UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2004
[ ] 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.
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(Exact Name of Registrant as Specified in its Charter)
Iowa 42-6234555
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
717 Mulberry Street, Des Moines, Iowa 50309
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(Address of Principal Executive Office) (Zip Code)
Registrant's telephone number, including area code: (515) 280-2902
---------------
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, Par Value $1.00
-----------------------------
(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 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 if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form
10-K or any amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Act). [ ] Yes [X] No
The aggregate market value of the voting stock held by non-affiliates of
the registrant as of June 30, 2004 was $52,032,153.
The number of shares outstanding of the registrant's common stock, $1.00
par value, on March 7, 2005, were 13,591,464.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's definitive proxy statement for the Annual
Meeting of Stockholders to be held on May 26, 2005, and to be filed pursuant
to Regulation 14A within 120 days after the registrant's fiscal year ended
December 31, 2004, are incorporated by reference under Part III.
TABLE OF CONTENTS
Part I
Item 1. Business ........................................................ 2
Executive Officers of the Company ............................... 36
Item 2. Properties ...................................................... 37
Item 3. Legal Proceedings ............................................... 37
Item 4. Submission of Matters to a Vote of Security Holders ............. 37
Part II
Item 5. Market for Registrant's Common Equity, Related Stockholder
Matters and Issuer Purchases of Equity Securities ............ 38
Item 6. Selected Financial Data ......................................... 40
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations .......................... 41
Item 7A. Quantitative and Qualitative Disclosures about Market Risk ...... 84
Item 8. Financial Statements and Supplementary Data ..................... 85
Item 9. Changes in and Disagreements With Accountants on
Accounting and Financial Disclosure .......................... 135
Item 9A. Controls and Procedures ......................................... 135
Item 9B. Other Information ............................................... 135
Part III
Item 10. Directors and Executive Officers of the Registrant .............. 135
Item 11. Executive Compensation .......................................... 136
Item 12. Security Ownership of Certain Beneficial Owners
and Management and Related Stockholder Matters ............... 136
Item 13. Certain Relationships and Related Transactions .................. 137
Item 14. Principal Accountant Fees and Services .......................... 137
Part IV
Item 15. Exhibits and Financial Statement Schedules ...................... 138
Index to Financial Statement Schedules ................................... 138
Signatures ............................................................... 142
Index to Exhibits ........................................................ 143
PART I
ITEM 1. BUSINESS.
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GENERAL
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EMC Insurance Group Inc. is an insurance holding company that was
incorporated in Iowa in 1974 by Employers Mutual Casualty Company (Employers
Mutual) and became a public company in 1982 following the initial public
offering of its common stock. EMC Insurance Group Inc. is 53.7 percent owned
by Employers Mutual, a multiple-line property and casualty insurance company
organized as an Iowa mutual insurance company in 1911 that is licensed in all
50 states and the District of Columbia. 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 conducts operations in property and casualty insurance and
reinsurance through its subsidiaries. The Company primarily focuses on the
sale of commercial lines of property and casualty insurance to small and
medium-sized businesses. These products are sold through independent
insurance agents who are supported by a decentralized network of branch
offices. Although the Company actively markets its insurance products in 41
states, the majority of its business is marketed and generated in the Midwest.
The Company conducts its insurance business through two business segments
as follows:
...............................
: :
: EMC INSURANCE GROUP INC. :
: :
:.............................:
:
:
Property and :
Casualty Insurance : Reinsurance
......................:................................
: :
: :
Illinois EMCASCO Insurance Company (Illinois EMCASCO) EMC
Dakota Fire Insurance Company (Dakota Fire) Reinsurance
Farm and City Insurance Company (Farm and City) Company
EMCASCO Insurance Company (EMCASCO)
:
:
EMC Underwriters, LLC
Illinois EMCASCO was formed in Illinois in 1976 and was redomesticated to
Iowa in 2001, Dakota Fire was formed in North Dakota in 1957 and EMCASCO was
formed in Iowa in 1958 for the purpose of writing property and casualty
insurance. Farm and City was formed in Iowa in 1962 to write nonstandard risk
automobile insurance and was purchased by the Company in 1984. In January
2004, the Company announced that Farm and City Insurance Company would
discontinue writing new business and implement non-renewal procedures on
existing business. Farm and City will continue to participate in the pooling
arrangement even though it will no longer write business directly (see
discussion under "Organizational Structure"). EMC Reinsurance Company was
formed in 1981 to assume reinsurance business from Employers Mutual. The
Company's excess and surplus lines insurance agency, EMC Underwriters, LLC,
was formed in Iowa in 1975 and was acquired in 1985. Effective December 31,
1998, the excess and surplus lines insurance agency was converted to a limited
liability company and the ownership was contributed to EMCASCO.
Property and casualty insurance is the most significant segment of the
Company's business, representing approximately 72 percent of premiums earned
in 2004. The property and casualty insurance operations are integrated with
the property and casualty insurance operations of Employers Mutual through
participation in a reinsurance pooling arrangement. Because the Company
conducts its property and casualty insurance operations together with
Employers Mutual through the pooling arrangement, the Company shares the same
business philosophy, management, employees and facilities as Employers Mutual
and offers the same types of insurance products. For a discussion of the
pooling arrangement and its benefits, please see "Organizational Structure"
below.
Reinsurance operations are conducted through EMC Reinsurance Company,
representing approximately 28 percent of premiums earned in 2004. The
principal business activity of EMC Reinsurance Company is to assume the
voluntary reinsurance business written directly by Employers Mutual with
unaffiliated insurance companies (subject to certain limited exceptions).
The Company's insurance agency, EMC Underwriters, LLC, specializes in
marketing excess and surplus lines of insurance. The excess and surplus lines
markets provide insurance coverage at negotiated rates for risks that are not
acceptable to licensed insurance companies. EMC Underwriters accesses this
market by working through independent agents and functions as managing
underwriter for excess and surplus lines insurance for several of the pool
participants. The Company derives income from this business based on the fees
and commissions earned through placement of the business, as opposed to the
underwriting of the risks associated with that business.
ORGANIZATIONAL STRUCTURE
Property and Casualty Insurance
The four property and casualty insurance subsidiaries of the Company and
two subsidiaries and an affiliate of Employers Mutual (Union Insurance Company
of Providence, EMC Property & Casualty Company and Hamilton Mutual Insurance
Company) 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 premiums, 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. Employers
Mutual negotiates reinsurance agreements that provide protection to the pool
and each of its participants, including protection against losses arising from
catastrophic events.
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.
Effective December 31, 2003, the pooling agreement was amended to provide that
Employers Mutual will make up any shortfall or difference resulting from an
error in its systems and/or computational processes that would otherwise
result in the required restatement of the pool participants' financial
statements.
The purpose of the pooling arrangement is to spread the risk of an
exposure insured by any of the participants among all of the participants.
The particular benefits that the Company's property and casualty insurance
companies realize from participating in the pooling arrangement include the
following:
o the ability to produce a more uniform and stable underwriting result
from year-to-year for each participant than might otherwise be
experienced on an individual basis, by spreading the risks over a
wide range of geographic locations, lines of insurance written, rate
filings, commission plans and policy forms;
o the ability to benefit from the capacity of the entire pool representing
$1.1 billion in direct premiums written in 2004 and $665.7 million in
statutory surplus as of December 31, 2004, rather than being limited to
policy exposures of a size commensurate with each participant's own
surplus level;
o the achievement of an "A-" (Excellent) rating from A.M. Best on the
basis of participation in the pool;
o the ability to take advantage of a significant distribution network of
independent agencies that the participants most likely could not access
on an individual basis;
o the ability to negotiate and purchase reinsurance from third-party
reinsurers on a combined basis, thereby achieving larger retentions
and better pricing; and
o the ability to achieve and benefit from economies of scale in
operations.
On October 20, 2004, the Company successfully completed a follow-on stock
offering and sold 2.0 million new shares of its common stock to the public at
a price of $18.75 per share. Employers Mutual participated in the stock
offering as a selling shareholder and sold 2.1 million shares of the Company's
common stock that it previously owned. As a result of these transactions,
Employers Mutual's ownership of the Company was reduced from approximately
80.9 percent to approximately 53.7 percent.
Net proceeds from the follow-on stock offering totaled $34,890,000.
These proceeds were contributed to three of the Company's property and
casualty insurance subsidiaries in late December to support a planned 6.5
percentage point increase in the Company's aggregate participation in the
pooling agreement effective January 1, 2005. As a result of this change, the
Company's aggregate participation in the pooling agreement will increase from
the current 23.5 percent to 30.0 percent and Employers Mutual's participation
will decrease from the current 65.5 percent to 59.0 percent. In connection
with this change in the pooling agreement, the Company's liabilities will
increase $115,042,000 and assets will increase $108,798,000. The Company will
reimburse Employers Mutual $6,519,000 for expenses that were incurred to
generate the additional business assumed by the Company, but this expense will
be offset by an increase in deferred policy acquisition costs. The Company
will also receive $275,000 in interest income from Employers Mutual as the
actual cash transfer did not occur until February 15, 2005.
Effective January 1, 2005, the pooling agreement was amended to provide
for a fixed term of three years commencing January 1, 2005 and continuing
until December 31, 2007, during which period the pooling agreement may not be
terminated and the revised participation interests will not be further
amended, absent the occurrence of a material event not in the ordinary course
of business that could reasonably be expected to impact the appropriateness of
the participation interests in the pool (such as the sale or dissolution of a
participant, or the acquisition by, or affiliation with, the Company or
Employers Mutual of a subsidiary or affiliated company that desires to become
a participant in the pooling arrangement). Commencing January 1, 2008, the
pooling agreement will be automatically renewed for an additional three-year
term (and automatically renewed for three-year terms after the end of each
renewal term), however, during any renewal term a participant may terminate
its participation in the pool as of the beginning of the next calendar year by
providing 12 months prior notice to Employers Mutual.
Effective January 1, 2005, the pooling agreement was further amended to
comply with certain conditions established by A.M. Best that will enable the
pool participants to have their financial strength ratings determined on a
"group" basis. These amendments: (i) provide that if a pool participant
becomes insolvent, or is otherwise subject to liquidation or receivership
proceedings, each of the other participants will, on a pro rata basis (based
on their participation interests in the pool), adjust their assumed portions
of the pool liabilities in order to assume in full the liabilities of the
impaired participant, subject to compliance with all regulatory requirements
applicable to such adjustment under the laws of all states in which the
participants are domiciled; (ii) clarify that all development on prior years'
outstanding losses and settlement expenses of the participants will remain in
the pool and be pro rated pursuant to the pooling agreement; and (iii) clarify
that all liabilities incurred prior to a participant withdrawing from the
pool, and associated with such withdrawing participant, shall remain a part of
the pool and subject to the pooling arrangement.
The amount of insurance a property and casualty insurance company writes
under industry standards is commonly expressed as a multiple of its surplus
calculated in accordance with statutory accounting practices. Generally, a
ratio of 3-to-1 or less is considered satisfactory by state insurance
departments. The ratios of the pool participants for the past three years are
as follows:
Year ended December 31,
------------------------------
2004 2003 2002
---- ---- ----
Employers Mutual .................... 1.23 1.26 1.55
EMCASCO (1) ......................... 1.65 2.15 2.41
Illinois EMCASCO (1) ................ 1.74 2.07 2.36
Dakota Fire (1) ..................... 1.67 2.11 2.41
Farm and City ....................... 2.67 2.35 2.49
EMC Property & Casualty Company ..... .93 .92 .94
Union Insurance Company of Providence .91 .91 .93
Hamilton Mutual Insurance Company ... 2.53 2.02 2.13
(1) The 2004 ratios for these companies reflect the receipt of an aggregate
of $34,890,000 in proceeds from the Company's follow-on stock offering. The
ratios for all three years for these companies also reflect the issuance of an
aggregate of $25,000,000 of surplus notes to Employers Mutual on December 28,
2001. Surplus notes are considered to be a component of surplus for statutory
reporting purposes; however, under U.S. generally accepted accounting
principles, surplus notes are considered to be debt and are reported as a
liability in the Company's financial statements.
Reinsurance
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 directly reinsure
any of the insurance business written by Employers Mutual; however, the
reinsurance subsidiary assumes reinsurance business from the Mutual
Reinsurance Bureau pool and this pool provides a very small amount of
reinsurance protection to the EMC Insurance Companies. As a result, the
reinsurance subsidiary's assumed exposures include a very small portion of the
EMC Insurance Companies direct business, after ceded reinsurance protections
purchased by the Mutual Reinsurance Bureau pool are applied. In addition, the
reinsurance subsidiary does not reinsure any "involuntary" facility or pool
business that Employers Mutual assumes pursuant to state law. 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.
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 is charged at a rate of 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.
Property and Casualty Insurance and Reinsurance
Employers Mutual provides various services to all of its subsidiaries and
affiliates. Such services include data processing, claims, financial,
actuarial, auditing, marketing and underwriting. Employers Mutual allocates a
portion of the cost of these services to the subsidiaries that do not
participate in the pooling agreement based upon a number of criteria. The
remaining costs are charged to the pooling agreement and each pool participant
shares in the total cost in accordance with its pool participation percentage.
Investment expenses are based on actual expenses incurred by the Company
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.
FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS
For information concerning the Company's revenues, operating income and
identifiable assets attributable to each of its industry segments over the
past three years, see note 7 of Notes to Consolidated Financial Statements
under Item 8 of this Form 10-K.
NARRATIVE DESCRIPTION OF BUSINESS
Principal Products
Property and Casualty Insurance
The Company's property and casualty insurance subsidiaries and other
parties to the pooling agreement underwrite both commercial and personal lines
of property and casualty insurance. Those coverages consist of the following
types of insurance:
Commercial Lines
o Automobile - policies purchased by insureds engaged in a commercial
activity that provide protection against liability for bodily injury and
property damage arising from automobile accidents and protection against
loss from damage to automobiles owned by the insured.
o Property - policies purchased by insureds engaged in a commercial
activity that provide protection against damage or loss to property
(other than autos) owned by the insured.
o Workers' Compensation - policies purchased by employers to provide
benefits to employees for injuries incurred during the course of
employment. The extent of coverage is established by the workers'
compensation laws of each state.
o Liability - policies purchased by insureds engaged in a commercial
activity that provide protection against liability for bodily injury or
property damage to others resulting from acts or omissions of the insured
or its employees.
o Other - includes a broad range of policies purchased by insureds engaged
in a commercial activity that provides protection with respect to
burglary and theft loss, aircraft, marine and other losses. This
category also includes fidelity and surety bonds issued to secure
performance.
Personal Lines
o Automobile - policies purchased by individuals that provide protection
against liability for bodily injury and property damage arising from
automobile accidents and protection against loss from damage to
automobiles owned by the insured.
o Property - policies purchased by individuals that provide protection
against damage or loss to property (other than autos) owned by the
individual, including homeowner's insurance.
o Liability - policies purchased by individuals that provide protection
against liability for bodily injury or property damage to others
resulting from acts or omissions of the insured.
The following table sets forth the aggregate direct written premiums of
all parties to the pooling agreement for the three years ended December 31,
2004, by line of business.
Percent Percent Percent
of of of
Line of Business 2004 total 2003 total 2002 total
- --------------- ---------- ----- ---------- ----- ---------- -----
(Dollars in thousands)
Commercial Lines:
Automobile .......... $ 248,542 21.8% $ 239,960 21.6% $ 224,321 21.5%
Property ............ 224,899 19.7 202,124 18.2 180,622 17.3
Workers' compensation 217,987 19.1 209,171 18.8 194,853 18.7
Liability ........... 231,091 20.2 213,150 19.1 195,682 18.8
Other ............... 25,430 2.2 22,524 2.0 20,489 2.0
---------- ----- ---------- ----- ---------- -----
Total commercial
lines ............ 947,949 83.0 886,929 79.7 815,967 78.3
---------- ----- ---------- ----- ---------- -----
Personal Lines:
Automobile .......... 110,063 9.6 128,671 11.5 134,405 12.9
Property ............ 82,786 7.2 95,550 8.6 89,248 8.6
Liability ........... 2,127 0.2 1,972 0.2 1,815 0.2
---------- ----- ---------- ----- ---------- -----
Total personal lines 194,976 17.0 226,193 20.3 225,468 21.7
---------- ----- ---------- ----- ---------- -----
Total .......... $1,142,925 100.0% $1,113,122 100.0% $1,041,435 100.0%
========== ===== ========== ===== ========== =====
Reinsurance
As previously noted, the reinsurance subsidiary assumes the voluntary
reinsurance business written directly by Employers Mutual with unaffiliated
insurance companies (subject to certain limited exceptions). Employers Mutual
writes both pro rata and excess-of-loss reinsurance for unaffiliated insurance
companies. Pro rata reinsurance is a form of reinsurance in which the
reinsurer assumes a stated percentage of all premiums, losses and related
expenses in a given class of business. In contrast, excess-of-loss
reinsurance provides coverage for a portion of losses incurred by an insurer
which exceed predetermined retention limits. Over the last several years,
Employers Mutual has emphasized writing excess-of-loss reinsurance business
and has worked to increase its participation on existing contracts that had
favorable terms. Employers Mutual strives to be flexible in the types of
reinsurance products it offers, but generally limits its writings to direct
reinsurance business rather than providing retrocessional coverage.
The following table sets forth the assumed written premiums of the
reinsurance subsidiary for the three years ended December 31, 2004, by line of
business.
Percent Percent Percent
of of of
Line of Business 2004 total 2003 total 2002 total
- ---------------- ------- ----- ------- ----- ------- -----
(Dollars in thousands)
Pro rata reinsurance:
Property and Casualty $21,785 22.3% $20,025 22.2% $17,856 23.4%
Property ............. 14,501 14.8 15,282 17.0 11,417 15.0
Crop ................. 4,084 4.2 2,693 3.0 1,535 2.0
Casualty ............. 1,206 1.2 1,771 2.0 2,886 3.8
Marine/Aviation ...... 11,202 11.5 12,377 13.7 12,073 15.8
------- ----- ------- ----- ------- -----
Total pro rata
reinsurance ...... 52,778 54.0 52,148 57.9 45,767 60.0
------- ----- ------- ----- ------- -----
Excess-of-loss
reinsurance:
Property ............. 26,935 27.6 23,744 26.4 18,925 24.9
Casualty ............. 17,358 17.8 12,954 14.4 10,610 13.9
Surety ............... 566 0.6 1,212 1.3 902 1.2
------- ----- ------- ----- ------- -----
Total excess-of-loss
reinsurance ...... 44,859 46.0 37,910 42.1 30,437 40.0
------- ----- ------- ----- ------- -----
Total .............. $97,637 100.0% $90,058 100.0% $76,204 100.0%
======= ===== ======= ===== ======= =====
MARKETING AND DISTRIBUTION
Property and Casualty Insurance
The Company markets a wide variety of commercial and personal lines
insurance products through 16 full service branch offices, which actively
write business in 41 states. The Company's products are marketed exclusively
through a network of over 3,150 local independent agencies contracted and
serviced by those branch offices. The Company primarily focuses on the sale
of commercial lines of property and casualty insurance to small and medium-
sized businesses, which are considered to be policyholders that pay less than
$100,000 in annual premiums. The Company also seeks to provide more than one
policy to a given customer, because this "account selling" strategy
diversifies risks and generally improves underwriting results.
The pool participants wrote over $1.1 billion in direct premiums in 2004,
with 83 percent of this business coming from commercial lines products and 17
percent coming from personal lines products. Although a majority of the
Company's business is generated by sales in the Midwest, its offices are
located across the country to take advantage of local market conditions and
opportunities, as well as to spread risk geographically. Each branch office
performs its own underwriting, claims, marketing and risk management functions
according to policies and procedures established and reviewed by the home
office. This decentralized network of branch offices allows the Company to
develop marketing strategies, products and pricing that target the needs of
individual marketing territories and take advantage of different opportunities
for profit in each market. This operating structure also enables the Company
to develop close relationships with the agents and customers with whom it does
business.
Although each branch office offers a slightly different combination of
products, the branches generally target three customer segments:
o a wide variety of small to medium-sized businesses, through a
comprehensive package of property and liability coverages;
o businesses and institutions eligible for the Company's target market and
safety dividend group programs (described below), which offer specialized
products geared to their members' unique protection needs; and
o individual consumers, through a number of personal lines products such
as homeowners, automobile and umbrella coverages.
The Company writes a number of target market and safety dividend group
programs throughout the country, and has developed a strong reputation for
these programs within the marketplace. These programs provide enhanced
insurance protection to businesses or institutions that have similar hazards
and exposures and are willing to implement loss prevention programs.
Underwriting results are based on the experience of the group, rather than the
individual participants. These groups include public schools, small
municipalities, petroleum marketers, contractors and mobile home parks. As an
example, the pool participants write coverage for over 1,200 school districts
throughout the Midwest, including all the districts in Iowa. These programs
have been successful because they offer risk management products and services
that are targeted to the needs of group members through a local independent
agent.
The following table sets forth the geographic distribution of the
aggregate direct written premiums of all parties to the pooling agreement for
the three years ended December 31, 2004.
2004 2003 2002
---- ---- ----
Arizona ............................ 3.8% 3.6% 3.8%
Colorado ........................... 3.1 2.9 2.8
Illinois ........................... 4.3 4.3 4.7
Iowa ............................... 15.1 15.4 15.9
Kansas ............................. 9.1 8.9 8.8
Michigan ........................... 4.1 4.9 5.1
Minnesota .......................... 3.3 3.3 3.3
Nebraska ........................... 6.4 6.9 6.8
Pennsylvania ....................... 3.4 3.1 3.1
Texas .............................. 4.6 4.9 5.0
Wisconsin .......................... 5.6 5.5 5.0
Other * ............................ 37.2 36.3 35.7
----- ----- -----
100.0% 100.0% 100.0%
===== ===== =====
* Includes all other jurisdictions, none of which accounted for more than
3 percent.
Reinsurance
Because the Company's reinsurance business is limited to assuming the
reinsurance business produced by Employers Mutual, the reinsurance subsidiary
does not engage in any independent marketing activities in the reinsurance
market. All reinsurance marketing is undertaken by Employers Mutual in its
role as the direct writer of reinsurance.
Employers Mutual's reinsurance business is derived from two sources.
Approximately 56.8 percent of premiums earned in 2004 from Employers Mutual's
reinsurance business was generated through the activities of its Home Office
Reinsurance Assumed Department (also known as "HORAD"). The reinsurance
business written by HORAD is brokered through independent intermediaries. As
a result, the risks assumed by HORAD do not materially overlap with the risks
assumed by MRB (discussed below). The risks which are assumed by Employers
Mutual through HORAD are directly underwritten and priced by Employers Mutual.
As such, Employers Mutual has discretion with respect to the type and size of
risks which it assumes and services through these activities.
The remaining 43.2 percent of Employers Mutual's premiums earned in 2004
was generated through participation in the Mutual Reinsurance Bureau pool
(also known as "MRB"), an unincorporated association through which Employers
Mutual and two other unaffiliated insurance companies participate in a
voluntary reinsurance pool to meet the reinsurance needs of small and medium-
sized, unaffiliated mutual insurance companies. Employers Mutual has
participated in MRB since 1957. As a member of this organization, Employers
Mutual assumes its proportionate share of the risks ceded to MRB by
unaffiliated insurers. Employers Mutual's proportionate share is currently
one third of all reinsurance business assumed by MRB. However, because MRB is
structured on a joint liability basis, Employers Mutual, and therefore the
Company's reinsurance company, would also be obligated with respect to the
proportionate share of risks assumed by the other participants in the event
they were unable to perform. MRB, which is operated by an independent
management team, manages assumed risks through typical underwriting practices,
including loss exposure controls through reinsurance coverage obtained for the
benefit of MRB. The risks for which MRB is the reinsurer arise primarily from
the Northeast and Midwest markets. Underwriting of risks and pricing of
coverage is performed by MRB management under general guidelines established
by Employers Mutual and the other participating insurers. Apart from these
procedures, Employers Mutual has only minimal control or influence over the
risks assumed and the results of these operations. There are currently two
other unaffiliated insurance companies participating in MRB with Employers
Mutual. Because of the joint liability structure, MRB participating companies
must maintain a rating of "A-" (Excellent) or above from A.M. Best and meet
certain other standards.
The board of directors of the MRB reinsurance pool, of which Employers
Mutual is a member, recently authorized management to pursue the addition of
one or two new assuming companies to the pool. If additional assuming
companies are added to the pool, Employers Mutual's participation would be
reduced and the reinsurance segment's premium volume would decline in the
short-term; however, this action will strengthen MRB's surplus base and should
favorably impact their ability to attract new business.
Over the last several years Employers Mutual has emphasized writing
excess-of-loss reinsurance business and has worked to increase its
participation on existing contracts that had favorable terms. Employers
Mutual strives to be flexible in the types of reinsurance products it offers,
but generally limits its writings to direct reinsurance business, rather than
providing retrocessional covers. During the last three years there has been a
trend in the reinsurance marketplace for "across the board" participation on
excess-of-loss reinsurance contracts. As a result, reinsurance companies must
be willing to participate on all layers offered under a specific contract in
order to be considered a viable reinsurer.
It is customary in the reinsurance business for the assuming company to
compensate the ceding company for the acquisition expenses incurred in the
generation of the business. Commissions paid by the reinsurance subsidiary to
Employers Mutual for this purpose amounted to $20,622,000 in 2004. The
reinsurance subsidiary also pays an annual override commission at the rate of
4.5 percent to Employers Mutual in connection with the $1.5 million cap on
losses assumed per event. This commission amounted to $4,394,000 in 2004.
EMC Re also pays for 100 percent of the third-party 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
and amounted to $3,627,000 in 2004.
COMPETITION
Property and Casualty Insurance
The property and casualty insurance business is very competitive. The
Company's property and casualty insurance subsidiaries and the other pool
members compete in the United States insurance market with numerous insurers,
many of which have greater financial resources. Competition in the types of
insurance in which the property and casualty insurance subsidiaries are
engaged is based on many factors, including the perceived overall financial
strength of the insurer, premiums charged, contract terms and conditions,
services offered, speed of claim payments, reputation and experience. Because
the insurance products of the pool members are marketed exclusively through
independent agencies, the Company faces competition to retain qualified
agencies, as well as competition within the agencies. The pool members also
compete with direct writers, who utilize salaried employees and generally
offer their products at a lower cost, exclusive agencies who write insurance
business for only one company, and to a lesser extent, Internet-based
enterprises. The pool members utilize a profit-sharing plan as an incentive
for the independent agencies to place high-quality insurance business with
them.
Reinsurance
Employers Mutual, in writing reinsurance business through its HORAD
operation, competes in the global reinsurance market with numerous reinsurance
companies, many of which have substantially greater financial resources.
Competition for reinsurance business is based on many factors, including
financial strength, industry ratings, stability in products offered and
licensing status. During the last several years, some ceding companies have
tended to favor large, financially strong reinsurance companies who are able
to provide "mega" line capacity for multiple lines of business. Employers
Mutual faces the risk of ceding companies becoming less interested in
diversity and spread of reinsurance risk in favor of having fewer, highly
capitalized reinsurance companies on their program.
While reinsurer competition for national and regional company business is
growing, the Company believes that MRB has a competitive advantage in the
smaller mutual company market that it serves. This segment of the market is
not targeted by the London and Bermuda markets, which tend to deal with larger
insurers at higher margins. MRB understands the needs of the smaller company
market and operates at a very low expense ratio, enabling it to offer
reinsurance coverage (on business that generally presents less risk) to an
under-served market at lower margins.
Best's Rating
Property and Casualty Insurance
A.M. Best Company rates insurance companies based on their relative
financial strength and ability to meet their contractual obligations. A.M.
Best announced on July 10, 2001 that their rating of the EMC Insurance
Companies, which includes the Company's property and casualty insurance
subsidiaries, was changed from "A" (Excellent) to "A-" (Excellent). This
rating action reflected A.M. Best's opinion of the EMC Insurance Companies'
underwriting performance and operating losses during the three years ended
December 31, 2000. Despite this rating action, A.M. Best stated that the EMC
Insurance Companies' "Excellent" rating reflects its strong capitalization,
conservative operating strategies and local-market presence. A.M. Best
reevaluates its ratings from time to time (normally on an annual basis) and
there can be no assurance that the Company's property and casualty insurance
subsidiaries and the other pool members will maintain their current rating in
the future. Management believes that a Best's rating of "A-" (Excellent) or
better is important to the Company's business since many insureds require that
companies with which they insure be so rated. Best's publications indicate
that these ratings are assigned to companies that have achieved excellent
overall performance and have a strong ability to meet their obligations over a
long period of time. Best's ratings are based upon factors of concern to
policyholders and insurance agents and are not necessarily directed toward the
protection of investors.
The most recent A.M. Best Property Casualty Key Rating Guide gives the
Company's property and casualty insurance subsidiaries an "A-" (Excellent)
policyholders rating in their capacity as participants in the pooling
arrangement. The pool participants were previously rated by A.M. Best on a
"pool" basis due to their participation in the pooling arrangement. However,
as a result of recently published changes to the methodology employed by A.M.
Best in assigning ratings to groups of affiliated insurance companies, the
Company has been informed that it no longer qualifies to be rated on a "pool"
basis, but will instead be rated on a "group" basis beginning in 2005. Under
the new methodology, each pool participant will be rated on a stand-alone
basis and Employers Mutual, as the parent organization, will be rated on a
consolidated basis. Each participant's strategic importance, and the level of
parental support it receives, will then be analyzed to determine if a
modification to its stand-alone rating is merited. According to A.M. Best,
each of the pool participants, with the exception of Farm and City Insurance
Company, are considered to be "core subsidiaries" and will therefore receive
Employers Mutual's rating and financial size category, and a "group"
affiliation code. Farm and City will not receive Employers Mutual's rating or
the "group" affiliation code due to the fact that it has discontinued writing
direct insurance business.
As part of the change in its rating methodology, A.M. Best also announced
that insurance companies that seek to be rated on a "group" basis must comply
with certain conditions. Because the Company and Employers Mutual believe
that a "group" rating is important to their business, the pool participants
intend to comply with these conditions. One of these conditions requires that
the parent organization retain greater than 50 percent ownership of each group
member. As a result of this requirement, Employers Mutual intends to retain a
minimum of 50.1 percent ownership of the Company's outstanding common stock.
Other conditions imposed by A.M. Best required amendments to the pooling
agreement, which became effective January 1, 2005. The most significant
amendment is a requirement that each pool participant assume its pro rata
share (based on its participation interest in the pool) of the liabilities of
any pool participant that becomes insolvent or is otherwise subject to
liquidation or receivership proceedings, subject to compliance with all
regulatory requirements applicable to such adjustment.
Reinsurance
The most recent A.M. Best Property Casualty Key Rating Guide gives the
Company's reinsurance subsidiary an "A-" (Excellent) policyholders' rating.
However, because all of the reinsurance business assumed by the reinsurance
subsidiary is produced by Employers Mutual, the rating of the reinsurance
subsidiary is not critical to the Company's reinsurance operations. The
rating of Employers Mutual is, however, critical to the Company's reinsurance
operations, as the unaffiliated insurance companies that cede business to
Employers Mutual are concerned with its rating as an indication of its ability
to meet its obligations to those insurance companies. The downgrade of
Employers Mutual's rating from "A" (Excellent) to "A-" (Excellent) in 2001 has
resulted in some loss of reinsurance business to Employers Mutual, as the
downgrade resulted in Employers Mutual becoming ineligible to assume certain
reinsurance business. Any further downgrade of Employers Mutual's rating
would have a material adverse impact on the Company's reinsurance subsidiary,
as a downgrade would negatively impact Employers Mutual's ability to assume
reinsurance business and, consequently, to cede that business to the Company's
reinsurance subsidiary.
STATUTORY COMBINED RATIOS
The following table sets forth the statutory combined trade ratios of the
Company's insurance subsidiaries and the property and casualty insurance
industry averages for the five years ended December 31, 2004. The combined
ratios below are the sum of the following: the loss ratio, calculated by
dividing losses and settlement expenses incurred by net premiums earned, and
the expense ratio, calculated by dividing underwriting expenses incurred by
net premiums written and policyholder dividends by net premiums earned.
Generally, if the combined ratio is below 100 percent, a company has an
underwriting profit; if it is above 100 percent, a company has an underwriting
loss.
Year ended December 31,
--------------------------------------
2004 2003 2002 2001 2000
------ ------ ------ ------ ------
Property and casualty insurance
Loss ratio ................... 79.0% 70.3% 69.8% 83.0% 82.2%
Expense ratio ................ 33.1 32.2 31.2 28.5 30.8
------ ------ ------ ------ ------
Combined ratio ............. 112.1% 102.5% 101.0% 111.5% 113.0%
====== ====== ====== ====== ======
Reinsurance
Loss ratio ................... 55.9% 65.2% 70.7% 86.6% 86.1%
Expense ratio ................ 27.8 27.2 31.6 29.1 29.1
------ ------ ------ ------ ------
Combined ratio ............. 83.7% 92.4% 102.3% 115.7% 115.2%
====== ====== ====== ====== ======
Total insurance operations
Loss ratio ................... 72.6% 68.9% 70.0% 83.8% 83.0%
Expense ratio ................ 31.6 30.9 31.3 28.6 30.5
------ ------ ------ ------ ------
Combined ratio ............. 104.2% 99.8% 101.3% 112.4% 113.5%
====== ====== ====== ====== ======
Property and casualty insurance
industry averages (1)
Loss ratio ................... 72.4% 75.0% 81.7% 88.5% 81.5%
Expense ratio ................ 25.2 25.1 25.7 27.5 28.9
------ ------ ------ ------ ------
Combined ratio ............. 97.6% 100.1% 107.4% 116.0% 110.4%
====== ====== ====== ====== ======
(1) As reported by A.M. Best Company. The ratio for 2004 is an estimate; the
actual combined ratio is not currently available.
The 2001 expense ratios and combined ratios for "property and casualty
insurance" and "total insurance operations" are distorted by $13,884,000 of
additional written premiums that were recorded in 2001 in connection with a
change in the recording of installment-based insurance policies. Excluding
this adjustment, the expense ratios would have been 30.2 percent and 30.0
percent, respectively, and the combined ratios would have been 113.2 percent
and 113.8 percent, respectively.
CLAIMS MANAGEMENT
The Company believes that effective claims management is critical to its
success. To this end, the Company has adopted a customer-focused claims
management process that it believes is cost efficient, delivers the
appropriate claims service and produces superior claims results. The
Company's claims management process is focused on controlling claims from
their inception, accelerating communication to insureds and claimants and
compressing the cycle time of claims to control both loss costs and claims-
handling costs. The Company believes its process provides quality service and
results in the appropriate handling of claims, allowing it to cost-effectively
pay valid claims and contest fraudulent claims.
The Company's claims management operation includes adjusters, appraisers,
special investigators, attorneys and claims administrative personnel. The
Company conducts its claims management operations out of its 16 branch offices
and six service offices located throughout the United States. The home office
claims group provides advice and counsel for branch claims staff in
investigating, reserving and disposing of claims. The home office claims
staff also evaluates branch claim operations and makes recommendations for
improvement in performance. Additional home office services provided include:
complex claim handling, physical damage and property review, medical case
management, medical bill review, legal coverage analysis, litigation
management and subrogation. The Company believes these home office services
assist the branch claims personnel in producing greater efficiencies than can
be achieved at the local level.
Each branch office is responsible for evaluating and settling claims
within the authority provided by home office claims. Authority levels within
the branch offices are granted based upon an adjuster's experience and
expertise. The branch office must request input from home office once a case
exceeds its authority. A claims committee exists within home office and is
chaired by the Senior Vice President of Claims. This committee meets on a
weekly basis to assist the branches in evaluating and settling claims beyond
their authority.
The Company will allow claims to go to litigation in matters such as
value disputes and questionable liability and it will defend appropriate
denials of coverage. The Company generally retains outside defense counsel to
litigate such matters. The Company's claims professionals manage the
litigation process rather than ceding control to an attorney. The Company has
implemented a litigation management system that provides data that will allow
claims staff to evaluate the quality and cost effectiveness of legal services
provided. Cases are constantly reviewed to adjust the litigation plan if
necessary, and all cases going to trial are carefully reviewed to assess the
value of trial or settlement.
LOSS AND SETTLEMENT EXPENSE RESERVES
Liabilities for losses and settlement expenses are estimates at a given
point in time of what an insurer expects to pay to claimants and the cost of
settling claims, based on facts and circumstances then known. It can be
expected that the insurer's ultimate liability for losses and settlement
expenses may either exceed or be less than such estimates. The Company's
estimates of the liabilities for losses and settlement expenses are based on
estimates of future trends and claims severity, judicial theories of liability
and other factors. However, during the loss adjustment period, which may
cover many years in some cases, the Company may learn additional facts
regarding individual claims, and consequently it often becomes necessary to
refine and adjust its estimates of the liability. The Company reflects any
adjustments to its liabilities for losses and settlement expenses in its
operating results in the period in which the changes in estimates are made.
The Company maintains reserves for losses and settlement expenses with
respect to both reported and unreported claims. The amount of reserves for
reported claims is primarily based upon a case-by-case evaluation of the
specific type of claim, knowledge of the circumstances surrounding each claim
and the policy provisions relating to the type of loss. Reserves on assumed
reinsurance business are the amounts reported by the ceding company.
The amount of reserves for unreported claims is determined on the basis
of statistical information for each line of insurance with respect to the
probable number and nature of claims arising from occurrences that have not
yet been reported. Established reserves are closely monitored and are
frequently recomputed using a variety of formulas and statistical techniques
for analyzing actual claim costs, frequency data and other economic and social
factors.
Settlement expense reserves are intended to cover the ultimate cost of
investigating claims and defending lawsuits arising from claims. These
reserves are established each year based on previous years experience to
project the ultimate cost of settlement expenses. To the extent that
adjustments are required to be made in the amount of loss reserves each year,
settlement expense reserves are correspondingly revised, if necessary.
The Company's actuaries conduct quarterly reviews of the direct loss and
settlement expense reserves. In addition, they specifically analyze direct
case loss reserves on a quarterly basis and direct incurred but not reported
("IBNR") loss reserves on an annual basis. Based on the results of these
regularly-scheduled evaluations, the Company's actuaries make recommendations
regarding adjustments and direct reserve levels.
The Company does not discount reserves. Inflation is implicitly provided
for in the reserving function through analysis of cost trends, reviews of
historical reserving results and projections of future economic conditions.
Large ($100,000 and over) incurred and reported gross reserves are reviewed
regularly for adequacy. In addition, long-term and lifetime medical claims
are periodically reviewed for cost trends and the applicable reserves are
appropriately revised, if necessary.
Despite the inherent uncertainties of estimating the loss and settlement
expense reserves, the Company believes that its reserves are being calculated
in accordance with sound actuarial practices and, based upon current
information, that its reserves for losses and settlement expenses at December
31, 2004 are adequate.
The following table sets forth a reconciliation of beginning and ending
reserves for losses and settlement expenses of the property and casualty
insurance subsidiaries and the reinsurance subsidiary. Amounts presented are
on a net basis, with a reconciliation of beginning and ending reserves to the
gross amounts presented in the consolidated financial statements.
Year ended December 31,
------------------------------
2004 2003 2002
-------- -------- --------
(Dollars in thousands)
Gross reserves at beginning of year ...... $373,783 $331,227 $314,519
Ceded reserves at beginning of year ...... (20,666) (10,368) (11,849)
-------- -------- --------
Net reserves at beginning of year ........ 353,117 320,859 302,670
-------- -------- --------
Incurred losses and settlement expenses
- ---------------------------------------
Provision for insured events
of the current year ................... 229,668 219,029 200,060
Increase in provision for
insured events of prior years ........ 20,138 7,476 6,998
-------- -------- --------
Total incurred losses and
settlement expenses ............ 249,806 226,505 207,058
-------- -------- --------
Payments
- --------
Losses and settlement expenses
attributable to insured events
of the current year .................. 83,531 86,072 81,124
Losses and settlement expenses
attributable to insured events
of prior years ....................... 115,073 108,175 107,745
-------- -------- --------
Total payments ................... 198,604 194,247 188,869
-------- -------- --------
Net reserves at end of year ............... 404,319 353,117 320,859
Ceded reserves at end of year ............. 25,358 20,666 10,368
-------- -------- --------
Gross reserves at end of year ............. $429,677 $373,783 $331,227
======== ======== ========
During the three years ended December 31, 2004, the Company has
experienced adverse development in the provision for insured events of prior
years. The majority of this adverse development has come from the property
and casualty insurance segment, primarily in the workers' compensation and
other liability lines of business. Following are the significant issues and
trends that the Company has identified as contributors to this adverse
development.
Workers' compensation claim severity has increased significantly over the
past five years, with the projected ultimate average claim amount increasing
approximately 72 percent over the five year period. An increase of this
magnitude has made the establishment of adequate case reserves challenging. A
review of the Company's claims data indicates that claims adjusters have
recently underestimated medical costs and the length of time injured workers
are away from work. In addition, partial disability benefits have been
underestimated or unanticipated. Large increases in drug costs and the
availability and utilization of new and costly medical procedures have
contributed to rapidly escalating medical costs.
Construction defect claims arising from general liability policies issued
to contractors have contributed to the adverse reserve development. States
with significant construction defect losses include Alabama, Arizona,
California, Colorado, Nevada and Texas.
Large umbrella claims have recently contributed to the adverse
development experienced in the other liability line of business. The
Company's pattern of increasing umbrella claims severity is believed to be
generally consistent with industry umbrella severity trends. Also
contributing to overall umbrella reserve development is an increase in claims
arising from underlying general liability policies.
Legal expenses for the other liability line of business have also
increased rapidly over the past three years, with defense costs increasing at
an average rate of approximately 14 percent per year. This increase in legal
expenses has occurred despite a reduction in the number of new lawsuits.
In response to an indicated deficiency in case reserves at December 31,
2003, the home office claims department in early 2004 instructed each of the
16 branch offices to review and carefully reevaluate all claim reserves for
adequacy. As a result of these reviews, case reserves were strengthened in
both the second and third quarters of 2004. However, during the required
fourth quarter inventory and review process, the branch offices further
strengthened their case reserves, generating a significant amount of adverse
development on prior years' reserves.
