SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

 

FORM 10-Q

 

 

No. 000-25425

(Commission File Number)

 

MERCER INSURANCE GROUP, INC.

(Exact name of Registrant as specified in its charter)

 

 

(609) 737-0426

(Registrant’s telephone number, including area code)

 

(Former name, former address and former fiscal year,

if changed since last report)

 

Check whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

Yes  ý    No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

 

Yes  o    NO  ý

 

State the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

 

 

TABLE OF CONTENTS

 

Part I. Financial Information
		Item 1. Financial Statements.
		Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
		Item 3. Quantitative and Qualitative Disclosures About Market Risk.
		Item 4. Control and Procedures.
Part II. Other Information
		Item 1. Legal Proceedings.
		Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities.
		Item 3. Defaults upon Senior Securities.
		Item 4. Submission of Matters to a Vote of Security Holders.
		Item 5. Other Information.
		Item 6. Exhibits and Reports on Form 8-K.
Signatures
Certification  of Chief Executive Officer pursuant to section 302
Certification of Chief Financial Officer pursuant to section 302
Certification of CEO and CFO pursuant to section 906

 

2

 

Forward-looking Statements

 

Mercer Insurance Group, Inc. (the “Company”) may from time to time make written or oral “forward-looking statements,” including statements contained in the Company’s filings with the Securities and Exchange Commission (including this Quarterly Report on Form 10-Q and the exhibits hereto and thereto), in its reports to shareholders and in other communications by the Company, which are made in good faith by the Company pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995.

 

These forward-looking statements include statements with respect to the Company’s beliefs, plans, objectives, goals, expectations, anticipations, estimates and intentions, that are subject to significant risks and uncertainties, and are subject to change based on various factors (some of which are beyond the Company’s control).  The words “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan” and similar expressions are intended to identify forward-looking statements.  The following factors, among others, could cause the Company’s financial performance to differ materially from the plans, objectives, expectations, estimates and intentions expressed in such forward-looking statements:

 

•                  future economic conditions in the regional and national markets in which the Company competes which are less favorable than expected;

 

•                  the effects of weather-related and other catastrophic events;

 

•                  the concentration of insured accounts in New Jersey and Pennsylvania;

 

•                  the effect of legislative, judicial, economic, demographic and regulatory events in the two states in which we do business;

 

•                  the continuation of an A.M. Best rating in the Excellent category;

 

•                  the ability to enter new markets successfully and capitalize on growth opportunities either through acquisitions or the expansion of our producer network;

 

•                  financial market conditions, including, but not limited to, changes in interest rates and the stock markets causing a reduction of investment income or investment gains, an acceleration of the amortization of deferred policy acquisition costs, reduction in the value of our investment portfolio or a reduction in the demand for our products;

 

•                  the impact of acts of terrorism and acts of war;

 

•                  the effects of terrorist related insurance legislation and laws;

 

•                  inflation;

 

•                  the cost, availability and collectibility of reinsurance;

 

•                  estimates and adequacy of loss reserves and trends in losses and loss adjustment expenses;

 

•                  heightened competition, including specifically the intensification of price competition, the entry of new competitors and the development of new products by new and existing competitors;

 

•                  changes in the coverage terms selected by insurance customers, including higher deductibles and lower limits;

 

•                  our inability to obtain regulatory approval of, or to implement, premium rate increases;

 

•                  the potential impact on our reported net income that could result from the adoption of future accounting standards issued by the Financial Accounting Standards Board or other standard-setting bodies;

 

•                  inability to carry out marketing and sales plans, including, among others, development of new products or changes to existing products and acceptance of the new or revised products in the market;

 

•                  unanticipated changes in industry trends and ratings assigned by nationally recognized rating organizations;

 

•                  adverse litigation or arbitration results;

 

•                  the ability to carry out our business plans; and

 

•                  adverse changes in applicable laws, regulations or rules governing insurance holding companies and insurance companies, and environmental, tax or accounting matters including limitations on premium levels, increases in minimum capital and reserves, and other financial viability requirements, and changes that affect the cost of, or demand for our products.

 

The Company cautions that the foregoing list of important factors is not exclusive.  Readers are also cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date of this report.  The Company does not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of the Company.

 

3

 

Part I – FINANCIAL INFORMATION

 

Item 1 – Financial Statements

 

MERCER INSURANCE GROUP, Inc. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED BALANCE SHEETS

As of March 31, 2004 and December 31, 2003

 

 

		As of March 31, 2004			As of December 31, 2003
		(Dollars in thousands)
		(Unaudited)
ASSETS
Investments, at fair value:
Fixed income securities, available-for-sale, at fair  value (Amortized cost of $91,001 and $46,282,  respectively)		$	91,472		$	46,277
Equity securities, at fair value (cost of $15,425  and $15,866, respectively)		22,907			22,656
Short-term investments, at amortized cost, which  approximates fair value		—			54,396
Total investments		114,379			123,329
Cash and cash equivalents		28,028			15,350
Premiums receivable		7,892			9,096
Reinsurance receivables		5,191			4,159
Prepaid reinsurance premiums		1,499			1,614
Deferred policy acquisition costs		7,062			7,387
Accrued investment income		699			596
Property and equipment, net		8,002			6,944
Goodwill		4,673			4,673
Other assets		2,917			2,727
Total assets		$	180,342		$	175,875
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Losses and loss adjustment expenses		$	38,440		$	37,261
Unearned premiums		29,271			30,329
Accounts payable and accrued expenses		11,303			7,937
Other reinsurance balances		9			81
Other liabilities		932			1,228
Deferred income taxes		854			713
Total liabilities		80,809			77,549
Stockholders’ Equity:
Preferred stock, no par value, authorized 5,000,000  shares, no shares issued and outstanding		—			—
Common stock, no par value, authorized 15,000,000  Shares, issued 6,845,733 shares, outstanding  6,297,800 and 6,282,233 shares		—			—
Additional paid-in capital		64,922			64,871
Accumulated other comprehensive income:
Unrealized gains in investments, net of deferred  income taxes		5,249			4,478
Retained Earnings		34,841			34,612
Unearned ESOP shares		(5,479		)	(5,635		)
Total stockholders’equity		99,533			98,326
Total liabilities and stockholders’ equity		$	180,342		$	175,875

 

See accompanying notes to condensed consolidated financial statements.

