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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, 2003
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 by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). [ ]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of July 31, 2003: 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 2002 2003
------ -------- -----------
(unaudited)
Investments:
Fixed maturities:
Held to maturity at amortized cost (fair value
$4,259 in 2002 and $2,965 in 2003) $ 4,092 $ 2,923
Available for sale at fair value (amortized cost
$186,302 in 2002 and $198,662 in 2003) 189,476 202,157
Preferred stock at fair value 7,367 5,785
Other long-term investments at fair value 2,042 2,103
Short-term investments 6,420 5,436
-------- --------
Total investments 209,397 218,404
Cash 9 10
Interest due and accrued 1,594 1,501
Premiums receivable, net of allowance for doubtful
accounts of $288 in 2002 and $347 in 2003 14,496 17,112
Deferred policy acquisition costs 8,817 8,756
Ceded reinsurance balances receivable 19,086 20,088
Prepaid reinsurance premiums 1,091 948
Receivable from affiliate - 1,668
Deferred income taxes 4,195 4,511
Other assets 10,031 9,806
-------- --------
Total assets $268,716 $282,804
======== ========
See Notes to the Consolidated Financial Statements
2
MERCHANTS GROUP, INC.
CONSOLIDATED BALANCE SHEET
(in thousands except share amounts)
December 31, June 30,
2002 2003
---- ----
(unaudited)
Liabilities and Stockholders' Equity
------------------------------------
Liabilities:
Reserve for losses and loss adjustment expenses $ 147,136 $ 147,254
Unearned premiums 35,119 34,565
Payable to affiliate 3,237 -
Payable for securities - 4,612
Short term borrowings - 11,692
Other liabilities 15,300 14,324
--------- ---------
Total liabilities 200,792 212,447
--------- ---------
Stockholders' equity:
Common stock, 10,000,000 shares authorized, 2,110,152
shares issued and outstanding at December 31, 2002
and June 30, 2003 32 32
Additional paid in capital 35,795 35,795
Treasury stock, 1,139,700 shares at December 31, 2002
and June 30, 2003 (22,766) (22,766)
Accumulated other comprehensive income 1,937 2,053
Accumulated earnings 52,926 55,243
--------- ---------
Total stockholders' equity 67,924 70,357
--------- ---------
Commitments and contingent liabilities - -
Total liabilities and stockholders' equity $268,716 $282,804
========= =========
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,
2002 2003 2002 2003
---- ---- ---- ----
(unaudited)
Revenues:
Net premiums earned $21,569 $16,215 $44,699 $32,356
Net investment income 2,727 2,183 5,297 4,514
Net realized investment gains 1,310 2,050 1,383 2,166
Other revenues 210 124 437 157
------- ------- ------- -------
Total revenues 25,816 20,572 51,816 39,193
------- ------- ------- -------
Expenses:
Net losses and loss adjustment
expenses 15,853 12,351 33,749 25,268
Amortization of deferred policy
acquisition costs 5,716 4,225 11,845 8,431
Other underwriting expenses 1,407 1,187 3,142 2,364
------- ------- ------- -------
Total expenses 22,976 17,763 48,736 36,063
------- ------- ------- -------
Income before income taxes 2,840 2,809 3,080 3,130
Income tax provision 1,136 286 1,234 391
------- ------- ------- -------
Net income $ 1,704 $ 2,523 $ 1,846 $ 2,739
======= ======= ======= =======
Basic and diluted earnings per share $ .81 $ 1.20 $ .86 $ 1.30
======= ======= ======= =======
Weighted average shares outstanding:
Basic 2,110 2,110 2,141 2,110
Diluted 2,115 2,110 2,145 2,111
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,
2002 2003 2002 2003
---- ---- ---- ----
(unaudited)
Net income $ 1,704 $ 2,523 $ 1,846 $ 2,739
------- ------- ------- -------
Other comprehensive income before taxes:
Unrealized gains on securities 1,479 3,092 543 2,341
Reclassification adjustment
for gains and losses included
in net income (1,310) (2,050) (1,383) (2,166)
------- ------- ------- -------
Other comprehensive income (loss)
before taxes 169 1,042 (840) 175
Income tax provision (benefit) related to
items of other comprehensive income 64 394 (317) 59
------- ------- ------- -------
Other comprehensive income (loss) 105 648 (523) 116
------- ------- ------- -------
Comprehensive income $ 1,809 $ 3,171 $ 1,323 $ 2,855
======= ======= ======= =======
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,
2002 2003
---- ----
(unaudited)
Common stock, beginning and end $ 32 $ 32
-------- --------
Additional paid in capital, beginning and end: 35,795 35,795
-------- --------
Treasury stock:
Beginning of period (20,332) (22,766)
Purchase of treasury shares (2,434) -
-------- --------
End of period (22,766) (22,766)
