Item 1 - “Business - Reinsurance.”
We may be unable to effectively develop and market new products, like PennEdge, which may negatively affect our operations.
Our ability to expand our business and to compete depends on our ability to successfully develop and market new products, like PennEdge. The success of new products such as PennEdge depends on many factors, including our ability to anticipate and satisfy customer needs, develop our products cost-effectively, differentiate our products from our competitors, and, where applicable, obtain the necessary regulatory approvals on a timely basis.
However, even if we successfully develop new products, the success of those products will be dependent upon market acceptance. Market acceptance could be affected by several factors, including, but not limited to:
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the availability of alternative products from our competitors;
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the price of our product relative to our competitors;
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the commissions paid to producers for the sale of our products relative to our competitors;
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the timing of our market entry; and
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our ability to market and distribute our products effectively.
The successful development and marketing of PennEdge and other products will require a significant investment. Our failure to effectively develop and market PennEdge and other products may have an adverse effect on our business and operating results.
The property and casualty insurance market in which we operate is highly competitive, which limits our ability to increase premiums for our products and recruit new producers.
Competition in the property and casualty insurance business is based on many factors. These factors include the perceived financial strength of the insurer, premiums charged, policy terms and conditions, services provided, reputation, financial ratings assigned by independent rating agencies and the experience of the insurer in the line of insurance to be written. We compete with stock insurance companies, mutual companies, local cooperatives and other underwriting organizations. Many of these competitors have substantially greater financial, technical and operating resources than we have. Many of the lines of insurance we write are subject to significant price competition. If our competitors price their products aggressively, our ability to grow or renew our business may be adversely affected. We pay producers on a commission basis to write our business. Some of our competitors may offer higher commissions or insurance at lower premium rates through the use of salaried personnel or other distribution methods that do not rely primarily on independent producers (as we do). Increased competition could adversely affect our ability to attract and retain business, and thereby, reduce our profits from operations.
Our results of operations may be adversely affected by any loss of business from key producers.
Our products are primarily marketed by independent producers. Other insurance companies compete with us for the services and allegiance of these producers. These producers may choose to direct business to our competitors, or may direct less desirable risks to us. One producer, Arthur J. Gallagher Risk Management Services, which writes business for us through nine of their offices, accounted for $11.2 million, or approximately 13%, of our direct premiums written in 2010. Only one other producer accounted for more than 5% of our 2010 direct premiums written. If we experience a significant decrease in business from, or lose entirely, our largest producers it would have a material adverse effect on us.
Assessments and premium surcharges for state guaranty funds, second injury funds and other mandatory pooling arrangements may reduce our profitability.
Most states require insurance companies licensed to do business in their state to participate in guaranty funds, which require the insurance companies to bear a portion of the unfunded obligations of impaired, insolvent or failed insurance companies. These obligations are funded by assessments, which are expected to continue in the future. State guaranty associations levy assessments, up to prescribed limits, on all member insurance companies in the state based on their proportionate share of premiums written in the lines of business in which the impaired, insolvent or failed insurance companies are engaged. Accordingly, the assessments levied on us may increase as we increase our written premiums. Some states also have laws that establish second injury funds to reimburse insurers and employers for claims paid to injured employees for aggravation of prior conditions or injuries. These funds are supported by either assessments or premium surcharges based on incurred losses.
In addition, as a condition to conducting business in some states, insurance companies are required to participate in residual market programs to provide insurance to those who cannot procure coverage from an insurance carrier on a negotiated basis. Insurance companies generally can fulfill their residual market obligations by, among other things, participating in a reinsurance pool where the results of all policies provided through the pool are shared by the participating insurance companies. Although we price our insurance to account for our potential obligations under these pooling arrangements, we may not be able to accurately estimate our liability for these obligations. Accordingly, mandatory pooling arrangements may cause a decrease in our profits. At December 31, 2010, we participated in mandatory pooling arrangements in the majority of the states in which we do business. As we write policies in new states that have mandatory pooling arrangements, we will be required to participate in additional pooling arrangements. Further, the impairment, insolvency or failure of other insurance companies in these pooling arrangements would likely increase the liability for other members in the pool. The effect of assessments and premium surcharges or increases in such assessments or surcharges could reduce our profitability
in any given period or limit our ability to grow our business. For more information, see Item 1 - “Business - Regulation.”
Our revenues may fluctuate with our investment results and changes in interest rates.
Our investment portfolio is comprised mostly of fixed maturity securities at December 31, 2010, including bonds, mortgage-backed securities (MBSs) and other securities. The fair values of these invested assets fluctuate depending upon economic conditions, particularly changes in interest rates.
MBSs are subject to prepayment risks that vary with, among other things, interest rates. MBSs represented approximately $24.6 million or approximately 14% of our investments at December 31, 2010. During periods of declining interest rates, MBSs generally return principal faster than expected as the underlying mortgages are prepaid and/or refinanced by the borrowers in order to take advantage of the lower rates. MBSs with an amortized cost that is greater than par (i.e., purchased at a premium) may incur a reduction in yield or a loss as a result of prepayments. In addition, during such periods, we generally will be unable to reinvest the proceeds of any prepayment at comparable yields. Conversely, during periods of rising interest rates, the frequency of prepayments generally decreases. MBSs that have an amortized value that is less than par (i.e., purchased at a discount) may incur a decrease in yield or a loss as a result of slower prepayments.
We may not be able to prevent or minimize the negative impact of interest rate changes. Additionally, unforeseen circumstances may force us to sell certain of our invested assets at a time when their fair values are less than their original cost, resulting in realized capital losses, which would reduce our net income.
Volatility in commodity and other prices could impact our financial results.
We provide insurance coverages to mills, silos, and other agribusinesses, which store large quantities of commodities such as corn, wheat, soybeans and fertilizer. Therefore, the amount of our losses is affected by the value of these commodities. Volatility in commodity prices may be a result of many factors, including, but not limited to, shortages or excess supply created by weather changes, catastrophes, changes in global or local demand, or the rise or fall of the U.S. dollar relative to other currencies. Unexpected increases in commodity prices could result in our losses exceeding our actual reserves for our agribusiness lines. Such volatility in commodity prices could cause substantial volatility in our financial results for any fiscal quarter or year and could have a material adverse affect on our financial condition or results of operations. In addition, the cost of construction materials and prevailing labor costs in areas affected by widespread storm damage can significantly impact our casualty losses. Higher costs for construction materials and shortages of skilled contractors such as electricians, plumbers and carpenters can increase the cost to repair or replace an insured property.
Proposals to federally regulate the insurance business could affect our business.
Currently, the U.S. federal government does not directly regulate the insurance business. However, federal legislation and administrative policies in several areas can significantly and adversely affect insurance companies. These areas include financial services regulation, securities regulation, pension regulation, privacy, tort reform legislation and taxation. In addition, various forms of direct federal regulation of insurance have been proposed. These proposals generally would maintain state-based regulation of insurance, but would affect state regulation of certain aspects of the insurance business, including rates, producer and company licensing, and market conduct examinations. We cannot predict whether any of these proposals will be adopted, or what impact, if any, such proposals or, if enacted, such laws may have on our business, financial condition or results of operations.
If we fail to comply with insurance industry regulations, or if those regulations become more burdensome, we may not be able to operate profitably.
We are regulated by the Pennsylvania Insurance Department, as well as, to a more limited extent, the federal government and the insurance departments of other states in which we do business. As of December 31, 2010 almost 20% of our direct premiums written originated from business written in Pennsylvania and New Jersey. Therefore, the cancellation or suspension of our license in these states, as a result of any failure to comply with the applicable insurance laws and regulations, may negatively impact our operating results.
Most insurance regulations are designed to protect the interests of policyholders rather than shareholders and other investors. These regulations relate to, among other things:
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approval of policy forms and premium rates;
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standards of solvency, including establishing requirements for minimum capital and surplus, and for risk-based capital;
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classifying assets as admissible for purposes of determining solvency and compliance with minimum capital and surplus requirements;
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licensing of insurers and their producers;
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advertising and marketing practices;
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restrictions on the nature, quality and concentration of investments;
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assessments by guaranty associations and mandatory pooling arrangements;
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restrictions on the ability to pay dividends;
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restrictions on transactions between affiliated companies;
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restrictions on the size of risks insurable under a single policy;
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requiring deposits for the benefit of policyholders;
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requiring certain methods of accounting;
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periodic examinations of our operations and finances;
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claims practices;
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prescribing the form and content of reports of financial condition required to be filed; and
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requiring reserves for unearned premiums, losses and other purposes.
The Pennsylvania Insurance Department also conducts periodic examinations of the affairs of insurance companies and requires the filing of annual and other reports relating to financial condition, holding company issues and other matters. These regulatory requirements may adversely affect or inhibit our ability to achieve some or all of our business objectives. Our last completed examination was as of December 31, 2009, the results of which have not been formally issued by the Pennsylvania Insurance Department.
In addition, regulatory authorities have relatively broad discretion to deny or revoke licenses for various reasons, including the violation of regulations. Further, changes in the level of regulation of the insurance industry or changes in laws or regulations themselves or interpretations by regulatory authorities could adversely affect our ability to operate our business.
Our ability to manage our exposure to underwriting risks depends on the availability and cost of reinsurance coverage.
Reinsurance is the practice of transferring part of an insurance company’s liability and premium under an insurance policy to another insurance company. We use reinsurance arrangements to limit and manage the amount of risk we retain, to stabilize our underwriting results and to increase our underwriting capacity. The availability and cost of reinsurance are subject to current market conditions and may vary significantly over time. Any decrease in the amount of our reinsurance will increase our risk of loss. We may be unable to maintain our desired reinsurance coverage or to obtain other reinsurance coverage in adequate amounts and at favorable rates. If we are unable to renew our expiring coverage or obtain new coverage, it will be difficult for us to manage our underwriting risks and operate our business profitably.
