-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Fb+EtPokxkF/ywuu+sZevj7cRZaBPLbEcQ1ZkAuYBnKVbkc5q5AP1tyDDpYVT1Mq IAYPb2ce2QDZ3pFuzjmVrg== 0001036050-98-000432.txt : 19980324 0001036050-98-000432.hdr.sgml : 19980324 ACCESSION NUMBER: 0001036050-98-000432 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980323 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: PENNSYLVANIA MANUFACTURERS CORP CENTRAL INDEX KEY: 0001041665 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 232217932 STATE OF INCORPORATION: PA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-22761 FILM NUMBER: 98570734 BUSINESS ADDRESS: STREET 1: THE PMA BLDG STREET 2: 380 SENTRY PKWY CITY: BLUE BELL STATE: PA ZIP: 19422-2328 BUSINESS PHONE: 2156655046 MAIL ADDRESS: STREET 1: THE PMA BLDG STREET 2: 380 SENTRY PARKWAY CITY: BLUE BELL STATE: PA ZIP: 19422-2328 10-K 1 FORM 10-K INDEX
PART I PAGE Item 1. Business 1 Item 2. Properties 34 Item 3. Legal Proceedings 34 Item 4. Submission of Matters to a Vote of Security Holders 34 Executive Officers of the Registrant 34 PART II Item 5. Market for the Registrant's Common Equity and Related Shareholder Matters 35 Item 6. Selected Financial Data 35 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 35 Item 7A. Quantitative and Qualitative Disclosure About Market Risk 35 Item 8. Financial Statements and Supplementary Data 36 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 36 PART III Item 10. Directors and Executive Officers of the Registrant 36 Item 11. Executive Compensation 36 Item 12. Security Ownership of Certain Beneficial Owners and Management 36 Item 13. Certain Relationships and Related Transactions 36 PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K 36
The Business Section and other parts of this Form 10-K contain forward-looking statements that involve risks and uncertainties. The Company's actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the subsection entitled "Forward-Looking Statements" in the Company's Management's Discussion and Analysis that has been incorporated by reference into Part II, Item 7 of this Form 10-K. ITEM 1. BUSINESS COMPANY OVERVIEW Pennsylvania Manufacturers Corporation (the "Company" or "PMC"), headquartered in Blue Bell, Pennsylvania, is a Pennsylvania insurance holding company. Presently, the Company operates in two principal segments, property and casualty reinsurance through PMA Reinsurance Corporation ("PMA Re"), and workers' compensation and standard property and casualty primary insurance through Pennsylvania Manufacturers' Association Insurance Company ("PMAIC") and other affiliated insurance companies (the "Property and Casualty Group"). PMA Re emphasizes risk-exposed, excess of loss reinsurance and operates in the domestic brokered market. The Property and Casualty Group offers workers' compensation products and services and certain other standard lines of commercial insurance primarily in nine contiguous jurisdictions in the Mid-Atlantic and Southern regions of the United States, utilizing the PMA Group trade name. The domestic insurance subsidiaries through which the Property and Casualty Group writes its insurance products and who share results through an intercompany pooling agreement are referred to herein as the "Pooled Companies." During 1997, the Company established a separate specialty insurance operation focusing on excess and surplus lines, Caliber One Management Company (Caliber One). Caliber One did not write any business during 1997. Management anticipates that Caliber One will primarily write multi-line business consisting of primary and excess commercial general liability, professional liability, excess automobile and certain property exposures beginning in 1998. Because Caliber One's operating revenues and results were not significant in 1997, its data was included in the Corporate and Other segment in the foregoing discussions. PMA Re and the Property and Casualty Group are sometimes collectively referred to herein as the "Insurance Subsidiaries." A.M. Best & Company ("A.M. Best") has currently assigned an "A+ (Superior)" rating to PMA Re, an "A- (Excellent)" rating to the Pooled Companies and an "A" (Excellent) to Caliber One Indemnity Company. At December 31, 1997, the Company had total assets of $3.1 billion and shareholders' equity of $478.3 million. Unless otherwise specified in this Form 10-K, dollar amounts set forth herein with respect to the Company are presented in accordance with generally accepted accounting principles ("GAAP"). After a period of rapid growth in the late 1980's, the Company's consolidated total net premiums written declined from $552.0 million in 1992 to $418.3 million in 1997. Between 1993 and 1997, PMA Re's premium volume expanded as a result of the increased demand for reinsurance in the markets in which PMA Re participates as well as trends towards ceding companies restricting the number of reinsurers with which they will do business. Those trends have facilitated PMA Re's increased participation on reinsurance treaties with its existing clients, the writing of additional layers and programs with existing clients, and to a lesser extent, the addition of business from new ceding companies. During this period, the market for the products written by the Property and Casualty Group was very competitive. The Property and Casualty Group restricted its premium volume, rather than write business at rates that were not commensurate with the risks assumed, and introduced loss-sensitive coverages and large-deductible programs, under which insureds pay less premium but bear a greater portion of loss exposure. Beginning in 1992, premiums written were also reduced as a result of the Property and Casualty Group's re-underwriting of its book of business and, commencing in 1993, rate reductions associated with workers' compensation benefit reform laws. Management believes that recent initiatives undertaken and workers' compensation reforms enacted in recent years afford the Property and Casualty Group an opportunity to increase its core business, workers' compensation insurance, on terms acceptable to it. See "The Property and Casualty Group -- Background and Recent Developments" below. 1 The composition of the Company's net premiums written for 1997 was as follows: (dollar amounts in thousands)
Net premiums written % of total ------------ ---------- PMA Re................................ $177,934 42.5% -------- ---- The Property and Casualty Group: Workers' Compensation............. 175,301 41.9% Other commercial lines............ 65,047 15.6% -------- ----- Total............................. 240,348 57.5% -------- ----- Total................................. $418,282 100.0% ======== ===== PMA RE
BACKGROUND PMA Re is primarily a treaty reinsurer of domestic property and casualty business that operates in the brokered market. The Reinsurance Association of America (the "RAA") reported that as of September 30, 1997, PMA Re was the eighteenth largest professional reinsurer in the brokered market and the twenty- second largest professional reinsurer in the United States market based upon statutory capital and surplus. In the brokered reinsurance market, the products (reinsurance coverages) are distributed to the ultimate customer (ceding companies) through reinsurance intermediaries, known as brokers. In exchange for providing such distribution services, the brokers are paid commissions, known as brokerage, which is typically based upon a percentage of the premiums ceded under a particular contract. The brokered reinsurance market differs from the direct reinsurance market in which reinsurers maintain their own sales forces and distribute their products directly to their ceding company clients. In the five-year period ended December 31, 1997, PMA Re has expanded its premium base without changing its underwriting standards. From 1992 to 1997, PMA Re reported premium volume growth which exceeded that of the overall reinsurance industry. During such period, PMA Re's compound annual growth rate for net premiums written was 13.2%, while it is estimated that the reinsurance industry's compound annual growth rate was 8.2% for the same period based upon information published by the RAA. Management believes that the expansion of PMA Re's premium base has been attributable to several factors. First, PMA Re's volume has been impacted by industry trends that have tended to increase the demand for reinsurance. Specifically, much of the growth that has occurred in the primary insurance market in recent years has been attributable to regional and niche companies. Typically, these companies demand more reinsurance than their larger counterparts. Second, there has been growth in primary industry segments in which PMA Re specializes, such as excess and surplus lines. Third, management believes that PMA Re has benefited from the greater selectivity by ceding companies which have restricted the number of reinsurers with which they will transact business. Additionally, commencing in 1996, PMA Re initiated a target marketing program, under which certain existing accounts and new accounts were identified as having certain desirable characteristics (such as quality management and underwriting) and such accounts were pursued for additional or new business. This program, as well as fallout from consolidation in the reinsurance industry has enabled PMA Re to grow faster than the industry in 1996 and 1997. These factors have more than offset the recent trends of ceding companies retaining more of their business and highly competitive conditions which caused PMA Re to non-renew certain accounts and not accept certain new business opportunities for underwriting or pricing reasons. PMA Re's premium volume increases have largely taken the form of increased participation levels on clients' existing programs, as well as writing of additional layers and programs with current clients. To a lesser extent, volume growth has been attributable to business written with new ceding company clients. 2 REINSURANCE PRODUCTS The following table indicates PMA Re's gross and net premiums written by major category of business: (dollar amounts in thousands)
1997 1996 1995 1994 1993 -------- -------- --------- -------- -------- Gross premiums written (1) Casualty................................ $151,901 $143,991 $128,736 $107,001 $ 94,482 Property................................ 72,625 63,325 63,693 36,592 28,217 Other................................... 795 842 (63) 837 1,854 -------- -------- -------- -------- -------- Total................................... $225,321 $208,158 $192,366 $144,430 $124,553 ======== ======== ======== ======== ======== Net premiums written (2) Casualty................................ $118,889 $122,008 $107,383 $ 88,585 $ 82,016 Property................................ 58,257 41,240 45,440 23,929 18,407 Other................................... 788 805 (63) 837 1,854 -------- -------- -------- -------- -------- Total................................... $177,934 $164,053 $152,760 $113,351 $102,277 ======== ======== ======== ======== ========
(1) In 1997 and 1996, gross premiums written include $5.8 million and $3.5 million of facultative reinsurance, respectively, comprised of the following: property, $2.4 million and $1.1 million, respectively; casualty, $3.4 million and $2.3 million, respectively; and other lines, $0.1 million in 1996. (2) In 1997 and 1996, net premiums written include $2.5 million and $1.0 Million of facultative reinsurance, respectively, comprised of the following: property, $1.7 million and $0.5 million, respectively; casualty, $0.8 million and $0.5 million, respectively; and other lines, less than $0.1 million in 1996. CASUALTY BUSINESS In terms of net premiums written, casualty business has increased at a compound annual growth rate of 7.2% in the five-year period ended December 31, 1997, and casualty business accounted for 66.8% of net premiums written in 1997. The following table indicates the mix of casualty business by class on the basis of net premiums written: (dollar amounts in thousands)
1997 1996 1995 1994 1993 -------- -------- -------- ------- ------- Umbrella.................. $ 30,967 $ 40,307 $ 51,558 $38,743 $34,189 Errors and Omissions...... 13,813 19,866 7,149 7,281 4,033 General Liability......... 15,174 11,702 7,460 8,936 8,665 Medical Malpractice....... 7,373 7,411 6,835 6,355 6,657 Directors' and Officers'.. 5,897 6,210 4,586 4,156 1,815 Miscellaneous Liability... 16,431 12,811 10,350 6,006 3,690 Auto Liability............ 22,268 17,056 13,032 10,134 12,616 Workers' Compensation..... 6,966 6,645 6,412 6,974 10,351 -------- -------- -------- ------- ------- Total..................... $118,889 $122,008 $107,382 $88,585 $82,016 ======== ======== ======== ======= =======
Due to the competitive conditions in the casualty market, management has maintained a relatively conservative growth posture for casualty business in the five-year period. PMA Re has generally focused on other liability coverages (which include general liability, products liability, professional liability and other more specialized liability coverages), while maintaining a relatively stable level of auto liability premiums, and de-emphasizing workers' compensation coverages. The decrease in 1997 casualty net premiums was primarily attributable to 3 increased retrocessional protection purchased (see "The Company's Reinsurance Ceded"), which offset increases in gross casualty premiums relating to new business with existing clients and larger lines taken on existing programs. In 1997, 1996 and 1995, PMA Re decreased the amount of its excess and umbrella business, as rates and terms for this type of business were no longer as attractive as they had been. Much of the growth in 1995 and 1996 related to the expansion and addition of several programs covering specialty business (which includes professional liability, directors' and officers' liability, environmental impairment liability, employment practices liability and other miscellaneous specialized coverages). Such specialty business now accounts for approximately 53.1% of in force casualty treaty business. In 1994, the growth in other liability was mainly attributable to excess and umbrella business, as PMA Re added several significant programs. PROPERTY BUSINESS Property business has increased at a compound annual growth rate of 40.4% in the five-year period ended December 31, 1997, and accounted for 32.7% of net premiums written in 1997. The increase in net property premiums written in 1997 was primarily the result of additional property underwriting expertise that PMA Re added to its underwriting staff in late 1996 to broaden its product offerings. Such expertise enabled PMA Re to increase cross-selling opportunities with its existing treaty reinsurance clients by offering additional and/or expanded property coverages. In addition, property premiums ceded decreased primarily related to changes in PMA Re's property retrocessional coverages in terms of premiums and ceding commissions (see "The Company's Reinsurance Ceded"). The decrease in net premiums written in 1996 was primarily attributable to higher ceding company retentions, competitive pricing conditions and higher ceded property premiums. The growth in net property business in 1995 and 1994, of 89.9% and 30.0%, respectively, was attributable to the expansion of several programs covering auto physical damage, inland marine risks and certain specialty property coverages written on a surplus lines basis. PMA Re has generally de-emphasized catastrophe coverages. As of December 31, 1997, catastrophe business accounted for approximately 4.0% of property premiums in force. The property programs written by PMA Re generally contain per occurrence limits and/or are not considered significantly catastrophe exposed, either because of the locations of the insured values or the nature of the underlying properties insured. However, as is common in property reinsurance, PMA Re is exposed to the possibility of loss from catastrophic events due to the aggregation of per occurrence limits and similar issues. PMA Re actively manages this exposure through aggregate management, avoidance of catastrophe business and retrocessional protection. As of January 1, 1998, PMA Re maintained catastrophe retrocessional protection of $46.0 million excess of $2.0 million. Management believes that its catastrophe retrocessional coverage is adequate to protect PMA Re against its probable maximum loss from a significant catastrophe. See "Underwriting" and "The Company's Reinsurance Ceded" below. FACULTATIVE REINSURANCE Facultative reinsurance is a form of reinsurance coverage which is placed on a risk-by-risk basis, and the reinsurer retains the right to accept or reject each individual risk submitted by the ceding company. Facultative differs from treaty reinsurance in that treaty reinsurance typically covers multiple risks within a particular classification, the reinsurer does not retain the right to accept or reject individual risks as long as such risks conform to the contract stipulations, and the ceding company is obligated to cede the risks to the reinsurer. Companies typically purchase facultative reinsurance for several reasons, including: (i) to cover unusual risks; (ii) to cover high hazard risks; (iii) to protect a ceding company's net retention and/or treaty reinsurers; (iv) to obtain additional capacity beyond that provided by a company's treaty reinsurers; (v) to cover risks excluded under a company's treaties; and (vi) to cover risks under a company's new line of business. There are some facultative products which are variations of the above general concept, such as automatic and semi-automatic facultative contracts. Under automatic facultative arrangements (sometimes known as facultative obligatory treaties), the cession is not obligatory from the ceding company's point of view, but the acceptance of the risk is automatic from the reinsurer's standpoint. For semi-automatic facultative contracts, the cession is not obligatory, but the acceptance of the risk is obligatory, unless the risk falls outside certain stipulated criteria. If the risk falls outside such criteria, the reinsurer has the option of either: (i) accepting the risk, (ii) declining the risk, or (iii) repricing the risk. 4 In 1997, PMA Re recorded $2.5 million of net facultative reinsurance premiums which represented 1.4% of total net premiums written for the year, compared to $1.0 million, or 0.6%, in 1996. PMA Re will offer facultative products as a complement to existing treaty business, as well as offering such products to companies with whom PMA Re does not presently have a relationship. The products offered include traditional facultative certificates and automatic or semi- automatic programs for both property and casualty exposures. PMA Re commenced writing facultative reinsurance in November 1995. MARKETING AND DISTRIBUTION PMA Re operates primarily through the domestic brokered reinsurance market in which it has developed relationships with major reinsurance brokers enabling it to gain access to a wide range of ceding companies with varying reinsurance and related service needs. PMA Re's brokers that accounted for more than 10% of the gross premiums in force as of December 31, 1997 were as follows: (dollar amounts in thousands)
Broker Gross Premiums in Force Percentage of Total - ------ ----------------------- -------------------- Aon Reinsurance............. $99,151 35.7% Guy Carpenter & Company..... 64,803 23.3% E. W. Blanch................ 38,267 13.8%
The above brokers are among the largest brokers in the reinsurance industry. Beginning in 1996, PMA Re began a target marketing program designed to identify companies in the smaller and medium company segments with whom PMA Re presently has either no or an insignificant relationship, but meet desired risk profiles. After such identification, marketing and underwriting personnel work with the ceding company's broker to enable PMA Re to have an opportunity to participate in the reinsurance coverage. As of December 31, 1997, PMA Re had approximately 200 unaffiliated clients, with no individual client accounting for more than 7.4% of gross premiums in force. UNDERWRITING PMA Re's underwriting process has two principal aspects: underwriting the specific program to be reinsured and underwriting the ceding company. Underwriting the specific program to be reinsured involves, in addition to pricing, a review of the type of program, the total risk and the ceding company's policy forms. Underwriting the ceding company involves an evaluation of the expected future performance of the ceding company through an examination of that company's management, financial strength, claims handling and underwriting abilities. PMA Re generally conducts underwriting and claim reviews at the offices of prospective ceding companies before entering into a major treaty, as well as throughout the life of the reinsurance contract. In underwriting excess-of-loss business, PMA Re has typically sought to write treaties that are exposed to loss on a per occurrence basis within the original policy limits of the ceding company. Management believes these layers in general lend themselves more effectively to actuarial pricing techniques. PMA Re's underwriters and actuaries work closely together to evaluate the particular reinsurance program. Using the information provided by the broker, the actuaries employ pricing models to estimate the ultimate exposure to the treaty. The pricing models that are utilized employ various experience rating and exposure rating techniques and are tailored in each case to the risk exposures underlying each treaty. The underwriters then weigh the results of the pricing models with the terms and conditions being offered to determine PMA Re's selected price. 5 As noted above, PMA Re typically requires per occurrence limits for property coverages and requires that the underlying insured values not be catastrophe exposed. Also, PMA Re does not emphasize catastrophe reinsurance coverages and has historically maintained sufficient retrocessional protection. Recent natural catastrophes did not have a significant adverse impact on PMA Re's combined ratio and earnings inasmuch as PMA Re has not focused on assuming catastrophe reinsurance business or catastrophe-exposed coverages and it has had sufficient retrocessional arrangements. The following table indicates PMA Re's gross, ceded and net losses from recent catastrophes as of December 31, 1997: (dollar amounts in thousands)
