ITEM 1A. RISK FACTORS
Set forth below is a description of risk factors related to the Company’s business, provided to enable investors to assess, and be appropriately apprised of, certain risks and uncertainties the Company faces in conducting its business. An investor should carefully consider the risks described below and elsewhere in this Form 10-K which could materially and adversely affect the Company’s business, financial condition or results of operations. The risks and uncertainties discussed below are also applicable to forward-looking statements contained in this Form 10-K and in other reports filed by the Company with the Securities and Exchange Commission, and in management presentations delivered and press releases issued by the Company. Given these risks and uncertainties, investors are cautioned not to place undue reliance on forward-looking statements.
Risks Relating to the Company and Its Business
The Company’s business is highly cyclical and competitive, which may make it difficult for it to market its products effectively and profitably.
The property and casualty insurance industry is highly cyclical and competitive, and individual lines of business experience their own cycles within the overall insurance industry cycle. Premium rate levels are subject to many variables, including the availability of insurance coverage, which can vary according to the level of capital within the industry. Increases in industry capital have generally been accompanied by increased price competition. If the pool participants find it necessary to reduce premiums or limit premium increases due to these competitive pressures on pricing, the Company may experience a reduction in its profit margins and revenues and, therefore, lower profitability.
The pool participants compete with insurers that sell insurance policies through independent agents and/or directly to their customers. These competitors are not only national companies, but also insurers and independent agents that operate in a specific region or a single state. Some of these competitors have substantially greater financial and other resources than the pool participants, and may offer a broader range of products or offer competing products at lower prices. The Company’s financial condition and results of operations could be materially and adversely affected by a loss of business to its competitors.
The reinsurance business is also highly cyclical and competitive. Employers Mutual, in writing reinsurance business through its HORAD operation, competes in the global reinsurance market with numerous reinsurance companies, many of which have substantially greater financial resources. Competition for reinsurance business is based on many factors, including the perceived financial strength of the reinsurer, industry ratings, stability in products offered and licensing status. There is a segment of the market that favors large, highly-capitalized reinsurance companies who are able to provide “mega” line capacity for multiple lines of business. Employers Mutual faces the risk of ceding companies becoming less interested in diversity and spread of reinsurance risk in favor of having fewer, highly-capitalized reinsurance companies on their program. If Employers Mutual loses reinsurance business to its competitors, the Company’s financial condition and results of operations could be materially and adversely affected.
Similar to other industries, the insurance industry is undergoing rapid and significant technological and other change. Traditional insurance industry participants, technology companies, "InsurTech" start-up companies, the number of which has increased significantly in recent years, and others are focused on using technology and innovation to alter business models and cause other potentially disruptive changes in the insurance industry. If management does not anticipate these changes, keep pace with and adapt to technological and other changes impacting the insurance industry, it could harm the Company's ability to compete, decrease the value of the Company's products to insureds and agents, and materially and adversely affect the Company's business. Furthermore, innovation, technological change and changing customer preferences in the markets in which the Company operates also pose risks to the Company's business.
The frequency and severity of significant catastrophe and storm activity could adversely affect the Company’s business, financial condition or results of operations.
The Company's insurance operations expose the Company to claims arising out of catastrophic events. Common catastrophic events include tornadoes, wind and hail storms, hurricanes, earthquakes, fires, explosions and severe winter storms. If changing climate conditions result in an increase in the frequency or severity of weather-related losses, the Company could experience additional losses from catastrophic events and destructive weather patterns. High levels of catastrophe and storm losses could lead to changes in the reinsurance programs protecting the Company (including the reinsurance coverage provided by Employers Mutual to the Company’s property and casualty insurance subsidiaries and the reinsurance subsidiary). These changes could include increases in the amount of losses retained, increased pricing and decreased availability of catastrophe reinsurance protection. Examples of such changes include increases in the pool participants’ retention amounts on ceded contracts covering the pool business, and increases in the amount of losses retained by the property and casualty insurance subsidiaries and the reinsurance subsidiary under the inter-company reinsurance program. Future increases in the cost of reinsurance protection, and/or the amount of catastrophe and storm losses retained, could materially adversely affect the Company’s business, financial condition or results of operations.
The pool participants currently conduct business in all 50 states and the District of Columbia, with a large portion of business in the Midwest. The occurrence of catastrophes, or other conditions affecting losses in this region, could adversely affect the Company’s business, financial condition or results of operations.
In 2017, 69 percent of the pool participant’s direct premiums written were generated through ten Midwest branch offices, with 12 percent of the direct premiums written generated in Iowa. While the pool participants actively manage their exposure to catastrophes through their underwriting process and the purchase of third-party reinsurance, a single catastrophic occurrence, destructive weather pattern, changing climate conditions, general economic trend, terrorist attack, regulatory development or any other condition affecting the states in which the pool participants conduct substantial business could materially adversely affect the Company’s business, financial condition or results of operations. Moreover, the Company’s revenues and profitability are affected by the prevailing regulatory, economic, demographic, competitive and other conditions in these states. Changes in any of these conditions could make it more costly or more difficult for the pool participants to conduct their business. Adverse regulatory developments in these states could include reductions in the maximum rates permitted to be charged, restrictions on rate increases, or fundamental changes to the design or operation of the regulatory framework, and any of these could have a material adverse effect on the Company’s business, financial condition or results of operations.
The Company cannot predict the impact that changing climate conditions, including legal, regulatory, and social responses thereto, may have on the Company’s business, financial condition or results of operations.
Some scientists, environmentalists, and other experts believe that changing climate conditions have added to the unpredictability, frequency, and severity of weather-related losses. If climate conditions are changing and affecting weather patterns, the Company could experience additional losses from catastrophic events and destructive weather patterns. The Company cannot predict the impact that changing climate conditions, if any, will have on the Company’s business, financial condition or results of operations. It is also possible that legal, regulatory and social responses to climate change could have a material adverse effect on the Company’s business, financial condition or results of operations.
Losses related to a terrorist attack could have a material adverse impact on the Company’s business, financial condition or results of operations.
Terrorist attacks could cause significant losses from insurance claims related to the property and casualty insurance operations of the pool participants and the reinsurance operations of the Company’s reinsurance subsidiary, and have a material adverse impact on the Company’s business, financial condition or results of operations. TRIA requires that some coverage for terrorism losses be offered by primary property and casualty insurers, and provides federal assistance for recovery of a portion of claims incurred (effective through December 31, 2020). While the pool participants are protected by this federally funded terrorism reinsurance with respect to claims under most commercial insurance products, the pool participants are prohibited from adding terrorism exclusions to the commercial lines policies they write, and a substantial deductible must be met before TRIA provides coverage to the pool. The pool participants’ personal lines products do not provide terrorism coverage. The pool participants have underlying reinsurance coverage to partially cover the TRIA deductible, but the Company can offer no assurances that the threats or actual occurrence of future terrorist-like events in the United States and abroad, or military actions by the United States, will not have a material adverse effect on its business, financial condition or results of operations.
The Company’s results of operations could suffer if the pool participants were to forecast future losses inaccurately, experience unusually severe or frequent losses, inadequately price their insurance products, or fail to control expenses.
The Company’s property and casualty insurance subsidiaries participate in a pooling agreement under which they share the underwriting results of the property and casualty insurance business written by all the pool participants (excluding certain assumed reinsurance business). Because of the pooled business the Company is allocated, the insurance operations of the Company’s pool participants are integrated with the insurance operations of the Employers Mutual pool participants, and the Company’s results of operations depend upon the forecasts, pricing and underwriting results of the Employers Mutual pool participants. Although the pool is intended to produce a more uniform and stable underwriting result from year to year for the participants than they would experience separately by spreading the risk of losses among the participants, if any of the pool participants experience unusually severe or frequent losses or do not adequately price their insurance products, the Company’s business, financial condition or results of operations could suffer.
One of the distinguishing features of the property and casualty insurance industry is that its products are priced before the costs are known, as premium rates are generally determined before losses are reported. Accordingly, the pool participants must establish premium rates from forecasts of the ultimate costs they expect to incur from risks underwritten during the policy period, and premiums may not be adequate to cover the ultimate losses incurred. Further, the pool participants must establish reserves for losses and settlement expenses based upon estimates involving actuarial and statistical projections of expected ultimate liability at a given time, and it is possible that the ultimate liability will exceed these estimates because of the future development of known losses, the existence of losses that have occurred but are currently unreported, or larger than expected settlements on pending and unreported claims. Prior to the end of each quarter, Employers Mutual's actuaries review the adequacy of the pool's previous quarter's reserves for the various lines of business underwritten and these reviews have in the past, and may in the future, indicate that additional reserves are necessary to adequately cover anticipated losses and settlement expenses. The process of estimating reserves is inherently judgmental and can be influenced by factors that are subject to variation. If the premium rates or reserves established are not sufficient, the Company’s business, financial condition and/or results of operations may be adversely impacted.
The Company's results are also subject to the expenses incurred by its subsidiaries and the other pool participants. One of the metrics used to evaluate property and casualty insurance companies is the underwriting expense ratio. This ratio weighs earned premiums against expenses. Underwriting and administrative expenses should be kept within an acceptable range. This range must be determined and managed with both a short term and long term outlook with regards to premium levels, the underwriting cycle, industry benchmarks, internal trends, and the annual corporate budgeting process. Pursuant to the terms of the pooling agreement, underwriting and administrative expenses are prorated between the participants in the pool. Thus, if the Company's subsidiaries or other pool participants fail to control underwriting or administrative expenses, the Company's financial condition or results of operation could suffer.
An increase in asbestos and environmental claims could have a material adverse effect on the Company's financial condition or results of operations.
The Company has exposure to asbestos and environmental claims arising primarily from the other liability line of business written by the parties to the pooling agreement, as well as the pro rata and excess of loss business assumed by the reinsurance subsidiary. These exposures are closely monitored by management and reserves have been established to cover estimated ultimate losses. Estimating loss and settlement expense reserves for asbestos and environmental claims is very difficult due to the many uncertainties surrounding these types of claims, such as whether coverage exists, the definition of an occurrence, determination of ultimate damages and the assignment of damages to the responsible parties. These uncertainties are compounded by the fact that claims typically emerge long after a policy has expired. It is possible that the ultimate liability for these exposures may increase significantly as a result of the settlement of lawsuits or the receipt of additional claims, which could have a material adverse effect on the Company's financial condition and/or results of operations.
The Company’s investment portfolio is subject to economic loss, principally from changes in the market value of financial instruments.
The Company had fixed maturity investments with a fair value of $1.3 billion at December 31, 2017 that are subject to:
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market risk, which is the risk that the Company’s invested assets will decrease in value due to:
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an increase in interest rates or a change in the prevailing market yields on its investments,
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an unfavorable change in the liquidity of an investment, or
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an unfavorable change in the financial prospects, or a downgrade in the credit rating, of the issuer of an investment;
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reinvestment risk, which is the risk that interest rates will decline and funds reinvested will earn less investment income than previously earned; and
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liquidity risk, which is the risk that the Company may have to sell assets at an undesirable time and/or price to provide cash for the payment of claims.
The Company maintains a well diversified portfolio of fixed maturity securities in an attempt to manage market, reinvestment and liquidity risk. The Company primarily pursues a buy and hold strategy for fixed maturity investments. Fixed maturity securities are purchased as new funds become available to the portfolio. This strategy has a laddering effect on portfolio maturities that mitigates some of the effects of adverse interest rate movements.
The Company’s fixed maturity investment portfolio includes mortgage-backed securities. As of December 31, 2017, mortgage-backed securities constituted approximately 16.3 percent of the fixed maturity portfolio. As with other fixed maturity investments, the fair value of these securities fluctuates depending on market and other general economic conditions and the interest rate environment. Changes in interest rates can expose the Company to prepayment risks on these investments. In periods of declining interest rates, mortgage prepayments generally increase and mortgage-backed securities are paid more quickly, requiring the Company to reinvest the proceeds at the then current market rates.
The Company’s common stock equity portfolio, with a fair value of $206.4 million as of December 31, 2017, is subject to economic loss from a decline in market prices. The Company invests in publicly traded companies listed in the United States with large market capitalizations. An adverse development in the stock market, or one or more securities that the Company invests in, could adversely affect its capital position. The Company is currently invested in a limited partnership that is designed to help protect the Company from significant monthly downside price volatility in the equity markets. However, this type of protection may be discontinued in the future depending on market conditions and/or the cost of the protection.
The success of any investment activity is affected by general economic conditions, which may adversely affect the markets for fixed maturity and equity securities. Unexpected volatility or illiquidity in the markets in which the Company holds securities could reduce its liquidity and stockholders’ equity. To mitigate these risks, the Company’s insurance and reinsurance subsidiaries are able to borrow funds on a short-term basis from Employers Mutual and its subsidiaries and affiliate under an Inter-Company Loan Agreement.
The Company relies on Employer Mutual’s information technology and telecommunication systems, and the disruption or failure of these systems, or the compromise of the security of the systems that results in the misuse of confidential information, could materially and adversely affect its business.
The Company’s business is highly dependent upon the successful and uninterrupted functioning of the information technology and telecommunications systems of Employers Mutual and its third party vendors. The Company relies on the capacity, reliability and security of these systems to process new and renewal business, provide customer service, process and pay claims, and facilitate collections and cancellations. These systems also enable the performance of actuarial and other modeling functions necessary for underwriting and rate development and establishing and evaluating reserves. Despite security measures in place, the information technology systems could be vulnerable to computer malware or viruses, unauthorized access, or other cyber attacks that could disrupt the systems. The failure or disruption of these systems could interrupt the Company’s operations and result in financial loss through remediation costs, reduced ability to underwrite and process new and renewal business, pay claims in a timely manner and provide customer service.
A security breach of information technology systems that results in the misuse or misappropriation of confidential information could expose Employers Mutual to litigation or regulatory actions, or damage Employers Mutual’s reputation. Any legal or other expenses resulting from the misuse of confidential information would be shared by all users of the systems, including the Company and its subsidiaries, and such losses could be significant.
Although Employers Mutual maintains insurance on its real property and other physical assets, this insurance will not compensate Employers Mutual for losses that may occur due to disruptions in service as a result of a computer, data processing or telecommunication systems failure unrelated to covered property damage. Also, this insurance may not necessarily compensate Employers Mutual for all losses resulting from covered events. Employers Mutual maintains insurance coverage for network business interruption, but it retains the risks from disruptions in computer processing and telecommunications services above the limits of such coverage. Employers Mutual has implemented a variety of controls to mitigate these risks including, but not limited to, off-site back-up and redundant processing capabilities, access restrictions to confidential customer data, and documented plans for resuming operations upon the occurrence of an event. A portion of any losses resulting from the failure or disruption of Employers Mutual’s information technology and telecommunication systems would be shared by all users of the systems, including the Company and its subsidiaries, and such losses could be significant.
The failure of the pool participants to maintain their current financial strength rating could materially and adversely affect the Company’s business and competitive position.
The pool participants, including the Company’s property and casualty insurance subsidiaries, are currently rated “A” (Excellent) by A.M. Best, an industry-accepted source of property and casualty insurance company financial strength ratings. A.M. Best ratings are specifically designed to provide an independent opinion of an insurance company’s financial health and its ability to meet ongoing obligations to policyholders. These ratings are directed toward the protection of policyholders, not investors. If the ratings of the pool participants were to be downgraded (particularly below "A-") by A.M. Best, it would adversely affect the Company’s competitive position and make it more difficult for it to market its products, and retain its existing agents and policyholders. A downgrade of Employers Mutual's rating below "A-" could make it ineligible to assume certain reinsurance business, which could lead to a reduction in the amount of business ceded to the Company's reinsurance subsidiary under the quota share agreement. Thus, a downgrade in the pool participants’ (including Employers Mutual’s) A.M. Best ratings below "A-" would likely result in a material reduction in the amount of the Company’s business.
The profitability of the Company’s reinsurance subsidiary is dependent upon the experience of Employers Mutual, and changes to this relationship may adversely affect the reinsurance subsidiary’s operations.
The Company’s reinsurance subsidiary operates under a quota share reinsurance agreement with Employers Mutual, which generated 22 percent of the Company’s net premiums earned in 2017. Under the quota share reinsurance agreement, the reinsurance subsidiary assumes the voluntary reinsurance business written directly by Employers Mutual (subject to certain limited exceptions). The reinsurance subsidiary also has in place an inter-company reinsurance program with Employers Mutual. The reinsurance subsidiary primarily relies on these agreements and on Employers Mutual for its business. If Employers Mutual terminates or otherwise seeks to modify these agreements, the reinsurance subsidiary may not be able to enter into similar arrangements with other companies and may be adversely affected.
Through the quota share reinsurance agreement, the reinsurance subsidiary assumes the voluntary reinsurance business written directly by Employers Mutual with unaffiliated insurance companies, and the reinsurance business assumed by Employers Mutual from MRB, a voluntary underwriting association of property and casualty insurers in which Employers Mutual participates. If Employers Mutual or the other participants of MRB discontinue or reduce the assumption of property and casualty risks, the reinsurance subsidiary could be adversely affected. In connection with the risks assumed from MRB, officers of the reinsurance subsidiary and Employers Mutual have reviewed the relevant underwriting policies and procedures, however, no officer of the reinsurance subsidiary directly reviews such risks assumed at the time of underwriting. If Employers Mutual or MRB are unable to sell reinsurance at adequate premium rates, or were to have poor underwriting experience, the reinsurance subsidiary could be adversely affected. In addition, since MRB is structured on a joint liability basis, Employers Mutual, and therefore the Company’s reinsurance subsidiary, would be obligated with respect to the proportionate share of risks assumed by the other participants in the event they were unable to perform. The failure of the other MRB participants to perform could have a material adverse effect on the Company’s financial condition or results of operations.
Changes in key assumptions or a deterioration in the debt and equity markets could lead to an increase in Employers Mutual’s employee benefit plans' costs and a decline in the funded status, which could have a material adverse effect on the Company’s financial condition and/or results of operations.
Employers Mutual's employee benefit plans' costs and funded status reflect the use of key assumptions regarding the discount rate, the expected long-term rate of return on plan assets, and the rate of future compensation increases (pension plans only). Changes in these assumptions could result in a significant decrease in the plans’ funded status and increase the future net periodic costs associated with these plans. In addition, large declines in the fair value of the assets held in the plans could result in a significant decrease in the plans’ funded status and increase the future net periodic costs associated with these plans. A decrease to the plans' funded status could require Employers Mutual to make significant contributions to its employee benefit plans to maintain adequate funding levels, and the Company would be responsible for its share of these contributions under the pooling agreement. The occurrence of these events could have a material adverse effect on the Company’s financial condition and/or results of operations.
The Company may not be successful in reducing its risks and increasing its underwriting capacity through reinsurance arrangements, which could adversely affect its business, financial condition or results of operations.
In order to reduce underwriting risk and increase underwriting capacity, the pool participants transfer portions of the pool’s insurance risk to other insurers through reinsurance contracts. The availability, cost and structure of reinsurance protection is subject to changing market conditions that are outside of the pool participants’ control. In order for these contracts to qualify for reinsurance accounting and thereby provide the additional underwriting capacity that the pool participants desire, the reinsurer generally must assume significant risk and have a reasonable possibility of a significant loss.
The reinsurance subsidiary assumes and cedes some selected reinsurance business through the quota share agreement in connection with “fronting” activities initiated by Employers Mutual. Under these arrangements, an agreed upon percentage of the selected assumed business is ceded to other reinsurer(s) on a pro rata basis. In addition, in 2016 the reinsurance subsidiary began purchasing additional reinsurance protection from external parties.
Although the reinsurers are liable to the extent they assume risk, the Company’s insurance subsidiaries remain ultimately liable on all risks reinsured. As a result, ceded reinsurance arrangements do not limit the ultimate obligation to pay claims. The Company’s insurance subsidiaries are subject to the credit risks of their reinsurers. They are also subject to the risk that their reinsurers may dispute obligations to pay their claims. As a result, the Company’s insurance subsidiaries may not recover on claims made against their reinsurers in a timely manner, if at all, which could have a material adverse effect on the Company’s business, financial condition or results of operations.
The Company is subject to comprehensive regulation that may restrict its ability to react to market or industry changes and earn profits.
The Company is subject to comprehensive regulation and supervision by the insurance departments in the states where its subsidiaries are domiciled and where its subsidiaries and the other pool participants sell insurance products, issue policies and handle claims. Certain regulatory restrictions and prior approval requirements may affect the pool participants’ ability to operate, compete, innovate or obtain necessary rate adjustments in a timely manner, and may also increase their costs and reduce profitability.
Supervision and regulation by insurance departments extend, among other things, to:
Required Licensing. The pool participants operate under licenses issued by various state insurance departments. These licenses govern, among other things, the types of insurance coverages, agency and claims services, and products that the pool participants may offer consumers in the states in which they operate. The pool participants must apply for and obtain appropriate licenses before they can implement any plan to expand into a new state or offer a new line of insurance or other new products that require separate licensing. If a regulatory authority denies or delays granting a new license, the pool participants’ ability to enter new markets quickly or offer new products they believe will be profitable can be substantially impaired.
Regulation of Premium Rates and Approval of Policy Forms. The insurance laws of most states in which the pool participants operate require insurance companies to file premium rate schedules and insurance policy forms for review and approval. State insurance departments have broad discretion in judging whether the pool participants’ rates are adequate, not excessive and not unfairly discriminatory. The speed at which the pool participants can change their rates in response to competition or increased costs depends, in part, on the method by which the applicable state’s rating laws are administered. Generally, state insurance departments have the authority to disapprove the pool participants’ requested rates. Thus, if the pool participants begin using new rates before they are approved, as permitted in some states, they may be required to issue premium refunds or credits to their policyholders if the new rates are ultimately deemed excessive or unfair, and are disapproved by the applicable state department. In addition, in some states, there has been pressure in past years to reduce premium rates for automobile and other personal insurance, or to limit how often an insurer may request increases for such rates. In states where such pressure is applied, the pool participants’ ability to respond to market developments or increased costs can be adversely affected.
Restrictions on Cancellation, Non-Renewal or Withdrawal. Many states have laws and regulations that limit an insurer’s ability to exit a market. Some states prohibit an insurer from withdrawing from one or more lines of business in the state, except pursuant to a plan approved by the state insurance department. A state insurance department may disapprove a plan that may lead, under its analyses, to market disruption. These laws and regulations could limit the pool participants’ ability to exit unprofitable markets or discontinue unprofitable products in the future.
Investment Restrictions. The Company’s subsidiaries are subject to state laws and regulations that require diversification of their investment portfolios, and that limit the amount of investments in certain categories. Failure to comply with these laws and regulations would cause nonconforming investments to be treated as non-admitted assets for purposes of measuring statutory surplus and, in some instances, would require divestiture.
Other Regulations. The Company must also comply with laws and regulations involving, among other things:
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disclosure, and in some cases prior approval, of transactions between members of an insurance holding company system;
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acquisition or disposition of an insurance company, or of any company controlling an insurance company;
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involuntary assignments of high-risk policies, participation in reinsurance facilities and underwriting associations, and assessments and other governmental charges;
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use of non-public consumer information and related privacy issues; and
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use of credit history in underwriting and rating.
These laws and regulations could adversely affect the Company’s profitability.
The Company cannot provide any assurance that states will not make existing insurance laws and regulations more restrictive in the future, or enact new restrictive laws.
From time to time, the United States Congress and certain federal agencies investigate the current condition of the insurance industry to determine whether federal regulation is necessary. The Company closely monitors these activities through its membership in various organizations. In particular, our trade organizations are working to monitor and shape the activities of the Federal Insurance Office as it continues to evolve and exercise its authority, to promote accident avoidance and accident prevention technology, and to pass appropriate tax reform legislation. The Company is unable to predict whether, or to what extent, new laws and regulations that could affect its business will be adopted in the future, the timing of any such adoption and what effects, if any, they may have on its business, financial condition or results of operations.
The Company's assumed reinsurance business from international sources could decline from the European Union's Solvency II, Brexit or other international regulatory changes.
Solvency II came into effect in the European Union (EU) on January 1, 2016. Solvency II requires that in order for insurers and reinsurers outside of the EU to conduct business in the European market, their country of domicile regulatory system must be deemed equivalent. The US regulatory system was not deemed equivalent, so trade negotiations began.
On January 13, 2017, the United States and the European Union announced they had completed negotiation of a "Bilateral Agreement between the European Union and the United States of America on Prudential Measures Regarding Insurance and Reinsurance" (the "Covered Agreement"). The United States signed the Covered Agreement on September 22, 2017. The European Union has yet to formally approve the Covered Agreement, but it is being provisionally applied in both the US and the EU.
The Covered Agreement eliminates collateral and local presence requirements for US and EU reinsurers operating on a cross-border basis. Management is closely monitoring provisional application of this agreement in the EU. Different interpretations of the Covered Agreement by EU countries may have unknown consequences on the reinsurance subsidiary's ability to write assumed reinsurance business in those countries. Further complicating application of the Covered Agreement in the EU will be the prospective withdrawal of the United Kingdom from the EU on March 30, 2019. The reinsurance subsidiary writes approximately $10 million of assumed reinsurance business in the EU. The Company is unable to predict to what extent application of the Covered Agreement, Brexit or other international regulatory changes will affect the Company's financial condition or results of operations.
Changes in U.S. federal tax laws could adversely affect the Company's financial condition and results of operations.