It is also possible that the losses we experience on risks we have reinsured will exceed the coverage limits on the reinsurance. If the amount of our reinsurance coverage is insufficient, our insurance losses could increase substantially.
We could be adversely affected by the loss of our existing management or key employees.
The success of our business is dependent, to a large extent, on our ability to attract and retain key employees, in particular our senior officers. These key officers have an average of over twenty years of experience in the property and casualty insurance industry. Our business may be adversely affected if labor market conditions make it difficult for us to replace our current key officers with individuals having equivalent qualifications and experience at compensation levels competitive for our industry. In particular, because of the shortage of experienced underwriters and claims personnel who have experience or training in the agribusiness sector of the insurance industry, replacing key employees in that line of our business could be challenging. While we have employment agreements with a number of key officers, we do not have agreements not to compete or employment agreements with most of our employees. Our employment agreements with our key officers have change of control provisions that provide for certain payments and the continuation of certain benefits in the event they are terminated without cause or they voluntarily quit for good reason after a change in control.
We could be adversely affected by any interruption to our ability to conduct business at our current location.
Our business operations are concentrated in one physical location in Wilkes-Barre, Pennsylvania, which is located on the Susquehanna River. Accordingly, our business operations could be substantially interrupted by flooding, snow, ice, and other weather-related incidents, or from fire, power loss, telecommunications failures, terrorism, or other such events. In such an event, we may not have sufficient redundant facilities to cover a loss or failure in all aspects of our business operations and to restart our business operations in a timely manner. Any damage caused by such a failure or loss may cause interruptions in our business operations that may adversely affect our service levels and business.
Statutory provisions and our articles and bylaws may discourage takeover attempts on Penn Millers that you may believe are in your best interests or that might result in a substantial profit to you.
We are subject to provisions of Pennsylvania corporate and insurance law that hinder a change of control. Pennsylvania law requires the Pennsylvania Insurance Department’s prior approval of a change of control of an insurance holding company. Under Pennsylvania law, the acquisition of 10% or more of the outstanding voting stock of an insurer or its holding company is presumed to be a change in control. Approval by the Pennsylvania Insurance Department may be withheld even if the transaction would be in the shareholders’ best interest if the Pennsylvania Insurance Department determines that the transaction would be detrimental to policyholders.
Our articles of incorporation and bylaws also contain provisions that may discourage a change in control. These provisions include:
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a prohibition on a person, including a group acting in concert, from acquiring voting control of more than 10% of our outstanding stock without prior approval of the board of directors;
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a classified board of directors divided into three classes serving for successive terms of three years each;
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the prohibition of cumulative voting in the election of directors;
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the requirement that nominations for the election of directors made by shareholders and any shareholder proposals for inclusion on the agenda at any annual meeting must be made by notice (in writing) delivered or mailed to us not less than 90 days prior to the meeting;
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the prohibition of shareholders’ action without a meeting and of shareholders’ right to call a special meeting;
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unless otherwise waived by the board of directors, to be elected as a director, a person must be a shareholder of Penn Millers Holding Corporation for the lesser of one year or the time that has elapsed since the completion of the conversion;
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the requirement imposing a mandatory tender offering requirement on a shareholder that has a combined voting power of 25% or more of the votes that our shareholders are entitled to cast;
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the requirement that certain provisions of our articles of incorporation can only be amended by an affirmative vote of shareholders entitled to cast at least 80% of all votes that shareholders are entitled to cast, unless approved by an affirmative vote of at least 80% of the members of the board of directors; and
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the requirement that certain provisions of our bylaws can only be amended by an affirmative vote of shareholders entitled to cast at least 662/3%, or in certain cases 80%, of all votes that shareholders are entitled to cast.
These provisions may serve to entrench management and may discourage a takeover attempt that you may consider to be in your best interest or in which you would receive a substantial premium over the current market price. These provisions may make it extremely difficult for any one person, entity or group of affiliated persons or entities to acquire voting control of Penn Millers, with the result that it may be extremely difficult to bring about a change in the board of directors or management. Some of these provisions also may perpetuate present management because of the additional time required to cause a change in the control of the board. Other provisions make it difficult for shareholders owning less than a majority of the voting stock to be able to elect even a single director.
If Penn Millers Insurance Company is not sufficiently profitable, our ability to pay dividends will be limited.
We depend primarily on dividends paid by Penn Millers Insurance Company and proceeds from the initial public offering that are not contributed to Penn Millers Insurance Company to provide funds for the payment of dividends to our shareholders. We will receive dividends only after all of Penn Millers Insurance Company’s obligations and regulatory requirements with the Pennsylvania Insurance Department have been satisfied. During any twelve-month period, the amount of dividends paid by Penn Millers Insurance Company to us, without the prior approval of the Pennsylvania Insurance Department, may not exceed the greater of 10% of the insurance company’s surplus as regards policyholders as reported on its most recent annual statement filed with the Pennsylvania Insurance Department or the insurance company’s statutory net income as reported on such statement. We presently do not intend to pay dividends to our shareholders. If Penn Millers Insurance Company is not sufficiently profitable, our ability to pay dividends to you in the future will be limited.
If our controls to ensure compliance with legal and regulatory policies and guidelines are not effective, our business, financial results and reputation could be materially adversely affected.
A control system, regardless of how well designed and effective we consider it to be, can only provide reasonable assurance that the control systems’ objectives will be met. If we determine that our controls are not effective, including internal controls over financial reporting, this could have an adverse effect on our financial results, liquidity, and reputation; and possibly subject us to litigation.
Item 1B.
Unresolved Staff Comments
None
Item 2.
Properties
Our headquarters are located at 72 North Franklin Street, Wilkes-Barre, Pennsylvania. We own this 39,963 square foot facility. We also rent office space in Indianapolis, IN. In the opinion of our management, the Company’s properties are adequate and suitable for its business as presently conducted and are adequately maintained.
Item 3.
Legal Proceedings
The Company is, from time to time, involved in legal proceedings that arise in the ordinary course of business. We believe that we have sufficient loss reserves and reinsurance to cover claims under insurance policies issued by us. Although there can be no assurance as to the ultimate disposition of these matters, we do not believe, based upon the information available at this time, that any current pending legal proceedings, either individually or in the aggregate, will have a material adverse effect on our business, financial conditions, or results of operations.
Item 4.
(Removed and Reserved)
PART II
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
On October 17, 2009, our common stock began trading on the Nasdaq Global Market under the symbol “PMIC.” The number of holders of record, including individual owners of our common stock was 329 as of February 28, 2011. This is not the actual number of beneficial owners of our common stock, as shares are held in “street name” by brokers and others on behalf of individual owners.
We do not currently pay dividends on our common stock. Payment of dividends in the future is at the discretion of our board of directors and will depend on a number of factors including our operating results, overall financial condition, capital requirements and general business conditions. We depend primarily on dividends paid by Penn Millers Insurance Company to us and proceeds from the initial public offering that were not contributed to Penn Millers Insurance Company to provide funds for the payment of dividends. If Penn Millers Insurance Company chooses to pay dividends to Penn Millers Holding Corporation, we will receive dividends only after Penn Millers Insurance Company provides notice to, and without objection from, the Pennsylvania Insurance Department. During any twelve-month period, the amount of dividends paid by Penn Millers Insurance Company to us, without the prior approval of the Pennsylvania Insurance Department, may not exceed the greater of 10% of the insurance company’s surplus as regards policyholders as reported on its most recent annual statement filed with the Pennsylvania Insurance Department or the insurance company’s statutory net income as reported on such statement. Information regarding the restrictions and limitations on the payment of cash dividends can be found in Item 1 “Business - Regulation.”
The following table sets forth the high and low closing sales prices of our common stock for the periods indicated that we were a publicly-traded company:
Issuer Purchases of Equity Securities
In the three months ended June 30, 2010, the 54,440 shares remaining under our October 27, 2009 stock repurchase program were purchased at an average cost of $14.60 per share.
On May 12, 2010, our board of directors authorized the repurchase of up to 5% of the issued and outstanding shares of our common stock. The repurchases are authorized to be made from time to time in open market or privately negotiated transactions as, in our management’s sole opinion, market conditions warrant. We have the right to repurchase issued and outstanding shares of common stock until 5% of the shares, or 258,591, are repurchased. In the year ended December 31, 2010, we repurchased under this second program 232,691 shares at an average cost of $14.44 per share.
All purchases were made in accordance with the safe harbor set forth in Exchange Act Rule 10-b-18. The repurchased shares will be held as treasury shares and will be used in connection with our stock-based incentive plan.
On August 11, 2010, our board of directors approved a third share repurchase plan, authorizing the repurchase of an additional 245,662 common shares in open market or privately negotiated transactions during a twelve month
period beginning August 18, 2010. For the year ended December 31, 2010, no shares were repurchased under the August 2010 program.
For more information on our stock repurchase programs, see “Liquidity and Capital Resources” in Item 7 of this Form 10-K.
Equity Compensation Plan Information
The following table summarizes the number of shares issuable pursuant to outstanding options and remaining available for issuance under the Company’s Stock Incentive Plan as of December 31, 2010:
Item 6.
Selected Financial Data
Not applicable.
Item 7.
