000 cap on losses assumed per
event. The override commission rate is charged at 4.50 percent of written
premiums. The reinsurance subsidiary also pays for 100 percent of the outside
reinsurance protection Employers Mutual purchases to protect itself from
catastrophic losses on the assumed reinsurance business, excluding
reinstatement premiums. This cost is recorded as a reduction to the premiums
received by the reinsurance subsidiary.
In the opinion of management, all adjustments (consisting of normal
recurring adjustments) considered necessary for a fair presentation have been
included. The results of operations for the interim periods reported are not
necessarily indicative of results to be expected for the year.
CRITICAL ACCOUNTING POLICIES
The accounting policies considered by management to be critically
important in the preparation and understanding of the Company's financial
statements and related disclosures are presented in the Company's 2002 Form
10-K. The following discussion updates or expands those accounting policies.
Processes and assumptions for establishing loss and settlement expense
reserves
Reinsurance Segment
Liabilities for losses are based upon case-basis estimates of reported
losses and estimates of incurred but not reported ("IBNR") losses. The
Company's IBNR reserves are estimates of liability for accidents that have
occurred, but have not yet been reported to the Company. For assumed
reinsurance business, IBNR reserves are also used to record anticipated
increases in reserves for claims that have previously been reported.
The reinsurance book of business is comprised of two major components.
The first is Home Office Reinsurance Assumed Department ("HORAD"), which is
the reinsurance business that is underwritten by Employers Mutual. The second
is the Mutual Reinsurance Bureau pool ("MRB"), which is a voluntary pool in
which Employers Mutual participates. For the HORAD component, Employers
Mutual records the case and IBNR reserves reported by the ceding companies.
Bulk IBNR reserves are established based on an actuarial reserve analysis.
There is generally a time lag in the reporting of assumed reinsurance
business. The typical lag ranges from one month to six months depending on
the reinsurance contract. In an effort to mitigate the reporting lag,
Employers Mutual establishes earned but not reported ("EBNR") premium along
with associated commissions and IBNR reserves.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
- ------- -------------------------------------------------
CONDITION AND RESULTS OF OPERATIONS, CONTINUED
----------------------------------------------
(Unaudited)
During the first quarter of 2003, the Company's actuarial department
reviewed and refined the estimation process utilized to establish HORAD IBNR
reserves for the latest policy year. In place of the loss ratio estimation
process, which had been used to calculate indicated IBNR reserves for the
first three quarters of the latest policy year, the Bornhuetter-Ferguson
estimation process was utilized. Under the loss ratio estimation process,
indicated IBNR reserves equal expected losses (expected loss ratio multiplied
by premiums earned) minus reported losses. As with the loss ratio estimation
process, Bornhuetter-Ferguson requires the selection of an expected loss
ratio. However, the indicated Bornhuetter-Ferguson IBNR reserves are
calculated as expected losses multiplied by the percentage of expected losses
that are as yet unreported. Consequently, the Bornhuetter-Ferguson estimation
process generates indicated IBNR reserves that are not affected by reported
losses. This is an advantage for an immature policy year because the
methodology avoids potential distortions in IBNR reserve indications that can
result from aberrations in reported losses. The expected loss ratio utilized
in the Bornhuetter-Ferguson estimation process will be based on historical
results adjusted for changes in rate level adequacy. The use of the
Bornhuetter-Ferguson estimation process during the first quarter of 2003 did
not significantly change the estimate of IBNR reserves.
Deferred policy acquisition costs and related amortization
Deferred policy acquisition costs are used to match the expenses incurred
in the production of insurance business to the income earned on this business.
This adjustment is necessary because statutory accounting principles require
that expenses incurred in the production of insurance business be expensed
immediately, while premium income is recognized ratably over the terms of the
underlying insurance policies.
Deferred policy acquisition costs are calculated by applying a
"deferrable expense ratio" to the unearned premium reserve at each statement
date. This deferrable expense ratio is calculated on a quarterly basis and
has historically approximated 22 percent on a consistent basis. The
deferrable expense ratio is calculated by dividing the sum of the acquisition
expenses deferred during the current period (incurred expenses that vary with
and are directly related to the production of insurance business, such as
commissions and premium taxes) by the written premiums for the period. This
ratio is evaluated for reasonableness based on current factors and historical
trends.
Amortization of deferred policy acquisition costs is calculated as the
difference between the beginning and ending amounts of deferred policy
acquisition costs plus the amount of costs deferred during the current period.