-------- --------
Accumulated other comprehensive income (loss):
Beginning of period 1,812 1,937
Other comprehensive income (loss) (523) 116
-------- --------
End of period 1,289 2,053
-------- --------
Accumulated earnings:
Beginning of period 51,244 52,926
Net income 1,846 2,739
Cash dividends (435) (422)
-------- --------
End of period 52,655 55,243
-------- --------
Total stockholders' equity $ 67,005 $ 70,357
======== ========
See Notes to the Consolidated Financial Statements
6
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands)
Six Months
Ended June 30,
2002 2003
-------- --------
(unaudited)
Cash flows from operations:
Collection of premiums $ 40,677 $ 29,790
Payment of losses and loss adjustment expenses (37,730) (26,678)
Payment of other underwriting expenses (14,521) (12,438)
Investment income received 5,916 4,717
Investment expenses paid (173) (144)
Income taxes (paid) recovered (545) 252
Other 437 157
-------- --------
Net cash used in operations (5,939) (4,344)
-------- --------
Cash flows from investing activities:
Proceeds from fixed maturities sold or matured 77,428 67,761
Purchase of fixed maturities (74,670) (78,867)
Net decrease in preferred stock 1,049 1,500
Net decrease in other long-term investments 558 1,990
Net decrease in short-term investments 2,560 984
Increase in payable for securities - 4,612
-------- --------
Net cash provided by (used in) investing activities 6,925 (2,020)
-------- --------
Cash flows from financing activities:
Settlement of affiliate balances, net 892 (4,905)
Decrease in demand loan, net (200) -
Increase in short-term borrowings - 11,692
Purchase of treasury stock (2,434) -
Cash dividends (435) (422)
-------- --------
Net cash provided by (used in) financing activities (2,177) 6,365
-------- --------
Increase (decrease) in cash (1,191) 1
Cash:
Beginning of period 1,197 9
-------- --------
End of period $ 6 $ 10
======== ========
See Notes to the Consolidated Financial Statements
7
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
RECONCILIATION OF NET INCOME TO NET CASH
USED IN OPERATIONS
(in thousands)
Six Months
Ended June 30,
2002 2003
------- -------
(unaudited)
Net income $ 1,846 $ 2,739
Adjustments:
Accretion (17) (34)
Realized investment gains (1,383) (2,166)
(Increase) decrease in assets:
Interest due and accrued 463 93
Premiums receivable 4,553 (2,616)
Deferred policy acquisition costs 2,167 61
Ceded reinsurance balances receivable (695) (1,002)
Prepaid reinsurance premiums 1,377 143
Deferred income taxes 179
Other assets (503) 225
Increase (decrease) in liabilities:
Reserve for losses and loss adjustment expenses (2,970) 118
Unearned premiums (9,556) (554)
Other liabilities (1,400) (976)
------- -------
Net cash used in operations $(5,939) $(4,344)
======= =======
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, 2003 and the related consolidated
statements of operations, and of comprehensive income for the three and six
month periods ended June 30, 2003 and, of changes in stockholders' equity and of
cash flows for the six month periods ended June 30, 2002 and 2003, 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, 2002.
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 individual who serves as both the President of the
Company and the Chief Operating Officer of MNH, the Company and MNH have no paid
employees. Under a management agreement dated September 26, 1986 (the Management
Agreement), Merchants Mutual Insurance Company (Mutual), which owned 12.1% of
the Company's common stock at June 30, 2003, provided the Company and MNH with
the facilities, management and personnel required to manage their day-to-day
business through December 31, 2002. All underwriting, administrative, claims and
investment expenses incurred on behalf of Mutual and MNH were shared on an
allocated cost basis. Effective January 1, 2003, the Company, MNH and Mutual
entered into a new agreement (the Services Agreement) for Mutual to provide
underwriting, administrative, claims and investment services to the Company and
MNH and to manage the traditional property and casualty insurance business of
MNH on substantially the same terms as under the Management Agreement. As of
January 1, 2003 MNH and Mutual entered into a reinsurance pooling agreement (the
Reinsurance Pooling Agreement) that provides for the pooling, or sharing, of the
insurance business traditionally written by Mutual and MNH. The Reinsurance
Pooling Agreement applies to premiums earned and losses incurred on or after its
effective date. The terms of these agreements are more fully described in the
Company's Annual Report of Form 10-K for the year ended December 31, 2002.
