ITEM 1. BUSINESS
OVERVIEW OF BUSINESS
The Insurance Company is a property and casualty insurance company that provides insurance products to individuals, farms and small businesses in Michigan. We were founded in 1876 and have served Michigan policyholders for over 133 years. We have 66 employees. We market our policies through approximately 172 independent insurance agencies. We have four business segments: personal, commercial, farm and marine. As of December 31, 2009, we had approximately 70,000 policies in force and assets of $105 million.
The Company’s executive offices are located at 933 E. Main Street, Fremont, Michigan 49412-9753, and the telephone number is (231) 924-0300. Our website address is www.fmic.com. Information on the Company’s website is not a part of this Form 10-K. The Company makes available free of charge on its website, or provides a link to, the Company’s Forms 3, 4, 5, 10-K, 10-Q and 8-K filed and any amendments to these Forms, that have been filed with the SEC as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to the SEC. To access these filings, go to the Company’s website, “www.fmic.com” and click on “Our Company/Investor Relations”, then click on “All SEC Filings.”
BUSINESS STRATEGIES
Our principal strategies for the future include:
Leveraging Technology
A key to success in continuing sustainable profitable growth is the emphasis on and delivery of enhanced smart underwriting business rules which complements existing agent knowledge and allows for straight through processing. An advanced, next generation technology platform will allow our agency force to efficiently quote, bind and issue both personal and commercial policies. We have had excellent success with our Fremont Complete platform which is our web-based rating platform. As of the end of 2009, agents are able to quote, bind and issue personal line policies in addition to the following commercial products: Business Owners, Commercial Auto and Workers’ Compensation. We plan to continue to leverage our success with Fremont Complete by expanding the commercial products that can be quoted, bound and issued by our agents to include the commercial package policy and deluxe contractor programs. Emphasis will continue to be placed on a single unified platform that will enable our agents to manage their policies from a billing, claims and documentation environment.
Ensuring Rate Adequacy
Ensuring that products are appropriately priced is paramount for the Company to grow profitably. As we grow, so does our database of information which allows us to pinpoint those risks and characteristics that afford us the greatest profit potential. Rates and rate adequacy are continually monitored, analyzed and adjusted as market conditions and results warrant. The Company is committed to matching price to the exposure.
Increasing our Commercial Business
Our strategy remains to increase our market presence in commercial lines of business and to provide balance to our insurance portfolio. We continue to target small to middle market business focusing on main street accounts. Our recent endorsement with the Michigan Retailers Association strengthens this position.
Our success in growing commercial lines is created by focusing on strong commercial based independent agents. Also, our web-based rating technology provides an “ease of doing business” as our agents can rate,
underwrite and issue business through our Fremont Complete platform. In addition to Business Owners, Workers’ Compensation and Commercial Auto, we will be adding Commercial Package Policies to our web based system in 2010. This will allow our agents to have quick turn around on middle market accounts. Along with the enhancements to our Fremont Complete platform we will be rolling out several new endorsements and products to better position the Company in the commercial markets.
Retaining and Attracting Agencies Committed to Profitable Growth
We are committed to our independent agency distribution system. The agents with whom we partner are an extension of the Company and are encouraged to participate as equity owners. Therefore, we are very selective in appointing and retaining agencies that represent the Company. In order for the Company to be successful we must ensure that the interests of the agency are aligned with the interest of the Company. We are committed to retaining agencies that produce long term profitable growth. Each year we perform a review of our agency force to determine if changes are needed or if there are geographic regions that we feel warrant representation by a new or existing agency.
Diversification of Risk
The Company has emphasized risk diversification for the last decade particularly the diversification of risk related to the geographic concentration of insured property. This process is annually modeled and the results are a decision factor for new agency appointments and pricing. Licensing in surrounding states at agent request and also for risk diversification is in process. The first state will be Wisconsin for planned service from bordering Upper Michigan agents followed by Indiana.
Reducing our Ratio of Expenses to Net Premiums Earned
We are committed to improving profitability and our competitiveness by reducing expenses. We will accomplish this by continuing to grow net premiums earned, weeding out operational inefficiencies through expanded use of technology, and ensuring that all products are appropriately priced.
Maintaining our Focus on Customer Service
While the statement, “Maintaining our Focus on Customer Service” has become a cliché, we feel that it has been and will continue to be a key component of our growth and profitability. Insurance is a service business and customer service is one of the basic ‘blocking and tackling’ strategies that we have to get right in order to be successful. While we service many ‘customers’, we work very hard to make sure that our policyholders and our agents receive the best customer service possible. We want our customers to have a pleasant experience when dealing with the Company. This ‘experience’ can be enhanced through technology by making information easily accessible through the web and by simply making sure that when our customers call they can expect to speak to a ‘live’ person, whether it is a customer service representative, a claim associate or an underwriter. We compete with many larger insurance companies in Michigan. What sets us apart from them is the relationship we have with our agents and the service we provide to our policyholders. We will continue to seek out ways to exceed our customers’ expectations.
Marketing
The Company’s marketing strategy begins with the qualification of the agency force. Currently, we are represented by 172 of the best agencies in the state who understand and appreciate the symbiotic relationship between the Company, agency and customer. This critical key is reflected in the Company’s continued profitability and growth. We support the agency’s efforts by providing dynamic products, exceptional service and competitive pricing. The “Pure Michigan” travel bureau campaign has been incorporated into our multi-channel marketing campaign. The Pure Michigan logo and tag line has been incorporated into our print, radio, television, social media, website, direct mail and our newest release for the general public, MichiganBoatQuote.com. From
this website, a consumer can now secure an approximate premium for their boat. This information is sent directly to the associated agency, who then has the responsibility of concluding the transaction. This is in its infancy stage and we will look to measure its success mid-summer.
SEGMENT INFORMATION
The Company defines its operations as property and casualty insurance operations. The Company writes four major insurance lines exclusively in the State of Michigan: Personal Lines, Commercial Lines, Farm and Marine. All revenues are generated from external customers and the Company does not have a significant reliance on any single major customer or agency.
The Company evaluates its product lines based on underwriting profitability. Certain expenses are allocated based on measurements including premiums, incurred losses or other departmental employee data. Underwriting profit by product line would change if different methods were applied. The Company does not allocate assets, net investment income, net realized gains (losses) on investments or other income (expense) to its product lines.
Segment data for the years ended December 31, 2009, 2008 and 2007 is included in the footnotes to the financial statements which are included herein under Part II, Item 8 - Financial Statements and Supplementary Data.
PRODUCTS
We offer a variety of property and casualty insurance products primarily designed to meet the insurance needs of property owners and small to mid sized businesses located in Michigan. The four primary segments of our business are personal, commercial, farm and marine. The following table presents the direct written premiums by major product line within each segment for the periods indicated:
Personal Lines. Personal lines policies include homeowners, mobilowners, dwelling fire and personal auto.
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Homeowners. The policy is a multiple line insurance contract providing protection for both property and liability exposures for homeowners, condominium owners and renters on a replacement cost or
actual cash value basis. Target areas in this line include home values between $100,000 and $500,000. Personal umbrella coverage can also be added. Personal umbrella is a form of excess liability insurance available to individuals protecting them against claims in excess of their limits on their primary policies or for claims not covered by their underlying policies. In order to be eligible, both an individual’s personal auto and home must be written with Fremont.
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Mobilowners. This is a similar product to homeowners providing coverage for mobile home owners. Units are insured for replacement cost, actual cash value or stated amount depending on the age of the mobile home. Personal umbrella coverage can also be added.
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Personal Auto. This is our fastest premium growth line and provides individuals with protection for their personal auto(s). For liability protection, coverage options include Residual Bodily Injury, Property Damage, Personal Injury Protection, Uninsured and Underinsured Motorists. For physical damage, coverage options include Comprehensive and Collision. For Personal Injury Protection, losses above certain thresholds are automatically reinsured by the Michigan Catastrophic Claim Association (MCCA). Personal umbrella coverage can also be added.
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Dwelling. This is a fire and wind coverage for owner occupied residences that do not qualify for a Homeowner policy or for residences that are non-owner occupied and rented to others. To be written, other supporting coverage must be written with Fremont and a residence must have no more than four units and be owned by individuals. Liability coverage for the owner is not included but may be added by endorsement.
Commercial Lines. Commercial lines consist of products designed to serve primarily small to medium business operations. They are:
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Business Owners (BOP). The policy is a multiple line insurance contract providing protection for both property and liability exposures for small business owners. Additional coverages can be added including equipment breakdown, employment practices liability, inland marine and umbrella liability. BOP risks are classified by the five categories listed below with each class having its own eligibility criteria primarily based on sales volume and property values.
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Bed & Breakfast/Condominiums. As the category name implies, insurance is provided for Bed & Breakfast owners and for condominium owner associations.
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Mercantile. This applies for buildings principally occupied for retail mercantile purposes (buying and selling of merchandise) and the contents of these operations.
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Offices. This applies to office buildings, building owners personal property or tenant personal property.
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Service. This applies to buildings occupied principally for service operations and the contents of these operations including mini storage businesses.
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Wholesale. As the category name implies, this covers wholesalers such as baked goods, plumbing supplies and clothing distributors.
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Commercial Package (CPP). The CPP policy is designed to insure a broader range of commercial operations with more specialized business coverage needs than the BOP provides. Examples of these types of businesses are manufacturing risks, contractors and restaurants. The policies are usually larger and generate higher premiums. Additional coverages can be added including equipment breakdown, employment practices liability, inland marine and umbrella liability.
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Commercial Auto (CA). CA covers vehicles owned by a business or used in businesses and owned by individuals. This includes vehicles ranging from passenger cars to tractor-trailer rigs and earth moving equipment. Our targeted market is passenger cars, service vehicles (usually a pickup truck owned by a contractor and driven to the job site) and light, local delivery vehicles. Long haul truckers are ineligible. Additional umbrella liability coverage can be added.
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Workers Compensation. Workers compensation provides coverage to a worker if he or she is injured while on the job for an employer, whether or not the employer has been negligent and is governed by state law. This product complements our Farm and Commercial offerings and affords us the ability to write all of the customer’s property and casualty insurance needs.
Farm Line. The Insurance Company originated as a “farm fire” insurance provider and continues to be a strong provider of coverage for the agricultural industry in Michigan. This segment’s products include: farmowners for fully operating farms, country estate for the hobby or part time farmer, and farm for non-owner occupied farms. Farmowners and country estate policies are comprehensive policies offering protection similar to our homeowner’s policy but also offer the option to cover the insured’s farm buildings, farm personal property (livestock, machinery, etc.), and provide farm liability protection. The farm policy is primarily a fire, wind and liability product designed for non-owner-occupied farms.
Marine. This line is composed of the boat owner’s program (usually smaller and less expensive boats) and the yacht program. The boat owner’s policy is designed for boats 32 feet long or less with values of $125,000 or less. Boats that exceed the length or value criteria for the boat owner’s policy are insured under the yacht program.
Product Pricing. Product pricing and the development of premium rates for all lines is performed under the direction of the Senior Vice President of Personal Lines and Product Management. Each product line goes through a rate review at least once a year with the exception of personal and commercial auto which are reviewed twice a year. That being said, it is not uncommon for us to perform an interim rate change if we feel market conditions and loss experience necessitates a rate change. Rate needs are analyzed on both an accident and calendar year basis and take into consideration the Company’s competitive position within each agent’s geographic territory, catastrophe loads, large loss impacts in addition to actual loss, expense and premium numbers. Each rate review is subject to a rigorous review process which involves all members of senior management. All rates are reviewed with senior management prior to implementation.
MARKETING
We market our property and casualty insurance products exclusively in Michigan through approximately 172 independent agencies. The company has maintained it strategic plans to expand in the northern and western regions of the state, but maintains a respectable presence in other areas. Our agency force has been selected from over 1,200 independent agencies within the State of Michigan. One of our keys to success is our selectivity of our agents. Our company standards are clearly communicated to our agents; they include a strong commitment to ethics, professionalism, honesty and accountability. The company is fortunate to have a top rated agency force. Each year the Company receives in excess of 50 appointment requests from agencies in Michigan and less than 10% actually receive an appointment. Our agent/company partnership philosophy has produced relationships focused on the common good of the Company, agency and policyholder. Our commitment to the agent force, in addition to our diverse product lineup has continued to solidify our position in the Michigan market.
Another key to the Company’s success is identifying and procuring profitable business. Profitable business is a direct result of exercising discipline in the underwriting process. The Company continues to focus on underwriting discipline, even when it means declining new business. This commitment to maintaining our discipline has provided stability and profitability, which is evident in our results. These underwriting responsibilities are shared with the Company and agent.
The Company remains committed to the independent agency force which is our source for future growth. We have established an agency network which is geographically spread across the state of Michigan. Our objective is to be ranked among the top four insurers within each agency. Our independent agencies represent other insurance companies and are established businesses in their local communities in which they operate. Our agencies generally market and write the full range of our products. We believe our relationships with our agencies are very good.
We depend upon our agency force to produce new business and to provide customer service. Policy retention is an important component of agency relations. Our network of independent agencies also serves as an important source of information about the needs of our policyholders. This information is used to develop new products and new product features. Semi-annually the Company holds an agency council meeting. Agency council is comprised of the Company’s top performing agents from communities throughout the State of Michigan. During these meetings information is received and distributed on new products and business strategies that are being planned by the Company. Agency council serves as a sounding board for management and our agents.
We compensate agencies through a fixed base commission with an opportunity for profit sharing, depending on the profitability of the business we receive from the agency. Our agencies are monitored and supported by the Vice President of Marketing and three experienced marketing representatives. Three personal lines underwriters and two commercial lines underwriters also support agency relations with direct calling efforts. Claim representatives also make direct contact with agencies while handling claims. The Company is very focused on developing strong relationships with our agency force and agency visits are an integral component of agency relations. Each agency visit is documented within a proprietary Agency Visit Log which serves as a customer relationship management tool used by all employees.
We continue to focus on our branding efforts. We compete against many larger companies that have sizeable advertising budgets so we are very conscious of where and how we invest our branding and advertising dollars. In 2009, we were able to partner with the Pure Michigan® campaign which promotes Michigan businesses. We have used the Pure Michigan® logo in billboard, radio and television advertising in 2009 and have received very positive feedback from our customers. We have also capitalized on the role of marketing partnerships such as the Company’s alliance with the Michigan Retailers Association (MRA). We are the endorsed property and casualty insurance carrier for MRA’s members.
UNDERWRITING
We underwrite each policy application by evaluating each risk with consistently applied standards. We maintain information on all aspects of our business that is regularly reviewed to determine product line profitability. We employ seven underwriters who specialize in personal lines, commercial lines, marine, and farm. The underwriters are supported by an experienced group of underwriting assistants and processors. This group handles initial screening of applications, running of reports, and policy issuance.
We have, in the past, relied heavily on underwriting information gathered from outside sources. Motor Vehicle Reports are obtained from the State of Michigan on all auto and marine applications. An exchange of claims information is available through two independent firms or through inquiry to the prior insurer and is accessed for all applicable applications. We believe the financial stability and responsibility of the insured has emerged as a reliable indicator of future loss potential. Extensive independent analysis has been done to support this correlation in the industry. In the commercial lines, financial stability has always been an acceptable underwriting criteria and the Insurance Company obtains either a Dun & Bradstreet report or other financial information on every policy application. In personal lines, an Insurance Score is obtained on every submission and insureds are tiered to receive the appropriate premium for their score. An Insurance Score is a numerical score from 200 to 900, with a higher number being a better score, which is based on information in a person’s credit report maintained by one of the national credit reporting firms. The Insurance Company’s pricing is targeted to attract policyholders with above average Insurance Scores. Insured’s with an Insurance Score of 700 or more or a strong Dun & Bradstreet report are part of the Insurance Company’s target market in all lines. Although we target insureds with Insurance Scores of 700 and above, we have policies in effect where the relevant Insurance Scores are less than our target. The Michigan Office of Financial and Insurance Regulation has adopted a ban on the use of a credit based insurance score, but the implementation has been stayed due to pending litigation. A further discussion on the use of credit based insurance scores is included under the heading “Insurance Scoring” in the “Regulation” section of Part 1, Item 1.
We also rely on photographs, inspections, and engineering reports. Agents are required to obtain photos on all new property business. The underwriter decides if additional engineering is necessary. A follow-up inspection may be made by us or subcontracted to an outside firm. If a loss occurs, the adjuster completes a risk evaluation form and sends it to underwriting for review. The Insurance Company’s agents have rating software available to them for use as pricing indicators. This software is a useful tool, but the ultimate underwriting decision is made by the Insurance Company.
CLAIMS
As of December 31, 2009, the Insurance Company’s claims department included the Senior Vice President of Administration, a claims manager, an attorney, thirteen adjusters and two support staff. Claims are normally received from our independent agencies. Typically, claims are assigned to an in-house adjuster who investigates and settles the claim. To a lesser extent, we assign claims to independent adjusters if, as in the case of a catastrophe, our in-house adjusters cannot promptly adjust such a large volume of claims, or if because of the location of the claim it is more economical to use an independent adjuster. Remote and independent adjusters report all information to the home office electronically. The majority of paper claim files are imaged and maintained electronically at the home office.
Claims settlement authority levels are established for each claims adjuster based upon his or her level of experience. We have multi-line teams to handle all claims. The claims department is responsible for investigating all claims, obtaining necessary documentation, estimating the loss reserves, and resolving the claims. The Company takes a proactive approach to liability and defense cost management. The Company’s in-house counsel is responsible for subrogation recovery, coverage-related issues and litigation, supervision of outside defense counsel and special projects. With the assistance of in-house counsel, the Insurance Company’s expeditious claims investigation creates the opportunity for exploration of an early negotiated resolution, where warranted, thereby avoiding protracted litigation and unnecessary legal expense. Additionally, in-house counsel provides valuable instruction for claims adjusters, as well as legal advice in connection with the drafting and revision of our policy and application forms.
The Company’s claims department has completed several technology initiatives in recent years. We now have the ability to issue payments electronically to claimants and vendors. We continue to enhance the information and reports available to our agents. The Company implemented an electronic first notice of loss so that agents can submit a notice of loss to the Company and inquire about the status of a claim electronically from their agency management system. This new feature allows the agent to notify the Company quicker in the event of a loss and allows our adjusters to get in touch with the policyholder in a shorter time frame. We are also in the process of implementing electronic reporting to comply with federal reporting regulations. The Company continues to focus on eliminating paper and enhancing inquiry capabilities which are expected to yield increased operating efficiency for the Company and it agency force.
TECHNOLOGY
The Company transacts a major share of its business using technology wherever possible and, in recent years, has made significant investments in information technology platforms, integrated systems and internet-based applications. These investments have generated positive results for the Company.
The focus of our ongoing information technology effort is:
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to leverage existing and newer automation technologies that bring about greater efficiencies through integration for the Company, the agency force and our customers;
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to deliver on a newer, robust business rule policy administration platform which removes redundancies while promoting straight through processing;
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to adopt recent software development processes and technology which attracts our customers and positions the Company to broaden it’s product offerings; and
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to take advantage of investments made by our independent agent partners and to leverage those to the complement of both parties.
We have been rewarded by our agent partners and customers with national award recognition and increased growth and profitability. Continued investment in our technology platform will provide us the opportunity to further lower expenses thereby increasing productivity and eliminating redundancies which inherently grow over time. This will further reduce technology expense and simplify information technology management.
We have also taken proactive steps to protect information. A core part of our disaster recovery and business continuity plan includes periodic and yearly recovery from a remote site. In addition, a number of security enhancements have been made to further protect Company data. Periodic audits by both internal and external sources contribute to the ongoing awareness by the Company of its responsibility in data protection.
REINSURANCE
General. A reinsurance transaction occurs when an insurance company transfers (cedes) a portion of its exposure on business written by it to a reinsurer which assumes that risk for a premium. Consistent with insurance industry practice, we reinsure a portion of our exposure and pay to reinsurers a portion of the premiums received on all policies reinsured. Insurance is ceded principally to reduce net liability on individual risks, to mitigate the effect of individual loss occurrences (including catastrophe losses), to stabilize underwriting results, and to increase our underwriting capacity.
Reinsurance can be facultative reinsurance or treaty reinsurance. Under facultative reinsurance, each risk or portion of a risk is reinsured individually. Under treaty reinsurance, an agreed-upon portion of business written is automatically reinsured. Treaty reinsurance can also be classified as quota share reinsurance, pro-rata insurance or excess of loss reinsurance. Under quota share reinsurance and pro-rata insurance, the ceding company cedes a percentage of its insurance liability to the reinsurer in exchange for a like percentage of premiums, less a ceding commission, and, in turn, will recover from the reinsurer the reinsurer’s share of losses and loss adjustment expenses incurred on those risks. Under excess of loss reinsurance, an insurer limits its liability to all or a particular portion of the amount in excess of a predetermined deductible or retention. Regardless of type, reinsurance does not legally discharge the ceding insurer from primary liability for the full amount due under the reinsured policies. However, the assuming reinsurer is obligated to reimburse the ceding company to the extent of the coverage ceded.
Our Reinsurance Coverage. We utilize three primary categories of treaty reinsurance coverage to reduce the impact of major losses. These include multi-lines excess of loss coverage, catastrophe excess of loss coverage, and quota share coverage. We determine the amount and scope of reinsurance coverage to purchase each year based on our evaluation of the risks accepted, consultation with reinsurance professionals and a review of market conditions, including availability and cost. During the years ended December 31, 2009, 2008 and 2007 we ceded to reinsurers $11.3 million, $10.7 million and $10.0 million of earned premiums, respectively.
Multi- Lines Excess of Loss Coverage. The multi-lines excess of loss program is the Company’s primary reinsurance coverage. The excess of loss program is designed to help stabilize financial results, limit exposure on larger risks, and increase our underwriting capacity. The largest exposure retained by us on any one risk in 2009 was $175,000. The 2009 property coverage for this program provided up to $2,825,000 over the $175,000 retention per risk. The 2009 casualty coverage for this program provided up to $5,825,000 over the $175,000 retention. Our 2009 workers compensation reinsurance provided up to $9,825,000 coverage above the $175,000 retention.