The Company is subject to U.S. federal tax laws, which may be changed in ways that could adversely impact the Company. Potential changes in U.S. tax laws may increase or decrease the Company's income tax expense recognized in results of operations. The Company is unable to predict whether, and to what extent, changes to U.S. tax laws would affect the Company's financial condition or results of operations.
On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (TCJA) was signed into law. Among other provisions, the TCJA lowered the federal corporate tax rate from 35 percent to 21 percent effective January 1, 2018. The Company recorded a one-time deferred income tax benefit in connection with the adoption of the TCJA in the fourth quarter.
The Company made reasonable estimates of the effects the TCJA had on deferred income tax assets and liabilities. For items where the Company could not make a reasonable estimate, primarily loss reserve discounting, the Company is using existing accounting guidance and the provisions of the tax laws that were in place prior to the enactment until further guidance is released by the Internal Revenue Service (IRS) with updated discount factors. As regulations and guidance evolve with respect to the TCJA, and as the Company gathers more information and performs more analysis, additional tax effects or adjustments may be needed in subsequent periods that could affect the Company's financial condition or results of operations.
The Company’s business may not continue to grow and may be adversely affected if it cannot retain existing, and attract new, independent agents, or if insurance consumers increase their use of other insurance delivery systems.
The continued growth of the Company’s business will depend upon the pool participants’ ability to retain existing, and attract new, independent agents. The pool participants’ agency force is one of the most important components of their competitive position. To the extent that the pool participants’ existing agents cannot maintain current levels of production, the Company’s business, financial condition and results of operations will suffer. Moreover, if independent agencies find it easier to do business with the pool participants’ competitors, it could be difficult for them to retain their existing business or attract new business. While the pool participants believe they maintain good relationships with their independent agents, they cannot be certain that these independent agents will continue to sell their products to the consumers they represent. Some of the factors that could adversely affect the ability to retain existing, and attract new, independent agents include:
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competition in the insurance industry to attract independent agents;
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the pool participants’ requirement that independent agents adhere to disciplined underwriting standards; and
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the pool participants’ ability to pay competitive and attractive commissions, profit share bonuses and other incentives to independent agents as compensation for selling their products.
While the pool participants sell substantially all their insurance through their network of independent agents, many of their competitors sell insurance through a variety of other delivery methods, including captive agencies, the internet and direct sales. To the extent that businesses and individuals represented by the pool participants’ independent agents change their delivery system preferences, the Company’s business, financial condition or results of operations may be adversely affected.
The Company's continued success as an insurance company is substantially dependent on the reputation of EMC Insurance Companies.
Management believes that one of the reasons independent agents and insureds prefer to purchase insurance from the pool participants, team members choose Employers Mutual as a place of employment, and vendors choose to do business with Employers Mutual is the reputation EMC Insurance Companies has built over 106 years. To be successful in the future, management must continue to preserve, grow, and leverage the value of EMC Insurance Companies reputation. Reputational value is based in large part on perceptions. While reputations may take decades to build, any negative incidents can quickly erode trust and confidence, particularly if they result in adverse mainstream and social media publicity, governmental investigations, or litigation. Those types of incidents could have an adverse impact on perceptions and lead to tangible adverse effects on the Company's business, including loss of trust, loss of premium, loss of accounts, loss of agency contracts, or team member retention and recruiting difficulties.
The Company’s operations are integrated with those of Employers Mutual, the parent company, and potential and actual conflicts exist between the best interests of the Company’s stockholders and the best interests of the policyholders of Employers Mutual.
Employers Mutual currently owns shares of the Company’s common stock entitling it to cast approximately 55 percent of the aggregate votes eligible to be cast by the Company’s stockholders at any meeting of stockholders. These holdings enable Employers Mutual to control the election of the Company’s board of directors. In addition, one of the six members of the Company’s board of directors is also a member of the board of directors of Employers Mutual. This director has a fiduciary duty to both the Company’s stockholders and to the policyholders of Employers Mutual. The Company’s executive officers hold the same positions with both Employers Mutual and the Company, and therefore also have a fiduciary duty to both the stockholders of the Company and to the policyholders of Employers Mutual. Certain potential and actual conflicts of interest arise from the Company’s relationship with Employers Mutual and these competing fiduciary duties. Among these conflicts of interest are:
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the Company and Employers Mutual must establish the relative participation interests of all the participating insurers in the pooling arrangement, along with other terms of the pooling agreement;
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the Company and Employers Mutual must establish the terms of the quota share agreement and the inter-company reinsurance programs between Employers Mutual and the Company’s reinsurance subsidiary and property and casualty insurance subsidiaries;
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the Company and Employers Mutual must establish the terms (including the interest rate, which is reviewed every five years) of the surplus notes issued by the Company’s property and casualty insurance subsidiaries to Employers Mutual;
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the Company and Employers Mutual must establish the terms (including the interest rate) of any inter-company loans between Employers Mutual and any of the Company’s insurance company subsidiaries;
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the Company and Employers Mutual must make judgments about the allocation of expenses to the Company and its subsidiaries and to Employers Mutual’s subsidiaries that do not participate in the pooling agreement; and
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the Company may enter into other transactions and contractual relationships with Employers Mutual and its subsidiaries or affiliates.
As a consequence, the Company and Employers Mutual have each established an Inter-Company Committee, with the Company’s Inter-Company Committee consisting of three of the Company’s independent directors who are not directors of Employers Mutual and Employers Mutual’s Inter-Company Committee consisting of three directors of Employers Mutual who are not members of the Company’s board of directors. Any new material agreement or transaction between Employers Mutual and the Company, as well as any proposed material change to an existing material agreement between Employers Mutual and the Company, must receive the approval of both Inter-Company Committees. This approval is granted only if the members of the Company’s Inter-Company Committee unanimously conclude that the new agreement or transaction, or proposed material change to an existing material agreement, is fair and reasonable to the Company and its stockholders, and the members of Employers Mutual’s Inter-Company Committee unanimously conclude that the new agreement or transaction, or proposed change to an existing material agreement, is fair and reasonable to Employers Mutual and its policyholders.
The Company relies on Employers Mutual to provide employees, facilities and information technology systems to conduct its operations.
The Company does not employ any staff to conduct its operations, nor does the Company own or, with one exception, lease any facilities or information technology systems necessary for its operations. As a result, the Company is totally dependent on Employers Mutual’s employees, facilities and information technology systems to conduct its business. There are no agreements in place that obligate Employers Mutual to provide the Company with access to its employees, facilities or information technology systems. In addition, the Company does not have any employment agreements with its executive officers, all of whom are employed by Employers Mutual. These arrangements make it unlikely that anyone could acquire control of the Company or replace its management unless Employers Mutual was in favor of such action. Any of these arrangements could diminish the value of the Company’s common stock.
The Company depends on Employers Mutual's ability to attract and retain qualified executive officers, experienced underwriting talent, and other skilled employees who are knowledgeable about insurance. Providing suitable succession planning for such positions is also important. If Employers Mutual cannot attract or retain top-performing executive officers, underwriters, and other employees, if the quality of their performance decreases, or if Employers Mutual fails to implement succession plans for its key staff, Employers Mutual and its subsidiaries and affiliate may be unable to maintain their current competitive position in the markets in which they operate and be unable to expand operations into new markets.
The insolvency of Employers Mutual could result in additional liabilities for the Company’s insurance subsidiaries participating in the pooling agreement.
The pooling agreement requires each pool participant to assume its pro rata share (based on its participation interest in the pool) of the liabilities of any pool participant that becomes insolvent or is otherwise subject to liquidation or receivership proceedings. Under this provision, the Company’s pool participants could become financially responsible for their pro rata share of the liabilities of Employers Mutual in the event of an insolvency, liquidation or receivership proceeding.
The Company is dependent on dividends from its subsidiaries for the payment of its operating expenses and dividends to stockholders; however, its subsidiaries may be unable to pay dividends to the Company.
As a holding company, the Company relies primarily on dividends from its subsidiaries as a source of funds to meet its corporate obligations and pay dividends to its stockholders. Payment of dividends by the Company’s subsidiaries is subject to regulatory restrictions, and depends on the surplus position of its subsidiaries. The maximum amount of dividends that the Company’s subsidiaries can pay it in 2018 without prior regulatory approval is approximately $54.2 million. In addition, state insurance regulators have broad discretion to limit the payment of dividends by the Company’s subsidiaries in the future. The ability of its subsidiaries to pay dividends to it may be further constrained by business and regulatory considerations, such as the impact of dividends on surplus, competitive position and the amount of premiums that can be written.
New pricing, claims, coverage issues, class action litigation, and technology innovations are continually emerging in the property and casualty insurance industry, and these new issues could adversely impact the Company’s revenues or its methods of doing business.
As property and casualty insurance industry practices, and regulatory, judicial and consumer conditions change, unexpected and unintended issues related to claims, coverages and business practices may emerge. These issues could have an adverse effect on the Company’s business by changing the way the pool participants price their products, by extending coverages beyond their underwriting intent, or by increasing the size of claims. The effect of unforeseen emerging issues could negatively affect the Company’s results of operations or its methods of doing business. In addition, the advent of autonomous vehicles and usage-based insurance could materially alter the way that automobile insurance is marketed, priced, and underwritten.
The Company's results of operations or financial condition could be adversely impacted if risks are not properly underwritten and priced.
The Company's financial condition, cash flows, and results of operations depend on the pool participants' ability to properly underwrite risks and accurately set rates for risks across several lines of business. This requires adherence to disciplined underwriting standards and pricing methodologies for the pool participants' products. To do this, the pool participants must collect, analyze, and use data to make decisions and take appropriate action based upon available information. This data must be sufficient, accurate, and accessible. If not, loss cost trends may be overestimated or underestimated, or these trends may unexpectedly change, leading to lost business from pricing risks above competitors or from charging rates too low to maintain profitability. Inflation trends, especially outside of historical norms, may make it more difficult to determine adequate pricing. If rates are not accurate, the Company may not generate enough premiums to offset losses and expenses, or may not be competitive in the marketplace.
Changes to existing accounting standards may adversely affect the Company’s consolidated financial statements.
The Company is required to prepare its consolidated financial statements in accordance with GAAP, as promulgated by the Financial Accounting Standards Board ("FASB"), subject to accounting rules and interpretations of the Securities and Exchange Commission. Accordingly, the Company is required to adopt new or revised accounting standards issued by these authoritative bodies from time to time. It is possible that changes to the Company’s accounting policies resulting from the adoption of future changes in GAAP, including an updated financial instruments standard effective January 1, 2018, and a new credit losses accounting standard effective January 1, 2020, could have a material adverse effect on the Company’s reported financial condition and/or results of operations. The Company's significant accounting policies are described in note 1 of Notes to Consolidated Financial Statements under Part II, Item 8 of this Form 10-K.
Risks Relating to the Company’s Common Stock
Employers Mutual has the ability to determine the outcome of all matters submitted to the Company’s stockholders for approval. The price of the Company’s common stock may be adversely affected because of Employers Mutual’s majority ownership of the Company’s common stock.
The Company’s common stock has one vote per share and voting control of the Company is currently vested in Employers Mutual, which owns approximately 55 percent of the Company’s outstanding common stock. Employers Mutual must retain a minimum 50.1 percent ownership of the Company’s outstanding common stock at all times in order for the pool participants to have their A.M. Best financial strength ratings determined on a “group” basis. Accordingly, Employers Mutual will retain the ability to control:
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the election of the Company’s entire board of directors, which in turn determines its management and policies;
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the outcome of any corporate transaction or other matter submitted to the Company’s stockholders for approval, including mergers or other transactions providing for a change of control; and
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the amendment of the Company’s organizational documents.
The interests of Employers Mutual may conflict with the interests of the Company’s other stockholders and may have a negative effect on the price of the Company’s common stock.
Employers Mutual’s ownership of the Company’s common stock and provisions of certain state laws make it unlikely anyone could acquire control of the Company or replace or remove its management unless Employers Mutual were in favor of such action, which could diminish the value of the Company’s common stock.
Employers Mutual’s ownership of the Company’s common stock and the laws and regulations of Iowa and North Dakota could delay, or prevent, the removal of members of its board of directors, and could make a merger, tender offer or proxy contest involving the Company more difficult to complete, even if such events were beneficial to the interest of its stockholders other than Employers Mutual. The insurance laws of the states in which the Company’ subsidiaries are domiciled prohibit any person from acquiring control of it, and thus indirect control of its subsidiaries, without the prior approval of each such state insurance department. Generally, these laws presume that control exists where any person, directly or indirectly, owns, controls, holds the power to vote, or holds proxies representing 10 percent or more of the Company’s outstanding common stock. Even persons who do not acquire beneficial ownership of 10 percent or more of the outstanding shares of the Company’s common stock may be deemed to have acquired such control, if the relevant insurance department determines that such control exists in fact. Therefore, any person seeking to acquire a controlling interest in the Company would face regulatory obstacles, which could delay, deter or prevent an acquisition that stockholders might consider to be in their best interests. Moreover, the Iowa Business Corporation Act, which governs the Company’s corporate activities, contains certain provisions that prohibit certain business combination transactions under certain circumstances. These factors could discourage a third party from attempting to acquire control of the Company and thus could have a negative impact on the value of the Company's common stock.
Although the Company has consistently paid cash dividends in the past, it may not be able to pay cash dividends in the future.
The Company has paid cash dividends to its stockholders on a consistent basis since 1982, following the initial public offering of its common stock. However, future cash dividends will depend upon various factors, including the ability of the Company’s subsidiaries to make distributions to it, which may be restricted by financial or regulatory constraints. Also, there can be no assurance that the Company will continue to pay dividends even if the necessary financial and regulatory conditions are met and if sufficient cash is available for distribution.
The Company may be adversely affected by foreign currency fluctuations.
The Company's reporting currency is the U.S. dollar. A portion of the Company's assumed reinsurance business is written in currencies other than the U.S. dollar. The Company may, from time to time, experience losses resulting from fluctuations in the values of foreign currencies, which could adversely affect the Company's financial condition and results of operations.
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
None.
The Company does not own any real property; however, one of the property and casualty insurance subsidiaries, Dakota Fire, leases from EMC National Life Company (an affiliate of Employers Mutual) office space in which the Bismarck, North Dakota branch office is located. The Company’s home office, which also serves as the home office of Employers Mutual, is located in four office buildings in Des Moines, Iowa, all of which are owned by Employers Mutual. Employers Mutual also owns office buildings in which the Milwaukee and Lansing branch offices operate, and leases office space in 16 other locations where other branch offices and service centers are located.
The Company’s subsidiaries that do not participate in the pooling agreement (EMC Reinsurance Company and EMC Underwriters, LLC), as well as subsidiaries of Employers Mutual that do not participate in the pooling agreement, are allocated rent expense based on the square footage occupied by the respective operations. The remaining rent expense is charged to the pool and is allocated among the pool participants based on their respective participation interests.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
The Company and Employers Mutual and its other subsidiaries are parties to numerous lawsuits arising in the normal course of the insurance business. The Company believes that the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations. The companies involved have established reserves which are believed adequate to cover any potential liabilities arising out of all such pending or threatened proceedings.
ITEM 4.
ITEM 4.
MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The Company’s common stock trades on the NASDAQ Global Select Market tier of The NASDAQ Stock Market, Inc. under the symbol EMCI. The following table shows the high and low sales prices, as reported by NASDAQ, and the dividends paid for each quarter within the two most recent years.
On February 20, 2018, there were 638 registered holders of the Company’s common stock.
There are certain regulatory restrictions relating to the payment of dividends by the Company’s insurance subsidiaries (see note 6 of Notes to Consolidated Financial Statements under Part II, Item 8 of this Form 10-K). It is the present intention of the Company’s Board of Directors to declare quarterly cash dividends, but the amount and timing thereof, if any, is determined by the Board of Directors at its discretion.
The Company maintains an Amended and Restated Dividend Reinvestment and Common Stock Purchase Plan. More information about the plan can be obtained by calling American Stock Transfer & Trust Company, LLC, the Company’s stock transfer agent and plan administrator. Additional information regarding the plan is contained in note 13 of Notes to Consolidated Financial Statements under Part II, Item 8 of this Form 10-K. Employers Mutual did not participate in the dividend reinvestment plan during 2017, 2016 or 2015.
The following graph compares the cumulative total stockholder return on the Company’s common stock to the NASDAQ Composite Index and a peer group consisting of publicly traded companies in SIC Code 6330-6339, Fire, Marine & Casualty Insurance, as provided by Research Data Group. The total stockholder return assumes $100.00 invested at the beginning of the period in the Company’s common stock, the NASDAQ Composite Index and the Peer Group Index. It also assumes reinvestment of all dividends for the periods presented.
The following table sets forth information regarding purchases of equity securities by the Company and affiliated purchasers for the three months ended December 31, 2017:
1 On November 3, 2011, the Company’s Board of Directors authorized a $15.0 million stock repurchase program. This program does not have an expiration date. A total of $14.6 million remains available in this plan for the purchase of additional shares.
2 On May 12, 2005, the Company announced that its parent company, Employers Mutual, had initiated a $15.0 million stock purchase program under which Employers Mutual may purchase shares of the Company’s common stock in the open market. This purchase program does not have an expiration date; however, this program has been dormant while the Company’s repurchase programs have been in effect. A total of $4.5 million remains in this program.
3 An account Employers Mutual maintains to hold previously granted restricted stock awards until they vest will occasionally contain excess shares of the Company's common stock stemming from forfeitures and surrenders. The Company will periodically repurchase the excess shares from this account. The Company is unable to determine the amount of stock that may be repurchased under this arrangement.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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.
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:
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catastrophic events and the occurrence of significant severe weather conditions;
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the adequacy of loss and settlement expense reserves;
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state and federal legislation and regulations;
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changes in the U.S. federal corporate tax law;
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changes in the property and casualty insurance industry, interest rates or the performance of financial markets and the general economy;
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rating agency actions;
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“other-than-temporary” investment impairment losses; and
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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”, "may", "intend", "likely" or similar expressions. Undue reliance should not be placed on these forward-looking statements. The Company disclaims any obligation to update such statements or to announce publicly the results of any revisions that it may make to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.
COMPANY OVERVIEW
The Company, a majority owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations that consist of a property and casualty insurance segment and a reinsurance segment. The operations of the Company are highly integrated with those of Employers Mutual through participation in a property and casualty reinsurance pooling agreement (the "pooling agreement"), a quota share retrocessional reinsurance agreement (the "quota share agreement") and inter-company reinsurance programs with Employers Mutual. All transactions occurring under the pooling agreement, quota share agreement and the inter-company reinsurance programs with Employers Mutual are based on statutory accounting principles. Certain adjustments are made to these amounts to bring them into compliance with U.S. generally accepted accounting principles (GAAP).
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 2017. 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 a pooling agreement with Employers Mutual. Under the terms of the pooling agreement, each company cedes to Employers Mutual all of its insurance business, 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 pool is 30 percent.
Since 2016, the Company's property and casualty insurance subsidiaries and Employers Mutual have been parties to an inter-company reinsurance program. This reinsurance program is intended to reduce the volatility of the Company's quarterly results caused by excessive catastrophe and storm losses, and provide protection from both the frequency and severity of such losses. The reinsurance program consists of two semi-annual aggregate catastrophe excess of loss treaties. The first treaty is effective each year from January 1 through June 30, and has a retention of $20.0 million and a limit of $24.0 million. The total cost of this treaty was approximately $6.0 million in 2017 and $6.3 million in 2016. The second treaty is effective each year from July 1 through December 31, and has a retention of $15.0 million and a limit of $12.0 million. The total cost of this treaty was approximately $1.4 million in 2017 and $1.5 million in 2016. Losses and settlement expenses ceded to Employers Mutual under this program totaled $19.2 million in 2017 and $7.5 million in 2016. All catastrophe and storm losses assumed by the property and casualty insurance subsidiaries (net of applicable reinsurance recoveries from external reinsurance protections purchased by the pool participants) are subject to the terms of these treaties, and there is no co-participation provision.
Operations of the pool and the inter-company reinsurance program give rise to inter-company balances with Employers Mutual, which are generally settled during the subsequent 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 participating in the pool. The pooling agreement produces a more uniform and stable underwriting result from year to year for the companies participating 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 surplus, 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 2017. The Company’s reinsurance subsidiary is party to a quota share agreement and an inter-company reinsurance program 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 inter-company reinsurance program in place with Employers Mutual covers both business assumed from Employers Mutual through the quota share agreement, as well as business obtained outside the quota share agreement. Since 2016, the reinsurance program has consisted of two treaties. The first is a per occurrence catastrophe excess of loss treaty with a retention of $10.0 million, a limit of $10.0 million, 20 percent co-participation, and no reinstatement. The total cost of this treaty was approximately $1.7 million in 2017 and $2.0 million in 2016. The second is an annual aggregate catastrophe excess of loss treaty with a retention of $20.0 million, a limit of $100.0 million, and 20 percent co-participation. The total cost of this treaty was approximately $3.2 million in both 2017 and 2016. Any losses recovered under the per occurrence treaty inure to the benefit of the aggregate treaty, and only catastrophic events with total losses greater than $500,000 are subject to the terms of the aggregate treaty. Prior to 2016, the reinsurance program with Employers Mutual consisted of a single excess of loss reinsurance agreement. Under the terms of that agreement, the reinsurance subsidiary retained the first $4.0 million of losses per event, and also retained 20 percent of any losses between $4.0 million and $10.0 million and 10 percent of any losses between $10.0 million and $50.0 million. The cost of the excess of loss reinsurance protection, which included reimbursement for the cost of reinsurance protection purchased by Employers Mutual to protect itself from the assumption of excessive losses in the event of a major catastrophe, was calculated as 8.0 percent of the reinsurance subsidiary’s total assumed reinsurance premiums written, and amounted to $10.8 million in 2015. Losses and settlement expenses ceded to Employers Mutual under these reinsurance programs totaled $16.8 million in 2017, ($467,000) in 2016 and $622,000 in 2015.
In connection with the change in the inter-company reinsurance program in 2016, the reinsurance subsidiary began purchasing additional reinsurance protection (through Employers Mutual) in peak exposure territories from external parties in which coverage is triggered when losses experienced by the insurance industry from a catastrophic event exceed a specified threshold. Any reinsurance recoveries received from external parties reduces the amount of losses ceded to Employers Mutual under the inter-company reinsurance program. The net cost of this external reinsurance protection was approximately $5.6 million and $3.5 million in 2017 and 2016, respectively. No recoveries were received from the external parties in 2017 or 2016.
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 underwriting association (MRB), 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 and the inter-company reinsurance program, as well as the purchase of the reinsurance protection from external parties, give rise to inter-company balances with Employers Mutual, which are generally settled during the month following the end of each quarter. The investment and income tax activities of the reinsurance subsidiary are not subject to the quota share agreement.
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). At the end of 2013, premium rate level increases were beginning to decline, after increasing consistently during the three previous years. This trend of declining premium rate increases has continued since then through 2017, with 2017 premium rates overall being essentially flat. The outlook for 2018 is that the Company's overall premium rate level will continue to remain relatively steady or increase slightly.
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 (i.e., 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 state legislatures, the United States Congress and federal and state agencies through its membership in various organizations. In particular, our trade organizations are working to achieve a nationwide data security and breach standard, to promote accident avoidance and accident prevention technology, to oppose legislative or regulatory changes that weaken the private workers' compensation insurance marketplace, and to prevent the weakening of the consumer-focused state insurance regulatory system.
MANAGEMENT ISSUES AND PERSPECTIVES
Management Changes
On August 30, 2017, an announcement was made that Kevin Hovick, Executive Vice President and Chief Operating Officer, would retire on January 2, 2018. On November 6, 2017, an announcement was made that effective January 2, 2018, Mick Lovell would become Executive Vice President of Operations, and that Scott Jean would become Executive Vice President of Finance and Strategy. The duties and responsibilities of these new positions have been finalized, and the reporting structures of the underlying departments have been established. No new initiatives have resulted from these management changes to date; however, executive management is currently reviewing the operations of the Company, with the intent of identifying changes that could improve the performance of the Company.
Tax reform
On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (TCJA) was signed into law. Among other provisions, the TCJA lowered the federal corporate tax rate from 35 percent to 21 percent effective January 1, 2018. The Company recorded a one-time deferred income tax benefit in connection with the adoption of the TCJA in the fourth quarter. Beginning in 2018, the Company's effective tax rate is expected to be in the mid-teens, compared to the upper twenties in prior years. While this reduction in the effective tax rate is viewed favorably by management, it is currently unknown what impact, if any, this reduction in the corporate tax rate will have on premium rate levels and competition in general. Because of the local market knowledge provided by the Company's sixteen branch offices, management can closely monitor market conditions for any indications of increased competition resulting from the lower tax rate, and can evaluate and respond to such actions in a timely manner.
Equity portfolio market risk
Approximately 14.8 percent of the Company’s investment portfolio is invested in equity securities. Net unrealized investment gains on the equity portfolio totaled approximately $66.2 million at December 31, 2017, which is reflected as accumulated other comprehensive income in the Company’s financial statements and represents $3.09 per share of the Company’s December 31, 2017 book value of $28.14 per share. To help protect the Company from a sudden and significant decline in the value of its equity portfolio, management began investing in a limited partnership during the first quarter of 2014 to implement and maintain an equity tail-risk hedging strategy. This hedging strategy is designed to help protect the Company from significant monthly downside price volatility in the equity markets. By maintaining this hedging strategy, management is able to reduce the level of risk contained in the Company’s financial statements without reducing the size of the equity portfolio. While there is a cost associated with this protection, management views this cost similar to the cost of an insurance policy. The cost of the hedging strategy is equal to the decline in the carrying value of the limited partnership that the Company invests in to maintain the strategy, and is reported as a realized investment loss in the Company's financial statements. The decline in the carrying value of the limited partnership primarily reflects the cost of hedging contracts that expired without value during the year, but also includes changes in the value of contracts that were still in effect at year-end.