9
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. For diluted earnings per share, the weighted number of shares
outstanding was increased by the assumed exercise of options for 35,500 shares
of common stock in the six month period in 2003 and in the three and six month
periods in 2002, which would have resulted in 704 additional shares outstanding
for the six month period ended June 30, 2003 and 5,044 and 3,976 additional
shares outstanding for the three and six month periods in 2002, 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
applicable period. Options to purchase 35,500 shares of common stock at $21.00
per share were outstanding during the three months ended June 30, 2003 but were
not included in the computation of diluted earnings per share because the
options' exercise price was greater than the average market price of the common
shares.
4. Income Taxes
------------
The provision for income taxes for the three and six month periods ended June
30, 2003 includes the effect of a May 2003 change in New York State law with
respect to the taxation of insurance companies. This change eliminates state
income taxes for all non-life insurance companies and increases the premium tax
rate from 1.3% to 2.0%. As a result of this change, the Company reduced its
deferred tax liability with respect to New York State income taxes to $0, and
recorded a one time benefit, net of federal income taxes, to its income tax
provision of $505,000 during the three and six month periods ended June 30,
2003. This one time benefit reduced the Company's effective income tax rate for
the three and six month periods ended June 30, 2003 by 18 and 16 percentage
points, respectively.
10
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Results of Operations for the Six Months Ended June 30, 2003 As Compared to the
- -------------------------------------------------------------------------------
Six Months Ended June 30, 2002
- ------------------------------
The following discussion should be considered in light of the statements under
the heading "Safe Harbor Statement under the Securities Litigation Reform Act of
1995," at the end of this Item. All capitalized terms used in this Item that are
not defined in this Item have the meanings given to them in the Notes to
Consolidated Financial Statements contained in Item 1 of this Form 10-Q, which
is incorporated herein by reference.
Results of operations for the six months ended June 30, 2003 reflect the effects
of the Services Agreement and the Reinsurance Pooling Agreement between the
Company and its wholly-owned insurance subsidiary, Merchants Insurance Company
of New Hampshire, Inc. (MNH) and Merchants Mutual Insurance Company (Mutual),
effective January 1, 2003. The Services Agreement calls for Mutual to provide
underwriting, administrative, claims and investment services to the Company and
MNH. The Reinsurance Pooling Agreement provides for the pooling, or sharing, of
insurance business traditionally written by Mutual and MNH on or after the
effective date. MNH's share of pooled (combined Mutual and MNH) premiums earned
and losses and loss adjustment expenses (LAE) for 2003 in accordance with the
Reinsurance Pooling Agreement is 40%. In addition to comparisons of the
Company's share of pooled premiums for 2003 to its unpooled premiums for the
same period in 2002, this item includes comparisons of the pooled, or combined
Mutual and MNH, premiums written for 2003 to the combined business of Mutual and
MNH for the same period in 2002, even though the companies were not party to a
reinsurance pooling agreement in 2002.
Total combined Mutual and MNH or "group-wide" direct premiums (DWP) written for
the six months ended June 30, 2003 were $86,398,000, an increase of $753,000 or
1% from $85,645,000 for the six months ended June 30, 2002. The Company's share
of combined direct premiums written for the six months ended June 30, 2003, in
accordance with the Reinsurance Pooling Agreement, was $34,559,000. The Company
recorded $38,120,000 of direct premiums written for the six months ended June
30, 2002. The table below shows a comparison of direct premiums written by major
category for the six months ended June 30, 2003 and 2002:
MNH
Pooled MNH
Group-wide DWP Share DWP
-------------- ----- ---
Six months ended Six months ended
June 30, June 30,
2003 2002 Variance 2003 2002
---- ---- -------- ---- ----
(000's omitted)
Voluntary Personal Lines $31,452 $32,339 (3%) $12,581 $18,582
Voluntary Commercial Lines 51,635 50,070 3% 20,654 16,670
Involuntary 3,311 3,236 2% 1,324 2,868
------- ------- ------- -------
Total Direct Written Premiums $86,398 $85,645 1% $34,559 $38,120
------- ------- ------- -------
11
The 3% decrease in group-wide voluntary personal lines direct premiums written,
which represented 36% and 38% of total group-wide direct premiums written, for
the six month periods ended June 30, 2003 and 2002, respectively, resulted from
a 5% decrease in private passenger automobile (PPA) direct premiums written,
somewhat offset by a 5% increase in homeowners direct premiums written. The
decrease in PPA direct premiums written is primarily the result of the group's
policy, implemented in 2002, not to write new PPA policies in certain
jurisdictions.
