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 Part II, Item 8 of this Form 10-K.
As discussed in Note 1 of Notes to Consolidated Financial Statements, effective
January 1, 2012 the Company adopted new accounting guidance related to deferred
policy acquisition costs that resulted in a retrospective adjustment of certain
amounts reported in the prior year's consolidated financial statements. Certain
financial information presented in this management's discussion and analysis of
the Company's financial condition and results of operations has also been
adjusted.
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 Part I, Item 1A, of this
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.
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.
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Property and casualty insurance operations are conducted through three
subsidiaries and represent the most significant segment of the Company's
business, totaling 78 percent of consolidated premiums earned in 2012. The
Company's three property and casualty insurance subsidiaries and two
subsidiaries and an affiliate of Employers Mutual (Union Insurance Company of
Providence, EMC Property & Casualty Company and Hamilton Mutual Insurance
Company) are parties to reinsurance pooling agreements with Employers Mutual
(collectively the "pooling agreement"). Under the terms of the pooling
agreement, each company cedes to Employers Mutual all of its insurance business,
with the exception of any voluntary reinsurance business assumed from
nonaffiliated insurance companies, and assumes from Employers Mutual an amount
equal to its participation in the pool. All premiums, losses, settlement
expenses, and other underwriting and administrative expenses, excluding the
voluntary reinsurance business assumed by Employers Mutual from nonaffiliated
insurance companies, are prorated among the parties on the basis of
participation in the pool. Employers Mutual negotiates reinsurance agreements
that provide protection to the pool and each of its participants, including
protection against losses arising from catastrophic events. The aggregate
participation of the Company's property and casualty insurance subsidiaries in
the pooling agreement is 30 percent.
Operations of the pool give rise to inter-company balances with Employers
Mutual, which are settled within 45 days after the end of each month. The
investment and income tax activities of the pool participants are not subject to
the pooling agreement. The pooling agreement provides that Employers Mutual will
make up any shortfall or difference resulting from an error in its systems
and/or computation processes that would otherwise result in the required
restatement of the pool participants' financial statements.
The purpose of the pooling agreement is to spread the risk of an exposure
insured by any of the pool participants among all the companies. The pooling
agreement produces a more uniform and stable underwriting result from year to
year for all companies in the pool than might be experienced individually. In
addition, each company benefits from the capacity of the entire pool, rather
than being limited to policy exposures of a size commensurate with its own
assets, and from the wide range of policy forms, lines of insurance written,
rate filings and commission plans offered by each of the companies.
Reinsurance operations are conducted through EMC Reinsurance Company and
accounted for 22 percent of consolidated premiums earned in 2012. The Company's
reinsurance subsidiary is party to a quota share reinsurance retrocessional
agreement (the "quota share agreement") and an excess of loss reinsurance
agreement (the "excess of loss agreement"), with Employers Mutual. Under the
terms of the quota share agreement, the reinsurance subsidiary assumes 100
percent of Employers Mutual's assumed reinsurance business, subject to certain
exceptions. The reinsurance subsidiary also writes a small amount of reinsurance
business on a direct basis outside the quota share agreement. Under the terms of
the excess of loss agreement, the reinsurance subsidiary cedes to Employers
Mutual all losses in excess of $4,000,000 ($3,000,000 in 2011) per event
(covering both business assumed from Employers Mutual through the quota share
agreement, as well as business obtained outside the quota share agreement). The
cost of the excess of loss reinsurance protection during 2012 and 2011 was 10.0
percent of the reinsurance subsidiary's total assumed reinsurance premiums
written.
Prior to 2011, the excess of loss agreement between the reinsurance subsidiary
and Employers Mutual did not exist. Rather, the cap on losses per event
($3,000,000) and the related cost of this protection (10.5 percent of the net
assumed premiums written subject to cession to the reinsurance subsidiary) was
contained in the quota share agreement, and the transactions were handled on a
net, rather than a gross, basis. The cost of the cap on losses per event was
recorded as a reduction in the premiums assumed by the reinsurance subsidiary,
and the cap on losses per event did not cover the business written directly by
the reinsurance subsidiary.
The terms of the excess of loss agreement have been revised for fiscal year
2013. Effective January 1, 2013, EMC Reinsurance Company will continue to retain
the first $4,000,000 of losses per event, but will also retain 20.0 percent of
any losses between $4,000,000 and $10,000,000 and 10.0 percent of any losses
between $10,000,000 and $50,000,000 associated with any event. In connection
with the change in the amount of losses retained per event, the cost of the
excess of loss coverage will decrease from the current 10.0 percent of total
assumed reinsurance premiums written to 9.0 percent of total assumed reinsurance
premiums written. These changes are a result of efforts to ensure that the terms
of the agreement are fair and equitable to both parties.
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The reinsurance subsidiary does not directly reinsure any of the insurance
business written by Employers Mutual or the other pool participants; however,
Employers Mutual assumes reinsurance business from the Mutual Reinsurance Bureau
(MRB) underwriting association, which provides a small amount of reinsurance
protection to the members of the EMC Insurance Companies pooling agreement. As a
result, the reinsurance subsidiary's assumed exposures include a small portion
of the EMC Insurance Companies' direct business, after ceded reinsurance
protections purchased by MRB are applied. In addition, the reinsurance
subsidiary does not reinsure any "involuntary" facility or pool business that
Employers Mutual assumes pursuant to state law. The reinsurance subsidiary
assumes all foreign currency exchange gain/loss associated with contracts
incepting on January 1, 2006 and thereafter that are subject to the quota share
agreement. Operations of the quota share agreement give rise to inter-company
balances with Employers Mutual, which are settled within 45 days after the end
of each quarter. The investment and income tax activities of the reinsurance
subsidiary are not subject to the quota share agreement.
Under the terms of the quota share agreement, the reinsurance subsidiary
receives reinstatement premium income that is collected by Employers Mutual from
the ceding companies when reinsurance coverage is reinstated after a loss event;
however, the cap on losses assumed per event contained in the excess of loss
agreement is automatically reinstated without cost.
Country Mutual Insurance Company terminated its participation in MRB effective
January 1, 2011. As a result, Employers Mutual became a one-fourth participant
in MRB, up from its previous approximate one-fifth participation. Effective
January 1, 2013, Church Mutual Insurance Company (Church Mutual) became a member
of MRB. As a result, Employers Mutual will once again become a one-fifth
participant in MRB. The addition of Church Mutual to MRB will strengthen MRB's
surplus base and should favorably impact future marketing efforts. However,
there will be a short-term negative impact on the Company's earned premiums
since the MRB business will now be split between five participants rather than
the current four.
INDUSTRY OVERVIEW
An insurance company's underwriting results reflect the profitability of its
insurance operations, excluding investment income. Underwriting profit or loss
is calculated by subtracting losses and expenses incurred from premiums earned.
Insurance companies collect cash in the form of insurance premiums and pay out
cash in the form of loss and settlement expense payments. Additional cash
outflows occur through the payment of acquisition and underwriting costs such as
commissions, premium taxes, salaries and general overhead. During the loss
settlement period, which varies by line of business and by the circumstances
surrounding each claim and may cover several years, insurance companies invest
the cash premiums; thereby earning interest and dividend income. This investment
income supplements underwriting results and contributes to net earnings. Funds
from called and matured fixed maturity securities are reinvested at current
interest rates. The low interest rate environment that has existed during the
past several years has had a negative impact on the insurance industry's
investment income.
Insurance pricing has historically been cyclical in nature. Periods of excess
capital and increased competition encourage price reductions and liberal
underwriting practices (referred to as a soft market) as insurance companies
compete for market share, while attempting to cover the inevitable underwriting
losses from these actions with investment income. A prolonged soft market
generally leads to a reduction in the adequacy of capital in the insurance
industry. To cure this condition, underwriting practices are tightened, premium
rate levels increase and competition subsides as companies strive to strengthen
their balance sheets (referred to as a hard market). The insurance industry is
currently experiencing a "hardening" market, with premium rate levels increasing
moderately in most lines of business during 2012. However, the market hardening
is being driven by a persistent decline in investment income and an increase in
severe weather events, not a reduction in capital adequacy. The outlook for 2013
is that overall premium rate levels will continue to increase at a moderate rate
for most lines of business.
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A substantial determinant of an insurance company's underwriting results is its
loss and settlement expense reserving practices. Insurance companies must
estimate the amount of losses and settlement expenses that will ultimately be
paid to settle claims that have occurred to date (loss and settlement expense
reserves). This estimation process is inherently subjective with the possibility
of widely varying results, particularly for certain highly volatile types of
claims (asbestos, environmental and various casualty exposures, such as products
liability, where the loss amount and the parties responsible are difficult to
determine). During a soft market, inadequate premium rates put pressure on
insurance companies to under-estimate their loss and settlement expense reserves
in order to report better results. Correspondingly, inadequate reserves can play
an integral part in bringing about a hard market, because increased
profitability from higher premium rate levels can be used to strengthen
inadequate reserves.
The Company closely monitors the activities of the United States Congress and
federal agencies through its membership in various organizations. In particular,
our trade organizations are actively seeking the renewal of terrorism insurance,
working to shape the activities of the Federal Insurance Office as it continues
to evolve and exercise its authority to monitor the insurance industry, and
pursuing a legal remedy for the Department of Housing and Urban Development's
rulemaking that suggests it could apply a "disparate impact" standard
(discrimination in effect) to the provision and pricing of homeowner's insurance
under the Fair Housing Act.
MANAGEMENT ISSUES AND PERSPECTIVES
Low interest rate environment
The interest rate environment has an influence on several operational areas that
have the potential to materially impact the Company's financial condition and
results of operations. Following is a brief discussion of the major operational
areas being monitored by management in light of the current low interest rate
environment.
Investment portfolio
The majority of the Company's investment portfolio is invested in fixed maturity
securities. The low interest rate environment is currently having a positive
impact on the Company's financial condition because the portfolio of fixed
maturity securities available-for-sale had net unrealized holding gains, net of
deferred taxes, of $51,318,000 at December 31, 2012, reflecting the fact that
the average yield on the Company's portfolio is higher than the yields currently
available in the fixed maturity marketplace. However, proceeds from maturing
securities and cash from operating activities are being invested at the current
low yields, which is having a negative impact on investment income. If the low
interest rate environment continues, as expected, future investment income will
decline from the current level. To help minimize the impact of the low interest
rate environment on the Company's future results of operations, management has
been working to reduce the average duration of the investment portfolio to
closer match the average duration of the insurance liabilities.
Underwriting results
The Company's portfolio of fixed maturity securities provides a substantial
amount of investment income that supplements underwriting results and
contributes to net earnings. A prolonged low interest rate environment could
result in a significant decline in future investment income, which would
increase the need to achieve an underwriting profit. Management continually
stresses the importance of striving for an underwriting profit, and is working
diligently with the branch offices to maintain prudent underwriting and pricing
standards, and establish long-term business plans with the Company's agency
force.
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Benefit plan liabilities
The low interest rate environment has resulted in a significant decline in the
discount rates used to value the obligations the Company has under Employers
Mutual's pension and postretirement benefit plans. As a result, the valuation of
the benefit obligations has increased, which has negatively impacted the funded
status of those plans and resulted in a higher level of annual cash
contributions and expenses. A prolonged low interest rate environment could
result in a continuation of higher cash contributions and increased expenses,
both of which would have a negative impact on the Company's future results of
operations.
Catastrophe and storm losses
The Company has experienced five consecutive years of above average catastrophe
and storm losses, and experienced record levels of catastrophe and storm losses
in two of those five years (2008 and 2011). Based on an analysis of nationwide
storm activity, management does not believe that overall storm activity or
intensity is trending upward. Rather, it appears that in recent years more of
the storms have occurred in more heavily-populated urban areas instead of
less-populated rural areas, which has impacted the number of claims
submitted. It should be noted that the Company has experienced periods of
increased catastrophe and storm losses in the past, the most recent period being
from 1998 to 2001. Management continues to monitor and make adjustments to the
Company's book of business to lessen exposure concentrations, and is prepared to
make additional adjustments to exposure concentrations if warranted.
Premium rate levels
Prior to 2011, the Company's overall premium rate level had declined for five
consecutive years. Management was able to implement moderate rate increases in
the personal lines of business during this time period, but rate levels in the
commercial lines of business, which account for more than 80 percent of the
property and casualty insurance segment's premium income, remained very
competitive. During 2011, in recognition of the above average amount of
catastrophe and storm losses incurred during the prior three years and a
projected decline in investment income due to the persistent low interest rate
environment, the commercial lines marketplace began to harden and the Company
was able to implement small rate level increases. This trend continued into
2012, and rate levels continued to steadily improve throughout the year. Over
the past two years, management has worked diligently with the sixteen branch
offices to stress the importance of achieving modest, but consistent, commercial
lines rate increases whenever possible. These efforts have been successful, and
the Company has been able to achieve a much needed increase in the overall
premium rate level for the commercial lines business. Commercial lines rate
levels are expected to continue to increase in 2013 at approximately the same
pace as the rate level increases that were obtained at the end of 2012
(approximately 6 percent), and management will continue to work with the branch
offices to ensure that all opportunities for additional rate increases are
pursued.
Possible changes in U.S. generally accepted accounting principles (GAAP)
The Financial Accounting Standards Board is expected to release several
significant proposed changes to current GAAP for public comment during
2013. Depending on the outcome of these initiatives, the accounting rules and
required disclosures for public companies, and for insurance companies in
particular, could change significantly. Management is closely monitoring
developments in this area and will evaluate any proposed accounting standards
that are exposed for public comment during 2013 to identify changes that would
be required in the Company's data/systems to comply with the new accounting
standards.
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Reserving Methodology
The Company's reserving methodology is focused on maintaining a consistent level
of overall reserve adequacy. Management does not use accident year loss picks to
establish the Company's carried reserves. Case loss and IBNR loss reserves, as
well as settlement expense reserves, are established independently of each other
and added together to get the Company's total loss and settlement expense
reserve. The Company's reserving methodology also includes bulk case loss
reserves, which supplement the aggregate case loss reserves and are used by
management to establish its best estimate of the Company's liability for
reported claims.
There is an inherent amount of uncertainty involved in the establishment of
insurance liabilities. This uncertainty is greatest in the current and more
recent accident years because a smaller percentage of the expected ultimate
claims have been reported, adjusted and settled compared to more mature accident
years. For this reason, carried reserves for these accident years reflect
prudently conservative assumptions. As the carried reserves for these accident
years run off, the overall expectation is that, more often than not, favorable
development will occur. However, there is also the possibility that the ultimate
settlement of liabilities associated with these accident years will show adverse
development, and such adverse development could be substantial.
The Company's bulk reserves (formula IBNR loss reserve, bulk case loss reserve
and settlement expense reserve) are initially established for all accident years
combined, and are then allocated to the various accident years for financial
reporting purposes. It is important to note that development on prior years'
reserves resulting solely from changes in the allocation of bulk reserves
between the current and prior accident years does not have an impact on
earnings. This is due to the fact that such development is simply a mathematical
by-product of the mechanical process used to reallocate bulk reserves to the
various accident years for financial reporting purposes. Earnings are only
impacted by changes in the total amount of carried reserves.
For the reasons noted above, development amounts reported on prior accident
years' reserves are less meaningful under the Company's reserving methodology
than other reserving methodologies. Accordingly, from management's perspective,
whether the Company has maintained a consistent level of overall reserve
adequacy is more relevant to understanding the Company's results of operations
than the composition of the underwriting results between the current and prior
accident years.
MEASUREMENT OF RESULTS
The Company's consolidated financial statements are prepared on the basis of
GAAP. The Company also prepares financial statements for each of its insurance
subsidiaries based on statutory accounting principles that are filed with
insurance regulatory authorities in the states where they do business. Statutory
accounting principles are designed to address the concerns of state regulators
and stress the measurement of the insurer's ability to satisfy its obligations
to its policyholders and creditors.
Management evaluates the Company's operations by monitoring key measures of
growth and profitability. Management measures the Company's growth by examining
direct premiums written and, perhaps more importantly, premiums written assumed
from affiliates. Management generally measures the Company's operating results
by examining the Company's net income and return on equity as well as the loss
and settlement expense, acquisition expense and combined ratios. The following
provides further explanation of the key measures management uses to evaluate the
Company's results:
Direct Premiums Written. Direct premiums written is the sum of the total policy
premiums, net of cancellations, associated with policies underwritten and issued
by the Company's property and casualty insurance subsidiaries. These direct
premiums written are transferred to Employers Mutual under the terms of the
pooling agreement and are reflected in the Company's consolidated financial
statements as premiums written ceded to affiliates. See note 3 of Notes to
Consolidated Financial Statements.