Following is a detailed analysis of the adverse development the Company
has experienced during the past three years.
YEAR ENDED DECEMBER 31, 2004
Property and casualty insurance segment
For the property and casualty insurance segment, the December 31, 2004
estimate of loss and settlement expense reserves for accident years 2003 and
prior increased $23,750,000 from the estimate at December 31, 2003. This
increase represents 10 percent of the December 31, 2003 carried reserves and
is attributed to a combination of newly reported claims in excess of carried
IBNR reserves, development on case reserves of previously reported claims,
bulk reserve strengthening and settlement expense reserve increases resulting
from increases in case reserves. None of the adverse development experienced
in 2004 is associated with changes in the key actuarial assumptions utilized
to estimate loss and settlement expense reserves.
During 2004, case reserves increased $39,644,000. Actuarial analysis
indicates that this increase represents substantial case reserve
strengthening. Although figures for the first quarter are not available, the
Company estimates that from the end of the first quarter through yearend 2004,
case reserves were strengthened $20,904,000. This reserving action is an
important underlying reason for the adverse reserve development that occurred
during 2004, which is discussed in detail below.
Because the Company establishes settlement expense reserves as a
percentage of case reserves, the increase in case reserves resulted in a
$8,731,000 increase in settlement expense reserves, approximately $3,122,000
of which can be attributed to case reserve strengthening. The case reserve
increase resulted in an estimated $6,209,000 of settlement expense adverse
development.
The emergence of IBNR claims in excess of carried IBNR reserves resulted
in approximately $14,758,000 of adverse development in 2004. The most
significant development occurred in the other liability ($7,812,000), personal
auto liability ($5,991,000), commercial auto liability ($1,871,000), and
workers' compensation ($1,634,000) lines of business. The other liability
development can be attributed to an unusual number of umbrella claims and to
construction defect claims. More than 80 percent of the other liability
development came from accident years 1999 - 2003, which are the years with the
vast majority of umbrella IBNR claims. For personal auto, nearly all of the
development resulted from a change in the recording of large Michigan no-fault
claims; however, the additional reserves are ceded 100 percent to the Michigan
Catastrophic Claims Association. For commercial auto, the upward development
arose mainly from accident years 2000 - 2003. Approximately 70 percent of the
workers' compensation development is from accident years 1999 - 2003. For all
other lines combined, IBNR reserves developed downward ($2,550,000), with
variations by line of business ranging from downward development of $1,139,000
for commercial property to upward development of $85,000 for bonds.
Reserves on previously reported claims also developed upward in 2004 by
approximately $11,037,000. Adverse case reserve development occurred
primarily in the workers' compensation line of business ($12,265,000), with a
smaller amount of adverse development occurring in the commercial auto
liability ($1,987,000) and other liability ($1,212,000) lines. Partially
offsetting these three lines was favorable development in the remaining lines,
most notably property ($1,853,000), auto physical damage ($1,041,000) and
homeowners ($905,000). About two-thirds of the workers' compensation adverse
development came from the latest three accident years. For all lines
combined, the latest three accident years were responsible for about 80
percent of the total adverse development.
For workers' compensation, the adverse development on previously reported
claims is tempered by a reduction of $2,609,000 in the bulk case reserve
allocated to accident years 2003 and prior. With this adjustment, the
workers' compensation adverse case reserve development was $9,656,000.
The Company also strengthened IBNR reserves in 2004 in response to the
results of a regularly-scheduled actuarial analysis, which indicated a higher
ratio of IBNR emergence in relation to premiums earned than the 2003 review.
The portion of IBNR reserve strengthening allocated to prior accident years
totaled $1,521,000. The largest indicated increase in IBNR reserves was in
the other liability line of business, where strengthening totaled $1,391,000.
As previously noted, case reserves for the property and casualty
insurance segment developed upward during 2004, which represented a
significant change from the historical development pattern prior to 2003. To
supplement the individual case reserves, the Company increased the bulk case
reserve for the workers' compensation line of business, which was primarily
responsible for the adverse development. The portion of the bulk reserve
increase allocated to prior accident years was $703,000. The increase in the
bulk reserve was in response to quarterly actuarial reviews of case reserves.
These reviews were initiated in 2003 and the methodology was refined in 2004.
The current methodology projects paid losses to an ultimate level, with the
data limited to claims reported as of the evaluation date.
Settlement expense reserves were strengthened during 2004 in response to
actuarial analyses completed in 2004. These reviews indicated generally
higher ultimate expense to loss ratios for the other liability line of
business, along with higher estimates of ultimate losses than projected during
2003. Accordingly, settlement expense reserves were strengthened, with
$2,735,000 of the increase allocated to prior accident years.
The above results reflect reserve development on a direct basis. During
2004, ceded losses for prior accident years increased $10,437,000.
Approximately three-fourths of the increase was in the workers' compensation
and personal auto lines of business, primarily as a result of increases in
prior year losses ceded to workers' compensation assigned risk pools and the
Michigan Catastrophic Claims Association. The impact of the increase in
reinsurance recoverables was to offset a portion of the adverse development on
direct business described above.
Reinsurance segment
For the reinsurance segment, the December 31, 2004 estimate of loss and
settlement expense reserves for accident years 2003 and prior decreased
$3,602,000 from the estimate at December 31, 2003. This decrease represents
3.1 percent of the December 31, 2003 carried reserves and is attributable to
the 2003 accident year in the HORAD book of business, which developed downward
by $3,674,000. This favorable development can be attributed to reported
policy year 2003 losses for property, casualty and multi-line classes that
were approximately $5,264,000 below 2003 implicit projections. HORAD accident
years 2002 and prior developed upward approximately $1,619,000. This
development arose from accident years 1998 - 2002, primarily in multi-line
excess, property pro rata and marine lines of business. Most accident years
prior to 1998 developed modestly downward.
MRB reserve development was essentially flat, with minor upward
development of $72,000.
The reserve development experienced in 2004 did not result from any
changes in the key actuarial assumptions utilized to estimate loss and
settlement expense reserves.
YEAR ENDED DECEMBER 31, 2003
Property and casualty insurance segment
For the property and casualty insurance segment, the December 31, 2003
estimate of loss and settlement expense reserves for accident years 2002 and
prior increased $9,015,000 from the estimate at December 31, 2002. This
increase represents 3.9 percent of the December 31, 2002 carried reserves and
is attributed to a combination of newly reported claims in excess of carried
IBNR reserves, development on case reserves of previously reported claims and
bulk reserve strengthening. None of the adverse development experienced in
2003 is associated with changes in the key actuarial assumptions utilized to
estimate loss and settlement expense reserves, although a shortage in workers'
compensation individual case reserves led to the establishment of a bulk case
reserve for that line of business.
The emergence of IBNR claims in excess of carried IBNR reserves resulted
in approximately $3,977,000 of adverse development in 2003. The most
significant development occurred in the workers' compensation ($1,742,000),
other liability ($1,565,000) and commercial auto liability ($659,000) lines of
business. Approximately 85 percent of the workers' compensation adverse
development was from accident years 1998 - 2002. The other liability
development is primarily attributed to construction defect and asbestos claims
for accident years prior to 1998, with modest downward development for
accident years 1998 - 2002. For commercial auto, the upward development
arose mainly from accident years 1998 - 2001, with 2002 developing downward.
For all other lines combined, IBNR reserves developed modestly upward with no
significant variations.
Reserves on previously reported claims also developed upward in 2003 by
approximately $3,529,000. Adverse case reserve development occurred primarily
in the workers' compensation ($7,234,000) and commercial auto liability
($1,562,000) lines of business. Partially offsetting these two lines was
favorable development in the remaining lines, most notably other liability
($1,520,000), property ($1,324,000) and auto physical damage ($1,193,000).
About 80 percent of the workers' compensation adverse development came from
the latest four accident years. For all lines combined, the latest four
accident years developed upward by $3,800,000, with the prior accident years
combined developing modestly downward.
The Company also strengthened IBNR reserves in 2003 in response to the
results of a regularly-scheduled actuarial analysis, which indicated a higher
ratio of IBNR emergence in relation to premiums earned than the 2002 review.
The portion of IBNR reserve strengthening allocated to prior accident years
totaled $1,980,000. The largest indicated increase in IBNR reserves was in
the other liability line of business, where strengthening totaled $1,428,000.
Relatively minor strengthening also occurred in the other lines of business,
the greatest of which was workers' compensation ($238,000).
As previously noted, case reserves for the property and casualty
insurance segment developed upward during 2003, which represented a
significant change from the historical development pattern. To supplement the
individual case reserves, the Company established a bulk case reserve for the
workers' compensation line of business, which was primarily responsible for
the adverse development. The portion of this bulk reserve allocated to prior
accident years was $917,000. This action does not represent a change in
assumptions, but rather a reaction to a change in circumstances that occurred
in 2003. Prior to 2003, there was no indication that overall case reserves
were inadequate.
Settlement expense reserves were also strengthened during 2003.
Actuarial analyses completed in 2003 indicated generally higher ultimate
expense to loss ratios for the other liability line of business, along with
higher estimates of ultimate losses than during 2002. Accordingly, the
Company strengthened settlement expense reserves, with $1,597,000 of the
increase allocated to prior accident years.
The above results reflect reserve development on a direct basis. During
2003, ceded losses for prior accident years increased $3,224,000.
Approximately three-fourths of the increase was in the other liability,
workers' compensation and surety bond lines of business, primarily as a result
of large claims exceeding the Company's excess of loss treaties' retentions.
The impact of the increase in reinsurance recoveries was to offset some of the
adverse development on direct business described above.
The Company also experienced $410,000 of adverse development on
involuntary pools during 2003. This development affected the auto and
workers' compensation lines of business. Since involuntary pool reserves are
booked as reported (except for a lag in IBNR reserves), this development did
not result from any change in actuarial assumptions.
Reinsurance Segment
For the reinsurance segment, the December 31, 2003 estimate of loss and
settlement expense reserves for accident years 2002 and prior decreased
$1,539,000 from the estimate at December 31, 2002. This decrease represents
1.5 percent of the December 31, 2002 carried reserves and is primarily
attributed to the 2002 accident year in the HORAD book of business, which
developed downward by $3,139,000. Much of this favorable development can be
attributed to reported policy year 2002 losses that were approximately
$3,200,000 below 2002 implicit projections. HORAD accident years 2001 and
prior developed upward approximately $1,190,000. Reserve strengthening
implemented in 2003 in response to an independent consultant's analysis of the
reinsurance segment's exposure to asbestos exposures resulted in $326,000 of
adverse development. The remainder of the upward development arose from
accident years 1997 - 2001, primarily from casualty and marine losses.
MRB reserves developed upward by $411,000 in 2003. Most of this
development arose from accident years 1995 - 1999 and is attributed to
construction defect claims arising from an account that has been in runoff
since 2000.
The reserve development experienced in 2003 did not result from any
changes in the key actuarial assumptions utilized to estimate loss and
settlement expense reserves.
YEAR ENDED DECEMBER 31, 2002
Property and casualty insurance segment
For the property and casualty insurance segment, the December 31, 2002
estimate of loss and settlement expense reserves for accident years 2001 and
prior increased $4,645,000 from the estimate at December 31, 2001. This
increase represents 2.1 percent of the December 31, 2001 carried reserves and
is attributed to three sources: direct IBNR reserves, involuntary pools and
contingent salary plan reserves. None of the adverse development experienced
in 2002 is associated with changes in the key actuarial assumptions utilized
to estimate loss and settlement expense reserves.
The emergence of IBNR claims in excess of carried IBNR reserves (before
consideration of IBNR reserve strengthening) resulted in approximately
$1,332,000 of adverse development in 2002. On a direct basis, adverse IBNR
development occurred in the surety bond ($914,000), workers' compensation
($905,000) and property ($587,000) lines of business. More than 90 percent of
the bond and property development arose from the latest two accident years
and about 85 percent of the workers' compensation development arose from the
latest five accident years. For all other lines, IBNR reserves developed
downward.
The Company also strengthened direct IBNR reserves in 2002, with $945,000
of this strengthening allocated to prior accident years. This reserve
strengthening was implemented in response to an actuarial analysis that
indicated a higher ratio of IBNR emergence in relation to premiums earned than
the prior review completed in 2001. The largest indicated increase was in the
other liability line of business, with minor adjustments being made in the
other lines of business.
Reserves on previously reported claims developed downward by
approximately $2,411,000 in 2002. The favorable case reserve development was
primarily in the auto physical damage ($1,973,000) and property ($1,513,000)
lines of business, with smaller contributions from other liability ($844,000),
homeowners ($837,000) and bonds ($433,000). Only the workers' compensation
line of business showed substantial adverse case reserve development
($2,724,000), which partially offset the downward development in the other
lines. Over 90 percent of the workers' compensation adverse case reserve
development was from the latest two accident years. Excluding workers'
compensation, 70 percent of the other lines' favorable case reserve
development arose from accident years 1997 - 2001.
Reserves for asbestos and pollution exposures were strengthened by
$3,126,000 during 2002. The asbestos strengthening was implemented in
response to an independent consultant's ground up study of asbestos exposures
that was completed in early 2003 and increased total direct asbestos reserves
to the consultant's point estimate. Pollution reserves were increased to
achieve a targeted three-year survival ratio in the neighborhood of twelve.
The reserve strengthening for asbestos and pollution primarily affected the
other liability line of business. These reserves relate primarily to
exposures from the mid-1980s and prior.
Settlement expense reserves were also strengthened during 2002. An
important assumption in the actuarial settlement expense methodology is
stability over time in the development pattern of the settlement expense to
loss ratio, which would result in stable projected ratios of ultimate
settlement expenses to ultimate losses from one evaluation to the next.
However, actuarial analyses in 2002 indicated generally higher estimated
ultimate ratios of settlement expense to loss for the other liability line of
business than in 2001. As a result, settlement expense reserves were
strengthened, with approximately $635,000 allocated to prior accident years.
This strengthening did not result from a change in assumptions, but rather
from a change in the indicated reserve arising from the data entering the
standard calculations.
Additional adverse development resulted from involuntary pool business
and the implementation of an employee contingent salary plan in 2002. The
Company records the reserves reported by the management of the involuntary
pools, along with a reserve for a lag in reporting. In 2002, these bookings
resulted in modest upward development of $400,000. This development affected
the auto and workers' compensation lines of business. Employers Mutual
implemented a contingent salary plan in 2002 and $400,000 of the reserve
established for this plan at December 31, 2002 was allocated to settlement
expenses for prior accident years. This reserve is allocated to all lines of
business.
Reinsurance segment
For the reinsurance segment, the December 31, 2002 estimate of loss and
settlement expense reserves for accident years 2001 and prior increased
$2,353,000 from the estimate at December 31, 2001. This increase represents
2.6 percent of the December 31, 2001 carried reserves. Virtually all of the
increase came from the MRB pool. Accident years 1995 - 1999 accounted for
about 85 percent of the development, with the majority of it coming from
construction defect claims arising from an account that has been in runoff
since 2000.
HORAD reserves developed slightly upward ($61,000) in 2002. Accident
year 2001 developed upward by $2,160,000. This is partially due to reported
policy year 2001 losses that exceeded implicit 2001 projections by
approximately $1,000,000. The remainder can be attributed to a substantial
increase in estimated policy year 2001 premiums during 2002. Accident years
2000 and prior developed downward by $2,100,000. Accident years 1981 - 1987
contributed $500,000 of favorable development from reductions in indicated
development factors. Another $526,000 was due to a reduction in IBNR reserves
booked as reported for a large marine contract. Most of the remainder can be
attributed to a 2002 decision to reallocate a modest amount of IBNR between
accident years. The overall reinsurance target reserve level is the upper
quartile of the indicated reserve range; a decision was made in 2002 to
reserve prior accident years nearer the middle of their respective ranges and
to reserve the latest policy year more conservatively. This decision was made
in recognition of the fact that the latest policy year has the most
uncertainty. This action did not affect the total reserve level because the
overall upper quartile target was maintained.
The reserve development experienced in 2002 did not result from any
changes in the key actuarial assumptions utilized to estimate loss and
settlement expense reserves.
The following table shows the calendar year development of loss and
settlement expense reserves of the property and casualty insurance
subsidiaries and the reinsurance subsidiary. Amounts presented are on a net
basis with (i) a reconciliation of the net loss and settlement expense
reserves to the gross amounts presented in the consolidated financial
statements and (ii) disclosure of the gross re-estimated loss and settlement
expense reserves and the related re-estimated reinsurance receivables.
Reflected in this table is (1) the reinsurance subsidiary's commutation
of all outstanding reinsurance balances ceded to Employers Mutual under
catastrophe and aggregate excess-of-loss reinsurance treaties related to
accident years 1991 through 1993 in 1994 and (2) the increase in the
reinsurance subsidiary's quota share assumption of Employers Mutual's assumed
reinsurance business from 95 percent to 100 percent in 1997. The table has
been restated to reflect the addition of Hamilton Mutual to the pooling
agreement effective January 1, 1997 and the addition of Farm and City to the
pooling agreement effective January 1, 1998.
In evaluating the table, it should be noted that each cumulative
redundancy (deficiency) amount includes the effects of all changes in reserves
for prior periods. Conditions and trends that have affected development of
the liability in the past, such as a time lag in the reporting of assumed
reinsurance business, the high rate of inflation associated with medical
services and supplies and the reform measures implemented by several states to
control administrative costs for workers' compensation insurance, may not
necessarily occur in the future. Accordingly, it may not be appropriate to
project future development of reserves based on this table.
Year ended December 31,
--------------------------------------------------------------------------------------------------
(Dollars in thousands) 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ----
Statutory reserves for losses
and settlement expenses ...... $191,514 196,293 191,892 205,606 230,937 257,201 276,103 303,643 321,945 354,200 405,683
Retroactive restatement of
reserves in conjunction with
admittance of new participants
into the pooling agreement ... 6,603 6,809 7,018 3,600 - - - - - - -
-------- ------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Statutory reserves after
reclassification ............. 198,117 203,102 198,910 209,206 230,937 257,201 276,103 303,643 321,945 354,200 405,683
GAAP adjustments ............... (2,479) (3,098) (3,186) (858) (890) (948) (839) (973) (1,086) (1,084) (1,364)
-------- ------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Reserves for losses and
settlement expenses .......... 195,638 200,004 195,724 208,348 230,047 256,253 275,264 302,670 320,859 353,116 404,319
Paid (cumulative) as of:
One year later ............... 57,247 62,012 59,856 62,949 77,699 87,599 99,530 107,744 108,175 115,073 -
Two years later .............. 88,831 92,626 92,191 99,870 119,620 138,701 156,337 170,512 176,777 - -
Three years later ............ 106,691 112,985 113,343 122,455 147,561 173,840 196,400 213,765 - - -
Four years later ............. 118,705 124,450 126,507 136,975 167,529 198,221 222,695 - - - -
Five years later ............. 126,384 132,044 135,321 148,708 181,008 212,930 - - - - -
Six years later .............. 130,977 137,522 143,105 157,808 190,159 - - - - - -
Seven years later ............ 134,923 143,044 149,313 163,150 - - - - - - -
Eight years later ............ 139,263 147,994 153,394 - - - - - - - -
Nine years later ............. 143,345 151,164 - - - - - - - - -
Ten years later .............. 145,879 - - - - - - - - - -
Reserves re-estimated as of:
End of year .................. 195,638 200,004 195,724 208,348 230,047 256,253 275,264 302,670 320,859 353,116 404,319
One year later ............... 179,818 183,760 188,579 197,271 224,313 254,350 280,431 309,668 328,335 373,254 -
Two years later .............. 173,162 182,285 185,465 194,287 225,288 256,111 288,465 321,761 349,901 - -
Three years later ............ 172,118 179,797 181,392 193,505 227,010 260,715 296,837 333,126 - - -
Four years later ............. 170,570 176,176 180,686 192,824 229,336 265,802 303,200 - - - -
Five years later ............. 167,763 175,465 179,898 195,910 232,446 271,332 - - - - -
Six years later .............. 166,764 174,695 181,567 198,162 236,846 - - - - - -
Seven years later ............ 166,280 176,012 182,690 201,274 - - - - - - -
Eight years later ............ 167,889 176,866 185,077 - - - - - - - -
Nine years later ............. 168,627 179,025 - - - - - - - - -
Ten years later .............. 170,706 - - - - - - - - - -
-------- ------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Cumulative redundancy
(deficiency) ................. $ 24,932 20,979 10,647 7,074 (6,799) (15,079) (27,936) (30,456) (29,042) (20,138) -
======== ======= ======= ======= ======= ======= ======= ======= ======= ======= =======
Gross loss and settlement
expense reserves
- end of year (A) ............ $209,785 212,231 209,521 221,378 245,610 266,514 286,489 314,519 331,227 373,783 429,677
Reinsurance receivables ........ 14,147 12,227 13,797 13,030 15,563 10,261 11,225 11,849 10,368 20,667 25,358
-------- ------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Net loss and settlement expense
reserves - end of year ....... $195,638 200,004 195,724 208,348 230,047 256,253 275,264 302,670 320,859 353,116 404,319
======== ======= ======= ======= ======= ======= ======= ======= ======= ======= =======
Gross re-estimated reserves
- latest (B) ................. $186,267 195,279 204,207 218,039 254,888 284,238 316,930 349,434 366,250 398,506 429,677
Re-estimated reinsurance
receivables - latest ......... 15,561 16,254 19,130 16,765 18,042 12,906 13,730 16,308 16,349 25,252 25,358
-------- ------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Net re-estimated reserves
- latest ..................... $170,706 179,025 185,077 201,274 236,846 271,332 303,200 333,126 349,901 373,254 404,319
======== ======= ======= ======= ======= ======= ======= ======= ======= ======= =======
Gross cumulative redundancy
(deficiency) (A-B) ........... $ 23,518 16,952 5,314 3,339 (9,278) (17,724) (30,441) (34,915) (35,023) (24,723) -
======== ======= ======= ======= ======= ======= ======= ======= ======= ======= =======
ASBESTOS AND ENVIRONMENTAL CLAIMS
The Company has exposure to asbestos and environmental-related claims
associated with the insurance business written by the parties to the pooling
agreement and the reinsurance business assumed from Employers Mutual by the
reinsurance subsidiary. With regard to the assumed reinsurance business,
however, all asbestos and environmental exposures related to 1980 and prior
accident years are retained by Employers Mutual.
Estimating loss and settlement expense reserves for asbestos and
environmental claims is very difficult due to the many uncertainties
surrounding these types of claims. These uncertainties exist because the
assignment of responsibility varies widely by state and claims often emerge
long after a policy has expired, which makes assignment of damages to the
appropriate party and to the time period covered by a particular policy
difficult. In establishing reserves for these types of claims, management
monitors the relevant facts concerning each claim, the current status of the
legal environment, the social and political conditions and the claim history
and trends within the Company and the industry.
During 2002, the Company re-evaluated the estimated ultimate losses for
direct asbestos and environmental exposures. Based on this re-evaluation, the
Company reallocated $752,000 of bulk IBNR reserves and $324,000 of settlement
expense reserves to these exposures. In addition, the Company diligently
evaluated the adequacy of its asbestos reserves by commissioning a "ground-up"
study to better quantify its exposure to asbestos liabilities. This study
concluded that the Company's exposure for direct asbestos claims ranged from
$1,000,000 to $5,100,000, with a point estimate of $3,000,000. Based on the
results of this study, the Company elected to increase the IBNR and
settlement expense reserves carried for direct asbestos exposures by
$2,069,000 at December 31, 2002, to $2,985,000. The study's results for
asbestos exposures on assumed reinsurance business were received during 2003,
and the Company elected to increase its IBNR reserves carried for assumed
asbestos exposures by $326,000 to the study's point estimate. The study and
its results assume no improvement in the current asbestos litigation
environment; however, continued efforts for federal legislation could reduce
the ultimate loss projections for asbestos litigation below the levels
currently projected for the industry.
The following table presents asbestos and environmental-related losses
and settlement expenses incurred and reserves outstanding for the Company:
Year ended December 31,
--------------------------
2004 2003 2002
------ ------ ------
(Dollars in thousands)
Losses and settlement expenses incurred:
Asbestos:
Property and casualty insurance ........ $ 186 $ - $2,378
Reinsurance ............................ - 293 (25)
------ ------ ------
186 293 2,353
------ ------ ------
Environmental:
Property and casualty insurance ........ 4 - 775
Reinsurance ............................ - - 21
------ ------ ------
4 - 796
------ ------ ------
Total losses and settlement
expenses incurred ................ $ 190 $ 293 $3,149
====== ====== ======
Loss and settlement expense reserves:
Asbestos:
Property and casualty insurance ........ $2,883 $2,885 $2,983
Reinsurance ............................ 667 732 534
------ ------ ------
3,550 3,617 3,517
------ ------ ------
Environmental:
Property and casualty insurance ........ 1,148 1,165 1,175
Reinsurance ............................ 762 802 835
------ ------ ------
1,910 1,967 2,010
------ ------ ------
Total loss and settlement expense
reserves ......................... $5,460 $5,584 $5,527
====== ====== ======
Based upon current facts, management believes the reserves established
for asbestos and environmental-related claims at December 31, 2004 are
adequate. Although future changes in the legal and political environment may
result in adjustments to these reserves, management believes any adjustments
will not have a material impact on the financial condition or results of
operations of the Company.
REINSURANCE CEDED
The following table presents amounts due to the Company from reinsurers
for losses and settlement expenses and prepaid reinsurance premiums as of
December 31, 2004:
2004
Amount Percent Best's
recoverable of total rating
----------- -------- ------
(Dollars in thousands)
Wisconsin Compensation Rating Bureau .. $ 6,917 23.1% (1)
Michigan Catastrophic Claims
Association (MCCA) .................. 5,579 18.6 (1)
XL Reinsurance America ................ 2,423 8.1 A+
Hartford Steam Boiler Inspection and
Insurance Company ................... 1,815 6.1 A+
Workers' Compensation Reinsurance
Association of Minnesota ............ 1,783 5.9 (1)
General Reinsurance Corporation ....... 1,411 4.7 A++
National Workers' Compensation
Reinsurance Pool .................... 1,212 4.0 (1)
Hannover Ruckversicherungs AG ......... 694 2.3 A
Partner Reinsurnance Company of US .... 630 2.1 A+
Platinum Underwriters Reinsurance ..... 617 2.1 A
Other Reinsurers ...................... 6,918 23.0
------- -----
Total ........................... $29,999(2) 100.0%
======= =====
(1) Amounts recoverable reflect the property and casualty insurance
subsidiaries' pool participation percentage of amounts ceded to these
organizations by Employers Mutual in connection with its role as "service
carrier." Under these arrangements, Employers Mutual writes business for
these organizations on a direct basis and then cedes 100 percent of the
business to these organizations. Credit risk associated with these
amounts is minimal as all companies participating in these organizations
are responsible for the liabilities of such organizations on a pro rata
basis.
(2) The total amount recoverable at December 31, 2004 represented $958,000
in paid losses and settlement expenses, $25,358,000 in unpaid losses
and settlement expenses and $3,683,000 in unearned premiums.
The effect of reinsurance on premiums written and earned, and losses and
settlement expenses incurred for the three years ended December 31, 2004 is
presented below. The 2003 losses and settlement expenses incurred amounts for
direct, assumed from affiliates, ceded to non-affiliates and ceded to
affiliates amounts incurred have been restated to reflect change in recording
claims associated with the MCCA. There was no effect on net losses and
settlement expenses incurred.
Year ended December 31,
------------------------------
2004 2003 2002
-------- -------- --------
(Dollars in thousands)
Premiums written:
Direct .......................... $191,823 $220,741 $235,597
Assumed from nonaffiliates ...... 4,125 3,817 3,985
Assumed from affiliates ......... 366,225 351,641 320,941
Ceded to nonaffiliates .......... (18,446) (15,809) (11,089)
Ceded to affiliates ............. (191,823) (220,741) (235,597)
-------- -------- --------
Net premiums written .......... $351,904 $339,649 $313,837
======== ======== ========
Premiums earned:
Direct .......................... $197,052 $221,662 $241,939
Assumed from nonaffiliates ...... 3,933 3,629 3,501
Assumed from affiliates ......... 359,605 341,948 304,463
Ceded to nonaffiliates .......... (18,060) (14,954) (10,921)
Ceded to affiliates ............. (197,052) (221,662) (241,939)
-------- -------- --------
Net premiums earned ........... $345,478 $330,623 $297,043
======== ======== ========
Losses and settlement expenses
incurred:
Direct .......................... $132,616 $176,461 $165,219
Assumed from nonaffiliates ...... 2,897 3,271 2,877
Assumed from affiliates ......... 258,134 239,683 206,614
Ceded to nonaffiliates .......... (11,225) (16,449) (2,433)
Ceded to affiliates ............. (132,616) (176,461) (165,219)
-------- -------- --------
Net losses and settlement
expenses incurred ........... $249,806 $226,505 $207,058
======== ======== ========
Property and Casualty Insurance
The parties to the pooling agreement cede insurance in the ordinary
course of business for the primary purpose of limiting their maximum loss
exposure. The pool participants also purchase catastrophe reinsurance to
cover multiple losses arising from a single event.
All major reinsurance treaties, with the exception of the pooling
agreement and a boiler treaty, are on an "excess-of-loss" basis whereby the
reinsurer agrees to reimburse the primary insurer for covered losses in excess
of a predetermined amount, up to a stated limit. The boiler treaty provides
for 100 percent reinsurance of the pool's direct boiler coverage written.
Facultative reinsurance from approved domestic markets, which provides
reinsurance on an individual risk basis and requires specific agreement of the
reinsurer as to the limits of coverage provided, is purchased when coverage by
an insured is required in excess of treaty capacity or where a high-risk type
policy could expose the treaty reinsurance programs.
Each type of reinsurance coverage is purchased in layers, and each layer
may have a separate retention level. Retention levels are adjusted according
to reinsurance market conditions and the surplus position of the EMC Insurance
Companies. The pooling arrangement aids efficient buying of reinsurance since
it allows for higher retention levels and correspondingly decreased dependence
on the reinsurance marketplace.
A summary of the reinsurance treaties benefiting the parties to the
pooling agreement during 2004 is presented below. Retention amounts reflect
the accumulated retentions and co-participation of all layers within a treaty.
Type of Reinsurance Treaty Retention Limits
-------------------------- ----------- --------------------------
Property per risk ........... $ 3,000,000 100 percent of $37,000,000
Property catastrophe ........ $14,450,000 95 percent of $90,000,000
Casualty .................... $ 2,000,000 100 percent of $38,000,000
Workers' compensation excess $ - $20,000,000 excess of
$40,000,000
Umbrella .................... $ 2,000,000 100 percent of $ 8,000,000
Fidelity .................... $ 1,200,000 95 percent of $ 4,000,000
Surety ...................... $ 2,200,000 91 percent of $14,000,000
Non-obligatory surety
quota share ............... $10,500,000 70 percent of $35,000,000
Boiler ...................... $ - 100 percent of $50,000,000
Terrorism aggregate excess-
of-loss ................... $36,000,000 70 percent of $70,000,000
Although reinsurance does not discharge the original insurer from its
primary liability to its policyholders, it is the practice of insurers for
accounting purposes to treat reinsured risks as risks of the reinsurer since
the primary insurer would only reassume liability in those situations where
the reinsurer is unable to meet the obligations it assumed under the
reinsurance agreements. The ability to collect reinsurance is subject to the
solvency of the reinsurers.
The major participants in the pool members' reinsurance programs during
2004 are presented below. The percentages represent the reinsurers' share of
the total reinsurance protection under all coverages. Each type of coverage
is purchased in layers, and an individual reinsurer may participate in more
than one type of coverage and at various layers within these coverages. The
property per risk, property catastrophe and casualty reinsurance programs are
handled by a reinsurance intermediary (broker). The reinsurance of those
programs is syndicated to approximately 50 domestic and foreign reinsurers.
In formulating reinsurance programs, Employers Mutual is selective in its
choice of reinsurers. Employers Mutual selects reinsurers on the basis of
financial stability and long-term relationships, as well as price of the
coverage. Reinsurers are generally required to have a Best's rating of "A-"
(Excellent) or higher and a minimum policyholders' surplus of $250,000,000.
Percent
of total 2004
Property per risk, property catastrophe reinsurance Best's
and casualty coverages: protection rating
- --------------------------------------- ---------- ------
Underwriters at Lloyd's of London .................... 28.2% A-
Mutual Reinsurance Bureau ............................ 14.4 (1)
Converium AG, (Switzerland) .......................... 8.0 B++
Hannover Ruckversicherung AG ......................... 6.2 A
Transatlantic Reinsurance Company .................... 4.7 A++
Folksamerica Reinsurance Company ..................... 3.5 A
XL Reinsurance America Inc. .......................... 3.1 A+
Workers' compensation excess coverage:
- --------------------------------------
Underwriters at Lloyd's of London .................... 72.7% A-
Catlin Insurance Company LTD ......................... 25.0 A
Umbrella coverage:
- ------------------
January 1 - June 30, 2004
Partner Reinsurance Company of the US ................ 27.5% A+
Platinum Underwriters Reinsurance, Inc. .............. 25.0 A
TOA Reinsurance Company of America ................... 17.5 A+
Hannover Ruckversicherung AG ......................... 30.0 A
July 1 - December 31, 2004
Partner Reinsurance Company of the US ................ 27.5% A+
Transatlantic Reinsurance Company .................... 27.5 A++
TOA Reinsurance Company of America ................... 17.5 A+
GE Reinsurance Corporation ........................... 15.0 A
Hannover Ruckversicherung AG ......................... 12.5 A
Fidelity and surety coverages:
- ------------------------------
Transatlantic Reinsurance Company .................... 40.0% A++
Partner Reinsurance Company of the US ................ 18.0 A+
Hannover Ruckversicherung AG ......................... 18.0 A
Everest Reinsurance Company .......................... 17.0 A+
Berkley Insurance Company ............................ 7.0 A
Boiler coverage:
- ----------------
Hartford Steam Boiler Inspection and Insurance Company 100.0% A+
Terrorism aggregate excess-of-loss:
- -----------------------------------
Axis Specialty Limited ............................... 40.0% A
Arch Reinsurance LTD ................................. 20.0 A-
Everest Reinsurance Company .......................... 10.0 A+
(1) Mutual Reinsurance Bureau (MRB) is composed of Employers Mutual and two
other non-affiliated mutual insurance companies. Each of the three
members cede primarily property insurance to MRB and assume, on an equal
and joint basis, proportionate shares of this business. Each member
benefits from the increased capacity provided by MRB. MRB is backed by
the financial strength of the three member companies. All of the members
of MRB were assigned an "A-" (Excellent) or better rating by A.M. Best.
Premiums ceded under the pool members' reinsurance programs by all pool
members and by the Company's property and casualty insurance subsidiaries for
the year ended December 31, 2004 are presented below. Each type of
reinsurance coverage is purchased in layers, and an individual reinsurer may
participate in more than one type of coverage and at various layers within the
coverages. Since each layer of coverage is priced separately, with the lower
layers being more expensive than the upper layers, a reinsurer's overall
participation in a reinsurance program does not necessarily correspond to the
amount of premiums it receives.
Premiums ceded by
-----------------------
Property
and casualty
All pool insurance
members subsidiaries
--------- ------------
Reinsurer (Dollars in thousands)
- ---------
Hartford Steam Boiler Inspection & Insurance Company $14,231 $ 3,344
Partner Reinsurance Company of the US .............. 4,917 1,156
Hannover Ruckversicherung AG ....................... 4,650 1,093
Transatlantic Reinsurance Company .................. 3,728 876
Axis Specialty Limited ............................. 3,179 747
Toa Reinsurance Company of America ................. 2,417 568
General Reinsurance Corporation..................... 1,888 444
Platinum Underwriters Reinsurance, Inc. ............ 1,815 426
Converium AG, Zurich ............................... 1,637 385
Converium Reinsurance (North America) .............. 1,382 325
Other Reinsurers ................................... 17,502 4,112
------- --------
Total ............................................ $57,346 $ 13,476
======= ========
The parties to the pooling agreement also cede reinsurance on both a
voluntary and a mandatory basis to state and national organizations in
connection with various workers' compensation and assigned risk programs and
to private organizations established to handle large risks. Premiums ceded by
all pool members and by the Company's property and casualty insurance
subsidiaries for the year ended December 31, 2004 are presented below.
Premiums ceded by
-----------------------
Property
and casualty
All pool insurance
members subsidiaries
--------- ------------
Reinsurer (Dollars in thousands)
- ---------
Wisconsin Compensation Rating Bureau ............... $16,917 $ 3,975
Michigan Catastrophic Claims Association ........... 1,484 349
North Carolina Reinsurance Facility ................ 1,480 348
Other Reinsurers ................................... 1,265 297
------- --------
Total ............................................ $21,146 $ 4,969
======= ========
The Terrorism Risk Insurance Act of 2002 ("TRIA") provides a temporary
Federal backstop on losses from certified terrorism events from foreign
sources and is effective until December 31, 2005. Coverage includes most
direct commercial lines of business, including coverage for losses from
nuclear, biological and chemical exposures. Each insurer has a deductible
amount, which is calculated as a percentage of the prior year's direct earned
commercial lines premiums and a ten percent retention above the deductible.
The percentage used in the deductible calculation increased from seven percent
in 2003 to ten percent in 2004 and to fifteen percent in 2005. TRIA caps
losses at $100 billion annually; no insurer that has met its deductible will
be liable for payment of any portion above that amount. Though it is
uncertain whether TRIA will be extended beyond 2005, it has and continues to
provide marketplace stability. As a result, coverage for terrorist events in
both the insurance and reinsurance markets is often available. For the
Company, the TRIA deductible will be approximately $40,500,000 in 2005. The
January 1, 2005 renewal of Employers Mutual's stand alone reinsurance coverage
for terrorism claims saw an increase in limits corresponding to the TRIA
deductible ($135,000,000 for the EMC Insurance Companies). The contract terms
provide for 70 percent coverage of $110,000,000 of terrorism losses in excess
of $25,000,000. Coverage includes all commercial lines of business, losses
from both certified and non-certified terrorist events, and nuclear,
biological and chemical coverage.
Reinsurance
The reinsurance subsidiary does not purchase outside reinsurance
protection due to the $1,500,000 cap on losses assumed per event under the
terms of the quota share agreement with Employers Mutual. The reinsurance
subsidiary pays an annual override commission to Employers Mutual for this
protection, which amounted to $4,394,000 in 2004. 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. This cost is recorded as a reduction to the premiums
received by the reinsurance subsidiary and amounted to $3,627,000 in 2004.
INVESTMENTS
As of December 31, 2004, the Company had total invested assets of $779.3
million, which are summarized in the following table:
December 31, 2004
-----------------------------------
Percent of
Carrying total at
($ in thousands) value Fair value fair value
-------- ---------- ----------
Fixed maturities, held-to-maturity .... $ 29,206 $ 30,594 3.9%
Fixed maturities, available-for-sale .. 619,654 619,654 79.4
Equity securities, available-for-sale 78,693 78,693 10.1
Short-term investments ................ 46,239 46,239 5.9
Other long-term investments ........... 5,550 5,550 0.7
-------- -------- -----
$779,342 $780,730 100.0%
======== ======== =====
At December 31, 2004, the portfolio of long-term fixed maturity
securities consists of 12.2 percent U.S. Treasury, 14.4 percent government
agency, 0.5 percent mortgage-backed, 41.1 percent municipal and 31.8 percent
corporate securities. As of December 31, 2004, all of the fixed maturity
securities were rated investment grade by nationally recognized rating
organizations, except $4.7 million of MCI Communications bonds that are non-
investment grade. The Company attempts to mitigate interest rate risk by
managing the duration of its fixed maturity portfolio. As of December 31,
2004, the effective duration of the Company's fixed maturity portfolio and
liabilities was 5.19 years and 2.8 years, respectively.
The Company's investment strategy is to conservatively manage its
investment portfolio by investing in equity securities and readily marketable,
investment grade fixed maturity securities. The Company does not have
exposure to foreign currency risk on its investments. The Company's equity
portfolio is diversified across a large range of industry sectors and is
managed by Harris Bank, N.A. for a fee that is based on total assets under
management. As of December 31, 2004, the equity portfolio was invested in the
following industry sectors: financial services - 23.5 percent, information
technology - 14.8 percent, healthcare - 13.4 percent, consumer discretionary -
10.1 percent, industrials - 13.8 percent, energy - 8.8 percent and other -
15.6 percent. The Company's board of directors has established investment
guidelines and periodically reviews the portfolio for compliance with those
guidelines.
EMPLOYEES
EMC Insurance Group Inc. and its subsidiaries have no employees. The
Company's business activities are conducted by the 2,216 employees of
Employers Mutual. EMC Insurance Group Inc., EMC Reinsurance Company and
Underwriters, LLC are charged their proportionate share of salary and employee
benefit costs based on time allocations. Costs not allocated to these
companies and other subsidiaries of Employers Mutual outside the pooling
agreement are charged to the participants in the pooling agreement. The
property and casualty insurance subsidiaries share the costs charged to the
pooling agreement in accordance with their pool participation percentages.
See "Organizational Structure - Property and Casualty Insurance."
REGULATION
The Company's insurance subsidiaries are subject to extensive regulation
and supervision by their state of domicile, as well as those states in which
they do business. The purpose of such regulation and supervision is primarily
to provide safeguards for policyholders, rather than to protect the interests
of stockholders. The insurance laws of the various states establish
regulatory agencies with broad administrative powers, including the power to
grant or revoke operating licenses and to regulate trade practices,
investments, premium rates, deposits of securities, the form and content of
financial statements and insurance policies, accounting practices and the
maintenance of specified reserves and capital for the protection of
policyholders.
Premium rate regulation varies greatly among jurisdictions and lines of
insurance. In most states in which the Company's subsidiaries write
insurance, premium rates for their lines of insurance are subject to either
prior approval or limited review upon implementation. States require rates
for property and casualty insurance that are adequate, not excessive, and not
unfairly discriminatory.
