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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
Form 10-Q
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[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ________ TO ________.
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2002
COMMISSION FILE NUMBER 1-9640
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MERCHANTS GROUP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE
(State or other jurisdiction of incorporation or organization)
16-1280763
(I.R.S. Employer Identification No.)
250 MAIN STREET, BUFFALO, NEW YORK
(Address of principal executive offices)
14202
(Zip Code)
716-849-3333
(Registrant's telephone number, including area code)
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, and (2) has been subject to such filing requirements
for the past 90 days. Yes [ x ] No [ ]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of July 31, 2002.
2,110,152 SHARES OF COMMON STOCK.
1
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
MERCHANTS GROUP, INC.
CONSOLIDATED BALANCE SHEET
(in thousands)
December 31, June 30,
ASSETS 2001 2002
-------- --------
(unaudited)
Investments:
Fixed maturities:
Held to maturity at amortized cost (fair value
$14,035 in 2001 and $8,317 in 2002) $ 13,042 $ 7,744
Available for sale at fair value (amortized cost
$178,815 in 2001 and $182,990 in 2002) 182,170 185,360
Preferred stock at fair value 9,422 8,284
Other long-term investments at fair value 1,593 1,034
Short-term investments 6,905 4,345
-------- --------
Total investments 213,132 206,767
Cash 1,197 6
Interest due and accrued 2,309 1,846
Premiums receivable, net of allowance for doubtful
accounts of $431 in 2001 and $339 in 2002 21,685 17,132
Deferred policy acquisition costs 12,354 10,187
Ceded reinsurance balances receivable 18,810 19,505
Prepaid reinsurance premiums 3,559 2,182
Deferred income taxes 4,790 4,928
Other assets 8,727 9,230
-------- --------
Total assets $286,563 $271,783
======== ========
See Notes to the Consolidated Financial Statements
2
MERCHANTS GROUP, INC.
CONSOLIDATED BALANCE SHEET
(in thousands except share amounts)
December 31, June 30,
2001 2002
--------- ---------
(unaudited)
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Reserve for losses and loss adjustment expenses $ 151,355 $ 148,385
Unearned premiums 50,179 40,623
Demand loan 200 --
Payable to affiliate 852 1,744
Other liabilities 15,426 14,026
--------- ---------
Total liabilities 218,012 204,778
--------- ---------
Stockholders' equity:
Common stock, 10,000,000 shares authorized, 2,224,452 shares
issued and outstanding at December 31, 2001 and 2,110,152
shares issued and outstanding at June 30, 2002 32 32
Additional paid in capital 35,795 35,795
Treasury stock, 1,025,400 shares at December 31, 2001
and 1,139,700 shares at June 30, 2002 (20,332) (22,766)
Accumulated other comprehensive income 1,812 1,289
Accumulated earnings 51,244 52,655
--------- ---------
Total stockholders' equity 68,551 67,005
--------- ---------
Commitments and contingent liabilities
Total liabilities and stockholders' equity $ 286,563 $ 271,783
========= =========
See Notes to the Consolidated Financial Statements
3
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF OPERATIONS
(in thousands except per share amounts)
Three Months Six Months
Ended June 30, Ended June 30,
2001 2002 2001 2002
------- ------- ------- -------
(unaudited)
Revenues:
Net premiums earned $23,154 $21,569 $46,507 $44,699
Net investment income 3,472 2,727 7,035 5,297
Net realized investment gains 39 1,310 82 1,383
Other revenues 117 210 254 437
------- ------- ------- -------
Total revenues 26,782 25,816 53,878 51,816
------- ------- ------- -------
Expenses:
Net losses and loss adjustment
expenses 17,620 15,853 36,381 33,749
Amortization of deferred policy
acquisition costs 6,136 5,716 12,324 11,845
Other underwriting expenses 1,116 1,407 2,933 3,142
------- ------- ------- -------
Total expenses 24,872 22,976 51,638 48,736
------- ------- ------- -------
Income before income taxes 1,910 2,840 2,240 3,080
Income tax provision 693 1,136 812 1,234
------- ------- ------- -------
Net income $ 1,217 $ 1,704 $ 1,428 $ 1,846
======= ======= ======= =======
Basic and diluted earnings per share $ .52 $ .81 $ .60 $ .86
======= ======= ======= =======
Weighted average shares outstanding:
Basic 2,357 2,110 2,389 2,141
Diluted 2,359 2,115 2,391 2,145
See Notes to the Consolidated Financial Statements
4
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
(in thousands)
Three Months Six Months
Ended June 30, Ended June 30,
2001 2002 2001 2002
------- ------- ------- -------
(unaudited)
Net income $ 1,217 $ 1,704 $ 1,428 $ 1,846
------- ------- ------- -------
Other comprehensive income (loss)
before taxes:
Unrealized gains on securities 467 1,479 3,302 543
Reclassification adjustment
for gains and losses included
in net income (39) (1,310) (82) (1,383)
------- ------- ------- -------
Other comprehensive income (loss)
before taxes 428 169 3,220 (840)
Income tax provision (benefit) related to
items of other comprehensive income 164 64 1,232 (317)
------- ------- ------- -------
Other comprehensive income (loss) 264 105 1,988 (523)
------- ------- ------- -------
Comprehensive income $ 1,481 $ 1,809 $ 3,416 $ 1,323
======= ======= ======= =======
See Notes to the Consolidated Financial Statements
5
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(in thousands)
Six Months
Ended June 30,
2001 2002
-------- --------