Catastrophic Excess of Loss Coverage. Catastrophic reinsurance protects us from significant aggregate loss exposure arising from a single event such as windstorm, hail, tornado, hurricane, earthquake, blizzard, freezing temperatures, and other extraordinary events. The contract is designed to help stabilize underwriting results and
to mitigate the effect of individual loss occurrences. In 2009, we had three layers of catastrophic excess of loss reinsurance providing coverage for up to $24,750,000 above the $1,250,000 retention. We had an automatic reinstatement provision after the first loss for each layer to provide coverage in the event of subsequent catastrophes during the year. Coverage would lapse after the second event, in which case we would evaluate the need for a new contract for the remainder of the year. The 2009 reinstatement fees were 100% of the initial premium.
Quota Share Coverage. The Company utilizes quota share reinsurance for its boiler and machinery coverage which is primarily an equipment breakdown endorsement to commercial and farm policies. The contracts are 100% quota share and the Company receives a ceding commission ranging from 32% to 35% on the premiums ceded. The agreements also include profit sharing provisions based on the profitability of the underlying underwriting performance of the business ceded. The Company also utilizes quota share reinsurance for its employment practices liability coverage which is an endorsement to commercial policies. The agreement is 100% quota share and the Company receives ceding commission of 35% on the premiums ceded.
Facultative. We utilize facultative reinsurance to provide additional underwriting capacity, to mitigate the effect of individual losses and to reduce net liability on individual risks. Coverage is determined on each individual risk. In 2009, the Company obtained coverage ranging from $100,000 up to $59,000,000 for certain commercial and farm properties it insured.
Michigan Catastrophic Claim Association. The Insurance Company is a member of the Michigan Catastrophic Claim Association, or MCCA, a statutorily created non-profit association which provides mandatory reinsurance to its members. Michigan is the only state that offers unlimited personal injury protection benefits which are offered through no-fault auto insurance policies. The reinsurance provided by the MCCA indemnifies its members for 100% of the losses sustained under personal injury protection policies issued by the members in excess of specified retention amounts. From July 1, 2008 through June 30, 2009, the retention was $440,000 and from July 1, 2009 through June 30, 2010 the retention is $460,000. The MCCA must provide this reinsurance and the Insurance Company, like all insurance companies that write automobile insurance in Michigan, must accept and pay for the reinsurance.
Our Reinsurers. The financial stability of our reinsurers is an important consideration. 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. As of December 31, 2009, our largest reinsurers based on a percentage of ceded premiums written are set forth in the following table. Except for the reinsurers listed below, no other individual reinsurer accounted for more than 5% of total ceded premiums written.
(1) The MCCA does not receive an A.M. Best rating.
The following table sets forth individual balances of loss and loss adjustment expenses recoverable from reinsurers on both paid and unpaid claims as of December 31, 2009. Except for the reinsurers listed below, no other individual reinsurer accounted for more than 5% of total loss and LAE recoverable from reinsurers.
(1) The MCCA does not receive an A.M. Best rating.
INVESTMENTS
All of our investments are classified as available for sale and are carried at fair market value. Our return on invested assets is an important component of our operating results. Our investment objectives are to:
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Maximize current yield;
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Maintain adequate liquidity for insurance operations;
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Maintain safety of principal through a balance of high quality and diversified investments;
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Maintain daily oversight to minimize risk;
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Minimize fluctuations in market valuations due to increasing interest rates by monitoring duration;
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Meet regulatory requirements; and
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Increase surplus and shareholders’ equity through appreciation.
The investment committee, appointed by the Insurance Company’s board of directors, sets our investment policy. The investment committee meets at least twice each year to review the investment portfolio, asset allocation, performance, and liquidity. The Company utilizes outside professional investment management firms for its fixed maturity and equity securities. The firm that manages the fixed maturity portfolio specializes in management of insurance company investment portfolios. Professional asset management was deemed practical to allow for constant review of the portfolio and specialized focus. During 2009, the Company engaged a professional management firm to manage a portion of its equity portfolio.
See Note 1-Summary of Significant Accounting Policies to the consolidated financial statements included under Item 8 of this Form 10-K for a description of the Company’s fair value measurement approach to its investment portfolio.
The following table sets forth information concerning the composition of the Company’s investment portfolio at December 31:
At December 31, 2009, our fixed maturity portfolio had a fair value of approximately $56 million. All of the fixed maturity investments are rated by Moody’s as investment grade with an average credit quality rating of AA and an average duration of 4.8 years. The market value of our investments may fluctuate in response to changes in interest rates. In addition, we may experience investment losses to the extent our liquidity needs require the disposition of fixed maturity securities in unfavorable interest rate environments.
At December 31, 2009, our equity portfolio included both mutual funds (61%) and stocks (39%). The mutual funds, as a percentage of total equities were spread among the following mutual fund types: large-cap-15%, mid-cap-17%, small-cap-15%, specialty-2%, and international-12%. Sector allocation for stocks is as follows: basic materials 4%, bond equivalent 2%, communications 1%, consumer cyclical 3%, consumer non-cyclical 3%, energy 7%, financial 4%, healthcare 3%, industrials 3%, technology 7%, and utilities 2%.
At December 31, 2008, our fixed maturity portfolio had a fair value of approximately $54.0 million. All of the fixed maturity investments are rated by Moody’s as investment grade with an average credit quality rating of AA+ and an average duration of 4.1 years. As a result, the market value of our investments may fluctuate in response to changes in interest rates. In addition, we may experience investment losses to the extent our liquidity needs require the disposition of fixed maturity securities in unfavorable interest rate environments. At December 31, 2008, our equity portfolio, which consists entirely of mutual funds, was spread among the following mutual fund types: large-cap-29%, mid-cap-24%, small-cap-26%, specialty-3% and international 18%.
The following table shows the rating distribution of the Company’s fixed maturity portfolio by rating as a percentage of fair value as of December 31, 2009:
The Company reviews the status and market value changes of its investment portfolio on at least a quarterly basis during the year, and any provisions for other-than-temporary impairments in the portfolio’s value are evaluated and established at each quarterly balance sheet date. In reviewing its fixed maturity securities for other than temporary impairment, the Company takes into consideration the security’s market price history, the length of time that the security’s fair value has been below cost, the issuer’s operating results, financial condition and liquidity, its ability to access capital markets, credit rating trends, most current audit opinion, industry and securities market conditions, and analyst expectations, to reach its conclusions. In reviewing its equity securities, which include common stock and mutual funds, the Company takes into consideration the security’s market price history, the length of time that the security’s fair value has been below cost, the individual investments held within the mutual fund, most current audit opinion, industry and securities market conditions, and analyst expectations to reach its conclusions. In addition to analyzing each individual security that has a fair value below cost, the Company also considers its intent and ability to hold a security until its fair value is equal to or greater than its cost.
The following two tables show the estimated fair value and gross unrealized losses, aggregated by investment category and length of time that individual investments have been in a continuous unrealized loss position at December 31, 2009 and 2008.
As of December 31, 2009, the portfolio included 23 fixed maturity securities and 7 equity securities in an unrealized loss position for less than 12 months and 4 fixed maturity securities and 14 equity securities in an unrealized loss position for more than 12 months. Of the fixed maturity securities, all twenty-seven were trading at or above 95% of amortized cost. All of the fixed maturity securities in an unrealized loss position and assigned a rating by a commercial credit rating agency are rated investment grade securities.
As of December 31, 2009, the investment portfolio included 21 equity securities in an unrealized loss position. Of these twenty-one equity securities, 2 were trading under 75% of amortized cost, 7 were trading between 75% and 85% of amortized cost, 8 were trading between 86% and 95% of amortized cost and the remaining 4 were trading above 95% of amortized cost. Management believes that the analysis of each of these securities in addition to the fact that the Company has both the intent and ability to hold these securities until their recovery supports our view that these securities were not other-than-temporarily impaired.
As of December 31, 2008, the portfolio included 26 fixed maturity securities and 10 equity securities in an unrealized loss position for less than 12 months and 12 fixed maturity securities and 5 equity securities in an unrealized loss position for more than 12 months. Of the fixed maturity securities, five were trading between 73% and 84% of amortized cost, twelve were trading between 85% and 94% of amortized cost and the remaining twenty-one were trading at or above 95% of amortized cost. All of the fixed maturity securities in an unrealized loss position and assigned a rating by a commercial credit rating agency are rated investment grade securities. During 2008, the Company wrote down a corporate bond as it deemed the security to be other than temporarily impaired. The impairment loss was $362,000 and is included in net realized investment losses in the consolidated statement of operations for the year ended December 31, 2008.
Of the fifteen equity securities in an unrealized loss position, the range of market value to cost was from 37% up to 83%. While all of these securities are monitored for potential impairment, the Company’s experience indicates that they generally do not present as great a risk of impairment, as fair value often recovers over time. These securities have generally been adversely affected by the downturn in the financial markets and overall economic conditions. Management believes that the analysis of each of these securities in addition to the fact that the Company has both the intent and ability to hold these securities until their recovery supports our view that these securities were not other-than-temporarily impaired.
The following table presents the maturity profile of our fixed maturity investments as of December 31, 2009 and 2008. As noted above the average duration of the portfolio at December 31, 2009 was 4.8 years compared to 4.1 years at December 31, 2008. Actual maturities of mortgaged-backed securities differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Prepayment rates are influenced by a number of factors that cannot be predicted with certainty, including: the relative sensitivity of the underlying mortgages or other collateral to changes in interest rates; a variety of economic, geographic and other factors; and the repayment priority of the securities in the overall securitization structures. These securities are presented separately in the maturity schedule due to the inherent risk associated with prepayment.
Management of Market Risk. We are subject to various market risk exposures, including interest rate risk and equity price risk. Our primary risk exposure is to changes in interest rates. We manage market risk through our investment committee and through the use of an outside professional investment management firm. We are vulnerable to interest rate changes because, like other insurance companies, we invest primarily in fixed maturity securities, which are interest-sensitive assets. Mortgage-backed securities, which make up approximately 24.6% of our investment portfolio, are particularly susceptible to interest rate changes. We invest primarily in classes of mortgage-backed securities that are less vulnerable to prepayment risk and, as a result, somewhat less sensitive to interest rate risk than other mortgage-backed securities.
The value of our equity securities is dependent upon general conditions in the securities markets and the business and financial performance of the individual companies in the portfolio. Values are typically based on future economic prospects as perceived by investors in the equity markets.
Effect of Interest Rate Changes. 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 market valuation of these securities. Therefore, an adverse change in market prices of these securities would result in losses reflected in the balance sheet. The following table shows the effects of a change in interest rates on the fair value of our fixed maturity investment portfolio. We have assumed an immediate increase or decrease of 1% or 2% in interest rates. You should not consider this assumption or the values shown in the table to be a prediction of actual future results. The other financial instruments, which include cash, premiums due from reinsurers and accrued investment income, do not produce a significant difference in fair value when included in the market risk due to their short-term nature.
A.M. BEST RATING
In October 2009, A.M. Best, which rates insurance companies based on factors of concern to policyholders, upgraded Fremont Insurance Company’s financial strength rating (FSR) to “A-” (Excellent) with a stable outlook. A.M. Best assigns “A-” ratings to companies that, in its opinion, have demonstrated an excellent ability to meet their ongoing insurance obligations. An “A-” rating is the fourth highest rating of the 16 A.M. Best rating categories.
In evaluating our financial and operating performance, A.M. Best reviews our profitability, leverage and liquidity, as well as our book of business, the adequacy and soundness of our reinsurance, the quality and estimated market value of our assets, the adequacy of our loss reserves, the adequacy of our surplus, our capital structure, the experience and competency of our management team, and our market presence. A.M. Best ratings are not directed toward the protection of investors. As such, our A.M. Best rating should not be relied upon as a basis for an investment decision to buy our common stock.
COMPETITION
The property and casualty insurance market is highly competitive. We compete against other Michigan-based insurance carriers as well as major regional and national carriers. The national carriers we compete with on a regular basis are Citizens Insurance Company of America, State Farm Mutual Automobile Insurance Company and the Allstate Corporation. Regional companies that are important competitors include Auto Owners Insurance Group, Allied Insurance, Farm Bureau Mutual Insurance Company of Michigan, Frankenmuth Mutual Insurance Company and Hastings Mutual Insurance Company. Smaller state competitors would include Michigan Insurance Company, Pioneer State Mutual Insurance Company and Wolverine Mutual Insurance Company. Some of these competitors are larger and have much greater financial, technical and operating resources than we have. Our ability to compete successfully depends upon a number of factors, many of which are out of our control, such as market conditions, our A.M. Best rating, and regulatory conditions. We compete primarily based upon the following factors:
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the price and quality of our insurance products;
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the quality and speed of our service and claims response;
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our financial strength;
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our A.M. Best rating;
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our sales and marketing capability; and
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our technical expertise.
REGULATION
General. Insurance companies are subject to supervision and regulation in the states in which they transact business relating to numerous aspects of their business and financial condition. The primary purpose of this supervision and regulation is the protection of policyholders. The extent of the regulation varies, but generally derives from state statutes that delegate regulatory, supervisory and administrative authority to state insurance departments.
We are licensed to write insurance only in Michigan and are subject to supervision and regulation by the Michigan Office of Financial and Insurance Regulation (“OFIR”). OFIR requires the filing of annual, quarterly and other reports relating to the financial condition of insurance companies doing business in Michigan. The authority of the OFIR includes, among other things:
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establishing standards of solvency which must be met and maintained by insurers;
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requiring certain methods of accounting;
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classifying assets as admissible for purposes of determining statutory surplus;
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licensing of insurers and their agents to do business;
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establishing guidelines for the nature of and limitations on investments by insurers;
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reviewing premium rates for various lines of insurance;
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approval of policy forms;
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reviewing the provisions which insurers must make for current losses and future liabilities;
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reviewing transactions involving a change in control;
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restrictions on payments of dividends to shareholders;
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restrictions on transactions between insurers and their affiliates; and
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reviewing claims, advertising and marketing practices.
Examinations. Examinations are regularly conducted by the OFIR every three to five years. In April 2008, OFIR completed an examination of the Insurance Company as of December 31, 2006. The examination did not result in any material adjustments to the Insurance Company’s financial position. In addition, there have been no substantive qualitative matters indicated that would have had an adverse impact on the Insurance Company’s operations.
NAIC Risk-Based Capital Requirements. In addition to state-imposed insurance laws and regulations, the OFIR administers the risk based capital standards adopted by the National Association of Insurance Commissioners (“NAIC”) that require insurance companies to calculate and report information under a risk-based formula that attempts to measure statutory capital and surplus needs based on the risks in a company’s mix of products and investment portfolio. Under the formula, we first determine our risk-based capital level by taking into account risks with respect to our assets and underwriting risks relating to our liabilities and obligations. We then compare our “total adjusted capital” to the base level. Our “total adjusted capital” is determined by subtracting our liabilities from our assets in accordance with rules established by the OFIR.
The following table highlights the ramifications of the various ranges of non-compliance. The ratios represent the relationship of a company’s total adjusted capital to its authorized control level risk-based capital.
Ratio and Category
Action
2.0 or more
None-in compliance
1.5-1.99: Company Action
Company must submit a comprehensive plan to the regulatory authority discussing proposed corrective actions to improve its capital position
1.0-1.49: Regulatory Action
Regulatory authority will perform a special examination of the company and issue an order specifying corrective actions that must be taken
0.7-0.99: Authorized Control
Regulatory authority may take any action it deems necessary, including placing the company under regulatory control
Less than 0.7: Mandatory Control
Regulatory authority is required to place the company under regulatory control
The Insurance Company has always exceeded the required levels of capital for compliance and has always been in compliance. There can be no assurance, however, that the capital requirements applicable to our business will not increase in the future. As of December 31, 2009, our risk-based capital authorized control level was $3,155,119 and our total adjusted capital was $39,435,244, yielding a ratio of 12.5.
IRIS Requirements. The NAIC has also developed a set of financial ratios, referred to as the Insurance Regulatory Information System (“IRIS”) for use by state insurance regulators in monitoring the financial condition of insurance companies. The NAIC has established an acceptable range of values for each of the IRIS financial ratios. Generally, an insurance company will become the subject of increased scrutiny when four or more of its IRIS ratio results fall outside the range deemed acceptable by the NAIC. The nature of increased regulatory scrutiny resulting from IRIS ratio results that are outside the acceptable range is subject to the judgment of the applicable state insurance department, but generally will result in accelerated review of annual and quarterly filings. Depending on the nature and severity of the underlying cause of the IRIS ratio results being outside the acceptable range, increased regulatory scrutiny could range from increased but informal regulatory oversight to placing a company under regulatory control.
NAIC values
(1) “*” denotes results outside of the usual range
(2) “-” denotes no lower limit on the range
As of December 31, 2009, all of the Company’s ratios were within the acceptable range except for the investment yield ratio. The Company’s investment yield ratio of 2.6 was below the lower end of the IRIS ratio due to the fact that interest rates remained at very low levels in 2009 compared to historic averages and the fact that the portfolio duration was decreased in order to lower market value volatility in the event of future rising interest rates.
Guaranty Fund. We participate in the Property and Casualty Guaranty Association of the State of Michigan (“PCGA”), which protects policyholders and claimants against losses due to insolvency of insurers. When an insurer becomes insolvent, the Association is authorized to assess member companies up to the amount of the shortfall of funds, including expenses. Member companies are assessed based on the type and amount of insurance written during the previous calendar year. We recognize a liability for insurance related assessments when an assessment has been imposed or information available indicates it is probable that an assessment will be imposed, or an event obligating us to pay an imposed or probable assessment has occurred and the amount of the assessment can be reasonably estimated. We incurred approximately $15,000 and $12,000 in assessments related to the PCGA in 2008 and 2007, respectively. There were no assessments during 2009.
Michigan Catastrophic Claim Association. Michigan’s no-fault law requires insurers to provide unlimited medical coverage to automobile accident victims. The cost of providing the unlimited medical coverage has somewhat offset the savings typically associated with a non-monetary threshold. In response, the Michigan Catastrophic Claim Association (“MCCA”), which is an unincorporated nonprofit association created by Michigan law, was established to spread the costs of medical coverage to all policyholders. The MCCA essentially acts as a reinsurer for all Michigan automobile insurers, reimbursing them for amounts paid on personal injury protection claims above a retention level. From July 1, 2008 through June 30, 2009, the MCCA retention was $440,000 and from July 1, 2009 through June 30, 2010 the retention is $460,000. This limit will increase incrementally to $500,000 by July 1, 2011. Every insurer engaged in writing automobile personal injury protection insurance coverage in Michigan is required to be a member of MCCA. Personal injury protection is included in automobile insurance. Member companies cede premiums which are based on the number of vehicles for which coverage is written, to cover the losses reported by all member companies. Although the MCCA acts in the same manner as a reinsurer, it is not an insurance company and is not rated by A.M. Best.
Michigan Basic Property Insurance Association. The Michigan Basic Property Insurance Association (“MBPIA”) provides basic insurance to property-owners who cannot obtain insurance through insurance carriers in the normal course of business due to a high-risk exposure. The MBPIA assesses insurance carriers in Michigan for continuation of the association based on the amount of losses incurred by the association and the amount of net written premium of the carrier related to property insurance. The assessment was approximately $105,000, $77,000 and $107,000 in 2009, 2008 and 2007, respectively.
Michigan No-Fault Automobile Insurance. Under a pure no-fault automobile insurance system, responsibility for an automobile accident is not at issue. Each policyholder’s own insurance company pays for his or her medical expenses and lost wages, regardless of who caused the accident, and the individuals relinquish the right to sue to recover damages. The objective of such a system is to eliminate the delays and costs of court disputes associated with the tort system, encourage prompt payment of compensation, and return a larger percentage of insurance premium dollars to accident victims. Michigan has a modified no-fault system that limits lawsuits relating to automobile accidents. For example, a suit for damages is permitted under Michigan’s no-fault law when an injured person has suffered death, permanent serious disfigurement, or serious impairment of a body function. Damages are assessed on the basis of comparative fault, except that damages will not be assessed in favor of a party who is more than 50% at fault.
The Michigan Essential Insurance Act. The Michigan Essential Insurance Act (“MEIA”) requires an insurer to insure every applicant for automobile and homeowner insurance that meets the minimum requirements and the insurer’s underwriting rules. The underwriting rules must be applied uniformly to all applicants and policyholders. Each insurer must file its underwriting rules with the Insurance Commissioner. In addition, the
MEIA limits rating criteria that insurers may employ, requires insurers to develop a “secondary” or merit rating plan under which premium surcharges are levied on poor drivers, establishes a joint underwriting association to provide insurance to individuals who cannot obtain coverage in the insurance market, and regulates other types of coverage and informational requirements.
Insurance Scoring. The financial stability of an insured, in all lines of business, has always been a strong consideration in underwriting and pricing. The Company currently uses insurance scoring (similar to a credit score) as a pricing tool in its homeowners, mobilowners, personal auto, marine and farm lines of business. Numerous studies have verified the validity of insurance scoring as a predictor of future losses.
On January 12, 2005, the Governor of Michigan and the Commissioner of the Office of Financial and Insurance Regulation (“OFIR”) issued proposed rules to reduce base insurance rates and ban the use of insurance credit scores as a rating factor or as a basis to refuse to insure or limit coverage on personal insurance. Personal insurance includes private passenger automobile, homeowners, motorcycle, boat, personal watercraft, snowmobile, recreational vehicle, mobile-homeowners and non-commercial dwelling fire lines. The proposed ban was to be effective on July 1, 2005. The Insurance Institute of Michigan (“IIM”), of which the Company is a member, mounted a legal challenge to the ban and filed a suit on March 25, 2005 in Barry County Circuit Court seeking relief from the proposed ban. On April 25, 2005 the Circuit Court issued a final order in the matter of IIM et al v. OFIR, pertaining to insurers’ use of insurance credit scores to provide discounts on personal lines of insurance. In the final order the Circuit Court ruled in favor of IIM, ordering that Plaintiff’s request for declaratory relief is granted, and the OFIR rules, R 500.2151-2155 were declared illegal, invalid and unenforceable. It was further ordered that Defendant was permanently enjoined from enforcing these rules.