Like other insurance companies, the Company is required to participate in
mandatory shared market mechanisms or state pooling arrangements as a
condition for maintaining its insurance licenses to do business in various
states. The purpose of these state-mandated arrangements is to provide
insurance coverage to individuals who, because of poor driving records or
other underwriting reasons, are unable to purchase such coverage voluntarily
provided by private insurers. These risks can be assigned to all insurers
licensed in the state and the maximum volume of such risks that any one
insurance company may be assigned typically is proportional to that insurance
company's annual premium volume in that state. The underwriting results of
this mandatory business traditionally have been unprofitable.
The Company's insurance subsidiaries are required to file detailed annual
reports with the appropriate regulatory agency in each state where they do
business based on applicable statutory regulations, which differ from
generally accepted accounting principles. Their businesses and accounts are
subject to examination by such agencies at any time. Since EMC Insurance
Group Inc. and Employers Mutual are domiciled in Iowa, the State of Iowa
exercises principal regulatory supervision, and Iowa law requires periodic
examination. The Company's insurance subsidiaries are subject to examination
by state insurance departments on a periodic basis, as applicable law
requires.
State laws governing insurance holding companies also impose standards on
certain transactions with related companies, which include, among other
requirements, that all transactions be fair and reasonable and that an
insurer's surplus as regards policyholders be reasonable and adequate in
relation to its liabilities. Under Iowa law, dividends or distributions made
by registered insurers are restricted in amount and may be subject to approval
from the Iowa Commissioner of Insurance. "Extraordinary" dividends or
distributions are subject to prior approval and are defined as dividends or
distributions made within a 12 month period which exceed the greater of 10
percent of statutory surplus as regards policyholders as of the preceding
December 31, or net income of the preceding calendar year on a statutory
basis. North Dakota imposes similar restrictions on the payment of dividends
and distributions. At December 31, 2004, $32,232,101 was available for
distribution to the Company in 2005 without prior approval. See note 6 of
Notes to Consolidated Financial Statements under Item 8 of this Form 10-K.
Under state insurance guaranty fund laws, insurance companies doing
business in a state can be assessed for certain obligations of insolvent
insurance companies to such companies' policyholders and claimants. Maximum
contributions required by laws in any one year generally vary between one
percent and two percent of annual premiums written in that state, but it is
possible that caps on such contributions could be raised if there are numerous
or large insolvencies. In most states, guaranty fund assessments are
recoverable either through future policy surcharges or offsets to state
premium tax liabilities.
The NAIC utilizes a risk-based capital model to help state regulators
assess the capital adequacy of insurance companies and identify insurers that
are in, or are perceived as approaching, financial difficulty. This model
establishes minimum capital needs based on the risks applicable to the
operations of the individual insurer. The risk-based capital requirements for
property and casualty insurance companies measure three major areas of risk:
asset risk, credit risk and underwriting risk. Companies having less
statutory surplus than required by the risk-based capital requirements are
subject to varying degrees of regulatory scrutiny and intervention, depending
on the severity of the inadequacy. At December 31, 2004, the Company's
insurance subsidiaries had total adjusted statutory capital of $216,868,207,
which is well in excess of the minimum risk-based capital requirement of
$43,484,541.
AVAILABLE INFORMATION
The Company's internet address is www.emcinsurance.com. The Company's
Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on
Form 8-K and any amendments to these reports filed or furnished pursuant to
Section 13(a) of the Securities Exchange Act of 1934 are available through the
Company's website as soon as reasonably practicable after the filing or
furnishing of such material with the Securities and Exchange Commission.
EXECUTIVE OFFICERS OF THE COMPANY
- ---------------------------------
The Company's executive officers and their positions and ages at March 1,
2005, unless otherwise noted, are shown in the table below:
NAME AGE POSITION
---- --- --------
Bruce G. Kelley 51 President and Chief Executive Officer of the
Company and of Employers Mutual since 1992.
Treasurer of Employers Mutual from 1996 until
2000 and the Company from 1996 until February
2001. He was President and Chief Operating
Officer of the Company and Employers Mutual
from 1991 to 1992 and was Executive Vice
President of the Company and Employers Mutual
from 1989 to 1991. He has been employed by
Employers Mutual since 1985.
William A. Murray 58 Executive Vice President and Chief Operating
Officer of the Company and Employers Mutual
since 2001. He was Resident Vice President
and Branch Manager of Employers Mutual from
1992 until 2001. He has been employed by
Employers Mutual since 1985.
Ronald W. Jean 55 Executive Vice President for Corporate
Development of the Company and Employers
Mutual since 2000. He was Senior Vice
President - Actuary of the Company and
Employers Mutual from 1997 until 2000. He
was Vice President - Actuary of the Company
and Employers Mutual from 1985 until 1997.
He has been employed by Employers Mutual
since 1979.
Raymond W. Davis 59 Senior Vice President - Investments of the
Company and Employers Mutual since 1998.
Treasurer of the Company since 2001 and of
Employers Mutual since 2000. He was Vice
President - Investments of the Company and
Employers Mutual from 1985 until 1998. He
has been employed by Employers Mutual since
1979.
Donald D. Klemme 59 Senior Vice President - Administration and
Secretary of the Company since 1998. Senior
Vice President - Administration of Employers
Mutual since 1998. He was Vice President -
Administration and Secretary of the Company
from 1996 until 1998 and was Vice President -
Director of Internal Audit prior to that. He
has been employed by Employers Mutual since
1972.
David O. Narigon 52 Senior Vice President - Claims of the Company
and of Employers Mutual from 1998 until
March 1, 2005, when he resigned. He was
Vice President - Claims of the Company and
Employers Mutual from 1988 until 1998. He
was employed by Employers Mutual from 1983
until March 1, 2005.
Steven C. Peck 57 Senior Vice President - Actuary of the
Company and of Employers Mutual since 2003.
He was Vice President of the Company and of
Employers Mutual from 1997 until 2003. He
has been employed by Employers Mutual since
1984.
Mark E. Reese 47 Senior Vice President and Chief Financial
Officer of the Company and of Employers
Mutual since 2004. He was Vice President
of the Company and Employers Mutual from
1996 until 2004 and has been Chief Financial
Officer of the Company and Employers Mutual
since 1997. He has been employed by
Employers Mutual since 1984.
Richard K. Schulz 57 Senior Vice President - Claims of Employers
Mutual since March 1, 2005. He was Vice
President of Illinois EMCASCO from 1999 until
2005. He has been employed by Employers
Mutual since 1999.
ITEM 2. PROPERTIES.
- ------- -----------
The Company does not own any real property; however, one of the property
and casualty insurance subsidiaries, Dakota Fire, leases from EMC National
Life Company (an affiliate of Employers Mutual) approximately 18,000 square
feet of office space in which the Bismarck, North Dakota branch office is
located. The Company's home office, which also serves as the home office of
Employers Mutual, is located in three office buildings containing
approximately 437,000 square feet of space in Des Moines, Iowa, all of which
are owned by Employers Mutual. Employers Mutual also owns office buildings in
which the Minneapolis, Milwaukee and Lansing branch offices operate.
Employers Mutual leases approximately 208,000 square feet of office space in
16 other locations where other branch offices and service centers are located.
Hamilton Mutual Insurance Company leases a property in Cincinnati, Ohio that
serves as a branch office.
The Company's subsidiaries that do not participate in the pooling
arrangement (EMC Reinsurance Company and EMC Underwriters, LLC), as well as
subsidiaries of Employers Mutual that do not participate in the pooling
arrangement, are allocated rent expense based on the square footage occupied
by the respective operations. The remaining rent expense is attributed to the
pool and is allocated among the pool participants based on their respective
participation interests.
ITEM 3. LEGAL PROCEEDINGS.
- ------- ------------------
The Company and Employers Mutual and its other subsidiaries are parties
to numerous lawsuits arising in the normal course of the insurance business.
The Company believes that the resolution of these lawsuits will not have a
material adverse effect on its financial condition or its results of
operations. The companies involved have reserves that are believed adequate
to cover any potential liabilities arising out of all such pending or
threatened proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
- ------- ----------------------------------------------------
None.
PART II
-------
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS
- ------- ------------------------------------------------------------------
AND ISSUER PURCHASES OF EQUITY SECURITIES.
------------------------------------------
The Company's common stock trades on the NASDAQ National Market tier of
the NASDAQ Stock Market under the symbol EMCI.
The following table shows the high and low bid prices, as reported by
NASDAQ, and the dividends paid for each quarter within the two most recent
years.
2004 2003
--------------------------- ---------------------------
High Low Dividends High Low Dividends
------ ------ --------- ------ ------ ---------
1st Quarter $24.60 $20.00 $ .15 $19.45 $15.50 $ .15
2nd Quarter 25.51 19.11 .15 20.85 18.00 .15
3rd Quarter 24.00 18.02 .15 21.64 17.52 .15
4th Quarter 22.50 18.35 .15 22.10 16.40 .15
Close on Dec. 31 21.64 21.14
On February 24, 2005, there were approximately 1,150 registered
stockholders of the Company's common stock.
There are certain regulatory restrictions relating to the payment of
dividends by the Company's insurance subsidiaries (see note 6 of Notes to
Consolidated Financial Statements under Item 8 of this Form 10-K). It is the
present intention of the Company's Board of Directors to declare quarterly
cash dividends, but the amount and timing thereof, if any, is to be determined
by the Board of Directors at its discretion.
A dividend reinvestment and common stock purchase plan provides
shareholders with the option of receiving additional shares of common stock
instead of cash dividends. Participants may also purchase additional shares
of common stock without incurring broker commissions by making optional cash
contributions to the plan and may sell shares of common stock through the plan
(See Note 12 of Notes to Consolidated Financial Statements under Item 8 of
this Form 10-K). Employers Mutual Casualty Company participated in the
Dividend Reinvestment Plan in 2002, 2003 and the first two quarters of 2004.
Employers Mutual reinvested 50 percent of its dividends in additional shares
of the Company's common stock in all but the second and third quarters of
2003, when it reinvested 75 percent and 25 percent, respectively, and in 2002,
when it reinvested 25 percent. Due to its participation in the Company's
recent stock offering, Employers Mutual discontinued its participation in the
plan for the third and fourth quarters of 2004 and has indicated that it will
likely not participate in the plan in 2005. More information about the plan
can be obtained by calling UMB Bank, n.a., the Company's stock transfer agent
and plan administrator.
The following table sets forth information regarding purchases of equity
securities by the Company and affiliated purchasers for the three months ended
December 31, 2004:
Issurer Purchases of Equity Securities
- ------------------------------------------------------------------------------
(a) Total (b) Average (c) Total (d) Maximum Number
Number of Price Paid Number of (or Approximate
Shares Per Share Shares (or Dollar Value) of
(or Units) (or Unit) Units) Shares (or Units)
Purchased Purchased as that May Yet Be
Part of Purchased Under
Publicly The Plans or
Announced Programs
Plans or
Period Programs
- ------------------ ---------- ----------- ------------- ------------------
10/1/04 - 10/31/04 137 (1) $18.80 - -
11/1/04 - 11/30/04 296 (1) 20.98 - -
12/1/04 - 12/31/04 1,191 (1) 22.11 - -
---------- ----------- ------------- ------------------
Total 1,624 $21.62 - -
========== =========== ============= ==================
(1) All shares were purchased in the open market under the Company's dividend
reinvestment and common stock purchase plan.
ITEM 6. SELECTED FINANCIAL DATA.
- ------- ------------------------
Year ended December 31,
--------------------------------------------------------------------------------------------------
2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994
-------- -------- -------- -------- -------- -------- -------- -------- -------- -------- --------
($ in thousands, except per share amounts)
INCOME STATEMENT DATA
Insurance premiums
earned ................ $345,478 $330,623 $297,043 $265,280 $231,459 $211,098 $194,244 $177,218 $165,191 $162,266 $164,829
Investment income, net .. 29,900 29,702 32,778 30,970 29,006 25,761 24,859 23,780 24,007 23,204 21,042
Realized investment gains
(losses) .............. 4,379 1,170 (3,159) 800 1,558 277 5,901 4,100 1,891 1,043 520
Other income ............ 602 862 866 774 1,473 2,194 1,701 1,023 904 1,005 1,128
-------- -------- -------- -------- -------- -------- -------- -------- -------- -------- --------
Total revenues ..... 380,359 362,357 327,528 297,824 263,496 239,330 226,705 206,121 191,993 187,518 187,519
Losses and expenses ..... 364,788 334,375 305,636 303,366 262,431 245,321 223,031 189,318 171,324 163,202 168,842
-------- -------- -------- -------- -------- -------- -------- -------- -------- -------- --------
Income (loss) before
income tax expense
(benefit) ............. 15,571 27,982 21,892 (5,542) 1,065 (5,991) 3,674 16,803 20,669 24,316 18,677
Income tax expense
(benefit) ............. 2,386 7,633 5,790 (3,436) (1,264) (5,187) (2,339) 3,586 5,635 6,967 5,171
-------- -------- -------- -------- -------- -------- -------- -------- -------- -------- --------
Net income (loss) ..... $ 13,185 $ 20,349 $ 16,102 $ (2,106)$ 2,329 $ (804)$ 6,013 $ 13,217 $ 15,034 $ 17,349 $ 13,506
======== ======== ======== ======== ======== ======== ======== ======== ======== ======== ========
Net income (loss) per
common share - basic
and diluted: .......... $ 1.10 $ 1.78 $ 1.42 $ (.19)$ .21 $ (.07)$ .53 $ 1.18 $ 1.37 $ 1.62 $ 1.29
======== ======== ======== ======== ======== ======== ======== ======== ======== ======== ========
Premiums earned by
segment:
Property and casualty
insurance ........... $250,034 $241,237 $225,013 $203,393 $184,986 $167,265 $155,523 $143,113 $128,516 $126,440 $127,573
Reinsurance ........... 95,444 89,386 72,030 61,887 46,473 43,833 38,721 34,105 36,675 35,826 37,256
-------- -------- -------- -------- -------- -------- -------- -------- -------- -------- --------
Total ............. $345,478 $330,623 $297,043 $265,280 $231,459 $211,098 $194,244 $177,218 $165,191 $162,266 $164,829
======== ======== ======== ======== ======== ======== ======== ======== ======== ======== ========
Balance Sheet Data
Total assets ............ $934,816 $899,712 $674,864 $671,565 $587,676 $542,395 $496,046 $459,110 $430,328 $412,881 $387,370
======== ======== ======== ======== ======== ======== ======== ======== ======== ======== ========
Stockholders' equity .... $228,473 $180,751 $157,768 $140,458 $148,393 $141,916 $163,938 $162,346 $148,729 $136,889 $116,727
======== ======== ======== ======== ======== ======== ======== ======== ======== ======== ========
OTHER DATA
Average return on equity 6.4% 12.0% 10.8% (1.5)% 1.6% (.5)% 3.7% 8.5% 10.5% 13.7% 11.9%
======== ======== ======== ======== ======== ======== ======== ======== ======== ======== ========
Book value per share .... $ 16.84 $ 15.72 $ 13.84 $ 12.40 $ 13.14 $ 12.60 $ 14.26 $ 14.30 $ 13.42 $ 12.66 $ 11.03
======== ======== ======== ======== ======== ======== ======== ======== ======== ======== ========
Dividends paid per share $ .60 $ .60 $ .60 $ .60 $ .60 $ .60 $ .60 $ .60 $ .57 $ .53 $ .52
======== ======== ======== ======== ======== ======== ======== ======== ======== ======== ========
Property and casualty
insurance subsidiaries
aggregate pool
percentage ............ 23.5% 23.5% 23.5% 23.5% 23.5% 23.5% 23.5% 22% 22% 22% 22%
======== ======== ======== ======== ======== ======== ======== ======== ======== ======== ========
Reinsurance subsidiary
quota share percentage 100% 100% 100% 100% 100% 100% 100% 100% 95% 95% 95%
======== ======== ======== ======== ======== ======== ======== ======== ======== ======== ========
Closing stock price ..... $ 21.64 $ 21.14 $ 17.87 $ 17.15 $ 11.75 $ 9.13 $ 12.75 $ 13.25 $ 12.00 $ 13.75 $ 9.50
======== ======== ======== ======== ======== ======== ======== ======== ======== ======== ========
Net investment yield
(pre-tax) ............. 4.33% 4.81% 5.92% 6.31% 6.47% 5.96% 6.02% 6.15% 6.54% 6.65% 6.59%
======== ======== ======== ======== ======== ======== ======== ======== ======== ======== ========
Cash dividends to
closing stock price ... 2.8% 2.8% 3.4% 3.5% 5.1% 6.6% 4.7% 4.5% 4.8% 3.9% 5.5%
======== ======== ======== ======== ======== ======== ======== ======== ======== ======== ========
Common shares outstanding 13,569 11,501 11,399 11,330 11,294 11,265 11,496 11,351 11,084 10,814 10,577
======== ======== ======== ======== ======== ======== ======== ======== ======== ======== ========
Statutory trade combined
ratio ................. 104.2% 99.8% 101.3% 112.4% 113.5% 115.2% 114.8% 106.2% 103.6% 99.6% 101.3%
======== ======== ======== ======== ======== ======== ======== ======== ======== ======== ========
Amounts previously reported in prior consolidated financial statements have
been reclassified to conform to current presentation.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
- ------- ---------------------------------------------------------------
RESULTS OF OPERATIONS.
----------------------
The following discussion and analysis of EMC Insurance Group Inc. and its
subsidiaries' financial condition and results of operations should be read in
conjunction with the Consolidated Financial Statements and Notes to
Consolidated Financial Statements included elsewhere herein.
COMPANY OVERVIEW
EMC Insurance Group Inc., a 53.7 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 72.4
percent of consolidated premiums earned in 2004. 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 premiums, 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. Employers Mutual negotiates reinsurance agreements that provide
protection to the pool and each of its participants, including protection
against losses arising from catastrophic events.
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.
Effective December 31, 2003, the pooling agreement was amended to provide that
Employers Mutual will make up any shortfall or difference resulting from an
error in its systems and/or computational processes that would otherwise
result in the required restatement of the pool participants' financial
statements.
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.
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 directly reinsure
any of the insurance business written by Employers Mutual; however, the
reinsurance subsidiary assumes reinsurance business from the Mutual
Reinsurance Bureau pool and this pool provides a very small amount of
reinsurance protection to the EMC Insurance Companies. As a result, the
reinsurance subsidiary's assumed exposures include a very small portion of the
EMC Insurance Companies direct business, after ceded reinsurance protections
purchased by the Mutual Reinsurance Bureau pool are applied. In addition,
reinsurance subsidiary does not reinsure any "involuntary" facility or pool
business that Employers Mutual assumes pursuant to state law. 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.
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.
CHANGES FOR 2005
On October 20, 2004, the Company successfully completed a follow-on stock
offering and sold 2.0 million new shares of its common stock to the public at
a price of $18.75 per share. Employers Mutual participated in the stock
offering as a selling shareholder and sold 2.1 million shares of the Company's
common stock that it previously owned. As a result of these transactions,
Employers Mutual's ownership of the Company was reduced from approximately
80.9 percent to 53.7 percent.
Net proceeds from the follow-on stock offering totaled $34,890,000.
These proceeds were contributed to three of the Company's property and
casualty insurance subsidiaries in late December to support a planned 6.5
percentage point increase in the Company's aggregate participation in the
pooling agreement effective January 1, 2005. As a result of this change, the
Company's aggregate participation in the pooling agreement will increase from
the current 23.5 percent to 30.0 percent and Employers Mutual's participation
will decrease from the current 65.5 percent to 59.0 percent. In connection
with this change in the pooling agreement, the Company's liabilities will
increase $115,042,000 and assets will increase $108,798,000. The Company will
reimburse Employers Mutual $6,519,000 for expenses that were incurred to
generate the additional business assumed by the Company, but this expense will
be offset by an increase in deferred policy acquisition costs. The Company
will also receive $275,000 in interest income from Employers Mutual as the
actual cash transfer did not occur until February 15, 2005.
In addition to changing the individual pool participation percentages of
Employers Mutual and three of the Company's property and casualty insurance
subsidiaries, the pooling agreement has been amended effective January 1, 2005
to comply with certain conditions established by the Iowa Insurance Department
and A.M. Best Company. These amendments: (1) provide for a fixed term of
three years commencing January 1, 2005 and continuing until December 31, 2007,
during which period the pooling agreement may not be terminated and the
revised participation interests will not be further amended, absent the
occurrence of a material event not in the ordinary course of business that
could reasonably be expected to impact the appropriateness of the
participation interests in the pool; (2) provide that if a pool participant
becomes insolvent, or is otherwise subject to liquidation or receivership
proceedings, each of the other participants will, on a pro rata basis, adjust
their assumed portions of the pool liabilities in order to assume in full the
liabilities of the impaired participant, subject to compliance with all
regulatory requirements applicable to such adjustment under the laws of all
states in which the participants are domiciled; (3) clarify that all
development on prior years' outstanding losses and settlement expenses of the
participants will remain in the pool and be pro rated pursuant to the pooling
agreement; and (4) clarify that all liabilities incurred prior to a
participant withdrawing from the pool, and associated with such withdrawing
participant, shall remain a part of the pool and subject to the pooling
agreement.
As a result of the planned change in aggregate pool participation, the
reinsurance segment will have slightly less impact on the Company's financial
results in 2005 and beyond. For example, the reinsurance segment represented
approximately 28 percent of total premiums earned in 2004. Had the new 30
percent aggregate pool participation been in effect in 2004, the reinsurance
segment would have represented approximately 23 percent of total premiums
earned.
The successful completion of the follow-on stock offering will result in
the Company surpassing the Securities and Exchange Commission's market value
threshold for determination of accelerated filer status when the test is
performed at June 30, 2005. As a result, the Company will become subject to
accelerated filing deadlines beginning with the December 31, 2005 Annual
Report on Form 10-K.
INDUSTRY OVERVIEW
An insurance company's underwriting results reflect the profitability of
its insurance operations, excluding investment income. Underwriting results
are calculated by subtracting losses and expenses incurred from premiums
earned. An underwriting profit indicates that a sufficient amount of premium
income was received to cover the risks insured. An underwriting loss
indicates that premium income was not adequate. The combined ratio is a
measure utilized by insurance companies to gauge underwriting profitability
and is calculated by dividing losses and expenses incurred by premiums earned.
A number less than 100 generally indicates an underwriting gain; a number
greater than 100 generally indicates an underwriting loss.
Insurance pricing has historically been cyclical in nature. Periods of
excess capital and increased competition encourage price cutting and liberal
underwriting practices (referred to as a soft market) as insurance companies
compete for market share, while attempting to cover the inevitable
underwriting losses from these actions with investment income. As capital
decreases and competition begins to subside in the interest of strengthening
the balance sheet, premium pricing rises, sometimes dramatically, and
underwriting practices are tightened (referred to as a hard market). During
the late 1990's the insurance industry had hit the depths of an extremely long
soft market. High interest rates and a strong stock market allowed insurers
to cover ever growing underwriting losses with investment income. As the year
2000 approached, declining interest rates and a weakening stock market
prompted the insurance industry to begin a movement toward increased pricing.
This movement was dramatically accelerated by the terrorist attacks of
September 11, 2001, pushing the industry toward a hard market. The ensuing
plunge in the stock market, a further decline in interest rates, high profile
bankruptcies and rising concerns about reserve deficiencies lead the insurance
industry to implement large premium rate increases in an effort to improve
capitalization. This hard market continued through 2002, but began to level
off somewhat during 2003 as premium rate increases slowed, or even flattened,
in most lines of business. Premium rates were fairly stable during 2004, but
moderated slightly in certain lines of business and select territories due to
an increase in price competition. Overall premium rate levels for 2005 are
expected to remain steady or decline slightly due to improved industry
capitalization and continued price competition.
A substantial determinant of an insurance company's underwriting results
is its loss and settlement expense reserving. Insurance companies must
estimate the amount of losses and settlement expenses that will ultimately be
paid to settle claims that have occurred to date (loss and settlement expense
reserves). This estimation process is inherently subjective with the
possibility of widely varying results, particularly for certain highly
volatile types of claims (asbestos, environmental, and various casualty
exposures, such as products liability, where the loss amount and the parties
responsible are difficult to determine). During a soft market, inadequate
premium rates put pressure on insurance companies to under-estimate their loss
and settlement expense reserves in order to show a profit. Correspondingly,
inadequate reserves play an integral part in bringing about a hard market,
because increased profitability from higher premium rate levels can be used to
strengthen an insurance company's loss and settlement expense reserves.
Despite large reserve strengthening actions taken by the insurance industry
during 2003 and 2004, there continues to be concern about the magnitude of
potential reserve deficiencies, particularly for asbestos and pollution
exposures.
Insurance companies collect cash in the form of insurance premiums and pay
out cash in the form of loss and settlement expense payments. Additional cash
outflows occur through the payment of acquisition and underwriting costs such
as commissions, premium taxes, salaries and general overhead. During the loss
settlement period, which varies by line of business and by the circumstances
surrounding each claim and may cover several years, insurance companies invest
the cash premiums and earn interest and dividend income. This investment
income supplements underwriting results and contributes to net earnings. The
weakening economy during the period 2000 through 2002 prompted the Federal
Reserve Bank to reduce interest rates several times, to the point of historic
lows. As a result, called and matured fixed maturity securities have been
reissued at much lower interest rates, which has had a negative impact on the
insurance industry's investment income. Interest rates generally trended
upward in 2004, but are still significantly lower than historic levels.
Recent actions by New York Attorney General Eliot Spitzer have raised
questions concerning the use of contingent commission arrangements whereby
insurance companies provide agents with financial incentives in addition to
the traditional commission structure. The arrangements targeted by Attorney
General Spitzer are variously referred to as "placement service agreements" or
"market service agreements" and, in essence, compensate an agent for directing
business to a particular insurance company. The Company, like many others in
the insurance industry, uses contingent compensation arrangements to
compensate independent agents for the valuable services they provide to their
clients.
Determination of the legality and propriety of the compensation
arrangements targeted by Attorney General Spitzer will take time to resolve
through the investigative and judicial processes. The Company intends to
closely monitor these developments and will be diligent in reviewing and
assessing its internal practices, as well as its contingent compensation
arrangements, with a goal of ensuring that they are in compliance with all
legal requirements.
Attorney General Spitzer has also alleged the use of bid-rigging
practices by some in the insurance industry. Bid-rigging constitutes a
violation of federal and state laws and is strictly prohibited by the
Company's Code of Corporate Conduct.
The United States Congress is currently studying, or has placed on their
agenda, several issues of critical importance to the Company and the insurance
industry. These issues include Federal regulation on top of or in place of
current state-run regulation, tort and class-action reform, extension for an
additional year of the federal back-stop for terrorism losses contained in
TRIA, and asbestos liability determination and funding. The Company is
closely monitoring activities by the United States Congress on these issues
through its membership in various trade organizations.
MANAGEMENT ISSUES AND PERSPECTIVES
The insurance industry is highly regulated and very competitive, and its
operations are impacted by many economic and social factors. In order to be a
viable source of insurance protection in today's marketplace, an insurance
company must be strongly capitalized, carry a secure rating from A.M. Best
Company (which is considered to be the leading insurance rating agency), and
offer competitive products and excellent service. Management recognizes that
insurance agents and their customers have many options to choose from when
selecting an insurance carrier and continually emphasizes the need to meet and
exceed their expectations in these areas.
Management has long recognized the importance of adequate capitalization
for its insurance subsidiaries and has strived to maintain a strong capital
position by investing their assets conservatively and, more importantly,
maintaining a consistent level of loss and settlement expense reserve
adequacy. Carried reserves are analyzed on a regular basis and adjustments,
if necessary, are implemented on a timely basis. This procedure not only
assures a consistent level of reserve adequacy, it also minimizes the impact
that any required adjustment will have on current operations. This dedication
to reserve adequacy was demonstrated during 2003 and again during 2004 as the
Company strengthened loss and settlement reserves in the property and casualty
insurance segment in response to the findings of regularly-scheduled actuarial
evaluations.
In addition to an ongoing review of claim files in the normal course of
business, the Company has for many years required each of its 16 branch
offices to perform a complete inventory of its open claim files during the
fourth quarter of each year and to review the adequacy of each carried reserve
based on current information. This fourth quarter review process has not
historically resulted in a significant increase in carried reserves; however,
because of heightened emphasis placed on case reserve adequacy during 2004,
the review performed in the fourth quarter of 2004 generated a significant and
unanticipated increase in carried reserves and a corresponding increase in
settlement expense reserves. In an effort to minimize the likelihood of this
occurring in the future, beginning in the 2005 the branch offices will be
required to perform a complete inventory and review of their open claim files
semi-annually rather than annually as previously required. The first review
is to be completed by the end of June and the second review is to be completed
by the end of November each year. This new procedure is designed to help
assure that necessary reserve adjustments are implemented on a timely basis.
In addition to the recent actions taken to improve reserve adequacy,
effective March 1, 2005, Richard K. Schulz, a current employee of Employers
Mutual, became the senior claims executive officer. Mr. Schulz has been the
claims manager at the Chicago branch office for the last five years and has
over ten years of prior insurance industry experience. Mr. Schulz will report
to William A. Murray, Executive Vice President and Chief Operating Officer.
The participants in the EMC Insurance Companies pooling agreement
currently carry an "A-" (Excellent) rating from A.M. Best Company. Management
has worked diligently over the last several years to improve profitability
through a combination of adequate pricing and focused underwriting practices.
Maintaining a consistent level of profitability is a primary goal of
management that will assist the Company in its quest to achieve an even higher
rating from A.M. Best Company.
The products offered by an insurance company must be priced so that they
are competitive in the marketplace, yet offer the prospect of producing an
underwriting profit. Management is keenly aware of the need to achieve an
underwriting profit in today's marketplace and has implemented focused
underwriting initiatives that stress profitability over production. Achieving
an underwriting profit has become increasingly important during the last
several years as investment income, which is used to supplement underwriting
results and contribute to net earnings, has been negatively impacted by the
lingering low interest rate environment.
Catastrophe and storm losses are unpredictable and can vary significantly
from year to year. Management uses modeling software to help identify and
estimate its potential loss exposure to a variety of events, both natural and
manmade. Natural events that are modeled include hurricanes, tornados and
windstorms, and earthquakes. Modeling activities for manmade events are
primarily directed toward identifying concentrations of risk, such as workers'
compensation coverage for a business or property that is subject to a
terrorist attack or other manmade event. Management purchases reinsurance
protection to mitigate the Company's loss potential to these types of
exposures.
The Company has completed the majority of the documentation of its work
flow and internal controls over financial reporting as required by Section 404
of the Sarbanes-Oxley Act of 2002. Efforts during 2005 will focus on
remediation of any identified gaps in existing controls, testing of the
documented controls, remediation of any controls that are found to be not
working as designed and the establishment of a maintenance process.
Management expects to complete its evaluation of the Company's internal
controls over financial reporting by mid July, which will allow sufficient
time for the Company's independent auditors to perform their analysis and
testing procedures and issue their audit report on the Company's internal
controls over financial reporting as of December 31, 2005.
MEASUREMENT OF RESULTS
The Company's consolidated financial statements are prepared on the basis
of accounting principles generally accepted in the United States (also known
as "GAAP"). The Company also prepares financial statements for each of its
insurance subsidiaries based on statutory accounting principles that are filed
with insurance regulatory authorities in the states in which they do business.
Statutory accounting principles are designed to address the concerns of state
regulators and stress the measurement of the insurer's ability to satisfy its
obligations to its policyholders and creditors.
Management evaluates the Company's operations by monitoring key measures
of growth and profitability. Management measures the Company's growth by
examining direct premiums written and, perhaps more importantly, premiums
written assumed from affiliates. Management generally measures the Company's
operating results by examining the Company's net income, return on equity, and
the loss and settlement expense, acquisition expense and combined ratios. The
following provides further explanation of the key measures management uses to
evaluate the Company's results:
Direct Premiums Written. Direct premiums written is the sum of the total
policy premiums, net of cancellations, associated with policies underwritten
and issued by the Company's property and casualty insurance subsidiaries.
These direct premiums written are transferred to Employers Mutual under the
terms of the pooling agreement and are reflected in the Company's consolidated
financial statements as premiums written ceded to affiliates. See note 3 of
Notes to Consolidated Financial Statements.
Premiums Written Assumed From Affiliates. Premiums written assumed from
affiliates reflects the Company's property and casualty insurance
subsidiaries' 23.5 percent aggregate participation interest in the total
direct premiums written by all the participants in the pooling arrangement and
the premiums written assumed by the Company's reinsurance subsidiary from
Employers Mutual under the quota share agreement. See note 3 of Notes to
Consolidated Financial Statements. Management uses premiums written assumed
from affiliates and non-affiliates, which excludes the impact of written
premiums ceded to reinsurers, as a measure of the underlying growth of the
Company's insurance business from period to period.
Net Premiums Written. Net premiums written is the sum of the premiums
written assumed from affiliates plus premiums written assumed from non-
affiliates less premiums written ceded to non-affiliates. Premiums written
ceded to non-affiliates is the portion of the Company's direct and assumed
premiums written that is transferred to reinsurers in accordance with the
terms of the reinsurance contracts and based upon the risks they accept. See
note 3 of Notes to Consolidated Financial Statements. Management uses net
premiums written to measure the amount of business retained after cessions to
reinsurers.
Loss and Settlement Expense Ratio. The loss and settlement expense ratio
is the ratio (expressed as a percentage) of losses and settlement expenses to
premiums earned and measures the underwriting profitability of a company's
insurance business. The loss and settlement expense ratio is generally
measured on both a gross (direct and assumed) and net (gross less ceded)
basis. Management uses the gross loss and settlement expense ratio as a
measure of the Company's overall underwriting profitability of the insurance
business it writes and to assess the adequacy of the Company's pricing. The
net loss and settlement expense ratio is meaningful in evaluating the
Company's financial results, which are net of ceded reinsurance, as reflected
in the consolidated financial statements. The loss and settlement expense
ratios are generally calculated in the same way for GAAP and statutory
accounting purposes.
Acquisition Expense Ratio. The acquisition expense ratio is the ratio
(expressed as a percentage) of net acquisition and other expenses to premiums
earned and measures a company's operational efficiency in producing,
underwriting and administering its insurance business. For statutory
accounting purposes, acquisition and other expenses of an insurance company
exclude investment expenses. There is no such industry definition for
determining an acquisition expense ratio for GAAP purposes. As a result,
management applies the statutory definition to calculate the Company's
acquisition expense ratio on a GAAP basis. The net acquisition expense ratio
is meaningful in evaluating the Company's financial results, which are net of
ceded reinsurance, as reflected in the consolidated financial statements.
GAAP Combined Ratio. The combined ratio is the sum of the loss and
settlement expense ratio and the acquisition expense ratio and measures a
company's overall underwriting profit. If the combined ratio is at or above
100, an insurance company cannot be profitable without investment income (and
may not be profitable if investment income is insufficient). Management uses
the GAAP combined ratio in evaluating the Company's overall underwriting
profitability and as a measure for comparison of the Company's profitability
relative to the profitability of its competitors who prepare GAAP-basis
financial statements.
Statutory Combined Ratio. The statutory combined ratio is calculated in
the same manner as the GAAP combined ratio, but is based on results determined
pursuant to statutory accounting rules and regulations. The statutory "trade
combined ratio" differs from the statutory combined ratio in that the
acquisition expense ratio is based on net premiums written rather than
premiums earned. Management uses the statutory trade combined ratio as a
measure for comparison of the Company's profitability relative to the
profitability of its competitors, all of whom must file statutory-basis
financial statements with insurance regulatory authorities.
CRITICAL ACCOUNTING POLICIES
The following accounting policies are considered by management to be
critically important in the preparation and understanding of the Company's
financial statements and related disclosures. The assumptions utilized in the
application of these accounting policies are complex and require subjective
judgment.
Loss and settlement expense reserves
Processes and assumptions for establishing loss and settlement expense
reserves
Liabilities for losses are based upon case-basis estimates of reported
losses and estimates of incurred but not reported ("IBNR") losses. For direct
insurance business, 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. An estimate of the expected expenses to be incurred in the
settlement of the claims provided for in the loss reserves is established as
the liability for settlement expenses.
Property and Casualty Insurance Segment
- ---------------------------------------
The Company's claims department establishes case loss reserves for direct
business. Branch claims personnel establish case reserves for individual
claims, with mandatory home office claims department review of reserves that
exceed a specified threshold. This reserving process implicitly assumes a
stable inflationary and legal environment. The Company's case loss reserve
philosophy is exposure based and implicitly assumes a stable inflationary and
legal environment. When claims department personnel establish loss reserves
they take into account various factors that influence the potential exposure,
such as the types of injuries being claimed, whether the insured is a target
defendant, the jurisdiction in which a potential court case would be litigated
and negligence of other parties. The goal of the claims department is to
establish and maintain loss reserves that are sufficient, but not excessive.
Most of the IBNR reserves for direct business are established through an
actuarial analysis of IBNR claims that have emerged after the end of recent
calendar years compared to the corresponding calendar year earned premiums
(adjusted for changes in rate level adequacy). The methodology used in
estimating these formula IBNR reserves assumes consistency in claims reporting
patterns and immaterial changes in loss development patterns due to loss cost
trends. From this analysis, IBNR factors are derived for each line of
business and are applied to the latest twelve months of earned premiums to
generate the formula IBNR reserves.
Ceded reserves are derived by applying the ceded contract terms to the
direct reserves. For excess of loss contracts (excluding the catastrophe
contract), this is accomplished by applying the ceded contract terms to the
case reserves of the ceded claims. For the catastrophe excess of loss
contract, ceded reserves are calculated by applying the contract terms to both
the aggregate case reserves on claims stemming from catastrophes and the
estimate of IBNR reserves developed for each individual catastrophe. For
quota share contracts, ceded reserves are calculated as the quota share
percentage multiplied by both case and IBNR reserves on the direct business.
The methodology used for reserving settlement expenses is based on an
analysis of historical ratios of paid expenses to paid losses. Assumptions
underlying this methodology include stability in the mix of business,
consistent claims processing procedures, immaterial impact of loss cost trends
on development patterns, and a consistent philosophy regarding the defense of
lawsuits. Based on this actuarial analysis, factors are derived for each line
of business, which are applied to loss reserves to generate the settlement
expense reserves.
As of December 31, 2004, IBNR loss reserves accounted for $55,720,000, or
18.0 percent, of the property and casualty insurance segment's total loss and
settlement expense reserves, compared to $49,259,000, or 19.6 percent at
December 31, 2003. IBNR reserves are, by nature, less precise than case
reserves. A five percent change in IBNR reserves at December 31, 2004 would
equate to a $2,786,000 change in loss reserves, which would represent 13.7
percent of net income and 0.8 percent of stockholders' equity.
The Company's direct IBNR reserves are established by applying factors to
the latest twelve months premiums earned. These factors are developed using a
methodology that compares (1) IBNR claims that have emerged after prior year-
ends to (2) corresponding prior years' premiums earned that have been adjusted
to the current level of rate adequacy. Included in the rate adequacy
adjustment is consideration of current frequency and severity trends compared
to the trends underlying prior years' calculations. The selected trends are
based on an analysis of industry and Company loss data. This methodology
assumes that future emerged IBNR claims relative to IBNR claims that have
emerged after prior year-ends will reflect the change in frequency and
severity trends underlying the rate adequacy adjustments. If this projected
relationship proves to be inaccurate, future IBNR claims may differ
substantially from the estimated IBNR reserves.
Following is a summary of the carried loss and settlement expense
reserves for the property and casualty insurance segment at December 31, 2004
and 2003.
December 31, 2004
-----------------------------------------
Settlement
Line of Business Case IBNR Expense Total
- ---------------- -------- ------- ------- --------
($ in thousands)
Commercial lines:
Automobile ..................... $ 31,139 $ 5,798 $ 6,987 $ 43,924
Property ....................... 8,339 2,468 1,816 12,623
Workers compensation ........... 80,615 16,928 13,315 110,858
Liability ...................... 50,561 25,631 34,055 110,247
Bonds .......................... 1,028 731 613 2,372
-------- ------- ------- --------
Total commercial lines ....... 171,682 51,556 56,786 280,024
-------- ------- ------- --------
Personal lines:
Automobile ..................... 17,271 2,275 2,339 21,885
Property ....................... 5,019 1,889 1,155 8,063
Total personal lines ......... 22,290 4,164 3,494 29,948
-------- ------- ------- --------
Total property and casualty
insurance segment .......... $193,972 $55,720 $60,280 $309,972
======== ======= ======= ========
December 31, 2003
-----------------------------------------
Settlement
Line of Business Case IBNR Expense Total
-------- ------- ------- --------
($ in thousands)
Commercial lines:
Automobile ..................... $ 27,807 $ 5,784 $ 6,427 $ 40,018
Property ....................... 7,582 2,372 1,690 11,644
Workers compensation ........... 63,275 13,348 10,220 86,843
Liability ...................... 38,241 22,457 25,542 86,240
Other .......................... 889 656 436 1,981
-------- ------- ------- --------
Total commercial lines ....... 137,794 44,617 44,315 226,726
-------- ------- ------- --------
Personal lines:
Automobile ..................... 11,968 2,468 2,260 16,696
Property ....................... 4,566 2,174 1,098 7,838
Total personal lines ......... 16,534 4,642 3,358 24,534
-------- ------- ------- --------
Total property and casualty
insurance segment .......... $154,328 $49,259 $47,673 $251,260
======== ======= ======= ========
Internal actuarial evaluations of overall loss reserve levels are
performed quarterly for all direct lines of business. There is a certain
amount of random variation in loss development patterns, which results in some
uncertainty regarding projected ultimate losses, particularly for longer tail
lines such as workers' compensation, other liability and commercial auto
liability. Therefore, the reasonability of the actuarial projections is
regularly monitored through an examination of loss ratio and claims severity
trends implied by these projections.
Historically, individual case reserves established by the claims
department have been adequate. However, actuarial analyses performed during
2003 indicated that overall case reserves appeared to be somewhat inadequate.
