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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
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ________ TO ________.
COMMISSION FILE NUMBER 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 checkmark 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 30, 2004: 2,114,152 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,
2003 2004
---- ----
(unaudited)
Assets
Investments:
Fixed maturities:
Available for sale at fair value (amortized cost
$192,315 in 2003 and $190,741 in 2004) $193,805 $187,813
Preferred stock at fair value 5,797 5,698
Other long-term investments at fair value 2,167 2,182
Short-term investments 1,118 3,014
-------- --------
Total investments 202,887 198,707
Cash 23 4
Interest due and accrued 1,260 1,130
Premiums receivable, net of allowance for doubtful
accounts of $278 in 2003 and $328 in 2004 16,677 16,288
Deferred policy acquisition costs 8,623 7,650
Reinsurance recoverable on paid and unpaid losses 22,715 19,085
Prepaid reinsurance premiums 3,066 4,702
Income taxes receivable 881 551
Deferred income taxes 4,497 5,791
Other assets 11,637 9,928
-------- --------
Total assets $272,266 $263,836
======== ========
See Notes to the Consolidated Financial Statements
2
MERCHANTS GROUP, INC.
CONSOLIDATED BALANCE SHEET
(in thousands except share amounts)
December 31, June 30,
2003 2004
---- ----
(unaudited)
Liabilities and Stockholders' Equity
Liabilities:
Reserve for losses and loss adjustment expenses $ 146,474 $ 136,177
Unearned premiums 36,176 34,106
Payable to affiliate 2,090 458
Payable for securities - 8,382
Other liabilities 17,267 15,425
--------- ---------
Total liabilities 202,007 194,548
--------- ---------
Stockholders' equity:
Common stock, 10,000,000 shares authorized, 2,110,152 shares issued and
outstanding at December 31, 2003 and 2,114,152 shares issued and
outstanding at June 30, 2004 32 33
Additional paid in capital 35,795 35,878
Treasury stock, 1,139,700 shares at December 31, 2003
and June 30, 2004 (22,766) (22,766)
Accumulated other comprehensive income (loss) 750 (2,246)
Accumulated earnings 56,448 58,389
--------- ---------
Total stockholders' equity 70,259 69,288
--------- ---------
Commitments and contingent liabilities - -
Total liabilities and stockholders' equity $ 272,266 $ 263,836
========= =========
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,
2003 2004 2003 2004
---- ---- ---- ----
(unaudited)
Revenues:
Net premiums earned $16,215 $14,364 $32,356 $28,433
Net investment income 2,183 1,965 4,514 4,019
Net realized investment gains 2,050 93 2,166 470
Other revenues 124 97 157 263
------- ------- ------- -------
Total revenues 20,572 16,519 39,193 33,185
------- ------- ------- -------
Expenses:
Net losses and loss adjustment expenses 12,351 9,152 25,268 19,241
Amortization of deferred policy acquisition
costs 4,225 3,739 8,431 7,397
Other underwriting expenses 1,187 1,670 2,364 3,459
------- ------- ------- -------
Total expenses 17,763 14,561 36,063 30,097
------- ------- ------- -------
Income before income taxes 2,809 1,958 3,130 3,088
Income tax provision 286 408 391 727
------- ------- ------- -------
Net income $ 2,523 $ 1,550 $ 2,739 $ 2,361
======= ======= ======= =======
Earnings per share:
Basic $ 1.20 $ .73 $ 1.30 $ 1.12
======= ======= ======= =======
Diluted $ 1.20 $ .73 $ 1.30 $ 1.11
======= ======= ======= =======
Weighted average shares outstanding:
Basic 2,110 2,114 2,110 2,113
Diluted 2,110 2,119 2,111 2,118
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,
2003 2004 2003 2004
---- ---- ---- ----
(unaudited)
Net income $ 2,523 $ 1,550 $ 2,739 $ 2,361
------- ------- ------- -------
Other comprehensive income (loss) before taxes:
Unrealized gains (losses) on securities 3,092 (5,853) 2,341 (4,069)
Reclassification adjustment
for gains included in net income (2,050) (93) (2,166) (470)
------- ------- ------- -------