Incurred PMA Re PMA Re PMA Re Catastrophe Year Loss(1) Gross Loss Ceded Loss Net Loss - ----------- ---- -------- ---------- ---------- -------- Hurricane Hugo................. 1989 $ 4,200,000 $13,200 $11,400 $1,800 San Francisco Earthquake....... 1989 1,000,000 2,300 1,000 1,300 Oakland Fires.................. 1991 1,700,000 2,700 1,400 1,300 Hurricane Andrew............... 1992 15,500,000 22,800 20,700 2,100 Hurricane Iniki................ 1992 1,600,000 4,100 2,900 1,200 Northridge, CA Earthquake...... 1994 12,500,000 17,600 11,700 5,900 Hurricane Fran................. 1996 1,500,000 1,300 900 400
(1) Source: Property Claims Services. PMA Re has no significant obligations to its reinsurers as a result of the above catastrophes. CLAIMS ADMINISTRATION PMA Re's claims department evaluates loss exposures, establishes individual claim reserves, pays claims, provides claims-related services to PMA Re's clients, audits the claims activities of current clients and assists in the underwriting process by evaluating the claims departments of prospective clients. PMA Re's claims department's evaluation of loss exposure includes reviewing loss reports received from ceding companies to confirm that claims are covered under the terms of the relevant reinsurance contract, establishing reserves on an individual case basis and monitoring the adequacy of those reserves. The claims department monitors the progress and ultimate outcome of the claims to determine that subrogation, salvage and other cost recovery opportunities have been adequately explored. The claims department performs these functions in coordination with PMA Re's actuarial and underwriting departments. In addition to evaluating and adjusting claims, the claims department conducts claims audits at the offices of prospective ceding companies. Satisfactory audit results are required in order for reinsurance coverage to be written by PMA Re. Also, the claims department conducts annual claims audits for many current and former client ceding companies. THE PROPERTY AND CASUALTY GROUP BACKGROUND AND RECENT DEVELOPMENTS The Property and Casualty Group provides workers' compensation insurance, other commercial property and casualty insurance coverages, and related services to entities located primarily in nine contiguous jurisdictions in the Mid-Atlantic and Southern regions of the United States, utilizing the PMA Group trade name. As a result primarily of the Property and Casualty Group's underwriting decisions, the introduction of loss-sensitive coverages and large deductible programs, competition and the impact of workers' compensation benefit reform laws, the Property and Casualty Group's statutory net premiums written declined from $434.7 million in 1993 to $240.3 million in 1997. 6 In 1997, the Property and Casualty Group completed a commutation program, in which it paid approximately $118.9 million, of which $17.8 million was paid in the fourth quarter of 1996, to injured workers in exchange for a release from any future indemnity payments. Commutations are agreements with claimants whereby the claimants, in exchange for a lump sum payment, release their rights to future indemnity payments from the Property and Casualty Group. Under Pennsylvania law, all such commutation agreements must be approved by the individual claimant, who is generally represented by outside legal counsel, and the Pennsylvania Workers' Compensation Board. Savings associated with these claims were consistent with management's expectations. The number of open claims for accident years 1991 and prior was substantially reduced as a result of the commutation program. This reduction in open claims is expected to reduce the possibility of any further adverse development on such reserves, although there can be no assurances that the level of commutations will have a significant impact on the future development of such reserves. The operating results of the Property and Casualty Group improved in 1997 relative to 1996, largely as a result of reserve strengthening that these companies incurred in 1996, and also as a result of expense initiatives instituted by the Property and Casualty Group in 1997. In 1996, the Property and Casualty Group strengthened its loss reserves by $191.4 million. Of this amount, $110.0 million related to workers' compensation, $60.4 million related to asbestos and environmental claims, and $21.0 million related to other lines and loss adjustment expenses ("LAE"). The adverse development arising from workers' compensation had reduced earnings by a cumulative $251.6 million between 1992 and 1995. The reform legislation enacted in Pennsylvania, the Property and Casualty Group's principal marketing territory, in 1993 and 1996 has introduced various controls and limitations on disability and medical benefits. Management believes that the reforms and more stringent underwriting standards adopted since 1991 have had and continue to have a beneficial effect on the Company's accident year loss ratios. The strengthening recorded for asbestos and environmental claims is based upon a detailed loss analysis that examined data on an account-by-account and site-by-site basis for asbestos, and an actuarial calendar year aggregate loss development technique for environmental claims. The Property and Casualty Group's net survival ratio is 7.4 years at December 31, 1997 (8.2 years at December 31, 1996). See "Loss Reserves" below. In 1997, the Property and Casualty Group did not record any adverse loss reserve development (see "Loss Reserves"), and additionally, the impact of a lower expense base has contributed to improved operating results for the Property and Casualty Group. The Property and Casualty Group continues to emphasize its traditional core business, workers' compensation. Management believes that it can capitalize on the recent regulatory reforms, attract additional business based upon the Property and Casualty Group's expertise in workers' compensation and reduce expenses, because acquisition costs are lower for workers' compensation than other lines of commercial insurance. Additionally, the Property and Casualty Group has aligned itself with network health care providers in an attempt to offer medical cost containment practices to its insureds. In Pennsylvania, the Property and Casualty Group will seek to expand and retain more of its premium base in territories which meet the Property and Casualty Group's underwriting and actuarial criteria. Recent regulatory reforms in Pennsylvania (Acts 44 and 57) have made workers' compensation business more attractive from an underwriting perspective than it had been in the early 1990's. The workers' compensation system in certain other existing marketing territories (specifically, New Jersey, North Carolina and Virginia) has also improved in recent years. In addition, the Property and Casualty Group intends to expand into certain new territories. In 1997, the Property and Casualty Group began writing business in Georgia, and in 1996, in New York and South Carolina. In all new territories, the Property and Casualty Group will undertake a target marketing effort by identifying profiles of entities that it desires to insure. These profiles will be communicated to the key producers in the territories. It is also contemplated that the Property and Casualty Group will seek to expand its relationships with larger national and regional brokerage operations in both its existing and new territories. However, no assurance can be given that the Property and Casualty Group will be able to accomplish the above marketing plan. The Property and Casualty Group intends to continue writing other lines of property and casualty insurance, but generally only if such writings are supported by its core workers' compensation business. Effective January 1, 1997, the Property and Casualty Group reduced its retention on commercial casualty lines of business to $175,000 per risk from $500,000 per risk. The Property and Casualty Group has established two internal run-off operations to reinsure certain obligations associated with workers' compensation claims for the years 1991 and prior of the Pooled Companies for statutory accounting purposes. The results of the internal run-off operations are included in the GAAP financial results of the Property and Casualty Group. See "PMA Insurance, Cayman Ltd." and "MASCCO" below. Additionally, 7 during 1997, PMA Life Insurance Company reinsured the majority of its in force annuity business with a third party reinsurer via a quota-share reinsurance agreement for approximately $15.4 million. The transaction effectively makes PMA Life Insurance Company a dormant company. BUSINESS WRITTEN The following table sets forth certain information on the Property and Casualty Group's net premiums written for the years ended December 31: (dollar amounts in thousands)
1997 1996 1995 1994 1993 --------- -------- -------- -------- -------- Workers' Compensation............ $175,301 $198,198 $236,742 $267,033 $342,184 Commercial Auto.................. 28,938 35,224 39,834 38,984 48,108 Commercial Multi-Peril........... 41,713 35,108 40,659 31,123 27,306 General Liability & Umbrella..... 8,751 8,204 11,370 12,691 16,788 Other............................ (14,355) 6,245 8,511 3,320 324 -------- -------- -------- -------- -------- Total............................ $240,348 $282,979 $337,116 $353,151 $434,710 ======== ======== ======== ======== ======== WORKERS' COMPENSATION INSURANCE
Workers' compensation is a statutory system that requires employers to provide workers' compensation benefits to their employees and their employees' dependents for injuries and occupational diseases arising out of employment, regardless of whether such injuries result from the employer's or the employee's negligence. Employers may insure their workers' compensation obligations or, subject to regulatory approval, self-insure such liabilities. State workers' compensation statutes require that a policy cover three types of benefits: medical expenses, disability (indemnity) benefits and death benefits. The amounts of disability and death benefits payable for various types of claims are established by statute, but no maximum dollar limitation exists for medical benefits. Workers' compensation benefits vary among states, and insurance rates are subject to differing forms of state regulation. Based upon direct written premium information published by A.M. Best for the most recently available year (1996), the Property and Casualty Group is the third largest private writer of workers' compensation insurance in Pennsylvania and between the third and twenty-third largest writer of workers' compensation insurance in the remaining named jurisdictions listed in the table below. The Property and Casualty Group has focused on these jurisdictions based upon its knowledge of their workers' compensation systems and the Property and Casualty Group's assessment of their business, economic and regulatory climates. Rate adequacy, regulatory climate, economic conditions and other factors in each state are closely monitored and taken into consideration in the underwriting process. Management intends to employ similar analyses in determining whether and to what extent the Property and Casualty Group will sell its products in additional jurisdictions. See "Underwriting" below. The following table sets forth statutory direct workers' compensation business written by jurisdiction for the years ended December 31: 8 (dollar amounts in thousands)
1997 1996 1995 1994 1993 -------- -------- -------- -------- -------- Pennsylvania $ 91,126 $134,171 $142,234 $169,448 $224,067 New Jersey 26,327 17,995 24,388 31,287 47,745 Virginia 19,552 17,449 26,395 29,938 31,545 Maryland 16,538 11,406 17,993 14,391 15,318 North Carolina 9,501 8,195 14,035 11,649 21,216 Delaware 7,041 7,545 5,763 4,831 4,274 Other 11,470 5,403 7,889 4,864 7,165 -------- -------- -------- -------- -------- Total $181,555 $202,164 $238,697 $266,408 $351,330 ======== ======== ======== ======== ========
Management of the Property and Casualty Group believes that conditions in the workers' compensation market have been improving in the last several years. In addition, several states, including Pennsylvania, have enacted reforms to the workers' compensation benefit system. In 1993, Pennsylvania enacted Act 44, which introduced medical cost containment measures to the workers' compensation benefit system and expanded the period of time during which the insurer may require an employee to accept medical treatment from the employer's list of designated health care providers. The law also reduced the minimum wage replacement benefit to injured workers, introduced a credit for unemployment compensation benefits, restored the right of subrogation against tort recoveries in work-related automobile accidents and created new anti-fraud measures. In June 1996, Pennsylvania enacted Act 57, which further reformed the workers' compensation system in the state. Among its provisions, Act 57: (i) imposes application of American Medical Association Impairment Guidelines for the assessment of permanent and total claims after the first two years of total disability compensation payments and limits indemnity benefits to an additional 500 weeks for workers who are not at least 50% disabled (as measured by those guidelines); (ii) contains certain Social Security and pension benefit offsets; (iii) further increases the time frame for directed medical treatment; (iv) addresses certain inequities in the average weekly wage calculation; and (v) increases the ability of employers to demonstrate that injured workers have earning capacity. To date, Act 44 has had a favorable impact on medical loss costs in Pennsylvania and Act 57 has had a favorable impact on indemnity loss costs. In recognition of these developments, in the respective first years following the enactments of Act 44 and Act 57, the average manual rate level in Pennsylvania decreased approximately 10% in 1994 and approximately 25% in 1997. The benefit reforms, management's re-underwriting of the Property and Casualty Group's book of business and the use of loss-sensitive and alternative market products have had a favorable impact on the Property and Casualty Group's accident year loss ratios, as evidenced below: Property and Casualty Group's Workers' Compensation Undiscounted Accident Year - ------------------------------------------------------------------------------ Pure Loss Ratios As Of December 31, 1997 ---------------------------------------- Accident Year Loss Ratio ---- ---------- 1990 100% 1991 86% 1992 80% 1993 64% 1994 64% 1995 63% 1996 63% 1997 66% WORKERS' COMPENSATION PRODUCTS The Property and Casualty Group offers a variety of workers' compensation products to its customers. Certain of these products are based on rates filed and approved by state insurance departments ("rate-sensitive products"), while others are priced to a certain extent on the basis of the insured's own loss experience ("loss-sensitive 9 products"). In the last five years, the Property and Casualty Group has also developed and sold large deductible products and other programs and services to customers who agree to assume an even greater exposure to loss than under more traditional loss-sensitive products ("alternative market products"). The Property and Casualty Group decides which type of product to offer a customer based upon the customer's needs and the underwriting review. See "Underwriting" below. Set forth below is percentage information on the voluntary workers' compensation direct premiums written by product type for the policy years indicated:
1997 1996 1995 1994 1993 1992 1991 1990 1989 ----- ----- ----- ----- ----- ----- ----- ----- ----- Rate-sensitive products 62% 57% 52% 50% 54% 53% 54% 60% 73% Loss-sensitive products 27% 30% 34% 39% 40% 46% 46% 40% 27% Alternative market products 11% 13% 14% 11% 6% 1% 0% 0% 0% ---- ---- ---- ---- ---- ---- ---- ---- ---- Total 100% 100% 100% 100% 100% 100% 100% 100% 100% ==== ==== ==== ==== ==== ==== ==== ==== ====
RATE-SENSITIVE WORKERS' COMPENSATION PRODUCTS Rate-sensitive products include fixed-cost policies and dividend paying policies. The premium charged on a fixed-cost policy is based upon the manual rates filed with and approved by the state insurance department and does not increase or decrease based upon the losses incurred during the policy period. Under policies that are subject to dividend plans, the customer may receive a dividend based upon loss experience during the policy period. Since the late 1980s, the Property and Casualty Group has reduced its proportion of rate- sensitive products from over 70% to approximately 62% in 1997. With the enactment of regulatory reform in several jurisdictions in the Property and Casualty Group's marketing territory, the Property and Casualty Group has become more interested in this type of business and increased its writings of rate- sensitive accounts in such jurisdictions in 1997. LOSS-SENSITIVE WORKERS' COMPENSATION PRODUCTS The Property and Casualty Group's loss-sensitive products adjust the amount of the insured's premiums after the policy period expires based upon the insured's actual losses incurred during the policy period. These loss-sensitive products are generally subject to less price regulation than rate-sensitive products and reduce, but do not eliminate, risk to the insurer. Under these types of policies, claims professionals and actuaries periodically evaluate the reserves on losses after the policy period expires to determine whether additional premiums or refunds are owed under the policy. Such policies are typically open for adjustments for an average of five years after policy expiration. The Property and Casualty Group generally restricts such loss-sensitive products to accounts developing annual minimum premiums in excess of $100,000. ALTERNATIVE MARKET WORKERS' COMPENSATION PRODUCTS Since 1992, the Property and Casualty Group has developed a variety of alternative market products for larger accounts, including large deductible policies and off-shore captive programs. Typically, the Property and Casualty Group receives a lower up-front premium for these types of alternative market product plans. However, under this type of business, the insured retains a greater share of the underwriting risk than under rate-sensitive or loss- sensitive products, which reduces the potential for unfavorable claim activity on the accounts and encourages loss control on the part of the insured. For example, under a large deductible policy, the customer is responsible for paying its own losses up to the amount of the deductible for each occurrence. The deductibles under such policies generally range from $250,000 to $1.0 million. In addition to these products, the Property and Casualty Group offers certain workers' compensation services to its clients unbundled from the insurance products. See "PMA Management Corp." WORKERS' COMPENSATION RESIDUAL MARKET BUSINESS Workers' compensation insurers doing business in certain states are required to provide insurance for risks which are not otherwise written on a voluntary basis by the private market ("residual market business"). This system exists in all of the Property and Casualty Group's current marketing jurisdictions, except Pennsylvania and Maryland. In these two states, separate governmental entities write all of the workers' compensation residual 10 market business. In 1997, the Property and Casualty Group wrote $5.2 million of residual market business, which constituted approximately 3% of its voluntary net workers' compensation premiums written. Based upon data for policy year 1997 reported by the National Council on Compensation Insurance, the percentage for the industry as a whole, in all states, was 9.7%. COMMERCIAL LINES The Property and Casualty Group writes property and liability coverages for larger and middle market accounts which satisfy its underwriting standards. See "Underwriting" below. These coverages feature package, umbrella and commercial automobile business. During the present soft market, prices for commercial coverages have been particularly competitive. The Property and Casualty Group intends to continue offering these products, but generally only if they support the core workers' compensation business. In addition, effective January 1, 1997, the Property and Casualty Group has reduced its retention on commercial casualty lines of business to $175,000 per risk from $500,000 per risk. See "The Company's Reinsurance Ceded" below. HOME OFFICE AND FIELD OPERATIONS As of December 31, 1997, approximately 220 employees worked in the home office located in Blue Bell, Pennsylvania, and approximately 660 employees were assigned to field offices located throughout the Property and Casualty Group's marketing territory. Senior executives, financial operations, management information systems, human resources, actuarial services and legal services are headquartered in the home office. The definition of overall underwriting standards and major account and alternative market underwriting support also take place in the home office. The home office works in conjunction with senior managers from the field to establish the Property and Casualty Group's business plan and underwriting standards, which are then implemented by the field organization. The field organization currently consists of three regional offices in Valley Forge, Pennsylvania, Harrisburg, Pennsylvania, and Richmond, Virginia, as well as branch offices in each of Georgia, Maryland, New Jersey, Pennsylvania, Virginia and North Carolina. Additionally, the Property and Casualty Group operates smaller satellite offices in Ohio and New York. The branch offices deliver a full range of services directly to customers located in their service territory, and the satellite offices offer primarily underwriting and claim adjustment services. DISTRIBUTION The Property and Casualty Group distributes its products through approximately 20 direct sales employees and approximately 240 independent brokers and agents. The direct sales employees are generally responsible for certain business located in Pennsylvania. For the year ended December 31, 1997, these employees produced $39.2 million in direct premiums written, constituting 13% of the Property and Casualty Group's direct written business. The brokers and agents write business throughout the marketing territory. In 1997, the top ten brokers and agents accounted for 22% of the Property and Casualty Group's business, the largest of which accounted for not more than 4% of its business. All brokers and agents are required to submit business to the Property and Casualty Group's underwriting process before business may be accepted. The Property and Casualty Group monitors several statistics with respect to its producer force, including the number of years the producer has been associated with the Property and Casualty Group, the percentage of the producer's business that is underwritten by the Property and Casualty Group, the ranking of the Property and Casualty Group within the producer's business, and the profitability of the producer's business. Since 1989, the Property and Casualty Group has reduced the number of its producers by approximately 35%. The relationships with former brokers and agents were terminated for a variety of reasons, including lack of profitability of a terminated producer's book of business, absence of the types of accounts that the Property and Casualty Group wants to write and lack of commitment by the producer to the Property and Casualty Group's customer service program. The current distribution network generally consists of large regional agents and brokers, local agents and national brokers that specialize in larger to middle market accounts that require the variety of workers' compensation, commercial lines and alternative market products offered by the Property and Casualty Group. 