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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 SEPTEMBER 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 October 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, September 30,
Assets 2001 2002
------ ------------ -------------
(unaudited)
Investments:
Fixed maturities:
Held to maturity at amortized cost (fair value
$14,035 in 2001 and $6,764 in 2002) $ 13,042 $ 6,458
Available for sale at fair value (amortized cost
$178,815 in 2001 and $183,459 in 2002) 182,170 186,652
Preferred stock at fair value 9,422 8,240
Other long-term investments at fair value 1,593 1,962
Short-term investments 6,905 5,935
-------- --------
Total investments 213,132 209,247
Cash 1,197 25
Interest due and accrued 2,309 1,828
Premiums receivable, net of allowance for doubtful
accounts of $431 in 2001 and $299 in 2002 21,685 15,005
Deferred policy acquisition costs 12,354 9,340
Ceded reinsurance balances receivable 18,810 19,314
Prepaid reinsurance premiums 3,559 1,462
Receivable from affiliate -- 957
Deferred income taxes 4,790 4,925
Other assets 8,727 8,659
-------- --------
Total assets $286,563 $270,762
======== ========
See Notes to the Consolidated Financial Statements
2
MERCHANTS GROUP, INC.
CONSOLIDATED BALANCE SHEET
(in thousands except share amounts)
December 31, September 30,
2001 2002
------------ -------------
(unaudited)
Liabilities and Stockholders' Equity
Liabilities:
Reserve for losses and loss adjustment expenses $ 151,355 $ 149,712
Unearned premiums 50,179 37,461
Payable for securities -- 1,455
Demand loan 200 --
Payable to affiliate 852 --
Other liabilities 15,426 14,164
--------- ---------
Total liabilities 218,012 202,792
--------- ---------
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 September 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 September 30, 2002 (20,332) (22,766)
Accumulated other comprehensive income 1,812 1,813
Accumulated earnings 51,244 53,096
--------- ---------
Total stockholders' equity 68,551 67,970
--------- ---------
Commitments and contingent liabilities
Total liabilities and stockholders' equity $ 286,563 $ 270,762
========= =========
See Notes to the Consolidated Financial Statements
3
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF OPERATIONS
(in thousands except per share amounts)
Three Months Nine Months
Ended September 30, Ended September 30,
2001 2002 2001 2002
-------- -------- -------- --------
(unaudited)
Revenues:
Net premiums earned $ 23,230 $ 20,198 $ 69,737 $ 64,897
Net investment income 3,244 2,593 10,279 7,890
Net realized investment gains 30 -- 112 1,383
Other revenues 161 128 415 565
-------- -------- -------- --------
Total revenues 26,665 22,919 80,543 74,735
-------- -------- -------- --------
Expenses:
Net losses and loss adjustment
expenses 20,298 14,752 56,679 48,501
Amortization of deferred policy
acquisition costs 6,156 5,552 18,480 17,398
Other underwriting expenses 1,441 1,523 4,374 4,664
-------- -------- -------- --------
Total expenses 27,895 21,827 79,533 70,563
-------- -------- -------- --------
Income (loss) before income taxes (1,230) 1,092 1,010 4,172
Income tax provision (benefit) (421) 442 391 1,676
-------- -------- -------- --------
Net income (loss) $ (809) $ 650 $ 619 $ 2,496
======== ======== ======== ========
Basic and diluted earnings (loss)
per share $ (.35) $ .31 $ .26 $ 1.17
======== ======== ======== ========
Weighted average shares outstanding:
Basic 2,317 2,110 2,365 2,130
Diluted 2,321 2,114 2,367 2,134
See Notes to the Consolidated Financial Statements
4
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
(in thousands)
Three Months Nine Months
Ended September 30, Ended September 30,
2001 2002 2001 2002
------- ------- ------- -------
(unaudited)
Net income (loss) $ (809) $ 650 $ 619 $ 2,496
------- ------- ------- -------
Other comprehensive income before taxes:
Unrealized gains on securities 1,276 849 4,578 1,392
Reclassification adjustment
for gains and losses included
in net income (28) -- (110) (1,383)
------- ------- ------- -------
Other comprehensive income
before taxes 1,248 849 4,468 9
Income tax provision related to
items of other comprehensive income 464 325 1,696 8
------- ------- ------- -------
