FORM 10-Q

 

Quarterly Report pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934

 

for the Quarterly Period Ended September 30, 2004,

or

 

Transition report pursuant to Section 13 or 15(d) Of the Exchange Act

 

for the Transition Period from                  to                 

 

No. 000-25425

(Commission File
Number)

 

MERCER INSURANCE GROUP, INC.

(Exact name of Registrant as specified in its charter)

 

 

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 ý       No ¨

 

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

 

		Number of Shares Outstanding as of October 15, 2004
COMMON STOCK (No Par Value)		6,810,733
(Title of Class)		(Outstanding Shares)

 

 

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.	Controls and Procedures
PART II.  OTHER INFORMATION
Item 1.	Legal Proceedings
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.	Defaults Upon Senior Securities
Item 4.	Submission of Matters to a Vote of Security Holders
Item 5.	Other Information
Item 6.	Exhibits
SIGNATURES
Exhibits:

 

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

 

i

 

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;

 

1

 

•                  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.

 

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Part I - FINANCIAL INFORMATION

 

Item 1.  Financial Statements

 

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED BALANCE SHEETS
As of September 30, 2004 and December 31, 2003

 

		As of September 30, 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 $94,897 and $46,282, respectively)		$	94,494		$	46,277
Equity securities, at fair value (cost of $16,131 and $15,866,respectively)		22,953			22,656
Short-term investments, at amortized cost, which approximates fair value		10,599			54,396
Total investments		128,046			123,329
Cash and cash equivalents		9,123			15,350
Premiums receivable		9,173			9,096
Reinsurance receivables		2,992			4,159
Prepaid reinsurance premiums		1,437			1,614
Deferred policy acquisition costs		7,618			7,387
Accrued investment income		877			596
Property and equipment, net		9,723			6,944
Goodwill		4,673			4,673
Other assets		2,112			2,727
Total assets		$	175,774		$	175,875
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Losses and loss adjustment expenses		$	37,227		$	37,261
Unearned premiums		30,728			30,329
Accounts payable and accrued expenses		7,359			7,937
Other reinsurance balances		13			81
Other liabilities		1,425			1,228
Deferred income taxes		704			713
Total liabilities		77,456			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 7,060,733 shares, outstanding 6,079,106 and 6,282,233 shares		—			—
Additional paid-in capital		67,608			64,871
Accumulated other comprehensive income:
Unrealized gains in investments, net of deferred income taxes		4,237			4,478
Retained earnings		37,033			34,612
Unearned restricted stock compensation		(2,419		)	—
Unearned ESOP shares		(5,166		)	(5,635		)
Treasury stock, at cost, 250,000 and -0- shares		(2,975		)	—
Total stockholders’equity		98,318			98,326
Total liabilities and stockholders’ equity		$	175,774		$	175,875

 

See accompanying notes to condensed consolidated financial statements.

 

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MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS
Nine Months Ended September 30, 2004 and 2003

 

		2004			2003
		(Dollars in thousands, except shares and per share data)
		(Unaudited)
Revenue:
Net premiums earned		$	41,617		$	34,762
Investment income, net of expenses		1,933			1,221
Net realized investment gains		439			130
Other revenue		266			292
Total revenue		44,255			36,405
Expenses:
Losses and loss adjustment expenses		21,103			19,600
Amortization of deferred policy acquisition costs (related party amounts of $1,120 and $884, respectively)		11,509			9,396
Other expenses		8,212			6,587
Stock conversion expenses		—			65
Total expenses		40,824			35,648
Income before income taxes and minority interest in income of subsidiary		3,431			757
Income taxes		1,010			188
Income before minority interest in income of subsidiary		2,421			569
Minority interest in income of subsidiary		—			(124		)
Net income		$	2,421		$	445
Earnings per common share:
Basic		$	0.39		N/A
Diluted		$	0.38		N/A
Weighted average shares:
Basic		6,287,602			N/A
Diluted		6,371,562			N/A

 

See accompanying notes to condensed consolidated financial statements.