Other comprehensive income (loss) before taxes 1,042 (5,946) 175 (4,539)
Income taxes (benefit) related to items
of other comprehensive income (loss) 394 (2,021) 59 (1,543)
------- ------- ------- -------
Other comprehensive income (loss) 648 (3,925) 116 (2,996)
------- ------- ------- -------
Comprehensive income (loss) $ 3,171 $(2,375) $ 2,855 $ (635)
======= ======= ======= =======
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,
2003 2004
---- ----
(unaudited)
Common stock:
Beginning of period $ 32 $ 32
Exercise of common stock options - 1
-------- --------
End of period 32 33
-------- --------
Additional paid in capital:
Beginning of period 35,795 35,795
Exercise of common stock options - 83
-------- --------
End of period 35,795 35,878
-------- --------
Treasury stock beginning and end: (22,766) (22,766)
-------- --------
Accumulated other comprehensive income (loss):
Beginning of period 1,937 750
Other comprehensive income (loss) 116 (2,996)
-------- --------
End of period 2,053 (2,246)
-------- --------
Accumulated earnings:
Beginning of period 52,926 56,448
Net income 2,739 2,361
Cash dividends (422) (420)
-------- --------
End of period 55,243 58,389
-------- --------
Total stockholders' equity $ 70,357 $ 69,288
======== ========
See Notes to the Consolidated Financial Statements
6
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands)
Six Months
Ended June 30,
2003 2004
---- ----
(unaudited)
Cash flows from operations:
Collection of premiums $ 29,790 $ 25,244
Payment of losses and loss adjustment expenses (26,678) (25,446)
Payment of other underwriting expenses (12,438) (11,271)
Investment income received 4,717 4,283
Investment expenses paid (144) (143)
Income taxes (paid) recovered 252 (376)
Other 157 263
-------- --------
Net cash used in operations (4,344) (7,446)
-------- --------
Cash flows from investing activities:
Proceeds from fixed maturities sold or matured 67,761 23,289
Purchase of fixed maturities (78,867) (21,259)
Net decrease in preferred stock 1,500 -
Net (increase) decrease in other long-term investments 1,990 (14)
Net (increase) decrease in short-term investments 984 (1,896)
Increase in payable for securities 4,612 8,382
Decrease in receivable for securities - 893
-------- --------
Net cash provided by investing activities (2,020) 9,395
-------- --------
Cash flows from financing activities:
Settlement of affiliate balances, net (4,905) (1,632)
Exercise of common stock options - 84
Increase in short-term borrowings 11,692 -
Cash dividends (422) (420)
-------- --------
Net cash provided (used) by financing activities 6,365 (1,968)
-------- --------
Increase (decrease) in cash 1 (19)
Cash:
Beginning of period 9 23
-------- --------
End of period $ 10 $ 4
======== ========
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,
2003 2004
---- ---
(unaudited)
Net income $ 2,739 $ 2,361
Adjustments:
Amortization (accretion), net (34) (9)
Realized investment gains (2,166) (470)
(Increase) decrease in assets:
Interest due and accrued 93 130
Premiums receivable (2,616) 389
Deferred policy acquisition costs 61 973
Reinsurance recoverable on paid and unpaid losses (1,002) 3,630
Prepaid reinsurance premiums 143 (1,636)
Income taxes receivable - 330
Deferred income taxes (375) 249
Other assets 225 816
Increase (decrease) in liabilities:
Reserve for losses and loss adjustment expenses 118 (10,297)
Unearned premiums (554) (2,070)
Other liabilities (976) (1,842)
-------- --------
Net cash used in operations $ (4,344) $ (7,446)
======== ========
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, 2004 and the related consolidated
statements of operations and comprehensive income for the three and six month
periods ended June 30, 2003 and 2004, and changes in stockholders' equity and
cash flows for the six month periods ended June 30, 2003 and 2004, 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, 2003.