This apparent inadequacy was driven by the workers' compensation line of
business, where adverse development more than offset the favorable development
experienced on all other lines of business combined. Further analysis
revealed that recent adverse development experienced in the workers'
compensation line of business was arising from both the indemnity and medical
portion of the claims. The underlying data indicated that the aggregate
liability associated with time away from work was somewhat underestimated and
that permanent injury awards were somewhat underestimated and/or not
anticipated when the reserves were established. In response to these
findings, the Company established a bulk case reserve for the workers'
compensation line of business to supplement the individual case reserves. An
actuarial evaluation of case reserve adequacy is now performed each quarter,
which resulted in additional increases in the bulk case reserve during 2004.
To address the underlying cause of the indicated deficiency in case
reserves, the home office claims department in early 2004 instructed each of
the 16 branch offices to review and carefully reevaluate all claim reserves
for adequacy. As a result of these reviews, case reserves were strengthened
significantly in both the second and third quarters of 2004 and the third
quarter actuarial review indicated that case reserves, as well as total loss
and settlement expense reserves, were adequate. However, during the required
fourth quarter inventory and review process, the branch offices further
strengthened their case reserves, generating a significant amount of adverse
development on prior years' reserves. With this additional strengthening,
carried loss and settlement expense reserves are toward the high end of the
range of actuarial reserve indications at December 31, 2004.
One of the variables impacting the estimation of IBNR reserves is the
assumption that the vast majority of future construction defect losses will
continue to occur in those states in which most construction defect claims
have historically arisen. Since the vast majority of these losses have been
confined to a relatively small number of states, which is consistent with
industry experience, there is no provision in the IBNR reserve for a
significant spread of construction defect claims to other states. It is also
assumed that various underwriting initiatives implemented in recent years will
gradually mitigate the amount of construction defect losses experienced.
These initiatives include exclusionary endorsements, increased care regarding
additional insured endorsements, a general reduction in the amount of
contractor business written relative to the total commercial lines book of
business and underwriting restrictions on the writing of residential
contractors. The estimation of the Company's IBNR reserves also does not
contemplate substantial losses from potential mass torts such as Methyl
Tertiary Butyl Ether (a gasoline additive that reduces emissions, but causes
pollution), tobacco, silicosis, cell phones and lead. Further, consistent
with general industry practice, the IBNR reserve for all liability lines does
not provide for any significant retroactive expansion of coverage through
judicial interpretation. If these assumptions prove to be incorrect, ultimate
paid amounts on emerged IBNR claims may differ substantially from the carried
IBNR reserves.
As previously noted, the estimation of settlement expense reserves
assumes a consistent claims department philosophy regarding the defense of
lawsuits. If the Company should in the future take a more aggressive defense
posture, defense costs would increase and it is likely that carried settlement
expense reserves would be deficient. However, such a change in philosophy
could be expected to reduce losses, generating some offsetting redundancy in
the loss reserves.
An important assumption underlying aggregate reserve estimation methods
is that the claims inflation trends implicitly built into the loss and
settlement expense development patterns will continue into the future. To
estimate the sensitivity of the estimated ultimate loss and settlement expense
payments to an unexpected change in inflationary trends, the actuarial
department derived expected payment patterns separately for each major line of
business. These patterns were applied to the December 31, 2004 loss and
settlement expense reserves to generate estimated annual incremental loss and
settlement expense payments for each subsequent calendar year. Then, for the
purpose of sensitivity testing, an explicit annual inflationary trend of one
percent was added to the inflationary trend that is implicitly embedded in the
estimated payment pattern, and revised incremental loss and settlement expense
payments were calculated. This additional unexpected claims inflation trend
could arise from a variety of sources including a general increase in economic
inflation, social inflation and, especially for the workers' compensation line
of business, the introduction of new medical technologies and procedures,
changes in the utilization of procedures and changes in life expectancy. The
estimated cumulative impact that this additional unexpected one percent
increase in the inflationary trend would have on the Company's results of
operations over the lifetime of the underlying claims is shown below.
After-tax
Line of business impact on earnings
---------------- ------------------
($ in thousands)
Personal auto liability ........... $ 149
Commercial auto liability ......... 511
Auto physical damage .............. 15
Workers' compensation ............. 3,357
Other liability ................... 2,879
Property .......................... 82
Homeowners ........................ 44
The property and casualty insurance companies have exposure to
environmental and asbestos claims arising primarily from the other liability
line of business. This exposure is closely monitored by management, and the
Company has established IBNR reserves to cover estimated ultimate losses.
Currently, asbestos reserves are based on the results of an independent
consultant's ground-up study of the Company's asbestos exposures, which was
completed in early 2003. Environmental reserves are established with
consideration to the implied three-year survival ratio (ratio of loss reserves
to the three-year average of loss payments). Estimation of ultimate
liabilities for these exposures is unusually difficult due to unresolved
issues such as whether coverage exists, the definition of an occurrence, the
determination of ultimate damages and the allocation of such damages to
financially responsible parties. Therefore, any estimation of these
liabilities is subject to greater than normal variation and uncertainty, and
ultimate payments for losses and settlement expenses for these exposures may
differ significantly from the carried reserves.
Reinsurance Segment
- -------------------
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
reinsurance pool in which Employers Mutual participates with other
unaffiliated insurers.
The primary actuarial methods used to project ultimate policy year losses
on the assumed reinsurance business are paid development, incurred development
and Bornhuetter-Ferguson, a recognized actuarial methodology. The assumptions
underlying the various projection methods include stability in the mix of
business, consistent claims processing procedures, immaterial impact of loss
cost trends on development patterns, consistent case reserving practices and
appropriate Bornhuetter-Ferguson expected loss ratio selections.
For the HORAD component, Employers Mutual records the case and IBNR
reserves reported by the ceding companies. Since many ceding companies in the
HORAD book of business do not report IBNR reserves, Employers Mutual
establishes a bulk IBNR reserve, which is based on an actuarial reserve
analysis, to cover the lag in reporting. For MRB, Employers Mutual records
the case and IBNR reserves reported to it by the management of the pool, along
with a relatively small IBNR reserve to cover a one month reporting lag. To
verify the adequacy of the reported reserves, an actuarial evaluation of MRB's
reserves is performed at each year-end.
Settlement expense reserves for both the HORAD and MRB books of business
are developed through the application of factors to carried loss reserves. The
factors are derived from an analysis of paid settlement expenses to paid
losses. The assumptions described for the property and casualty insurance
segment also apply to the reinsurance segment settlement expense reserving
process.
At December 31, 2004, the carried reserves for HORAD and MRB combined
were in the upper quarter of the range of actuarial reserve indications. This
conservative selection reflects the fact that there are inherent uncertainties
involved in establishing reserves for assumed reinsurance business. Such
uncertainties include the fact that a reinsurance company generally has less
knowledge than the ceding company about the underlying book of business and
the ceding company's reserving practices. Because of these uncertainties,
there is a risk that the reinsurance segment's reserves for losses and
settlement expenses could prove to be inadequate, with a consequent adverse
impact on the Company's future earnings and stockholders' equity.
At December 31, 2004, there was no backlog in the processing of assumed
reinsurance information. Approximately $72,525,000 or 61 percent of the
reinsurance segment's carried reserves were reported by the ceding companies.
Employers Mutual receives loss reserve and paid loss data from the ceding
companies on individual excess-of-loss business. If a claim involves a single
or small group of claimants, a summary of the loss and claim outlook is
normally provided. Summarized data is provided for catastrophe claims and pro
rata business, which is subject to closer review if inconsistencies are
suspected. Unearned premiums are generally reported on pro rata accounts, but
are usually calculated by Employers Mutual on excess-of-loss business.
Carried reserves established in addition to those reported by the ceding
companies totaled approximately $47,196,000 at December 31, 2004. Since many
ceding companies in the HORAD book of business do not report IBNR reserves,
Employers Mutual establishes a bulk IBNR reserve to cover the lag in
reporting. For the few ceding companies that do report IBNR reserves,
Employers Mutual carries them as reported. These reported IBNR reserves are
subtracted from the total IBNR reserve calculated by Employers Mutual's
actuaries, with the difference carried as bulk IBNR reserves. Except for a
small IBNR reserve established to cover a one-month lag in reporting, the MRB
IBNR reserve is established by the management of MRB. Employers Mutual rarely
records additional case reserves.
Assumed reinsurance losses tend to be reported later than direct losses.
This lag is reflected in loss projection factors for assumed reinsurance that
tend to be higher than for direct business. The result is that assumed
reinsurance IBNR reserves as a percentage of total reserves tend to be higher
than for direct reserves. IBNR reserves totaled $66,092,000 and $58,427,000
at December 31, 2004 and 2003, respectively, and accounted for approximately
55% and 50% percent, respectively, of the reinsurance segment's total loss
reserves. IBNR reserves are, by nature, less precise than case reserves. A
five percent change in IBNR reserves at December 31, 2004 would equate to a
$3,305,000 change in loss reserves, which would represent 16.3 percent of net
income and 0.9 percent of stockholders' equity.
Following is a summary of the carried loss and settlement expense
reserves for the reinsurance segment at December 31, 2004 and 2003.
December 31, 2004
-----------------------------------------
Settlement
Line of Business Case IBNR Expense Total
- ---------------- -------- ------- ------- --------
($ in thousands)
Pro Rata Reinsurance:
Property and casualty ........ $ 3,125 $ 2,899 $ 237 $ 6,261
Property ..................... 6,097 7,127 335 13,559
Crop ......................... 1,034 36 54 1,124
Casualty ..................... 2,267 4,418 296 6,981
Marine/Aviation .............. 9,187 7,802 890 17,879
-------- ------- ------- --------
Total pro rata reinsurance 21,710 22,282 1,812 45,804
-------- ------- ------- --------
Excess Reinsurance:
Excess per risk reinsurance:
Property ..................... 9,961 11,805 475 22,241
Casualty ..................... 16,436 31,050 1,719 49,205
Surety ....................... 1,440 955 60 2,455
-------- ------- ------- --------
Total excess per risk
reinsurance .............. 27,837 43,810 2,254 73,901
-------- ------- ------- --------
Total reinsurance segment .. $ 49,547 $66,092 $ 4,066 $119,705
======== ======= ======= ========
December 31, 2003
-----------------------------------------
Settlement
Line of Business Case IBNR Expense Total
- ---------------- -------- ------- ------- --------
($ in thousands)
Pro Rata Reinsurance:
Property and casualty ........ $ 3,881 $ 2,564 $ 206 $ 6,651
Property ..................... 6,824 9,031 276 16,131
Crop ......................... 683 35 18 736
Casualty ..................... 2,703 4,714 237 7,654
Marine/Aviation .............. 8,273 5,599 1,049 14,921
-------- ------- ------- --------
Total pro rata reinsurance 22,364 21,943 1,786 46,093
-------- ------- ------- --------
Excess Reinsurance:
Excess per risk reinsurance:
Property ..................... 11,190 10,695 373 22,258
Casualty ..................... 18,959 24,835 1,859 45,653
Surety ....................... 1,690 954 16 2,660
-------- ------- ------- --------
Total excess per risk
reinsurance .............. 31,839 36,484 2,248 70,571
-------- ------- ------- --------
Total reinsurance segment .. $ 54,203 $58,427 $ 4,034 $116,664
======== ======= ======= ========
To ensure the accuracy and completeness of the information received from
the ceding companies, the actuarial department carefully reviews the latest
four HORAD policy years on a quarterly basis, and all policy years on an
annual basis. Any significant departures from historical reporting patterns
are brought to the attention of the reinsurance department staff, who check
the bookings for accuracy and, if necessary, contact the ceding company or
broker for clarification.
Employers Mutual's actuarial department annually reviews the MRB reserves
for reasonableness. These analyses use a variety of actuarial techniques,
which are applied at a line-of-business level. MRB staff supplies the reserve
analysis data, which is verified for accuracy by Employers Mutual's actuaries.
This review process is replicated by certain other MRB member companies, using
actuarial techniques they deem appropriate. Based on these reviews, Employers
Mutual and the other MRB member companies have consistently found the MRB
reserves to be appropriate.
For the HORAD book of business, paid and incurred loss development
patterns for relatively short-tail lines of business (property and marine) are
based on data reported by the ceding companies. Employers Mutual has
determined that there is sufficient volume and stability in the reported
losses to base projections of ultimate losses on these patterns. For longer
tail lines of business (casualty), industry incurred development patterns are
referenced due to the instability of development patterns based on reported
historical losses.
For long-tail lines of business, unreliable estimates of unreported
losses can result from the application of loss projection factors to reported
losses. To some extent, this is also true for short-tail lines of business in
the early stages of a policy year's development. Therefore, in addition to
loss-based projections, we generate estimates of unreported losses based on
earned premiums. The latter estimates are sometimes more stable and reliable
than projections based on losses.
Disputes with ceding companies do not occur often. Employers Mutual
performs claims audits and 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, 2004.
Toxic tort (primarily asbestos), environmental and other uncertain exposures
- ----------------------------------------------------------------------------
Toxic tort claims include those claims where the claimant seeks
compensation for harm allegedly caused by exposure to a toxic substance or
substance that increases the risk of contracting a serious disease, such as
cancer. Typically the injury is caused by latent effects of direct or
indirect exposure to a substance or combination of substances through
absorption, contact, ingestion, inhalation, implantation or injection.
Examples of toxic tort claims include injuries arising out of exposure to
asbestos, silica, mold, drugs, carbon monoxide, chemicals or lead.
Asbestos and environmental losses paid by the Company have averaged only
$244,000 per year over the past five years. During 2002, the Company re-
evaluated the estimated ultimate loss projections for asbestos exposures.
Based on this re-evaluation, the Company reallocated $176,000 of bulk IBNR
reserves and $74,000 of settlement expense reserves to direct asbestos
exposures. In addition, the Company diligently evaluated the adequacy of its
asbestos reserves by commissioning a "ground-up" study to better quantify its
exposure to asbestos liabilities. This study concluded that the Company's
exposure for direct asbestos claims ranged from $1,100,000 to $5,100,000, with
a point estimate of $3,000,000. Based on the results of this study, the
Company elected to increase the IBNR and settlement expense reserves carried
for direct asbestos exposures by $2,069,000 at December 31, 2002, to
$2,985,000. The study's results for asbestos exposures on assumed reinsurance
business were received during 2003, and the Company elected to increase its
IBNR reserves carried for assumed asbestos exposures by $326,000 to the
study's point estimate. The study and its results assume no improvement in
the current asbestos litigation environment; however, continued efforts for
federal legislation could reduce the ultimate loss projections for asbestos
litigation below the levels currently projected for the industry.
Since 1989, the Company has included an asbestos exclusion in liability
policies issued for most lines of business. The exclusion prohibits liability
coverage for "bodily injury", "personal injury" or "property damage"
(including any associated clean-up obligations) arising out of the
installation, existence, removal or disposal of asbestos or any substance
containing asbestos fibers. Therefore, the Company's present asbestos
exposures are primarily limited to commercial policies issued prior to 1989.
At present, the Company is defending approximately 500 asbestos bodily injury
lawsuits. Most of these defenses are subject to express reservation of rights
based upon the lack of an injury within the Company's policy periods because
many asbestos lawsuits do not specifically allege dates of asbestos exposure
or dates of injury. The Company's policyholders that have been named as
defendants in these asbestos lawsuits are peripheral defendants who have had
little or no exposure and are routinely dismissed from asbestos litigation
with nominal or no payment at all (i.e., small contractors, insulators,
electrical welding supply, furnace manufacturers, gasket, and building supply
companies).
During 2003, as a direct result of proposed federal legislation in the
areas of asbestos and class action reform, the Company was presented with
several hundred additional lawsuits filed against three former policyholders
representing approximately 40,500 claims related to exposure to asbestos or
asbestos containing products. These claims are based upon nonspecific
asbestos exposure and nonspecific injuries. As a result, management did not
establish a significant amount of loss reserves associated with these claims.
The vast majority of the 40,500 claims are multi-plaintiff suits filed in
Mississippi. One lawsuit lists multiple named plaintiffs of approximately
2,000 individuals. While the expense of handling these lawsuits is higher
than what the Company has averaged in the past, it is not proportional based
upon the number of plaintiffs, and is mitigated to some extent through cost
sharing agreements reached with other insurance companies. The Company
believes its settlement expense reserve adequately accounts for these
additional expenses.
The Company has denied coverage to one of the former policyholders,
representing approximately 10,000 claims, because of express asbestos
exclusion language contained in the policy. Minimal expense payments have
been made to date on the lawsuits related to the other two former
policyholders and no payments have been made for either defense or indemnity.
Four former policyholders and one current policyholder dominate the Company's
asbestos claims. To date, actual losses paid have been minimal due to the
plaintiffs' failure to identify an asbestos-containing product to which they
were exposed that is associated with the Company's policyholders. Defense
costs, on the other hand, have typically increased due to the increased number
of parties involved in the litigation and the length of time required to
obtain a favorable judgment. Whenever possible, the Company has participated
in cost sharing agreements with other insurance companies to reduce overall
asbestos claim expenses.
While proposed federal asbestos legislation was not successful in 2004,
plaintiffs' attorneys have already altered their pleadings across the country
to anticipate the enactment of federal legislation. Specifically, asbestos
plaintiffs' attorneys are pleading "silica" and "pnuemoconisis dust" exposure
for new clients, as well as former asbestos plaintiffs. The Company is
defending approximately 200 such claims in Texas and Mississippi
jurisdictions, some of which involve multiple plaintiffs. The plaintiffs
allege employment exposure to "airborne respirable silica dust," causing
"serious and permanent lung injuries," i.e., silicosis. Silicosis injuries
are identified in the upper lobes of the lungs while asbestos injuries are
localized in the lower lobes.
The plaintiffs in the silicosis lawsuits are sandblasters, gravel and
concrete workers, ceramic workers and road construction workers. All of these
defenses are subject to express reservation of rights based upon the lack of
an injury within the Company's policy periods because many silica lawsuits,
like asbestos lawsuits, do not specifically allege dates of exposure or dates
of injury. The Company's policyholders (a refractory product manufacturer,
small local concrete and gravel companies and a concrete cutting machine
manufacturer) that have been named as defendants in these silica lawsuits have
had little or no exposure and are routinely dismissed from silica litigation
with nominal, or no, payment. While the expense of handling these lawsuits is
high, it is not proportional based upon the number of plaintiffs, and is
mitigated to some extent through cost sharing agreements reached with other
insurance companies.
In 2004, the Company developed, filed and attached "pneumoconiosis dust
exclusions" in the majority of jurisdictions where such action was warranted.
"Mixed dust" is defined as dust, or a mixture of dusts, composed of one or
more of the following: asbestos, silica, fiberglass, iron, tin, coal, cement,
cadminium, carbon, mica, cobalt, barium, tungsten, kaolin, graphite, clay,
ceramic, talc, vitallium, beryllium, zinc, cotton, hemp, flax or grain. This
exclusion precludes liability coverage for "any injury, damage, expense, cost,
loss, liability, defense or legal obligation arising out of, resulting from or
in any way related to, in whole or in part "mixed dust" pneumoconiosis,
pleural plaques, pleural effusion, mesothelioma, lung cancer, emphysema,
bronchitis, tuberculosis or pleural thickening, or other pneumoconiosis-
related ailments such as arthritis, cancer (other than lung), lupus, heart,
kidney or gallbladder disease. It is anticipated that this mixed dust
exclusion will further limit the Company's exposure in silica claims, and may
be broad enough to limit exposure in other dust claims.
The Company's environmental claims are defined as 1) claims for bodily
injury, personal injury, property damage, loss of use of property, diminution
of property value, etc., allegedly due to contamination of air, and/or
contamination of surface soil or surface water, and/or contamination of ground
water, aquifers, wells, etc.; or 2) any/all claims for remediation or clean up
of hazardous waste sites by the United States Environmental Protection Agency,
or similar state and local environmental or government agencies, usually
presented in conjunction with federal or local clean up statutes (i.e.,
CERCLA, RCRA, etc.).
Examples include, but are not limited to: chemical waste; hazardous waste
treatment, storage and/or disposal facilities; industrial waste disposal
facilities; landfills; superfund sites; toxic waste spills; and underground
storage tanks. Widespread use of pollution exclusions since 1970 in virtually
all lines of business, except personal lines, has resulted in limited exposure
to environmental claims. Absolute pollution exclusions have been used since
the 1980's. The Company's exposure to environmental claims is therefore
limited primarily to accident years preceding the 1980s. The pre-1980's
exposures include municipality exposures for closed landfills, small
commercial businesses involved with disposing waste at landfills or leaking
underground storage tanks. During 2002, the Company re-evaluated the
estimated ultimate losses for direct environmental exposures. Based on this
re-evaluation, the Company reallocated $576,000 of bulk IBNR reserves and
$191,000 of settlement expense reserves to direct environmental exposures. No
additional IBNR reserves were established for these exposures.
In 2004, the Company was presented with eight contamination claims filed
against four of its petroleum marketers in Iowa and Indiana. The claims arise
out of alleged contamination of municipal public water systems by the gasoline
additive Methyl Tertiary Butyl Ether ("MTBE"). All MTBE lawsuits initiated in
California, Connecticut, Florida, Indiana, Iowa, Massachusetts, New Hampshire,
New Jersey and New York were moved to their respective federal courts and were
then transferred to the United States District Court for the Southern District
of New York where they were consolidated under the caption, In re: Methyl
Tertiary Butyl Ether ("MTBE") Products Liability Litigation. The Company is
defending these claims under commercial auto policies which afford broadened
pollution liability coverage for overfills. These defenses are subject to
express reservations of rights based upon the lack of property damage within
the policy periods because these lawsuits do not specifically allege dates of
property damage or contamination or any contamination that is the result of an
overfill.
The Company's exposure to asbestos and environmental claims through
assumed reinsurance is very limited due to the fact that the Company's
reinsurance subsidiary entered into the reinsurance marketplace in the early
1980s after much attention had already been brought to these issues. The
Company took action to commute one reinsurance contract during the first
quarter of 2003 that had some asbestos and environmental reserves associated
with it.
At December 31, 2004, the Company carried asbestos and environmental
reserves for direct insurance and assumed reinsurance business totaling
$5,460,000, which represents 1.3% of total loss and settlement expense
reserves. The asbestos and environmental reserves include $1,662,000 of case
reserves, $2,836,000 of IBNR reserves and $962,000 of bulk settlement expense
reserves.
The Company's non-asbestos direct product liability claims are considered
to be highly uncertain exposures due to the many uncertainties inherent in
determining the loss, and the significant periods of time that can elapse
between the occurrence of the loss and the ultimate settlement of the claim.
The majority of the Company's product liability claims arise from small to
medium sized manufacturers, contractors, petroleum distributors, and mobile
home and auto dealerships. No specific claim trends are evident from the
Company's manufacturer policies, as the claims activity on these policies is
generally isolated and can be severe. Specific product coverage is provided
to the Company's mobile home and auto dealership policyholders, and the claims
from these policies tend to be relatively small. Certain construction defect
claims are reported under product liability coverage. During 2004, 67 of
these claims were reported to the Company.
The Company's assumed casualty excess reinsurance is also considered to
be a highly uncertain exposure due to the significant periods of time that can
elapse during the settlement of the underlying claims and the fact that a
reinsurance company generally has less knowledge than the ceding company about
the underlying book of business and the ceding company's reserving practices.
The Company attempts to account for this uncertainty by establishing bulk IBNR
reserves, using conservative assumed treaty limits and, to a much lesser
extent, booking of individual treaty IBNR (if reported by the ceding company)
or establishing additional case reserves if the reported case reserves appear
inadequate on an individual claim. While the Company's reinsurance subsidiary
is predominantly a property reinsurer, it does write casualty excess business
oriented mainly towards shorter tail casualty lines of coverage. The Company
avoids reinsuring large company working layer casualty risks, and does not
write risks with heavy product liability exposures, risks with obvious latent
injury manifestation, medical malpractice, and "for profit" Directors and
Officers coverage. A small amount of casualty excess business on large
companies is written, but generally on a "clash" basis only (layers above the
limits written for any individual policyholder).
The Company has exposure to construction defect claims arising from
general liability policies issued to contractors. Most of the Company's
construction defect claims are concentrated in a limited number of states, and
the Company has taken steps to mitigate this exposure. Construction defect is
a highly uncertain exposure due to such issues as whether coverage exists,
definition of an occurrence, determination of ultimate damages, and allocation
of such damages to financially responsible parties. The Company has recently
implemented additional coding to identify and monitor construction defect
claims. Newly reported construction defect claims numbered 685, 668, and 555
in 2004, 2003, and 2002, respectively, and produced incurred losses and paid
settlement expenses of approximately $2,498,000, $3,200,000, and $1,913,000 in
each respective period. Incurred losses and paid settlement expenses on all
construction defect claims totaled approximately $3,895,000 in 2004. At year-
end 2004, the Company carried case reserves of approximately $6,075,000 on 982
open construction defect claims.
Following is a schedule of claims activity for asbestos, environmental,
products liability and casualty excess reinsurance for 2004, 2003 and 2002.
Property and casualty
insurance segment Reinsurance segment
--------------------------- --------------------------
Settlement Settlement
($ in thousands) Case IBNR expense Case IBNR expense
------- ------- ------- ------- ------- -------
Reserves at 12/31/04
Asbestos ...........$ 1,395 $ 837 $ 651 $ 153 $ 515 $ -
Environmental ...... 30 807 311 84 677 -
Products(1) ........ 6,491 3,056 6,861 - - -
Casualty excess(2) - - - 16,436 31,049 1,724
Reserves at 12/31/03
Asbestos ...........$ 1,138 $ 991 $ 756 $ 86 $ 646 $ -
Environmental ...... 13 836 316 52 750 -
Products(1) ........ 4,235 2,557 4,657 - - -
Casualty excess(2) - - - 18,959 24,834 1,866
Reserves at 12/31/02
Asbestos ...........$ 451 $ 1,693 $ 839 $ 80 $ 454 $ -
Environmental ...... 14 839 322 49 786 -
Products(1) ........ 2,314 1,856 2,000 - - -
Casualty excess(2) - - - 13,393 21,472 1,385
Paid during 2004
Asbestos ...........$ 47 $ 141 $ 64 $ -
Environmental ...... 11 11 40 -
Products(1) ........ 1,079 1,401 - -
Casualty excess(2) - - 7,911 916
Paid during 2003
Asbestos ...........$ 14 $ 83 $ 93 $ 2
Environmental ...... 5 6 33 -
Products(1) ........ 705 959 - -
Casualty excess(2) - - 4,523 386
Paid during 2002
Asbestos ...........$ 18 $ 97 $ 8 $ -
Environmental ...... 44 10 12 -
Products(1) ........ 577 586 - -
Casualty excess(2) - - 5,019 498
(1) Products includes the portion of asbestos and environmental claims
reported above that are non-premises/operations claims.
(2) Casualty excess includes the asbestos and environmental
claims reported above.
Environ-
Asbestos mental Products
-------- -------- --------
Open claims, 12/31/04 ... 39,738 6 1,721
Reported in 2004 ........ 9,655 2 295
Disposed of in 2004 ..... 10,993 3 358
Open claims, 12/31/03 ... 41,076 7 1,784
Reported in 2003 ........ 40,893 7 1,008
Disposed of in 2003 ..... 123 6 304
Open claims, 12/31/02 ... 306 6 1,080
Reported in 2002 ........ 123 - 781
Disposed of in 2002 ..... 83 3 260
Variability of loss and settlement expense reserves
The Company does not determine a range of estimates for all components of
the loss and settlement expense reserves at the time those reserves are
established. However, at each year-end an actuarially determined range of
estimates is developed for the major components of the loss and settlement
expense reserves. All reserves are reviewed, except for the involuntary
workers' compensation pools, for which reliance is placed on a reserve opinion
received from the National Council on Compensation Insurance certifying the
reasonableness of those reserves. Shown below are the actuarially determined
ranges of reserve estimates as of December 31, 2004, along with the carried
reserves. The last two columns display the estimated after-tax impact on
earnings if the reserves were moved to the high endpoint and the low endpoint
of the ranges.
After-Tax Impact
Range of Reserve Estimates on Earnings
-------------------------- ------------------
Reserves Reserves
($ in thousands) High Low Carried at High at Low
-------- -------- ------- -------- --------
Property and casualty
insurance segment .........$294,723 $248,453 $285,962 $ (5,694) $ 24,381
Reinsurance segment ......... 119,880 102,484 119,721 (104) 11,204
-------- -------- -------- -------- --------
$414,603 $350,937 $405,683 $ (5,798) $ 35,585
======== ======== ======== ======== ========
Changes in loss and settlement expense reserve estimates of prior periods
Loss and settlement expense reserves are estimates at a given time of
what an insurer expects to pay on incurred losses, based on facts and
circumstances then known. During the loss settlement period, which may be
many years, additional facts regarding individual claims become known, and
accordingly, it often becomes necessary to refine and adjust the estimates of
liability on a claim. Such changes in reserves for losses and settlement
expenses are reflected in operating results in the year such changes are
recorded.
During the three years ended December 31, 2004, the Company has
experienced adverse development in the provision for insured events of prior
years. The majority of this adverse development has come from the property
and casualty insurance segment, primarily in the workers' compensation and
other liability lines of business. Following are the significant issues and
trends that have been identified as contributors to this adverse development.
Workers' compensation claim severity has increased significantly over the
past five years, with the projected ultimate average claim amount increasing
approximately 72 percent over the five year period. An increase of this
magnitude has made the establishment of adequate case reserves challenging. A
review of claim data indicates that claims adjusters have recently
underestimated medical costs and the length of time injured workers are away
from work. In addition, partial disability benefits have been underestimated
or unanticipated. Large increases in drug costs and the availability and
utilization of new and costly medical procedures have contributed to rapidly
escalating medical costs.
Construction defect claims arising from general liability policies issued
to contractors have contributed to adverse reserve development. States with
significant construction defect losses include Alabama, Arizona, California,
Colorado, Nevada and Texas.
Large umbrella claims have recently contributed to the adverse
development experienced in the other liability line of business. A pattern of
increasing umbrella claims severity is believed to be generally consistent
with industry umbrella severity trends. Also contributing to overall umbrella
reserve development is an increase in claims arising from underlying general
liability policies.
Legal expenses for the other liability line of business have also
increased rapidly over the past three years, with defense costs increasing at
an average rate of approximately 14 percent per year. This increase in legal
expenses has occurred despite a reduction in the number of new lawsuits.
In response to an indicated deficiency in case reserves at December 31,
2004, the home office claims department in early 2004 instructed each of the
16 branch offices to review and carefully reevaluate all claim reserves for
adequacy. As a result of these reviews, case reserves were strengthened in
both the second and third quarters of 2004. However, during the required
fourth quarter inventory and review process, the branch offices further
strengthened their case reserves, generating a significant amount of adverse
development on prior years' reserves.
For detailed discussion of the factors influencing the adverse
development on prior years' reserves, see the discussion entitled "Loss and
Settlement Expense Reserves" under the "Narrative Description of Business"
heading in the Business Section under Item I of this Form 10-K.
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.
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 year.
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 estimated 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 December 31, 2004, and management does not anticipate future
limitations to be likely due to the improved premium rate environment in both
the insurance and reinsurance marketplaces.
Deferred income taxes
The realization of the deferred income tax asset is based upon
projections that indicate that a sufficient amount of future taxable income
will be earned to utilize the tax deductions that will reverse in the future.
These projections are based on the Company's history of producing significant
amounts of taxable income, the improved premium rate environment for both the
property and casualty insurance segment and the reinsurance segment and loss
and expense control initiatives that have been implemented in recent years.
In addition, management has formulated tax-planning strategies that could be
implemented to generate taxable income if needed. Should the projected
taxable income and tax planning strategies not provide sufficient taxable
income to recover the deferred tax asset, a valuation allowance would be
required.
RESULTS OF OPERATIONS
Segment information and consolidated net income for the three years ended
December 31, 2004 are as follows:
($ in thousands) 2004 2003 2002
-------- -------- --------
PROPERTY AND CASUALTY INSURANCE
Premiums earned .......................... $250,035 $241,237 $225,013
Losses and settlement expenses ........... 196,460 168,239 156,152
Acquisition and other expenses ........... 85,837 80,493 72,483
-------- -------- --------
Underwriting loss ........................ $(32,262) $ (7,495) $ (3,622)
======== ======== ========
Loss and settlement expense ratio ........ 78.6% 69.7% 69.4%
Acquisition expense ratio ................ 34.3 33.4 32.2
-------- -------- --------
Combined ratio ........................... 112.9% 103.1% 101.6%
======== ======== ========
Losses and settlement expenses:
Insured events of current year ....... $172,722 $159,224 $151,507
Increase in provision for insured
events of prior years .............. 23,738 9,015 4,645
-------- -------- --------
Total losses and settlement
expenses ....................... $196,460 $168,239 $156,152
======== ======== ========
Catastrophe and storm losses ............. $ 13,481 $ 17,531 $ 8,055
======== ======== ========
($ in thousands) 2004 2003 2002
-------- -------- --------
REINSURANCE
Premiums earned .......................... $ 95,444 $ 89,386 $ 72,030
Losses and settlement expenses ........... 53,346 58,266 50,906
Acquisition and other expenses ........... 26,870 24,403 23,150
-------- -------- --------
Underwriting income (loss) ............... $ 15,228 $ 6,717 $ (2,026)
======== ======== ========
Loss and settlement expense ratio ........ 55.9% 65.2% 70.7%
Acquisition expense ratio ................ 28.1 27.3 32.1
-------- -------- --------
Combined ratio ........................... 84.0% 92.5% 102.8%
======== ======== ========
Losses and settlement expenses:
Insured events of current year ....... $ 56,946 $ 59,805 $ 48,553
(Decrease) increase in provision for
insured events of prior years ...... (3,600) (1,539) 2,353
-------- -------- --------
Total losses and settlement
expenses ....................... $ 53,346 $ 58,266 $ 50,906
======== ======== ========
Catastrophe and storm losses ............. $ 5,011 $ 3,411 $ 249
======== ======== ========
CONSOLIDATED
REVENUES
Premiums earned .......................... $345,479 $330,623 $297,043
Net investment income .................... 29,900 29,702 32,778
Realized investment gains (losses) ....... 4,379 1,170 (3,159)
Other income ............................. 601 862 866
-------- -------- --------
380,359 362,357 327,528
-------- -------- --------
LOSSES AND EXPENSES
Losses and settlement expenses ........... 249,806 226,505 207,058
Acquisition and other expenses ........... 112,707 104,896 95,633
Interest expense ......................... 1,112 1,320 1,639
Other expense ............................ 1,163 1,654 1,306
-------- -------- --------
364,788 334,375 305,636
-------- -------- --------
Income before income tax expense ......... 15,571 27,982 21,892
Income tax expense ....................... 2,386 7,633 5,790
-------- -------- --------
Net income ............................... $ 13,185 $ 20,349 $ 16,102
======== ======== ========
Earnings per share ....................... $ 1.10 $ 1.78 $ 1.42
======== ======== ========
Loss and settlement expense ratio ........ 72.3% 68.5% 69.7%
Acquisition expense ratio ................ 32.6 31.7 32.2
-------- -------- --------
Combined ratio ........................... 104.9% 100.2% 101.9%
======== ======== ========
Losses and settlement expenses:
Insured events of current year ....... $229,668 $219,029 $200,060
Increase in provision for insured
events of prior years .............. 20,138 7,476 6,998
-------- -------- --------
Total losses and settlement
expenses ....................... $249,806 $226,505 $207,058
======== ======== ========
Catastrophe and storm losses ............. $ 18,492 $ 20,942 $ 8,304
======== ======== ========
Year ended December 31, 2004 compared to year ended December 31, 2003
- ---------------------------------------------------------------------
Net income decreased 35.2 percent to $13,185,000 ($1.10 per share) in
2004 from $20,349,000 ($1.78 per share) in 2003. This decrease is attributed
to a significant increase in the amount of adverse development experienced on
prior years' reserves. The majority of this adverse development occurred
during the fourth quarter and is attributed to a diligent review and
reevaluation of the individual case reserves carried by the property and
casualty insurance segment. In addition to an ongoing review of claims files
in the normal course of business, the Company has for many years required each
of its 16 branch office to perform a complete inventory of its open claim
files during the fourth quarter of each year and to review the adequacy of
each carried reserve based on current information. This review process has
not historically resulted in a significant increase in case reserves; however,
because of heightened emphasis placed on case reserve adequacy during 2004,
the review performed in the fourth quarter of 2004 generated a significant and
unanticipated increase in carried reserves and a corresponding increase in
settlement expense reserves. Catastrophe and storm losses declined 11.7
percent in 2004 but remained at an unusually high level due to the four
hurricanes that hit the Southern United States in August and September.
To help assure that necessary case reserve adjustment are implemented on
a timely basis in the future, beginning in 2005 the branch offices will be
required to perform a complete inventory and review of their case reserves
semi-annually, rather than annually as previously required. The first review
is to be completed by the end of June and the second review is to be completed
by the end of November each year.
The calculation of 2004 earning per share is impacted by the Company's
recently completed follow-on stock offering in which 2.0 million new shares of
common stock were issued on October 20, 2004. The Company earned
approximately $170,000 of additional interest income on the net proceeds of
the stock offering during the fourth quarter; however, this additional
interest income was not sufficient to avoid an approximate 3.0 percent
dilution in the 2004 earnings per share calculation.
Premium income
Premiums earned increased 4.5 percent to $345,479,000 in 2004 from
$330,623,000 in 2003. This increase is primarily attributed to rate increases
implemented during the last few years in the property and casualty insurance
business as well as moderate growth and improved pricing in the assumed
reinsurance business. The overall market for property and casualty insurance
was stable during 2004, but moderated slightly in certain lines of business
and select territories due to an increase in price competition. Price
competition is expected to increase for most lines of business in 2005, but
not to the extent seen in the last soft market. The Company will continue its
efforts to maintain current pricing levels and will implement rate increases
in those lines of business and/or territories where such action is warranted;
however, the overall impact of these rate increases will continue to dissipate
as the increases become smaller and less frequent.
Premiums earned for the property and casualty insurance segment increased
3.6 percent to $250,035,000 in 2004 from $241,237,000 in 2003. This increase
is primarily the result of rate increases that were implemented during the
prior two years. After the broad-based rate increases implemented during the
peak of the hard market in 2001 and 2002, premium rate levels for most lines
of business were considered to be at, or near, adequate levels at the end of
2002. Accordingly, moderate and more targeted rate increases were implemented
during 2003 and 2004. This fine tuning of the Company's rate structure has
been directed toward specific accounts, territories and lines of business
where additional rate increases were warranted. 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. During 2004, premiums written increased
only 1.9 percent due to a decline in policy count and an increase in ceded
premiums. The decline in policy count is attributed to several factors,
including the non-renewal of existing business that was under-priced and/or
under-performing, a reluctance to accept new risks in under-priced lines of
business and a decrease in new business associated with a moderate increase in
price competition. The increase in ceded premiums primarily reflects an
increase in the cost of the Company's reinsurance programs. Premium rate
levels for most lines of business are not expected to change significantly in
2005. In light of the improvements that have been achieved in both the
pricing and the quality of the Company's book of business, management has
become more receptive to opportunities to write new business, but continues to
stress profitability over production.
Premiums earned for the reinsurance segment increased 6.8 percent to
$95,444,000 in 2004 from $89,386,000 in 2003 due to increased participation in
the MRB reinsurance pool. For 2004, Employers Mutual's participation in the
MRB reinsurance pool (which is ceded to the reinsurance segment under the
terms of the quota share agreement) increased to 33 percent from 25 percent in
2003, producing $8,176,000 of additional premiums earned. The increase in the
MRB premiums earned was partially offset by a decline in the HORAD book of
business because Employers Mutual was unsuccessful in its attempt to renew
several accounts during the January 1 and July 1, 2004 renewal seasons due to
its current "A-" (Excellent) A.M. Best rating. Employers Mutual is attempting
to replace this business with new accounts and increased participation on
existing accounts. Following large across-the-board rate increases
implemented in 2002, premium rate increases on excess-of-loss contracts
moderated during 2003 and 2004 due to the influx of new capital into the
reinsurance marketplace; however, contracts with poor loss experience
continued to receive large rate increases. The rate increases implemented
during the last several years 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 have benefited from improved industry-wide rate
levels at the primary company level. Premiums earned in 2004 reflect a
decrease in the estimate of earned but not reported premiums of $190,000,
compared to an increase of $3,575,000 in 2003.
The board of directors of the MRB reinsurance pool, of which Employers
Mutual is a member, recently authorized management to pursue the addition of
one or two new assuming companies to the pool. If additional assuming
companies are added to the pool, Employers Mutual's participation would be
reduced and the reinsurance segment's premium volume would decline in the
short-term; however, this action will strengthen MRB's surplus base and should
favorably impact their ability to attract new business.
Losses and settlement expenses
Losses and settlement expenses increased 10.3 percent to $249,806,000 in
2004 from $226,505,000 in 2003. The loss and settlement expense ratio
increased to 72.3 percent in 2004 from 68.5 percent in 2003. The increase in
the 2004 ratio is primarily attributed to a significant amount of adverse
development on prior years' reserves in the property and casualty insurance
segment, but was partially offset by a decline in reported losses in the
reinsurance segment. Catastrophe and storm losses declined 11.7 percent in
2004, but remained at an unusually high level.
The loss and settlement expense ratio for the property and casualty
insurance segment increased to 78.6 percent in 2004 from 69.7 percent in 2003.