Deferred policy acquisition costs and related amortization are calculated
separately for the property and casualty insurance segment and the reinsurance
segment. The method followed in computing deferred policy acquisition costs
limits the amount of such deferred costs to their realizable value, which
gives effect to the premium to be earned, related investment income, losses
and settlement expenses and certain other costs expected to be incurred as the
premium is earned. Deferred policy acquisition costs were not subject to
limitation at March 31, 2003, and management does not anticipate future
limitations to be likely due to the improving premium rate environment in both
the insurance and reinsurance marketplaces.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
- ------- -------------------------------------------------
CONDITION AND RESULTS OF OPERATIONS, CONTINUED
----------------------------------------------
(Unaudited)
ACCOUNTING FOR INSTALLMENT-BASED INSURANCE POLICIES
There are two accepted methods for recording installment-based insurance
contracts. The first method is referred to as the "West Coast" method. Under
the West Coast method, premiums written (e.g., monthly or quarterly
installments) are recorded when billed to the insured. Under this method, an
unearned premium reserve is established for the current installment payment
and revenue is earned ratably over the period covered by the current
installment. The second method is referred to as the "East Coast" method.
Under the East Coast method, the full-term written premium (e.g., annual
premium) is recorded at the inception of the policy. An unearned premium
reserve is established for the full-term premium amount and revenue is earned
ratably over the period covered by the policy. From an insurance industry
prospective, the predominate practice has been to utilize the East Coast
method of recognizing the full-term written premium at the inception of
installment-based insurance contracts; however, prior to 2001 the Company was
utilizing the West Coast method for both statutory and GAAP reporting
purposes. Both the East Coast method and the West Coast method satisfy the
requirement that premiums from short-duration insurance contracts ordinarily
shall be recognized as revenue over the period of the contract in proportion
to the amount of insurance protection, with no difference in reported revenue.
As a result of the implementation of Codification of Statutory Accounting
Principles, the Company's property and casualty insurance subsidiaries were
required to change to the East Coast method of accounting for installment-
based insurance contracts for statutory reporting purposes effective January
1, 2001. The Company elected to implement the East Coast method for GAAP
reporting at the same time, since it was not practical to maintain the systems
necessary to support both methodologies. In addition, the Company could not
find any authoritative justification for a difference in the accounting
treatment of installment-based insurance contracts for statutory and GAAP
financial reporting.
As a result of the change to the East Coast method on January 1, 2001,
the Company increased written premiums and unearned premiums by $13,884,000.
There was no income statement effect from this change as there was no change
in earned premiums. The Company also recorded an increase in the receivable
balance due from agents equal to the increase in written premiums
(representing the portion of the full-term written premium that had not
previously been recorded). Under the terms of the inter-company pooling
agreement with Employer Mutual, all agents' balance receivables are carried in
Employers Mutual's financial statements. Therefore, the Company's insurance
subsidiaries transferred these balances to Employers Mutual, which produced
cash flow to the Company.
In conjunction with the increase in written premiums, the Company
established accruals for the related commissions and premium taxes that would
be paid on these premiums, resulting in $1,706,000 of commission expense and
$297,000 of premium tax expense. As discussed below, this required an
adjustment to the deferred policy acquisition cost asset.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
- ------- -------------------------------------------------
CONDITION AND RESULTS OF OPERATIONS, CONTINUED
----------------------------------------------
(Unaudited)
Deferred policy acquisition costs are calculated by applying a
"deferrable expense ratio" to the unearned premium reserve at each statement
date. This deferrable expense ratio is calculated on a quarterly basis and
has historically approximated 22 percent on a consistent basis. The Company
determined that the historical deferrable expense ratio of 22 percent was the
best estimate for this calculation at March 31, 2001. As a result, the
deferred policy acquisition cost asset increased $3,055,000 due to the
$13,884,000 increase in the unearned premium reserve. Management presumed
that the historical 22 percent deferrable expense ratio would continue to be
the Company's best estimate for the remainder of 2001; however, management
could not be certain of this assumption. As a result, the Company determined
that it would be inappropriate to recognize the entire increase in the
deferred policy acquisition cost asset in the first quarter of 2001. It was
therefore determined that this one-time increase in the deferred policy
acquisition cost asset should be recognized on a straight-line basis over the
four quarters of 2001, subject to verification that the 22 percent deferrable
expense ratio continued to be appropriate.
The $3,055,000 of income resulting from the increase in the deferred
policy acquisition cost asset was partially offset by the $1,706,000 increase
in commission expense and $298,000 increase in premium tax expense. The net
impact on pre-tax income from the change in accounting methodology for
installment-based insurance contracts was $1,051,000, or $683,000 after tax.
On a quarterly basis, this amounted to $263,000, or $171,000 after tax.
