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EX-31.1 - EXHIBIT 31.1 - EMC INSURANCE GROUP INCa2016930ex311.htm
EX-32.2 - EXHIBIT 32.2 - EMC INSURANCE GROUP INCa2016930ex322.htm
EX-32.1 - EXHIBIT 32.1 - EMC INSURANCE GROUP INCa2016930ex321.htm
EX-31.2 - EXHIBIT 31.2 - EMC INSURANCE GROUP INCa2016930ex312.htm

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q 
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2016
OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ________________to __________________ 
Commission File Number: 0-10956
EMC INSURANCE GROUP INC.
(Exact name of registrant as specified in its charter)
Iowa
 
42-6234555
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
717 Mulberry Street, Des Moines, Iowa
 
50309
(Address of principal executive offices)
 
(Zip Code)
(515) 345-2902
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (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.
ý  Yes    o  No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
ý  Yes    o  No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
o
Accelerated filer
ý
Non-accelerated filer
o
Smaller reporting company
o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
o  Yes    ý  No
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Class
 
Outstanding at October 31, 2016
Common stock, $1.00 par value
 
21,103,634
 



TABLE OF CONTENTS




PART I.
FINANCIAL INFORMATION

ITEM 1.
FINANCIAL STATEMENTS

EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
 
 
September 30, 
 2016
 
December 31, 
 2015
($ in thousands, except share and per share amounts)
 
(Unaudited)
 

ASSETS
 
 
 
 
Investments:
 
 
 
 
Fixed maturity securities available-for-sale, at fair value (amortized cost $1,184,470 and $1,130,217)
 
$
1,237,150

 
$
1,161,025

Equity securities available-for-sale, at fair value (cost $151,852 and $144,176)
 
219,282

 
206,243

Other long-term investments
 
9,941

 
9,930

Short-term investments
 
42,611

 
38,599

Total investments
 
1,508,984

 
1,415,797

 
 
 
 
 
Cash
 
350

 
224

Reinsurance receivables due from affiliate
 
22,590

 
24,236

Prepaid reinsurance premiums due from affiliate
 
11,588

 
6,563

Deferred policy acquisition costs (affiliated $44,320 and $40,535)
 
44,620

 
40,720

Prepaid pension and postretirement benefits due from affiliate
 
11,043

 
12,133

Accrued investment income
 
12,143

 
10,789

Amounts receivable under reverse repurchase agreements
 
16,850

 
16,850

Accounts receivable
 
2,958

 
804

Income taxes recoverable
 

 
1,735

Goodwill
 
942

 
942

Other assets (affiliated $4,838 and $4,595)
 
5,437

 
5,162

Total assets
 
$
1,637,505

 
$
1,535,955

All affiliated balances presented above are the result of related party transactions with Employers Mutual.

See accompanying Notes to Consolidated Financial Statements.

3


EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
 
 
September 30, 
 2016
 
December 31, 
 2015
($ in thousands, except share and per share amounts)
 
(Unaudited)
 

LIABILITIES
 
 
 
 
Losses and settlement expenses (affiliated $695,461 and $671,169)
 
$
700,565

 
$
678,774

Unearned premiums (affiliated $271,539 and $238,637)
 
272,900

 
239,435

Other policyholders' funds (all affiliated)
 
11,809

 
8,721

Surplus notes payable to affiliate
 
25,000

 
25,000

Amounts due affiliate to settle inter-company transaction balances
 
4,025

 
6,408

Pension benefits payable to affiliate
 
3,826

 
4,299

Income taxes payable
 
156

 

Deferred income taxes
 
25,894

 
19,029

Other liabilities (affiliated $24,659 and $28,598)
 
30,921

 
29,351

Total liabilities
 
1,075,096

 
1,011,017

 
 
 
 
 
STOCKHOLDERS' EQUITY
 
 
 
 
Common stock, $1 par value, authorized 30,000,000 shares; issued and outstanding, 21,084,948 shares in 2016 and 20,780,439 shares in 2015
 
21,085

 
20,781

Additional paid-in capital
 
115,724

 
108,747

Accumulated other comprehensive income
 
75,529

 
58,433

Retained earnings
 
350,071

 
336,977

Total stockholders' equity
 
562,409

 
524,938

Total liabilities and stockholders' equity
 
$
1,637,505

 
$
1,535,955

All affiliated balances presented above are the result of related party transactions with Employers Mutual.

See accompanying Notes to Consolidated Financial Statements.


4


EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
 
 
Three months ended 
 September 30,
($ in thousands, except share and per share amounts)
 
2016
 
2015
REVENUES
 
 
 
 
Premiums earned (affiliated $149,988 and $144,540)
 
$
152,181

 
$
145,788

Net investment income
 
11,474

 
11,299

Net realized investment gains (losses), excluding impairment losses on securities available-for-sale
 
(917
)
 
8,126

Total "other-than-temporary" impairment losses on securities available-for-sale
 
(275
)
 
(628
)
Portion of "other-than-temporary" impairment losses on fixed maturity securities available-for-sale reclassified from other comprehensive income (before taxes)
 

 

Net impairment losses on securities available-for-sale
 
(275
)
 
(628
)
Net realized investment gains (losses)
 
(1,192
)
 
7,498

Other income (loss) (affiliated $39 and $420)
 
(85
)
 
519

Total revenues
 
162,378

 
165,104

 
 
 
 
 
LOSSES AND EXPENSES
 
 
 
 
Losses and settlement expenses (affiliated $106,795 and $101,323)
 
108,173

 
102,685

Dividends to policyholders (all affiliated)
 
3,944

 
3,555

Amortization of deferred policy acquisition costs (affiliated $26,256 and $25,835)
 
26,845

 
26,139

Other underwriting expenses (affiliated $17,600 and $16,046)
 
17,606

 
16,045

Interest expense (all affiliated)
 
84

 
84

Other expenses (affiliated $481 and $473)
 
679

 
675

Total losses and expenses
 
157,331

 
149,183

Income before income tax expense
 
5,047

 
15,921

 
 
 
 
 
INCOME TAX EXPENSE (BENEFIT)
 
 
 
 
Current
 
1,448

 
3,081

Deferred
 
(530
)
 
1,651

Total income tax expense
 
918

 
4,732

Net income
 
$
4,129

 
$
11,189

 
 
 
 
 
Net income per common share - basic and diluted
 
$
0.20

 
$
0.54

 
 
 
 
 
Dividend per common share
 
$
0.190

 
$
0.170

 
 
 
 
 
Average number of common shares outstanding - basic and diluted
 
21,060,665

 
20,684,890

All affiliated balances presented above are the result of related party transactions with Employers Mutual.

See accompanying Notes to Consolidated Financial Statements.

5


EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
 
 
Nine months ended September 30,
($ in thousands, except share and per share amounts)
 
2016
 
2015
REVENUES
 
 
 
 
Premiums earned (affiliated $436,804, and $425,513)
 
$
441,364

 
$
429,124

Net investment income
 
35,883

 
33,946

Net realized investment gains (losses), excluding impairment losses on securities available-for-sale
 
333

 
12,848

Total "other-than-temporary" impairment losses on securities available-for-sale
 
(976
)
 
(1,293
)
Portion of "other-than-temporary" impairment losses on fixed maturity securities available-for-sale reclassified from other comprehensive income (before taxes)
 

 

Net impairment losses on securities available-for-sale
 
(976
)
 
(1,293
)
Net realized investment gains (losses)
 
(643
)
 
11,555

Other income (loss) (affiliated $307 and $1,119)
 
(19
)
 
1,622

Total revenues
 
476,585

 
476,247

 
 
 
 
 
LOSSES AND EXPENSES
 
 
 
 
Losses and settlement expenses (affiliated $295,061 and $278,915)
 
296,102

 
280,603

Dividends to policyholders (all affiliated)
 
11,292

 
6,492

Amortization of deferred policy acquisition costs (affiliated $79,584 and $77,872)
 
80,740

 
78,823

Other underwriting expenses (affiliated $52,120 and $50,297)
 
52,134

 
50,351

Interest expense (all affiliated)
 
253

 
253

Other expenses (affiliated $1,414 and $1,363)
 
2,053

 
1,992

Total losses and expenses
 
442,574

 
418,514

Income before income tax expense
 
34,011

 
57,733

 
 
 
 
 
INCOME TAX EXPENSE (BENEFIT)
 
 
 
 
Current
 
11,440

 
15,594

Deferred
 
(2,340
)
 
1,872

Total income tax expense
 
9,100

 
17,466

Net income
 
$
24,911

 
$
40,267

 
 
 
 
 
Net income per common share - basic and diluted
 
$
1.19

 
$
1.96

 
 
 
 
 
Dividend per common share
 
$
0.570

 
$
0.503

 
 
 
 
 
Average number of common shares outstanding - basic and diluted
 
20,964,236

 
20,577,493

All affiliated balances presented above are the result of related party transactions with Employers Mutual.

See accompanying Notes to Consolidated Financial Statements.


6


EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
 
 
Three months ended 
 September 30,
($ in thousands)
 
2016
 
2015
Net income
 
$
4,129

 
$
11,189

 
 
 
 
 
OTHER COMPREHENSIVE INCOME (LOSS)
 
 
 
 
Unrealized holding gains (losses) on investment securities, net of deferred income tax expense (benefit) of $(1,226) and $(2,288)
 
(2,275
)
 
(4,252
)
Reclassification adjustment for realized investment gains included in net income, net of income tax expense of $(252) and $(89)
 
(466
)
 
(164
)
Reclassification adjustment for amounts amortized into net periodic pension and postretirement benefit income, net of deferred income tax expense of $(62) and $(169):
 
 
 
 
Net actuarial loss
 
722

 
224

Prior service credit
 
(839
)
 
(537
)
Total reclassification adjustment associated with affiliate's pension and postretirement benefit plans
 
(117
)
 
(313
)
 
 
 
 
 
Other comprehensive income (loss)
 
(2,858
)
 
(4,729
)
 
 
 
 
 
Total comprehensive income
 
$
1,271

 
$
6,460


 
 
Nine months ended 
 September 30,
($ in thousands)
 
2016
 
2015
Net income
 
$
24,911

 
$
40,267

 
 
 
 
 
OTHER COMPREHENSIVE INCOME (LOSS)
 
 
 
 
Unrealized holding gains (losses) on investment securities, net of deferred income tax expense (benefit) of $11,145 and $(7,998)
 
20,698

 
(14,855
)
Reclassification adjustment for realized investment gains included in net income, net of income tax expense of $(1,613) and $(2,713)
 
(2,995
)
 
(5,039
)
Reclassification adjustment for amounts amortized into net periodic pension and postretirement benefit income, net of deferred income tax expense of $(327) and $(520):
 
 
 
 
Net actuarial loss
 
1,271

 
648

Prior service credit
 
(1,878
)
 
(1,612
)
Total reclassification adjustment associated with affiliate's pension and postretirement benefit plans
 
(607
)
 
(964
)
 
 
 
 
 
Other comprehensive income (loss)
 
17,096

 
(20,858
)
 
 
 
 
 
Total comprehensive income
 
$
42,007

 
$
19,409

All affiliated balances presented above are the result of related party transactions with Employers Mutual.

See accompanying Notes to Consolidated Financial Statements.


7


EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
 
Nine months ended 
 September 30,
($ in thousands)
 
2016
 
2015
CASH FLOWS FROM OPERATING ACTIVITIES
 
 
 
 
Net income
 
$
24,911

 
$
40,267

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Losses and settlement expenses (affiliated $24,292 and $24,595)
 
21,791

 
22,621

Unearned premiums (affiliated $32,902 and $32,636)
 
33,465

 
31,593

Other policyholders' funds due to affiliate
 
3,088

 
(1,560
)
Amounts due to/from affiliate to settle inter-company transaction balances
 
(2,383
)
 
(1,212
)
Net pension and postretirement benefits due from affiliate
 
(317
)
 
(2,366
)
Reinsurance receivables due from affiliate
 
1,646

 
3,204

Prepaid reinsurance premiums due from affiliate
 
(5,025
)
 
1,227

Commissions payable (affiliated $(3,682) and $(801))
 
(3,743
)
 
(778
)
Deferred policy acquisition costs (affiliated $(3,785) and $(5,629))
 
(3,900
)
 
(5,367
)
Accrued investment income
 
(1,354
)
 
(1,421
)
Current income tax
 
1,891

 
(2,577
)
Deferred income tax
 
(2,340
)
 
1,872

Net realized investment (gains) losses
 
643

 
(11,555
)
Other, net (affiliated $(451) and $704)
 
6,769

 
9,092

Total adjustments to reconcile net income to net cash provided by operating activities
 
50,231

 
42,773

Net cash provided by operating activities
 
75,142

 
83,040

CASH FLOWS FROM INVESTING ACTIVITIES
 
 
 
 
Purchases of fixed maturity securities available-for-sale
 
(338,659
)
 
(185,108
)
Disposals of fixed maturity securities available-for-sale
 
282,787

 
118,513

Purchases of equity securities available-for-sale
 
(45,632
)
 
(66,030
)
Disposals of equity securities available-for-sale
 
40,525

 
54,411

Purchases of other long-term investments
 
(5,920
)
 
(7,758
)
Disposals of other long-term investments
 
480

 
1,958

Net (purchases) disposals of short-term investments
 
(4,012
)
 
20,464

Net disbursements under reverse repurchase agreements
 

 
(16,850
)
Net cash used in investing activities
 
(70,431
)
 
(80,400
)
CASH FLOWS FROM FINANCING ACTIVITIES
 
 
 
 
Issuance of common stock through affiliate’s stock plans
 
7,615

 
7,738

Repurchase of common stock
 
(383
)
 

Excess tax benefit associated with affiliate’s stock plans
 

 
83

Dividends paid to stockholders (affiliated $(6,710) and $(5,925))
 
(11,817
)
 
(10,274
)
Net cash used in financing activities
 
(4,585
)
 
(2,453
)
NET INCREASE IN CASH
 
126

 
187

Cash at the beginning of the year
 
224

 
383

Cash at the end of the quarter
 
$
350

 
$
570

All affiliated balances presented above are the result of related party transactions with Employers Mutual.
See accompanying Notes to Consolidated Financial Statements.

8


EMC INSURANCE GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1.
BASIS OF PRESENTATION
EMC Insurance Group Inc., a majority owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance and reinsurance.  The Company writes property and casualty insurance in both commercial and personal lines of insurance, with a focus on medium-sized commercial accounts.  The term “Company” is used interchangeably to describe EMC Insurance Group Inc. (Parent Company only) and EMC Insurance Group Inc. and its subsidiaries.
The accompanying unaudited consolidated financial statements have been prepared on the basis of U.S. generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements.  The Company has evaluated all subsequent events through the date the financial statements were issued.  In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the interim financial statements have been included.  The results of operations for the interim periods reported are not necessarily indicative of results to be expected for the year.  The consolidated balance sheet at December 31, 2015 has been derived from the audited financial statements at that date, but does not include all of the information and notes required by GAAP for complete financial statements.
In reading these financial statements, reference should be made to the Company’s 2015 Form 10-K or the 2015 Annual Report to Stockholders for more detailed footnote information.

Accounting Pronouncements Adopted
In February 2015, the Financial Accounting Standards Board (FASB) updated its guidance related to the Consolidation Topic 810 of the Accounting Standards CodificationTM (Codification or ASC). The objective of this update is to improve consolidation guidance through changes in the analysis that a reporting entity must perform to determine whether it should consolidate certain types of legal entities. The guidance modifies the evaluation of whether limited partnerships and similar legal entities are variable interest entities or voting interest entities, while also eliminating the presumption that a general partner should consolidate a limited partnership. This guidance is effective for interim and annual periods beginning after December 15, 2015, and is to be applied either retrospectively or through a modified retrospective approach by recording a cumulative-effect adjustment to equity as of the beginning of the fiscal year of adoption. The Company adopted this guidance in the first quarter of 2016. Adoption of this guidance did not have an impact on the consolidated financial condition or operating results of the Company.
In March 2016, the FASB updated its guidance related to Stock Compensation Topic 718 of the ASC.  The objective of this update was to simplify the accounting for employee share-based payments. The provisions applicable to the Company primarily involve the accounting treatment for excess tax benefits, which is the excess of the actual tax benefit realized by the Company upon the exercise of non-qualified stock options (by Employers Mutual's employees) over the deferred income tax benefit previously recognized in conjunction with the compensation expense (tax deficiency if the actual tax benefit realized is less than the previously recognized deferred income tax benefit). The FASB permitted early prospective adoption of these provisions, and the Company elected to adopt effective January 1, 2016. As a result, effective January 1, 2016 the Company no longer records to additional paid-in capital the excess tax benefits (deficiencies) allocated to it through the pooling agreement, but instead recognizes these amounts through the consolidated statements of income as components of current and deferred income taxes. The requirement that these excess tax benefits (deficiencies) be reflected as financing cash flows in the consolidated statements of cash flows was also removed, and these amounts are now reflected as cash flows from operating activities on a prospective basis.