The increase in the 2004 ratio is primarily attributed to a significant
increase in adverse development on prior years' reserves. The adverse
development of 2004 reflects a combination of newly reported claims in excess
of carried IBNR reserves ($14,758,000), development on case reserves of
previously reported claims ($11,037,000), bulk reserve strengthening
($2,350,000), and settlement expense reserve increases resulting from
increases in case reserves ($6,209,000). This adverse development was
partially offset by $10,437,000 of reinsurance recoveries associated with the
case reserve development and IBNR emergence. Substantial case reserve
strengthening performed at the branch offices, primarily in the workers'
compensation and other liability lines of business, is the underlying reason
for the adverse reserve development that occurred during 2004. As discussed
further under the "Critical Accounting Policies" heading of this discussion,
the economic factors behind this case reserve strengthening include, most
notably, an increase in workers' compensation claim severity, increases in
construction defect claim activity, the recent occurrence of several large
umbrella claims, and increasing legal expenses in the other liability line of
business. Loss severity continued to trend upward during 2004 while overall
loss frequency continued to trend downward; however, there are some
indications that loss frequency may be leveling out. Catastrophe and storm
losses for 2004 include $2,888,000 (net of reinsurance) from the four
hurricanes that hit the Southern United States in August and September.
The loss and settlement expense ratio for the reinsurance segment
decreased to 55.9 percent in 2004 from 65.2 percent in 2003, despite an
increase in catastrophe and storm losses. The decline in the 2004 ratio
reflects a decrease in the ratio of reported losses to premiums earned for
2004 policy year business, an increase in favorable development on prior
years' reserves and continued improvement in overall premium rate adequacy.
The favorable development experienced in 2004 is attributed to reported policy
year 2003 losses for property, casualty and multi-line classes that are below
2003 implicit projections. Catastrophe and storm losses for 2004 include
$4,830,000 associated with the four hurricanes that hit the Southern United
States in August and September. The reinsurance segment had exposure to all
four hurricanes and reached its $1,500,000 cap on losses assumed per
occurrence on three of them. During 2003, two events (Midwest storms in the
month of May and Hurricane Isabel) reached the $1,500,000 cap.
Acquisition and other expenses
Acquisition and other expenses increased 7.4 percent to $112,707,000 in
2004 from $104,896,000 in 2003. The expense ratio (acquisition and other
expenses expressed as a percentage of premiums earned) increased to 32.6
percent in 2004 from 31.7 percent in 2003, primarily due to increases in
contingent commission and policyholder dividend expenses.
For the property and casualty insurance segment, the acquisition expense
ratio increased to 34.3 percent in 2004 from 33.4 percent in 2003. The rise
in this ratio is primarily attributed to an increase in contingent commission
expense from the Company's agent profit share program and an increase in
policyholder dividend expense. The Company will be implementing a new agent
profit share program, which is designed to better equate agent compensation
with the quality and quantity of the insurance business produced, effective
January 1, 2005. Under the new program, the Company's best performing agents
will be rewarded with increased compensation while agents with marginal
business will experience a decline in compensation. Total profit share
expense under the new program is expected to decline slightly. The increase
in contingent commission expense was partially offset by $387,000 of ceded
contingent commission income recognized in the fourth quarter of 2004 related
to a no-claims bonus on the terrorism reinsurance contract for years 2003 and
2004.
For the reinsurance segment, the acquisition expense ratio increased to
28.1 percent in 2004 from 27.3 percent in 2003. The increase is primarily
attributed to a large amount of contingent commission expense reported by MRB
during 2004, but was reduced by a $666,000 increase in contingent commission
income from a retrocession contract on the HORAD book of business. Both
increases are a reflection of recent favorable underwriting performance. The
asset for deferred acquisitions costs increased in 2004 and 2003 in connection
with the increased participation in the MRB pool. These increases offset
commission expense of $1,033,000 and $782,000 recorded for statutory purposes
in those respective years with the increased participation in the MRB pool.
Investment results
Net investment income remained relatively flat at $29,900,000 in 2004
compared to $29,702,000 in 2003, despite an increase in invested assets. This
is primarily attributed to the lingering low interest rate environment, which
has negatively impacted the rate of return earned on the Company's
investments. During this prolonged period of low interest rates, many of the
Company's higher yielding securities have been called. The proceeds from
these called securities, and from maturing securities, have been reinvested at
the current lower interest rates, resulting in less investment income. In
addition, until the second quarter of 2004 the Company had been reluctant to
invest in long-term securities due to the low interest rate environment, and
had therefore accumulated a significant amount of short-term and cash
equivalent investments. Since these investments carry lower interest rates
than long-term securities, the decline in the Company's rate of return was
magnified. However, during the second quarter of 2004 interest rates became
more attractive and the Company began investing in long-term securities.
The Company reported net realized investment gains of $4,379,000 in 2004
and $1,170,000 in 2003. The large amount of realized investment gains in 2004
includes $2,558,000 of net gain recognized during the second quarter on the
Company's investment in MCI Communications Corporation bonds in conjunction
with a payout award received under a bankruptcy court approved "Plan of
Reorganization." The MCI bonds had previously been determined to be other-
than-temporarily impaired during the second quarter of 2002. The new MCI
bonds were sold during the third quarter, resulting in an additional realized
gain of $187,000. Reflected in the gains of 2003 are $1,567,000 of other-
than-temporary impairment losses recognized in the Company's equity portfolio
during the first quarter, $2,689,000 of net losses recognized by the Company's
equity managers during the first quarter as they rebalanced the Company's
portfolios to enhance future returns, and $4,342,000 of losses recognized on
the sale of American Airlines and United Airlines bonds during the first
quarter. These losses were more than offset by gains recognized on the sale
of certain bond and equity investments during the remainder of 2003. The
Company has not recognized any additional other-than-temporary impairment
losses since the first quarter of 2003, and all the impaired equity securities
were sold before year-end 2003, generating gross realized gains of $619,000
and gross realized losses of $48,000.
Other information
Income tax expense decreased 68.7 percent to $2,386,000 in 2004 from
$7,633,000 in 2003. The effective tax rate declined to 15.3 percent in 2004
from 27.3 percent in 2003, primarily due to an increase in tax-exempt
investment income and a decline in pre-tax income. Effective April 1, 2003,
the Company was included in Employers Mutual's consolidated tax return due to
the fact that Employers Mutual attained 80 percent ownership of the Company at
the end of March. The Company filed a short-period tax return with its
subsidiaries for the period January 1, 2003 through March 31, 2003. During
October 2004 Employers Mutual's ownership of the Company fell below 80 percent
upon successful completion of the follow-on stock offering. Accordingly, the
Company will no longer be included in Employers Mutual's consolidated tax
return effective October 1, 2004, and the Company will file a short-period tax
return for the period October 1, 2004 through December 31, 2004.
On December 8, 2003, the Medicare Prescription Drug, Improvement and
Modernization Act of 2003 (the "Act") was signed into law. The Act expanded
Medicare to include, for the first time, coverage for prescription drugs. In
January 2004, the Financial Accounting Standards Board (FASB) issued Staff
Position FAS No. 106-1 "Accounting and Disclosure Requirements Related to the
Medicare Prescription Drug, Improvement and Modernization Act of 2003."
Because of various uncertainties, including Employers Mutual's response to
this legislation and the appropriate accounting methodology for this event,
the Company elected to defer financial recognition of this legislation as
permitted under FAS 106-1. In May 2004, the FASB issued Staff Position FAS
No. 106-2, which became effective for interim and annual periods beginning
after June 15, 2004. FAS No. 106-2 provides accounting guidance and
disclosure requirements for the prescription drug subsidy established under
the Act. The effect of the subsidy on the measurement of the Employers Mutual
postretirement benefit plan resulted in a decrease in the accumulated
projected benefit obligation of $9,899,000 and the net periodic postretirement
benefit cost for 2004 was reduced by $1,537,000. Adoption of FAS 106-2
resulted in a $344,000 reduction in the Company's share of the net periodic
postretirement benefit cost for 2004.
Employers Mutual participated in the Company's Dividend Reinvestment and
Common Stock Purchase Plan during the first two quarters of 2004 and
reinvested 50 percent of its dividends in additional shares of the Company's
common stock. Due to its participation in the Company's recent stock
offering, Employers Mutual discontinued its participation in the plan for the
third and fourth quarters of 2004 and has indicated that it will likely not
participate in the plan in 2005.
On November 26, 2002, President Bush signed into law the Terrorism Risk
Insurance Act of 2002 ("TRIA"). TRIA provides a temporary Federal backstop on
losses from certified terrorism events from foreign sources and is effective
until December 31, 2005. Coverage includes most direct commercial lines of
business, including coverage for losses from nuclear, biological and chemical
exposures. Each insurer has a deductible amount, which is calculated as a
percentage of the prior year's direct earned commercial lines premium and a
ten percent retention above the deductible. The percentage used in the
deductible calculation increased from seven percent in 2003 to ten percent in
2004, and will increase to 15 percent in 2005. TRIA caps losses at $100
billion annually; no insurer that has met its deductible will be liable for
payment of any portion above that amount. Congress is currently debating
whether TRIA should be extended for one or possibly two years due to concerns
that terrorism insurance may not be available in the private insurance market
when TRIA expires; however, no action has yet been taken.
Year ended December 31, 2003 compared to year ended December 31, 2002
- ---------------------------------------------------------------------
Net income increased 26.4 percent to a record $20,349,000 ($1.78 per
share) in 2003 from $16,102,000 ($1.42 per share) in 2002. This increase was
attributed to improved premium rate adequacy, an improvement in the quality of
the Company's book of business and strong second half earnings in the
reinsurance segment. The improvement in 2003 net income was achieved even
though the Company experienced an unusually high level of catastrophe and
storm losses and performed some necessary reserve strengthening in the
property and casualty insurance segment.
Premium income
Premiums earned increased 11.3 percent to $330,623,000 in 2003 from
$297,043,000 in 2002. This increase was attributed to rate increases that
were implemented in the property and casualty insurance segment during the
preceding two years as well as significant growth and improved pricing in the
reinsurance segment. The market for property and casualty insurance softened
somewhat during 2003 but was considered to be firm at year-end.
Premiums earned for the property and casualty insurance segment increased
7.2 percent to $241,237,000 in 2003 from $225,013,000 in 2002, primarily as a
result of rate increases that were implemented during the preceding three
years. The rate increases implemented in 2002 and 2001 were broad based in
nature and resulted in premium rate levels for most lines of business that
were considered to be at, or near, adequate levels at December 31, 2002.
Accordingly, moderate and more targeted rate increases were implemented during
2003. This fine tuning of the Company's rate structure was directed toward
specific accounts, territories and lines of business where additional rate
increases were warranted. 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 for 2003 reflect this delay and continued to
show strong growth as the rate increases obtained in 2002 became earned;
however, the growth rate in 2003 was limited by a decline in policy count
(overall approximately 5.8 percent from December 31, 2002) that resulted from
a decrease in new business associated with a moderate increase in rate
competition and a reluctance to accept new risks in under-priced lines of
business, and the non-renewal of existing business that was under-priced
and/or under-performing.
Premiums earned for the reinsurance segment increased 24.1 percent to
$89,386,000 in 2003 from $72,030,000 in 2002, primarily as a result of
improved premium rate levels and increased participation in the MRB
reinsurance pool. Following the large across-the-board rate increases
implemented in 2002, premium rate increases on excess of loss contracts
moderated in 2003 due to the influx of new capital into the reinsurance
marketplace; however, contracts with poor loss experience continued to receive
exceptionally large rate increases. The rate increases implemented during
2003 and 2002 were 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 were benefiting from improved industry-wide rate levels at
the primary company level. For 2003, Employers Mutual's participation in the
MRB reinsurance pool increased to 25 percent from 20 percent in 2002,
producing $7,262,000 of additional earned premium. In addition to these
factors, the growth in earned premiums for 2003 reflected an increase in the
estimate of earned but not reported premiums of $3,575,000, compared to a
decrease in this estimate of approximately $1,135,000 in 2002.
Losses and settlement expenses
Losses and settlement expenses increased 9.4 percent to $226,505,000 in
2003 from $207,058,000 in 2002. The loss and settlement expense ratio (losses
and settlement expenses expressed as a percentage of premiums earned)
decreased to 68.5 percent in 2003 from 69.7 percent in 2002, despite an
unusually high level of catastrophe and storm losses that was second only to
the record amount reported in storm-plagued 2001, and some necessary reserve
strengthening. This decline in the loss and settlement expense ratio was
attributed to improved premium rate adequacy, an improvement in the quality of
the Company's book of business and unusually good loss experience in the
reinsurance segment during the second half of the year.
The loss and settlement expense ratio for the property and casualty
segment increased slightly to 69.7 percent in 2003 from 69.4 percent in 2002.
Despite an unusually high level of catastrophe and storm losses ($17,531,000
in 2003 compared to $8,055,000 in 2002) and some necessary reserve
strengthening, the loss and settlement expense ratio did not increase
appreciably during 2003. This is due to management's diligent efforts over
the last several years to improve both premium rate adequacy and the quality
of the risks insured. Loss frequency continued to trend downward in 2003
while loss severity continued to increase. The reserve strengthening performed
in 2003 amounted to approximately $12,825,000, which represented only 5.6
percent of the property and casualty insurance segment's carried reserves at
December 31, 2002.
The loss and settlement expense ratio for the reinsurance segment
decreased to 65.2 percent in 2003 from 70.7 percent in 2002. This improvement
was attributed to an unusually low level of reported loss activity from both
proportional and excess of loss business, and from favorable development on
prior years' reserves. However, this improvement was partially offset by a
significant increase in catastrophe losses ($3,411,000 in 2003 compared to
$249,000 in 2002). During 2003, two events (Midwest storms in the month of
May and hurricane Isabel) reached the $1,500,000 cap on losses assumed per
event from Employers Mutual. In addition, the reinsurance segment established
$326,000 of additional IBNR reserves in 2003 in response to the findings of an
independent study conducted on the Company's asbestos exposures.
Acquisition and other expenses
Acquisition and other expenses increased 9.7 percent to $104,896,000 in
2003 from $95,633,000 in 2002. The expense ratio (acquisition and other
expenses expressed as a percentage of premiums earned) decreased to 31.7
percent in 2003 from 32.2 percent in 2002, primarily due to the improvement in
premium rate adequacy achieved in 2003.
For the property and casualty insurance segment, the expense ratio
increased to 33.4 percent in 2003 from 32.2 percent in 2002. This increase
was primarily due to an increase in contingent commission expense and higher
employee benefit costs. The increase in contingent commission expense was a
direct result of the fundamental improvement achieved in underwriting results.
The increase in employee benefit costs was associated with a 50 basis-point
decrease in the discount rate and expected long-term rate of return on plan
assets assumptions utilized in the pension plan and postretirement benefit
plans actuarial valuations.
For the reinsurance segment, the expense ratio decreased to 27.3 percent
in 2003 from 32.1 percent in 2002. The decrease in 2003 was attributed to a
decline in contingent commission expense and a shift in the mix of business
towards property excess, which carries a lower commission rate. The decline
in contingent commission expense was attributed to several sources, including
a decline of approximately $413,000 associated with the MRB pool and a marine
syndicate account, a decline of approximately $400,000 associated with the
commutation of a retrocession contract related to the World Trade Center
catastrophe, and a general trend toward a reduction in the number of contracts
with contingent commission provisions. The asset for deferred acquisitions
costs increased in 2003 and 2002 in connection with the increased
participation in the MRB pool. These increases offset commission expense of
$782,000 and $379,000 recorded for statutory purposes in those respective
years with the increased participation in the MRB pool.
Investment results
Net investment income decreased 9.4 percent to $29,702,000 in 2003 from
$32,778,000 in 2002, despite an increase in invested assets. This decrease
was primarily attributed to the lingering low interest rate environment, which
negatively impacted the rate of return earned on the Company's investments,
but also reflected an increase in investment expenses. During this period of
low interest rates, many of the Company's higher yielding securities were
called. The proceeds from those called securities, and from maturing
securities, were reinvested at the current lower interest rates, resulting in
less investment income. In addition, until the latter half of 2003 the
Company was reluctant to invest in long-term securities in this current low
interest rate environment and therefore had accumulated a significant amount
of short-term and cash equivalent investments. Since these investments carry
lower interest rates than long-term fixed maturity securities, the decline in
the Company's rate of return was magnified.
Realized investment gains totaled $1,170,000 in 2003 compared to a loss
of $3,159,000 in 2002. Reflected in the gains of 2003 were $1,567,000 of
other-than-temporary impairment losses recognized in the Company's equity
portfolio during the first quarter of 2003, $2,689,000 of net losses
recognized by the Company's equity managers during the first quarter as they
rebalanced the Company's portfolios to enhance future returns, and $4,342,000
of losses recognized on the sale of American Airlines and United Airlines
bonds during the first quarter. These bonds were collateralized by aircraft
with an appraised value sufficient to recover the Company's investment at
December 31, 2002; however, during the first quarter of 2003 the value of the
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. The losses
recognized in the first quarter were more than offset by gains recognized on
the sale of certain bond and equity investments during the remainder of 2003.
The Company did not recognize any additional other-than-temporary impairment
losses during 2003 and all the impaired equity securities were sold before
year-end, generating gross realized gains of $619,000 and gross realized
losses of $48,000. The realized investment loss for 2002 primarily reflected
a $3,821,000 impairment loss on the Company's investment in MCI Communications
Corporation bonds.
Other information
The Company refinanced its $36,000,000 of surplus notes with Employers
Mutual effective April 1, 2003 at an interest rate of 3.09 percent, resulting
in a 19.4 percent decline in interest expense in 2003.
Income tax expense increased 31.8 percent to $7,633,000 in 2003 from
$5,790,000 in 2002. The effective tax rate increased slightly to 27.3 percent
in 2003 from 26.4 percent in 2002.
In response to the declining interest rate environment, Employers Mutual
changed several key assumptions utilized in the preparation of the actuarial
valuation reports for its pension and postretirement benefit plans during 2003
and 2002. Key assumption changes include a reduction in the discount rate
from 6.5 percent in 2002 to 6.0 percent in 2003 and a reduction in the
expected long-term rate of return on plan assets for the pension plan from 8.0
percent in 2002 to 7.5 percent in 2003 and for the postretirement benefit
plans from 6.0 percent in 2002 to 5.0 percent in 2003. In addition, the
assumed health care cost trend rate utilized in the postretirement benefit
plan valuation report was decreased from 12 percent in 2002 to 11 percent in
2003.
Prior to 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 received 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 2002, the Company
concluded that it was 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 was equal
to the fair value of the stock at the date of grant. Accordingly, during 2002
the Company reversed the accrual for stock option expense allocated to it by
Employers Mutual, resulting in $349,000 of pre-tax income.
The Company's insurance subsidiaries reimburse Employers Mutual for their
share of the statutory-basis compensation expense associated with stock option
exercises under the terms of the pooling and quota share agreements.
Beginning in 2003, the statutory-basis compensation expense that was paid by
the Company's subsidiaries to Employers Mutual ($505,000 in 2003) was
reclassified as a dividend payment to Employers Mutual in these GAAP-basis
financial statements. Since the corresponding amounts for 2002 were not
material, the financial statements for that year were not restated.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity
Liquidity is a measure of a company's ability to generate sufficient cash
to meet cash obligations as they come due. The Company generated positive
cash flows from operations of $60,794,000 in 2004, $63,095,000 in 2003 and
$56,566,000 in 2002. The Company typically generates substantial positive
cash flows from operations because cash from premium payments is generally
received in advance of cash payments made to settle claims. These positive
cash flows provide the foundation of the Company's asset/liability management
program and are the primary drivers of the Company's liquidity. When
investing funds made available from operations, the Company invests in
securities with maturities that approximate the anticipated liabilities of the
insurance issued. In addition, the Company maintains a portion of its
investment portfolio in relatively short-term and highly liquid assets as a
secondary source of liquidity should net cash flows from operating activities
prove inadequate to fund current operating needs. As of December 31, 2004,
the Company did not have any significant variations between the maturity dates
of its investments and the expected payment of its loss and settlement expense
reserves.
The Company is a holding company whose principal assets are its
investments in its insurance subsidiaries. As a holding company, the Company
is dependent upon cash dividends from its insurance company subsidiaries to
meet its obligations and to pay cash dividends to its stockholders. State
insurance regulations restrict the maximum amount of dividends insurance
companies can pay without prior regulatory approval. See note 6 of Notes to
Consolidated Financial Statements for additional information regarding
dividend restrictions. The maximum amount of dividends that the insurance
company subsidiaries can pay to the Company in 2005 without prior regulatory
approval is approximately $32.2 million. The Company received $7,029,000,
$7,255,000 and $6,250,000 of dividends from its insurance company subsidiaries
and paid cash dividends to its stockholders totaling $7,233,000, $6,874,000
and $6,828,000 in 2004, 2003 and 2002, respectively.
The Company's insurance company subsidiaries must have adequate liquidity
to ensure that their cash obligations are met; however, because of their
participation in the pooling agreement and the quota share agreement, they do
not have the daily liquidity concerns normally associated with an insurance or
reinsurance company. This is due to the fact that under the terms of the
pooling and quota share agreements, Employers Mutual receives all premiums and
pays all losses and expenses associated with the insurance business produced
by the pool participants and the assumed reinsurance business ceded to the
Company's reinsurance subsidiary, and then settles the inter-company balances
generated by these transactions with the participating companies on a
quarterly basis.
At the insurance company subsidiary level, the primary sources of cash
are premium income, investment income and maturing 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. Cash outflows can be variable because of
uncertainties regarding settlement dates for unpaid losses and because of the
potential for large losses, either individually or in the aggregate.
Accordingly, the insurance company subsidiaries maintain investment and
reinsurance programs generally intended to provide adequate funds to pay
claims without forced sales of investments.
The Company maintains a portion of its investment portfolio in relatively
short-term and highly liquid investments to ensure the availability of funds
to pay 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
written. At December 31, 2004, approximately 27 percent of the Company's
fixed maturity securities were in U.S. government or U.S. 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 totaling $15,511,000 and $15,779,000 at
December 31, 2004 and 2003, respectively. 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 administered by
Mellon Bank, N.A. 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. The cash collateral that
secures the Company's loaned securities is invested in a Delaware statutory
trust that is managed by Mellon Bank. The earnings from this trust are used,
in part, to pay the fee the Company receives for each security loaned under
the program.
The Company held $5,550,000 and $4,758,000 in minority ownership
interests in limited partnerships and limited liability companies at December
31, 2004 and 2003, respectively. The Company does not hold any other
unregistered securities.
The Company's cash balance was $61,000 and ($14,069,000) at December 31,
2004 and 2003, respectively. The balance at December 31, 2003 reflects a
$14,346,000 transfer of funds out of the cash account on December 31, 2003 to
purchase a fixed maturity security; however, due to timing, the account does
not reflect the corresponding transfer of cash into the account to fund the
purchase. This timing difference resulted in the negative balance in the
account.
The Company carried a pension asset of $2,684,000 at December 31, 2004.
At December 31, 2003 the Company reported a pension liability of $1,453,000
(including $1,016,000 of additional minimum liability). This change in the
funded status of the pension plan was driven by a $5,236,000 pension plan
contributions made during 2004. Along with the additional minimum liability
reported on the Company's pension plan at December 31, 2003 was an intangible
asset of $1,016,000. Postretirement benefit liabilities reflected in the
Company's financial statements totaled $9,486,000 and $8,512,000 at December
31, 2004 and 2003, respectively.
Capital Resources
Capital resources consist of stockholders' equity and debt, representing
funds deployed or available to be deployed to support business operations.
For the Company's insurance subsidiaries, capital resources are required to
support premium writings. Regulatory guidelines suggest that the ratio of a
property and casualty insurer's annual net premiums written to its statutory
surplus should not exceed 3 to 1. All of the Company's insurance subsidiaries
were well under this guideline at December 31, 2004.
The Company's insurance subsidiaries are required to maintain certain
minimum surplus on a statutory basis and are subject to regulations under
which payment of dividends from statutory surplus is restricted and may
require prior approval of their domiciliary insurance regulatory authorities.
The Company's insurance subsidiaries are also subject to Risk Based Capital
(RBC) requirements that may further impact their ability to pay dividends.
RBC requirements attempt to measure minimum statutory capital needs based upon
the risks in a company's mix of products and investment portfolio. At
December 31, 2004, the Company's insurance subsidiaries had total adjusted
statutory capital of $216,868,000, which is well in excess of the minimum RBC
requirement of $43,485,000.
The Company had total cash and invested assets with a carrying value of
$779.4 million and $676.9 million as of December 31, 2004 and December 31,
2003, respectively. The following table summarizes the Company's cash and
invested assets as of the dates indicated:
December 31, 2004
-----------------------------------
Percent of
Amortized total at
($ in thousands) cost Fair value fair value
--------- ---------- ----------
Fixed maturities, held-to-maturity .... $ 29,206 $ 30,594 3.9%
Fixed maturities, available-for-sale .. 595,791 619,654 79.4
Equity securities, available-for-sale 59,589 78,693 10.1
Cash .................................. 61 61 -
Short-term investments ................ 46,239 46,239 5.9
Other long-term investments ........... 5,550 5,550 0.7
-------- -------- -----
$736,436 $780,791 100.0%
======== ======== =====
December 31, 2003
-----------------------------------
Percent of
Amortized total at
($ in thousands) cost Fair value fair value
--------- ---------- ----------
Fixed maturities, held-to-maturity .... $ 49,845 $ 53,854 7.9%
Fixed maturities, available-for-sale .. 499,511 523,786 76.9
Equity securities, available-for-sale 38,998 49,008 7.2
Cash .................................. (14,069) (14,069) (2.0)
Short-term investments ................ 63,568 63,568 9.3
Other long-term investments ........... 4,758 4,758 0.7
-------- -------- -----
$642,611 $680,905 100.0%
======== ======== =====
The amortized cost and estimated fair value of fixed maturity and equity
securities at December 31, 2004 were as follows:
Held-to maturity
----------------------------------------------
Gross Gross Estimated
Amortized unrealized unrealized fair
($ in thousands) cost gains losses value
--------- ---------- ---------- ---------
U.S. treasury securities and
obligations of U.S.
government corporations
and agencies ............. $ 28,037 $ 1,280 $ - $ 29,317
Mortgage-backed securities 1,169 108 - 1,277
--------- ---------- ---------- ---------
Total securities
held-to-maturity ..... $ 29,206 $ 1,388 $ - $ 30,594
========= ========== ========== =========
Available-for sale
----------------------------------------------
Gross Gross Estimated
Amortized unrealized unrealized fair
($ in thousands) cost gains losses value
--------- ---------- ---------- ---------
U.S. treasury securities and
obligations of U.S.
government corporations
and agencies ............. $ 137,274 $ 413 $ 148 $ 137,539
Obligations of states and
political subdivisions ... 257,483 10,329 136 267,676
Mortgage-backed securities 11,136 715 - 11,851
Public utilities ........... 8,687 1,181 - 9,868
Debt securities issued by
foreign governments ...... 7,178 321 - 7,499
Corporate securities ....... 174,033 11,226 38 185,221
---------- ---------- ---------- --------
Total fixed maturity
securities ........... 595,791 24,185 322 619,654
---------- ---------- ---------- --------
Equity securities .......... 59,589 19,225 121 78,693
---------- ---------- ---------- --------
Total securities
available-for-sale $ 655,380 $ 43,410 $ 443 $ 698,347
========== ========== ========== =========
In December 2001, three of the Company's property and casualty insurance
subsidiaries issued surplus notes totaling $25 million to Employers Mutual at
an annual interest rate of 5.38 percent. In June 2002, the Company's
reinsurance subsidiary issued an $11.0 million surplus note to Employers
Mutual at an annual interest rate of 5.25 percent. Effective April 1, 2003,
these surplus notes were reissued at an annual interest rate of 3.09 percent.
These notes do not have a maturity date. Payment of interest and repayment of
principal can only be made out of the applicable subsidiary's statutory
surplus and is subject to prior approval by the insurance commissioner of the
respective state of domicile. The surplus notes are subordinate and junior in
right of payment to all obligations or liabilities of the applicable insurance
subsidiaries. The Company's subsidiaries incurred interest expense of
$1,112,000, $1,320,000, and $1,639,000 in 2004, 2003, and 2002, respectively,
on these surplus notes. The surplus notes were issued in response to
statutory capital adequacy concerns raised by certain rating agencies because
the statutory surplus position of the subsidiaries had declined over the
preceding three years due to unfavorable operating results and the payment of
dividends to the parent corporation. At December 31, 2004, the Company's
subsidiaries had received approval for the payment of interest accrued on the
surplus notes during 2004.
As of December 31, 2004, the Company had no material commitments for
capital expenditures.
Off-Balance Sheet Arrangements
Employers Mutual receives all premiums and pays all losses and expenses
associated with the assumed reinsurance business ceded to the reinsurance
subsidiary and the insurance business produced by the pool participants, and
then settles the inter-company balances generated by these transactions with
the participating companies on a quarterly basis. When settling the inter-
company balances, Employers Mutual provides the reinsurance subsidiary and the
pool participants with full credit for the premiums written during the quarter
and retains all receivable amounts. Any receivable amounts that are
ultimately deemed to be uncollectible are charged-off by Employers Mutual and
the expense is charged to the reinsurance subsidiary or allocated to the pool
members on the basis of pool participation. As a result, the Company has an
off-balance sheet arrangement with an unconsolidated entity that results in a
credit-risk exposure that is not reflected in the Company's financial
statements. Based on historical data, this credit-risk exposure is not
considered to be material to the Company's results of operations or financial
position.
Investment Impairments and Considerations
During 2004 the Company had one fixed maturity security series (MCI
Communications Corporation) that was determined other-than-temporarily
impaired. MCI Communications Corporation was owned by WorldCom Inc., whose
corporate bonds were downgraded to junk status in May 2002 when it reported
the detection of accounting irregularities. 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. The fair value of the MCI bonds then
partially recovered, resulting in pre-tax unrealized gains of $1,035,000
recognized during 2002 and $1,811,000 recognized during 2003. During the
second quarter of 2004 the Company received three new series of fixed maturity
securities (with impaired book values) issued by MCI Communications
Corporation in conjunction with a payout award received under a bankruptcy
court approved "Plan of Reorganization." This payout was recorded as a tax-
free exchange and the new bonds were assigned a book value equal to the book
value of the defaulted bonds that were replaced ($5,509,000). The par value
of the new bonds reflected the settlement amount of 79.2 cents per dollar
($4,552,000) and the fair value of the new bonds was $4,241,000 at the time of
the payout. Based on these facts, a realized investment gain of $3,826,000
was recognized in the second quarter of 2004 to offset the other-than-
temporary impairment loss previously recognized in the second quarter of 2002
and an other-than-temporary impairment loss of $1,268,000 was recognized to
reduce the book value of the new bonds to fair value at the time of the
payout. The new bonds were sold during the third quarter of 2004, resulting
in an additional realized gain of $187,000.
At December 31, 2004, 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 other-than-temporarily impaired.
Such factors include, but are not limited to, the security's value and
performance in the context of the overall markets, length of time and extent
the security's fair value has been below carrying value, key corporate events
and collateralization of fixed maturity securities. Based on these factors,
and the Company's ability and intent to hold the fixed maturity securities
until maturity, it was determined that the carrying value of these securities
was not other-than-temporarily impaired at December 31, 2004. 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 $288,000, net of tax;
however, the Company's financial position would not be affected due to the
fact that unrealized losses on available-for-sale securities are reflected in
the Company's financial statements as a component of stockholders' equity, net
of deferred taxes.
Following is a schedule of the length of time securities have
continuously been in an unrealized loss position as of December 31, 2004.
Description of securities Fair value Unrealized losses
- ------------------------- ---------- -----------------
($ in thousands)
Fixed maturity securities:
Less than six months ........ $ 42,063 $ 183
Six to twelve months ........ 6,829 13
Twelve months or longer ..... 8,064 126
-------- -----
Total fixed maturity
securities .............. 56,956 322
-------- -----
Equity securities:
Less than six months ........ 7,061 111
Six to twelve months ........ 334 10
Twelve months or longer ..... - -
-------- -----
Total equity securities ... 7,395 121
-------- -----
Total temporarily
impaired securities ... $ 64,351 $ 443
======== =====
Following is a schedule of the maturity dates of the fixed maturity
securities presented in the above table. Note that this schedule includes
only fixed maturity securities available-for-sale, as the Company does not
have any fixed maturity securities held-to-maturity with unrealized losses.
Gross
Book Fair unrealized
($ in thousands) value value loss
------- ------- ----------
Due in one year or less ................. $ - $ - $ -
Due after one year through five years ... 2,000 1,990 10
Due after five years through ten years .. 27,491 27,384 107
Due after ten years ..................... 27,787 27,582 205
------- ------- ----
$57,278 $56,956 $322
======= ======= ====
The Company has no fixed maturity securities available-for-sale that are
non-investment grade and have unrealized losses at December 31, 2004. As
previously noted, the Company does not invest in junk bonds. Any
non-investment grade securities held by the Company are the result of rating
downgrades that occurred subsequent to their purchase.
Following is a schedule of gross realized losses recognized in 2004 along
with the associated book values and sales prices aged according to the length
of time the underlying securities were in an unrealized loss position. This
schedule does not include realized losses stemming from corporate actions such
as calls, pay-downs, redemptions, etc. The Company's equity portfolio is
managed on a "tax-aware" basis, which generally results in sales of securities
at a loss to offset sales of securities at a gain, thus minimizing the
Company's income tax expense. Fixed maturity securities are generally held
until maturity.
Gross
Book Sales realized
($ in thousands) value price loss
--------- --------- ---------
Fixed maturity securities
available-for-sale:
Three months or less ............... $ 5,509 $ 4,186 $ 1,323
Over three months to six months .... 14,202 14,000 202
Over six months to nine months ..... 2,601 2,550 51
Over nine months to twelve months .. - - -
Over twelve months ................. - - -
--------- --------- ---------
$ 22,312 $ 20,736 $ 1,576
========= ========= =========
Equity securities:
Three months or less ............... $ 10,309 $ 9,279 $ 1,030
Over three months to six months .... 2,262 1,935 327
Over six months to nine months ..... 1,280 1,075 205
Over nine months to twelve months .. 1,018 712 306
Over twelve months ................. 1,271 1,113 158
--------- --------- ---------
$ 16,140 $ 14,114 $ 2,026
========= ========= =========
The realized losses recognized on fixed maturity securities that were in
an unrealized loss position for three months or less reflects the $1,268,000
other-than-temporary impairment loss recognized during the second quarter of
2004 on a new series of bonds issued by MCI Communications Corporation in
conjunction with a bankruptcy court approved payout award. The bonds were
sold at a gain during the third quarter of 2004.
LEASES, COMMITMENTS AND CONTINGENT LIABILITIES
The following table reflects the contractual obligations of the Company
as of December 31, 2004. Included in the table are the estimated payments
that the Company expects to make in the settlement of its loss reserves and
with respect to its long-term debt. One of the Company's property and
casualty insurance subsidiaries leases office facilities in Bismarck, North
Dakota with lease terms expiring in 2014. Hamilton Mutual Insurance Company,
an affiliate of Employers Mutual and a pool participant, leases office
facilities for the Cincinnati branch office with lease terms expiring in 2005.
Employers Mutual has entered into various leases for branch and service office
facilities with lease terms expiring through 2013. Employers Mutual also
leases computer software under various operating lease agreements expiring
through 2005. All lease costs are included as expenses under the pooling
agreement after allocation of the portion of these expenses to the
subsidiaries that do not participate in the pool. The table reflects the
Company's current 23.5 percent aggregate participation in the pooling
agreement. As discussed further under the caption "Company Overview," the
Company's aggregate participation in the pooling agreement will increase to
30.0 percent effective January 1, 2005.
Payments due by period
-----------------------------------------------
Less More
than 1-3 4-5 than
Total 1 year years years 5 years
-------- -------- -------- ------- --------
($ in thousands)
Contractual Obligations
- -----------------------
Loss and settlement expense
reserves (1) ............. $429,677 $171,138 $157,146 $52,971 $ 48,422
Long-term debt (2) ......... 36,000 - - - 36,000
Real estate operating leases 6,863 1,086 1,977 1,560 2,240
Software operating leases .. 375 375 - - -
-------- -------- -------- ------- --------
Total ...................... $472,915 $172,599 $159,123 $54,531 $ 86,662
======== ======== ======== ======= ========
(1) The amounts presented are estimates of the dollar amounts and time period
in which the Company expects to pay out its gross loss and settlement expense
reserves. These amounts are based on historical payment patterns and do not
represent actual contractual obligations. The actual payment amounts and the
related timing of those amounts could differ significantly from these
estimates.
(2) Long-term debt reflects the surplus notes issued by the Company's
insurance subsidiaries to Employer Mutual, which have no maturity date.
Interest on the surplus notes amounts to $1,112,000 annually, and is subject
to approval by the issuing company's state of domicile. Excluded from long-
term debt are pension and other postretirement benefit obligations.
Estimated guaranty fund assessments of $1,207,000 and $1,253,000, which
are used by states to pay claims of insolvent insurers domiciled in that
state, have been accrued as of December 31, 2004 and 2003, respectively. The
guaranty fund assessments are expected to be paid over the next two years with
premium tax offsets of $1,544,000 expected to be realized within ten years of
the payments. Estimated second injury fund assessments of $1,390,000 and
$1,109,000, which are designed to encourage employers to employ a worker with
a pre-existing disability, have been accrued as of December 31, 2004 and 2003,
respectively. The second injury fund assessment accruals are based on
projected loss payments. The periods over which the assessments will be paid
is not known.
The participants in the pooling agreement have purchased annuities from
life insurance companies, under which the claimant is payee, to fund future
payments that are fixed pursuant to specific claim settlement provisions. The
Company's share of loss reserves eliminated by the purchase of these annuities
was $700,000 at December 31, 2004. The Company has a contingent liability of
$700,000 should the issuers of these annuities fail to perform under the terms
of the annuities. The Company's share of the amount due from any one life
insurance company does not equal or exceed one percent of its subsidiaries'
policyholders' surplus.
MARKET RISK
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.
Interest rate risk includes the price sensitivity of a fixed maturity
security to changes in interest rates, and the affect on future earnings from
short-term investments and maturing long-term investments given a change in
interest rates. The following analysis illustrates the sensitivity of the
Company's financial instruments to selected changes in market rates and
prices. A hypothetical one percent increase in interest rates as of December
31, 2004 would result in a corresponding pre-tax decrease in the fair value of
the fixed maturity portfolio of approximately $39,229,000, or 5.6 percent. In
addition, a hypothetical one percent decrease in interest rates at December
31, 2004 would result in a corresponding decrease in pre-tax income over the
next twelve months of approximately $1,463,000, assuming the current maturity
and prepayment patterns. The Company monitors interest rate risk through the
analysis of interest rate simulations, and adjusts the average duration of its
fixed maturity portfolio by investing in either longer or shorter term
instruments given the results of interest rate simulations and judgments of
cash flow needs. The effective duration of the Company's fixed maturity
portfolio at December 31, 2004 was 5.19 years.
The valuation of the Company's marketable equity portfolios is subject to
equity price risk. In general, equities have more year-to-year price
variability than bonds. However, returns from equity securities have been
consistently higher over longer time frames. The Company invests in a
diversified portfolio of readily marketable equity securities. A hypothetical
10 percent decrease in the S&P 500 index as of December 31, 2004 would result
in a corresponding pre-tax decrease in the fair value of the Company's equity
portfolio of approximately $8,980,000.
The Company invests in high quality fixed maturity securities, thus
minimizing credit quality risk. At December 31, 2004, the portfolio of long-
term fixed maturity securities consists of 12.2 percent U.S. Treasury, 14.4
percent government agency, 0.5 percent mortgage-backed, 41.1 percent
municipal, and 31.8 percent corporate securities. At December 31, 2003, the
portfolio of long-term fixed maturity securities consisted of 26.7 percent
U.S. Treasury, 13.0 percent government agency, 2.8 percent mortgage-backed,
25.6 percent municipal, and 31.9 percent corporate securities.
Fixed maturity securities held by the Company generally have an
investment quality rating of "A" or better by independent rating agencies.
The following table shows the composition of the Company's fixed maturity
securities, by rating, as of December 31, 2004.
Securities Securities
held-to-maturity available-for-sale
(at amortized cost) (at fair value)
------------------- ------------------
($ in thousands) Amount Percent Amount Percent
-------- ------- -------- -------
Rating:
AAA ..................... $ 29,206 100.0% $349,176 56.3%
AA ...................... - - 90,847 14.7
A ....................... - - 134,837 21.7
BAA ..................... - - 40,046 6.5
B ....................... - - 4,748 0.8
-------- ----- -------- -----
Total fixed maturities $ 29,206 100.0% $619,654 100.0%
======== ===== ======== =====
Ratings for preferred stocks and fixed maturity securities with initial
maturities greater than one year are assigned by Moody's Investor's Services,
Inc. Moody's rating process seeks to evaluate the quality of a security by
examining the factors that affect returns to investors. Moody's ratings are
based on quantitative and qualitative factors, as well as the economic, social
and political environment in which the issuing entity exists. The
quantitative factors include debt coverage, sales and income growth, cash
flows and liquidity ratios. Qualitative factors include management quality,
access to capital markets and the quality of earnings and balance sheet items.
Ratings for securities with initial maturities less than one year are based on
an evaluation of the underlying assets or the credit rating of the issuer's
parent company.
Prepayment risk refers to the changes in prepayment patterns that can
shorten or lengthen the expected timing of principal repayments and thus the
average life and the effective yield of a security. Such risk exists
primarily within the portfolio of mortgage-backed securities. The prepayment
risk analysis is monitored regularly through the analysis of interest rate
simulations. At December 31, 2004, the effective duration of the mortgage-
backed securities is 1.7 years with an average life and current yield of 2.8
years and 7.1 percent, respectively. At December 31, 2003, the effective
duration of the mortgage-backed securities was 1.6 years with an average life
and current yield of 2.4 years and 7.0 percent, respectively.
IMPACT OF INFLATION
Inflation has a widespread effect on the Company's results of operations,
primarily through increased losses and settlement expenses. The Company
considers inflation, including social inflation that reflects an increasingly
litigious society and increasing jury awards, when setting reserve amounts.
Premiums are also affected by inflation, although they are often restricted or
delayed by competition and the regulatory rate-setting environment.