The 3% increase in group-wide voluntary commercial lines direct premiums
written, which comprised 60% and 58% of total group-wide direct premiums
written, for the six month periods ended June 30, 2003 and 2002, respectively,
primarily resulted from higher pricing.
Group-wide pooled net premiums written for the six months ended June 30, 2003
were $81,101,000, a decrease of $120,000, or less than 1% from $81,221,000 for
the six months ended June 30, 2002. The Company's share of pooled net premiums
written in accordance with the Reinsurance Pooling Agreement for the six months
ended June 30, 2003 was $31,944,000. Net premiums written for the six months
ended June 30, 2002 were $36,520,000.
Total revenues for the six months ended June 30, 2003 were $39,193,000, a
decrease of $12,623,000 or 24% from $51,816,000 for the six months ended June
30, 2003.
The Company's share of pooled net premiums earned in accordance with the
Reinsurance Pooling Agreement for the six months ended June 30, 2003 was
$32,356,000. Net premiums earned for the six months ended June 30, 2002 were
$44,699,000. The decrease in net premiums earned was due to the allocation of
group-wide net premiums earned caused by the Reinsurance Pooling Agreement.
Net investment income was $4,514,000 for the six months ended June 30, 2003, a
decrease of 15% from $5,297,000 for the six months ended June 30, 2002. The
average pre-tax yield associated with the investment portfolio decreased 102
basis points to 4.6% for the six months ended June 30, 2003 compared to the six
months ended June 30, 2002. Average invested assets for the six months ended
June 30, 2003 decreased 4% compared to the year earlier period.
Net realized investment gains were $2,166,000 for the six months ended June 30,
2003 compared to $1,383,000 for the six months ended June 30, 2002. The majority
of the net realized gains for 2003 resulted from the Company taking advantage of
a share repurchase program related to an otherwise illiquid equity security.
Equity securities comprised less than 1% of the Company's investment portfolio
at June 30, 2003.
Other revenues decreased $280,000 or 64% to $157,000 for the six months ended
June 30, 2003 from $437,000 for the six months ended June 30, 2002. This
decrease resulted primarily from a 29% decrease in service fee income which in
turn was due to a reduction in policies in force and a $132,000 increase in
charge-offs related to uncollectable premiums receivable.
Net losses and LAE, which include the Company's share of pooled 2003 accident
year losses, were $25,268,000 for the six months ended June 30, 2003, a decrease
of $8,481,000, or 25%, from $33,749,000
12
for the six months ended June 30, 2002. The loss and LAE ratio increased to
78.1% for the six months ended June 30, 2003 from 75.5% for the six months ended
June 30, 2002.
The ratio of amortized deferred policy acquisition costs and other underwriting
expenses to net premiums earned decreased to 33.4% for the six months ended June
30, 2003 from 33.5% for the six months ended June 30, 2002. An increase in the
premium tax rate in New York State, which is discussed in the following
paragraph, added .4 percentage points to the Company's ratio of amortized
deferred policy acquisition costs and other underwriting expenses to net
premiums earned. Other underwriting expenses included $253,000 of retrospective
commission income to be received from Mutual in accordance with the Reinsurance
Pooling Agreement. This retrospective commission income reduced the ratio of
deferred policy acquisition costs and other underwriting expenses to net
premiums earned by .8 percentage points. Commissions, premium taxes and other
state assessments that vary directly with the Company's premium volume
represented 19.6% of net premiums earned in the six months ended June 30, 2003
compared to 20.1% in the six months ended June 30, 2002.
The provision for income taxes for the six months ended June 30, 2003 includes
the effect of a May 2003 change in New York State law with respect to the
taxation of insurance companies. This change eliminates state income taxes for
all non-life insurance companies and increases the premium tax rate from 1.3% to
2.0%. As a result of this change, the Company reduced its deferred tax liability
with respect to New York State income taxes to $0, and recorded a one-time
benefit, net of federal income taxes, to its income tax provision of $505,000
during the six months ended June 30, 2003. This one time benefit reduced the
Company's effective income tax rate for the six month period ended June 30, 2003
by 16 percentage points.