Other comprehensive income 784 524 2,772 1
------- ------- ------- -------
Comprehensive income (loss) $ (25) $ 1,174 $ 3,391 $ 2,497
======= ======= ======= =======
See Notes to the Consolidated Financial Statements
5
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(in thousands)
Nine Months Ended
September 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 (2,161) (2,434)
-------- --------
End of period (18,224) (22,766)
-------- --------
Accumulated other comprehensive income (loss):
Beginning of period (875) 1,812
Other comprehensive income 2,772 1
-------- --------
End of period 1,897 1,813
-------- --------
Accumulated earnings:
Beginning of period 51,348 51,244
Net income 619 2,496
Cash dividends (704) (644)
-------- --------
End of period 51,263 53,096
-------- --------
Total stockholders' equity $ 70,648 $ 67,970
======== ========
See Notes to the Consolidated Financial Statements
6
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands)
Nine Months
Ended September 30,
2001 2002
--------- ---------
(unaudited)
Cash flows from operations:
Collection of premiums $ 69,102 $ 60,522
Payment of losses and loss adjustment expenses (56,144) (50,410)
Payment of other underwriting expenses (22,926) (20,707)
Investment income received 10,282 8,625
Investment expenses paid (228) (242)
Income taxes paid (906) (1,158)
Other 410 565
--------- ---------
Net cash used in operations (410) (2,805)
--------- ---------
Cash flows from investing activities:
Proceeds from fixed maturities sold or matured 75,248 103,184
Purchase of fixed maturities (80,696) (99,567)
Net decrease in preferred stock 2,597 1,048
Net increase in other long-term investments (517) (370)
Net (increase) decrease in short-term investments (5,165) 970
--------- ---------
Net cash provided by (used in) investing activities (8,533) 5,265
--------- ---------
Cash flows from financing activities:
Settlement of affiliate balances (772) (1,809)
Cash borrowed to purchase securities 12,597 1,455
Decrease in demand loan, net -- (200)
Purchase of treasury stock (2,161) (2,434)
Cash dividends (704) (644)
--------- ---------
Net cash provided by (used in) financing activities 8,960 (3,632)
--------- ---------
Increase (decrease) in cash 17 (1,172)
Cash:
Beginning of period 5 1,197
--------- ---------
End of period $ 22 $ 25
========= =========
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)
Nine Months
Ended September 30,
2001 2002
-------- --------
(unaudited)
Net income $ 619 $ 2,496
Adjustments:
Amortization (accretion) of bond premium (discount) (853) 12
Realized investment gains (112) (1,383)
(Increase) decrease in assets:
Interest due and accrued 623 481
Premiums receivable (1,603) 6,680
Deferred policy acquisition costs (151) 3,014
Ceded reinsurance balances receivable (3,833) (504)
Prepaid reinsurance premiums 225 2,097
Deferred income taxes (66) (143)
Other assets (556) 68
Increase (decrease) in liabilities:
Reserve for losses and loss adjustment expenses 4,699 (1,643)
Unearned premiums 347 (12,718)
Other liabilities 251 (1,262)
-------- --------
Net cash used in operations $ (410) $ (2,805)
======== ========
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 September 30, 2002 and the related
consolidated statements of operations, and of comprehensive income for the three
and nine month periods ended September 30, 2002, and of changes in stockholders'
equity and of cash flows for the nine month periods ended September 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 September 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 43,500 and 8,000 shares of common
stock options for the three and nine month periods in 2001 and by
9
the assumed exercise of 35,500 shares of common stock options for each of the
three and nine month periods in 2002. The common stock options assumed to be
exercised would have resulted in 3,641 and 3,953 additional shares outstanding
for the three month periods ended September 30, 2002 and 2001, respectively, and
3,887 and 2,229 additional shares outstanding for the nine month periods ending
September 30, 2002 and 2001, 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,"
on page 22 of this report which is incorporated in this Item by reference.