NEW ACCOUNTING PRONOUNCEMENTS
In December 2004, the Financial Accounting Standards Board (FASB) issued
SFAS No. 123 (revised 2004) "Share-Based Payment," which is a revision of SFAS
No. 123 "Accounting for Stock-Based Compensation" and supersedes Accounting
Principles Board (APB) Opinion No. 25 "Accounting for Stock Issued to
Employees." SFAS No. 123(R) requires all share-based payments to employees,
including grants of employee stock options, to be recognized in the financial
statements based on their fair values beginning with the first interim and
annual periods after June 15, 2005, with earlier adoption encouraged. The pro
forma disclosures previously allowed under Statement No. 123 will no longer be
an alternative to financial statement recognition. The transition methods for
adoption include the modified-prospective and modified-retroactive methods.
The modified-prospective method requires that compensation expense be recorded
for all unvested stock options that exist upon the adoption of Statement
123(R). Under the modified-retroactive method, prior periods may be restated
either as of the beginning of the year of adoption or for all periods
presented. The Company is currently evaluating the requirements of Statement
123(R), but does not expect adoption of this statement to have a material
effect on the operating results of the Company.
In 2003, the Emerging Issues Task Force (EITF) of the FASB reached a
consensus on certain disclosures required by EITF Issue 03-1, "The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments,"
which was effective for fiscal years ending after December 15, 2003. The
Company adopted this EITF in 2003, which only required additional disclosures
and did not have any effect on the operating results of the Company. In March
of 2004, the EITF reached a consensus on the guidance provided to determine
whether an investment is within the scope of Issue 3-1. Under EITF Issue
03-1, an investment is impaired if the fair value of the investment is less
than its cost including adjustments for amortization, accretion, foreign
exchange and hedging. An impairment would be considered other-than-temporary
unless a) the investor has the ability and intent to hold an investment for a
reasonable period of time sufficient for the recovery of the fair value up to
(or beyond) the cost of the investment, and b) evidence indicating that the
cost of the investment is recoverable within a reasonable period of time
outweighs evidence to the contrary. This new guidance for determining whether
the decline in the fair value of the investment is other-than-temporary was to
be effective for reporting periods beginning after June 15, 2004. On
September 30, 2004, the FASB issued EITF Issue 03-1-1 "Effective Date of
Paragraphs 10-20 of EITF Issue 3-1, The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments," which delayed the
effective date for the measurement and recognition guidance included in EITF
Issue 03-1 until additional implementation guidance is provided. Pending
adoption of the final rule, the Company continues to apply existing accounting
guidance for determining when a decline in fair value is other-than-temporary.
DEVELOPMENTS IN INSURANCE REGULATION
The NAIC has taken initial steps toward adopting selected provisions of
the Sarbanes-Oxley Act of 2002 into its model audit rule. The provisions most
likely to be adopted include the provisions on audit committees and auditor
independence, as well as the requirements that insurers include in their
annual statutory financial statements a statement of management's
responsibility for establishing and maintaining adequate internal control over
financial reporting, a report of management's assessment of the company's
internal control over financial reporting, and an attestation report by the
external auditor on the assessment. A working group is holding a series of
meetings to further study the implications of revising the model audit rule to
incorporate the Sarbanes-Oxley Act of 2002 Section 404-type requirements.
Adoption of these requirements into the model audit rule is expected to have
little consequence to either the Company or the EMC Insurance Companies, as
the Company is already subject to the provisions of the Sarbanes-Oxley Act of
2002.
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 beliefs, assumptions and expectations
of the Company's future performance, taking into account all information
currently available to management. These beliefs, assumptions and
expectations can change as the result of many possible events or factors, not
all of which are known to management. If a change occurs, the Company's
business, financial condition, liquidity, results of operations, plans and
objectives may vary materially from those expressed in the forward-looking
statements. 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; the
adequacy of loss and settlement expense reserves; state and federal
legislation and regulations; changes in the Company's industry, interest rates
or the performance of financial markets and the general economy; rating agency
actions and other risks and uncertainties inherent to the Company's business.
When the Company uses the words "believe", "expect", "anticipate", "estimate"
or similar expressions, the Company intends to identify forward-looking
statements. You should not place undue reliance on these forward-looking
statements.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The information under the caption "Market Risk" in the "Management's
Discussion and Analysis of Financial Condition and Results of Operations",
which is included in Part II, Item 7 of this Form 10-K, is incorporated herein
by reference.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
- ------- --------------------------------------------
Management's Responsibility for Financial Reporting
The management of EMC Insurance Group Inc. and Subsidiaries is
responsible for the preparation, integrity and objectivity of the accompanying
financial statements, as well as other financial information in this report.
The financial statements have been prepared in accordance with U.S. generally
accepted accounting principles and include amounts that are based on
management's estimates and judgments where necessary.
The Company's financial statements have been audited by Ernst & Young
LLP, Independent Registered Public Accounting Firm. Management has made
available to Ernst & Young LLP all of the Company's financial records and
related data, as well as the minutes of the stockholders' and directors'
meetings. Furthermore, management believes that all representations made to
Ernst & Young LLP during its audit were valid and appropriate. Their report
appears elsewhere in this annual report.
Management of the Company has established and continues to maintain a
system of internal controls that are designed to provide assurance as to the
integrity and reliability of the financial statements, the protection of
assets from unauthorized use or disposition, and the prevention and detection
of fraudulent financial reporting. The system of internal controls provides
for appropriate division of responsibility. Certain aspects of these systems
and controls are tested periodically by the Company's internal auditors.
Management considers the recommendations of its internal auditors and the
independent auditors concerning the Company's internal controls and takes the
necessary actions that are cost-effective in the circumstances to respond
appropriately to the recommendations presented. Although management is not
required to issue an annual report on internal control over financial
reporting until December 31, 2005, management believes that as of December 31,
2004, the Company's system of internal controls was adequate to accomplish the
above objectives.
The Audit Committee of the Board of Directors, composed solely of outside
directors, met during the year with management and the independent auditors to
review and discuss audit findings and other financial and accounting matters.
The independent auditors and the internal auditors have free access to the
Audit Committee, with and without management present, to discuss the results
of their audit work.
/s/ Bruce G. Kelley /s/ Mark E. Reese
- ------------------------ -------------------------
Bruce G. Kelley Mark E. Reese
President and Senior Vice President and
Chief Executive Officer Chief Financial Officer
Report of Ernst & Young LLP, Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
EMC Insurance Group Inc.
We have audited the accompanying consolidated balance sheets of EMC
Insurance Group Inc. and Subsidiaries as of December 31, 2004 and 2003, and
the related consolidated statements of income, comprehensive income,
stockholders' equity, and cash flows for each of the three years in the period
ended December 31, 2004. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on
these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require
that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. We were
not engaged to perform an audit of the Company's internal control over
financial reporting. Our audit included consideration of internal control
over financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present
fairly, in all material respects, the consolidated financial position of EMC
Insurance Group Inc. and Subsidiaries at December 31, 2004 and 2003 and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 2004, in conformity with U.S.
generally accepted accounting principles.
/s/Ernst & Young LLP
March 11, 2005
Des Moines, Iowa
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31,
--------------------------
2004 2003
------------ ------------
ASSETS
Investments:
Fixed maturities:
Securities held-to-maturity, at amortized cost
(fair value $16,908,726 and $21,167,655) .... $ 15,895,607 $ 19,423,013
Securities available-for-sale, at fair value
(amortized cost $541,401,950 and
$382,326,388) ............................... 565,000,931 405,758,798
Fixed maturity securities on loan:
Securities held-to-maturity, at amortized cost
(fair value $13,684,880 and $32,686,769) ... 13,310,264 30,422,335
Securities available-for-sale, at fair value
(amortized cost $54,389,046 and
$117,184,150) .............................. 54,653,472 118,026,960
Equity securities available-for-sale, at fair
value (cost $59,589,434 and $38,998,075) ..... 78,692,893 49,008,498
Other long-term investments, at cost ........... 5,550,093 4,758,019
Short-term investments, at cost ................ 46,238,853 63,568,064
------------ ------------
Total investments .......................... 779,342,113 690,965,687
Balances resulting from related party transactions
with Employers Mutual:
Reinsurance receivables ..................... 26,316,358 21,720,789
Prepaid reinsurance premiums ................ 3,682,676 3,297,228
Deferred policy acquisition costs ........... 27,940,583 26,737,784
Intangible asset, pension plan .............. - 1,016,492
Pension plan prepaid asset .................. 2,684,463 -
Other assets ................................ 1,877,564 1,857,284
Cash ............................................. 61,088 (14,069,102)
Accrued investment income ........................ 8,726,292 7,821,652
Accounts receivable (net of allowance for
uncollectible accounts of $0 and $0) ........... 216,836 379,423
Income taxes recoverable ......................... 3,399,485 -
Deferred income taxes ............................ 9,504,193 10,345,429
Goodwill, at cost less accumulated amortization
of $2,616,234 and $2,616,234 ................... 941,586 941,586
Securities lending collateral .................... 70,122,695 154,556,758
------------ ------------
Total assets .............................. $934,815,932 $905,571,010
============ ============
See accompanying Notes to Consolidated Financial Statements.
CONSOLIDATED BALANCE SHEETS
December 31,
--------------------------
2004 2003
------------ ------------
LIABILITIES
Balances resulting from related party transactions
with Employers Mutual:
Losses and settlement expenses ............. $429,677,302 $373,782,916
Unearned premiums .......................... 131,589,365 124,832,607
Other policyholders' funds ................. 2,825,809 1,390,594
Surplus notes payable ...................... 36,000,000 36,000,000
Indebtedness to related party .............. 6,058,848 2,175,118
Employee retirement plans .................. 9,764,406 9,965,600
Other liabilities .......................... 20,304,475 19,336,366
Income taxes payable ............................. - 2,780,500
Securities lending obligation .................... 70,122,695 154,556,758
------------ ------------
Total liabilities ........................ 706,342,900 724,820,459
------------ ------------
STOCKHOLDERS' EQUITY
Common stock, $1 par value,
authorized 20,000,000 shares;
issued and outstanding, 13,568,945 shares
in 2004 and 11,501,065 shares in 2003 .......... 13,568,945 11,501,065
Additional paid-in capital ....................... 103,467,293 69,113,228
Accumulated other comprehensive income ........... 27,928,463 22,285,668
Retained earnings ................................ 83,508,331 77,850,590
------------ ------------
Total stockholders' equity ................. 228,473,032 180,750,551
------------ ------------
Total liabilities and stockholders' equity $934,815,932 $905,571,010
============ ============
See accompanying Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF INCOME
All balances presented below, with the exception of investment income,
realized investment gains (losses) and income tax expense (benefit), are the
result of related party transactions with Employers Mutual.
Year ended December 31,
----------------------------------------
2004 2003 2002
------------ ------------ ------------
REVENUES
Premiums earned .................... $345,478,461 $330,622,810 $297,043,033
Investment income, net ............. 29,900,203 29,702,461 32,778,133
Realized investment gains (losses) 4,379,314 1,169,698 (3,159,201)
Other income ....................... 600,732 862,070 865,819
------------ ------------ ------------
380,358,710 362,357,039 327,527,784
------------ ------------ ------------
LOSSES AND EXPENSES
Losses and settlement expenses ..... 249,806,210 226,504,550 207,057,856
Dividends to policyholders ......... 4,478,169 3,011,433 2,977,154
Amortization of deferred
policy acquisition costs ......... 75,444,837 71,959,232 65,727,016
Other underwriting expenses ........ 32,783,686 29,924,942 26,928,972
Interest expense ................... 1,112,400 1,320,266 1,638,716
Other expenses ..................... 1,162,411 1,654,320 1,306,034
------------ ------------ ------------
364,787,713 334,374,743 305,635,748
------------ ------------ ------------
Income before income
tax expense (benefit) ...... 15,570,997 27,982,296 21,892,036
------------ ------------ ------------
INCOME TAX EXPENSE (BENEFIT)
Current .......................... 4,583,505 8,336,381 5,061,093
Deferred ......................... (2,197,191) (703,208) 729,205
------------ ------------ ------------
2,386,314 7,633,173 5,790,298
------------ ------------ ------------
Net income ................... $ 13,184,683 $ 20,349,123 $ 16,101,738
============ ============ ============
Net income per common share
- basic and diluted .............. $ 1.10 $ 1.78 $ 1.42
============ ============ ============
Average number of shares outstanding
- basic and diluted .............. 11,948,710 11,453,324 11,375,779
============ ============ ============
See accompanying Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Year ended December 31,
----------------------------------------
2004 2003 2002
------------ ------------ ------------
Net income ......................... $ 13,184,683 $ 20,349,123 $ 16,101,738
------------ ------------ ------------
OTHER COMPREHENSIVE INCOME
Unrealized holding gains
arising during the period,
before deferred income tax
expense ........................ 13,051,438 13,290,568 7,454,522
Deferred income tax expense ...... 4,568,003 4,651,699 2,609,079
------------ ------------ ------------
8,483,435 8,638,869 4,845,443
------------ ------------ ------------
Reclassification adjustment for
(gains) losses included in net
income, before income
tax expense (benefit) .......... (4,370,215) (1,168,918) 3,159,201
Income tax expense (benefit) ..... 1,529,575 409,121 (1,105,720)
------------ ------------ ------------
(2,840,640) (759,797) 2,053,481
------------ ------------ ------------
Adjustment for minimum liability
associated with Employers
Mutual's pension plan .......... - 289,639 (289,639)
Deferred income tax expense
(benefit) ...................... - 101,373 (101,373)
------------ ------------ ------------
- 188,266 (188,266)
------------ ------------ ------------
Other comprehensive income ... 5,642,795 8,067,338 6,710,658
------------ ------------ ------------
Total comprehensive income ... $ 18,827,478 $ 28,416,461 $ 22,812,396
============ ============ ============
See accompanying Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Year ended December 31,
--------------------------------------
2004 2003 2002
------------ ------------ ------------
COMMON STOCK
Beginning of year .................. $ 11,501,065 $ 11,399,050 $ 11,329,987
Issuance of common stock through
follow-on stock offering ......... 2,000,000 - -
Issuance of common stock through
Employers Mutual's stock option
plans ............................ 67,880 102,015 69,063
------------ ------------ ------------
End of year ........................ 13,568,945 11,501,065 11,399,050
------------ ------------ ------------
ADDITIONAL PAID-IN CAPITAL
Beginning of year .................. 69,113,228 67,270,591 66,013,203
Issuance of common stock through
follow-on stock offering ......... 32,890,085 - -
Issuance of common stock through
Employers Mutual's stock option
plans ............................ 1,463,980 1,842,637 1,257,388
------------ ------------ ------------
End of year ........................ 103,467,293 69,113,228 67,270,591
------------ ------------ ------------
ACCUMULATED OTHER COMPREHENSIVE
INCOME
Beginning of year .................. 22,285,668 14,218,330 7,507,672
Unrealized gains on
available-for-sale securities .... 5,642,795 7,879,072 6,898,924
Minimum liability associated with
Employers Mutual's pension plan .. - 188,266 (188,266)
------------ ------------ ------------
End of year ........................ 27,928,463 22,285,668 14,218,330
------------ ------------ ------------
RETAINED EARNINGS
Beginning of year .................. 77,850,590 64,880,393 55,606,761
Net income ......................... 13,184,683 20,349,123 16,101,738
Dividends paid to public
stockholders ($.60 per share in
2004, 2003 and 2002) ............. (1,941,181) (1,350,736) (1,405,064)
Dividends paid to Employers Mutual
($.60 per share in 2004, 2003 and
2002) ............................ (5,292,178) (5,522,994) (5,423,042)
Dividends paid to Employers Mutual
(reimbursement for non-GAAP
expenses) ........................ (293,583) (505,196) -
------------ ------------ ------------
End of year ........................ 83,508,331 77,850,590 64,880,393
------------ ------------ ------------
Total stockholders' equity ....... $228,473,032 $180,750,551 $157,768,364
============ ============ ============
See accompanying Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year ended December 31,
-------------------------------------
2004 2003 2002
----------- ----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income .......................... $13,184,683 $20,349,123 $16,101,738
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 .................. 55,894,386 42,556,163 16,708,165
Unearned premiums ........... 6,756,758 9,085,793 16,364,638
Other policyholders' funds .. 1,435,215 354,972 562,670
Indebtedness of related party 3,883,730 (1,129,421) 620,121
Employee retirement plans ... (2,885,657) 636,114 774,079
Reinsurance receivables ..... (4,595,569) (10,138,653) 2,919,200
Prepaid reinsurance premiums (385,448) (854,329) (167,668)
Commission payable .......... 2,594,243 2,470,516 2,732,425
Interest payable ............ 278,100 (1,003,066) 1,641,205
Prepaid assets .............. 8,029 (87,676) 27,894
Deferred policy acquisition costs (1,202,799) (1,810,923) (3,563,333)
Accrued investment income ....... (904,640) 1,357,903 (520,547)
Accrued income taxes:
Current ....................... (6,179,985) 2,994,004 (112,890)
Deferred ...................... (2,197,191) (703,208) 729,205
Realized investment (gains)
losses ........................ (4,379,314) (1,169,698) 3,159,201
Accounts receivable ............. 162,587 393,521 308,080
Other, net ...................... (672,675) (206,551) (1,717,779)
----------- ----------- -----------
47,609,770 42,745,461 40,464,666
----------- ----------- -----------
Net cash provided by
operating activities .... $60,794,453 $63,094,584 $56,566,404
=========== =========== ===========
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED
Year ended December 31,
----------------------------------------
2004 2003 2002
------------ ------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES
Maturities of fixed maturity
securities held-to-maturity .... $ 20,635,775 $ 5,293,717 $ 11,074,685
Purchases of fixed maturity
securities available-for-sale .. (830,263,629) (791,156,969) (229,504,732)
Disposals of fixed maturity
securities available-for-sale .. 737,364,629 753,004,136 180,717,143
Purchases of equity securities
available-for-sale ............. (52,518,206) (34,283,972) (43,930,432)
Disposals of equity securities
available-for-sale ............. 32,685,028 31,151,627 33,884,190
Purchase of other long-term
investments .................... (3,078,000) (2,040,000) (4,057,004)
Disposals of other long-term
investments .................... 2,285,926 338,981 1,000,004
Net sales (purchases) of
short-term investments ......... 17,329,211 (33,917,835) (11,925,773)
------------ ------------ ------------
Net cash used in investing
activities ............. (75,559,266) (71,610,315) (62,741,919)
------------ ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Balances resulting from related
party transactions with
Employers Mutual:
Issuance of common stock
through Employers Mutual's
stock option plans ......... 1,531,860 1,944,652 1,326,451
Dividends paid to
Employers Mutual ........... (5,292,178) (5,522,994) (5,423,042)
Dividends paid to Employers
Mutual (reimbursement for
non-GAAP expense) .......... (293,583) (505,196) -
Issuance of surplus notes .... - - 11,000,000
Issuance of common stock through
follow-on stock offering ....... 34,890,085 - -
Dividends paid to public
stockholders ................... (1,941,181) (1,350,736) (1,405,064)
------------ ------------ ------------
Net cash provided by (used
in) financing activities 28,895,003 (5,434,274) 5,498,345
------------ ------------ ------------
Net increase (decrease) in cash .... 14,130,190 (13,950,005) (677,170)
Cash at beginning of year .......... (14,069,102) (119,097) 558,073
------------ ------------ ------------
Cash at end of year ................ $ 61,088 $(14,069,102) $ (119,097)
============ ============ ============
Income taxes paid .................. $ 10,957,163 $ 5,400,010 $ 4,755,010
Interest paid ...................... $ 884,310 $ 615,709 $ 19,232
See accompanying Notes to Consolidated Financial Statements
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation and Basis of Presentation
EMC Insurance Group Inc., a 53.7 percent owned subsidiary of Employers
Mutual Casualty Company (Employers Mutual), is an insurance holding company
with operations in property and casualty insurance and reinsurance. Both
commercial and personal lines of insurance are written, with a focus on
medium-sized commercial accounts. Approximately 38 percent of the premiums
written are in Iowa and contiguous states. The term "Company" is used
interchangeably to describe EMC Insurance Group Inc. (Parent Company only) and
EMC Insurance Group Inc. and its subsidiaries.
The Company's subsidiaries include EMCASCO Insurance Company, Illinois
EMCASCO Insurance Company, Dakota Fire Insurance Company, Farm and City
Insurance Company, EMC Reinsurance Company and EMC Underwriters, LLC.
The consolidated financial statements have been prepared on the basis of
U.S. generally accepted accounting principles (GAAP), which differ in some
respects from those followed in reports to insurance regulatory authorities.
All significant inter-company balances and transactions have been eliminated.
The preparation of financial statements in conformity with GAAP requires
management to make estimates and assumptions that affect the reported amounts
of assets and liabilities and the disclosure of contingent assets and
liabilities at the date of the financial statements, and the reported amounts
of revenues and expenses during the reporting periods. Actual results could
differ from those estimates.
Property and Casualty Insurance and Reinsurance Operations
Property and casualty insurance premiums are recognized as revenue
ratably over the terms of the respective policies. Unearned premiums are
calculated on the daily pro rata method. Both domestic and foreign assumed
reinsurance premiums are recognized as revenues ratably over the terms of the
contract period. Amounts paid as ceded reinsurance premiums are reported as
prepaid reinsurance premiums and are amortized over the remaining contract
period in proportion to the amount of reinsurance protection provided.
Reinsurance reinstatement premiums are recognized in the same period as the
loss event that gave rise to the reinstatement premiums.
Certain costs of acquiring new business, principally commissions, premium
taxes and other underwriting expenses that vary with and are directly related
to the production of business have been deferred. Such deferred costs are
being amortized as premium revenue is recognized. The method followed in
computing deferred policy acquisition costs limits the amount of such deferred
costs to their estimated 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.
Certain commercial lines of business, primarily workers' compensation,
are eligible for policyholder dividends in accordance with provisions of the
underlying insurance policies. Net premiums written subject to policyholder
dividends represented approximately 49 percent of the Company's total net
premiums written in 2004. Policyholder dividends are accrued over the terms
of the underlying policies.
Liabilities for losses are based upon case-basis estimates of reported
losses, estimates of unreported losses based upon prior experience adjusted
for current trends, and estimates of losses expected to be paid under assumed
reinsurance contracts. Liabilities for settlement expenses are provided by
estimating expenses expected to be incurred in settling the claims provided
for in the loss reserves. Changes in estimates are reflected in current
operating results (see note 4).
Ceded reinsurance amounts with nonaffiliated reinsurers relating to
reinsurance receivables for paid and unpaid losses and settlement expenses and
prepaid reinsurance are reported on the balance sheet on a gross basis.
Amounts ceded to Employers Mutual relating to the affiliated reinsurance
pooling agreement (see note 2) have not been grossed up because the contracts
provide that receivables and payables may be offset upon settlement.
Based on current information, the liabilities for losses and settlement
expenses are considered to be adequate. Since the provisions are necessarily
based on estimates, the ultimate liability may be more or less than such
provisions.
Investments
Securities classified as held-to-maturity are purchased with the intent
and ability to be held to maturity and are carried at amortized cost.
Unrealized holding gains and losses on securities held-to-maturity are not
reflected in the financial statements. All other securities have been
classified as securities available-for-sale and are carried at fair value,
with unrealized holding gains and losses reported as accumulated other
comprehensive income in stockholders' equity, net of deferred income taxes.
Other long-term investments represent minor ownership interests in limited
partnerships and limited liability companies and are carried at cost. Short-
term investments represent money market funds and are carried at cost, which
approximates fair value.
The Company's carrying value for investments is reduced to its estimated
realizable value if a decline in the fair value is deemed other-than-
temporary. Such reductions in carrying value are recognized as realized
losses and are charged to income. Premiums and discounts on debt securities
are amortized over the life of the security as an adjustment to yield using
the effective interest method. Realized gains and losses on disposition of
investments are included in net income. The cost of investments sold is
determined on the specific identification method using the highest cost basis
first. Included in investments at December 31, 2004 and 2003 are securities
on deposit with various regulatory authorities as required by law amounting to
$13,000,797 and $12,960,435, respectively.
The Company participates in a securities lending program whereby certain
fixed maturity securities from the investment portfolio are loaned to other
institutions for a short period of time. The Company requires initial
collateral equal to 102 percent of the market value of the loaned securities.
The collateral is invested by the lending agent, in accordance with the
Company's guidelines, and generates fee income for the Company that is
recognized ratably over the time period the security is on loan. The
securities on loan to others are segregated from the other invested assets on
the Company's balance sheet. In accordance with relevant accounting
literature, the collateral held by the Company is accounted for as a secured
borrowing and is recorded as an asset on the Company's balance sheet with a
corresponding liability reflecting the Company's obligation to return this
collateral upon the return of the loaned securities.
Income Taxes
Effective April 1, 2003, the Company was included in Employers Mutual's
consolidated tax return due to the fact that Employers Mutual attained 80
percent ownership of the Company at the end of March. The Company filed a
short-period tax return with its subsidiaries for the period January 1, 2003
through March 31, 2003. During October 2004, Employers Mutual's ownership of
the Company fell below 80 percent upon successful completion of the follow-on
stock offering. Accordingly, the Company is no longer included in Employers
Mutual's consolidated tax return effective October 1, 2004, and the Company
will file a short-period tax return for the period October 1, 2004 through
December 31, 2004. Consolidated income taxes/benefits are allocated among the
entities based upon separate tax liabilities.
Deferred income taxes are provided for temporary differences between the
tax basis of assets and liabilities and the reported amounts of those assets
and liabilities for financial reporting purposes. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to be
recovered or settled. Income tax expense provisions increase or decrease in
the same period in which a change in tax rates is enacted. A valuation
allowance is established to reduce deferred tax assets to their net realizable
value if it is "more likely than not" that a tax benefit will not be realized.
Stock Based Compensation
The Company has no stock based compensation plans of its own; however,
Employers Mutual has several stock plans that utilize the common stock of the
Company. The Company receives the current fair value for any shares issued
under these plans. Under the terms of the pooling and quota share agreements
(see note 2), stock option expense is allocated to the Company as determined
on a statutory basis of accounting; however, for these GAAP basis financial
statements the Company accounts for the stock option plans using the intrinsic
value method of accounting as prescribed by Accounting Principles Board (APB)
Opinion No. 25, "Accounting for Stock Issued to Employees," and related
interpretations. Under the provisions of APB 25, no compensation expense is
recognized from the operation of Employers Mutual's stock option plans since
the exercise price of the options is equal to the fair value of the stock on
the date of grant.
The Company's insurance subsidiaries reimburse Employers Mutual for their
share of the statutory-basis compensation expense associated with stock option
exercises under the terms of the pooling and quota share agreements.
Beginning in 2003, the statutory-basis compensation expense that was paid by
the Company's subsidiaries to Employers Mutual ($293,583 in 2004 and $505,196
in 2003) was reclassified as a dividend payment to Employers Mutual in these
GAAP-basis financial statements. Since the corresponding amount for 2002 was
not material, the financial statements for 2002 were not restated.
The following table illustrates the effect on net income and earnings per
share if the Company had applied the fair value recognition provisions of
Financial Accounting Standards Board (FASB) Statement of Financial Accounting
Standards (SFAS) SFAS No. 123 (as amended by SFAS No. 148) "Accounting for
Stock-Based Compensation" to Employers Mutual's stock option plans:
2004 2003 2002
----------- ----------- -----------
Net income, as reported ........ $13,184,683 $20,349,123 $16,101,738
Deduct:
Stock-based employee
compensation expense
determined under the
fair value method for all
awards, net of related
tax effects .................. 32,373 25,383 18,992
----------- ----------- -----------
Pro forma net income ........... $13,152,310 $20,323,740 $16,082,746
=========== =========== ===========
Net income per share:
Basic and diluted -
As reported ................ $1.10 $1.78 $1.42
Pro forma .................. $1.10 $1.77 $1.41
The weighted average fair value of options granted amounted to $4.44,
$2.93 and $3.28 for 2004, 2003 and 2002, respectively. The fair value of each
option grant is estimated on the date of grant using the Black-Scholes-Merton
option-pricing model with the following weighted-average assumptions used for
the grants:
2004 2003 2002
-------- -------- --------
Dividend yield .......................... 2.69% 3.56% 3.28%
Expected volatility ..................... .239 .247 .218
Risk-free interest rate ................. 3.12% 2.99% 4.37%
Expected term (years) ................... 5.75 5.35 5.00
In December 2004, the FASB issued SFAS No. 123 (revised 2004) "Share-
Based Payment," which is a revision of SFAS No. 123 and supersedes APB No. 25.
SFAS No. 123(R) requires all share-based payments to employees, including
grants of employee stock options, to be recognized in the financial statements
based on their fair values beginning with the first interim and annual periods
after June 15, 2005, with earlier adoption encouraged. The pro forma
disclosures previously allowed under SFAS No. 123 will no longer be an
alternative to financial statement recognition. The transition methods for
adoption include the modified-prospective and modified-retroactive methods.
The modified-prospective method requires that compensation expense be recorded
for all unvested stock options that exist upon the adoption of Statement
123(R). Under the modified-retroactive method, prior periods may be restated
either as of the beginning of the year of adoption or for all periods
presented. The Company is currently evaluating the requirements of Statement
123(R), but does not expect adoption of this statement to have a material
effect on the financial position or the results of operations of the Company.
Net Income Per Share - Basic and Diluted
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 any shares issued under Employers Mutual's stock plans.
As a result, the Company had no potential common shares outstanding during
2004, 2003 and 2002 that would have been dilutive to net income per share.
Goodwill
Goodwill represents the excess of cost over the fair value of net assets
of acquired subsidiaries. Goodwill is not amortized, but is subject to annual
impairment testing to determine if the carrying value of the goodwill exceeds
the estimated fair value of net assets. If the carrying amount of the
subsidiary (including goodwill) exceeds the computed fair value, an impairment
loss is recognized through earnings equal to the excess amount, but not
greater then the balance of the goodwill. The annual impairment test is
completed in the fourth quarter of each year and goodwill was not deemed to be
impaired in 2004, 2003 or 2002.
Reclassifications
Certain amounts previously reported in prior years' consolidated
financial statements have been reclassified to conform to current year
presentation.
2. AFFILIATION AND TRANSACTIONS WITH AFFILIATES
Property and Casualty Insurance Subsidiaries
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 premiums, 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. Employers Mutual negotiates reinsurance agreements that provide
protection to the pool and each of its participants, including protection
against losses arising from catastrophic events.
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.
Effective December 31, 2003, the pooling agreement was amended to provide that
Employers Mutual will make up any shortfall or difference resulting from an
error in its systems and/or computational processes that would otherwise
result in the required restatement of the pool participants' financial
statements.
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.
On October 20, 2004, the Company successfully completed a follow-on stock
offering and sold 2.0 million new shares of its common stock to the public at
a price of $18.75 per share. Employers Mutual participated in the stock
offering as a selling shareholder and sold 2.1 million shares of the Company's
common stock that it previously owned. As a result of these transactions,
Employers Mutual's ownership of the Company was reduced from approximately
80.9 percent to approximately 53.7 percent.
Net proceeds from the follow-on stock offering totaled $34,890,085.
These proceeds were contributed to three of the Company's property and
casualty insurance subsidiaries in late December to support a planned 6.5
percentage point increase in the Company's aggregate participation in the
pooling agreement effective January 1, 2005. As a result of this change, the
Company's aggregate participation in the pooling agreement will increase from
the current 23.5 percent to 30.0 percent and Employers Mutual's participation
will decrease from the current 65.5 percent to 59.0 percent. In connection
with this change in the pooling agreement, the Company's liabilities will
increase $115,042,355 and invested assets will increase $108,798,583. The
Company will reimburse Employers Mutual $6,518,735 for expenses that were
incurred to generate the additional business assumed by the Company, but this
expense will be offset by an increase in deferred policy acquisition costs.
The Company will also receive $274,963 in interest income from Employers
Mutual as the actual cash transfer did not occur until February 15, 2005.
In addition to changing the individual pool participation percentages of
Employers Mutual and three of the Company's property and casualty insurance
subsidiaries, the pooling agreement has been amended effective January 1, 2005
to comply with certain conditions established by the Iowa Insurance Department
and A.M. Best Company. These amendments: (1) provide for a fixed term of
three years commencing January 1, 2005 and continuing until December 31, 2007,
during which period the pooling agreement may not be terminated and the
revised participation interests will not be further amended, absent the
occurrence of a material event not in the ordinary course of business that
could reasonably be expected to impact the appropriateness of the
participation interests in the pool; (2) provide that if a pool participant
becomes insolvent, or is otherwise subject to liquidation or receivership
proceedings, each of the other participants will, on a pro rata basis, adjust
their assumed portions of the pool liabilities in order to assume in full the
liabilities of the impaired participant, subject to compliance with all
regulatory requirements applicable to such adjustment under the laws of all
states in which the participants are domiciled; (3) clarify that all
development on prior years' outstanding losses and settlement expenses of the
participants will remain in the pool and be pro rated pursuant to the pooling
agreement; and (4) clarify that all liabilities incurred prior to a
participant withdrawing from the pool, and associated with such withdrawing
participant, shall remain a part of the pool and subject to the pooling
agreement.
During 2004, the Company's wholly-owned subsidiary, Farm and City
Insurance Company, discontinued writing new nonstandard risk automobile
insurance business and began instituting non-renewal procedures on all
existing business. The effective dates for these actions were determined by
the requirements of the six states in which it conducts business and the terms
of the individual policies. Farm and City will continue to participate in the
pooling agreement even though it will no longer write any direct insurance
business. Discontinuance of the nonstandard risk automobile insurance
business did not have a material impact on the results of operations of the
Company. In 2004, Farm and City's direct premiums written declined to
$1,553,000 from $9,849,000 in 2003. Under the terms of the pooling agreement,
only 23.5 percent of this decline ($1,950,000) was assumed by the Company.
Reinsurance Subsidiary
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 directly reinsure
any of the insurance business written by Employers Mutual; however, the
reinsurance subsidiary assumes reinsurance business from the Mutual
Reinsurance Bureau pool and this pool provides a very small amount of
reinsurance protection to the EMC Insurance Companies. As a result, the
reinsurance subsidiary's assumed exposures include a very small portion of the
EMC Insurance Companies direct business, after ceded reinsurance protections
purchased by the Mutual Reinsurance Bureau pool are applied. In addition,
reinsurance subsidiary does not reinsure any "involuntary" facility or pool
business that Employers Mutual assumes pursuant to state law. 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.
Premiums assumed by the reinsurance subsidiary from Employers Mutual
amounted to $97,637,066, $90,057,773 and $76,203,278 in 2004, 2003 and 2002,
respectively. It is customary in the reinsurance business for the assuming
company to compensate the ceding company for the acquisition expenses incurred
in the generation of the business. Commissions paid by the reinsurance
subsidiary to Employers Mutual amounted to $20,621,898, $18,936,008 and
$18,117,058 in 2004, 2003 and 2002, respectively.
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. Total override commission paid to Employers Mutual amounted to
$4,393,668, $4,052,600 and $3,429,148 in 2004, 2003 and 2002, respectively.
Employers Mutual retained losses and settlement expenses under this agreement
totaling $11,277,246 in 2004, $2,747,334 in 2003 and $1,186,598 in 2002. 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 and amounted to $3,626,833, $3,802,878 and $3,247,969
in 2004, 2003 and 2002, respectively.
Services Provided by Employers Mutual
Employers Mutual provides various services to all of its subsidiaries and
affiliates. Such services include data processing, claims, financial,
actuarial, auditing, marketing and underwriting. Employers Mutual allocates a
portion of the cost of these services to the subsidiaries that do not
participate in the pooling agreement based upon a number of criteria,
including usage and number of transactions. The remaining costs are charged
to the pooling agreement and each pool participant shares in the total cost in
accordance with its pool participation percentage. Costs allocated to the
Company by Employers Mutual for services provided to the holding company and
its subsidiaries that do not participate in the pooling agreement amounted to
$2,300,700, $2,097,057 and $1,765,287 in 2004, 2003 and 2002, respectively.
Costs allocated to the Company through the operation of the pooling agreement
amounted to $73,305,162, $63,293,517 and $56,897,066 in 2004, 2003 and 2002,
respectively.
Investment expenses are based on actual expenses incurred by the Company
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 $699,807, $699,954 and $559,136 in 2004, 2003 and
2002, respectively.
3. REINSURANCE
The parties to the pooling agreement cede insurance business to other
insurers in the ordinary course of business for the purpose of limiting their
maximum loss exposure through diversification of their risks. In its
consolidated financial statements, the Company treats risks to the extent they
are reinsured as though they were risks for which the Company is not liable.
Insurance ceded by the pool participants does not relieve their primary
liability as the originating insurers. Employers Mutual evaluates the
financial condition of the reinsurers of the parties to the pooling agreement
and monitors concentrations of credit risk arising from similar geographic
regions, activities or economic characteristics of the reinsurers to minimize
exposure to significant losses from reinsurer insolvencies.
As of December 31, 2004, reinsurance ceded to two nonaffiliated
reinsurers aggregated $12,495,837, which represents a significant portion of
the total prepaid reinsurance premiums and reinsurance receivables for losses
and settlement expenses. These amounts reflect the property and casualty
insurance subsidiaries' aggregate pool participation percentage of amounts
ceded by Employers Mutual to these organizations in connection with its role
as "service carrier". Under these arrangements, Employers Mutual writes
business for these organizations on a direct basis and then cedes 100 percent
of this business to these organizations. Credit risk associated with these
amounts is minimal, as all companies participating in these organizations are
responsible for the liabilities of such organizations on a pro rata basis.
In 2004 the Company changed the recording of large no-fault auto claims
associated with the Michigan Catastrophic Claims Association (MCCA) and began
recording the reserves, which are ceded 100 percent to this association, on a
gross basis. The 2003 consolidated balance sheet was restated for comparative
purposes. As a result, the 2003 balances for "Reinsurance receivables" and
"Losses and settlement expenses" were increased $5,859,035.
The effect of reinsurance on premiums written and earned, and losses and
settlement expenses incurred, for the three years ended December 31, 2004 is
presented below. The 2003 losses and settlement expenses incurred amounts for
direct, assumed from affiliates, ceded to non-affiliates and ceded to
affiliates amounts incurred have been restated to reflect change in recording
claims associated with the MCCA. There was no effect on net losses and
settlement expenses incurred.
Year ended December 31,
----------------------------------------
2004 2003 2002
------------ ------------ ------------
Premiums written
Direct ......................... $191,823,068 $220,741,419 $235,596,547
Assumed from nonaffiliates ..... 4,125,092 3,816,789 3,985,370
Assumed from affiliates ........ 366,224,505 351,641,368 320,940,551
Ceded to nonaffiliates ......... (18,445,768) (15,808,709) (11,089,041)
Ceded to affiliates ............ (191,823,068) (220,741,419) (235,596,547)
------------ ------------ ------------
Net premiums written ......... $351,903,829 $339,649,448 $313,836,880
============ ============ ============
Premiums earned
Direct ......................... $197,051,604 $221,662,098 $241,939,466
Assumed from nonaffiliates ..... 3,933,665 3,629,346 3,501,616
Assumed from affiliates ........ 359,605,116 341,947,846 304,462,790
Ceded to nonaffiliates ......... (18,060,320) (14,954,382) (10,921,373)
Ceded to affiliates ............ (197,051,604) (221,662,098) (241,939,466)
------------ ------------ ------------
Net premiums earned .......... $345,478,461 $330,622,810 $297,043,033
============ ============ ============
Losses and settlement expenses
incurred
Direct ......................... $132,616,303 $176,461,490 $165,218,514
Assumed from nonaffiliates ..... 2,897,364 3,270,406 2,876,808
Assumed from affiliates ........ 258,134,261 239,682,836 206,614,356
Ceded to nonaffiliates ......... (11,225,415) (16,448,692) (2,433,308)
Ceded to affiliates ............ (132,616,303) (176,461,490) (165,218,514)
------------ ------------ ------------
Net losses and settlement
expenses incurred .......... $249,806,210 $226,504,550 $207,057,856
============ ============ ============
4. LIABILITY FOR LOSSES AND SETTLEMENT EXPENSES
The following table sets forth a reconciliation of beginning and ending
reserves for losses and settlement expenses of the Company. Amounts presented
are on a net basis, with a reconciliation of beginning and ending reserves to
the gross amounts presented in the consolidated financial statements.
Year ended December 31,
----------------------------------------
2004 2003 2002
------------ ------------ ------------
Gross reserves at beginning of year $373,782,916 $331,226,753 $314,518,588
Ceded reserves at beginning of year (20,666,429) (10,367,624) (11,848,597)
------------ ------------ ------------
Net reserves at beginning of year .. 353,116,487 320,859,129 302,669,991
------------ ------------ ------------
Incurred losses and
settlement expenses
Provision for insured events
of the current year ............ 229,667,776 219,028,236 200,059,798
Increase in provision for
insured events of prior years .. 20,138,434 7,476,314 6,998,058
------------ ------------ ------------
Total incurred losses and
settlement expenses ...... 249,806,210 226,504,550 207,057,856
------------ ------------ ------------
Payments
Losses and settlement expenses
attributable to insured events
of the current year ............ 83,530,727 86,072,127 81,124,276
Losses and settlement expenses
attributable to insured events
of prior years ................. 115,072,988 108,175,065 107,744,442
------------ ------------ ------------
Total payments ............. 198,603,715 194,247,192 188,868,718
------------ ------------ ------------
Net reserves at end of year ........ 404,318,982 353,116,487 320,859,129
Ceded reserves at end of year ...... 25,358,320 20,666,429 10,367,624
------------ ------------ ------------
Gross reserves at end of year ...... $429,677,302 $373,782,916 $331,226,753
============ ============ ============
Underwriting results of the Company are significantly influenced by
estimates of loss and settlement expense reserves. Changes in reserve
estimates are reflected in operating results in the year such changes are
recorded. The property and casualty insurance segment experienced adverse
development on prior years' reserves for all three years presented, while the
reinsurance segment experienced favorable development in the two most recent
years and adverse development in 2002.