Results of Operations for the Three Months Ended June 30, 2003 As Compared to
- -----------------------------------------------------------------------------
the Three Months Ended June 30, 2002
- ------------------------------------
Total combined Mutual and MNH direct premiums written for the three months ended
June 30, 2003 were $45,645,000, an increase of $1,890,000 or 4% from $43,755,000
for the three months ended June 30, 2002. The Company's share of combined direct
premiums written for the three months ended June 30, 2003, in accordance with
the Reinsurance Pooling Agreement was $18,257,000. The Company recorded
$17,639,000 of direct premiums written for the three months ended June 30, 2002.
The table below shows a comparison of direct premiums written by major category
for the three months ended June 30, 2003 and 2002:
MNH
Pooled MNH
Group-wide DWP Share DWP
-------------- ----- ---
Three months ended Three months ended
June 30, June 30,
2003 2002 Variance 2003 2002
---- ---- -------- ---- ----
(000's omitted)
Voluntary Personal Lines $16,240 $17,179 (5%) $ 6,496 $ 9,851
Voluntary Commercial Lines 27,954 24,701 13% 11,181 6,128
Involuntary 1,451 1,875 (23%) 580 1,660
------- ------- ------- -------
Total Direct Written Premiums $45,645 $43,755 4% $18,257 $17,639
------- ------- ------- -------
13
The 5% decrease in group-wide voluntary personal lines direct premiums written
resulted from an 8% decrease in PPA direct premiums written, somewhat offset by
a 3% increase in homeowners direct premiums written. The decrease in PPA direct
premiums written is primarily the result of the group's policy, implemented in
2002, not to write new PPA policies in certain jurisdictions.
The 13% increase in group-wide voluntary commercial lines direct premiums
written primarily resulted from higher pricing.
Group-wide pooled net premiums written for the three months ended June 30, 2003
were $42,743,000, an increase of $957,000, or 2% from $41,786,000 for the three
months ended June 30, 2002. The Company's share of pooled net premiums written
in accordance with the Reinsurance Pooling Agreement for the three months ended
June 30, 2003 was $17,097,000. Net premiums written for the three months ended
June 30, 2002 were $17,398,000.
Total revenues for the three months ended June 30, 2003 were $20,572,000, a
decrease of $5,244,000 or 20% from $25,816,000 for the three months ended June
30, 2003.
The Company's share of pooled net premiums earned in accordance with the
Reinsurance Pooling Agreement for the three months ended June 30, 2003 was
$16,215,000. Net premiums earned for the three months ended June 30, 2002 were
$21,569,000. The decrease in net premiums earned was a result of the Company's
allocated share of group-wide net premiums earned under the Reinsurance Pooling
Agreement.
Net investment income was $2,183,000 for the three months ended June 30, 2003, a
decrease of 20% from $2,727,000 for the three months ended June 30, 2002. The
average pre-tax yield associated with the investment portfolio decreased 109
basis points to 4.5% for the three months ended June 30, 2003 when compared to
the three months ended June 30, 2002. Average invested assets for the three
months ended June 30, 2003 decreased 3% compared to the year earlier period.
Net realized investment gains were $2,050,000 for the three months ended June
30, 2003 compared to $1,310,000 for the three months ended June 30, 2002. The
majority of the net realized gains for 2003 resulted from the Company taking
advantage of a share repurchase program related to an illiquid security.
Net losses and LAE, which include the Company's share of pooled 2003 accident
year losses, were $12,351,000 for the three months ended June 30, 2003, a
decrease of $3,502,000, or 22%, from $15,853,000 for the three months ended June
30, 2002. The loss and LAE ratio increased to 76.2% for the three months ended
June 30, 2003 from 73.5% for the three months ended June 30, 2002.
The ratio of amortized deferred policy acquisition costs and other underwriting
expenses to net premiums earned increased to 33.4% for the three months ended
June 30, 2003 from 33.0% for the three months ended June 30, 2002. The
aforementioned increase in the New York State premium tax rate added .9
percentage points to the ratio of amortized deferred policy acquisition costs
and other
14
underwriting expenses to net premiums earned. Other underwriting expenses
included $165,000 of retrospective commission income to be received from Mutual
in accordance with the Reinsurance Pooling Agreement. This retrospective
commission income reduced the ratio of deferred policy acquisition costs and
other underwriting expenses to net premiums earned by 1 percentage point.