 

4

 

MERCER INSURANCE GROUP, Inc. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS

Three Months Ended March 31, 2004 and 2003

 

		2004			2003
		(Dollars in thousands, except shares and per share data)
		(Unaudited)
Revenue:
Net premiums earned		$	13,862		$	11,056
Investment income, net of expenses		668			427
Net realized investment gains (losses)		(97		)	149
Other revenue		92			80
Total revenue		14,525			11,712
Expenses:
Losses and loss adjustment expenses		8,323			6,514
Amortization of deferred policy acquisition costs (related  party amounts of $317 and $285, respectively)		3,863			2,973
Other expenses		2,070			1,849
Stock conversion expenses		—			12
Total expenses		14,256			11,348
Income before income taxes and minority interest in income of subsidiary		269			364
Income taxes		40			88
Income before minority interest in income of subsidiary		229			276
Minority interest in income of subsidiary		—			(43		)
Net income		$	229		$	233
Earnings per common share:
Basic		$	0.04		N/A
Diluted		$	0.04		N/A
Weighted average shares, basic and diluted		6,290,102			N/A

 

See accompanying notes to condensed consolidated financial statements.

 

5

 

MERCER INSURANCE GROUP, Inc. AND SUBSIDIARIES

 

Consolidated Statement of Stockholders’  Equity

 

Three months ended March 31, 2004

 

(Unaudited, dollars in thousands)

 

		Preferred stock			Common stock		Additional paid-in capital		Accumulated other comprehensive income		Retained Earnings		Unearned ESOP Shares		Total
Balance, December 31, 2003		$	—		—		64,871		4,478		34,612		(5,635	)	98,326
Net income											229				229
Unrealized gains on securities:
Unrealized holding gains arising during period, net of related income tax expense of $364									707						707
Less reclassification adjustment for losses included in net income, net of related income tax benefit of $33									64						64
Other comprehensive income															771
Comprehensive income															1,000
ESOP shares committed							51						156		207
Balance, March 31, 2004		$	—		—		64,922		5,249		34,841		(5,479	)	99,533

 

See accompanying notes to condensed consolidated financial statements.

 

6

 

MERCER INSURANCE GROUP, Inc. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Three Months Ended March 31, 2004 and 2003

 

		March 31,
		2004			2003
		(Dollars in thousands)
		(Unaudited)
Cash flows from operating activities:
Net income		$	229		$	233
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization of fixed assets		343			325
Net accretion of discount		(199		)	(24		)
ESOP share commitment		207			—
Net realized investment (gains) losses		97			(149		)
Deferred income tax		(256		)	(50		)
Change in assets and liabilities:
Premiums receivable		1,204			(153		)
Reinsurance receivables		(1,032		)	(271		)
Prepaid reinsurance premiums		115			69
Deferred policy acquisition costs		325			(22		)
Other assets		(293		)	(221		)
Losses and loss expenses		1,179			1,572
Unearned premiums		(1,058		)	134
Other		2,998			(3,052		)
Net cash provided by (used in) operating activities		3,859			(1,609		)
Cash flows from investing activities:
Purchase of fixed income securities, available-for- sale		(63,673		)	(6,220		)
Purchase of equity securities		(204		)	(879		)
Sale and maturity of fixed income securities available-for-sale		19,045			10,252
Sale of equity securities		656			2,297
Sale of short-term investments, net		54,396			—
Purchase of property and equipment		(1,401		)	(639		)
Net cash provided by investing activities		8,819			4,811
Net increase in cash and cash equivalents		12,678			3,202
Cash and cash equivalents at beginning of period		15,350			7,201
Cash and cash equivalents at end of period		$	28,028		$	10,403
Cash paid during the period for:
Interest		$	10		$	7
Income taxes		$	—		$	—

 

See accompanying notes to condensed consolidated financial statements.

 

7

 

MERCER INSURANCE GROUP, Inc. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands)

(Unaudited)

 

(1)  Basis of Presentation

 

The financial information for the interim periods included herein is unaudited; however, such information reflects all adjustments which are, in the opinion of management, necessary to a fair presentation of the financial position, results of operations, and cash flows for the interim periods. The results of operations for interim periods are not necessarily indicative of results to be expected for the full year.

 

These financial statements should be read in conjunction with the financial statements and notes for the year ended December 31, 2003 included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission.

 

8

 

(2)  Segment Information

 

The Company manages its business in three segments: commercial lines insurance, personal lines insurance, and investments. The commercial lines insurance and personal lines insurance segments are managed based on underwriting results determined in accordance with accounting principles generally accepted in the United States of America, and the investment segment is managed based on after-tax investment returns.

 

Underwriting results for commercial lines and personal lines take into account premiums earned, incurred losses and loss adjustment expenses, and underwriting expenses. The investments segment is evaluated by consideration of net investment income (investment income less investment expenses), and realized gains and losses.

 

In determining the results of each segment, assets are not allocated to segments and are reviewed in the aggregate for decision-making purposes.