9


2.
TRANSACTIONS WITH AFFILIATES
The Inter-Company Committees of the boards of directors of the Company and Employers Mutual approved a new inter-company reinsurance program between the Company's insurance subsidiaries in the property and casualty insurance segment and Employers Mutual for calendar year 2016. This reinsurance program is intended to reduce the volatility of the Company's quarterly results caused by excessive catastrophe and storm losses, and provide protection from both the frequency and severity of such losses. The reinsurance program consists of two semi-annual aggregate catastrophe excess of loss treaties. The first treaty was effective from January 1, 2016 through June 30, 2016, and had a retention of $20.0 million and a limit of $24.0 million. The total cost of this treaty was approximately $6.3 million. The second treaty is effective from July 1, 2016 through December 31, 2016, and has a retention of $15.0 million and a limit of $12.0 million. The total cost of this treaty is approximately $1.5 million. All catastrophe and storm losses assumed by the property and casualty insurance subsidiaries (net of applicable reinsurance recoveries from external reinsurance protections purchased by the pool participants) are subject to the terms of these treaties, and there is no co-participation provision. Losses and settlement expenses ceded to Employers Mutual under these treaties totaled $3.5 million and $5.1 million during the three and nine months ended September 30, 2016, respectively. Only $213,000 remains in the $15.0 million retention before recoveries will be realized under the July 1, 2016 through December 31, 2016 treaty.
The Inter-Company Committees of the boards of directors of the Company and Employers Mutual also approved a change in the inter-company reinsurance program between the Company's reinsurance subsidiary and Employers Mutual for calendar year 2016. The reinsurance program consists of two treaties. The first is a per occurrence catastrophe excess of loss treaty with a retention of $10.0 million, a limit of $10.0 million, 20 percent co-participation, and no reinstatement. The total cost of this treaty is approximately $2.0 million. The second is an annual aggregate catastrophe excess of loss treaty with a retention of $20.0 million, a limit of $100.0 million, and 20 percent co-participation. The total cost of this treaty is approximately $3.1 million. Any losses recovered under the per occurrence treaty inure to the benefit of the aggregate treaty. Only catastrophic events with total losses greater than $500,000 are subject to the terms of the aggregate treaty. The reinsurance subsidiary has purchased additional reinsurance protection (Industry Loss Warranties) in peak exposure territories from external parties in which coverage is triggered when losses experienced by the insurance industry from a catastrophic event exceed a specified threshold. Any reinsurance recoveries received from external parties reduce the amount of losses ceded to Employers Mutual under the catastrophe excess of loss program. The net cost of the external reinsurance protection will be approximately $3.5 million in 2016. There were no recoveries under the reinsurance program during the first nine months of 2016.

3.
REINSURANCE
The effect of reinsurance on premiums written and earned, and losses and settlement expenses incurred, for the three and nine months ended September 30, 2016 and 2015 is presented below.  The classification of the assumed and ceded reinsurance amounts between affiliates and nonaffiliates is based on the participants in the underlying reinsurance agreements, and is intended to provide an understanding of the actual source of the reinsurance activities.  This presentation differs from the classifications used in the consolidated financial statements, where all amounts flowing through the pooling, quota share and excess of loss agreements with Employers Mutual are reported as “affiliated” balances.

10


 
 
Three months ended September 30, 2016
($ in thousands)
 
Property and
casualty
insurance
 
Reinsurance
 
Total
Premiums written
 
 
 
 
 
 
Direct
 
$
119,849

 
$

 
$
119,849

Assumed from nonaffiliates
 
1,221

 
39,592

 
40,813

Assumed from affiliates
 
146,289

 

 
146,289

Ceded to nonaffiliates
 
(7,841
)
 
(983
)
 
(8,824
)
Ceded to affiliates
 
(120,614
)
 
(1,270
)
 
(121,884
)
Net premiums written
 
$
138,904

 
$
37,339

 
$
176,243

 
 
 
 
 
 
 
Premiums earned
 
 
 
 
 
 
Direct
 
$
96,730

 
$

 
$
96,730

Assumed from nonaffiliates
 
1,170

 
39,394

 
40,564

Assumed from affiliates
 
122,058

 

 
122,058

Ceded to nonaffiliates
 
(6,091
)
 
(2,315
)
 
(8,406
)
Ceded to affiliates
 
(97,495
)
 
(1,270
)
 
(98,765
)
Net premiums earned
 
$
116,372

 
$
35,809

 
$
152,181

 
 
 
 
 
 
 
Losses and settlement expenses incurred
 
 
 
 
 
 
Direct
 
$
59,831

 
$

 
$
59,831

Assumed from nonaffiliates
 
793

 
27,206

 
27,999

Assumed from affiliates
 
85,196

 
280

 
85,476

Ceded to nonaffiliates
 
(895
)
 
(944
)
 
(1,839
)
Ceded to affiliates
 
(63,282
)
 
(12
)
 
(63,294
)
Net losses and settlement expenses incurred
 
$
81,643

 
$
26,530

 
$
108,173


11


 
 
Three months ended September 30, 2015
($ in thousands)
 
Property and
casualty
insurance
 
Reinsurance
 
Total
Premiums written
 
 
 
 
 
 
Direct
 
$
117,187

 
$

 
$
117,187

Assumed from nonaffiliates
 
1,178

 
34,954

 
36,132

Assumed from affiliates
 
141,200

 

 
141,200

Ceded to nonaffiliates
 
(7,656
)
 
(774
)
 
(8,430
)
Ceded to affiliates
 
(117,187
)
 
(2,734
)
 
(119,921
)
Net premiums written
 
$
134,722

 
$
31,446

 
$
166,168

 
 
 
 
 
 
 
Premiums earned
 
 
 
 
 
 
Direct
 
$
92,083

 
$

 
$
92,083

Assumed from nonaffiliates
 
1,073

 
35,939

 
37,012

Assumed from affiliates
 
118,784

 

 
118,784

Ceded to nonaffiliates
 
(6,104
)
 
(1,170
)
 
(7,274
)
Ceded to affiliates
 
(92,083
)
 
(2,734
)
 
(94,817
)
Net premiums earned
 
$
113,753

 
$
32,035

 
$
145,788

 
 
 
 
 
 
 
Losses and settlement expenses incurred
 
 
 
 
 
 
Direct
 
$
53,717

 
$

 
$
53,717

Assumed from nonaffiliates
 
655

 
27,677

 
28,332

Assumed from affiliates
 
76,697

 
252

 
76,949

Ceded to nonaffiliates
 
(1,376
)
 
(877
)
 
(2,253
)
Ceded to affiliates
 
(53,717
)
 
(343
)
 
(54,060
)
Net losses and settlement expenses incurred
 
$
75,976

 
$
26,709

 
$
102,685


12


 
 
Nine months ended September 30, 2016
($ in thousands)
 
Property and
casualty
insurance
 
Reinsurance
 
Total
Premiums written
 
 
 
 
 
 
Direct
 
$
311,542

 
$

 
$
311,542

Assumed from nonaffiliates
 
3,430

 
111,378

 
114,808

Assumed from affiliates
 
393,418

 

 
393,418

Ceded to nonaffiliates
 
(19,069
)
 
(8,814
)
 
(27,883
)
Ceded to affiliates
 
(318,617
)
 
(3,810
)
 
(322,427
)
Net premiums written
 
$
370,704

 
$
98,754

 
$
469,458

 
 
 
 
 
 
 
Premiums earned
 
 
 
 
 
 
Direct
 
$
284,281

 
$

 
$
284,281

Assumed from nonaffiliates
 
3,332

 
111,790

 
115,122

Assumed from affiliates
 
359,985

 

 
359,985

Ceded to nonaffiliates
 
(17,653
)
 
(5,205
)
 
(22,858
)
Ceded to affiliates
 
(291,356
)
 
(3,810
)
 
(295,166
)
Net premiums earned
 
$
338,589

 
$
102,775

 
$
441,364

 
 
 
 
 
 
 
Losses and settlement expenses incurred
 
 
 
 
 
 
Direct
 
$
167,827

 
$

 
$
167,827

Assumed from nonaffiliates
 
2,298

 
71,787

 
74,085

Assumed from affiliates
 
232,472

 
1,033

 
233,505

Ceded to nonaffiliates
 
(4,498
)
 
(2,336
)
 
(6,834
)
Ceded to affiliates
 
(172,892
)
 
411

 
(172,481
)
Net losses and settlement expenses incurred
 
$
225,207

 
$
70,895

 
$
296,102


13


 
 
Nine months ended September 30, 2015
($ in thousands)
 
Property and
casualty
insurance
 
Reinsurance
 
Total
Premiums written
 
 
 
 
 
 
Direct
 
$
297,974

 
$

 
$
297,974

Assumed from nonaffiliates
 
3,296

 
107,821

 
111,117

Assumed from affiliates
 
379,761

 

 
379,761

Ceded to nonaffiliates
 
(18,728
)
 
(2,480
)
 
(21,208
)
Ceded to affiliates
 
(297,974
)
 
(8,427
)
 
(306,401
)
Net premiums written
 
$
364,329

 
$
96,914

 
$
461,243

 
 
 
 
 
 
 
Premiums earned
 
 
 
 
 
 
Direct
 
$
273,441

 
$

 
$
273,441

Assumed from nonaffiliates
 
3,165

 
109,134

 
112,299

Assumed from affiliates
 
347,686

 

 
347,686

Ceded to nonaffiliates
 
(17,639
)
 
(4,795
)
 
(22,434
)
Ceded to affiliates
 
(273,441
)
 
(8,427
)
 
(281,868
)
Net premiums earned
 
$
333,212

 
$
95,912

 
$
429,124

 
 
 
 
 
 
 
Losses and settlement expenses incurred
 
 
 
 
 
 
Direct
 
$
151,565

 
$

 
$
151,565

Assumed from nonaffiliates
 
1,878

 
69,041

 
70,919

Assumed from affiliates
 
216,197

 
721

 
216,918

Ceded to nonaffiliates
 
(2,607
)
 
(4,065
)
 
(6,672
)
Ceded to affiliates
 
(151,565
)
 
(562
)
 
(152,127
)
Net losses and settlement expenses incurred
 
$
215,468

 
$
65,135

 
$
280,603


Individual lines in the above tables are defined as follows:
“Direct” represents business produced by the property and casualty insurance subsidiaries.
“Assumed from nonaffiliates” for the property and casualty insurance subsidiaries represents their aggregate 30 percent pool participation percentage of involuntary business assumed by the pool participants pursuant to state law. For the reinsurance subsidiary, this line represents the reinsurance business assumed through the quota share agreement (including “fronting” activities initiated by Employers Mutual) and the business assumed outside the quota share agreement.
“Assumed from affiliates” for the property and casualty insurance subsidiaries represents their aggregate 30 percent pool participation percentage of all the pool members’ direct business.  The amounts reported under the caption “Losses and settlement expenses incurred” also include claim-related services provided by Employers Mutual that are allocated to the property and casualty insurance subsidiaries and the reinsurance subsidiary.
“Ceded to nonaffiliates” for the property and casualty insurance subsidiaries represents their aggregate 30 percent pool participation percentage of 1) the amounts ceded to nonaffiliated reinsurance companies in accordance with the terms of the reinsurance agreements providing protection to the pool and each of its participants, and 2) the amounts ceded on a mandatory basis to state organizations in connection with various programs.  For the reinsurance subsidiary, this line includes 1) reinsurance business that is ceded to other insurance companies in connection with “fronting” activities initiated by Employers Mutual, and 2) starting in 2016, amounts ceded to purchase Industry Loss Warranties (ILWs) from external parties that provide additional reinsurance protection for the assumed reinsurance business.
“Ceded to affiliates” for the property and casualty insurance subsidiaries represents the cession of their direct business to Employers Mutual under the terms of the pooling agreement and amounts ceded to Employers Mutual under the terms of the catastrophe excess of loss reinsurance program.  For the reinsurance subsidiary this line represents amounts ceded to Employers Mutual under the terms of the catastrophe excess of loss reinsurance program.

14


4.
SEGMENT INFORMATION

The Company’s operations consist of a property and casualty insurance segment and a reinsurance segment.  The property and casualty insurance segment writes both commercial and personal lines of insurance, with a focus on medium-sized commercial accounts.  The reinsurance segment provides reinsurance for other insurers and reinsurers.  The segments are managed separately due to differences in the insurance products sold and the business environments in which they operate. Management evaluates the performance of its insurance segments using financial measurements based on Statutory Accounting Principles (SAP) instead of GAAP. Such measures include premiums written, premiums earned, statutory underwriting profit (loss), and investment results, as well as loss and loss adjustment expense ratios, trade underwriting expense ratios, and combined ratios.
Summarized financial information for the Company’s segments is as follows:
Three months ended September 30, 2016
 
Property and
casualty
insurance
 
Reinsurance
 
Parent
company
 
Consolidated
($ in thousands)
 
 
 
 
Premiums earned
 
$
116,372

 
$
35,809

 
$

 
$
152,181

 
 
 
 
 
 
 
 
 
Underwriting profit (loss):
 
 
 
 
 
 
 
 
SAP underwriting profit (loss)
 
(8,081
)
 
689

 

 
(7,392
)
GAAP adjustments
 
2,970

 
35

 

 
3,005

GAAP underwriting profit (loss)
 
(5,111
)
 
724

 

 
(4,387
)
 
 
 
 
 
 
 
 
 
Net investment income (loss)
 
8,185

 
3,285

 
4

 
11,474

Net realized investment gains (losses)
 
(799
)
 
(393
)
 

 
(1,192
)
Other income (loss)
 
172

 
(257
)
 

 
(85
)
Interest expense
 
84

 

 

 
84

Other expenses
 
190

 

 
489

 
679

Income (loss) before income tax expense (benefit)
 
$
2,173

 
$
3,359

 
$
(485
)
 
$
5,047


Three months ended September 30, 2015
 
Property and
casualty
insurance
 
Reinsurance
 
Parent
company
 
Consolidated
($ in thousands)
 
 
 
 
Premiums earned
 
$
113,753

 
$
32,035

 
$

 
$
145,788

 
 
 
 
 
 
 
 
 
Underwriting profit (loss):
 
 
 
 
 
 
 
 
SAP underwriting profit (loss)
 
(2,487
)
 
(2,167
)
 

 
(4,654
)
GAAP adjustments
 
2,386

 
(368
)
 

 
2,018

GAAP underwriting profit (loss)
 
(101
)
 
(2,535
)
 

 
(2,636
)
 
 
 
 
 
 
 
 
 
Net investment income (loss)
 
8,125

 
3,176

 
(2
)
 
11,299

Net realized investment gains (losses)
 
4,889

 
2,609

 

 
7,498

Other income (loss)
 
210

 
309

 

 
519

Interest expense
 
84

 

 

 
84

Other expenses
 
196

 

 
479

 
675

Income (loss) before income tax expense (benefit)
 
$
12,843

 
$
3,559

 
$
(481
)
 
$
15,921


15


Nine months ended September 30, 2016
 
Property and
casualty
insurance
 
Reinsurance
 
Parent
company
 
Consolidated
($ in thousands)
 
 
 
 
Premiums earned
 
$
338,589

 
$
102,775

 
$

 
$
441,364

 
 
 
 
 
 
 
 
 
Underwriting profit (loss):
 
 
 
 
 
 
 
 
SAP underwriting profit (loss)
 
(8,904
)
 
7,777

 

 
(1,127
)
GAAP adjustments
 
3,026

 
(803
)
 

 
2,223

GAAP underwriting profit (loss)
 
(5,878
)
 
6,974

 

 
1,096

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net investment income (loss)
 
25,524

 
10,350

 
9

 
35,883

Net realized investment gains (losses)
 
(627
)
 
(16
)
 

 
(643
)
Other income (loss)
 
466

 
(485
)
 

 
(19
)
Interest expense
 
253

 

 

 
253

Other expenses
 
558

 

 
1,495

 
2,053

Income (loss) before income tax expense (benefit)
 
$
18,674

 
$
16,823

 
$
(1,486
)
 
$
34,011

 
 
 
 
 
 
 
 
 
Assets
 
$
1,170,108

 
$
465,733

 
$
562,535

 
$
2,198,376

Eliminations
 

 

 
(554,093
)
 
(554,093
)
Reclassifications
 
(2,187
)
 
(3,426
)
 
(1,165
)
 
(6,778
)
Total assets
 
$
1,167,921

 
$
462,307

 
$
7,277

 
$
1,637,505


Nine months ended September 30, 2015
 
Property and
casualty
insurance
 
Reinsurance
 
Parent
company
 
Consolidated
($ in thousands)
 
 
 
 
Premiums earned
 
$
333,212

 
$
95,912

 
$

 
$
429,124

 
 
 
 
 
 
 
 
 
Underwriting profit (loss):
 
 
 
 
 
 
 
 
SAP underwriting profit (loss)
 
(497
)
 
4,685

 

 
4,188

GAAP adjustments
 
7,962

 
705

 

 
8,667

GAAP underwriting profit (loss)
 
7,465

 
5,390

 

 
12,855

 
 
 
 
 
 
 
 
 
Net investment income (loss)
 
24,301

 
9,654

 
(9
)
 
33,946

Net realized investment gains (losses)
 
7,866

 
3,689

 

 
11,555

Other income (loss)
 
582

 
1,040

 

 
1,622

Interest expense
 
253

 

 

 
253

Other expenses
 
568

 

 
1,424

 
1,992

Income (loss) before income tax expense (benefit)
 
$
39,393

 
$
19,773

 
$
(1,433
)
 
$
57,733

 
 
 
 
 
 
 
 
 
Year ended December 31, 2015
 
 
 
 
 
 
 
 
Assets
 
$
1,092,820

 
$
437,575

 
$
525,042

 
$
2,055,437

Eliminations
 

 

 
(514,309
)
 
(514,309
)
Reclassifications
 

 
(5,173
)
 

 
(5,173
)
Total assets
 
$
1,092,820

 
$
432,402

 
$
10,733

 
$
1,535,955


16


The following table displays the net premiums earned for the property and casualty insurance segment and the reinsurance segment for the three and nine months ended September 30, 2016 and 2015, by line of insurance.
 