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Premiums Written Assumed From Affiliates and Premiums Written Assumed From
Nonaffiliates. For the property and casualty insurance segment, premiums written
assumed from affiliates and nonaffiliates reflects the property and casualty
insurance subsidiaries' aggregate 30 percent participation interest in 1) the
total direct premiums written by all the participants in the pooling
arrangement, and 2) the involuntary business assumed by the pool participants
pursuant to state law, respectively. For the reinsurance segment, premiums
written assumed from nonaffiliates reflects the reinsurance business assumed
through the quota share agreement (including "fronting" activities initiated by
Employers Mutual) and reinsurance business assumed outside the quota share
agreement. See note 3 of Notes to Consolidated Financial Statements. Management
uses premiums written assumed from affiliates and nonaffiliates, which excludes
the impact of written premiums ceded to reinsurers, as a measure of the
underlying growth of the Company's insurance business from period to period.
Net Premiums Written. Net premiums written is calculated by summing direct
premiums written, premiums written assumed from affiliates, and premiums written
assumed from nonaffiliates, and then subtracting from that result premiums
written ceded to affiliates and premiums written ceded to nonaffiliates. For the
property and casualty insurance segment, premiums written ceded to nonaffiliates
is the portion of the Company's direct and assumed premiums written that is
transferred to reinsurers in accordance with the terms of the underlying
reinsurance contracts, based upon the risks they accept. For the reinsurance
segment, premiums written ceded to nonaffiliates reflects reinsurance business
that is ceded to other insurance companies in connection with "fronting"
activities initiated by Employers Mutual. Premiums written ceded to affiliates
includes both the cession of the Company's property and casualty insurance
subsidiaries' direct business to Employers Mutual under the terms of the pooling
agreement, and premiums ceded by the Company's reinsurance subsidiary to
Employers Mutual under the terms of the excess of loss agreement with Employers
Mutual. See note 3 of Notes to Consolidated Financial Statements. Management
uses net premiums written to measure the amount of business retained after
cessions to reinsurers.
Loss and Settlement Expense Ratio. The loss and settlement expense ratio is the
ratio (expressed as a percentage) of losses and settlement expenses incurred to
premiums earned, and measures the underwriting profitability of a company's
insurance business. The loss and settlement expense ratio is generally measured
on both a gross (direct and assumed) and net (gross less ceded)
basis. Management uses the gross loss and settlement expense ratio as a measure
of the Company's overall underwriting profitability of the insurance business it
writes and to assess the adequacy of the Company's pricing. The net loss and
settlement expense ratio is meaningful in evaluating the Company's financial
results, which are net of ceded reinsurance, as reflected in the consolidated
financial statements. The loss and settlement expense ratios are generally
calculated in the same way for GAAP and statutory accounting purposes.
Acquisition Expense Ratio. The acquisition expense ratio is the ratio (expressed
as a percentage) of net acquisition and other expenses incurred to premiums
earned, and measures a company's operational efficiency in producing,
underwriting and administering its insurance business. For statutory accounting
purposes, acquisition and other expenses of an insurance company exclude
investment expenses. There is no such industry definition for determining an
acquisition expense ratio for GAAP purposes. As a result, management applies the
statutory definition to calculate the Company's acquisition expense ratio on a
GAAP basis. The net acquisition expense ratio is meaningful in evaluating the
Company's financial results, which are net of ceded reinsurance, as reflected in
the consolidated financial statements.
GAAP Combined Ratio. The combined ratio (expressed as a percentage) is the sum
of the loss and settlement expense ratio and the acquisition expense ratio, and
measures a company's overall underwriting profit/loss. If the combined ratio is
at or above 100, an insurance company cannot be profitable without investment
income (and may not be profitable if investment income is
insufficient). Management uses the GAAP combined ratio in evaluating the
Company's overall underwriting profitability and as a measure for comparison of
the Company's profitability relative to the profitability of its competitors who
prepare GAAP-basis financial statements.
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Statutory Combined Ratio. The statutory combined ratio (expressed as a
percentage) is calculated in the same manner as the GAAP combined ratio, but is
based on results determined pursuant to statutory accounting rules and
regulations. The statutory "trade combined ratio" differs from the statutory
combined ratio in that the acquisition expense ratio is based on net premiums
written rather than net premiums earned. Management uses the statutory trade
combined ratio as a measure for comparison of the Company's profitability
relative to the profitability of its competitors, all of whom must file
statutory-basis financial statements with insurance regulatory authorities.
Catastrophe and storm losses. For the property and casualty insurance segment,
catastrophe and storm losses include losses attributed to events that have
occurred in the United States which have been assigned an occurrence number by
Property Loss Reinsurance Bureau (PLRB) Catastrophe Services. According to PLRB,
an occurrence number is assigned when an event has produced conditions severe
enough to have caused, or to be likely to have caused, property damage. For the
reinsurance segment, catastrophe and storm losses include losses that have
occurred in the United States, Puerto Rico and the U.S. Virgin Islands which
have been designated as catastrophes by Property Claims Services (PCS), as well
as non-U.S. catastrophe and storm losses reported by the ceding
companies. According to PCS, catastrophe serial numbers are assigned to events
that cause $25,000,000 or more in direct insured losses to property and affect a
significant number of policyholders and insurers.
CRITICAL ACCOUNTING POLICIES
The following accounting policies are considered by management to be critically
important in the preparation and understanding of the Company's financial
statements and related disclosures. The assumptions utilized in the application
of these accounting policies are complex and require subjective judgment.
Loss and settlement expense reserves
Processes and assumptions for establishing loss and settlement expense reserves
Liabilities for losses are based upon case-basis estimates of reported losses
supplemented with bulk case loss reserves, and estimates of incurred but not
reported (IBNR) losses. Case loss reserves are established independently of the
IBNR loss reserves and the two amounts are added together to determine the total
liability for losses. Under this methodology, adjustments to the individual case
loss reserve estimates do not result in a corresponding adjustment in IBNR loss
reserves. For direct insurance business, the Company's IBNR loss reserves are
estimates of liability for events that have occurred, but have not yet been
reported to the Company. For assumed reinsurance business, IBNR loss reserves
are also used to record anticipated increases in reserves for claims that have
previously been reported. An estimate of the expected expenses to be incurred in
the settlement of the claims provided for in the loss reserves is established as
the liability for settlement expenses.
Property and Casualty Insurance Segment
The Company's claims department establishes individual case loss reserves for
direct business. Branch claims personnel establish case loss reserves for
individual claims, with mandatory home office claims department review of
reserves that exceed a specified threshold. The Company's case loss reserve
philosophy is exposure based and implicitly assumes a consistent inflationary
and legal environment. When claims department personnel establish case loss
reserves, they take into account various factors that influence the potential
exposure.
The Company has implemented specific line-of-business guidelines that are used
to establish the individual case loss reserve estimates. These guidelines, which
are used for both short-tail and long-tail claims, require the claims department
personnel to reserve for the probable (most likely) exposure for each
claim. Probable exposure is defined as what is likely to be awarded if the case
were to be decided by a civil court in the applicable venue or, in the case of a
workers' compensation case, by that state's workers' compensation
commission. This evaluation process is repeated throughout the life of the claim
at regular intervals, and as additional information becomes available. While
performing these regular reviews, the branch claims personnel are able to make
adjustments to the case loss reserves for location and time specific factors,
such as legal venue, inflation, and changes in applicable laws.
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To provide consistency in the reserving process, the Company utilizes
established claims management processes and an automated claims system. Claims
personnel conduct periodic random case loss reserve reviews to verify the
accuracy of the reserve estimates and adherence to the reserving guidelines. In
addition, the Company has specific line-of-business management controls for case
loss reserves. For example, all workers' compensation claim files are reviewed
by management before benefits are declined, and all casualty case loss reserves
are reviewed every 60 days for reserve adequacy.
The Company's automated claims system utilizes an automatic diary process that
helps ensure that case loss reserve estimates are reviewed on a regular
basis. The claims system requires written documentation each time a case loss
reserve is established or modified, and provides management with the information
necessary to perform individual reserve reviews and monitor reserve
development. In addition, the claims system produces monthly reports that allow
management to analyze case loss reserve development in the aggregate, by branch,
by line of business, or by claims adjuster.
The goal of the Company's claims department is to establish and maintain case
loss reserves that are sufficient, but not excessive. Since specific guidelines
are utilized for establishing case loss reserves, the Company does not
incorporate a provision for uncertainty (either implicitly or explicitly) when
setting individual case loss reserve estimates. The Company's actuaries do,
however, review the adequacy of the aggregate case loss reserves on a quarterly
basis and, if deemed appropriate, make recommendations for adjustments to
management. Management reviews all recommendations submitted by the Company's
actuaries and considers such recommendations in the determination of its best
estimate of the Company's overall liability. Adjustments to the aggregate case
loss reserves, when approved by management, are accomplished through the
establishment of bulk case loss reserves in the applicable line(s) of business,
which supplement the aggregate case loss reserves. For financial reporting
purposes, bulk case loss reserves are included in case loss reserves.
At December 31, 2012, IBNR loss reserves accounted for $70,321,000, or 17.1
percent, of the property and casualty insurance segment's total loss and
settlement expense reserves, compared to $67,809,000, or 16.1 percent, at
December 31, 2011. IBNR loss reserves are, by nature, less precise than case
loss reserves. A five percent change in IBNR loss reserves at December 31, 2012
would equate to $2,285,000, net of tax, which represents 6.0 percent of the net
income reported for 2012 and 0.6 percent of stockholders' equity.
The property and casualty insurance segment's formula IBNR loss reserves are
established for each line of business by applying actuarially derived "IBNR
factors" to the latest twelve months premiums earned. These factors are
developed using a methodology that utilizes historical ratios of (1) actual IBNR
claims that have emerged after prior year-ends to (2) corresponding prior years'
premiums earned that have been adjusted to the current level of rate
adequacy. In order to minimize the volatility that naturally exists in the early
stages of IBNR claims emergence, IBNR claims are not utilized in this process
until 18 months after the end of a respective calendar year. For example, during
2012 the actual IBNR claims reported in the 18 months following year-end 2010
were compared to the adjusted 2010 premiums earned. The 2010 ratios, together
with the ratios for several prior years, were then used to develop the 2012
"IBNR factors" that were applied to premiums earned for each line of
business. Included in the rate adequacy adjustment noted above is consideration
of current frequency and severity trends compared to the trends underlying prior
years' calculations. The selected trends are based on an analysis of industry
and Company loss data.
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The methodology used in estimating formula IBNR loss reserves assumes
consistency in claims reporting patterns and immaterial changes in loss
development patterns. Implicit in this assumption is that future IBNR claims
emergence, relative to IBNR claims that have emerged following prior year-ends,
will reflect the change in frequency and severity trends underlying the rate
adequacy adjustments. If this projected relationship proves to be inaccurate,
future IBNR claims may differ substantially from the estimated IBNR loss
reserves. The following table displays the impact that a five percent variance
in future IBNR emergence from the projected level reflected in the December 31,
2012 IBNR factors would have on the Company's results of operations. This
variance in future IBNR emergence could occur in one year or over multiple
years, depending when the claims were reported. A variance in future IBNR
emergence would also affect the Company's financial position in that the
Company's equity would be impacted by an amount equivalent to the change in net
income. A variance of this type would typically be recognized in loss and
settlement expense reserves and, accordingly, would not have a material effect
on liquidity because the claims have not been paid. A five percent variance in
future IBNR emergence is considered reasonably likely based on the range of
actuarial indications developed during the analysis of the property and casualty
insurance segment's carried reserves.
After-tax impact on
earnings from a five
percent variance in
future IBNR
emergence from
frequency and severity
trends underlying rate
Line of business adequacy adjustments
($ in thousands)
Personal auto liability $(62) to $62
Commercial auto liability (250) to 250
Auto physical damage (23) to 23
Workers' compensation (588) to 588
Other liability (1,246) to 1,246
Property (79) to 79
Homeowners (21) to 21
All Other (19) to 19
Ceded loss reserves are derived by applying the ceded contract terms to the
direct loss reserves. For excess of loss contracts (excluding the catastrophe
contract), this is accomplished by applying the ceded contract terms to the case
loss reserves of the ceded claims. For the catastrophe excess of loss contract,
ceded loss reserves are calculated by applying the contract terms to (1) the
aggregate case loss reserves on claims stemming from catastrophes and (2) the
estimate of IBNR loss reserves developed for each individual catastrophe. For
quota share contracts, ceded loss reserves are calculated as the quota share
percentage multiplied by both case and IBNR loss reserves on the direct
business.
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The methodology used for reserving settlement expenses is based on an analysis
of historical ratios of paid expenses to paid losses. Assumptions underlying
this methodology include stability in the mix of business, consistent claims
processing procedures, immaterial impact of loss cost trends on development
patterns, and a consistent philosophy regarding the defense of lawsuits. Based
on this actuarial analysis, factors are derived for each line of business, which
are then applied to loss reserves to generate the settlement expense
reserves. The following table displays the impact on the Company's results of
operations, for the latest ten accident years, of a one percent variance in the
ratio of ultimate settlement expenses to ultimate losses due to departures from
any of the above assumptions. This variance in the ultimate settlement expense
ratio could occur in one year or over multiple years, depending on the loss and
settlement expense payment patterns. A variance in the ultimate settlement
expense ratio would also affect the Company's financial position in that the
Company's equity would be impacted by an amount equivalent to the change in net
income. A variance of this type would typically be recognized in loss and
settlement expense reserves and, accordingly, would not have a material effect
on liquidity because the expenses have not been paid. A one percent variance in
the ratio of ultimate settlement expenses to ultimate losses is considered
reasonably likely based on the range of actuarial indications developed during
the analysis of the property and casualty insurance segment's carried reserves.
After-tax impact on
earnings from a one
percent variance in the
ultimate settlement
Line of business expense ratio
($ in thousands)
Personal auto liability $(34) to $34
Commercial auto liability (177) to 177
Auto physical damage (24) to 24
Workers' compensation (231) to 231
Other liability (620) to 620
Property (118) to 118
Homeowners (66) to 66
All Other (31) to 31
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Following is a summary of the carried loss and settlement expense reserves for
the property and casualty insurance segment at December 31, 2012 and 2011.
December 31, 2012
Settlement
Line of business Case IBNR expense Total
($ in thousands)
Commercial lines:
Automobile $ 41,381 $ 7,084 $ 10,475 $ 58,940
Property 14,816 590 3,129 18,535
Workers' compensation 118,074 20,255 19,757 158,086
Liability 57,405 41,911 48,425 147,741
Bonds 3,953 (1,407 ) 1,002 3,548
Total commercial lines 235,629 68,433 82,788 386,850
Personal lines:
Automobile 16,227 1,267 1,998 19,492
Property 4,118 621 1,236 5,975
Total personal lines 20,345 1,888 3,234 25,467
Total property and
casualty insurance
segment $ 255,974 $ 70,321 $ 86,022 $ 412,317
December 31, 2011
Settlement
Line of business Case IBNR expense Total
($ in thousands)
Commercial lines:
Automobile $ 45,821 $ 8,610 $ 10,221 $ 64,652
Property 22,748 2,289 3,425 28,462
Workers' compensation 119,846 16,905 18,627 155,378
Liability 54,911 36,884 46,382 138,177
Bonds 1,936 (397 ) 619 2,158
Total commercial lines 245,262 64,291 79,274 388,827
Personal lines:
Automobile 16,400 1,976 2,269 20,645
Property 7,271 1,542 1,706 10,519
Total personal lines 23,671 3,518 3,975 31,164
Total property and
casualty insurance
segment $ 268,933 $ 67,809 $ 83,249 $ 419,991
Internal actuarial evaluations of the prior quarter's overall loss reserve
levels are performed each quarter for all direct lines of business. There is a
certain amount of random variation in loss development patterns, which results
in some uncertainty regarding projected ultimate losses, particularly for
longer-tail lines such as workers' compensation, other liability and commercial
auto liability. Therefore, the reasonability of the actuarial projections is
regularly monitored through an examination of loss ratio and claims severity
trends implied by these projections. Following is a discussion of the major
assumptions underlying the quarterly internal actuarial loss reserve
evaluations.