Premium rate levels
Premium rate level increases have slowed over the past several years due to increased competition resulting from excess capital in the insurance industry. During this time, management has worked diligently with the sixteen branch offices to stress the importance of achieving modest, but consistent, commercial lines rate level increases whenever possible. These efforts have been successful, as the Company has been able to achieve modest rate level increases during the past four years. Premium rate levels for most commercial lines of business are projected to increase moderately on an industry-wide basis in 2018, and management currently expects the Company's overall rate level to remain steady or increase slightly in 2018. Management will continue to work with the branch offices to ensure that all opportunities for additional rate level increases are pursued.
Personal lines operation
Effective January 1, 2016, Personal Lines Operations assumed responsibility for the growth and profitability of personal lines business throughout the country. In connection with this change in oversight, management implemented new personal auto and homeowners products that have been rolled-out in all locations and have been well received by agents and policyholders. Management believes that the overall quality of the personal lines book of business improved during 2017; however, that improvement was overshadowed by an increased level of catastrophe and storm losses. Management continues to closely monitor the performance of the personal lines business, and expects to expand personal lines into additional states in the future to further diversify the exposures of this business.
Commercial auto line of business
The Company, like most of the insurance industry, continues to experience high levels of claims frequency and severity in the commercial auto line of business. The commercial auto line of business represents approximately 25 percent of the property and casualty insurance segment's commercial business; therefore, improving the profitability is a top priority for management. Management continues to devote a significant amount of resources to the intensive, multi-year Accelerate Commercial Auto Profitability project that was implemented in 2016, which has a goal of returning this line of business to profitability by mid-2019. There are indications that the action plans developed by each of the eight teams charged with returning this line of business to profitability are beginning to take effect; however, the actuarially determined ultimate loss and settlement expense ratio projections have not, and will not, be adjusted until there is clear evidence that adequate premium is being charged for the exposures being assumed.
Investing in innovation
Innovation continues to be an important part of the Company's overall strategy and has become entrenched in its operations. The Company simply cannot maintain the status quo and expect to be successful as the pace of change in the insurance industry continues to accelerate. To remain competitive in this quickly changing market and achieve our goal of being a leader in innovation, systems are being upgraded and additional team members with the skills necessary to meet these objectives are being hired. This will result in an increase in the Company's acquisition expense ratio. While a higher acquisition expense ratio is not desirable, management views these expenses as an investment in the Company's future, and expects future results to benefit from these expenditures.
Reserving methodology
During the third quarter of 2016, management implemented a new reserving methodology for the determination of bulk reserves in the property and casualty insurance segment. The new methodology, which is referred to as the accident year ultimate estimate approach, utilizes explicit claim frequency and severity assumptions to establish ultimate loss and settlement expense ratio projections for each line of business and each accident year. This methodology better conforms to industry practices, and provides improved transparency of the drivers of the property and casualty insurance segment's performance.
Over the past eighteen months, management has gained additional insight using this new methodology. As a result, ultimate loss and settlement expense ratio selections have been refined to produce what are believed to be better estimates of expected ultimates than when the methodology change was first implemented. For several lines of business this resulted in a decrease of previously selected ultimate ratios. Accordingly, some portion of the reductions implemented in the ultimate loss and settlement expense ratio selections during 2017 may not represent actual improvement in the performance of the underlying lines of business.
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, the property and casualty insurance segment's carried reserves for these accident years continue to 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, with the familiarity gained and the adjustments made under the new reserving methodology, the magnitude of favorable development reported in future periods is expected to be somewhat less than what has been observed in recent periods.
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.
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 nonaffiliates, and then subtracting from that result premiums written ceded to affiliates and nonaffiliates. For the property and casualty insurance segment, premiums written ceded to nonaffiliates is the portion of the direct and assumed premiums written that is transferred to 1) reinsurers in accordance with the terms of the underlying reinsurance contracts, based upon the risks they accept, and 2) state organizations on a mandatory basis in connection with various workers' compensation and assigned risk programs. For the reinsurance segment, premiums written ceded to nonaffiliates reflects reinsurance business that is ceded to other insurance companies in connection with 1) “fronting” activities initiated by Employers Mutual, and 2) amounts ceded to purchase additional reinsurance protection in peak exposure territories. 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 subsidiaries to Employers Mutual under the terms of the inter-company reinsurance programs 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.
Underlying Loss and Settlement Expense Ratio. The underlying loss and settlement expense ratio is a non-GAAP financial measure that represents the loss and settlement expense ratio, excluding the impact of catastrophe and storm losses and development on prior years' reserves. Management uses this ratio as an indicator of the property and casualty insurance segment's underwriting discipline and performance for the current accident year. Management believes this ratio is useful for investors to understand the property and casualty insurance segment's periodic earnings and variability of earnings caused by the unpredictable nature (i.e., the timing and amount) of catastrophe and storm losses and development on prior years' reserves. While this measure is consistent with measures utilized by investors and analysts to evaluate performance, it is not intended as a substitute for the GAAP financial measure of loss and settlement expense ratio. The loss and settlement expense ratio is reconciled to this non-GAAP financial measure under "Results of Operations" below.
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.
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 the Property & Liability Resource 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 $25.0 million or more in direct insured losses to property, and affect a significant number of policyholders and insurers.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of the Company's financial statements in conformity with GAAP requires management to adopt accounting policies and make estimates and assumptions that affect amounts reported in the consolidated financial statements and related disclosures. The Company's significant accounting policies are described in note 1, Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements under Part II, Item 8 of this Form 10-K. The following estimates and assumptions are considered by management to be critically important in the preparation and understanding of the Company's financial statements and related disclosures. The estimates and assumptions utilized are complex and require subjective judgment.
Loss and settlement expense reserves
Processes and assumptions for establishing loss and settlement expense reserves
In the property and casualty insurance segment, the methodology used to establish direct loss and allocated settlement expense reserves changed in 2016. Beginning in September 2016, estimated ultimate loss and allocated settlement expense amounts for most claims are established by accident year and line of business using standard actuarial techniques. At each reporting date, the amounts to be carried for incurred but not reported (IBNR) loss reserves and allocated settlement expense reserves are determined by subtracting the amounts incurred to date (paid amounts plus case loss reserves carried for reported claims) from the estimated ultimate amounts. Under this methodology, changes in the incurred amounts result in corresponding adjustments to the reserve amounts. Prior to September 2016, case loss reserves (including bulk case loss reserves), IBNR loss reserves and settlement expense reserves were all established independently of each other, and the amounts were added together to determine the total liability for losses and settlement expenses. Under that methodology, adjustments to any of the reserve components did not result in corresponding adjustments to the other reserve components. The implementation of the new reserving methodology did not have a material impact on total carried reserves for the property and casualty insurance segment; however, there was some movement of allocated settlement expense reserves to IBNR loss reserves, and a reallocation of loss and allocated settlement expense reserves by accident year. In connection with this reallocation of reserves by accident year, approximately $5.6 million of IBNR loss and allocated settlement expense reserves were moved from prior accident years to the current accident year in multiple lines of business. This reduction in prior accident years' reserves produced favorable development; however, this development is "mechanical in nature", and did not have any impact on earnings because the total amount of carried reserves did not change.
In the reinsurance segment, Employers Mutual records the case and IBNR loss reserves reported by the ceding companies for the Home Office Reinsurance Assumed Department (“HORAD”) book of business. 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. The booking of the lag IBNR loss reserve may be suspended, and negative bulk IBNR loss reserves may be established, during periods when the actuarial reviews indicate MRB's carried reserves are more than adequate to cover its liabilities. To verify the adequacy of the reported reserves, an actuarial evaluation of MRB’s reserves is performed at each year-end.
Property and Casualty Insurance Segment
Following is a summary of the carried loss and settlement expense reserves for the property and casualty insurance segment at December 31, 2017 and 2016.
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 philosophy utilized to establish case loss reserves 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 claims department 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.
To provide consistency in the reserving process, the claims department 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 claims department 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 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.
As previously noted, a new reserving methodology was implemented in 2016. Under this new methodology, ultimate loss and allocated settlement expense amounts expected to be incurred are established by accident year and line of business. The amount of IBNR loss and allocated settlement expense reserves carried at each reporting date is determined by subtracting the amounts incurred to date from the ultimate estimated incurred amounts.
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.
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 and allocated settlement expense development patterns, which results in some uncertainty regarding the estimated ultimate projections, particularly for longer-tail lines such as workers’ compensation, other liability and commercial auto liability. Therefore, the reasonableness of the actuarial projections is regularly monitored through an examination of the assumptions underlying those projections.
As previously noted, one assumption underlying the reserve estimation process is that the inflation trends implicitly built into the historical loss and allocated settlement expense development patterns will continue into the future. To estimate the sensitivity of the estimated ultimate loss and allocated 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, 2017 loss and allocated settlement expense reserves to generate estimated annual incremental loss and allocated 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 patterns, and revised incremental loss and settlement expense payments were calculated. This unexpected 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. The after tax impact on earnings is calculated using the federal corporate tax rate of 35 percent.
The Company uses standard actuarial methods to produce estimates of ultimate loss ratios by accident year and line of business. Underlying each selection are explicit assumptions regarding the ultimate claim frequency and severity associated with the selected ultimate ratio. As the assumptions are based on estimates made at a specific point in time, it is likely that the ultimate claim frequency and severity experience, and, therefore, the ultimate loss ratio, will vary upwards or downwards from prior estimates. The expected variation will be greater for less mature accident years, and decreases as each accident year ages. This uncertainty is reflected in the unpaid loss estimates underlying the selected estimated ultimate loss ratios, which produce the carried loss reserves. Assuming the unpaid loss estimates are unbiased, the cumulative impact on the Company's results of operations of a one percent variance in the associated carried loss reserves over the lifetime of the underlying claims is shown below. A variance in carried loss reserves 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 one percent variance in the unpaid loss estimates underlying the selected ultimate loss ratio estimates is considered reasonably likely based on the range of actuarial indications developed during the analysis of the property and casualty insurance segment’s carried loss reserves. The after tax impact on earnings is calculated using the federal corporate tax rate of 35 percent.
Similar to the loss reserving process, the Company uses standard actuarial methods to produce estimates of ultimate ratios by accident year and line of business for allocated settlement expenses. Underlying each selection are explicit assumptions regarding the ultimate claim frequency and settlement expense severity associated with the selected estimated ultimate ratio. As the assumptions are based on estimates made at a specific point in time, it is likely that the ultimate allocated settlement expense ratios will vary upwards or downwards from prior estimates. The expected variation will be greater for less mature accident years, and decreases as each accident year ages. This uncertainty is reflected in the unpaid allocated settlement expense estimates underlying the selected estimated ultimate ratios, which produce the carried allocated settlement expense reserves. Assuming the unpaid allocated settlement expense estimates are unbiased, the cumulative impact on the Company's results of operations of a one percent variance in the associated allocated settlement expense reserves over the lifetime of the underlying claims is shown below. A variance in carried allocated settlement expense reserves 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 one percent variance in the unpaid allocated settlement expense estimates underlying the selected estimated ultimate allocated settlement expense ratios is considered reasonably likely based on the range of actuarial indications developed during the analysis of the property and casualty insurance segment’s carried allocated settlement expense reserves. The after tax impact on earnings is calculated using the federal corporate tax rate of 35 percent.
One of the variables impacting the estimation of 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 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 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 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 losses may differ substantially from the carried loss reserves.
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 allocated settlement expense reserves would be deficient. However, such a change in philosophy would likely reduce losses, generating some offsetting redundancy in the loss reserves.
The property and casualty insurance subsidiaries have exposure to asbestos and environmental 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 loss and settlement expense reserves associated with asbestos claims have been increased each year for the last several years due to continued reporting of new claims at a rate not previously anticipated, as well as updated internal ultimate loss and settlement expense evaluations. During 2017, a settlement was reached with a former insured, resulting in the Company recognizing $4.5 million (its share) of losses and settlement expenses to remove all past and future asbestos liability exposure related to that policyholder, and loss and settlement expense reserves for asbestos claims were also strengthened approximately $900,000.
Environmental IBNR loss reserves are established in consideration 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). 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
Following is a summary of the carried loss and settlement expense reserves for the reinsurance segment at December 31, 2017 and 2016.
The reinsurance book of business is comprised of two major components. The first is 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 MRB, which is a voluntary reinsurance pool in which Employers Mutual participates with four 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.
At December 31, 2017, the carried reserves for HORAD and MRB combined were in the upper third 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, 2017, there was no backlog in the processing of assumed reinsurance information. Approximately $151.9 million, or 66 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.
Carried reserves established in addition to those reported by the ceding companies totaled approximately $77.8 million at December 31, 2017. 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 a negative bulk IBNR loss reserve established by Employers Mutual's actuaries in 2016 and 2015, and a small IBNR loss reserve generally established to cover a 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 $103.1 million and $98.4 million at December 31, 2017 and 2016, respectively, and accounted for approximately 45 percent and 48 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, 2017 would equate to $3.3 million, net of tax, which represents 8.3 percent of the net income reported for 2017 and 0.5 percent of stockholders’ equity.
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 one 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 one 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 one 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.
The after-tax impact on the Company’s earnings, calculated using the federal corporate tax rate of 35 percent, under each scenario is as follows:
To ensure the accuracy and completeness of the information received from the ceding companies, Employers Mutual’s actuarial department reviews contract years 1988 and subsequent every quarter, 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 supplement the data reported by ceding companies 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, 2017.
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 1,872 asbestos bodily injury lawsuits, some of which involve multiple plaintiffs. Claims activity associated with eight policyholders dominates the pool participants’ asbestos claims, representing an aggregate 1,798 lawsuits. 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 often dismissed from asbestos litigation with nominal or no payment (i.e., small contractors, supply companies, and a furnace manufacturer).
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 one former policyholder. During the period 2009 through 2017, the Company's share of paid losses and settlement expenses attributed to this former policyholder, a furnace manufacturer, was $12.5 million (mostly settlement expenses). 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 a driver behind recent 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 692 asbestos exposure claims associated with this former policyholder remain open. During 2017, a settlement was reached with another former insured, resulting in the Company recognizing $4.5 million (its share) of losses and settlement expenses stemming from the settlement of claims for past and future legal fees and losses on a multi-year asbestos exposure.
The pool participants are defending approximately 25 claim files because of lawsuits alleging “silica” exposure in Mississippi, 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 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’ policyholder (a sand and gravel hauler) that has been named as defendant in these silica lawsuits has had little or no exposure, and is routinely dismissed from silica litigation with nominal or no payment.
Since 2004, the pool participants have included a “pneumoconiosis dust” exclusion to their commercial lines liability policies in most 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.
The Company’s exposure to asbestos and environmental claims through assumed reinsurance is 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.
At December 31, 2017, the Company carried asbestos and environmental reserves for direct insurance and assumed reinsurance business totaling $11.7 million, which represents 1.6 percent of total loss and settlement expense reserves. The asbestos and environmental reserves include $4.5 million of case loss reserves, $4.3 million of IBNR loss reserves and $2.9 million of bulk settlement expense reserves. Ceded reinsurance on these reserves totaled $290,000. Loss and settlement expense reserves were strengthened approximately $900,000 in 2017 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 2017, 42 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 463, 374 and 338 in 2017, 2016 and 2015, respectively, and produced incurred losses and paid settlement expenses of approximately $4.8 million, $3.6 million and $3.2 million in each respective period. Incurred losses and paid settlement expenses on all construction defect claims totaled approximately $6.4 million in 2017. At December 31, 2017, the Company carried case loss reserves of approximately $7.4 million on 427 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.
Following is a summary of loss and settlement expense reserves and payments associated with asbestos, environmental, products liability and casualty excess reinsurance exposures for 2017, 2016 and 2015:
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.
Following is a summary of the claim activity associated with asbestos, environmental and products liability exposures for 2017, 2016 and 2015:
Variability of loss and settlement expense reserves
During each quarter 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, 2017 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, calculated using the federal corporate tax rate of 35 percent, if the reserves were moved to the high end-point or low end-point of the ranges.
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 net income in the year such changes are recorded.
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 1 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 the significant inputs are observable (e.g., interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.) or can be corroborated by observable market data.
Level 3 -
Prices or valuation techniques that require significant unobservable inputs because observable inputs are not available. The unobservable inputs may reflect the Company’s own judgments about the assumptions that market participants would use.
The Company uses an independent pricing source to obtain the estimated fair values of a majority of its securities, subject to an internal validation. The fair values are based on quoted market prices, where available. This is typically the case for equity securities and money market funds, which are accordingly classified as Level 1 fair value measurements. In cases where quoted market prices are not available, fair values are based on a variety of valuation techniques depending on the type of security. Fixed maturity securities, non-redeemable preferred stocks and various short-term investments in the Company’s portfolio may not trade on a daily basis; however, observable inputs are utilized in their valuations, and these securities are therefore classified as Level 2 fair value measurements. Following is a brief description of the various pricing techniques used by the independent pricing source for different asset classes.
•
U.S. Treasury securities (including bonds, notes, and bills) are priced according to a number of live data sources, including active market makers and inter-dealer brokers. Prices from these sources are reviewed based on the sources’ historical accuracy for individual issues and maturity ranges.
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U.S. government-sponsored agencies and corporate securities (including fixed-rate corporate bonds and medium-term notes) are priced by determining a bullet (non-call) spread scale for each issuer for maturities going out to forty years. These spreads represent credit risk and are obtained from the new issue market, secondary trading, and dealer quotes. An option adjusted spread model is incorporated to adjust spreads of issues that have early redemption features. The final spread is then added to the U.S. Treasury curve.
•
Obligations of states and political subdivisions are priced by tracking and analyzing actively quoted issues and reported trades, material event notices and benchmark yields. Municipal bonds with similar characteristics are grouped together into market sectors, and internal yield curves are constructed daily for these sectors. Individual bond evaluations are extrapolated from these sectors, with the ability to make individual spread adjustments for attributes such as discounts, premiums, alternative minimum tax, and/or whether or not the bond is callable.
•
Mortgage-backed and asset-backed securities are first reviewed for the appropriate pricing speed (if prepayable), spread, yield and volatility. The securities are priced with models using spreads and other information solicited from market 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, 2017 and 2016, the Company had no securities priced solely from broker quotes.
Essentially all securities in the Company’s investment portfolios have transparent pricing. All equity securities (with two exceptions) 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) municipal, corporate, high-yield and finally mortgage-backed 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, 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.
Investment Impairments
The Company regularly monitors its investments which have a fair value that is less than the amortized cost for indications of “other-than-temporary” impairment. Several factors are used to determine whether the amortized cost 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 amortized cost, (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 amortized cost 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, 2017. 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 19.9 percentage points in the property and casualty insurance segment and 6.3 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 initiatives that have been implemented recently to improve performance in the commercial auto and personal lines of business. 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.
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 certain health reimbursement arrangement (HRA) and life insurance benefits for eligible retired employees. 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, and the rate of future compensation increases (pension plans 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, 2017, 2016 and 2015 were 3.60 percent, 4.07 percent and 3.90 percent, respectively. The discount rates used in the postretirement benefit obligation valuations at December 31, 2017, 2016 and 2015 were 3.63 percent, 4.21 percent and 4.42 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 2017 valuations would increase the Company’s net periodic pension and postretirement benefit costs for 2018 by approximately $132,000. Conversely, a 0.25 percentage point increase in the 2017 discount rates would decrease the Company’s net periodic pension and postretirement benefit costs for 2018 by approximately $13,000.
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, 2017 and 2016 was 7.00 percent and 7.00 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, 2017 and 2016 was 6.50 percent and 6.50 percent, respectively. The expected rate of return on plan assets to be used in the calculation of the 2018 net periodic benefit costs for the pension and postretirement benefit plans will be 7.00 percent and 6.50 percent, respectively. The actual rate of return earned on plan assets during 2017 was approximately 18 percent for the pension plan and 15 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 2018 would change the Company’s net periodic pension and postretirement benefit costs by approximately $312,000. 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.
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, 2017, all of the benefit plans, other than the qualified pension plan, had accumulated actuarial losses in excess of the corridor that will be partially amortized into expense in 2018. The Company’s share of the accumulated actuarial losses that will be amortized into expense during 2018 amounts to $410,000. Prior service credits for plan amendments are also contained in the valuations, and are amortized into income over the future service periods of the participants. As of December 31, 2017, the postretirement benefit plans have prior service credits that are being amortized into income in future periods. The prior service credit being amortized into income during 2018 is $3.2 million.
In accordance with GAAP, the funded status of defined benefit pension and 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, 2017 are as follows:
1 Underlying 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, which management uses as a measure of underwriting profitability of the Company’s property and casualty insurance business. The underlying loss and settlement expense ratio is a non-GAAP financial measure which represents the loss and settlement expense ratio, excluding the impact of catastrophe and storm losses and development on prior years’ reserves. Management uses this ratio as an indicator of the property and casualty insurance segment’s underwriting discipline and performance for the current accident year. Management believes this ratio is useful for investors to understand the property and casualty insurance segment’s periodic earnings and variability of earnings caused by the unpredictable nature (i.e., the timing and amount) of catastrophe and storm losses and development on prior years’ reserves. While this measure is consistent with measures utilized by investors and analysts to evaluate performance, it is not intended as a substitute for the GAAP financial measure of loss and settlement expense ratio.
2 During the third quarter of 2016, management implemented a new reserving methodology for the determination of direct bulk reserves in the property and casualty insurance segment. The new methodology, which is referred to as the accident year ultimate estimate approach, better conforms to industry practices and provides increased transparency of the drivers of the property and casualty insurance segment's performance. In connection with this change in reserving methodology, there was a reallocation of IBNR loss reserves and allocated settlement expense reserves from prior accident years to the current accident year in multiple lines of business. This resulted in the movement of approximately $5.6 million of reserves from prior accident years to the current accident year that is technically reportable as favorable development; however, this development is "mechanical in nature" and did not have an impact on earnings because the total amount of carried reserves did not change. During 2015, revisions to the accident year allocation factors used in the prior reserving methodology produced $423,000 of favorable development that was also "mechanical in nature". These "mechanical" development amounts have been excluded from the favorable development amounts presented for 2016 and 2015 to improve comparability.
2 During 2015, a reallocation of reserves from the current accident year to prior accident years on a two-year contract produced $1.0 million of adverse development that is "mechanical in nature" and had no impact on earnings. This development amount has been excluded from the favorable development amount presented for 2015 to improve comparability.
2 See notes above regarding adjustments made to the development amounts presented for the property and casualty insurance segment and the reinsurance segment in 2016 and 2015.
Year ended December 31, 2017 compared to year ended December 31, 2016
The Company reported net income of $39.2 million ($1.84 per share) in 2017 compared to $46.2 million ($2.20 per share) in 2016. Net income declined in 2017 despite a one-time $9.1 million deferred income tax benefit resulting from the enactment of the TCJA. This decline is primarily attributed to a large amount of catastrophe and storm losses incurred by the reinsurance segment during the third quarter, as well as a reduction in the amount of favorable development experienced on prior years' reserves. Considering the extraordinary amount of catastrophe and storm losses incurred by the insurance industry during 2017, management is satisfied with the Company's results. The property and casualty insurance segment continued to perform well, as the underlying loss and settlement expense ratio improved during the second half of the year. Also encouraging is the recent improvement in the pricing environment in the property and casualty insurance segment and the reinsurance segment during the January 1, 2018 renewals.
The TCJA was signed into law on December 22, 2017. Among other provisions, the TCJA lowered the federal corporate tax rate from 35 percent to 21 percent effective January 1, 2018. Companies are required to calculate deferred income taxes using tax rates expected to be in effect when tax timing differences reverse, which, as of December 22, is now 21 percent rather than the previous 35 percent. The Company was in a net deferred tax liability position on the date of enactment, which means that the reduction in the tax rate resulted in a lower deferred tax liability. In accordance with GAAP, this reduction in the deferred tax liability, which is reflected as a deferred income tax benefit, was recognized in net income in the fourth quarter.
Because the change in the deferred tax liability was recognized in net income, the amounts contained in the accumulated other comprehensive income line in stockholders' equity continued to reflect deferred income taxes at the previous 35 percent tax rate (commonly referred to as "stranded tax effects"). In February 2018, the Financial Accounting Standards Board issued updated guidance to allow a reclassification to be made from accumulated other comprehensive income to retained earnings for the stranded tax effects resulting from the enactment of the TCJA. The Company adopted this guidance in 2017, and transfered the stranded tax effects in accumulated other comprehensive income to retained earnings. The consolidated balance sheet that was included in the Company's February 8, 2018 earnings release announcing 2017 results did not reflect this reclassification, as it was not permitted at that time.