The Commissioner of the OFIR filed an appeal to this ruling in the Michigan Court of Appeals. The appeal was heard before the appellate court on October 10, 2006. In a 2-1 decision, the Michigan Court of Appeals on September 22, 2008 vacated the Barry County Circuit Court and ruled that the administrative rules to ban the use of credit-based insurance scoring were valid. The industry had been prepared in the event of an unfavorable ruling and on October 2, 2008 IIM has sought leave to appeal that decision to the Michigan Supreme Court. The Supreme Court agreed to hear the case and the case was presented to the court on October 7, 2009. Until a decision is rendered, which is not expected until late spring 2010 at the earliest, the stay remains in effect and we will continue to utilize insurance scoring as a pricing tool.
Holding Company Regulation. Most states, including Michigan, have enacted legislation that regulates insurance holding company systems. Each insurance company in a holding company system is required to register with the insurance supervisory agency of its state of domicile and furnish information concerning the operations of companies within the holding company system that may materially affect the operations, management or financial condition of the insurers within the system. These laws permit the OFIR and any other relevant insurance departments to examine the Insurance Company and the Holding Company at any time, to require disclosure of material transactions between them and to require prior approval of transactions, such as extraordinary dividends from the Insurance Company to the Holding Company. All transactions between companies within a holding company system must be fair and equitable to the insurance company. Under Michigan law, the maximum amount of dividends that may be paid by an insurer to its stockholders during any twelve-month period without approval of the OFIR is the greater of 10% of the insurer’s surplus as reported on the most recent annual statement filed with the OFIR or the net income, excluding realized capital gains, of the insurer for the twelve-month period covered by such annual statement.
Change in Control. The Michigan Insurance Code requires that the Insurance Commissioner receive prior notice and approve of a change of control in either the Insurance Company or the Holding Company. The Insurance Code contains a complete definition of “control.” In simplified terms, a person, corporation or other entity would obtain “control” of the Insurance Company or the Holding Company if they possessed, had a right to acquire possession or had the power to direct any other person acquiring possession, directly or indirectly, of 10% or more of the voting securities of either company. To obtain approval for a change of control, the proposed
acquirer must file an application with the Insurance Commissioner containing detailed information such as the identity and background of the acquirer and its affiliates, the sources and amount of funds to be used to effect the acquisition, and financial information regarding the proposed acquirer.
Sarbanes-Oxley Act of 2002. On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002, or the SOA. The stated goals of the SOA are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies, and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. The SOA generally applies to all companies, both U.S. and non-U.S., that file or are required to file periodic reports with the Securities and Exchange Commission (the SEC) under the Securities Exchange Act of 1934 (the Exchange Act).
The SOA includes very specific additional disclosure requirements and new corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules, and mandates further studies of specified issues by the SEC and the Comptroller General. The SOA represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees. The SOA addresses, among other matters:
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audit committees, including the independence of members, communications with auditors and selection and oversight of auditors;
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certification of financial statements by the chief executive officer and the chief financial officer;
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disclosure of off-balance sheet transactions;
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a prohibition on personal loans to directors and officers;
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expedited filing requirements for Form 4 statements of changes of beneficial ownership of securities required to be filed by officers, directors and 10% shareholders;
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disclosure of whether or not a company has adopted a code of ethics;
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various increased criminal penalties for violations of securities laws.
Under the current rules we are subject to the provisions of Section 404 of the Sarbanes-Oxley Act that require an annual management assessment of our internal control over financial reporting. For the year ended December 31, 2010, we will be subject to both the management assessment of our internal controls over financial reporting as well as the related attestation by our independent registered public accounting firm.
ITEM 1A.
ITEM 1A. RISK FACTORS
The Company’s financial performance is dependent upon its own specific business characteristics, however, risk factors do exist which could result in a significant or material adverse effect on our results of operations or financial condition and a corresponding decline in the market price of our common stock. Risk factors include, but may not be limited to, the following:
Our financial results could be affected by the cyclical patterns of the soft and hard market in the property and casualty industry.
The financial performance of the property and casualty industry tends to fluctuate in patterns of soft markets followed by hard markets. The Company’s strategy is to focus on disciplined underwriting and avoid riding the cycle of soft and hard markets. However, if the marketplace puts pressure on pricing we may not be able to implement rate increases which could have a negative effect on our financial performance.
Because we concentrate all of our business in Michigan, its weather will affect our results.
All insurance policies we write are generated in Michigan, with a significant portion in four counties: Kent, Muskegon, Newaygo and Oakland. Companies with a more diversified geographic portfolio would not be as exposed to Michigan weather as we are.
Catastrophe and natural peril losses may hurt our financial condition.
By their nature, catastrophe losses are unpredictable in their number and severity. They can be caused by various severe weather events, including snow storms, ice storms, freezing temperatures, tornadoes, wild fires, wind and hail. The extent of net losses from catastrophes depends upon three factors:
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the total amount of insured exposure in the area affected by the event,
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the severity of the event, and
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the amount and structure of our reinsurance coverage.
We obtain reinsurance to aid in paying catastrophe loss claims, but we may experience operating losses in years when catastrophe claims are higher than expected. Natural perils such as freezing rain, snow storms, wind storms and tornadoes, which may occur frequently but not rise to the level of a catastrophe, may cause us to lose money because they are not classified as a catastrophe under our reinsurance program. If our reinsurance pays catastrophe loss claims, we may still incur substantial expense to reinstate the coverage used.
If we underestimated the amount of our required loss reserves, our results may suffer.
We maintain reserves to cover our estimated liability for losses and loss adjustment expenses (“LAE”) with respect to reported and unreported claims incurred. Reserves are estimates involving actuarial and statistical projections at a given point in time of what we expect to be the cost of the ultimate settlement and administration of claims based on facts and circumstances then known, actual and historical information, predictions of future events, estimates of future trends in claims severity and judicial theories of liability, legislative activity and other variable factors, such as inflation, investment returns, and price increases because of local shortages. The Company’s overall reserving practice provides for ongoing claims evaluation and adjustment (if necessary) based on the development of related data and other relevant information pertaining to such claims. Loss and LAE reserves, including reserves for claims that have been incurred but not yet reported, are analyzed regularly and we adjust our reserves based on such reviews. We believe our reserves are adequate. However, establishing appropriate reserves is an uncertain process. There is no guarantee that our ultimate losses will not exceed our reserves. To the extent that reserves prove to be inadequate in the future, we would have to increase reserves, which would reduce our earnings and could have a material adverse effect on the Company’s results of operations and financial condition.
We face strong competition from large companies, which may reduce our earnings and profits.
We principally insure against property and casualty losses. This segment of the market is highly competitive. We compete against other Michigan-based insurance carriers as well as major regional and national carriers. The national carriers we compete with on a regular basis are Citizens Insurance Company of America, State Farm Mutual Automobile Insurance Company and the Allstate Corporation. Regional companies that are important competitors include Auto Owners Insurance Group, Allied Insurance, Farm Bureau Mutual Insurance Company of Michigan, Frankenmuth Mutual Insurance Company and Hastings Mutual Insurance Company. Smaller state competitors would include Michigan Insurance Company, Pioneer State Mutual Insurance Company and Wolverine Mutual Insurance Company. Many of our competitors have substantially greater financial, technical and operating resources than we do. As a result, many of our lines of insurance are subject to strong price competition and heavy advertising by larger companies, which could result in loss of business and adversely affect our earnings.
Our reliance on independent insurance agencies to sell our products as well as their ability to sell products of our competitors could adversely affect the sale of our products.
We market our property and casualty insurance products exclusively in Michigan through approximately 172 independent agencies. Our independent insurance agencies represent other insurance companies, including our competitors, which also compete for the service and allegiance of these agencies. If a significant number of the independent agencies shift profitable accounts from us to our competitors, it could adversely affect our business.
We rely on internet based systems for the application, underwriting and processing for the majority of our products, and disruptions or frustrations with our business platforms could adversely affect us.
We rely on internet systems for the application, underwriting and processing for the majority of our products, and we may increasingly rely on internet applications for our operations. In some instances, our agents are required to access separate business platforms to execute the sale of our insurance. Should internet disruptions occur, or frustration with our business platforms or distribution initiatives develop among our independent agents, the resulting loss of business could materially and adversely affect our future business volume and results of operations.
Our business success and profitability depend, in part, on effective information technology systems and on continuing to develop and implement improvements in technology.
We depend in large part on our technology systems for conducting business and processing claims, and thus our business success is dependent on maintaining the effectiveness of existing technology systems and on continuing to develop and enhance technology systems that support our business processes and strategic initiatives in a cost and resource efficient manner. Some system development projects are long-term in nature, may negatively impact our expense ratio as we invest in the projects and may cost more than we expect to complete. In addition, system development projects may not deliver the benefits we expect once they are complete, or may be replaced or become obsolete more quickly than expected, which could result in accelerated recognition of expenses. If we do not effectively and efficiently manage and upgrade our technology, or if the costs of doing so are higher than we expect, our ability to provide competitive services in a cost effective manner and our ability to implement our strategic initiatives could be adversely impacted.
If we experience difficulties with technology and data security our ability to conduct our business could be negatively impacted.
While technology can streamline business processes and ultimately reduce the cost of operations, technology initiatives present certain risks. Our business is highly dependent upon the ability of our agents and employees to perform business functions in an efficient and uninterrupted fashion. A shut-down or inability to access our facility, a power outage or a failure of one or more of our information technology, telecommunications or other systems could significantly impair our ability to perform such functions on a timely basis. If sustained or repeated, such a business interruption, system failure or service denial could result in a deterioration of our ability to write and process new and renewal business, provide customer service, pay claims in a timely manner or perform other business functions. Computer viruses, hackers and other external hazards could expose our data systems to security breaches. These increased risks, and expanding regulatory requirements regarding data security, could expose us to data loss, monetary and reputational damages and significant increases in compliance costs. As a result, our ability to conduct our business might be adversely affected.
A downgrade in our A.M. Best rating could hurt our premium volume.
Ratings assigned by A.M. Best Company, Inc. influence the competitive position of insurance companies. Their ratings are based upon factors of concern to policyholders and are not directed toward the protection of
investors. Our current rating is “A-” (Excellent). Our business is sensitive to those ratings. If we were to experience a rating downgrade, our independent agents could be inclined to place their customers with higher-rated insurance carriers, which could result in a loss of premium volume and could have a material adverse effect on us. In addition, a downgrade in our A.M. Best rating could make it more difficult or costly to obtain reinsurance.
If we are unable to obtain adequate reinsurance coverage at reasonable rates in the future, we may be unable to manage our underwriting risks and operate our business profitably.
Reinsurance is the practice of transferring part of the liabilities and the premiums under an insurance policy to another insurance company. Like other insurance companies, we use reinsurance arrangements to limit and manage the amount of risk we retain and to stabilize our underwriting results. Reinsurance can be facultative reinsurance or treaty reinsurance. Under facultative reinsurance, each risk or portion of a risk is reinsured individually. Under treaty reinsurance, an agreed-upon portion of business written is automatically reinsured. Treaty reinsurance can also be classified as quota share reinsurance, pro-rata insurance or excess of loss reinsurance. Under quota share reinsurance and pro-rata insurance, the ceding company cedes a percentage of its insurance liability to the reinsurer in exchange for a like percentage of premiums, less a ceding commission, and, in turn, will recover from the reinsurer the reinsurer’s share of losses and loss adjustment expenses incurred on those risks. Under excess of loss reinsurance, an insurer limits its liability to all or a particular portion of the amount in excess of a predetermined deductible or retention. Regardless of type, reinsurance does not legally discharge the ceding insurer from primary liability for the full amount due under the reinsured policies. However, the assuming reinsurer is obligated to reimburse the ceding company to the extent of the coverage ceded. The availability and cost of reinsurance are subject to prevailing market conditions and may vary significantly over time. Reinsurance rates are not regulated and reinsurers are able to quickly raise their rates in response to changing market conditions. On the other hand, the Insurance Company’s rates are regulated, and it could take us years to obtain regulatory approval and collect rate increases based on the rising costs of reinsurance. There is no assurance that regulators would approve a rate increase based on these costs. Reinsurance may not be available to us in the future at commercially reasonable rates. If it is not available at reasonable rates, we may be unable to manage our underwriting risks and operate our business profitably.
If our reinsurers do not fulfill their financial obligations to us it may jeopardize our earnings and financial condition.
We are subject to loss and credit risk relating to the reinsurers we deal with because buying reinsurance does not relieve us of our liability to policyholders. The insolvency or inability of any reinsurer to meet its obligations may have a material adverse effect on the business, results of operations and financial condition of the Insurance Company.
If we do not have adequate reinsurance coverage, our earnings and financial condition would be in jeopardy.
It is 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 is not sufficient, our insurance losses would increase which could jeopardize our earnings and financial condition
Changes in prevailing interest rates may reduce our revenues, cash flows and shareholders’ equity.
We have invested a significant portion of our investment portfolio in fixed maturity securities. In recent years, we have earned our investment income primarily from interest income on this portfolio. Lower interest rates could reduce the return on our portfolio and the amount of this income if we must reinvest at rates below those we have on securities currently in the portfolio. The reduced investment income could also reduce our cash flows. In addition, in a declining interest rate environment, we may lower our credit quality standards in order to
maintain yield on the investment portfolio, which would negatively impact the quality of our investment portfolio. A decline in the quality of our portfolio could result in realized losses on securities, creating additional volatility in our statement of operations. Higher interest rates could reduce the market value of our fixed income investments resulting in a reduction to stockholders’ equity.
We could be forced to sell investments to meet our liquidity requirements.
We believe that we maintain adequate amounts of cash and short-term investments to pay claims, and do not expect to sell securities prematurely for such purposes. We may, however, decide to sell securities as a result of changes in interest rates, credit quality, the rate of repayment or other similar factors. A significant increase in market interest rates could result in a situation in which we are required to sell securities at depressed prices to fund payments to our insureds. Since we carry debt securities at fair value, we expect that these securities would be sold with no material impact on our net equity. However, if these securities are sold, future net investment income may be reduced if we are unable to reinvest in securities with similar or better yields.
Declining debt and equity markets could adversely affect our investment portfolio.
A declining market could stress the values of investments of all firms and could cause the investment ratings of the issuers of debt or equity to decline. Therefore, a declining market could negatively impact the credit quality of our investment portfolio as adverse equity markets also affect issuers of securities held by us. Declines in the quality of the portfolio could cause additional realized losses on securities, thus causing volatility in our statement of operations.
The Sarbanes-Oxley Act of 2002 may have a material adverse effect on our business.
The Sarbanes-Oxley Act of 2002 requires new corporate governance standards, increased disclosures, expanded insider accountability, broadened sanctions and increased oversight by the Board and its committees. It also requires higher standards for the composition of the audit committee, heightens auditor independence, and limits non-audit services we can obtain from our outside auditor. In addition, the requirements of the Sarbanes-Oxley Act of 2002 will increase our audit-related costs as we and our independent auditors have elevated our standards and procedures. Our costs for legal compliance will also increase.
Regulatory changes could adversely affect our business.
The Michigan Office of Financial and Insurance Regulation (“OFIR”) regulates numerous aspects of our business and financial condition, which include:
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approving premium rates;
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establishing standards of solvency;
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licensing our agents and us;
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regulating the types and amounts of our investments;
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regulating the reserves we must establish for our current losses and future liabilities; and
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approving our policy forms.
The regulation and supervision are primarily for the protection of policyholders and not for the benefit of shareholders.
The insurance regulatory structure has been subject to increased scrutiny in recent years by federal and state legislative bodies and state regulatory authorities. Future legislation or regulatory changes could adversely affect our business and results of operations. Adverse legislative and regulatory activity, which increases our costs,
adversely affects our capital or constrains our ability to adequately price insurance coverage, may occur in the future. In recent years, insurers have been under pressure from state insurance regulators, legislatures and special interest groups to reduce, freeze or set rates at levels that may not correspond with current underlying costs.
Regulators may limit our use of credit-based insurance scoring, adversely affecting our ability to effectively price our products.
We use credit-based insurance scoring as one means to price our products. Insurance companies have been criticized for using credit-based insurance scoring as a means to improve underwriting results. There are many variations of credit-based insurance scoring formulas and projections used by insurance companies. We use a form of credit- based insurance scoring which projects a numerical score ranging from 200 to 900 (“Insurance Score”), with the higher number indicating a better score, based on information in a person’s credit report maintained by one of the several national credit reporting firms. An Insurance Score, like a credit score, is based on various factors such as payment history, collections, credit utilization and bankruptcies. The score is used to predict how often you are likely to file claims, and how expensive those claims will be.
On January 12, 2005, the Governor of Michigan and the Commissioner of the Office of Financial and Insurance Regulation (“OFIR”) issued proposed rules to reduce base insurance rates and ban the use of insurance credit scores as a rating factor or as a basis to refuse to insure or limit coverage on personal insurance. Personal insurance includes private passenger automobile, homeowners, motorcycle, boat, personal watercraft, snowmobile, recreational vehicle, mobile-homeowners and non-commercial dwelling fire lines. The proposed ban was to be effective on July 1, 2005. The Insurance Institute of Michigan (“IIM”), of which the Company is a member, mounted a legal challenge to the ban and filed a suit on March 25, 2005 in Barry County Circuit Court seeking relief from the proposed ban. On April 25, 2005 the Circuit Court issued a final order in the matter of IIM et al v. OFIR, pertaining to insurers’ use of insurance credit scores to provide discounts on personal lines of insurance. In the final order the Circuit Court ruled in favor of IIM, ordering that Plaintiff’s request for declaratory relief is granted, and the OFIR rules, R 500.2151-2155 were declared illegal, invalid and unenforceable. It was further ordered that Defendant was permanently enjoined from enforcing these rules.
The Commissioner of the OFIR filed an appeal to this ruling in the Michigan Court of Appeals. The appeal was heard before the appellate court on October 10, 2006. In a 2-1 decision, the Michigan Court of Appeals on September 22, 2008 vacated the Barry County Circuit Court and ruled that the administrative rules to ban the use of credit-based insurance scoring were valid. The industry had been prepared in the event of an unfavorable ruling and on October 2, 2008 IIM has sought leave to appeal that decision to the Michigan Supreme Court. The Supreme Court agreed to hear the case and the case was presented to the court on October 7, 2009. Until a decision is rendered, which is not expected until late spring 2010 at the earliest, the stay remains in effect and we will continue to utilize insurance scoring as a pricing tool.
Even if successful on appeal, other reform legislation or regulatory action by OFIR could limit the effective use of this underwriting measure.
We believe that a higher Insurance Score indicates a lower expected risk of loss. If regulators were to restrict or prohibit our use of insurance scoring, it could impede us from effectively pricing our products.
Assessments and other surcharges for guaranty funds, second-injury funds and other mandatory pooling arrangements may reduce our profitability.
We participate in the Michigan Property and Casualty Guaranty Association (“MPCGA”), which protects policyholders and claimants against losses due to insolvency of insurers. When insolvency occurs, the MPCGA is authorized to assess member companies up to the amount of the shortfalls of funds, including expenses. Member companies are assessed based on the type and amount of insurance written during the previous calendar year. We recognize a liability for insurance related assessments when an assessment has been imposed or information
available indicates it is probable that an assessment will be imposed, or an event obligating us to pay an imposed or probable assessment has occurred and the amount of the assessment can be reasonably estimated.
The Michigan Basic Property Insurance Association (“MBPIA”) provides basic insurance to property-owners who cannot obtain insurance through insurance carriers in the normal course of business due to a high-risk exposure. The MBPIA assesses insurance carriers in Michigan a fee for continuation of the association based on the amount of losses incurred by the association and the amount of net written premium of the carrier related to property insurance.
We cannot predict with certainty the amount of future assessments for these programs. Significant assessments could have a material adverse effect on our financial condition and results of operations and mandatory shared-market mechanisms or changes in them could reduce our profitability in any given period or limit our ability to grow our business.
Michigan’s regulatory environment restricts our ability to exclude potentially unprofitable risks.
Michigan’s laws and regulations, specifically the Michigan Essential Insurance Act (“MEIA”), limit our ability to cancel or refuse to renew personal automobile and homeowner policies and subject program withdrawals to prior approval by OFIS. The MEIA requires an insurer to insure every applicant for insurance that meets the minimum requirements and the insurer’s underwriting rules. The underwriting rules must be applied uniformly to all applicants and policyholders. Each insurer must file its underwriting rules with OFIR. In addition, MEIA limits rating criteria that insurers may employ, requires insurers to develop a “secondary” or merit rating plan under which premium surcharges are levied on poor drivers, establishes a joint underwriting association to provide insurance to individuals who cannot obtain coverage in the insurance market, and regulates other types of coverage and informational requirements.
Inflation could increase the cost of claims resolutions and hurt our profitability.
Changes in the severity of claims have an impact on the profitability of our business. Changes in bodily injury claim severity are driven primarily by inflation in the medical sector of the economy. Changes in auto physical damage claim severity are driven primarily by inflation in auto repair costs, auto parts prices and used car prices. Changes in homeowners insurance claims severity are driven by inflation in the construction industry, in building materials and in home furnishings and other economic and environmental factors. However, changes in the level of the severity of claims that we pay do not necessarily match or track with changes in the rate of inflation in these various sectors of the economy.
Acts of terrorism may adversely impact our financial results.
We are continuing to examine the potential exposure of our operations to acts of terrorism. In the event that a terrorist act occurs, we do not anticipate material direct losses from claims by our insureds, but our reinsurers may suffer significant losses that could adversely affect our reinsurers’ ability to provide adequate reinsurance coverage and our ability to obtain cost effective reinsurance coverage.