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One assumption underlying aggregate reserve estimation methods is that the
claims inflation trends implicitly built into the historical loss and settlement
expense development patterns will continue into the future. To estimate the
sensitivity of the estimated ultimate loss and settlement expense payments to an
unexpected change in inflationary trends, the actuarial department derived
expected payment patterns separately for each major line of business. These
patterns were applied to the December 31, 2012 loss and settlement expense
reserves to generate estimated annual incremental loss and settlement expense
payments for each subsequent calendar year. Then, for the purpose of sensitivity
testing, an explicit annual inflationary variance of one percent was added to
the inflationary trend that is implicitly embedded in the estimated payment
pattern, and revised incremental loss and settlement expense payments were
calculated. This unexpected claims inflation trend could arise from a variety of
sources including a change in economic inflation, social inflation and,
especially for the workers' compensation line of business, the introduction of
new medical technologies and procedures, changes in the utilization of
procedures and changes in life expectancy. The estimated cumulative impact that
this unexpected one percent variance in the inflationary trend would have on the
Company's results of operations over the lifetime of the underlying claims is
shown below. A variance in the inflationary trend would also affect the
Company's financial position in that the Company's equity would be impacted by
an amount equivalent to the change in net income. A variance of this type would
typically be recognized in loss and settlement expense reserves and,
accordingly, would not have a material effect on liquidity because the claims
have not been paid. A one percent variance in the projected inflationary trend
is considered reasonably likely based on the range of actuarial indications
developed during the analysis of the property and casualty insurance segment's
carried reserves.
After-tax impact on
earnings from a one
percent variance in the
projected inflationary
Line of business trend
($ in thousands)
Personal auto liability $(156) to $150
Commercial auto liability (762) to 736
Auto physical damage (11) to 10
Workers' compensation (5,424) to 4,733
Other liability (3,320) to 3,082
Property (121) to 119
Homeowners (30) to 30
A second assumption is that historical loss payment patterns have not
changed. In other words, the percentage of ultimate losses that are not yet paid
at any given stage of accident year development is consistent over time. The
following table displays the impact on the Company's results of operations, for
the latest ten accident years, of a five percent variance in unpaid losses to
date from the percentages anticipated in the paid loss projection factors. That
is, future loss payments under this scenario would be expected to differ from
the original actuarial loss reserve estimates by these amounts. This variance in
future loss payments could occur in one year or over multiple years. A variance
in future loss payments would also affect the Company's financial position in
that the Company's equity would be impacted by an amount equivalent to the
change in net income. A variance of this type would typically be recognized in
loss and settlement expense reserves and, accordingly, would not have a material
effect on liquidity because the claims have not been paid. A five percent
variance in projected future loss payments is considered reasonably likely based
on the range of actuarial indications developed during the analysis of the
property and casualty insurance segment's carried reserves.
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After-tax impact on
earnings from a five
percent variance in
Line of business future loss payments
($ in thousands)
Personal auto liability $(540) to $489
Commercial auto liability (1,617) to 1,464
Auto physical damage (104) to 95
Workers' compensation (3,631) to 3,284
Other liability (3,103) to 2,808
Property (634) to 574
Homeowners (147) to 133
All Other (86) to 79
A third assumption is that individual case loss reserve adequacy is consistent
over time. The following table displays the impact on the Company's results of
operations, for the latest ten accident years, of a five percent variance in
individual case loss reserve adequacy from the level anticipated in the incurred
loss projection factors. In other words, future loss payments under this
scenario would be expected to vary from actuarial reserve estimates by these
amounts. This variance in expected loss payments could occur in one year or over
multiple years. A change in individual case loss reserve adequacy would also
affect the Company's financial position in that the Company's equity would be
impacted by an amount equivalent to the change in net income. A variance of this
type would typically be recognized in loss and settlement expense reserves and,
accordingly, would not have a material effect on liquidity because the claims
have not been paid. A five percent variance in individual case loss reserve
adequacy is considered reasonably likely based on the range of actuarial
indications developed during the analysis of the property and casualty insurance
segment's carried reserves.
After-tax impact on
earnings from a five
percent variance in
individual case loss
Line of business reserve adequacy
($ in thousands)
Personal auto liability $(488) to $443
Commercial auto liability (1,442) to 1,305
Auto physical damage (77) to 70
Workers' compensation (3,001) to 2,716
Other liability (2,451) to 2,219
Property (625) to 565
Homeowners (146) to 132
All Other (156) to 141
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A fourth assumption is that IBNR emergence as a percentage of reported losses is
historically consistent and will continue at the historical level. The following
table displays the estimated impact on the Company's results of operations, for
the latest ten accident years, of a five percent variance in IBNR losses from
the level anticipated in the loss projection factors. Under this scenario,
future loss payments would be expected to vary from actuarial reserve estimates
by these amounts. This variance in IBNR emergence could occur in one year or
over multiple years. A variance in IBNR emergence would also affect the
Company's financial position in that the Company's equity would be impacted by
an amount equivalent to the change in net income. A variance of this type would
typically be recognized in loss and settlement expense reserves and,
accordingly, would not have a material effect on liquidity because the claims
have not been paid. A five percent variance in IBNR emergence is considered
reasonably likely based on the range of actuarial indications developed during
the analysis of the property and casualty insurance segment's carried reserves.
After-tax impact on
earnings from a five
percent variance in
Line of business IBNR emergence
($ in thousands)
Personal auto liability $(38) to $38
Commercial auto liability (213) to 213
Auto physical damage (22) to 22
Workers' compensation (617) to 617
Other liability (1,030) to 1,030
Property (120) to 120
Homeowners (23) to 23
An actuarial evaluation of the prior quarter's case and bulk case loss reserve
adequacy is performed each quarter. If that analysis indicates that the
aggregate reserves of the individual claim files established by the claims
department combined with the carried bulk case loss reserve (if any) is not
within a few percentage points of a benchmark established by the actuarial
department, the actuarial department will recommend that an adjustment be made
to the current quarter's bulk case loss reserve. Management reviews all
recommendations submitted by the actuarial department and considers such
recommendations in the determination of its best estimate of the Company's
overall liability.
One of the variables impacting the estimation of IBNR loss reserves is the
assumption that the vast majority of future construction defect losses will
continue to occur in those states in which most construction defect claims have
historically arisen. Since the vast majority of these losses have been confined
to a relatively small number of states, which is consistent with industry
experience, there is no provision in the IBNR loss reserve for a significant
spread of construction defect claims to other states. It is also assumed that
various underwriting initiatives implemented in recent years will gradually
mitigate the amount of construction defect losses experienced. These initiatives
include exclusionary endorsements, increased care regarding additional insured
endorsements, a general reduction in the amount of contractor business written
relative to the total commercial lines book of business, and underwriting
restrictions on the writing of residential contractors. The estimation of the
Company's IBNR loss reserves also does not contemplate substantial losses from
potential mass torts such as Methyl Tertiary Butyl Ether (a gasoline additive
that reduces emissions, but causes pollution), tobacco, silicosis, cell phones
and lead. Further, consistent with general industry practice, the IBNR loss
reserve for all liability lines does not provide for any significant retroactive
expansion of coverage through judicial interpretation. If these assumptions
prove to be incorrect, ultimate paid amounts on emerged IBNR claims may differ
substantially from the carried IBNR loss reserves.
As previously noted, the estimation of settlement expense reserves assumes a
consistent claims department philosophy regarding the defense of lawsuits. If
the pool participants should in the future take a more aggressive defense
posture, defense costs would increase and it is likely that the Company's
carried settlement expense reserves would be deficient. However, such a change
in philosophy would likely reduce losses, generating some offsetting redundancy
in the loss reserves.
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The property and casualty insurance subsidiaries have exposure to environmental
and asbestos claims arising primarily from the other liability line of
business. These exposures are closely monitored by management, and IBNR loss
reserves have been established to cover estimated ultimate losses. The asbestos
IBNR reserves were increased in each of the last five years based on
examinations of the implied three-year survival ratio (ratio of loss and
settlement expense reserves to the three-year average of loss and settlement
expense payments), which has deteriorated due to an increase in both paid losses
and paid settlement expenses. Settlement expense payments have increased
significantly since 2008 and have been the primary driver behind recently
implemented reserve increases.
Environmental IBNR reserves are established in consideration of the implied
three-year survival ratio. Estimation of ultimate liabilities for these
exposures is unusually difficult due to unresolved issues such as whether
coverage exists, the definition of an occurrence, the determination of ultimate
damages and the allocation of such damages to financially responsible
parties. Therefore, any estimation of these liabilities is subject to greater
than normal variation and uncertainty, and ultimate payments for losses and
settlement expenses for these exposures may differ significantly from the
carried reserves.
Reinsurance Segment
The reinsurance book of business is comprised of two major components. The first
is the Home Office Reinsurance Assumed Department ("HORAD"), which includes the
reinsurance business assumed by the reinsurance subsidiary through the quota
share agreement and the business written directly by the reinsurance subsidiary
outside of the quota share agreement. The second is the MRB underwriting
association, which is a voluntary reinsurance pool in which Employers Mutual
participates with three other unaffiliated insurers.
The primary actuarial methods used to project ultimate policy year losses on the
assumed reinsurance business are paid development, incurred development and
Bornhuetter-Ferguson. The assumptions underlying the various projection methods
include stability in the mix of business, consistent claims processing
procedures, immaterial impact of loss cost trends on development patterns,
consistent case loss reserving practices and appropriate Bornhuetter-Ferguson
expected loss ratio selections.
For the HORAD component, Employers Mutual records the case and IBNR loss
reserves reported by the ceding companies. Since many ceding companies in the
HORAD book of business do not report IBNR loss reserves, Employers Mutual
establishes a bulk IBNR loss reserve, which is based on an actuarial reserve
analysis, to cover a lag in reporting. For MRB, Employers Mutual records the
case and IBNR loss reserves reported to it by the management of the association,
along with a relatively small IBNR loss reserve to cover a one month reporting
lag. To verify the adequacy of the reported reserves, an actuarial evaluation of
MRB's reserves is performed at each year-end.
At December 31, 2012, the carried reserves for HORAD and MRB combined were in
the upper quartile of the range of actuarial reserve indications. This selection
reflects the fact that there are inherent uncertainties involved in establishing
reserves for assumed reinsurance business. Such uncertainties include the fact
that a reinsurance company generally has less knowledge than the ceding company
about the underlying book of business and the ceding company's reserving
practices. Because of these uncertainties, there is a risk that the reinsurance
segment's reserves for losses and settlement expenses could prove to be
inadequate, with a consequential adverse impact on the Company's future earnings
and stockholders' equity.
At December 31, 2012, there was no backlog in the processing of assumed
reinsurance information. Approximately $108,003,000, or 63 percent, of the
reinsurance segment's carried reserves were reported by the ceding
companies. Employers Mutual receives loss reserve and paid loss data from its
ceding companies on individual excess of loss contracts. If a claim involves a
single or small group of claimants, a summary of the loss and claim outlook is
normally provided. Summarized data is provided for catastrophe claims and pro
rata business, which is subject to closer review if inconsistencies are
suspected.
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Carried reserves established in addition to those reported by the ceding
companies totaled approximately $62,777,000 at December 31, 2012. Since many
ceding companies in the HORAD book of business do not report IBNR loss reserves,
Employers Mutual establishes a bulk IBNR loss reserve to cover the lag in
reporting. For the few ceding companies that do report IBNR loss reserves,
Employers Mutual carries them as reported. These reported IBNR loss reserves are
subtracted from the total IBNR loss reserve calculated by Employers Mutual's
actuaries, with the difference carried as bulk IBNR loss reserves. Except for
the small IBNR loss reserve established to cover the one-month lag in reporting,
the MRB IBNR loss reserve is established by the management of MRB. Employers
Mutual rarely records additional case loss reserves.
Assumed reinsurance losses tend to be reported later than direct losses. This
lag is reflected in loss projection factors for assumed reinsurance that tend to
be higher than for direct business. The result is that assumed reinsurance IBNR
loss reserves as a percentage of total reserves tend to be higher than for
direct loss reserves. IBNR loss reserves totaled $90,778,000 and $91,184,000 at
December 31, 2012 and 2011, respectively, and accounted for approximately 53
percent and 53 percent, respectively, of the reinsurance segment's total loss
and settlement expense reserves. IBNR loss reserves are, by nature, less precise
than case loss reserves. A five percent change in IBNR loss reserves at December
31, 2012 would equate to $2,943,000, net of tax, which represents 7.8 percent of
the net income reported for 2012 and 0.7 percent of stockholders' equity.
Following is a summary of the carried loss and settlement expense reserves for
the reinsurance segment at December 31, 2012 and 2011.
December 31, 2012
Settlement
Line of business Case IBNR expense Total
($ in thousands)
Pro rata reinsurance:
Property and casualty $ 4,233 $ 647 $ 282 $ 5,162
Property 10,794 9,381 558 20,733
Crop 1,605 745 26 2,376
Casualty 729 5,111 134 5,974
Marine/Aviation 1,455 4,602 93 6,150
Total pro rata reinsurance 18,816 20,486 1,093 40,395
Excess of loss reinsurance:
Property 25,944 17,778 1,018 44,740
Casualty 29,567 52,264 2,866 84,697
Surety 648 250 50 948
Total excess of loss reinsurance 56,159 70,292 3,934 130,385
Total reinsurance segment $ 74,975 $ 90,778 $ 5,027 $ 170,780
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December 31, 2011
Settlement
Line of business Case IBNR expense Total
($ in thousands)
Pro rata reinsurance:
Property and casualty $ 5,064 $ 765 $ 527 $ 6,356
Property 11,795 11,790 584 24,169
Crop 3,848 59 50 3,957
Casualty 380 4,745 83 5,208
Marine/Aviation 1,006 1,882 75 2,963
Total pro rata reinsurance 22,093 19,241 1,319 42,653
Excess of loss reinsurance:
Property 28,557 18,297 944 47,798
Casualty 26,172 53,375 2,362 81,909
Surety 627 271 51 949
Total excess of loss reinsurance 55,356 71,943 3,357 130,656
Total reinsurance segment $ 77,449 $ 91,184 $ 4,676 $ 173,309
As previously noted, the assumptions implicit in the methodologies utilized to
establish reserves for the reinsurance segment are stability in the mix of
business, consistent claims processing procedures, immaterial impact of loss
cost trends on development patterns, consistent case loss reserving practices
and appropriate Bornhuetter-Ferguson expected loss ratio selections. The tables
below display the impact on the Company's results of operations from (1) a five
percent variance in case loss reserve adequacy from the level anticipated in the
incurred loss projection factors, (2) a one percent variance in the implicit
annual claims inflation rate, (3) a five percent variance in IBNR losses as a
percentage of reported incurred losses (due, for example, to changes in mix of
business or claims processing procedures) and (4) a five percent variance in the
expected loss ratios used with the Bornhuetter-Ferguson method. In other words,
under each scenario, future loss and settlement expense payments would be
expected to vary from actuarial reserve estimates by the amounts shown
below. These variances in future loss and settlement expense payments could
occur in one year or over multiple years. Variances in future loss and
settlement payments would also affect the Company's financial position in that
the Company's equity would be impacted by an amount equivalent to the change in
net income. Variances of this type would typically be recognized in loss and
settlement expense reserves and, accordingly, would not have a material effect
on liquidity because the claims have not been paid. Such variances are
considered reasonably likely based on the range of actuarial indications
developed during the analysis of the reinsurance segment's carried reserves.
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The after-tax impact on the Company's earnings under each scenario is as
follows:
Reinsurance segment
MRB HORAD
($ in thousands)(1) Five percent variance in case
loss reserve adequacy from
the level anticipated in the
incurred loss projection
factors $ (689 ) to $ 623 $ (4,751 ) to $ 4,298
(2) One percent variance in the
implicit annual claims
inflation rate (680 ) to 628 (3,810 ) to 3,379
(3) Five percent variance in IBNR
losses from the level
anticipated in the loss
projection factors (594 ) to 594 (3,416 ) to 3,416
(4) Five percent variance in the
expected loss ratios used
with the Bornhuetter-Ferguson
method (547 ) to 547 (3,046 ) to 3,046
To ensure the accuracy and completeness of the information received from the
ceding companies, Employers Mutual's actuarial department reviews the latest
five HORAD policy years on a quarterly basis, and all policy years on an annual
basis. Any significant unexplained departures from historical reporting patterns
are brought to the attention of the reinsurance department's staff, who contacts
the ceding company or broker for clarification.
Employers Mutual's actuarial department annually reviews the MRB reserves for
reasonableness. These analyses use a variety of actuarial techniques, which are
applied at a line-of-business level. MRB staff supplies the reserve analysis
data, which is verified for accuracy by Employers Mutual's actuaries. This
review process is replicated by certain other MRB member companies, using
actuarial techniques they deem appropriate. Based on these reviews, Employers
Mutual and the other MRB member companies have consistently found the MRB
reserves to be adequate.