(unaudited)
Common stock, beginning and end $ 32 $ 32
-------- --------
Additional paid in capital, beginning and end: 35,680 35,795
-------- --------
Treasury stock:
Beginning of period (16,063) (20,332)
Purchase of treasury shares (2,060) (2,434)
-------- --------
End of period (18,123) (22,766)
-------- --------
Accumulated other comprehensive income (loss):
Beginning of period (875) 1,812
Other comprehensive income (loss) 1,988 (523)
-------- --------
End of period 1,113 1,289
-------- --------
Accumulated earnings:
Beginning of period 51,348 51,244
Net income 1,428 1,846
Cash dividends (472) (435)
-------- --------
End of period 52,304 52,655
-------- --------
Total stockholders' equity $ 71,006 $ 67,005
======== ========
See Notes to the Consolidated Financial Statements
6
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands)
Six Months
Ended June 30,
2001 2002
-------- --------
(unaudited)
Cash flows from operations:
Collection of premiums $ 44,657 $ 40,677
Payment of losses and loss adjustment expenses (37,661) (37,730)
Payment of other underwriting expenses (17,193) (14,521)
Investment income received 6,919 5,916
Investment expenses paid (157) (173)
Income taxes paid (830) (545)
Other 252 437
-------- --------
Net cash used in operations (4,013) (5,939)
-------- --------
Cash flows from investing activities:
Proceeds from fixed maturities sold or matured 53,140 77,428
Purchase of fixed maturities (47,978) (74,670)
Net (increase) decrease in preferred stock (117) 1,049
Net (increase) decrease in other long-term investments (480) 558
Net decrease in short-term investments 795 2,560
-------- --------
Net cash provided by investing activities 5,360 6,925
-------- --------
Cash flows from financing activities:
Settlement of affiliate balances 1,184 892
Decrease in demand loan, net -- (200)
Purchase of treasury stock (2,060) (2,434)
Cash dividends (472) (435)
-------- --------
Net cash used in financing activities (1,348) (2,177)
-------- --------
Decrease in cash (1) (1,191)
Cash:
Beginning of period 5 1,197
-------- --------
End of period $ 4 $ 6
======== ========
See Notes to the Consolidated Financial Statements
7
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
RECONCILIATION OF NET INCOME TO NET CASH
PROVIDED BY OPERATIONS
(in thousands)
Six Months
Ended June 30,
2001 2002
------- -------
(unaudited)
Net income $ 1,428 $ 1,846
Adjustments:
Accretion of bond discount (718) (17)
Realized investment gains (82) (1,383)
(Increase) decrease in assets:
Interest due and accrued 445 463
Premiums receivable (1,193) 4,553
Deferred policy acquisition costs 155 2,167
Ceded reinsurance balances receivable (3,032) (695)
Prepaid reinsurance premiums 251 1,377
Deferred income taxes 233 179
Other assets (274) (503)
Increase (decrease) in liabilities:
Reserve for losses and loss adjustment expenses 1,578 (2,970)
Unearned premiums (834) (9,556)
Other liabilities (1,970) (1,400)
------- -------
Net cash used in operations $(4,013) $(5,939)
======= =======
See Notes to the Consolidated Financial Statements
8
MERCHANTS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION
The consolidated balance sheet as of June 30, 2002 and the related consolidated
statements of operations, and of comprehensive income for the three and six
month periods ended June 30, 2002 and of changes in stockholders' equity and of
cash flows for the six month period ended June 30, 2001 and 2002, respectively,
are unaudited. In the opinion of management, the interim financial statements
reflect all adjustments necessary for a fair presentation of financial position
and results of operations. Such adjustments consist only of normal recurring
items. Interim results are not necessarily indicative of results for a full
year.
The consolidated financial statements include the accounts of Merchants Group,
Inc. (the Company), its wholly-owned subsidiary, Merchants Insurance Company of
New Hampshire, Inc. (MNH), and M.F.C. of New York, Inc., an inactive premium
finance company which is a wholly-owned subsidiary of MNH. The accompanying
consolidated financial statements should be read in conjunction with the
following notes and the Notes to Consolidated Financial Statements included in
the Company's Annual Report on Form 10-K for the year ended December 31, 2001.
The consolidated financial statements have been prepared in conformity with
generally accepted accounting principles (GAAP) which differ in some respects
from those followed in reports to insurance regulatory authorities. All
significant intercompany balances and transactions have been eliminated.
2. RELATED PARTY TRANSACTIONS
With the exception of the Chief Operating Officer of MNH, the Company and MNH
have no paid employees. Under a management agreement dated September 29, 1986
(the Management Agreement), Merchants Mutual Insurance Company (Mutual), which
owned 12.1% of the Company's common stock at June 30, 2002, provides the Company
and MNH with the facilities, management and personnel required to manage their
day-to-day business. All underwriting, administrative, claims and investment
expenses incurred on behalf of Mutual and MNH are shared on an allocated cost
basis, determined as follows: for underwriting and administrative expenses, the
respective share of total direct premiums written for Mutual and MNH serves as
the basis of allocation; for claims expenses, the average number of outstanding
claims is used; investment expenses are shared based on each company's share of
total invested assets.