Federal regulation of insurers may have a material effect on our operations.
Although the federal government does not currently directly regulate the insurance business, there have been proposals, especially after the financial crisis in 2008 and 2009, to impose federal regulation on the insurance industry, to establish a federal office of insurance or to allow an optional federal charter for insurance companies. Some legislative proposals being considered could, if enacted, give one or more federal regulators supervisory authority over a number of financial services companies, including insurance companies, viewed as systemically important. This authority could include the ability to impose regulation and market conduct rules. Such proposals or other additional federal regulation, if adopted and applicable to us, could impose significant burdens on us, including impacting the ways in which we conduct our business, increasing compliance costs and duplicating state regulation.
Even if we are not subject to regulation by the federal government, significant financial sector regulatory reform could have a significant impact on us. For example, regulatory reform could have an unexpected impact on our rights as a creditor or on our competitive position. Some legislative proposals may impose assessments on property and casualty insurance companies and related entities to pay for the resolution of other financial institution failures or insolvencies. Such costs could be material to us and difficult for us to estimate. Other potential changes in federal legislation, regulation and administrative policies, including the potential repeal of the McCarran-Ferguson Act and potential changes in federal taxation, could also significantly harm the insurance industry, including us.
State or federal insurance laws or regulations that are adopted or amended may be more restrictive than current laws or regulations and may result in lower revenues and higher costs of compliance and thus could materially and adversely affect our results of operations and limit our growth.
The Gramm-Leach-Bliley Act of 1999 allows banks to affiliate with insurers, which may increase the number and financial strength of our competitors.
The Gramm-Leach-Bliley Act of 1999 permits mergers that combine commercial banks, insurers and securities firms under one holding company. Until passage of the Gramm-Leach-Bliley Act of 1999, the Glass Steagall Act of 1933 had limited the ability of banks to engage in securities-related businesses and the Bank Holding Company Act of 1956 had restricted banks from being affiliated with insurers. With the passage of the Gramm-Leach-Bliley Act of 1999, bank holding companies may acquire insurers and insurance holding companies may acquire banks. In addition, grandfathered unitary thrift holding companies may engage in activities that are not financial in nature. The ability of banks to affiliate with insurers may materially and adversely affect our product lines by substantially increasing the number, size and financial strength of potential competitors.
Anti-takeover provisions in our articles of incorporation and bylaws may discourage takeover attempts and prevent or frustrate attempts to replace or remove our management, which could limit your opportunity to receive a high value for your stock if another company seeks to acquire us.
Our articles of incorporation and bylaws contain provisions that have the effect of discouraging or preventing takeover attempts not supported by our Board of Directors. In addition, these provisions may also prevent or frustrate attempts to replace or remove our management. Management entrenchment may also have the effect of discouraging potential purchasers from making takeover offers. Examples of these provisions include, among other things:
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Staggered three-year terms for the members of the board of directors;
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Super-majority provisions for amendment of our articles of incorporation or bylaws;
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Provisions allowing the directors to issue preferred stock with voting rights;
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Provisions that require the board of directors, before it approves, adopts or recommends any offer of any person to make a tender or exchange offer for any stock of the Company, to merge or consolidate the Company with any other entity, or to purchase or acquire all or substantially all of the Company’s assets, to evaluate the offer and determined that it would be in compliance with all applicable laws and that the offer is in the best interests of the Company and its shareholders; and
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The shareholder rights plan.
In addition, the Michigan Insurance Code provides that no person may acquire control (ownership of 10% of the voting power is presumed control) without approval of the Commissioner of OFIR (“Insurance Commissioner”).
Takeover attempts generally include offering shareholders a premium for their stock. Therefore, preventing a takeover attempt may cause you to lose an opportunity to sell your shares at a premium.
The current financial crisis has resulted in unprecedented levels of market volatility. Governmental initiatives intended to alleviate the crisis that have been adopted may not be effective and, in any event, may be accompanied by other initiatives, including new capital requirements or other regulations, that could materially affect our results of operations, financial condition and liquidity in ways that we cannot predict.
Markets in the United States and elsewhere have been experiencing extreme volatility and disruption for the past 2 years, due in part to the financial stresses affecting the liquidity of the banking system and the financial markets generally. These circumstances have also exerted downward pressure on stock prices and reduced access to the debt markets. This unprecedented market volatility and general decline in the equity markets has directly and materially affected our results of operations and our investment portfolio.
Legislation has been passed in an attempt to stabilize the financial markets. This legislation includes a provision to grant the U.S. Treasury Department the authority to, among other things, purchase up to $700 billion of mortgage-backed and other securities from financial institutions. This legislation or similar proposals, as well as companion actions such as monetary or fiscal actions of the U.S. Federal Reserve Board or comparable authorities in other countries, may fail to stabilize the financial markets. This legislation and other proposals or actions may also have other adverse consequences, including material effects on interest rates and foreign exchange rates, which could materially affect our investments, results of operations and liquidity in ways that we cannot predict. Further legislative activity or the failure to effectively implement existing or future legislation and related proposals or actions could also result in material adverse effects, notably increased constraints on the liquidity available in the banking system and financial markets and increased pressure on stock prices, any of which could materially and adversely affect our results of operations, financial condition and liquidity. In the event of future material deterioration in business conditions, we may need to raise additional capital or consider other transactions to manage our capital position or our liquidity.
In addition, we are subject to extensive laws and regulations that are administered and enforced by a number of different governmental authorities and non-governmental self-regulatory agencies, including state insurance regulators, state securities administrators, the Securities and Exchange Commission, the U.S. Department of Justice and state attorneys general. In light of the current financial crisis, some of these authorities are or may in the future consider enhanced or new regulatory requirements intended to prevent future crises or otherwise assure the stability of institutions under their supervision. These authorities may also seek to exercise their supervisory or enforcement authority in new or more robust ways. All of these possibilities, if they occurred, could affect the way we conduct our business and manage our capital, and may require us to satisfy increased capital requirements, any of which in turn could materially affect our results of operations, financial condition and liquidity.
The markets in the United States and elsewhere have been experiencing extreme and unprecedented volatility and disruption. We are exposed to significant financial and capital markets risk, including changes in interest rates and equity prices which may adversely affect our results of operations, financial condition or liquidity.
The markets in the United States and elsewhere have been experiencing extreme and unprecedented volatility and disruption. We are exposed to significant financial and capital markets risk, including changes in interest rates and equity prices. Our exposure to interest rate risk relates primarily to the market price and cash flow variability associated with changes in interest rates. A rise in interest rates, in the absence of other countervailing changes, will increase the net unrealized loss position of our investment portfolio. If significant, declines in equity prices and changes in U.S. interest rates could have a material adverse effect on our consolidated results of operations, financial condition or liquidity. In addition, in the conduct of our business, there could be scenarios where in order to fulfill our obligations and to raise incremental liquidity, we would need to sell assets at a loss due to the unrealized loss position in our overall investment portfolio and the lack of liquidity in the credit markets.
Losses due to defaults by others, including issuers of investment securities or reinsurance and derivative instrument counterparties, could adversely affect the value of our investments, results of operations, financial condition or cash flows.
Issuers or borrowers whose securities or loans we hold, customers, reinsurers, clearing agents, exchanges, clearing houses and other financial intermediaries and guarantors may default on their obligations to us due to bankruptcy, insolvency, lack of liquidity, adverse economic conditions, operational failure, fraud or other reasons. Such defaults could have a material adverse effect on our results of operations, financial condition and cash flows.
Our investment portfolio includes investment securities in the financial services sector that have experienced defaults recently. Further defaults could have a material adverse effect on our results of operations, financial condition or cash flows. The Company is not exposed to any credit concentration risk of a single issuer greater than 10% of the Company’s stockholders’ equity other than U.S. government and U.S. government agencies backed by the full faith and credit of the U.S. government. However, if issuers or borrowers, whose securities or loans we hold, are acquired, merge or otherwise consolidate with other issuers or borrowers whose securities or loans we hold, the Company’s credit concentration risk could increase above the 10% threshold, for a period of time, until the Company is able to sell securities to get back in compliance with the established investment credit policies.
The amount of statutory capital that we have and the amount of statutory capital that we must hold to maintain our financial strength and credit ratings and meet other requirements can vary significantly from time to time and is sensitive to a number of factors outside of our control, including equity market and credit market conditions and changes in rating agency models.
We conduct our business through our licensed insurance company subsidiary. Accounting standards and statutory capital and reserve requirements for this entity are prescribed by the applicable insurance regulators and the National Association of Insurance Commissioners (“NAIC”). The NAIC has established regulations that provide minimum capitalization requirements based on risk-based capital (“RBC”) formulas for property and casualty companies. The RBC formula for property and casualty companies adjusts statutory surplus levels for certain underwriting, asset, credit and off-balance sheet risks.
In any particular year, statutory surplus amounts and RBC ratios may increase or decrease depending on a variety of factors - the amount of statutory income or losses generated by our insurance subsidiary (which itself is sensitive to equity market and credit market conditions), the amount of additional capital our insurance subsidiary must hold to support business growth, changes in equity market levels, the value of certain fixed-income and equity securities in our investment portfolio, the value of certain derivative instruments that do not get hedge accounting, changes in interest rates and changes to the NAIC RBC formulas. Most of these factors are outside of the Company’s control. The Company’s financial strength and credit ratings are significantly influenced by the statutory surplus amounts and RBC ratios of our insurance company subsidiary. In addition, rating agencies may implement changes to their internal models that have the effect of increasing or decreasing the amount of statutory capital we must hold in order to maintain our current rating.
To the extent that our statutory surplus is deemed to be insufficient to maintain a particular rating by one or more rating agencies, we may seek to raise additional capital through public or private equity or debt financing. Alternatively, if we were not to raise additional capital in such a scenario, either at our discretion or because we were unable to do so, our financial strength and credit ratings might be downgraded by one or more rating agencies.
We may experience a downgrade in our financial strength or credit ratings, which may make our products less attractive, which would have an adverse effect on our business, results of operations, financial condition and liquidity.
Financial strength and credit ratings are an important factor in establishing the competitive position of insurance companies. Rating agencies assign ratings based upon several factors. While most of the factors relate to the rated company, some of the factors relate to the views of the rating agency, general economic conditions, and circumstances outside the rated company’s control. In addition, rating agencies may employ different models and formulas to assess the financial strength of a rated company, and from time to time rating agencies have, in their discretion, altered these models. Changes to the models, general economic conditions, or circumstances outside our control could impact a rating agency’s judgment of its rating and the rating it assigns us. We cannot predict what actions rating agencies may take, or what actions we may be required to take in response to the actions of rating agencies, which may adversely affect us.
Our financial strength ratings, which are intended to measure our ability to meet policyholder obligations, are an important factor affecting public confidence in most of our products and, as a result, our competitiveness. A downgrade, or an announced potential downgrade in the rating of our financial strength or of our insurance subsidiary could affect our competitive position in the insurance industry and make it more difficult for us to market our products, as potential customers may select companies with higher financial strength ratings.
The Company is Affected by General Economic Conditions in the State of Michigan.
The Company is affected by general economic conditions in the U.S., although most directly within Michigan. A further economic downturn or continued weak business environment within Michigan could negatively impact household and corporate incomes. This impact may lead to decreased demand for both loan and deposit products and increase the number of customers who fail to pay interest or principal on their loans.
Other factors not currently anticipated by management may also materially and adversely affect our financial position and results of operations. We do not undertake, and expressly disclaim, any obligation to update or alter our statements, whether as a result of new information, future events or otherwise, except as required by applicable law.
ITEM 2.
ITEM 2. PROPERTIES
We own our office, located at 933 E. Main Street, Fremont, Michigan, which is a 30,000 square foot brick veneer building constructed in 1981. There is no mortgage indebtedness on the building. Management believes that the building is sufficient for the needs of the Company, both now and in the foreseeable future.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is party to litigation in the normal course of business. Based upon information presently available to us, we do not consider any litigation to be material. However, given the uncertainties attendant to litigation, we cannot be sure that our results of operations and financial condition will not be materially adversely affected by any litigation.
ITEM 4.
ITEM 4. RESERVED
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Quotes on our common stock are published on the OTC Bulletin Board (“OTCBB”) under the symbol “FMMH”. We consider our common stock to be thinly traded, therefore, any reported bid or ask price may not reflect a true market-based valuation. The following table sets forth the high and low bid prices of our common stock as reported on the OTCBB and our quarterly dividends declared during the periods indicated. These bid quotations are inter-dealer prices without retail mark-up or mark-down or commissions and may not necessarily represent actual transactions.
Any payment of dividends in the future on the common stock is subject to determination and declaration by the Company’s Board of Directors, who will take into consideration the Company’s financial condition, results of operations and future prospects. The Holding Company’s principal source of cash available for payment of dividends is dividends from the Insurance Company. The payment of dividends by the Insurance Company is subject to limitations imposed by the Michigan Insurance Code. Information regarding restrictions and limitations on the payment of cash dividends can be found in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the “Liquidity and Capital Resources” section.
As of February 26, 2010, the Company had 64 shareholders of record. For purposes of this determination, Cede & Co., the nominee for the Depositary Trust Company which holds all but 19,543 shares of the Company’s outstanding shares, is treated as one holder.
Information relating to securities authorized for issuance under equity compensation plans is set forth under Part III, Item 12 of this report and is incorporated herein by reference.
On November 25, 2008, the Company’s Board of Directors adopted the Agent Stock Purchase Plan (“Plan”). The Plan provides for the sale of up to 100,000 shares of the Company’s Class A Common Stock over the five year estimated term of the Plan. The Plan has been established by the Company to provide incentive to independent insurance agencies that sell products and services of its subsidiary, Fremont Insurance Company, by enabling them to participate in the Company’s long-term growth and success and to help align their success with the interests of the Company’s stockholders.
The Common Stock offered by the Company under this Plan will not have been registered with, or approved, by the United States Securities and Exchange Commission (“SEC”). The offering of the Common Stock under the Plan is based on an exemption from such registration as set forth in §4(2) of the Securities Act of 1933, as amended (“Act”), and Rule 506 of Regulation D issued under the Act. The offering is being made only to eligible agencies of the Insurance Company and eligible persons designated by those agencies who are
“accredited investors” as defined under Regulation D issued under the Act and to not more than 35 eligible persons in any 12 month period who may not be accredited investors, but are “sophisticated” investors. Resales of the unregistered Class A Common Stock will require registration or the availability of an exemption to registration such as SEC Rule 144.
The Common Stock will be offered directly to participants through our officers, and we will not use a broker or a dealer. We will not pay commissions, discounts or any other payments to any person for services in connection with the offer or sale of shares under the Plan. Participants will not incur brokerage commissions or service charges. The Company intends to use the proceeds of this offering for general corporate purposes which include making investments in and advances to the Insurance Company, which in turn will use the proceeds for general corporate purposes.
The following table sets forth the sales of unregistered securities under the Plan during the year ended December 31, 2009:
The following table sets forth the repurchases of common stock for the quarter ended December 31, 2009:
(1) On May 8, 2008, the Company announced a share repurchase plan for up to 100,000 shares of common stock.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The following table sets forth selected financial data for the Company. You should read this data in conjunction with the Company’s consolidated financial statements and accompanying notes, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial information included elsewhere in this report.
(1) In 2005, the Company recorded a federal income tax benefit of $1,152,000 despite having pre-tax income of $7,930,000. The federal income tax benefit was due to the Company recognizing a $3,855,000 reduction in its deferred tax valuation allowance in 2005. See Note 5 to the consolidated financial statements, included elsewhere in this report, for further information regarding federal income taxes.
(2) The net loss and loss adjustment expense (LAE) ratio is the net loss and LAE in relation to net premium earned.
(3) The expense ratio is the policy acquisition and other underwriting expenses in relation to net premium earned.
(4) The sum of net losses, loss adjustment expenses and policy acquisition and other underwriting expenses divided by net premiums earned. A combined ratio of less than 100% means a company is making an underwriting profit.
(5) The ratio of net premiums written divided by ending statutory surplus.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following presents management’s discussion and analysis of our financial condition and results of operations as of the dates and for the periods indicated. You should read this discussion in conjunction with the consolidated financial statements and notes thereto included in this report, and the narrative under the “Business” heading contained in Item 1 of this report. The following discussion contains forward-looking information that involves risks and uncertainties. Actual results could differ significantly from these forward-looking statements. See “Forward-Looking Statements”.
Critical Accounting Policies and Estimates
General. Our discussion and analysis of financial condition, results of operations and liquidity and capital resources is based upon the consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. We generally base our estimates on historical experience or other appropriate assumptions that we believe are reasonable and relevant under the circumstances and evaluate them on an ongoing basis. The results of these estimation processes form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
We believe the critical accounting policies and estimates discussed below reflect our more significant judgments and estimates used in the preparation of the consolidated financial statements. These may be further commented upon in applicable sections on Results of Operations and Liquidity and Capital Resources that follow. Information about the significant accounting policies we use in the preparation of our financial statements is included in Note 1-Significant Accounting Policies to the consolidated financial statements included in Item 8. Financial Statements and Supplementary Data.
Liabilities for Loss and Loss Adjustment Expenses. The liability for losses and loss adjustment expenses represents estimates of the ultimate unpaid cost of all losses incurred, including losses for claims that have not yet been reported. The amount of loss reserves for reported claims is based primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss. The amounts of loss reserves for unreported claims and loss adjustment expenses are determined using historical information by line of insurance as adjusted to current conditions. Inflation is ordinarily implicitly provided for in the reserving function through analysis of costs, trends and reviews of historical reserving results over multiple years.
Reserves are closely monitored and are recomputed periodically using the most recent information on reported claims and a variety of statistical techniques. Specifically, on a quarterly basis, we review existing reserves, new claims, changes to existing case reserves, and paid losses with respect to the current and prior accident years. We use historical paid and incurred losses and accident year data to derive expected ultimate loss and loss adjustment expense ratios by line of business. We then apply these expected loss and loss adjustment expense ratios to earned premium to derive a reserve level for each line of business. In connection with the determination of the reserves, we also consider other specific factors such as recent weather-related losses, trends in historical paid losses, and legal and judicial trends with respect to theories of liability. Some of our business relates to coverage for short-term risks, and for these risks loss development is comparatively rapid and historical paid losses, adjusted for known variables, have been a reliable predictive measure of future losses for purposes of our reserving. Some of our business relates to longer-term risks, where the claims are slower to emerge and the estimate of damage is more difficult to predict. For these lines of business, more sophisticated actuarial methods, such as the Bornhuetter-Ferguson loss development methods (see “Methods” below) must be employed to project an ultimate loss expectation, and then the related loss history must be regularly evaluated and loss expectations updated, with the possibility of variability from the initial estimate of ultimate losses.
When a claim is reported to us, our claims representatives establish a “case reserve” for the estimated amount of the ultimate payment. This estimate reflects an informed judgment based upon general insurance reserving practices and on the experience and knowledge of the estimator. The individual estimating the reserve considers the nature and value of the specific claim, the severity of injury or damage, and the policy provisions relating to the type of loss. Case reserves are adjusted by our claims staff as more information becomes available. It is our policy to settle each claim as expeditiously as possible.
We maintain incurred but not reported (“IBNR”) reserves to provide for already incurred claims that have not yet been reported and developments on reported claims. The IBNR reserve is determined by estimating our ultimate net liability for both reported and IBNR claims and then subtracting the case reserves and payments made to date for reported claims.
Methods Used to Estimate Loss & Loss Adjustment Expense Reserves. We applied the following general methods in projecting loss and loss adjustment expense reserves:
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Incurred loss development
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Paid loss development
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Bornhuetter-Ferguson incurred loss development
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Bornhuetter-Ferguson paid loss development
Description of Ultimate Loss Estimation Methods. The incurred loss development method relies on the assumption that, at any given state of maturity, ultimate losses can be predicted by multiplying cumulative reported losses (paid losses plus case reserves) by a cumulative development factor. The validity of the results of this method depends on the stability of claim reporting and settlement rates, as well as the consistency of case reserve levels. Case reserves do not have to be adequately stated for this method to be effective; they only need to have a fairly consistent level of adequacy at all stages of maturity. Historical “age-to-age” loss development factors were calculated to measure the relative development of an accident year from one maturity point to the next. We then selected appropriate age-to-age loss development factors based on these historical factors and used the selected factors to project the ultimate losses.
The paid loss development method is mechanically identical to the incurred loss development method described above. The paid method does not rely on case reserves or claim reporting patterns in making projections.
The validity of the results from using a loss development approach can be affected by many conditions, such as internal claim department processing changes, a shift between single and multiple claim payments, legal changes, or variations in a company’s mix of business from year to year. Also, since the percentage of losses paid for immature years is often low, development factors are volatile. A small variation in the number of claims paid can have a leveraging effect that can lead to significant changes in estimated ultimates. Therefore, ultimate values for immature accident years are often based on alternative estimation techniques.
The Bornhuetter-Ferguson expected loss projection method based on incurred loss data relies on the assumption that remaining unreported losses are a function of the total expected losses rather than a function of currently reported losses. The expected losses used in this analysis were selected judgmentally. The expected losses are multiplied by the unreported percentage to produce expected unreported losses. The unreported percentage is calculated as one minus the reciprocal of the selected incurred loss development factors. Finally, the expected unreported losses are added to the current reported losses to produce ultimate losses.
The calculations underlying the Bornhuetter-Ferguson expected loss projection method based on paid loss data are similar to the incurred Bornhuetter-Ferguson calculations with the exception that paid losses and unpaid percentages replace reported losses and unreported percentages.
The Bornhuetter-Ferguson method is most useful as an alternative to other models for immature accident years. For these immature years, the amounts reported or paid may be small and unstable and therefore not predictive of future development. Therefore, future development is assumed to follow an expected pattern that is supported by more stable historical data or by emerging trends. This method is also useful when changing reporting patterns or payment patterns distort the historical development of losses. As noted below, the Company tends to rely more heavily on the incurred Bornhuetter-Ferguson method for its most recent accident years due to the smaller size of each line of business and the instability in incurred and paid amounts.