Commissions, premium taxes and other state assessments that vary directly with
the Company's premium volume represented 19.7% of net premiums earned in the
three months ended June 30, 2003 compared to 19.8% in the three months ended
June 30, 2002.
The provision for income taxes for the three month period ended June 30, 2003
includes the effect of the May 2003 change in New York State law with respect to
the taxation of insurance companies. This change eliminates state income taxes
for all non-life insurance companies and increases the premium tax rate from
1.3% to 2.0%. As a result of this change, the Company reduced its deferred tax
liability with respect to New York State income taxes to $0, and recorded a
one-time benefit, net of federal income taxes, to its income tax provision of
$505,000 during the three months ended June 30, 2003.
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. The reduction in the
Company's share of net premiums written under the Reinsurance Pooling Agreement
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 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 return within investment guidelines while protecting
policyholders' surplus 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 relative
to the duration of its liabilities is closely managed, increases or decreases in
market interest rates are not expected to have a material effect on the
Company's liquidity or its results of operations.
The Company 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 accumulated other
comprehensive income within stockholders' equity. At June 30, 2003, the Company
recorded as accumulated other comprehensive income in its Consolidated Balance
Sheet $2,053,000 of unrealized gains, net of taxes, associated with its
investments classified as available for sale. During the six months ended June
30, 2003 the Company recorded $116,000 of unrealized gains, net of tax,
associated with its available for sale investments as other comprehensive
income.
At June 30, 2003, the Company's portfolio of fixed maturity investments
represented 93.9% of invested assets. Management believes that this level of
bond holdings is consistent with the Company's liquidity needs because it
anticipates that cash receipts from net premiums written and investment income
will enable the Company to satisfy its cash obligations. Furthermore, a portion
of the Company's bond portfolio
15
is invested in mortgage-backed and other asset-backed securities which, in
addition to interest income, provide monthly paydowns of bond principal.
At June 30, 2003, $95,983,000 or 46.8%, 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 derivative types of CMO products such as
interest only, principal only or inverse floating rate securities. All of the
Company's CMO investments have a secondary market and their effect on the
Company's liquidity does not differ from that of other fixed maturity
investments.
At June 30, 2003 $4,890,000, or 2.2%, of the Company's investment portfolio was
invested in non-investment grade securities compared to $4,965,000, or 2.4%, at
December 31, 2002.
The balance at June 30, 2003 classified in the Company's Consolidated Balance
Sheet as "short term borrowings" represents amounts owed to a broker. The
Company borrows funds bearing interest at the London Interbank Offered Interest
Rate (LIBOR) which is reset monthly and invests those funds in longer term
securities.
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, 2003, no amount was outstanding on this loan.
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 2003 without the prior approval of the New Hampshire Insurance
Commissioner is $5,492,000. MNH paid $3,700,000 of dividends to the Company in
2002. Dividends were paid in February 2002, May 2002 and November 2002, of
$2,300,000, $900,000 and $500,000, respectively. MNH paid dividends to the
Company of $600,000 in April of 2003. The Company paid cash dividends to its
common stockholders of $.10 per share in the first and second quarters of 2003
amounting to $422,000. On July 31, 2003 the Company declared a quarterly cash
dividend of $.10 per share payable on September 5, 2003 to shareholders of
record as of the close of business on August 20, 2003.
Under the Management Agreement and the Services Agreement, Mutual has provided
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 by or to the Company
for the difference between premiums collected and payments made for losses,
employees, services and facilities by Mutual on behalf of MNH.
16
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 six months of 2003, MNH's ratio
of net premiums written to statutory surplus, annualized for a full year, was
1.1 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 a 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, which was effective from 1986 through December 31, 2002, Mutual
provided the Company and MNH with facilities and personnel to conduct the
traditional Merchants insurance business and other services. With the exception
of the individual who serves as both the President of the Company and the Chief
Operating Officer of MNH, the officers of the Company and MNH are paid full time
employees of Mutual whose services are provided under the Services Agreement.
Also, effective January 1, 2003, the Reinsurance Pooling Agreement between MNH
and Mutual provides for MNH to cede all of its net risk on its traditional
insurance business to Mutual and then to assume from Mutual an agreed percentage
(40% in 2003) of the combined traditional insurance business of both MNH and
Mutual. This will create a common underwriting result for MNH and Mutual under
the Reinsurance Pooling Agreement and further align the interests of the
parties.