3. EARNINGS PER SHARE
Basic and diluted earnings per share were computed by dividing net income by the
weighted average number of shares of common stock outstanding during each
period, increased by the assumed exercise of 35,500 and 8,000 shares of common
stock options for the three and six month periods in 2002 and 2001,
9
respectively, which would have resulted in 5,044 and 2,015 additional shares
outstanding for the three month periods, respectively, and 3,976 and 1,949
additional shares outstanding for the six month periods, respectively, assuming
the proceeds to the Company from exercise were used to purchase shares of the
Company's common stock at its average market value per share during the
respective period.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
See "Safe Harbor Statement under the Private Securities Litigation Reform Act,"
which is incorporated in this Item by reference.
RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED JUNE 30, 2002 AS COMPARED TO THE
SIX MONTHS ENDED JUNE 30, 2001
Total revenues for the six months ended June 30, 2002 were $51,816,000, a
decrease of $2,062,000 or 4%, from $53,878,000 for the six months ended June 30,
2001.
Direct premiums written for the six months ended June 30, 2002 were $38,120,000,
a decrease of $11,615,000 or 23%, from $49,735,000 for the six months ended June
30, 2001. Voluntary direct premiums written for the six months ended June 30,
2002 were $35,251,000, a decrease of $12,961,000 or 27%, from $48,212,000 for
the six months ended June 30, 2001.
Voluntary personal lines direct premiums written for the six months ended June
30, 2002 were $18,582,000, a decrease of less than 1% from $18,605,000 for the
six months ended June 30, 2001. The modest reduction in voluntary personal lines
direct premiums written is due to the Company's decision not to accept new
private passenger automobile (PPA) applications in certain states where the
Company intends to reduce its PPA exposures due to unfavorable market
conditions. This decision was implemented effective April 1, 2002. The reduction
in voluntary personal lines direct premiums written is a result of fewer
policies in force due to the Company's decision not to accept new PPA
applications. The reduction in the number of auto policies has been
substantially offset by rate increases implemented in some territories.
Voluntary commercial lines direct premiums written for the six months ended June
30, 2002 were $16,670,000, a decrease of $12,937,000 or 44%, from $29,607,000
for the six months ended June 30, 2001. Commercial lines new business units
decreased 64% compared to the year earlier period. Direct premiums written
decreased for every commercial line of business for the six months ended June
30, 2002 compared to the six months ended June 30, 2001.
The decrease in voluntary commercial lines direct premiums written is consistent
with the actions undertaken by the Company in the fourth quarter of 2001 to exit
certain classes of commercial insurance, thereby reducing direct premiums
written in business segments that it believes do not provide the opportunity to
earn a satisfactory return. The magnitude of the decrease in voluntary
commercial lines direct premiums written was greater than anticipated due in
part to some commercial business, other than in the exited classes and related
policies, moving to other insurance carriers. As a result of
10
the withdrawal from certain classes of commercial insurance, the Company expects
its commercial business to decline for the remainder of 2002.
Involuntary direct premiums written, primarily PPA insurance, which comprised 8%
and 3% of all direct premiums written during the six months ended June 30, 2002
and 2001, respectively, increased by $1,346,000, or 88%, to $2,869,000 for the
six months ended June 30, 2002 from $1,523,000 for the six months ended June 30,
2001, primarily due to an increase in the number of policies written under the
New York Automobile Insurance Plan (NYAIP). The Company is unable to predict the
volume of future assignments it will receive from the NYAIP.
Net premiums written decreased $9,404,000, or 20%, to $36,520,000 for the six
months ended June 30, 2002 from $45,924,000 for the six months ended June 30,
2001, due to the 23% decrease in direct premiums written. Net premiums earned
for the six months ended June 30, 2002 were $44,699,000, a decrease of 4% from
$46,507,000 for the six months ended June 30, 2001.
Net investment income was $5,297,000 for the six months ended June 30, 2002, a
decrease of 25% from $7,035,000 for the six months ended June 30, 2001. The
average pre-tax yield associated with the investment portfolio decreased 113
basis points to 5.62% for the six months ended June 30, 2002. Average invested
assets for the six months ended June 30, 2002 decreased 3% compared to the year
earlier period.
Net realized investment gains were $1,383,000 for the six months ended June 30,
2002 compared to $82,000 for the six months ended June 30, 2001. In April 2002,
the Company sold its entire position of United States Treasury Inflation Index
Notes (TIPS) and recorded a realized gain of $1,303,000.
Other revenues were $437,000 for the six months ended June 30, 2002, an increase
of $183,000, or 72%, from $254,000 for the six months ended June 30, 2001. This
increase primarily resulted from an increase in installment fee income that in
turn resulted from the Company's mid-2001 implementation of a new billing system
that allowed for an increase in the number of payment options to the Company's
policyholders as well as the initiation of late payment fees.
Losses and LAE were $33,749,000 for the six months ended June 30, 2002, a
decrease of $2,632,000 or 7%, from $36,381,000 for the six months ended June 30,
2001. The loss and LAE ratio decreased to 75.5% for the six months ended June
30, 2002 from 78.2% for the six months ended June 30, 2001. The decrease in the
loss and LAE ratio related primarily to the current accident year and was
attributable to a decrease in claims frequency and severity in the Company's
commercial lines of business.