CONSOLIDATED RESULTS OF OPERATIONS
Net income for the three months ended March 31, 2003 and 2002 is as
follows:
($ in thousands) 2003 2002
REVENUES -------- --------
Premiums earned ............................... $ 80,382 $ 68,509
Investment income, net ........................ 7,847 8,259
Realized investment (losses) gains ............ (1,750) 272
Other income .................................. 168 117
-------- --------
86,647 77,157
-------- --------
LOSSES AND EXPENSES
Losses and settlement expenses ................ 50,227 48,551
Acquisition and other expenses ................ 25,982 22,547
Interest expense .............................. 486 332
Other expense ................................. 408 257
-------- --------
77,103 71,687
-------- --------
Income before income tax expense .............. 9,544 5,470
Income tax expense ............................ 3,098 1,780
-------- --------
Net income .................................... $ 6,446 $ 3,690
======== ========
Incurred losses and settlement expenses:
Insured events of the current year .......... $ 49,541 $ 49,702
Increase (decrease) in provision for
insured events of prior years ............. 686 (1,151)
-------- --------
Total losses and settlement expenses .... $ 50,227 $ 48,551
======== ========
Catastrophe and storm losses .................. $ 1,087 $ 883
======== ========
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
- ------- -------------------------------------------------
CONDITION AND RESULTS OF OPERATIONS, CONTINUED
----------------------------------------------
(Unaudited)
Net income improved significantly in the first three months of 2003
compared to the same period in 2002, resulting in the Company's most
profitable first quarter ever. This improvement was achieved through improved
pricing, prudent risk selection and careful claims management. The
initiatives implemented in recent years to improve profitability have been
successful and this trend is expected to continue during the remainder of
2003.
Premiums earned increased 17.3 percent for the three months ended March
31, 2003 from the same period in 2002. This increase is primarily attributed
to rate increases that were implemented during the last two years in the
property and casualty insurance business and growth and improved pricing in
the assumed reinsurance business. The Company continued to implement rate
increases in the property and casualty insurance business during the first
three months of 2003 and additional rate increases are anticipated for the
remainder of 2003. These rate increases will be targeted to specific
territories and lines of business and generally will be smaller than the rate
increases implemented during the past several months.
Net investment income decreased 5.0 percent for the three months ended
March 31, 2003 from the same period in 2002. This decrease is primarily
attributable to the lingering low interest rate environment. Proceeds from
called and maturing securities are being reinvested at the current lower
interest rates, resulting in a lower rate of return.
The Company reported net realized investment losses of $1,750,000 during
the first quarter of 2003 as compared to a net realized investment gain of
$272,000 in the first quarter of 2002. Included in the losses of the first
quarter of 2003 is $1,567,000 of investment impairment losses recognized on
the Company's equity portfolio and $2,689,000 of net realized losses
recognized by the Company's equity managers as they rebalanced the Company's
portfolios to enhance future returns. The Company also recognized $4,342,000
of losses from the sale of its American Airlines and United Airlines bonds.
At December 31, 2002, these bonds were collateralized by aircraft with an
appraised value sufficient to recover the Company's investment; however,
during the first quarter of 2003 the value of this collateral declined below
the Company's investment as a result of the war with Iraq, a significant
decline in air travel, and the prospects of a bankruptcy filing by American
Airlines and a liquidation of United Airlines. These losses were largely
offset by $6,854,000 of gains recognized on the sale of certain bond
investments.
Losses and settlement expenses increased 3.5 percent for the three months
ended March 31, 2003 from the same period in 2002. This increase, which is
significantly less than the increase in premium income for this time period,
is primarily attributed to the implementation of more stringent underwriting
standards and a substantial decrease in loss frequency. Adverse development
on prior years' losses in the reinsurance segment more than offset the
favorable development experienced in the property and casualty insurance
segment, while catastrophe and storm losses increased slightly.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
- ------- -------------------------------------------------
CONDITION AND RESULTS OF OPERATIONS, CONTINUED
----------------------------------------------
(Unaudited)
Acquisition and other expenses increased 15.2 percent for the three
months ended March 31, 2003 from the same period in 2002. This increase is
primarily attributed to an increase in commission expense, which reflects the
growth in premium volume experienced during the first three months of 2003 as
well as commission expense associated with increased participation in the MRB
reinsurance pool that Employers Mutual participates in. Higher contingent
commission expense, in the form of agents' profit share expenses, and
increased employee benefits costs also contributed to the increase in
acquisition and other expenses, but were limited by a decline in policyholder
dividends.
The Company incurred $486,000 and $332,000 of interest expense on surplus
notes during the first quarter of 2003 and 2002, respectively. This interest
expense did not have a material impact on the Company's results of operations
as the proceeds of the surplus notes were invested and earned a similar amount
of interest income. Due to the recent decline in interest rates, the Company
refinanced its surplus notes with Employers Mutual at the end of March 2003.
Effective April 1, 2003, the interest rate on the Company's $36,000,000 of
surplus notes was reduced to 3.09 percent.
Income tax expense increased substantially for the three months ended
March 31, 2003 from the same period in 2002. This increase is primarily
attributable to the substantial increase in pre-tax income for the first three
months of 2003.