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Dollars in Thousands, Except Per Share Amounts
(Unaudited)
Some of the statements contained in this document are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “intend,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or “continue,” the negative of these terms or other terminology. Forward-looking statements are based on the opinions and estimates of management at the time the statements are made and are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forward-looking statements. These forward-looking statements include statements of goals, intentions and expectations; statements regarding prospects and business strategy; and estimates of future costs, benefits and results. The forward-looking statements are subject to numerous assumptions, risks and uncertainties, including, among other things, the factors discussed under the heading Item 1A
Item 7A.
Quantitative and Qualitative Disclosures about Market Risk
Under smaller reporting company rules we are not required to disclose information required under Item 7A. However, in order to provide information to our investors, we have elected to provide information related to our market risks.
Market risk is the risk that we will incur losses due to adverse changes in the fair value of financial instruments. We have exposure to three principal types of market risks through our investment activities: interest rate risk, credit risk and equity risk. Our primary market risk exposure is to changes in interest rates. We have not entered, and do not plan to enter, into any derivative financial instruments for trading or speculative purposes.
Interest Rate Risk
Interest rate risk is the risk that we will incur economic losses due to adverse changes in interest rates. Our exposure to interest rate changes primarily results from our significant holdings of fixed rate investments. Fluctuations in interest rates have a direct impact on the fair value of these securities.
The average effective duration of the fixed maturity securities in our investment portfolio at December 31, 2010, was 3.2 years. Our fixed maturity securities investments include U.S. government bonds, securities issued by government agencies, obligations of state and local governments and governmental authorities, corporate bonds and mortgage-backed securities, most of which are exposed to changes in prevailing interest rates and which may experience moderate fluctuations in fair value resulting from changes in interest rates. We carry these investments as available for sale. This allows us to manage our exposure to risks associated with interest rate fluctuations through active review of our investment portfolio by our management and board of directors and consultation with our external investment manager.
Approximately 6% of our investment portfolio at December 31, 2010 is in a high-yield bond fund that invests primarily in U.S. debt securities. This is a publicly traded mutual fund in which we have an ownership stake in the overall assets of the fund (that is stated as a number of shares), and we are not a creditor in the underlying debt securities. Because this is an investment in shares of a mutual fund, we have classified this investment as an equity security on our consolidated balance sheets. This fund is also subject to interest rate risk and has an option-adjusted duration of 4.77 years at December 31, 2010.
Fluctuations in near-term interest rates could have an impact on our results of operations and cash flows. Certain of these securities may have call features. In a declining interest rate environment these securities may be
called by their issuer and replaced with securities bearing lower interest rates. If we are required to sell these securities in a rising interest rate environment we may recognize losses.
As a general matter, we attempt to match the durations of our assets with the durations of our liabilities. Our investment objectives include maintaining adequate liquidity to meet our operational needs, optimizing our after-tax investment income, and our after-tax total return, all of which are subject to our tolerance for risk.
The table below shows the interest rate sensitivity of our investments measured in terms of fair value (which is equal to carrying value) at December 31, 2010:
Credit Risk
Credit risk is the potential economic loss principally arising from adverse changes in the financial condition of a specific debt issuer. We address this risk by investing primarily in fixed maturity securities that are rated investment grade with a minimum average portfolio quality of “Aa2” by Moody’s or an equivalent rating quality. We also independently, and through our outside investment manager, monitor the financial condition of all of the issuers of fixed maturity securities in the portfolio. To limit our exposure to risk, we employ diversification rules that limit the credit exposure to any single issuer or asset class.
The insolvency or inability of any reinsurer to meet its obligations to us could have a material adverse effect on our results of operations or financial condition. We monitor the solvency of reinsurers through regular review of their financial statements and, if available, their A.M. Best ratings. All of our significant reinsurance partners that A.M. Best follows have at least an “A−” A.M. Best rating. According to A.M. Best, companies with a rating of “A−” or better “have an excellent ability to meet their ongoing obligations to policyholders.” In certain instances, we may partner with a reinsurer who is not rated by A.M. Best. However, in such instances the reinsurer must be well capitalized and have a strong credit rating from Standard and Poor’s or Moody’s rating agencies. We will generally only make exceptions for property related reinsurance in which there is typically little or no delay in the reporting of losses by insureds and the settlement of the claims. We have experienced no significant difficulties collecting amounts due from reinsurers. For more information regarding the credit ratings of our reinsurers, see Item 1 “Business - Reinsurance.”
Equity Risk
Equity price risk is the risk that we will incur economic losses due to adverse changes in equity prices. In the fourth quarter of 2010, we sold all of our equity securities (which represented approximately 6% of our investment portfolio) that had been invested in a passively-managed equity index fund, and invested the proceeds in a high-yield bond mutual fund.
Item 8.
Item 8.
Financial Statements and Supplementary Data
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
Penn Millers Holding Corporation:
We have audited the accompanying consolidated balance sheets of Penn Millers Holding Corporation and subsidiary (the Company) as of December 31, 2010 and 2009, and the related consolidated statements of operations, shareholders’ equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Penn Millers Holding Corporation and subsidiary as of December 31, 2010 and 2009, and the results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.
/s/ KPMG LLP
Philadelphia, PA
March 28, 2011
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Consolidated Balance Sheets
December 31, 2010 and 2009
See accompanying notes to consolidated financial statements.
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Consolidated Statements of Operations
Years ended December 31, 2010 and
See accompanying notes to consolidated financial statements.
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Consolidated Statements of Shareholders’ Equity
Years ended December 31, 2010 and
See accompanying notes to consolidated financial statements.
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Consolidated Statements of Cash Flows
Years ended December 31, 2010 and
See accompanying notes to consolidated financial statements.
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(1)
Description of Business
Penn Millers Holding Corporation and subsidiary (the Company) are engaged in the marketing and sale of commercial property and liability insurance in 33 states throughout the United States. Coverage is written directly by the Company’s employees and through independent producers.
On April 22, 2009, Penn Millers Mutual Holding Company (Penn Millers Mutual), a Pennsylvania mutual holding company, formed Penn Millers Holding Corporation (Corporation) to effect its conversion from a mutual to stock form of organization. On October 16, 2009, Penn Millers Mutual converted from mutual to stock form and was renamed PMMHC Corp. (PMMHC). PMMHC then issued all of its outstanding capital stock to the Corporation, thereby becoming its wholly owned subsidiary. Immediately following the conversion, PMHC Corp., the wholly owned subsidiary of PMMHC, merged with and into PMMHC, thereby terminating PMHC Corp.’s existence. On October 16, 2009, Penn Millers Holding Corporation completed a stock offering (Offering) and sold 5,444,022 shares of common stock in a concurrently-held subscription and community offering for $10 per share, raising approximately $45,172, net of offering costs and the purchase of common stock by the Employee Stock Ownership Plan (ESOP). Shares of the Corporation began trading on October 19, 2009 on the Nasdaq Global Market under the symbol “PMIC.” The historical consolidated financial statements of Penn Millers Mutual prior to the conversion became the consolidated financial statements of the Corporation upon completion of the conversion.
Upon conversion, and consistent with the terms of the plan of conversion, the board of directors authorized and approved PMMHC to issue 1,000,000 shares of $0.01 par stock to the Corporation at par per share. PMMHC also retired 1,000 shares previously held in PMHC Corp.
Upon completion of the merger of PMHC Corp. into PMMHC, PMMHC became the stock holding company for Penn Millers Insurance Company (PMIC). PMIC is a property and casualty insurance company incorporated in Pennsylvania. The stock of PMIC is the most significant asset of PMMHC. American Millers Insurance Company (AMIC) is a property and casualty insurance company incorporated in Pennsylvania and is a wholly owned subsidiary of PMIC. PMMHC owns all of the outstanding common stock of PMIC, which owns all of the outstanding common stock of Penn Millers Agency, Inc. and AMIC. The Corporation and PMMHC conduct no business other than acting as holding companies.
The Company reports its operating results in three segments: agribusiness insurance, commercial business insurance, and a third segment, which is referred to as “other.” However, assets are not allocated to segments and are reviewed in the aggregate for decision-making purposes. The agribusiness insurance segment markets its product in a bundled offering that includes fire and allied lines, inland marine, general liability, commercial automobile, workers’ compensation, and umbrella liability insurance. This segment specializes in writing coverage for manufacturers, processors, and distributors of products for the agricultural industry. The commercial business insurance segment targets small and middle market businesses and offers coverages for property, liability, business interruption, crime coverage, workers’ compensation, commercial automobile, and umbrella liability. The types of businesses this segment targets include retail, service, hospitality, wholesalers, manufacturers, and printers. Both the commercial and agribusiness lines are marketed primarily through independent producers. The “other” segment includes the runoff of discontinued lines of insurance business and the results of mandatory assigned risk reinsurance programs that the Company must participate in as a condition of doing business in the states in which it operates.
The Company owned Eastern Insurance Group (EIG), an insurance agency, and Penn Software & Technology Services, Inc. (PSTS), which provided both hardware and computer programming services to its clients. The Company sold substantially all of the assets of EIG and PSTS in 2009 and 2008, respectively (see note 17). The financial results of each of these subsidiaries have been presented as discontinued operations during the year ended December 31, 2009. The Company ceased all operations of EIG in 2009 and PSTS in 2008.
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
(2)
Summary of Significant Accounting Policies
(a)
Basis of Presentation
The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) and include the accounts and operations of the Company and its subsidiary. All material intercompany balances and accounts have been eliminated in consolidation.
(b)
Use of Estimates
The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements. These reported amounts include the financial statement recognition of loss reserves, contingent liabilities, tax valuation allowances, valuation of deferred policy acquisition costs, valuation of defined benefit pension obligations and valuation of investments, including other-than-temporary impairment of investments. These reported amounts also include the disclosure of contingent assets and liabilities. Management’s estimates and assumptions also affect the reported amounts of revenues and expenses, during the reporting period. Actual results could differ from these estimates.