The ratio of amortized deferred policy acquisition costs and other underwriting
expenses to net premiums earned increased to 33.5% for the six months ended June
30, 2002 from 32.8% for the six months ended June 30, 2001. Commissions, premium
taxes and state assessments that vary directly with the Company's premium volume
represented 21.9% of net premiums earned in the six months ended June 30, 2002
compared to 20.2% for the six months ended June 30, 2001.
11
The Company's effective income tax rate for the six months ended June 30, 2001
was 40.1%. This rate was calculated based upon the Company's estimate of its
effective income tax rate for all of 2002.
RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED JUNE 30, 2002 AS COMPARED TO
THE THREE MONTHS ENDED JUNE 30, 2001
Total revenues for the three months ended June 30, 2002 were $25,816,000, a
decrease of $966,000, or 4%, from $26,782,000 for the three months ended June
30, 2001.
Voluntary personal lines direct premiums written for the three months ended June
30, 2002 were $9,851,000, a decrease of $241,000, or 2%, from $10,092,000 for
the three months ended June 30, 2001. PPA direct premiums written decreased 3%
from the year earlier period. Homeowners direct premiums written for the three
months ended June 30, 2001 increased 1% compared to the three months ended June
30, 2001. The decrease in voluntary personal lines direct premiums written for
the three months ended June 30, 2002 is attributable to the same factors
affecting voluntary personal lines direct premiums written for the six months
ended June 30, 2002, discussed earlier in this item.
Voluntary commercial lines direct premiums written for the three months ended
June 30, 2002 were $6,128,000, a decrease of $10,268,000, or 63%, from
$16,396,000 for the three months ended June 30, 2001. This decrease in
commercial lines direct written premiums is attributable to the same factors
affecting voluntary commercial lines direct premiums written for the six months
ended June 30, 2002, as discussed earlier in this item.
Involuntary direct premiums written for the three months ended June 30, 2002
were $1,660,000, an increase of $655,000, or 65%, from $1,005,000 for the three
months ended June 30, 2001. Involuntary written premiums are affected by the
size of the involuntary markets in which the Company operates, primarily the
NYAIP.
Net investment income was $2,727,000 for the three months ended June 30, 2002, a
$745,000, or 21%, decrease from $3,472,000 for the three months ended June 30,
2001, primarily due to a 3% decrease in average invested assets and a 102 basis
point decrease in the investment portfolio yield.
Net realized investment gains were $1,310,000 for the three months ended June
30, 2002 compared to $39,000 for the three months ended June 30, 2001 due to the
sale of the Company's entire TIPS position as discussed earlier in this item.
Losses and LAE were $15,853,000 for the three months ended June 30, 2002, a
decrease of $1,767,000, or 10%, from $17,620,000 for the three months ended June
30, 2001. The loss and LAE ratio decreased to 73.5% for the three months ended
June 30, 2002 from 76.1% for the three months ended June 30, 2001. The decrease
in the loss and LAE ratio is attributable to the same factors affecting losses
and LAE for the six months ended June 30, 2002 discussed earlier in this item.
The ratio of amortized deferred policy acquisition costs and other underwriting
expenses to net premiums earned increased to 33.0% for the three months ended
June 30, 2002 from 31.3% for the three
12
months ended June 30, 2001. Commissions, premium taxes and other state
assessments that vary with the Company's premium volume represented 22.2% of net
premiums earned in the three months ended June 30, 2002 compared to 19.4% for
the three months ended June 30, 2001 primarily due to increased reinsurance
commissions paid on a higher volume of assumed premiums from various reinsurance
facilities.
LIQUIDITY AND CAPITAL RESOURCES
In developing its investment strategy, the Company determines a level of cash
and short-term investments which, when combined with expected cash flow, is
estimated to be adequate to meet expected cash obligations. Historically, the
excess of premiums collected over payments on claims, combined with cash flow
from investments, has provided the Company with short-term funds in excess of
normal operating demands for cash. For the six months ended June 30, 2002, the
Company's operating activities used $5,939,000 of cash, an increase of
$1,926,000 or 48% compared to the six months ended June 30, 2001. The Company's
intention to continue to reduce direct premiums written in business segments
where returns are unsatisfactory will likely result in continued negative cash
flows from operations. The Company believes that careful management of the
relationship between assets and liabililities will minimize the likelihood that
unanticipated investment portfolio sales will be necessary to fund insurance
operations and that the effect of any such sale on the Company's stockholders'
equity will not be material.
The Company's objectives with respect to its investment portfolio include
maximizing total returns within investment guidelines while protecting
stockholders' equity and maintaining flexibility. Like other property and
casualty insurers, the Company relies on premiums as a major source of cash, and
therefore liquidity. Cash flows from the Company's investment portfolio, either
in the form of interest or principal payments, are an additional source of
liquidity. Because the duration of the Company's investment portfolio is less
than the duration of its liabilities, increases or decreases in market interest
rates are not expected to have a material effect on the Company's liquidity.
The Company generally designates newly acquired fixed maturity investments as
available for sale and carries these investments at fair value. Unrealized gains
and losses related to these investments are recorded as a component of
accumulated other comprehensive income within stockholders' equity. At June 30,
2002, the Company had recorded $1,289,000 of net unrealized gains, net of taxes,
associated with its investments classified as "available for sale" as
accumulated other comprehensive income. During the six months ended June 30,
2002 the Company recorded $523,000 of net unrealized losses, net of tax,
associated with its available for sale investments as a component of other
comprehensive income.