 
Three months ended September 30,
 
Nine months ended September 30,
($ in thousands)
 
2016
 
2015
 
2016
 
2015
Property and casualty insurance segment
 
 
 
 
 
 
 
 
Commercial lines:
 
 
 
 
 
 
 
 
Automobile
 
$
28,113

 
$
27,080

 
$
82,449

 
$
78,698

Property
 
27,471

 
26,526

 
77,292

 
77,518

Workers' compensation
 
24,536

 
23,777

 
71,272

 
69,150

Liability
 
24,277

 
23,449

 
72,086

 
68,952

Other
 
2,102

 
2,032

 
6,246

 
6,044

Total commercial lines
 
106,499

 
102,864

 
309,345

 
300,362

 
 
 
 
 
 
 
 
 
Personal lines
 
9,873

 
10,889

 
29,244

 
32,850

Total property and casualty insurance
 
$
116,372

 
$
113,753

 
$
338,589

 
$
333,212

 
 
 
 
 
 
 
 
 
Reinsurance segment
 
 
 
 
 
 
 
 
Pro rata reinsurance
 
$
15,066

 
$
13,037

 
$
44,175

 
$
40,154

Excess of loss reinsurance
 
20,743

 
18,998

 
58,600

 
55,758

Total reinsurance
 
$
35,809

 
$
32,035

 
$
102,775

 
$
95,912

 
 
 
 
 
 
 
 
 
Consolidated
 
$
152,181

 
$
145,788

 
$
441,364

 
$
429,124


5.
INCOME TAXES
The actual income tax expense for the three and nine months ended September 30, 2016 and 2015 differed from the “expected” income tax expense for those periods (computed by applying the United States federal corporate tax rate of 35 percent to income before income tax expense) as follows:
 
 
Three months ended 
 September 30,
 
Nine months ended 
 September 30,
($ in thousands)
 
2016
 
2015
 
2016
 
2015
Computed "expected" income tax expense
 
$
1,767

 
$
5,573

 
$
11,904

 
$
20,207

Increases (decreases) in tax resulting from:
 
 
 
 
 
 
 
 
Tax-exempt interest income
 
(709
)
 
(687
)
 
(2,101
)
 
(2,072
)
Dividends received deduction
 
(336
)
 
(266
)
 
(1,110
)
 
(809
)
Proration of tax-exempt interest and dividends received deduction
 
157

 
143

 
482

 
432

Other, net
 
39

 
(31
)
 
(75
)
 
(292
)
Total income tax expense
 
$
918

 
$
4,732

 
$
9,100

 
$
17,466


The Company had no provision for uncertain income tax positions at September 30, 2016 or December 31, 2015.  The Company did not recognize any interest expense or other penalties related to U.S. federal or state income taxes during the three or nine months ended September 30, 2016 or 2015.  It is the Company’s accounting policy to reflect income tax penalties as other expense, and interest as interest expense.
The Company files a U.S. federal income tax return, along with various state income tax returns.  The Company is no longer subject to U.S. federal and state income tax examinations by tax authorities for years before 2013.  


17


6.
EMPLOYEE RETIREMENT PLANS
The components of net periodic benefit cost (income) for Employers Mutual’s pension and postretirement benefit plans is as follows:
 
 
Three months ended 
 September 30,
 
Nine months ended 
 September 30,
($ in thousands)
 
2016
 
2015
 
2016
 
2015
Pension plans:
 
 
 
 
 
 
 
 
Service cost
 
$
3,639

 
$
3,497

 
$
10,824

 
$
10,471

Interest cost
 
2,551

 
2,341

 
7,620

 
6,983

Expected return on plan assets
 
(4,841
)
 
(5,074
)
 
(14,521
)
 
(15,223
)
Amortization of net actuarial loss
 
1,111

 
719

 
3,233

 
2,033

Amortization of prior service cost
 
9

 
8

 
24

 
23

Net periodic pension benefit cost
 
$
2,469

 
$
1,491

 
$
7,180

 
$
4,287

 
 
 
 
 
 
 
 
 
Postretirement benefit plans:
 
 
 
 
 
 
 
 
Service cost
 
$
319

 
$
353

 
$
955

 
$
1,059

Interest cost
 
553

 
537

 
1,661

 
1,611

Expected return on plan assets
 
(1,056
)
 
(1,104
)
 
(3,168
)
 
(3,312
)
Amortization of net actuarial loss
 
374

 
437

 
1,121

 
1,309

Amortization of prior service credit
 
(2,835
)
 
(2,867
)
 
(8,504
)
 
(8,600
)
Net periodic postretirement benefit income
 
$
(2,645
)
 
$
(2,644
)
 
$
(7,935
)
 
$
(7,933
)

Net periodic pension benefit cost allocated to the Company amounted to $1.1 million and $456,000 for the three months and $2.5 million and $1.3 million for the nine months ended September 30, 2016 and 2015, respectively.  Net periodic postretirement benefit income allocated to the Company amounted to $937,000 and $761,000 for the three months and $2.4 million and $2.3 million for the nine months ended September 30, 2016 and 2015, respectively.
The Company’s share of Employers Mutual’s remaining 2016 planned contribution to the pension plan, if made, will be approximately $2.5 million. No contributions will be made to the Voluntary Employee Beneficiary Association (VEBA) trust in 2016.

7.
STOCK-BASED COMPENSATION
The Company has no stock-based compensation plans of its own; however, Employers Mutual has several stock plans which utilize the common stock of the Company. Employers Mutual can provide the common stock required under its plans by: 1) using shares of common stock that it currently owns; 2) purchasing common stock in the open market; or 3) directly purchasing common stock from the Company at the current fair value.  Employers Mutual's current practice is to purchase common stock from the Company for use in all of its stock plans (including its non-employee director stock purchase plan and its employee stock purchase plan).
Stock Plans
Employers Mutual currently maintains two separate stock plans for the benefit of officers and key employees of Employers Mutual and its subsidiaries.  A total of 2,250,000 shares of the Company’s common stock have been reserved for issuance under the 2003 Employers Mutual Casualty Company Incentive Stock Option Plan (2003 Plan) and a total of 3,000,000 shares have been reserved for issuance under the 2007 Employers Mutual Casualty Company Stock Incentive Plan (2007 Plan). During the second quarter of 2016, the compensation committees of Employers Mutual and the Company approved the issuance of restricted stock awards to the non-employee directors of the Company under the 2007 Plan.

18


The 2003 Plan permitted the issuance of incentive stock options only, while the 2007 Plan permits the issuance of performance shares, performance units, and other stock-based awards, in addition to qualified (incentive) and non-qualified stock options, stock appreciation rights, restricted stock and restricted stock units.  Both plans provide for a ten-year time limit for granting awards.  No additional options can be granted under the 2003 Plan due to the expiration of the term of the plan. Options granted under the plans generally have a vesting period of five years, with options becoming exercisable in equal annual cumulative increments commencing on the first anniversary of the option grant.  Option prices cannot be less than the fair value of the common stock on the date of grant. Restricted stock awards granted under the 2007 Plan generally have a vesting period of four years, with shares vesting in equal annual cumulative increments commencing on the first anniversary of the grant, with the exception of death or permanent disability, any unvested shares of restricted stock are forfeited on termination of employment, including retirement. Holders of unvested shares of restricted stock receive compensation income equal to the amount of any dividends declared on the common stock. During the second quarter of 2016, 2,000 shares of restricted stock was granted to non-employee directors of the Company. The restricted stock vests over a period of three years or upon a director reaching 75 years of age while an active director.
The Senior Executive Compensation Committee of Employers Mutual’s Board of Directors grants the awards and is the administrator of the plans.  The Company’s Compensation Committee must consider and approve all awards granted to the Company’s executive officers and directors.
The Company recognized compensation expense from these plans of $218,000 ($142,000 net of tax) and $167,000 ($108,000 net of tax) for the three months and $542,000 ($353,000 net of tax) and $351,000 ($228,000 net of tax) for the nine months ended September 30, 2016 and 2015, respectively.  During the first nine months of 2016, 118,588 shares of restricted stock were granted under the 2007 Plan to eligible participants, 69,057 shares of restricted stock vested, and 196,248 options were exercised under the plans at a weighted average exercise price of $15.54.


19


8.
DISCLOSURES ABOUT THE FAIR VALUES OF FINANCIAL INSTRUMENTS
The carrying amounts and estimated fair values of the Company’s financial instruments as of September 30, 2016 and December 31, 2015 are summarized in the tables below.
September 30, 2016
 
Carrying
amounts
 
Estimated
fair values
($ in thousands)
 
 
Assets:
 
 
 
 
Fixed maturity securities available-for-sale:
 
 
 
 
U.S. treasury
 
$
8,207

 
$
8,207

U.S. government-sponsored agencies
 
237,494

 
237,494

Obligations of states and political subdivisions
 
349,912

 
349,912

Commercial mortgage-backed
 
41,882

 
41,882

Residential mortgage-backed
 
99,509

 
99,509

Other asset-backed
 
28,251

 
28,251

Corporate
 
471,895

 
471,895

Total fixed maturity securities available-for-sale
 
1,237,150

 
1,237,150

 
 
 
 
 
Equity securities available-for-sale:
 
 
 
 
Common stocks:
 
 
 
 
Financial services
 
32,419

 
32,419

Information technology
 
30,937

 
30,937

Healthcare
 
27,519

 
27,519

Consumer staples
 
21,066

 
21,066

Consumer discretionary
 
24,046

 
24,046

Energy
 
18,829

 
18,829

Industrials
 
23,694

 
23,694

Other
 
21,322

 
21,322

Non-redeemable preferred stocks
 
19,450

 
19,450

Total equity securities available-for-sale
 
219,282

 
219,282

 
 
 
 
 
Short-term investments
 
42,611

 
42,611

 
 
 
 
 
Liabilities:
 
 
 
 
Surplus notes
 
25,000

 
12,131


20


December 31, 2015
 
Carrying
amounts
 
Estimated
fair values
($ in thousands)
 
 
Assets:
 
 
 
 
Fixed maturity securities available-for-sale:
 
 
 
 
U.S. treasury
 
$
12,589

 
$
12,589

U.S. government-sponsored agencies
 
202,666

 
202,666

Obligations of states and political subdivisions
 
344,359

 
344,359

Commercial mortgage-backed
 
46,108

 
46,108

Residential mortgage-backed
 
88,543

 
88,543

Other asset-backed
 
17,844

 
17,844

Corporate
 
448,916

 
448,916

Total fixed maturity securities available-for-sale
 
1,161,025

 
1,161,025

 
 
 
 
 
Equity securities available-for-sale:
 
 
 
 
Common stocks:
 
 
 
 
Financial services
 
33,955

 
33,955

Information technology
 
28,102

 
28,102

Healthcare
 
25,894

 
25,894

Consumer staples
 
18,200

 
18,200

Consumer discretionary
 
18,923

 
18,923

Energy
 
21,068

 
21,068

Industrials
 
20,416

 
20,416

Other
 
20,683

 
20,683

Non-redeemable preferred stocks
 
19,002

 
19,002

Total equity securities available-for-sale
 
206,243

 
206,243

 
 
 
 
 
Short-term investments
 
38,599

 
38,599

 
 
 
 
 
Liabilities:
 
 
 
 
Surplus notes
 
25,000

 
10,823


The estimated fair values of fixed maturity and equity securities is based on quoted market prices, where available.  In cases where quoted market prices are not available, fair values are based on a variety of valuation techniques depending on the type of security.
Short-term investments generally include money market funds, U.S. Treasury bills and commercial paper.  Short-term investments are carried at fair value, which approximates cost, due to the highly liquid nature of the securities.   Short-term securities are classified as Level 1 fair value measurements when the fair values can be validated by recent trades.  When recent trades are not available, fair value is deemed to be the cost basis and the securities are classified as Level 2 fair value measurements.
The estimated fair value of the surplus notes is derived by discounting future expected cash flows at a rate deemed appropriate.  The discount rate was set at the average of current yields-to-maturity on several insurance company surplus notes that are traded in observable markets, adjusted upward by 50 basis points to reflect illiquidity and perceived risk premium differences. Other assumptions include a 25-year term (the surplus notes have no stated maturity date) and an interest rate that continues at the current 1.35 percent interest rate. The rate is typically adjusted every five years and is based upon the then-current Federal Home Loan Bank borrowing rate for 5-year funds available to Employers Mutual.

21


Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  The following fair value hierarchy prioritizes inputs to valuation techniques used to measure fair value.
 
Level 1 -
Unadjusted quoted prices for identical assets or liabilities in active markets that the Company has the ability to access.
 
 
 
 
Level 2 -
Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in inactive markets; or valuations based on models where the significant inputs are observable (e.g., interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.) or can be corroborated by observable market data.
 
 
 
 
Level 3 -
Prices or valuation techniques that require significant unobservable inputs because observable inputs are not available.  The unobservable inputs may reflect the Company’s own judgments about the assumptions that market participants would use.
The Company uses an independent pricing source to obtain the estimated fair values of a majority of its securities, subject to an internal validation.  The fair values are based on quoted market prices, where available.  This is typically the case for equity securities and money market funds, which are accordingly classified as Level 1 fair value measurements.  In cases where quoted market prices are not available, fair values are based on a variety of valuation techniques depending on the type of security.  Fixed maturity securities, non-redeemable preferred stocks and various short-term investments in the Company’s portfolio may not trade on a daily basis; however, observable inputs are utilized in their valuations, and these securities are therefore classified as Level 2 fair value measurements.  Following is a brief description of the various pricing techniques used by the independent pricing source for different asset classes.
U.S. Treasury securities (including bonds, notes, and bills) are priced according to a number of live data sources, including active market makers and inter-dealer brokers.  Prices from these sources are reviewed based on the sources’ historical accuracy for individual issues and maturity ranges.
U.S. government-sponsored agencies and corporate securities (including fixed-rate corporate bonds and medium-term notes) are priced by determining a bullet (non-call) spread scale for each issuer for maturities going out to forty years.  These spreads represent credit risk and are obtained from the new issue market, secondary trading, and dealer quotes.  An option adjusted spread model is incorporated to adjust spreads of issues that have early redemption features.  The final spread is then added to the U.S. Treasury curve.
Obligations of states and political subdivisions are priced by tracking and analyzing actively quoted issues and reported trades, material event notices and benchmark yields.  Municipal bonds with similar characteristics are grouped together into market sectors, and internal yield curves are constructed daily for these sectors.  Individual bond evaluations are extrapolated from these sectors, with the ability to make individual spread adjustments for attributes such as discounts, premiums, alternative minimum tax, and/or whether or not the bond is callable.
Mortgage-backed and asset-backed securities are first reviewed for the appropriate pricing speed (if prepayable), spread, yield and volatility.  The securities are priced with models using spreads and other information solicited from Wall Street buy- and sell-side sources, including primary and secondary dealers, portfolio managers, and research analysts.  To determine a tranche’s price, first the benchmark yield is determined and adjusted for collateral performance, tranche level attributes and market conditions.  Then the cash flow for each tranche is generated (using consensus prepayment speed assumptions including, as appropriate, a prepayment projection based on historical statistics of the underlying collateral).  The tranche-level yield is used to discount the cash flows and generate the price.  Depending on the characteristics of the tranche, a volatility-driven, multi-dimensional single cash flow stream model or an option-adjusted spread model may be used.  When cash flows or other security structure or market information is not available, broker quotes may be used.

22


On a quarterly basis, the Company receives from its independent pricing service a list of fixed maturity securities, if any, that were priced solely from broker quotes.  For these securities, fair value may be determined using the broker quotes, or by the Company using similar pricing techniques as the Company’s independent pricing service.  Depending on the level of observable inputs, these securities would be classified as Level 2 or Level 3 fair value measurements.   At September 30, 2016 and December 31, 2015, the Company had no securities priced solely from broker quotes.
A small number of the Company’s securities are not priced by the independent pricing service.  One equity security is reported as a Level 3 fair value measurement at September 30, 2016 and December 31, 2015, since no reliable observable inputs are used in its valuation.  This equity security continues to be reported at the fair value obtained from the Securities Valuation Office (SVO) of the National Association of Insurance Commissioners (NAIC).  The SVO establishes a per share price for this security based on an annual review of that company’s financial statements, typically performed during the second quarter.  The other securities not priced by the Company’s independent pricing service at September 30, 2016 include nine fixed maturity securities (seven at December 31, 2015). Two of these fixed maturity securities, classified as Level 3 fair value measurements, are corporate securities that convey premium tax benefits and are not publicly traded. The fair values for these securities are based on discounted cash flow analyses. The other fixed maturity securities are classified as Level 2 fair value measurements.  The fair values for these fixed maturity securities were obtained from either the SVO, the Company's investment custodian, or the Company's investment department using similar pricing techniques as the Company’s independent pricing service.