For the HORAD book of business, paid and incurred loss development patterns for
relatively short-tail lines of business (property and marine) are based on data
reported by the ceding companies. Employers Mutual has determined that there is
sufficient volume and stability in the reported losses to base projections of
ultimate losses on these patterns. For longer tail lines of business (casualty),
industry incurred development patterns are referenced due to the instability of
the development patterns based on reported historical losses.
For long-tail lines of business, unreliable estimates of unreported losses can
result from the application of loss projection factors to reported losses. To
some extent, this is also true for short-tail lines of business in the early
stages of a policy year's development. Therefore, in addition to loss-based
projections, Employers Mutual generates estimates of unreported losses based on
premiums earned. The latter estimates are sometimes more stable and reliable
than projections based on losses.
Disputes with ceding companies do not occur often. Employers Mutual performs
claims audits and encourages prompt reporting of reinsurance claims. Employers
Mutual also reviews claim reports for accuracy, completeness and adequate
reserving. Most reinsurance contracts contain arbitration clauses to resolve
disputes, but such disputes are generally resolved without arbitration due to
the long-term and ongoing relationships that exist with those companies. There
were no matters in dispute at December 31, 2012.
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Toxic tort (primarily asbestos), environmental and other uncertain exposures
(property and casualty insurance segment and reinsurance segment)
Toxic tort claims include those where the claimant seeks compensation for harm
allegedly caused by exposure to a toxic substance or a substance that increases
the risk of contracting a serious disease, such as cancer. Typically the injury
is caused by latent effects of direct or indirect exposure to a substance or
combination of substances through absorption, contact, ingestion, inhalation,
implantation or injection. Examples of toxic tort claims include injuries
arising out of exposure to asbestos, silica, mold, drugs, carbon monoxide,
chemicals and lead.
Since 1989, the pool participants have included an asbestos exclusion in
liability policies issued for most lines of business. The exclusion prohibits
liability coverage for "bodily injury", "personal injury" or "property damage"
(including any associated clean-up obligations) arising out of the installation,
existence, removal or disposal of asbestos or any substance containing asbestos
fibers. Therefore, the pool participants' current asbestos exposures are
primarily limited to commercial policies issued prior to 1989. At present, the
pool participants are defending approximately 1,600 asbestos bodily injury
lawsuits, some of which involve multiple plaintiffs. Six former policyholders
and one current policyholder dominate the pool participants' asbestos
claims. Most of the lawsuits are subject to express reservation of rights based
upon the lack of an injury within the applicable policy periods, because many
asbestos lawsuits do not specifically allege dates of asbestos exposure or dates
of injury. The pool participants' policyholders named as defendants in these
asbestos lawsuits are typically peripheral defendants who have little or no
exposure and are routinely dismissed from asbestos litigation with nominal or no
payment (i.e., small contractors, insulators, electrical welding suppliers,
furnace manufacturers, and gasket and building supply companies).
During 2003, the pool participants were presented with several hundred plaintiff
lawsuits filed against three former policyholders representing approximately
66,500 claimants related to exposure to asbestos or products containing
asbestos. The vast majority of the 66,500 claims are the result of
multi-plaintiff lawsuits. These claims are based upon nonspecific asbestos
exposure and nonspecific injuries. As a result, management did not establish a
significant amount of case loss reserves for these claims. Several of the
multi-plaintiff lawsuits (including the vast majority of those associated with
one former policyholder) were dismissed. As of December 31, 2012, approximately
2,235 of the claims remain open. During 2006, the pool participants received
notice that another former policyholder was a named defendant in approximately
33,000 claims nationwide. The last of these claims were settled during 2012 for
approximately $690,000 (the Company's share).
Prior to 2008, actual losses paid for asbestos-related claims had been minimal
due to the plaintiffs' failure to identify an exposure to any
asbestos-containing products associated with the pool participants' current and
former policyholders. However, paid losses and settlement expenses have
increased significantly since 2008 as a result of claims attributed to two
former policyholders. One of these former policyholders, a broker of various
products, including asbestos, settled a claim for approximately $450,000 (the
Company's share) in 2008. Prior to 2008, the asbestos exposure associated with
this former policyholder had been thought to be relatively small. At December
31, 2012, 11 additional claims associated with this former policyholder remain
open, though similar exposure on these claims is not anticipated. The other
former policyholder, a furnace manufacturer, had multiple claims settle for a
total of approximately $1,296,000 (the Company's share) during the period 2009
through 2012. The asbestos exposure associated with this former policyholder has
increased in recent years, and this trend may possibly continue into the future
with increased per plaintiff settlements. Settlement expense payments associated
with this former policyholder have increased significantly since 2008 and have
been the primary driver behind recently implemented reserve increases. The
primary cause of this increase in paid settlement expenses is the retention of a
national coordinating counsel in 2008 due to this former policyholder's exposure
in numerous jurisdictions. The national coordinating counsel has provided, and
continues to provide, significant services in the areas of document review,
discovery, deposition and trial preparation. Approximately 490 asbestos exposure
claims associated with this former policyholder remain open. Whenever possible,
the pool participants have participated in cost sharing agreements with other
insurance companies to reduce overall asbestos claim expenses.
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The pool participants are defending approximately 99 claims as a result of
lawsuits alleging "silica" exposure in Texas and Mississippi jurisdictions, some
of which involve multiple plaintiffs. The plaintiffs allege employment exposure
to "airborne respirable silica dust," causing "serious and permanent lung
injuries" (i.e., silicosis). Silicosis injuries are identified in the upper
lobes of the lungs, while asbestos injuries are localized in the lower lobes.
The plaintiffs in the silicosis lawsuits are sandblasters, gravel and concrete
workers, ceramic workers and road construction workers. All of these lawsuits
are subject to express reservation of rights based upon the lack of an injury
within the applicable policy periods because many silica lawsuits, like asbestos
lawsuits, do not specifically allege dates of exposure or dates of injury. The
pool participants' policyholders (a refractory product manufacturer, small local
concrete and gravel companies and a concrete cutting machine manufacturer) that
have been named as defendants in these silica lawsuits have had little or no
exposure and are routinely dismissed from silica litigation with nominal or no
payment. While the expense of handling these lawsuits is high, it is not
proportional to the number of plaintiffs, and is mitigated through cost sharing
agreements with other insurance companies.
Since 2004, the pool participants have included a "pneumoconiosis dust"
exclusion to their commercial lines liability policies in the majority of
jurisdictions where such action was warranted. This exclusion precludes
liability coverage due to "mixed dust" pneumoconiosis, pleural plaques, pleural
effusion, mesothelioma, lung cancer, emphysema, bronchitis, tuberculosis or
pleural thickening, or other pneumoconiosis-related ailments such as arthritis,
cancer (other than lung), lupus, heart, kidney or gallbladder disease. "Mixed
dust" includes dusts composed of asbestos, silica, fiberglass, coal, cement, or
various other elements. It is anticipated that this mixed dust exclusion will
further limit the pool participants' exposure in silica claims, and may be broad
enough to limit exposure in other dust claims.
The Company's environmental claims are defined as 1) claims for bodily injury,
personal injury, property damage, loss of use of property, diminution of
property value, etc., allegedly due to contamination of air, and/or
contamination of surface soil or surface water, and/or contamination of ground
water, aquifers, wells, etc.; or 2) any/all claims for remediation or clean-up
of hazardous waste sites by the United States Environmental Protection Agency,
or similar state and local environmental or government agencies, usually
presented in conjunction with Federal or local clean up statutes (i.e., CERCLA,
RCRA, etc.).
Examples include, but are not limited to: chemical waste; hazardous waste
treatment, storage and/or disposal facilities; industrial waste disposal
facilities; landfills; superfund sites; toxic waste spills; and underground
storage tanks. Widespread use of pollution exclusions since 1970 in virtually
all lines of business, except personal lines, has resulted in limited exposure
to environmental claims. Absolute pollution exclusions have been used since the
1980's; however, the courts in the State of Indiana have ruled that the absolute
pollution exclusion is ambiguous.
The Company's current exposures to environmental claims include losses involving
petroleum haulers, lead contamination, and soil and groundwater contamination in
the State of Indiana. Claims from petroleum haulers are generally caused by
overturned commercial vehicles and overfills at commercial and residential
properties. Exposures for accident year losses preceding the 1980s include
municipality exposures for closed landfills, small commercial businesses
involved with disposing waste at landfills, leaking underground storage tanks
and contamination from dry cleaning operations. As of December 31, 2012, all
Methyl Tertiary Butyl Ether ("MTBE") claims related to the pool participants'
policyholders had been dismissed.
During 2009, the Company completed a comprehensive policy search and coverage
review, and began defending (pursuant to policies issued 1969-1975) a lawsuit
filed against a municipalities' sewerage commission in United States District
Court in Wisconsin in 2008. The Company has a joint defense agreement with two
other companies but currently retains the majority share. The lawsuit is
potentially one of the largest CERCLA actions pending against numerous parties
in the United States and seeks in excess of $1.5 billion from the
defendants. The Company has established reserves for each of the six years of
alleged liability (approximately $600,000 in aggregate as the Company's share)
along with associated settlement expenses. While the insured's summary judgment
motion was successful, future appeals are possible.
The Company's exposure to asbestos and environmental claims through assumed
reinsurance is very limited due to the fact that the Company's reinsurance
subsidiary entered into the reinsurance marketplace in the early 1980's, after
much attention had already been brought to these issues.
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At December 31, 2012, the Company carried asbestos and environmental reserves
for direct insurance and assumed reinsurance business totaling $9,433,000, which
represents 1.6 percent of total loss and settlement expense reserves. The
asbestos and environmental reserves include $4,182,000 of case loss reserves,
$3,419,000 of IBNR loss reserves and $1,832,000 of bulk settlement expense
reserves. Ceded reinsurance on these reserves totaled $655,000. Loss and
settlement expense reserves were increased in 2012 because of deterioration in
the implied survival ratio.
The pool participants' non-asbestos direct product liability claims are
considered to be highly uncertain exposures due to the many uncertainties
inherent in determining the loss, and the significant periods of time that can
elapse between the occurrence of the loss and the ultimate settlement of the
claim. The majority of the pool participants' product liability claims arise
from small to medium-sized manufacturers, contractors, petroleum distributors,
and mobile home and auto dealerships. No specific claim trends are evident from
the pool participants' manufacturing clients, as the claims activity on these
policies is generally isolated and can be severe. Specific product liability
coverage is provided to the pool participants' mobile home and auto dealership
policyholders, and the claims from these policies tend to be relatively
small. Certain construction defect claims are also reported under product
liability coverage. During 2012, 18 of these claims were reported to the pool
participants.
The Company has exposure to construction defect claims arising from general
liability policies issued by the pool participants to contractors. Most of the
pool participants' construction defect claims are concentrated in a limited
number of states, and the pool participants have taken steps to mitigate this
exposure. Construction defect is a highly uncertain exposure due to such issues
as whether coverage exists, definition of an occurrence, determination of
ultimate damages, and allocation of such damages to financially responsible
parties. Newly reported construction defect claims numbered 209, 383 and 469 in
2012, 2011 and 2010, respectively, and produced incurred losses and paid
settlement expenses of approximately $2,008,000, $2,157,000 and $3,276,000 in
each respective period. Incurred losses and paid settlement expenses on all
construction defect claims totaled approximately $5,048,000 in 2012. At December
31, 2012, the Company carried case loss reserves of approximately $5,843,000 on
659 open construction defect claims.
The Company's assumed casualty excess reinsurance business is also considered a
highly uncertain exposure due to the significant periods of time that can elapse
during the settlement of the underlying claims, and the fact that a reinsurance
company generally has less knowledge than the ceding company about the
underlying book of business and the ceding company's reserving
practices. Employers Mutual attempts to account for this uncertainty by
establishing bulk IBNR loss reserves, using conservative assumed treaty limits
and, to a much lesser extent, booking of individual treaty IBNR loss reserves
(if reported by the ceding company) or establishing additional case loss
reserves if the reported case loss reserves appear inadequate on an individual
claim. While Employers Mutual is predominantly a property reinsurer, it does
write casualty excess business oriented mainly towards shorter tail casualty
lines of coverage. Employers Mutual avoids reinsuring large company working
layer casualty risks, and does not write risks with heavy product liability
exposures, risks with obvious latent injury manifestation and medical
malpractice. Casualty excess business on large companies is written, but
generally on a "clash" basis only (layers above the limits written for any
individual policyholder) or specialty casualty written with claims-made forms.
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Following is a summary of loss and settlement expense reserves and payments
associated with asbestos, environmental, products liability and casualty excess
reinsurance exposures for 2012, 2011 and 2010:
Property and casualty
insurance segment Reinsurance segment
Settlement Settlement($ in thousands) Case IBNR expense Case
IBNR expense
Reserves at 12/31/12
Asbestos $ 3,778 $ 1,834 $ 1,711 $ 99 $ 353 $ -
Environmental 237 572 121 67 660 -
Products1 6,044 5,309 5,212 - - -
Casualty excess2 - - - 27,759 52,127 2,730
Reserves at 12/31/11
Asbestos $ 2,584 $ 872 $ 1,933 $ 113 $ 372 $ -
Environmental 219 663 188 66 662 -
Products1 5,133 4,938 4,589 - - -
Casualty excess2 - - - 24,141 53,376 2,259
Reserves at 12/31/10
Asbestos $ 2,483 $ 1,000 $ 2,380 $ 156 $ 382 $ -
Environmental 125 668 128 64 656 -
Products1 5,532 4,759 6,209 - - -
Casualty excess2 - - - 23,715 53,217 1,575
Paid during 2012
Asbestos $ 468 $ 1,585 $ 32 $ -
Environmental - 87 1 -
Products1 1,768 3,065 - -
Casualty excess2 - - 6,291 1,227
Paid during 2011
Asbestos $ 299 $ 802 $ 51 $ 2
Environmental 6 95 - (8 )
Products1 1,524 2,107 - -
Casualty excess2 - - 7,440 1,379
Paid during 2010
Asbestos $ 461 $ 1,022 $ 34 $ 1
Environmental 17 179 - -
Products1 2,564 2,124 - -
Casualty excess2 - - 5,040 1,107
1 Products includes the portion of asbestos and environmental claims reported
that are non-premises/operations claims.
2 Casualty excess includes the asbestos and environmental claims reported above.
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Following is a summary of the claim activity associated with asbestos,
environmental and products liability exposures for 2012, 2011 and 2010:
Asbestos Environmental Products
Open claims, 12/31/12 4,469 5 107
Reported in 2012 363 - 414
Disposed of in 2012 4,748 2 411
Open claims, 12/31/11 8,854 7 104
Reported in 2011 213 3 411
Disposed of in 2011 696 - 406
Open claims, 12/31/10 9,337 4 99
Reported in 2010 207 1 387
Disposed of in 2010 24,347 2 1,407
Variability of loss and settlement expense reserves
The Company does not determine a range of estimates for all components of the
loss and settlement expense reserve at the time the reserves are
established. During each quarter, however, an actuarially determined range of
estimates is developed for the major components of the loss and settlement
expense reserves as of the preceding quarter-end. All reserves are reviewed with
the exception of reserves for involuntary workers' compensation pools, which are
set by the National Council on Compensation Insurance (NCCI) and are assumed to
be adequate (the impact of potential variability of this segment on overall
reserve adequacy is considered immaterial). Shown below are the actuarially
determined ranges of reserve estimates as of December 31, 2012 along with the
statutory-basis carried reserves, which are displayed net of ceded
reinsurance. The GAAP-basis loss and settlement expense reserves contained in
the Company's financial statements are reported gross of ceded reinsurance and
contain a small number of adjustments from the statutory-basis amounts presented
here. The last two columns display the estimated after-tax impact on earnings if
the reserves were moved to the high end-point or low end-point of the ranges.
Range of reserve estimates
After-tax impact on earnings
Reserves Reserves
($ in thousands) High Low Carried at high at low
Property and casualty
insurance segment $ 404,167 $ 351,607 $ 389,631 $ (9,448 ) $ 24,716
Reinsurance segment 167,870 136,749 165,458 (1,568 ) 18,661
$ 572,037 $ 488,356 $ 555,089 $ (11,016 ) $ 43,377
The precise location of total carried reserves within the actuarial range is
unknown at the time the reserves are established because the actuarial
evaluation of reserve adequacy is conducted after the establishment of the
reserves.
Changes in loss and settlement expense reserve estimates of prior periods
Loss and settlement expense reserves are estimates at a given time of what an
insurer expects to pay on incurred losses, based on facts and circumstances then
known. During the loss settlement period, which may be many years, additional
facts regarding individual claims become known, and accordingly, it often
becomes necessary to refine and adjust the estimates of liability. Such changes
in the reserves for losses and settlement expenses are reflected in operating
results in the year such changes are recorded.