Premiums earned, losses and settlement expenses incurred, and the corresponding loss and settlement expense ratios, by line of business for each segment and on a consolidated basis, for the two years ended December 31, 2017 are as follows:
Premium income
Premiums earned increased 2.5 percent to $607.2 million in 2017 from $592.4 million in 2016. Rate levels for both segments continue to be constrained by a high level of competition, especially for quality accounts with good loss experience; however, there were some indications of moderate rate level improvement during the fourth quarter. Average rate level increases were slightly positive for the year in the property and casualty insurance segment, with variances by line of business. In the reinsurance segment, rate levels stabilized somewhat during the January 1, 2017 renewal season, when approximately 70 percent of the business renews, after several years of continuous declines. The lines of business experiencing the greatest profitability challenges in the property and casualty insurance segment, namely commercial auto and personal lines, are currently receiving larger (mid-single digit) rate increases. During the January 1, 2018 renewal season, moderate price increases were achieved on most of the reinsurance segment's property per risk and catastrophe programs.
Premiums earned for the property and casualty insurance segment increased 3.5 percent to $472.4 million in 2017 from $456.5 million in 2016. This increase is primarily attributed to new business in both commercial and personal lines of business, growth in insured exposures and an increase in retained policies in the commercial lines of business. New business premium (representing 15 percent of the pool participants’ direct premiums written) was approximately 15 percent higher than in 2016. Commercial lines new business continues to be in the desired range of growth, and accounted for most of the increase in total new business premium. Personal lines new business premium was up significantly, but is measured against a relatively small amount of new business premium in 2016. While management continues to seek growth in most territories, it is particularly focused on achieving growth outside of the core Midwest market, which will help diversify the pool participants' book of business geographically, while staying consistent with the industry and line of business mix of the existing book of business. Renewal business premium increased approximately five percent during 2017. After factoring in the continued implementation of some mandatory rate reductions on workers' compensation business in a few states, the overall rate change on renewal business was positive, but less than one percent. Rates are expected to continue to be mixed in 2018, with the largest rate increases expected in the commercial auto line of business. Rate decreases are expected in the workers' compensation and general liability lines of business, and rates on most other lines of business are expected to be flat or increase slightly. The overall policy retention rate remained strong during 2017 at 85.8 percent (commercial lines at 86.9 percent and personal lines at 83.7 percent). These retention rates approximate those reported at the end of 2016.
Premiums earned for the reinsurance segment decreased 0.8 percent to $134.8 million in 2017 from $135.9 million in 2016. This decrease is primarily attributed to MRB's withdrawal from non-standard automobile business, but also reflects a decline in some casualty business that converted from a pro rata structure in 2016 to an excess of loss structure in 2017. However, the addition of some new business and growth on some existing accounts largely offset those declines. Underwriting capacity remained strong during the January 1, 2018 renewal season, despite the unusually large amount of catastrophe and storm losses incurred by the reinsurance industry in 2017. As a result, reinsurance rate levels only increased moderately for those lines and territories most affected by the 2017 events (property per risk and catastrophe programs), and remained stable in most segments of the market not affected by the 2017 events. Rate levels for international business were also stable, with renewal rates largely flat or up slightly.
Losses and settlement expenses
Losses and settlement expenses increased 9.1 percent to $422.0 million in 2017 from $386.9 million in 2016, and the loss and settlement expense ratio increased to 69.5 percent in 2017 from 65.3 percent in 2016. Higher catastrophe and storm losses in the reinsurance segment (including a record amount during the third quarter of 2017), along with a decline in favorable development on prior years' reserves, were the primary drivers of the increase in the ratio. These increases were partially offset by an improvement in the property and casualty insurance segment's underlying loss and settlement expense ratio. Fourth quarter catastrophe and storm losses in the reinsurance segment, which primarily resulted from the California wildfires, were mitigated by the inter-company reinsurance program with Employers Mutual. Since the retention amount under the annual aggregate treaty was filled during the third quarter, the reinsurance segment only retained 20 percent of the fourth quarter wildfire losses. The inter-company reinsurance programs implemented in 2016 have performed as expected, and have reduced the volatility of the Company's quarterly earnings. The actuarial analysis of the Company’s carried reserves at December 31, 2017 indicates that they are in the upper third of the range of reasonable reserves.
The loss and settlement expense ratio for the property and casualty insurance segment decreased to 64.1 percent in 2017 from 64.5 percent in 2016. Lower catastrophe and storm losses and an improvement in the underlying loss and settlement expense ratio were the primary drivers of the decline in the loss and settlement expense ratio. Catastrophe and storm losses, net of the amounts ceded to Employers Mutual under the inter-company reinsurance program, accounted for 6.3 percentage points of the loss and settlement expense ratio in 2017, compared to 7.7 percentage points in 2016. The property and casualty insurance subsidiaries ceded $19.2 million of catastrophe and storm losses to Employers Mutual under the inter-company reinsurance program in 2017, compared to $7.5 million in 2016. Taking the loss recoveries and the premiums paid to Employers Mutual into consideration, the inter-company reinsurance program reduced the property and casualty insurance segment's loss and settlement expense ratios by 3.1 and 0.5 percentage points for the years ended December 31, 2017 and 2016, respectively. The inter-company reinsurance program has been renewed for 2018. The only change is a $2 million increase in the retention amount under the treaty covering the first half of the year (from $20.0 million to $22.0 million). The cost of the program will remain at $7.4 million. The underlying loss and settlement expense ratio improved during the second half of 2017, primarily reflecting reductions in the current accident year ultimate loss and settlement expense ratio projections in the commercial property and other liability lines of business. The commercial auto and personal lines of business, which posted loss and settlement expense ratios of 85.4 percent and 72.1 percent, respectively, in 2017, continue to under perform. Management continues to devote a significant amount of time and effort to the initiatives that have been undertaken to improve the performance of these lines of business, including rate increases and more selective risk selection.
Favorable development on the property and casualty insurance segment's prior years' reserves totaled $15.7 million and $24.4 million in 2017 and 2016, respectively. Included in the development amount reported for 2017 is $4.5 million of adverse development experienced in the other liability line of business stemming from the settlement of claims for past and future legal fees and losses on a multi-year asbestos exposure associated with a former insured. Under the new reserving methodology implemented in the third quarter of 2016, development on prior accident years' reserves is determined primarily by changes in the prior accident years' ultimate loss and settlement expense ratio projections established by management. As a result, the explicit drivers of development on prior years' reserves are identifiable beginning in 2017. Due to additional insights gained and the adjustments made under the new reserving methodology during 2017, the magnitude of favorable development reported in future periods is expected to be somewhat less than what has been observed in recent periods. For a detailed discussion of the development experienced on prior accident years’ reserves during 2017 and 2016, see the discussion entitled “Loss and Settlement Expense Reserves” under the “Narrative Description of Business” heading in the Business Section under Part I, Item 1 of this Form 10-K.
The loss and settlement expense ratio for the reinsurance segment increased to 88.3 percent in 2017 from 68.1 percent in 2016. The large increase is primarily due to a significant increase in catastrophe and storm losses, which accounted for 22.4 percentage points of the loss and settlement expense ratio in 2017 compared to just 9.3 percentage points in 2016. Gross losses from Hurricanes Harvey, Irma and Maria are currently estimated to be approximately $9.0 million, $7.0 million and $3.5 million, respectively, and the aggregate losses from the California wildfires are estimated at approximately $9.5 million. The reinsurance subsidiary ceded $16.8 million and ($467,000) of catastrophe and storm losses to Employers Mutual under the inter-company reinsurance program in 2017 and 2016, respectively. Taking the loss recoveries and the premiums paid to Employers Mutual into consideration, the inter-company reinsurance program reduced the reinsurance segment's loss and settlement expense ratio by 9.0 percentage points for the year ended December 31, 2017, but increased it by 2.8 percentage points in 2016. The inter-company reinsurance program has been renewed for 2018. The only change is a $400,000 increase in the cost of the program.
Aside from catastrophe and storm losses, the remaining increase in the reinsurance segment's loss and settlement expense ratio is due to a decline in favorable development on prior years' reserves. It is expected that future development will still be favorable, but less so than what has been observed in the recent past, and closer to neutral. For a detailed discussion of the development experienced on prior accident years’ reserves during 2017 and 2016, see the discussion entitled “Loss and Settlement Expense Reserves” under the “Narrative Description of Business” heading in the Business Section under Part I, Item 1 of this Form 10-K.
Acquisition and other expenses
Acquisition and other expenses increased 0.8 percent to $193.3 million in 2017 from $191.8 million in 2016. The acquisition expense ratio decreased to 31.8 percent in 2017 from 32.4 percent in 2016. Both segments contributed to the decrease in this ratio. Acquisition and other expenses reported for both years include net periodic postretirement benefit income resulting from the amortization of a large prior service credit that resulted from an amendment of Employers Mutual's postretirement medical plan in the fourth quarter of 2013. This prior service credit was recognized in accumulated other comprehensive income in the fourth quarter of 2013, and is being amortized out of accumulated other comprehensive income and into net income over a period of 10 years. To remain competitive in the quickly changing insurance market and achieve management's goal of being a leader in innovation, upgrades are being made to the Company's systems and additional team members with the skills necessary to meet these objectives are being hired. As a result, the Company's acquisition expense ratio is projected to increase in 2018.
The acquisition expense ratio for the property and casualty insurance segment decreased to 34.2 percent in 2017 from 34.8 percent in 2016. This decrease is primarily attributed to a decline in policyholder dividend expense, largely from a couple of the pool participants' safety dividend groups. Partially offsetting the decrease were higher expenses for agents' contingent commissions, data analytics initiatives, and salaries.
The acquisition expense ratio for the reinsurance segment decreased to 23.6 percent in 2017 from 24.3 percent in 2016. This decrease reflects a shift in the mix of business towards excess of loss contracts from pro rata contracts, as pro rata contracts typically have higher commission rates. The decrease also reflects declines in salary and benefit expenses (inclusive of bonuses) and contingent commissions.
Investment results
Net investment income decreased 4.2 percent to $45.5 million in 2017 from $47.5 million in 2016. The decrease primarily reflects a lower book yield in the fixed maturity portfolio and a decline in dividend income. Current interest rate levels remain below the average book yield of the fixed maturity portfolio, and will therefore likely continue to limit future growth in net investment income. The average coupon rate on the fixed maturity portfolio, excluding interest-only securities, declined slightly over the past year, coming in at 3.7 percent at December 31, 2017 compared to 3.8 percent at December 31, 2016 and 3.9 percent at December 31, 2015. The effective duration of the fixed maturity portfolio, excluding interest-only securities, also declined slightly to 5.0 at December 31, 2017 from 5.2 at December 31, 2016. The Company’s equity portfolio produced dividend income of $6.0 million in 2017, compared to $6.9 million in 2016.
The Company reported net realized investment gains of $6.6 million in 2017, compared to $4.1 million in 2016. Included in these amounts are losses of $6.3 million in both 2017 and 2016 from declines in the carrying value of a limited partnership that the Company invests in to help protect the equity portfolio from a sudden and significant decline in value (an equity tail-risk hedging strategy). The Company recognized "other-than-temporary" impairment losses of $1.1 million and $1.3 million during 2017 and 2016, respectively. With the exception of a $209,000 impairment loss recorded in 2016 on a new investment that conveys investment tax credits (included in other long-term investments), these impairment losses were recognized on securities held in the Company's equity portfolio.
Other income (loss)
Included in other income (loss) are foreign currency exchange gains and losses recognized on the reinsurance segment’s foreign currency denominated reinsurance business. The reinsurance segment had foreign currency exchange losses of $1.6 million in 2017 compared to gains of $356,000 in 2016.
Income tax
Income tax expense decreased 96.6 percent to $578,000 in 2017 from $17.0 million in 2016. As noted above, the TCJA was signed into law on December 22, 2017, lowering the federal corporate tax rate from 35 percent to 21 percent effective January 1, 2018. Companies are required to calculate deferred taxes using tax rates expected to be in effect when tax timing differences reverse, which, as of December 22, 2017, is now 21 percent rather than the previous 35 percent. The Company was in a net deferred tax liability position on the date of enactment, which means that the reduction in the tax rate resulted in a lower deferred tax liability. This reduction in the deferred tax liability ($9.1 million) is reflected as a deferred income tax benefit in the fourth quarter. Including this deferred income tax benefit, the effective tax rate for 2017 was 1.5 percent, and is expected to be in the mid-teens in future years compared to the upper twenties historically. Excluding this deferred income tax benefit, the effective tax rate for 2017 was 24.2 percent, compared to 26.9 percent in 2016. The primary contributors to the differences between these effective tax rates and the United States federal corporate tax rate of 35 percent are tax-exempt interest income earned, the dividends received deduction, and, especially in 2016, investment tax credits recognized from renewable energy tax credit investments ($672,000 in 2017 and $1.4 million in 2016).
Year ended December 31, 2016 compared to year ended December 31, 2015
The Company reported net income of $46.2 million ($2.20 per share) in 2016 compared to $50.2 million ($2.43 per share) in 2015. The decrease in net income was primarily due to declines in underwriting profitability and realized investment gains.
Premiums earned, losses and settlement expenses incurred, and the corresponding loss and settlement expense ratios, by line of business for each segment and on a consolidated basis, for the two years ended December 31, 2016 are as follows:
Premium income
Premiums earned increased 3.9 percent to $592.4 million in 2016 from $570.3 million in 2015. Despite increasingly competitive market conditions, both segments reported an increase in premium income. Rate levels for both segments continued to be constrained by a high level of competition, especially for quality accounts with good loss experience. Average rate level increases were just slightly positive in the property and casualty insurance segment in 2016, while the reinsurance segment continued to experience pricing pressure during the January 1, 2016 renewal season, when approximately 70 percent of its business renewed; however, the deterioration in pricing did slow considerably from that experienced in 2015. On an overall basis, the new and revised inter-company reinsurance programs between the Company's insurance segments and Employers Mutual reduced premiums earned by $5.6 million in 2016. For 2017, the cost the inter-company reinsurance programs would decline by $730,000.
Premiums earned for the property and casualty insurance segment increased 2.1 percent to $456.5 million in 2016 from $447.2 million in 2015. The premium amount for 2016 reflects $7.8 million ceded to Employers Mutual for the cost of the new inter-company reinsurance program. Excluding this amount, premiums earned increased 3.8 percent, primarily due to growth in insured exposures, new business, and small rate level increases on renewal business. New business premium (representing 14 percent of the pool participants’ direct written premiums) was approximately ten percent higher than in 2015. Commercial lines accounted for most of the increase in new business premium; however, personal lines also reported an increase in new business premium after several years of declining premium. Commercial lines new business continued to be in the desired range of growth, and management was encouraged by the reversal in personal lines, which experienced an approximate 36 percent increase in new business premium. This large increase was based on a relatively small amount of new business premium in 2015; however, it did reflect agents' and policyholders' satisfaction with the new products that were rolled out during 2016. While management continued to seek growth in most territories, it was particularly focused on achieving the strongest growth outside of the core Midwest market, which would help diversify the pool participants' book of business geographically, while staying consistent with the industry and line of business mix of the existing book of business. Renewal business premium increased approximately three percent during 2016. After factoring in the continued implementation of some mandatory rate reductions on workers' compensation business in a few states, the overall rate change on renewal business remained positive, but was less than one percent. Rates were expected to be mixed in 2017, with the largest rate increases expected in the troubled commercial auto line of business. Rate decreases were expected in the workers' compensation and general liability lines of business, and rates on most other lines of business were expected to be flat or increase slightly. During 2016, the overall policy retention rate remained strong at 86.8 percent (commercial lines at 87.0 percent and personal lines at 84.6 percent). These retention rates approximated those reported at the end of 2015.
Premiums earned for the reinsurance segment increased 10.5 percent to $135.9 million in 2016 from $123.1 million in 2015. This increase reflected a $2.3 million reduction in the total cost of the revised inter-company reinsurance program with Employers Mutual. For purposes of this comparison, the total cost of the 2016 reinsurance program included the premium paid to Employers Mutual ($5.1 million), as well as the cost of additional reinsurance protection purchased from external parties to provide increased protection in peak exposure territories. During 2015, the premium paid to Employers Mutual ($10.8 million, or 8 percent of total assumed reinsurance premiums written) included the cost of reinsurance protection purchased from external parties by Employers Mutual for its benefit. The reinsurance subsidiary purchased $5.1 million of additional reinsurance protection from external parties during 2016, with $3.5 million of ceded earned premium recognized in 2016. Excluding the reduction in the cost of the revised inter-company reinsurance program with Employers Mutual, premiums earned increased 8.6 percent, or $10.5 million; however, a $7.2 million negative premium adjustment recorded in the fourth quarter of 2015 was distorting this percentage increase. This premium adjustment was reported by the ceding company for the offshore energy and liability proportional account, and reduced the ultimate amount of premiums expected to be earned for underwriting years 2012 through 2014. Without this adjustment, and excluding the reduction in the cost of the revised inter-company reinsurance program with Employers Mutual, premiums earned increased approximately 2.6 percent in 2016. This increase was largely from growth in the property pro rata line of business, as well as the addition of some new domestic excess of loss contracts. During 2015, the ceded premium associated with the inter-company reinsurance program was allocated to all lines of business (both pro rata and excess of loss) because the premium was based on total assumed reinsurance premiums written. Beginning in 2016, the ceded premium for the inter-company reinsurance program was a fixed amount that was allocated to only the excess of loss line of business. The assumed reinsurance market continued to experience pricing pressure due to the influx of nontraditional capital and the lack of major catastrophic events. Pricing declines moderated somewhat during the January 1, 2017 renewal season, as rate level declines were much lower than those experienced on January 1, 2016 renewals. Rate decreases were estimated to be in the low-to-mid single digits across the excess of loss book of business.
Losses and settlement expenses
Losses and settlement expenses increased 4.4 percent to $386.9 million in 2016 from $370.7 million in 2015, and the loss and settlement expense ratio increased slightly to 65.3 percent in 2016 from 65.0 percent in 2015. An increase in the reinsurance segment's loss and settlement expense ratio was largely offset by a decline in the property and casualty insurance segment's ratio. During the third quarter of 2016, management implemented a new reserving methodology for the determination of direct bulk reserves in the property and casualty insurance segment, which impacted the process for determining how reserve adequacy was measured, and how reserves were allocated by accident year. Due to the expansion of the number of historical accident years included in the review process, the size of the range of reasonable reserves increased. The actuarial analysis of the Company’s carried reserves at December 31, 2016 indicated that they were in the upper half of the range of reasonable reserves. This placement in the range was lower than in previous years due to the range expansion associated with the process change; however, exclusive of the process change, the adequacy of the carried reserves appeared to be consistent with prior evaluations.
The loss and settlement expense ratio for the property and casualty insurance segment decreased to 64.5 percent in 2016 from 65.3 percent in 2015. This decrease was primarily attributed to a significant amount of favorable reserve development experienced on loss reserves and allocated settlement expense reserves in the workers' compensation and other liability lines of business. The favorable development in the workers' compensation line of business was generated by decreases in the claim frequency assumption for accident year 2015 and decreases in the claim severity assumptions for the five most recent accident years. The favorable development in the other liability line of business was generated by decreases in the claim severity assumptions for the last ten accident years. As previously noted, approximately $5.6 million of "mechanical" favorable development was generated during the implementation of the new reserving methodology in 2016. This development did not have any impact on earnings because it resulted from the movement of direct bulk reserves from prior accident years into the current accident year, with no change in total reserves.
Other factors impacting the property and casualty insurance segment's 2016 loss and settlement expense ratio include an increase in claim severity in the commercial auto line of business, and an increase in catastrophe and storm losses. Both the commercial auto and personal lines of business continued to generate unfavorable results in 2016, posting loss and settlement expense ratios of 84.2 percent and 72.8 percent, respectively. The industry was forecasting continued deterioration in the commercial auto line of business in 2017, and management was forecasting similar deterioration in the property and casualty insurance segment's results for this line of business if no additional steps were taken to improve profitability. Recognizing the importance of this issue, management implemented an intensive, multi-year Accelerate Commercial Auto Profitability project during 2016, with a goal of returning this line of business to profitability by mid-2019. Management continued to focus on the implementation of its new personal lines strategy, and had completed the roll-out of the new personal auto and homeowners policies in all states where personal lines business was written. Early indications were that the new policies had been well received by agents and policyholders; however, it would take some time before profitability improves.
Catastrophe and storm losses accounted for 7.7 percentage points of the property and casualty insurance segment's loss and settlement expense ratio in 2016, compared to 6.6 percentage points in 2015. The most recent 10-year average for this period was 9.8 percentage points. The property and casualty insurance segment recovered $7.5 million of catastrophe and storm losses under the new inter-company reinsurance program with Employers Mutual in 2016 ($5.0 million under the treaty covering the period from January 1 through June 30, and $2.5 million under the treaty covering the period from July 1 through December 31). Taking the loss recoveries received and the premiums paid to Employers Mutual into consideration, the new inter-company reinsurance program with Employers Mutual reduced the catastrophe and storm loss ratio for 2016 by 0.5 percentage points.
The loss and settlement expense ratio for the reinsurance segment increased to 68.1 percent in 2016 from 64.1 percent in 2015. The loss and settlement expense ratio for 2015 reflected an unusually low amount of reported large losses (losses greater than $100,000) and two large reductions in reported reserves for prior accident year events. A decline in catastrophe and storm losses helped limit the increase in the reinsurance segment's loss and settlement expense ratio. The largest catastrophe and storm loss incurred in 2016 was a $3.5 million loss stemming from the Alberta, Canada wildfire, while the largest loss incurred in 2015 was $4.5 million ($4.1 million net of reinsurance recovery under the inter-company reinsurance program with Employers Mutual) from the Tianjin, China explosion. No recoveries were made under the revised inter-company reinsurance program with Employers Mutual during 2016. The decline in the total cost of the revised inter-company reinsurance program with Employers Mutual produced a 1.4 percentage point decline in the loss and settlement expense ratio for 2016. This reduction was reflected in the catastrophe and storm loss ratio, which declined to 9.3 percentage points in 2016 from 12.0 percentage points in 2015. The most recent 10-year average for catastrophe and storm losses was 13.0 percentage points.
Acquisition and other expenses
Acquisition and other expenses increased 7.6 percent to $191.8 million in 2016 from $178.3 million in 2015. The acquisition expense ratio increased to 32.4 percent in 2016 from 31.3 percent in 2015. Acquisition and other expenses reported for both years included net periodic postretirement benefit income resulting from the amortization of a large prior service credit that resulted from an amendment of Employers Mutual's postretirement medical plan in the fourth quarter of 2013. This prior service credit was recognized in accumulated other comprehensive income in the fourth quarter of 2013, and is being amortized out of accumulated other comprehensive income and into net income over a period of 10 years. The increase in the 2016 ratio was primarily attributed to higher policyholder dividend expense in the property and casualty insurance segment.
The acquisition expense ratio for the property and casualty insurance segment increased to 34.8 percent in 2016 from 32.9 percent in 2015. The increase was primarily attributed to higher policyholder dividend expense resulting from favorable loss experience on some safety dividend groups. The 2016 ratio also reflected the premiums ceded to Employers Mutual under the new inter-company reinsurance program, which added 0.6 percentage points to the ratio.
The acquisition expense ratio for the reinsurance segment decreased to 24.3 percent in 2016 from 25.1 percent in 2015. The 2015 ratio reflected a $1.1 million commission adjustment for prior periods reported by a ceding company. A decrease in contingent commission expense on the offshore energy and liability proportional account contributed to the decline in the acquisition expense ratio in 2016. The 2016 ratio also reflected the reduction in the total cost of the revised inter-company reinsurance program with Employers Mutual, which reduced the acquisition expense ratio by 0.2 percentage points.
Investment results
Net investment income increased 4.2 percent to $47.5 million in 2016 from $45.6 million in 2015. The increase was primarily attributed to a higher amount of dividend income in 2016, but also reflected an increase in investment income from other long-term investments. The Company’s equity portfolio produced dividend income of $6.9 million and $5.6 million in 2016 and 2015, respectively. Current interest rate levels remained below the average book yield of the fixed maturity portfolio, and would therefore likely continue to limit future growth in net investment income. The average coupon rate on the fixed maturity portfolio, excluding interest-only securities, had declined slightly over the past year, coming in at 3.8 percent at December 31, 2016 compared to 3.9 percent at both December 31, 2015 and 2014. The effective duration of the fixed maturity portfolio, excluding interest-only securities, increased to 5.2 at December 31, 2016 from 4.6 at December 31, 2015.
The Company reported net realized investment gains of $4.1 million in 2016, compared to $6.2 million in 2015. Included in these amounts were losses of $6.3 million and $1.5 million in 2016 and 2015, respectively, from declines in the carrying value of a limited partnership that the Company had invested in since 2014 to help protect the equity portfolio from a sudden and significant decline in value (an equity tail-risk hedging strategy). Due to the sharp decline in the equity markets in August of 2015, the losses from this investment were much lower in 2015. The large amount of losses experienced in 2016 were more than offset by gains recognized during the fourth quarter from the sale of some equity securities in connection with a small re-balance of the investment portfolio. The Company recognized "other-than-temporary" impairment losses of $1.3 million and $1.5 million during 2016 and 2015, respectively. With the exception of a $209,000 impairment loss recorded in 2016 on a new investment that conveys investment tax credits (included in other long-term investments), these impairment losses were recognized on securities held in the Company's equity portfolio.
Other income
Included in other income were foreign currency exchange gains and losses recognized on the reinsurance segment’s foreign currency denominated reinsurance business. The reinsurance segment had foreign currency exchange gains of $356,000 and $898,000 in 2016 and 2015, respectively.