23


Presented in the tables below are the estimated fair values of the Company’s financial instruments as of September 30, 2016 and December 31, 2015.
September 30, 2016
 
 
 
Fair value measurements using
($ in thousands)
 
Total
 
Quoted
prices in
active markets
for identical
assets
(Level 1)
 
Significant
other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
Financial instruments reported at fair value on recurring basis:
 
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
 
Fixed maturity securities available-for-sale:
 
 
 
 
 
 
 
 
U.S. treasury
 
$
8,207

 
$

 
$
8,207

 
$

U.S. government-sponsored agencies
 
237,494

 

 
237,494

 

Obligations of states and political subdivisions
 
349,912

 

 
349,912

 

Commercial mortgage-backed
 
41,882

 

 
41,882

 

Residential mortgage-backed
 
99,509

 

 
99,509

 

Other asset-backed
 
28,251

 

 
28,251

 

Corporate
 
471,895

 

 
470,825

 
1,070

Total fixed maturity securities available-for-sale
 
1,237,150

 

 
1,236,080

 
1,070

 
 
 
 
 
 
 
 
 
Equity securities available-for-sale:
 
 
 
 
 
 
 
 
Common stocks:
 
 
 
 
 
 
 
 
Financial services
 
32,419

 
32,416

 

 
3

Information technology
 
30,937

 
30,937

 

 

Healthcare
 
27,519

 
27,519

 

 

Consumer staples
 
21,066

 
21,066

 

 

Consumer discretionary
 
24,046

 
24,046

 

 

Energy
 
18,829

 
18,829

 

 

Industrials
 
23,694

 
23,694

 

 

Other
 
21,322

 
21,322

 

 

Non-redeemable preferred stocks
 
19,450

 
11,991

 
7,459

 

Total equity securities available-for-sale
 
219,282

 
211,820

 
7,459

 
3

 
 
 
 
 
 
 
 
 
Short-term investments
 
42,611

 
42,611

 

 

 
 
 
 
 
 
 
 
 
Financial instruments not reported at fair value:
 
 
 
 
 
 
 
 
Liabilities:
 
 
 
 
 
 
 
 
Surplus notes
 
12,131

 

 

 
12,131


24


December 31, 2015
 
 
 
Fair value measurements using
($ in thousands)
 
Total
 
Quoted
prices in
active markets
for identical
assets
(Level 1)
 
Significant
other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
Financial instruments reported at fair value on recurring basis:
 
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
 
Fixed maturity securities available-for-sale:
 
 
 
 
 
 
 
 
U.S. treasury
 
$
12,589

 
$

 
$
12,589

 
$

U.S. government-sponsored agencies
 
202,666

 

 
202,666

 

Obligations of states and political subdivisions
 
344,359

 

 
344,359

 

Commercial mortgage-backed
 
46,108

 

 
46,108

 

Residential mortgage-backed
 
88,543

 

 
88,543

 

Other asset-backed
 
17,844

 

 
17,844

 

Corporate
 
448,916

 

 
447,587

 
1,329

Total fixed maturity securities available-for-sale
 
1,161,025

 

 
1,159,696

 
1,329

 
 
 
 
 
 
 
 
 
Equity securities available-for-sale:
 
 
 
 
 
 
 
 
Common stocks:
 
 
 
 
 
 
 
 
Financial services
 
33,955

 
33,952

 

 
3

Information technology
 
28,102

 
28,102

 

 

Healthcare
 
25,894

 
25,894

 

 

Consumer staples
 
18,200

 
18,200

 

 

Consumer discretionary
 
18,923

 
18,923

 

 

Energy
 
21,068

 
21,068

 

 

Industrials
 
20,416

 
20,416

 

 

Other
 
20,683

 
20,683

 

 

Non-redeemable preferred stocks
 
19,002

 
11,706

 
7,296

 

Total equity securities available-for-sale
 
206,243

 
198,944

 
7,296

 
3

 
 
 
 
 
 
 
 
 
Short-term investments
 
38,599

 
38,599

 

 

 
 
 
 
 
 
 
 
 
Financial instruments not reported at fair value:
 
 
 
 
 
 
 
 
Liabilities:
 
 
 
 
 
 
 
 
Surplus notes
 
10,823

 

 

 
10,823


25


Presented in the tables below are a reconciliation of the assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and nine months ended September 30, 2016 and 2015.  Any unrealized gains or losses on these securities are recognized in other comprehensive income.  Any gains or losses from settlements, disposals or impairments of these securities are reported as realized investment gains or losses in net income.
Three months ended September 30, 2016
 
Fair value measurements using significant unobservable (Level 3) inputs
($ in thousands)
 
Fixed maturity securities available-for-sale, corporate
 
Equity securities
available-for-sale,
financial services
 
Total
Beginning balance
 
$
1,191

 
$
3

 
$
1,194

Settlements
 
(117
)
 

 
(117
)
Unrealized gains (losses) included in other comprehensive income (loss)
 
(4
)
 

 
(4
)
Balance at September 30, 2016
 
$
1,070

 
$
3

 
$
1,073

 
 
 
 
 
 
 
Nine months ended September 30, 2016
 
 
 
 
 
 
Beginning balance
 
$
1,329

 
$
3

 
$
1,332

Settlements
 
(262
)
 

 
(262
)
Unrealized gains (losses) included in other comprehensive income (loss)
 
3

 

 
3

Balance at September 30, 2016
 
$
1,070

 
$
3

 
$
1,073


Three months ended September 30, 2015
 
Fair value measurements using significant unobservable (Level 3) inputs
($ in thousands)
 
Fixed maturity securities available-for-sale, corporate
 
Equity securities
available-for-sale,
financial services
 
Total
Beginning balance
 
$
1,622

 
$
3

 
$
1,625

Settlements
 
(171
)
 

 
(171
)
Unrealized gains (losses) included in other comprehensive income (loss)
 
2

 

 
2

Balance at September 30, 2015
 
$
1,453

 
$
3

 
$
1,456

 
 
 
 
 
 
 
Nine months ended September 30, 2015
 
 
 
 
 
 
Beginning balance
 
$
1,662

 
$
3

 
$
1,665

Settlements
 
(214
)
 

 
(214
)
Unrealized gains (losses) included in other comprehensive income (loss)
 
5

 

 
5

Balance at September 30, 2015
 
$
1,453

 
$
3

 
$
1,456


There were no transfers into or out of Levels 1 or 2 during the nine months ended September 30, 2016 or 2015.  It is the Company’s policy to recognize transfers between levels at the beginning of the reporting period.


26


9.
INVESTMENTS
Investments of the Company’s insurance subsidiaries are subject to the insurance laws of the state of their incorporation. These laws prescribe the kind, quality and concentration of investments that may be made by insurance companies.  In general, these laws permit investments, within specified limits and subject to certain qualifications, in federal, state and municipal obligations, corporate bonds, preferred and common stocks and real estate mortgages.  The Company believes that it is in compliance with these laws.
The amortized cost and estimated fair value of securities available-for-sale as of September 30, 2016 and December 31, 2015 are as follows.  All securities are classified as available-for-sale and are carried at fair value.
September 30, 2016
 
Amortized
cost
 
Gross
unrealized
gains
 
Gross
unrealized
losses
 
Estimated
fair values
($ in thousands)
 
 
 
 
Securities available-for-sale:
 
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
 
U.S. treasury
 
$
7,835

 
$
372

 
$

 
$
8,207

U.S. government-sponsored agencies
 
236,698

 
1,408

 
612

 
237,494

Obligations of states and political subdivisions
 
320,330

 
29,601

 
19

 
349,912

Commercial mortgage-backed
 
40,800

 
1,208

 
126

 
41,882

Residential mortgage-backed
 
106,044

 
2,245

 
8,780

 
99,509

Other asset-backed
 
27,239

 
1,112

 
100

 
28,251

Corporate
 
445,524

 
26,584

 
213

 
471,895

Total fixed maturity securities
 
1,184,470

 
62,530

 
9,850

 
1,237,150

 
 
 
 
 
 
 
 
 
Equity securities:
 
 
 
 
 
 
 
 
Common stocks:
 
 
 
 
 
 
 
 
Financial services
 
24,115

 
8,748

 
444

 
32,419

Information technology
 
19,482

 
11,457

 
2

 
30,937

Healthcare
 
16,522

 
11,040

 
43

 
27,519

Consumer staples
 
14,059

 
7,066

 
59

 
21,066

Consumer discretionary
 
15,399

 
8,983

 
336

 
24,046

Energy
 
14,021

 
5,167

 
359

 
18,829

Industrials
 
13,390

 
10,375

 
71

 
23,694

Other
 
16,833

 
4,700

 
211

 
21,322

Non-redeemable preferred stocks
 
18,031

 
1,501

 
82

 
19,450

Total equity securities
 
151,852

 
69,037

 
1,607

 
219,282

Total securities available-for-sale
 
$
1,336,322

 
$
131,567

 
$
11,457

 
$
1,456,432


27


December 31, 2015
 
Amortized
cost
 
Gross
unrealized
gains
 
Gross
unrealized
losses
 
Estimated
fair values
($ in thousands)
 
 
 
 
Securities available-for-sale:
 
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
 
U.S. treasury
 
$
12,566

 
$
23

 
$

 
$
12,589

U.S. government-sponsored agencies
 
202,486

 
1,817

 
1,637

 
202,666

Obligations of states and political subdivisions
 
319,940

 
24,419

 

 
344,359

Commercial mortgage-backed
 
44,433

 
1,692

 
17

 
46,108

Residential mortgage-backed
 
94,279

 
1,059

 
6,795

 
88,543

Other asset-backed
 
17,000

 
883

 
39

 
17,844

Corporate
 
439,513

 
12,992

 
3,589

 
448,916

Total fixed maturity securities
 
1,130,217

 
42,885

 
12,077

 
1,161,025

 
 
 
 
 
 
 
 
 
Equity securities:
 
 
 
 
 
 
 
 
Common stocks:
 
 
 
 
 
 
 
 
Financial services
 
24,557

 
9,731

 
333

 
33,955

Information technology
 
19,427

 
8,807

 
132

 
28,102

Healthcare
 
15,599

 
10,359

 
64

 
25,894

Consumer staples
 
11,136

 
7,090

 
26

 
18,200

Consumer discretionary
 
10,270

 
8,658

 
5

 
18,923

Energy
 
16,384

 
5,972

 
1,288

 
21,068

Industrials
 
11,525

 
8,902

 
11

 
20,416

Other
 
17,246

 
3,672

 
235

 
20,683

Non-redeemable preferred stocks
 
18,032

 
1,168

 
198

 
19,002

Total equity securities
 
144,176

 
64,359

 
2,292

 
206,243

Total securities available-for-sale
 
$
1,274,393

 
$
107,244

 
$
14,369

 
$
1,367,268


28


The following tables set forth the estimated fair values and gross unrealized losses associated with investment securities that were in an unrealized loss position as of September 30, 2016 and December 31, 2015, listed by length of time the securities were in an unrealized loss position.
September 30, 2016
 
Less than twelve months
 
Twelve months or longer
 
Total
($ in thousands)
 
Fair
values
 
Unrealized
losses
 
Fair
values
 
Unrealized
losses
 
Fair
values
 
Unrealized
losses
Fixed maturity securities:
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government-sponsored agencies
 
$
56,223

 
$
612

 
$

 
$

 
$
56,223

 
$
612

Obligations of states and political subdivisions
 
2,836

 
19

 

 

 
2,836

 
19

Commercial mortgage-backed
 
20,698

 
126

 

 

 
20,698

 
126

Residential mortgage-backed
 
24,298

 
1,103

 
25,791

 
7,677

 
50,089

 
8,780

Other asset-backed
 
7,526

 
100

 

 

 
7,526

 
100

Corporate
 
22,582

 
134

 
8,646

 
79

 
31,228

 
213

Total fixed maturity securities
 
134,163

 
2,094

 
34,437

 
7,756

 
168,600

 
9,850

Equity securities:
 
 
 
 
 
 
 
 
 
 
 
 
Common stocks:
 
 
 
 
 
 
 
 
 
 
 
 
Financial services
 
4,802

 
444

 

 

 
4,802

 
444

Information technology
 
52

 
2

 

 

 
52

 
2

Healthcare
 
873

 
43

 

 

 
873

 
43

Consumer staples
 
1,079

 
59

 

 

 
1,079

 
59

Consumer discretionary
 
3,813

 
336

 

 

 
3,813

 
336

Energy
 
4,899

 
359

 

 

 
4,899

 
359

Industrials
 
1,097

 
71

 

 

 
1,097

 
71

Other
 
2,448

 
211

 

 

 
2,448

 
211

Non-redeemable preferred stocks
 

 

 
1,918

 
82

 
1,918

 
82

Total equity securities
 
19,063

 
1,525

 
1,918

 
82

 
20,981

 
1,607

Total temporarily impaired securities
 
$
153,226

 
$
3,619

 
$
36,355

 
$
7,838

 
$
189,581

 
$
11,457



29


December 31, 2015
 
Less than twelve months
 
Twelve months or longer
 
Total
($ in thousands)
 
Fair
values
 
Unrealized
losses
 
Fair
values
 
Unrealized
losses
 
Fair
values
 
Unrealized
losses
Fixed maturity securities:
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government-sponsored agencies
 
$
78,800

 
$
1,228

 
$
34,079

 
$
409

 
$
112,879

 
$
1,637

Commercial mortgage-backed
 
6,807

 
17

 

 

 
6,807

 
17

Residential mortgage-backed
 
22,028

 
1,694

 
22,781

 
5,101

 
44,809

 
6,795

Other asset-backed
 
6,013

 
39

 

 

 
6,013

 
39

Corporate
 
101,088

 
2,683

 
14,212

 
906

 
115,300

 
3,589

Total fixed maturity securities
 
214,736

 
5,661

 
71,072

 
6,416

 
285,808

 
12,077

Equity securities:
 
 
 
 
 
 
 
 
 
 
 
 
Common stocks:
 
 
 
 
 
 
 
 
 
 
 
 
Financial services
 
6,387

 
333

 

 

 
6,387

 
333

Information technology
 
1,316

 
132

 

 

 
1,316

 
132

Healthcare
 
3,199

 
64

 

 

 
3,199

 
64

Consumer staples
 
1,244

 
26

 

 

 
1,244

 
26

Consumer discretionary
 
176

 
5

 

 

 
176

 
5

Energy
 
8,233

 
1,272

 
116

 
16

 
8,349

 
1,288

Industrials
 
1,263

 
11

 

 

 
1,263

 
11

Other
 
4,064

 
235

 

 

 
4,064

 
235

Non-redeemable preferred stocks
 
2,450

 
53

 
1,855

 
145

 
4,305

 
198

Total equity securities
 
28,332

 
2,131

 
1,971

 
161

 
30,303

 
2,292

Total temporarily impaired securities
 
$
243,068

 
$
7,792

 
$
73,043

 
$
6,577

 
$
316,111

 
$
14,369


The fair values of fixed maturity securities generally increased during the first nine months of 2016 due to a decline in interest rates. Most of the securities that are in an unrealized loss position are considered investment grade by credit rating agencies. Because management does not intend to sell these securities, does not believe it will be required to sell these securities before recovery, and believes it will collect the amounts due on these securities, it was determined that these securities were not “other-than-temporarily” impaired at September 30, 2016.
The majority of the unrealized losses on common stocks at September 30, 2016 are from the financial services, energy and consumer discretionary sectors, though no individual security accounted for a material amount of unrealized losses.  Because the Company has the ability and intent to hold these securities for a reasonable amount of time to allow for recovery, it was determined that these securities were not “other-than-temporarily” impaired at September 30, 2016.
All of the Company’s preferred stock holdings are perpetual preferred stocks.  The Company evaluates perpetual preferred stocks with unrealized losses for “other-than-temporary” impairment similar to fixed maturity securities since they have debt-like characteristics such as periodic cash flows in the form of dividends and call features, are rated by rating agencies and are priced like other long-term callable fixed maturity securities.  There was no evidence of any credit deterioration in the issuers of the preferred stocks and the Company does not intend to sell these securities before recovery, nor does it believe it will be required to sell these securities before recovery; therefore, it was determined that these securities were not “other-than-temporarily” impaired at September 30, 2016.

30


The amortized cost and estimated fair values of fixed maturity securities at September 30, 2016, by contractual maturity, are shown below.  Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties.
($ in thousands)
 
Amortized
cost
 
Estimated
fair values
Securities available-for-sale:
 
 
 
 
Due in one year or less
 
$
33,776

 
$
34,148

Due after one year through five years
 
165,885

 
174,885

Due after five years through ten years
 
324,442

 
344,608

Due after ten years
 
510,334

 
538,909

Securities not due at a single maturity date
 
150,033

 
144,600

Totals
 
$
1,184,470

 
$
1,237,150


A summary of realized investment gains and (losses) is as follows:
 
Three months ended September 30,
 
Nine months ended September 30,
($ in thousands)
2016
 
2015
 
2016
 
2015
Fixed maturity securities available-for-sale:
 
 
 
 
 
 
 
Gross realized investment gains
$
261

 
$
61

 
$
1,935

 
$
642

Gross realized investment losses
(218
)
 

 
(517
)
 

 
 
 
 
 
 
 
 
Equity securities available-for-sale:
 
 
 
 
 
 
 
Gross realized investment gains
1,001

 
3,345

 
5,849

 
11,681

Gross realized investment losses
(50
)
 
(2,525
)
 
(1,683
)
 
(3,278
)
"Other-than-temporary" impairments
(275
)
 
(628
)
 
(976
)
 
(1,293
)
 
 
 
 
 
 
 
 
Other long-term investments, net
(1,911
)
 
7,245

 
(5,251
)
 
3,803

Totals
$
(1,192
)
 
$
7,498

 
$
(643
)
 
$
11,555


Gains and losses realized on the disposition of investments are included in net income.  The cost of investments sold is determined on the specific identification method using the highest cost basis first.  The Company did not have any outstanding cumulative credit losses on fixed maturity securities that have been recognized in earnings from “other-than-temporary” impairments during any of the reported periods. The amounts reported as “other-than-temporary” impairments on equity securities do not include any individually significant items. The net realized investment losses recognized on other long-term investments during the three and nine months ended September 30, 2016 and 2015 represent changes in the carrying value of a limited partnership that is used solely to support an equity tail-risk hedging strategy.

10.
CONTINGENT LIABILITIES
The Company and Employers Mutual and its other subsidiaries are parties to numerous lawsuits arising in the normal course of the insurance business.  The Company believes that the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations.  The companies involved have established reserves which are believed adequate to cover any potential liabilities arising out of all such pending or threatened proceedings.

31


The participants in the pooling agreement have purchased annuities from life insurance companies, under which the claimant is payee, to fund future payments that are fixed pursuant to specific claim settlement provisions.  The Company’s share of case loss reserves eliminated by the purchase of those annuities was $110,000 at December 31, 2015.  The Company had a contingent liability for the aggregate guaranteed amount of the annuities of $183,000 at December 31, 2015 should the issuers of those annuities fail to perform.  Although management is not able to verify the amount, the Company would likely have a similar contingent liability at September 30, 2016.  The probability of a material loss due to failure of performance by the issuers of these annuities is considered remote.