(c)
Concentration of Risk
The Company’s business is subject to concentration of risk with respect to geographic concentration. Although the Company’s operating subsidiaries are licensed collectively in 40 states, direct premiums written for two states, New Jersey and Pennsylvania, accounted for almost 20% of the Company’s direct premiums written for the year ended December 31, 2010. Consequently, changes in the New Jersey or Pennsylvania legal, regulatory, or economic environment could adversely affect the Company.
Additionally, one producer, Arthur J. Gallagher Risk Management Services, which writes business for the Company through nine of its offices, accounted for 13% of the Company’s direct premium writings for 2010. Only one other producer accounted for more than 5% of the Company’s 2010 direct premium writings.
(d)
Investments
The Company classifies all of its fixed maturity securities as available for sale. Fixed maturities classified as available for sale are carried at fair value. Short-term investments are recorded at cost, which approximates fair value. The fair value of Level 1 and Level 2 fixed maturities is based upon data supplied by an independent pricing service. The fair value of Level 3 fixed maturity securities is based on cash flow analysis and other valuation techniques.
Premiums and discounts on fixed maturity securities are amortized or accreted using the interest method. Mortgage-backed securities are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted as necessary to reflect actual prepayments and changes in expectations. Adjustments related to changes in prepayment assumptions are recognized on a retrospective basis. Dividends and interest on securities are recognized in operations when declared and earned, respectively. Accrual of income is suspended on fixed maturities or mortgage-backed securities that are in default, or on which it is likely that future payments will not be made as scheduled. Interest income on investments in default is recognized after principal is paid and when payments are received. There are no investments included in the consolidated balance sheets that were not income-producing for the preceding 12 months.
Realized gains and losses on sale of investments are recognized in net income on the specific identification basis as of the trade date. Realized losses also include losses for fair value declines that are considered to be other-than-temporary. Changes in unrealized gains or losses on investments carried at fair value, net of applicable
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
income taxes, are reflected directly in shareholders’ equity as a component of comprehensive income (loss) and, accordingly, have no effect on net income.
Prior to April 1, 2009, the Company recognized in earnings an other-than-temporary impairment for a fixed maturity security in an unrealized loss position unless it could assert that it had both the intent and ability to hold the fixed maturity security for a period of time sufficient to allow for a recovery of fair value to the security’s amortized cost basis. During that time, the entire difference between the fixed maturity security’s amortized cost basis and its fair value was recognized in earnings if it was determined to have an other-than-temporary impairment.
On April 1, 2009, the Financial Accounting Standards Board (FASB) issued new guidance on the recognition and presentation of other-than-temporary impairments. This new guidance amends the previously used methodology for determining whether an other-than-temporary impairment exists for fixed maturity securities. Per the Company’s current policy, a fixed maturity security is other-than-temporarily impaired if the present value of the cash flows expected to be collected is less than the amortized cost of the security or where the security’s fair value is below cost and the Company intends to sell or more likely than not will be required to sell the security before recovery of its value. If the fixed maturity security meets either of these two criteria, the other-than-temporary impairment recognized in earnings is equal to the entire difference between the security’s amortized cost basis and its estimated fair value at the impairment measurement date. If the Company does not intend to sell, or more likely than not will not be required to sell, a fixed maturity security whose fair value has declined below its cost, the amount of the decline below cost due to credit-related reasons is charged to earnings and the remaining difference is included in comprehensive income.
The fair value of investments is reported in note 3. The fair value of other financial instruments, principally receivables, accounts payable and accrued expenses approximates their December 31, 2010 and 2009 carrying values.
(e)
Cash and Cash Equivalents
Cash and cash equivalents consist of cash, bank drafts, balances on deposit with banks, and investments with maturity at date of purchase of three months or less in qualified banks and trust companies.
(f)
Reinsurance Accounting and Reporting
The Company relies upon reinsurance agreements to limit its maximum net loss from large single risks or risks in concentrated areas, and to increase its capacity to write insurance. Reinsurance does not relieve the primary insurer from liability to its policyholders. To the extent that a reinsurer may be unable to pay losses for which it is liable under the terms of a reinsurance agreement, the Company is exposed to the risk of continued liability for such losses. Estimated amounts of reinsurance receivables and recoverables, net of amounts payable that have the right of offset, are reported as assets in the accompanying consolidated balance sheets. Prepaid reinsurance premiums represent the unexpired portion of premiums ceded to reinsurers. The Company considers numerous factors in choosing reinsurers, the most important of which are the financial stability and creditworthiness of the reinsurer.
(g)
Deferred Policy Acquisition Costs
Policy acquisition costs, such as commissions, premium taxes, and certain other underwriting expenses that vary with, and are primarily related to, the production of new and renewal business, have been deferred and are amortized over the effective period of the related insurance policies. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, losses and loss adjustment expenses, and certain other costs expected to be incurred as the premium is earned. Future changes in estimates, the most significant of which is expected losses and loss adjustment expenses, may require adjustments to deferred policy acquisition
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
costs. If the estimation of net realizable value indicates that the deferred policy acquisition costs are not recoverable, they would be written off.
(h)
Property and Equipment
The costs of property and equipment are depreciated using the straight-line method over the estimated useful lives of the assets. Maintenance, repairs, and minor renewals are charged to expense as incurred, while expenditures that substantially increase the useful life of the assets are capitalized. Fixed assets are depreciated over three to seven years. Property is depreciated over useful lives generally ranging from five to forty years. The Company continually monitors the reasonableness of the estimated useful lives and adjusts them as necessary.
The Company tests for impairment of property, plant, and equipment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. As of December 31, 2010, an impairment is not considered necessary.
(i)
Income Taxes
The Company and its subsidiary file a consolidated federal income tax return. Incomes taxes are allocated to each legal entity based on income before income tax expense. Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using tax rates and laws that are expected to be in effect when the differences reverse. The Company regularly reviews its deferred tax assets for recoverability taking into consideration such factors as historical losses, projected future taxable income and the character of such income and the expected timing of the reversals of existing temporary differences. A valuation allowance is recorded when it is more likely than not that some portion or all of the deferred tax assets will not be realized. The Company’s policy is to account for interest as a component of interest expense and penalties as a component of other expense.
(j)
Deferred Offering Costs
In accordance with the Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) Topic 5A, Expenses of Offering, the Company had deferred offering costs consisting principally of legal, underwriting, and audit fees incurred through the completion of the offering, on October 16, 2009. At December 31, 2009, $3,867 of offering costs were netted against the offering proceeds in equity.
(k)
Discontinued Operations
Discontinued operations represent components of the Company that have been disposed of. The results of operations of reporting units classified as discontinued operations are done so for all periods presented.
(l)
Losses and Loss Adjustment Expenses
The liability for unpaid losses and loss adjustment expenses represents the estimated liability for claims reported to the Company plus claims incurred but not yet reported and the related estimated adjustment expenses. The liability for losses and related loss adjustment expenses is determined using case basis evaluations and statistical analyses. Although considerable variability is inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are reasonable. These estimates are periodically reviewed and adjusted as necessary and such adjustments are reflected in current operations.
The Company’s estimated liability for asbestos and environmental claims is $2,363 and $2,397 at December 31, 2010 and 2009, respectively, a substantial portion of which results from the Company’s participation in assumed reinsurance pools. The Company estimates this liability based on its pro rata share of asbestos and environmental case reserves reported by the pools and an additional estimate of incurred but not reported losses and loss adjustment expenses based on actuarial analysis of the historical development patterns. The estimation of the
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
ultimate liability for these claims is difficult due to outstanding 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 significantly greater than normal variation and uncertainty.
(m)
Employee Benefit Plans
The Company records annual amounts relating to its defined benefit pension plan and nonqualified Supplemental Executive Retirement Plan (SERP) based on calculations that include various actuarial assumptions, such as discount rates, mortality and rates of return. These estimates are highly susceptible to change from period to period based on the performance of plan assets, demographic changes, and market conditions. The Company reviews its actuarial assumptions on an annual basis and makes modifications to the assumptions based on current rates and trends. The Company believes that the assumptions used in recording its defined benefit pension plan and SERP obligations are reasonable based on its experience, market conditions, and input from its actuaries and investment advisors.
The Company utilizes the corridor method of amortizing actuarial gains and losses. The amortization of experience gains and losses is recognized only to the extent that the cumulative unamortized net actuarial gain or loss exceeds 10% of the greater of the projected benefit obligation and the fair value of plan assets at the beginning of the year. When required, the excess of the cumulative gain or loss balance is amortized over the expected average remaining service life of the employees covered by the plan.
(n)
Employee Stock Ownership Plan
The Company recognizes compensation expense related to its ESOP equal to the product of the number of shares earned, or committed to be released during the period, and the average price of the Company’s common stock during the period. The estimated fair value of unearned ESOP shares is calculated based on the average price of the Company’s common stock for the period. For purposes of calculating earnings per share, the Company includes the weighted average of ESOP shares committed to be released for the period.
(o)
Premium Revenue
Insurance premiums on property and casualty insurance contracts are recognized in proportion to the underlying risk insured and are earned ratably over the duration of the policies. The reserve for unearned premiums on these contracts represents the portion of premiums written relating to the unexpired terms of coverage. The Company estimates earned but unbilled (EBUB) audit premiums and records them as an adjustment to earned premiums. The estimation of EBUB is based on a quantitative analysis of the Company’s historical audit experience.
(p)
Earnings per Share
Basic and diluted earnings per share (EPS) are computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period. The denominator for basic EPS includes ESOP shares committed to be released. In calculating diluted EPS, the weighted average shares outstanding includes all potentially dilutive securities.