 

4

 

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS
Three Months Ended September 30, 2004 and 2003

 

		2004			2003
		(Dollars in thousands, except shares and per share data)
		(Unaudited)
Revenue:
Net premiums earned		$	14,032		$	12,379
Investment income, net of expenses		639			400
Net realized investment gains		340			167
Other revenue		86			101
Total revenue		15,097			13,047
Expenses:
Losses and loss adjustment expenses		6,173			6,859
Amortization of deferred policy acquisition costs (related party amounts of $457 and $304, respectively)		3,867			3,325
Other expenses		3,373			2,571
Stock conversion expenses		—			3
Total expenses		13,413			12,758
Income before income taxes and minority interest in income of subsidiary		1,684			289
Income taxes		563			84
Income before minority interest in income of subsidiary		1,121			205
Minority interest in income of subsidiary		—			(33		)
Net income		$	1,121		$	172
Earnings per common share:
Basic		$	0.18		N/A
Diluted		$	0.17		N/A
Weighted average shares:
Basic		6,267,258			N/A
Diluted		6,482,258			N/A

 

See accompanying notes to condensed consolidated financial statements.

 

5

 

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
Nine months ended September 30, 2004
(Unaudited, dollars in thousands)

 

		Preferred stock			Common stock		Additional paid-in capital		Accumulated other comprehensive income		Retained earnings		Unearned restricted stock compensation		Unearned ESOP shares		Treasury Stock		Total
Balance, December 31, 2003		$	—		—		64,871		4,478		34,612		—		(5,635	)	—		$	98,326
Net income											2,421								2,421
Unrealized losses on securities:
Unrealized holding gains arising during period, net of related income tax expense of ($25)									49										49
Less reclassification adjustment for gains included in net income, net of related income tax expense of ($149)									(290	)									(290		)
Other comprehensive loss																			(241		)
Comprehensive income																			2,180
Unearned restricted stock compensation							2,625						(2,625	)					—
Amortization of restricted stock compensation													206						206
ESOP shares committed							112								469				581
Treasury stock purchased																	(2,975	)	(2,975		)
Balance, September 30, 2004		$	—		—		67,608		4,237		37,033		(2,419	)	(5,166	)	(2,975	)	$	98,318

 

See accompanying notes to condensed consolidated financial statements.

 

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MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended September 30, 2004 and 2003

 

		2004			2003
		(Dollars in thousands) (Unaudited)
Cash flows from operating activities:
Net income		$	2,421		$	445
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization of fixed assets		1,087			974
Net amortization of premium or (accretion of discount)		67			(50		)
Amortization of restricted stock compensation		206			—
ESOP share commitment		581			—
Net realized investment gains		(439		)	(130		)
Deferred income tax		115			(234		)
Change in assets and liabilities:
Premiums receivable		(77		)	(2,251		)
Reinsurance receivables		1,167			(879		)
Prepaid reinsurance premiums		177			(379		)
Deferred policy acquisition costs		(231		)	(963		)
Other assets		334			(1,522		)
Losses and loss expenses		(34		)	3,962
Unearned premiums		399			4,849
Other		(449		)	(2,413		)
Net cash provided by operating activities		5,324			1,409
Cash flows from investing activities:
Purchase of fixed income securities, available-for- sale		(74,287		)	(23,189		)
Purchase of equity securities		(2,532		)	(3,342		)
Sale and maturity of fixed income securities, available-for-sale		25,459			23,694
Sale of equity securities		2,857			4,424
Sale of short-term investments, net		43,797			—
Purchase of property and equipment		(3,870		)	(1,776		)
Net cash used by investing activities		(8,576		)	(189		)
Cash flows from financing activities:
Purchase of treasury stock		(2,975		)	—
Net cash used by financing activities		(2,975		)	—
Net (decrease) increase in cash and cash equivalents		(6,227		)	1,220
Cash and cash equivalents at beginning of period		15,350			7,201
Cash and cash equivalents at end of period		$	9,123		$	8,421
Cash paid during the period for:
Interest		$	35		$	36
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.