11.
STOCK REPURCHASE PROGRAM
On November 3, 2011, the Company’s Board of Directors authorized a $15.0 million stock repurchase program.  This program does not have an expiration date.  The timing and terms of the purchases are determined by management based on board approved parameters and market conditions, and are conducted in accordance with the applicable rules of the Securities and Exchange Commission.  Common stock repurchased under this program will be retired by the Company.  The Company repurchased 17,300 shares of its common stock at an average cost of $22.14 during the first nine months of 2016. No other purchases have been made under this program.

12.
ACCUMULATED OTHER COMPREHENSIVE INCOME
The Company has available-for-sale securities and receives an allocation of the actuarial losses and net prior service credits associated with Employers Mutual’s pension and postretirement benefit plans, both of which generate accumulated other comprehensive income (loss) amounts.  The following table reconciles, by component, the beginning and ending balances of accumulated other comprehensive income, net of tax.
 
 
Accumulated other comprehensive income by component
($ in thousands)
 
Unrealized
gains (losses) on
available-for-
sale securities
 
Unrecognized
pension and
postretirement
benefit obligations
 
Total
Balance at December 31, 2015
 
$
60,369

 
$
(1,936
)
 
$
58,433

Other comprehensive income before reclassifications
 
20,698

 

 
20,698

Amounts reclassified from accumulated other comprehensive income
 
(2,995
)
 
(607
)
 
(3,602
)
Other comprehensive income (loss)
 
17,703

 
(607
)
 
17,096

Balance at September 30, 2016
 
$
78,072

 
$
(2,543
)
 
$
75,529



32


The following tables display amounts reclassified out of accumulated other comprehensive income and into net income during the three and nine months ended September 30, 2016 and 2015, respectively.
($ in thousands)
 
Amounts reclassified from accumulated other comprehensive income
 
 
Accumulated other comprehensive
income components
 
Three months ended 
 September 30, 2016
 
Nine months ended 
 September 30, 2016
 
Affected line item in the
consolidated statements
of income
Unrealized gains on investments:
 
 
 
 
 
 
Reclassification adjustment for realized investment gains included in net income
 
$
718

 
$
4,608

 
Net realized investment gains
Deferred income tax expense
 
(252
)
 
(1,613
)
 
Income tax expense, current
Net reclassification adjustment
 
466

 
2,995

 
 
 
 
 
 
 
 
 
Unrecognized pension and postretirement benefit obligations:
 
 
 
 
 
 
Reclassification adjustment for amounts amortized into net periodic pension and postretirement benefit income:
 
 
 
 
 
 
Net actuarial loss
 
(1,112
)
 
(1,956
)
 
(1)
Prior service credit
 
1,291

 
2,890

 
(1)
Total before tax
 
179

 
934

 
 
Deferred income tax expense
 
(62
)
 
(327
)
 
Income tax expense, current
Net reclassification adjustment
 
117

 
607

 
 
 
 
 
 
 
 
 
Total reclassification adjustment
 
$
583

 
$
3,602

 
 
(1)
These reclassified components of accumulated other comprehensive income are included in the computation of net periodic pension and postretirement benefit income (see Note 6, Employee Retirement Plans, for additional details).

33


($ in thousands)
 
Amounts reclassified from accumulated other comprehensive income
 
 
Accumulated other comprehensive
income components
 
Three months ended September 30, 2015
 
Nine months ended September 30, 2015
 
Affected line item in the
consolidated statements
of income
Unrealized gains on investments:
 
 
 
 
 
 
Reclassification adjustment for realized investment gains included in net income
 
$
253

 
$
7,752

 
Net realized investment gains
Deferred income tax expense
 
(89
)
 
(2,713
)
 
Income tax expense, current
Net reclassification adjustment
 
164

 
5,039

 
 
 
 
 
 
 
 
 
Unrecognized pension and postretirement benefit obligations:
 
 
 
 
 
 
Reclassification adjustment for amounts amortized into net periodic pension and postretirement benefit income:
 
 
 
 
 
 
Net actuarial loss
 
(345
)
 
(996
)
 
(1)
Prior service credit
 
827

 
2,480

 
(1)
Total before tax
 
482

 
1,484

 
 
Deferred income tax expense
 
(169
)
 
(520
)
 
Income tax expense, current
Net reclassification adjustment
 
313

 
964

 
 
 
 
 
 
 
 
 
Total reclassification adjustment
 
$
477

 
$
6,003

 
 
(1)
These reclassified components of accumulated other comprehensive income are included in the computation of net periodic pension and postretirement benefit income (see Note 6, Employee Retirement Plans, for additional details).

13.
NEW ACCOUNTING PRONOUNCEMENTS NOT YET ADOPTED
In May 2014, the FASB updated its guidance related to the Revenue from Contracts with Customers Topic 606 of the ASC.  The objective of this update (and other related following updates) is to improve the reporting of revenue by providing a more robust framework for addressing revenue issues, and improved disclosure requirements. Current revenue recognition guidance in U.S. GAAP is comprised of broad revenue recognition concepts together with numerous revenue requirements for particular industries or transactions, which sometimes result in different accounting for economically similar transactions. This guidance is to be applied retrospectively to annual and interim reporting periods beginning after December 15, 2017, with early adoption permitted as of the original effective date (annual and interim reporting periods beginning after December 15, 2016).  The Company will adopt this guidance during the first quarter of 2018. Since premium revenue from insurance contracts is excluded from the scope of this updated guidance, adoption is expected to have little or no impact on the consolidated financial condition or operating results of the Company. The Company's largest non-premium revenue items are service charges related to the billing of the pool participants' direct written premiums to policyholders, and commission income on excess and surplus lines business marketed by EMC Underwriters, LLC, both of which are included in "Other income" in the consolidated statements of income.

34


In May 2015, the FASB updated its guidance related to the Financial Services-Insurance Topic 944 of the ASC.  The objective of this update is to add disclosures which provide transparency of significant estimates made in measuring the liability for losses and settlement expenses, thus providing more insight into an insurance entity's ability to underwrite and anticipate costs associated with claims. The new disclosures primarily include incurred and paid claims development tables prepared net of reinsurance (not to exceed ten years), and a reconciliation of the carrying amount of the liability for losses and settlement expenses. Also included (for each accident year of incurred claims development disclosed), is disclosure of incurred but not reported (IBNR) loss reserves, claim frequency information, and the average annual percentage payout of incurred claims by age. This guidance is to be applied retrospectively to annual reporting periods beginning after December 15, 2015, and certain disclosures to interim reporting periods beginning after December 15, 2016.  The Company will adopt this guidance during the fourth quarter of 2016. Since the guidance only affects disclosure, adoption will have no impact on the consolidated financial condition or operating results of the Company.
In January 2016, the FASB updated its guidance related to the Financial Instruments-Overall Subtopic 825-10 of the ASC.  The objective of this update is to enhance the reporting model for financial instruments to provide financial statement users with more decision-useful information. The major change in reporting from this update that will impact the Company is a requirement that equity investments (excluding those accounted for under the equity method of accounting or those that are consolidated) be measured at fair value with changes in fair value recognized in net income. While all of the Company's equity investments are already measured at fair value (with the exception of those that are consolidated and those that are accounted for under the equity method of accounting), the Company currently classifies all of its investments in equity securities as available-for-sale, and as such, the changes in fair value are currently recognized in other comprehensive income rather than net income. This guidance is to be applied to annual and interim reporting periods beginning after December 15, 2017, with recognition of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption.  Early adoption is not permitted. The Company will adopt this guidance during the first quarter of 2018. Adoption is not expected to impact consolidated stockholders' equity, but is expected to introduce a material amount of volatility to the Company's consolidated net income.
In February 2016, the FASB issued updated guidance in Leases Topic 842 of the ASC, which supersedes the guidance in Leases Topic 840 of the ASC. The objective of this update is to increase transparency and comparability among organizations by requiring recognition of lease assets and lease liabilities on the balance sheet, and disclosure of key information about leasing arrangements. This guidance is effective for interim and annual periods beginning after December 15, 2018, and is to be applied using a modified retrospective approach. Early adoption is permitted. The Company will adopt this guidance during the first quarter of 2019. The Company is currently evaluating the impact this guidance will have on the Company's consolidated financial condition and operating results.
In June 2016, the FASB issued updated guidance in Financial Instruments-Credit Losses Topic 326 of the ASC. The objective of this update is to provide information about expected credit losses on financial instruments and other commitments to extend credit. Specifically, this updated guidance replaces the current incurred loss impairment methodology, that delays recognition of a loss until it is probable a loss has been incurred, with a methodology that reflects expected credit losses considering a broader range of reasonable and supportable information. This guidance covers financial assets that are not accounted for at fair value through net income, thus will not be applicable to the Company's equity investments upon implementation of the updated guidance described above for the Financial Instruments-Overall Subtopic 825-10. This guidance is effective for interim and annual periods beginning after December 15, 2019, and is to be applied with a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective (modified-retrospective approach). Early adoption is permitted, but only to fiscal years beginning after December 15, 2018. The Company will adopt this guidance during the first quarter of 2020. The Company is currently evaluating the impact this guidance will have on the Company's consolidated financial condition and operating results.


35


EMC INSURANCE GROUP INC. AND SUBSIDIARIES
ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Unaudited)

The term “Company” is used below interchangeably to describe EMC Insurance Group Inc. (Parent Company only) and EMC Insurance Group Inc. and its subsidiaries.  The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included under Item 1 of this Form 10-Q, and the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of the Company’s 2015 Form 10-K.

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides issuers the opportunity to make cautionary statements regarding forward-looking statements.  Accordingly, any forward-looking statement contained in this report is based on management’s current beliefs, assumptions and expectations of the Company’s future performance, taking all information currently available into account.  These beliefs, assumptions and expectations can change as the result of many possible events or factors, not all of which are known to management.  If a change occurs, the Company’s business, financial condition, liquidity, results of operations, plans and objectives may vary materially from those expressed in the forward-looking statements.  The risks and uncertainties that may affect the actual results of the Company include, but are not limited to, the following:
catastrophic events and the occurrence of significant severe weather conditions;
the adequacy of loss and settlement expense reserves;
state and federal legislation and regulations;
changes in the property and casualty insurance industry, interest rates or the performance of financial markets and the general economy;
rating agency actions;
“other-than-temporary” investment impairment losses; and
other risks and uncertainties inherent to the Company’s business, including those discussed under the heading “Risk Factors” in the Company’s Annual Report on Form 10-K.
Management intends to identify forward-looking statements when using the words “believe”, “expect”, “anticipate”, “estimate”, “project” or similar expressions.  Undue reliance should not be placed on these forward-looking statements. The Company disclaims any obligation to update such statements or to announce publicly the results of any revisions that it may make to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

COMPANY OVERVIEW
The Company, a majority owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance and reinsurance.
Property and casualty insurance operations are conducted through three subsidiaries and represent the most significant segment of the Company’s business, totaling 77 percent of consolidated premiums earned during the first nine months of 2016.  The property and casualty insurance operations are integrated with the property and casualty insurance operations of Employers Mutual through participation in a reinsurance pooling agreement.  Because the Company conducts its property and casualty insurance operations together with Employers Mutual through the reinsurance pooling agreement, the Company shares the same business philosophy, management, employees and facilities as Employers Mutual and offers the same types of insurance products.

36


Reinsurance operations are conducted through EMC Reinsurance Company and accounted for 23 percent of consolidated premiums earned during the first nine months of 2016.  The principal business activity of EMC Reinsurance Company is to assume, through a quota share reinsurance agreement, 100 percent of Employers Mutual’s assumed reinsurance business, subject to certain exceptions.
The Inter-Company Committees of the boards of directors of the Company and Employers Mutual approved a change in the inter-company reinsurance program between the Company's reinsurance subsidiary and Employers Mutual for calendar year 2016, and also approved a new inter-company reinsurance program between the Company's three insurance subsidiaries in the property and casualty insurance segment and Employers Mutual for calendar year 2016. These reinsurance programs are intended to reduce the volatility of the Company's quarterly results caused by excessive catastrophe and storms losses, and will provide protection from both the frequency and severity of such losses. For detailed information regarding the inter-company reinsurance programs, see note 2 of Notes to Consolidated Financial Statements under Part I, Item 1 of this Form 10-Q.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The accounting policies and estimates considered by management to be critically important in the preparation and understanding of the Company’s financial statements and related disclosures are presented in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of the Company’s 2015 Form 10-K.
During the third quarter of 2016, management implemented a new reserving methodology for the determination of direct bulk reserves in the property and casualty insurance segment. The new methodology, which is referred to as the accident year ultimate estimate approach, better conforms to industry practices and will provide increased transparency of the drivers of the property and casualty insurance segment's performance. Although the reserves carried at September 30, 2016 were calculated under the new reserving methodology, the explicit drivers of development on prior years' reserves for the three and nine months ended September 30, 2016 cannot be identified because the reserves carried at December 31, 2015 were calculated under the prior reserving methodology, and the implicit accident year ultimate assumptions underlying that methodology are not known. The explicit drivers of development on prior years' reserves will be identifiable beginning in the first quarter of 2017.
The implementation of the new reserving methodology did not have a material impact on total carried reserves for the property and casualty insurance segment at September 30, 2016; however, approximately $5.6 million of incurred but not reported (IBNR) loss reserves and settlement expense reserves were reallocated from prior accident years to the current accident year in multiple lines of business. This reduction in prior accident years' reserves is reported as favorable development; however, this development is "mechanical" in nature, and did not have any impact on earnings because the total amount of carried reserves did not change as a result of this reallocation.



37


RESULTS OF OPERATIONS
Results of operations by segment and on a consolidated basis for the three and nine months ended September 30, 2016 and 2015 are as follows:
 
 
Three months ended September 30,
 
Nine months ended September 30,
($ in thousands)
 
2016
 
2015
 
2016
 
2015
Property and casualty insurance
 
 
 
 
 
 
 
 
Premiums earned
 
$
116,372

 
$
113,753

 
$
338,589

 
$
333,212

Losses and settlement expenses
 
81,643

 
75,976

 
225,207

 
215,468

Acquisition and other expenses
 
39,840

 
37,878

 
119,260

 
110,279

Underwriting profit (loss)
 
$
(5,111
)
 
$
(101
)
 
$
(5,878
)
 
$
7,465

 
 
 
 
 
 
 
 
 
GAAP ratios:
 
 
 
 
 
 
 
 
Loss and settlement expense ratio
 
70.2
%
 
66.8
%
 
66.5
%
 
64.7
%
Acquisition expense ratio
 
34.2
%
 
33.3
%
 
35.2
%
 
33.1
%
Combined ratio
 
104.4
%
 
100.1
%
 
101.7
%
 
97.8
%
 
 
 
 
 
 
 
 
 
Losses and settlement expenses:
 
 
 
 
 
 
 
 
Insured events of current year
 
$
94,085

 
$
80,698

 
$
247,436

 
$
229,645

Decrease in provision for insured events of prior years
 
(12,442
)
 
(4,722
)
 
(22,229
)
 
(14,177
)
 
 
 
 
 
 
 
 
 
Total losses and settlement expenses
 
$
81,643

 
$
75,976

 
$
225,207

 
$
215,468

 
 
 
 
 
 
 
 
 
Catastrophe and storm losses
 
$
14,787

 
$
9,920

 
$
34,787

 
$
28,651

 
 
 
 
 
 
 
 
 
Large losses1
 
N/A
 
$
10,304

 
N/A
 
$
21,453

1 Large losses are defined as reported current accident year losses greater than $500 for the EMC Insurance Companies' pool, excluding catastrophe and storm losses. Under the property and casualty insurance segment's prior reserving methodology, large losses had a direct impact on earnings. Under the new reserving methodology, large losses are taken into consideration when establishing the current accident quarter/year ultimate estimates of losses, but there is no longer a direct relationship between large losses and earnings. As a result, it is no longer meaningful to report large losses separately. The amount of large losses previously reported for the first six months of 2016 has not been carried forward and disclosed for the nine months ended September 30, 2016, because it would not be comparable to the amount reported for the first nine months of 2015.

The following table presents the reported amounts of favorable development experienced on prior years’ reserves and the portion of the reported development amounts that resulted from the reallocation of direct bulk reserves from prior accident years to the current accident year in connection with the change in reserving methodology that was implemented in the property and casualty insurance segment during the third quarter of 2016 (no impact on earnings).  The result is an approximation of the implied amount of favorable development that had an impact on earnings.
 