 

Financial data by segment is as follows for the three months ended March 31, 2004 and 2003:

 

		Three Months Ended March 31,
		2004			2003
Revenues:
Net premiums earned:
Commercial lines		$	8,025		$	5,736
Personal lines		5,837			5,320
Total net premiums earned		13,862			11,056
Net investment income		668			427
Realized investment gains (losses)		(97		)	149
Other		92			80
Total revenues		14,525			11,712
Income before income taxes:
Underwriting income (loss):
Commercial lines		2,242			1,076
Personal lines		(2,636		)	(1,356		)
Total underwriting loss		(394		)	(280		)
Net investment income		668			427
Realized investment gains (losses)		(97		)	149
Other		92			68
Income before income taxes and minority interest in income of subsidiary		$	269		$	364

 

9

 

(3) Reinsurance

 

Premiums earned are net of amounts ceded of $2,019 and $2,101 for the three months ended March 31, 2004 and 2003, respectively. Losses and loss adjustment expenses are net of amounts ceded of $683 and $602 for the three months ended March 31, 2004 and 2003.

 

(4) Comprehensive Income

 

The Company’s comprehensive income for the three month period ended March 31, 2004 and 2003 is as follows:

 

 

 

 

		Three Months ended March 31
		2004			2003
Net income		$	229		$	233
Other comprehensive income (loss), net of tax:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising during period, net of related income tax expense (benefit) of $364, and $(146)		707			(283		)
Less reclassification adjustment for (gains) losses included in net income, net of related income tax benefit (expense) of $33 and $(51)		64			(98		)
		771			(381		)
Comprehensive Income		$	1,000		$	(148	)

 

Item 2

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

 

The following presents management’s discussion and analysis of our financial condition and results of operations as of the dates and for the periods indicated. You should read this discussion in conjunction with the condensed consolidated financial statements and notes thereto included in this report. This discussion contains forward-looking information that involves risks and uncertainties. Actual results could differ significantly from these forward-looking statements. See “Forward-Looking Statements”.

 

Overview

 

THE CONVERSION TRANSACTION AND THE HOLDING COMPANY

 

Mercer Insurance Group, Inc. (the “Company” or the “Holding Company”) is a holding company owning all of the outstanding shares of Mercer Insurance Company, the company resulting from the conversion of Mercer Mutual Insurance Company from the mutual to the stock form of organization on December 15,

 

10

 

2003 (the “Conversion”). Prior to the Conversion, and since 1844, Mercer Mutual Insurance Company was engaged in the business of selling property and casualty insurance.

 

The Company had no activity prior to the Conversion, and was formed for the purpose of owning all of the stock of the Mercer Mutual Insurance Company after the Conversion. At the time of the Conversion, 6,845,733 shares of Mercer Insurance Group, Inc. were issued (including 502,525 shares issued immediately after the Conversion to acquire the remaining 51% of common stock as well as all manditorily redeemable preferred stock of Franklin Holding Company, Inc., of which Mercer Mutual Insurance Company had acquired 49% for cash in 2001) with net cash proceeds of approximately $53 million received by the Company in exchange for the shares (approximately $27 million was contributed to the capital of Mercer Insurance Company after the Conversion). Also included in the total shares are 626,111 shares issued in the Conversion to the Mercer Insurance Group, Inc. Employee Stock Ownership Plan, (the “ESOP”) as to which no cash proceeds were received because the ESOP funded the purchase of these shares with a loan from the Company.  The shares held by the ESOP will be allocated to participant accounts evenly over a ten-year period. The first annual allocation occurred in December, 2003, in the amount of 62,611 shares, and an additional 15,567 shares were committed in the first quarter of 2004.

 

Our Business

 

The Company and its subsidiaries underwrite property and casualty insurance in New Jersey and Pennsylvania. Our consolidated operating insurance company subsidiaries are:

 

•                  Mercer Insurance Company, a Pennsylvania property and casualty stock insurance company offering insurance coverage to businesses and individuals in New Jersey and Pennsylvania,

•                  Mercer Insurance Company of New Jersey, Inc., a New Jersey property and casualty stock insurance company that currently offers only workers’ compensation insurance to businesses located in New Jersey; and

•                  Franklin Insurance Company, a property and casualty stock insurance company offering private passenger automobile and homeowners insurance to individuals located in Pennsylvania.

 

The Holding Company is subject to regulation by the Pennsylvania Insurance Department and the New Jersey Department of Banking and Insurance as its primary regulators because it is the holding company for Mercer Insurance Company, and, indirectly, Mercer Insurance Company of New Jersey, Inc. and its holding company, Queenstown Holding Company, Inc., and Franklin Holding Company, Inc. and its subsidiary, Franklin Insurance Company.

 

We manage our business and report our operating results in three operating segments: commercial lines insurance, personal lines insurance and the investment function. See Note 2 of the notes to our condensed consolidated financial statements included in this report. However, assets are not allocated to segments and are reviewed in the aggregate for decision-making purposes. Our commercial lines insurance business consists primarily of multi-peril and general liability and related coverages. Our personal lines insurance business consists primarily of homeowners and private passenger automobile insurance coverages. We market both the commercial and personal insurance lines through independent producers.

 

11

 

Our income is principally derived from insurance premiums received from insureds in the commercial lines (businesses insured) and personal lines (individuals insured) segments, less the costs of underwriting the insurance policies, the costs of settling and paying claims reported on the policies, and from investment income reduced by investment expenses and gains or losses on holdings in our investment portfolio. Variability in our income is caused by a variety of circumstances, some within the control of our companies and some not within their control. Premium volume is affected by, among other things, the availability of quality, properly-priced underwriting risks being produced by our agents, the ability to retain on renewal existing good-performing accounts, competition from other insurance companies, regulatory rate approvals, our reputation, and other limitations created by the marketplace or regulators. Our underwriting costs are affected by, among other things, the amount of commission and profit-sharing we pay our agents to produce the underwriting risks we receive premiums for, the cost of issuing insurance policies and maintaining our customer and agent relationships, marketing costs, taxes we pay to the states we operate in on the amount of premium we collect, and other assessments and charges imposed on our companies by the regulators in the states in which we do business. Our claim and claim settlement costs are affected by, among other things, the quality of our underwriting accounts, severe weather in our operating region, the nature of the claim, the regulatory and legal environment in our territories, inflation in underlying medical and property repair costs, and the availability and cost of reinsurance. Our investment income and realized gains and losses are determined by, among other things, market forces, the rates of interest and dividends paid on our investment portfolio holdings, the credit or investment quality of the issuer and the success of its underlying business, the market perception of the company invested in, and other factors such as ratings by rating agencies and analysts.