11 UNDERWRITING Home office underwriters, in consultation with casualty actuaries, determine the general types of business to be written using a number of criteria, including past performance, relative exposure to hazard, premium size, type of business and other indicators of potential loss. The home office underwriting team also establishes classes of business that the Property and Casualty Group generally will not write, such as most coastal property exposures, certain hazardous products and activities and certain environmental coverages. The home office establishes the overall business goals and the underwriting authority for each regional and branch office. It also identifies specific types of business that must be referred to home office underwriting specialists and actuaries for individual pricing, including large accounts over a specified dollar limit and alternative market workers' compensation products. Underwriters and risk-control professionals in the field report functionally to the Chief Underwriting Officer, but also work as a team with the field marketing force to identify business that meets prescribed underwriting standards and to develop specific strategies to write the desired business. In performing this assessment, the field office professionals also consult with actuaries who have been assigned to the specific field office regarding loss trends and pricing and utilize actuarial loss rating models to assess the projected underwriting results of accounts. The Property and Casualty Group also employs credit analysts. These employees review the financial strength and stability of customers whose business is written on loss-sensitive and alternative market products and specify the type and amount of collateral that customers must provide under these arrangements. REHABILITATION AND MANAGED CARE The Property and Casualty Group uses a variety of managed care techniques to reduce costs and losses. Disability management coordinators and point-of-service case managers, all of whom are registered nurses, work together with claims professionals to provide expeditious medical and disability management to injured workers and to investigate injuries. The case managers and professionals also help employers identify opportunities that allow injured employees to make a gradual transition to full-time, full-duty jobs. The Property and Casualty Group also has contracts with preferred provider networks consisting of medical practitioners selected for their expertise in treating injured workers. Specialties include occupational medicine, physical medicine, orthopedics and neurology. There are also preferred pharmacy networks to reduce the cost of medication. Finally, an automated program is used to check medical bills for accuracy, duplication, unrelated charges and overcharges. Questionable bills are forwarded to the Cost Containment Unit, which is staffed by registered nurses and resolves disputed or suspect charges. CLAIMS ADMINISTRATION Claims services are delivered to customers primarily through employees in the field offices. Certain specialized matters, such as asbestos and environmental claims, are referred to a special unit in the home office. The Property and Casualty Group also employs in-house attorneys who represent customers in workers' compensation cases and other insurance matters. The Property and Casualty Group has a separate, formal anti-fraud unit. The anti-fraud unit investigates suspected false claims and other irregularities and cooperates with regulatory and law enforcement officials in prosecuting violators. PMA MANAGEMENT CORP. PMA Management Corp. offers claims, risk management and related services primarily to self-insureds on an unbundled basis. In addition, PMA Management Corp. offers "rent-a-captive" products for certain insureds and associations. The purpose of a rent-a-captive program is to offer a customer an alternative method of managing its loss exposures by obtaining many of the benefits of a captive insurer without establishing and capitalizing its own captive; in effect, the insured is "renting" a captive facility that the Company has already established. Under this arrangement, the client purchases an insurance policy from the Pooled Companies and chooses a participation level. The Pooled Companies then cede this portion of the premium and loss exposures to a Bermuda subsidiary of PMC. The client participates in the loss and investment experience of the portion ceded to the Bermuda subsidiary through a dividend mechanism. The client is responsible for any loss that may arise within its participation level, 12 and such potential obligation is typically secured through a letter of credit or similar arrangement. The Company's principal sources of income from its rent-a- captive program are the premium income on the excess risk retained by the Pooled Companies and captive management fees earned by PMA Management Corp. PMA INSURANCE, CAYMAN LTD. PMA Insurance, Cayman Ltd. ("PMA Cayman"), a wholly owned subsidiary of the Company, was incorporated in Grand Cayman, and had no material operations until 1996. At December 31, 1997, PMA Cayman has $260.5 million in total assets and $256.2 million in total reserves. Substantially all of PMA Cayman's assets are held in trust for the benefit of the Pooled Companies. PMA Cayman is included in the Property and Casualty Group's GAAP results. MID-ATLANTIC STATES CASUALTY COMPANY Mid-Atlantic States Casualty Company ("MASCCO") is a Pennsylvania insurance company and a wholly owned subsidiary of the Company. Prior to December 31, 1996, MASCCO was a party to a pooling agreement with the Pooled Companies. Effective December 31, 1996, and with the approval of the Pennsylvania Insurance Commissioner (the "Commissioner"), MASCCO withdrew from the pool and ceased writing any new business. The Pooled Companies also ceded to MASCCO the indemnity portion of Pennsylvania workers' compensation claims for accident years 1991 and prior. At December 31, 1997, MASCCO had $111.6 million in total assets and $96.2 million in total reserves. Substantially all of MASCCO's assets are held in trust for the benefit of the Pooled Companies. MASCCO is also included in the Property and Casualty Group's GAAP results. Pursuant to a surplus maintenance agreement between PMC and the Commissioner, MASCCO is required to discount its reserves at no more than 5%, maintain a reserve to surplus ratio not in excess of 8:1 and continue to invest its assets only in investment grade securities. At December 31, 1997, MASCCO's level of reserves to surplus was 6.6:1. CALIBER ONE In 1997, the Company established a specialty insurance operation, Caliber One. In starting Caliber One, the Company's intention is to expand PMC's access to the insurance market by offering products and marketing to classes of business that the neither PMA Re nor the Property and Casualty Group presently does. The Company has hired an experienced senior underwriting professional to be the Chief Operating Officer of this unit (see "Executive Officers of the Registrant"), as well as other individuals with experience in underwriting and claims management for specialty insurance. PRODUCTS, UNDERWRITING AND DISTRIBUTION Caliber One's initial focus will be on excess and surplus lines of insurance for difficult risks that are typically declined by the standard market. Caliber One plans to offer liability coverages for low frequency/high severity classes, including pharmaceuticals, chemicals, machinery manufacturers, toy makers, medical product manufacturers, and other difficult-to-insure product liability risks. In addition, Caliber One plans to market environmental impairment liability coverages, clinical trials coverage for emerging biotechnology products, intellectual property rights liability coverages, as well as property coverages for unprotected and vacant buildings. Caliber One's policy forms will contain appropriate and flexible manuscript endorsements and exclusions, and in some cases, will contain defense costs within the policy limits rather than offering such coverage on an unlimited basis. The underwriting of these specialty products involves a significant amount of judgment. The senior underwriters that Caliber One has hired and those that it intends to hire have a significant amount of experience in dealing with esoteric high severity risks. The underwriting process involves reviewing the claim experience of an account (if any), the claim experience of the particular class or similar classes, and responding to special risks that an account has through the use of policy features that can be changed for the circumstances, such as retentions, exclusions, and endorsements. Caliber One's underwriting teams for casualty products have been divided into three regions 13 within the U.S., each led by a regional underwriting vice president who reports to the Chief Operating Officer. For property products, one underwriting team will support the activities of the three regions. Caliber One will distribute its excess and surplus lines products, on a nationwide basis, through approximately 30 appointed surplus lines brokers. For most product offerings, Caliber One will not grant underwriting or binding authority to its brokers. ACQUISITION OF CALIBER ONE INDEMNITY COMPANY In December 1997, PMA Re acquired 100% of the common stock of Lincoln Insurance Company ("Lincoln"), a Delaware domiciled insurance company, which was subsequently renamed Caliber One Indemnity Company. PMA Re paid $16.0 million to acquire the company and made an $11.3 million capital contribution to bring Caliber One Indemnity Company's statutory surplus to $25.0 million, the minimum surplus level required by several states to be an authorized excess and surplus lines carrier. Caliber One Indemnity Company was essentially a shell company, as affiliates of the former parent had taken over the business that had been previously written by Lincoln. Additionally, an affiliate of the former parent entered into a reinsurance transaction with Lincoln immediately prior to the acquisition whereby such company assumed all of Lincoln's existing loss reserves and is providing protection against adverse loss reserve development and uncollectible reinsurance of up to $68.5 million. Also, PMA Re has entered into a surplus maintenance agreement with Caliber One Indemnity Company whereby PMA Re will maintain Caliber One Indemnity Company's statutory surplus such that the amount is not less than $25.0 million and so that the net premiums written to surplus ratio does not exceed 1.0 to 1.0. Caliber One Indemnity Company is presently authorized as an excess and surplus lines carrier in 32 states, and it is management's intention to be authorized in 49 states so that products can be offered on a national basis. Caliber One Indemnity Company has obtained an "A" (Excellent) rating from A.M. Best. THE COMPANY'S REINSURANCE CEDED The Company follows the customary insurance practice of reinsuring with other insurance companies a portion of the risks under the policies written by the Insurance Subsidiaries. This reinsurance is maintained to protect the Insurance Subsidiaries against the severity of losses on individual claims and unusually serious occurrences in which a number of claims produce an aggregate extraordinary loss. Although reinsurance does not discharge the Insurance Subsidiaries from their primary maximum liabilities to their policyholders for the full amount of the losses insured under the insurance policies, it does make the assuming reinsurer liable to the Insurance Subsidiaries for the reinsured portion of the risk. The Insurance Subsidiaries' reinsurance ceded agreements generally may be terminated at their annual anniversary by either party upon 30 to 90 days' notice. In general, the reinsurance agreements are of the treaty variety, which cover all underwritten risks of the types specified in the treaties. Presently, the maximum gross lines that PMA Re will write are $5.0 million for property covers, $1.0 million for property catastrophe covers and $7.5 million for casualty covers. Net retentions on any one claim are $750,000 for property covers and $1.5 million for casualty covers. PMA Re maintains property catastrophe retrocession programs in an aggregate amount of $46.0 million in excess of $2.0 million for multiple claims arising from two or more risks in a single occurrence or event. PMA Re also maintains casualty retrocession programs. PMA Re has a casualty retrocession contract, written on a funds withheld basis, which covers individual casualty losses and provides low-layer clash protection. For individual losses, the contract covers $6.0 million in excess of $1.5 million on a per occurrence basis. The contract has clash limits for losses arising from two or more risks of $1.25 million in excess of $1.5 million. The term of the contract is three years, and the term aggregate limit is $25.0 million plus the amount of funds withheld. In addition to the above programs, PMA Re maintains casualty clash protection of $12.5 million in excess of $2.75 million per occurrence and a workers' compensation retrocession program with limits of $53.0 million in excess of $2.0 million per occurrence. 14 Also, PMA Re maintains aggregate protection up to $22.3 million in excess of $178.0 million for the current accident year. Effective January 1, 1998, PMA Re added a new workers' compensation program which includes coverage of $98.0 million excess of $2.0 million per occurrence, $98.5 million excess of $1.5 million per program per occurrence and $18.5 million excess of $1.5 million per person per occurrence. The Property and Casualty Group has its own ceded reinsurance program, and carries excess-of-loss per occurrence reinsurance for $103.5 million over a net retention of $1.5 million on workers' compensation. The Property and Casualty Group also carries excess-of-loss per risk reinsurance for $4.8 million ($49.8 million per occurrence) over a net retention of $175,000 on other casualty lines; $2.0 million on automobile physical damage and $19.5 million ($48.5 million per occurrence) on property claims over its combined net retention of $500,000. A property catastrophe program with a per occurrence limit of $27.7 million in excess of an $850,000 retention is maintained to provide protection for multiple property losses involved in one occurrence. The Property and Casualty Group also maintains reinsurance protection for its umbrella risks at $9.0 million over a net retention of $1.0 and purchases facultative reinsurance for certain other risks. Effective January 1, 1998, Caliber One maintains reinsurance protection of $4.5 million excess of $500,000 per policy. For primary coverages, the reinsurance is written on an excess of loss basis, and for excess coverages, the reinsurance is written on a surplus share basis. Caliber One Indemnity Company is also reinsured by an affiliate of its former parent relating to all business written prior to its acquisition by PMA Re in December 1997 (see "Caliber One"). The Company actively manages its exposure to catastrophic events. In the underwriting process, the Company generally avoids the accumulation of insurable values in catastrophe prone regions. Also, in writing property reinsurance coverages, PMA Re typically requires per occurrence loss limitations for contracts that could have catastrophe exposure. Through per risk reinsurance, the Company also manages its net retention in each exposure. As a result, the Company's loss ratios have not been significantly impacted by catastrophes, and management believes that the Company has adequate reinsurance to protect against the estimated probable maximum gross loss from a catastrophic event; however, though management believes it is unlikely, an especially severe catastrophic event could exceed the Company's reinsurance and/or retrocessional protection, and adversely impact the Company's financial position, perhaps materially. The Company performs extensive credit reviews on its reinsurers, focusing on, among other things, financial capacity, stability, trends, and commitment to the reinsurance business. Prospective and existing reinsurers failing to meet the Company's standards are excluded from the Company's reinsurance programs. In addition, the Company requires letters of credit to support balances due from reinsurers not authorized to transact business in the applicable jurisdictions. LOSS RESERVES In many cases significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured loss, the reporting of the loss to the insurer and the insurer's payment of that loss. Liabilities for reinsurers generally become known more slowly than for primary insurers and are generally subject to more unforeseen development. To recognize liabilities for unpaid losses, insurers establish reserves, which are balance sheet liabilities representing estimates of future amounts needed to pay claims with respect to insured events which have occurred, including events that have not been reported to the insurer. Reserves are also established for LAE representing the estimated expenses of settling claims, including legal and other fees, and general expenses of administering the claims adjustment process. When a claim is reported, claims personnel establish a case reserve for the estimated amount of the ultimate payment. The estimate reflects the informed judgment of such personnel, based on general corporate reserving practices and the experience and knowledge of such personnel regarding the nature and value of the specific type of claim. Reserves are also established on an aggregate basis to provide for losses incurred but not yet reported to the insurer, for the overall adequacy of case reserves and the estimated expenses of settling claims. Such reserves are estimated using various generally accepted actuarial techniques. 15 As part of the reserving process, historical data is reviewed and consideration is given to the anticipated impact of various factors such as legal developments, changes in social attitudes and economic conditions, including the effects of inflation. This process relies on the basic assumption that past experience, adjusted for the effect of current developments and likely trends, is an appropriate basis for predicting future events. The reserving process provides implicit recognition of the impact of inflation and other factors affecting claims payments by taking into account changes in historic payment patterns and perceived probable trends. There is generally no precise method, however, for subsequently evaluating the adequacy of the consideration given to inflation or to any other specific factor, since the eventual deficiency or redundancy of reserves is affected by many factors, some of which are interdependent. Estimating the Company's ultimate claims liability is necessarily a complex and judgmental process as the amounts are based on management's informed estimates and judgments using data currently available. As additional experience and data become available regarding claims payment and reporting patterns, legislative developments and economic conditions, the estimates are revised accordingly. If the Company's ultimate net losses prove to be substantially greater than the amounts recorded at December 31, 1997, the related adjustments could have a material adverse impact on the Company's financial condition and results of operations. In 1997, the Company had favorable loss and LAE development (of which $51.8 million has offsetting impacts to earned premiums as more fully described in "Management's Discussion and Analysis of Financial Condition and Results of Operations" incorporated herein by reference). The Company's losses and LAE were impacted by significant loss reserve strengthening for the Property and Casualty Group in 1996, partially offset by favorable development for PMA Re. The components of the Company's incurred losses and LAE for prior accident years, excluding accretion of discount, are as follows: (dollar amounts in millions)
1997 1996 1995 ------- ------- ------- PMA Re............................ $(32.1) $(35.3) $(15.0) ------ ------ ------ The Property and Casualty Group: Workers' compensation............ (44.1) 110.0 54.7 Asbestos and environmental....... -- 60.4 23.4 Other losses and LAE............. 5.0 21.0 (11.6) ------ ------ ------ Total............................ (39.1) 191.4 66.5 ------ ------ ------ Other............................. (14.8) -- -- ------ ------ ------ Total............................. $(86.0) $156.1 $ 51.5 ====== ====== ======