Prior to the fourth quarter of 2002, the Company had concluded that it
was not subject to the accounting requirements of Accounting Principles Board
(APB) Opinion No. 25, "Accounting for Stock Issued to Employees", and related
interpretations, since it receives the current fair value for any common stock
issued under Employers Mutual's stock option plans. As a result, the Company
was recognizing as compensation expense its pool participation share of the
stock option expense recorded by Employers Mutual for these plans. During the
fourth quarter of 2002, the Company concluded that it is subject to the
accounting requirements of APB 25 and, accordingly, should not be recognizing
compensation expense from Employers Mutual's stock option plans since the
exercise price of the options is equal to the fair value of the stock at the
date of grant. The results for the first quarter of 2002 reflect $187,000 of
expense associated with stock options. Since this amount is not material, the
financial statements for the first quarter of 2002 have not been restated.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS, CONTINUED
(Unaudited)
SEGMENT RESULTS
Property and Casualty Insurance
Income before income tax expense for the three months ended March 31,
2003 and 2002 is as follows:
($ in thousands) 2003 2002
-------- --------
Premiums earned .......................... $ 59,206 $ 52,443
Losses and settlement expenses ........... 35,289 36,219
Acquisition and other expenses ........... 19,447 17,415
-------- --------
Underwriting gain (loss) ................. 4,470 (1,191)
Net investment income .................... 5,551 6,008
Realized (losses) gains .................. (1,359) 249
Other income ............................. 168 117
Interest expense ......................... 340 332
Other expense ............................ 277 150
-------- --------
Income before income tax expense ......... $ 8,213 $ 4,701
======== ========
Incurred losses and settlement expenses:
Insured events of the current year ..... $ 36,663 $ 38,703
Decrease in provision for insured
events of prior years ................ (1,374) (2,484)
-------- --------
Total losses and settlement expenses $ 35,289 $ 36,219
======== ========
Catastrophe and storm losses ............. $ 913 $ 659
======== ========
Premiums earned increased 12.9 percent for the three months ended March
31, 2003 from the same period in 2002. This increase is primarily
attributable to rate increases that were implemented during the last two
years. Moderate rate increases were implemented during the first three months
of 2003 and additional rate increases are anticipated for the remainder of
2003. Premium rate levels for most lines of business have reached adequate or
near-adequate levels. The rate level increases implemented during 2002 were
broad based in nature and averaged from five to eighteen percent for most
lines of business. The rate changes in 2003 will be targeted to specific
territories and lines of business and generally will be smaller than the rate
increases implemented during the past several months as the Company attempts
to fine tune its rate structure. However, due to the timing of policy renewals
and the earning of premiums ratably over the terms of the underlying policies,
a time delay exists for implemented rate increases to have a noticeable impact
on premiums earned. Premiums earned in 2003 will reflect this delay and,
therefore, are expected to continue to show strong growth as the rate
increases obtained in 2002 become earned.
Losses and settlement expenses decreased 2.6 percent for the three months
ended March 31, 2003 from the same period in 2002. This improvement is
primarily attributed to a substantial decline in claim frequency. Partially
offsetting the impact of this decline in claim frequency was a decrease in the
amount of favorable development experienced on prior years reserves, an
increase in catastrophe and storm losses and an increase in loss severity.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
- ------- -------------------------------------------------
CONDITION AND RESULTS OF OPERATIONS, CONTINUED
----------------------------------------------
(Unaudited)
Acquisition and other expenses increased 11.7 percent for the three
months ended March 31, 2003 from the same period in 2002. This increase is
primarily related to the growth in premium income noted above, but also
reflects an increase in contingent commission expense, a decline in the amount
of acquisition expenses deferred during the first quarter of 2003 and higher
employee benefit costs. A decline in policyholder dividends partially offset
these increases.
Underwriting results for the property and casualty insurance segment
improved in the first quarter of 2003 in comparison to the same period in
2002. This improvement is attributed to improved premium rate adequacy, a
decline in loss frequency and more stringent underwriting standards. The
implemented rate increases of the last two years have pushed premium rates for
most lines of business to adequate or near adequate levels. Results for the
remainder of 2003 are expected to continue to reflect this improvement in
premium rate adequacy, but the unpredictable nature of catastrophe and storm
losses will remain. Underwriting for profitability is always stressed, but
has become even more critical in light of the poor performance of the stock
markets and the low interest rate environment. New and renewal business is
being closely scrutinized to ensure that there is potential for an
underwriting profit.
Reinsurance
Income before income tax expense for the three months ended March 31,
2003 and 2002 is as follows:
($ in thousands) 2003 2002
-------- --------
Premiums earned ............................ $ 21,176 $ 16,066
Losses and settlement expenses ............. 14,938 12,332
Acquisition and other expenses ............. 6,535 5,132
-------- --------
Underwriting loss .......................... (297) (1,398)
Net investment income ...................... 2,246 2,219
Realized (losses) gains .................... (391) 23
Interest expense ........................... 146 -
-------- --------
Income before income tax expense ........... $ 1,412 $ 844
======== ========
Incurred losses and settlement expenses:
Insured events of the current year ....... $ 12,878 $ 10,999
Increase in provision for insured
events of prior years .................. 2,060 1,333
-------- --------
Total losses and settlement expenses $ 14,938 $ 12,332
======== ========
Catastrophe losses ......................... $ 174 $ 224
======== ========
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
- ------- -------------------------------------------------
CONDITION AND RESULTS OF OPERATIONS, CONTINUED
----------------------------------------------
(Unaudited)
Premium income increased 31.8 percent for the three months ended March
31, 2003 from the same period in 2002. Approximately half of this growth is
attributed to increased participation in the MRB reinsurance pool. Employers
Mutual's participation in this pool has increased from 16.7 percent (one-sixth
share) in 2001 to 20 percent (one-fifth share) in 2002 to 25 percent (one-
fourth share) in 2003. Also contributing to the increase in premium income
are rate increases implemented during the January 2003 renewal season,
fluctuations in the estimates of earned but not reported premiums (includes
the estimate of reinstatement premiums from the World Trade Center
catastrophe), and continued growth in a marine syndicate account. Premium
rate increases on excess of loss contracts moderated in 2003 due to an influx
of new capital into the reinsurance marketplace; however, contracts with poor
loss experience continued to receive exceptionally large rate increases. The
rate increases of 2002 and 2003 have been realized in conjunction with
moderate declines in the related exposure base due to increased retention
levels and coverage exclusions for terrorist activities. In addition, both
excess of loss and pro-rata contracts are benefiting from improved industry-
wide rating at the primary company level.