 
Three months ended September 30,
 
Nine months ended September 30,
($ in thousands)
 
2016
 
2015
 
2016
 
2015
Reported amount of favorable development experienced on prior years' reserves
 
$
(12,442
)
 
$
(4,722
)
 
$
(22,229
)
 
$
(14,177
)
Adjustment for favorable development included in the reported development amount that had no impact on earnings
 
5,592

 

 
5,592

 

Approximation of the implied amount of favorable development that had an impact on earnings
 
$
(6,850
)
 
$
(4,722
)
 
$
(16,637
)
 
$
(14,177
)

38



 
 
Three months ended September 30,
 
 
2016
 
2015
($ in thousands)
 
Premiums earned
 
Losses and settlement expenses
 
Loss and settlement expense ratio
 
Premiums earned
 
Losses and settlement expenses
 
Loss and settlement expense ratio
Property and casualty insurance
 
 
 
 
 
 
 
 
 
 
 
 
Commercial lines:
 
 
 
 
 
 
 
 
 
 
 
 
Automobile
 
$
28,113

 
$
26,274

 
93.5
%
 
$
27,080

 
$
24,555

 
90.7
%
Property
 
27,471

 
17,227

 
62.7
%
 
26,526

 
19,290

 
72.7
%
Workers' compensation
 
24,536

 
13,510

 
55.1
%
 
23,777

 
12,098

 
50.9
%
Liability
 
24,277

 
14,179

 
58.4
%
 
23,449

 
10,726

 
45.7
%
Other
 
2,102

 
705

 
33.6
%
 
2,032

 
348

 
17.1
%
Total commercial lines
 
106,499

 
71,895

 
67.5
%
 
102,864

 
67,017

 
65.2
%
Personal lines
 
9,873

 
9,748

 
98.7
%
 
10,889

 
8,959

 
82.3
%
Total property and casualty insurance
 
$
116,372

 
$
81,643

 
70.2
%
 
$
113,753

 
$
75,976

 
66.8
%

 
 
Nine months ended September 30,
 
 
2016
 
2015
($ in thousands)
 
Premiums earned
 
Losses and settlement expenses
 
Loss and settlement expense ratio
 
Premiums earned
 
Losses and settlement expenses
 
Loss and settlement expense ratio
Property and casualty insurance
 
 
 
 
 
 
 
 
 
 
 
 
Commercial lines:
 
 
 
 
 
 
 
 
 
 
 
 
Automobile
 
$
82,449

 
$
69,763

 
84.6
%
 
$
78,698

 
$
61,843

 
78.6
%
Property
 
77,292

 
52,687

 
68.2
%
 
77,518

 
53,652

 
69.2
%
Workers' compensation
 
71,272

 
39,680

 
55.7
%
 
69,150

 
39,591

 
57.3
%
Liability
 
72,086

 
38,045

 
52.8
%
 
68,952

 
34,668

 
50.3
%
Other
 
6,246

 
648

 
10.4
%
 
6,044

 
794

 
13.1
%
Total commercial lines
 
309,345

 
200,823

 
64.9
%
 
300,362

 
190,548

 
63.4
%
Personal lines
 
29,244

 
24,384

 
83.4
%
 
32,850

 
24,920

 
75.9
%
Total property and casualty insurance
 
$
338,589

 
$
225,207

 
66.5
%
 
$
333,212

 
$
215,468

 
64.7
%


39


 
 
Three months ended September 30,
 
Nine months ended September 30,
($ in thousands)
 
2016
 
2015
 
2016
 
2015
Reinsurance
 
 
 
 
 
 
 
 
Premiums earned
 
$
35,809

 
$
32,035

 
$
102,775

 
$
95,912

Losses and settlement expenses
 
26,530

 
26,709

 
70,895

 
65,135

Acquisition and other expenses
 
8,555

 
7,861

 
24,906

 
25,387

Underwriting profit (loss)
 
$
724

 
$
(2,535
)
 
$
6,974

 
$
5,390

 
 
 
 
 
 
 
 
 
GAAP ratios:
 
 
 
 
 
 
 
 
Loss and settlement expense ratio
 
74.1
%
 
83.4
%
 
69.0
%
 
67.9
%
Acquisition expense ratio
 
23.9
%
 
24.5
%
 
24.2
%
 
26.5
%
Combined ratio
 
98.0
%
 
107.9
%
 
93.2
%
 
94.4
%
 
 
 
 
 
 
 
 
 
Losses and settlement expenses:
 
 
 
 
 
 
 
 
Insured events of current year
 
$
27,326

 
$
24,214

 
$
77,775

 
$
70,915

(Decrease) increase in provision for insured events of prior years
 
(796
)
 
2,495

 
(6,880
)
 
(5,780
)
 
 
 
 
 
 
 
 
 
Total losses and settlement expenses
 
$
26,530

 
$
26,709

 
$
70,895

 
$
65,135

 
 
 
 
 
 
 
 
 
Catastrophe and storm losses
 
$
2,266

 
$
7,844

 
$
10,747

 
$
12,104


The following table presents the reported amounts of (favorable) adverse development experienced on prior years’ reserves and the portion of the reported development amounts that resulted from the reallocation of reserves on a two-year contract from the current accident year to the prior accident year in the reinsurance segment during the third quarter of 2015 (no impact on earnings).  The result is an approximation of the implied amount of (favorable) adverse development that had an impact on earnings.
 
 
Three months ended September 30,
 
Nine months ended September 30,
($ in thousands)
 
2016
 
2015
 
2016
 
2015
Reported amount of (favorable) adverse development experienced on prior years' reserves
 
$
(796
)
 
$
2,495

 
$
(6,880
)
 
$
(5,780
)
Adjustment for adverse development included in the reported development amount that had no impact on earnings
 

 
(2,361
)
 

 
(2,361
)
Approximation of the implied amount of (favorable) adverse development that had an impact on earnings
 
$
(796
)
 
$
134

 
$
(6,880
)
 
$
(8,141
)



40


 
 
Three months ended September 30,
 
 
2016
 
2015
($ in thousands)
 
Premiums earned
 
Losses and settlement expenses
 
Loss and settlement expense ratio
 
Premiums earned
 
Losses and settlement expenses
 
Loss and settlement expense ratio
Reinsurance
 
 
 
 
 
 
 
 
 
 
 
 
Pro rata reinsurance
 
$
15,066

 
$
10,235

 
67.9
%
 
$
13,037

 
$
9,667

 
74.2
%
Excess of loss reinsurance
 
20,743

 
16,295

 
78.6
%
 
18,998

 
17,042

 
89.7
%
Total reinsurance
 
$
35,809

 
$
26,530

 
74.1
%
 
$
32,035

 
$
26,709

 
83.4
%

 
 
Nine months ended September 30,
 
 
2016
 
2015
($ in thousands)
 
Premiums earned
 
Losses and settlement expenses
 
Loss and settlement expense ratio
 
Premiums earned
 
Losses and settlement expenses
 
Loss and settlement expense ratio
Reinsurance
 
 
 
 
 
 
 
 
 
 
 
 
Pro rata reinsurance
 
$
44,175

 
$
26,367

 
59.7
%
 
$
40,154

 
$
23,468

 
58.4
%
Excess of loss reinsurance
 
58,600

 
44,528

 
76.0
%
 
55,758

 
41,667

 
74.7
%
Total reinsurance
 
$
102,775

 
$
70,895

 
69.0
%
 
$
95,912

 
$
65,135

 
67.9
%


41


 
 
Three months ended September 30,
 
Nine months ended September 30,
($ in thousands, except per share amounts)
 
2016
 
2015
 
2016
 
2015
Consolidated
 
 
 
 
 
 
 
 
REVENUES
 
 
 
 
 
 
 
 
Premiums earned
 
$
152,181

 
$
145,788

 
$
441,364

 
$
429,124

Net investment income
 
11,474

 
11,299

 
35,883

 
33,946

Realized investment gains (losses)
 
(1,192
)
 
7,498

 
(643
)
 
11,555

Other income (loss)
 
(85
)
 
519

 
(19
)
 
1,622

 
 
162,378

 
165,104

 
476,585

 
476,247

LOSSES AND EXPENSES
 
 
 
 
 
 
 
 
Losses and settlement expenses
 
108,173

 
102,685

 
296,102

 
280,603

Acquisition and other expenses
 
48,395

 
45,739

 
144,166

 
135,666

Interest expense
 
84

 
84

 
253

 
253

Other expense
 
679

 
675

 
2,053

 
1,992

 
 
157,331

 
149,183

 
442,574

 
418,514

 
 
 
 
 
 
 
 
 
Income before income tax expense
 
5,047

 
15,921

 
34,011

 
57,733

Income tax expense
 
918

 
4,732

 
9,100

 
17,466

Net income
 
$
4,129

 
$
11,189

 
$
24,911

 
$
40,267

 
 
 
 
 
 
 
 
 
Net income per share
 
$
0.20

 
$
0.54

 
$
1.19

 
$
1.96

 
 
 
 
 
 
 
 
 
GAAP ratios:
 
 
 
 
 
 
 
 
Loss and settlement expense ratio
 
71.1
%
 
70.4
%
 
67.1
%
 
65.4
%
Acquisition expense ratio
 
31.8
%
 
31.4
%
 
32.7
%
 
31.6
%
Combined ratio
 
102.9
%
 
101.8
%
 
99.8
%
 
97.0
%
 
 
 
 
 
 
 
 
 
Losses and settlement expenses:
 
 
 
 
 
 
 
 
Insured events of current year
 
$
121,411

 
$
104,912

 
$
325,211

 
$
300,560

Decrease in provision for insured events of prior years
 
(13,238
)
 
(2,227
)
 
(29,109
)
 
(19,957
)
 
 
 
 
 
 
 
 
 
Total losses and settlement expenses
 
$
108,173

 
$
102,685

 
$
296,102

 
$
280,603

 
 
 
 
 
 
 
 
 
Catastrophe and storm losses
 
$
17,053

 
$
17,764

 
$
45,534

 
$
40,755

 
 
 
 
 
 
 
 
 
Large losses1
 
N/A
 
$
10,304

 
N/A
 
$
21,453

1 Large losses are defined as reported current accident year losses greater than $500 for the EMC Insurance Companies' pool, excluding catastrophe losses. Under the property and casualty insurance segment's prior reserving methodology, large losses had a direct impact on earnings. Under the new reserving methodology, large losses are taken into consideration when establishing the current accident quarter/year ultimate estimates of losses, but there is no longer a direct relationship between large losses and earnings. As a result, it is no longer meaningful to report large losses separately. The amount of large losses previously reported for the first six months of 2016 has not been carried forward and disclosed for the nine months ended September 30, 2016, because it would not be comparable to the amount reported for the first nine months of 2015.


42


The following table presents the reported amounts of favorable development experienced on prior years’ reserves and the portion of the reported development amounts that resulted from 1) the reallocation of direct bulk reserves from prior accident years to the current accident year in connection with the change in reserving methodology that was implemented in the property and casualty insurance segment during the third quarter of 2016 (no impact on earnings), and 2) the reallocation of reserves on a two-year contract from the current accident year to the prior accident year in the reinsurance segment during the third quarter of 2015 (no impact on earnings).  The result is an approximation of the implied amount of favorable development that had an impact on earnings.
 
 
Three months ended September 30,
 
Nine months ended September 30,
($ in thousands)
 
2016
 
2015
 
2016
 
2015
Reported amount of favorable development experienced on prior years' reserves
 
$
(13,238
)
 
$
(2,227
)
 
$
(29,109
)
 
$
(19,957
)
Adjustment for favorable (adverse) development included in the reported development amount that had no impact on earnings
 
5,592

 
(2,361
)
 
5,592

 
(2,361
)
Approximation of the implied amount of favorable development that had an impact on earnings
 
$
(7,646
)
 
$
(4,588
)
 
$
(23,517
)
 
$
(22,318
)

The Company reported net income of $4.1 million ($0.20 per share) during the three months ended September 30, 2016, compared to $11.2 million ($0.54 per share) during the same period in 2015.  For the nine months ended September 30, 2016, net income totaled $24.9 million ($1.19 per share) compared to $40.3 million ($1.96 per share) during the same period in 2015. The decreases in net income are primarily attributed to a significant decline in realized investment gains (realized investment losses were reported for the three and nine months ended September 30, 2016, compared to realized investment gains for the same periods in 2015), and a decline in underwriting profitability. The decline in realized investment gains was primarily driven by the Company's equity tail-risk hedging strategy, which generated a large amount of realized investment gains in August of 2015 when the equity markets declined sharply, but has otherwise generated realized investment losses. The decline in underwriting profitability is attributed to the property and casualty insurance segment, which was primarily driven by an increase in catastrophe and storm losses, but also reflects poor underwriting results in the personal lines of business and commercial auto line of business, and an increase in policyholder dividend expense. On a consolidated basis, underwriting results remained profitable through the first nine months of the year, as the reinsurance segment's underwriting profit more than offset an underwriting loss in the property and casualty insurance segment.

Premium income
Premiums earned increased 4.4 percent and 2.9 percent to $152.2 million and $441.4 million for the three and nine months ended September 30, 2016 from $145.8 million and $429.1 million for the same periods in 2015.  Both segments reported small increases in premium income for these periods, despite increasingly competitive market conditions. Rate levels for both segments continue to be constrained by increased competition, especially for quality accounts with good loss experience. Average rate level increases are just slightly positive in the property and casualty insurance segment during the first nine months of 2016, and are expected to remain at that level during the remainder of the year. The January 1, 2016 renewal season, when approximately 70 percent of the reinsurance segment's business renews, saw continued pricing pressure, though the deterioration in pricing slowed considerably from that experienced in 2015.

43


Premiums earned for the property and casualty insurance segment increased 2.3 percent and 1.6 percent to $116.4 million and $338.6 million for the three and nine months ended September 30, 2016 from $113.8 million and $333.2 million for the same periods in 2015.  The increases reported in 2016 reflect $765,000 and $7.1 million, respectively, of premiums ceded to Employers Mutual for the cost of the new inter-company reinsurance program. Excluding these amounts, premiums earned increased 3.7 percent and 3.0 percent for the three and nine month periods, reflecting growth in insured exposures, an increase in new business, and small rate level increases on renewal business. New business premium (representing 14 percent of the pool participants’ direct written premiums at September 30, 2016) is approximately 13 percent higher than the same period in 2015. Commercial lines accounted for most of the increase in new business premium; however, personal lines also reported an increase after several years of declining premium. Commercial lines new business continues to be in the desired range of growth, and was strongest outside of the core Midwest market, which helps diversify the pool participants' book of business geographically, while staying consistent with the industry and line of business mix of the existing book of business. Renewal business premium increased approximately two percent during the first nine months of 2016. Excluding the workers' compensation line of business, renewal rates across both commercial and personal lines of business increased approximately one percent during the first nine months of 2016. Factoring in the continued implementation of some mandatory rate reductions on workers' compensation business in a few states, the overall renewal rate increase is still positive, but is less than one percent. Management continues to focus on the implementation of its new personal lines strategy, and is encouraged by the increase in new business premium. During the first nine months of 2016, the overall policy retention rate remained strong at 86.7 percent (commercial lines at 86.9 percent and personal lines at 84.5 percent). These retention rates approximate those at the end of 2015.
Premiums earned for the reinsurance segment increased 11.8 percent and 7.2 percent to $35.8 million and $102.8 million for the three and nine months ended September 30, 2016 from $32.0 million and $95.9 million for the same periods in 2015. These increases reflect reductions in the total cost of the revised excess of loss reinsurance program with Employers Mutual totaling $246,000 for the three months and $2.4 million for the nine months ended September 30, 2016. In 2016, the total cost of the reinsurance program includes the premium paid to Employers Mutual, as well as the cost of Industry Loss Warranties (ILWs) that have been purchased from external parties to provide increased protection in peak exposure territories. During 2015, the premium paid to Employers Mutual (8 percent of total assumed reinsurance premiums written) included the cost of ILWs purchased by Employers Mutual for its benefit. The reinsurance subsidiary has purchased $5.1 million of ILWs during the first nine months of 2016, with $1.2 million and $2.2 million of ceded earned premium recognized on the ILWs during the three and nine months ended September 30, 2016, respectively. Excluding the reduction in the cost of the revised excess of loss reinsurance program with Employers Mutual, premiums earned were up 11.0 percent and 4.7 percent for the three and nine months ended September 30, 2016. These increases were driven by new accounts and growth in the pro rata line of business, partially offset by a decline in the marine business attributed to the offshore energy and liability proportional account. During 2015, the ceded premium associated with the excess of loss reinsurance program was allocated to all lines of business (both pro rata and excess of loss) because it was a quota share arrangement whereby the premium was based on total assumed reinsurance premiums written. Beginning in 2016, the ceded premium for the revised excess of loss reinsurance program is being allocated to only the excess of loss business.

Losses and settlement expenses
Losses and settlement expenses increased 5.3 percent and 5.5 percent to $108.2 million and $296.1 million for the three and nine months ended September 30, 2016 from $102.7 million and $280.6 million for the same periods in 2015.  The loss and settlement expense ratios increased to 71.1 percent and 67.1 percent for the three and nine months ended September 30, 2016 from 70.4 percent and 65.4 percent for the same periods in 2015.  The loss and settlement expense ratios increased for both segments during the nine months ended September 30, 2016. The increase in the property and casualty insurance segment's ratio is attributed to an increase in catastrophe and storm losses, while the reinsurance segment's increase is largely due to a low amount of reported large losses in 2015. The actuarial analysis of the Company’s carried reserves as of September 30, 2016 indicated that the level of reserve adequacy was consistent with other recent evaluations. From management’s perspective, this measure is more relevant to an understanding of the Company’s results of operations than the composition of the underwriting results between the current and prior accident years.