 

(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.

 

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Financial data by segment is as follows for the nine months ended September 30, 2004 and 2003:

 

		Nine Months Ended September 30
		2004			2003
		(In thousands)
Revenues:
Net premiums earned:
Commercial lines		$	24,150		$	18,569
Personal lines		17,467			16,193
Total net premiums earned		41,617			34,762
Net investment income		1,933			1,221
Realized investment gains		439			130
Other		266			292
Total revenues		44,255			36,405
Income before income taxes:
Underwriting income (loss):
Commercial lines		5,384			2,568
Personal lines		(4,591		)	(3,389		)
Total underwriting income (loss)		793			(821		)
Net investment income		1,933			1,221
Realized investment gains		439			130
Other		266			227
Income before income taxes and minority interest in income of subsidiary		$	3,431		$	757

 

Financial data by segment is as follows for the three months ended September 30, 2004 and 2003:

 

		Three Months Ended September 30
		2004			2003
		(In thousands)
Revenues:
Net premiums earned:
Commercial lines		$	8,295		$	6,881
Personal lines		5,737			5,498
Total net premiums earned		14,032			12,379
Net investment income		639			400
Realized investment gains		340			167
Other		86			101
Total revenues		15,097			13,047
Income before income taxes:
Underwriting income (loss):
Commercial lines		1,880			899
Personal lines		(1,261		)	(1,275		)
Total underwriting income (loss)		619			(376		)
Net investment income		639			400
Realized investment gains		340			167
Other		86			98
Income before income taxes and minority interest in income of subsidiary		$	1,684		$	289

 

(3)  Reinsurance

 

Premiums earned are net of amounts ceded of $6,377 and $7,087 for the nine months ended September 30, 2004 and 2003, respectively, and $2,048 and $2,428 for the three months ended September 30, 2004 and 2003, respectively. Losses and loss adjustment expenses are net of amounts ceded of $451 and $2,122 for the nine months ended September 30, 2004 and 2003, respectively, and $157 and $1,513 for the three months ended September 30, 2004 and 2003, respectively.

 

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(4)  Comprehensive Income

 

The Company’s comprehensive income for the nine month period ended September 30, 2004 and 2003 is as follows:

 

		Nine Months ended September 30
		2004			2003
		(In thousands)
Net income		$	2,421		$	445
Other comprehensive income, net of tax:
Unrealized gains on securities:
Unrealized holding gains arising during period, net of related income tax expense of $25, and $566		49			1,099
Less reclassification adjustment for gains included in net income, net of related income tax expense of $149 and $44		(290		)	(86		)
		(241		)	1,013
Comprehensive Income		$	2,180		$	1,458

 

The Company’s comprehensive income for the three month period ended September 30, 2004 and 2003 is as follows:

 

		Three Months ended September 30
		2004			2003
		(In thousands)
Net income		$	1,121		$	172
Other comprehensive income, net of tax:
Unrealized gains on securities:
Unrealized holding gains arising during period, net of related income tax expense of $611, and $89		1,186			173
Less reclassification adjustment for gains included in net income, net of related income tax expense of $116 and $57		(224		)	(110		)
		962			63
Comprehensive Income		$	2,083		$	235

 

(5)  Stock-based Compensation

 

Stock-based compensation plans are accounted for under the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, no compensation expense is recognized for fixed stock option grants. Compensation expense would be recorded on the date of a stock option grant only if the current market price of the underlying stock exceeded the exercise price. The following table illustrates the effect on net income and earnings per share as if the provisions of Statement of Financial Accounting Standards (SFAS) No. 123 (as amended by SFAS No. 148), “Accounting for Stock-Based Compensation,” had been applied to all periods presented.