Losses and settlement expenses increased 21.1 percent for the three
months ended March 31, 2003 from the same period in 2002, primarily due to the
increase in the exposure base on the MRB reinsurance pool and the marine
syndicate account noted above. In addition, adverse development on prior
years' reserves increased in the first quarter of 2003 from the same period in
2002. The majority of the adverse development reported for 2003 came from
property pro rata and ocean marine business, in addition to approximately
$330,000 of adverse development from the MRB reinsurance pool. Nearly all of
the adverse development of 2002 came from the MRB reinsurance pool, and was
attributed to several contracts written through that pool.
Acquisition and other expenses increased 27.3 percent for the three
months ended March 31, 2003 as compared to the same period in 2002. This
increase is primarily attributed to an increase in commission expense, which
reflects the growth in premium volume during the first three months of 2003.
Commission expense in the first quarter of 2003 and 2002 includes $782,262 and
$378,837, respectively, of commissions incurred in connection with the
increased participation in the MRB reinsurance pool. To a small extent, the
increase in acquisition and other expenses was limited by a decline in
contingent commission expense and a higher amount of deferred acquisition
costs during the first quarter of 2003 compared to the same period in 2002.
The improvement in the underwriting results of the reinsurance segment in
the first quarter of 2003 is primarily attributed to continued moderate
improvement in premium rate adequacy coupled with low levels of catastrophe
losses. The rate increases implemented in 2002 and 2003, coupled with
increased retentions and coverage exclusions, have pushed premium rates to
near adequate levels. In addition to pricing its reinsurance premiums at
adequate rates, Employers Mutual continues to work toward improving
profitability on the assumed book of business by accepting larger shares of
coverage on desirable programs, utilizing relationships with reinsurance
intermediaries and monitoring exposures.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
- ------- -------------------------------------------------
CONDITION AND RESULTS OF OPERATIONS, CONTINUED
----------------------------------------------
(Unaudited)
Parent Company
The parent company reported a loss before income taxes of $81,000 for the
three months ended March 31, 2003 compared to a loss of $75,000 for the same
period in 2002. The increase in operating expenses outpaced the increase in
investment income.
LIQUIDITY AND CAPITAL RESOURCES
The Company maintains a portion of its investment portfolio in relatively
short-term and highly liquid investments to ensure the availability of funds
to meet claims and expenses. The remainder of the investment portfolio,
excluding investments in equity securities, is invested in securities with
maturities that approximate the anticipated liabilities of the insurance
issued. At March 31, 2003, approximately 52 percent of the Company's fixed
maturity securities were in government or government agency issued securities.
A variety of maturities are maintained in the Company's portfolio to assure
adequate liquidity. The maturity structure of the fixed maturity investments
is also established by the relative attractiveness of yields on short,
intermediate and long-term securities. The Company does not invest in any
high-yield debt investments (commonly referred to as junk bonds.)
The Company considers itself to be a long-term investor and generally
purchases fixed maturity investments with the intent to hold them to maturity.
Despite this intent, the Company has historically classified a portion of its
fixed maturity investments as available-for-sale securities to provide
flexibility in the management of the portfolio. Since the third quarter of
1999, all newly acquired fixed maturity investments have been classified as
available-for-sale securities to provide increased management flexibility.
The Company had unrealized holding gains, net of deferred taxes, on fixed
maturity securities available-for-sale of $15,428,000 at March 31, 2003 and
$16,907,000 at December 31, 2002. The fluctuation in the market value of
these investments is primarily due to changes in the interest rate environment
during this time period. Since the Company does not actively trade in the
bond market, 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 changing
conditions warrant.
The majority of the Company's assets are invested in fixed maturity
securities. These investments provide a substantial amount of investment
income that supplements underwriting results and contributes to net earnings.
As these investments mature, or are called, the proceeds will be reinvested at
current rates, which may be higher or lower than those now being earned;
therefore, more or less investment income may be available to contribute to
net earnings depending on the interest rate level.