44


The loss and settlement expense ratios for the property and casualty insurance segment increased to 70.2 percent and 66.5 percent for the three and nine months ended September 30, 2016 from 66.8 percent and 64.7 percent for the same periods in 2015.  These increases are primarily attributed to higher catastrophe and storm losses. Catastrophe and storm losses accounted for 12.7 and 10.3 percentage points of the loss and settlement expense ratios for the three and nine months ended September 30, 2016, respectively, compared to 8.7 and 8.6 percentage points for the same periods in 2015. The most recent 10-year averages for these periods are 13.6 and 12.7 percentage points, respectively. The property and casualty insurance segment recovered $3.5 million and $5.1 million of catastrophe and storm losses under the January 1 through June 30 excess of loss reinsurance treaty with Employers Mutual during the three and nine months ended September 30, 2016, respectively. No recoveries were made under the July 1 through December 31 treaty; however, only $213,000 of the retention remains under that treaty, meaning that catastrophe and storms losses will be capped at $213,000 in the fourth quarter, unless the $12.0 million limit of protection is exceeded. Taking the loss recoveries received and the premiums paid to Employers Mutual into consideration, the new reinsurance program with Employers Mutual reduced the catastrophe and storm loss ratios for the three and nine months ended September 30, 2016 by 2.4 and 0.1 percentage points, respectively. The personal lines of business and the commercial auto line of business continued to generate unfavorable results during the third quarter, posting loss and settlement expense ratios of 98.7 percent and 93.5 percent, respectively. The personal lines' ultimate loss estimate reflects an increase in loss severity for the current accident quarter, and the commercial auto line's ultimate loss estimate reflects an increase in both loss frequency and severity for the current accident quarter. As previously noted, management continues to focus on the implementation of its new personal lines strategy, and has invested a significant amount of time and resources toward improving the performance of the commercial auto line of business in 2016, including more aggressive underwriting and pricing, proper classification of risks and a review of the class of business restrictions; however, these efforts have not yet had a significant impact on performance. Industry projections forecast continued deterioration in this line of business, and management forecasts similar deterioration in the Company's commercial auto business if no additional steps are taken to improve profitability. Recognizing the importance of this issue, management has implemented a more intensive, multi-year project with a goal of returning this line of business to profitability within the next three years. Favorable development on prior years' reserves increased substantially for the three months ended September 30, 2016. As previously noted, approximately $5.6 million of the increase in favorable development is "mechanical" in nature and did not have an impact on earnings because it resulted from the movement of direct bulk reserves from prior accident years into the current accident year in connection with the change in reserving methodology. Under the previous reserving methodology employed through the second quarter of 2016, development amounts could vary significantly from quarter to quarter and year to year depending on a number of factors, including the number of claims settled and the settlement terms. With the conversion to the new reserving methodology as of the end of the third quarter, development on prior accident years' reserves is determined solely by changes in the prior accident years' ultimate loss and settlement expense ratios. During the transition to the new reserving methodology, changes in the assumptions underlying the ultimate ratios previously established for accident years 2015 and prior are difficult to quantify as the implied ultimate ratios under the previous methodology were based on implicit, rather than explicit, actuarial assumptions. Therefore, comparison of 2016 third quarter and year-to-date development amounts to the 2015 development amounts provides little meaningful information, as the prior accident year reserve allocation method lacked explicit frequency and severity assumptions. The explicit drivers of development on prior years' reserves will be identifiable beginning in the first quarter of 2017.
The loss and settlement expense ratio for the reinsurance segment decreased to 74.1 percent for the three months ended September 30, 2016 from 83.4 percent for the same period in 2015. For the nine months ended September 30, 2016, the loss and settlement expense ratio increased to 69.0 percent from 67.9 percent for the same period in 2015. The decrease for the three months ended September 30, 2016 is attributed to a decline in catastrophe and storm losses. Catastrophe and storm losses for the third quarter of 2015 included an estimated loss of $4.5 million ($4.1 million net of reinsurance recovery under the excess of loss reinsurance protection provided by Employers Mutual) from the Tianjin, China explosion. Catastrophe and storm losses were also lower for the nine months ended September 30, 2016, but to a lesser extent, due to a $3.5 million loss stemming from the Alberta, Canada wildfire that occurred during the second quarter. No recoveries have been made under the revised excess of loss reinsurance program with Employers Mutual during the first nine months of 2016. The decline in the total cost of the revised excess of loss reinsurance program with Employers Mutual produced decreases of 1.2 and 1.8 percentage points, respectively, in the loss and settlement expense ratios for the three and nine months ended September 30, 2016. These reductions are reflected in the catastrophe and storm loss ratios, which declined to 6.3 and 10.5 percentage points for the three and nine months ended September 30, 2016, from 24.5 and 12.6 percentage points for the same periods in 2015. The most recent 10-year averages for catastrophe and storm losses for the three and nine month periods ending September 30, are 17.1 and 14.1 percentage points, respectively. The increase in the loss and settlement expense ratio for the nine months ended September 30, 2016 is attributed to an increase in reported large losses (losses greater than $100,000). The development amounts reported for the three months and nine months ended September 30, 2015 included $2.4 million of adverse development that resulted from a reallocation of reserves on a two-year contract from the current accident year to the prior accident year, and therefore did not have an impact on earnings.


45


Acquisition and other expenses
Acquisition and other expenses increased 5.8 percent and 6.3 percent to $48.4 million and $144.2 million for the three and nine months ended September 30, 2016 from $45.7 million and $135.7 million for the same periods in 2015.  The acquisition expense ratios increased to 31.8 percent and 32.7 percent for the three and nine months ended September 30, 2016 from 31.4 percent and 31.6 percent for the same periods in 2015.  These increases are primarily attributed to an increase in policyholder dividend expense resulting from favorable loss experience on some safety dividend groups in the property and casualty insurance segment.
The acquisition expense ratios for the property and casualty insurance segment increased to 34.2 percent and 35.2 percent for the three and nine months ended September 30, 2016 from 33.3 percent and 33.1 percent for the same periods in 2015. These increases are largely attributed to higher policyholder dividend expense resulting from favorable loss experience on some safety dividend groups. The 2016 ratios also reflect the premiums ceded to Employers Mutual under the new aggregate catastrophe excess of loss reinsurance program, which added 0.2 and 0.7 percentage points, respectively, to the ratios.
The acquisition expense ratios for the reinsurance segment decreased to 23.9 percent and 24.2 percent for the three and nine months ended September 30, 2016 from 24.5 percent and 26.5 percent for the same periods in 2015. The larger decrease for the nine month period is primarily attributed to a $1.1 million commission adjustment reported by a ceding company during the first quarter of 2015 that related to prior periods. The 2016 ratios reflect the reduction in the total cost of the revised catastrophe excess of loss reinsurance program with Employers Mutual, which reduced the acquisition expense ratios by 1.0 and 0.1 percentage points, respectively, for the three and nine months ended September 30, 2016. An increase in contingent commission expense during the third quarter partially offset the decline in the acquisition expense ratio for the three months ended September 30, 2016.

Investment results
Net investment income increased 1.5 percent and 5.7 percent to $11.5 million and $35.9 million for the three and nine months ended September 30, 2016 from $11.3 million and $33.9 million for the same periods in 2015. These increases are primarily attributed to higher amounts of dividend income in 2016, but also reflect an increase in interest income resulting from a higher average invested balance in fixed maturity securities. Current interest rate levels remain below the average book yield of the fixed maturity portfolio, and will therefore likely continue to limit future growth in net investment income. The average coupon rate on the fixed maturity portfolio, excluding interest-only securities, has declined slightly over the past year, coming in at 3.7 percent at September 30, 2016 compared to 3.9 percent at both December 31, 2015 and September 30, 2015.  The effective duration of the fixed maturity portfolio, excluding interest-only securities, increased slightly to 4.7 at September 30, 2016 from 4.6 at December 31, 2015. The Company’s equity portfolio produced dividend income of $1.6 million and $5.4 million during the three and nine months ended September 30, 2016 compared to $1.3 million and $4.0 million during the same periods in 2015.
The Company had net realized investment losses of $1.2 million and $643,000 during the three and nine months ended September 30, 2016 compared to net realized investment gains of $7.5 million and $11.6 million during the same periods in 2015. The reported amounts include losses of $1.9 million and $5.3 million generated during the three and nine months ended September 30, 2016 from declines in the carrying value of a limited partnership that the Company invests in to help protect it from a sudden and significant decline in the value of its equity portfolio (an equity tail-risk hedging strategy). Due to the sharp decline of the equity markets in August of 2015, this limited partnership produced gains of $7.2 million and $3.8 million during the same respective periods in 2015. The Company recognized "other-than-temporary" impairment losses of $275,000 and $976,000 during the three and nine months ended September 30, 2016, compared to $628,000 and $1.3 million during the same periods in 2015. These impairment losses were recognized on securities held in the Company's equity portfolio.

Other income
Included in other income are foreign currency exchange gains and losses recognized on the reinsurance segment’s foreign currency denominated reinsurance business.  The reinsurance segment had foreign currency exchange losses of $317,000 and $545,000 during the three and nine months ended September 30, 2016, compared to gains of $254,000 and $984,000 during the same periods in 2015.


46


Income tax
Income tax expense decreased to $918,000 and $9.1 million for the three and nine months ended September 30, 2016 from $4.7 million and $17.5 million for the same periods in 2015. The effective tax rates for the three and nine months ended September 30, 2016 were 18.2 percent and 26.8 percent, compared to 29.7 percent and 30.3 percent for the same periods in 2015. The primary contributors to the differences between these effective tax rates and the United States federal corporate tax rate of 35 percent are tax-exempt interest income earned and the dividends received deduction.

LIQUIDITY AND CAPITAL RESOURCES
Liquidity
Liquidity is a measure of a company’s ability to generate sufficient cash flows to meet cash obligations.  The Company had positive cash flows from operations of $75.1 million and $83.0 million during the first nine months of 2016 and 2015, respectively. The Company typically generates substantial positive cash flows from operations because cash from premium payments is generally received in advance of cash payments made to settle claims.  These positive cash flows provide the foundation of the Company’s asset/liability management program and are the primary driver of the Company’s liquidity.  The Company invests in high quality, liquid securities to match the anticipated payments of losses and settlement expenses of the underlying insurance policies.  Because the timing of the losses is uncertain, the majority of the portfolio is maintained in short to intermediate maturity securities that can be easily liquidated or that generate adequate cash flow to meet liabilities.
The Company is a holding company whose principal asset is its investment in its property and casualty insurance subsidiaries and its reinsurance subsidiary (“insurance subsidiaries”).  As a holding company, the Company is dependent upon cash dividends from its insurance subsidiaries to meet all its obligations, including cash dividends to stockholders and the funding of the Company’s stock repurchase programs.  State insurance regulations restrict the maximum amount of dividends insurance companies can pay without prior regulatory approval.  The maximum amount of dividends that the insurance subsidiaries can pay to the Company in 2016 without prior regulatory approval is approximately $49.8 million.  The Company received $3.6 million and $7.1 million of dividends from its insurance subsidiaries and paid cash dividends to its stockholders totaling $11.8 million and $10.3 million during the first nine months of 2016 and 2015, respectively.
The Company’s insurance subsidiaries must maintain adequate liquidity to ensure that their cash obligations are met; however, because of the property and casualty insurance subsidiaries’ participation in the pooling agreement and the reinsurance subsidiary’s participation in the quota share agreement, they do not have the daily liquidity concerns normally associated with an insurance company.  This is because under the terms of the pooling and quota share agreements, Employers Mutual receives all premiums and pays all losses and expenses associated with the insurance business produced by the pool participants and the assumed reinsurance business ceded to the Company’s reinsurance subsidiary, and then settles inter-company balances generated by these transactions with the participating companies on a monthly (pool participants) or quarterly (reinsurance subsidiary) basis.
At the insurance subsidiary level, the primary sources of cash are premium income, investment income and proceeds from called or matured investments.  The principal outflows of cash are payments of claims, commissions, premium taxes, operating expenses, income taxes, dividends, interest and principal payments on debt, and investment purchases.  Cash outflows vary because of uncertainties regarding settlement dates for unpaid losses and the potential for large losses, either individually or in the aggregate.  Accordingly, the insurance subsidiaries maintain investment and reinsurance programs intended to provide adequate funds to pay claims without forced sales of investments.  The insurance subsidiaries also have the ability to borrow funds on a short-term basis (180 days) from Employers Mutual and its subsidiaries and affiliate under an Inter-Company Loan Agreement. In addition, Employers Mutual maintains access to a line of credit with the Federal Home Loan Bank that could be used to provide the insurance subsidiaries additional liquidity if needed.
The Company maintains a portion of its investment portfolio in relatively short-term and highly liquid investments to ensure the availability of funds to pay claims and expenses.  A variety of maturities are maintained in the Company’s investment portfolio to assure adequate liquidity.  The maturity structure of the fixed maturity portfolio is also established by the relative attractiveness of yields on short, intermediate and long-term securities.  The Company does not invest in non-investment grade debt securities.  Any non-investment grade securities held by the Company are the result of rating downgrades subsequent to their purchase.

47


The Company invests for the long term and generally purchases fixed maturity securities with the intent to hold them to maturity.  Despite this intent, the Company currently classifies fixed maturity securities as available-for-sale to provide flexibility in the management of its investment portfolio.  At September 30, 2016 and December 31, 2015, the Company had net unrealized holding gains, net of deferred taxes, on its fixed maturity securities available-for-sale of $34.2 million and $20.0 million, respectively.  The fluctuation in the fair value of these investments is primarily due to changes in the interest rate environment during this time period, but also reflects fluctuations in risk premium spreads over U.S. Treasuries.  Since the Company intends to hold fixed maturity securities to maturity, such fluctuations in the fair value of these investments are not expected to have a material impact on the operations of the Company, as forced liquidations of investments are not anticipated. The Company closely monitors the bond market and makes appropriate adjustments in its portfolio as conditions warrant.
The majority of the Company’s assets are invested in fixed maturity securities.  These investments provide a substantial amount of investment income that supplements underwriting results and contributes to net earnings.  As these investments mature, or are called, the proceeds are reinvested at current interest rates, which may be higher or lower than those now being earned; therefore, more or less investment income may be available to contribute to net earnings.  Due to the prolonged low interest rate environment, proceeds from calls and maturities in recent years have been reinvested at lower yields, which has had a negative impact on investment income.
The Company held $9.9 million in minority ownership interests in limited partnerships and limited liability companies at both September 30, 2016 and December 31, 2015.  During the first nine months of 2016 and 2015, the Company invested $4.9 million and $4.0 million, respectively, in a limited partnership that is designed to help protect the Company from a sudden and significant decline in the value of its equity portfolio. This investment is included in "other long-term investments" in the Company's financial statements and is carried under the equity method of accounting.
During 2015, the Company began participating in a reverse repurchase arrangement, involving the purchase of investment securities from third-party sellers with the agreement that the purchased securities be sold back to the third-party sellers for agreed-upon prices at specified future dates. The third-party sellers are required to pledge collateral with a value greater than the amount of cash received in the transactions. In accordance with GAAP, the investment securities purchased under the reverse repurchase agreements are not reflected in the Company's consolidated balance sheets, but instead a receivable is recorded for the principal amount lent. The Company's receivable under reverse repurchase agreements was $16.9 million at both September 30, 2016 and December 31, 2015.
The Company’s cash balance was $350,000 and $224,000 at September 30, 2016 and December 31, 2015, respectively.
During the first nine months of 2016, Employers Mutual made no contributions to its qualified pension plan or postretirement benefit plans.  The Company’s share of Employers Mutual’s 2016 planned contribution to its pension plan, if made, will be approximately $2.5 million. No contributions will be made to the postretirement benefit plans in 2016.
During the first nine months of 2015, Employers Mutual contributed $4.0 million to its qualified pension plan ($1.2 million allocated to the Company), but made no contributions to its postretirement benefit plans.  The Company reimbursed Employers Mutual $1.2 million for its share of the total 2015 pension contribution (no contributions were made to the postretirement benefit plans during 2015).

Capital Resources
Capital resources consist of stockholders’ equity and debt, representing funds deployed or available to be deployed to support business operations.  For the Company’s insurance subsidiaries, capital resources are required to support premium writings.  Regulatory guidelines suggest that the ratio of a property and casualty insurer’s annual net premiums written to its statutory surplus should not exceed three to one.  On an annualized basis, all of the Company’s property and casualty insurance subsidiaries were well under this guideline at September 30, 2016.
The Company’s insurance subsidiaries are required to maintain a certain minimum level of surplus on a statutory basis, and are subject to regulations under which the payment of dividends from statutory surplus is restricted and may require prior approval of their domiciliary insurance regulatory authorities.  The Company’s insurance subsidiaries are also subject to annual Risk Based Capital (RBC) requirements that may further impact their ability to pay dividends.  RBC requirements attempt to measure minimum statutory capital needs based upon the risks in a company’s mix of products and investment portfolio.  At December 31, 2015, the Company’s insurance subsidiaries had total adjusted statutory capital of $485.2 million, which is well in excess of the minimum risk-based capital requirement of $77.4 million.