(q)
Adoption of New Accounting Standards
In January 2010, the Financial Accounting Standards Board (FASB) issued guidance to improve the disclosures related to fair value measurements. The new guidance requires expanded fair value disclosures, including the reasons for significant transfers between Level 1 and Level 2 and the amount of significant transfers into each level disclosed separately from transfers out of each level. For Level 3 fair value measurements,
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
information in the reconciliation of recurring Level 3 measurements about purchases, sales, issuances and settlements shall be presented separately on a gross basis, rather than as one net number. In addition, clarification is provided about existing disclosure requirements, such as presenting fair value measurement disclosures for each class of assets and liabilities that are determined based on their nature and risk characteristics and their placement in the fair value hierarchy (that is, Level 1, 2, or 3), as opposed to each major category of assets and liabilities, as required in the previous guidance. Disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements are required for fair value measurement that fall in either Level 2 or Level 3. The Company adopted this new guidance effective January 1, 2010, except for the gross presentation of purchases, sales, issuances and settlements in the Level 3 reconciliation, which is effective for annual and interim reporting periods beginning after December 15, 2010. The disclosures required by this new guidance are provided in the accompanying note 3.
In July 2010, the FASB issued Accounting Standards Update (ASU) 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, which requires significant new disclosures about the allowance for credit losses and the credit quality of financing receivables. The requirements are intended to enhance transparency regarding credit losses and the credit quality of loan and lease receivables. Under this statement, allowance for credit losses and fair value are to be disclosed by portfolio segment, while credit quality information, impaired financing receivables and nonaccrual status are to be presented by class of financing receivable. The disclosures are to be presented at the level of disaggregation that management uses when assessing and monitoring the portfolio’s risk and performance. This ASU is effective for interim and annual reporting periods after December 15, 2010. Excluding certain agency receivables, which are immaterial, all of the Company’s financing receivables have maturity dates of less than one year. The adoption of this ASU did not have an impact on the Company’s financial position and results of operations.
In October 2010, the FASB issued ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts (a consensus of the FASB Emerging Issues Task Force). This ASU amends FASB ASC Topic 944, Financial Services - Insurance, to address which costs related to the acquisition of new or renewal insurance contracts qualify for deferral. The ASU allows insurance entities to defer costs related to the acquisition of new or renewal insurance contracts that are (1) incremental direct costs of the contract transaction (i.e., would not have occurred without the contract transaction), (2) a portion of the employees’ compensation and fringe benefits related to certain activities for successful contract acquisitions, (3) other costs related directly to the insurer’s acquisition activities in (2) that would not have been incurred had the acquisition contract transaction not occurred, and (4) direct-response advertising costs as defined in ASC Subtopic 340-20, Other Assets and Deferred Costs - Capitalized Advertising Costs. An insurance entity would expense as incurred all other costs related to the acquisition of new or renewal insurance contracts. The amendments in the ASU are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011, and can be applied either prospectively or retrospectively. Early application is permitted at the beginning of an entity’s annual reporting period. The Company is currently evaluating the impact that the adoption of this ASU will have on its financial position and results of operations.
All other standards and updates of those standards issued during the year ended December 31, 2010 either (i) provide supplemental guidance, (ii) are technical corrections, (iii) are not applicable to the Company, or (iv) are not expected to have a significant impact on the Company.
(3)
Fair Value Measurements
The Company’s estimates of fair value for financial assets and financial liabilities are based on the framework established in the fair value accounting guidance, which is a part of ASC 820.
The fair value of a financial asset or financial liability is the amount at which the asset or liability could be bought or sold in a current transaction between willing parties, that is, other than in a forced or liquidated sale. In accordance with the guidance set forth by ASC 820, the Company’s financial assets and financial liabilities
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
measured at fair value are categorized into three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:
Level 1 - Unadjusted quoted market prices for identical assets or liabilities in active markets that the Company has the ability to access.
Level 2 - Valuations based on observable inputs, other than quoted prices included in Level 1, for assets and liabilities traded in less active dealer or broker markets. Valuations are based on identical or comparable assets and liabilities.
Level 3 - Valuations for assets and liabilities that are derived from other valuation methodologies, including option pricing models, discounted cash flow models, and similar techniques, and not based on market exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections that are often unobservable in determining the fair value assigned to such assets or liabilities.
Transfers between level categorizations may occur due to changes in the availability of market observable inputs. Transfers in and out of level categorizations are reported as having occurred at the beginning of the quarter in which the transfer occurred. There were no transfers between level categorizations during the years ended December 31, 2010 and 2009.
The table below presents the balances of assets and liabilities measured at fair value on a recurring basis as of December 31, 2010 and December 31, 2009:
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
The Company uses quoted values and other data provided by a nationally recognized independent pricing service in its process for determining fair values of its investments. The pricing service provides the Company one quote per instrument. Level 1 securities consist of U.S. Treasury fixed maturity securities and publicly traded mutual funds. Level 2 securities are comprised of available for sale fixed maturity securities whose fair value was determined using observable market inputs. For fixed maturity securities that have quoted prices in active markets, market quotations are provided. Fair values for securities for which quoted market prices were unavailable were estimated based upon reference to observable inputs such as benchmark interest rates, market comparables, and other relevant inputs. Investments valued using these inputs include obligations of U.S. government agencies, obligations of states and political subdivisions, commercial and residential mortgage-backed securities, and corporate securities. Inputs into the fair value application that are utilized by asset class include but are not limited to:
U.S. government agencies (depending on the specific market or program): broker quotes; U.S. treasury market and floating rate indices; overall credit quality, including assessments of market sectors and the level and variability of sources of payment; credit support including collateral; the establishment of a risk adjusted credit spread over the applicable risk free yield curve for discounted cash flow valuations; assessments of the level of economic sensitivity;
States and political subdivisions: overall credit quality, including assessments of market sectors and the level and variability of sources of payment such as general obligation, revenue or lease; credit support such as insurance, state or local economic and political base; prefunded and escrowed to maturity covenants;
Commercial mortgage-backed securities: overall credit quality, including assessments of the level and variability of credit support and collateral type such as office, retail, or lodging; predictability of cash flows for the deal structure; prevailing economic market conditions;
Residential mortgage-backed securities: estimates of prepayment speeds based upon historical prepayment rate trends; underlying collateral interest rates; original weighted average maturity; vintage year; borrower credit quality characteristics; interest rate and yield curve forecasts; U.S. government support programs; tax policies; and delinquency/default trends; and
Corporate securities: overall credit quality; the establishment of a risk adjusted credit spread over the applicable risk free yield curve for discounted cash flow valuations; assessments of the level of industry economic sensitivity; company financial policies; indenture restrictive covenants; and/or security and collateral.
All unadjusted estimates of fair value for our fixed maturities priced by the pricing services as described above are included in the amounts disclosed in Level 2.
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
Should the independent pricing service be unable to provide a fair value estimate, the Company would attempt to obtain a non-binding fair value estimate, derived from observable inputs, from a number of broker-dealers and review this estimate in conjunction with a fair value estimate reported by an independent business news service or other sources. In instances where only one broker-dealer provides a fair value for a fixed maturity security, the Company uses that estimate. In instances where the Company is able to obtain fair value estimates from more than one broker-dealer, the Company would review the range of estimates and would select the most appropriate value based on the facts and circumstances. Should neither the independent pricing service nor a broker-dealer provide a fair value estimate, the Company would develop a fair value estimate based on cash flow analyses and other valuation techniques that utilize certain unobservable inputs. Accordingly, the Company would classify such a security as a Level 3 investment.
The fair value estimates of the Company’s investments provided by the independent pricing service at December 31, 2010, were utilized, among other resources, in reaching a conclusion as to the fair value of investments. As of December 31, 2010, all of the Company’s fixed maturity investments were priced using this one primary service. Management reviews the reasonableness of the pricing provided by the independent pricing service by employing various analytical procedures. The Company reviews all securities to identify recent downgrades, significant changes in pricing, and pricing anomalies on individual securities relative to other similar securities. This will include looking for relative consistency across securities in various common blocks or sectors, durations, and credit ratings. This review will also include all fixed maturity securities rated lower than “A” by Moody’s or Standard & Poor’s (S&P). If, after this review, management does not believe the pricing for any security is a reasonable estimate of fair value, then it will seek to resolve the discrepancy through discussions with the pricing service or its asset manager. The classification within the fair value hierarchy as presented in ASC 820 is then confirmed based on the final conclusions from the pricing review. The Company did not have any such discrepancies at December 31, 2010.
The fair value of other financial instruments, principally receivables, accounts payable and accrued expenses, approximates their December 31, 2010 and December 31, 2009 carrying values.
(4)
Investments
The amortized cost and fair value of investments in fixed maturity and equity securities, which are all available for sale, at December 31, 2010 and December 31, 2009, are as follows:
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
The amortized cost and estimated fair value of fixed maturity securities at December 31, 2010 by contractual maturity, are shown below:
The expected maturities may differ from contractual maturities in the foregoing table because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
At December 31, 2010 and December 31, 2009, investments with a fair value of $4,348 and $4,358, respectively, were on deposit with regulatory authorities, as required by law.
Major categories of net investment income are as follows:
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
Realized gross gains from investments and the change in difference between fair value and cost of investments, before applicable income taxes, are as follows:
Income tax expense on net realized investment gains was $922 and $61 for the years ended December 31, 2010 and 2009, respectively. Deferred income tax expense applicable to net unrealized investment gains, included in accumulated other comprehensive income, was $1,845 at both December 31, 2010 and December 31, 2009, respectively. See note 10 for additional information related to the allocation of tax between continuing operations and accumulated other comprehensive income.