In 1997, the Property and Casualty Group recorded a reserve release of approximately $53.9 million on prior year losses and LAE, excluding the accretion of discount. The release primarily relates to favorable reserve development of $9.0 million related to retrospectively rated policies for accident years 1991 and prior and favorable development of $28.0 million related to retrospectively rated policies pertaining to accident years 1992 through 1996. The Property and Casualty Group also recorded favorable development on guaranteed cost workers' compensation reserves for accident years 1991 and prior of $7.1 million, partially offset by reserve strengthening in commercial multi- peril business for accident year 1996 of $5.0 million. Furthermore, incurred losses on prior accident years were also affected by the cession of prior year reserves included in the PMA Life Insurance Company transaction of $14.8 million. In 1996 and 1995, the loss ratio included $191.4 million and $66.5 million, respectively, of strengthening of unpaid losses and loss adjustment expenses of prior accident years. 16 The following table shows the composition of changes in the reserves for losses and LAE for the past three years: (dollar amounts in thousands)
1997 1996 1995 ----------- ---------- ---------- Balance at January 1............................................ $2,091,072 $2,069,986 $2,103,714 Less: Reinsurance recoverable on unpaid losses and LAE.......... 256,576 261,492 247,856 ---------- ---------- ---------- Net balance at January 1...................................... 1,834,496 1,808,494 1,855,858 ---------- ---------- ---------- Losses and LAE incurred, net: Current year.................................................. 341,880 323,069 357,787 Prior years................................................... (86,006) 156,074 51,491 Accretion of discount (includes ($35,000) effect of the change in the discount rate for the Property and Casualty Group's workers' compensation unpaid losses from 4% to 5% in 1995)................................. 51,407 57,480 13,300 ---------- ---------- ---------- Total losses and LAE incurred, net.............................. 307,281 536,623 422,578 ---------- ---------- ---------- Losses and LAE paid, net: Current year.................................................. (72,399) (72,194) (71,126) Prior years................................................... (398,475) (438,427) (398,816) ---------- ---------- ---------- Total losses and LAE paid, net.................................. (470,874) (510,621) (469,942) ---------- ---------- ---------- Net balance at December 31...................................... 1,670,903 1,834,496 1,808,494 Reinsurance recoverable on unpaid losses and LAE................ 332,284 256,576 261,492 ---------- ---------- ---------- Balance at December 31.......................................... $2,003,187 $2,091,072 $2,069,986 ========== ========== ==========
The following table shows how the Company's losses have been paid and reserves re-estimated over time, compared to the liability initially estimated: 17 CONSOLIDATED LOSS AND LOSS ADJUSTMENT EXPENSE DEVELOPMENT (dollar amounts in millions)
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- I. Initial estimated liability for unpaid losses and LAE net of reinsurance recoverables $1,246.1 $1,457.4 $1,632.2 $1,734.6 $1,824.3 $1,941.0 $1,932.0 $1,855.9 $1,808.5 $1,834.5 $1,670.9 II. Amount of reserve paid, net of reinsurance through: - - one year later........ 305.2 322.3 444.6 470.8 490.5 442.4 407.8 398.9 437.6 398.8 -- - - two years later....... 504.4 601.1 771.5 842.0 848.8 779.1 746.1 763.7 780.0 - - three years later..... 691.8 825.9 1,042.6 1,133.8 1,127.0 1,066.8 1,055.9 1,072.9 - - four years later...... 834.0 1,011.4 1,258.0 1,353.1 1,364.9 1,329.2 1,330.6 - - five years later...... 955.8 1,165.8 1,421.4 1,539.4 1,585.4 1,573.8 - - six years later....... 1,063.1 1,283.8 1,553.1 1,715.1 1,788.9 - - seven years later..... 1,143.3 1,380.1 1,684.6 1,882.1 - - eight years later..... 1,214.0 1,478.9 1,817.3 - - nine years later...... 1,288.2 1,584.2 - - ten years later....... 1,366.9 III. Reestimated liability, net of reinsurance as of: - - one year later........ 1,280.1 1,468.3 1,696.0 1,795.3 1,966.8 1,998.1 1,932.3 1,907.4 1,964.6 1,748.5 -- - - two years later....... 1,303.9 1,511.9 1,742.5 1,949.9 2,067.5 2,006.5 1,982.5 2,073.4 1,866.8 - - three years later..... 1,339.1 1,553.3 1,876.0 2,034.1 2,081.5 2,060.6 2,163.9 1,986.7 - - four years later...... 1,358.5 1,607.3 1,938.2 2,040.8 2,134.8 2,258.2 2,078.3 - - five years later...... 1,368.4 1,651.5 1,935.1 2,123.0 2,302.0 2,170.3 - - six years later....... 1,391.1 1,648.7 1,985.3 2,273.3 2,209.3 - - seven years later..... 1,392.8 1,684.2 2,098.2 2,205.4 - - eight years later..... 1,425.4 1,783.6 2,052.2 - - nine years later...... 1,503.9 1,751.8 - - ten years later....... 1,484.7 IV. Indicated deficiency (redundancy) $ 238.6 $ 294.4 $ 420.0 $ 470.8 $ 385.0 $ 229.3 $ 146.3 $ 130.8 $ 58.3 $ (86.0) $ -- V. Net liability - December 31, $1,932.0 $1,855.9 $1,808.5 $1,834.5 $1,670.9 Reinsurance recoverables 218.7 247.9 261.5 256.6 332.3 Gross liability - December 31, $2,150.7 $2,103.8 $2,070.0 $2,091.1 $2,003.2 VI. Re-estimated net liability $2,078.3 $1,986.7 $1,866.8 $1,748.5 $1,670.9 Re-estimated reinsurance recoverables 178.1 221.3 253.5 250.8 332.3 Re-estimated gross liability $2,256.4 $2,208.0 $2,120.3 $1,999.3 $2,003.2
The columns in the above exhibit are not mutually exclusive. For example, if a reserve established in 1987 for a claim incurred during that year had been re- estimated during 1989, the re-estimate would be reflected in the table for each of the statement years from 1987 and 1988 during calendar years 1989 through 1997. Conditions and trends that have affected the reserve development reflected in the table may change and care should be exercised in making conclusions about the relative adequacy of reserves from such development. The 1996 aggregate workers' compensation adverse development was allocated $102.0 million to Pennsylvania and $8.0 million to all other states in the Company's marketing territory. Of the $102.0 million, the allocation by year is as follows: prior to 1987: $16.0 million; 1987 to 1991: $101.0 million; and 1992 and subsequent years: ($15.0 million). In 1995, substantially all of the workers' compensation adverse development related to accident years 1987 to 1991 in Pennsylvania. For accident years prior to 1992, the traditional paid loss development schedules for workers' compensation had begun to exhibit an increasing trend in loss development factors by 1993. This trend was initially attributed to an increase in commutation activity. In 1995, management began to question whether loss data was developing in a manner that was consistent with the conclusion that the loss development trends were impacted solely by commutation activity. As a result, management began to accumulate additional data in order to determine whether there were additional causes of the increase in the paid loss development data; 18 management obtained claim count data that was far more detailed than had been historically utilized in the reserve setting process. This data indicated that the paid loss development factors were not only impacted by commutation activity, but also by a decline in the claims closure rate in Pennsylvania. Management believes that the decline of the closure rates was due to several interrelated factors. One factor related to the fact that efforts to rehabilitate claimants and return them to work were not as successful as anticipated. For accident years 1987 to 1991, in particular, extensive efforts were made by the Company to rehabilitate claimants and return them to work at either full or modified duty. By late 1995 and into 1996, it was recognized, by a review of a slow down in the claims closure pattern that these rehabilitation efforts were not impacting the closure rates as expected. Another factor negatively impacting claims closure rates related to the economic conditions in Pennsylvania in the early 1990's. During the period from 1990 to 1994, economic conditions in Pennsylvania were considered to be depressed in the Company's major industry niches for workers' compensation insurance (construction, heavy manufacturing). Payrolls in these industries were stagnant, and in many cases, employment was flat or declining. The Company believes that in periods of declining employment opportunities, there is a tendency for indemnity periods to increase, which occurred for workers who suffered injuries in these industries. The above factors, when considered with the fact that the benefits period in Pennsylvania was unlimited, caused the Company to believe that a substantial portion of claimants from the pre-1992 period, who had already been out of work five to nine years, would not return to work in any capacity. In late 1995 and during 1996, management undertook an effort to quantify the impact of the declining closure rates versus the increase in commutation activity. During the fourth quarter of 1995, management strengthened the Property and Casualty Group's workers' compensation reserves by $54.7 million; however, the quantification of the effect of the claims closure rate was an extremely complex process, and as such, the data was not fully understood at that time. As the data under analysis was more mature and refined in 1996, management determined that the workers' compensation loss reserves for Pennsylvania in the pre-1992 accident years needed to be increased substantially; therefore, the Property and Casualty Group increased its workers' compensation reserves by $110.0 million. Benefit reforms enacted by states in which the Property and Casualty Group transacts business, most significantly Pennsylvania, have had a beneficial impact on more recent accident year loss ratios. Prior to 1996, the principal revisions of the Pennsylvania system included medical cost containment measures and an expansion of the period of time during which the insurer may require an employee to accept medical treatment from the employer's list of designated health care providers. In July 1996, Pennsylvania enacted Act 57, a workers' compensation reform bill which is expected to substantially reduce indemnity benefit periods in Pennsylvania. In addition to regulatory reforms, the loss ratios have been favorably impacted by the conversion to loss sensitive and alternative market products. Such a trend is evidenced by the fact that accident year pure loss ratios (losses recorded for the year in which the event occurred expressed as a percentage of the earned premiums for that year) for workers' compensation have been generally lower in more recent accident years, as the following chart indicates: Property and Casualty Group's Workers' Compensation Undiscounted Accident Year ------------------------------------------------------------------------------ Pure Loss Ratios as of December 31, 1997 ---------------------------------------- Accident Years Loss Ratio -------------- ---------- 1990 100% 1991 86% 1992 80% 1993 64% 1994 64% 1995 63% 1996 63% 1997 66% In addition, management took several steps to reduce the outstanding claims associated with the Pennsylvania workers' compensation business written through 1991. A formal commutation program was initiated in the fourth quarter 1996 and continued into late 1997. Commutations are agreements with claimants whereby the claimants, in exchange for a lump sum payment, will forego their rights to future indemnity payments from the Property and Casualty Group. Under Pennsylvania workers' compensation laws, all such commutation arrangements must be approved by the claimant and the Pennsylvania Workers' Compensation Board. The Property and Casualty Group paid $101.1 million and $17.8 million in 1997 and the fourth quarter of 1996, respectively, to commute workers' 19 compensation indemnity claims. Savings associated with these claims were consistent with management's expectations. The number of open claims for accident years 1991 and prior was substantially reduced as a result of the commutation program. This reduction in open claims is expected to reduce the possibility of any further adverse development on such reserves, although there can be no assurances that the level of commutations will have a significant impact on the future development of such reserves. Estimating reserves for workers' compensation claims can be more difficult than many other lines of property and casualty insurance for several reasons, including (i) the long payment 'tail' associated with the business; (ii) the impact of social, political and regulatory trends on benefit levels for both medical and indemnity payments; (iii) the impact of economic trends; and (iv) the impact of changes in the mix of business. At various times, one or a combination of such factors can make the interpretation of actuarial data associated with workers' compensation loss development more difficult, and it can take additional time to recognize changes in loss development patterns. Under such circumstances, adjustments will be made to such reserves as loss patterns develop and new information becomes available and such adjustments may be material. The adverse development in reserves associated with asbestos and environmental claims is the result of a detailed analysis of loss and LAE reserves associated with asbestos and environmental liability claims completed in 1996. The reserving for asbestos and environmental claims has undergone change at both the Company and in the insurance industry in general. For environmental and asbestos liability claims, reserving methodology has been evolving into accepted industry practice in the recent past; the Company's actuaries were able to apply these methods to its loss reserves in 1997 and 1996. To reserve for environmental claims, the Company currently utilizes a calendar year development technique known as aggregate loss development. This technique focuses on the aggregate losses paid as of a particular date and aggregate payment patterns associated with such claims. Several elements including remediation studies, remediation, defense, declaratory judgment, and third party bodily injury claims were considered in estimating the costs and payment patterns of the environmental and toxic tort losses. Prior to the development of these techniques, there was a substantial range in the nature of reserving for environmental and toxic tort liabilities. The methods employed by the Company prior to the review performed in 1996 included a review of aggregate loss and loss adjustment paid and case incurred data along with resulting "survival ratios" to establish IBNR for environmental and toxic tort claims. For asbestos claims, the Company had previously reserved costs to defend, and any indemnification payments anticipated on, claims for which it had received notice that it was a responsible party, plus a bulk factor applied to the estimated case reserves to provide for potential development of indemnification and defense cost related to such claims. In 1996, the Company performed a ground up analysis of asbestos loss reserves using an actuarially accepted modeling technique. Using historical information as a base and information obtained from a review of open claims files, assumptions were made about future claims activity in order to estimate ultimate losses. For each individual major account, projections were made regarding new plaintiffs per year, the number of years new claims will be reported, the average loss severity per plaintiff and the ratio of loss adjustment expense to loss. In many cases involving larger asbestos claims, the Company reserved up to the policy limits for the applicable loss coverage parts for the affected accounts. Policy terms and reinsurance treaties were applied in the modeling of future losses. Estimation of obligations for asbestos and environmental exposures continues to be more difficult than for other loss reserves because of several factors, including: (i) evolving methodologies for the estimation of the liabilities; (ii) lack of reliable historical claim data; (iii) uncertainties with respect to insurance and reinsurance coverage related to these obligations; (iv) changing judicial interpretations; and (v) changing government standards. 20 The Company's asbestos-related loss reserves for the years ended December 31, were as follows: (dollar amounts in thousands)
1997 1996 1995 ---------- --------- --------- Gross of reinsurance: Beginning reserves.......................... $ 80,055 $ 27,611 $ 13,969 Incurred losses and LAE..................... 2,435 62,854 22,482 Calendar year payments for losses and LAE... (5,764) (10,410) (8,840) -------- -------- -------- Ending reserves............................. $ 76,726 $ 80,055 $ 27,611 ======== ======== ======== Net of reinsurance: Beginning reserves.......................... $ 53,300 $ 23,443 $ 8,168 Incurred losses and LAE..................... (36) 39,427 21,826 Calendar year payments for losses and LAE.. (4,686) (9,570) (6,551) -------- -------- -------- Ending reserves............................. $ 48,578 $ 53,300 $ 23,443 ======== ======== ========
The Company's environmental-related loss reserves for the years ended December 31, were as follows: (dollar amounts in thousands)
1997 1996 1995 ---------- --------- --------- Gross of reinsurance: Beginning reserves........................... $ 35,626 $ 20,134 $ 20,952 Incurred losses and LAE...................... 1,130 22,143 3,516 Reserves acquired through purchase of Caliber One Indemnity Company (1).................... 13,060 - - Calendar year payments for losses and LAE..... (4,708) (6,651) (4,334) -------- -------- -------- Ending reserves.............................. $ 45,108 $ 35,626 $ 20,134 ======== ======== ======== Net of reinsurance: Beginning reserves............................ $ 34,592 $ 20,134 $ 20,952 Incurred losses and LAE....................... 1,068 21,109 3,516 Calendar year payments for losses and LAE.... (3,965) (6,651) (4,334) -------- -------- -------- Ending reserves............................... $ 31,695 $ 34,592 $ 20,134 ======== ======== ========
(1) Such acquired reserves have been reinsured by an affiliate of the former parent (see "Caliber One" for further discussion). Of the total net asbestos reserves, $6.7 million, $6.8 million, and $6.7 million related to established claims reserves at December 31, 1997, 1996, and 1995, respectively, and $41.9 million, $46.5 million, and $16.7 million related to incurred but not reported losses at December 31, 1997, 1996, and 1995, respectively. Of the total net environmental reserves, $11.2 million, $12.5 million, and $10.3 million related to established claims reserves at December 31, 1997, 1996, and 1995, respectively, and $20.5 million, $22.1 million, and $9.8 million related to incurred but not reported losses at December 31, 1997, 1996, and 1995, respectively. All incurred asbestos and environmental losses were for accident years 1986 and prior. Management believes that its reserves for asbestos and environmental claims are appropriately established based upon known facts, existing case law and generally accepted actuarial methodologies. However, due to changing interpretations by courts involving coverage issues, the potential for changes in federal and state standards for clean-up and liability and other factors, the ultimate exposure to the Property and Casualty Group for these claims may vary significantly from the amounts currently recorded, resulting in a potential future adjustment in the claims reserves recorded. Additionally, issues involving policy provisions, allocation of liability among participating insurers, proof of coverage and other factors make quantification of liabilities exceptionally difficult and subject to adjustment based upon newly available data. 21 In 1996, Commercial Lines experienced reserve strengthening of $21.0 million, as compared to a reserve release of $11.6 million in 1995. The reserve strengthening in 1996 was principally due to a re-estimation of loss adjustment costs associated with general liability claims. Through 1991, the Property and Casualty Group's mix of general liability insurance policies were weighted towards the manufacturing classes of business. Subsequent to 1991, the Property and Casualty Group's mix of business became more heavily weighted towards the construction and contracting classes of business. These particular classes of business have experienced losses due to construction defects and similar matters, that have taken longer to emerge than the classes of business previously written by the Property and Casualty Group. Defense costs associated with these claims have also exceeded the original estimate of the Property and Casualty Group's management, which was based on the patterns of indemnification payments associated with the earlier classes of business written. When this issue was discovered, the Property and Casualty Group factored the increased defense costs and the emergence pattern in determining a more appropriate reserve amount for loss handling costs. The release of reserves in 1995 was primarily due to favorable loss experience in commercial automobile business. PMA Re has reported net favorable development of unpaid losses and LAE of $23.3 in 1997, $28.6 million in 1996 and $15.0 million in 1995. Such favorable development is attributable to losses emerging at a lower rate than was anticipated when the initial accident year reserves were established. At December 31, 1997, the Company's loss reserves were stated net of $59.9 million of salvage and subrogation, of which $50.8 million related to the Property and Casualty Group, which was comprised of $46.0 million related to workers' compensation and $4.8 million related to Commercial Lines. The anticipated salvage and subrogation was $9.1 million for PMA Re. Incurred salvage and subrogation (increased) reduced losses and LAE by ($18.5) million, ($0.6) million and $9.5 million in 1997, 1996 and 1995, respectively. The Company's policy with respect to estimating the amounts and realizability of salvage and subrogation is to develop accident year schedules of historic paid salvage and subrogation by line of business, which are then projected to an ultimate basis using actuarial projection techniques. The anticipated salvage and subrogation is the estimated ultimate salvage and subrogation less any amounts received by the Company. The realizability of anticipated salvage and subrogation is reflected in the historical data that is used to complete the projection, as historic paid data implicitly considers realization and collectibility. INVESTMENTS The Company's investment policy objectives are to (i) seek competitive after-tax income and total return, (ii) maintain very high grade asset quality and marketability, (iii) maintain maturity distribution commensurate with the Company's business objectives, (iv) provide portfolio flexibility for changing business and investment climates and (v) provide liquidity to meet operating objectives. The Company has established strategies, asset quality standards, asset allocations and other relevant criteria for its fixed maturity and equity portfolios. In addition, maturities are structured after projecting liability cash flows with actuarial models. The Company also does not invest in various types of investments, including speculative derivatives. The Company's portfolio does not contain any significant concentrations in single issuers (other than U.S. treasury and agency obligations), industry segments or geographic regions. The Company's Board of Directors is responsible for the Company's investment policy objectives. The Company retains outside investment advisers to provide investment advice and guidance, supervise the Company's portfolio and arrange securities transactions through brokers and dealers. The Company's Executive and Finance Committees of the Board of Directors meet periodically with the investment advisers to review the performance of the investment portfolio and to determine what actions should be taken with respect to the Company's investments. Investments by the Pooled Companies, MASCCO and PMA Re must comply with the insurance laws and regulations of the Commonwealth of Pennsylvania and investments for Caliber One Indemnity Company must comply with the insurance laws and regulations of Delaware. The Company's capital not allocated to the Pooled Companies, MASCCO, PMA Re and Caliber One Indemnity Company may be invested in securities and other investments that are not subject to such insurance laws, but nonetheless conform to the Company's investment policy. 22 The following table summarizes the Company's investments by carrying value as of December 31, 1997, and 1996: (dollar amounts in millions)