 

Critical Accounting Policies

 

General.  We are required to make estimates and assumptions in certain circumstances that affect amounts reported in our consolidated financial statements and related footnotes. We evaluate these estimates and assumptions on an on-going basis based on historical developments, market conditions, industry trends and other information that we believe to be reasonable under the circumstances. There can be no assurance that actual results will conform to our estimates and assumptions, and that reported results of operations will not be materially adversely affected by the need to make accounting adjustments to reflect changes in these estimates and assumptions from time to time. We believe the following policies are the most sensitive to estimates and judgments.

 

Liabilities for Loss and Loss Adjustment Expenses.  The liability for losses and loss adjustment expenses represents estimates of the ultimate unpaid cost of all losses incurred, including losses for claims that have not yet been reported to our insurance companies. The amount of loss reserves for reported claims is based primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss. The amounts of loss reserves for unreported claims and loss adjustment expenses are determined using historical information by line of insurance as adjusted to current conditions. Inflation is implicitly provided for in the reserving function through analysis of costs, trends and reviews of historical reserving results over multiple years.

 

12

 

Reserves are closely monitored and are recomputed periodically using the most recent information on reported claims and a variety of statistical techniques. Specifically, on a quarterly basis, we review, by line of business, existing reserves, new claims, changes to existing case reserves, and paid losses with respect to the current and prior accident years. We use historical paid and incurred losses and accident year data to derive expected ultimate loss and loss adjustment expense ratios by line of business. We then apply these expected loss and loss adjustment expense ratios to in-force business to derive a reserve level for each line of business. This amount, together with reserves required by new reported claims and changes to existing case reserves, is compared to existing reserves to establish the adjustment to reserves that is required. In connection with the determination of the reserves, we also consider other specific factors such as recent weather-related losses, trends in historical paid losses, and legal and judicial trends with respect to theories of liability. Because of the nature of our business, which generally provides coverage for short-term risks, loss development is comparatively rapid and historical paid losses have been a reliable predictive measure of future losses.

 

Nevertheless, reserves are estimates because there are uncertainties inherent in the determination of ultimate losses. Court decisions, regulatory changes and economic conditions can affect the ultimate cost of claims that occurred in the past as well as create uncertainties regarding future loss cost trends. Accordingly, the ultimate liability for unpaid losses and loss settlement expenses will likely differ from the amount recorded at March 31, 2004. Changes in estimates or differences between estimates and amounts ultimately paid are reflected in current operations. Loss reserving techniques and assumptions have been consistently applied during the periods presented.

 

The table below summarizes the effect on net loss reserves and equity in the event of reasonably likely changes in the variables considered in establishing loss and loss adjustment expense reserves. The range of reasonably likely changes was established based on a review of changes in accident year development by line of business and applied to loss reserves as a whole. The selected range of changes does not indicate what could be the potential best or worst case or likely scenarios:

 

Change in Loss and Loss Adjustment Reserves Net of Reinsurance		Adjusted Loss and Loss Adjustment Reserves Net of Reinsurance as of March 31, 2004		Percentage Change in Stockholders’ Equity as of March 31, 2004(1)		Adjusted Loss and Loss Adjustment Reserves Net of Reinsurance as of December 31, 2003			Percentage Change in Stockholders’ Equity as of December 31, 2003(1)
(Dollars in thousands)
–10.0%		30,814		2.3	%	$	29,003		2.2	%
–7.5%		31,670		1.7	%	29,808			1.6	%
–5.0%		32,526		1.1	%	30,614			1.1	%
–2.5%		33,382		0.6	%	31,419			0.5	%
Base		34,238		—		32,225			—
2.5%		35,094		-0.6	%	33,031			–0.5	%
5.0%		35,950		-1.1	%	33,836			–1.1	%
7.5%		36,806		-1.7	%	34,642			–1.6	%
10.0%		37,662		-2.3	%	35,448			–2.2	%

 

13

 

(1)                                  Net of Tax

 

The property and casualty industry has incurred substantial aggregate losses from claims related to asbestos-related illnesses, environmental remediation, product and construction defect liability, mold, and other uncertain exposures. We have not experienced significant losses from these types of claims.

 

The table below summarizes loss and loss adjustment reserves by major line of business:

 

		March 31, 2004			December 31, 2003
		(Dollars In thousands)
Commercial lines:
Commercial multi-peril		$	6,152		$	6,998
Other liability		8,713			8,708
Workers’ compensation		4,698			4,684
Commercial automobile		2,082			2,251
Fire, allied, inland marine		97			242
		21,742			22,883
Personal lines:
Homeowners		11,472			9,509
Personal automobile		3,220			3,073
Fire, allied, inland marine		394			328
Other liability		1,524			1,400
Workers’ compensation		88			68
		16,698			14,378
Total		$	38,440		$	37,261

 

Investments.  Unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in stockholders’’ equity as a component of comprehensive income and, accordingly, have no effect on net income. A decline in fair value of an investment below its cost that is deemed other than temporary is charged to earnings as a realized loss. We monitor our investment portfolio and review investments that have experienced a decline in fair value below cost to evaluate whether the decline is other than temporary. These evaluations involve judgment and consider the magnitude and reasons for a decline and the prospects for the fair value to recover in the near term. For the three months ended March 31, 2004 and 2003, we did not have any investments in our portfolio with a decline in value determined to be other than temporary. Adverse investment market conditions, or poor operating results of underlying investments, could result in impairment charges in the future.