In estimating our loss reserves for the multi-peril lines of business (homeowners, farmowners and commercial), as well as the personal and commercial auto liability lines of business and the general liability line of business we relied on the incurred Bornhuetter-Ferguson method for accident years 2006 to 2009 and the incurred loss development for accident years prior to 2006.
For the property lines of business including special property and personal and commercial auto physical damage we relied on the incurred Bornhuetter-Ferguson method for accident years 2007 to 2009 while the incurred loss development method was used for accident years prior to 2007.
For the workers’ compensation line of business we relied on an average of the incurred and paid Bornhuetter-Ferguson methods for accident years 2005 to 2009 and the paid loss development method for all prior years. This is different than the approach we took as of December 31, 2008. At December 31, 2008, we relied on the incurred Bornhuetter-Ferguson method for the most recent 6 accident years (2003 - 2008) and the incurred loss development method for all prior years. In the workers’ compensation line there are a lot of smaller partial payments over the claim settlement period (which can span several years). While case reserves and incurred losses provide good information, the paid method has more importance particularly when comparing our results to industry trends. Given the continued growth in the workers’ compensation line, we plan to rely more on paid indicators for the older accident years moving forward. Typically, the paid method will also provide a more conservative estimate of the ultimate loss which we feel is an important consideration in establishing our loss reserves.
Each quarter, we review our loss reserves to ascertain whether new developments have occurred which would require adjustment to our ultimate loss estimates. The quarterly review involves roundtable discussion involving the claims, accounting and underwriting departments. Discussion is generally focused on claims involving liability and those claims that involve significant judgment. Because the establishment of loss reserves is an inherently uncertain process, we cannot be certain that ultimate losses will not exceed the established loss reserves and have a material adverse effect on the Company’s results of operations and financial condition. Changes in estimates, or differences between estimates and amounts ultimately paid, are reflected in the operating results of the period during which such adjustments are made.
Reserves are estimates because there are uncertainties inherent in the determination of ultimate losses. Court decisions, regulatory changes and economic conditions can affect the ultimate cost of claims that occurred in the past as well as create uncertainties regarding future loss cost trends. Accordingly, the ultimate liability for unpaid losses and loss adjustment expenses will likely differ from the amount recorded at December 31, 2009.
The following table shows the breakdown of our gross loss reserves between reported losses and IBNR losses by segment (in thousands):
The following table shows the activity in the loss and LAE reserve balances of the Company for the years ended December 31, 2009, 2008 and 2007, prepared in accordance with accounting principles generally accepted in the United States of America.
In 2009, the Company experienced favorable development of $2,336,000 on loss and loss adjustment expense (LAE) reserves for prior accident years. In the personal segment, homeowners had redundant development of $760,000, personal auto experienced redundant development of $853,000 and other personal segment products had redundant development of $8,000. In the commercial segment, commercial multi-peril had redundant development of $660,000 offset by adverse development in workers compensation of $129,000. The development experienced in the workers compensation line was concentrated in accident years 2003, 2005 and 2007. The farm segment experienced redundant development of $63,000 while the marine segment had redundant development of $121,000.
In 2008, the Company experienced favorable development on losses and LAE reserves for prior accident years of $2,722,000. The redundant development included $814,000 related to homeowners, $864,000 related to commercial multi-peril, $336,000 related to workers compensation, $179,000 related to farm, $204,000 relating to general liability while the remaining lines of business had redundant development of $325,000. The favorable development was concentrated in accident years 2005 through 2007 and is a result of downward development on both case and incurred but not reported reserves and loss adjusting expense reserves. There were no significant changes in the key assumptions utilized in the analysis and calculations of the Company’s reserves during 2008.
In 2007, the Company experienced favorable development on losses and LAE reserves for prior accident years of $4,132,000. The redundant development included $1,334,000 related to homeowners, $939,000 related to personal auto, $873,000 related to commercial multi-peril, $280,000 related to workers compensation, $281,000 related to farm while the remaining lines of business had redundant development of $425,000. The favorable development was concentrated in accident years 2004 through 2006 and is a result of downward development on both case and incurred but not reported reserves and loss adjusting expense reserves. There were no significant changes in the key assumptions utilized in the analysis and calculations of the Company’s reserves during 2007.
The following table shows the development of our reserves for unpaid losses and LAE on a GAAP basis for each of the years ended December 31, from 1999 to 2009. The line in the table titled “Net liability for loss and LAE,” shows the initial reserves at the balance sheet date, including losses and LAE incurred but not reported. The portion of the table titled “Cumulative net paid as of,” shows the cumulative amounts subsequently paid as of successive years with respect to the reserve shown at the top of the table. The portion of the table titled “Re-estimated net liability as of:” shows the re-estimated amount of the previously reported liability for loss and LAE based on experience as of the end of each succeeding year. The estimates of liability for loss and LAE change as more information becomes available about the frequency and severity of claims for individual years. A redundancy (or deficiency) exists when the re-estimated amount of liability at each December 31 is less (or greater) than the prior liability estimate. The “Net cumulative redundancy (deficiency)” depicted in the table, for any particular calendar year, represents the aggregate change in the initial estimates over all subsequent calendar years and does not present accident year loss development. The portion of the table titled “Gross liability end of year” shows the impact of reinsurance for the years shown, reconciling the net reserves in the upper portion of the table to gross reserves. In evaluating the re-estimated liability and cumulative redundancy (deficiency), it should be noted that each data point includes the effects of changes in amounts for prior periods. Conditions and trends that have affected development of the liability in the past may not necessarily exist in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table.
Investments. At December 31, 2009 and 2008, all of the Company’s investments are classified as available-for-sale and are those investments that would be available to be sold in response to the Company’s liquidity needs, changes in market interest rates and asset-liability management strategies, among others. Available-for-sale investments are recorded at fair value, with the corresponding unrealized appreciation or depreciation, net of deferred income taxes, reported as a component of accumulated other comprehensive income or loss until realized.
The Company reviews the status and market value changes of its investment portfolio on at least a quarterly basis during the year, and any provisions for other-than-temporary impairments in the portfolio’s value are evaluated and established at each quarterly balance sheet date. When a fixed maturity security has a decline in value, where fair value is below amortized cost, an OTTI write-down is triggered in circumstances where (1) the Company has the intent to sell the security, (2) it is more-likely-than-not that the Company will be required to sell the security before recovery of its amortized cost basis, or (3) the Company does not expect to recover the entire amortized cost basis of the security. If the Company intends to sell the security or if it is more-likely-than-not the Company will be required to sell the security before recovery, an OTTI write-down is recognized as a realized loss in the statement of operations equal to the difference between the security’s amortized cost and its fair value. If the Company does not intend to sell the security or it is not more-likely-than-not that the Company will be required to sell the security before recovery, the OTTI write-down is separated into an amount representing the credit loss, which is recognized as a realized loss in the statement of operations, and the amount related to all other factors, which is recognized in other comprehensive income.
When an equity security has a decline in value, where fair value is below cost, that is deemed to be other than temporary, the Company reduces the book value of such security to its current fair value, recognizing the decline as a realized loss in the statement of operations. Any future increases in the market value of investments written down are reflected as changes in unrealized gains as part of accumulated other comprehensive income within stockholders’ equity.
In reviewing its fixed maturity securities for other than temporary impairment, the Company takes into consideration the security’s market price history, the length of time that the security’s fair value has been below cost, the issuer’s operating results, financial condition and liquidity, its ability to access capital markets, credit rating trends, most current audit opinion, industry and securities market conditions, and analyst expectations, to reach its conclusions.
In reviewing its equity securities, which include common stock and mutual funds, the Company takes into consideration the security’s market price history, the length of time that the security’s fair value has been below cost, the individual investments held within the mutual fund, most current audit opinion, industry and securities market conditions, and analyst expectations to reach its conclusions. In addition to analyzing each individual security that has a fair value below cost, the Company also considers its intent and ability to hold a security until its fair value is equal to or greater than its cost.
Reinsurance. Net premiums earned, losses and LAE and policy acquisition and other underwriting expenses are reported net of the amounts related to reinsurance ceded to other companies. Amounts recoverable from reinsurers related to the portions of the liability for losses and LAE and unearned premiums ceded to them are reported as assets. Reinsurance assumed from other companies, including assumed premiums written and earned and losses and LAE, is accounted for in the same manner as direct insurance written.
Reinsurance recoverables include balances due from reinsurance companies for paid and unpaid losses and LAE that will be recovered from reinsurers, based on contracts in force. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Reinsurance contracts do not relieve the Company from its primary obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers and monitors concentrations of credit risk with respect to the individual reinsurer that participates in its
ceded programs to minimize its exposure to significant losses from reinsurer insolvencies. When necessary the Company holds collateral in the form of letters of credit or trust accounts for amounts recoverable from reinsurers that are not considered authorized insurers by the State of Michigan Office of Financial and Insurance Regulation.
Federal Income Taxes. Deferred federal income tax assets and liabilities are recognized for the expected future tax consequences attributable to differences between the financial statement carrying amount of assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which these temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized.
Results of Operations-Fiscal Years Ended December 31, 2009 and 2008
Consolidated Results of Operations. The following table shows the underwriting gain or loss as well as other revenue and expense items included in our consolidated statements of income for the years ended December 31, 2009 and 2008. The Company’s underwriting gain or loss consists of net premiums earned less loss and LAE and policy acquisition and other underwriting expenses. The Company’s underwriting performance is the most important factor in evaluating the overall results of operations given the fluctuations which can occur in loss and LAE due to weather related events as well as the uncertainties involved in the process of estimating reserves for losses and LAE. The underwriting results and the fluctuations in other revenue and expense items are discussed in greater detail below.
Underwriting Results. The following table shows the components of the Company’s underwriting gain or loss for the years ended December 31, 2009 and 2008.
Premiums. Direct premiums written by major business segment for the years ended December 31 was as follows:
During 2009, we continued to expand our market share in Michigan evidenced by a 9.8% increase in direct premiums written. The growth that we experienced in 2009 as well as over the last several years is a direct result of our continued focus on developing mutually beneficial relationships with our independent agents. We believe that we have the best and most profitable agencies representing us in the State of Michigan. The independent agent is on the front line when it comes to sending a policy to the Company. We continue to be very clear with our agents on the type of business that we want to write and we can be very selective in the type of business that we will accept from them. A component of that relationship is our ability to provide the agents with a consistent, competitive and stable market for their preferred business. In addition to strong agency relationships, our growth has also been positively affected by our Fremont Insurance Pure Michigan campaign which began in early 2009. The Pure Michigan campaign included print, billboard and television advertising. The campaign has increased Fremont Insurance’s brand awareness with Michigan consumers. We have found that Michigan consumers are more apt to do business with and in our case buy insurance from a carrier that is headquartered and solely focused on the Michigan consumer. We will continue to promote the fact that Fremont Insurance is Pure Michigan as we move into 2010.
Direct written premium was up 9.8%, with new business up 5.5% and renewal business up 10.7%. Personal auto continues to contribute to these results as planned. Direct premiums written for personal auto increased 15.5% with new business up 18.2% and renewal business up 15.0%. Growth in personal auto is driven by the ease of placing business with Fremont through our award winning web-based rating platform, Fremont Complete, coupled with several book of business transfers, account rounding of current homeowner business and a strong renewal retention ratio which is in the low 90s. Direct premiums written for the homeowners product was up 6.6%. Homeowner’s growth was driven by renewals which were up 8.1% offset by a decline in new business which was down 2.0%. Overall, personal lines direct premiums written was up 11.4%, with new business up 8.7% and renewals up 11.9%. In-force policy count increased 7.3% for the personal lines segment.
While the commercial segment, especially property driven accounts, continues to be hit hardest by the soft market, we were able to grow 6.0%. Growth was driven by commercial auto, up 26.7%, and workers compensation, up 32.9%. Contributing to the growth in workers compensation was a large premium audit charge to our largest account which was recorded in the fourth quarter. Businessowners (BOP) was up 0.1% while commercial multi-peril (CPP) was down 0.8%. Commercial in-force policy count continues to increase and was up 4.0% in 2009. We continue to focus on expanding our commercial segment. The current market conditions make this a challenge however we continue to write business which we feel is appropriately priced for the risk assumed. In 2010, we plan to add the commercial multi-peril product to our web based application system, which will make it easier for agents to quote and bind target market business with Fremont. Our experience has been that once our agents have the ability to quote and bind policies through Fremont Complete it makes the process much more efficient for them which leads to premium growth for us. In January 2010, we also added a seasoned commercial underwriter with over 30 years of industry experienced. We believe that by expanding our commercial book of business we can better diversify our risk profile.
Farm direct premiums written were up 7.7% driven by new business which was up 43.1% and renewals which were up 2.5%. The new business increase was impacted by a larger farm written during the first quarter of 2009. Direct premium written for the marine segment was basically flat (up 0.2%). Renewal premiums were up 4.8%, with new business premium down 21.7%. The flat marine volume is due to a competitive market place coupled with the Michigan economy. The farm in-force count was up slightly, at 0.7% and marine was down 0.7%.
Net premiums written by business segment for the years ended December 31 were as follows:
The increase in net premiums written is due to the overall increase in direct premiums written of $5,974,000 offset by an increase of $342,000 in ceded premiums written under the Company’s reinsurance agreements. The commercial segment experienced a decline in net premiums written due to increased premiums ceded under our treaty reinsurance programs as a result of increased reinsurance costs associated with commercial products.
Net premiums earned by major business segment for the years ended December 31 was as follows:
The increase in net premiums earned is due to the overall increase in direct premiums earned of $6,435,000 offset by an increase of $406,000 in ceded premiums earned under the Company’s reinsurance agreements. The commercial segment experienced a decline in net premiums earned due to increased premiums ceded under our treaty reinsurance programs as a result of increased reinsurance costs associated with commercial products.
Loss and Loss Adjustment Expenses (LAE). The Company’s net loss and LAE by major business segment as well as the loss and LAE ratio’s are shown in the tables below:
In 2009, the personal segment’s loss ratio dropped 2.9 percentage points to 66.2% compared to 69.1% in 2008. Items affecting the lower loss ratio include continued growth in net premiums earned, a decrease in loss severity in the personal auto line, redundant development on prior accident year losses in both the personal auto and homeowners lines offset by an increase in fire related losses experienced in 2009. During 2009, the personal segment’s net premium earned grew by 17.7% while incurred losses and LAE increased only 12.9%. The homeowners line contributed $1,753,000 to the increase in incurred losses and LAE for 2009 and was caused by increased fire related losses and to a lesser extent an increase in losses related to winter weather experienced during the first quarter of 2009.
In 2009, the commercial segment’s loss ratio increased to 56.8%. The loss ratio in 2009 was negatively affected by increased losses in commercial multi-peril, increased reinsurance costs resulting in lower net premiums earned for the commercial segment and increased incurred losses in the workers compensation line. These factors were partially offset by redundant loss development in all commercial product lines except for workers compensation. The increase in commercial multi-peril losses was driven by an increase in fire related losses in 2009.
The farm segment’s loss and LAE ratio dropped 3.8 percentage points as a result of lower weather related losses and a drop in claim frequency in 2009 as compared to 2008. The marine segment’s loss and LAE ratio increased 0.4 percentage points due to increased loss severity in 2009 as compared to 2008 offset by redundant development on prior accident year losses.
Policy Acquisition and Other Underwriting Expenses. Policy acquisition and other underwriting expenses for the years ended December 31 were as follows:
Amortization of deferred policy acquisition costs (“DAC”) increased 7.7% in 2009 as compared to 2008. The increase is a result of growth in earned premium volume. As a percentage of net premiums earned, DAC amortization decreased from 16.5% to 15.7% due to increased volume of personal automobile premium which pays a lower commission than other products as well as increased ceding commission. Other underwriting expenses increased $591,000 or 7.4% in 2009 compared to 2008. As a percentage of net premiums earned, other underwriting expenses decreased to 16.1% in 2009 compared to 16.9% in 2008. The decline is due to lower assessments from state mandated pools and associations, a decrease in depreciation expense and continued growth in net premiums earned.
Investment Income. The Company’s net investment income excluding realized gains and losses, average invested assets including cash and cash equivalents and the rate of return for the years ended December 31 are as follows:
Gross investment income from the fixed portfolio declined during 2009 compared to 2008. As interest rates remained at very low levels in 2009 compared to historic averages, the portfolio duration was decreased in order to lower market value volatility in the event of future rising interest rates. The average portfolio duration was 4.42 in 2009, compared to 5.10 in 2008. With a very steep yield curve exhibited in the market, this tended to reduce the portfolio’s income. Additionally, in 2009 the Company realized a large portion of the unrealized gains in the portfolio by selling securities with market values considerably greater than their book values. This was the primary catalyst for the reduction of the portfolio’s tax-equivalent book yield from 4.72% at December 31, 2008 to 4.24% at December 31, 2009.
The increase in income from the equity portfolio is due to higher dividend income as a result of the Company increasing its holdings of dividend paying common stocks. During the second quarter 2009, the Company began adding to its equity portfolio via purchases of common stocks and mutual funds. The increase in interest income from cash and cash equivalents was affected by approximately $73,000 in interest received in 2009 as a result of a settlement of a claim. Excluding this item, interest from cash and cash equivalents decreased approximately $62,000 due to the lower yield environment in 2009. Investment expenses are up as a result of an increase in general expenses associated with investment activities including management fees based on invested assets.
Net realized gains from the portfolio for the years ended December 31 are as follows:
In 2009, the Company sold approximately $22.5 million in fixed maturity securities which generated realized gains of $795,000. Sales within the equity portfolio generated realized gains of $11,000 on sales of $1,280,000 in 2009. In 2008, the Company generated net realized gains on the sale of fixed maturity securities of approximately $82,000 and a net realized loss of $362,000 as a result of a write-down of a fixed maturity security determined to be other than temporarily impaired.
Other Income, Net. Other income, net which includes premium installment charges, fees for non-sufficient fund checks, late payment fees and other miscellaneous income items increased 4.7% to $644,000 in 2009 compared to $615,000 in 2008. The increase was driven by premium volume growth in 2009.
Federal Income Tax. During the years ended December 31, 2009 and 2008, the Company recorded income tax expense of approximately $1,818,000 and $1,577,000, respectively. The increase is due to growth in pre-tax income in 2009 compared to 2008. The effective tax rate for 2009 was 30.0% compared to 29.5 % in 2008.
Results of Operations-Fiscal Years Ended December 31, 2008 and 2007
Consolidated Results of Operations. The following table shows the underwriting gain or loss as well as other revenue and expense items included in our consolidated statements of income for the years ended December 31, 2008 and 2007. The Company’s underwriting gain or loss consists of net premiums earned less loss and LAE and policy acquisition and other underwriting expenses. The Company’s underwriting performance is the most important factor in evaluating the overall results of operations given the fluctuations which can occur in loss and LAE due to weather related events as well as the uncertainties involved in the process of estimating reserves for losses and LAE. The underwriting results and the fluctuations in other revenue and expense items are discussed in greater detail below.
Underwriting Results. The following table shows the components of the Company’s underwriting gain or loss for the years ended December 31, 2008 and 2007.
Premiums. Direct premiums written by major business segment for the years ended December 31 was as follows:
While the Michigan market remained soft and very competitive in 2008 the Company continued to capitalize on the relationships that it has developed with its independent agents. Fremont’s ability to provide its agency force with a consistent, competitive and stable market for their preferred business led to our continued strong growth in 2008. Direct premiums written increased 12.8% in 2008 compared to 2007, with new business up 17.2% and renewal business up 13.0%. The personal segment experienced an increase of 15.4% in direct premiums written in 2008 driven by continued growth in personal auto and homeowners. The in-force policy count increased 11.5% during 2008 compared to 2007 for the personal segment.
Direct premiums written for personal auto increased 25.2% in 2008 with new business up 18.6% and renewal business up 26.5%. Personal auto’s in-force policy count increased 25.0% during 2008 compared to 2007. Personal auto growth continues to be driven by the ease of doing business with Fremont that agents experience via our proprietary web-based rating platform, coupled with several book of business transfers, account rounding of current Fremont homeowner business and a renewal retention ratio in the low 90’s. Homeowners direct premiums written grew by 8.6% in 2008. Homeowners new business increased 7.5% and renewals increased 8.8%. Homeowners in-force policy count increased 6.7% during 2008 compared to 2007. As with personal auto, results were driven by the ease of doing business, book transfers and retention in the low 90’s.
While the commercial segment, especially property driven accounts, has been hit hardest by the soft market, Fremont was able to gain market share and increase its commercial direct premiums written by 9.6%. All commercial product lines showed positive growth with commercial auto up 24.9%, business owners (BOP) up 3.2%, commercial package (CPP) up 2.5% and workers compensation up 29.1%. Our agents have begun to look to Fremont for their commercial business and we were able to write several larger commercial accounts which accounted for upwards of over $325,000 in new business premium. Commercial policy count was up 7.4%.
Farm direct premiums written were up 3.0% driven by renewal premiums which were up 4.8% as new business was down 5.2%. Direct premiums written for the marine business increased 3.8% driven by renewal premiums which were up 5.8%. New business premium was down 1.1% as competition for Michigan boat business remained very strong even with the poor economic factors facing Michigan. The in-force policy count for farm was up slightly, at 0.1% while marine was up 2.6%.
Net premiums written by business segment for the years ended December 31 were as follows:
The increase in net premiums written is due to the overall increase in direct premiums written of $6,926,000 offset by an increase of $905,000 in ceded premiums written under the Company’s reinsurance agreements.
Net premiums earned by major business segment for the years ended December 31 was as follows:
The increase in net premiums earned is due to the overall increase in direct premiums earned of $5,462,000 offset by an increase of $733,000 in ceded premiums earned under the Company’s reinsurance agreements.