The Company participates in a securities lending program whereby certain
fixed maturity securities from the investment portfolio are loaned to other
institutions for short periods of time. The Company receives a fee for each
security loaned out under this program and requires initial collateral,
primarily cash, equal to 102 percent of the market value of the loaned
securities. This program was temporarily suspended at December 31, 2002 to
eliminate financial ratio concerns expressed by certain regulatory
authorities.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
- ------- -------------------------------------------------
CONDITION AND RESULTS OF OPERATIONS, CONTINUED
----------------------------------------------
(Unaudited)
The Company invested a net $476,000 in the first quarter of 2003 and
$3,057,000 in 2002 into minor ownership interests in limited partnerships and
limited liability companies. The Company does not hold any other non-traded
securities.
The major ongoing sources of the Company's liquidity are insurance
premium income, investment income and cash provided from maturing or
liquidated investments. The principal outflows of cash are payments of
claims, commissions, premium taxes, operating expenses, income taxes,
dividends, interest and principal payments on debt, and investment purchases.
The Company generated positive cash flows from operations of $2,887,000
during the first quarter of 2003 compared to $5,779,000 for the same period
of 2002.
Employers Mutual reinvested 50 percent of its dividends in additional
shares of the Company's common stock during the first quarter of 2003. As a
result of this dividend reinvestment, the Company became an 80 percent owned
subsidiary of Employers Mutual at the end of March. In order to build and
maintain a sufficient cushion above the 80 percent ownership threshold,
Employers Mutual recently announced two separate 30,000-share open market
stock purchase programs. In addition, Employers Mutual will increase its
dividend reinvestment percentage to 75 percent for the second quarter of 2003.
Employers Mutual has indicated that it may continue to participate in the
dividend reinvestment plan in the future; however, its reinvestment percentage
will likely be reduced to a level necessary to maintain the 80 percent
ownership threshold. During 2002, Employers Mutual was reinvesting 25 percent
of its dividends in additional shares of the Company's common stock.
As a result of becoming an 80 percent owned subsidiary of Employers
Mutual, the Company will be included in Employers Mutual's consolidated tax
return effective April 1, 2003. The Company will file a short-period tax
return for the first quarter of 2003.
Investment Impairments and Considerations
At March 31, 2003, the Company had one fixed maturity security series, MCI
Communications Corporation, and nine common stock issues that have been
determined to be "other than temporarily" impaired. MCI Communications
Corporation is owned by WorldCom Inc., whose corporate bonds were downgraded
to junk status in May 2002 when it reported the detection of accounting
irregularities. The MCI bonds are supported by the assets of MCI; however,
the magnitude of the WorldCom collapse cast doubt on the prospect of
collecting the entire amount of principal and interest payments due the
Company. As a result, on June 30, 2002 the Company recognized $3,821,000 of
realized loss when the carrying value of this investment was reduced from an
aggregate book value of $5,604,000 to the then current fair value of
$1,783,000. As of March 31, 2003, the fair value of the MCI bonds has
partially recovered, resulting in pre-tax unrealized gains of $1,035,000
reported during 2002 and $690,000 reported during the first quarter of 2003,
which were recorded in accumulated other comprehensive income in stockholders'
equity rather than through net income. The nine common stock issues
considered to be "other than temporarily" impaired have an aggregate cost
basis of $4,409,000, with a realized loss of $1,567,000 recognized upon
adjustment of the book value down to the current fair value of $2,842,000.
The factors surrounding these "other than temporary" impairments did not have
any impact on the carrying value of any other investments held by the Company.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
- ------- -------------------------------------------------
CONDITION AND RESULTS OF OPERATIONS, CONTINUED
----------------------------------------------
(Unaudited)
At March 31, 2003, the Company had unrealized losses on held-to-maturity
and available-for-sale securities as presented in the table below. The
estimated fair value is based on quoted market prices, where available, or on
values obtained from independent pricing services. 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 impaired. Such factors include, but are not
limited to, the security's value and performance in the context of the overall
market, key corporate events and collateralization of fixed maturity
securities. Based on these factors, and the Company's ability and intent to
hold these securities until maturity, it was determined that the carrying
value of these securities was not impaired at March 31, 2003. 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 $2,201,000, net of tax;
however, the Company's financial position would not be affected due to the
fact that unrealized losses on available-for-sale securities are reflected in
the Company's financial statements as a component of stockholders' equity, net
of deferred taxes.
Gross
unrealized
losses
----------
Securities held-to-maturity:
Fixed maturity securities:
U.S. treasury securities and obligations of U.S.
government corporations and agencies .............$ -
Mortgage-backed securities ......................... -
----------
Total securities held-to-maturity .............. -
----------
Securities available-for-sale:
Fixed maturity securities:
U.S. treasury securities and obligations of U.S.
government corporations and agencies ............. 1,691
Obligations of states and political subdivisions ... -
Mortgage-backed securities ......................... -
Debt securities issued by foreign governments ...... -
Public utilities ................................... 139,607
Corporate securities ............................... 935,467
----------
Total fixed maturity securities ................ 1,076,765
----------
Equity securities:
Common stocks ...................................... 2,310,029
Non-redeemable preferred stocks .................... -
----------
Total equity securities ........................ 2,310,029
----------
Total securities available-for-sale ............ 3,386,794
----------
Total all securities ...........................$3,386,794
==========
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
- ------- -------------------------------------------------
CONDITION AND RESULTS OF OPERATIONS, CONTINUED
----------------------------------------------
(Unaudited)
Following is a schedule of the length of time the securities presented in
the above table have continuously been in an unrealized loss position.