At June 30, 2002, the Company's portfolio of fixed maturities represented 93.4%
of invested assets. Management believes that this level of bond holdings is
consistent with the Company's liquidity needs because a portion of the Company's
bond portfolio is invested in mortgage-backed and other asset-backed securities
which, in addition to interest income, provide monthly paydowns of bond
principal.
13
At June 30, 2002, $105,876,000, or 51.2%, of the Company's fixed maturity
portfolio was invested in mortgage-backed and other asset backed securities. The
Company invests in a variety of collateralized mortgage obligation (CMO)
products but has not invested in the derivative type of CMO products such as
interest only, principal only or inverse floating rate securities. All of the
Company's CMO investments have an active secondary market and their effect on
the Company's liquidity does not differ from that of other fixed maturity
investments. The Company does not own any other derivative financial
instruments.
At June 30, 2002, $5,603,853, or 2.7% of the Company's investment portfolio was
invested in non-investment grade securities compared to $10,522,000, or 4.9% at
June 30, 2001.
The Company has arranged for a $2,000,000 unsecured credit facility from a bank
in the form of a master grid note. Any borrowings under this facility are
payable on demand and carry an interest rate which can be fixed or variable and
is negotiated at the time of each advance. This facility is available for
general working capital purposes and for repurchases of the Company's common
stock. At June 30, 2002, no amount was outstanding on this loan.
During the six months ended June 30, 2002, the Company repurchased 114,300
shares of its common stock at an average price per share of $21.29. The Company
was holding 1,139,700 shares of its common stock in treasury at June 30, 2002.
The Company has suspended its program of repurchasing shares of its common stock
on the open market. See RELATIONSHIP WITH MUTUAL.
As a holding company, the Company is dependent on cash dividends from MNH to
meet its obligations, pay any cash dividends and repurchase its shares. MNH is
subject to New Hampshire insurance laws which place certain restrictions on its
ability to pay dividends without the prior approval of state regulatory
authorities. These restrictions limit dividends to those that, when added to all
other dividends paid within the preceding twelve months, would not exceed 10% of
the insurer's statutory policyholders' surplus as of the preceding December
31st. The maximum amount of dividends that MNH could pay during any twelve-month
period ending in 2002 without the prior approval of the New Hampshire Insurance
Commissioner is $5,263,000. MNH paid $5,060,000 of dividends to the Company in
2001. Dividends were paid in February 2001, May 2001 and September 2001, of
$2,200,000, $1,350,000 and $1,510,000, respectively. MNH paid dividends to the
Company of $2,300,000 and $900,000 on February 19, 2002 and May 30, 2002,
respectively. The Company paid cash dividends to its common stockholders of $.10
per share in each of the first two quarters of 2002 amounting to $435,000 in the
aggregate.
Under the Management Agreement, Mutual provides employees, services and
facilities for MNH to conduct its insurance business on a cost reimbursed basis.
The balance in the payable to or receivable from affiliate account represents
the amount owing to or owed by Mutual to the Company for the difference between
premiums collected and payments made for losses, employees, services and
facilities by Mutual on behalf of MNH.
Regulatory guidelines suggest that the ratio of a property-casualty insurer's
annual net premiums written to its statutory surplus should not exceed 3 to 1.
MNH has consistently followed a business strategy that
14
would allow it to meet this 3 to 1 regulatory guideline. For the first six
months of 2002, MNH's ratio of net premiums written to statutory surplus,
annualized for a full year, was 1.4 to 1.
RELATIONSHIP WITH MUTUAL
The Company's and MNH's business and day-to-day operations are closely aligned
with those of Mutual. This is the result of a combination of factors. Mutual has
had an historical ownership interest in the Company and MNH. Prior to November
1986 MNH was a wholly-owned subsidiary of Mutual. Following the Company's
initial public offering in November 1986 and until a secondary stock offering in
July 1993 the Company was a majority-owned subsidiary of Mutual. Mutual
currently owns 12.1% of the Company's common stock. Under the Management
Agreement, Mutual provides the Company and MNH with all facilities and personnel
to operate their business. With the exception of the Chief Operating Officer of
MNH, the only officers of the Company or MNH who are paid full time employees
are employees of Mutual whose services are purchased under the Management
Agreement. Also, the operation of the Company's insurance business, which offers
substantially the same lines of insurance as Mutual through the same independent
insurance agents, creates a very close relationship among the companies.
During 1998, the Company determined that the Management Agreement as currently
written, creates a conflict of interest between the Company and Mutual in their
joint operations. Accordingly, on July 23, 1998 the Company gave notice to
Mutual of its intention to terminate the Management Agreement and therefore, the
Management Agreement will terminate on July 23, 2003 unless the parties agree to
renew or extend it.
The Company is evaluating its existing insurance business and its relationship
with Mutual as well as other opportunities in the insurance marketplace. The
Board and management, in consultation with financial and other industry
professionals, are formulating a plan to develop one or more opportunities that
have the potential for meaningful profitability. The Company is in negotiations
with Mutual to develop a new relationship for the operational management of the
Company's existing business only. If made, any such agreement is expected to
entail, among other things, Mutual writing a larger portion of the combined
personal lines of MNH and Mutual. Compensation of the Mutual would be based, in
part, upon participation in profits (or losses) incurred in the existing
portfolio of business. The Company anticipates that in the future it will
appoint its own management to oversee its existing business and to develop and
oversee other opportunities independent of Mutual.