The fair value and unrealized losses for securities temporarily impaired as of December 31, 2010 and December 31, 2009 are as follows:
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
These fixed maturity and equity securities are classified as available for sale because the Company will, from time to time, sell securities that are not impaired, consistent with its investment goals and policies. Fair values of interest rate sensitive instruments may be affected by increases and decreases in prevailing interest rates which generally translate, respectively, into decreases and increases in fair values of fixed maturity investments. The fair values of interest rate sensitive instruments also may be affected by the credit worthiness of the issuer, prepayment options, relative values of other investments, the liquidity of the instrument, and other general market conditions. There are $4,092 in fixed maturity securities, at fair value, that at December 31, 2010, had been below cost for 12 months or longer. The $58 of unrealized losses on such securities relates to securities which carry an investment grade debt rating and have declined in fair value roughly in line with overall market conditions. The Company has evaluated each fixed maturity security and taken into account the severity and duration of the impairment, the current rating on the bond, and the outlook for the issuer according to independent analysts. The Company has found that the declines in fair value of these assets are most likely attributable to the current interest rate environment.
Per the Company’s current policy, a fixed maturity security is other-than-temporarily impaired if the present value of the cash flows expected to be collected is less than the amortized cost of the security or where the Company intends to sell or more likely than not will be required to sell the security before recovery of its value.
A portion of the Company’s investment portfolio is in a high-yield bond fund that invests primarily in U.S. debt securities. This is a publicly traded mutual fund in which the Company has an ownership stake in the overall assets of the fund, which is stated as a number of shares, and the Company is not a creditor in the underlying debt securities. Therefore, the mutual fund is classified as an equity security.
The Company believes, based on its analysis, that the fixed maturity and equity securities are not other-than-temporarily impaired. However, depending on developments involving both the issuers and overall economic conditions, these investments may be written down in the consolidated statements of operations in the future.
For the years ended December 31, 2010 and December 31, 2009, the Company incurred impairment charges of $0 and $197, respectively. The impairment in 2009 was related to one fixed maturity security and the carrying value of the security was written down to fair value in the second quarter of 2009. Subsequently, the security was sold in July 2009.
The Company does not engage in subprime residential mortgage lending. The only securitized financial assets that the Company owns are residential and commercial mortgage-backed securities of high credit quality. The
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
Company’s exposure to subprime lending is limited to investments in corporate bonds of banks, which may contain some subprime loans on their balance sheets. These bonds are reported at fair value. As of December 31, 2010, fixed maturity securities issued by banks accounted for 10.7% of the bond portfolio’s book value.
(5)
Comprehensive (Loss) Income
Comprehensive (loss) income for the years ended December 31, 2010 and 2009 consisted of the following (all amounts net of taxes):
Accumulated other comprehensive income at December 31, 2010 and December 31, 2009 consisted of the following amounts (all amounts net of taxes):
See note 10 for additional information related to the allocation of tax between continuing operations and accumulated other comprehensive income.
(6)
Deferred Policy Acquisition Costs
Changes in deferred policy acquisition costs for the years ended December 31, 2010 and 2009 are as follows:
(7)
Property and Equipment
Property and equipment consisted of land and buildings with a cost of $5,784 and $5,746 and equipment, capitalized software costs, and other items with a cost of $9,317 and $9,177 at December 31, 2010 and 2009,
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
respectively. Accumulated depreciation related to such assets was $11,778 and $11,154 at December 31, 2010 and 2009, respectively.
Rental expense under leases for continuing operations amounted to $100 and $100 for 2010 and 2009, respectively.
At December 31, 2010, the minimum aggregate rental and lease commitments for continuing operations are as follows:
(8)
Employee Benefit Plans
Retirement Plans
The Company has a noncontributory defined benefit pension plan covering substantially all employees. Retirement benefits are a function of both the years of service and level of compensation. In October 2009, the plan was amended and all participants’ accrued benefits under the plan were frozen. It is the Company’s policy to fund the plan in amounts not greater than the amount deductible for federal income tax purposes and not less than the minimum required contribution under the Pension Protection Act of 2006. The Company also sponsors a Supplemental Executive Retirement Plan (SERP). The SERP, which is unfunded, provides defined pension benefits outside of the qualified defined benefit pension plan to eligible executives based on average earnings, years of service, and age at retirement.
On August 1, 2009, upon approval by the board of directors, the Company’s administrator amended the defined benefit pension plan, whereby all participants’ accrued benefits under the plan were frozen as of October 31, 2009. The Company recognized a curtailment benefit of $1,659 for the year ended December 31, 2009, which has been reflected in accumulated other comprehensive income in equity. Due to a decline in interest rates, this benefit was partially offset by an actuarial loss of $717.
On May 12, 2010, upon approval by the Board of Directors, the Company terminated the SERP for four of the five participants. The one remaining participant is a retired employee in pay status. The SERP benefit obligation was re-measured on that date and the Company recorded a net curtailment loss of $68 and a settlement gain of $747 which were classified as underwriting and administrative expenses in the consolidated statements of operations. The net curtailment loss of $68 was a result of the recognition of $472 of prior unrecognized service costs which was net of a $404 reduction of the projected benefit obligation to the accumulated benefit obligation. The settlement gain of $747 was the result of a further reduction of the accumulated benefit obligation to zero for the four former participants. On the re-measurement date, the weighted average discount rate was 5.41% compared to 5.67% at December 31, 2009. The accumulated benefit obligation for the one remaining participant in pay status at December 31, 2010 is $627.
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
(a)
Obligations and Funded Status at December 31
Amounts recognized in accumulated other comprehensive income:
See note 10 for additional information related to the allocation of tax between continuing operations and accumulated other comprehensive income.
The accumulated benefit obligation for the qualified defined benefit pension plan was $8,001 and $7,380 at December 31, 2010 and 2009, respectively.
(b)
Components of Net Periodic Benefit Cost
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
(c)
Assumptions
Weighted average assumptions used to determine benefit obligations at December 31, 2010 and 2009 are as follows:
Weighted average assumptions used to determine net periodic benefit cost for the years ended December 31, 2010 and 2009 are as follows:
Discount rates are selected considering yields available on high quality debt instruments at durations that approximate the timing of the benefit payments for the pension liabilities at the measurement date. The expected rate of return reflects the Company’s long-term expectation of earnings on the assets held in the plan trust, taking into account asset allocations, investment strategy, the views of the asset managers, and the historical performance.
(d)
Plan Assets
Pension plan assets are invested for the exclusive benefit of the plan participants and beneficiaries and are intended, over time, to satisfy the benefit obligations under the plan. The Company maintains an investment policy for the pension plan, which is reviewed at least annually. The overall investment strategy is to maintain appropriate liquidity to meet the cash requirements of the short-term plan obligations and to maximize the plan’s return while adhering to the policy’s objectives and risk guidelines, as well as the regulations set forth by various government entities. The policy sets forth asset allocation guidelines that emphasize U.S. investments with strong credit quality and restricts traditionally risky investments.
The current target allocation for plan assets is 60% for equity securities and 40% for fixed income securities. Equity securities include investments in domestic large and small cap index funds, as well as an international developed markets index fund. The target asset allocation within equities is 70% domestic large cap, 15% domestic small cap, and 15% international developed markets. Fixed income securities are in an investment grade long term bond index fund. Investment asset allocation is measured and monitored on an ongoing basis.
To develop the expected long-term rate of return on assets assumption, the Company considered the historical returns and the future expectations for returns for each asset class, as well as the target asset allocation of the pension plan portfolio. This resulted in the selection of the 7.5% long-term rate of return on assets assumption.
Fair Value Measurement - Pension Plan Assets
For a discussion of the methods employed by the Company to measure the fair value of invested assets, see note 3. The following discussion of fair value measurements apply exclusively to the Company’s pension plan assets.
The estimated fair value of the Company’s equity and debt mutual index funds is disclosed in Level 1 as the estimates are based on unadjusted market prices.
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
The estimated fair value of money market mutual funds, which approximates cost, is included in the amount disclosed in Level 1 as the estimates are based on unadjusted market prices.
The following table presents the level within the fair value hierarchy at which the financial assets of the Company’s pension plan are measured on a recurring basis at December 31, 2010.
(a)
This category seeks to track the performance of a benchmark index that measures the investment return of stocks issued by companies located in the major markets of Europe and the Pacific region. It follows a passively managed, full replication approach.
(b)
This category seeks to track the performance of the MSCI®
US Small Cap 1750 Index and it is a small-cap equity, diversified across growth and value styles. It follows a passively managed, full replication approach.
(c)
This category seeks to track the performance of a benchmark index that measures the investment return of large-capitalization stocks. The fund employs a passive management investment approach designed to track the performance of the Standard & Poor’s 500 index. It invests all, or substantially all, of its assets in the stocks that make up the index, holding each stock in approximately the same proportion as its weighting in the index.
(d)
This category seeks to track the performance of the Barclays Capital U.S. Long Government/Credit Float Adjusted Bond Index with diversified exposure to the long-term, investment-grade U.S. bond market. It is passively managed using index sampling.
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
(e)
Cash Flows
Estimated Future Benefit Payments
The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid:
The Company’s minimum required contribution for the defined benefit pension plan in 2011 is $37.
The expected contribution in 2011 for the SERP plan will be a minimum of $47, representing the normal benefit payments to the lone participant in payment status.
Savings Plan
The Company has a defined contribution benefit plan sponsored by PMIC covering all employees who have attained age 21. Eligible employees may contribute up to 30% of their salary to the plan, subject to statutory limits. The Company matches 50% of employee contributions up to 3% of employee compensation. Amounts charged to operations were $201 and $175 for 2010 and 2009, respectively.