Results of Operations for the Nine Months Ended September 30, 2002 As Compared
to the Nine Months Ended September 30, 2001
Total revenues for the nine months ended September 30, 2002 were $74,735,000, a
decrease of $5,808,000 or 7%, from $80,543,000 for the nine months ended
September 30, 2001.
Direct premiums written for the nine months ended September 30, 2002 were
$56,036,000, a decrease of $19,836,000 or 26%, from $75,872,000 for the nine
months ended September 30, 2001. Voluntary direct premiums written for the nine
months ended September 30, 2002 were $51,537,000, a decrease of $21,233,000 or
29%, from $72,770,000 for the nine months ended September 30, 2001.
Voluntary personal lines direct premiums written for the nine months ended
September 30, 2002 were $29,676,000, an increase of less than 1% from
$29,614,000 for the nine months ended September 30, 2001. The slight increase in
voluntary personal lines direct premiums written is due to rate increases
implemented in some territories offset by the effect of the Company's decision
not to accept new private passenger automobile (PPA) applications effective
April 1, 2002 in certain states where the Company intends to reduce its PPA
exposures due to unfavorable market conditions. Total voluntary personal lines
policies in force at September 30, 2002 were 38,911, a decrease of 2% from
39,692 at September 30, 2001. Voluntary PPA policies in force decreased 7% to
21,988 at September 30, 2002 from 23,674 at September 30, 2001.
Voluntary commercial lines direct premiums written for the nine months ended
September 30, 2002 were $21,861,000, a decrease of $21,295,000 or 49%, from
$43,156,000 for the nine months ended September 30, 2001. Commercial lines new
business units decreased 67% compared to the year earlier period. Direct
premiums written decreased for every commercial line of business for the nine
months ended September 30, 2002 compared to the nine months ended September 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 Company believes that a portion of the decrease
in
10
voluntary commercial lines direct premiums written was due in part to some
commercial business, other than in the exited classes and related policies,
moving to other insurance carriers including the Company's affiliate, Merchants
Mutual Insurance Company. As a result of the withdrawal from certain classes of
commercial insurance, the Company expects its commercial business to decline
during the remainder of 2002 and the first quarter of 2003.
Involuntary direct premiums written, primarily PPA insurance, which comprised 8%
and 4% of all direct premiums written during the nine months ended September 30,
2002 and 2001, respectively, increased by $1,396,000, or 45%, to $4,498,000 for
the nine months ended September 30, 2002 from $3,102,000 for the nine months
ended September 30, 2001, primarily due to an increase in the number of policies
written by 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 $16,032,000, or 23%, to $54,277,000 for the nine
months ended September 30, 2002 from $70,309,000 for the nine months ended
September 30, 2001, due primarily to the 26% decrease in direct premiums
written. Net premiums earned for the nine months ended September 30, 2002 were
$64,897,000, a decrease of 7% from $69,737,000 for the nine months ended
September 30, 2001. The percentage decrease in net premiums earned will continue
to grow in the next quarter, due to the aforementioned decrease in net premiums
written.
Net investment income was $7,890,000 for the nine months ended September 30,
2002, a decrease of 23% from $10,279,000 for the nine months ended September 30,
2001. The average pre-tax yield associated with the investment portfolio
decreased 116 basis points to 5.51% for the nine months ended September 30,
2002. Average invested assets for the nine months ended September 30, 2002
decreased 3% compared to the year earlier period.
Net realized investment gains were $1,383,000 for the nine months ended
September 30, 2002 compared to $112,000 for the nine months ended September 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 $565,000 for the nine months ended September 30, 2002, an
increase of $150,000, or 36%, from $415,000 for the nine months ended September
30, 2001. This increase primarily resulted from the Company's mid-2001
implementation of late payment fees.