Income tax
Income tax expense decreased 20.9 percent to $17.0 million in 2016 from $21.5 million in 2015. The effective tax rate for 2016 was 26.9 percent, compared to 30.0 percent in 2015. The primary contributors to the differences between these effective tax rates and the United States federal corporate tax rate of 35 percent were tax-exempt interest income earned, the dividends received deduction, and, in 2016, $1.5 million of investment tax credits recognized from a renewable energy tax credit investment.
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 $58.9 million in 2017, $83.4 million in 2016 and $85.6 million in 2015. The Company typically generates substantial positive cash flows from operations because cash from premium payments is generally received in advance of cash payments made to settle claims. These positive cash flows provide the foundation of the Company’s asset/liability management program and are the primary driver of the Company’s liquidity. The Company invests in high quality, liquid securities to match the anticipated payments of losses and settlement expenses of the underlying insurance policies. Because the timing of the losses is uncertain, the majority of the portfolio is maintained in short to intermediate maturity securities that can be easily liquidated or that generate adequate cash flow to meet liabilities.
The Company is a holding company whose principal asset is its investment in its property and casualty insurance subsidiaries and its reinsurance subsidiary (“insurance subsidiaries”). As a holding company, the Company is dependent upon cash dividends from its insurance subsidiaries to meet all its obligations, including cash dividends to stockholders and the funding of the Company’s stock repurchase program. State insurance regulations restrict the maximum amount of dividends insurance companies can pay without prior regulatory approval. The maximum amount of dividends that the insurance subsidiaries can pay to the Company in 2018 without prior regulatory approval is approximately $54.2 million. The Company received $5.7 million, $9.7 million and $9.2 million of dividends from its insurance subsidiaries and paid cash dividends to its stockholders totaling $18.0 million, $16.2 million and $14.2 million in 2017, 2016 and 2015, respectively.
The Company’s insurance subsidiaries must maintain adequate liquidity to ensure that their cash obligations are met; however, because of the property and casualty insurance subsidiaries’ participation in the pooling agreement and the reinsurance subsidiary’s participation in the quota share agreement, they do not have the daily liquidity concerns normally associated with an insurance company. This is because under the terms of the pooling and quota share agreements, Employers Mutual receives all premiums and pays all losses and expenses associated with the insurance business produced by the pool participants and the assumed reinsurance business ceded to the Company’s reinsurance subsidiary, and then settles inter-company balances generated by these transactions with the participating companies on a monthly (pool participants) or quarterly (reinsurance subsidiary) basis.
At the insurance subsidiary level, the primary sources of cash are premium income, investment income and proceeds from called or matured investments. The principal outflows of cash are payments of claims, commissions, premium taxes, operating expenses, income taxes, dividends, interest and principal payments on debt, and investment purchases. Cash outflows vary because of uncertainties regarding settlement dates for unpaid losses and the potential for large losses, either individually or in the aggregate. Accordingly, the insurance subsidiaries maintain investment and reinsurance programs intended to provide adequate funds to pay claims without forced sales of investments. The insurance subsidiaries also have the ability to borrow funds on a short-term basis (180 days) from Employers Mutual under an Inter-Company Loan Agreement. In addition, Employers Mutual maintains access to a line of credit with the Federal Home Loan Bank that could be used to provide the insurance subsidiaries additional liquidity if needed.
The Company maintains a portion of its investment portfolio in relatively short-term and highly liquid investments to ensure the availability of funds to pay claims and expenses. A variety of maturities are maintained in the Company’s investment portfolio to assure adequate liquidity. The maturity structure of the fixed maturity portfolio is also established by the relative attractiveness of yields on short, intermediate and long-term securities. The Company does not invest in non-investment grade debt securities. Any non-investment grade securities held by the Company are the result of rating downgrades subsequent to their purchase.
The Company invests for the long term and generally purchases fixed maturity securities with the intent to hold them to maturity. Despite this intent, the Company currently classifies fixed maturity securities as available-for-sale to provide flexibility in the management of its investment portfolio. At December 31, 2017 and 2016, the Company had net unrealized holding gains, net of deferred taxes, on its fixed maturity securities available-for-sale of $17.3 million and $6.6 million, respectively. The fluctuation in the fair value of these investments is primarily due to changes in the interest rate environment during this time period, but also reflects fluctuations in risk premium spreads over U.S. Treasuries. Since the Company intends to hold fixed maturity securities to maturity, such fluctuations in the fair value of these investments are not expected to have a material impact on the operations of the Company, as forced liquidations of investments are not anticipated. The Company closely monitors the bond market and makes appropriate adjustments in its portfolio as conditions warrant.
The majority of the Company’s assets are invested in fixed maturity securities. These investments provide a substantial amount of investment income that supplements underwriting results and contributes to net earnings. As these investments mature, or are called, the proceeds are reinvested at current interest rates, which may be higher or lower than those now being earned; therefore, more or less investment income may be available to contribute to net earnings. Due to the prolonged low interest rate environment, proceeds from calls and maturities in recent years have been reinvested at lower yields, which has had a negative impact on investment income.
The Company held $13.6 million and $12.5 million in minority ownership interests in limited partnerships and limited liability companies at December 31, 2017 and 2016, respectively. These balances generally include investments in private equity arrangements, with the following two notable exceptions. The Company funds a limited partnership that is designed to help protect it from a sudden and significant decline in the value of its equity portfolio. During the 2017 and 2016, the Company invested additional funds of $5.8 million and $4.9 million, respectively, into this program. The Company's reinsurance subsidiary began investing in limited liability companies that convey renewable energy tax credits in 2016. During 2016, the reinsurance subsidiary invested $6.6 million in a limited liability company that produced $4.4 million of tax credits in 2016 and $775,000 of tax credits in 2017. During 2017, the reinsurance subsidiary invested $2.1 million in another limited liability company that produced $1.7 million of tax credits in 2017. After reductions for the utilization of the tax credits and a $209,000 impairment loss recognized during the fourth quarter of 2016, the carrying values of these investments totaled approximately $1.5 million and $2.0 million at December 31, 2017 and 2016, respectively. These investments are included in "other long-term investments" in the Company's financial statements, with the limited partnership carried under the equity method of accounting.
The Company participates in reverse repurchase arrangements, involving the purchase of investment securities from third-party sellers with the agreement that the purchased securities be sold back to the third-party sellers for agreed-upon prices at specified future dates. The third-party sellers are required to pledge collateral with a value greater than the amount of cash received in the transactions. In accordance with GAAP, the investment securities purchased under the reverse repurchase agreements are not reflected in the Company's consolidated balance sheets, but instead a receivable is recorded for the principal amount lent. The Company's receivable under reverse repurchase agreements was $16.5 million and $20.0 million at December 31, 2017 and 2016, respectively.
The Company’s cash balance was $347,000 and $307,000 at December 31, 2017 and 2016, respectively.
Employers Mutual contributed $7.0 million, $9.0 million and $4.0 million to its qualified pension plan in 2017, 2016 and 2015, respectively, and plans to contribute approximately $8.0 million to the qualified pension plan in 2018. The Company reimbursed Employers Mutual $2.1 million, $2.7 million and $1.2 million for its share of the pension contributions in 2017, 2016 and 2015, respectively. Employers Mutual did not make any contributions to its postretirement benefit plans during 2017, 2016, or 2015, and does not expect to make any contributions in 2018 due to the plan amendment that was announced during 2013.
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, 2017.
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, 2017, the Company’s insurance subsidiaries had total adjusted statutory capital of $560.1 million, which is well in excess of the minimum risk-based capital requirement of $94.4 million.
The Company’s total cash and invested assets at December 31, 2017 and 2016 are summarized as follows:
The amortized cost and estimated fair value of fixed maturity and equity securities at December 31, 2017 were as follows:
The Company’s property and casualty insurance subsidiaries have $25.0 million of surplus notes issued to Employers Mutual. The interest rate on the surplus notes is 1.35 percent. Reviews of the interest rate are conducted by the Inter-Company Committees of the boards of directors of the Company and Employers Mutual every five years, and was recently increased to 2.73 percent effective February 1, 2018, subject to regulatory approval. Payments of interest and repayments of principal can only be made out of the applicable subsidiary’s statutory surplus and are subject to prior approval by the insurance commissioner of the respective states of domicile. The surplus notes are subordinate and junior in right of payment to all obligations or liabilities of the applicable insurance subsidiaries. Total interest expense incurred on these surplus notes was $337,000 in 2017, 2016 and 2015. At December 31, 2017, the Company’s property and casualty insurance subsidiaries had received approval for the payment of interest accrued on the surplus notes during 2017.
As of December 31, 2017, the Company had no material commitments for capital expenditures.
Off-Balance Sheet Arrangements
Employers Mutual collects from agents, policyholders and ceding companies all written premiums associated with the insurance business produced by the pool participants and the assumed reinsurance business ceded to the reinsurance subsidiary. Employers Mutual also collects from its reinsurers all losses and settlement expenses recoverable under the reinsurance contracts protecting the pool participants and, starting in 2016, the reinsurance subsidiary, as well as the fronting business ceded to the reinsurance subsidiary. Employers Mutual settles with the pool participants (monthly) and the reinsurance subsidiary (quarterly) the premiums written from these insurance policies and the paid losses and settlement expenses recoverable under the external reinsurance contracts, providing full credit for the premiums written and the paid losses and settlement expenses recoverable under the external reinsurance contracts generated during the period (not just the collected portion). Due to this arrangement, and since a significant portion of the premium balances are collected over the course of the underlying coverage periods, Employers Mutual carries a substantial receivable balance for insurance and reinsurance premiums in process of collection and, to a lesser extent, paid losses and settlement expenses recoverable from the external reinsurance companies. Any of these receivable amounts that are ultimately deemed to be uncollectible are charged-off by Employers Mutual and the expense is charged to the reinsurance subsidiary or allocated to the pool members on the basis of pool participation. As a result, the Company has off-balance sheet arrangements with an unconsolidated entity that results in credit-risk exposures (Employers Mutual’s insurance and reinsurance premium receivable balances, and paid loss and settlement expense recoverable amounts) that are not reflected in the Company’s financial statements. The average annual expense for such charge-offs allocated to the Company over the past ten years is $380,000. 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 $1.1 million of “other-than-temporary” investment impairment losses during 2017, compared to $1.3 million during 2016. With the exception of a $209,000 impairment loss recorded in 2016 on a new investment that conveys renewable energy tax credits (included in other long-term investments), these impairment losses were recognized on securities held in the Company's equity portfolio.
At December 31, 2017, the Company had unrealized losses on available-for-sale securities as presented in the following table. The estimated fair value is based on quoted market prices, where available. In cases where quoted market prices are not available, fair values are based on a variety of valuation techniques depending on the type of security. None of these securities are considered to be in concentrations by either security type or industry. The Company uses several factors to determine whether the carrying value of an individual security has been “other-than-temporarily” impaired. Such factors include, but are not limited to, the security’s value and performance in the context of the overall markets, length of time and extent the security’s fair value has been below carrying value, key corporate events and, for fixed maturity securities, the amount of collateral available. Based on these factors, the absence of management’s intent to sell these securities prior to recovery or maturity, and the fact that management does not anticipate that it will be forced to sell these securities prior to recovery or maturity, it was determined that the carrying value of these securities were not “other-than-temporarily” impaired at December 31, 2017. 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 $9.9 million, net of tax; however, the Company’s financial position would not be affected because unrealized losses on available-for-sale securities are reflected in the Company’s financial statements as a component of stockholders’ equity, net of deferred taxes.
Following is a schedule of the length of time securities have continuously been in an unrealized loss position as of December 31, 2017.
Following is a schedule of the maturity dates of the fixed maturity securities presented in the above table.
The Company does not purchase non-investment grade fixed maturity securities. Any non-investment grade fixed maturity securities held are the result of rating downgrades that occurred subsequent to their purchase. At December 31, 2017, the Company held $2.9 million of non-investment grade fixed maturity securities in a net unrealized gain position of $38,000.
Following is a schedule of gross realized losses recognized in 2017. The schedule is aged according to the length of time the underlying securities were in an unrealized loss position.
LEASES, COMMITMENTS AND CONTINGENT LIABILITIES
The following table reflects the Company's contractual obligations as of December 31, 2017. 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 2024. Employers Mutual has entered into various leases for branch and service office facilities with lease terms expiring through 2027. 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.
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 increased to 2.73 percent effective February 1, 2018, with the next review scheduled for 2023). 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. The Company has accrued estimated guaranty fund assessments of $706,000 and $851,000 as of December 31, 2017 and 2016, respectively. Premium tax offsets of $897,000 and $1.0 million, which are related to prior guarantee fund payments and current assessments, have been accrued as of December 31, 2017 and 2016, respectively. The guaranty fund assessments are expected to be paid over the next two years and the premium tax offsets are expected to be realized within ten years of the payments. The participants in the pooling agreement are also subject to second-injury fund assessments, which are designed to encourage employers to employ workers with pre-existing disabilities. The Company had accrued estimated second-injury fund assessments of $2.0 million and $1.9 million as of December 31, 2017 and 2016, respectively. The second-injury fund assessment accruals are based on projected loss payments. The periods over which the assessments will be paid is not known.
The participants in the pooling agreement have purchased annuities from life insurance companies, under which the claimant is payee, to fund future payments that are fixed pursuant to specific claim settlement provisions. The Company’s share of case loss reserves eliminated by the purchase of those annuities was $110,000 at December 31, 2017. The Company had a contingent liability for the aggregate guaranteed amount of the annuities of $183,000 at December 31, 2017 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 the economic environment, business cycle, regulatory requirements, fluctuations in interest rates, underwriting results and consideration of other market risks. Investment decisions are centrally managed by investment professionals and are supervised by the investment committees of the respective boards of directors for each of the Company’s subsidiaries.
Market risk represents the potential for loss due to adverse changes in the fair value of financial instruments, and is directly influenced by the volatility and liquidity in the markets in which the related underlying assets are traded. The market risks of the financial instruments owned by the Company relate to the investment portfolio, which exposes the Company to interest rate (inclusive of credit spreads) and equity price risk and, to a lesser extent, credit quality and prepayment risk. Monitoring systems and analytical tools are in place to assess each of these elements of market risk; however, there can be no assurance that future changes in interest rates, creditworthiness of issuers, prepayment activity, liquidity available in the market and other general market conditions will not have a material adverse impact on the Company’s results of operations, liquidity or financial position.
Interest rate risk (inclusive of credit spreads) includes the price sensitivity of a fixed maturity security to changes in interest rates, and the effect 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.
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, excluding interest-only securities, at December 31, 2017 was 5.0.
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, 2017 would result in a corresponding pre-tax decrease in the fair value of the Company’s equity portfolio of approximately $19.9 million. Management implemented an equity tail-risk hedging strategy during 2014 to protect the Company from significant monthly downside price volatility in the equity markets. The cost of this protection (recorded as a realized investment loss) totaled $6.3 million during 2017. This hedging strategy may be discontinued in the future depending on market conditions and/or the cost of the protection.
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, 2017.
Ratings for preferred stocks and fixed maturity securities are assigned by nationally recognized statistical rating organizations ("NRSRO"). NRSRO rating processes seek to evaluate the quality of a security by examining the factors that affect returns to investors. NRSRO 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, 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 $307.5 million as of December 31, 2017. 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 Aa1/AA+ with over 98 percent of securities rated A3/A- or higher. Approximately $35.6 million 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 within the portfolio of mortgage-backed securities. Prepayment risk is monitored regularly through the analysis of interest rate simulations. At December 31, 2017, the effective duration of the mortgage-backed securities, excluding interest-only securities, is 6.9 with an average life of 8.6 years and a yield to worst of 3.1 percent. At December 31, 2016, the effective duration of the mortgage-backed securities, excluding interest-only securities, was 4.9, with an average life of 5.9 years and a yield to worst of 2.8 percent.
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
See note 1 of Notes to Consolidated Financial Statements under Part II, Item 8 of this Form 10-K for a description of new accounting pronouncements not yet adopted by the Company.
ITEM 7A.
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.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Management’s Report on Internal Control Over Financial Reporting
Management of EMC Insurance Group Inc. and Subsidiaries is responsible for the preparation, integrity and objectivity of the accompanying Consolidated Financial Statements, as well as all other financial information in this report. The Consolidated Financial Statements and the accompanying notes have been prepared in accordance with U.S. generally accepted accounting principles and include amounts that are based on management’s estimates and judgments where necessary.
Management is responsible for establishing and maintaining adequate internal control over financial reporting, including safeguarding of assets and reliability of financial records. The Company’s internal control over financial reporting, designed by or under the supervision of management, includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements. This control structure is further reinforced by a program of internal audits, including audits of the Company’s decentralized branch locations, which requires responsive management action.
There are inherent limitations in the effectiveness of any internal control, including the possibility of human error and the circumvention or overriding of controls. Accordingly, adequate internal controls can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of internal control may vary over time.
Management assessed the effectiveness of the Company’s internal control over financial reporting based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 Framework) (the COSO criteria). Based on this assessment, management believes that, as of December 31, 2017, the Company maintained effective internal control over financial reporting.
The Audit Committee of the Board of Directors is comprised of three directors who are independent of the Company’s management. The Audit Committee is responsible for the selection of the independent registered public accounting firm. It meets periodically with management, the independent registered public accounting firm, and the internal auditors to ensure that they are carrying out their responsibilities. In addition to reviewing the Company’s financial reports, the Audit Committee is also responsible for performing an oversight role by reviewing and monitoring the financial, accounting and auditing procedures of the Company. The independent registered public accounting firm and the internal auditors have full and free access to the Audit Committee, with or without the presence of management, to discuss the adequacy of internal control over financial reporting and any other matters which they believe should be brought to the attention of the Audit Committee.
The Company’s financial statements and internal control over financial reporting have been audited by Ernst & Young LLP, an independent registered public accounting firm. Management has made available to Ernst & Young LLP all of the Company’s financial records and related data, as well as the minutes of the stockholders’ and directors’ meetings. Furthermore, management believes that all representations made to Ernst & Young LLP during its audit were valid and appropriate. Their reports with respect to the fairness of presentation of the Company’s financial statements and the effectiveness of the Company’s internal control over financial reporting appear elsewhere in this annual report.
/s/ Bruce G. Kelley
/s/ Mark E. Reese
Bruce G. Kelley
Mark E. Reese
President, Chief Executive Officer and Treasurer
Senior Vice President and Chief Financial Officer
(Principal Executive Officer)
(Principal Financial and Accounting Officer)
Report of Independent Registered Public Accounting Firm
To the Stockholders and the Board of Directors of EMC Insurance Group Inc.
Opinion on Internal Control over Financial Reporting
We have audited EMC Insurance Group Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, EMC Insurance Group Inc. and Subsidiaries (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the 2017 consolidated financial statements of the Company and our report dated March 5, 2018 expressed an unqualified opinion thereon.
Basis for Opinion
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.
Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
Definition and Limitations of Internal Control Over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Stockholders and the Board of Directors of EMC Insurance Group Inc.
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of EMC Insurance Group Inc. and Subsidiaries (the Company) as of December 31, 2017 and 2016, the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2017, and the related notes and financial statement schedules listed in the Index at Item 15(a) (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations and the Treadway Commission (2013 framework), and our report dated March 5, 2018 expressed an unqualified opinion thereon.
Basis for Opinion
These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatements of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and the significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
All affiliated balances presented above are the result of related party transactions with Employers Mutual.
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
All affiliated balances presented above are the result of related party transactions with Employers Mutual.
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
All affiliated balances presented above are the result of related party transactions with Employers Mutual.
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
All affiliated balances presented above are the result of related party transactions with Employers Mutual.
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
All affiliated balances presented above are the result of related party transactions with Employers Mutual.
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
All affiliated balances presented above are the result of related party transactions with Employers Mutual.
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED
All affiliated balances presented above are the result of related party transactions with Employers Mutual.
See accompanying Notes to Consolidated Financial Statements.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of Business
EMC Insurance Group Inc., a majority owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance and reinsurance. The Company conducts its property and casualty insurance operations through the following subsidiaries: EMCASCO Insurance Company, Illinois EMCASCO Insurance Company and Dakota Fire Insurance Company, and its reinsurance operations through its subsidiary, EMC Reinsurance Company. The Company also has an excess and surplus lines insurance agency subsidiary, EMC Underwriters, LLC. The term “Company” is used interchangeably to describe EMC Insurance Group Inc. (Parent Company only) and EMC Insurance Group Inc. and its subsidiaries.
The Company writes property and casualty insurance in both commercial and personal lines of insurance, with a focus on medium-sized commercial accounts. Approximately 37 percent of the premiums written are in Iowa and contiguous states. The Company’s reinsurance business is primarily written through a quota share reinsurance agreement with Employers Mutual. A small portion of the assumed reinsurance business is written on a direct basis, outside the quota share reinsurance agreement.
Principles of Consolidation and Basis of Presentation
The consolidated financial statements have been prepared on the basis of U.S. generally accepted accounting principles (GAAP), which differ in some respects from those followed in reports to insurance regulatory authorities. All significant inter-company balances and transactions have been eliminated.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. The Company has evaluated all subsequent events through the date the financial statements were issued.
Property and Casualty Insurance and Reinsurance Operations
Premiums written is the amount charged for policies issued during a reporting period. Property and casualty insurance premiums are recognized as revenue ratably over the terms of the respective policies. Unearned premiums are calculated on the daily pro rata method. Both domestic and foreign assumed reinsurance premiums are recognized as revenues ratably over the terms of the related contracts and underlying policies. Amounts paid as ceded reinsurance premiums are reported as prepaid reinsurance premiums and are amortized over the remaining contract period in proportion to the amount of reinsurance protection provided. Reinsurance reinstatement premiums are recognized in the same period as the loss event that gave rise to the reinstatement premiums.
Costs related to the acquisition of insurance contracts are deferred and amortized to expense as the associated premium revenue is recognized. Only incremental costs or costs directly related to the successful acquisition of new or renewal insurance contracts are capitalized. Accordingly, acquisition costs consist of commissions, premium taxes, and salary and benefit expenses of employees directly involved in the underwriting of insurance policies that are successfully issued.
The method 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 not discounted and are based on the Company’s projected loss and settlement expense ratios for the next twelve months, which include catastrophe loads based on historical results adjusted for recent trends. The occurrence of a significant catastrophic event, and/or the accumulation of catastrophe losses would not have a direct impact on the determination of premium deficiencies; however, such occurrences would be included in the historical results that are used to establish the catastrophe loads. A premium deficiency is first recognized by expensing the amount of unamortized deferred policy acquisition costs necessary to eliminate the deficiency. If the premium deficiency is greater than the unamortized deferred policy acquisition costs, a liability is accrued for the excess deficiency. The Company did not record a premium deficiency for the years ended December 31, 2017, 2016 or 2015.
Certain commercial lines of business written by the property and casualty insurance subsidiaries, including workers’ compensation, are eligible for policyholder dividends in accordance with provisions of the underlying insurance policies. Net premiums written subject to policyholder dividends represented approximately 26 percent and 22 percent of the property and casualty insurance subsidiaries’ total net commercial line premiums written in 2017 and 2016, respectively. Policyholder dividends are accrued over the terms of the underlying policy periods.
Liabilities for losses reflect losses incurred through the balance sheet date and are based upon the estimated ultimate loss ratios established by line of business and accident year, and estimates of losses expected under assumed reinsurance contracts. Liabilities for settlement expenses are provided by estimating expenses expected to be incurred in settling the claims provided for in the loss reserves. Changes in reserves estimates are reflected in net income in the year such changes are recorded (see note 4).
Ceded reinsurance amounts with nonaffiliated reinsurers relating to reinsurance receivables for unpaid losses and settlement expenses and prepaid reinsurance premiums are reported on the balance sheet on a gross basis. Amounts ceded to Employers Mutual under the affiliated reinsurance pooling agreement and the inter-company reinsurance programs (see note 2) have not been grossed up because the contracts provide that receivables and payables may be offset upon settlement.
Based on current information, the liabilities for losses and settlement expenses are considered to be adequate. Since the provisions are necessarily based on estimates, the ultimate liabilities may be more or less than such provisions.
Investments
Currently, all securities are classified as available-for-sale and are carried at fair value, with unrealized holding gains and losses reported as a component of accumulated other comprehensive income in stockholders’ equity, net of deferred income taxes. Other long-term investments consist of holdings in limited partnerships that are carried under the equity method of accounting, and holdings in limited partnerships and limited liability companies that are carried at amortized cost. The Company has an investment in a limited partnership that is designed to help protect the Company from a sudden and significant decline in the value of its equity portfolio. This limited partnership is carried under the equity method of accounting. Because of the nature of this investment, which is used solely to support the equity tail-risk hedging strategy, changes in the carrying value of the limited partnership are recorded as realized investment gains (losses), rather than as a component of investment income. Short-term investments generally include money market funds, U.S. Treasury bills and commercial paper that are carried at fair value, which approximates cost.
The Company participates in a reverse repurchase arrangement involving the purchase of investment securities from third-party sellers, with the agreement that the purchased securities be sold back to the third-party sellers for agreed-upon prices at specified future dates. The third-party sellers are required to pledge collateral with a value greater than the amount of cash received in the transactions. In accordance with GAAP, the investment securities purchased under the reverse repurchase agreements are not reflected in the Company's consolidated balance sheets, but instead a receivable is recorded for the principal amount lent. Net proceeds/disbursements related to the reverse repurchase transactions are reported as a component of investing activities in the consolidated statements of cash flows, and the income as a component of operating activities.