Gross
Book Fair unrealized
value value loss
----------- ----------- -----------
Fixed maturity securities
available-for-sale:
Three months or less ...............$53,661,059 $53,659,367 $ 1,692
Over three months to six months .... 3,577,107 3,307,500 269,607
Over six months to nine months ..... - - -
Over nine months to twelve months .. - - -
Over twelve months ................. 15,354,200 14,548,734 805,466
----------- ----------- -----------
$72,592,366 $71,515,601 $ 1,076,765
=========== =========== ===========
Equity securities:
Three months or less ...............$10,716,185 $ 9,811,479 $ 904,706
Over three months to six months .... 2,332,187 2,091,070 241,117
Over six months to nine months ..... 4,003,251 3,463,236 540,015
Over nine months to twelve months .. 3,010,266 2,457,930 552,336
Over twelve months ................. 452,353 380,498 71,855
----------- ----------- -----------
$20,514,242 $18,204,213 $ 2,310,029
=========== =========== ===========
Following is a schedule of fixed maturity securities available-for-sale
that are non-investment grade and have unrealized losses at March 31, 2003.
As previously noted, the Company does not invest in junk bonds. The non-
investment grade securities held by the Company are the result of rating
downgrades that occurred subsequent to their purchase. The percentages
displayed are of the fair values of these securities to the total fair value
of fixed maturity securities available-for-sale, and of the unrealized losses
on these securities to the total gross unrealized losses on fixed maturity
securities available-for-sale. This schedule does not include fixed maturity
securities held-to-maturity due to the fact that none of these securities have
unrealized losses and are below investment grade at March 31, 2003. This
schedule also does not include the Company's MCI bonds, which carry a Moody's
Bond Rating of CA, due to the fact that these bonds were written-down to their
fair value in the second quarter of 2002 and have since partially recovered,
resulting in unrealized gains of $1,725,000 as of March 31, 2003.
Percent Percent
Moody's of of gross
bond Carrying Unrealized market unrealized
rating value Loss value losses
-------- ---------- ---------- ------ ----------
Potomac Edison Co........ BAA3(1) $2,437,500 $ 139,607 0.5% 13.0%
(1) Split-rated bond with an S&P rating below investment grade (BB+)
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
- ------- -------------------------------------------------
CONDITION AND RESULTS OF OPERATIONS, CONTINUED
----------------------------------------------
(Unaudited)
Following is a schedule of gross realized losses recognized in 2003 along
with the associated book values and sales prices aged according to the length
of time the underlying securities were in an unrealized loss position. This
schedule does not include realized losses stemming from corporate actions such
as calls, pay-downs, redemptions, etc. The Company's equity portfolio is
managed on a "tax-aware" basis, which generally results in sales of securities
at a loss to offset sales of securities at a gain, thus minimizing the
Company's income tax expense. Fixed maturity securities are generally held
until maturity.
Gross
Book Sales realized
value price loss
----------- ----------- -----------
Fixed maturity securities
available-for-sale:
Three months or less ...............$ - $ - $ -
Over three months to six months .... - - -
Over six months to nine months ..... - - -
Over nine months to twelve months .. - - -
Over twelve months ................. 5,592,110 1,249,902 4,342,208
----------- ----------- -----------
$ 5,592,110 $ 1,249,902 $ 4,342,208
=========== =========== ===========
Equity securities:
Three months or less ...............$ 3,521,179 $ 2,664,041 $ 857,138
Over three months to six months .... 444,242 257,437 186,805
Over six months to nine months ..... 5,222,087 3,222,981 1,999,106
Over nine months to twelve months .. 2,658,171 1,667,579 990,592
Over twelve months ................. 860,832 530,056 330,776
----------- ----------- -----------
$12,706,511 $ 8,342,094 $ 4,364,417
=========== =========== ===========
CAUTIONARY STATEMENT REGARDING FORWARD LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides issuers the
opportunity to make cautionary statements regarding forward-looking
statements. Accordingly, any forward-looking statement contained in this
report is based on management's current expectations and actual results of the
Company may differ materially from such expectations. The risks and
uncertainties that may affect the actual results of the Company include but
are not limited to the following: catastrophic events and the occurrence of
significant severe weather conditions; state and federal legislation and
regulations; rate competition; changes in interest rates and the performance
of financial markets; the adequacy of loss and settlement expense reserves,
including asbestos and environmental claims; terrorist activities and federal
solutions to make available insurance coverage for acts of terrorism; timely
collection of amounts due under ceded reinsurance contracts; rating agency
actions; and other risks and uncertainties inherent in the Company's business.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
- ------- ----------------------------------------------------------
(Unaudited)
The main objectives in managing the investment portfolios of the Company
are to maximize after-tax investment income and total investment return while
minimizing credit risks, in order to provide maximum support for the
underwriting operations. Investment strategies are developed based upon many
factors including underwriting results and the Company's resulting tax
position, regulatory requirements, fluctuations in interest rates and
consideration of other market risks. Investment decisions are centrally
managed by investment professionals and are supervised by the investment
committees of the respective board of directors for each of the Company's
subsidiaries.