Agreements between MNH and Mutual or other entities to provide services and
underwrite business for MNH will require the approval of the New Hampshire
Insurance Department, MNH's state of domicile, and possibly the insurance
departments of other states, as well. State insurance departments have broad
discretion to approve or disallow actions or agreements of their subject
insurers in order to protect the interests of the public and policyholders.
15
The Company has suspended the repurchasing of shares of its common stock on the
open market at least until its negotiations with Mutual have been completed, its
revised plan has been adopted, and these matters have been approved by the
applicable regulators.
In June 2002, MNH gave notice to Mutual that it is terminating the quota share
reinsurance between MNH and Mutual as of December 31, 2002. The agreement became
effective on January 1, 1993 and allowed Mutual to cede and MNH to assume, up to
10% of Mutual's direct voluntary written premiums and related losses and LAE in
exchange for a reinsurance commission of 35%. Mutual has not ceded any of its
direct voluntary written premiums to MNH since 1995. The termination is subject
to the prior approval of the New York Superintendent of Insurance.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
MARKET RISK
Market risk represents the potential for loss due to changes in the fair value
of financial instruments. The market risk related to the Company's financial
instruments primarily relates to its investment portfolio. The value of the
Company's investment portfolio of $207,340,000 at June 30, 2002 is subject to
changes in interest rates and to a lesser extent on credit quality. Further,
certain mortgage-backed and asset-backed securities are exposed to accelerated
prepayment risk generally caused by interest rate movements. If interest rates
were to decline, mortgage holders would be more likely to refinance existing
mortgages at lower rates. Acceleration of future repayments could adversely
affect future investment income, if reinvestment of the accelerated receipts was
made in lower yielding securities.
The following table provides information related to the Company's fixed maturity
investments at June 30, 2002. The table presents cash flows of principal amounts
and related weighted average interest rates by expected maturity dates. The cash
flows are based upon the maturity date or, in the case of mortgage-backed and
asset-backed securities, expected payment patterns. Actual cash flows could
differ from those shown in the table.
16
FIXED MATURITIES
Expected Cash Flows of Principal Amounts ($ in 000's):
HELD TO MATURITY 2002 2003 2004 2005 2006
-------- -------- -------- -------- --------
Mortgage & asset backed
securities $ 1,397 $ 2,425 $ 1,809 $ 1,620 $ 220
Average interest rate 7.0% 7.0% 7.0% 7.1% 7.2%
-------- -------- -------- -------- --------
Total $ 1,397 $ 2,425 $ 1,809 $ 1,620 $ 220
======== ======== ======== ======== ========
AVAILABLE FOR SALE
U.S. Treasury securities and
obligations of U.S.
Government corporations
and agencies $ 499 $ 4,195 $ 0 $ 8,285 $ 0
Average interest rate 7.1% 4.1% 0.0% 4.0% 0.0%
Obligations of states and
political subdivisions 0 6,337 1,009 0 0
Average interest rate 0.0% 7.2% 4.3% 0.0% 0.0%
Corporate securities 15,820 27,811 6,814 12,626 0
Average interest rate 7.1% 4.8% 7.6% 4.1% 0.0%
Mortgage & asset
backed securities 17,650 32,751 22,390 12,620 4,167
Average interest rate 5.6% 5.6% 5.7% 5.7% 5.8%
-------- -------- -------- -------- --------
Total $ 33,969 $ 71,094 $ 30,213 $ 33,531 $ 4,167
======== ======== ======== ======== ========
TOTAL
-----
AMOR-
THERE- TIZED MARKET
HELD TO MATURITY AFTER COST VALUE
-------- -------- --------
Mortgage & asset backed
securities $ 273 $ 7,744 $ 8,317
Average interest rate 7.2% -- --
-------- -------- --------
Total $ 273 $ 7,744 $ 8,317
======== ======== ========
AVAILABLE FOR SALE
U.S. Treasury securities and
obligations of U.S.
Government corporations
and agencies $ 0 $ 12,979 $ 13,126
Average interest rate 0.0% -- --
Obligations of states and
political subdivisions 24 7,370 7,582
Average interest rate 7.3% -- --
Corporate securities 2,713 65,784 66,520
Average interest rate 13.6% -- --
Mortgage & asset
backed securities 7,279 96,857 98,132
Average interest rate 5.9% -- --
-------- -------- --------
Total $ 10,016 $182,990 $185,360
======== ======== ========
The discussion and the estimated amounts referred to above include
forward-looking statements of market risk which involve certain assumptions as
to market interest rates and the credit quality of the fixed maturity
investments. Actual future market conditions may differ materially from such
assumptions. See "Safe Harbor Statement under the Private Securities Litigation
Reform Act," which is incorporated in this Item by reference.
17
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.
None.
Item 2. Changes in Securities and Use of Proceeds.
None.
Item 3. Defaults Upon Senior Securities.
None.
Item 4. Submission of Matters to a Vote of Security Holders
On May 1, 2002 the Company held its annual meeting of stockholders. During the
meeting, Andrew A. Alberti and Frank J. Colantuono were re-elected Directors of
the Company for three year terms to expire at the annual meeting in 2005. Brent
D. Baird, Richard E. Garman, Thomas E. Kahn, Henry P. Semmelhack and Robert M.
Zak are Directors of the Company whose terms of office as Director continue
beyond the date of the meeting. Mr. Kahn's, Mr. Semmelhack's and Mr. Zak's terms
expire in 2003 and Mr. Baird's and Mr. Garman's terms expire in 2004.