Loss and Loss Adjustment Expenses (LAE). The Company’s net loss and LAE by major business segment as well as the loss and LAE ratio’s are shown in the tables below:
In 2008, the personal segment experienced an increase in incurred loss and LAE as well as the loss and LAE ratio driven primarily by the personal auto product line and, to a lesser extent, the homeowner’s line. Incurred loss and LAE from personal auto increased $3,759,000 or 45.7% while homeowners increased $1,366,000 or 14.6%. Other personal segment products experienced a decline in incurred loss and LAE of $387,000. The increased incurred loss and LAE in personal auto is driven by exposure and premium growth (up 25.2% in 2008) coupled with increased severity and frequency, particularly in liability coverages. In 2008, incurred loss and LAE from personal auto liability increased $1,588,000 or 84.6%. The increase in incurred loss and LAE in the homeowners line was driven by increased weather related losses experienced primarily during the fourth quarter.
The commercial segment experienced a decrease in incurred loss and LAE of $1,038,000 in 2008. The decreases came from the following product lines: BOP ($150,000), CPP ($756,000), workers compensation ($85,000) and all others ($47,000). BOP and CPP were positively impacted by fewer fire related losses in 2008 coupled with redundant loss development on prior year claims. Workers compensation was also positively impacted by redundant development on prior years claims.
The farm segment experienced higher loss and LAE during 2008 as compared to 2007 due to an increase in losses attributable to weather conditions as well as fire related losses. The increase in loss and LAE in the marine segment is due to an increase in both frequency and severity experienced in 2008 compared to 2007.
Policy Acquisition and Other Underwriting Expenses. Policy acquisition and other underwriting expenses for the years ended December 31 were as follows:
Amortization of deferred policy acquisition costs (“DAC”) increased in 2008 as compared to 2007 as a result of increased earned premium volume. However, as a percentage of net premiums earned DAC amortization decreased from 17.2% to 16.5% as a result of the increased volume of personal automobile premium which pays a lower commission than other products as well as increased ceding commission. Other underwriting expenses decreased $549,000 or 6.4% in 2008 compared to 2007. The major item contributing to the decrease from 2007 to 2008 was higher non-recurring assessments from state mandated pools and associations in 2007. This decrease was offset by higher depreciation expense and surveys and inspections costs in 2008. Depreciation was up in 2008 due to continued investment in Fremont Complete while surveys and inspections were up due to the continued growth experienced in the personal auto and homeowners product lines.
Investment Income. The Company’s net investment income excluding realized gains and losses, average invested assets including cash and cash equivalents and the rate of return for the years ended December 31 are as follows:
In 2008, gross investment income from fixed maturities was nearly $280,000 which is 13.5% higher than in 2007. The majority of the increase came from the steady growth in the book value of the portfolio which is up 5.5%. The tax-equivalent portfolio yield on fixed maturities ended 2008 at 4.72%, versus 5.33% at the end of 2007. Up until the fourth quarter of 2008 the tax-equivalent book yield ranged from 5.14% to 5.33%. During the fourth quarter of 2008 the portfolio duration was decreased which resulted in a corresponding decline in the tax-equivalent yield. At December 31, 2008, the portfolio duration was 4.1 years compared to 5.1 years as of December 31, 2007. The moderate duration of the fixed income portfolio should allow for a predictable income stream from these maturities, since the yields are locked in for a number of years even as interest rates in the current market have dropped significantly. If yields remain low for an extended period of time, however, the income from the portfolio may begin to decrease as principal from maturing securities is reinvested into lower rates.
The decrease in investment income from equity securities is due to a decrease in ordinary dividend distributions received from the mutual funds held by the Company as compared to the prior year period. Investment income from cash and cash equivalents was higher during 2007 due to the fact that the Company held a higher level of cash equivalents in contemplation of paying off its surplus notes which took place in September 2007. Investment expenses are up as a result of an increase in general expenses associated with investment activities.
Net realized gains from the portfolio for the years ended December 31 are as follows:
In 2008, the Company generated net realized gains on the sale of fixed maturity securities of approximately $82,000 and a net realized loss of $362,000 as a result of a write-down of a fixed maturity security determined to be other than temporarily impaired. Selling activity and net realized gains in the equity portfolio declined in 2008 as a result of the depressed market valuations. During 2007, the Company generated approximately $2,211,000 in equity realized gains as a result of rebalancing the equity portfolio and taking advantage of the unrealized market value appreciation.
Other Income, Net. Other income, net which includes premium installment charges, fees for non-sufficient fund checks, late payment fees and other miscellaneous income and expense items increased 30.4% to $615,000 in 2008 compared to $471,000 in 2007. The increase was driven by premium volume growth in 2008.
Interest Expense. The Company did not incur interest expense in 2008 as a result of paying off its surplus notes in September 2007. 2007 interest expense was approximately $146,000.
Federal Income Tax. During the year ended December 31, 2008 and 2007 the Company recorded income tax expense of approximately $1,577,000 and $2,036,000 respectively. The decrease is due to a decline in pre-tax income in 2008 compared to 2007. The effective tax rate for 2008 was 29.5 % compared to 29.4% for 2007.
Liquidity and Capital Resources
The principal sources of funds for the Company are insurance premiums, investment income and proceeds from the maturity and sale of invested assets. Funds are primarily used for the payment of claims, commissions, salaries and employee benefits, other operating expenses and dividends paid to stockholders.
Liquidity is a measure of the ability to generate sufficient cash to meet cash obligations as they come due. In addition to the need for cash flow to meet operating expenses, our liquidity requirements relate primarily to the payment of losses and loss adjustment expenses. Our short and long term liquidity requirements vary because of the uncertainties regarding the settlement dates for liabilities for unpaid claims and because of the potential for large losses, either individually or in the aggregate.
We maintain investment and reinsurance programs that are intended to provide sufficient funds to meet our obligations without forced sales of investments. A portion of our investment portfolio is maintained in relatively short term and highly liquid assets, including mortgage-backed securities, which have shorter estimated durations, to ensure the availability of funds.
Cash flow provided by operations was $6,646,000 in 2009 compared to $9,452,000 in 2008, a decrease of $2,806,000. During the year ended December 31, 2009 as compared to 2008 premiums collected increased
$5,391,000 as a result of increased premium writings, net loss and LAE paid increased $8,932,000 while policy acquisition and other underwriting expenses paid increased $1,440,000. Cash paid for income taxes decreased $2,239,000 during 2009 compared to 2008. Other cash used in operational activities increased $64,000 during the year ended December 31, 2009 compared to 2008.
Cash used in investing activities was $6,002,000 and $6,087,000 during the years ended December 31, 2009 and 2008, respectively, a decrease of $85,000. During 2009, net cash invested into the Company’s investment portfolio was $4,763,000 compared to $4,945,000 in 2008, a decrease of $182,000. During the second quarter 2009, the Company began adding to its equity portfolio via purchases of common stocks and mutual funds. Since March 31, 2009, the Company has added approximately $4,078,000 to the equity portfolio. Funding for the equity purchases has come from existing cash balances, operating cash flow and sales and maturities of fixed maturities.
During 2009, capital expenditures increased $114,000 to $1,263,000. The majority of the Company’s capital expenditures were related to Fremont Complete, the Company’s web based rating platform. The focus has been to add the commercial package product line to the platform. Cash used in financing activities during 2009 amounted to $157,000 and consisted of shares repurchases of $274,000 and dividends to stockholders of $228,000 offset by proceeds from the issuance of stock of $345,000.
Cash flow provided by operations was $9,452,000 in 2008 compared to $4,303,000 in 2007, an increase of $5,149,000. During the year ended December 31, 2008 as compared to 2007 premiums collected increased $4,878,000 as a result of increased premium writings, net loss and LAE paid increased $716,000 while policy acquisition and other underwriting expenses paid decreased $592,000. Cash paid for income taxes increased $215,000 during 2008 compared to 2007. Other cash provided by operational activities increased $610,000 during the year ended December 31, 2008 compared to 2007.
Cash used in investing activities was $6,087,000 and $2,000,000 during the years ended December 31, 2008 and 2007, respectively, an increase of $4,087,000. During 2008, net cash invested into the Company’s investment portfolio was $4,945,000 compared to $494,000 in 2007, an increase of $4,451,000. The increase in cash placed into the investment portfolio was due to the increase in cash provided by operations. During 2008, there was a decrease in capital expenditures of $367,000. The majority of the Company’s capital expenditures were related to Fremont Complete. Cash used in financing activities of $821,000 consisted primarily of share repurchase of common stock of $732,000 and dividends paid to shareholders of $105,000.
We believe that our existing cash and funds generated from operations will be sufficient to satisfy our financial requirements during the foreseeable future.
During 2009, the Holding Company paid a quarterly cash dividend. The Holding Company paid a quarterly dividend of $.03 per share in the first, second and third quarters and $.04 per share in the fourth quarter of 2009. Total dividends paid was approximately $228,000. The Company cannot assure our stockholders that dividends will continue to be paid in the future. The Board’s current intention is to evaluate each quarter whether a cash dividend will be declared. The payment of future dividends will depend upon the availability of cash resources at the Holding Company, the financial condition and results of operations of the Company and such other factors as are deemed relevant by the Board of Directors. The Holding Company’s principal source of cash available for payment of dividends is dividends from the Insurance Company. The annual future cash requirements of the Holding Company are not foreseen to be significant. They include dividends paid to shareholders and other administrative expenses related to annual filings such as income tax returns and other compliance type filings. During 2009, the Board of Directors of the Insurance Company declared and paid ordinary dividends totaling $250,000 to the Holding Company, its sole shareholder. As of December 31, 2009, the Holding Company had a cash balance of approximately $98,000.
The payment of dividends by the Insurance Company is subject to limitations imposed by the Michigan Insurance Code. The Insurance Company may not pay an extraordinary dividend unless it notifies the Insurance
Commissioner and he does not disapprove the payment. An extraordinary dividend includes any dividend which, when taken together with other dividends paid within the preceding 12 months, exceeds the greater of 10% of the Insurance Company’s statutory policyholders’ surplus as of December 31 of the immediately preceding year or its statutory net income, excluding realized capital gains, for the 12-month period ending December 31 of the immediately preceding year. During the year ending December 31, 2010, the Insurance Company can pay a non-extraordinary dividend of up to $3,694,000 without prior approval from the Insurance Commissioner. In order to pay any dividends, the Insurance Company must be in a position to satisfy the requirement that the company continue to be safe, reliable and entitled to public confidence. Also, in the absence of approval of the Insurance Commissioner, dividends may only be paid from statutory earned surplus. Also, dividends may not exceed the amount of the Insurance Company’s statutory capital stock account in any one-year unless it meets certain other requirements.
Income Taxes
Under current accounting standards, we may recognize certain tax assets whose realization depends upon generating future taxable income. These tax assets can only be realized through the generation of future taxable income and thereby utilizing the net operating loss (NOL) and Alternative Minimum Tax (AMT) credit carry-forwards we have available. At December 31, 2009, the Company has NOL carryforwards of approximately $6,548,000 and an AMT credit carryforward of approximately $358,000. The AMT credit carryforward can be carried forward indefinitely. The NOL carryforward expires as follows:
As a result of the Holding Company’s acquisition of the stock of the Insurance Company a limitation on the ability to fully utilize the NOL occurred. The amount of annual taxable income that can be offset each year by the NOL carryforward is approximately $400,000. See Note 5 to the consolidated financial statements, included elsewhere in this report, for further information regarding federal income taxes. Such information is incorporated herein by reference.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE INFORMATION ABOUT MARKET RISK
Not Applicable.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Report of Independent Registered Public Accounting Firm
Board of Directors and Stockholders
Fremont Michigan InsuraCorp, Inc.
Fremont, Michigan
We have audited the accompanying consolidated balance sheets of Fremont Michigan InsuraCorp, Inc. as of December 31, 2009 and 2008 and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the three years in the period ended December 31, 2009. Our responsibility is to express an opinion on these 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. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements and schedules. 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 Fremont Michigan InsuraCorp, Inc. at December 31, 2009 and 2008, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2009, in conformity with accounting principles generally accepted in the United States of America.
/s/ BDO Seidman, LLP
Grand Rapids, Michigan
March 5, 2010
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Consolidated Balance Sheets
December 31, 2009 and 2008
The accompanying notes are an integral part of the consolidated financial statements.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Consolidated Statements of Operations
For the Years Ended December 31, 2009, 2008 and 2007
The accompanying notes are an integral part of the consolidated financial statements.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Consolidated Statements of Stockholders’ Equity and Comprehensive Income
For the Years Ended December 31, 2009, 2008 and 2007
The accompanying notes are an integral part of the consolidated financial statements.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Consolidated Statements of Cash Flow
For the Years Ended December 31, 2009, 2008 and 2007
The accompanying notes are an integral part of the consolidated financial statements.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
1. Summary of Significant Accounting Policies
Nature of operations
Fremont Michigan InsuraCorp, Inc. and subsidiary (collectively, the “Company”) includes Fremont Michigan InsuraCorp, Inc. (“FMIC”) and its wholly owned subsidiary Fremont Insurance Company (“FIC”). FIC is a Michigan licensed property and casualty insurance carrier operating exclusively in the State of Michigan and writing principally personal lines, commercial lines, farm and marine insurance policies through independent agents.
Principles of consolidation and presentation
The accompanying consolidated financial statements which include the accounts of FMIC and its wholly-owned subsidiary, FIC, have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”), which vary in certain respects from statutory accounting practices followed in reporting to insurance regulatory authorities. See Note 12-Statutory Insurance Accounting Practices for additional information regarding statutory accounting practices. All significant intercompany transactions have been eliminated.
Stock Splits and Dividends
The fair value of shares issued for stock dividends of 25% or less is transferred from retained earnings to additional paid-in capital, to the extent of available retained earnings. No transfer is recorded for stock dividends or splits in excess of 25%. All share and per share amounts are retroactively adjusted for stock dividends and stock splits. On May 8, 2008, the Board of Directors declared a 3% stock dividend, which was paid on June 5, 2008.
Investments
At December 31, 2009 and 2008, all of the Company’s investments are classified as available-for-sale and are those investments that would be available to be sold in response to the Company’s liquidity needs, changes in market interest rates and asset-liability management strategies, among others. Available-for-sale investments are recorded at fair value, with the corresponding unrealized appreciation or depreciation, net of deferred income taxes, reported as a component of accumulated other comprehensive income or loss until realized.
When a fixed maturity security has a decline in value, where fair value is below amortized cost, an OTTI write-down is triggered in circumstances where (1) the Company has the intent to sell the security, (2) it is more-likely-than-not that the Company will be required to sell the security before recovery of its amortized cost basis, or (3) the Company does not expect to recover the entire amortized cost basis of the security. If the Company intends to sell the security or if it is more-likely-than-not the Company will be required to sell the security before recovery, an OTTI write-down is recognized as a realized loss in the statement of operations equal to the difference between the security’s amortized cost and its fair value. If the Company does not intend to sell the security or it is not more-likely-than-not that the Company will be required to sell the security before recovery, the OTTI write-down is separated into an amount representing the credit loss, which is recognized as a realized loss in the statement of operations, and the amount related to all other factors, which is recognized in other comprehensive income.
When an equity security has a decline in value, where fair value is below cost, that is deemed to be other than temporary, the Company reduces the book value of such security to its current fair value, recognizing the
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
decline as a realized loss in the statement of operations. Any future increases in the market value of investments written down are reflected as changes in unrealized gains as part of accumulated other comprehensive income within stockholders’ equity.
Realized gains and losses on sales of investments are computed based on a specific identification basis and include write downs on available-for-sale investments considered to have other than temporary declines in market value.
Dividend and interest income are recognized when earned. Discount or premium on fixed maturities purchased at other than par value is amortized using the effective interest method.
Discount or premium on loan-backed investments is amortized using anticipated prepayments with significant changes in anticipated prepayments accounted for retrospectively. Prepayment assumptions for loan-backed investments were obtained from broker dealer survey values or internal estimates. These assumptions are consistent with the current interest rate environment.
Cash and cash equivalents
Cash and cash equivalents include cash on hand and highly liquid short-term investments. The Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents.
Revenue recognition
Insurance premium revenue is recognized on a pro rata basis over the respective terms of the policies in-force and unearned premiums represent the portion of premiums written which is applicable to the unexpired terms of the policies in-force. Generally, premiums are collected in advance of providing risk coverage, minimizing the Company’s exposure to credit risk. Premiums due from policyholders are net of an allowance for doubtful accounts of $43,034 and $58,678 at December 31, 2009 and 2008, respectively.
Other income consists primarily of premium installment charges which are recognized when earned and other miscellaneous income.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
Other comprehensive income or loss
The Company presents other comprehensive income or loss as a component of stockholders’ equity on the consolidated statements of stockholders’ equity and comprehensive income. For the years ended December 31, 2009, 2008, and 2007 the components of other comprehensive income consisted of the following:
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
The components of and changes to accumulated other comprehensive income (loss) as of and for the years ended December 31, 2009, 2008, and 2007 were as follows:
Losses and loss adjustment expense reserves
Losses and loss adjustment expense (“LAE”) reserves represent the estimated liability for reported losses and loss adjustment expenses and actuarial estimates for incurred but not reported losses and loss adjustment expenses based upon the Company’s actual experience, assumptions and projections as to claims frequency, severity, inflationary trends and settlement payments. The reserve for losses and loss adjustment expenses is intended to cover the ultimate net cost of all losses and loss adjustment expenses incurred but unsettled through the balance sheet date. The reserves are reported gross of any amounts recoverable from reinsurers and are reduced for anticipated salvage and subrogation. The methods of making estimates and establishing these reserves are reviewed regularly, and resulting adjustments are reflected in income currently. The liability for losses and loss adjustment expenses is necessarily an estimate and while it is believed to be adequate, the ultimate liability could exceed or be less than such estimate. The anticipated recoverable salvage and subrogation at December 31, 2009 and 2008 was approximately $151,000 and $131,000, respectively.
Reinsurance
Net premiums earned, losses and LAE and policy acquisition and other underwriting expenses are reported net of the amounts related to reinsurance ceded to other companies. Amounts recoverable from reinsurers related to the portions of the liability for losses and LAE and unearned premiums ceded to them are reported as assets. Reinsurance assumed from other companies, including assumed premiums written and earned and losses and LAE, is accounted for in the same manner as direct insurance written.
Reinsurance recoverables include balances due from reinsurance companies for paid and unpaid losses and LAE that will be recovered from reinsurers, based on contracts in force. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Reinsurance contracts do not relieve the Company from its primary obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers and monitors concentrations of credit risk with respect to the individual reinsurer that participates in its ceded programs to minimize its exposure to significant losses from reinsurer insolvencies. When necessary the Company holds collateral in the form of letters of credit or trust accounts for amounts recoverable from reinsurers that are not considered authorized insurers by the State of Michigan Office of Financial and Insurance Regulation.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
Property, equipment and depreciation
Property and equipment is recorded at cost, net of accumulated depreciation. Depreciation is computed using the straight-line method. Estimated useful lives are: building-35 years, computer equipment including software-3 to 5 years and furniture, fixtures and equipment-5 to 7 years. Software is capitalized and amortized on a straight-line method over the estimated useful life of the software, generally not exceeding 3 years. Maintenance, repairs and minor renewals are charged to expense as incurred. Depreciation expense was $921,098 $1,194,211 and $769,161 for the years ended December 31, 2009, 2008, and 2007, respectively. Property and equipment are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Upon sale or retirement, the cost and related accumulated depreciation of assets disposed of are removed from the accounts; any resulting gain or loss is reflected in income.
Deferred policy acquisition costs
Policy acquisition costs, which consist of commissions net of ceding commissions and premium taxes, that vary with and are primarily related to the production of new and renewal business are deferred, subject to ultimate recoverability from future income, including investment income, and amortized to expense over the period in which the related premiums are earned.
Other Postretirement Benefits
The Company provides certain postretirement health care benefits for retired employees. The Company accrues service cost as incurred. The Company’s measurement date for plan assets and obligations is its fiscal year-end.
Current accounting guidance requires companies to recognize the funded status of defined benefit postretirement plans on the balance sheet and recognize changes in the funded status of the plan in the year in which the changes occur. See Note 10-Employee Benefits for additional information.
Accrued Expenses and Other Liabilities
Accrued expenses and other liabilities included the following:
Stock-based compensation
The Company accounts for stock-based compensation using the fair value based method. The Company values stock options issued based upon an option-pricing model and recognizes the fair value as an expense over the period in which the options vest.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
Federal income taxes
Income tax expense is computed under the liability method, whereby deferred income taxes reflect the estimated future tax effects of temporary differences between the carrying value of assets and liabilities for financial reporting purposes and those for income tax purposes. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which these temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. 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 evaluates all tax positions taken on its U.S. federal income tax return. No material uncertainties exist for any tax positions taken by the Company.
The Company files income tax returns in the U.S. federal jurisdiction. The Company is subject to U.S federal income tax examinations for all tax years from 1994 to the current year (with the exception of the 2002 tax year) due to the utilization of its net operating losses in current open tax years. The Company has not recently been examined by the Internal Revenue Service for any open tax year. It is the Company’s policy to recognize interest and penalties related to uncertain tax positions in income tax expense.
Commitments and contingencies
Liabilities for loss contingencies arising from claims, assessments, litigation, fines and penalties and other sources are recorded when it is probable that a liability has been incurred and the amount of the assessment and/or remediation can be reasonably estimated.
Preparation of financial statements
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Reclassifications
Certain 2008 and 2007 amounts have been reclassified from the prior year financial statements to confirm to the 2009 presentation.