Market risk represents the potential for loss due to adverse changes in
the fair value of financial instruments. The market risks of the financial
instruments of the Company relate to the investment portfolio, which exposes
the Company to interest rate and equity price risk, and to a lesser extent
credit quality and prepayment risk. Monitoring systems and analytical tools
are in place to assess each of these elements of market risk.
Two categories of influences on market risk exist as it relates to
financial instruments. First are systematic aspects, which relate to the
investing environment and are out of the control of the investment manager.
Second are non-systematic aspects, which relate to the construction of the
investment portfolio through investment policies and decisions, and are under
the direct control of the investment manager. Due to systematic changes,
several components of market risk have increased noticeably during 2002 and
continue into the first three months of 2003. As it relates to equity price
risk, the poor performance of the markets during this period has resulted in
declines in the values of the Company's equity investments. Credit quality
risk has risen resulting in declines in the values of several bond investments
stemming from the many high-profile bankruptcies and other downgrade
activities during this period. Prepayment risk has increased, primarily for
the mortgage-backed securities, as declines in interest rates during this
period have accelerated the payment of higher-interest rate mortgages through
re-financing activity. And finally, to a lesser extent interest rate risk has
increased due to interest rates bottoming-out during this period. Future
interest rate increases will result in declines in the values of fixed
maturity securities from their current values. Throughout all these
systematic changes, the Company continues its commitment to controlling non-
systematic risk through sound investment policies and diversification.
ITEM 4. CONTROLS AND PROCEDURES
- ------- -----------------------
Within the 90 days prior to the filing date of this report, the Company's
management, including the Chief Executive Officer and Chief Financial Officer,
conducted an evaluation of the effectiveness of the Company's disclosure
controls and procedures. Based upon that evaluation, the Chief Executive
Officer and Chief Financial Officer concluded that the Company's disclosure
controls and procedures are functioning effectively to provide reasonable
assurance that the Company can meet its disclosure obligations. Since the
date of the most recent evaluation of the Company's internal controls by the
Chief Executive Officer and Chief Financial Officer there have been no
significant changes in the Company's internal controls or in other factors
that could significantly affect these controls.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
PART II. OTHER INFORMATION
- -------- -----------------
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
- ------- --------------------------------
(a) 99.1 Certification of President and Chief Executive Officer pursuant
to 18 U.S.C. Section 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.
99.2 Certification of Vice President and Chief Financial Officer
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
(b) On January 29, 2003, the Company filed a report on Form 8-K
clarifying financial information released by it parent company,
Employers Mutual Casualty Company, and announcing a change in
Employers Mutual's dividend reinvestment percentage.
On March 12, 2003, the Company filed a report on Form 8-K announcing
a revision of its previous earnings release for the fourth quarter
and year ended December 31, 2002, due to new information regarding
asbestos reserves.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
EMC INSURANCE GROUP INC.
Registrant
/s/ Bruce G. Kelley
------------------------
Bruce G. Kelley
President & Chief Executive Officer
/s/ Mark E. Reese
------------------------
Mark E. Reese
Vice President and
Chief Financial Officer
Date: May 14, 2003
CERTIFICATIONS
I, Bruce G. Kelley, certify that:
1. I have reviewed this quarterly report on Form 10-Q of EMC Insurance
Group Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report.
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and have:
a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant, including
its consolidated subsidiaries, is made known to us by others
within those entities, particularly during the period in which
this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this quarterly report (the "Evaluation
Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and
the audit committee of registrant's board of directors (or persons
performing the equivalent functions):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes
in internal controls or in other factors that could significantly
affect internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
Date: May 14, 2003
/s/ Bruce G. Kelley
--------------------------
Bruce G. Kelley, President
and Chief Executive Officer
CERTIFICATIONS
I, Mark Reese, certify that:
1. I have reviewed this quarterly report on Form 10-Q of EMC Insurance
Group Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report.
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and have:
a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant, including
its consolidated subsidiaries, is made known to us by others
within those entities, particularly during the period in which
this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this quarterly report (the "Evaluation
Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and
the audit committee of registrant's board of directors (or persons
performing the equivalent functions):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes
in internal controls or in other factors that could significantly
affect internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
Date: May 14, 2003
/s/ Mark E. Reese
--------------------------
Mark E. Reese, Vice President
and Chief Financial Officer