2004 Development
- ----------------
For the property and casualty insurance segment, the December 31, 2004
estimate of loss and settlement expense reserves for accident years 2003 and
prior increased $23,738,375 from the estimate at December 31, 2003. This
increase represents 9.4 percent of the December 31, 2003 carried reserves and
is attributed to a combination of newly reported claims in excess of carried
IBNR reserves ($14,758,000), development on case reserves of previously
reported claims ($11,037,000), bulk reserve strengthening ($2,350,000), and
settlement expense reserve increases resulting from increases in case reserves
($6,209,000). This adverse development was partially offset by $10,437,000 of
reinsurance recoveries associated with the case reserve development and IBNR
emergence. Substantial case reserve strengthening performed at the Company's
branch offices, primarily in the workers' compensation and other liability
lines of business, is the underlying reason for the adverse reserve
development that occurred during 2004. The economic factors behind this case
reserve strengthening include, most notably, an increase in workers'
compensation claim severity, increases in construction defect claim activity,
the recent occurrence of several large umbrella claims and increasing legal
expenses in the other liability line of business.
For the reinsurance segment, the December 31, 2004 estimate of loss and
settlement expense reserves for accident years 2003 and prior decreased
$3,599,941 from the estimate at December 31, 2003. This decrease represents
3.1 percent of the December 31, 2003 carried reserves and is primarily from
reported policy year 2003 losses for property, casualty and multi-line classes
that were below 2003 implicit projections.
2003 Development
- ----------------
For the property and casualty insurance segment, the December 31, 2003
estimate of loss and settlement expense reserves for accident years 2002 and
prior increased $9,014,984 from the estimate at December 31, 2002. This
increase represents 3.9 percent of the December 31, 2002 carried reserves and
is attributed to a combination of bulk reserve strengthening, development on
case reserves of previously reported claims and newly reported claims in
excess of carried incurred but not reported (IBNR) reserves. Included in the
reserve strengthening actions taken during 2003 was an increase of
approximately $6,055,000 in formula IBNR reserves, an increase of
approximately $3,245,000 in settlement expense reserves and a $3,525,000 bulk
reserve established for the workers' compensation line of business. The
remaining adverse development of approximately $4,521,000 came from case
reserve development and IBNR claim emergence.
For the reinsurance segment, the December 31, 2003 estimate of loss and
settlement expense reserves for accident years 2002 and prior decreased
$1,538,670 from the estimate at December 31, 2002. This decrease represents
1.5 percent of the December 31, 2002 carried reserves. This decrease is
primarily from the 2002 accident year on the Home Office Reinsurance Assumed
Department (HORAD) book of business, which has experienced very low reported
loss activity. The favorable development was partially offset by $326,000 of
asbestos reserve strengthening.
2002 Development
- ----------------
For the property and casualty insurance segment, the December 31, 2002
estimate of loss and settlement expense reserves for accident years 2001 and
prior increased $4,645,194 from the estimate at December 31, 2001. This
increase represents 2.1% of the December 31, 2001 carried reserves and is
primarily attributable to three sources: direct IBNR reserves, involuntary
pools and contingent salary plan reserves. With regard to direct IBNR
reserves, the methodology utilized to establish these reserves assumes
consistency in claims reporting patterns. However, in recent years emerged
IBNR losses have increased as a percentage of earned premiums. As a result of
these actuarial indications, the Company strengthened direct IBNR reserves by
$3,564,000 in 2002, $1,697,000 of which was allocated to accident years 2001
and prior. In addition, the Company established $2,068,705 of additional IBNR
asbestos reserves at December 31, 2002 based on the results of a recently
completed study of the Company's asbestos exposures, all of which was
allocated to accident years 2001 and prior. As previously noted, the Company
books the reserves reported by the management of the involuntary pools and in
2002 these bookings resulted in modest upward development of $353,000.
Finally, Employers Mutual implemented a contingent salary plan in 2002 and
$376,000 of the reserve established for this plan at December 31, 2002 was
allocated to settlement expenses for accident years 2001 and prior.
For the reinsurance segment, the December 31, 2002 estimate of loss and
settlement expense reserves for accident years 2001 and prior increased
$2,352,864 from the estimate at December 31, 2001. This increase represents
2.6% of the December 31, 2001 carried reserves. Virtually all of the increase
arose from the MRB pool, for which the Company books the reserves established
and reported by the pool. The carried MRB reserves at December 31, 2001 were
above the midpoint of the actuarial range of estimates. However, reported
losses and settlement expenses during pool year 2002 exceeded by approximately
$1,249,792 the amounts predicted by the actuarial analysis. In addition,
management of the MRB pool increased the IBNR reserves for prior years by
$345,800. Finally, the losses and settlement expenses reported during January
2002 exceeded by $762,000 the IBNR reserve established at December 31, 2001 to
cover the one-month reporting lag.
5. ASBESTOS AND ENVIRONMENTAL RELATED CLAIMS
The Company has exposure to asbestos and environmental related claims
associated with the insurance business written by the parties to the pooling
agreement and the reinsurance business assumed from Employers Mutual by the
reinsurance subsidiary. These exposures are not considered to be significant.
Asbestos and environmental losses paid by the Company have averaged only
$244,000 per year over the past five years. During 2002, the Company re-
evaluated the estimated ultimate losses for direct asbestos and environmental
exposures. Based on this re-evaluation, the Company reallocated $752,000 of
bulk IBNR reserves and $324,303 of settlement expense reserves to these
exposures. In addition, the Company diligently evaluated the adequacy of its
asbestos reserves by commissioning a "ground-up" study to better quantify its
exposure to asbestos liabilities. This study concluded that the Company's
exposure for direct asbestos claims ranged from $1,000,000 to $5,100,000, with
a point estimate of $3,000,000. Based on the results of this study, the
Company elected to increase the IBNR and settlement expense reserves carried
for direct asbestos exposures by $2,068,705 at December 31, 2002, to
$2,985,402. The study's results for asbestos exposures on assumed reinsurance
business were received during 2003, and the Company elected to increase its
IBNR reserves carried for assumed asbestos exposures by $326,000 to the
study's point estimate. The study and its results assume no improvement in
the current asbestos litigation environment; however, continued efforts for
federal legislation could reduce the ultimate loss projections for asbestos
litigation below the levels currently projected for the industry. Reserves
for asbestos and environmental related claims for direct insurance and assumed
reinsurance business totaled $5,459,912 and $5,584,196 at December 31, 2004
and 2003, respectively.
At present, the Company is defending approximately 500 asbestos bodily
injury lawsuits. Most of these defenses are subject to express reservation of
rights based upon the lack of an injury within the Company's policy periods,
because many asbestos lawsuits do not specifically allege dates of asbestos
exposure or dates of injury. During 2003, as a direct result of proposed
federal legislation in the areas of asbestos and class action reform, the
Company was presented with several hundred additional lawsuits filed against
three former policyholders representing approximately 40,500 claims related to
exposure to asbestos or asbestos containing products. These claims are based
upon nonspecific asbestos exposure and nonspecific injuries. As a result,
management did not establish a significant amount of loss reserves associated
with these claims. The Company has denied coverage to one of the former
policyholders, representing approximately 10,000 claims, because of express
asbestos exclusion language contained in the policy. Minimal expense payments
have been made to date on the lawsuits related to the other two former
policyholders and no payments have been made for either defense or indemnity.
Defense costs, on the other hand, have typically increased due to the
increased number of parties involved in the litigation and the length of time
required to obtain a favorable judgment. Whenever possible, the Company has
participated in cost sharing agreements with other insurance companies to
reduce overall asbestos claim expenses.
Estimating loss and settlement expense reserves for asbestos and
environmental claims is very difficult due to the many uncertainties
surrounding these types of claims. These uncertainties exist because the
assignment of responsibility varies widely by state and claims often emerge
long after the policy has expired, which makes assignment of damages to the
appropriate party and to the time period covered by a particular policy
difficult. In establishing reserves for these types of claims, management
monitors the relevant facts concerning each claim, the current status of the
legal environment, social and political conditions, and claim history and
trends within the Company and the industry.
6. STATUTORY INFORMATION AND DIVIDEND RESTRICTIONS
The Company's insurance subsidiaries are required to file financial
statements with state regulatory authorities. The accounting principles used
to prepare these statutory financial statements follow prescribed or permitted
accounting practices that differ from GAAP. Prescribed statutory accounting
principles include state laws, regulations and general administrative rules
issued by the state of domicile as well as a variety of publications and
manuals of the National Association of Insurance Commissioners (NAIC).
Permitted accounting practices encompass all accounting practices not
prescribed, but allowed by the state of domicile. The Company's insurance
subsidiaries had no permitted accounting practices during 2004, 2003 and 2002.
Statutory surplus of the Company's insurance subsidiaries was
$216,868,207 and $170,232,871 at December 31, 2004 and 2003, respectively.
Statutory net income of the Company's insurance subsidiaries was $11,878,844,
$16,700,374 and $13,729,028 for 2004, 2003 and 2002, respectively.
The NAIC utilizes a risk-based capital model to help state regulators
assess the capital adequacy of insurance companies and identify insurers that
are in, or are perceived as approaching, financial difficulty. This model
establishes minimum capital needs based on the risks applicable to the
operations of the individual insurer. The risk-based capital requirements for
property and casualty insurance companies measure three major areas of risk:
asset risk, credit risk and underwriting risk. Companies having less
statutory surplus than required by the risk-based capital requirements are
subject to varying degrees of regulatory scrutiny and intervention, depending
on the severity of the inadequacy. At December 31, 2004, the Company's
insurance subsidiaries had total adjusted statutory capital of $216,868,207,
which is well in excess of the minimum risk-based capital requirement of
$43,484,541.
Retained earnings of the Company's insurance subsidiaries available for
distribution as dividends are limited by law to the statutory unassigned
surplus of each of the subsidiaries as of the previous December 31, as
determined in accordance with accounting practices prescribed by insurance
regulatory authorities of the state of domicile of each subsidiary. Subject
to this limitation, the maximum dividend that may be paid within a 12 month
period without prior approval of the insurance regulatory authorities is
restricted to the greater of 10 percent of statutory surplus as regards
policyholders as of the preceding December 31, or net income of the preceding
calendar year on a statutory basis. At December 31, 2004, $32,232,101 was
available for distribution to the Company in 2005 without prior approval.
7. 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. The accounting policies of the segments
are described in note 1, Summary of Significant Accounting Policies.
Summarized financial information for the Company's segments is as
follows:
Property
Year ended and casualty Parent
December 31, 2004 insurance Reinsurance company Consolidated
- ----------------- ------------ ------------ ------------ --------------
Premiums earned ....... $250,034,561 $ 95,443,900 $ - $ 345,478,461
Underwriting gain
(loss) .............. (32,261,993) 15,227,552 - (17,034,441)
Net investment income 20,236,342 9,498,925 164,936 29,900,203
Realized gains ........ 3,270,862 1,108,452 - 4,379,314
Interest expense ...... 772,500 339,900 - 1,112,400
Other income .......... 600,732 - - 600,732
Other expenses ........ 495,783 - 666,628 1,162,411
------------ ------------ ------------ --------------
Income (loss) before
income tax expense
(benefit) ......... $ (9,422,340)$ 25,495,029 $ (501,692)$ 15,570,997
============ ============ ============ ==============
Assets ................ $691,745,896 $242,694,389 $228,686,424 $1,163,126,709
Eliminations .......... - - (223,101,504) (223,101,504)
Reclassifications ..... (62,040) (5,147,233) - (5,209,273)
------------ ------------ ------------ --------------
Net assets ....... $691,683,856 $237,547,156 $ 5,584,920 $ 934,815,932
============ ============ ============ ==============
Property
Year ended and casualty Parent
December 31, 2003 insurance Reinsurance company Consolidated
- ----------------- ------------ ------------ ------------ -------------
Premiums earned ....... $241,237,313 $ 89,385,497 $ - $ 330,622,810
Underwriting gain
(loss) .............. (7,493,703) 6,716,356 - (777,347)
Net investment income 20,724,017 8,948,076 30,368 29,702,461
Realized gains (losses) 1,312,252 (142,554) - 1,169,698
Interest expense ...... (919,362) (400,904) - (1,320,266)
Other income .......... 862,070 - - 862,070
Other expenses ........ (1,044,757) - (609,563) (1,654,320)
------------ ------------ ------------ --------------
Income (loss) before
income tax expense
(benefit) ......... $ 13,440,517 $ 15,120,974 $ (579,195)$ 27,982,296
============ ============ ============ ==============
Assets ................ $639,366,058 $256,579,831 $180,961,286 $1,076,907,175
Eliminations .......... - - (176,087,397) (176,087,397)
Reclassifications ..... (896,043) - (211,760) (1,107,803)
------------ ------------ ------------ --------------
Net assets ....... $638,470,015 $256,579,831 $ 4,662,129 $ 899,711,975
============ ============ ============ ==============
Property
Year ended and casualty Parent
December 31, 2002 insurance Reinsurance company Consolidated
- ----------------- ------------ ------------ ------------ ------------
Premiums earned ......... $225,013,076 $ 72,029,957 $ - $297,043,033
Underwriting loss ....... (3,621,656) (2,026,309) - (5,647,965)
Net investment income ... 23,517,163 9,147,127 113,843 32,778,133
Realized gains (losses) (2,154,246) (1,010,268) 5,313 (3,159,201)
Interest expense ........ (1,345,153) (293,563) - (1,638,716)
Other income ............ 865,819 - - 865,819
Other expenses .......... (869,346) - (436,688) (1,306,034)
------------ ------------ ------------ ------------
Income (loss) before
income tax expense
(benefit) ........... $ 16,392,581 $ 5,816,987 $ (317,532)$ 21,892,036
============ ============ ============ ============
8. INVESTMENTS
Investments of the Company's insurance subsidiaries are subject to the
insurance laws of the state of their incorporation. These laws prescribe the
kind, quality and concentration of investments that may be made by insurance
companies. In general, these laws permit investments, within specified limits
and subject to certain qualifications, in federal, state and municipal
obligations, corporate bonds, preferred and common stocks and real estate
mortgages. The Company believes that it is in compliance with these laws.
The amortized cost and estimated fair value of securities held-to-
maturity and available-for-sale as of December 31, 2004 and 2003 are as
follows. The estimated fair value is based on quoted market prices, where
available, or on values obtained from independent pricing services.
Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value
------------ ----------- ----------- ------------
December 31, 2004
- -----------------
Securities held-to-maturity:
Fixed maturity securities:
U.S. treasury securities
and obligations of
U.S. government
corporations and
agencies ............. $ 28,037,203 $ 1,279,346 $ - $ 29,316,549
Mortgage-backed
securities ........... 1,168,668 108,389 - 1,277,057
------------ ----------- ----------- ------------
Total securities
held-to-maturity $ 29,205,871 $ 1,387,735 $ - $ 30,593,606
============ =========== =========== ============
Securities available-for-
sale:
Fixed maturity securities:
U.S. treasury securities
and obligations of
U.S. government
corporations and
agencies ............. $137,273,717 $ 413,027 $ (148,047)$137,538,697
Obligations of states
and political
subdivisions ......... 257,483,428 10,329,065 (136,682) 267,675,811
Mortgage-backed
securities ........... 11,136,193 714,925 - 11,851,118
Public utilities ....... 8,686,436 1,181,467 - 9,867,903
Debt securities issued
by foreign governments 7,177,870 321,329 - 7,499,199
Corporate securities ... 174,033,352 11,225,843 (37,520) 185,221,675
------------ ----------- ----------- ------------
Total fixed maturity
securities ....... 595,790,996 24,185,656 (322,249) 619,654,403
------------ ----------- ----------- ------------
Equity securities:
Common stocks .......... 59,089,434 19,195,320 (120,861) 78,163,893
Non-redeemable
preferred stocks ..... 500,000 29,000 - 529,000
------------ ----------- ----------- ------------
Total equity
securities ....... 59,589,434 19,224,320 (120,861) 78,692,893
------------ ----------- ----------- ------------
Total securities
available-for-sale $655,380,430 $43,409,976 $ (443,110)$698,347,296
============ =========== =========== ============
Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value
------------ ----------- ----------- ------------
December 31, 2003
- -----------------
Securities held-to-maturity:
Fixed maturity securities:
U.S. treasury securities
and obligations of
U.S. government
corporations and
agencies ............. $ 47,547,267 $ 3,780,331 $ - $ 51,327,598
Mortgage-backed
securities ........... 2,298,081 228,745 - 2,526,826
------------ ----------- ----------- ------------
Total securities
held-to-maturity $ 49,845,348 $ 4,009,076 $ - $ 53,854,424
============ =========== =========== ============
Securities available-for-
sale:
Fixed maturity securities:
U.S. treasury securities
and obligations of
U.S. government
corporations and
agencies ............. $170,445,955 $ 703,239 $ - $171,149,194
Obligations of states
and political
subdivisions ......... 140,694,351 6,381,069 (300,188) 146,775,232
Mortgage-backed
securities ........... 19,311,455 1,967,145 - 21,278,600
Public utilities ....... 20,171,434 1,714,421 (86,518) 21,799,337
Corporate securities ... 148,887,343 14,194,708 (298,656) 162,783,395
------------ ----------- ----------- ------------
Total fixed maturity
securities ....... 499,510,538 24,960,582 (685,362) 523,785,758
------------ ----------- ----------- ------------
Equity securities:
Common stocks .......... 38,498,075 10,188,751 (206,828) 48,479,998
Non-redeemable
preferred stocks ..... 500,000 28,500 - 528,500
------------ ----------- ----------- ------------
Total equity
securities ....... 38,998,075 10,217,251 (206,828) 49,008,498
------------ ----------- ----------- ------------
Total securities
available-for-sale $538,508,613 $35,177,833 $ (892,190)$572,794,256
============ =========== =========== ============
In 2003, the Emerging Issues Task Force (EITF) of the FASB reached a
consensus on certain disclosures required by EITF Issue 03-1, "The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments,"
which was effective for fiscal years ending after December 15, 2003. The
Company adopted this EITF in 2003, which only required additional disclosures
and did not have any effect on the results of operations of the Company. In
March of 2004, the EITF reached a consensus on the guidance provided to
determine whether an investment is within the scope of Issue 03-1. Under
EITF Issue 03-1 an investment is impaired if the fair value of the investment
is less than its cost including adjustments for amortization, accretion,
foreign exchange and hedging. An impairment would be considered other-than-
temporary unless a) the investor has the ability and intent to hold an
investment for a reasonable period of time sufficient for the recovery of the
fair value up to (or beyond) the cost of the investment, and b) evidence
indicating that the cost of the investment is recoverable within a reasonable
period of time outweighs evidence to the contrary. This new guidance for
determining whether the decline in the fair value of the investment is other-
than-temporary was to be effective for reporting periods beginning after June
15, 2004. On September 30, 2004, the FASB issued EITF Issue 03-1-1 "Effective
Date of Paragraphs 10-20 of EITF Issue 03-1, The Meaning of Other-Than-
Temporary Impairment and Its Application to Certain Investments," which
delayed the effective date for the measurement and recognition guidance
included in EITF Issue 03-1 until additional implementation guidance is
provided. Pending adoption of the final rule, the Company continues to apply
existing accounting guidance for determining when a decline in fair value is
other-than-temporary.
The following table sets forth the estimated fair value and unrealized
losses of securities in an unrealized loss position as of December 31, 2004,
listed by length of time the securities have been in an unrealized loss
position.
Less than twelve Twelve months or
months or longer Total
-------------------- ------------------- --------------------
Description of Fair Unrealized Fair Unrealized Fair Unrealized
securities value losses value losses value losses
- --------------- -------------------- ------------------- --------------------
U.S. Treasury
securities
and
obligations
of U.S.
government
corporations
and agencies $35,342,656 $148,047 $ - $ - $35,342,656 $148,047
Obligations of
states and
political
subdivisions 11,962,755 35,038 7,241,675 101,644 19,204,430 136,682
Corporate
Securities 1,587,243 13,245 821,546 24,275 2,408,789 37,520
----------- -------- ---------- -------- ----------- --------
Subtotal, debt
securities 48,892,654 196,330 8,063,221 125,919 56,955,875 322,249
----------- -------- ---------- -------- ----------- --------
Common stocks 7,394,774 120,861 - - 7,394,774 120,861
----------- -------- ---------- -------- ----------- --------
Total
temporarily
impaired
securities $56,287,428 $317,191 $8,063,221 $125,919 $64,350,649 $443,110
=========== ======== ========== ======== =========== ========
The Company uses several factors to determine whether the carrying value
of an individual security has been other-than-temporarily impaired. Such
factors include, but are not limited to, the security's value and performance
in the context of the overall markets, length of time and extent the
security's fair value has been below carrying value, key corporate events and
collateralization of fixed maturity securities. Based on these factors, and
the Company's ability and intent to hold the fixed maturity securities until
maturity, it was determined that the carrying value of these securities was
not other-than-temporarily impaired at December 31, 2004.
The amortized cost and estimated fair value of fixed maturity securities
at December 31, 2004, by contractual maturity, are shown below. Expected
maturities may differ from contractual maturities because borrowers may have
the right to call or prepay obligations with or without call or prepayment
penalties.
Estimated
Amortized fair
cost value
------------ ------------
Securities held-to-maturity:
Due in one year or less ................... $ 8,999,646 $ 9,059,063
Due after one year through five years ..... 18,041,555 19,180,894
Due after five years through ten years .... 996,003 1,076,592
Due after ten years ....................... - -
Mortgage-backed securities ................ 1,168,667 1,277,057
------------ ------------
Totals ................................ $ 29,205,871 $ 30,593,606
============ ============
Securities available-for-sale:
Due in one year or less ................... $ 90,137,120 $ 90,176,150
Due after one year through five years ..... 52,831,899 56,265,211
Due after five years through ten years .... 118,069,601 125,200,014
Due after ten years ....................... 323,616,183 336,161,910
Mortgage-backed securities ................ 11,136,193 11,851,118
------------ ------------
Totals ................................ $595,790,996 $619,654,403
============ ============
The mortgage-backed securities shown in the above table include
$3,405,529 of securities issued by government corporations and agencies.
Investment yields may vary from those anticipated due to changes in prepayment
patterns of the underlying collateral.
A summary of realized investment gains and losses is as follows:
Year ended December 31,
-------------------------------------
2004 2003 2002
----------- ----------- -----------
Fixed maturity securities
held-to-maturity: (1)
Gross realized investment gains .. $ 9,099 $ 781 $ -
Gross realized investment losses - - -
Fixed maturity securities
available-for-sale: (2)
Gross realized investment gains .. 5,188,496 8,624,525 960,705
Gross realized investment losses (1,576,462) (4,877,307) (3,831,374)
Equity securities
available-for-sale: (3)
Gross realized investment gains .. 2,784,039 2,885,412 4,654,622
Gross realized investment losses (2,025,858) (5,463,713) (4,943,154)
----------- ----------- -----------
Totals ......................... $ 4,379,314 $ 1,169,698 $(3,159,201)
=========== =========== ===========
(1) Investment gains realized on fixed maturity securities held-to-
maturity are the result of calls and prepayments.
(2) Investment losses realized on fixed maturity securities available-
for-sale for the year ended December 31, 2004 and 2002 include other-than-
temporary impairment write-downs totaling $1,323,475 and $3,821,466,
respectively.
(3) Investment losses realized on equity securities for the year ended
December 31, 2003 include other-than-temporary impairment write-downs totaling
$1,566,985. All of the impaired equity securities were sold during 2003,
generating gross realized gains of $619,069 and gross realized losses of
$47,558.
A summary of net investment income is as follows:
Year ended December 31,
-------------------------------------
2004 2003 2002
----------- ----------- -----------
Interest on fixed maturities .......... $28,305,693 $29,027,370 $31,909,946
Dividends on equity securities ........ 827,112 587,723 605,079
Interest on short-term investments .... 985,105 440,902 690,046
Interest on long-term investments ..... 518,793 371,340 103,763
Fees from securities lending .......... 104,953 92,671 120,489
----------- ----------- -----------
Total investment income ........... 30,741,656 30,520,006 33,429,323
Investment expenses ................... (841,453) (817,545) (651,190)
----------- ----------- -----------
Net investment income ............. $29,900,203 $29,702,461 $32,778,133
=========== =========== ===========
A summary of net changes in unrealized holding gains (losses) on
securities available-for-sale is as follows:
Year ended December 31,
----------------------------------------
2004 2003 2002
------------ ------------ ------------
Fixed maturity securities ......... $ (411,813) $ (1,735,818) $ 19,097,214
Applicable deferred income tax
expense (benefit) ............... (144,134) (607,536) 6,684,025
------------ ------------ ------------
Total fixed maturity securities (267,679) (1,128,282) 12,413,189
------------ ------------ ------------
Equity securities ................. 9,093,037 13,857,468 (8,483,491)
Applicable deferred income tax
expense (benefit) ............... 3,182,563 4,850,114 (2,969,226)
------------ ------------ ------------
Total equity securities ....... 5,910,474 9,007,354 (5,514,265)
------------ ------------ ------------
Total available-for-sale
securities .................. $ 5,642,795 $ 7,879,072 $ 6,898,924
============ ============ ============
9. INCOME TAXES
Temporary differences between the consolidated financial statement
carrying amount and tax basis of assets and liabilities that give rise to
significant portions of the deferred income tax asset at December 31, 2004
and 2003 are as follows:
Year ended December 31,
-------------------------
2004 2003
----------- -----------
Loss reserve discounting .......................... $18,864,562 $17,036,591
Unearned premium reserve limitation ............... 9,037,165 8,592,924
Postretirement benefits ........................... 3,007,951 2,671,261
Other policyholders' funds payable ................ 989,033 486,708
Net operating loss carry forward .................. 2,427,675 -
Minimum tax credits ............................... 954,953 954,954
Other-than-temporary impairment losses on
investments ..................................... - 1,337,513
Other, net ........................................ 1,135,774 1,311,318
----------- -----------
Total deferred income tax asset ............. 36,417,113 32,391,269
----------- -----------
Deferred policy acquisition costs ................. (9,779,204) (9,358,224)
Net unrealized holding gains ...................... (15,038,403) (11,999,975)
Other, net ........................................ (2,095,313) (687,641)
----------- -----------
Total deferred income tax liability ......... (26,912,920) (22,045,840)
----------- -----------
Net deferred income tax asset ............. $ 9,504,193 $10,345,429
=========== ===========
At December 31, 2004, the Company has $6,936,214 of net operating loss
carry forwards which will expire, if unused, in 2024.
Based upon anticipated future taxable income and consideration of all
other available evidence, management believes that it is "more likely than
not" that the Company's net deferred income tax asset will be realized.
The actual income tax expense for the years ended December 31, 2004, 2003
and 2002 differed from the "expected" tax expense for those years (computed by
applying the United States federal corporate tax rate of 35 percent to income
before income tax expense) as follows:
Year ended December 31,
-------------------------------------
2004 2003 2002
----------- ----------- -----------
Computed "expected" tax expense ....... $ 5,449,848 $ 9,793,804 $ 7,662,213
Increases (decreases) in
tax resulting from:
Tax-exempt interest income ........ (3,430,616) (2,079,465) (1,441,502)
Pro-ration of tax-exempt interest
and dividends received deduction 544,317 334,243 163,770
Other, net ........................ (177,235) (415,409) (594,183)
----------- ----------- -----------
Income tax expense .............. $ 2,386,314 $ 7,633,173 $ 5,790,298
=========== =========== ===========
Comprehensive income tax expense included in the consolidated financial
statements for the years ended December 31, 2004, 2003 and 2002 is as follows:
Year ended December 31,
-------------------------------------
2004 2003 2002
----------- ----------- -----------
Income tax expense on:
Operations .......................... $ 2,386,314 $ 7,633,173 $ 5,790,298
Unrealized holding gains on
revaluation of securities
available-for-sale ................ 3,038,428 4,242,578 3,714,799
Minimum pension liability ........... - 101,373 (101,373)
----------- ----------- -----------
Comprehensive income tax expense $ 5,424,742 $11,977,124 $ 9,403,724
=========== =========== ===========
10. SURPLUS NOTES
On December 28, 2001, three of the Company's property and casualty
insurance subsidiaries issued surplus notes totaling $25,000,000 to Employers
Mutual at an annual interest rate of 5.38 percent. On June 27, 2002, the
Company's reinsurance subsidiary issued an $11,000,000 surplus note to
Employers Mutual at an annual interest rate of 5.25 percent. These surplus
notes do not have a maturity date. Effective April 1, 2003, the surplus notes
were reissued at an annual interest rate of 3.09 percent. Payment of interest
and repayment of principal can only be repaid out of the subsidiary's
statutory surplus earnings and is subject to approval by the issuing company's
state of domicile. The surplus notes are subordinate and junior in right of
payment to all obligations or liabilities of the subsidiaries. Interest
expense on surplus notes amounted to $1,112,400 for 2004, $1,320,266 for 2003
and $1,638,716 for 2002.
11. EMPLOYEE RETIREMENT PLANS
Employers Mutual has various employee benefit plans, including a defined
benefit retirement plan (pension) and two postretirement benefit plans.
Although the Company has no employees of its own, under the terms of the
pooling agreement and the allocation of costs to the subsidiaries that do not
participate in the pooling agreement (see note 2) the Company is responsible
for its share of Employers Mutual's benefit plan expenses and related benefit
plan prepaid assets and liabilities. Accordingly, the Company's consolidated
balance sheets reflect the Company's share of the total plans' assets and
liabilities.
Employers Mutual's pension plan covers substantially all of its
employees. The plan is funded by employer contributions and provides benefits
under two different formulas, depending on an employee's age and date of
service. Benefits generally vest after five years of service. It is
Employers Mutual's policy to fund pension costs according to regulations
provided under the Internal Revenue Code.
Employers Mutual also offers postretirement benefit plans, which provide
certain health care and life insurance benefits for retired employees.
Substantially all of its employees may become eligible for those benefits if
they reach normal retirement age and have attained the required length of
service while working for Employers Mutual or its subsidiaries. The health
care postretirement plan requires contributions from participants and contains
certain cost sharing provisions such as coinsurance and deductibles. The life
insurance plan is noncontributory. The benefits provided under both plans are
subject to change.
Employers Mutual maintains two Voluntary Employee Beneficiary Association
(VEBA) trusts, which accumulate funds for the payment of postretirement health
care and life insurance benefits. Contributions to the VEBA trusts are used
to fund the accumulated postretirement benefit obligation, as well as pay
current year benefits.
On December 8, 2003, the Medicare Prescription Drug, Improvement and
Modernization Act of 2003 (the "Act") was signed into law. The Act expanded
Medicare to include, for the first time, coverage for prescription drugs. In
January 2004, the Financial Accounting Standards Board (FASB) issued Staff
Position FAS No. 106-1 "Accounting and Disclosure Requirements Related to the
Medicare Prescription Drug, Improvement and Modernization Act of 2003", which
permitted a sponsor of a postretirement health care plan that provides
prescription drug benefits to make a one-time election to defer accounting for
the effects of the Act. In May 2004, the FASB issued Staff Position FAS No.
106-2 which superseded FAS 106-1 and was effective for interim and annual
periods beginning after June 15, 2004. FAS No. 106-2 provides accounting
guidance and disclosure requirements for the prescription drug subsidy
established under the Act.
The Company concluded that the accounting guidance provided by FAS 106-2
was applicable since the prescription drug benefit provided under Employers
Mutual's postretirement benefit plan is actuarially equivalent to Medicare
Part D. The expected subsidy reduced Employers Mutual's share of the cost of
the underlying postretirement prescription drug coverage. The Company elected
the retroactive method of transition to the date of the enactment of the Act.
The effect of the subsidy on the measurement of Employers Mutual's
postretirement benefit plan resulted in a decrease in the accumulated
projected benefit obligation of $9,899,120 and the net periodic postretirement
benefit cost for 2004 was reduced by $1,536,635. The components of the
reduction in the net periodic postretirement benefit cost for 2004 are as
follows:
Postretirement benefit plans:
Service cost ........................ $ 580,952
Interest cost ....................... 494,956
Expected return on plan assets ...... -
Amortization of net loss ............ 460,727
----------
Total reduction in net periodic
postretirement benefit cost ..... $1,536,635
==========
Adoption of FAS 106-2 resulted in a $344,235 reduction in the Company's
share of the net periodic postretirement benefit cost for the year ended
December 31, 2004.
The following table sets forth the funded status of the Employers Mutual
pension plan and postretirement benefit plans as of December 31, 2004 and
2003, based upon a measurement date of November 1, 2004 and 2003,
respectively:
Postretirement
Pension plan benefit plans
-------------------------- --------------------------
2004 2003 2004 2003
------------ ------------ ------------ ------------
Change in projected
benefit obligation:
Benefit obligation at
beginning of year ...$120,616,776 $111,790,069 $ 72,787,471 $ 66,309,000
Service cost .......... 6,818,518 6,161,019 3,995,559 4,401,000
Interest cost ......... 7,020,887 6,992,656 3,819,081 4,263,000
Actuarial (gain) loss 4,929,150 5,316,003 (10,254,086) (5,157,878)
Benefits paid ......... (5,223,965) (9,642,971) (1,402,273) (1,481,498)
Acquisition ........... - - - 4,453,847
------------ ------------ ------------ ------------
Projected benefit
obligation at end
of year ......... 134,161,366 120,616,776 68,945,752 72,787,471
------------ ------------ ------------ ------------
Change in plan assets:
Fair value of plan
assets at beginning
of year ............. 93,676,748 82,198,366 15,974,241 12,737,000
Actual return on plan
assets .............. 9,897,006 11,252,353 1,047,459 418,739
Employer contributions 21,600,000 9,869,000 3,835,000 4,300,000
Benefits paid ......... (5,223,965) (9,642,971) (1,402,273) (1,481,498)
------------ ------------ ------------ ------------
Fair value of plan
assets at end
of year ......... 119,949,789 93,676,748 19,454,427 15,974,241
------------ ------------ ------------ ------------
Funded status ......... (14,211,577) (26,940,028) (49,491,325) (56,813,230)
Unrecognized net
actuarial loss ...... 22,513,895 21,576,909 5,056,132 15,587,383
Unrecognized prior
service costs ....... 3,343,641 4,109,466 - -
Employer contributions - - 610,000 500,000
------------ ------------ ------------ ------------
Net amount
recognized ......$ 11,645,959 $ (1,253,653) $(43,825,193) $(40,725,847)
============ ============ ============ ============
Amounts recognized in
EMC Insurance
Companies balance
sheets consist of:
Accrued benefit
liability .......$ - $ (4,831,428) $(43,825,193) $(40,725,847)
Prepaid pension
asset ........... 11,645,959 - - -
Intangible asset .. - 3,577,775 - -
------------ ------------ ------------ ------------
Net amount
recognized ..$ 11,645,959 $ (1,253,653) $(43,825,193) $(40,725,847)
============ ============ ============ ============
The accumulated benefit obligation for the pension plan amounted to
$109,635,159 and $98,508,176 for the years ended December 31, 2004 and 2003,
respectively.
During 2003, Employers Modern Life Company (EML), an affiliate of
Employers Mutual, acquired National Travelers Life Company (NTL) and the
company's name was changed to EMC National Life Company (EMCNL). EML
participated in Employers Mutual's pension plan and postretirement benefit
plans. As a result of the acquisition, EML pension plan participants were
"spun-off" into a separate EMCNL pension plan. A payment of $2,567,367 was
made from Employers Mutual's plan assets to the EMCNL pension plan, which is
reflected as a benefit payment. The corresponding reduction in the benefit
obligation is reflected as an actuarial gain of the plan. The employees and
retirees of NTL were also granted benefits under the Employers Mutual
postretirement benefit plans. As a result, an additional liability of
$4,453,847 was recognized by the plans. EMCNL is responsible for the entire
additional liability.
The components of net periodic benefit cost for the Employers Mutual
pension plan and postretirement benefit plans is as follows:
Year ended December 31,
-------------------------------------
2004 2003 2002
----------- ----------- -----------
Pension plan:
Service cost ....................... $ 6,818,518 $ 6,161,019 $ 5,299,831
Interest cost ...................... 7,020,887 6,992,656 6,576,584
Expected return on plan assets ..... (6,760,528) (6,516,913) (6,744,907)
Recognized net actuarial loss ...... 855,686 967,226 -
Amortization of prior service costs 765,825 789,648 784,219
----------- ----------- -----------
Net periodic pension benefit
cost ....................... $ 8,700,388 $ 8,393,636 $ 5,915,727
=========== =========== ===========
Postretirement benefit plans:
Service cost ....................... $ 3,995,555 $ 4,401,000 $ 2,964,000
Interest cost ...................... 3,819,081 4,263,000 3,223,000
Expected return on assets .......... (900,883) (737,000) (518,000)
Amortization of net loss ........... 130,593 1,011,000 150,000
Amortization of prior service costs - - 535,000
----------- ----------- -----------
Net periodic postretirement
benefit cost ................. $ 7,044,346 $ 8,938,000 $ 6,354,000
=========== =========== ===========
The weighted average assumptions used to measure the benefit obligations
are as follows:
Year ended December 31,
-----------------------
2004 2003
---------- ----------
Pension plan:
Discount rate ...................... 6.00% 6.00%
Rate of compensation increase ..... 4.81% 4.82%
Postretirement benefit plans:
Discount rate ...................... 6.00% 6.00%
The weighted average assumptions used to measure the net periodic benefit
cost are as follows:
Year ended December 31,
----------------------------------
2004 2003 2002
-------- -------- --------
Pension plan:
Discount rate ...................... 6.00% 6.50% 7.00%
Expected long-term rate of return on
plan assets ........................ 7.50% 8.00% 8.50%
Rate of compensation increase ..... 4.82% 5.93% 5.96%
Postretirement benefit plans:
Discount rate ...................... 6.00% 6.50% 7.00%
Expected long-term rate of return on
plan assets ....................... 5.00% 5.00% 6.00%
The expected long-term rates of return on plan assets were developed
considering actual historical results, current and expected market conditions,
plan asset mix and management's investment strategy.
The assumed weighted average annual rate of increase in the per capita
cost of covered health care benefits (i.e. the health care cost trend rate)
for 2004 is 10 percent, and is assumed to decrease gradually to 5 percent in
2009 and remain at that level thereafter. The health care cost trend rates
have a significant effect on the amounts reported for the health care plan. A
one-percentage-point change in assumed health care cost trend rates would have
the following effects:
One-Percentage-Point
-----------------------------
Increase Decrease
----------- -------------
Effect on total of service and interest cost .. $ 1,628,900 ($ 1,265,062)
Effect on postretirement benefit obligation ... $11,146,706 ($ 8,871,308)
The Company's financial statements reflect a pension asset of $2,684,463
in 2004 and a pension liability of $1,453,421 (including $1,016,492 of
additional minimum liability) in 2003. The Company's financial statements
also reflect an intangible asset associated with the pension plan of $0 in
2004 and $1,016,492 in 2003. Pension expense allocated to the Company
amounted to $2,114,890, $2,023,292 and $1,406,306 in 2004, 2003 and 2002,
respectively.
Postretirement benefit liabilities reflected in the Company's financial
statements totaled $9,485,896 in 2004 and $8,512,179 in 2003. Net periodic
postretirement benefit cost allocated to the Company for the years ended
December 31, 2004, 2003 and 2002 was $1,583,172, $2,106,010 and $1,486,724,
respectively.
The weighted average asset allocations of the Employers Mutual pension
plan as of the measurement dates of November 1, 2004 and 2003 are as follows:
Plan Assets at November 1,
---------------------------
Asset Category 2004 2003
- -------------- ------------ ------------
Equity securities ............................ 56.0% 51.0%
Debt securities .............................. 32.0 41.0
Real estate .................................. 12.0 8.0
----- -----
Total ...................................... 100.0% 100.0%
Employers Mutual has hired Principal Financial Advisors, Inc. to manage
the asset allocation strategy for its pension plan (herein referred to as Fund
Selection Service). The asset allocation strategy and process of the Fund
Selection Service consists of a long-term, risk-controlled approach using
diversified investment options with a minimal exposure to volatile investment
options like derivatives. The long-term strategy of the Fund Selection
Service is foremost preserving plan assets from downside market risk while
secondarily out-performing its peers over a full market cycle. The investment
process of Fund Selection Service uses a diversified allocation of equity,
debt, and real estate exposures that are customized to each plan's cash flow
needs.
The Fund Selection Service reviews a plan's assets and liabilities with
an emphasis on forecasting a plan's cash flow needs. This forecast calculates
the allocation percentage of fixed income assets needed to cover the
liabilities of each plan. The model is quantitatively based and evaluates the
plan's current assets plus five years of deposit projections and compares it
to the current monthly benefit payments and the emerging benefit liabilities
for the next ten years. The data for the deposits and emerging liabilities is
provided from the plan's actuarial valuation while the current assets and
monthly benefit payments data is provided from Principal Life Insurance
Company's retirement plan account system.
The weighted average asset allocations of the Employers Mutual
postretirement benefit plan as of the measurement dates of November 1, 2004
and 2003 are as follows:
Plan Assets at November 1,
---------------------------
Asset Category 2004 2003
- -------------- ------------ ------------
Life insurance policies ...................... 52.8% 64.3%
Short-term investments ....................... 13.8 29.4
Real estate .................................. 1.0 -
Equity securities ............................ 22.1 -
Debt securities .............................. 10.3 6.3
----- -----
Total ...................................... 100.0% 100.0%
Plan assets for Employers Mutual's postretirement benefit plans are
primarily invested in universal life insurance policies issued by EMCNL, an
affiliate of Employers Mutual. The assets supporting these universal life
insurance policies are invested in S&P 500 mutual funds and debt securities
and have a guaranteed interest rate of 4.50 percent.
Employers Mutual plans to contribute approximately $2,500,000 to the
pension plan and $3,800,000 to the postretirement benefit plans in 2005.
The Company participates in several other retirement plans sponsored by
Employers Mutual, including a 401(k) Plan, an Executive Non-Qualified Excess
Plan and a Supplemental Retirement Plan. The Supplemental Retirement Plan was
effective October 1, 2004 and replaced the Excess Retirement Benefit Agreement
and the Supplemental Executive Retirement Plan. The Company's share of
expenses for these plans amounted to $1,139,411, $912,103 and $703,555 in
2004, 2003 and 2002, respectively.