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For a detailed discussion of the development experienced on prior accident
years' reserves during the past three years, see the discussion entitled "Loss
and Settlement Expense Reserves" under the "Narrative Description of Business"
heading in the Business Section under Part I, Item I of this Form 10-K.
Investments
Fair Value Measurement
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 thesignificant
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
value of a majority of its securities, subject to an internal validation. The
fair value is based on quoted market prices, where available. This is typically
the case for equity securities, which are accordingly classified as Level 1 fair
value measurements. In cases where quoted market prices are not available, fair
value is based on a variety of valuation techniques depending on the type of
security. Fixed maturity securities 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.
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· 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.
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
December 31, 2012 and 2011, the Company did not hold any fixed maturity
securities that were priced solely from broker quotes.
Essentially all securities in the Company's investment portfolios have
transparent pricing. All equity securities (with one exception) are traded on
national exchanges with observable prices. Fixed maturity securities are
typically high quality, liquid issues with daily pricing from the Company's
independent pricing source. Prices are validated through a variety of
techniques. When performing these validations, the Company uses graduated
tolerance levels for determining exceptions. Equity securities and U.S. treasury
and government-sponsored agency fixed maturity securities have the highest
transparency in pricing, and therefore have the smallest tolerance levels for
variance. These are followed by (in order of decreasing transparency/increasing
tolerance levels) mortgage-backed, corporate, municipal, and finally high-yield
fixed maturity securities. The validations performed include:
1. Comparisons of the prices reported by the independent pricing source to daily
runs of offerings and bids from several brokers for a sample of securities.
2. Comparison of the prices reported by the independent pricing source to prices
realized from the Company's own purchase and sale transactions.
3. Comparison of the prices reported by the independent pricing source to prices
from the Company's investment custodian. It should be noted that the
independent pricing source used by the Company is often the same source used
by the Company's investment custodian (except for municipal fixed maturity
securities), thus limiting the confidence gained from this validation
technique.
Rarely are the independent pricing source's prices outside of tolerance
levels. This is most likely to occur in less frequently traded municipal fixed
maturity securities, where the price reported by the independent pricing source
may have become stale due to a lack of recent trading activity. If it is
believed that the price reported by the independent pricing source does not
reflect the quality, maturity, optionality and liquidity characteristics of the
fixed maturity security, alternative pricing sources are examined, including
Bloomberg matrix pricing, regression pricing, and broker runs for offering
prices of similar securities. A judgment is then made as to what price best
reflects the characteristics of the security, and if the result is materially
different than the fair value reported by the independent pricing source for
that security, then management's judgment of the fair value is used in the
financial statements.
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Investment Impairments
The Company regularly monitors its investments which have a fair value that is
less than the carrying value for indications of "other-than-temporary"
impairment. Several factors are used to determine whether the carrying value of
an individual security has been "other-than-temporarily" impaired. Such factors
include, but are not limited to (1) the security's value and performance in the
context of the overall markets, (2) length of time and extent the security's
fair value has been below carrying value, (3) key corporate events, and (4) for
equity securities, the ability and intent to hold the security until recovery to
its cost basis.
The evaluation of an impaired fixed maturity security includes an assessment of
whether the Company has the intent to sell the security, and whether it is more
likely than not that the Company will be required to sell the security before
recovery of its amortized cost basis. In addition, if the present value of cash
flows expected to be collected is less than the amortized cost of the security,
a credit loss is deemed to exist and the security is considered
"other-than-temporarily" impaired. The portion of the impairment related to
credit loss is recognized through earnings, and the portion of the impairment
related to other factors, if any, is recognized through "other comprehensive
income".
When an equity security is deemed to be "other-than-temporarily" impaired, the
carrying value is reduced to fair value and a realized loss is recognized
through earnings.
Deferred policy acquisition costs and related amortization
Acquisition costs, consisting of commissions, premium taxes, and salary and
benefit expenses of employees directly involved in the underwriting of insurance
policies that are successfully issued, are deferred and amortized to expense as
premium revenue is recognized. Deferred policy acquisition costs and related
amortization are calculated separately for the property and casualty insurance
segment and the reinsurance segment. The methodology followed in computing
deferred policy acquisition costs limits the amount of such deferred costs to
the estimated realizable value. In determining estimated realizable value, the
computation gives effect to the premium to be earned, related investment income,
anticipated losses and settlement expenses, anticipated policyholder dividends,
and certain other costs expected to be incurred to administer the insurance
policies as the premium is earned. The anticipated losses and settlement
expenses are based on the segment's projected loss and settlement expense ratios
for the next twelve months, which include provisions for anticipated catastrophe
and storm losses based on historical results adjusted for recent
trends. Utilizing these projections, deferred policy acquisition costs for the
property and casualty insurance segment and the reinsurance segment were not
subject to limitation at December 31, 2012. Based on an analysis performed by
management, the actuarial projections of the expected loss and settlement
expense ratios for the next twelve months would have needed to increase 18.36
percentage points in the property and casualty insurance segment and 13.97
percentage points in the reinsurance segment before deferred policy acquisition
costs would have been subject to limitation. Such increases in the expected loss
and settlement expense ratios would likely be driven by many factors, including
higher provisions for anticipated catastrophe and storm losses.
Deferred income taxes
The realization of the deferred income tax asset is based upon projections
indicating that a sufficient amount of future taxable income will be earned to
utilize the tax deductions that will reverse in the future. These projections
are based on the Company's history of producing significant amounts of taxable
income, the current premium rate environment for both the property and casualty
insurance segment and the reinsurance segment, and expense control initiatives
that have been implemented in recent years. In addition, management has
formulated tax-planning strategies that could be implemented to generate taxable
income if needed. Should the projected taxable income and tax planning
strategies not provide sufficient taxable income to recover the deferred tax
asset, a valuation allowance would be required.
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Benefit Plans
Employers Mutual sponsors two defined benefit pension plans (a qualified plan
and a non-qualified supplemental plan) and two postretirement benefit plans that
provide retiree healthcare and life insurance coverage. Although the Company has
no employees of its own, it is responsible for its share of the expenses and
related prepaid assets and liabilities of these plans, as determined under the
terms of the pooling agreement and the cost allocation methodologies applicable
to its subsidiaries that do not participate in the pooling agreement.
The net periodic pension and postretirement benefit costs, as well as the
prepaid assets and liabilities of these plans, are determined by actuarial
valuations. Inherent in these valuations are key assumptions regarding the
discount rate, the expected long-term rate of return on plan assets, the rate of
future compensation increases (pension plans only), and the health care cost
trend rate (healthcare postretirement plan only). The assumptions used in the
actuarial valuations are updated annually. Material changes in the net periodic
pension and postretirement benefit costs may occur in the future due to changes
in these assumptions or changes in other factors, such as the number of plan
participants, the level of benefits provided, asset values and applicable
legislation or regulations.
The discount rate utilized in the valuations is based on an analysis of the
total rate of return that could be generated by a hypothetical portfolio of
high-quality bonds created to generate cash flows that match the plans' expected
benefit payments. No callable bonds are used in this analysis and the discount
rate produced by this analysis is compared to interest rates of applicable
published indices for reasonableness. The discount rates used in the pension
benefit obligation valuations at December 31, 2012, 2011 and 2010 were 3.24
percent, 4.13 percent and 5.00 percent, respectively. The discount rates used in
the postretirement benefit obligation valuations at December 31, 2012, 2011 and
2010 were 4.03 percent, 4.59 percent and 5.50 percent, respectively. The
discount rates used in the pension and postretirement benefit obligation
valuations are also used in the calculation of the net periodic benefit costs
for the subsequent year. A 0.25 percentage point decrease in the discount rates
used in the 2012 valuations would increase the Company's net periodic pension
and postretirement benefit costs for 2013 by approximately $154,000. Conversely,
a 0.25 percentage point increase in the 2012 discount rates would decrease the
Company's net periodic pension and postretirement benefit costs for 2013 by
approximately $148,000.
The expected long-term rate of return on plan assets is developed considering
actual historical results, current and expected market conditions, the mix of
plan assets and investment strategy. The expected long-term rate of return on
plan assets produced by this analysis and used in the calculation of the net
periodic pension benefit costs for the years ended December 31, 2012 and 2011
was 7.25 percent and 7.50 percent, respectively. The expected long-term rate of
return on plan assets used in the calculation of the net periodic postretirement
benefit costs for the years ended December 31, 2012 and 2011 was 6.25
percent. The expected rate of return on plan assets to be used in the
calculation of the 2013 net periodic benefit costs for the pension and
postretirement benefit plans will be 7.25 percent and 6.50 percent,
respectively. The actual rate of return earned on plan assets during 2012 was
approximately 14 percent for the pension plan and 11 percent for the
postretirement benefit plans. The expected long-term rate of return assumption
is subject to the general movement of the economy, but is generally less
volatile than the discount rate assumption. A decrease in the expected
long-term rate of return assumption increases future expenses, whereas an
increase in the assumption reduces future expenses. A 0.25 percentage point
change in the expected long-term rate of return assumption for 2013 would change
the Company's net periodic pension and postretirement benefit costs by
approximately $219,000. For detailed information regarding the current
allocation of assets within the pension and postretirement benefit plans, see
note 12 of Notes to Consolidated Financial Statements under Part II, Item 8 of
this Form 10-K.
The health care cost trend rate assumption represents the anticipated change in
the cost of health care benefits due to factors outside of the plan. These
factors include health care inflation, changes in health care utilization and
delivery patterns, technological advances, and the overall health of the plan
participants. The health care cost trend rate assumption is based on published
information and general economic conditions. The health care cost trend rate
assumption for 2012 was 7.75 percent, and is assumed to decrease gradually to 5
percent in 2024 and remain at that level thereafter. In 2011 and 2010 the
assumptions were 8.0 percent and 8.5 percent, respectively, both declining
gradually to 5 percent and remaining at that level thereafter. A one percentage
point increase in the assumed health care cost trend rate would increase the
Company's net periodic postretirement benefit cost for 2013 by approximately
$768,000. Conversely, a one percentage point decrease in the assumed health care
cost trend rate would decrease the Company's net periodic postretirement benefit
cost for 2013 by approximately $599,000.
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In accordance with GAAP, actuarial gains/losses contained in the valuations that
result from (1) actual experience that differs from that assumed, or (2) a
change in actuarial assumptions, is accumulated and, if in excess of a specified
corridor, amortized to expense over future periods. As of December 31, 2012, all
of the benefit plans had accumulated actuarial losses in excess of the corridor
that will be partially amortized into expense in 2013. The Company's share of
the accumulated actuarial losses that will be amortized into expense during 2013
amounts to $2,865,000. Prior service costs/credits for plan amendments are also
contained in the valuations, and are amortized into expense/income over the
future service periods of the participants. As of December 31, 2012, the
postretirement benefit plans have prior service credits that are being amortized
into income in future periods, while the qualified defined benefit pension plan
has prior service costs that are being amortized into expense in future
periods. The net amount of prior service credit being amortized into income
during 2013 is $708,000.
In accordance with GAAP, the funded status of defined benefit pension or other
postretirement plans is recognized as an asset or liability on the balance
sheet. Changes in the funded status of the plans are recognized through other
comprehensive income.
RESULTS OF OPERATIONS
Results of operations by segment and on a consolidated basis for the three years
ended December 31, 2012 are as follows:
Year ended December 31,
($ in thousands) 2012 2011
2010
Property and casualty insurance
Premiums earned $ 357,139 $ 321,649 $
305,647
Losses and settlement expenses 233,892 251,449
208,114
Acquisition and other expenses 131,454 116,588
116,704
Underwriting loss $ (8,207 ) $ (46,388 ) $
(19,171 )
Loss and settlement expense ratio 65.5 % 78.2 % 68.1 %
Acquisition expense ratio 36.8 % 36.2 % 38.2 %
Combined ratio 102.3 % 114.4 % 106.3 %
Losses and settlement expenses:
Insured events of current year $ 246,949 $ 271,612 $
236,840
Decrease in provision for insured events of
prior years (13,057 ) (20,163 )
(28,726 )
Total losses and settlement expenses $ 233,892 $ 251,449 $ 208,114
Catastrophe and storm losses $ 34,372 $ 52,448 $ 33,062
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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 solely from changes in the allocation of bulk reserves
between the current and prior accident years (no impact on earnings). The result
is an approximation of the implied favorable development that had an impact on
earnings.
Year ended December 31,
2012 2011 2010
($ in thousands)
Reported favorable development experienced
on prior years' reserves $ (13,057 ) $ (20,163 ) $ (28,726 )
Adjustment for (adverse) favorable
development that had no impact on earnings (4,551 ) 1,396 (6,036 )
Approximation of the implied favorable
development that had an impact on earnings $ (17,608 ) $ (18,767 ) $ (34,762 )
Year ended December 31,
($ in thousands) 2012 2011 2010
Reinsurance
Premiums earned $ 101,707 $ 94,753 $ 83,475
Losses and settlement expenses 69,496 91,525 46,527
Acquisition and other expenses 22,370 20,501
26,829
Underwriting profit (loss) $ 9,841 $ (17,273 ) $
10,119
Loss and settlement expense ratio 68.3 % 96.6 % 55.7 %
Acquisition expense ratio 22.0 % 21.6 % 32.1 %
Combined ratio 90.3 % 118.2 % 87.8 %
Losses and settlement expenses:
Insured events of current year $ 82,172 $ 104,461 $
68,550
Decrease in provision for insured events of
prior years (12,676 ) (12,936 )
(22,023 )
Total losses and settlement expenses $ 69,496$ 91,525 $
46,527
Catastrophe and storm losses $ 19,088 $ 27,883 $ 9,082
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Year ended December 31,
($ in thousands) 2012 2011 2010
Consolidated
REVENUES
Premiums earned $ 458,846 $ 416,402 $ 389,122
Net investment income 44,145 46,111 49,489
Realized investment gains 8,017 9,303 3,869
Other income 859 828 783
511,867 472,644 443,263
LOSSES AND EXPENSES
Losses and settlement expenses 303,388 342,974 254,641
Acquisition and other expenses 153,824 137,089 143,533
Interest expense 900 900 900
Other expense 2,122 2,673 1,741
460,234 483,636 400,815
Income (loss) before income tax expense
(benefit) 51,633 (10,992 ) 42,448
Income tax expense (benefit) 13,667 (8,255 ) 11,099
Net income (loss) $ 37,966 $ (2,737 ) $ 31,349
Net income (loss) per share $ 2.95 $ (0.21 ) $ 2.40
Loss and settlement expense ratio 66.1 % 82.4 % 65.4 %
Acquisition expense ratio 33.5 % 32.9 % 36.9 %
Combined ratio 99.6 % 115.3 % 102.3 %
Losses and settlement expenses:
Insured events of current year $ 329,121 $ 376,073 $ 305,390
Decrease in provision for insured events of
prior years (25,733 ) (33,099 )
(50,749 )
Total losses and settlement expenses $ 303,388 $ 342,974 $ 254,641
Catastrophe and storm losses $ 53,460 $ 80,331 $ 42,144
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 solely from changes in the allocation of bulk reserves
between the current and prior accident years (no impact on earnings). The result
is an approximation of the implied favorable development that had an impact on
earnings.
Year ended December 31,
2012 2011 2010
($ in thousands)
Reported favorable development experienced
on prior years' reserves $ (25,733 ) $ (33,099 ) $ (50,749 )
Adjustment for (adverse) favorable
development that had no impact on earnings (4,551 ) 1,396 (6,036 )
Approximation of the implied favorable
development that had an impact on earnings $ (30,284 ) $ (31,703 ) $ (56,785 )
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Year ended December 31, 2012 compared to year ended December 31, 2011
The Company reported net income of $37,966,000 ($2.95 per share) in 2012, a
significant improvement from the $2,737,000 ($0.21 per share) net loss reported
in 2011. Both the property and casualty insurance segment and the reinsurance
segment experienced good operating results during the second half of 2012. The
primary drivers of these good results were an increase in premium income, and a
significant decline in catastrophe and storm losses from the record amount
experienced in 2011. Management has expended a great deal of time and resources
into implementing much needed rate level increases in the commercial lines of
business during the past two years, and those efforts have been
successful. These rate level increases had an increasingly positive impact on
operating results during 2012 as they became earned. Future operating results
will continue to be positively impacted as the rate level increases become fully
earned.