Losses and LAE were $48,501,000 for the nine months ended September 30, 2002, a
decrease of $8,178,000 or 14%, from $56,679,000 for the nine months ended
September 30, 2001. The loss and LAE ratio decreased to 74.7 for the nine months
ended September 30, 2002 from 81.3 for the nine months ended September 30, 2001.
Incurred losses for the nine months ended September 30, 2001 included $1,990,000
of losses and LAE related to the September 2001 terrorist attack on the World
Trade Center (WTC event), which added 2.9 points to that period's loss and LAE
ratio. Without the effect of the WTC event, the Company's loss and LAE ratio for
the nine months ended September 30, 2001 would have been 78.4. The decrease in
the loss and LAE ratio not pertaining to the WTC event
11
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 34.0% for the nine months ended
September 30, 2002 from 32.8% for the nine months ended September 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 nine
months ended September 30, 2002 compared to 20.3% for the nine months ended
September 30, 2001.
The Company's effective income tax rate for the nine months ended September 30,
2002 was 40.2%. 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 September 30, 2002 As Compared
to the Three Months Ended September 30, 2001
Total revenues for the three months ended September 30, 2002 were $22,919,000, a
decrease of $3,746,000, or 14%, from $26,665,000 for the three months ended
September 30, 2001.
Voluntary personal lines direct premiums written for the three months ended
September 30, 2002 were $11,094,000, an increase of $85,000, or 1%, from
$11,009,000 for the three months ended September 30, 2001. PPA direct premiums
written decreased less than 1% from the year earlier period. Homeowners direct
premiums written for the three months ended September 30, 2001 increased 4%
compared to the three months ended September 30, 2001. The increase in voluntary
personal lines direct premiums written for the three months ended September 30,
2002 is attributable to the same factors affecting voluntary personal lines
direct premiums written for the nine months ended September 30, 2002, discussed
earlier in this item.
Voluntary commercial lines direct premiums written for the three months ended
September 30, 2002 were $5,192,000, a decrease of $8,357,000, or 62%, from
$13,549,000 for the three months ended September 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 nine months
ended September 30, 2002, as discussed earlier in this item.
Involuntary direct premiums written for the three months ended September 30,
2002 were $1,629,000, an increase of $50,000, or 3%, from $1,579,000 for the
three months ended September 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 $2,593,000 for the three months ended September 30,
2002, a $651,000, or 20%, decrease from $3,244,000 for the three months ended
September 30, 2001, primarily due to a 4% decrease in average invested assets
and a 122 basis point decrease in the average investment portfolio yield.
12
Losses and LAE were $14,752,000 for the three months ended September 30, 2002, a
decrease of $5,546,000, or 27%, from $20,298,000 for the three months ended
September 30, 2001. The loss and LAE ratio decreased to 73.0 for the three
months ended September 30, 2002 from 87.4 for the three months ended September
30, 2001. Incurred losses for the three months ended September 30, 2001 included
$1,990,000 of losses and LAE related to the WTC event, which added 8.6 points to
the loss and LAE ratio for that period. Without the effect of the WTC event, the
Company's loss and LAE ratio for the three months ended September 30, 2001 would
have been 78.8. The decrease in the loss and LAE ratio not pertaining to the WTC
event is attributable to the same factors affecting losses and LAE for the nine
months ended September 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 35.0% for the three months ended
September 30, 2002 from 32.7% for the three months ended September 30, 2001.
Commissions, premium taxes and other state assessments that vary with the
Company's premium volume represented 21.9% of net premiums earned in the three
months ended September 30, 2002 compared to 20.1% for the three months ended
September 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 nine months ended September 30, 2002,
the Company's operating activities used $2,805,000 of cash, an increase of
$2,395,000 or 584% compared to the nine months ended September 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 liabilities 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
13
September 30, 2002, the Company had recorded $1,813,000 of net unrealized gains,
net of taxes, associated with its investments classified as "available for sale"
as accumulated other comprehensive income. During the nine months ended
September 30, 2002 the Company recorded $1,000 of net unrealized gains, net of
tax, associated with its available for sale investments as a component of other
comprehensive income.