1997 1996 ------------------- ----------------- Carrying Carrying Investment Value Percent Value Percent - ---------- -------- ------- -------- ------- U.S. Treasury securities and obligations of U.S. Government agencies......................... $1,119.5 51.0% $1,602.8 70.8% Obligations of states and political subdivisions..................... -- -- 76.5 3.4% Corporate debt securities............ 687.7 31.3% 372.8 16.5% Mortgage backed securities........... 122.3 5.6% 74.0 3.3% Equity securities.................... -- -- 0.3 -- Short-term investments............... 265.2 12.1% 135.0 6.0% -------- ----- -------- ------ Total (1)............................ $2,194.7 100.0% $2,261.4 100.0% ======== ===== ======== ======
(1) As of December 31, 1997, the market value of the Company's total investments was $2,194.7 million. The following table indicates the composition of the Company's fixed maturities portfolio at carrying value, excluding short-term investments, by rating as of December 31, 1997, and 1996: (dollar amounts in millions)
1997 1996 ------------------- ----------------- Carrying Carrying Ratings (1) Value Percent Value Percent - ---------- -------- ------- -------- ------- Total (1)............................ $2,194.7 100.0% $2,261.4 100.0% U.S. Treasury securities and AAA.. $1,449.0 75.1% $1,882.4 88.5% AA................................ 150.0 7.8% 95.8 4.5% A................................. 282.2 14.6% 147.9 7.0% BBB............................... 48.3 2.5% -- -- -------- ----- -------- ------ Total............................. $1,929.5 100.0% $2,126.1 100.0% ======== ===== -------- ------
(1) Ratings as assigned by Standard and Poor's. Such ratings are generally assigned at the issuance of the securities, subject to revision on the basis of ongoing evaluations. Ratings in the table are as of December 31 of the years indicated. The following table sets forth scheduled maturities for the Company's investments in fixed maturities, excluding short-term investments, based on stated maturity dates as of December 31, 1997. Expected maturities will differ from contractual maturities because the issuers may have the right to call or prepay obligations with or without call or prepayment penalties: (dollar amounts in millions)
Carrying Value Percent -------------- ------- 1 year or less................. $ 128.9 6.7% Over 1 year through 5 years.... 633.6 32.8% Over 5 years through 10 years.. 396.5 20.6% Over 10 years.................. 648.2 33.6% Mortgage backed securities..... 122.3 6.3% -------- ----- Total.......................... $1,929.5 100.0% ======== =====
23 The following table reflects the Company's investment results for each year in the three-year period ended December 31, 1997: (dollar amounts in millions)
1997 1996 1995 --------- --------- --------- Average invested assets (1).... $2,247.7 $2,366.8 $2,395.8 Net investment income (2)...... $ 136.7 $ 133.9 $ 139.4 Net effective yield (3)........ 6.09% 5.66% 5.82% Net realized investment gains.. $ 8.6 $ 3.0 $ 31.9
(1) Average of beginning and ending amounts of cash and investments for the period at carrying value. (2) After investment expenses, excluding net realized investment gains. (3) Net investment income for the period divided by average invested assets for the same period. As of December 31, 1997, the duration of the Company's investments was approximately 5.3 years and the duration of its liabilities was approximately 5.1 years. During 1997, the Company established a securities lending program through which securities are loaned from the Company's portfolio to qualifying third parties, subject to certain limits, via a lending agent for short periods of time. Borrowers of these securities must provide collateral equal to a minimum of 102% of the market value and accrued interest of the loaned securities. Acceptable collateral may be in the form of either cash or securities. Cash received as collateral is invested in short-term investments, and all securities received as collateral are of similar quality to those securities lent by the Company. Additionally, the Company limits securities lending to 40% of statutory admitted assets of its insurance subsidiaries, with a 2% limit on statutory admitted assets to any individual borrower. The Company receives either a fee from the borrower or retains a portion of the income earned on the collateral. Under the terms of the securities lending program, the Company is indemnified against borrower default, with the lending agent responsible to the Company for any deficiency between the cost of replacing a security that was not returned and the amount of collateral held by the Company. In 1997, the Company recognized income from securities lending transactions of approximately $524,000, net of lending fees, which was included in investment income. The Company had approximately $175.0 million of securities on loan as of December 31, 1997. COMPETITION The domestic property-casualty insurance industry consists of many companies, with no one company dominating the market. In addition, the degree and nature of competition varies from state to state for a variety of reasons, including the regulatory climate and other market participants in each state. In addition to competition from other insurance companies, the Property and Casualty Group and Caliber One compete with certain alternative market arrangements, such as captive insurers, risk-sharing pools and associations, risk retention groups, and self-insurance programs. PMA Re competes with other reinsurers in the brokered market as well as reinsurers that directly underwrite reinsurance business. Many of the Company's competitors are larger and have greater financial resources than the Company. The main factors upon which entities in the Company's markets compete are price, service, product capabilities and financial security. The Property and Casualty Group, PMA Re and Caliber One attempt to price their products in such a way that the prices charged to their clients are commensurate with the overall marketplace while still meeting return targets. Given the present soft pricing environment, competing solely on the basis of price has become increasingly difficult for the Property and Casualty Group and PMA Re, and both have had to reject risks submitted and non-renew certain accounts in recent years, as the market rates for such risks did not provide the opportunity to achieve what management considers to be an acceptable return. In terms of service, management maintains service standards to ensure that clients are satisfied with the products and services provided by the Company. Such standards concern turn-around time for underwriting submissions, information flow, claims handling and the quality of other services. Management periodically participates in surveys of intermediaries and clients to gain an understanding of the perceptions of the Company's service as compared to its competitors. 24 Management attempts to design products which meet the needs of clients in the Company's markets. In recent years, the Property and Casualty Group has developed products which reflect the evolving nature of the workers' compensation market. Specifically, management has increased its focus on rehabilitation and managed care to keep workers' compensation costs lower for the employers. Additionally, the Property and Casualty Group has introduced and refined alternative market products, as well as unbundled risk management and claims administration services. See "The Property and Casualty Group." PMA Re has also expanded its product line in recent years to satisfy the needs of its client base. Products introduced by PMA Re in the last two years include: facultative reinsurance, finite risk reinsurance, and integrated capital management (which involves providing reinsurance as well as some type of direct investment in a ceding company). See "PMA Re." For Caliber One, it is management's intention to design products that meet the needs of new classes of business and that cover emerging risks. See "Caliber One." Management continues to review new product opportunities for the Property and Casualty Group, PMA Re and Caliber One. For many intermediaries and clients, financial security is measured by the ratings assigned by independent rating agencies. Therefore, management believes that the ratings assigned by independent rating agencies, particularly A.M. Best, are material to the Company's operations. A.M. Best has currently assigned an "A+" (Superior) rating to PMA Re, an "A-" (Excellent) rating to the Pooled Companies and an "A" (Excellent) to Caliber One Indemnity Company (see "Caliber One"). According to A.M. Best, its ratings are based on an analysis of the financial condition and operating performance of an insurance company as they relate to the industry in general. These ratings represent an independent opinion of a company's financial strength and ability to meet its obligations to policyholders. These ratings are not shareholder ratings, however, and do not represent an opinion as to the value of the Company's stock. No assurance can be given that these ratings can be maintained by PMA Re, the Pooled Companies and Caliber One Indemnity Company. YEAR 2000 ISSUE The unprecedented advances in computer technology over the past several decades have resulted in dramatic changes in the way companies do business. Most of these developments have been beneficial, but some have proven costly, as businesses have struggled to adapt to various features of the new technological landscape. One such well-publicized problem has arisen out of the worldwide use of the so-called "Year 2000" programming convention, in which two digit numbers were generally used instead of four digit numbers to identify the years used in dates. As a consequence, most computers require relatively costly reprogramming to enable them to correctly perform date operations involving years 2000 or later, a problem anticipated to have substantial repercussions on the business world, since computer operations involving date calculations are pervasive. With the assistance of outside consulting groups, the Company began evaluating and reprogramming its own computer systems to address the Year 2000 issue in late 1995. Management anticipates that by year-end 1998, it will have substantially completed all necessary programming work so that Year 2000 issues are not likely to result in any material adverse disruptions in the Company's computer systems or its internal business operations. The cost of this work through year-end 1997 has been approximately $3.8 million. The Company estimates that the total remaining cost will be approximately $1.3 million, which will be expensed in 1998. Many experts now believe that Year 2000 problem may have a material adverse impact on the national and global economy generally. In addition, it seems likely that if businesses are materially damaged as a result of Year 2000 problems, at least some such businesses may attempt to recoup their losses by claiming coverage under various types of insurance policies. Although management has concluded that under a fair reading of the various policies of insurance issued by it no coverage for Year 2000 problems should be considered to exist, it is not possible to predict whether or to what extent any such coverage could ultimately be found to exist by courts in various jurisdictions. Accordingly, important factors which could cause actual results to differ materially from those expressed in the forward looking statements include, but are not limited to, the inability of the Company to accurately estimate the impact of the Year 2000 problem on the insurance issued by, or other business operations of, the Company. 25 REGULATORY MATTERS GENERAL PMA Re is licensed or accredited to transact its reinsurance business in, and is subject to regulation and supervision by 50 states and the District of Columbia. The Pooled Companies are licensed to transact insurance business in, and are subject to regulation and supervision by 45 states and the District of Columbia. Caliber One Indemnity Company is licensed in one state and is an eligible excess and surplus lines carrier in 32 states. The Insurance Subsidiaries are authorized and regulated in all jurisdictions where they conduct insurance business. Inasmuch as PMA Re and the Pooled Companies are domiciled in Pennsylvania, however, the Pennsylvania Insurance Department exercises principal regulatory jurisdiction over them, and Delaware exercises principal jurisdiction over Caliber One Indemnity Company. The extent of regulation by the states varies, but in general, most jurisdictions have laws and regulations governing standards of solvency, adequacy of reserves, reinsurance, capital adequacy and standards of business conduct. In addition, statutes and regulations usually require the licensing of insurers and their agents, the approval of policy forms and related material and, for certain lines of insurance, the approval of rates. Property and casualty reinsurers and excess and surplus lines carriers are generally not subject to filing or other regulatory requirements applicable to primary standard lines insurers with respect to rates, policy forms or contract wording. The form and content of statutory financial statements are regulated. State insurance departments in jurisdictions in which the Insurance Subsidiaries do business also conduct periodic examinations of their respective operations and accounts and require the filing of annual and other reports relating to their financial condition. The Pennsylvania Department of Insurance last conducted examinations of PMA Re and the Pooled Companies as of December 31, 1992, and the Delaware Department of Insurance last conducted an examination of Caliber One Indemnity Company as of December 31, 1996. No adjustments to previously filed statutory financial statements were required as a result of such examinations. In addition, there were no substantive qualitative matters indicated in the examination reports that had or are expected to have a material adverse impact on the operations of PMA Re, the Pooled Companies or Caliber One Indemnity Company. In supervising and regulating insurance companies, including reinsurers, state insurance departments, charged primarily with protecting policyholders and the public rather than investors, enjoy broad authority and discretion in applying applicable insurance laws and regulations for the protection of policyholders and the public. INSURANCE HOLDING COMPANY REGULATION The Company and the Insurance Subsidiaries are subject to regulation pursuant to the insurance holding company laws of Pennsylvania and Delaware. These state insurance holding company laws generally require an insurance holding company and insurers and reinsurers that are members of such insurance holding company's system to register with the state regulatory authorities, to file with those authorities certain reports disclosing information including their capital structure, ownership, management, financial condition, certain intercompany transactions including material transfers of assets and intercompany business agreements, and to report material changes in such information. Such laws also require that intercompany transactions be fair and reasonable and that an insurer's surplus as regards policyholders following any dividends or distributions to shareholder affiliates be reasonable in relation to the insurer's outstanding liabilities and adequate for its financial needs. Under Pennsylvania and Delaware law, no person may acquire, directly or indirectly, a controlling interest in the capital stock of the Company unless such person, corporation or other entity has obtained prior approval from the Commissioner(s) for such acquisition of control. Pursuant to the Pennsylvania and Delaware law, any person acquiring, controlling or holding with the power to vote, directly or indirectly, ten percent or more of the voting securities of an insurance company, is presumed to have "control" of such company. This presumption may be rebutted by a showing that control does not exist in fact. The respective Commissioner(s), however, may find that "control" exists in circumstances in which a person owns or controls a smaller amount of voting securities. To obtain approval from the Commissioner(s) of any acquisition of control of an insurance company, the proposed acquirer must file with the Commissioner(s) an application containing information regarding the identity and background of the acquirer and its affiliates, the nature, source and amount of funds to be used to effect the acquisition, the financial statements of the acquirer and its affiliates, any potential plans for disposition of the 26 securities or business of the insurer, the number and type of securities to be acquired, any contracts with respect to the securities to be acquired, any agreements with broker-dealers and other matters. Other jurisdictions in which the Insurance Subsidiaries are licensed to transact business may have requirements for prior approval of any acquisition of control of an insurance or reinsurance company licensed or authorized to transact business in such jurisdictions. Additional requirements in such jurisdictions may include re-licensing or subsequent approval for renewal of existing licenses upon an acquisition of control. As further described below, laws also govern the holding company structure payment of dividends by the Insurance Subsidiaries to the Company. RESTRICTIONS ON INSURANCE SUBSIDIARIES DIVIDENDS The principal source of funds for servicing debt of the Company and paying dividends to shareholders of the Company is derived from receipt of dividends from the subsidiaries. Under the Pennsylvania insurance laws, PMA Re and the Pooled Companies may pay dividends only from unassigned funds (surplus), as reported in the statutory financial statement filed by them with the Insurance Department for the most recent annual period. As of December 31, 1997, PMA Re and the Pooled Companies reported unassigned funds (surplus) in the amount of $294.2 million. Caliber One Indemnity Company had an unassigned deficit of $6.4 million as of December 31, 1997, and therefore, cannot pay non-extraordinary dividends; also, Caliber One Indemnity Company is directly owned by PMA Re, and as such, its dividends may not be paid directly to PMC. Subject to such constraints, PMA Re, any of the Pooled Companies and Caliber One Indemnity Company may declare and pay non-extraordinary dividends subject to certain notice requirements to the Commissioner and extraordinary dividends to stockholders subject to certain notice and approval requirements by the Commissioner. Under Pennsylvania law, an "extraordinary" dividend is any dividend or other distribution which, together with other dividends and distributions made within the preceding twelve months, exceeds the greater of (i) 10% of such insurer's surplus as regards policyholders as shown on its last annual statement on file with the Commissioner; or (ii) statutory net income for the previous year. Payment of extraordinary dividends is permissible only if the Commissioner has approved the payment of such extraordinary dividends, or if the Commissioner has not disapproved the payment of such extraordinary dividend within thirty days from the date the Commissioner receives notice of the declaration of such dividend. In addition to the foregoing standards, following the payment of any dividends, the policyholders' surplus of the insurance company must be reasonable in relation to its outstanding liabilities and adequate for its financial needs. The Commissioner may bring an action to enjoin or rescind the payment of a dividend or distribution by any insurance company that would cause its statutory surplus to be unreasonable or inadequate under this standard. For the years ended December 31, 1997, 1996 and 1995, the aggregate cash dividends paid by PMA Re and the Pooled Companies were $20.0 million, $53.6 million, and $71.5 million, respectively. None of the dividends paid was "extraordinary" for purposes of the Pennsylvania insurance laws. For 1998, PMA Re and the Pooled Companies collectively are permitted to declare and pay dividends to the Company in the aggregate amount of $51.2 million, subject to the notice requirements on dividend declarations and payments. In accordance with its plan of operation filed with the Pennsylvania Insurance Department, MASCCO must maintain a ratio of unpaid losses and LAE to policyholders' surplus of no more than 8:1. As of December 31, 1997, MASCCO was in compliance with such requirements. RISK-BASED CAPITAL The National Association of Insurance Commissioners (the "NAIC") has adopted risk-based capital ("RBC") requirements for property/casualty insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks such as asset quality, asset and liability matching, loss reserve adequacy and other business factors. Under RBC requirements, regulatory compliance is determined by the ratio of a Company's total adjusted capital, as defined by the NAIC, to its authorized control level, also as defined by the NAIC. Companies below prescribed trigger points in terms of such ratio are classified as follows: 27 Company action level......... 