New Accounting Standards
Adopted Accounting Standards
In 2006, a new accounting standard was issued which provided guidance for using fair value to measure assets and liabilities and enhanced disclosures about fair value measurements. The new accounting standard, which became effective for us on January 1, 2008 for financial assets and financial liabilities, applies whenever other accounting standards require, or permit, assets or liabilities to be measured at fair value. The accounting standard did not expand the use of fair value in any new circumstances and therefore, did not have an impact on our financial position, results of operations or cash flows. The accounting standard established a fair value hierarchy that prioritizes the observable and unobservable inputs to valuation techniques used to measure fair value into three levels. Quantitative and qualitative disclosures focus on the inputs used to measure fair value for
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
these measurements and the effect of these measurements in the financial statements. The required disclosures concerning inputs used to measure fair value are disclosed in Note 3-Fair Value Measurements. Effective January 1, 2009, the Company adopted the provisions of this accounting standard related to all non-financial assets and non-financial liabilities. This adoption did not have any impact on our consolidated financial statements.
In December 2007, a new accounting standard was issued which established accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent’s ownership interest and the valuation of retained noncontrolling equity investments when a subsidiary is deconsolidated. This new accounting standard also established disclosure requirements that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. This new accounting standard, which became effective for us on January 1, 2009, did not have a material impact on our consolidated financial statements.
In March 2008, a new accounting standard was issued which amended and expanded the disclosure requirements of a previously issued accounting standard related to the accounting for derivative instruments and hedging activities. The new accounting standard requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments and disclosures about credit-risk-related contingent features in derivative agreements. This new accounting standard, which became effective for us on January 1, 2009, did not affect our consolidated financial condition or results of operations, but may require additional disclosures if we enter into derivative and hedging activities.
In April 2009, a new accounting standard was issued which amends the recognition guidance for other-than-temporary impairments (OTTI) of debt securities and expands the financial statement disclosures for OTTI on debt and equity securities. We adopted this new accounting standard in the second quarter of 2009.
This new accounting standard states that an OTTI write-down of debt securities, where fair value is below amortized cost, is triggered in circumstances where (1) an entity has the intent to sell a security, (2) it is more-likely-than-not that the entity will be required to sell the security before recovery of its amortized cost basis, or (3) the entity does not expect to recover the entire amortized cost basis of the security. If an entity intends to sell a security or if it is more-likely-than-not the entity will be required to sell the security before recovery, an OTTI write-down is recognized in earnings equal to the difference between the security’s amortized cost and its fair value. If an entity does not intend to sell the security or it is not more-likely-than-not that it will be required to sell the security before recovery, the OTTI write-down is separated into an amount representing the credit loss, which is recognized in earnings, and the amount related to all other factors, which is recognized in other comprehensive income.
This new accounting standard requires that companies record, as of the beginning of the interim period of adoption, a cumulative-effect adjustment to reclassify the noncredit component of a previously recognized OTTI loss from retained earnings to other comprehensive income if the company does not intend to sell the security and it is more-likely-than-not that the company will not be required to sell the security before recovery of its amortized cost basis. The adoption had no impact on our financial position or results of operations. We had no cumulative-effect adjustment upon adoption at the beginning of the second quarter.
In April 2009, a new accounting standard was issued related to determining fair value when the volume and level of activity for the asset or liability have significantly decreased and identifying transactions that are not orderly. Our adoption of this new accounting standard was effective April 1, 2009. The new accounting standard
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
reaffirms that fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions. The new accounting standard also reaffirms the need to use judgment in determining if a formerly active market has become inactive and in determining fair values when the market has become inactive. The adoption did not impact our financial position or results of operations.
In April 2009, a new accounting standard was issued related to interim disclosures about fair value of financial instruments. The new accounting standard requires disclosing qualitative and quantitative information about the fair value of all financial instruments on a quarterly basis, including methods and significant assumptions used to estimate fair value during the period. These disclosures were previously only done annually. The disclosures required by the new accounting standard were effective for the quarter ending June 30, 2009 and are included in Note 4-Fair Value Measurements to the unaudited consolidated financial statements.
In June 2009, a new accounting standard was issued related to Accounting Standards Codification™ and the hierarchy of Generally Accepted Accounting Principles. The new accounting standard establishes the Financial Accounting Standard Board Accounting Standard Codification™ (Codification) as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with generally accepted accounting principles in the United States (U.S. GAAP). All guidance contained in the Codification carries an equal level of authority. The Codification does not change current U.S. GAAP, but is intended to simplify user access to all authoritative U.S. GAAP by providing all the authoritative literature related to a particular topic in one place. On the effective date of this new accounting standard, the Codification will supersede all then-existing non-SEC accounting and reporting standards. All other nongrandfathered non-SEC accounting literature not included in the Codification will become nonauthoritative. The new accounting standard is effective for financial statements issued for interim and annual periods ending after September 15, 2009. The implementation of this new accounting standard did not have an impact on the Company’s results of operations or financial position.
In August 2009, new accounting guidance was issued for the fair value measurement of liabilities. The new guidance provides clarification, that in certain circumstances in which a quoted price in an active market for the identical liability is not available, a company is required to measure fair value using one or more of the following valuation techniques: the quoted price of the identical liability when traded as an asset, the quoted prices for similar liabilities or similar liabilities when traded as assets, and/or another valuation technique that is consistent with the principles of fair value measurements. The new guidance clarifies that a company is not required to include an adjustment for restrictions that prevent the transfer of the liability and if an adjustment is applied to the quoted price used in a valuation technique; the result is a Level 2 or 3 fair value measurement. The new guidance was effective for the company on October 1, 2009. The implementation of the new guidance did not have a significant impact on our financial statements.
Prospective Accounting Standards
In June 2009, a new accounting standard was issued related to the accounting for transfers of financial assets, which updates accounting for securitizations and special-purpose entities. The new accounting standard is a revision of previously issued accounting standards related to accounting for transfers and servicing of financial assets and extinguishments of liabilities, and will require additional information regarding financial asset transfers, including securitization transactions, and the presence of continuing exposure around the risks related to transferred financial assets. In addition, the new accounting standard removes the concept of a qualifying special-purpose entity and changes the requirements for derecognizing financial assets. The new accounting standard was effective January 1, 2010. We do not expect the implementation this new accounting standard to have a significant impact on our financial statements.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
In June 2009, new consolidation guidance was issued which 1) replaces the quantitative-based risks and rewards calculation for determining whether an enterprise is the primary beneficiary in a variable interest entity with an approach that is primarily qualitative, 2) requires ongoing assessments whether an enterprise is the primary beneficiary of a variable interest entity, and 3) requires additional disclosure about an enterprise’s involvement in variable interest entities. This guidance is effective for financial statements issued for fiscal years beginning after November 15, 2009. We do not expect the adoption of this guidance to have a material impact on our financial statements.
2. Investments
The cost or amortized cost, gross unrealized gains, gross unrealized losses and estimated fair value of investments at December 31, 2009 and 2008 are as follows:
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
The cost or amortized cost and estimated fair value of fixed maturities at December 31, 2009, by contractual maturity, are shown below. Expected maturities on certain corporate and mortgage-backed investments may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Net investment income for the years ended December 31, 2009, 2008 and 2007 is summarized as follows:
Net realized gains (losses) on investments for the years ended December 31, 2009, 2008 and 2007 are summarized as follows:
During the year ended December 31, 2008, other-than-temporary impairment losses on available-for-sale fixed maturity investments amounted to $362,000 and are included in net realized investment gains (losses) on investments in the consolidated statement of operations. There were no other-than-temporary impairment losses in 2009 or 2007.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
Sales of available-for-sale fixed maturities resulted in the following during the years ended December 31, 2009, 2008 and 2007:
Evaluating Investments for Other-than-Temporary Impairments
The Company reviews the status and market value changes of its investment portfolio on at least a quarterly basis during the year, and any provisions for other-than-temporary impairments in the portfolio’s value are evaluated and established at each quarterly balance sheet date. The following tables are used as part of our impairment analysis.
The tables below show the total value of securities that were in an unrealized loss position as of December 31, 2009 and 2008 including the length of time they have been in an unrealized loss position. As of December 31, 2009 and 2008, unrealized losses, as shown in the following tables, were 2.0% and 7.1%, respectively of total invested assets including cash and cash equivalents.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
The following table shows the composition of the fixed maturity securities in unrealized loss positions at December 31, 2009 by the National Association of Insurance Commissioners (NAIC) rating and the generally equivalent Standard & Poor’s (S&P) and Moody’s ratings. The vast majority of the securities are rated by S&P and/or Moody’s.
In reviewing its fixed maturity securities for other than temporary impairment, the Company takes into consideration the security’s market price history, the length of time that the security’s fair value has been below cost, the issuer’s operating results, financial condition and liquidity, its ability to access capital markets, credit rating trends, most current audit opinion, industry and securities market conditions, and analyst expectations, to reach its conclusions.
As of April 1, 2009, we adopted new accounting standards related to the recognition guidance for other-than-temporary impairments (OTTI) of debt securities and the financial statement disclosures for OTTI on debt and equity securities. Accordingly, any credit-related impairment related to fixed maturity securities we do not plan to sell and for which we are not more likely than not to be required to sell is recognized in net income, with the non-credit related impairment recognized in comprehensive income. Based on our analysis, our fixed maturity portfolio is of a high credit quality and we believe we will recover our amortized cost basis of our fixed maturity securities. The fixed maturity unrealized losses can primarily be attributed to changes in interest rates and corresponding spread widening as opposed to fundamental changes in the credit quality of the issuers of the securities. We continually monitor the credit quality of our fixed maturity investments to gauge the likelihood of principal and interest being collected.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
In reviewing its equity securities, which include common stock and mutual funds, the Company takes into consideration the security’s market price history, the length of time that the security’s fair value has been below cost, the individual investments held within the mutual fund, most current audit opinion, industry and securities market conditions, and analyst expectations to reach its conclusions. In addition to analyzing each individual security that has a fair value below cost, the Company also considers its intent and ability to hold a security until its fair value is equal to or greater than its cost.
As of December 31, 2009, the portfolio included 23 fixed maturity securities and 7 equity securities in an unrealized loss position for less than 12 months and 4 fixed maturity securities and 14 equity securities in an unrealized loss position for more than 12 months. Of the fixed maturity securities, all twenty-seven were trading above 95% of amortized cost. All of the fixed maturity securities in an unrealized loss position and assigned a rating by a commercial credit rating agency are rated investment grade securities.
As of December 31, 2009, the investment portfolio included 21 equity securities in an unrealized loss position. Of these twenty-one equity securities, 2 were trading under 75% of amortized cost, 7 were trading between 75% and 85% of amortized cost, 8 were trading between 86% and 95% of amortized cost and the remaining 4 were trading above 95% of amortized cost.
While all of these securities are monitored for potential impairment, the Company’s experience indicates that they generally do not present as great a risk of impairment, as fair value often recovers over time. These securities have generally been adversely affected by the downturn in the financial markets and overall economic conditions. Management believes that the analysis of each of these securities in addition to the fact that the Company has both the intent and ability to hold these securities until their recovery supports our view that these securities were not other-than-temporarily impaired.
As of December 31, 2008, the portfolio included 26 fixed maturity securities and 10 equity securities in an unrealized loss position for less than 12 months and 12 fixed maturity securities and 5 equity securities in an unrealized loss position for more than 12 months. Of the fixed maturity securities, five were trading between 73% and 84% of amortized cost, twelve were trading between 85% and 94% of amortized cost and the remaining twenty-one were trading at or above 95% of amortized cost. All of the fixed maturity securities in an unrealized loss position and assigned a rating by a commercial credit rating agency are rated investment grade securities. During 2008, the Company wrote down a corporate bond as it deemed the security to be other than temporarily impaired. The impairment loss was $362,000 and is included in net realized investment losses in the consolidated statement of operations for the year ended December 31, 2008. Of the fifteen equity securities in an unrealized loss position, the range of market value to cost was from 37% up to 83%.
At December 31, 2009, fixed maturities with a fair value approximating $431,000 were on deposit with regulatory authorities, as required by law.
3. Fair Value Measurements
Investments
Our available-for-sale investment portfolio consists of fixed maturity and equity securities, and is recorded at fair value in the accompanying consolidated balance sheets. The change in the fair value of these investments, unless deemed to be other than temporarily impaired, is recorded as a component of other comprehensive income.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
We are permitted to elect to measure financial instruments and certain other items at fair value, with the change in fair value recorded in earnings. We elected not to measure any eligible items using the fair value option.
Accounting standards define fair value as the price that would be received to sell an asset or would be paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date, and establishes a framework to make the measurement of fair value more consistent and comparable. In determining fair value, we primarily use prices and other relevant information generated by market transactions involving identical or comparable assets (“market approach”).
Accounting standards provide a three-level hierarchy for fair value measurements that distinguishes between market participant assumptions developed based on market data obtained from sources independent of the reporting entity (“observable inputs”) and the reporting entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (“unobservable inputs”). The hierarchy level assigned to each security in our available-for-sale portfolio is based on our assessment of the transparency and reliability of the inputs used in the valuation of such instrument at the measurement date. The three hierarchy levels are defined as follows:
Level 1
Valuations based on unadjusted quoted market prices in active markets for identical securities. The fair value of fixed maturity and equity securities included in the Level 1 category were based on quoted prices that are readily and regularly available in an active market. The Level 1 category includes publicly traded equity securities and U.S. Government Treasury and Agency securities.
Level 2
Valuations based on observable inputs (other than Level 1 prices), such as quoted prices for similar assets at the measurement date; quoted prices in markets that are not active; or other inputs that are observable, either directly or indirectly. The fair value of fixed maturity securities in the Level 2 category were based on the market values obtained from an independent pricing service that were evaluated using pricing models that vary by asset class and incorporate available trade, bid and other market information. The independent pricing service also monitors market indicators, industry and economic events. For broker-quoted only securities, quotes are obtained from market makers or broker-dealers that the Company recognizes to be market participants. The Level 2 category includes corporate bonds, municipal bonds, and mortgage-backed securities.
Level 3
Valuations based on inputs that are unobservable and significant to the overall fair value measurement, and involve management judgment. The Company did not hold any available-for-sale investments on the measurement date that are classified in the Level 3 category.
If the inputs used to measure fair value fall in different levels of the fair value hierarchy, a financial security’s hierarchy level is based upon the lowest level of input that is significant to the fair value measurement.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
The following table presents our available-for-sale investments measured at fair value on a recurring basis as of December 31, 2009 classified by the valuation hierarchy (as discussed above):
The following methods and assumptions were used to estimate the fair value of each class of financial instrument for which it is practicable to estimate that value:
Cash and cash equivalents
The carrying amount is a reasonable estimate of fair value.
Mortgage receivables
The carrying amount is a reasonable estimate of fair value due to the restrictive nature and limited marketability of the mortgage notes.
The carrying amount and estimated fair value of the Company’s financial instruments as of December 31, are as follows:
4. Reinsurance
In the normal course of business, the Company seeks to reduce the loss that may arise from events that cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with other insurance enterprises or reinsurers. The Company determines the amount and scope of reinsurance coverage to purchase each year based on an evaluation of the risks accepted, consultation with reinsurance professionals and a review of market conditions, including availability and cost. The Company utilizes three primary categories of treaty reinsurance coverage, as well as facultative coverage, to reduce the impact of major losses. The treaty reinsurance includes multi-line excess of loss, catastrophic excess of loss and quota share coverages.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
Multi-line excess of loss coverage
The excess of loss program is the Company’s primary reinsurance coverage. For all lines of business covered by this treaty, the Company’s retention on any one risk in 2009 was $175,000 and in 2008 and 2007 was $150,000.
In 2009, the property excess of loss layers provided up to $2,825,000 of coverage over the $175,000 retention. In 2008 and 2007, the property excess of loss layers provided up to $2,850,000 of coverage over the $150,000 retention. In 2009, the casualty and workers compensation excess of loss layers provided up to $5,825,000 of coverage over the $175,000 retention. In 2008 and 2007, the casualty and workers compensation excess of loss layers provided up to $4,850,000 of coverage over the $150,000 retention. In 2009, an additional workers compensation catastrophe excess of loss layer provided an additional $4,000,000 of coverage to cover a catastrophic event. In 2008 and 2007, an additional workers compensation catastrophe excess of loss layer provided an additional $5,000,000 of coverage to cover a catastrophic event.
Catastrophic coverage
The Company’s catastrophe treaty has three layers which in total provided up to $24,750,000 of coverage above a $1,250,000 retention in 2009 and 2008 and $21,750,000 of coverage above a $1,250,000 retention in 2007. The Company has an automatic reinstatement provision after the first loss for each layer to provide coverage in the event of subsequent catastrophes during the year. Coverage would have lapsed after the second event, in which case the Company would have evaluated the need for a new contract for the remainder of a particular year. During 2009, 2008 and 2007 the coverage could be reinstated for a fee of 100% of the original premium.
Quota share coverage
The Company’s boiler and machinery quota share agreements are primarily an equipment breakdown endorsement to commercial and farm policies. The agreements are 100% quota share and the Company receives ceding commissions ranging from 32% to 35% on the premiums ceded. The agreements also include profit sharing provisions based on the profitability of the underlying underwriting performance of the business ceded. In 2008, the Company entered into a quota share agreement which covers employment practices liability which is an endorsement to commercial policies. The agreement is 100% quota share and the Company receives ceding commission of 35% on the premiums ceded.
Facultative
The Company utilizes facultative reinsurance to provide additional underwriting capacity, to mitigate the effect of individual losses and to reduce the Company’s net liability on individual risks. Coverage is determined on each individual risk. In 2009, the Company obtained coverage ranging from $100,000 up to $59,000,000 for certain commercial and farm properties it insured. In 2008, the Company obtained coverage ranging from $100,000 up to $18,900,000 for certain commercial properties it insured. The Company also purchased facultative reinsurance on certain casualty risks ranging from $1,000,000 to $3,000,000 for certain commercial umbrella policies. In 2007, the Company obtained coverage ranging from $1,200,000 up to $5,600,000 for certain commercial properties it insured.
Although reinsurance agreements contractually obligate the Company’s reinsurers to reimburse the Company for their share of losses, they do not discharge the primary liability of the Company. The Company remains liable for the ceded amount of reserves for unpaid losses and loss adjustment expenses and ceded
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
unearned premiums in the event the assuming insurance organizations are unable to meet their contractual obligations. As a result, the Company is subject to credit risk with respect to the obligations of its reinsurers. In order to minimize its exposure to significant losses from reinsurer insolvencies, the Company evaluates the financial condition of its reinsurers and monitors the economic characteristics of the reinsurers on an ongoing basis. All reinsurers are rated A- or better by A. M. Best Company. The Company has not experienced a collectibility problem with any reinsurer.
The Company receives a ceding commission in conjunction with certain reinsurance activities. These ceding commissions are offset against direct commission expense and were $390,059, $413,592 and $180,158 in 2009, 2008 and 2007, respectively.
Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. At December 31, 2009 and 2008, amounts recoverable from reinsurers consisted of the following:
The Company holds collateral in the form of letters of credit, trust accounts or funds withheld accounts for amounts recoverable from reinsurers that are not considered authorized insurers by the State of Michigan Office of Financial and Insurance Regulation. At December 31, 2009, the Company had 7 reinsurance recoverable amounts from reinsurers whose individual recoverable balance exceeded 5% of the total recoverable amount. The amount due from these 7 reinsurers accounts for 92% of the total recoverable.
The effect of reinsurance on premiums written and earned for the years ended December 31, 2009, 2008 and 2007, are as follows:
The effect of reinsurance on incurred losses and loss adjustment expenses for the years ended December 31, 2009, 2008 and 2007, are as follows:
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
5. Federal Income Taxes
The provision for federal income taxes consists of the following:
Actual federal income taxes vary from amounts computed by applying the current federal income tax rate of 34 percent to income before federal income taxes. For the years ended December 31, 2009, 2008 and 2007, the reasons for these differences and the tax effects thereof, are as follows:
Deferred federal income tax assets and liabilities are recognized for the estimated future tax consequences attributable to the difference between financial statement carrying amounts of existing assets and liabilities, and their respective tax bases. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized. In determining the need for a valuation allowance, the Company’s management reviews both positive and negative evidence, including current and historical results of operations, the annual limitation on utilization of net operating loss carryforwards pursuant to Internal Revenue Code Section 382 (“Section 382”), future income projections and the overall prospects of our business. As of December 31, 2009, the Company has net operating loss carryforwards of approximately $6,548,000, which begin to expire in 2010 and fully expire in 2021, and alternative minimum tax credits of approximately $358,000, which may be carried forward indefinitely. As a result of the demutualization of FIC in 2004 the aforementioned net operating losses are subject to certain “change in control” limitations under Section 382. The annual limitation on the utilization of the net operating losses is approximately $400,000. In addition to the net operating loss carryforwards, the Company’s alternative minimum tax credit carryforwards are also subject to the Section 382 limitation however these credit carryforwards have no expiration and can be carried forward indefinitely. Based on the annual Section 382 limitation of the utilization of net operating loss carryforwards management has determined that approximately $2,971,000 of net operating loss carryforwards will not be realized and therefore a valuation allowance of approximately $1,010,000 will be maintained for the deferred tax asset associated with these amounts. During the years ended December 31, 2009, 2008 and 2007, there were no changes in the deferred tax valuation allowance.
Based upon management’s assessment of all available evidence, including the Company’s cumulative net income for recent fiscal years, estimates of current and future profitability and the overall prospects of our business, it has been determined that as of December 31, 2009 it is more likely than not that sufficient taxable income will exist in the periods of reversal in order to realize the recorded net deferred tax asset.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
The tax effects of temporary differences that give rise to deferred federal income tax assets and deferred federal income tax liabilities are as follows:
6. Property and Equipment
At December 31, 2009 and 2008, property and equipment consisted of the following:
At December 31, 2009, computer equipment, including software includes $1,212,386 of capitalized costs related to software that has not yet been placed in-service. The Company expects to begin using the software in 2010 at which time it will begin depreciating the asset.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
7. Deferred Policy Acquisition Costs
Deferred policy acquisition costs and the related amortization were as follows:
The Company assesses the recoverability of deferred policy acquisition costs against future expected underwriting income and reduces deferred policy acquisition costs if it appears that a premium deficiency may exist. There were no premium deficiencies at December 31, 2009, 2008 and 2007.