At September 30, 2002, the Company's portfolio of fixed maturities represented
92.3% 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.
At September 30, 2002, $103,685,000, or 53.7%, 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 September 30, 2002, $4,647,000, or 2.2% of the Company's investment portfolio
was invested in non-investment grade securities compared to $10,302,000, or 4.5%
at September 30, 2001. The Company's non-investment grade securities at
September 30, 2002 included a real estate investment trust (REIT) with a cost
basis of $1,012,500 and a market value of approximately $715,000. In November
2002, the Company sold approximately one-half of its position in this REIT and
realized a loss of $216,000. The Company expects to sell the remainder of this
REIT investment during the fourth quarter of 2002 resulting in a similar loss.
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 September 30, 2002, no amount was outstanding on this loan.
During the nine months ended September 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 September 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
14
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. On October 24, 2002, the Board of Directors of MNH declared a
$500,000 cash dividend payable on November 25, 2002 to common stockholders of
record on November 25, 2002. The Company paid cash dividends to its common
stockholders of $.10 per share in each of the first three quarters of 2002
amounting to $644,000 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 would allow it to meet
this 3 to 1 regulatory guideline. For the first nine months of 2002, MNH's ratio
of net premiums written to statutory surplus, annualized for a full year, was
1.3 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 MNH's Chief Operating Officer, 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
15
Company continues in negotiations with Mutual to develop a new relationship for
the operational management of the Company's existing business only. The Company
is also exploring the possibility that in the future it will appoint its own
management separate from that of Mutual to oversee its existing business and to
develop and oversee other opportunities independent of Mutual. It is likely that
agreements between MNH and Mutual or other entities related to these matters
will require the approval of the New Hampshire Insurance Department (NHID),
MNH's state of domicile, the New York Insurance Department (NYID), Mutual'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. MNH and Mutual are conducting ongoing
discussions with representatives of the NHID and the NYID regarding the
structure of a possible future relationship.
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 $209,553,000 at September 30, 2002 is subject
to changes in interest rates and to a lesser extent on credit quality. Further,
certain mortgage-backed and asset-backed securities are exposed to accelerated
prepayment risk generally caused by interest rate movements. If interest rates
were to decline, mortgage holders would be more likely to refinance existing
mortgages at lower rates. Acceleration of future repayments could adversely
affect future investment income, if reinvestment of the accelerated receipts was
made in lower yielding securities.
The following table provides information related to the Company's fixed maturity
investments at September 30, 2002. The table presents cash flows of principal
amounts and related weighted average interest rates by expected maturity dates.
The cash flows are based upon the maturity date or, in the case of
mortgage-backed and asset-backed securities, expected payment patterns. Actual
cash flows could differ from those shown in the table.
16
Fixed Maturities
Expected Cash Flows of Principal Amounts ($ in 000's):
TOTAL
--------------------
Amor- Estimated
There- tized Market
Held to Maturity 2002 2003 2004 2005 2006 after Cost Value
- ---------------- ------- ------- ------- ------- ------ ------- -------- --------
Mortgage & asset backed
securities $ 29 $ 2,425 $ 1,809 $ 1,620 $ 398 $ 177 $ 6,458 $ 6,764
Average interest rate 7.0% 7.0% 7.0% 7.1% 7.2% 7.2% -- --
------- ------- ------- ------- ------ ------- -------- --------
Total $ 29 $ 2,425 $ 1,809 $ 1,620 $ 398 $ 177 $ 6,458 $ 6,764
======= ======= ======= ======= ====== ======= ======== ========
Available for Sale
U.S. Treasury securities and
obligations of U.S.