Also during the meeting, stockholders ratified the appointment of
PricewaterhouseCoopers LLP to serve as the Company's independent accountants for
the year ending December 31, 2002.
A summary of stockholder voting with respect to the election of Directors is as
follows:
Election of Election of
A. Alberti F. Colantuono
----------- -------------
For 1,893,206 1,892,206
Withheld 2,325 3,325
A summary of stockholder voting with respect to the ratification of
PricewaterhouseCoopers to serve as the Company's independent accountants for the
year ending December 31, 2002 is as follows:
For 1,892,509
Against 1,452
Abstained 1,570
Item 5. Other Information.
None.
18
Item 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
Exhibits required by Item 601 of Regulation S-K.
3(a) Restated Certificate of Incorporation (incorporated by
reference to Exhibit No. 3C to Amendment No. 1 to the
Company's Registration Statement No. 33-9188 on Form S-1 Filed
on November 7, 1986.
(b) Restated By-laws (incorporated by reference to Exhibit 3D to
Amendment No. 1 to the Company's Registration Statement No.
33-9188 on Form S-1 filed on November 7, 1986.
4 Instruments defining the rights of security holders, including
indentures - N/A.
5 Opinion re legality - N/A.
10(a) Management Agreement dated as of September 29, 1986 by and
among Merchants Mutual Insurance Company, Registrant and
Merchants Insurance Company of New Hampshire, Inc.
(incorporated by reference to Exhibit No. 10a to the Company's
Registration Statement (No. 33-9188) on Form S-1 filed on
September 30, 1986).
(b) Agreement of Reinsurance No. 6922 between Merchants Mutual
Insurance Company, Merchants Insurance Company of New
Hampshire, Inc. and General Reinsurance Corporation
(incorporated by reference to Exhibit No. 10e to the Company's
Registration Statement (No. 33-9188) on Form S-1 filed on
September 30, 1986).
(c) Agreement of Reinsurance No. 7299 between Merchants Mutual
Insurance Company, Merchants Insurance Company of New
Hampshire, Inc. and General Reinsurance Corporation,
(incorporated by reference to Exhibit No. 10o to the Company's
1987 Annual Report on Form 10-K (File No. 1-9640) filed on
March 19, 1988).
(d) Agreement of Reinsurance dated January 27, 1993, between
Merchants Mutual Insurance Company and Merchants Insurance
Company of New Hampshire, Inc. (incorporated by reference to
Exhibit (3) in the Company's Current Report on Form 8-K (File
No. 1-9640) filed on January 29, 1993).
(e) Agreement of Reinsurance No. 8009 between Merchants Mutual
Insurance Company, Merchants Insurance Company of New
Hampshire, Inc. and General Reinsurance Corporation,
(incorporated by reference to Exhibit 10e to the Company's
1995 Annual Report on Form 10-K filed on March 28, 1996).
19
(f) Property and Casualty Excess of Loss Reinsurance Agreement
between Merchants Mutual Insurance Company, Merchants Insurance
Company of New Hampshire, Inc. and American Reinsurance
Company, including endorsement, (incorporated by reference to
Exhibit 10g to the Company's 1998 Annual Report on Form 10-K
filed on March 29, 1999).
(g) Property Catastrophe Excess of Loss Reinsurance Agreement
between Merchants Mutual Insurance Company, Merchants Insurance
Company of New Hampshire, Inc. and the Subscribing Reinsurers
Executing the Interest and Liabilities Contracts attached to
this agreement, effective January 1, 2000 (incorporated by
reference to Exhibit 10g to the Company's 2000 Annual Report on
Form 10-K filed on March 28, 2001).
(h) Quota Share Reinsurance Treaty Agreement between Merchants
Insurance Company of New Hampshire, Inc. and The Subscribing
Underwriting Members of Lloyd's, London specifically identified
on the schedules attached to this agreement dated January 1,
2000 (incorporated by reference to Exhibit 10h to the Company's
2000 Annual Report on Form 10-K filed on March 28, 2001).
*(i) Merchants Mutual Capital Accumulation Plan (incorporated by
reference to Exhibit No. 10g to the Company's Registration
Statement (No. 33-9188) on Form S-1 filed on September 30,
1986).
*(j) Merchants Mutual Capital Accumulation Plan, fifth amendment,
effective January 1, 1999 (incorporated by reference to Exhibit
10j to the Company's 2000 Annual Report on Form 10-K filed on
March 28, 2001).
*(k) Merchants Mutual Capital Accumulation Plan Trust Agreement
(restated as of January 1, 1996 (incorporated by reference to
Exhibit 10(i) to the Company's 1996 Annual Report on Form 10-K
(File No. 1-9640) filed on March 28, 1997).
*(l) Merchants Mutual Supplemental Executive Retirement Plan dated
as of December 29, 1989 and Agreement of Trust dated as of
December 29, 1989 (incorporated by reference to Exhibit No. 10k
to the Company's 1989 Annual Report on Form 10-K (File No.
1-9640) filed on March 21, 1990).
*(m) Amendment dated June 10, 1992 to Agreement of Trust under
Merchants Mutual Supplemental Executive Retirement Plan dated
as of December 29, 1989 (incorporated by reference to Exhibit
No. 10r to the Company's 1992 Annual Report on Form 10-K (File
No. 1-9640) filed on March 31, 1993).