 

We generally apply the following standards in determining whether the decline in fair value of an investment is other than temporary:

 

Equities – If an equity security has a fair value below 50% of cost or remains below 80% of cost for more than three months, a review of the financial condition and prospects of the company is performed by the Investment Committee of the Board of Directors to determine if the decline in fair value is other than temporary. A specific determination is made for any

 

14

 

such security. Other equity securities in an unrealized loss position not meeting these quantitative thresholds are evaluated considering, among other things, the magnitude and reasons for the decline and the prospects for the fair value of the securities to recover in the near term. If it is determined that the decline in fair value is judged to be “other than temporary” then the cost basis of the security is written down to “realizable value” and the amount of the write down accounted for as a realized loss. “Realizable value” is defined as the quoted market price of the security. Write-down to a value other than the market price requires objective evidence in support of that value.

 

We have one significant non-traded equity security, a non-voting common stock in Excess Reinsurance Company, which is carried at $1.2 million. Its fair value is estimated at the statutory book value as reported to the National Association of Insurance Commissioners (NAIC). Other non-traded securities, which are not material in the aggregate, are carried at cost.

 

Fixed Income Securities – A fixed maturity security generally is written down if we are unable to hold it or otherwise intend to sell a security with an unrealized loss, or if it is probable that we will be unable to collect all amounts due according to the contract terms of a debt security not impaired at acquisition.

 

A fixed maturity security review for collectibility is done if any of the following situations occur:

 

•             A review of the financial condition and prospects of the company performed by the Investment Committee indicates that the security should be evaluated.

 

•             Moody’s or Standard & Poors rate the security below investment grade.

 

•             The security has a fair value below 70% of amortized cost at quarter end due to deterioration in credit quality.

 

Policy Acquisition Costs.  We defer policy acquisition costs, such as commissions, premium taxes and certain other underwriting expenses that vary with and are directly related to the production of business. These costs are amortized over the effective period of the related insurance policies. The method followed in computing deferred policy acquisition costs limits the amount of deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, loss and loss adjustment expenses, and certain other costs expected to be incurred as the premium is earned. Future changes in estimates, the most significant of which is expected loss and loss adjustment expenses, may require acceleration of the amortization of deferred policy acquisition costs.

 

Reinsurance.  Amounts recoverable from property and casualty reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Amounts paid for reinsurance contracts are expensed over the contract period during which insured events are covered by the reinsurance contracts.

 

Ceded unearned premiums and reinsurance balances recoverable on paid and unpaid loss and loss adjustment expenses are reported separately as assets,

 

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instead of being netted with the appropriate liabilities, because reinsurance does not relieve us of our legal liability to our policyholders. Reinsurance balances recoverable are subject to credit risk associated with the particular reinsurer. Additionally, the same uncertainties associated with estimating unpaid loss and loss adjustment expenses affect the estimates for the ceded portion of these liabilities.

 

We continually monitor the financial condition of our reinsurers.

 

Income Taxes.  We use the asset and liability method of accounting for income taxes. Deferred income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax bases of our assets and liabilities. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. The effect of a change in tax rates is recognized in the period of the enactment date.

 

Results of Operations

 

Our results of operations are influenced by factors affecting the property and casualty insurance industry in general. The operating results of the United States property and casualty insurance industry are subject to significant variations due to competition, weather, catastrophic events, regulation, general economic conditions, judicial trends, fluctuations in interest rates and other changes in the investment environment.

 

Our growth in premiums and underwriting results have been, and continue to be, influenced by market conditions. Pricing in the property and casualty insurance industry historically has been cyclical. During a soft market cycle, price competition is prevalent and makes it difficult to write and retain properly priced personal and commercial lines business. Our policy is to maintain our disciplined underwriting and pricing standards during soft markets, even at the expense of premium growth. The insurance industry is currently experiencing a hard market cycle during which price competition is less significant than during a soft market cycle. The hard market cycle allowing higher premium rates has been ongoing now for more than three years, and some pricing competition is re-appearing in the market, particularly in lines of business which are predominantly property exposures. The cyclicality of the market is difficult to anticipate, and while pricing competitiveness has recently become more apparent in the market, today’s pricing remains generally consistent with a continuing hard market.

 

Three months Ended March 31, 2004 Compared to three months Ended March 31, 2003

 

For the three months ended March 31, 2004, the Company had net income of $229,000 compared to $233,000 for the same period in 2003. Although the underwriting gain from our commercial lines segment for 2004 increased to $2.2 million from the prior year amount of $1.1 million, our personal lines segment incurred an underwriting loss of $2.6 million in 2004, an increase from the loss of $1.4 million in the prior comparable period. In our investment segment, net investment income increased 56% in 2004 to $668,000 from $427,000, and realized losses for 2004 were $97,000, as compared to a net realized gain of $149,000 for 2003.

 

Total revenues for the first quarter of 2004 were $14.5 million, which was 24% greater than 2003 revenues of $11.7 million. This increase was due

 

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primarily to a $2.8 million increase in net premiums earned in 2004, and to an increase in net investment income of $241,000 as compared to 2003, offset by a realized investment loss of $97,000 in 2004 as compared to a realized investment gain of $149,000 in 2003.

 

Direct premiums written increased 10% to $14.3 million in 2004 when compared to 2003, and consisted of $8.6 million of commercial lines premiums, a 17% increase, and $5.7 million of personal lines premiums, a 1% increase. Net premiums earned increased by 25% to $13.9 million for 2004 as compared to $11.1 million for the prior year. Commercial lines net premiums earned increased 40% to $8.0 million in 2004, and personal lines net premiums earned increased 10% to $5.8 million in 2004. The overall increases in direct premiums written and net premiums earned are generally attributable to firmer pricing and continued strong growth, particularly in our commercial lines business.

 

Consistent with our goal of increasing commercial business, we increased direct commercial multi-peril premiums written, the largest component of our commercial lines segment, by 18% to $4.3 million in 2004, compared to $3.6 million for 2003, and increased commercial multi-peril net premiums earned by 41% to $4.0 million in 2004, as compared to $2.8 million for 2003. We expect this trend of increasing commercial writings to continue by targeting certain types of risks with selected producers.