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
The Company and MNH operate and manage their business in conjunction with
Merchants Mutual Insurance Company (Mutual), under a services agreement (the
Services Agreement) effective January 1, 2003. At June 30, 2004, Mutual owned
12.1% of the Company's issued and outstanding common stock. The Company and MNH
do not have any operating assets and MNH has only one employee. Under the
Services Agreement, Mutual provides the Company and MNH with the facilities,
management and personnel required to operate their day-to-day business. The
Services Agreement covers substantially the same services previously provided
under a management agreement amongst the Company, MNH and Mutual from 1986 to
2002. The Services Agreement provides for negotiated fees (subject to periodic
adjustment for administrative, underwriting, claims and investment managements
services).
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 under the heading "Administration" in Part I, Item 1, Business, in the
Company's Annual Report of Form 10-K for the year ended December 31, 2003.
8
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 average number of shares
outstanding was increased by the assumed exercise of options for each period.
The effect on the number of shares outstanding assumes 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 period. The number of options
assumed to be exercised and the incremental effect on average shares outstanding
for purposes of calculating diluted earnings per share are show below:
Three Months Six Months
Ended June 30, Ended June 30,
-------------- --------------
2003 2004 2003 2004
---- ---- ---- ----
Options assumed exercised - 31,500 35,500 31,500
Incremental shares outstanding - 5,260 704 5,043
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 property and casualty insurance companies. 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 month 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, 2004 As Compared to the
Six Months Ended June 30, 2003
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 Notes to
Consolidated Financial Statements contained in Item 1 of this Form 10-Q, which
is incorporated herein by reference.
Total revenues for the six months ended June 30, 2004 were $33,185,000, a
decrease of $6,008,000 or 15% from $39,193,000 for the six months ended June 30,
2003.
Results of operations for the six months ended June 30, 2004 and 2003 reflect
the effects of the Services Agreement and the Reinsurance Pooling Agreement
among 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 2004 in
accordance with the Reinsurance Pooling Agreement is 35%. MNH's share of pooled
premiums earned and losses and LAE was 40% in 2003. The Reinsurance Pooling
Agreement pertains to premiums earned and incurred losses and LAE. Direct
premiums written by MNH and Mutual are not pooled.
Total combined Mutual and MNH or "group-wide" direct premiums written (DWP) for
the six months ended June 30, 2004 were $97,367,000, an increase of $10,969,000
or 13% from $86,398,000 in 2003. The Company's pro-forma share of combined
direct premiums written in 2004, in accordance with the Reinsurance Pooling
Agreement, was $34,078,000 compared to $34,559,000 in 2003. The table below
shows a comparison of direct premiums written by major category in 2004 and
2003:
Group-wide DWP MNH Pro-forma Share
---------------- -------------------
Six months ended Six months ended
June 30, June 30,
-------- --------
2003 2004 Variance 2003 2004 Variance
---- ---- -------- ---- ---- --------
(000's omitted) (000's omitted)
Voluntary Personal Lines $31,452 $25,928 (18%) $12,581 $ 9,075 (28%)
Voluntary Commercial Lines 51,635 59,469 15% 20,654 20,814 1%
Umbrella Program - 10,138 - - 3,548 -
Involuntary 3,311 1,832 (45%) 1,324 641 (52%)
------- ------- ------- -------
Total Direct Written Premiums $86,398 $97,367 13% $34,559 $34,078 (1%)
======= ======= ======= =======
The 18% (or $5,524,000) decrease in group-wide voluntary personal lines direct
premiums written resulted from a 22% (or $5,158,000) decrease in private
passenger automobile (PPA) direct premiums written and a 4% (or $287,000)
decrease in homeowners direct premiums written. The decrease in PPA direct
premiums
11
written is the result of the companies' decision, implemented in 2002, not to
write new policies in certain jurisdictions and of the approval of the
companies' plan to withdraw from the New Jersey PPA market by the New Jersey
Department of Banking and Insurance, which was effective in June 2003. As a
result, voluntary PPA policies in force at June 30, 2004 were 24,370, a decrease
of 7,823, or 24%, from 32,193 at June 30, 2003.