The Services Agreement and the Reinsurance Pooling Agreement have been approved
by the New Hampshire and New York Insurance Departments.
"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 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 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
17
relationship with Mutual; and the other risks and uncertainties discussed or
indicated in all documents filed by the Company with the Securities and Exchange
Commission. The Company expressly disclaims any obligation to update any
forward-looking statements as a result of developments occurring after the
filing of this report.
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 $218,446,000 at June 30, 2003 is subject to
changes in interest rates and to a lesser extent on credit quality. Further,
certain mortgage-backed and asset-backed securities are exposed to accelerated
prepayment risk generally caused by interest rate movements. If interest rates
were to decline, mortgage holders would be more likely to refinance existing
mortgages at lower rates. Acceleration of future repayments could adversely
affect future investment income, if reinvestment of the accelerated receipts was
made in lower yielding securities.
The following table provides information related to the Company's fixed maturity
investments at June 30, 2003. The table presents cash flows of principal amounts
and related weighted average interest rates by expected maturity dates. The cash
flows are based upon the maturity date or, in the case of mortgage-backed and
asset-backed securities, expected payment patterns. Actual cash flows could
differ from those shown in the table.
18
Fixed Maturities
- ----------------
Expected Cash Flows of Principal Amounts ($ in 000's): TOTAL
- ------------------------------------------------------ -----
Esti-
Amor- mated
There- tized Market
2003 2004 2005 2006 2007 after Cost Value
-------- -------- -------- -------- -------- -------- -------- --------
Held to Maturity
- ----------------
Mortgage & asset backed
securities $ 2,923 $ 0 $ 0 $ 0 $ 0 $ 0 $ 2,923 $ 2,965
Average interest rate 7.3% 0.0% 0.0% 0.0% 0.0% 0.0% --- ---
-------- -------- -------- -------- -------- -------- -------- --------
Total $ 2,923 $ 0 $ 0 $ 0 $ 0 $ 0 $ 2,923 $ 2,965
======== ======== ======== ======== ======== ======== ======== ========
Available for Sale
- ------------------
U.S. Treasury securities and
obligations of U.S.
Government corporations
and agencies $ 4,187 $ 0 $ 8,195 $ 0 $ 0 $ 3,009 $ 15,391 $ 15,905
Average interest rate 4.1% 0.0% 3.6% 0.0% 0.0% 3.2% --- ---
Obligations of states and
political subdivisions 4,697 1,386 8,589 9,729 3,902 15,944 44,247 44,673
Average interest rate 7.6% 4.1% 3.2% 3.4% 4.3% 3.8% --- ---
Corporate securities 16,769 6,897 17,763 0 0 5,706 47,135 48,505
Average interest rate 4.4% 7.9% 4.0% 0.0% 0.0% 8.2% --- ---
Mortgage & asset
backed securities 17,186 19,536 20,797 16,681 6,628 11,061 91,889 93,074
Average interest rate 5.4% 5.3% 5.3% 5.3% 5.4% 5.5% --- ---
-------- -------- -------- -------- -------- -------- -------- --------
Total $ 42,839 $ 27,819 $ 55,344 $ 26,410 $ 10,530 $ 35,720 $198,662 $202,157
======== ======== ======== ======== ======== ======== ======== ========
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. Accordingly, the forward-looking statements should not be
considered projections of future events by the Company.
Item 4. Controls and Procedures
The Company's chief executive officer and chief financial officer, after
evaluating the effectiveness of the Company's "disclosure controls and
procedures" (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities
Exchange Act of 1934) as of a date (the "Evaluation Date") within 90 days before
the filing date of this quarterly report, concluded that as of the Evaluation
Date the Company's disclosure controls and procedures were effective to ensure
that material information relating to the Company was being made known to them
by others within the Company in a timely manner, including the period when this
quarterly report was being prepared.
19
There were no significant changes in the Company's internal controls or, to
the knowledge of the Company's chief executive officer and chief financial
officer, in other factors that could significantly affect the Company's
disclosure controls and procedures subsequent to the Evaluation Date.
20
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 7, 2003 the Company held its annual meeting of stockholders.
During the meeting Thomas E. Kahn, Henry P. Semmelhack and Robert M.
Zak were re-elected Directors of the Company for three year terms to
expire at the annual meeting in 2006. Andrew A. Alberti, Brent D.
Baird, Frank J. Colantuono and Richard E. Garman are Directors of the
Company whose terms of office as Director continue beyond the date of
the meeting. Mr. Baird's and Mr. Garman's terms expire in 2004 and Mr.