Premium income
Premiums earned increased 10.2 percent to $458,846,000 in 2012 from $416,402,000
in 2011. A number of factors contributed to the increase in premium income. In
the property and casualty insurance segment, the majority of the increase is
attributed to rate level increases, growth in insured exposures and an increase
in retained policies. In the reinsurance segment, the increases are attributed
to rate level increases and a new offshore energy and liability account. Premium
rate levels improved in all lines of business, and are expected to continue to
improve in 2013.
Premiums earned for the property and casualty insurance segment increased 11.0
percent to $357,139,000 in 2012 from $321,649,000 in 2011. The vast majority of
the increase in premiums earned is associated with renewal business, and
reflects a combination of rate level increases, growth in insured exposures and
an increase in retained policies. Renewal business premium increased 9.5 percent
during 2012. Renewal rates on the six major lines of commercial business
increased steadily during 2012 and ended the year at approximately 6
percent. Management anticipates that overall rate level increases of
approximately 6 percent will continue to be achieved at least through
2013. Renewal rates for personal lines of business also increased, but did not
have a significant impact on premiums earned due to an intentional reduction in
policy count. Overall policy retention remained stable at approximately 87
percent. New business continues to account for a relatively small portion (just
14 percent) of the pool participants' direct written premiums. New business
premium increased 19 percent in the commercial lines of business (the associated
policy count increased 8.5 percent), but total new business premium increased
only 7 percent due to a significant decline in personal lines new business
premium. New business applications in the commercial lines of business were up
significantly during 2012, but careful underwriting resulted in a large number
of declinations.
Premiums earned for the reinsurance segment declined 14.4 percent in the fourth
quarter, but increased 7.3 percent to $101,707,000 for the year from $94,753,000
in 2011. The decrease in the fourth quarter is primarily attributed to a
significant decline in the year-end estimate of "earned but not reported"
premiums on several pro rata accounts, including the new offshore energy and
liability account. The increase for the year is primarily attributed to rate
level increases implemented during the January 1 renewal season and the new
offshore energy and liability proportional account; however, the increase was
limited by the cancellation of a large pro rata account written by MRB. Rate
levels, which had previously been declining, began trending higher during 2011
due to the large number of severe catastrophic events that occurred during the
year. This improved pricing continued through the January 1, 2012 renewal
season, with rate increases averaging approximately 10 percent, and larger
increases being achieved on contracts containing catastrophe exposures. However,
the pace of rate increases slowed somewhat during 2012, with July 1 renewal
rates increasing approximately five to seven percent. The new offshore energy
and liability account generated approximately $12,375,000 of annual premiums
(after the 10.0 percent charge for the excess of loss coverage) during the 2012
underwriting year. Since the underlying policies have effective dates throughout
the 2012 underwriting year, approximately 48.0 percent of this amount was earned
during calendar year 2012, with the balance to be earned during calendar year
2013. Annual premiums for the 2013 underwriting year are currently projected to
be approximately $14,000,000. The account covers oil rigs, platforms, and
floating production, storage and offloading systems worldwide, with 56 percent
of the premiums coming from the United States and United Kingdom. The focus is
on small to medium-sized enterprises involved with energy exploration and
production, which comprises approximately 75 percent of the account. The account
also includes a small number of larger enterprises and a number of state-owned
oil and gas companies. Specialized underwriting and engineering areas work
closely together to technically analyze each risk. Gulf of Mexico windstorm
exposure is minimal and first party removal of wreck is restricted in liability
policies.
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Effective January 1, 2012, MRB cancelled a large pro rata account with poor
experience. As a result, the reinsurance segment recorded a $3,406,000 portfolio
adjustment decrease in premiums written in the first quarter of 2012 that offset
a corresponding decrease in unearned premiums. Ten percent of this amount
($341,000) was recorded as a reduction in the cost of the excess of loss
coverage provided by Employers Mutual, and the reinsurance segment recognized
$1,362,000 of negative commission allowance (commission income) to compensate
for the acquisition costs incurred to generate this business.
Effective January 1, 2011, Country Mutual Insurance Company (Country Mutual)
discontinued its participation in MRB. As a result, Employers Mutual became a
one-fourth participant in MRB, up from its previous approximate one-fifth
participation. In connection with Employers Mutual's increased participation in
MRB, the reinsurance segment recorded a $1,023,000 portfolio adjustment increase
in premiums written in the first quarter of 2011 that offset a corresponding
increase in unearned premium. The reinsurance segment ceded ten percent of this
amount ($102,000) to Employers Mutual under the terms of the excess of loss
agreement, and recognized $399,000 of commission expense to compensate Country
Mutual for the acquisition costs incurred to generate this business.
Effective January 1, 2013, Church Mutual Insurance Company (Church Mutual)
became a member of MRB. As a result, Employers Mutual will once again become a
one-fifth participant in MRB. The addition of Church Mutual will strengthen the
association's surplus base and should favorably impact future marketing
efforts. However, there will be a short-term negative impact on the Company's
earned premiums since the association's business will now be split between five
participants rather than the current four.
Under the terms of the quota share agreement, the reinsurance subsidiary
receives reinstatement premium income that is collected by Employers Mutual from
the ceding companies when reinsurance coverage is reinstated after a loss event;
however, the cap on losses assumed per event contained in the excess of loss
agreement is automatically reinstated without cost. This arrangement can produce
unusual underwriting results for the reinsurance subsidiary when a large loss
event occurs because the reinstatement premium income received by the
reinsurance subsidiary may approximate, or even exceed, the amount of losses
retained. The reinsurance subsidiary recognized $2,344,000 and $3,139,000 of
reinstatement premium income (net amount after 10 percent was ceded back to
Employers Mutual under the terms of the excess of loss agreement) in 2012 and
2011, respectively.
Losses and settlement expenses
Losses and settlement expenses decreased 11.5 percent to $303,388,000 in 2012
from $342,974,000 in 2011, and the loss and settlement expense ratio decreased
to 66.1 percent in 2012 from 82.4 percent in 2011. The significant improvement
in the 2012 loss and settlement expense ratio is primarily attributed to a
decline in catastrophe and storm losses, as well as the increase in premium
income previously noted. Catastrophe and storm losses declined from the record
amount experienced in 2011 to a more normal level of 11.7 percentage points of
the 2012 loss and settlement expense ratio. The most recent 10-year average for
this period (which includes the record catastrophe and storm losses experienced
in 2008 and 2011) is 9.7 percentage points. In comparison, catastrophe and storm
losses accounted for 19.3 percentage points of the loss and settlement expense
ratio in 2011. Losses associated with Superstorm Sandy were capped at $4,000,000
in the reinsurance segment and totaled only $907,000 in the property and
casualty insurance segment. Since premiums earned are utilized in the
calculation of the loss and settlement expense ratio, the rate level increases
implemented during the past two years also had a favorable impact on the 2012
ratio. The actuarial analysis of the Company's carried reserves as of December
31, 2012 indicates that the level of reserve adequacy is 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.
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The loss and settlement expense ratio for the property and casualty insurance
segment decreased to 65.5 percent in 2012 from 78.2 percent in 2011. This
decrease is primarily attributed to a significant decline in catastrophe and
storm losses and an increase in premium income. Catastrophe and storm losses
declined in 2012 to a more normal level of 9.6 percentage points of the loss and
settlement expense ratio, which is slightly higher than the most recent 10-year
average of 9.2 percentage points (which includes the record catastrophe and
storm losses experienced in 2008 and 2011). In comparison, catastrophe and storm
losses accounted for 16.3 percentage points of the 2011 loss and settlement
expense ratio. Claim frequency declined in nearly all lines of business;
however, the savings associated with this decline was largely offset by an
increase in loss severity. Large losses (which the Company defines as losses
greater than $500,000 for the EMC Insurance Companies' pool, excluding
catastrophe and storm losses) decreased to $21,241,000 in 2012 from $24,044,000
in 2011. The property and casualty insurance segment experienced $13,057,000 of
favorable development on prior years' reserves in 2012, compared to $20,163,000
in 2011. The development amount for 2012 includes $4,551,000 of adverse
development stemming from changes in the allocation of bulk reserves between the
current and prior accident years, while the 2011 amount includes $1,396,000 of
favorable development stemming from similar changes in the allocation of bulk
reserves. Development on prior years' reserves resulting solely from changes in
the allocation of bulk reserves between the current and prior accident years
does not have an impact on earnings. This is due to the fact that such
development is simply a mathematical by-product of the mechanical process used
to reallocate bulk reserves to the various accident years for financial
reporting purposes. Earnings are only impacted by changes in the total amount of
carried reserves.
The loss and settlement expense ratio for the reinsurance segment decreased to
68.3 percent in 2012 from 96.6 percent in 2011. This decrease is primarily
attributed to the rate level increases previously noted and a decline in
catastrophe and storm losses. While less than 2011, catastrophe and storm losses
were well above average in 2012. During 2012, the reinsurance segment had three
events, including Superstorm Sandy, which exceeded the $4,000,000 retention
amount under the excess of loss agreement. Losses from these three events
totaled $23,722,000, with $12,000,000 retained by the reinsurance segment and
the remaining $11,722,000 ($11,000,000 from Superstorm Sandy alone) ceded to
Employers Mutual. During 2011, the reinsurance segment experienced an
unprecedented five events with losses greater than the $3,000,000 retention
amount. Losses from those five events totaled $31,500,000 at December 31, 2011,
with $15,000,000 retained by the reinsurance segment and the remaining
$16,500,000 ceded to Employers Mutual. During 2012, the reinsurance segment also
incurred $6,057,000 of losses on U.S. multi-peril crop reinsurance programs that
resulted from the severe drought conditions that existed in much of the United
States. Because the losses from the crop reinsurance programs are not
attributable to a specific event, they are not subject to the $4,000,000 cap on
losses per event under the excess of loss agreement. The favorable development
experienced on prior years' reserves in 2012 is primarily the HORAD book of
business, and reflects a reduction in IBNR reserves for prior accident years
that was greater than the actual losses reported for those accident years.
Acquisition and other expenses
Acquisition and other expenses increased 12.2 percent to $153,824,000 in 2012
from $137,089,000 in 2011. The acquisition expense ratio also increased,
totaling 33.5 percent in 2012 compared to 32.9 percent in 2011. The large
increase in acquisition and other expenses is primarily attributed to
significant increases in both contingent commission and policyholder dividend
expenses, both of which are reflective of the better underwriting results
experienced in 2012. The increase in the acquisition expense ratio was tempered
by the significant increase in premium income.
For the property and casualty insurance segment, the acquisition expense ratio
increased to 36.8 percent in 2012 from 36.2 percent in 2011. The increase
reflects higher contingent commission and policyholder dividend expenses
resulting from the better underwriting results experienced in 2012, but was
moderated by the significant increase in premium income.
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For the reinsurance segment, the acquisition expense ratio increased to 22.0
percent in 2012 from 21.6 percent in 2011. While the increase is primarily
attributed to higher contingent commission expense, the impact on the
acquisition expense ratio was limited by non-recurring commission adjustments
recorded in 2012 and 2011. During 2012, a $1,362,000 negative commission
allowance was recorded in connection with the cancellation of a large MRB
account. However, a portion of this negative commission allowance was offset by
the resulting release (amortization) of the related deferred policy acquisition
cost asset, resulting in an immediate expense reduction of approximately
$654,000 during the first quarter of 2012. In 2011, the reinsurance segment
recognized $399,000 of commission expense in conjunction with Country Mutual's
withdrawal from MRB. A portion of this commission expense was capitalized as
part of the deferred policy acquisition cost asset (to be expensed as the
related premiums are earned), resulting in an immediate expense recognition of
approximately $181,000 during the first quarter of 2011.
Investment results
Net investment income decreased 4.3 percent to $44,145,000 in 2012 from
$46,111,000 in 2011. The decrease is primarily attributed to the low interest
rate environment that has persisted for the past several years. During this time
period, available cash flow has been invested in fixed maturity securities with
progressively lower yields, resulting in a decline in the annualized yield of
the fixed maturity portfolio. The average coupon on the fixed maturity portfolio
was 4.23 percent at December 31, 2012, compared to 4.58 percent and 4.98 percent
at December 31, 2011 and 2010, respectively. Management is actively pursuing
ways to minimize the decline in investment income without increasing overall
risk, such as the implementation of the new equity strategy during 2012 that
emphasizes dividend income (see discussion below); however, investment income is
currently projected to decline an additional 5.0 percent in 2013. The effective
duration of the Company's fixed maturity portfolio was 4.20 years at December
31, 2012, compared to 4.65 years at December 31, 2011.
At the end of the first quarter of 2012, management reinvested approximately
$35,000,000 from the current equity portfolio and $10,000,000 of cash into a new
equity portfolio with an emphasis on dividend income. In addition to a higher
dividend return, this new equity strategy is expected to carry less market
volatility. The Company's equity security holdings produced dividend income of
$3,852,000 in 2012, compared to $2,362,000 in 2011.
The Company reported a net realized investment gain of $8,017,000 in 2012
compared to $9,303,000 in 2011. The Company experienced an unusually large
amount of realized investment gains in the first quarters of both 2012 and 2011,
totaling $8,918,000 and $8,258,000, respectively. The realized investment gains
recognized in the first quarter of 2012 primarily resulted from the sale of
equity securities. Proceeds from those sales were used to fund the purchase of
equity securities in the new portfolio that emphasizes dividend income. The
realized investment gains recognized during the first quarter of 2011 resulted
from normal activity in the equity portfolio when market prices were at elevated
levels. "Other-than-temporary" investment impairment losses totaled $186,000
during 2012 compared to $5,960,000 in 2011. The impairment losses in 2012 were
recognized on four equity securities, while the impairment losses in 2011 were
recognized on four residential mortgage-backed securities (all resulting from
the intent to sell) and 36 equity securities.
Other expense
Other expense decreased 20.6 percent to $2,122,000 in 2012 from $2,673,000 in
2011. The decrease is attributed to changes in the foreign currency exchange
gains and losses recognized on the reinsurance segment's foreign currency
denominated reinsurance business. Foreign currency exchange losses of $25,000
and $592,000 were recognized during 2012 and 2011, respectively.
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Income tax
The Company had income tax expense of $13,667,000 in 2012 compared to an income
tax benefit of $8,255,000 in 2011. The effective tax rate for 2012 was 26.5
percent compared to 75.1 percent in 2011. Note that the effective tax rate for
2011 is based on a tax benefit relative to pre-tax loss, thus an effective tax
rate greater than the United States federal corporate tax rate of 35 percent is
indicative of a favorable or "low" effective tax rate. The fluctuation in the
effective tax rate primarily reflects the variation in the amount of pre-tax
income (loss) reported relative to the amount of tax-exempt interest income
earned.
Year ended December 31, 2011 compared to year ended December 31, 2010
The Company had a net loss of $2,737,000 ($0.21 per share) in 2011, compared to
net income of $31,349,000 ($2.40 per share) in 2010. The net loss of 2011 was
primarily attributed to an unprecedented amount of catastrophe and storm losses,
as well as a significant decline in investment income. 2011 marked the fourth
consecutive year of above average catastrophe and storm losses for the
Company. While this was not unprecedented, having most recently occurred during
the period 1998 through 2001, it was also not common. What was unusual about
this current period of above-average catastrophe and storm losses was the fact
that the Company had experienced record levels of catastrophe and storm losses
in two of the four years. This was due to the fact that during the past four
years, tornados and hail storms had tended to hit more densely populated areas
with larger concentrations of exposures, resulting in much higher levels of
insured losses. Historically, similar periods of increased storm activity had
been associated with cyclical weather patterns, and high catastrophe and storm
loss years such as 2011 had not necessarily been indicative of the
future. Nonetheless, the current active weather cycle accentuated the need for
appropriate reinsurance coverage, and reinforced management's ongoing attention
to property exposure concentrations.
Premium income
Premiums earned increased 7.0 percent to $416,402,000 in 2011 from $389,122,000
in 2010. Premium rate levels for the property and casualty insurance segment had
risen slightly during 2011, and were beginning to show an upward trend. Moderate
rate increases continued to be implemented in the personal lines of business,
most notably in personal property exposures. The commercial lines of business
remained very competitive; however, for the first time in six years, small rate
increases were being obtained on most accounts and lines of business. The
unusually severe weather experienced during 2011 was not expected to have a
significant impact on commercial lines rate levels in 2012; however, rate levels
were expected to continue to improve steadily throughout the year and into 2013.