Mutual introduced a monoline commercial umbrella program in the fourth quarter
of 2003 (the Umbrella Program). The Umbrella Program is marketed exclusively
through one independent agent and approximately 95% of the premiums related to
Umbrella Program Policies are reinsured with an "A+" rated national reinsurer
through a quota share reinsurance treaty. There were no similar direct premiums
written in the six months ended June 30, 2003 as the program was initiated
during the fourth quarter of 2003.
Group-wide voluntary commercial lines direct premiums written increased
$7,834,000, or 15%, to $59,469,000 for the six months ended June 30, 2004, from
$51,635,000 for the six months ended June 30, 2003. This increase resulted from
period to period increases in every group-wide commercial line of business. The
average premium per group-wide, non-Umbrella Program commercial lines policy
increased 9% from the year earlier period. Total non-Umbrella Program commercial
lines policies in force at June 30, 2004 were 31,907, substantially unchanged
from 31,629 at June 30, 2003.
The 45% decrease in group-wide involuntary written premiums resulted primarily
from a decrease in assignments from the New York Automobile Insurance Plan
(NYAIP). Direct premiums written related to policies assigned from the NYAIP
decreased to $1,325,000 for the six months ended June 30, 2004, compared to
$2,342,000 for the six months ended June 30, 2003. The NYAIP provides coverage
for individuals who are unable to obtain auto insurance in the voluntary market.
Assignments from the NYAIP vary depending upon a company's PPA market share and
the size of the NYAIP. The Company is unable to predict the volume of future
assignments from the NYAIP.
In order to minimize the adverse impact of assignments from the NYAIP, the
Company purchased territorial credits from an unaffiliated insurance company
pursuant to Section 6.A.7. of the NYAIP Manual. The credits against NYAIP
assignments were generated by the other insurance company for writing PPA
business in certain localities in New York with PPA market availability
problems. The other insurance company, by nature of its concentration in PPA
business in "credit" territories, generated more credits than it required to
offset its NYAIP assignments. The credits purchased reduced the Company's share
of the NYAIP. The credits purchased decreased direct premiums written related to
NYAIP assignments during the six months ended June 30, 2004 by approximately
$1,188,000 compared to approximately $584,000 for the six months ended June 30,
2003.
Group-wide pooled net premiums written for 2004 were $82,471,000, an increase of
$1,370,000, or 2% from $81,101,000 for the six months ended June 30, 2003. This
increase resulted from the 3% increase in non-Umbrella Program group-wide direct
premiums written. The Company's pro forma share of 2004 pooled net premiums
written was $24,726,000, a decrease of $7,218,000, or 23%, from $31,944,000 in
2003. The decrease in the Company's share of net premiums written resulted
primarily from the 5 percentage point decrease in the Company's participation in
the Reinsurance Pooling Agreement.
12
The Company's share of pooled net premiums earned in accordance with the
Reinsurance Pooling Agreement for the six months ended June 30, 2004 was
$28,433,000, compared to $32,356,000 for the six months ended June 30, 2003.
This $3,923,000, or 12%, decrease in net premiums earned resulted primarily from
the 5 percentage point decrease in the Company's participation in the
Reinsurance Pooling Agreement.
Net investment income was $4,019,000 for the six months ended June 30, 2004, a
decrease of 12% from $4,514,000 for the six months ended June 30, 2003. The
average pre-tax yield on the investment portfolio decreased 34 basis points to
4.3% for the six months ended June 30, 2004 reflecting the lower interest rate
environment. Average invested assets for the six months ended June 30, 2004 were
substantially unchanged from the year earlier period.
Net losses and LAE were $19,241,000 for the six months ended June 30, 2004, a
decrease of $6,027,000, or 24%, from $25,268,000 for the six months ended June
30, 2003. The decrease in net losses and LAE was due to the 12% decrease in net
premiums earned and a 10.4 percentage point decrease in the loss and LAE ratio
to 67.7% for the six months ended June 30, 2004 from 78.1% for the six months
ended June 30, 2003. Substantially all of the decrease in the loss and LAE ratio
related to an improvement in the loss and LAE ratio for the 2004 accident year
(losses occurring in the first half of 2004) compared to the 2003 accident year
(losses occurring in the first half of 2003).