 

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		Nine months ended
		September 30, 2004			September 30, 2003
		(In thousands, except per share data)
Net income, as reported		$	2,421		$	445
Plus: Stock-based employee compensation expense included in reported net income, net of related tax effects		136			0
Less: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(289		)	0
Pro forma net income		$	2,268		$	445
Basic earnings per share:
As reported		$	0.39		N/A
Pro forma		$	0.36		N/A
Diluted earnings per share:
As reported		$	0.38		N/A
Pro forma		$	0.36		N/A

 

		Quarter ended
		September 30, 2004			September 30, 2003
		(In thousands, except per share data)
Net income, as reported		$	1,121		$	172
Plus: Stock-based employee compensation expense included in reported net income, net of related tax effects		114			0
Less: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(246		)	0
Pro forma net income		$	989		$	172
Basic earnings per share:
As reported		$	0.18		N/A
Pro forma		$	0.16		N/A
Diluted earnings per share:
As reported		$	0.17		N/A
Pro forma		$	0.15		N/A

 

The Company adopted the Mercer Insurance Group, Inc. 2004 Stock Incentive Plan (the Plan) on June 16, 2004. Awards may be made in the form of incentive stock options, nonqualified stock options, restricted stock or any combination to employees and non-employee Directors. The Plan limits to 250,000 the number of shares that may be awarded as restricted stock, and to 500,000 the number of shares for which incentive stock options may be granted. The total number of shares authorized in the plan is 876,555 shares, with an annual increase equal to 1% of the shares outstanding at the end of the previous year. The Plan provides that stock options and restricted stock awards may include vesting restrictions and performance criteria at the discretion of the Compensation Committee of the Board of Directors. The term of options may not exceed ten years for

 

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incentive stock options, and ten years and 1 month for nonqualified stock options, and the option price may not be less than fair market value on the date of grant. The 2004 grants have vesting periods of 3 or 5 years on restricted stock, incentive stock options, and nonqualified stock options.

 

Information regarding fixed stock option activity in Mercer Insurance Group’s plan is presented below:

 

		Number of shares		Weighted Average Exercise Price Per Share
Outstanding at December 31, 2003		0		$	0.00
Granted – 2004		537,700		12.21
Exercised – 2004		0		0.00
Forfeited – 2004		0		0.00
Outstanding at September 30, 2004		537,700		$	12.21
Exercisable at:
September 30, 2004		0		$	0.00
Weighted-average remaining contractual life		9.7 years

 

The per share weighted-average fair value of options granted during 2004 was $4.19. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2004: dividend yield of 0%; expected volatility of 20.91%; risk-free interest rate of 4.73%, and an expected life of 6.5 years.

 

Grants of 215,000 shares of restricted stock were awarded to employees and non-employee Directors in 2004.  The weighted average price per share on the grant date was $12.21 per share.

 

(6)  Earnings per Share

 

The computation of basic and diluted earnings per share is as follows:

 

		Nine months ended September 30,
		2004			2003
		(Dollars in thousands, except per share data)
Numerator for basic and diluted earnings per share:
Net income		$	2,421		N/A
Denominator for basic earnings per share – weighted-average shares outstanding		6,287,602			N/A
Effect of stock incentive plans		83,960			N/A
Denominator for diluted earnings per share		6,371,562			N/A
Basic earnings per share		$	0.39		N/A
Diluted earnings per share		$	0.38		N/A

 

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		Quarter Ended September 30,
		2004			2003
		(Dollars in thousands, except per share data)
Numerator for basic and diluted earnings per share:
Net Income		$	1,121		N/A
Denominator for basic earnings per share – weight – average shares outstanding		6,267,258			N/A
Effect of stock incentive plans		215,000			N/A
Denominator for diluted earnings per share		6,482,258			N/A
Basic earnings per share		$	0.18		N/A
Diluted earnings per share		$	0.17		N/A

 

Options to purchase 537,700 shares of common stock were not included in the computation of diluted earnings per share for the 3 months and 9 months ended September 30, 2004, because the exercise price of the options was greater than the average market price.

 

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, 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 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 of this amount 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 46,873 shares were committed in the first three quarters of 2004.