The Company uses independent pricing sources to obtain the estimated fair value of securities. The 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 investment. The fair values obtained from independent pricing sources are reviewed for reasonableness and any discrepancies are investigated for final valuation (see note 8). The Company uses a practical expedient to measure the pooled separate account investments in Employers Mutual's qualified pension plan at the net asset value per share (see note 12).
Premiums and discounts on fixed maturity securities are amortized over the expected life of the security as an adjustment to yield using the effective interest method. Amortization of premiums and discounts on mortgage-backed securities incorporates prepayment assumptions to estimate expected lives. Prepayment assumptions are reviewed quarterly and adjusted as necessary. Gains and losses realized on the disposition of investments are included in net income. The cost of investments sold is determined on the specific identification method using the highest cost basis first. Included in investments at December 31, 2017 and 2016 are securities on deposit with various regulatory authorities as required by law amounting to $11.3 million and $11.0 million, respectively.
The Company regularly monitors its investment portfolio for securities whose fair value 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, (4) for fixed maturity securities, the amount of collateral available, and (5) for equity securities, the ability and intent to hold the security until recovery to its cost basis. 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 and charged to income. For fixed maturity securities, 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 a credit loss is recognized through earnings, and the portion of the impairment related to other factors, if any, is recognized through “other comprehensive income”. Alternatively, if the Company has the intent to sell a fixed maturity security that is in an unrealized loss position, or determines that it will "more likely than not" be required to sell a fixed maturity security that is in an unrealized loss position before recovery of its amortized cost basis, then the carrying value is reduced to fair value and the entire amount of the impairment is recognized through earnings.
Income Taxes
The Company files a consolidated Federal income tax return with its subsidiaries. Consolidated income taxes/benefits are allocated among the entities based upon separate tax liabilities.
Deferred income taxes are provided for temporary differences between the tax basis of assets and liabilities and the reported amounts of those assets and liabilities for financial reporting purposes. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Income tax expense provisions increase or decrease in the same period in which a change in tax rates is enacted. A valuation allowance is established to reduce deferred tax assets to their net realizable value if it is “more likely than not” that a tax benefit will not be realized.
In February 2018, the Financial Accounting Standards Board (FASB) issued updated guidance in Income Statement-Comprehensive Income Topic 220 of the Accounting Standards CodificationTM (Codification or ASC). The objective of this update is to allow a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act of 2017 (TCJA), and requires certain disclosures about the stranded tax effects. The Company adopted this guidance in 2017, and elected to transfer the stranded tax effects in accumulated other comprehensive income to retained earnings as reflected in the consolidated statements of stockholders' equity. The Company releases the tax effects in accumulated other comprehensive income on an individual unit of account basis.
An assessment of the Company’s current tax positions indicated no uncertainties that would warrant different recognition and valuation from that applied in the Company’s tax returns.
Stock-Based Compensation
The Company has a stock-based compensation plan for non-employee directors. Compensation expense under this plan is based upon grant date fair value, which is recognized as the requisite service period is rendered. The Company has no other stock-based compensation plans of its own; however, Employers Mutual has several stock plans that utilize the common stock of the Company. The Company receives the current fair value for all shares issued under Employers Mutual's plans, and a portion of the compensation expense recognized by Employers Mutual is allocated to the Company’s property and casualty insurance subsidiaries though their participation in the pooling agreement (see note 2). For granted options and restricted stock awards, the expense is based upon the grant date fair value, which is recognized as the requisite service periods are rendered. For granted restricted stock units, the expense is determined in accordance with the liability-based model, whereby Employers Mutual records a liability representing the current value of the Company's stock granted for the portion of the service period that has been rendered (both the liability and the resulting expense are allocated to the Company's property and casualty insurance subsidiaries through the pooling agreement). Excess tax benefits (deficiencies) related to non-qualified stock option activities allocated to the Company's property and casualty insurance subsidiaries through the pooling agreement are recognized through the consolidated statements of income as components of current and deferred income taxes, with the associated cash flows reflected as cash flows from operating activities. Because a portion of Employers Mutual’s stock compensation expense is reflected in the Company’s financial statements and issuances of the Company’s stock under Employers Mutual’s stock plans have an impact on the Company’s capital accounts, the disclosures required by the Compensation - Stock Compensation Topic 718 of the FASB ASC are included in the Company’s consolidated financial statements (see note 13).
Employee Retirement Plans
Employers Mutual has various employee benefit plans, including two defined benefit pension plans, and two postretirement benefit plans that provide retiree healthcare and life insurance benefits. Although the Company has no employees of its own, it is responsible for its share of the plans' expenses and related prepaid assets and liabilities (the "funded status") as determined under the terms of the pooling agreement. Accordingly, the Company recognizes its share of the funded status of Employers Mutual’s pension and postretirement benefit plans on its balance sheet, with changes in the funded status of the plans recognized through “other comprehensive income.” In addition, the Company is responsible for its share of costs of these plans allocated by Employers Mutual to subsidiaries that do not participate in the pooling agreement (see note 2). During 2016, Employers Mutual's management determined that an allocation of the plans' funded status to the Company's reinsurance subsidiary would no longer be made because the amounts were immaterial and significant time and cost was needed to determine the allocation. As a result, the assets and liabilities allocated to the reinsurance subsidiary as of December 31, 2015 were settled with Employers Mutual during 2016.
Accounts Receivable
The accounts receivable balance consists of assumed reinsurance premiums receivable (net of any commissions) on business written directly by the reinsurance subsidiary, and commission income receivable on excess and surplus lines business marketed by EMC Underwriters, LLC. These receivables are carried at their initial recognition amounts. It is the Company’s policy to reflect the impairment of receivables through a valuation allowance until ultimately collected or charged-off. No valuation allowance is currently carried, as no amounts are deemed impaired. No interest income, other fees, or deferred costs related to these receivables are assessed or recognized.
Off-Balance-Sheet Credit Exposure
Employers Mutual collects from agents, policyholders and ceding companies all written premiums associated with the insurance business produced by the pool participants and the assumed reinsurance business ceded to the reinsurance subsidiary. Employers Mutual also collects from its reinsurers all losses and settlement expenses recoverable under the reinsurance contracts protecting the pool participants and, starting in 2016, the reinsurance subsidiary (see note 2), as well as the fronting business ceded to the reinsurance subsidiary. Employers Mutual settles with the pool participants (monthly) and the reinsurance subsidiary (quarterly) the premiums written from these insurance policies and the paid losses and settlement expenses recoverable under the external reinsurance contracts, providing full credit for the premiums written and the paid losses and settlement expenses recoverable under the external reinsurance contracts generated during the period (not just the collected portion). Due to this arrangement, and since a significant portion of the premium balances are collected over the course of the underlying coverage periods, Employers Mutual carries a substantial receivable balance for insurance and reinsurance premiums in process of collection and, to a lesser extent, paid losses and settlement expenses recoverable from the external reinsurance companies. Any of these receivable amounts that are ultimately deemed to be uncollectible are charged-off by Employers Mutual and the expense is charged to the reinsurance subsidiary or allocated to the pool members on the basis of pool participation. As a result, the Company has off-balance sheet arrangements with an unconsolidated entity that results in credit-risk exposures (Employers Mutual’s insurance and reinsurance premium receivable balances, and paid loss and settlement expense recoverable amounts) that are not reflected in the Company’s financial statements. The average annual expense for such charge-offs allocated to the Company over the past ten years is $380,000. 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.
Foreign Currency Transactions
Included in the underlying reinsurance business assumed by the reinsurance subsidiary are reinsurance transactions conducted with foreign cedants denominated in their local functional currencies. In accordance with the terms of the quota share agreement (see note 2), the reinsurance subsidiary assumes all foreign currency exchange gains/losses associated with contracts that are subject to the quota share agreement. The reinsurance subsidiary also has foreign currency exchange gains/losses associated with the business assumed outside the quota share agreement. The assets and liabilities resulting from these foreign reinsurance transactions are reported in U.S. dollars based on the foreign currency exchange rates that existed at the balance sheet dates. The foreign currency exchange rate gains/losses reported in the consolidated statements of income that resulted from these foreign reinsurance transactions are reported in U.S. dollars re-measured from the foreign currency exchange rates that existed at the inception of each reinsurance contract. The foreign currency exchange rate gains/losses resulting from these re-measurements to U.S. dollars are reported as a component of other income in the consolidated statements of income.
Net Income Per Share - Basic and Diluted
The Company’s basic and diluted net income per share is computed by dividing net income by the weighted average number of common shares outstanding during each period. As previously noted, the Company receives the current fair value for all shares issued under Employers Mutual’s stock plans. As a result, with the exception of the immaterial number of shares of outstanding non-vested restricted stock issued to the Company's non-employee directors, the Company had no potential common shares outstanding during 2017, 2016 or 2015 that would have been dilutive to the calculation of net income per share. The outstanding non-vested restricted stock issued to the Company's non-employee directors is not material enough to produce a diluted net income per share different from the basic net income per share; therefore, the Company does not disclose an amount for the diluted weighted average number of common shares outstanding.
Goodwill
Goodwill represents the excess of cost over the fair value of net assets of acquired subsidiaries. Goodwill is not amortized, but is instead subject to impairment if the carrying value of the goodwill exceeds the estimated fair value of net assets. If the carrying amount of the reporting unit (including goodwill) exceeds the computed fair value, an impairment loss is recognized through the income statement equal to the excess amount, but not greater than the balance of the goodwill. Goodwill was not deemed to be impaired in 2017, 2016 or 2015.
New Accounting Pronouncements Not Yet Adopted
In May 2014, the FASB updated its guidance related to the Revenue from Contracts with Customers Topic 606 of the ASC. The objective of this update (and other related following updates) is to improve the reporting of revenue by providing a more robust framework for addressing revenue issues, and improved disclosure requirements. Current revenue recognition guidance in U.S. GAAP is comprised of broad revenue recognition concepts together with numerous revenue requirements for particular industries or transactions, which sometimes result in different accounting for economically similar transactions. This guidance is to be applied retrospectively to annual and interim reporting periods beginning after December 15, 2017, with early adoption permitted as of the original effective date (annual and interim reporting periods beginning after December 15, 2016). The Company has adopted this guidance as of January 1, 2018. Since premium revenue from insurance contracts is excluded, the Company has only minimal revenue items that are covered by this guidance. The largest revenue item, outside of premium income, is commission income on excess and surplus lines business marketed by EMC Underwriters, LLC, which is included in "Other income" in the consolidated statements of income. Applying this new revenue recognition guidance to commission income produces no material difference compared to that recognized under current practices, as the commission income is typically recognized in full at the time the policy is issued, which is when substantially all of the performance obligation is performed. Adoption of this guidance will have no impact on the consolidated financial condition or operating results of the Company.
In January 2016, the FASB updated its guidance related to the Financial Instruments-Overall Subtopic 825-10 of the ASC. The objective of this update is to enhance the reporting model for financial instruments to provide financial statement users with more decision-useful information. The major change in reporting from this update that will impact the Company is a requirement that equity investments (excluding those accounted for under the equity method of accounting or those that are consolidated) be measured at fair value, with changes in fair value recognized in net income. While all of the Company's equity investments are already measured at fair value (with the exception of those that are consolidated and those that are accounted for under the equity method of accounting), the Company currently classifies all of its investments in equity securities as available-for-sale, and as such, the changes in fair value are currently recognized in other comprehensive income rather than net income. This guidance is to be applied to annual and interim reporting periods beginning after December 15, 2017, with recognition of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. Early adoption is not permitted. The Company adopted this guidance on January 1, 2018, and reclassified $66.2 million from accumulated other comprehensive income to retained earnings which is equal to the amount of net unrealized gains on available-for-sale equity securities as of December 31, 2017, net of deferred income tax. Adoption of this guidance is expected to introduce volatility to the Company's consolidated net income.
In February 2016, the FASB issued updated guidance in Leases Topic 842 of the ASC, which supersedes the guidance in Leases Topic 840 of the ASC. The objective of this update is to increase transparency and comparability among organizations by requiring recognition of lease assets and lease liabilities on the balance sheet, and disclosure of key information about leasing arrangements. This guidance is effective for interim and annual periods beginning after December 15, 2018, and is to be applied using a modified retrospective approach. Early adoption is permitted. The Company will adopt this guidance during the first quarter of 2019. Management continues to research this guidance, which thus far has led management to a preliminary determination that lease costs allocated to the Company through the pooling and quota share agreements can not be attributed to a specified asset, and therefore do not meet the definition of a leased asset contained in the guidance. As a result, adoption of this guidance is not expected to have a material impact on the Company's consolidated financial condition or net income.
In June 2016, the FASB issued updated guidance in Financial Instruments-Credit Losses Topic 326 of the ASC. The objective of this update is to provide information about expected credit losses on financial instruments and other commitments to extend credit. Specifically, this updated guidance replaces the current incurred loss impairment methodology, which delays recognition of a loss until it is probable a loss has been incurred, with a methodology that reflects expected credit losses considering a broader range of reasonable and supportable information. This guidance covers financial assets that are not accounted for at fair value through net income, thus will not be applicable to the Company's equity investments upon implementation of the updated guidance described above for the Financial Instruments-Overall Subtopic 825-10. This guidance is effective for interim and annual periods beginning after December 15, 2019, and is to be applied with a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective (modified-retrospective approach). Early adoption is permitted, but only to fiscal years beginning after December 15, 2018. The Company will adopt this guidance during the first quarter of 2020. The Company is currently evaluating the impact this guidance will have on the Company's consolidated financial condition and net income.
In March 2017, the FASB issued updated guidance in Compensation-Retirement Benefits Topic 715 of the ASC. The objective of this update is to improve the presentation of net periodic pension and postretirement benefit costs by disaggregating the components of these expenses (disclosing the service cost component separately from the other components) for income statement reporting. Also included in this update is a prohibition against including components of the net periodic pension and postretirement benefit costs, other than the service cost component, in any capitalized assets. This guidance is effective for interim and annual periods beginning after December 15, 2017. The portion of the guidance related to the income statement display of net periodic pension and postretirement benefit costs is to be applied retrospectively, while the prohibition against including these costs, other than the service cost component, in capitalized assets is to be applied prospectively. Early adoption is permitted. The Company has adopted this guidance as of January 1, 2018. Adoption will not impact consolidated stockholders' equity initially; however, the prohibition against including components of the net periodic pension and postretirement benefit costs, other than the service cost component, in capitalized assets is expected to result in a relatively small change in the deferred policy acquisition cost asset starting March 31, 2018, which is expected to have an immaterial impact, net of tax, on consolidated stockholders' equity and net income from that which would otherwise have been reported.
2.
AFFILIATION AND TRANSACTIONS WITH AFFILIATES
The operations of the Company are highly integrated with those of Employers Mutual through participation in a property and casualty reinsurance pooling agreement (the "pooling agreement"), a quota share retrocessional reinsurance agreement (the "quota share agreement") and inter-company reinsurance programs. All transactions occurring under the pooling agreement, quota share agreement and the inter-company reinsurance programs are based on statutory accounting principles. Certain adjustments are made to the statutory-basis amounts assumed by the property and casualty insurance subsidiaries and the reinsurance subsidiary to bring the amounts into compliance with GAAP.
Property and Casualty Insurance Subsidiaries
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 a pooling agreement with Employers Mutual. Under the terms of the pooling agreement, each company cedes to Employers Mutual all of its insurance business, 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 pool is 30 percent.
Since 2016, the Company's property and casualty insurance subsidiaries and Employers Mutual have been parties to an inter-company reinsurance program. This reinsurance program is intended to reduce the volatility of the Company's quarterly results caused by excessive catastrophe and storm losses, and provide protection from both the frequency and severity of such losses. The reinsurance program consists of two semi-annual aggregate catastrophe excess of loss treaties. The first treaty is effective each year from January 1 through June 30, and has a retention of $20.0 million and a limit of $24.0 million. The total cost of this treaty was approximately $6.0 million in 2017. The second treaty is effective each year from July 1 through December 31, and has a retention of $15.0 million and a limit of $12.0 million. The total cost of this treaty was approximately $1.4 million in 2017. The terms of these treaties were the same in 2016 with the exception of the costs, which were $6.3 million during the first half of 2016 and $1.5 million during the second half of 2016. Losses and settlement expenses ceded to Employers Mutual under the inter-company reinsurance program totaled $19.2 million, compared to $7.5 million during 2016. All catastrophe and storm losses assumed by the property and casualty insurance subsidiaries (net of applicable reinsurance recoveries from external reinsurance protections purchased by the pool participants) are subject to the terms of these treaties, and there is no co-participation provision. In accordance with the terms of the treaties, all outstanding balances associated with the 2016 treaties were commuted at the end of 2017. In connection with that commutation, Employers Mutual paid the property and casualty insurance subsidiaries $2.8 million to settle the outstanding loss and settlement expense reserves, with no gain or loss recognized on the commutation.
Operations of the pool and the inter-company reinsurance program give rise to inter-company balances with Employers Mutual, which are generally settled during the subsequent 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 participating in the pool. The pooling agreement produces a more uniform and stable underwriting result from year to year for the companies participating 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 statutory surplus, and from the wide range of policy forms, lines of insurance written, rate filings and commission plans offered by each of the companies.
Reinsurance Subsidiary
The Company’s reinsurance subsidiary is party to a quota share agreement and an inter-company reinsurance program 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 inter-company reinsurance program in place with Employers Mutual covers both business assumed from Employers Mutual through the quota share agreement, as well as business obtained outside the quota share agreement. The Inter-Company Committees of the boards of directors of the Company and Employers Mutual approved a change in the inter-company reinsurance program between the Company's reinsurance subsidiary and Employers Mutual starting in 2016. This revised reinsurance program now consists of two treaties. The first is a per occurrence catastrophe excess of loss treaty with a retention of $10.0 million, a limit of $10.0 million, 20 percent co-participation, and no reinstatement. The total cost of this treaty was approximately $1.7 million in 2017. The second is an annual aggregate catastrophe excess of loss treaty with a retention of $20.0 million, a limit of $100.0 million, and 20 percent co-participation. The total cost of this treaty was approximately $3.2 million in 2017. Any losses recovered under the per occurrence treaty inure to the benefit of the aggregate treaty, and only catastrophic events with total losses greater than $500,000 are subject to the terms of the aggregate treaty. The terms of the program were the same in 2016 with the exception of the costs, which were $2.0 million for the per occurrence treaty and $3.2 million for the annual aggregate treaty. Prior to 2016, the reinsurance program with Employers Mutual consisted of a single excess of loss reinsurance agreement. Under the terms of that agreement, the reinsurance subsidiary retained the first $4.0 million of losses per event, and also retained 20 percent of any losses between $4.0 million and $10.0 million and 10 percent of any losses between $10.0 million and $50.0 million. The cost of the excess of loss reinsurance protection, which included reimbursement for the cost of reinsurance protection purchased by Employers Mutual to protect itself from the assumption of excessive losses in the event of a major catastrophe, was calculated as 8.0 percent of the reinsurance subsidiary’s total assumed reinsurance premiums written in 2015, and amounted to $10.8 million. Losses and settlement expenses ceded to Employers Mutual under the inter-company reinsurance program totaled $16.8 million in 2017, compared to a negative $467,000 during 2016, and $622,000 during 2015. In accordance with the terms of the treaties, the 2016 treaties were commuted at the end of 2017, with no payment and no gain or loss recognized on the commutation.
In connection with the change in the inter-company reinsurance program in 2016, the reinsurance subsidiary began purchasing additional reinsurance protection in peak exposure territories from external parties in which coverage is triggered when losses experienced by the insurance industry from a catastrophic event exceed a specified threshold. Any reinsurance recoveries received from external parties reduces the amount of losses ceded to Employers Mutual under the inter-company reinsurance program. No recoveries have been made from external parties in 2017 or 2016.
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 underwriting association (MRB), 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 and the inter-company reinsurance program, as well as the purchase of the reinsurance protection from external parties, give rise to inter-company balances with Employers Mutual, which are generally settled during the month following the end of each quarter. The investment and income tax activities of the reinsurance subsidiary are not subject to the quota share agreement.
Premiums earned assumed by the reinsurance subsidiary from Employers Mutual amounted to $135.7 million, $135.2 million and $129.6 million in 2017, 2016 and 2015, respectively. Losses and settlement expenses assumed by the reinsurance subsidiary from Employers Mutual amounted to $131.1 million, $90.9 million and $77.5 million in 2017, 2016 and 2015, respectively. It is customary in the reinsurance business for the assuming company to compensate the ceding company for the acquisition expenses incurred in the generation of the business. Commissions incurred by the reinsurance subsidiary under the quota share agreement with Employers Mutual amounted to $27.5 million, $27.4 million and $27.3 million in 2017, 2016 and 2015, respectively.
The net foreign currency exchange gains (losses) assumed by the reinsurance subsidiary from Employers Mutual were $(978,000) in 2017, $367,000 in 2016 and $386,000 in 2015. The total amount of net foreign currency exchange gains (losses) assumed by the reinsurance subsidiary, including the business written on a direct basis outside the quota share agreement, were $(1.6) million in 2017, $356,000 in 2016 and $898,000 in 2015.
Services Provided by Employers Mutual
The Company does not have any employees of its own. Employers Mutual performs all operations for all of its subsidiaries and affiliate. Such services include data processing, claims, financial, actuarial, legal, auditing, marketing and underwriting. Employers Mutual allocates a portion of the cost of these services to its subsidiaries that do not participate in the pooling agreement based upon a number of criteria, including usage of the services and the number of transactions. The remaining costs are charged to the pooling agreement and each pool participant shares in the total cost in accordance with its pool participation percentage. Costs allocated to the Company by Employers Mutual for services provided to the holding company and its subsidiaries that do not participate in the pooling agreement amounted to $4.4 million, $4.7 million and $3.4 million in 2017, 2016 and 2015, respectively. Costs allocated to the Company through the operation of the pooling agreement amounted to $97.7 million, $92.3 million and $87.4 million in 2017, 2016 and 2015, respectively.
Investment expenses are based on actual expenses incurred by the Company and its subsidiaries, plus an allocation of other investment expenses incurred by Employers Mutual, which is based on a weighted-average of total invested assets and number of investment transactions. Investment expenses allocated to the Company by Employers Mutual amounted to $1.6 million, $1.4 million and $1.4 million in 2017, 2016 and 2015, respectively.
3.
REINSURANCE
The parties to the pooling agreement cede insurance business to other insurers in the ordinary course of business for the purpose of limiting their maximum loss exposure through diversification of their risks. In its consolidated financial statements, the Company treats risks to the extent they are reinsured as though they were risks for which the Company is not liable. However, insurance ceded by the pool participants does not relieve their primary liability as the originating insurers. Employers Mutual evaluates the financial condition of the reinsurers of the parties to the pooling agreement and monitors concentrations of credit risk arising from similar geographic regions, activities or economic characteristics of the reinsurers to minimize exposure to significant losses from reinsurer insolvencies.
As of December 31, 2017 and 2016, amounts recoverable from nonaffiliated reinsurers (three in 2017 and two in 2016) totaled $22.7 million and $10.4 million respectively, which represents a significant portion of the total prepaid reinsurance premiums and reinsurance receivables for losses and settlement expenses. Included in the 2017 balance is the property and casualty insurance subsidiaries’ aggregate pool participation percentage of amounts ceded by Employers Mutual to an organization on a mandatory basis. Credit risk associated with these amounts are minimal, as all companies participating in the organization are responsible for the liabilities of the organization on a pro rata basis.
The effect of reinsurance on premiums written and earned, and losses and settlement expenses incurred, for the three years ended December 31, 2017 is presented below. The classification of the assumed and ceded reinsurance amounts between affiliates and nonaffiliates is based on the participants in the underlying reinsurance agreements, and is intended to provide an understanding of the actual source of the reinsurance activities. This presentation differs from the classifications used in the consolidated financial statements, where all amounts flowing through the pooling and quota share agreements and inter-company reinsurance programs with Employers Mutual are reported as “affiliated” balances.
Individual lines in the above tables are defined as follows:
•
“Direct” represents business produced by the property and casualty insurance subsidiaries.
•
“Assumed from nonaffiliates” for the property and casualty insurance subsidiaries represents their aggregate 30 percent pool participation percentage of involuntary business assumed by the pool participants pursuant to state law. For the reinsurance subsidiary, this line represents the reinsurance business assumed through the quota share agreement (including “fronting” activities initiated by Employers Mutual) and the business assumed outside the quota share agreement.
•
“Assumed from affiliates” for the property and casualty insurance subsidiaries represents their aggregate 30 percent pool participation percentage of all the pool members’ direct business. The amounts reported under the caption “Losses and settlement expenses incurred” also include claim-related services provided by Employers Mutual that are allocated to the property and casualty insurance subsidiaries and the reinsurance subsidiary.
•
“Ceded to nonaffiliates” for the property and casualty insurance subsidiaries represents their aggregate 30 percent pool participation percentage of 1) the amounts ceded to nonaffiliated reinsurance companies in accordance with the terms of the reinsurance agreements providing protection to the pool and each of its participants, and 2) the amounts ceded on a mandatory basis to state organizations in connection with various programs. For the reinsurance subsidiary, this line includes 1) reinsurance business that is ceded to other insurance companies in connection with “fronting” activities initiated by Employers Mutual, and 2) starting in 2016, amounts ceded to purchase additional reinsurance protection in peak exposure territories from external parties.