Involuntary automobile insurance business increased the Company's calendar year
loss and LAE ratio by approximately .8 and 1.4 percentage points for the six
months ended June 30, 2004 and 2003, respectively. The combined ratio on
involuntary automobile business was greater than the combined ratio on voluntary
automobile business.
The ratio of amortized deferred policy acquisition costs and other underwriting
expenses to net premiums earned increased to 38.2% for the six months ended June
30, 2004 from 33.3% for the six months ended June 30, 2003. Other underwriting
expenses included $749,000 (2.6 percentage points of the expense ratio) of
retrospective commissions owed to Mutual pursuant to the Reinsurance Pooling
Agreement. The commissions owed to Mutual are based on a decrease during 2004 in
the estimated cumulative loss and LAE ratio on the "pooled" business since the
inception of the Reinsurance Pooling Agreement. During the first six months of
2003 the Company recorded $253,000 retrospective commission income related to
the Reinsurance Pooling Agreement. This amount reduced the 2003 ratio of
amortized deferred policy acquisition costs and other underwriting expenses to
net premiums earned by .8 percentage points. During 2004 the Company also
recorded as other underwriting expenses $227,000 of amortization related to the
purchase of NYAIP territorial credits (described above), compared to $48,000 of
such amortization in 2003. Commissions (other than retrospective commissions
under the Reinsurance Pooling Agreement), premium taxes and other state
assessments that vary directly with the Company's premium volume represented
19.2% of net premiums earned in the six month period ended June 30, 2004
compared to 19.6% of net premiums earned in the six months ended June 30, 2003.
The provision for income taxes for the six months ended June 30, 2003 included
the effect of a May 2003 change in New York State law governing the taxation of
property and casualty insurance companies. As a result of this change the
Company recorded a $505,000 one time benefit, net of federal income taxes, to
its
13
income tax provision during the six months ended June 30, 2003. This one time
benefit reduced the Company's effective income tax rate for the six months ended
June 30, 2003 by 16 percentage points.
Results of Operations for the Three Months Ended June 30, 2004 As Compared to
the Three Months Ended June 30, 2003
Total combined Mutual and MNH direct premiums written for the three months ended
June 30, 2004 were $52,265,000, an increase of $6,620,000 or 15% from
$45,645,000 for the three months ended June 30, 2003. The Company's share of
combined direct premiums written for the three months ended June 30, 2004, in
accordance with the Reinsurance Pooling Agreement was $18,292,000. The Company
recorded $18,258,000 of direct premiums written for the three months ended June
30, 2003. The table below shows a comparison of direct premiums written by major
category for the three months ended June 30, 2004 and 2003:
Group-wide DWP MNH Pro-Forma Share
-------------- ------------- -----
Three months ended Three months ended
June 30, June 30,
2003 2004 Variance 2003 2004 Variance
---- ---- -------- ---- ---- --------
(000's omitted)
Voluntary Personal Lines $16,240 $13,372 (18%) $ 6,496 $ 4,680 (28%)
Voluntary Commercial Lines 27,954 32,607 17% 11,182 11,412 2%
Umbrella Program - 5,339 - - 1,869 -
Involuntary 1,451 947 (35%) 580 331 (43%)
------- ------- ------- -------
Total Direct Written Premiums $45,645 $52,265 15% $18,258 $18,292 -
======= ======= ======= =======
The 18% (or $2,868,000) decrease in group-wide voluntary personal lines direct
premiums written resulted primarily from a 23% (or $2,716,000) decrease in PPA
direct premiums written. The decrease in PPA direct premiums written is
primarily the result of the group's decision, implemented in 2002 not to write
new PPA policies in certain jurisdictions and, the approval of the group's plan
to withdraw from the New Jersey PPA market by the New Jersey Department of
Banking and Insurance which was effective in June 2003 and provided for the
non-renewal of policies beginning in June 2004.