ESOP
The Company sponsors an ESOP, which became effective on October 16, 2009. Eligible employees generally include those employees who have completed six months of service. All employees who had completed six months of service with the Company, prior to the effective date of the plan, were determined to have met the eligibility requirements on that date. ESOP shares are allocated to participants based on the ratio of their individual compensation during the plan year multiplied by a factor that corresponds with their combined age and years of service. A final allocation percentage is then determined by calculating the ratio of an individual’s initial compensation allocation percentage to the total of all eligible participants’ initial compensation allocation percentages.
The Company issued 539,999 shares of its common stock to the ESOP on October 16, 2009. The ESOP was funded entirely by an employer loan in the amount of $5,400, which will be repaid in ten equal installments. For the years ended December 31, 2010 and 2009, the Corporation made a cash contribution of $667 and $111, respectively, to the ESOP. The ESOP used these contributions to make the annual payment to the Corporation related to the outstanding balance of the loan. These shares held by the ESOP will be allocated over the same 10-year period to eligible employees. Shares purchased are held in a suspense account for allocation among participating employees as the loan is repaid.
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
Suspense shares, allocated shares, shares committed to be released, average price per share and stock compensation expense for the periods ended December 31, 2010 and October 17, 2009 through December 31, 2009 are as follows:
Suspense shares represent shares held by the ESOP that have not been allocated to participant accounts. Allocated shares have been earned and allocated to participant accounts, while shares committed to be released have been earned, but have not yet been allocated to participant accounts.
As of December 31, 2010, the estimated fair value of unearned ESOP shares was $6,311.
(9)
Stock-Based Compensation
The Company accounts for its stock based compensation in accordance with Accounting Standards Codification (ASC) 718-10, Compensation - Stock Based Compensation. ASC 718-10 addresses all forms of share-based payment awards, including shares under stock options and restricted stock. ASC 718-10 requires all share-based payments to be recognized as expense, based upon their fair values, in the financial statements over the service period of the awards.
On May 12, 2010, the Company’s shareholders approved the Penn Millers Stock Incentive Plan (the Plan). The Plan authorizes the award of incentive stock options, nonqualified stock options, restricted stock and restricted stock units (including performance-based awards) to employees and non-management directors of the Company. According to the Plan, the maximum aggregate number of shares of common stock that may be awarded under the plan is 762,163 shares, subject to certain adjustments. The shares issued pursuant to the Plan may be from authorized but unissued common stock or treasury shares. Upon a change in control, or in the event that a participant terminates employment due to death or disability, the outstanding unvested awards will become fully vested.
On May 12, 2010, 141,122 shares of restricted stock were granted to executives of the Company. The restricted stock will be issued from treasury shares upon vesting. The restricted stock had a grant date fair value of $14.83 per share, which was the Company’s closing stock price on that date. The restricted stock vests 25% in the first year and 15% in each of the five years thereafter, based on the satisfaction of service conditions.
On May 12, 2010, 114,960 stock options were awarded to executives, non-management directors and select employees of the Company. The stock options, which vest over five years at 20% per year, have a contractual term of seven years, and vesting is based on the satisfaction of service conditions. The stock options were awarded at a grant date fair value of $5.22 per option as calculated using a Black-Scholes Merton valuation model with the following assumptions:
The expected volatility assumption was derived from share price data over the expected term of the options of fourteen companies the Company considers to be its peers based upon asset size, market capitalization, profitability
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
level and other relevant factors. The expected term assumption was derived using the “simplified” approach for plain vanilla options as set forth in SEC Staff Accounting Bulletin (SAB) Topic 14 for new public companies. The risk-free interest rate assumption was based upon the implied yield on the measurement date of a zero-coupon U.S. Treasury bond with a maturity period equal to the options’ expected term. The Company does not expect to pay dividends; therefore, the expected dividend yield is assumed to be zero. No post-vesting restrictions exist for these options.
The total compensation cost recognized in the statements of operations and classified as underwriting and administrative expenses for all stock-based compensation awards, excluding the Company’s ESOP, was $385 for the year ended December 31, 2010. The related tax benefit recognized was $110 for the same period. The total compensation cost recognized in the statements of operations and classified as underwriting and administrative expenses for the Company’s ESOP was $703 and $92 for the years ended December 31, 2010 and 2009, respectively. The related tax benefit recognized was $184 and $31 for the same periods.
The total unrecognized compensation cost related to all nonvested Plan awards at December 31, 2010 was $2,137, which is expected to be recognized in future periods over a weighted average period of 4.9 years.
No equity awards were exercised or forfeited during the year ended December 31, 2010. No additional awards were granted during the year ended December 31, 2010.
The summary of stock-based award activity is as follows:
(10)
Federal Income Tax
Components of the provision for income tax expense (benefit) from continuing operations for the years ended December 31, 2010 and 2009 are as follows:
The Company’s net payment (refunds) for income taxes in 2010 and 2009 were $969 and $(907), respectively.
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
A reconciliation of the expected and actual federal income tax expense (benefit) from continuing operations for the years ended December 31, 2010 and 2009 is as follows:
Deferred income taxes reflect the tax effect of temporary differences between the amounts of assets and liabilities for financial reporting and the amounts for income tax purposes. Components of the Company’s deferred tax assets and liabilities from continuing operations for the years ended December 31, 2010 and 2009 are as follows:
At December 31, 2010 and 2009, the Company had available $1,128 and $3,503, respectively, of federal capital loss carryforwards. The capital loss carryforwards have a five year carryforward and will completely expire in 2013. In addition, at December 31, 2010, the Company had available $2,252 of federal (net operating loss NOL) carryforwards. The federal NOL carryforwards have a twenty year carryforward and will completely expire in 2030.
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
At December 31, 2010 and 2009, the Company had available $6,489 and $6,295, respectively, of state income tax NOL carryforwards. The Company concluded it is not more likely than not that state taxable income will be generated in the future to utilize the state NOL carryforwards. At December 31, 2010 and 2009, a valuation allowance of $648 and $629, respectively, was recorded against the deferred tax asset associated with the state income tax NOL carryforwards. The state NOL carryforwards have a twenty year carryforward and will expire from 2019 through 2030.
At December 31, 2010, the Company had available alternative minimum tax credit carryforwards of $272 that do not expire.
Deferred income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax bases of our assets and liabilities. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. The Company must assess the likelihood that any recorded deferred tax assets will be recovered against future taxable income. The Company considers many factors when assessing the likelihood of future realization of deferred tax assets, including recent cumulative earnings experience by taxing jurisdiction, expectations of future taxable income or loss, the carry-forward periods available to us for tax reporting purposes, and other relevant factors. To the extent the Company believes that recovery is not more likely than not, a valuation allowance must be established.
Although the Company’s current financial forecasts indicate that taxable income will be generated in the future, those forecasts were not considered sufficient positive evidence to overcome the observable negative evidence associated with its three year cumulative loss position. Accordingly, the Company recorded a full valuation allowance of $3,468 on its federal net deferred tax assets for the year ended December 31, 2010.
In any interim period, the Company may generate income or loss. To the extent that any income is generated, the related tax expense may be offset by a reduction in the valuation allowance. Conversely, any tax benefits arising from losses may be offset by an additional valuation allowance to reduce the net deferred tax asset to an amount that is more likely than not to be realized. Any reduction of the valuation allowance will be allocated to continuing operations and other comprehensive income based on the intraperiod tax allocation rules. The intraperiod tax allocation rules in FASB ASC 740, related to items charged directly to accumulated other comprehensive income, can result in disproportionate tax effects that remain in accumulated other comprehensive income until certain events occur. The following schedule shows the amounts and corresponding tax effects in accumulated other comprehensive income as of December 31, 2010 and 2009 and the related change for the year:
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
As of December 31, 2010, the Company had no material unrecognized tax benefits or accrued interest and penalties. The Company’s policy is to account for interest as a component of interest expense and penalties as a component of other expense. Federal tax years 2007 through 2010 were open for examination as of December 31, 2010.
(11)
Reinsurance
Reinsurance is ceded by the Company on a pro rata and excess of loss basis, with the Company’s retention generally at $500 per occurrence in 2010 and 2009. The Company purchased catastrophe excess-of-loss reinsurance with a retention of $2,000 per event in 2009. Effective January 1, 2010, the Company increased its retention to $3,000 per event.
Effective January 1, 2010, the Company increased its participation in the per-risk reinsurance treaty. Losses between $500 and $1,000 are retained at a rate of 60.0% in 2010 versus a 52.5% retention rate in 2009.
The Company continues to maintain a whole account, accident year aggregate excess of loss (aggregate stop loss) contract. This contract covers the 2008 and 2009 accident years and provides reinsurance coverage for loss and allocated loss adjustment expense (ALAE) from all lines of business, in excess of a 72% loss and ALAE ratio. The reinsurance coverage has a limit of 20% of subject net earned premiums. As of December 31, 2010 and 2009, the Company has not ceded any losses under the aggregate stop loss contract. Effective January 1, 2010, the Company has not entered into a new stop loss contract.
The Company’s assumed reinsurance relates primarily to its participation in various involuntary pools and associations and the runoff of the Company’s participation in voluntary reinsurance agreements that have been terminated.