Alberti and Mr. Colantuono's terms expire in 2005.
A summary of stockholder voting with respect to the election of
Directors is as follows:
Election of Election of Election of
Thomas E. Kahn Henry P. Semmelhack Robert M. Zak
-------------- ------------------- -------------
For 1,869,870 1,869,870 1,869,870
Withheld 11,600 11,600 11,600
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.
21
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) Services Agreement Among Merchants Mutual Insurance Company,
Merchants Insurance Company of New Hampshire, Inc. and Merchants
Group, Inc. dated January 1, 2003 (incorporated by reference to
Exhibit No. 10b to the Company's 2003 Quarterly Report on Form
10-Q filed on May 14, 2003).
(c) Reinsurance Pooling Agreement between Merchants Insurance
Company of New Hampshire, Inc. and Merchants Mutual Insurance
Company effective January 1, 2003 (incorporated by reference to
Exhibit No. 10c to the Company's 2003 Quarterly Report on Form
10-Q filed on May 14, 2003).
(d) 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).
(e) 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).
(f) 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).
(g) 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).
(h) Casualty Excess of Loss Reinsurance Agreement between Merchants
Mutual Insurance Company, Merchants Insurance Company of New
Hampshire, Inc. and American Reinsurance Company (incorporated
by reference to Exhibit 10(f) to the Company's 2002 Annual
Report on Form 10-K filed on March 31, 2002).
(i) Property Per Risk Excess of Loss Reinsurance Agreement between
Merchants Mutual Insurance Company, Merchants Insurance Company
of New Hampshire, Inc. and American
22
Reinsurance Company (incorporated by reference to Exhibit
10(g) to the Company's 2002 Annual Report on Form 10-K filed
on March 31, 2002).
(j) 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 (incorporated by reference to
Exhibit 10g to the Company's 2002 Quarterly Report on Form 10-Q
filed on November 8, 2002).
(k) 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).
*(l) 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).
*(m) 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).
*(n) 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).
*(o) 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).
*(p) 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).
*(q) 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).
*(r) Form of Amended Indemnification Agreement entered into by
Registrant with each director and executive officer of
Registrant (incorporated by reference to Exhibit No. 10n to
23
Amendment No. 1 to the Company's Registration Statement on
(No. 33-9188) Form S-1 filed on November 7, 1986).
*(s) 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).
*(t) 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).
*(u) Amendment No. 1 to Employee Retention Agreement between Robert
M. Zak and Merchants Mutual Insurance Company originally dated
as of May 1, 1999, dated February 6, 2002 (incorporated by
reference to Exhibit 10(s) to the Company's 2002 Annual Report
on Form 10-K filed on March 31, 2003).
*(v) Amendment No. 1 to Employee Retention Agreement between Edward
M. Murphy and Merchants Mutual Insurance Company originally
dated as of March 1, 1999, dated February 6, 2002 (incorporated
by reference to Exhibit 10(t) to the Company's 2002 Annual
Report on Form 10-K filed on March 31, 2003).
*(w) Amendment No. 1 to Employee Retention Agreement between Kenneth
J. Wilson and Merchants Mutual Insurance Company originally
dated as of March 1, 1999, dated February 6, 2002 incorporated
by reference to Exhibit 10(u) to the Company's 2002 Annual
Report on Form 10-K filed on March 31, 2003.
*(x) Consulting Agreement between Stephen C. June and Merchants
Insurance Company of New Hampshire, Inc. 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).
*(y) Employment Agreement between Stephen C. June and Merchants
Insurance Company of New Hampshire, Inc. 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.
24
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.
31 Rule 13a-14(a)/15d-14(a) Certifications
32 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.
On May 12, 2003, the Company filed a Form 8-K reporting the issuance of a press
release announcing the appointment of Stephen C. June as President of the
Company.
On May 15, 2003, the Company filed a Form 8-K reporting the issuance of a press
release announcing results for the quarter ended March 31, 2003.
On May 15, 2003, the Company filed a Form 8-K reporting the issuance of a press
release announcing that both the New Hampshire and New York Insurance
Departments approved the previously announced Services Agreement and Reinsurance
Pooling Agreement with Merchants Mutual Insurance Company.
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 11, 2003 By:/s/ Kenneth J. Wilson
---------------------
Kenneth J. Wilson
Chief Financial Officer and
Treasurer (duly authorized
officer of the registrant and
chief accounting officer)
25