Government corporations
and agencies $ 0 $ 4,194 $ 0 $14,252 $ 0 $ 0 $ 18,446 $ 18,890
Average interest rate 0.0% 4.1% 0.0% 3.6% 0.0% 0.0% -- --
Obligations of states and
political subdivisions $ 0 6,365 1,373 2,823 499 25 11,085 11,298
Average interest rate 0.0% 7.2% 4.1% 3.2% 3.2% 7.3% -- --
Corporate securities 3,003 27,746 6,833 17,850 0 2,712 58,144 59,238
Average interest rate 7.4% 4.8% 7.6% 4.0% 0.0% 13.6% -- --
Mortgage & asset
backed securities 13,840 31,771 22,404 14,066 6,166 7,537 95,784 97,226
Average interest rate 5.6% 5.6% 5.7% 5.7% 5.8% 5.9% -- --
------- ------- ------- ------- ------ ------- -------- --------
Total $16,843 $70,076 $30,610 $48,991 $6,665 $10,274 $183,459 $186,652
======= ======= ======= ======= ====== ======= ======== ========
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," on page 22 of this report which is incorporated in this Item by
reference.
Item 4. Controls and Procedures
The Company's disclosure controls and procedures are designed to ensure that the
information required to be disclosed in reports filed under the Securities Act
of 1934 is recorded, processed, summarized and reported within the time periods
specified in the rules and forms of the Securities and Exchange Commission. The
Chief Operating Officer and the Chief Financial Officer have reviewed the
effectiveness of the Company's disclosure controls and procedures within the
last 90 days and have concluded that the disclosure controls and procedures are
effective. There were no significant changes in our internal controls or in
other factors that could significantly effect these controls subsequent to the
last day they were evaluated by the Company's Chief Operating Officer and Chief
Financial Officer.
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
None.
Item 5. Other Information.
None.
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
18
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).
(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 Agreements Attached Hereto, effective
January 1, 2002 (filed herewith).
(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).
19
*(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).
*(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).
20
*(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.
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.
* * * * * * * * *
21
"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 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: November 8, 2002 By:/s/ Kenneth J. Wilson
---------------------
Kenneth J. Wilson
Chief Financial Officer and
Treasurer (duly authorized
officer of the registrant and
chief accounting officer)
22
CERTIFICATIONS
I, Robert M. Zak, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Merchants
Group, Inc.
2. Based on my knowledge, this report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statement made, in light of the circumstances
under which such statements were made, not misleading with respect
to the period covered by the report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in
this report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and we have:
a. designed such disclosure controls and procedures that material
information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others
within those entities, particularly during the period in which
periodic reports are being prepared;
b. evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this report (the Evaluation Date); and
c. presented in this report our conclusions about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditor and
the audit committee of registrant's board of directors (or persons
performing the equivalent function):
a. all significant deficiencies in the design or operation of
internal controls which could adversely affect the
registrant's ability to record, process, summarize and report
financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b. any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
23
6. The registrant's other certifying officers and I have indicated in
this report whether or not there were significant changes in
internal controls or in other factors that could significantly
affect internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
Date: November 8, 2002 By:/s/ Robert M. Zak
----------------------------------------
Robert M. Zak, Senior Vice President and
Chief Operating Officer
(Chief Executive Officer)
24
CERTIFICATIONS
I, Kenneth J. Wilson, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Merchants
Group, Inc.
2. Based on my knowledge, this report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statement made, in light of the circumstances
under which such statements were made, not misleading with respect
to the period covered by the report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in
this report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and we have:
a. designed such disclosure controls and procedures that material
information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others
within those entities, particularly during the period in which
periodic reports are being prepared;
b. evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this report (the Evaluation Date); and
c. presented in this report our conclusions about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditor and
the audit committee of registrant's board of directors (or persons
performing the equivalent function):
a. all significant deficiencies in the design or operation of
internal controls which could adversely affect the
registrant's ability to record, process, summarize and report
financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b. any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
25
6. The registrant's other certifying officers and I have indicated in
this report whether or not there were significant changes in
internal controls or in other factors that could significantly
affect internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
Date: November 8, 2002 By:/s/ Kenneth J. Wilson
-------------------------------------
Kenneth J. Wilson, Vice President and
Chief Financial Officer
(Chief Financial Officer)
26