Group-wide voluntary commercial lines direct premiums written increased
$4,653,000, or 17%, to $32,607,000 for the three months ended June 30, 2004 from
$27,954,000 for the three months ended June 30, 2003. This increase resulted
from period to period increased in every group-wide commercial line of business.
The average premium per group-wide voluntary commercial lines policy increased
9% compared to the year earlier period. Total voluntary commercial lines
policies in force at June 30, 2004 increased 1% from June 30, 2003.
Umbrella Program direct premiums written relate to the monoline commercial
umbrella program introduced by Mutual in the fourth quarter of 2003 which was
discussed earlier in this Item. There were no similar direct premiums written in
the three months ended June 30, 2003.
Group-wide pooled net premiums written for the three months ended June 30, 2004
were $44,561,000, an increase of $1,818,000, or 4% from $42,743,000 for the
three months ended June 30, 2003. The Company's share of pooled net premiums
written in accordance with the Reinsurance Pooling Agreement
14
for the three months ended June 30, 2004 was $15,596,000 compared to $17,097,000
for the three months ended June 30, 2003.
Total revenues for the three months ended June 30, 2004 were $16,519,000, a
decrease of $4,053,000 or 20% from $20,572,000 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, 2004 was
$14,364,000 a decrease of $1,851,000 or 11% from $16,215,000 for the three
months ended June 30, 2003. The decrease in net premiums earned was a result of
the reduction in the Company's share of group-wide net premiums earned under the
Reinsurance Pooling Agreement from 40% in 2003 to 35% in 2004.
Net investment income was $1,965,000 for the three months ended June 30, 2004, a
decrease of 10% from $2,183,000 for the three months ended June 30, 2003. The
average pre-tax yield associated with the investment portfolio decreased 30
basis points to 4.2% for the three months ended June 30, 2004 reflecting the
lower interest rate environment Average invested assets for the three months
ended June 2004 decreased 1% compared to the year earlier period.
Net realized investment gains were $93,000 for the three months ended June 30,
2004 compared to $2,050,000 for the three months ended June 30, 2003. The 2003
amount related exclusively to the sale of an otherwise illiquid security to its
issuer through a share repurchase program.
Net losses and LAE, which include the Company's share of pooled 2004 accident
year losses, were $9,152,000 for the three months ended June 30, 2004, a
decrease of $3,199,000, or 26%, from $12,351,000 for the three months ended June
30, 2003. This decrease in net losses and LAE was due to the 11% decrease in net
premiums earned and a 12.5 percentage point decrease in the loss and LAE ratio
to 63.7% for the three months ended June 30, 2004 from 76.2% for the three
months ended June 30, 2003. The decrease in the loss and LAE ratio was due to
improvement in claims experience for the 2004 accident year compared to the 2003
accident year. The development in each quarter of losses related to prior
accident years' losses and LAE had only a minor impact on the loss and LAE ratio
for each quarter.
The ratio of amortized deferred policy acquisition costs and other underwriting
expenses to net premiums earned increased to 37.7% for the three months ended
June 30, 2004 from 33.4% for the three months ended June 30, 2003. Other
underwriting expenses included $405,000 (2.8 percentage points of the expense
ratio) of retrospective commissions related to the Reinsurance Pooling
Agreement. During the three months ended June 30, 2003, the Company recorded
$165,000 of reinsurance commission income related to the Reinsurance Pooling
Agreement which reduced the expense ratio for that period by .5 percentage
points. During the three months ended June 30, 2004, the Company also recorded
as other underwriting expenses $112,000 of amortization expense related to the
purchase of AIP territorial credits as compared to $41,000 of such expense
recorded in the three months ended June 30, 2003. 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 three months ended June 30, 2004
compared to 19.7% in the three months ended June 30, 2003.
15
The provision for income taxes for the three months ended June 30, 2003 included
the effect of a May 2003 change in New York State law governing the taxation of
property and casualty insurance companies. As a result of this change the
Company recorded a $505,000 one time benefit, net of federal income taxes, to
its income tax provision during the three months ended June 30, 2003. This one
time benefit reduced the Company's effective income tax rate by 18 percentage
points.