 

13

 

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 offering insurance coverage to businesses and individuals 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 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. through 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 (in New Jersey and Pennsylvania) and private passenger automobile (in Pennsylvania only) insurance coverages.  We market both the commercial and personal insurance lines through independent producers.

 

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 our control. Premium volume is affected by, among other things, the availability and regular flow to our insurance companies of quality, properly-priced 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 for which we receive premiums, the cost of issuing insurance policies and maintaining our customer and agent relationships, marketing costs, taxes we pay to the states in which we operate 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 accounts, severe or extreme 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 issuers and the success of their underlying businesses, the market perception of the issuers, and other factors such as ratings by rating agencies and analysts.

 

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Critical Accounting Policies

 

General.  The Company’s financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (GAAP). 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.

 

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 September 30, 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.

 

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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:

 

Adjustment Change in Loss and Loss Adjustment Reserves Net of Reinsurance		Adjusted Loss and Loss Reserves Net of Reinsurance as of September 30, 2004		Percentage Change in Stockholders’ Equity as of September 30, 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	%	30,047		2.2	%	29,003		2.2	%
-7.5	%	30,882		1.7	%	29,808		1.6	%
-5.0	%	31,717		1.1	%	30,614		1.1	%
-2.5	%	32,551		0.6	%	31,419		0.5	%
Base		33,386		—		32,225		—
2.5	%	34,221		-0.6	%	33,031		-0.5	%
5.0	%	35,055		-1.1	%	33,836		-1.1	%
7.5	%	35,890		-1.7	%	34,642		-1.6	%
10.0	%	36,725		-2.2	%	35,448		-2.2	%

 

(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:

 

		September 30, 2004			December 31, 2003
		(Dollars in thousands)
Commercial lines:
Commercial multi-peril		$	5,651		$	6,998
Other liability		8,613			8,708
Workers’ compensation		4,716			4,684
Commercial automobile		2,112			2,251
Fire, allied, inland marine		586			242
		21,678			22,883
Personal lines:
Homeowners		10,372			9,509
Personal automobile		2,923			3,073
Fire, allied, inland marine		268			328
Other liability		1,885			1,400
Workers’ compensation		101			68
		15,549			14,378
Total		$	37,227		$	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.  In the nine months ended September 30, 2004 and 2003, we recorded a pre-tax charge to earnings of $0 and $445,000, respectively, and no charges in

 

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the quarters ended September 30, 2004 and 2003. These charges are primarily with respect to equity securities that we determined under our policy to be other than temporarily impaired.  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 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 issuer 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.

 

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Ceded unearned premiums and reinsurance balances recoverable on paid and unpaid loss and loss adjustment expenses are reported separately as assets, 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. For more than three years, the industry has enjoyed a hard market with pricing power, however pricing competition has re-appeared in the market, particularly in lines of business which are predominantly property exposures, and pricing power has diminished accordingly.  The cyclicality of the market is difficult to anticipate, and pricing has leveled off consistent with the late stages of a hard market, resulting in slower overall revenue growth than the Company has enjoyed in the last three years.

 

Nine months and three months ended September 30, 2004, compared to nine months and three months ended September 30, 2003

 

For the nine months ended September 30, 2004, the Company had net income of $2.4 million compared to $445,000 for the same period in 2003.  The underwriting gain from our commercial lines segment for the nine months of 2004 increased to $5.4 million from the prior year amount of $2.6 million, but our personal lines segment incurred an underwriting loss of $4.6 million, an increased loss from the loss of $3.4 million in the prior comparable period.  In our investment segment, net investment income increased 58% in the first nine months of 2004 to $1.9 million from $1.2 million, and net realized gains for the first nine months of 2004 were $439,000, as compared to net realized gains of $130,000 for the 2003 period.