The following benefit payments, which reflect expected future service, as
appropriate, are expected to be paid over the next ten years:
Postretirement Benefits
------------------------------------------
Pension Benefits Gross Medicare Subsidy Net
---------------- ----------- ---------------- -----------
2005 ......... $ 8,713,000 $ 2,056,651 $ - $ 2,056,651
2006 ......... 8,284,000 2,334,266 254,146 2,080,120
2007 ......... 8,976,000 2,605,362 292,745 2,312,617
2008 ......... 10,220,000 2,888,512 340,904 2,547,608
2009 ......... 12,718,000 3,303,794 385,068 2,918,726
2010 - 2014 .. 105,127,000 23,222,122 3,011,185 20,210,937
12. STOCK PLANS
Stock Based Compensation
The Company has no stock based compensation plans of its own; however,
Employers Mutual has several stock plans which utilize the common stock of the
Company. Employers Mutual can provide the common stock required under its
plans by: 1) using shares of common stock that it currently owns; 2)
purchasing common stock on the open market; or 3) directly purchasing common
stock from the Company at the current fair value. Employers Mutual has
historically purchased common stock from the Company for use in its incentive
stock option plans and its non-employee director stock purchase plan.
Employers Mutual generally purchases common stock on the open market to
fulfill its obligations under its employee stock purchase plan.
Incentive Stock Option Plans
Employers Mutual maintains two separate stock option plans for the
benefit of officers and key employees of Employers Mutual and its
subsidiaries. A total of 500,000 shares have been reserved for the 2003
Employers Mutual Casualty Company Incentive Stock Option Plan (2003 Plan) and
a total of 1,000,000 shares have been reserved for issuance under the 1993
Employers Mutual Casualty Company Incentive Stock Option Plan (1993 Plan).
There is a ten year time limit for granting options under the plans.
Options can no longer be granted under the 1993 Plan. Options granted under
the plans have a vesting period of two, three, four or five years with options
becoming exercisable in equal annual cumulative increments. Option prices
cannot be less than the fair value of the stock on the date of grant.
The Senior Executive Compensation and Stock Option Committee (the
"Committee") of Employers Mutual's Board of Directors (the "Board") is the
administrator of the plans. Options granted are initially determined by the
Committee and subsequently approved by the Board. In 2004, the Company's
Board of Directors established its own Compensation Committee (the "Company
Compensation Committee") and, commencing in 2005, the Company Compensation
Committee will consider and approve all stock options granted to the Company's
executive officers.
During 2004, 70,025 options were granted under the 2003 Plan to eligible
participants at a price of $22.28 and 108,648 options were exercised under the
plans at prices ranging from $19.71 to $24.95. A summary of the activity
under Employers Mutual's incentive stock option plans for 2004, 2003 and 2002
is as follows:
2004 2003 2002
------------------- ------------------ -----------------
Weighted- Weighted- Weighted-
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
------ -------- ------ -------- ------ ---------
Outstanding,
beginning of year 630,615 $12.86 678,757 $11.65 723,378 $10.84
Granted ............. 70,025 22.28 113,225 16.88 65,900 18.30
Exercised ........... (108,648) 11.21 (157,392) 10.50 (98,864) 10.26
Expired ............. (8,454) 10.03 (3,975) 13.96 (11,657) 10.88
-------- -------- --------
Outstanding,
end of year ....... 583,538 14.34 630,615 12.86 678,757 11.65
======== ======== ========
Exercisable,
end of year ....... 332,918 $12.33 349,960 $11.85 404,807 $11.35
======== ======== ========
December 31, 2004
----------------------------------------------------------
Options Outstanding Options Exercisable
----------------------------------- ---------------------
Weighted-
Weighted- average Weighted-
average remaining average
Range of option Number exercise contractual Number exercise
exercise prices outstanding price life exercisable price
- ------------------ ----------- --------- ----------- ----------- ---------
$ 9.25 - $12.69 253,359 $10.35 4.46 200,124 $10.59
13.25 - 16.88 198,414 15.41 5.61 109,034 14.21
18.30 - 22.28 131,765 20.42 8.16 23,760 18.30
------- -------
583,538 14.34 5.68 332,918 12.33
======= =======
Employee Stock Purchase Plan
A total of 500,000 shares of the Company's common stock have been
reserved for issuance under the Employers Mutual Casualty Company 1993
Employee Stock Purchase Plan. Any employee who is employed by Employers
Mutual or its subsidiaries on the first day of the month immediately preceding
any option period is eligible to participate in the plan. Participants pay 85
percent of the fair market value of the stock purchased, which is fully vested
on the date purchased. The plan is administered by the Board of Employers
Mutual and the Board has the right to amend or terminate the plan at any time;
however, no such amendment or termination shall adversely affect the rights
and privileges of participants with unexercised options. Expenses allocated
to the Company in connection with this plan totaled $9,752, $13,214 and $6,817
in 2004, 2003 and 2002, respectively.
During 2004, a total of 13,531 options were exercised at prices of $20.06
and $18.46. Activity under the plan was as follows:
Year ended December 31,
----------------------------
2004 2003 2002
-------- -------- --------
Shares available for purchase,
beginning of year ...................... 288,322 300,206 311,922
Shares purchased under plan .............. (13,531) (11,884) (11,716)
-------- -------- --------
Shares available for purchase, end of year 274,791 288,322 300,206
======== ======== ========
Non-Employee Director Stock Purchase Plan
A total of 200,000 shares of the Company's common stock have been
reserved for issuance under the 2003 Employers Mutual Casualty Company Non-
Employee Director Stock Purchase Plan. All non-employee directors of
Employers Mutual and its subsidiaries and affiliates who are not serving on
the "Disinterested Director Committee" of the Board as of the beginning of the
option period are eligible to participate in the plan. Each eligible director
can purchase shares of common stock at 75 percent of the fair value of the
stock in an amount equal to a minimum of 25 percent to a maximum of 100
percent of their annual cash retainer. The plan will continue through the
option period for options granted at the 2012 annual meetings. The plan is
administered by the Disinterested Director Committee of the Board. 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 participants
with unexercised options. The Employers Mutual Casualty Company Non-Employee
Director Stock Purchase Plan previously in place expired on May 20, 2003 and
the remaining 139,328 shares were deregistered. Expenses allocated to the
Company in connection with these plans totaled $4,080, $1,878 and $0 in 2004,
2003 and 2002, respectively.
During 2004, a total of 1,359 options were exercised at prices ranging
from $14.97 to $15.81. Activity under the plan was as follows:
Year ended December 31,
----------------------------
2004 2003 2002
-------- -------- --------
Shares available for purchase,
beginning of year ...................... 198,156 141,197 143,158
Shares purchased under expired plan ...... - (1,869) -
Shares deregistered under expired plan ... - (139,328) -
Shares registered for use in 2003 plan ... - 200,000 -
Shares purchased under plans ............. (1,359) (1,844) (1,961)
-------- -------- --------
Shares available for purchase, end of year 196,797 198,156 141,197
======== ======== ========
Dividend Reinvestment Plan
The Company maintains a dividend reinvestment and common stock purchase
plan which provides stockholders with the option of reinvesting cash dividends
in additional shares of the Company's common stock. Participants may also
purchase additional shares of common stock without incurring broker
commissions by making optional cash contributions to the plan and may sell
shares of common stock through the plan. Since the third quarter of 1998, all
shares of common stock issued under the plan have been purchased in the open
market through the Company's transfer agent. Employers Mutual participated in
the Dividend Reinvestment Plan in 2002, 2003 and the first two quarters of
2004, reinvesting 50 percent of its dividends in additional shares of the
Company's common stock in all but the second and third quarters of 2003, when
it reinvested 75 percent and 25 percent, respectively, and in 2002, when it
reinvested 25 percent. Due to its participation in the Company's recent stock
offering, Employers Mutual discontinued its participation in the plan for the
third and fourth quarters of 2004 and has indicated that it will likely not
participate in the plan in 2005. Activity under the plan was as follows:
Year ended December 31,
--------------------------------
2004 2003 2002
-------- -------- --------
Shares available for purchase,
beginning of year .................. 271,838 416,899 501,230
Shares purchased under plan .......... (63,018) (145,061) (84,331)
-------- -------- --------
Shares available for purchase,
end of year ........................ 208,820 271,838 416,899
======== ======== ========
Range of purchase prices ............. $18.75 $16.98 $15.38
to to to
$24.97 $21.32 $21.99
13. DISCLOSURES ABOUT THE FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair value for fixed maturities, equity securities and
short-term investments is based on quoted market prices, where available, or
on values obtained from independent pricing services (see note 8).
The carrying value of the surplus notes approximates their estimated fair
value since their interest rates approximate current interest rates and the
companies' credit ratings have not changed.
Other long-term investments, consisting primarily of holdings in limited
partnerships and limited liability companies, are valued by the various fund
managers. In management's opinion, these values reflect fair value at
December 31, 2004.
The estimated fair value of the Company's financial instruments is
summarized below.
Carrying Estimated
amount fair value
------------ ------------
December 31, 2004
- -----------------
Assets:
Fixed maturity securities:
Held-to-maturity ............................ $ 29,205,871 $ 30,593,606
Available-for-sale .......................... 619,654,403 619,654,403
Equity securities available-for-sale .......... 78,692,893 78,692,893
Short-term investments ........................ 46,238,853 46,238,853
Other long-term investments ................... 5,550,093 5,550,093
Liabilities:
Surplus notes ................................. 36,000,000 36,000,000
December 31, 2003
- -----------------
Assets:
Fixed maturity securities:
Held-to-maturity ............................ $ 49,845,348 $ 53,854,424
Available-for-sale .......................... 523,785,758 523,785,758
Equity securities available-for-sale .......... 49,008,498 49,008,498
Short-term investments ........................ 63,568,064 63,568,064
Other long-term investments ................... 4,758,019 4,758,019
Liabilities:
Surplus notes ................................. 36,000,000 36,000,000
14. LEASES, COMMITMENTS AND CONTINGENT LIABILITIES
One of the Company's property and casualty insurance subsidiaries leases
office facilities in Bismarck, North Dakota with lease terms expiring in 2014.
Hamilton Mutual Insurance Company, an affiliate of Employers Mutual and a
pool participant, leases office facilities for the Cincinnati branch office
with lease terms expiring in 2005. Employers Mutual has entered into various
leases for branch and service office facilities with lease terms expiring
through 2013. Employers Mutual also leases computer software under various
operating lease agreements expiring through 2005. All lease costs are
included as expenses under the pooling agreement after allocation of the
portion of these expenses to the subsidiaries that do not participate in the
pool. The following table reflects the lease commitments of the Company as of
December 31, 2004. The table reflects the Company's current 23.5 percent
aggregate participation in the pooling agreement. As discussed further in
note 2, the Company's aggregate participation in the pooling agreement will
increase to 30.0 percent effective January 1, 2005.
Payments due by period
------------------------------------------------------
Less More
than 1-3 4-5 than
Total 1 year years years 5 years
---------- ---------- ---------- ---------- ----------
Lease Commitments
- -----------------
Real estate operating
leases ............. $6,863,044 $1,086,053 $1,976,714 $1,559,701 $2,240,576
Software operating
leases ............. 375,363 375,363 - - -
---------- ---------- ---------- ---------- ----------
Total ................ $7,238,407 $1,461,416 $1,976,714 $1,559,701 $2,240,576
========== ========== ========== ========== ==========
Estimated guaranty fund assessments of $1,206,984 and $1,252,564, which
are used by states to pay claims of insolvent insurers domiciled in that
state, have been accrued as of December 31, 2004 and 2003, respectively. The
guaranty fund assessments are expected to be paid over the next two years with
premium tax offsets of $1,543,735 expected to be realized within ten years of
the payments. Estimated second injury fund assessments of $1,389,590 and
$1,108,605, which are designed to encourage employers to employ a worker with
a pre-existing disability, have been accrued as of December 31, 2004 and 2003,
respectively. The second injury fund assessment accruals are based on
projected loss payments. The periods over which the assessments will be paid
is not known.
The participants in the pooling agreement have purchased annuities from
life insurance companies, under which the claimant is payee, to fund future
payments that are fixed pursuant to specific claim settlement provisions. The
Company's share of loss reserves eliminated by the purchase of these annuities
was $699,913 at December 31, 2004. The Company has a contingent liability of
$699,913 should the issuers of these annuities fail to perform under the terms
of the annuities. The Company's share of the amount due from any one life
insurance company does not equal or exceed one percent of its subsidiaries'
policyholders' surplus.
The Company and Employers Mutual and its other subsidiaries are parties
to numerous lawsuits arising in the normal course of the insurance business.
The Company believes that the resolution of these lawsuits will not have a
material adverse effect on its financial condition or its results of
operations. The companies involved have reserves which are believed adequate
to cover any potential liabilities arising out of all such pending or
threatened proceedings.
15. UNAUDITED INTERIM FINANCIAL INFORMATION
Three months ended,
-----------------------------------------------------
March 31 June 30 September 30 December 31
----------- ----------- ------------ -----------
2004
- ----
Total revenues ........ $91,209,265 $94,296,170 $96,455,388 $98,397,887
=========== =========== =========== ===========
Income (loss) before
income tax expense
(benefit) ........... $12,363,360 $ 3,775,979 $ 1,641,750 $(2,210,092)
Income tax expense
(benefit) ........... 4,014,265 310,043 (216,710) (1,721,284)
----------- ----------- ----------- -----------
Net income (loss) $ 8,349,095 $ 3,465,936 $ 1,858,460 $ (488,808)
=========== =========== =========== ===========
Net income (loss)
per share
- basic and diluted* $ .72 $ .30 $ .16 $ (.04)
=========== =========== =========== ===========
2003
- ----
Total revenues ........ $86,646,867 $90,215,736 $92,594,260 $92,900,176
=========== =========== =========== ===========
Income before income
tax expense (benefit) $ 9,543,476 $ 1,419,592 $ 8,922,814 $ 8,096,414
Income tax expense
(benefit) ........... 3,097,798 (10,600) 2,540,710 2,005,265
----------- ----------- ----------- -----------
Net income ....... $ 6,445,678 $ 1,430,192 $ 6,382,104 $ 6,091,149
=========== =========== =========== ===========
Net income per share
- basic and diluted* $ .57 $ .12 $ .56 $ .53
=========== =========== =========== ===========
2002
- ----
Total revenues ........ $77,157,134 $78,582,787 $81,763,105 $90,024,758
=========== =========== =========== ===========
Income before income
tax expense ......... $ 5,470,323 $ 3,518,303 $ 5,971,780 $ 6,931,630
Income tax expense .... 1,780,446 573,617 1,670,595 1,765,640
----------- ----------- ----------- -----------
Net income ....... $ 3,689,877 $ 2,944,686 $ 4,301,185 $ 5,165,990
=========== =========== =========== ===========
Net income per share
- basic and diluted* $ .33 $ .26 $ .38 $ .45
=========== =========== =========== ===========
* Since the weighted average shares for the quarters are calculated
independent of the weighted average shares for the year, quarterly net income
(loss) per share may not total to annual net income (loss) per share.
REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM,
ON SCHEDULES
We have audited the consolidated financial statements of EMC Insurance
Group Inc. and Subsidiaries as of December 31, 2004 and 2003, and for each of
the three years in the period ended December 31, 2004, and have issued our
report thereon dated March 11, 2005 (included elsewhere in this Annual Report
on Form 10-K). Our audits also included the financial statement schedules
listed in Item 15(a)2 of this Annual Report on Form 10-K. These schedules are
the responsibility of the Company's management. Our responsibility is to
express an opinion based on our audits.
In our opinion, the financial statement schedules referred to above, when
considered in relation to the basic financial statements taken as a whole,
present fairly in all material respects the information set forth therein.
/s/ Ernst & Young LLP
March 11, 2005
Des Moines, Iowa
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Schedule I - Summary of Investments -
Other Than Investments in Related Parties
December 31, 2004
Amount at
which shown
Fair in the
Type of investment Cost value balance sheet
------------------ ------------ ------------ -------------
Securities held-to-maturity:
Fixed maturities:
United States Government
and government agencies
and authorities .............. $ 28,037,203 $ 29,316,549 $ 28,037,203
Mortgage-backed securities ..... 1,168,668 1,277,057 1,168,668
------------ ------------ ------------
Total fixed maturity
securities ............. 29,205,871 30,593,606 29,205,871
------------ ------------ ------------
Securities available-for-sale:
Fixed maturities:
United States Government
and government agencies
and authorities .............. 137,273,717 137,538,697 137,538,697
States, municipalities and
political subdivisions ....... 257,483,428 267,675,811 267,675,811
Mortgage-backed securities ..... 11,136,193 11,851,118 11,851,118
Public utilities ............... 8,686,436 9,867,903 9,867,903
Debt securities issued by
foreign governments .......... 7,177,870 7,499,199 7,499,199
Corporate securities ........... 174,033,352 185,221,675 185,221,675
------------- ------------ ------------
Total fixed maturity
securities ............. 595,790,996 619,654,403 619,654,403
------------- ------------ ------------
Equity securities:
Common stocks
Banks, trusts and insurance
companies .................. 10,242,918 16,019,824 16,019,824
Industrial, miscellaneous and
all other .................. 48,846,516 62,144,069 62,144,069
Non-redeemable preferred
stocks ..................... 500,000 529,000 529,000
------------- ------------ ------------
Total equity securities .. 59,589,434 78,692,893 78,692,893
------------- ------------ ------------
Other long-term investments ........ 5,550,093 5,550,093 5,550,093
Short-term investments ............. 46,238,853 46,238,853 46,238,853
------------ ------------ ------------
Total investments ...... $736,375,247 $780,729,848 $779,342,113
============ ============ ============
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Schedule II - Condensed Financial Information of Registrant
Condensed Balance Sheets
December 31,
--------------------------
2004 2003
------------ ------------
ASSETS
Investment in common stock of
subsidiaries (equity method) .................. $223,101,504 $176,087,397
Fixed maturity investments:
Securities available-for-sale, at fair value .. 2,018,185 516,775
Short-term investments .......................... 3,262,867 3,768,427
Cash ............................................ 88,890 168,072
Accrued investment income ....................... 38,288 4,545
Income taxes recoverable ........................ 164,069 211,760
Deferred income taxes ........................... 12,621 204,310
------------ ------------
Total assets ............................... $228,686,424 $180,961,286
============ ============
LIABILITIES
Accounts payable ................................ $ 208,252 $ 199,015
Indebtedness to related party ................... 5,140 11,720
------------ ------------
Total liabilities .......................... 213,392 210,735
------------ ------------
STOCKHOLDERS' EQUITY
Common stock, $1 par value,
authorized 20,000,000 shares;
issued and outstanding, 13,568,945 shares
in 2004 and 11,501,065 shares in 2003 ......... 13,568,945 11,501,065
Additional paid-in capital ...................... 103,467,293 69,113,228
Accumulated other comprehensive income .......... 27,928,463 22,285,668
Retained earnings ............................... 83,508,331 77,850,590
------------ ------------
Total stockholders' equity ................. 228,473,032 180,750,551
------------ ------------
Total liabilities and stockholders' equity $228,686,424 $180,961,286
============ ============
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Schedule II - Condensed Financial Information of Registrant, Continued
Condensed Statements of Income
Years ended December 31,
-------------------------------------
2004 2003 2002
----------- ----------- -----------
REVENUES
Dividends received from subsidiaries .. $ 7,028,641 $ 7,255,228 $ 6,250,016
Investment income ..................... 164,936 30,368 113,843
Realized investment gains ............. - - 5,313
----------- ----------- -----------
7,193,577 7,285,596 6,369,172
Operating expenses .................... 666,628 609,563 436,688
----------- ----------- -----------
Income before income tax benefit
and equity in undistributed net
income of subsidiaries ............ 6,526,949 6,676,033 5,932,484
Income tax benefit .................... (175,591) (195,932) (101,747)
----------- ----------- -----------
Income before equity in undistributed
net income of subsidiaries ....... 6,702,540 6,871,965 6,034,231
Equity in undistributed net income
of subsidiaries ..................... 6,482,143 13,477,158 10,067,507
----------- ----------- -----------
Net income .............. $13,184,683 $20,349,123 $16,101,738
=========== =========== ===========
Condensed Statements of Comprehensive Income
Years ended December 31,
----------------------------------------
2004 2003 2002
------------ ------------ ------------
Net income ......................... $ 13,184,683 $ 20,349,123 $ 16,101,738
------------ ------------ ------------
Other Comprehensive Income:
Unrealized holding gains arising
during the period, net of
deferred income tax expense .... 8,483,435 8,638,869 4,845,443
Reclassification adjustment for
(gains) losses included in net
income (loss), net of income tax
expense (benefit) .............. (2,840,640) (759,797) 2,053,481
Adjustment for minimum pension
liability associated with
Employers Mutual's pension plan,
net of deferred income tax
expense (benefit) .............. - 188,266 (188,266)
------------ ------------ ------------
Other comprehensive income ....... 5,642,795 8,067,338 6,710,658
------------ ------------ ------------
Total comprehensive income ... $ 18,827,478 $ 28,416,461 $ 22,812,396
============ ============ ============
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Schedule II - Condensed Financial Information of Registrant, Continued
Condensed Statements of Cash Flows
Years ended December 31,
-------------------------------------
2004 2003 2002
----------- ----------- -----------
Net cash provided by
operating activities ................ $ 6,910,340 $ 6,691,273 $ 5,988,850
----------- ----------- -----------
Cash flows from investing activities
Maturities of fixed maturity
securities available-for-sale ..... - 1,665,000 1,505,313
Purchases of fixed maturity
securities available-for-sale ..... (1,500,000) (500,000) (1,694,104)
Net sales (purchases) of short-term
investments ...................... 505,560 (2,312,603) (467,269)
Capital contribution to subsidiaries (34,890,085) - -
----------- ----------- -----------
Net cash used in investing
activities .................... (35,884,525) (1,147,603) (656,060)
----------- ----------- -----------
Cash flows from financing activities
Balances resulting from related
party transactions with Employers
Mutual:
Issuance of common stock
through Employers Mutual stock
option plans .................. 1,531,860 1,944,652 1,326,451
Dividends paid to Employers
Mutual ........................ (5,292,178) (5,522,994) (5,423,042)
Dividends paid to Employers
Mutual (reimbursement for
non-GAAP expense) ............. (293,583) (505,196) -
Issuance of common stock through
follow-on stock offering .......... 34,890,085 - -
Dividends paid to public stockholders (1,941,181) (1,350,736) (1,405,064)
----------- ----------- -----------
Net cash provided by (used in)
financing activities .......... 28,895,003 (5,434,274) (5,501,655)
----------- ----------- -----------
Net increase (decrease) in cash ....... (79,182) 109,396 (168,865)
Cash at beginning of year ............. 168,072 58,676 227,541
----------- ----------- -----------
Cash at end of year ................... $ 88,890 $ 168,072 $ 58,676
=========== =========== ===========
Income taxes received .................$ 414,477 $ - $ 2,253
Interest paid .........................$ - $ - $ -
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Schedule III - Supplementary Insurance Information
For Years Ended December 31, 2004, 2003 and 2002
Deferred Loss and
policy settlement Net
acquisition expense Unearned Premium investment
Segment costs reserves premiums revenue income
------- ----------- ------------ ------------ ------------ -----------
Year ended December 31, 2004:
Property and casualty insurance $23,763,927 $309,972,237 $111,700,528 $250,034,561 $20,236,342
Reinsurance ................... 4,176,656 119,705,065 19,888,837 95,443,900 9,498,925
Parent company ................ - - - - 164,936
----------- ------------ ------------ ------------ -----------
Consolidated ............. $27,940,583 $429,677,302 $131,589,365 $345,478,461 $29,900,203
=========== ============ ============ ============ ===========
Year ended December 31, 2003:
Property and casualty insurance $22,844,736 $257,119,295 $107,136,936 $241,237,313 $20,724,017
Reinsurance ................... 3,893,048 116,663,621 17,695,671 89,385,497 8,948,076
Parent company ................ - - - - 30,368
----------- ------------ ------------ ------------ -----------
Consolidated ............. $26,737,784 $373,782,916 $124,832,607 $330,622,810 $29,702,461
=========== ============ ============ ============ ===========
Year ended December 31, 2002:
Property and casualty insurance $21,181,714 $229,876,996 $ 98,723,419 $225,013,076 $23,517,163
Reinsurance ................... 3,745,147 101,349,757 17,023,395 72,029,957 9,147,127
Parent company ................ - - - - 113,843
----------- ------------ ------------ ------------ -----------
Consolidated ............. $24,926,861 $331,226,753 $115,746,814 $297,043,033 $32,778,133
=========== ============ ============ ============ ===========
Amortization
Losses and of deferred
settlement policy Other
expenses acquisition underwriting Premiums
Segment incurred costs expenses written
------- ------------ ------------ ------------ ------------
Year ended December 31, 2004:
Property and casualty insurance $196,460,047 $ 55,746,217 $ 25,612,121 $254,266,763
Reinsurance ................... 53,346,163 19,698,620 7,171,565 97,637,066
Parent company ................ - - - -
------------ ------------ ------------ ------------
Consolidated ............. $249,806,210 $ 75,444,837 $ 32,783,686 $351,903,829
============ ============ ============ ============
Year ended December 31, 2003:
Property and casualty insurance $168,238,623 $ 52,932,215 $ 24,548,745 $249,591,675
Reinsurance ................... 58,265,927 19,027,017 5,376,197 90,057,773
Parent company ................ - - - -
------------ ------------ ------------ ------------
Consolidated ............. $226,504,550 $ 71,959,232 $ 29,924,942 $339,649,448
============ ============ ============ ============
Year ended December 31, 2002:
Property and casualty insurance $156,152,022 $ 49,057,682 $ 20,447,874 $237,633,602
Reinsurance ................... 50,905,834 16,669,334 6,481,098 76,203,278
Parent company ................ - - - -
------------ ------------ ------------ ------------
Consolidated ............. $207,057,856 $ 65,727,016 $ 26,928,972 $313,836,880
============ ============ ============ ============
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Schedule IV - Reinsurance
For years ended December 31, 2004, 2003 and 2002
Percentage
Ceded to Assumed of amount
Gross other from other Net assumed
amount companies companies amount to net
------------ ------------ ------------ ------------ ----------
Year ended December 31, 2004:
Consolidated earned premiums ........... $197,051,604 $215,111,924 $363,538,781 $345,478,461 105.2%
============ ============ ============ ============ ==========
Year ended December 31, 2003:
Consolidated earned premiums ........... $221,662,098 $236,616,480 $345,577,192 $330,622,810 104.5%
============ ============ ============ ============ ==========
Year ended December 31, 2002:
Consolidated earned premiums ........... $241,939,466 $252,860,839 $307,964,406 $297,043,033 103.7%
============ ============ ============ ============ ==========
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Schedule VI - Supplemental Information Concerning
Property-Casualty Insurance Operations
For Years Ended December 31, 2004, 2003 and 2002
Discount,
Deferred Reserves for if any,
policy losses and deducted Net
Consolidated property- acquisition settlement from Unearned Earned investment
casualty entities costs expenses reserves premiums premiums income
- ---------------------- ----------- ------------ -------- ------------ ------------ -----------
Year ended December 31, 2004: $27,940,583 $429,677,302 $ -0- $131,589,365 $345,478,461 $29,735,267
=========== ============ ======== ============ ============ ===========
Year ended December 31, 2003: $26,737,784 $373,782,916 $ -0- $124,832,607 $330,622,810 $29,672,093
=========== ============ ======== ============ ============ ===========
Year ended December 31, 2002: $24,926,861 $331,226,753 $ -0- $115,746,814 $297,043,033 $32,664,290
=========== ============ ======== ============ ============ ===========
Losses and
settlement expenses Amortization
incurred related to of deferred Paid
-------------------------- policy losses and
Consolidated property- Current Prior acquisition settlement Premiums
casualty entities Year Years costs expenses written
- ---------------------- ------------ ----------- ------------ ------------ ------------
Year ended December 31, 2004: $229,667,776 $20,138,434 $ 75,444,837 $198,603,715 $351,903,829
============ =========== ============ ============ ============
Year ended December 31, 2003: $219,028,236 $ 7,476,314 $ 71,959,232 $194,247,192 $339,649,448
============ =========== ============ ============ ============
Year ended December 31, 2002: $200,059,798 $ 6,998,058 $ 65,727,016 $188,868,718 $313,836,880
============ =========== ============ ============ ============
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
- ------- ------------------------------------------------
ACCOUNTING AND FINANCIAL DISCLOSURE.
------------------------------------
None.
ITEM 9A. 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.
Management has not issued a report on internal control over financial
reporting since the Company is not an accelerated filer as of the fiscal year
ended December 31, 2004. Accordingly, the Company's independent auditor has
not performed an assessment of the Company's internal controls for the fiscal
year ended December 31, 2004.
ITEM 9B. OTHER INFORMATION.
- -------- ------------------
None.
PART III
--------
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
- -------- ---------------------------------------------------
The information required by Item 10 regarding the Company's executive
officers appears under the caption "Executive Officers of the Company" at the
end of Part I, Item 1 of this Form 10-K.
The information required by Item 10 regarding the audit committee
financial expert and the members of the Company's Audit Committee of the Board
of Directors is incorporated by reference from the information under the
caption "Information about the Board of Directors and its Committees" in the
Company's Proxy Statement for the Annual Meeting of Stockholders to be held on
May 26, 2005.
The information required by Item 10 regarding the Company's directors is
incorporated by reference from the information under the captions "Election of
Directors", and "Security Ownership of Management and Directors" in the
Company's Proxy Statement for the Annual Meeting of Stockholders to be held on
May 26, 2005.
The Company has adopted a code of ethics that applies to the Company's
principal executive officer, principal financial officer, principal accounting
officer or controller, or persons performing similar functions. The code of
ethics is posted on the Investor Relations section of the Company's internet
website found at www.emcinsurance.com.
Section (16)a Beneficial Ownership Reporting Compliance
During 2004, there were two occasions when a Form 4 was not filed on a
timely basis by Employers Mutual. Employers Mutual sold 1,800,000 shares of
the Company's common stock in October and 260,542 shares in November. These
transactions were made pursuant to the S-1 Registration Statement filed in
conjunction with the Company's follow-on stock offering. The Form 4's for
these two transactions were filed thirty days and twelve days late,
respectively.
ITEM 11. EXECUTIVE COMPENSATION.
- -------- -----------------------
See the information under the caption "Compensation of Management" in the
Company's Proxy Statement in connection with its Annual Meeting of
Stockholders to be held on May 26, 2005, which information is incorporated
herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
- -------- ------------------------------------------------------------------
RELATED STOCKHOLDER MATTERS.
----------------------------
See information under the captions "Security Ownership of Certain
Beneficial Owners" and "Security Ownership of Management and Directors" in the
Company's Proxy Statement in connection with its Annual Meeting of
Stockholders to be held on May 26, 2005, which information is incorporated
herein by reference.
The following table presents information regarding Employers Mutual's
equity compensation plans as of December 31, 2004:
Number of
securities
remaining
available for
Number of future issuance
securities to under equity
be issued upon Weighted-average compensation
exercise of exercise price plans (excluding
outstanding of outstanding securities
options, warrants options, warrants reflected in
Plan category and rights and rights column (a))
- ------------------- ----------------- ----------------- -----------------
(a) (b) (c)
----------------- ----------------- -----------------
Equity compensation
plans approved by
security holders 583,538 $14.34 316,750
Equity compensation
plans not
approved by
security holders - N/A N/A
----------------- ----------------- -----------------
Total 583,538 $14.34 316,750
================= ================= =================
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
- -------- -----------------------------------------------
The property and casualty insurance operations of the Company are
integrated with those of Employers Mutual through the participation in a
pooling arrangement. As a result of this operational relationship there are
numerous transactions between the Company and the Employers Mutual pool
participants that occur on an ongoing basis in the ordinary course of
business.
Premiums assumed by the reinsurance subsidiary from Employers Mutual
amounted to $97,637,066 in 2004. It is customary in the reinsurance business
for the assuming company to compensate the ceding company for the acquisition
expenses incurred in the generation of the business. Commissions paid by the
reinsurance subsidiary to Employers Mutual amounted to $20,621,898 in 2004.
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. Total override commission paid to Employers Mutual in 2004 amounted
to $4,393,668. Employers Mutual retained losses and settlement expenses under
this agreement totaling $11,277,246 in 2004. 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 and
amounted to $3,626,833 in 2004.
Employers Mutual provides various services to all of its subsidiaries and
affiliates, including the Company and its subsidiaries. Such services include
data processing, claims, financial, legal, actuarial, auditing, marketing and
underwriting. Employers Mutual allocates a portion of the cost of these
services to the subsidiaries that do not participate in the pooling agreement
based upon a number of criteria, including usage and number of transactions.
The remaining costs are charged to the pooling agreement and each pool
participant shares in the total cost in accordance with its pool participation
percentage. Costs allocated to the Company by Employers Mutual for services
provided to the holding company and its subsidiaries that do not participate
in the pooling agreement amounted to $2,300,700 in 2004. Costs allocated to
the Company through the operation of the pooling agreement amounted to
$73,305,162 in 2004.
Investment expenses are based on actual expenses incurred by the Company
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 $699,807 in 2004. In the third quarter of 2004,
subsidiaries of the Company sold $4,447,000 of MCI Communications Corporation
bonds to an affiliated company. In addition, a subsidiary of the Company
leased office space from an affiliate of Employers Mutual which is used as a
branch office. These lease payments amounted to $352,000 in 2004.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
- -------- ---------------------------------------
See the information under the captions "Audit Fees", "Audit Related
Fees", "Tax Fees" and "All Other Fees" in the Company's Proxy Statement in
connection with its Annual Meeting of Stockholders to be held on May 26, 2005,
which information is incorporated herein by reference.
PART IV
-------
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
- -------- -------------------------------------------
(a) List of Financial Statements and Schedules.
1. Financial Statements
Page
Report of Ernst & Young LLP, Independent Registered
Public Accounting Firm .................................... 86
Consolidated Balance Sheets, December 31, 2004 and 2003 ..... 87
Consolidated Statements of Income for the years ended
December 31, 2004, 2003 and 2002 ......................... 89
Consolidated Statements of Comprehensive Income for the
Years ended December 31, 2004, 2003 and 2002 ............. 90
Consolidated Statements of Stockholders' Equity for the
Years ended December 31, 2004, 2003 and 2002 ............. 91
Consolidated Statements of Cash Flows for the years ended
December 31, 2004, 2003 and 2002 ......................... 92
Notes to Consolidated Financial Statements .................. 94
2. Schedules
Report of Ernst & Young LLP, Independent Registered Public
Accounting Firm, On Schedules ............................. 127
Schedule I - Summary of Investments - Other Than
Investments in Related Parties ............... 128
Schedule II - Condensed Financial Information of Registrant 129
Schedule III - Supplementary Insurance Information .......... 132
Schedule IV - Reinsurance .................................. 133
Schedule VI - Supplemental Information Concerning
Property-Casualty Insurance Operations ..... 134
All other schedules have been omitted for the reason that the items
required by such schedules are not present in the consolidated
financial statements, are covered in the notes to the consolidated
financial statements or are not significant in amount.
3. Management contracts and compensatory plan arrangements
Exhibit 10(b). 2004 Senior Executive Compensation Bonus Program.
Exhibit 10(d). Deferred Bonus and Compensation Plans.
Exhibit 10(e). 2004 Executive Contingent Salary Plan -
EMC Reinsurance Company.
Exhibit 10(g) Employers Mutual Casualty Company Excess Retirement
Benefit Agreement.
Exhibit 10(h). Employers Mutual Casualty Company 1993 Employee
Stock Purchase Plan.
Exhibit 10(i). 1993 Employers Mutual Casualty Company Incentive
Stock Option Plan, as amended.
Exhibit 10(j). 2003 Employers Mutual Casualty Company Non-Employee
Director Stock Option Plan.
Exhibit 10(k). Employers Mutual Casualty Company Supplemental
Retirement Plan.
Exhibit 10(l). EMCC Option It! Deferred Bonus Compensation Plan.
Exhibit 10(m). EMCC Board of Directors Option It! Deferred
Compensation Plan.
Exhibit 10(n). Employers Mutual Casualty Company Executive Non-
Qualified Excess Plan.
Exhibit 10(o). 2003 Employers Mutual Casualty Company Incentive
Stock Option Plan.
(b) Exhibits.
3. Articles of incorporation and by-laws:
(a) Restated Articles of Incorporation of the Company.
(Incorporated by reference to Exhibit 3.1 filed with the
Company's Registration Statement on Form S-1, Registration
No. 333-117406.)
(b) By-Laws of the Company, as amended. (Incorporated by
reference to the Company's Form 10-K for the calendar
year ended December 31, 2001.)
10. Material contracts.
(a) Quota Share Reinsurance Contract between Employers Mutual
Casualty Company and EMC Reinsurance Company. (Incorporated by
reference to Exhibit 10.1 filed with the Company's Registration
Statement on Form S-1, Registration No. 333-117406.)
(b) 2004 Senior Executive Compensation Bonus Program.
(Incorporated by reference to Exhibit 10.2 filed with the
Company's Registration Statement on Form S-1, Registration
No. 333-117406.)
(c) EMC Insurance Companies reinsurance pooling agreements
between Employers Mutual Casualty Company and certain of its
affiliated companies, as amended. (Incorporated by reference to
the Company's Form 10-K/A for the calendar year ended
December 31, 2003.)
(d) Deferred Bonus and Compensation Plans.
(e) 2004 Executive Contingent Salary Plan - EMC Reinsurance Company.
(Incorporated by reference to Exhibit 10.5 filed with the
Company's Registration Statement on Form S-1, Registration
No. 333-117406.)
(f) EMC Insurance Group Inc. Amended and Restated Dividend
Reinvestment and Common Stock Purchase Plan. (Incorporated by
reference to Registration No. 33-34499.)
(g) Employers Mutual Casualty Company Excess Retirement Benefit
Agreement.
(h) Employers Mutual Casualty Company 1993 Employee Stock Purchase
Plan. (Incorporated by reference to Registration No. 33-49335.)
(i) 1993 Employers Mutual Casualty Company Incentive Stock Option
Plan. (Incorporated by reference to Registration Nos. 33-49337
and 333-45279.)
(j) 2003 Employers Mutual Casualty Company Non-Employee Director
Stock Option Plan. (Incorporated by reference to Registration
No. 333-104469.)
(k) Employers Mutual Casualty Company Supplemental Retirement Plan.
(Incorporated by reference to Exhibit 10.1 filed with the
Company's Form 8-K on January 18, 2005.)
(l) EMCC Option It! Deferred Bonus Compensation Plan. (Incorporated
by reference to the Company's Form 10-K for the calendar year
ended December 31, 2001.)
(m) EMCC Board of Directors Option It! Deferred Compensation Plan.
(Incorporated by reference to the Company's Form 10-K for the
calendar year ended December 31, 2001.)
(n) Employers Mutual Casualty Company Executive Non-Qualified Excess
Plan. (Incorporated by reference to the Company's Form 10-K/A
for the calendar year ended December 31, 2003.)
(o) 2003 Employers Mutual Casualty Company Incentive Stock Option
Plan. (Incorporated by reference to Registration No.
333-103722.)
(p) EMC Insurance Companies reinsurance pooling agreements
between Employers Mutual Casualty Company and certain of its
affiliated companies, as amended, effective January 1, 2005.
(Incorporated by reference to Exhibit 10.3 filed with the
Company's Registration Statement on Form S-1, Amendment No. 2,
Registration No. 333-117406.)
21. Subsidiaries of the Registrant.
23. Consent of Ernst & Young LLP, Independent Registered Public
Accounting Firm, with respect to Forms S-8 (Registration Nos.
33-49335, 33-49337, 333-104469, 333-45279 and 333-103722)
and Form S-3 (Registration no. 33-34499).
24. Power of Attorney.
31.1 Certification of President and Chief Executive Officer as required
by Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Senior Vice President and Chief Financial Officer
as required by Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of the 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.
32.2 Certification of the Senior 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.
(c) Financial statements required by Regulation S-X which are excluded from
the Annual Report to Stockholders by Rule 14a-3(b)(1).
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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, on March 30,
2005.
EMC INSURANCE GROUP INC.
/s/ Bruce G. Kelley
-----------------------
Bruce G. Kelley
President and
Chief Executive Officer
/s/ Mark E. Reese
-----------------------
Mark E. Reese
Senior Vice President - Chief Financial Officer
(Principal Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities indicated on March 30, 2005.
/s/ Mark E. Reese
-----------------------
Margaret A. Ball
Director
/s/ Mark E. Reese
-----------------------
George C. Carpenter III*
Director
/s/ Mark E. Reese
-----------------------
David J. Fisher*
Director
/s/ Bruce G. Kelley
-----------------------
Bruce G. Kelley
Director
/s/ Mark E. Reese
-----------------------
George W. Kochheiser*
Chairman of the Board
/s/ Mark E. Reese
-----------------------
Raymond A. Michel*
Director
/s/ Mark E. Reese
-----------------------
Fredrick A. Schiek*
Director
/s/ Mark E. Reese
-----------------------
Joanne L. Stockdale
Director
* by power of attorney
EMC Insurance Group Inc. and Subsidiaries
Index to Exhibits
Exhibit
number Item Page number
------ ---- -----------
10(d) Deferred Bonus and Compensation Plans. 144
10(g) Employers Mutual Casualty Company Excess
Retirement Benefit Agreement. 148
21 Subsidiaries of the Registrant. 151
23 Consent of Ernst & Young LLP, Independent
Registered Public Accounting Firm. 152
24 Power of Attorney. 153
31.1 Certification of President and Chief Executive
Officer as required by Section 302 of the Sarbanes-
Oxley Act of 2002. 154
31.2 Certification of Senior Vice President and Chief
Financial Officer as required by Section 302 of the
Sarbanes-Oxley Act of 2002. 156
32.1 Certification of the 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. 158
32.2 Certification of the Senior 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. 159