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. Due to declining
written premiums however, the Company's operating activities have resulted in a
use of cash each year since 2001. The Company's decreasing participation
percentage in the pooled business over the remaining years of the Reinsurance
Pooling Agreement will likely result in future 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 sales, if any, on the Company's stockholders' equity will not
be material. As a result, 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's objectives with respect to its investment portfolio include
maximizing total return within investment guidelines while protecting
policyholders' surplus and maintaining flexibility. The Company relies on
premiums as a major source of cash, and therefore liquidity. Cash flows from the
Company's investment portfolio, in the form of interest or principal payments as
well as from the maturity of fixed income investments, are an additional source
of liquidity.
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, 2004, the Company
recorded as accumulated other comprehensive income in its Consolidated Balance
Sheet $2,246,000 of unrealized losses, net of taxes, associated with its
investments classified as available for sale.
At June 30, 2004, the Company's portfolio of fixed maturity investments
represented 94.5% of invested assets. Management believes that this level of
fixed maturity investments is consistent with the Company's liquidity needs
because it anticipates that cash receipts from net premiums written, investment
income and maturing securities will enable the Company to satisfy its cash
obligations. Furthermore, a portion of the Company's fixed maturity investments
are invested in mortgage-backed and other asset-backed securities which, in
addition to interest income, provide monthly paydowns of bond principal.
At June 30, 2004 $113,898,000, or 57.3%, 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 a secondary market and their effect on the
Company's liquidity does not differ from that of other fixed maturity
investments.
16
At June 30, 2004 $1,302,000, or .6%, of the Company's investment portfolio was
invested in non-investment grade securities compared to $2,496,000, or 1%, at
December 31, 2003.
The Company has arranged for a $2,000,000 unsecured credit facility from a bank.
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, 2004 no amount was
outstanding on this loan.
As a holding company, the Company is dependent on cash dividends from MNH to
meet its obligations and to pay any cash dividends. 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
2004 without the prior approval of the New Hampshire Insurance Commissioner is
$5,767,000. MNH paid $1,200,000 of dividends to the Company in 2003. Dividend
payments of $600,000 were made in November 2003. On July 29, 2004 the Board of
Directors of MNH declared a $1,200,000 dividend to be paid to MGI on August 20,
2004. The Company paid cash dividends to its common stockholders of $.10 per
share in the first and second quarters of 2004 amounting to $420,000. On July
29, 2004 the Company declared a quarterly cash dividend of $.10 per share
payable on September 3, 2004 to shareholders of record as of the close of
business on August 18, 2004.
Under 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, commissions (including retrospective
commissions), 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 six months of 2004, MNH's ratio
of net premiums written to statutory surplus, annualized for a full year, was .8
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 Services
Agreement, Mutual provides the Company and MNH with all facilities and personnel
to operate their business. With the exception of the individual who serves as
President of the Company and as the Chief Operating Officer of MNH, the only
other officers of the Company or MNH are
17
employees of Mutual whose services are provided to, and paid for by, the Company
and MNH through the Services Agreement. Also, the operation of MNH'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.
"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 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 $198,707,000 at June 30, 2004 is subject to
changes in interest rates and to a lesser extent on credit quality. Further,
certain mortgage-backed and asset-backed securities are exposed to accelerated
prepayment risk generally caused by interest rate movements. If interest rates
were to decline, mortgage holders would be more likely to refinance existing
mortgages at lower rates. Acceleration of future repayments could adversely
affect future investment income, if reinvestment of the accelerated receipts was
made in lower yielding securities.
The following table provides information related to the Company's fixed maturity
investments at June 30, 2004. The table presents cash flows of principal amounts
and related weighted average interest rates by expected maturity dates. The cash
flows are based upon the maturity date or, in the case of mortgage-
18
backed and asset-backed securities, expected payment patterns. Actual cash flows
could differ from those shown in the table.