•
“Ceded to affiliates” for the property and casualty insurance subsidiaries represents the cession of their direct business to Employers Mutual under the terms of the pooling agreement and, beginning in 2016, amounts ceded to Employers Mutual under the terms of the inter-company reinsurance program. For the reinsurance subsidiary this line represents amounts ceded to Employers Mutual under the terms of the inter-company reinsurance program.
4.
LIABILITY FOR LOSSES AND SETTLEMENT EXPENSES
The following table sets forth a reconciliation of beginning and ending reserves for losses and settlement expenses of the Company. Amounts presented are on a net basis, with a reconciliation of beginning and ending reserves to the gross amounts presented in the consolidated financial statements.
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.
Changes in reserve estimates are reflected in net income in the year such changes are recorded. Following is an analysis of the reserve development the Company experienced during the past three years. Care should be exercised when attempting to analyze the financial impact of the reported development amounts because, as noted above, the overall expectation is that, more often than not, favorable development will occur as the prior accident years’ reserves run off.
2017 Development
For the property and casualty insurance segment, the December 31, 2017 estimate of loss and settlement expense reserves for accident years 2016 and prior decreased $15.7 million from the estimate at December 31, 2016. This decrease represents 3.2 percent of the December 31, 2016 gross carried reserves and is primarily attributed to reductions in prior year ultimate loss ratios for every line of business except commercial auto liability and surety bonds (included in "other" lines of business). Commercial auto liability experienced adverse development as ultimate loss and settlement expense ratios were increased for accident years 2013-2016 due to increases in projected severity and/or frequency. The adverse development from surety bonds was due to two large accident year 2015 losses. The two lines of business contributing the majority of favorable development were other liability and workers' compensation. Other liability’s ultimate loss ratios were decreased for most accident years from 2001 through 2016 mainly in response to decreases in expected ultimate severity. Workers' compensation’s favorable development reflects a reduction in the accident year 2016 ultimate ratio as reported losses to date are materially more favorable than anticipated in frequency and severity assumptions underlying the December 31, 2016 selection. Included in the development amount is adverse development experienced in the other liability line of business stemming from the settlement of claims for past and future legal fees and losses on a multi-year asbestos exposure associated with a former insured, and a slight strengthening of remaining reserves.
For the reinsurance segment, the December 31, 2017 estimate of loss and settlement expense reserves for accident years 2016 and prior decreased $3.9 million from the estimate at December 31, 2016. This decrease represents 1.9 percent of the December 31, 2016 gross carried reserves and primarily reflects favorable development in the property/casualty global pro rata and excess contracts, and the per risk excess contracts. For the property/casualty global pro rata contracts, the favorable development was related to a change in ultimate loss assumptions for several prior years due to the use of company experience in place of Reinsurance Association of America data for calculating development factors to ultimate.
2016 Development
During the third quarter of 2016, management implemented a new reserving methodology for the determination of direct bulk reserves in the property and casualty insurance segment. The new methodology, which is referred to as the accident year ultimate estimate approach, better conforms to industry practices and provides increased transparency of the drivers of the property and casualty insurance segment's performance. In connection with this change in reserving methodology, there was a reallocation of IBNR loss reserves and allocated settlement expense reserves from prior accident years to the current accident year in multiple lines of business. This change resulted in the movement of approximately $5.6 million of reserves from prior accident years to the current accident year that was reported as favorable development; however, this development is "mechanical in nature", and did not have an impact on earnings because the total amount of carried reserves did not change.
For the property and casualty insurance segment, the December 31, 2016 estimate of loss and settlement expense reserves for accident years 2015 and prior decreased $30.0 million from the estimate at December 31, 2015. Excluding the $5.6 million of "mechanical" favorable development that resulted from the change in reserving methodology noted above, the implied amount of favorable development that had an impact on earnings was approximately $24.4 million. This decrease represented 5.1 percent of the December 31, 2015 gross carried reserves and was primarily attributed to a significant amount of favorable reserve development experienced in the workers' compensation and other liability lines of business. The favorable development in the workers' compensation line of business was generated from a change in assumptions due to better than expected loss frequency for accident year 2015 and loss severity for the most recent accident years. The favorable development in the other liability line of business was generated from a change in assumptions due to better than expected loss severity.
For the reinsurance segment, the December 31, 2016 estimate of loss and settlement expense reserves for accident years 2015 and prior decreased $10.9 million from the estimate at December 31, 2015. This decrease represented 5.5 percent of the December 31, 2015 gross carried reserves and was attributed to favorable development in the 2015 accident year in the HORAD pro rata line of business, and an increase in the amount of negative bulk IBNR loss reserve carried on prior years' reserves in the MRB book of business.
During 2016, the expected loss ratios utilized for prior contract years remained unchanged, except for ocean marine pro rata business. The expected loss ratios associated with this contract type were decreased in contract years 2012, 2014 and 2015 from the ratios utilized during 2015. Additionally, the expected loss ratio for contract year 2013 was increased slightly relative to the 2015 value. These changes were made in response to reserving information supplied by the ceding company, a large writer of ocean marine pro rata business.
2015 Development
For the property and casualty insurance segment, the December 31, 2015 estimate of loss and settlement expense reserves for accident years 2014 and prior decreased $13.8 million from the estimate at December 31, 2014. No changes were made in the key actuarial assumptions utilized to estimate loss and settlement expense reserves during 2015; however, the accident year allocation factors applied to IBNR loss reserves, bulk case loss reserves and the defense and cost containment portion of settlement expense reserves were revised at December 31, 2015 as part of the annual review. This change resulted in the movement of $423,000 of reserves from prior accident years to the current accident year, and hence, was reported as favorable development on prior years' reserves. Development on prior years’ reserves resulting solely from changes in the allocation of bulk reserves between the current and prior accident years is also "mechanical in nature", and does not have an impact on earnings. Excluding this $423,000 of "mechanical" favorable development, the implied amount of favorable development that had an impact on earnings was approximately $13.4 million. This decrease represented 2.9 percent of the December 31, 2014 gross carried reserves and was primarily attributed to better than expected outcomes on claims reported in prior years and favorable development on prior years' settlement expenses.
For the reinsurance segment, the December 31, 2015 estimate of loss and settlement expense reserves for accident years 2014 and prior decreased $21.3 million from the estimate at December 31, 2014. No changes were made in the key actuarial assumptions utilized to estimate loss and settlement expense reserves during 2015; however, the accident year allocation factors applied to IBNR loss reserves were revised during 2015, resulting in $1.0 million of "mechanical" adverse development. Excluding this $1.0 million of adverse development, the implied amount of favorable development that had an impact on earnings was approximately $22.3 million. This decrease represented 11.3 percent of the December 31, 2014 gross carried reserves and was attributed to several factors, including adjustments made in the offshore energy and liability proportional account, a reduction in carried IBNR loss reserves that was no longer necessary and a negative bulk IBNR loss reserve established for the MRB book of business.
Following is information about reported incurred and paid claims development as of December 31, 2017, net of reinsurance, as well as cumulative claim frequency and the amount of IBNR loss reserves carried (representing both IBNR liabilities and expected loss reserve development on reported claims). The information displayed for assumed reinsurance is restated to reflect all foreign currency denominated transactions on the basis of current (December 31, 2017) exchange rates. The number of reported claims (cumulative claim frequency) for the Company’s direct insurance business represents the total number of claims reported by the participants in the pooling agreement, and is determined on the basis of each unique combination of claimant, specific policy coverage, and type of loss. This is in contrast to all other reported amounts that are stated at the aggregate 30 percent pool participation percentage of the Company's property and casualty insurance subsidiaries. The cumulative claim frequency for the Company’s assumed reinsurance business is not readily available. Consistent with industry practices, bordereauxs on pro rata accounts often exclude claim frequency information, and if it is included, the level of detail provided by the ceding companies can vary significantly. Excess of loss contracts customarily report total losses subject to the treaty without detailed loss listings.
The following table sets forth a reconciliation of the incurred and paid claims development tables to the liability for losses and settlement expenses:
5.
ASBESTOS AND ENVIRONMENTAL CLAIMS
The Company has exposure to asbestos and environmental related claims associated with the insurance business written by the parties to the pooling agreement and the reinsurance business assumed from Employers Mutual by the reinsurance subsidiary. Asbestos and environmental losses paid by the Company have averaged $2.9 million per year over the past five years. Reserves for asbestos and environmental related claims for direct insurance and assumed reinsurance business totaled $11.7 million and $13.3 million ($11.4 million and $13.0 million net of reinsurance) at December 31, 2017 and 2016, respectively.
Estimating loss and settlement expense reserves for asbestos and environmental claims is very difficult due to the many uncertainties surrounding these types of claims. These uncertainties exist because the assignment of responsibility varies widely by state and claims often emerge long after a policy has expired, which makes assignment of damages to the appropriate party and to the time period covered by a particular policy difficult. In establishing reserves for these types of claims, management monitors the relevant facts concerning each claim, the current status of the legal environment, social and political conditions, and claim history and trends within the Company and the industry.
At present, the pool participants are defending approximately 1,872 asbestos bodily injury lawsuits, some of which involve multiple plaintiffs. 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 often dismissed from asbestos litigation with nominal or no payment (i.e., small contractors, supply companies, and a furnace manufacturer).
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 one former policyholder. During the period 2009 through 2017, the Company's share of paid losses and settlement expenses attributed to this former policyholder, a furnace manufacturer, was $12.5 million (mostly settlement expenses). A coverage-in-place agreement was executed with this former policyholder in 2009 and a national coordinating counsel was retained to address the multi-state litigation issues. 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. Approximately 692 asbestos exposure claims associated with this former policyholder remain open. During 2017 a settlement was reached with another former insured, resulting in the Company recognizing $4.5 million (its share) of settlement expenses to remove all past and future asbestos liability exposure related to that policyholder.
While the Company does not have a significant amount of exposure to asbestos claims, management has been strengthening the reserves carried for these exposures each year to the amount believed to be management's best estimate. In 2017, the settlement expense reserves for asbestos claims were strengthened by $900,000.
6.
STATUTORY INFORMATION AND DIVIDEND RESTRICTIONS
The Company’s insurance subsidiaries are required to file financial statements with state regulatory authorities. The accounting principles used to prepare these statutory financial statements follow prescribed or permitted accounting practices that differ from GAAP. Prescribed statutory accounting principles include state laws, regulations and general administrative rules issued by the state of domicile, as well as a variety of publications and manuals of the National Association of Insurance Commissioners (NAIC). Permitted accounting practices encompass all accounting practices not prescribed, but allowed by the state of domicile. The Company’s insurance subsidiaries had no permitted accounting practices during 2017, 2016 or 2015.
Statutory surplus of the Company’s insurance subsidiaries was $560.1 million and $526.8 million at December 31, 2017 and 2016, respectively. Statutory net income of the Company’s insurance subsidiaries was $30.1 million, $48.3 million and $48.8 million for 2017, 2016 and 2015, respectively.
The NAIC utilizes a risk-based capital model to help state regulators assess the capital adequacy of insurance companies and identify insurers that are in, or are perceived as approaching, financial difficulty. This model establishes minimum capital needs based on the risks applicable to the operations of the individual insurer. The risk-based capital requirements for property and casualty insurance companies measure three major areas of risk: asset risk, credit risk and underwriting risk. Companies having less statutory surplus than required by the risk-based capital requirements are subject to varying degrees of regulatory scrutiny and intervention, depending on the severity of the inadequacy. At December 31, 2017, the Company’s insurance subsidiaries had total adjusted statutory capital of $560.1 million, which exceeds the minimum risk-based capital requirement of $94.4 million.
The amount of dividends available for distribution to the Company by its insurance subsidiaries is limited by law to a percentage of the statutory unassigned surplus of each of the subsidiaries as of the previous December 31, as determined in accordance with accounting practices prescribed by insurance regulatory authorities of the state of domicile of each subsidiary. Under Iowa law, the maximum dividend that may be paid within a 12 month period without prior regulatory approval is restricted to the greater of 10 percent of statutory surplus as regards policyholders as of the preceding December 31, or net income of the preceding calendar year on a statutory basis, not greater than earned statutory surplus (North Dakota, the state of domicile of Dakota Fire Insurance Company, imposes similar restrictions, except that it is limited to the lesser of 10 percent of statutory surplus as regards policyholders as of the preceding December 31, or net income excluding capital gains of the preceding calendar year on a statutory basis, not greater than earned statutory surplus). At December 31, 2017, $54.2 million was available for distribution to the Company in 2018 without prior approval.
7. SEGMENT INFORMATION
The Company’s operations consist of a property and casualty insurance segment and a reinsurance segment. The property and casualty insurance segment writes both commercial and personal lines of insurance, with a focus on medium-sized commercial accounts. The reinsurance segment provides reinsurance for other insurers and reinsurers. The segments are managed separately due to differences in the insurance products sold and the business environments in which they operate. Management evaluates the performance of its insurance segments using financial measurements based on Statutory Accounting Principles (SAP) instead of GAAP. Such measures include premiums written, premiums earned, statutory underwriting profit (loss), and investment results, as well as loss and loss adjustment expense ratios, trade underwriting expense ratios, and combined ratios. The GAAP accounting policies of the segments are described in note 1, Summary of Significant Accounting Policies.
Summarized financial information for the Company’s segments is as follows:
The following table displays the premiums earned for the property and casualty insurance segment and the reinsurance segment for the three years ended December 31, 2017, by line of insurance.
8.
DISCLOSURES ABOUT THE FAIR VALUES OF FINANCIAL INSTRUMENTS
The carrying amounts and the estimated fair values of the Company’s financial instruments as of December 31, 2017 and 2016 are summarized in the tables below.
The estimated fair values of fixed maturity and equity securities is based on quoted market prices, where available. In cases where quoted market prices are not available, fair values are based on a variety of valuation techniques depending on the type of security.
Short-term investments generally include money market funds, U.S. Treasury bills and commercial paper. Short-term investments are carried at fair value, which approximates cost, due to the highly liquid nature of the securities. Short-term securities are classified as Level 1 fair value measurements when the fair values can be validated by recent trades. When recent trades are not available, fair value is deemed to be the cost basis and the securities are classified as Level 2 fair value measurements.
The estimated fair value of the surplus notes is derived by discounting future expected cash flows at a rate deemed appropriate. The discount rate was set at the average of current yields-to-maturity on several insurance company surplus notes that are traded in observable markets, adjusted upward by 50 basis points to reflect illiquidity and perceived risk premium differences. Other assumptions include a 25-year term (the surplus notes have no stated maturity date) and an interest rate that continues at the current 1.35 percent interest rate. The rate is typically adjusted every five years (next review due in 2018) and is based upon the then-current Federal Home Loan Bank borrowing rate for 5-year funds available to Employers Mutual.
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The following fair value hierarchy prioritizes inputs to valuation techniques used to measure fair value.
Level 1 -
Unadjusted quoted prices for identical assets or liabilities in active markets that the Company has the ability to access.
Level 2 -
Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in inactive markets; or valuations based on models where the significant inputs are observable (e.g., interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.) or can be corroborated by observable market data.
Level 3 -
Prices or valuation techniques that require significant unobservable inputs because observable inputs are not available. The unobservable inputs may reflect the Company’s own judgments about the assumptions that market participants would use.
The Company uses an independent pricing source to obtain the estimated fair values of a majority of its securities, subject to an internal validation. The fair values are based on quoted market prices, where available. This is typically the case for equity securities and money market funds, which are accordingly classified as Level 1 fair value measurements. In cases where quoted market prices are not available, fair values are based on a variety of valuation techniques depending on the type of security. Fixed maturity securities, non-redeemable preferred stocks and various short-term investments in the Company’s portfolio may not trade on a daily basis; however, observable inputs are utilized in their valuations, and these securities are therefore classified as Level 2 fair value measurements. Following is a brief description of the various pricing techniques used by the independent pricing source for different asset classes.
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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.
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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.
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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 market 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, 2017 and 2016, the Company had no securities priced solely from broker quotes.
A small number of the Company’s securities are not priced by the independent pricing service. Two of these are equity securities that are reported as Level 3 fair value measurements since no observable inputs are used in their valuations. The largest of these equity security holdings is in a privately placed non-redeemable convertible preferred stock investment in a start-up technology company that Employers Mutual is working closely with in its data analytics activities. This security is carried at its cost, which is presumed to approximate fair value. The other equity security, a much smaller holding, continues to be reported at the fair value obtained from the Securities Valuation Office (SVO) of the NAIC. The SVO establishes a per share price for this security based on an annual review of that company’s financial statements, typically performed during the second quarter. The other securities not priced by the Company’s independent pricing service consist of eight fixed maturity securities (nine at December 31, 2016). Two of these fixed maturity securities, classified as Level 3 fair value measurements, are corporate securities that convey premium tax benefits and are not publicly traded. The fair values for these securities are based on discounted cash flow analyses. The other fixed maturity securities are classified as Level 2 fair value measurements. The fair values for these fixed maturity securities were obtained from either the SVO, the Company’s investment custodian, or the Company's investment department using similar pricing techniques as the Company's independent pricing service.
Presented in the tables below are the estimated fair values of the Company’s financial instruments as of December 31, 2017 and 2016.
Presented in the table below is a reconciliation of the assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the years ended December 31, 2017 and 2016. Any unrealized gains or losses on these securities are recognized in other comprehensive income (loss). Any gains or losses from settlements, disposals or impairments of these securities are reported as realized investment gains or losses in net income.
There were no transfers into or out of Levels 1 or 2 during 2017 or 2016. It is the Company’s policy to recognize transfers between levels at the beginning of the reporting period.
9.
INVESTMENTS
Investments of the Company’s insurance subsidiaries are subject to the insurance laws of the state of their incorporation. These laws prescribe the kind, quality and concentration of investments that may be made by insurance companies. In general, these laws permit investments, within specified limits and subject to certain qualifications, in federal, state and municipal obligations, corporate bonds, preferred and common stocks and real estate mortgages. The Company believes that it is in compliance with these laws.
The amortized cost and estimated fair value of securities available-for-sale as of December 31, 2017 and 2016 are as follows. All securities are classified as available-for-sale and are carried at fair value.
The following tables set forth the estimated fair values and gross unrealized losses associated with investment securities that were in an unrealized loss position as of December 31, 2017 and 2016, listed by length of time the securities were consistently in an unrealized loss position.
All of the fixed maturity securities that are in an unrealized loss position are considered investment grade by credit rating agencies. Because management does not intend to sell these securities, does not believe it will be required to sell these securities before recovery, and believes it will collect the amounts due on these securities, it was determined that these securities were not “other-than-temporarily” impaired at December 31, 2017.
No individual equity security accounted for a material amount of unrealized losses. Because the Company has the ability and intent to hold these securities for a reasonable amount of time to allow for recovery, it was determined that these securities were not “other-than-temporarily” impaired at December 31, 2017.
All of the Company’s preferred stock holdings that are in an unrealized loss position are perpetual preferred stocks. The Company evaluates these perpetual preferred stocks with unrealized losses for “other-than-temporary” impairment similar to fixed maturity securities since they have debt-like characteristics such as periodic cash flows in the form of dividends and call features, are rated by rating agencies and are priced like other long-term callable fixed maturity securities. There was no evidence of any credit deterioration in the issuers of the preferred stocks and the Company does not intend to sell these securities before recovery, nor does it believe it will be required to sell these securities before recovery; therefore, it was determined that these securities were not “other-than-temporarily” impaired at December 31, 2017.
The amortized cost and estimated fair values of fixed maturity securities at December 31, 2017, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties.
A summary of realized investment gains and (losses) is as follows:
Gains and losses realized on the disposition of investments are included in net income. The cost of investments sold is determined on the specific identification method using the highest cost basis first. The Company did not have any outstanding cumulative credit losses on fixed maturity securities that have been recognized in earnings from “other-than-temporary” impairments during any of the reported periods. The amounts reported as “other-than-temporary” impairments on equity securities do not include any individually significant items. The net realized investment losses recognized on other long-term investments primarily represent changes in the carrying value of a limited partnership that is used solely to support an equity tail-risk hedging strategy, but for 2016 also included an "other-than-temporary" impairment loss of $209,000 on an investment that conveys investment tax credits.
A summary of net investment income is as follows:
A summary of net changes in unrealized holding gains (losses) on securities available-for-sale is included in the table below.
10.
INCOME TAXES
On December 22, 2017 the TCJA was signed into law. Among other provisions, the TCJA lowered the federal corporate tax rate from 35 percent to 21 percent, effective January 1, 2018. Since the change in tax rate is not effective until 2018, current tax expense in 2017 is unaffected; however, the temporary tax differences that comprised the net deferred income tax liability at the enactment date are now projected to reverse at the lower 21 percent tax rate. The re-measurement of deferred income tax assets and liabilities resulted in the recognition of a $9.1 million deferred income tax benefit.
On December 22, 2017, the Securities Exchange Commission issued Staff Accounting Bulletin No. 118 (SAB 118), which allows a company to record a provisional amount for certain income tax effects of the TCJA that are based on reasonable estimates in circumstances in which the accounting is incomplete. Pursuant to SAB 118, the Company made reasonable estimates of the effects the TCJA had on the deferred income tax assets and liabilities. For other items where the Company could not make a reasonable estimate, primarily loss reserve discounting, the Company is using existing accounting guidance and the provisions of the tax laws that were in place prior to the enactment until further guidance is released by the Internal Revenue Service (IRS) with updated discount factors. The Company will continue to gather information to provide a more precise re-measurement of deferred income tax assets and liabilities, and expects to complete its analysis of the effects of the TCJA within a year of the enactment date.
Temporary differences between the consolidated financial statement carrying amount and tax basis of assets and liabilities that give rise to significant portions of the deferred income tax asset (liability) at December 31, 2017 and 2016 are as follows:
Based upon anticipated future taxable income and consideration of all other available evidence, management believes that it is “more likely than not” that the Company’s deferred income tax assets will be realized.
The actual income tax expense for the years ended December 31, 2017, 2016 and 2015 differed from the “expected” income tax expense for those years (computed by applying the United States federal corporate tax rate of 35 percent to income before income tax expense) as follows:
Comprehensive income tax expense included in the consolidated financial statements for the years ended December 31, 2017, 2016 and 2015 is as follows. The deferred income tax benefit that resulted from the enactment of the TCJA in 2017 is included in the "operations" line.
The Company had no provision for uncertain income tax positions at December 31, 2017 or 2016. The Company recognized no interest expense or other penalties related to U.S. federal or state income taxes during 2017, 2016 or 2015. It is the Company’s accounting policy to reflect income tax penalties as other expense, and interest as interest expense.
The Company files a U.S. federal income tax return, along with various state income tax returns. The Company is no longer subject to U.S. federal and state income tax examinations by tax authorities for years before 2014.
11.
SURPLUS NOTES
The Company’s property and casualty insurance subsidiaries have $25.0 million of surplus notes issued to Employers Mutual at an interest rate of 1.35 percent. The Inter-Company Committees of the boards of directors of the Company and Employers Mutual approved a change in the interest rate on the surplus notes to 2.73 percent effective February 1, 2018, subject to regulatory approval. Reviews of the interest rate are conducted every five years, with the next review due in 2023. Payments of interest and repayments of principal can only be made out of the applicable subsidiary’s statutory surplus and are subject to prior approval by the insurance commissioner of the respective states of domicile. The surplus notes are subordinate and junior in right of payment to all obligations or liabilities of the applicable insurance subsidiaries. Total interest expense on these surplus notes was $337,000 in 2017, 2016 and 2015. At December 31, 2017, the Company’s property and casualty insurance subsidiaries had received approval for the payment of the 2017 interest expense on the surplus notes.
12.
EMPLOYEE RETIREMENT PLANS
Employers Mutual has various employee benefit plans, including a qualified defined benefit pension plan, a non-qualified defined benefit supplemental pension plan, a retiree life insurance benefit and a retiree health reimbursement arrangement (HRA) benefit.
The qualified defined benefit plan covers substantially all of its employees. This plan is funded by employer contributions and provides a benefit under a cash balance formula for most employees; however, benefits are provided to a few long-term employees based on a traditional benefit formula. On December 18, 2017, Employers Mutual notified its employees that effective January 1, 2019, the benefits provided under the cash balance formula will be based on a combination of age and years of service, rather than just age. This change did not have a material impact on the pension benefit obligation. Benefits generally vest after three years of service or the attainment of 55 years of age. It is Employers Mutual’s funding policy to make contributions sufficient to be in compliance with minimum regulatory funding requirements, plus additional amounts as determined by management.
Employers Mutual’s non-qualified defined benefit supplemental retirement plan provides additional retirement benefits for a select group of management and highly-compensated employees. This plan enables select employees to receive retirement benefits without the limit on compensation imposed on qualified defined benefit pension plans by the Internal Revenue Service (IRS) and to recognize compensation that has been deferred in the non-qualified deferred compensation plan. The plan is unfunded and benefits generally vest after three years of service.