 

For the same comparative periods, net premiums earned for our homeowners insurance, the largest component of our personal lines segment, increased 10% to $3.4 million for 2004, compared to $3.1 million for 2003, while homeowners direct premiums written increased 2% to $3.1 million in 2004 from $3.0 million in 2003. The growth rate for homeowners insurance primarily reflects the reclassification of certain homeowners risks from our preferred program to our standard program, resulting in a higher premium, as part of a general review of the homeowners program which is substantially complete. Premiums are higher for the standard program compared to the preferred program.

 

Personal automobile direct written premiums, written exclusively in Pennsylvania, increased 1% to $2.0 million in 2004. Net earned premiums for personal automobile increased by 13% to $1.8 million for 2004, from $1.6 million for 2003. Despite the increases in personal lines net earned premiums, our focus is principally on our commercial lines growth. Our personal auto premium is currently being evaluated to determine whether we will seek an appropriate rate increase where possible.

 

Net investment income increased $241,000, or 56%, to $668,000 in 2004, due primarily to higher average invested assets. Net realized losses were $97,000 in 2004, compared to a realized gain of $149,000 in 2003. In 2004, realized investment losses of $97,000 were comprised of gains on securities sales of $130,000, offset by losses on securities sales of $227,000. The losses from securities sales were comprised of $223,000 from the sale of bonds and $4,000 from the sale of equities. The following table summarizes the period of time that equity securities sold at a loss during 2004 had been in a continuous unrealized loss position:

 

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PERIOD OF TIME IN AN UNREALIZED LOSS POSITION		Fair Value on Sale Date			Realized Loss
		(In thousands)
0-6 months		$	—		$	—
7-12 months		276			4
More than 12 months		—			—
Total		$	276		$	4

 

The equity securities sold at a loss had been expected to appreciate in value but after reevaluation were sold so that sale proceeds could be reinvested. Securities were sold due to a desire to reduce exposure to certain issuers and industries or in light of changing economic conditions.

 

The following table summarizes the length of time equity securities with unrealized losses at March 31, 2004 have been in an unrealized loss position:

 

								Length of Unrealized Loss
		Fair Value			Unrealized Losses			Less than 6 months			6 to 12 Months			Over 12 Months
		(In thousands)
Equity securities
More than 80% of cost		$	1,685		$	55		$	55		$	0		$	0
Less than 80% of cost		—			—			—			—			—
Total		$	1,685		$	55		$	55		$	0		$	0

 

For 2004, we had a GAAP combined ratio (the “combined ratio” is an industry measurement of a company’s underwriting success, and is the sum of the ratios of a company’s loss and loss adjustment expense, and underwriting expenses to net earned premium. A combined ratio of less than 100% means a company is making an underwriting profit)of 102.8%, a loss and loss adjustment expense ratio of 60.0% and an underwriting expense ratio of 42.8%, compared to a GAAP combined ratio of 102.5%, a loss and loss adjustment expense ratio of 58.9% and an underwriting expense ratio of 43.6% for 2003.

 

In the commercial lines segment for 2004, we had an underwriting gain of $2.2 million, a combined ratio of 72.1%, a loss and loss adjustment expense ratio of 28.0% and an underwriting expense ratio of 44.1%, compared to an underwriting gain of $1.1 million, a combined ratio of 81.3%, a loss and loss adjustment expense ratio of 34.1% and an underwriting expense ratio of 47.2% for 2003.

 

In the personal lines segment for 2004, we had an underwriting loss of $2.6 million, a combined ratio of 145.2%, a loss and loss adjustment expense ratio of 104.1% and an underwriting expense ratio of 41.1%, compared to an underwriting loss of $1.4 million, a combined ratio of 125.5%, a loss and loss adjustment expense ratio of 85.7% and an underwriting expense ratio of 39.8% for 2003.

 

Net loss and loss adjustment expenses incurred increased overall by $1.8 million, or 28%, to $8.3 million for 2004 from 2003. The increase in loss and loss adjustment expenses reflects the increase in commercial and personal lines volume and an increase in the frequency of personal lines losses. The increase in personal lines losses is attributable to harsher weather conditions for 2004 compared to 2003, particularly extremely cold temperatures in the first half of the quarter in 2004. In addition, there was a considerable amount of snow during the first quarter of 2004. These conditions lead to losses from frozen pipes, structural collapses, more

 

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frequent automobile losses and slip-and-fall accidents. The increase in these losses is evidenced by the increase in the homeowners loss and loss expense ratio to 122.4% for 2004, compared to 88.2% for 2003, and an increase in the personal automobile loss and loss expense ratio to 84.8% for 2004, compared to 78.9% for 2003. Our claims frequency across the entire book increased in January 2004 by approximately 50% over the average number of claims reported in that month in the two prior years, and in February 2004 by approximately 25% over the average of the two prior years.

 

Underwriting expenses increased by $1.1 million in 2004, or 23%, to $5.9 million from 2003. This increase was principally attributable to an increase in expenses due to higher amortization of deferred policy acquisition costs resulting from higher premium volume, and a charge of $207,000 (pre-tax) associated with the commitment of shares to employee participants in the ESOP for 2004. We are currently in the process of converting our information system. When completed, we expect some costs to moderate as conversion costs and costs associated with operating dual systems will no longer be incurred. These reduced costs will be offset by some higher staffing costs, but we also should be positioned to expand premium volume without material incremental labor and facility costs because of increased processing capacity.