Premiums earned for the property and casualty insurance segment increased 5.2
percent to $321,649,000 in 2011 from $305,647,000 in 2010. This growth was
primarily attributed to an increase in policy retention, rate and exposure
increases and, to a lesser extent, an increase in policy counts in both the
commercial and personal lines of business. Premium income for both 2011 and 2010
was negatively impacted by return premiums resulting from audits of
policyholders' insured exposures; however, the amount of premiums returned in
2011 was much less than the amount returned in 2010. Premium income for 2011 was
also negatively impacted by $964,000 of additional premiums ceded to outside
reinsurance companies to reinstate the property and casualty insurance segment's
share of the pool's catastrophe reinsurance protection as a result of the severe
tornado losses in the second quarter. Renewal business premium increased
approximately seven percent during 2011 compared to 2010; however, new business
premium was down slightly. The overall policy retention rate increased to
approximately 88 percent from 86 percent in 2010. Premium rates continued to
improve in the personal lines of business during 2011, but the commercial lines
of business, which accounted for more than 80 percent of the property and
casualty insurance segment's premium income, remained very competitive. While
the overall rate level of the commercial lines of business remained relatively
steady during 2011, the pool participants were able to begin implementing some
small rate increases for the first time since 2005.
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Premiums earned for the reinsurance segment increased 13.5 percent to
$94,753,000 in 2011 from $83,475,000 in 2010. This increase was primarily
attributed to increased participation in the MRB pool (from an approximate
one-fifth share in 2010 to a one-fourth share in 2011), an increase in facility
business (includes reinsurance business from small to mid-size insurance
companies, and new property business in central and eastern Europe) and an
increase in reinstatement premium income. The reinsurance segment benefited from
a small decline in the cost of the excess of loss reinsurance protection
provided by Employers Mutual (from 10.5 percent in 2010 to 10.0 percent in
2011); however, this benefit was offset by additional reinsurance premiums paid
to Employers Mutual to provide reinsurance protection on the direct reinsurance
business written outside the quota share agreement. Due to the mild 2010
hurricane season and a recovery in the reinsurance industry's capital level,
premium rate levels declined slightly during the January 1, 2011 renewal
season. However, the market subsequently trended higher due to the number of
severe catastrophic events that occurred in 2011 (including the Japan earthquake
and tsunami, and the unprecedented number of severe tornadoes in the United
States during the second quarter), and this improved pricing continued through
the January 1, 2012 renewal season.
Under the terms of the quota share agreement, the reinsurance subsidiary
receives reinstatement premium income that is collected by Employers Mutual from
the ceding companies when coverage is reinstated after a loss event; however,
the cap on losses assumed per event contained in the excess of loss agreement is
automatically reinstated without cost to the reinsurance subsidiary. The
reinsurance subsidiary recognized approximately $3,139,000 of reinstatement
premium income during 2011 (net amount after 10 percent was ceded back to
Employers Mutual under the terms of the excess of loss agreement).
Effective January 1, 2011, Country Mutual Insurance Company (Country Mutual)
discontinued its participation in the MRB pool. As a result, Employers Mutual
became a one-fourth participant in the MRB pool, up from its previous
approximate one-fifth participation. In connection with Employers Mutual's
increased participation in the MRB pool, the reinsurance subsidiary recorded a
$1,023,000 portfolio adjustment increase in written premiums in the first
quarter of 2011 that offset a corresponding increase in unearned premium. The
reinsurance subsidiary ceded ten percent of this amount ($102,000) to Employers
Mutual for the cost of the excess of loss reinsurance protection and recognized
$399,000 of commission allowance to compensate Country Mutual for the
acquisition costs incurred to generate this business.
Losses and settlement expenses
Losses and settlement expenses increased 34.7 percent to $342,974,000 in 2011
from $254,641,000 in 2010, and the loss and settlement expense ratio increased
to 82.4 percent in 2011 from 65.4 percent in 2010. The ratio for 2010 reflected
a reduction of 1.6 percentage points associated with the reclassification of
$6,065,000 from IBNR reserves to contingent commission reserves in the
reinsurance segment. The large increase in the 2011 loss and settlement expense
ratio was primarily attributed to a record amount of catastrophe and storm
losses, which totaled $80,331,000 ($4.04 per share after tax), compared to
$42,144,000 ($2.10 per share after tax) in 2010. Catastrophe and storm losses
accounted for 19.3 percentage points of the loss and settlement expense ratio in
2011, which was significantly higher than the 10.8 percentage points reflected
in the 2010 ratio, and the 10-year (2001 through 2010) historical average of
approximately 8.0 percentage points. The increase in the 2011 loss and
settlement expense ratio also reflected a significant decline in the amount of
favorable development experienced on prior years' reserves. The actuarial
analysis of the Company's carried reserves as of December 31, 2011 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.
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The loss and settlement expense ratio for the property and casualty insurance
segment increased to 78.2 percent in 2011 from 68.1 percent in 2010. The
increase in the 2011 ratio was primarily attributed to a record amount of
catastrophe and storm losses, which totaled $52,448,000, compared to $33,062,000
in 2010. Catastrophe and storm losses accounted for 16.3 percentage points of
the 2011 loss and settlement expense ratio, which was significantly higher than
the 10.8 percentage points reflected in the 2010 ratio, and the 10-year (2001
through 2010) historical average of 7.8 percentage points. The property and
casualty insurance segment continued to experience favorable development on
prior years' reserves during 2011, but the amount was substantially less than
the amount reported in 2010. The decline in favorable development was largely
attributed to a decline in the amount of favorable development experienced with
the final settlement of prior accident years' claims and less favorable IBNR
emergence. Development amounts can vary significantly from year to year
depending on a number of factors, including the number of claims settled and the
settlement terms, and should therefore not be considered a reliable factor in
assessing the adequacy of carried reserves.
The loss and settlement expense ratio for the reinsurance segment increased to
96.6 percent in 2011 from 55.7 percent in 2010. The ratio for 2010 reflected a
reduction of 7.3 percentage points associated with the reclassification of
$6,065,000 from IBNR reserves to contingent commission reserves. The increase in
the 2011 ratio was primarily attributed to a significant increase in catastrophe
and storm losses and a decline in the amount of favorable development
experienced on prior years' reserves (excluding the reclassification of the IBNR
reserves). During 2011, the reinsurance subsidiary experienced an unprecedented
five events with losses greater than the $3,000,000 retention amount contained
in the excess of loss agreement. Total losses from these five events were
estimated at $31,500,000, with $15,000,000 retained by the reinsurance
subsidiary and the remaining $16,500,000 ceded to Employers Mutual. The
reinsurance subsidiary continued to experience favorable development on prior
years' reserves in 2011. The amount reported for 2010 included $6,065,000 of
favorable development resulting from the previously noted reclassification of
IBNR reserves to contingent commissions, which had no impact on operating
income. The HORAD book of business (which accounted for almost all of the
favorable reserve development) experienced uncharacteristic adverse development
on the 2010 catastrophe excess and property pro rata lines of business. The MRB
book of business experienced little development in 2011.
Acquisition and other expenses
Acquisition and other expenses decreased 4.5 percent to $137,089,000 in 2011
from $143,533,000 in 2010. The acquisition expense ratio decreased to 32.9
percent in 2011 from 36.9 percent in 2010. The ratio for 2010 reflected an
increase of 1.6 percentage points associated with the reclassification of
$6,065,000 from IBNR reserves to contingent commission reserves in the
reinsurance segment.
For the property and casualty insurance segment, the acquisition expense ratio
decreased to 36.2 percent in 2011 from 38.2 percent in 2010. This decrease was
primarily attributed to declines in policyholder dividend expense and agents'
contingent commissions, both of which reflect the deterioration in 2011
underwriting results. Growth in premium revenue, coupled with continued careful
oversight of general administrative costs, also contributed to the decline in
the 2011 ratio.
For the reinsurance segment, the acquisition expense ratio decreased to 21.6
percent in 2011 from 32.1 percent in 2010. The ratio for 2010 reflected an
increase of 7.3 percentage points associated with the reclassification of
$6,065,000 from IBNR reserves to contingent commission reserves. Excluding this
one-time adjustment, the decrease in the 2011 ratio was primarily attributed to
a decline in contingent commissions on the MRB book of business, as well as the
growth in premium revenue. Partially offsetting the decline in contingent
commissions was $399,000 of commission expense recorded in conjunction with
Country Mutual's withdrawal from the MRB pool. However, a portion of these
commissions were capitalized as part of the deferred policy acquisition cost
asset (to be expensed as the related premiums were earned), resulting in an
immediate expense recognition of approximately $181,000 during the first quarter
of 2011.
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Investment results
Net investment income decreased 6.8 percent to $46,111,000 in 2011 from
$49,489,000 in 2010. This decrease was primarily attributed to the low interest
rate environment that had existed for the past several years. During this time
period, available cash flow was invested in fixed maturity securities with
progressively lower yields, resulting in a persistent decline in the annualized
yield of the fixed maturity portfolio. The average coupon on the fixed maturity
portfolio had declined to 4.58 percent at December 31, 2011, compared to 4.98
percent and 5.27 percent at December 31, 2010 and 2009, respectively. Also
contributing to the decline in investment income was a decrease in the par value
of the fixed maturity portfolio, which resulted from claim payments associated
with the record catastrophe losses experienced during 2011. The effective
duration of the Company's fixed maturity portfolio was 4.65 years at December
31, 2011, compared to 5.75 years at December 31, 2010. The Company's equity
portfolio returned 4.46 percent during 2011, compared to 2.11 percent for the
S&P 500. Due to the factors described above, investment income was projected to
decline again in 2012; however, the decline was expected to be less than the
decline experienced in 2011.
The Company reported a net realized investment gain of $9,303,000 in 2011
compared to $3,869,000 in 2010. The large amount of realized investment gain for
2011 resulted from first quarter activity in the equity portfolio, when market
prices were at elevated levels. "Other-than-temporary" impairment losses totaled
$5,960,000 during 2011 compared to $2,384,000 in 2010. The impairment losses in
2011 were recognized on four residential mortgage-backed securities (all
resulting from an intent to sell) and 36 equity securities, while the impairment
losses in 2010 were recognized on two residential mortgage-backed securities
($121,000 associated with credit loss on one security, and $83,000 associated
with management's intent to sell another security) and 23 equity securities.
Other expense
Other expense increased 53.5 percent to $2,673,000 in 2011 from $1,741,000 in
2010. This increase was attributed to changes in the amount of foreign currency
exchange gains and losses recognized on the reinsurance segment's foreign
currency denominated reinsurance business. During 2011, the reinsurance segment
had a foreign currency exchange loss of $592,000, compared to a foreign currency
exchange gain of $346,000 in 2010.
Income tax
The Company had an income tax benefit of $8,255,000 in 2011 compared to income
tax expense of $11,099,000 in 2010. The effective tax rate for 2011 was 75.1
percent compared to 26.1 percent in 2010. Note that the 2011 effective tax rate
was based on tax benefits relative to pre-tax losses, thus an effective tax rate
larger than the United States federal corporate tax rate of 35 percent was
indicative of a favorable or "low" effective tax rate. The "low" effective tax
rate for 2011 primarily reflected a small amount of pre-tax loss relative to the
amount of tax-exempt interest income earned. The effective tax rate for 2010 was
elevated by 1.9 percentage points due to the impact of tax law changes signed
into law during the first quarter of 2010 in connection with the passage of the
Patient Protection and Affordable Care Act (H.R. 3590) and the follow-up Health
Care and Education Reconciliation Act of 2010 (H.R. 4872) (the "Acts"). In
accordance with these Acts, beginning in 2013 the Company will no longer be able
to claim a tax deduction for drug expenses that are reimbursed under the
Medicare Part D retiree drug subsidy program. Although this tax change did not
take effect until 2013, the Company was required to recognize the financial
impact of the change beginning in the period in which the Acts were signed. As a
result of the Acts, the Company recognized a decrease in its deferred tax asset
of $794,000 during the first quarter of 2010.
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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
$55,038,000 in 2012, $11,765,000 in 2011 and $30,322,000 in 2010. 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 drivers 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. See
note 6 of Notes to Consolidated Financial Statements for additional information
regarding dividend restrictions. The maximum amount of dividends that the
insurance subsidiaries can pay to the Company in 2013 without prior regulatory
approval is approximately $38,839,000. The Company received $12,050,000,
$10,000,000 and $17,000,000 of dividends from its insurance subsidiaries and
paid cash dividends to its stockholders totaling $10,439,000, $9,941,000 and
$9,512,000 in 2012, 2011 and 2010, 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. Prior to the second
quarter of 2011, all inter-company balances were settled on a quarterly 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. In addition, the insurance
subsidiaries have access to a line of credit maintained by Employers Mutual with
the Federal Home Loan Bank to provide additional liquidity if needed. Beginning
in 2012, 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 a newly implemented inter-company loan agreement.
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 high-yield, non-investment grade debt securities. Any non-investment
grade securities held by the Company are the result of rating downgrades
subsequent to their purchase.
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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 purchases of fixed maturity securities as
available-for-sale to provide flexibility in the management of its investment
portfolio. At December 31, 2012 and 2011, the Company had net unrealized holding
gains, net of deferred taxes, on its fixed maturity securities
available-for-sale of $51,318,000 and $37,872,000, 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
does not actively trade in the bond market, 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 declining interest rate environment, proceeds from calls
and maturities in recent years have been reinvested at lower yields, which has
negatively impacted current investment income.
The Company held $863,000 and $15,000 in minority ownership interests in limited
partnerships and limited liability companies at December 31, 2012 and 2011,
respectively. The Company does not hold any other unregistered securities.
The Company's cash balance was $330,000 and $255,000 at December 31, 2012 and
2011, respectively.
Employers Mutual contributed $15,000,000, $17,400,000 and $26,000,000 to its
qualified pension plan in 2012, 2011 and 2010, respectively, and plans to
contribute approximately $15,000,000 to the qualified pension plan in 2013. The
Company reimbursed Employers Mutual $4,589,000, $5,348,000 and $7,973,000 for
its share of the pension contributions in 2012, 2011 and 2010,
respectively. Employers Mutual contributed $1,500,000, $8,000,000 and $2,480,000
to its postretirement benefit plans in 2012, 2011 and 2010, respectively, and
expects to contribute approximately $4,000,000 to the postretirement benefit
plans in 2013. The Company reimbursed Employers Mutual $434,000, $2,244,000 and
$697,000 for its share of the postretirement benefit plan contributions in 2012,
2011 and 2010, respectively.
Capital Resources
Capital resources consist of stockholders' equity and debt, representing funds
deployed or available to be deployed to support business operations. For the
Company's insurance subsidiaries, capital resources are required to support
premium writings. Regulatory guidelines suggest that the ratio of a property and
casualty insurer's annual net premiums written to its statutory surplus should
not exceed three to one. All of the Company's property and casualty insurance
subsidiaries were well under this guideline at December 31, 2012.
The Company's insurance subsidiaries are required to maintain a certain minimum
level of surplus on a statutory basis, and are subject to regulations under
which the payment of dividends from statutory surplus is restricted and may
require prior approval of their domiciliary insurance regulatory
authorities. The Company's insurance subsidiaries are also subject to annual
Risk Based Capital (RBC) requirements that may further impact their ability to
pay dividends. RBC requirements attempt to measure minimum statutory capital
needs based upon the risks in a company's mix of products and investment
portfolio. At December 31, 2012, the Company's insurance subsidiaries had total
adjusted statutory capital well in excess of the minimum RBC requirement.
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The Company's total cash and invested assets at December 31, 2012 and 2011 are
summarized as follows:
December 31, 2012
Percent of
Amortized Fair total Carrying
($ in thousands) cost value fair value value
Fixed maturity securities available-for-sale $ 920,844 $ 999,795 83.7 % $ 999,795
Equity securities available-for-sale 111,852 140,294 11.8 140,294
Cash 330 330 - 330
Short-term investments 53,419 53,419 4.5 53,419
Other long-term investments 863 863 - 863
$ 1,087,308 $ 1,194,701 100.0 % $ 1,194,701
December 31, 2011
Percent of
Amortized Fair total Carrying
($ in thousands) cost value fair value value
Fixed maturity securities available-for-sale $ 899,940 $ 958,204 86.1 % $ 958,204
Equity securities available-for-sale 90,866 111,300 10.0 111,300
Cash 255 255 - 255
Short-term investments 42,629 42,629 3.9 42,629
Other long-term investments 14 14 - 14
$ 1,033,704 $ 1,112,402 100.0 % $ 1,112,402
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The amortized cost and estimated fair value of fixed maturity and equity
securities at December 31, 2012 were as follows:
Gross Gross
Amortized unrealized unrealized Estimated
($ in thousands) cost gains losses fair value
Securities available-for-sale:
Fixed maturity securities:
U.S. treasury $ 4,698 $ 287 $ - $ 4,985
US government-sponsored agencies 159,548 3,229 334 162,443
Obligations of states and political
subdivisions 335,188 35,776 2 370,962
Commercial mortgage-backed 69,952 10,413 16 80,349
Residential mortgage-backed 46,287 1,777 274 47,790
Other asset-backed 9,721 1,566 - 11,287
Corporate 295,450 26,775 246 321,979
Total fixed maturity securities 920,844 79,823 872 999,795
Equity securities:
Common stocks:
Financial services 14,497 3,630 34 18,093
Information technology 12,331 4,723 128 16,926
Healthcare 14,824 4,200 - 19,024
Consumer staples 12,020 1,593 3 13,610
Consumer discretionary 10,830 6,261 - 17,091
Energy 14,630 4,800 - 19,430
Industrials 7,639 936 - 8,575
Other 16,749 2,215 283 18,681
Non-redeemable preferred stocks 8,332 648 116 8,864
Total equity securities 111,852 29,006 564 140,294
Total securities available-for-sale $ 1,032,696$ 108,829 $ 1,436 $ 1,140,089
The Company's property and casualty insurance subsidiaries have $25,000,000 of
surplus notes issued to Employers Mutual at an interest rate of 3.60
percent. The Inter-Company Committees of the boards of directors of the Company
and Employers Mutual approved a decrease in the interest rate on the outstanding
notes to 1.35 percent effective February 1, 2013, subject to regulatory
approval. Reviews of the interest rate are conducted by the Inter-Company
Committees 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 is 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 $900,000 in each of the years 2012, 2011 and 2010. At December
31, 2012, the Company's property and casualty insurance subsidiaries had
received approval for the payment of interest accrued on the surplus notes
during 2012.