Employers Mutual also offers postretirement benefit plans which provide an HRA and life insurance benefits for eligible retired employees. Substantially all of its employees may become eligible for those benefits if they reach age 55 and have attained the required length of service while working for Employers Mutual. Under the HRA, Employers Mutual reimburses eligible participants, up to a pre-determined maximum, for amounts expended to enroll in publicly available individual health care plans and/or pay for qualifying out-of-pocket health care costs. The obligations of the HRA are based on the total amount of reimbursements expected to be made by Employers Mutual over the lives of the participants, rather than the total amount of medical benefits expected to be paid over the participants’ lives. Therefore, the obligations of the HRA are not directly impacted by changes in the cost of health care. However, the maximum amount Employers Mutual will reimburse eligible participants is adjusted periodically based on an analysis of the change in health care costs. Such adjustments are reflected as plan amendments and increased the postretirement benefit plans' benefit obligation $2.7 million in 2017 and $2.2 million in 2016. During December 2017, Employers Mutual notified its employees that the life insurance benefit will be eliminated for employees retiring after 2018. As a result, the postretirement benefit plans' benefit obligation as of December 31, 2017 decreased $3.8 million. This change is also reflected as a plan amendment. The life insurance plan is noncontributory. The benefits provided under both plans are subject to change.
Employers Mutual maintains a Voluntary Employee Beneficiary Association (VEBA) trust that has historically been used to accumulate funds for the payment of postretirement benefits. Given the overfunded position of the postretirement benefit plans, contributions to the VEBA trust are not anticipated for the foreseeable future.
The following table sets forth the funded status of Employers Mutual’s pension and postretirement benefit plans as of December 31, 2017 and 2016, based upon measurement dates of December 31, 2017 and 2016, respectively.
The following tables set forth the amounts recognized in the Company’s financial statements as a result of the property and casualty insurance subsidiaries’ aggregate 30 percent participation in the pooling agreement.
Amounts recognized in the Company’s consolidated balance sheets:
Amounts recognized in the Company’s consolidated balance sheets under the caption “accumulated other comprehensive income”, before deferred income taxes:
During 2018, the Company will amortize $150,000 of net actuarial loss and no prior service cost associated with the pension plans into net periodic benefit cost. In addition, the Company will amortize $260,000 of net actuarial loss and $3.2 million of prior service credit associated with the postretirement benefit plans into net periodic postretirement benefit income in 2018.
Amounts recognized in the Company’s consolidated statements of comprehensive income, before deferred income taxes:
The following table sets forth the projected benefit obligation, accumulated benefit obligation and fair value of plan assets of Employers Mutual’s non-qualified pension plan. The amounts related to the qualified pension plan are not included since the plan assets exceeded the accumulated benefit obligation.
The components of net periodic benefit cost (income) for Employers Mutual’s pension and postretirement benefit plans is as follows:
The net periodic postretirement benefit income recognized on Employers Mutual's postretirement benefit plans is due to a plan amendment that was announced in the fourth quarter of 2013. This plan amendment generated a prior service credit that is being amortized into net periodic benefit cost over a period of 10 years.
Net periodic pension benefit cost allocated to the Company amounted to $2.8 million, $2.9 million and $1.8 million for the years ended December 31, 2017, 2016 and 2015, respectively. Net periodic postretirement benefit income allocated to the Company for the years ended December 31, 2017, 2016 and 2015 amounted to $2.9 million, $3.0 million, and $3.0 million, respectively.
The weighted-average assumptions used to measure the benefit obligations are as follows:
The weighted-average assumptions used to measure the net periodic benefit costs are as follows:
The expected long-term rates of return on plan assets were developed considering actual historical results, current and expected market conditions, plan asset mix and management’s investment strategy.
The following benefit payments, which reflect expected future service, are expected to be paid from the plans over the next ten years:
Employers Mutual manages its VEBA trust assets internally. The VEBA trust assets are reviewed relative to liabilities to determine the optimum allocation focusing on both asset accumulation and income generation. Assets contained in the VEBA trust are invested in fixed income, international equity and domestic equity mutual funds, an emerging markets exchange traded fund (ETF) and universal life insurance policies issued by EMC National Life Company, an affiliate of Employers Mutual, that carry a guaranteed interest rate of 4.5 percent.
See note 8 for a discussion on fair value measurement. Following is a description of the valuation techniques and inputs used for each major class of assets measured at fair value in Employers Mutual’s VEBA trust.
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Money Market Fund: Valued at amortized cost, which approximates fair value. Under this method, investments purchased at a discount or premium are valued by accreting or amortizing the difference between the original purchase price and maturity value of the issue over the period to maturity. The net asset value of each share held by the trust at year-end was $1.00.
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Mutual Funds: Valued at the net asset value of shares held by the trust at year-end. For purposes of calculating the net asset value, portfolio securities and other assets for which market quotes are readily available are valued at fair value. Fair value is generally determined on the basis of last reported sales prices, or if no sales are reported, based on quotes obtained from a quotation reporting system, established market makers, or independent pricing services.
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ETF: Valued at the closing price from the applicable exchange.
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Life Insurance Contract: Valued at the cash surrender value, which approximates fair value.
The fair values of the assets held in Employers Mutual’s VEBA trust are as follows:
Presented below is a reconciliation of the assets measured at fair value using significant unobservable inputs (Level 3) for the years ended December 31, 2017 and 2016.
Employers Mutual uses Global Portfolio Strategies, Inc. to advise on the asset allocation strategy for its qualified pension plan. The asset allocation strategy and process of Global Portfolio Strategies, Inc. uses a diversified allocation of equity, debt and real estate exposures that is customized to the plan’s payment risk and return targets.
Global Portfolio Strategies, Inc. reviews the plan’s assets and liabilities in relation to expectations of long-term market performance and liability development to determine the appropriate asset allocation. The data for the contributions and emerging liabilities is provided from the plan’s actuarial valuation, while the current asset and monthly benefit payment data is provided by the plan record keeper.
Following is a description of the valuation techniques and inputs used for pooled separate accounts, the only major class of assets measured at fair value in Employers Mutual’s qualified pension plan.
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Pooled Separate Accounts: Each of the funds held by the Plan is in a pooled or commingled investment vehicle that is maintained by the fund sponsor, each with many investors. The Plan asset is represented by a “unit of account” and a per unit value, whose value is the accumulated value of the underlying investments less liabilities. The net asset value is determined by the issuer of the fund by taking the fair value of the underlying investments less any liabilities divided by the number of units outstanding. Sponsors of the funds specify the source(s) used for the underlying investment asset prices and the protocol used to value each fund.
In accordance with ASU 2015-07, a fair value hierarchy table is not included here since all of the Plan's investments are measured at fair value using the net asset value per share (or its equivalent) practical expedient, which are not classified in the fair value hierarchy. Presented below are the fair values of assets held in Employers Mutual's defined benefit retirement plan:
Employers Mutual plans to contribute approximately $8.0 million to the pension plan in 2018. No contributions are expected to be made to the VEBA trust in 2018.
The Company participates in other benefit plans sponsored by Employers Mutual, including its 401(k) Plan, Board and Executive Non-Qualified Excess Plans and Defined Contribution Supplemental Executive Retirement Plan. The Company’s share of expenses for these plans amounted to $2.9 million, $2.7 million and $2.5 million in 2017, 2016 and 2015, respectively.
13.
STOCK-BASED COMPENSATION
The Company has a stock-based compensation plan for non-employee directors. Employers Mutual also has several stock plans which utilize the common stock of the Company. Employers Mutual can provide the common stock required under its plans by: 1) using shares of common stock that it currently owns; 2) purchasing common stock in the open market; or 3) directly purchasing common stock from the Company at the current fair value. Employers Mutual's current practice is to purchase common stock from the Company for use in all of its stock plans (including its non-employee director stock purchase plan and its employee stock purchase plan). A portion of the compensation expense recognized by Employers Mutual (as the requisite service period for granted options and restricted stock awards/units is rendered) is allocated to the Company’s property and casualty insurance subsidiaries though their participation in the pooling agreement.
Stock Plans
On May 26, 2017, the Company registered 150,000 shares of its common stock for use in the EMC Insurance Group Inc. 2017 Non-Employee Director Stock Plan (the "2017 Director Plan"). The 2017 Director Plan provides for the awarding of non-qualified stock options, restricted stock, restricted stock units and other stock-based awards to the Company's non-employee directors. During 2017, 2,000 shares of restricted stock were granted to non-employee directors of the Company under this plan. These shares of restricted stock vest over a one year period. Dividends on the unvested restricted stock are accrued and will be paid to the directors at the time of vesting.
Employers Mutual currently maintains two separate stock plans for the benefit of officers and key employees of Employers Mutual and its subsidiaries. A total of 3,000,000 shares of the Company’s common stock have been reserved for issuance under the 2007 Employers Mutual Casualty Company Stock Incentive Plan (2007 Plan), and a total of 1,000,000 shares have been reserved for issuance under the Employers Mutual Casualty Company 2017 Stock Incentive Plan (2017 Plan).
Both of Employers Mutual's plans permit the issuance of performance shares, performance units, and other stock-based awards, in addition to qualified (incentive) and non-qualified stock options, stock appreciation rights, restricted stock and restricted stock units. Both plans provide for a ten-year time limit for granting awards. No additional grants can be made under the 2007 Plan due to the expiration of the term of the plan. The Senior Executive Compensation Committee of Employers Mutual’s Board of Directors grants the awards and is the administrator of the plans. The Company’s Compensation Committee must consider and approve all awards granted to the Company’s executive officers. Awards granted to directors are approved by the Company's Corporate Governance and Nominating Committee.
Options granted under the 2007 Plan generally had a vesting period of five years, with options becoming exercisable in equal annual cumulative increments commencing on the first anniversary of the option grant. Option prices cannot be less than the fair value of the common stock on the date of grant. Restricted stock awards granted under the 2007 Plan generally have a vesting period of four years, with shares vesting in equal annual cumulative increments commencing on the first anniversary of the grant. With the exception of death, permanent disability or a change in control, any unvested shares of restricted stock are forfeited on termination of employment, including retirement. Holders of unvested shares of restricted stock receive compensation income equal to the amount of any dividends declared on the common stock.
During 2017, Employers Mutual began issuing restricted stock unit awards rather than restricted stock awards. In connection with this change, Employers Mutual will now acquire stock to fulfill its obligations to the recipients of the restricted stock unit awards on the date they vest, rather than on the grant date of the awards. Because of this change, an account Employers Mutual established to hold previously granted restricted stock awards until they vest will contain excess shares of the Company's stock stemming from forfeitures and surrenders. During 2017, the Company repurchased 67,974 shares of stock from this unvested restricted stock account at an average cost of $27.34. Like restricted stock awards, restricted stock unit awards generally have a vesting period of four years, with shares vesting in equal annual cumulative increments commencing on the first anniversary of the grant. Upon death, disability or change in control, any granted but unvested restricted stock units become fully vested and settled. Upon qualifying for "Approved Retirement" [attaining 70 points (combined age plus whole years of continuous service) with a minimum age of 55 years, or reaching age 65], restricted stock units will generally become non-forfeitable on a pro-rated basis over the 12 months following the grant date. Settlement of non-forfeitable restricted stock units is deferred until the date on which the restricted stock units otherwise vest and settle pursuant to the normal four-year vesting schedule. Holders of unvested restricted stock units do not receive compensation income equal to the amount of dividends declared on the common stock.
During 2016, 2,000 shares of restricted stock were granted to non-employee directors of the Company under the 2007 Plan. These shares of restricted stock vest over a period of three years, or upon a director reaching 75 years of age while an active director. The directors are entitled to receive compensation income (equal to the amount of dividends paid on the Company's common stock) earned on unvested shares of restricted stock.
The Company recognized compensation expense from these plans of $801,000 ($521,000 net of tax), $788,000 ($512,000 net of tax) and $500,000 ($325,000 net of tax) in 2017, 2016 and 2015, respectively. Due to the historically small number of forfeitures, the Company has elected to recognize the reduction to compensation expense from forfeitures as they occur.
A summary of the stock option activity under Employers Mutual’s stock plans for 2017, 2016 and 2015 is as follows:
As discussed above, during 2017 Employers Mutual began issuing restricted stock unit awards to eligible employees. These awards are accounted for as liability-based awards, whereby the liability is remeasured at each reporting date as the average of the high and low trading prices of the Company's common stock on that date. Upon settlement, the Company will receive the full fair value for all shares issued. The Company's share of this liability at December 31, 2017 was $543,000. A summary of restricted stock unit awards activity for 2017 is as follows:
For restricted stock awards, the average of the high and low trading prices of the Company's common stock on the dates of grant were used to determine their fair values. The Company received in 2016 and 2015 the full fair value, as of the grant date, for all shares issued in connection with Employers Mutual's grant of restricted stock awards. At December 31, 2017, the Company’s portion of the unrecognized compensation cost associated with restricted stock awards that are not currently vested was $640,000 with a 1.56 year weighted-average period over which the compensation expense is expected to be recognized. The Company's portion of the total fair value of restricted stock awards that vested was $545,000, $414,000 and $233,000 in 2017, 2016 and 2015, respectively. A summary of restricted stock awards activity for 2017, 2016 and 2015 is as follows:
The Company’s portion of the total intrinsic value of options exercised under Employers Mutual’s stock plans was $901,000, $1.1 million and $770,000 in 2017, 2016 and 2015, respectively. Under the terms of the pooling and quota share agreements, these amounts were paid to Employers Mutual. The Company receives the full fair value, as of the exercise date, for all shares issued in connection with option exercises. Additional information relating to options outstanding and options vested (exercisable) at December 31, 2017 is as follows:
Incentive stock options generally do not generate income tax deductions for the Company. The Company has recorded a deferred income tax benefit for non-qualified stock options and restricted stock awards that have been issued. The Company’s portion of the current income tax deduction realized from exercises of non-qualified stock options was $239,000, $284,000 and $121,000 in 2017, 2016 and 2015, respectively. These actual deductions are generally in excess of the deferred tax benefits recorded in conjunction with the compensation expense (referred to as excess tax benefits), which reduce income tax expense (prior to 2016 were recorded to additional paid in capital). The income tax benefit that results from disqualifying dispositions of stock purchased through the exercise of incentive stock options is deemed immaterial.
Employee Stock Purchase Plan
On May 30, 2008, the Company registered 750,000 shares of its common stock for use in the Employers Mutual Casualty Company 2008 Employee Stock Purchase Plan. All employees are eligible to participate in the plan. An employee may participate in the plan by delivering, during the first twenty days of the calendar month preceding the first day of an election period, a payroll deduction authorization to the plan administrator; or making a cash contribution (employees designated as “Insiders” are required to give six months advance notice prior to participating in the plan). Participants pay 85 percent of the fair market value of the stock on the date of purchase. The plan is administered by the Board of Directors of Employers Mutual, which has the right to amend or terminate the plan at any time; however, no such amendment or termination shall adversely affect the rights and privileges of participants. Expenses allocated to the Company in connection with this plan totaled $100,000, $78,000 and $59,000 in 2017, 2016 and 2015, respectively.
During 2017, shares were purchased under the plan at prices ranging from $23.64 to $25.15. Activity under the plan was as follows:
Non-Employee Director Stock Purchase Plan
On March 14, 2013, the Company registered 300,000 shares of its common stock for issuance under the 2013 Employers Mutual Casualty Company Non-Employee Director Stock Purchase Plan. All non-employee directors of Employers Mutual and its subsidiaries and affiliates, as well as non-employee directors of the Company, are eligible to participate in the plan. Each eligible director can purchase shares of common stock at 75 percent of the fair value of the stock on the exercise date in an amount equal to a minimum of 25 percent and a maximum of 100 percent of their annual cash retainer. The plan will continue through the period of the 2023 annual meetings. The plan is administered by the Corporate Governance and Nominating Committee of the Board of Directors of Employers Mutual. The Board may amend or terminate the plan at any time; however, no such amendment or termination shall adversely affect the rights and privileges of the participants. Expenses allocated to the Company in connection with this plan totaled $65,000, $84,000 and $62,000 in 2017, 2016 and 2015, respectively.
During 2017, shares were purchased under the plan at prices ranging from $20.15 to $23.15. Activity under the plan was as follows:
Dividend Reinvestment Plan
The Company maintains a dividend reinvestment and common stock purchase plan (the “Plan”) which provides stockholders with the option of reinvesting cash dividends in additional shares of the Company’s common stock. Participants can also purchase additional shares of common stock without incurring broker commissions by making optional cash contributions to the plan, and sell shares of common stock through the plan.
Employers Mutual did not participate in this plan in 2017, 2016 or 2015. Activity under the plan was as follows:
14.
ACCUMULATED OTHER COMPREHENSIVE INCOME
The Company has available-for-sale securities and receives an allocation of the actuarial losses and net prior service credits associated with Employers Mutual’s pension and postretirement benefit plans, both of which generate accumulated other comprehensive income (loss) amounts. The following table reconciles, by component, the beginning and ending balances of accumulated other comprehensive income, net of tax.
The following tables display amounts reclassified out of accumulated other comprehensive income and into net income during the three years ended December 31, 2017.
(1)
These reclassified components of accumulated other comprehensive income are included in the computation of net periodic pension and postretirement benefit income (see note 12, Employee Retirement Plans, for additional details).
(1)
These reclassified components of accumulated other comprehensive income are included in the computation of net periodic pension and postretirement benefit income (see note 12, Employee Retirement Plans, for additional details).
(1)
These reclassified components of accumulated other comprehensive income are included in the computation of net periodic pension and postretirement benefit income (see note 12, Employee Retirement Plans, for additional details).
15.
STOCK REPURCHASE PROGRAMS
Stock Repurchase Plans
On November 3, 2011, the Company’s Board of Directors authorized a $15.0 million stock repurchase program. This program does not have an expiration date. The timing and terms of the purchases are determined by management based on board approved parameters and market conditions, and are conducted in accordance with the applicable rules of the Securities and Exchange Commission. Common stock repurchased under this program will be retired by the Company. During 2016, the Company repurchased 17,300 shares under this program at an average cost of $22.14.
Stock Purchase Plan
During the second quarter of 2005, Employers Mutual initiated a $15.0 million stock purchase program under which Employers Mutual may purchase shares of the Company’s common stock in the open market. This purchase program does not have an expiration date; however, this program is currently dormant and will remain so while the Company’s repurchase program is in effect. The timing and terms of the purchases are determined by management based on market conditions and are conducted in accordance with the applicable rules of the Securities and Exchange Commission. No purchases were made during 2017, 2016 and 2015. As of December 31, 2017, $4.5 million remained available under this plan for additional purchases.
16.
LEASES, COMMITMENTS AND CONTINGENT LIABILITIES
One of the Company’s property and casualty insurance subsidiaries leases office facilities in Bismarck, North Dakota with lease terms expiring in 2024. Employers Mutual has entered into various leases for branch and service office facilities with lease terms expiring through 2027. All of these lease costs are included as expenses under the pooling agreement. The following table reflects the Company's share of lease commitments as of December 31, 2017.
The participants in the pooling agreement are subject to guaranty fund assessments by states in which they write business. Guaranty fund assessments are used by states to pay policyholder liabilities of insolvent insurers domiciled in those states. Many states allow assessments to be recovered through premium tax offsets. The Company has accrued estimated guaranty fund assessments of $706,000 and $851,000 as of December 31, 2017 and 2016, respectively. Premium tax offsets of $897,000 and $1.0 million, which are related to prior guarantee fund payments and current assessments, have been accrued as of December 31, 2017 and 2016, respectively. The guaranty fund assessments are expected to be paid over the next two years and the premium tax offsets are expected to be realized within ten years of the payments. The participants in the pooling agreement are also subject to second-injury fund assessments, which are designed to encourage employers to employ workers with pre-existing disabilities. The Company has accrued estimated second-injury fund assessments of $2.0 million and $1.9 million as of December 31, 2017 and 2016, respectively. The second-injury fund assessment accruals are based on projected loss payments. The periods over which the assessments will be paid is not known.
The participants in the pooling agreement have purchased annuities from life insurance companies, under which the claimant is payee, to fund future payments that are fixed pursuant to specific claim settlement provisions. The Company’s share of case loss reserves eliminated by the purchase of those annuities was $110,000 at December 31, 2017. The Company had a contingent liability for the aggregate guaranteed amount of the annuities of $183,000 at December 31, 2017 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.
The Company and Employers Mutual and its other subsidiaries are parties to numerous lawsuits arising in the normal course of the insurance business. The Company believes that the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations. The companies involved have established reserves which are believed adequate to cover any potential liabilities arising out of all such pending or threatened proceedings.
17. UNAUDITED INTERIM FINANCIAL INFORMATION
1 Since the weighted-average number of shares outstanding for the quarters are calculated independently of the weighted-average number of shares outstanding for the year, quarterly net income per share may not total to annual net income per share.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Schedule I - Summary of Investments-
Other than Investment in Related Parties
December 31, 2017
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Schedule II - Condensed Financial Information of Registrant
Condensed Balance Sheets
All affiliated balances presented above are the result of related party transactions with Employers Mutual.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Schedule II - Condensed Financial Information of Registrant, Continued
Condensed Statements of Income
All affiliated balances presented above are the result of related party transactions with Employers Mutual.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Schedule II - Condensed Financial Information of Registrant, Continued
Condensed Statements of Comprehensive Income
All balances labeled with "affiliate" above are the result of related party transactions with Employers Mutual. All other comprehensive income (loss) balances presented above are from the Registrant's subsidiaries.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Schedule II - Condensed Financial Information of Registrant, Continued
Condensed Statements of Cash Flows
All affiliated balances presented above are the result of related party transactions with Employers Mutual.
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Schedule III - Supplementary Insurance Information
For Years Ended December 31, 2017, 2016 and 2015
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Schedule IV - Reinsurance
For Years Ended December 31, 2017, 2016 and 2015
EMC INSURANCE GROUP INC. AND SUBSIDIARIES
Schedule VI - Supplemental Information Concerning
Property-Casualty Insurance Operations
For Years Ended December 31, 2017, 2016 and 2015
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
The Company, under the supervision and with the participation of its management, including the Chief Executive Officer and the Chief Financial Officer, evaluated the effectiveness of the design and operation of the Company’s “disclosure controls and procedures” (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely making known to them material information relating to the Company and the Company’s consolidated subsidiaries required to be disclosed in the Company’s reports filed or submitted under the Exchange Act.
The report called for by Item 308(a) of Regulation S-K is included in “Management’s Report on Internal Control Over Financial Reporting,” under Part II, Item 8 of this report.
The attestation report called for by Item 308(b) of Regulation S-K is included in “Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting,” under Part II, Item 8 of this report.
There were no changes in the Company’s internal control over financial reporting that occurred during the fourth quarter ended December 31, 2017 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by Item 10 regarding the Company’s executive officers is included in “Executive Officers of the Company” under Part I, Item 1 of this report.
The information required by Item 10 regarding the audit committee financial expert and the members of the Company’s Audit Committee of the Board of Directors is incorporated by reference from the information under the caption “Corporate Governance of the Company- Board Meetings and Committees” in the Company’s Proxy Statement for the Annual Meeting of Stockholders to be held on May 16, 2018.
The information required by Item 10 regarding the Company’s directors is incorporated by reference from the information under the captions “Election of Directors” and “Corporate Governance of the Company - Board Meetings and Committees” in the Company’s Proxy Statement for the Annual Meeting of Stockholders to be held on May 16, 2018.
The information required by Item 10 regarding compliance with Section 16(a) of the Exchange Act is incorporated by reference from the information under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s Proxy Statement for the Annual Meeting of Stockholders to be held on May 16, 2018.
The Company has adopted a code of ethics that applies to the Company’s principal executive officer, principal financial officer, principal accounting officer, controller, and/or persons performing similar functions. The code of ethics is posted on the Corporate Governance page of the Company’s website found at investors.emcins.com. In the event that the Company makes any amendments to, or grants any waivers from, a provision of the ethics policy that requires disclosure under applicable Securities and Exchange Commission rules, the Company intends to disclose such amendments or waivers and the reasons therefore on its website.
See the information under the captions “Executive Compensation,” “Compensation Committee Report” and “Compensation Committee Interlocks and Insider Participation” in the Company’s Proxy Statement in connection with its Annual Meeting of Stockholders to be held on May 16, 2018, which information is incorporated herein by reference.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
See the information under the captions “Security Ownership of Certain Beneficial Owners”, “Security Ownership of Management and Directors” and “Securities Authorized For Issuance Under Equity Compensation Plans” in the Company’s Proxy Statement in connection with its Annual Meeting of Stockholders to be held on May 16, 2018, which information is incorporated herein by reference.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
See the information under the captions “Certain Relationships and Related Persons Transactions” and “Corporate Governance of the Company- Independence of Directors” in the Company’s Proxy Statement in connection with its Annual Meeting of Stockholders to be held on May 16, 2018, which information is incorporated herein by reference.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
See the information under the caption “Independent Registered Public Accounting Firm’s Fees” in the Company’s Proxy Statement in connection with its Annual Meeting of Stockholders to be held on May 16, 2018, which information is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a) List of Financial Statements and Schedules
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 5, 2018.
EMC INSURANCE GROUP INC.
/s/ Bruce G. Kelley
Bruce G. Kelley
President, Chief Executive Officer and Treasurer
(Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 5, 2018.
/s/ Bruce G. Kelley
Bruce G. Kelley
President, Chief Executive Officer, Treasurer
and Director
(Principal Executive Officer)
/s/ Mark E. Reese
Mark E. Reese
Senior Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)
/s/ Mark E. Reese
Stephen A. Crane*
Chairman of the Board
/s/ Mark E. Reese
Peter S. Christie*
Director
/s/ Mark E. Reese
Jonathan R. Fletcher*
Director
/s/ Mark E. Reese
Robert L. Howe*
Director
/s/ Mark E. Reese
Gretchen H. Tegeler*
Director
* by power of attorney