 

We also expect underwriting expenses to moderate in future periods because we intend to significantly reduce the amount of business written in Mercer Insurance Company, the New Jersey business of which became subject to New Jersey’s retaliatory premium tax when it redomesticated to Pennsylvania in 1997. We plan to do this by writing new policies, beginning in the 3^rd quarter of 2004, and renewing existing policies (after regulatory approval is received, which has been applied for) for New Jersey accounts in Mercer Insurance Company of New Jersey, Inc., our New Jersey domestic insurer that is not subject to this retaliatory tax. We had not previously renewed policies in our New Jersey subsidiary because only policyholders of Mercer Insurance Company, domiciled in Pennsylvania, had subscription and voting rights in the Conversion. Therefore, renewing policies in the New Jersey subsidiary before completion of the Conversion would have denied subscription rights to Mercer Insurance Company’s policyholders and disenfranchised them. The New Jersey Division of Taxation has billed us for all prior retaliatory tax and related interest, and these amounts have been paid in full, although under protest, thereby preserving our right to a recovery if the retaliatory tax is successfully challenged while the statute of limitations remains open for any refund claim by us. It is unclear whether any such challenge will be successful. Until the business is moved to Mercer Insurance Company of New Jersey, Mercer Insurance Company will continue to accrue and pay current retaliatory taxes. After paying the disputed retaliatory taxes to New Jersey for prior periods, an accrual of $300,000 for estimated retaliatory taxes remained which was reversed during the first quarter of 2004 and reduced premium tax expense accordingly.

 

Federal income tax expense was $40,000 for 2004, an effective rate of 14.9%, compared to $88,000, an effective rate of 24.2%, in 2003. The decrease in the effective tax rate in 2004 is attributable to tax-exempt investment income being a larger percentage of net income than in the prior year.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Our insurance companies generate sufficient funds from their operations and maintain a high degree of liquidity in their investment portfolios. The

 

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primary source of funds to meet the demands of claim settlements and operating expenses are premium collections, investment earnings and maturing investments. Mercer Insurance Company is expanding its existing facilities in Pennington, New Jersey, at a cost estimated at $2.8 million as of March 31, 2004. We are also in the process of building an information system platform that will allow our producers to conduct their business through the Internet or through the method they have historically used. As of March 31, 2004, we have spent $2.5 million on the development of this platform, which includes license fees for software used in the platform. It is anticipated to be completed after mid-year 2005, at an additional cost of $0.8 million. Mercer Insurance Company possesses sufficient resources for these future expenditures without incurring any debt.

 

Our insurance companies maintain investment and reinsurance programs that are intended to provide sufficient funds to meet their obligations without forced sales of investments. They maintain a portion of their investment portfolio in relatively short-term and highly liquid assets to ensure the availability of funds.

 

The principal source of liquidity for Mercer Insurance Group will be the net proceeds it retained from the Conversion stock offering of approximately $25 million, and dividend payments and other fees received from Mercer Insurance Company. For a period of three years after the Conversion, Mercer Insurance Company may not declare or pay any dividend to Mercer Insurance Group without the approval of the Pennsylvania Insurance Department. After this three-year period, Mercer Insurance Company will be restricted by the insurance laws of Pennsylvania as to the amount of dividends or other distributions it may pay to its holding company. Under Pennsylvania law, there is a maximum amount that may be paid by Mercer Insurance Company during any twelve-month period after notice to, but without prior approval of, the Pennsylvania Insurance Department. This limit is the greater of 10% of Mercer Insurance Company’s statutory surplus as reported on its most recent annual statement filed with the Pennsylvania Insurance Department, or the net income of Mercer Insurance Company for the period covered by such annual statement.

 

If the dividend restrictions imposed on Mercer Insurance Company related to the Conversion were not in effect, then as of December 31, 2003, the amounts available for payment of dividends from Mercer Insurance Company in 2004, without the prior approval of the Pennsylvania Insurance Department would have been approximately $5.8 million. Similar statutory limitations are imposed on the dividends which may be paid to Mercer Insurance Company by its insurance subsidiaries, and, based on their December 31, 2003 surplus positions, allowable dividends would be restricted to approximately $2 million in the aggregate.

 

Total assets increased 3%, or $4.5 million to $180.3 million, at March 31, 2004 from December 31, 2003. A premium volume decrease as compared to the fourth quarter of 2003 drove decreases in premium receivables of $1.2 million, or 13%, and deferred policy acquisition costs of $0.3 million, or 4%. Reinsurance recoverable on losses and loss expenses increased $1 million, or 25%, due to loss activity above the Company’s loss retention under its reinsurance agreements. Investments decreased $9.0 million, or 7%, to $114.4 million, and cash balances increased $12.7 million, or 83%. The movement between investments and cash and cash equivalents is due to the nature of the investment vehicles in which cash proceeds of the Conversion which await longer-term investment have been held, and their classification for financial statement purposes.

 

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Contemporaneous with the Conversion, the Company and its subsidiaries engaged a new manager for its fixed income portfolio. The manager will invest the proceeds of the Conversion and reallocate most other fixed maturity securities with a view to achieving an appropriate duration, targeted at approximately 4 years, and proportionately higher yields. Given the large amount of new capital to invest, the need to reallocate some existing investment funds, and a bond market presenting investment challenges, some funds are being maintained in very short term investments or money market funds while they await investment in fixed income securities appropriate to the Company’s investment goals. It is anticipated that these amounts will be fully invested in accordance with the Company’s investment goals and policy in the second quarter of 2004, with a related increase in investment income resulting from such placement.

 

Total liabilities increased 4%, or $3.3 million, in 2004, to $80.8 million. Decreased premium volume in the first quarter of 2004, as compared to the fourth quarter of 2003, is primarily responsible for the decrease in unearned premium reserves of $1.1 million, or 3%. Loss and loss expense reserves increased $1.2 million, or 3%, as a result of earned premium increases and the related increases in losses, and the higher level of losses experienced in 2004. Accounts payable increased 42% to $11.3 million primarily due to payables relating to unsettled securities transactions at March 31, 2004.

 

Total stockholders’ equity increased by $1.2 million, or 1%, due principally to net income and unrealized gains on the investment portfolio in the first quarter of 2004. Unrealized gains on the investment portfolio increased $0.8 million (after tax), or 17% in 2004 due principally to the strong equities market performance.