20
*(n) Merchants Group, Inc. 1986 Stock Option Plan As Amended
Through February 16, 1993 (incorporated by reference to
Exhibit No. 10e to the Company's 1992 Annual Report on Form
10-K (File No. 1-9640) filed on March 31, 1993).
*(o) Form of Amended Indemnification Agreement entered into by
Registrant with each director and executive office of
Registrant (incorporated by reference to Exhibit No. 10n to
Amendment No. 1 to the Company's Registration Statement on
(No. 33-9188) Form S-1 filed on November 7, 1986).
*(p) Merchants Mutual Insurance Company Adjusted Return on Equity
Incentive Compensation Plan January 1, 2000 (incorporated by
reference to Exhibit 10p to the Company's 2000 Annual Report
on Form 10-K filed on March 28, 2001).
*(q) Merchants Mutual Insurance Company Adjusted Return on Equity
Long Term Incentive Compensation Plan January 1, 2000
(incorporated by reference to Exhibit 10q to the Company's
2000 Annual Report on Form 10-K filed on March 28, 2001).
*(r) Employee Retention Agreement between Robert M. Zak and
Merchants Mutual Insurance Company dated as of March 1, 1999
(incorporated by reference to Exhibit No. 10a to the Company's
June 30, 1999 Quarterly Report on Form 10-Q filed on August
12, 1999).
*(s) Employee Retention Agreement between Edward M. Murphy and
Merchants Mutual Insurance Company dated as of March 1, 1999
(incorporated by reference to Exhibit 10r to the Company's
1998 Annual Report on Form 10-K filed on March 29, 1999).
*(t) Employee Retention Agreement between Kenneth J. Wilson and
Merchants Mutual Insurance Company dated as of March 1, 1999
(incorporated by reference to Exhibit 10s to the Company's
1998 Annual Report on Form 10-K filed on March 29, 1999).
*(u) Consulting Agreement between Stephen C. June and Merchants
Insurance Company of New Hampshire, Inc. ("MNH") dated as of
May 7, 2001 incorporated by reference to Exhibit 10t to the
Company's 2001 Annual Report on Form 10-K filed on March 21,
2002.
*(v) Employment Agreement between Stephen C. June and MNH dated as
of April 1, 2002 incorporated by reference to Exhibit 10u to
the Company's 2001 Annual Report on Form 10-K filed on March
21, 2002.
11 Statement re computation of per share earnings - N/A.
12 Statement re computation of ratios - N/A.
21
15 Letter re unaudited interim financial information - N/A.
18 Letter re change in accounting principles - N/A.
19 Report furnished to security holder - N/A.
22 Published report regarding matters submitted to vote of
security holders - N/A.
23 Consents of experts and counsel - N/A.
24 Power of attorney - N/A.
99(a) Certification Pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002 (Subsections (a) and (b) of Section 1350, Chapter 63 of
Title 18, United States Code) (filed herewith).
* Indicates a management contract or compensation plan or arrangement.
(b) Reports on Form 8-K.
No reports on Form 8-K were filed during the period for which this
report is filed.
* * * * * * * * *
"Safe Harbor" Statement under the Private Securities Litigation Reform Act of
1995:
With the exception of historical information, the matters and statements
discussed, made or incorporated by reference in this Quarterly Report on Form
10-Q constitute forward-looking statements and are discussed, made or
incorporated by reference, as the case may be, pursuant to the safe harbor
provisions of the Private Securities Litigation Reform Act of 1995.
Forward-looking statements may include, without limitation, statements relating
to the Company's plans, strategies, objectives, expectations and intentions.
Words such as "believes," "forecasts," "intends," "possible," "expects,"
"anticipates," "estimates," or "plans" and similar expressions are intended to
identify forward-looking statements. Such forward-looking statements involve
certain assumptions, risks and uncertainties that could cause actual results to
differ materially from those included in or contemplated by the statements.
These assumptions, risks and uncertainties include, but are not limited to,
those associated with factors affecting the property-casualty insurance industry
generally, including price competition, the Company's dependence on state
insurance departments for approval of rate increases; size and frequency of
claims, escalating damage awards, natural disasters, fluctuations in interest
rates and general business conditions; the Company's dependence on investment
income; the geographic concentration of the Company's business in the
Northeastern United States and in particular in New York, New
22
Hampshire, New Jersey, Rhode Island, Pennsylvania and Massachusetts; the
adequacy of the Company's loss reserves; the Company's dependence on the general
reinsurance market; government regulation of the insurance industry; exposure to
environmental claims; dependence of the Company on its relationship with Mutual
and the uncertainty concerning what will happen if the Management Agreement with
Mutual is either not renewed or extended beyond its termination date of July 23,
2003, or replaced with a different arrangement; the Company's intention to
reduce written premium in business segments that it believes no longer provide a
satisfactory return; and the other risks and uncertainties discussed or
indicated in all documents filed by the Company with the Commission. The Company
expressly disclaims any obligation to update any forward-looking statements as a
result of developments occurring after the date of this report.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. MERCHANTS GROUP, INC. (Registrant)
Date: August 13, 2002 By:/S/ Kenneth J. Wilson
---------------------
Kenneth J. Wilson
Chief Financial Officer and
Treasurer (duly authorized
officer of the registrant and
chief accounting officer)
23