200% Regulatory action level...... 150% Authorized control level..... 100% Mandatory control level...... 70% At December 31, 1997, the ratios of the domestic insurance subsidiaries of the Property and Casualty Group ranged from 293% to 324%, PMA Re's ratio was 355% and Caliber One Indemnity Company's ratio was 1,922%. RBC requirements for property/casualty insurance companies allow a discount for workers' compensation reserves to be included in the adjusted surplus calculation. However, the calculation for RBC requires the phase-out of non- tabular reserve discounts previously taken for workers' compensation reserves. The discount phase-out has increased by 20% in each year since 1994, ultimately phasing out 100% of such discount by 1998. As a result, this phase-out negatively impacts the RBC ratios of companies which write workers' compensation insurance and discount such reserves on a non-tabular basis relative to companies which write other types of property/casualty insurance. Management believes that it will be able to maintain the Pooled Companies' RBC in excess of regulatory requirements through prudent underwriting and claims handling, investing and capital management. However, no assurances can be given that developments affecting the Property and Casualty Group, many of which could be outside of management's control, including but not limited to changes in the regulatory environment, economic conditions and competitive conditions in the jurisdictions in which the Property and Casualty Group writes business, will cause the Pooled Companies' RBC to fall below required levels resulting in a corresponding regulatory response. EMPLOYEES As of March 31, 1998, the Company had approximately 1,020 full-time employees. None of the employees of the Company is represented by a labor union and the Company is not a party to any collective bargaining agreements. The Company considers its employee relations to be good. 28 GLOSSARY OF SELECTED INSURANCE TERMS Actuarial analysis..................Evaluation of risks in order to attempt to assure that premiums and loss reserves adequately reflect expected future loss experience and claims payments; in evaluating risks, mathematical models are used to predict future loss experience and claims payments based on past loss ratios and loss development patterns and other relevant data and assumptions. Adverse loss development............Increases in losses and ALAE exceeding anticipated loss and ALAE experience over a given period of time. Aggregate excess reinsurance arrangements........................Reinsurance arrangements under which a reinsurer assumes the risks and/or loss reserves of certain business of a ceding company in their entirety. Allocated loss adjustment expenses ("ALAE")...................Allocated loss adjustment expenses include all legal expenses and other expenses incurred by a company in connection with the investigation, adjustment, settlement or litigation of claims or losses under business covered. ALAE does not include costs of "in-house" counsel, claims staff or other overhead or general expense of the reinsured. Attachment point....................The amount of losses above which excess of loss reinsurance becomes operative. Automatic facultative arrangements........................Facultative insurance contracts whereby the ceding company has the right, but not the obligation, to cede risks to a reinsurer and the reinsurer is obligated to accept such risks pursuant to the contract terms. Broker; intermediary................One who negotiates contracts of reinsurance between a primary insurer or other reinsured and a reinsurer on behalf of the primary insurer or reinsured. The broker receives from the reinsurer a commission for placement and other services rendered. Broker reinsurer....................A reinsurer that markets and sells reinsurance through brokers rather than through its own employees. Case reserves.......................Loss reserves established with respect to individual reported claims. Casualty insurance and/or reinsurance.........................Insurance and/or reinsurance that is concerned primarily with the losses caused by injuries to third persons (in other words, persons other than the policyholder) and the legal liability imposed on the insured resulting therefrom. Catastrophe reinsurance.............A form of excess of loss property reinsurance that, subject to a specified limit, indemnifies the ceding company for the amount of loss in excess of a specified retention with respect to an accumulation of losses resulting from a catastrophic event. The actual reinsurance document is called a "catastrophe cover." Cede; ceding company; cedent..............................When a company reinsures its risk with another, it "cedes" business and is referred to as the "ceding company" or the "cedent". 29 Claim closure rate..................The number of closed lost time workers' compensation claims divided by total reported lost time workers' compensation claims by accident year as of a given evaluation date. Clash cover.........................A form of excess of loss casualty reinsurance policy covering losses arising from a single set of circumstances covered by more than one primary policy. For example, if an insurer covers both motorists involved in an accident, a clash cover would protect the insurer from suffering a net loss in the full amount of both parties. The clash cover would pay to the insurer a portion of the loss in excess of the coverage of one of the two parties. Combined ratio......................A combination of the underwriting expense ratio, the loss and LAE ratio, and the policyholder dividend ratio. The loss and LAE ratio measures the ratio of net incurred losses and LAE to net earned premiums. The underwriting expense ratio measures the ratio of underwriting expenses to net premiums written. The policyholder dividend ratio measures policyholder dividends as a percent of net premiums earned. Generally, companies which write predominately long- tailed liability risks will have a higher combined ratio than those companies writing predominately property risks. Direct reinsurer, direct underwriter, direct writer..........A reinsurer that markets and sells reinsurance directly to its reinsureds without the assistance of brokers. Excess and surplus lines............Surplus lines risks are those risks not fitting normal underwriting patterns, involving a degree of risk that is not commensurate with standard rates and/or policy forms, or that will not be written by standard carriers because of general market conditions. Excess insurance refers to coverage that attaches for an insured over the limits of a primary policy or a stipulated self-insured retention. Policies are bound or accepted by carriers not licensed in the jurisdiction where the risk is located, and generally are not subject to regulations governing premium rates or policy language. Excess of loss reinsurance..........The generic term describing reinsurance that indemnifies the reinsured against all or a specified portion of losses on underlying insurance policies in excess of a specified dollar amount, called a "layer" or "retention." Also known as nonproportional reinsurance or stop loss coverage. Facultative reinsurance.............The reinsurance of all or a portion of the insurance provided by a single policy. Each policy reinsured is separately negotiated. Gross premiums written..............Total premiums for direct insurance and reinsurance assumed during a given period. Incurred but not reported ("IBNR") reserves...................Loss reserves for estimated losses that have been incurred but not yet reported to the insurer or reinsurer. Incurred losses.....................The total losses sustained by an insurance company under a policy or policies, whether paid or unpaid. Incurred losses include a provision for claims that have occurred but have not yet been reported to the insurer ("IBNR"). IRIS ratios.........................Financial ratios annually calculated by the NAIC to assist state insurance departments in monitoring the financial condition of insurance companies. 30 Layers..............................The division of a particular reinsurance program delineated by an attachment point and a maximum limit. Often, a reinsurance program will be divided into several layers, with the lower layers (See "Low or working layer excess of loss reinsurance") typically having higher premiums and higher claim frequency and the higher layers typically having lower premiums and claim frequency. Loss adjustment expenses ("LAE").............................The expenses of settling claims, including legal and other fees and the portion of general expenses allocated to claim settlement costs. Loss ratio/pure loss ratio..........Loss ratio is equal to losses and LAE divided by earned premiums. The pure loss ratio refers to losses divided by earned premiums. Undiscounted loss ratios refer to loss ratios that do not consider the net effect of discounting of loss reserves; the Company's current practice is to discount loss reserves for workers' compensation insurance. Loss reserves.......................Liabilities established by insurers and reinsurers to reflect the estimated cost of claims payments that the insurer or reinsurer ultimately will be required to pay in respect of insurance or reinsurance it has written. Reserves are established for losses and for LAE and consist of case reserves and IBNR reserves. Low or working layer excess of loss reinsurance....................Reinsurance that absorbs the losses immediately above the reinsured's retention layer. A low layer excess of loss reinsurer will pay up to a certain dollar amount at which point a higher layer reinsurer (or the ceding company) will be liable for additional losses. Manual rates........................Refers to insurance rates for lines and classes of business approved and published by state insurance departments. Manual rate level or average manual rate level...................Refers to the manual rates for lines and classes of business relative to a benchmark; within this document, the term refers to the manual rates, as compared to other periods, such as a prior policy year. Net premiums earned.................The portion of net premiums written that is recognized for accounting purposes as income during a period. Net premiums written................Gross premiums written for a given period less premiums ceded to reinsurers during such period. Operating ratio.....................The combined ratio, reduced by the net investment income ratio. The net investment income ratio is the ratio of net investment income to net premiums earned. The ratio measures a company's operating profitability, exclusive of realized gains and federal income taxes. Per occurrence......................A form of insurance or reinsurance under which the date of the loss event is deemed to be the date of the occurrence, regardless of when reported and permits all losses arising out of one event to be aggregated instead of being handled on a risk-by-risk basis. Primary insurer.....................An insurance company that issues insurance policies to the general public or to certain non-insurance entities. 31 Pro rata reinsurance................A generic term describing all forms of reinsurance in which the reinsurer shares a proportional part of the original premiums and losses of the reinsured. Pro rata reinsurance also is known as proportional reinsurance, quota share reinsurance and participating reinsurance. Property insurance and/or reinsurance..................Insurance and/or reinsurance that indemnifies a person with an insurable interest in tangible property for his property loss, damage or loss of use. Pure loss ratio.....................See "Loss ratio/pure loss ratio" above. Reinsurance.........................The practice whereby one party, called the reinsurer, in consideration of a premium paid to it, agrees to indemnify another party, called the reinsured, for part or all of the liability assumed by the reinsured under a policy or policies of insurance that it has issued. The reinsured may be referred to as the original or primary insurer, the direct writing company or the ceding company. Retention, retention layer..........The amount or portion of risk that an insurer or reinsurer retains for its own account. Losses in excess of the retention layer are paid by the reinsurer or retrocessionaire. In proportional treaties, the retention may be a percentage of the original policy's limit. In excess of loss business, the retention is a dollar amount of loss, a loss ratio or a percentage. Retrocession; retrocessionaire....................A transaction whereby a reinsurer cedes to another reinsurer (the "retrocessionaire") all or part of the reinsurance it has assumed. Retrocession does not legally discharge the ceding reinsurer from its liability with respect to its obligations to the reinsured. Semi-automatic facultative arrangements........................Facultative reinsurance contracts where the ceding company has the right, but not the obligation to cede risks to a reinsurer and the reinsurer is obligated to accept such risks as long as they are within stated criteria. If a risk falls outside such criteria, the reinsurer has the option of either: (i) accepting the risk, (ii) declining the risk, or (iii) repricing the risk. Statutory accounting principles ("SAP")..................Recording transactions and preparing financial statements in accordance with the rules and procedures prescribed or permitted by state insurance regulatory authorities including the NAIC, which in general reflect a liquidating, rather than going concern, concept of accounting. Statutory or policyholder's surplus; statutory capital & surplus...........................The excess of admitted assets over total liabilities (including loss reserves), determined in accordance with SAP. Stop loss...........................See "Excess of loss reinsurance". Survival ratio......................For asbestos and environmental (A&E) claims, the survival ratio is equal to the average normalized loss and LAE payments for A&E over three years divided by loss reserves established for A&E. 32 Treaty reinsurance..................The reinsurance of a specified type or category of risks defined in a reinsurance agreement (a "treaty") between a primary insurer or other reinsured and a reinsurer. Typically, in treaty reinsurance, the primary insurer or reinsured is obligated to offer and the reinsurer is obligated to accept a specified portion of all such type or category of risks originally written by the primary insurer or reinsured. Underwriting........................The reinsurer's process of reviewing applications submitted for insurance coverage, deciding whether to accept all or part of the coverage requested and determining the applicable premiums. Underwriting cycle..................An historical pattern in which property and casualty insurance and reinsurance premiums, profits and availability of coverage rise and fall with some regularity over time. Underwriting expenses...............The aggregate of policy acquisition costs, including commissions, and the portion of administrative, general and other expenses attributable to underwriting operations. Unearned premiums...................The portion of a premium representing the unexpired portion of the exposure period as of a certain date. Unearned premium reserve............Liabilities established by insurers and reinsurers to reflect unearned premiums which are refundable to policyholders if an insurance or reinsurance contract is canceled prior to expiration of the contract term. 33 ITEM 2. PROPERTIES The Company's headquarters are located in a four story, 110,000 square foot building in Blue Bell, Pennsylvania. PMA Re's headquarters are located in 78,000 square feet of leased space in Mellon Bank Center, Philadelphia, Pennsylvania. Through various wholly owned subsidiaries, the Company also owns and occupies additional office facilities in three other locations and rents additional office space for its insurance operations in 15 other locations. The Company believes that such owned properties are suitable and adequate for its current business operations. Subsidiaries of the Company also own various real estate properties that are not used by the Company in its insurance operations but are leased to third parties. These properties are one to eight story buildings that are generally located in Philadelphia. ITEM 3. LEGAL PROCEEDINGS The Insurance Subsidiaries are defendants in actions arising out of their insurance business and from time to time are involved in various governmental and administrative proceedings. These actions include lawsuits seeking coverage for alleged damages relating to exposure to asbestos and other toxic substances and environmental clean-up actions under federal and state law. See "Item 1. Business - Loss Reserves" and "Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations." ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the fourth quarter of 1997. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of the Company are as follows:
Name Age Position ---- --- -------------------------------------- Frederick W. Anton III.... 64 Chairman of the Board John W. Smithson.......... 52 President and Chief Executive Officer Francis W. McDonnell...... 41 Senior Vice President, Chief Financial Officer and Treasurer Vincent T. Donnelly....... 45 President and Chief Operating Officer - The Property and Casualty Group Stephen G. Tirney......... 44 President and Chief Operating Officer - PMA Re Ronald S. Austin.......... 40 President and Chief Operating Officer - Caliber One