Fixed Maturities
Expected Cash Flows of Principal Amounts ($ in 000's):
TOTAL
-----
Esti-
Amor- mated
There- tized Market
2004 2005 2006 2007 2008 after Cost Value
---- ---- ---- ---- ---- ----- ---- -----
Available for Sale
U.S. Treasury securities and
obligations of U.S.
Government corporations
and agencies $ 0 $ 2,035 $ 0 $ 0 $ 3,007 $ 0 $ 5,042 $ 5,040
Average interest rate 0.0% 4.4% 0.0% 0.0% 3.2% 0.0% --- ---
Obligations of states and
political subdivisions 1,403 7,272 9,599 3,885 15,213 5,005 42,377 41,883
Average interest rate 4.1% 3.1% 3.4% 4.3% 3.9% 4.2% --- ---
Corporate securities 0 18,599 997 0 3,238 4,016 26,850 26,992
Average interest rate 5.4% 4.3% 3.2% 0.0% 3.7% 4.8% --- ---
Mortgage & asset
backed securities 10,485 24,746 24,786 18,132 6,818 31,505 116,472 113,898
Average interest rate 5.0% 5.0% 5.0% 5.0% 5.1% 5.2% --- ---
-------- -------- -------- -------- -------- -------- -------- --------
Total $ 11,888 $ 52,652 $ 35,382 $ 22,017 $ 28,276 $ 40,526 $190,741 $187,813
======== ======== ======== ======== ======== ======== ======== ========
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 the end of the period covered by this report,
concluded that 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.
There was no change in the Company's internal control over financial
reporting identified in connection with the evaluation required by paragraph (d)
of Rules 13a-15 or 15d-15 under the Securities Exchange Act of 1934 that
occurred during the Company's last fiscal quarter that has materially affected,
or is reasonably likely to materially affect, the Company's internal control
over financial reporting.
19
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) 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).
20
(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) 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).
(e) Endorsement to the Casualty Excess of Loss Reinsurance
agreement between Merchants Mutual Insurance Company,
Merchants Insurance Company of New Hampshire, Inc. and
American Reinsurance Company dated September 29, 2003
(incorporated by reference to Exhibit 10 (f) to the Company's
2003 Quarterly Report on Form 10-Q filed on November 13,
2003).
(f) Property Per Risk 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(g) to the
Company's 2002 Annual Report on Form 10-K filed on March 31,
2002).
(g) Endorsement to the Property Per Risk Excess of Loss
Reinsurance Agreement between Merchants Mutual Insurance
Company, Merchants Insurance Company of New Hampshire, Inc.
and American Reinsurance Company dated September 24, 2003
(incorporated by reference to Exhibit 10(h) to the Company's
2003 Quarterly Report on Form 10-Q filed on November 13,
2003).
(h) Property Catastrophe Excess of Loss Reinsurance Agreement
between Merchants Mutual Insurance Company, Merchants
Insurance Company of New Hampshire, Inc. and the various
reinsurers as identified by the Interest and Liabilities
Agreements attaching to and forming part of this Agreement
(incorporated by reference to Exhibit 10(g) to the Company's
2003 Quarterly Report on Form 10-Q filed on November 13,
2003).
(i) 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).
(j) 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).
21
(k) 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).
*(l) 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
Amendment No. 1 to the Company's Registration Statement on
(No. 33-9188) Form S-1 filed on November 7, 1986).
*(m) 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).
*(n) 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).
*(o) 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).
*(p) 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).
*(q) 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.
*(r) 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 27,
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.
22
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.
31 Rule 13a-14(a)/15d-14(a) Certifications (filed herewith)
32(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.
On July 29, 2004, the Company filed a Form 8-K reporting the issuance of a press
release announcing results for the quarter ended June 30, 2004 and the
declaration of the Company's regular quarterly common stock dividend.
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 9, 2004 By: /s/ Kenneth J. Wilson
---------------------
Kenneth J. Wilson
Chief Financial Officer and
Treasurer (duly authorized
officer of the registrant and
chief accounting officer)
23