 

For the three months ended September 30, 2004, the Company had net income of $1.1 million compared to $172,000 for the same period in 2003.  The underwriting gain from our commercial lines segment for the third quarter of 2004 increased to $1.9 million from the prior year amount of $899,000. The personal lines segment incurred an underwriting loss of $1.3 million in the third quarter of 2004, compared to a loss of $1.3 million in the prior year period.  In our investment segment, net investment income increased 60% in the

 

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third quarter of 2004 to $639,000 from $400,000, and we had a net realized gain for the third quarter of 2004 of $340,000, as compared to a net realized gain of $167,000 for the 2003 period.

 

Total revenues for the first nine months of 2004 were $44.3 million, which was 22% greater than 2003 revenues of $36.4 million.  This increase was due to a $6.9 million, or 20%,  increase in net premiums earned in the first nine months of 2004, an increase in net investment income of $712,000, or 58%, as well as to a realized gain on investments of $439,000 in 2004 as compared to a realized gain of $130,000 in 2003.

 

Total revenues for the third quarter of 2004 were $15.1 million, which was 16% greater than revenues of $13.0 million during the comparable 2003 period.  This increase was due to a $1.7 million, or 13%,  increase in net premiums earned in the third quarter of 2004, an increase in net investment income of $239,000, or 60%, as well as to a realized gain on investments of $340,000 in 2004 as compared to a realized gain of $167,000 during the comparable 2003 period.

 

Direct premiums written increased 3% to $46.9 million in the first nine months of 2004 when compared to 2003, and consisted of $28.1 million of commercial lines premiums, a 6% increase, and $18.8 million of personal lines premiums, a 2% decrease.  Net premiums earned increased by 20% to $41.6 million for the first nine months of 2004 as compared to $34.8 million for the prior year period.  Commercial lines net premiums earned increased 30% to $24.2 million in the first nine months of 2004, and personal lines net premiums earned increased 8% to $17.4 million in 2004.  The overall increases in direct premiums written and net premiums earned are generally attributable to the Company’s focus on growth in our commercial lines business, and a reduction in the amount of reinsurance utilized by the Company.

 

Direct premiums written for the third quarter of 2004 decreased 3% to $14.6 million when compared to 2003, and consisted of $8.0 million of commercial lines premiums, a 1% decrease, and $6.6 million of personal lines premiums, a 5% decrease.  Direct premiums written decreased in the quarter as compared to the same period in 2003 due to increasing competition in the marketplace, particularly in the case of property exposures. Net premiums earned increased by 13% to $14.0 million for the third quarter of 2004 as compared to $12.4 million for the prior year period.  Commercial lines net premiums earned increased 21% to $8.3 million in the third quarter, and personal lines net premiums earned increased 4% to $5.7 million.

 

Consistent with our goal of increasing our commercial lines business, we increased commercial lines direct premiums written in the first nine months of 2004 to 60% of our business, as compared to 58% in the prior year period. Similarly, commercial lines net premium earned increased to 58% of our business, as compared to 53% in the 2003 period. Our direct commercial multi-peril premiums written, the largest component of our commercial lines segment, increased by 6% to $14.3 million in the first nine months of 2004, compared to $13.4 million for the 2003 period. Commercial multi-peril net premiums earned increased by 33% to $12.1 million in 2004, as compared to $9.1 million for the prior year period.  We expect this trend of increasing commercial writings to continue as we target growth in certain types of risks and with selected producers.

 

For the first nine months of 2004, net premiums earned for our homeowners insurance, the largest component of our personal lines segment, increased 9% to $10.1 million, compared to $9.3 million for the 2003 period, while homeowners direct premiums written remained flat at $11.0 million for both periods. The growth in homeowners insurance net premiums earned primarily reflects the reduction in reinsurance utilization initiated by the Company at the beginning of 2004.

 

Personal automobile direct written premiums for the first nine months of 2004, written exclusively in Pennsylvania, decreased 3% to $5.8 million from $6.0 million for the 2003 period.  Net premiums earned for personal automobile increased in the first nine months of 2004 by 7% to $5.4 million, from $5.1 million for the

 

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