 

In connection with the Conversion, the ESOP was established, and purchased 626,111 shares from the Company in return for a note bearing interest at 4% on the principal amount of $6,261,110. Mercer Insurance Company will make annual employee benefit contributions to the ESOP sufficient to repay that loan to the Company. It is anticipated that the loan will be repaid in 10 equal annual installments, and that, in proportion to annual principal and interest payments, approximately 10% of the original ESOP shares will be allocated annually to employee participants of the ESOP. An expense charge will be booked ratably during each year for the shares committed to be allocated to participants that year, determined with reference to the fair market value of the Company’s stock at the time the commitment to allocate the shares is accrued and recognized. The issuance of the shares to the ESOP was fully recognized in the Additional Paid-in Capital account at Conversion, with a contra account entitled Unearned ESOP Shares established in the Shareholders’ Equity section of the balance sheet for the unallocated shares at an amount equal to their original per-share purchase price.

 

Mercer Insurance Group expects to adopt a stock-based incentive plan, subject to the approval of its shareholders at Mercer Insurance Group’s 2004 annual meeting of shareholders.  Pursuant to that plan, Mercer Insurance Group may issue a total number of shares equal to 14% of the shares of common stock that were issued in the Conversion. Of this amount, an amount equal to 4% of the shares of common stock issued in the Conversion may be used to make restricted stock awards under the stock-based incentive plan. If the stock-based incentive plan is approved in 2004, the Company may purchase shares of its common stock in the open market and contribute those shares to the stock-based incentive plan for use in making restricted stock awards under that

 

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plan. Any such purchase will require the prior approval of the Pennsylvania Insurance Department. The fair market value of any common stock used for restricted stock awards will initially represent unearned compensation. As Mercer Insurance Group accrues compensation expense to reflect the vesting of such shares, unearned compensation will be reduced accordingly. This compensation expense will be deductible for federal income tax purposes upon vesting.

 

IMPACT OF INFLATION

 

Inflation increases an insured’s need for property and casualty insurance coverage. Inflation also increases claims incurred by property and casualty insurers as property repairs, replacements and medical expenses increase. These cost increases reduce profit margins to the extent that rate increases are not implemented on an adequate and timely basis. We establish property and casualty insurance premiums levels before the amount of losses and loss expenses, or the extent to which inflation may affect these expenses, are known. Therefore, our insurance companies attempt to anticipate the potential impact of inflation when establishing rates. Because inflation has remained relatively low in recent years, financial results have not been significantly affected by inflation.

 

Inflation also often results in increases in the general level of interest rates, and, consequently, generally results in increased levels of investment income derived from our investments portfolio, although increases in investment income will generally lag behind increases in loss costs caused by inflation.

 

OFF BALANCE SHEET COMMITMENTS AND CONTRACTUAL OBLIGATIONS

 

The Company was not a party to any unconsolidated arrangement or financial instrument with special purpose entities or other vehicles at March 31, 2004 which would give rise to previously undisclosed market, credit or financing risk.

 

The Company and its subsidiaries have no significant contractual obligations at March 31, 2004.

 

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

 

General.  Market risk is the risk that we will incur losses due to adverse changes in market rates and prices. We have exposure to three principal types of market risk through our investment activities: interest rate risk, credit risk and equity risk. Our primary market risk exposure is to changes in interest rates. We have not entered, and do not plan to enter, into any derivative financial instruments for hedging, trading or speculative purposes.

 

Interest Rate Risk.  Interest rate risk is the risk that we will incur economic losses due to adverse changes in interest rates. Our exposure to interest rate changes primarily results from our significant holdings of fixed rate investments. Fluctuations in interest rates have a direct impact on the market valuation of these securities.

 

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Equity Risk.  Equity price risk is the risk that we will incur economic losses due to adverse changes in equity prices. Our exposure to changes in equity prices primarily results from our holdings of common stocks, mutual funds and other equities. Our portfolio of equity securities is carried on the balance sheet at fair value. Therefore, an adverse change in market prices of these securities would result in losses.

 

There have been no material changes in Market Risk from the end of the most recent fiscal year ended December 31, 2003, and the information disclosed in connection therewith.

 

Item 4.  Controls and Procedures

 

The Company, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and the Chief Financial Officer, has evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures.  Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer conclude that the Company’s disclosure controls and procedures are effective as of March 31, 2004.  There has been no change in the Company’s internal control over financial reporting that occurred during the quarter ended March 31, 2004 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

Securities and Exchange Commission rules define “disclosure controls and procedures” as controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time specified in the Commission’s rules and forms.  Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that such information is accumulated and communicated to the issuer’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

 

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PART II - - OTHER INFORMATION

 

Item 1.            Legal Proceedings - None

 

Item 2.            Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities - None

 

Item 3.            Defaults Upon Senior Securities – None

 

Item 4.            Submission of Matters to Vote of Security Holders -

None

 

Item 5.            Other Information - - None

 

Item 6.    Exhibits and Reports on Form 8-K

 

(a)  Exhibits

 

Exhibit No.		Title
31.1		Certification of Chief Executive Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002, (filed herewith)
31.2		Certification of Chief Financial Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002, (filed herewith)
32.1		Certifications of Chief Executive Officer and Chief Financial Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002, (filed herewith)

 

(b)         Reports on Form 8-K

 

In a report on Form 8-K dated and filed on February 25, 2004, the Company reported a press release, dated February 25, 2004, announcing its earnings for the three month and twelve month periods ended December 31, 2003, which is incorporated herein by reference.

 

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SIGNATURES

 

In accordance with the requirements of the Exchange Act, the Registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

		MERCER INSURANCE GROUP, INC.
			(Registrant)
Dated: May 14, 2004		By	/s/Andrew R. Speaker
			Andrew R. Speaker
				President and Chief
				Executive Officer

 

 

Dated: May 14, 2004		By	/s/ David B. Merclean
				David B. Merclean
				Chief Financial Officer

 

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