8. Loss and Loss Adjustment Expense Liability
The Company regularly updates its reserve estimates as new information becomes available and further events occur that may impact the resolution of unsettled claims. Changes in prior years’ reserve estimates are reflected in the results of operations in the year such changes are determined. Activity in the liability for loss and loss adjustment expenses is summarized as follows (in thousands):
In 2009, the Company experienced favorable development of $2,336,000 on loss and loss adjustment expense (LAE) reserves for prior accident years. In the personal segment, homeowners had redundant development of $760,000 while personal auto experienced redundant development of $853,000 and other personal segment products had redundant development of $8,000. In the commercial segment, commercial multi-peril had redundant development of $660,000 offset by adverse development in workers compensation of $129,000. The development experienced in the workers compensation line was concentrated in accident years
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
2003, 2005 and 2007. The farm segment experienced redundant development of $63,000 while the marine segment had redundant development of $121,000. The development which occurred in 2009 is a result of downward development on both case and incurred but not reported reserves and loss adjusting expense reserves. There were no significant changes in the key assumptions utilized in the analysis and calculations of the Company’s reserves during 2009.
In 2008, the Company experienced favorable development on losses and loss adjustment expenses for prior accident years of $2,722,000. The redundant development included $814,000 related to homeowners, $864,000 related to commercial multi-peril, $336,000 related to workers compensation, $179,000 related to farm, $204,000 relating to general liability while the remaining lines of business had redundant development of $325,000. The favorable development was concentrated in accident years 2005 through 2007 and is a result of downward development on both case and incurred but not reported reserves and loss adjusting expense reserves. There were no significant changes in the key assumptions utilized in the analysis and calculations of the Company’s reserves during 2008.
In 2007, the Company experienced favorable development on losses and loss adjustment expenses for prior accident years of $4,132,000. The redundant development included $1,334,000 related to homeowners, $939,000 related to personal auto, $873,000 related to commercial multi-peril, $280,000 related to workers compensation, $281,000 related to farm while the remaining lines of business had redundant development of $425,000. The favorable development was concentrated in accident years 2004 through 2006 and is a result of downward development on both case and incurred but not reported reserves and loss adjusting expense reserves. There were no significant changes in the key assumptions utilized in the analysis and calculations of the Company’s reserves during 2007.
9. Surplus Notes
Up until September 2007, the Company had surplus notes outstanding of approximately $2,890,000 which included approximately $1,955,000 of surplus notes held by related parties consisting of a non-employee director, agents of the Company and an investment broker who provided services to the Company. The notes, which matured and were repaid in September 2007, carried an annual interest rate of 7 percent. Interest expense on the surplus notes for 2007 was approximately $146,000. Interest expense on surplus notes held by related parties was approximately $97,000 in 2007.
10. Employee Benefit Plans
Other postretirement plans
The Company provides certain postretirement health care benefits for retired employees. In December 2004 the Company’s board of directors approved an amendment to the plan effective December 31, 2004 which significantly reduced the number of eligible participants in the plan, discontinued future eligibility for all other employees and reduced the level of health care benefits for future retirees determined to be eligible as of December 31, 2004. The plan amendment resulted in a reduction to the accumulated projected benefit obligation at December 31, 2004 of $2,003,943 of which $486,915 reduced the unrecognized transition obligation while the remaining credit balance of $1,517,028 represents the unrecognized reduction to prior service cost as a result of the plan amendment. The balance of the unrecognized reduction to prior service cost will be amortized over 17.7 years which represents the average future lifetime of retirees and fully eligible active participants at the date of the amendment.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
Changes in the accumulated benefit obligation were:
At December 31, 2009, 2008 and 2007 the funded status of $1,819,308, $1,738,697 and $1,895,238, respectively, is recognized in the accompanying balance sheet as accrued expenses and other liabilities.
Gross amounts recognized in accumulated other comprehensive income consist of:
Components of net periodic benefit cost and the weighted average discount rate are below:
The discount rate assumption used to determine the benefit obligation was lowered from 6.3% to 5.82% as of December 31, 2009 to match the effective rate produced when matching the expected future benefit payments to the Citigroup Discount Pension Curve.
The estimated prior service credit and net actuarial loss that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next fiscal year are $85,682 and $2,480, respectively.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
The Company uses a December 31 measurement date for its other postretirement plan. As this plan is not pre-funded, no contributions other than those necessary to cover benefit payments are anticipated. At December 31, 2009, the Company’s expected future benefit payments are as follows:
For measurement purposes as of December 31, 2009, 2008 and 2007 the annual rate of increase in the per capita cost of covered health care benefits assumed for the subsequent year was 8.0%, 9.0% and 8.0%, respectively. The rate was assumed to decrease to an ultimate rate of 5.0% in 2013. Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plan. A one percentage-point change in assumed health care cost trend rates would have the following effects:
Defined contribution plan
The Company has a defined contribution 401(k) plan covering substantially all employees meeting certain eligibility requirements. The 401(k) plan provides for matching contributions and /or profit sharing contributions as defined by the Board of Directors. Company contributions approximated $147,000 in 2009, $150,000 in 2008 and $135,000 in 2007.
11. Lease Agreements
The Company leased various vehicles under non-cancelable operating lease agreements. The vehicle lease agreements expired in 2009. Rental expense was approximately $3,000, $9,000 and $22,000 in 2009, 2008 and 2007, respectively.
12. Capital and Surplus and Related Restrictions
As of December 31, 2009 and 2008, approximately $104,875,000 and $93,771,000, respectively, of consolidated assets represent assets of FIC that are subject to regulation and may not be transferred to FMIC in the form of dividends, loans or advances without the prior approval of the Michigan Office of Financial and Insurance Regulation (“OFIR”). Dividends paid by FIC are subject to limitations imposed by the Michigan Insurance Code (“Code”). Under the Code, FIC may pay dividends only from statutory earnings and capital and surplus. In addition, FIC may not declare an “extraordinary” dividend to its shareholders without the prior approval of OFIR. An extraordinary dividend or distribution is defined as a dividend or distribution of cash or other property whose fair market value, together with that of other dividends and distributions made within the preceding 12 months, exceeds the greater of 10% of statutory capital and surplus as of December 31, of the preceding year or the statutory net income, excluding net realized investment gains, for the immediately preceding calendar year. Accordingly, FIC may pay dividends of approximately $3,694,000 in 2010 without prior approval. However, the OFIR has the authority to prohibit payment of any dividend.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
Certain regulations that affect the insurance industry are promulgated by the National Association of Insurance Commissioners (“NAIC”), which is an association of state insurance commissioners, regulators and support staff that acts as a coordinating body for the state insurance regulatory process. The NAIC has established risk-based capital (“RBC”) requirements to assist regulators in monitoring the financial strength and stability of property and casualty insurers. Under the NAIC requirements, each insurer must maintain its total capital and surplus above a calculated minimum threshold or take corrective measures to achieve that threshold. The Company has calculated its RBC level based on these requirements and has determined that it passed the RBC test and has capital and surplus in excess of the minimum threshold.
FIC’s statutory capital and surplus at December 31, 2009 and 2008 and statutory net income for the years ended December 31, 2009, 2008 and 2007 are as follows:
13. Contingencies
The Company participates in the Property and Casualty Guaranty Association (“Association”) of the State of Michigan which protects policyholders and claimants against losses due to insolvency of insurers. When insolvency occurs, the Association is authorized to assess member companies up to the amount of the shortfall of funds, including expenses. Member companies are assessed based on the type and amount of insurance written during the previous calendar year. Assessments to date have not been significant; however, in the opinion of management, while uncertain, the liability for future assessments will not materially affect the financial condition or results of operations of the Company.
14. Related Party Transactions
During 2005, the Company issued a $130,000 mortgage receivable to an agent of the Company. The note requires a monthly payment, including interest at 8%, of $1,097, which is based on a 15 year amortization. The note includes a 5 year balloon payment, which becomes due June 2010. During 2009, 2008 and 2007 the agent earned $58,805, $70,586 and $62,946, respectively, in regular and profit sharing commissions. The terms and conditions of the agency agreement between this agent and the Company are similar in all material respects to agency agreements with other agents of the Company.
During 2003, the Company issued a $140,000 mortgage receivable to an agent of the Company. The note required a monthly payment, including interest at 6%, of $1,003, which is based on a 20 year amortization. The note included a 5 year balloon payment, which became due January 2009. In January 2009, the Company extended the note with the following terms: a monthly payment, including interest at 6%, of $849, which is based on a 20 year amortization. The note includes a 5 year balloon payment which becomes due in January 2014. During 2009, 2008 and 2007, the agent earned $98,743, $91,082 and $90,422, respectively, in regular and profit sharing commissions. The terms and conditions of the agency agreement between this agent and the Company are similar in all material respects to agency agreements with other agents of the Company.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
Three nonemployee directors of the Company are also owners of independent insurance agencies. These individuals are currently appointed as agents with and write insurance for the Company. The terms and conditions of the agency agreements between these agencies and the Company are similar in all material respects to agency agreements with other agents of the Company. The Company pays all agencies commissions on business produced. All agencies are also able to earn profit sharing commissions based on the profit margins of the business produced. Total regular and profit sharing commissions earned by these agencies approximated $548,000, $545,000 and $526,000 in 2009, 2008 and 2007, respectively. The commission rates, including profit sharing commission opportunity, are the same as other agents of the Company. The agencies are independent agents and also write with regional and national insurers that may be competitors of the Company.
A nonemployee director of the Company is a partner in a law firm. The Company has retained this law firm for certain legal matters in the past and plans to continue to do so in the future. Legal fees paid by the Company to the law firm were approximately $138,000 in 2009, $69,000 in 2008 and $74,000 in 2007.
Various agents of the Company participated in the surplus note offerings and held surplus notes at December 31, 2006. The notes were paid in full in September 2007, as disclosed in Note 9-Surplus Notes. The terms and conditions of the agency agreements between the agencies and the Company are similar in all material respects to agency agreements with other agents of the Company. The Company pays the agencies commissions on business produced. The agencies are also able to earn profit sharing commissions based on the profit margins of the business produced. For the year ending December 31, 2007, agents holding surplus notes earned regular and profit sharing commissions of approximately $224,000.
A non-employee director of the Company also participated in the surplus note offerings and held a surplus note at December 31, 2006. The note was paid in full in September 2007, as disclosed in Note 9-Surplus Notes. For the year ending December 31, 2007, the non-employee director holding a surplus note received director fees of $11,350.
The Company also paid investment commissions to a firm controlled by an individual who held a surplus note at December 31, 2006. The note was paid in full in September 2007. Total investment commissions paid during the year ending December 31, 2007 were approximately $40,000.
15. Segment Information
The Company defines its operations as property and casualty insurance operations. The Company writes four major insurance lines exclusively in the State of Michigan: Personal Lines, Commercial Lines, Farm and Marine. The separate financial information of these four major insurance lines is consistent with the way results are regularly evaluated by management in deciding how to allocate resources and in assessing performance. All revenues are generated from external customers and the Company does not have a significant reliance on any single major customer or agent.
The Company evaluates product line profitability based on underwriting gain (loss). Certain expenses are allocated based on net premiums earned and net losses incurred. Underwriting gain (loss) by product line would change if different methods were applied.
During the quarter ended June 30, 2009, the Company completed its implementation of a new financial reporting system. The new system has expanded the Company’s capability in assigning expenses to a product line, a department or one of the major insurance lines. Prior to April 1, 2009, expenses were allocated to the four major insurance lines based on either net premiums earned or net losses incurred. Effective, April 1, 2009,
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
expenses which are not directly assigned to a product line, a department or a major insurance line are allocated based on measurements including premiums, incurred losses or other departmental employee data. The underwriting gain (loss) by major insurance line would change if different methods were applied.
The Company does not allocate assets, net investment income, net realized gains (losses) on investments, other income (expense), interest expense or demutualization expenses to its product lines. The accounting policies of the operating segments are the same as those described in Note 1-Summary of Significant Accounting Policies.
Segment data for the years ended December 31 are as follows:
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
As previously noted, effective April 1, 2009, the Company changed its method for determining how certain expenses are assigned to its four major insurance lines. The table below reflects the impact of these changes on each of the affected statement lines:
16. Earnings Per Share
Basic earnings per share are calculated by dividing net income by the weighted-average common shares outstanding. Diluted earnings per share are calculated by dividing net income by the weighted-average common shares outstanding and the weighted-average dilutive share equivalents outstanding. The computation of basic and diluted earnings per share is as follows:
17. Stock-based Compensation
The Company has two stock-based compensation plans which are described below. The compensation cost for these plans that has been charged against income for the years ended December 31, 2009, 2008 and 2007 was $122,057, $103,228 and $95,772, respectively. The total income tax benefit recognized in the statement of operations for stock-based compensation was $41,499, $35,098 and $32,562, for the years ended December 31, 2009, 2008 and 2007, respectively.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
The Company adopted the Fremont Michigan InsuraCorp, Inc. Stock-based Compensation Plan (the “2003 Plan”) in November of 2003 and the plan was subsequently approved by shareholders in May 2005. In February 2006 the Company adopted the Fremont Michigan InsuraCorp, Inc. Stock Incentive Plan of 2006 (the “2006 Plan”) and the plan was subsequently approved by shareholders in May 2006. Under both plans awards may include, among others, nonqualified stock options (“NQSOs”), restricted stock and stock appreciation rights.
Pursuant to the 2003 Plan, the Company is authorized to grant up to 88,796 shares. Pursuant to the 2006 Plan, the Company is authorized to grant up to 154,500 shares. Upon exercise of an option the Company issues new shares. Option awards under both plans are generally granted with an exercise price equal to the market price of the Company’s stock at the date of grant; those option awards vest 20% per year and have a 10 year contractual term. The options may fully vest upon the death or disability of the optionee or a change in control of the Company as defined in the plans. Under both plans if awards should expire, become unexercisable or be forfeited for any reason without having been exercised or without becoming vested in full, the shares of common stock subject to those awards would be available for the grant of additional awards.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2009, 2008 and 2007. The expected volatility is based on historical volatility of the Company’s stock. The expected dividend yield is based on the Company’s historical dividend payout. The expected term is an estimate based on expected behavior of the group of optionees. The risk free rate for the periods within the contractual life of the option is based on U.S. Treasury Strips in effect at the time of grant.
A summary of option activity under the plans as of December 31, 2009 and changes during the year then ended is presented below:
The weighted-average grant-date fair value of options granted in 2009, 2008 and 2007 was $10.30, $5.20 and $8.30, respectively. The total intrinsic value of options exercised in 2009, 2008 and 2007 was $41,966, $24,177 and $38,800, respectively.
FREMONT MICHIGAN INSURACORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements-(Continued)
A summary of the status of the Company’s nonvested options as of December 31, 2009 and changes during the year ended December 31, 2009 is presented below:
As of December 31, 2009, there was $367,595 of total unrecognized compensation cost related to nonvested stock-based compensation awards granted under both plans. That cost is expected to be recognized over a weighted average period of 3.5 years.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
ITEM 9A(T).
ITEM 9A(T). CONTROLS AND PROCEDURES.
Evaluation of Disclosure Controls and Procedures. We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Vice President of Finance, as appropriate, to allow timely decisions regarding required disclosure. Management necessarily applied its judgment in assessing the costs and benefits of such controls and procedures which, by their nature, can provide only reasonable assurance regarding management’s control objectives.
We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Vice President of Finance, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15, as of the end of the fiscal period covered by this report on Form 10-K. Based upon that evaluation, each of our Chief Executive Officer and our Vice President of Finance concluded that our disclosure controls and procedures are effective.
Management’s Report on Internal Control over Financial Reporting. Management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Exchange Act Rules 13a-15(f). The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Because of its inherent limitations, internal controls over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may be inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.
Under the supervision and with the participation of the Company’s Chief Executive Officer and Vice President of Finance, management conducted an evaluation of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2009 based on the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2009 under this framework.
This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.
Changes in Internal Control over Financial Reporting. In connection with our evaluation, no change was identified in our internal controls over financial reporting that occurred during the fourth quarter of 2009 that has materially affected, or is reasonably likely to materially affect, our internal controls 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 sections of the Registrant’s definitive 2010 Proxy Statement to be filed on or about April 2, 2010 in connection with the solicitation of proxies for the Annual Meeting of Stockholders to be held May 13, 2010 pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended appearing under the headings: “Matter No. 1 Election of Fremont Directors (including biographical information regarding Nominees for Election as Class I Directors, Continuing Directors and Executive Officers Who are not Directors),” “Section 16(a) Beneficial Ownership Reporting Compliance” and, “Audit Committee Report”.
The Company’s Code of Ethics, which applies to its principal executive officer and principal financial officer, or persons performing similar functions, was filed as Exhibit 14 to the Company’s Form 10-K for the year ended December 31, 2005. The Company has posted its Code of Ethics on its website (www.fmic.com) and it is available in print to any stockholder upon request. As of December 31, 2009, no amendments or waivers had been made to our Code of Ethics as previously filed with the Securities and Exchange Commission. The Company intends to post any amendments to or any waivers from a provision of its Code of Ethics that applies to its principal executive officer and principal financial officer, or persons performing similar functions on its website.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by Item 11 is incorporated by reference to the sections entitled “Executive Compensation (including the tables)” and “Director Compensation” of the Registrant’s definitive 2010 Proxy Statement to be filed on or about April 2, 2010 in connection with the solicitation of proxies for the Annual Meeting of Stockholders to be held May 13, 2010 pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended.
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 sections entitled “Security Ownership of Certain Beneficial Owners” and “Security Ownership of Management” of the Registrant’s definitive 2010 Proxy Statement to be filed on or about April 2, 2010 in connection with the solicitation of proxies for the Annual Meeting of Stockholders to be held May 13, 2010 pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended.
The Company has two equity compensation plans pursuant to which it has granted stock options to employees and non-employee directors. The Stock-Based Compensation Plan dated November 18, 2003 was approved by the shareholders on May 12, 2005 and the Stock Incentive Plan of 2006 was approved by the shareholders on May 11, 2006. The following table sets forth, with respect to the equity compensation plans, as of December 31, 2009, (a) the number of shares of common stock to be issued upon the exercise of outstanding options, (b) the weighted average exercise price of outstanding options, and (c) the number of shares remaining available for future issuance.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE.
The information required by Item 13 is incorporated by reference to the section entitled “Corporate Governance-Director Independence” and “Certain Transactions with Executive Officers and Directors” of the Registrant’s definitive 2010 Proxy Statement to be filed on or about April 2, 2010 in connection with the solicitation of proxies for the Annual Meeting of Stockholders to be held May 13, 2010 pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES.
The information required by Item 14 is incorporated by reference to the section entitled “Independent Public Accountants” of the Registrant’s definitive 2010 Proxy Statement to be filed on or about April 2, 2010 in connection with the solicitation of proxies for the Annual Meeting of Stockholders to be held May 13, 2010 pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
(a)(1) The following consolidated financial statements are filed as a part of this report in Item 8.
Report of Independent Registered Public Accounting Firm
Consolidated Financial Statements:
Consolidated Balance Sheets as of December 31, 2009 and 2008
Consolidated Statements of Operations for Each of the Years in the Three-year Period Ended December 31,
Consolidated Statements of Stockholders’ Equity for Each of the Years in the Three-year Period Ended December 31, 2009
Consolidated Statements of Cash Flows for Each of the Years in the Three-year Period Ended December 31,
Notes to Consolidated Financial Statements
(2) The following consolidated financial statement schedules for the years 2009, 2008 and 2007 are submitted herewith:
Report of Independent Registered Public Accounting Firm
Financial Statement Schedules:
Schedule I Summary of Investments-Other Than Investments in Related Parties
Schedule II Condensed Financial Information of Parent Company
Schedule III Supplementary Insurance Information
Schedule IV Reinsurance
Schedule V Allowance for Uncollectible Premiums and other Receivables
All other schedules under Regulation S-X are not required in accordance with the related instructions and, therefore, have been omitted.
(3) Exhibits:
The exhibits required by Item 601 of Regulation S-K are listed in the Exhibit Index. Documents not accompanying this report are incorporated by reference as indicated on the 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.
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints Richard E. Dunning and Kevin G. Kaastra, or either of them acting individually, his true and lawful attorney-in-fact and agent, each with full power of substitution, for him and in his name and in all capacities, to sign all amendments to this report and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, 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 date indicated.
Report of Independent Registered Public Accounting Firm
Board of Directors and Stockholders
Fremont Michigan InsuraCorp, Inc.
Fremont, Michigan
The audits referred to in our report dated March 5, 2010 relating to the consolidated financial statements of Fremont Michigan InsuraCorp, Inc. for the three years ended December 31, 2009, which is contained in Item 8 of this Form 10-K also included the audit of the financial statement schedules listed in the accompanying index. These financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statement schedules based on our audits.
In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
/s/ BDO Seidman, LLP
Grand Rapids, Michigan
March 5, 2010
Fremont Michigan InsuraCorp Inc. and Subsidiary
Schedule I-Summary of Investments-Other than
Investments in Related Parties as of December 31, 2009
Fremont Michigan InsuraCorp Inc.
Schedule II-Condensed Financial Information of Parent Company
Condensed Balance Sheet
Fremont Michigan InsuraCorp Inc.
Schedule II-Condensed Financial Information of Parent Company
Condensed Statement of Earnings
Fremont Michigan InsuraCorp Inc.
Schedule II-Condensed Financial Information of Parent Company
Condensed Statement of Cash Flows
Fremont Michigan InsuraCorp Inc. and Subsidiary
Schedule III-Supplementary Insurance Information
Fremont Michigan InsuraCorp Inc. and Subsidiary
Schedule IV-Reinsurance
Fremont Michigan InsuraCorp Inc. and Subsidiary
For the years ended December 31,
Schedule V-Allowance for Uncollectible Premiums
EXHIBIT INDEX