48


The Company’s total cash and invested assets at September 30, 2016 and December 31, 2015 are summarized as follows:
 
 
September 30, 2016
($ in thousands)
 
Amortized
cost
 
Fair
value
 
Percent of total
fair value
 
Carrying
value
Fixed maturity securities available-for-sale
 
$
1,184,470

 
$
1,237,150

 
82.0
%
 
$
1,237,150

Equity securities available-for-sale
 
151,852

 
219,282

 
14.5

 
219,282

Cash
 
350

 
350

 

 
350

Short-term investments
 
42,611

 
42,611

 
2.8

 
42,611

Other long-term investments
 
9,941

 
9,941

 
0.7

 
9,941

 
 
$
1,389,224

 
$
1,509,334

 
100.0
%
 
$
1,509,334


 
 
December 31, 2015
($ in thousands)
 
Amortized
cost
 
Fair
value
 
Percent of total
fair value
 
Carrying
value
Fixed maturity securities available-for-sale
 
$
1,130,217

 
$
1,161,025

 
82.0
%
 
$
1,161,025

Equity securities available-for-sale
 
144,176

 
206,243

 
14.6

 
206,243

Cash
 
224

 
224

 

 
224

Short-term investments
 
38,599

 
38,599

 
2.7

 
38,599

Other long-term investments
 
9,930

 
9,930

 
0.7

 
9,930

 
 
$
1,323,146

 
$
1,416,021

 
100.0
%
 
$
1,416,021



49


The amortized cost and estimated fair value of fixed maturity and equity securities at September 30, 2016 were as follows:
($ in thousands)
 
Amortized
cost
 
Gross
unrealized
gains
 
Gross
unrealized
losses
 
Estimated
fair values
Securities available-for-sale:
 
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
 
U.S. treasury
 
$
7,835

 
$
372

 
$

 
$
8,207

U.S. government-sponsored agencies
 
236,698

 
1,408

 
612

 
237,494

Obligations of states and political subdivisions
 
320,330

 
29,601

 
19

 
349,912

Commercial mortgage-backed
 
40,800

 
1,208

 
126

 
41,882

Residential mortgage-backed
 
106,044

 
2,245

 
8,780

 
99,509

Other asset-backed
 
27,239

 
1,112

 
100

 
28,251

Corporate
 
445,524

 
26,584

 
213

 
471,895

Total fixed maturity securities
 
1,184,470

 
62,530

 
9,850

 
1,237,150

 
 
 
 
 
 
 
 
 
Equity securities:
 
 
 
 
 
 
 
 
Common stocks:
 
 
 
 
 
 
 
 
Financial services
 
24,115

 
8,748

 
444

 
32,419

Information technology
 
19,482

 
11,457

 
2

 
30,937

Healthcare
 
16,522

 
11,040

 
43

 
27,519

Consumer staples
 
14,059

 
7,066

 
59

 
21,066

Consumer discretionary
 
15,399

 
8,983

 
336

 
24,046

Energy
 
14,021

 
5,167

 
359

 
18,829

Industrials
 
13,390

 
10,375

 
71

 
23,694

Other
 
16,833

 
4,700

 
211

 
21,322

Non-redeemable preferred stocks
 
18,031

 
1,501

 
82

 
19,450

Total equity securities
 
151,852

 
69,037

 
1,607

 
219,282

Total securities available-for-sale
 
$
1,336,322

 
$
131,567

 
$
11,457

 
$
1,456,432


The Company’s property and casualty insurance subsidiaries have $25.0 million of surplus notes issued to Employers Mutual.  The interest rate on the surplus notes is 1.35 percent.  Reviews of the interest rate are conducted by the Inter-Company Committees of the boards of directors of the Company and Employers Mutual every five years, with the next review due in 2018.  Payments of interest and repayments of principal can only be made out of the applicable subsidiary’s statutory surplus and are subject to prior approval by the insurance commissioner of the respective states of domicile.  The surplus notes are subordinate and junior in right of payment to all obligations or liabilities of the applicable insurance subsidiaries.  Total interest expense incurred on these surplus notes was $253,000 during the first nine months of 2016 and 2015.  During the first quarter of 2016, the Company’s property and casualty insurance subsidiaries paid Employers Mutual for the interest that had been accrued on the surplus notes during 2015.
As of September 30, 2016, the Company had no material commitments for capital expenditures.


50


Off-Balance Sheet Arrangements
Employers Mutual collects from agents, policyholders and ceding companies all written premiums associated with the insurance business produced by the pool participants and the assumed reinsurance business ceded to the reinsurance subsidiary. Employers Mutual also collects from its reinsurers all losses and settlement expenses recoverable under the reinsurance contracts protecting the pool participants and, starting in 2016, the reinsurance subsidiary, as well as the fronting business ceded to the reinsurance subsidiary. Employers Mutual settles with the pool participants (monthly) and the reinsurance subsidiary (quarterly) the premiums written from these insurance policies and the paid losses and settlement expenses recoverable under the external reinsurance contracts, providing full credit for the premiums written and the paid losses and settlement expenses recoverable under the external reinsurance contracts generated during the period (not just the collected portion). Due to this arrangement, and since a significant portion of the premium balances are collected over the course of the underlying coverage periods, Employers Mutual carries a substantial receivable balance for insurance and reinsurance premiums in process of collection and, to a lesser extent, paid losses and settlement expenses recoverable from the external reinsurance companies.  Any of these receivable amounts that are ultimately deemed to be uncollectible are charged-off by Employers Mutual and the expense is charged to the reinsurance subsidiary or allocated to the pool members on the basis of pool participation.  As a result, the Company has off-balance sheet arrangements with an unconsolidated entity that results in credit-risk exposures (Employers Mutual’s insurance and reinsurance premium receivable balances, and paid loss and settlement expense recoverable amounts) that are not reflected in the Company’s financial statements.  The average annual expense for such charge-offs allocated to the Company over the past ten years is $366,000. Based on this historical data, this credit-risk exposure is not considered to be material to the Company’s results of operations or financial position and, accordingly, no loss contingency liability has been recorded.

Investment Impairments and Considerations
The Company recorded $275,000 and $976,000 of "other-than-temporary" investment impairment losses during the three and nine months ended September 30, 2016, compared to $628,000 and $1.3 million during the same periods in 2015. The impairment losses were recognized on securities held in the Company's equity portfolio.
At September 30, 2016, the Company had unrealized losses on available-for-sale securities as presented in the following table. The estimated fair value is based on quoted market prices, where available.  In cases where quoted market prices are not available, fair values are based on a variety of valuation techniques depending on the type of security.  None of these securities are considered to be in concentrations by either security type or industry.  The Company uses several factors to determine whether the carrying value of an individual security has been “other-than-temporarily” impaired.  Such factors include, but are not limited to, the security’s value and performance in the context of the overall markets, length of time and extent the security’s fair value has been below carrying value, key corporate events and, for fixed maturity securities, the amount of collateral available. Based on these factors, the absence of management’s intent to sell these securities prior to recovery or maturity, and the fact that management does not anticipate that it will be forced to sell these securities prior to recovery or maturity, it was determined that the carrying value of these securities were not “other-than-temporarily” impaired at September 30, 2016.  Risks and uncertainties inherent in the methodology utilized in this evaluation process include interest rate risk, equity price risk, and the overall performance of the economy, all of which have the potential to adversely affect the value of the Company’s investments. Should a determination be made at some point in the future that these unrealized losses are “other-than-temporary”, the Company’s earnings would be reduced by approximately $7.4 million, net of tax; however, the Company’s financial position would not be affected because unrealized losses on available-for-sale securities are reflected in the Company’s financial statements as a component of stockholders’ equity, net of deferred taxes.

51


Following is a schedule of the length of time securities have continuously been in an unrealized loss position as of September 30, 2016.
 
 
Less than twelve months
 
Twelve months or longer
 
Total
($ in thousands)
 
Fair
values
 
Unrealized
losses
 
Fair
values
 
Unrealized
losses
 
Fair
values
 
Unrealized
losses
Fixed maturity securities:
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government-sponsored agencies
 
$
56,223

 
$
612

 
$

 
$

 
$
56,223

 
$
612

Obligations of states and political subdivisions
 
2,836

 
19

 

 

 
2,836

 
19

Commercial mortgage-backed
 
20,698

 
126

 

 

 
20,698

 
126

Residential mortgage-backed
 
24,298

 
1,103

 
25,791

 
7,677

 
50,089

 
8,780

Other asset-backed
 
7,526

 
100

 

 

 
7,526

 
100

Corporate
 
22,582

 
134

 
8,646

 
79

 
31,228

 
213

Total fixed maturity securities
 
134,163

 
2,094

 
34,437

 
7,756

 
168,600

 
9,850

Equity securities:
 
 
 
 
 
 
 
 
 
 
 
 
Common stocks:
 
 
 
 
 
 
 
 
 
 
 
 
Financial services
 
4,802

 
444

 

 

 
4,802

 
444

Information technology
 
52

 
2

 

 

 
52

 
2

Healthcare
 
873

 
43

 

 

 
873

 
43

Consumer staples
 
1,079

 
59

 

 

 
1,079

 
59

Consumer discretionary
 
3,813

 
336

 

 

 
3,813

 
336

Energy
 
4,899

 
359

 

 

 
4,899

 
359

Industrials
 
1,097

 
71

 

 

 
1,097

 
71

Other
 
2,448

 
211

 

 

 
2,448

 
211

Non-redeemable preferred stocks
 

 

 
1,918

 
82

 
1,918

 
82

Total equity securities
 
19,063

 
1,525

 
1,918

 
82

 
20,981

 
1,607

Total temporarily impaired securities
 
$
153,226

 
$
3,619

 
$
36,355

 
$
7,838

 
$
189,581

 
$
11,457


The Company does not purchase non-investment grade fixed maturity securities.  Any non-investment grade fixed maturity securities held are the result of rating downgrades that occurred subsequent to their purchase.  At September 30, 2016, the Company held $3.1 million of non-investment grade fixed maturity securities in a net unrealized gain position of $57,000.

52


Following is a schedule of gross realized losses recognized in the first nine months of 2016.  The schedule is aged according to the length of time the underlying securities were in an unrealized loss position.  
 
 
Realized losses from sales
 
"Other-than-
temporary"
impairment
losses
 
Total
gross
realized
losses
($ in thousands)
 
Book
value
 
Sales
price
 
Gross
realized
losses
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
 
 
 
Three months or less
 
$

 
$

 
$

 
$

 
$

Over three months to six months
 

 

 

 

 

Over six months to nine months
 

 

 

 

 

Over nine months to twelve months
 

 

 

 

 

Over twelve months
 
7,008

 
6,491

 
517

 

 
517

Subtotal, fixed maturity securities
 
7,008

 
6,491

 
517

 

 
517

 
 
 
 
 
 
 
 
 
 
 
Equity securities:
 
 
 
 
 
 
 
 
 
 
Three months or less
 
10,783

 
9,361

 
1,422

 
237

 
1,659

Over three months to six months
 
1,979

 
1,796

 
183

 
104

 
287

Over six months to nine months
 
360

 
354

 
6

 
450

 
456

Over nine months to twelve months
 
900

 
828

 
72

 

 
72

Over twelve months
 

 

 

 
185

 
185

Subtotal, equity securities
 
14,022

 
12,339

 
1,683

 
976

 
2,659

 
 
 
 
 
 
 
 
 
 
 
Total realized losses
 
$
21,030

 
$
18,830

 
$
2,200

 
$
976

 
$
3,176


LEASES, COMMITMENTS AND CONTINGENT LIABILITIES
One of the Company’s property and casualty insurance subsidiaries leases office facilities in Bismarck, North Dakota with lease terms expiring in 2024.  Employers Mutual has entered into various leases for branch and service office facilities with lease terms expiring through 2025.  All of these lease costs are included as expenses under the pooling agreement.  The Company’s contractual obligations as of September 30, 2016 did not change materially from those presented in the Company’s 2015 Form 10-K.
The participants in the pooling agreement are subject to guaranty fund assessments by states in which they write business.  Guaranty fund assessments are used by states to pay policyholder liabilities of insolvent insurers domiciled in those states.  Many states allow assessments to be recovered through premium tax offsets.  The Company has accrued estimated guaranty fund assessments of $869,000 and $912,000 as of September 30, 2016 and December 31, 2015, respectively. Premium tax offsets of $1.1 million and $1.1 million, which are related to prior guarantee fund payments and current assessments, have been accrued as of September 30, 2016 and December 31, 2015, respectively.  The guaranty fund assessments are expected to be paid over the next two years and the premium tax offsets are expected to be realized within ten years of the payments.  The participants in the pooling agreement are also subject to second-injury fund assessments, which are designed to encourage employers to employ workers with pre-existing disabilities.  The Company had accrued estimated second-injury fund assessments of $2.0 million and $1.9 million as of September 30, 2016 and December 31, 2015, respectively.  The second-injury fund assessment accruals are based on projected loss payments.  The periods over which the assessments will be paid is not known.
The participants in the pooling agreement have purchased annuities from life insurance companies, under which the claimant is payee, to fund future payments that are fixed pursuant to specific claim settlement provisions.  Based on information provided by the life insurance companies on an annual basis, the Company’s share of case loss reserves eliminated by the purchase of those annuities was $110,000 at December 31, 2015.  The Company had a contingent liability for the aggregate guaranteed amount of the annuities of $183,000 at December 31, 2015 should the issuers of those annuities fail to perform. Although management is not able to verify the amount, the Company would likely have a similar contingent liability at September 30, 2016.  The probability of a material loss due to failure of performance by the issuers of these annuities is considered remote.

53


ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The main objectives in managing the Company’s investment portfolios are to maximize after-tax investment return while minimizing risk, in order to provide maximum support for the underwriting operations.  Investment strategies are developed based upon many factors including underwriting results, regulatory requirements, fluctuations in interest rates and consideration of other market risks.  Investment decisions are centrally managed by investment professionals and are supervised by the investment committees of the respective boards of directors for each of the Company’s subsidiaries.
Market risk represents the potential for loss due to adverse changes in the fair value of financial instruments, and is directly influenced by the volatility and liquidity in the markets in which the related underlying assets are traded.  The market risks of the financial instruments owned by the Company relate to the investment portfolio, which exposes the Company to interest rate (inclusive of credit spreads) and equity price risk and, to a lesser extent, credit quality and prepayment risk. Monitoring systems and analytical tools are in place to assess each of these elements of market risk; however, there can be no assurance that future changes in interest rates, creditworthiness of issuers, prepayment activity, liquidity available in the market and other general market conditions will not have a material adverse impact on the Company’s results of operations, liquidity or financial position.
Two categories of influences on market risk exist as it relates to financial instruments.  First are systematic aspects, which relate to the investing environment and are out of the control of the investment manager.  Second are non-systematic aspects, which relate to the construction of the investment portfolio through investment policies and decisions, and are under the direct control of the investment manager.  The Company is committed to controlling non-systematic risk through sound investment policies and diversification.
Further analysis of the components of the Company’s market risk (including interest rate risk, equity price risk, credit quality risk, and prepayment risk) can be found in the Company’s 2015 Form 10-K.

ITEM 4.
CONTROLS AND PROCEDURES
The Company, under the supervision and with the participation of its management, including the Chief Executive Officer and the Chief Financial Officer, evaluated the effectiveness of the design and operation of the Company’s “disclosure controls and procedures” (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely making known to them material information relating to the Company and the Company’s consolidated subsidiaries required to be disclosed in the Company’s reports filed or submitted under the Exchange Act.
There were no changes in the Company’s internal control over financial reporting that occurred during the third quarter ended September 30, 2016 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.



54


PART II.
OTHER INFORMATION

ITEM 2.
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

The following table sets forth information regarding purchases of equity securities by the Company and affiliated purchasers for the three months ended September 30, 2016:
Period
 
(a) Total
number of
shares
(or units)
purchased (1)
 
(b) Average
price
paid
per share
(or unit)
 
(c) Total number
of shares (or
units) purchased
as part of publicly
announced plans
or programs (2)
 
(d) Maximum number
(or approximate dollar
value) of shares
(or units) that may yet
be purchased under the
plans or programs
($ in thousands) (2) (3)
7/1/2016 - 7/31/2016
 
35

 
$
28.32

 

 
$
19,108

8/1/2016 - 8/31/2016
 
29

 
27.77

 

 
19,108

9/1/2016 - 9/30/2016
 
1,146

 
28.08

 

 
19,108

Total
 
1,210

 
$
28.08

 

 
 

(1)
Included in this column are shares purchased in the open market to fulfill the Company's obligations under its dividend reinvestment and common stock purchase plan.
(2)
On November 3, 2011, the Company’s Board of Directors authorized a $15.0 million stock repurchase program.  This program does not have an expiration date.  A total of $14.6 million remains available in this plan for the purchase of additional shares.
(3)
On May 12, 2005, the Company announced that its parent company, Employers Mutual, had initiated a $15.0 million stock purchase program under which Employers Mutual may purchase shares of the Company’s common stock in the open market.  This purchase program does not have an expiration date; however, this program has been dormant while the Company’s repurchase programs have been in effect.  A total of $4.5 million remains in this program.

55


ITEM 6.
EXHIBITS
31.1
 
Certification of President, Chief Executive Officer and Treasurer as required by Section 302 of the Sarbanes-Oxley Act of 2002
 
 
 
31.2
 
Certification of Senior Vice President and Chief Financial Officer as required by Section 302 of the Sarbanes-Oxley Act of 2002
 
 
 
32.1
 
Certification of President, Chief Executive Officer and Treasurer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
32.2
 
Certification of Senior Vice President and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
101.INS
 
XBRL Instance Document
 
 
 
101.SCH
 
XBRL Taxonomy Extension Schema Document
 
 
 
101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
 
101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document
 
 
 
101.LAB
 
XBRL Taxonomy Extension Label Linkbase Document
 
 
 
101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document
* Indicates management contract or compensatory plan or arrangement.

56


EMC INSURANCE GROUP INC. AND SUBSIDIARIES
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on November 4, 2016.

EMC INSURANCE GROUP INC.
Registrant
 
/s/ Bruce G. Kelley
Bruce G. Kelley
President, Chief Executive Officer, Treasurer and Director
(Principal Executive Officer)

/s/ Mark E. Reese
Mark E. Reese
Senior Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)

57


EMC INSURANCE GROUP INC. AND SUBSIDIARIES
INDEX TO EXHIBITS
Exhibit number
Item
31.1*
Certification of President, Chief Executive Officer and Treasurer as required by Section 302 of the Sarbanes-Oxley Act of 2002
 
 
31.2*
Certification of Senior Vice President and Chief Financial Officer as required by Section 302 of the Sarbanes-Oxley Act of 2002
 
 
32.1*
Certification of the President, Chief Executive Officer and Treasurer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
32.2*
Certification of the Senior Vice President and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
101.INS**
XBRL Instance Document
 
 
101.SCH**
XBRL Taxonomy Extension Schema Document
 
 
101.CAL**
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
101.DEF**
XBRL Taxonomy Extension Definition Linkbase Document
 
 
101.LAB**
XBRL Taxonomy Extension Label Linkbase Document
 
 
101.PRE**
XBRL Taxonomy Extension Presentation Linkbase Document
*
Filed herewith
**
Furnished, not filed

58