The effect of reinsurance, with respect to premiums and losses, for the years ended December 31, 2010 and 2009 is as follows:
(a)
Premiums
(b)
Losses and Loss Adjustment Expenses
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
(c)
Unearned Premiums
(d)
Loss and Loss Adjustment Expense Reserves
(12)
Liability for Losses and Loss Adjustment Expenses
Activity in the liability for losses and loss adjustment expenses is summarized as follows:
The Company recognized favorable development in the provision for insured events of prior years of $2,086 in 2010 and unfavorable development of $1,555 in 2009. Increases or decreases of this nature occur as the result of claim settlements during the current year, and as additional information is received regarding individual claims, causing changes from the original estimates of the cost of these claims. Recent loss development trends are also taken into account in evaluating the overall adequacy of unpaid losses and loss adjustment expenses.
The favorable prior year reserve development for 2010 of $2,086 includes reversals in additional reserves carried above the actuarial central estimate and was due to lower level of incurred loss emergence relative to expectations in the workers’ compensation, commercial auto, and liability lines of business in the Company’s agribusiness segment. Within the agribusiness segment, the commercial auto line of business was also impacted positively by favorable prior year claims settlements. This favorable development was partly offset by unfavorable
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
development in the fire and allied lines of business due to updated information on previously reported large property claims. In the commercial business segment, the Company experienced net favorable prior year reserve development of $26. Favorable loss emergence, relative to expectations, in the commercial multi-peril line and favorable claims settlements in the fire and allied lines were offset by unfavorable development in the commercial auto liability line and other liability lines.
The net unfavorable development for 2009 of $1,555 is due to the $4,292 stop loss reversal on ceded losses that impacted all lines of business. Excluding the impact of the stop loss reversal, the net favorable development of $2,737 was primarily attributable to: favorable loss development of approximately $1,659 in the fire and allied, resulting from favorable settlements on prior years’ claims; favorable loss development of approximately $1,812 in the commercial multi-peril lines attributable to lower level emergence of incurred losses, relative to expectations, for the 2007 and 2008 accident years; and unfavorable development of approximately $1,501 in the Company’s workers’ compensation line due to a higher level of incurred loss emergence relative to expectations for the 2008 and 2007 accident years.
(13)
Commitments and Contingencies
The Company is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse impact on the Company’s financial position or results of operations.
Total retirement and severance expense of $118 and $363 was unpaid as of December 31, 2010 and 2009, respectively.
(14)
Guaranty Fund and Other Insurance-Related Assessments
The Company records its estimated future payment related to guaranty fund assessments and its estimated ultimate exposure related to other insurance-related assessments. Estimates are based on historical assessment and payment patterns, the Company’s historical premium volume, and known industry developments that affect these assessments, such as insurance company insolvencies and industry loss and pricing trends. The Company’s net accrued liability for guaranty fund and other insurance related assessments is $1,348 and $1,397 at December 31, 2010 and 2009, respectively. The accrual is expected to be paid as assessments are made over the next several years.
(15)
Segment Information
The Company’s operations are organized into three segments: agribusiness, commercial business, and other. These segments reflect the manner in which the Company currently manages the business based on type of customer, how the business is marketed, and the manner in which risks are underwritten. Within each segment, the Company underwrites and markets its insurance products through a packaged offering of coverages sold to generally consistent types of customers.
The other segment includes the runoff of discontinued lines of insurance business and the results of mandatory-assigned risk reinsurance programs that the Company must participate in as a cost of doing business in the states in which the Company operates. The discontinued lines of insurance business include personal lines, which the Company began exiting in 2001, and assumed reinsurance contracts for which the Company participated on a voluntary basis. Participation in these assumed reinsurance contracts ceased in the 1980s and early 1990s.
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
Segment information for years ended December 31, 2010 and 2009 is as follows:
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
The following table sets forth the net premiums earned by major lines of business for our core insurance products in the years ended December 31, 2010 and 2009:
(16)
Reconciliation of Statutory Filings to Amounts Reported Herein
A reconciliation of the Company’s statutory net income and surplus to net (loss) income and equity, under GAAP, is as follows:
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
The above statutory basis net income and capital and surplus amounts relate to the Company’s insurance subsidiaries, PMIC and AMIC.
The Company’s insurance subsidiaries are required by law to maintain certain minimum surplus on a statutory basis, are subject to risk-based capital requirements, and are subject to regulations under which payment of a dividend from statutory surplus is restricted and may require prior approval of regulatory authorities. As of December 31, 2010, the Company’s insurance subsidiaries were in compliance with its risk-based capital requirements. Applying the current regulatory restrictions as of December 31, 2010, approximately $6,819 would be available for distribution to the Company during 2011 without prior approval.
(17)
Discontinued Operations
In July 2008, the Company completed the sale of PSTS. As of December 31, 2009, results of operations from PSTS consisted of $50 in income before tax expense of $17.
In February 2009, the Company completed the sale of EIG, resulting in a pretax loss on sale of $6. As of December 31, 2009, results of operations from EIG consisted of a loss of $11 before income tax expense of $862.
(18)
Shareholders’ Equity
(a) On October 16, 2009, Penn Millers Mutual completed its conversion to stock form. The Corporation sold a total of 5,444,022 shares in a subscription and community offering at $10.00 per share, through which the Corporation received proceeds of $45,172, net of conversion and offering costs of $3,867. On July 28, 2009, the board of directors approved the implementation of an ESOP. The ESOP acquired 539,999 shares at $10.00 per share.
(b) In April 2009, the board of directors approved the authorization of 1,000,000 shares of no par preferred stock of the Corporation upon conversion. The authorized but unissued preferred shares may be issued in one or more series and the share of each series shall have such rights as fixed by the board of directors.
(c) The activity of the Corporation’s common stock was as follows:
(d) As of December 31, 2010, 271,562 shares remain to be purchased under the share repurchase plans approved by the Board of Directors. The authorization has no expiration date.
(19)
Earnings Per Share
Basic earnings per common share is computed by dividing net (loss) income by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per common share is computed by dividing net (loss) income by the weighted-average number of shares of common stock outstanding during the
PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements - (Continued)
period increased to include the number of additional shares of common stock that would have been outstanding if the potentially dilutive securities had been issued. Potentially dilutive securities include outstanding stock options and unvested restricted stock. The dilutive effect of potentially dilutive securities is reflected in diluted earnings per common share by application of the treasury stock method. Under the treasury stock method, an increase in the fair market value of the Company’s common stock can result in a greater dilutive effect from potentially dilutive securities. Potentially dilutive securities representing approximately 33,543 and 0 shares of common stock for the periods ended December 31, 2010 and December 31, 2009, respectively, were excluded from the computation of diluted loss per common share for these periods because their effect would have been antidilutive.
As described in note 1, the Offering resulted in the issuance of common shares of the Company on October 16, 2009. The following table sets forth the computation of basic and diluted earnings per common share for the years ended December 31, 2010 and 2009:
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None
Item 9A.
Item 9A.
Controls and Procedures
(a)
Evaluation of Disclosure Controls and Procedures
The Company’s Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of December 31, 2010, and based on that evaluation they have concluded that these controls and procedures are effective as of that date.
(b)
Changes in Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) is a process designed by, or under the supervision of, a company’s principal executive and principal financial officers and effected by the Board, management and other personnel, 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 and includes those policies and procedures that:
•
Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the company;
•
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
•
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.
Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2010. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework.
Based on its assessment, our management believes that, as of December 31, 2010, our internal control over financial reporting is effective.
No changes in our internal control over financial reporting (as such term is defined in Rule 13a-15(f) of the Exchange Act) occurred during the fourth quarter of 2010 that materially affected, or are reasonably likely to materially affect, our 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 is incorporated by reference to the information contained under the captions “Proposal No. 1 - Election of Directors,” “Executive Officers,” “Board of Directors and Governance Information - Penn Millers’ Commitment to Shareowner - Sensitive Governance - Conduct Codes,” “Section 16(a) Beneficial Ownership Reporting Compliance,” “Board of Directors and Governance Information - Committees of the Board and Meetings - Audit Committee,” and “Report of the Audit Committee” of our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, within 120 days after December 31, 2010.
Item 11.
Item 11.
Executive Compensation
The information required by Item 11 is incorporated by reference to the information contained under the captions “Executive Compensation” and “Director Compensation” of our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, within 120 days after December 31, 2010.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by Item 12 is incorporated by reference to the information contained under the captions “Principal Shareholders” and “Beneficial Ownership by Management” of our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, within 120 days after December 31, 2010.
Item 13.
Item 13.
Certain Relationships and Related Transactions, and Director Independence
The information required by Item 13 is incorporated by reference to the information contained under the captions “Board of Directors and Governance Information - Director Independence” and “Board of Directors and Governance Information - Governance Committee - Transactions with Related Persons, Promoters and Certain Control Persons” of our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, within 120 days after December 31, 2010.
Item 14.
Item 14.
Principal Accounting Fees and Services
The information required by Item 14 is incorporated by reference to the information contained under the caption “Proposal No. 2 - Ratification of the Appointment of KPMG LLP as the Company’s Independent Registered Public Accounting Firm” of our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, within 120 days after December 31, 2010.
PART IV
Item 15.
Item 15.
Exhibits, Financial Statement Schedules
(a)(1) The consolidated financial statements filed as part of this Report are listed in the Index to the Consolidated Financial Statements under Part II Item 8 - “Financial Statements and Supplementary Data.”
(a)(2) The financial statement schedules or other required schedules are omitted because they are not required, or the required information is included in the consolidated financial statements or notes thereto.
(a)(3) Exhibits
The exhibits required by Item 601 of Regulation S-K are listed in the Exhibit Index. Exhibits marked with an asterisk are filed herewith.
EXHIBIT INDEX
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.
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints Douglas A. Gaudet and Michael O. Banks, and each of them acting individually, his true and lawful attorney-in-fact and agent, each with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Annual Report and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission and any other regulatory authority, granting unto said attorney-in-fact and agent, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as such person might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent, his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
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 and on the dates indicated.