As of December 31, 2012, the Company had no material commitments for capital
expenditures.
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Off-Balance Sheet Arrangements
Employers Mutual collects from agents, policyholders and ceding companies all
premiums associated with the insurance business produced by the pool
participants and the assumed reinsurance 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 reinsurance contracts, providing full credit for the premiums
written during the period (not just the collected portion). Due to this
arrangement, and since a significant portion of these premium balances are
collected over the course of the coverage period, Employers Mutual carries a
substantial receivable balance for insurance and reinsurance premiums in process
of collection. 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 an off-balance sheet arrangement
with an unconsolidated entity that results in a credit-risk exposure (Employers
Mutual's insurance and reinsurance premium receivable balances) that is 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
$325,000. 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 "other-than-temporary" investment impairment losses
totaling $186,000 on four equity securities during 2012, compared to $5,960,000
on 36 equity securities and four residential mortgage-backed securities (all
resulting from an intent to sell) during 2011.
The Company has no direct exposure to sub-prime residential lending, and holds
no sub-prime residential collateralized debt obligations or sub-prime
collateralized mortgage obligations. The Company does have indirect exposure to
sub-prime residential lending markets as it has significant holdings of
government agency securities, prime and Alt-A collateralized mortgage
obligations, as well as fixed maturity and equity securities in both the banking
and financial services sectors. While these holdings do not include companies
engaged in originating residential lending as their primary business, they do
include companies that may be indirectly engaged in this type of lending.
The Company has no direct exposure to European sovereign debt, but does have
indirect exposure to European sovereign debt through its holdings of
dollar-denominated fixed maturity securities issued by European-based financial
institutions. This includes (at par value) $8,000,000 from Great Britain,
$14,500,000 from Switzerland, and $4,750,000 from Germany.
At December 31, 2012, the Company had unrealized losses on available-for-sale
securities as presented in the table below. 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 collateralization of fixed maturity
securities. 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 December 31,
2012. 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
$933,000, net of tax; however, the Company's financial position would not be
affected because unrealized losses on available-for-sale securities are
reflected in the Company's financial statements as a component of stockholders'
equity, net of deferred taxes.
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Following is a schedule of the length of time securities have continuously been
in an unrealized loss position as of December 31, 2012.
Less than twelve months Twelve months or longer Total
Fair Unrealized Fair Unrealized Fair Unrealized
($ in thousands) value losses value losses value losses
Fixed maturity securities:
U.S. government-sponsored
agencies $ 33,950 $ 334 $ - $ - $ 33,950 $ 334
Obligations of states and
political subdivisions 3,234 2 - - 3,234 2
Commercial mortgage-backed 3,773 16 - - 3,773 16
Residential mortgage-backed 5,304 274 - - 5,304 274
Corporate 17,568 246 - - 17,568 246
Subtotal, fixed maturity
securities 63,829 872 - - 63,829 872
Equity securities:
Common stocks:
Financial services 881 34 - - 881 34
Information technology 1,435 128 - - 1,435 128
Consumer staples 90 3 - - 90 3
Other 2,404 283 - - 2,404 283
Non-redeemable preferred
stocks - - 1,884 116 1,884 116
Subtotal, equity securities 4,810 448 1,884 116 6,694 564
Total temporarily impaired
securities $ 68,639 $ 1,320 $ 1,884 $ 116 $ 70,523 $ 1,436
Following is a schedule of the maturity dates of the fixed maturity securities
presented in the above table.
Gross
Book Fair unrealized
($ in thousands) value value loss
Due in one year or less $ - $ - $ -
Due after one year through five years 1,951 1,951 -
Due after five years through ten years 5,978 5,937 41
Due after ten years 47,405 46,864 541
Mortgage-backed securities 9,367 9,077 290
$ 64,701 $ 63,829 $ 872
The Company does not purchase non-investment grade securities. Any
non-investment grade securities held are the result of rating downgrades that
occurred subsequent to their purchase. At December 31, 2012, non-investment
grade fixed maturity securities held by the Company included eleven securities,
ten of which were residential mortgage-backed securities. None of these
securities were in an unrealized loss position at December 31, 2012.
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Following is a schedule of gross realized losses recognized in 2012 from the
sale of securities and from "other-than-temporary" investment impairments. The
schedule is aged according to the length of time the underlying securities were
in an unrealized loss position. This schedule does not include realized losses
stemming from corporate actions such as calls, pay-downs, redemptions, etc.
Realized losses from sales "Other-than- Total
Gross temporary" gross
Book Sales realized impairment realized
($ in thousands) value price losses losses 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 509 499 10 - 10
$ 509 $ 499 $ 10 $ - $ 10
Equity securities:
Three months or less $ 26,434 $ 24,183 $ 2,251 $ 149 $ 2,400
Over three months to six months 2,092 1,794 298 37 335
Over six months to nine months - - - - -
Over nine months to twelve months 137 120 17 - 17
Over twelve months - - - - -
$ 28,663 $ 26,097 $ 2,566 $ 186 $ 2,752
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LEASES, COMMITMENTS AND CONTINGENT LIABILITIES
The following table reflects the Company's contractual obligations as of
December 31, 2012. Included in the table are the estimated payments that the
Company expects to make in the settlement of its loss and settlement expense
reserves and with respect to its long-term debt. One of the Company's property
and casualty insurance subsidiaries leases office facilities in Bismarck, North
Dakota with lease terms expiring in 2014. Employers Mutual has entered into
various leases for branch and service office facilities with lease terms
expiring through 2021. All of these lease costs are included as expenses under
the pooling agreement. Included in the following table is the Company's current
30.0 percent aggregate participation percentage of all operating lease
obligations of the parties to the pooling agreement.
Payments due by period
Less than 1 - 3 4 - 5 More than
Total 1 year years years 5 years
Contractual obligations ($ in thousands)
Loss and settlement expense
reserves (1) $ 583,097 $ 230,396 $ 216,838 $ 79,182 $ 56,681
Long-term debt (2) 25,000 - - - 25,000
Interest expense on long-term
debt (3) 3,984 900 722 675 1,687
Real estate operating leases 7,602 1,328 2,454
1,811 2,009
Total $ 619,683 $ 232,624 $ 220,014 $ 81,668 $ 85,377
(1) The amounts presented are estimates of the dollar amounts and time periods in
which the Company expects to pay out its gross loss and settlement expense
reserves. These amounts are based on historical payment patterns and do not
represent actual contractual obligations. The actual payment amounts and the
related timing of those payments could differ significantly from these
estimates.
(2) Long-term debt reflects the surplus notes issued by the Company's property
and casualty insurance subsidiaries to Employer Mutual, which have no
maturity date. Excluded from long-term debt are pension and other
postretirement benefit obligations.
(3) Interest expense on long-term debt reflects the interest expense on the
surplus notes issued by the Company's property and casualty insurance
subsidiaries to Employers Mutual. The interest rate on the surplus notes is
subject to change every five years (rate was decreased to 1.35 percent
effective February 1, 2013, with the next review scheduled for
2018). Interest payments on the surplus notes are subject to prior approval
of the regulatory authorities of the issuing company's state of domicile. The
balance shown under the heading "More than 5 years" represents estimated
interest expense for years six through ten. Since the surplus notes have no
maturity date and the interest rate is subject to change every five years,
interest expense could be greater than the amounts shown.
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. Estimated guaranty fund assessments of $1,016,000 and
$1,039,000 have been accrued as of December 31, 2012 and 2011,
respectively. Premium tax offsets of $653,000 and $666,000, which are related to
prior guarantee fund payments and current assessments, have been accrued as of
December 31, 2012 and 2011, 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. Estimated second-injury fund assessments of $1,579,000 and
$1,873,000 have been accrued as of December 31, 2012 and 2011, 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.
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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
$165,000 at December 31, 2012. The Company has a contingent liability for the
aggregate guaranteed amount of the annuities of $239,000 at December 31, 2012
should the issuers of those annuities fail to perform. The probability of a
material loss due to failure of performance by the issuers of these annuities is
considered remote.
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 of 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.
Interest rate risk (inclusive of credit spreads) includes the price sensitivity
of a fixed maturity security to changes in interest rates, and the affect on the
Company's future earnings from short-term investments and maturing long-term
investments given a change in interest rates. The following table illustrates
the sensitivity of the Company's portfolio of fixed maturity securities
available-for-sale to hypothetical changes in market rates and prices.
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Estimated Hypothetical
fair value percentage
Estimated fair Hypothetical after increase
value at change in hypothetical (decrease) in
December 31, interest rate change in Stockholders'
($ in thousands) 2012 (bp=basis points) interest rate Equity
Fixed maturity securities:
U.S. treasury $ 4,985 200 bp decrease $ 5,296 0.05 %
100 bp decrease 5,137 0.02
100 bp increase 4,837 (0.02 )
200 bp increase 4,695 (0.05 )
U.S. government-sponsored agencies $ 162,443 200 bp decrease $ 168,552 0.99 %
100 bp decrease 165,963 0.57
100 bp increase 151,473 (1.78 )
200 bp increase 137,962 (3.97 )
Obligations of states and political subdivisions $ 370,962 200 bp decrease $ 404,117 5.37 %
100 bp decrease 387,334 2.65
100 bp increase 352,033 (3.07 )
200 bp increase 330,069 (6.63 )
Commercial mortgage-backed $ 80,349 200 bp decrease $ 83,873 0.57 %
100 bp decrease 82,078 0.28
100 bp increase 78,683 (0.27 )
200 bp increase 77,076 (0.53 )
Residential mortgage-backed $ 47,790 200 bp decrease $ 48,960 0.19 %
100 bp decrease 48,740 0.15
100 bp increase 45,921 (0.30 )
200 bp increase 43,390 (0.71 )
Other asset-backed $ 11,287 200 bp decrease $ 12,460 0.19 %
100 bp decrease 11,852 0.09
100 bp increase 10,760 (0.09 )
200 bp increase 10,270 (0.16 )
Corporate $ 321,979 200 bp decrease $ 355,244 5.39 %
100 bp decrease 338,120 2.62
100 bp increase 306,704 (2.47 )
200 bp increase 292,403 (4.79 )
Total fixed maturity securities $ 999,795 200 bp decrease $ 1,078,502 12.75 %
100 bp decrease 1,039,224 6.39
100 bp increase 950,411 (8.00 )
200 bp increase 895,865 (16.84 )
The Company monitors interest rate risk through an analysis of interest rate
simulations, and adjusts the average duration of its fixed maturity portfolio by
investing in either longer or shorter term instruments given the results of
interest rate simulations and judgments of cash flow needs. The effective
duration of the Company's fixed maturity portfolio at December 31, 2012 was 4.20
years.
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The valuation of the Company's marketable equity portfolio is subject to equity
price risk. In general, equities have more year-to-year price variability than
bonds. However, returns from equity securities have been consistently higher
over longer time frames. The Company invests in a diversified portfolio of
readily marketable equity securities. A hypothetical 10 percent decrease in the
S&P 500 index as of December 31, 2012 would result in a corresponding pre-tax
decrease in the fair value of the Company's equity portfolio of approximately
$13,143,000.
Fixed maturity securities held by the Company generally have an investment
quality rating of "A" or better by independent rating agencies. The following
table shows the composition of the Company's fixed maturity securities, by
rating, as of December 31, 2012.
Securities
available-for-sale
(at fair value)
($ in thousands) Amount Percent
Rating:
AAA $ 296,157 29.6 %
AA 375,960 37.6
A 291,043 29.1
BAA 30,423 3.1
BA 3,048 0.3
B 1,743 0.2
CAA 1,122 0.1
CA 299 -
Total fixed maturities $ 999,795 100.0 %
Ratings for preferred stocks and fixed maturity securities are assigned by
nationally recognized statistical rating organizations (referred to generically
as NRSROs, which includes such organizations as Moody's Investor's Services,
Inc., Standard and Poor, etc.). The NRSROs' rating processes seek to evaluate
the quality of a security by examining the factors that affect returns to
investors. NRSROs' ratings are based on quantitative and qualitative factors, as
well as the economic, social and political environment in which the issuing
entity operates. For further discussion of credit risk and related topics (i.e.,
"other-than-temporary" impairment losses, residential mortgage-backed
securities, unrealized losses in the investment portfolios, and non-investment
grade securities held by the Company) see the section entitled "Investment
Impairments and Considerations" within this Management's Discussion and Analysis
of Financial Condition and Results of Operations.
Municipal fixed maturity securities, including taxable, tax-exempt and
pre-refunded securities, totaled $370,962,000 as of December 31, 2012. Municipal
securities are well diversified between general obligation and revenue bonds, as
well as geographically. The Company's credit analysis of municipal securities is
predominantly based on the underlying credit quality of the obligor. Therefore,
although a portion of the Company's municipal securities are guaranteed by
financial guaranty insurers, reliance is placed on the underlying obligor to pay
all contractual cash flows. The ratings of insured municipal securities
generally reflect the rating of the underlying primary obligor. The average
quality of the municipal fixed maturity securities portfolio is Aa2/AA with over
99 percent of securities rated A3/A- or higher. Approximately $92,877,000 of the
Company's municipal securities have been pre-refunded, which means that funds
have been set aside in escrow to satisfy the future interest and principal
obligations of the securities.
Prepayment risk refers to changes in prepayment patterns that can shorten or
lengthen the expected timing of principal repayments and thus the average life
and the effective yield of a security. Such risk exists primarily within the
portfolio of mortgage-backed securities. Prepayment risk is monitored regularly
through the analysis of interest rate simulations. At December 31, 2012, the
effective duration of the mortgage-backed securities is 2.6 years with an
average life of 3.3 years and a yield to worst of 1.4 percent. At December 31,
2011, the effective duration of the mortgage-backed securities was 3.1 years,
with an average life of 3.6 years and a yield to worst of 3.6 percent.
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IMPACT OF INFLATION
Inflation has a widespread effect on the Company's results of operations,
primarily through increased losses and settlement expenses. The Company
considers inflation, including social inflation that reflects an increasingly
litigious society and increasing jury awards, when setting loss and settlement
expense reserve amounts. Premiums are also affected by inflation, although they
are often restricted or delayed by competition and the regulatory rate-setting
environment.
NEW ACCOUNTING PRONOUNCEMENTS
In February 2013, the FASB updated its guidance related to the Comprehensive
Income Topic 220 of the ASC. The objective of this update is to improve the
reporting of reclassifications out of accumulated other comprehensive
income. This updated guidance requires an entity to report the impact of the
reclassified amounts on the respective line items of the statement of income if
the amount is required to be reclassified in its entirety. For amounts that are
not reclassified in their entirety on the statement of income in the same
reporting period, cross-referencing to other existing disclosures that provide
additional detail about those amounts is required. This guidance is to be
applied prospectively to annual and interim reporting periods beginning after
December 15, 2012. Early adoption is permitted. The Company will adopt this
guidance during the first quarter of 2013. Adoption of this guidance will have
no impact on the consolidated financial condition or operating results of the
Company.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The information under the caption "Market Risk" in "Management's Discussion and
Analysis of Financial Condition and Results of Operations", which is included in
Part II, Item 7 of this Form 10-K, is incorporated herein by reference.
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