Frederick W. Anton III has served as Chairman of the Board since 1995 and as a director of the Company since 1972. Mr. Anton's current term as a director of the Company expires in 2000. Mr. Anton served as Chairman of the Board and Chief Executive Officer from 1995 to May 1997, as President and Chief Executive Officer from 1981 to 1995, as President of the Property and Casualty Group from 1972 to 1989 and as Secretary and General Counsel of PMAIC from 1962 to 1972. John W. Smithson has served as President and Chief Executive Officer of the Company since May 1997, and as a director of the Company since 1987. Mr. Smithson's current term as a director of the Company expires in 1999. Mr. Smithson served as President and Chief Operating Officer of the Company from 1995 to May 1997, as Chairman and Chief Executive Officer of PMA Re from 1984 to 1997 and as Chairman and Chief Executive Officer of the Property and Casualty Group from April 1995 to 1997, and was employed by PMAIC from 1972 to 1984. Mr. Smithson is a designated Chartered Property-Casualty Underwriter. 34 Francis W. McDonnell has served as Senior Vice President and Chief Financial Officer of the Company since 1995 and as Treasurer since 1997, and has served as Senior Vice President and Chief Financial Officer of PMA Re since 1995. From 1993 to 1995, Mr. McDonnell served as Vice President Finance of PMA Re. Prior to joining PMA Re in 1993, Mr. McDonnell served in various controllership positions with Reliance Insurance Company from 1985 to 1993. Mr. McDonnell is a Certified Public Accountant and a designated Chartered Property-Casualty Underwriter. Vincent T. Donnelly has served as President and Chief Operating Officer of the Property and Casualty Group since February 1997. Mr. Donnelly served as Senior Vice President - Finance and Chief Actuary of the Property and Casualty Group from 1992 to 1997. Prior to joining the Property and Casualty Group, Mr. Donnelly served as Vice President and Corporate Actuary of Continental Insurance Company from 1987 to 1992 and as an actuary for American International Group from 1978 to 1987. Mr. Donnelly is a Fellow of the Casualty Actuarial Society and a member of the American Academy of Actuaries. Stephen G. Tirney has served as President and Chief Operating Officer of PMA Re since 1997. Mr. Tirney served as Executive Vice President of PMA Re from 1993 to 1997, as Senior Vice President of PMA Re from 1989 to 1993 and has been an employee of PMA Re since 1976. Ronald S. Austin was hired in 1997 as the President and Chief Operating Officer of Caliber One. From 1988 to 1997, Mr. Austin served as an officer and director of General Star Management Company, a member of the General Re Group. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS Footnote number 20 on pages 85 through 87 of PMC's 1997 Annual Report to Shareholders is incorporated herein by reference. RECENT SALES OF UNREGISTERED SECURITIES During the years ended December 31, 1997, 1996 and 1995, the Company sold shares of Class A Common Stock in connection with the exercise of employee stock options pursuant to the terms of the Company's stock option plans. In 1997, an aggregate of 162,248 shares were sold to fourteen officers and employees of the Company pursuant to such options at exercise prices ranging from $8.00 to $15.00 per share for an aggregate price of $1,424,349. Additionally, in 1997, the Company sold 1,000 shares to employees at $18.00 per share. In 1996, an aggregate of 97,150 shares were sold to five officers of the Company pursuant to such options at exercise prices ranging from $6.60 to $10.00 per share for an aggregate price of $806,000. In 1995, an aggregate of 205,199 shares were sold to six officers and employees of the Company pursuant to such options at exercise prices ranging from $6.60 to $11.50 per share for an aggregate price of $1,776,288. The Company believes that these sales were made pursuant to the exemption afforded by Section 4(2) of the Securities Act inasmuch as the sales were made to a limited number of sophisticated investors in transactions not involving a public offering. ITEM 6. SELECTED FINANCIAL DATA Selected Financial Data on pages 24 through 25 of PMC's 1997 Annual Report to Shareholders is incorporated herein by reference. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 26 through 51 of PMC's 1997 Annual Report to Shareholders is incorporated herein by reference. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK Not applicable. 35 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Item 14a below ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT See "Executive Officers of the Registrant" under Item 4. Director information is incorporated by reference to the caption "Directors and Executive Officers" in the definitive proxy statement involving the election of directors and other matters (the "Proxy Statement") which PMC intends to file with the Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934 not later than 120 days after December 31, 1997. ITEM 11. EXECUTIVE COMPENSATION Incorporated by reference to the caption "Compensation of Directors and Executive Officers" in the Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference to the caption "Security Ownership of Certain Beneficial Owners and Management" in the Proxy Statement. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Incorporated by reference to the caption "Certain Transactions" and "Compensation Committee Interlocks and Insider Participation" in the Proxy Statement. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K FINANCIAL STATEMENTS AND SCHEDULES (a)(1) The following consolidated financial statements of PMC and its subsidiary companies, included on pages 52 through 88 of PMC's 1997 Annual Report to Shareholders, are incorporated herein by reference: . Consolidated Balance Sheets at December 31, 1997 and 1996. . Consolidated Statements of Operations for the years ended December 31, 1997, 1996 and 1995. . Consolidated Statements of Shareholders' Equity for the years ended December 31, 1997, 1996 and 1995. . Consolidated Statements of Cash Flows for the years ended December 31, 1997, 1996 and 1995. . Notes to the Consolidated Financial Statements . Report of Independent Accountants 36 (a)(2) SCHEDULES SUPPORTING FINANCIAL STATEMENTS
Schedule No. Description Page - -------------- ----------- ---- I Summary of Investments - Other Than S-1 Investments in Related Parties at December 31, 1997 II Condensed Financial Information of S-2 - S-4 Registrant as of December 31, 1997 and 1996 and for the years ended December 31, 1997, 1996 and 1995 III Supplementary Insurance Information for the S-5 years ended December 31, 1997, 1996 and 1995 IV Reinsurance for the years ended December 31, S-6 1997, 1996 and 1995 V Valuation and Qualifying Accounts for the S-7 years ended December 31, 1997, 1996 and 1995 VI Supplementary Information Concerning S-8 Property & Casualty Insurance Operations for the years ended December 31, 1997, 1996 and 1995 Report of Independent Accountants S-9
All other schedules specified by Article 7 of Regulation S-X are not required pursuant to the related instructions or are inapplicable and, therefore, have been omitted. (a)(3) See Exhibits listed on pages 38 through 39. (b) Reports on Form 8-K filed in the fourth quarter of 1997 None. 37
PENNSYLVANIA MANUFACTURERS CORPORATION SCHEDULE I SUMMARY OF INVESTMENTS-OTHER THAN INVESTMENTS IN RELATED PARTIES DECEMBER 31, 1997 Amount at which shown in Type of investment Cost Value the balance sheet - ------------------------------------------------------------------ --------------- ---------------- (Dollar amounts in thousands) Fixed maturities: Bonds: U.S. Treasury Securities and obligations of U.S. Government agencies $1,105,689 $1,119,566 $1,119,566 Corporate debt securities 675,218 687,671 687,671 Mortgage-backed securities 119,687 122,281 122,281 --------------- --------------- ---------------- Total fixed maturities 1,900,594 1,929,518 1,929,518 --------------- --------------- ---------------- Equity securities: Common Stocks: Industrial, miscellaneous and all other 5 13 13 --------------- --------------- ---------------- Total equity securities 5 13 13 --------------- --------------- ---------------- Short-term investments 265,207 265,207 265,207 --------------- --------------- ---------------- Total investments $2,165,806 $2,194,738 $2,194,738 ============== ============== ===============
S-1 PENNSYLVANIA MANUFACTURERS CORPORATION SCHEDULE II BALANCE SHEETS (PARENT COMPANY ONLY)
as of December 31 (in thousands, except share data) 1997 1996 - ----------------------------------------------------------------------------------------------------------- ASSETS Cash $ 253 $ - Investments in subsidiaries 632,680 584,608 Deferred tax asset, net 29,163 36,602 Related party receivables 7,074 727 Other assets 22,545 21,096 --------- -------- Total assets $691,715 $643,033 ========= ======== LIABILITIES Long term debt $203,000 $204,571 Related party payables - 1,605 Dividends payable to shareholders 2,008 1,983 Other liabilities 8,360 9,046 --------- -------- Total liabilities 213,368 217,205 --------- -------- SHAREHOLDERS' EQUITY Common stock, $5 par value (40,000,000 shares authorized; 15,286,263 shares issued and 14,850,789 outstanding - 1997 16,095,416 shares issued and 15,670,052 outstanding - 1996) 76,431 80,477 Class A common stock, $5 par value (40,000,000 shares authorized; 9,156,682 shares issued and 9,117,735 outstanding - 1997 8,247,804 shares issued and 8,173,023 outstanding - 1996) 45,783 41,239 Additional paid-in capital - Class A common stock 339 - Retained earnings 343,368 336,921 Unrealized gain (loss) on investments of subsidiaries (net of deferred income taxes: 1997 - $(10,126); 1996 - $13,394) 18,806 (24,874) Notes receivable from officers (198) (1,162) Treasury stock, at cost: Common stock (1997 - 435,474 shares; 1996 - 425,364 shares (5,572) (5,408) Class A common stock (1997 - 38,947 shares; 1996 - 74,781 shares) (610) (1,365) --------- -------- Total shareholders' equity 478,347 425,828 --------- -------- Total liabilities and shareholders' equity $691,715 $643,033 ========= ========
These financial statements should be read in conjunction with the Consolidated Financial Statements and the notes thereto. S-2 PENNSYLVANIA MANUFACTURERS CORPORATION SCHEDULE II STATEMENTS OF OPERATIONS (PARENT COMPANY ONLY)
for the years ended December 31, (in thousands) 1997 1996 1995 - -------------------------------------------------------------------------------------------------------------------- REVENUES: Net investment income $ 263 $ 354 $ 217 Net realized investment gains - 35 4 Management fees 8,977 5,974 350 Other related party income - 263 1,642 -------------------------------- Total revenues 9,240 6,626 2,213 -------------------------------- EXPENSES: General expenses 9,375 7,082 6,982 Interest expense 15,764 17,039 18,712 -------------------------------- Total expenses 25,139 24,121 25,694 -------------------------------- Loss before income taxes and equity in earnings (losses) of subsidiaries (15,899) (17,495) (23,481) Benefit for income taxes (14,271) (60,345) (13,210) -------------------------------- (Loss) income before equity in earnings (losses) of subsidiaries and extraordinary item (1,628) 42,850 (10,271) Equity in earnings (losses) of subsidiaries 21,381 (178,184) 34,401 -------------------------------- Income (loss) before extraordinary item 19,753 (135,334) 24,130 Extraordinary loss from early extinguishment of debt (net of income tax benefit of $2,549) (4,734) - - -------------------------------- Net income (loss) $ 15,019 $(135,334) $ 24,130 ================================
These financial statements should be read in conjunction with the Consolidated Financial Statements and the notes thereto. S-3 PENNSYLVANIA MANUFACTURERS CORPORATION SCHEDULE II STATEMENTS OF CASH FLOWS (PARENT COMPANY ONLY)
for the years ended December 31, (in thousands) 1997 1996 1995 - ------------------------------------------------------------------------------------------------------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss) $ 15,019 $(135,334) $ 24,130 Adjustments to reconcile net income to net cash flows provided by operating activities: Equity in (earnings) losses of subsidiaries (21,381) 178,184 (34,401) Net realized investment gains - (35) (4) Provision (benefit) for deferred income taxes 9,614 (19,822) 7,000 Extraordinary loss from early extingusihment of debt (4,734) - - Dividends received from subsidiaries 22,500 53,634 103,213 Other, net 5,331 (33,283) (20,384) --------------------------------- Net cash flows provided by operating activities 26,349 43,344 79,554 --------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES: Cash contributions to subsidiaries (11,000) (50,000) (61,000) Sales of fixed maturity investments, net - 45 2,122 Sales (purchases) of equity investments, net - 70 (16) --------------------------------- Net cash flows used by investing activities (11,000) (49,885) (58,894) --------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES: Change in related party receivables and payables (7,952) 10,863 (12,939) Proceeds from issuance of long-term debt 210,000 26,000 125,000 Repayments of long-term debt (211,571) (25,000) (125,000) Dividends paid to shareholders (7,965) (7,926) (7,885) Proceeds from exercised stock options and issuance of Class A common stock 837 - - Treasury stock transactions, net 591 (929) 480 Repayments of notes receivable from officers 964 2,734 478 --------------------------------- Net cash flows (used) provided by financing activities (15,096) 5,742 (19,866) --------------------------------- Net increase (decrease) in cash 253 (799) 794 Cash January 1 - 799 5 --------------------------------- Cash December 31 253 $ - $ 799 =================================
These financial statements should be read in conjunction with the Consolidated Financial Statements and the notes thereto. S-4 PENNSYLVANIA MANUFACTURERS CORPORATION SCHEDULE III SUPPLEMENTARY INSURANCE INFORMATION
Future policy Benefits, Amortization Deferred benefits, claims, of deferred Other Policy losses, Net losses and policy oparting Net (in thousands) Acquistion claims, and Unearned Premium investment settlement acquisition expenses premiums Costs lost expenses premiums revenue income(1) expenses costs (2) written - --------------------------- ----------- ------------- ---------- ---------- ----------- ----------- ----------- --------- --------- Year ended December 31, 1997: The Property and Casualty Group $20,010 $1,353,917 $115,998 $212,348 $ 82,098 $ 193,530 $48,343 $57,206 $240,348 PMA Re 25,278 622,484 95,457 163,603 52,270 113,931 45,158 11,982 177,934 Corporate and Other - 26,786 - - 2,330 (180) - 5,951 - - --------------------------- ----------- ------------- ---------- ---------- ----------- ----------- ----------- --------- --------- Total $45,288 $2,003,187 $211,455 $375,951 $136,698 $ 307,281 $93,501 $75,139 $418,282 =========================== =========== ============= ========== ========== =========== =========== =========== ========= ========= Year ended December 31, 1996 The Property and Casualty Group $23,488 $1,501,897 $127,986 $268,601 $ 82,455 $ 424,900 $52,706 $86,003 $279,422 PMA Re 20,518 589,175 77,996 151,974 48,676 111,937 37,586 8,344 164,053 Corporate and Other - - - - 2,805 (214) - 3,509 - - --------------------------- ----------- ------------- ---------- ---------- ----------- ----------- ----------- --------- --------- Total $44,006 $2,091,072 $205,982 $420,575 $133,936 $ 536,623 $90,292 $97,856 $443,475 ======================================= ============= ========== ========== =========== =========== =========== ========= ========= Year ended December 31, 1995 The Property and Casualty Group $20,747 $1,518,163 $124,988 $345,607 $ 92,275 $ 319,644 $53,420 $57,486 $337,116 PMA Re 17,154 551,823 67,734 139,345 45,166 103,947 33,787 7,334 152,760 Corporate and Other - - - - 1,914 (1,013) - 16,341 - - --------------------------- ----------- ------------- ---------- ---------- ----------- ----------- ----------- --------- --------- Total $37,901 $2,069,986 $192,722 $484,952 $139,355 $ 422,578 $87,207 $81,161 $489,876 ======================================= ============= ========== ========== =========== =========== =========== ========= =========
(1) Net investment income is based on each segment's invested assets. (2) Other operating expenses are allocated primarily on the specific identification basis. When indirect expenses cannot be directly related to a segment, these expenses are allocated depending on the nature of the expense. S-5 PENNSYLVANIA MANUFACTURERS CORPORATION SCHEDULE IV REINSURANCE
ASSUMED CEDED TO FROM PERCENTAGE OF DIRECT OTHER OTHER NET AMOUNT ASSUMED (dollar amounts in thousands) AMOUNT COMPANIES COMPANIES AMOUNT TO NET - -------------------------------------- ----------- ----------- ------------- ------------ -------------- Year Ended December 31, 1997: Premiums: Property and liability insurance $277,871 $118,277 $216,357 $375,951 58% =========== =========== ============= ============ ============== Year Ended December 31, 1996: Premiums: Property and liability insurance $299,386 $88,499 $209,688 $420,575 50% =========== =========== ============= ============ ============== Year Ended December 31, 1995: Premiums: Property and liability insurance $370,590 $35,476 $149,838 $484,952 31% =========== =========== ============= ============ ==============
S-6 PENNSYLVANIA MANUFACTURERS CORPORATION SCHEDULE V VALUATION AND QUALIFYING ACCOUNTS
Deductions - Balance at Charged to write-offs of Balance at beginning of costs and uncollectible end of Description period expenses accounts period ------------------------------------- ------------- ------------ ----------------- ---------------- Year ended December 31, 1997: Allowance for uncollectible accounts: Uncollected premiums $18,877 - 471 $18,406 ------------------------------------- ------------- ------------ ----------------- ---------------- Year ended December 31, 1996: Allowance for uncollectible accounts: Uncollected premiums $16,330 19,532 16,985 $18,877 ------------------------------------- ------------- ------------ ----------------- ---------------- Year ended December 31, 1995: Allowance for uncollectible accounts: Uncollected premiums $22,402 - 6,072 $16,330 ------------------------------------- ------------- ------------ ----------------- ----------------
S-7 PENNSYLVANIA MANUFACTURERS CORPORATION SCHEDULE VI SUPPLEMENTAL INFORMATION CONCERNING PROPERTY AND CASUALTY INSURANCE OPERATIONS
- ----------------------------------------------------------------------------------------------------------------------------------- Discounts on Reserves Reserves for Unpaid Claim and claim for Unpaid Claims and adjustment expenses Deferred Claims and Claim incurred related to policy Claim Adjustment Net ------------------------ Affiliation with acquisition Adjustment Expenses Unearned Earned Investment Current Prior Registrant costs Expenses (1) Premiums Premiums Income Year Years(2) - ---------------------- ----------- ------------ ---------- ---------- ---------- ---------- ---------- --------- Consolidated property- casualty subsidiaries Year Ended December 31, 1997 $45,288 $2,033,187 $460,230 $211,455 $375,951 $134,368 $141,880 $(86,036) Year Ended December 31, 1996 44,086 2,091,072 514,248 205,982 420,979 131,130 323,069 156,074 Year Ended December 31, 1995 37,901 2,069,986 581,025 192,722 484,952 137,441 157,787 51,491 - ---------------------- ----------- ------------ ---------- ---------- ---------- ---------- ---------- --------- Amortization of deferred policy Paid claims and Net Premium acquisition costs adjustment expenses Written ----------------- ------------------- ---------- Year Ended December 31, 1997 93,501 470,874 418,282 Year Ended December 31, 1996 90,292 510,620 443,475 Year Ended December 31, 1995 87,207 469,942 489,876 ----------------- ------------------- ----------
(1) - Workers' compensation reserves discounted at approximately 5%. (2) - Excludes accretion of less reserve discount of $51,407, $857,480 and $13,300 in 1997, 1996 and 1995, respectively. S-8 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders Pennsylvania Manufacturers Corporation: Our report on the consolidated financial statements of Pennsylvania Manufacturers Corporation has been incorporated by reference in this Form 10-K from page 88 of the 1997 Annual Report to Shareholders. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index on page 37 of this Form 10-K. In our opinion, the financial statements schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. /s/ Coopers & Lybrand L.L.P. One South Market Square Harrisburg, Pennsylvania February 6, 1998 S-9 EXHIBITS
Exhibit No. Description of Exhibit (3) Article of incorportion and bylaws: *3.1 Amended and Restated Artilce of Incorporation of the Company. *3.2 Amended and Restated Bylaws of the Company. (10) Material contracts: *10.1 Employment Agreement dated April 1, 1995 between the Company and Frederick W. Anton III. *10.2 Employment Agreement dated May 1, 1995 between the Company and John W. Smithson. *10.3 The PMC EDC Plan Trust Agreement dated as of 1994. *10.4 The PMC Supplemental Executive Retirement Plan (SERP) dated July 1995. *10.5 The Company's Amended and Restated 1987 Incentive Stock Option Plan *10.6 The Company's Amended and Restated 1991 Equity Incentive Plan. *10.7 The Company's Amended and Restated 1993 Equity Incentive Plan. *10.8 The Company's Amended and Restated 1994 Equity Incentive Plan. *10.9 The Company's 1995 Equity Incentive Plan. *10.10 The Company's 1996 Equity Incentive Plan. *10.11 Federal Tax Allocation Agreement. *10.12 Office lease between Nine Penn Center Associates, L.P., as Landlord, and Lorjo Corp., as Tenant, covering premises located at Mellon Bank Center, 1735 Market Street, Philadelphia, Pennsylvania, dated May 26, 1994. *10.13 Credit Agreement dated as of March 14, 1997 by and among the Company, The Bank of New York, First Union National Bank of North Carolina, Fleet National Bank, PNC Bank, National Association, Mellon Bank, N.A., CoreStates Bank, N.A. and Dresdener Bank AG, New York Branch and Grand Cayman Branch. *10.14 Master Agreement dated as of February 7, 1997 between the Company and First Union National Bank of North Carolina. *10.15 First Amended and Restated Letter of Credit Agreement by and among the Company, the Bank of New York, Mellon Bank, N.A., Fleet Bank, National Association, PNC Bank, National Association and First Union Bank of North Carolina. 10.16 Amendment No. 1 to Tax Allocation Agreement dated January 7, 1998. 10.17 Caliber One Indemnity Company Purchase Agreement dated December 15, 1997.
38
(11) Statement regarding computation of per share earnings. (13) PMC's 1997 Annual Report to Shareholders only those portions thereof which are expressly incorporated by reference in PMC's Annual report on Form 10-K for 1997, are "filed" as part of this Annual Report on Form 10-K (21) Subsidiaries of the Company. (23) Consents of experts and counsel (27) Financial Data Schedule.
* Incorporated by reference to initial filing of Registrant's Registration Statement on Form 10, filed June 26, 1997. 39 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. PENNSYLVANIA MANUFACTURERS CORPORATION Date: March 23, 1998 By: /s/ John W. Smithson -------------- ------------------------ John W. Smithson, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Title Date - --------- ----- ---- /s/ Frederick W. Anton III _________________________ Chairman of the Board and March 23, 1998 Frederick W. Anton III a Director /s/ John W. Smithson _________________________ President, Chief Executive March 23, 1998 John W. Smithson Officer and a Director /s/ Francis W. McDonnell _________________________ Senior Vice President, Chief March 23, 1998 Francis W. McDonnell Financial Officer and Treasurer (principal financial and accounting officer) _________________________ Director March __, 1998 Paul I Detwiler, Jr. /s/ Joseph H. Foster _________________________ Director March 23, 1998 Joseph H. Foster /s/ Anne S. Genter _________________________ Director March 23, 1998 Anne S. Genter /s/ James F. Malone III _________________________ Director March 23, 1998 James F. Malone III /s/ A. John May _________________________ Director March 23, 1998 A. John May /s/ Louis N. McCarter III _________________________ Director March 23, 1998 Louis N. McCarter III
40
Signature Title Date - --------- ----- ---- /s/ John W. Miller, Jr. _________________________ Director March 23, 1998 John W. Miller, Jr. /s/ Edward H. Owlett _________________________ Director March 23, 1998 Edward H. Owlett /s/ Louis I. Pollock _________________________ Director March 23, 1998 Louis I. Pollock _________________________ Director March __, 1998 Roderic H. Ross /s/ L.J. Rowell, Jr. _________________________ Director March 23, 1998 L.J. Rowell, Jr.
41 EXHIBITS
Exhibit No. Description of Exhibit (3) Articles of incorporation and bylaws: *3.1 Amended and Restated Articles of Incorporation of the Company. *3.2 Amended and Restated Bylaws of the Company. (10) Material contracts: *10.1 Employment Agreement dated April 1, 1995 between the Company and Frederick W. Anton III. *10.2 Employment Agreement dated May 1, 1995 between the Company and John W. Smithson. *10.3 The PMC EDC Plan Trust Agreement dated as of 1994. *10.4 The PMC Supplemental Executive Retirement Plan (SERP) dated July 1995. *10.5 The Company's Amended and Restated 1987 Incentive Stock Option Plan *10.6 The Company's Amended and Restated 1991 Equity Incentive Plan. *10.7 The Company's Amended and Restated 1993 Equity Incentive Plan. *10.8 The Company's Amended and Restated 1994 Equity Incentive Plan. *10.9 The Company's 1995 Equity Incentive Plan. *10.10 The Company's 1996 Equity Incentive Plan. *10.11 Federal Tax Allocation Agreement. *10.12 Office lease between Nine Penn Center Associates, L.P., as Landlord, and Lorjo Corp., as Tenant, covering premises located at Mellon Bank Center, 1735 Market Street, Philadelphia, Pennsylvania, dated May 26, 1994. *10.13 Credit Agreement dated as of March 14, 1997 by and among the Company, The Bank of New York, First Union National Bank of North Carolina, Fleet National Bank, PNC Bank, National Association, Mellon Bank, N.A., CoreStates Bank, N.A. and Dresdener Bank AG, New York Branch and Grand Cayman Branch. *10.14 Master Agreement dated as of February 7, 1997 between the Company and First Union National Bank of North Carolina. *10.15 First Amended and Restated Letter of Credit Agreement by and among the Company, the Bank of New York, Mellon Bank, N.A., Fleet Bank, National Association, PNC Bank, National Association and First Union Bank of North Carolina. 10.16 Amendment No. 1 to Tax Allocation Agreement dated January 7, 1998. 10.17 Caliber One Indemnity Company Purchase Agreement dated December 15, 1997.
42
(11) Statement regarding computation of per share earnings. (13) PMC's 1997 Annual Report to Shareholders only those portions thereof which are expressly incorporated by reference in PMC's Annual report on Form 10-K for 1997, are "filed" as part of this Annual Report on Form 10-K (21) Subsidiaries of the Company. (23) Consents of experts and counsel (27) Financial Data Schedule.
* Incorporated by reference to initial filing of Registrant's Registration Statement on Form 10, filed June 26, 1997. 43 EX-10.16 2 AMENDMENT NO. 1 TO TAX ALLOCATION AGREEMENT Exhibit 10.16 AMENDMENT NO. 1 TO TAX ALLOCATION AGREEMENT BETWEEN PENNSYLVANIA MANUFACTURERS CORPORATION (HEREINAFTER REFERRED TO AS "PMC") AND THE VARIOUS SUBSIDIARIES OF PMC Whereas, PMC is the Common Parent, as discussed in Section 1504 of the Internal Revenue Code of 1986 (Code), of the corporations party to this Agreement; Whereas, the following companies are subsidiaries (hereafter referred to collectively as "Subsidiaries") of PMC: Pennsylvania Manufacturers' Association Ajon, Inc. Insurance Company Rosemarie, Inc. PMA Reinsurance Corporation Cris-Jen, Inc. Manufacturers Alliance Insurance Company Aud-Evad, Inc. Pennsylvania Manufacturers Indemnity Company Walprop, Inc. Mid-Atlantic States Casualty Company DP Corp. Lee-Ward, Inc. REM Corp. Sarfred, Inc. Gulph Industries, Inc. Syl-Bar, Inc. Dauphin Equities, Inc. PMA Services, Inc. Pennsylvania Manufacturers Wisteve, Inc. Association Finance Co. Marpan, Inc. 925 Chestnut, Inc. Lorjo Corp. Mid-Atlantic States Presque, Inc. Investment Company PMA Management Corporation Whereas, PMC and the Subsidiaries entered into a Tax Allocation Agreement (the "Agreement") effective September 24, 1996 to cover all tax allocations beginning January 1, 1996 and after and until this Agreement is canceled or otherwise terminated; Whereas, Caliber One Management Company Inc. ("Management") has become a subsidiary of PMC and PMC's Consolidated Group and wishes to become a party to this Agreement effective July 8, 1997; Whereas, Caliber One Indemnity Company ("Indemnity") (formerly, "Lincoln Insurance Company) has become a subsidiary of PMC and PMC' s Consolidated Group and wishes to become a party to this Agreement effective December 16, 1997; and Whereas, the Board of Directors of Management and Indemnity have adopted a resolution accepting the provisions of this Agreement. Now, therefore, in consideration of the premises and the mutual covenants hereinafter contained, the Agreement is amended as follows: 1. Management is added as a party to the Agreement effective July 8, 1997. The term "Subsidiary"/"Subsidiaries" as used in the Agreement shall include Management. 2. Indemnity is added as a party to the Agreement effective December 16, 1997. The term "Subsidiary"/"Subsidiaries" as used in the Agreement shall include Indemnity. 3. The second "Whereas" clause of the Agreement is restated to read as follows: Whereas, the following companies are subsidiaries (hereafter referred to collectively as "Subsidiaries") of PMC: Pennsylvania Manufacturers' Association Rosemarie, Inc. Insurance Company Cris-Jen, Inc. PMA Reinsurance Corporation Aud-Evad, Inc. Manufacturers Alliance Insurance Company Walprop, Inc. Pennsylvania Manufacturers Indemnity Company DP Corp. Mid-Atlantic States Casualty Company REM Corp. Lee-Ward, Inc. Gulph Industries, Inc. Sarfred, Inc. Dauphin Equities, Inc. Syl-Bar, Inc. Pennsylvania Manufacturers PMA Services, Inc. Association Finance Co. Wisteve, Inc. 925 Chestnut, Inc. Marpan, Inc. Mid-Atlantic States Lorjo Corp. Investment Company Presque, Inc. Caliber One Management PMA Management Corporation Company, Inc. Ajon, Inc. Caliber One Indemnity Company 4. This Amendment shall not amend or otherwise modify any of the terms or provisions of the Agreement except as stated herein. In witness whereof, Management and Indemnity have caused this Amendment No. 1 to the Agreement to be duly executed and attested as of the 7th day of January, 1998. Attest: Caliber One Management Company, Inc. By:/s/ Edward S. Hochberg By:/s/ Francis W. McDonnell ----------------------- ------------------------- Attest: Caliber One Indemnity Company By:/s/ Edward S. Hochberg By:/s/ Francis W. McDonnell ----------------------- ------------------------- EX-10.17 3 STOCK PURCHASE AGREEMENT STOCK PURCHASE AGREEMENT This AGREEMENT is made as of October , 1997, by and between MARKEL CORPORATION, a Virginia corporation (the "Seller") and PMA REINSURANCE CORPORATION, a Pennsylvania corporation (the "Buyer"). Preamble The Seller is the beneficial and record owner of all of the issued and outstanding shares of the common stock, $100.00 par value per share (the "Shares"), of Lincoln Insurance Company, a Delaware domestic insurance corporation (the "Company"). The Seller wishes to sell, and the Buyer wishes to purchase, all of the Shares upon the terms and subject to the conditions of this Agreement. Accordingly, in consideration of the premises and the mutual promises contained herein, the parties hereto, each intending to be legally bound hereby, agree as follows: Article 1. Sale and Purchase of Shares. 1.1 Sale and Purchase of Shares. At the closing provided for in Section 2 (the "Closing") and upon the terms and subject to the conditions of this Agreement, the Seller shall sell to the Buyer, and the Buyer shall purchase from the Seller, all of the Shares. In consideration thereof and the covenants of the Seller hereunder, the Buyer shall pay to the Seller an amount (the "Purchase Price") equal to $2.2 million in excess of the Statutory Capital and Surplus of the Company (hereinafter defined) existing at the close of business on the day immediately preceding the Closing (defined in Section 2.1), subject to any Unrealized Adjustment (hereinafter defined). 1.1.1 "Statutory Capital and Surplus" of the Company at any time means the aggregate amount of capital and surplus of the Company for a period ending at such time as would be shown on page 3, line 25 of the Company's annual statement, prepared in accordance with Law for filing with the Delaware Department of Insurance in accordance with Statutory Accounting Principles (defined in Section 3.6), consistently applied with the principles applied to the preparation of the financial statement of the Company referred to in Section 3.6. Seller will prepare such a statement reflecting capital and surplus as of the Closing Date (the "Closing Date Statement"). Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- 1.1.2 "Unrealized Adjustment" shall mean an adjustment for the difference between the aggregate market value of the Company's bonds and cash or cash equivalents (as reported at the close of business on the day immediately preceding the Closing by Bloomberg or a similar service mutually acceptable to the parties) and the amount at which such amounts would be reported on such date on page 2, lines 1 and 6 of the Company's annual statement. 1.2 Payment of Purchase Price. The Purchase Price shall be determined and paid as follows: 1.2.1 Earnest Money Deposit. Prior to the execution hereof, Buyer deposited with Seller $50,000 as earnest money toward the purchase of the Shares (the "Earnest Money Deposit"). 1.2.2 Purchase Price Payable at Closing. At least two business days before the Closing, the Seller will deliver to the Buyer a reasonable estimate of the amount of the Company's Statutory Capital and Surplus which will exist at the Closing Date ("Seller's Estimated Statutory Capital and Surplus") and the amount of the Purchase Price based thereon (the "Estimated Purchase Price"), together with such details of the basis for such Estimated Purchase Price as the Seller shall have relied upon in making such estimate or as the Buyer shall reasonably request. At the Closing, the Buyer shall pay to Seller, in cash by interbank wire transfer of immediately available funds to an account previously designated by the Seller, an amount equal to the excess of the Estimated Purchase Price over the Earnest Money Deposit. 1.2.3 Adjustment of Estimated Purchase Price. Within ten days after the Closing, the Buyer and Seller will agree upon the amount of the Company's Capital and Surplus (determined in accordance with Sections 3.6 and 3.7), the amount of any Unrealized Adjustment, and the amount of the Purchase Price based thereon. Promptly thereafter, Buyer shall pay to the Seller any shortfall, or the Seller shall pay to the Buyer any excess, as the case may be, of the Estimated Purchase Price compared to the Purchase Price as so determined. - -------------------------------------------------------------------------------- Confidential page 2 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- 1.3 Delivery of Shares. At the Closing, the Seller shall deliver to the Buyer stock certificates representing all of the Shares, duly endorsed in blank or accompanied by stock powers duly executed in blank, in proper form for transfer, and with all appropriate stock transfer stamps affixed. Article 2. Closing. 2.1 Closing Date and Location. The Closing of the sale and purchase of the Shares contemplated hereby shall take place at the offices of Seller in Glen Allen, Virginia at 10:00 a.m. local time, on the fifth full Business Day after satisfaction or waiver of all of the conditions set forth in Articles 7 and 8, or such other time or date as the Buyer and the Seller may otherwise agree in writing. The time and date upon which the Closing occurs is herein called the "Closing Date." Article 3 Representations, Warranties and Covenants of the Seller. The Seller represents, warrants and covenants to the Buyer as follows: 3.1 Due Incorporation and Authority. The Seller is a corporation duly organized, validly existing and in good standing under the laws of the State of Virginia, and is not a foreign person within the meaning of Section 1. 1445- 2(b)(2)(i) of the Treasury Regulations (hereinafter defined), or any other applicable Treasury Regulations. The Company is a corporation duly organized, validly existing and in good standing under the laws of the State of Delaware and has all requisite corporate power and authority to own, lease and operate its Properties and to carry on its business as now and heretofore conducted. Neither the character of the properties currently owned or leased by the Company nor the current nature of its business makes necessary qualification by it to do business as a foreign corporation in any jurisdiction. 3.2 Subsidiaries and Other Affiliates. The Company does not directly or indirectly own or have the power to vote shares of any capital stock or other ownership interests of any corporation or other Person such that it has voting power to elect a majority of the directors of such corporation or other Persons performing similar functions for such Person, as the case may be. - -------------------------------------------------------------------------------- Confidential page 3 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- Except for readily marketable securities held in its investment portfolio, the Company does not directly or indirectly own any interest in any other Person. 3.3 Outstanding Capital Stock and Title to the Shares. The Company is authorized to issue (i) thirty-five thousand (35,000) shares of common stock, par value $100.00 per share, all of which shares are issued and outstanding, and (ii) five thousand (5,000) shares of Adjustable Rate Cumulative Redeemable Preferred Stock, par value $0.01 per share, none of which is currently outstanding. There are no other authorized, issued or outstanding shares (including treasury shares) of capital stock or other equity securities of the Company, no securities of the Company convertible directly or indirectly into or exchangeable directly or indirectly for any capital stock or other equity security of the Company, no options, warrants, puts, calls or other rights (including any preemptive rights) to acquire directly or indirectly from the Company or Seller any capital stock or other equity security of the Company, and no other contracts, understandings, arrangements or obligations (whether or not contingent) by which the Company is or may be bound to issue or repurchase any capital stock or other equity security of the Company. 3.3.1 All of the Shares are owned beneficially and of record by the Seller free and clear of any lien, pledge, mortgage, security interest, claim, lease, charge, option, right of first or last refusal or offer, easement, servitude, transfer restriction under any shareholder or similar agreement, encumbrance or any other restriction or limitation whatsoever, other than any applicable state and federal securities and insurance laws (collectively, "Liens"). Upon delivery of and payment for the Shares as herein provided, the Seller will convey to the Buyer good and valid title thereto, free and clear of any Lien, except for Liens arising through the Buyer or as a result of the Buyer's actions. 3.3.2 All of the Shares are duly authorized and validly issued, fully paid and nonassessable. 3.3.3 Except as provided in Section 3.12 (Required Consents), there are no restrictions on the sale by Seller of the Shares to Buyer, and no approval or consent of any Person is required for Seller to validly effect the sale of the Shares. The Company is not a party to any agreement concerning any or all of the Shares other than this Agreement. - -------------------------------------------------------------------------------- Confidential page 4 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- 3.3.4 To the Knowledge of the Seller, any securities issued by the Company were issued in compliance with, or pursuant to available exemptions under, the Securities Act of 1933 ("1933 Act") and applicable state securities laws. To the Knowledge of the Seller, the Company has not failed to file any documents or failed to take any action required to be filed or taken under the 1933 Act or applicable state securities laws, and to the Knowledge of the Seller neither the Company nor any affiliate thereof is or has been subject to any action, proceeding, inquiry or investigation under any federal or state securities laws. 3.4 Authority to Execute and Perform Agreement; Enforceability. The Seller has the full legal right and power and all corporate authority and approvals required to execute and deliver this Agreement and the Related Agreements to which it is a party (defined in Section 8.3) and to perform fully its obligations hereunder. This Agreement and the Related Agreements to which Seller is a party have been duly executed and delivered by the Seller and each is a valid and binding obligation of the Seller enforceable against it in accordance with its terms, except as enforceability may be limited by (i) bankruptcy, insolvency, reorganization, moratorium and other such laws of general application affecting the rights and remedies of creditors and (ii) general principles of equity, as such may be applied by courts of competent jurisdiction. 3.5 Charter Documents and Corporate Records. The Seller has heretofore delivered to the Buyer true and complete copies of the Certificate of Incorporation and Bylaws, or comparable instruments, of the Company as in effect on the date hereof, and no amendments thereto shall be made from the date hereof through the Closing Date. 3.5.1 Minute Books and Stock Certificate Books and Records. The minute books of the Company now contain, and on the Closing Date will contain, a true and complete record of all such records received by Seller from the previous owner of the Company, and all corporate action taken by Company since its acquisition by Seller prior to the date hereof, or hereafter taken on or prior to the Closing Date, at the meetings or by written consents of shareholders and directors and committees thereof. The stock certificate books and records of the Company accurately reflect the capital ownership of the Company. - -------------------------------------------------------------------------------- Confidential page 5 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- 3.6 Statutory Financial Statements. The Seller has heretofore delivered to the Buyer true and complete copies of the Annual Statements of the Company as filed with the Delaware Department of Insurance for the years ended December 31, 1995 and 1996, and will deliver before the Closing, a true and complete copy of the Quarterly Statement of the Company as filed with the Delaware Department of Insurance for the quarter ended September 30, 1997 (the "Quarterly Statement"). The balance sheet of the Company as of December 31, 1996, and the related statement of income and cash flow for the year then ended, included in the Annual Statement for the year ended December 31, 1996, were prepared in conformity with the insurance laws of Delaware applicable to such reports of the Company and related regulations of the Delaware Department of Insurance ("Statutory Accounting Principles" or "SAP") consistently applied, except as otherwise noted therein, for the period covered thereby, and fairly present, in accordance with SAP, the statutory financial position of the Company as at the date thereof and the results of operations and cash flow of the Company for the period then ended; provided that this representation shall not be deemed to be -------- breached by reason of the development of Reserves for Losses and Loss Adjustment Expenses and Reserves for Uncollectible Reinsurance after the date of such financial statement. The balance sheet of the Company as of September 30, 1997, and the related statement of income and cash flow for the period then ended, included in the Quarterly Statement were prepared in conformity with Statutory Accounting Principles applicable to interim financial statements consistently applied during the period involved, except as otherwise noted therein, subject to normal year-end adjustments, and fairly present, in accordance with SAP, the statutory financial position of the Company as at the date thereof and the results of operations and cash flow of the Company for the period then ended; provided that this representation shall not be deemed to be breached by reason - -------- of the development of Reserves for Losses and Loss Adjustment Expenses and Reserves for Uncollectible Reinsurance after the date of such financial statement. 3.7 Statutory Capital and Surplus. At the Closing: (a) the assets of the Company will consist solely of (i) cash and bonds and other obligations which are not voting securities of the kind described on Schedule - -------------------------------------------------------------------------------- Confidential page 6 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- 3.7, having a fair market value reflected therefor on the Closing Date Statement and (ii) Non-Statement Assets (hereinafter defined) and (b) the liabilities of the Company, including any contingent liabilities, will consist solely of Non-Statement Liabilities (hereinafter defined). 3.7.1 "Non-Statement Assets and Liabilities" are assets and liabilities, respectively, of the Company: (a) the existence of which does not breach any representation, warranty or covenant herein of the Seller, and (b) either (i) is not an asset or liability which would properly be reflected in, reserved against or disclosed by the Closing Date Statement or (ii) is offset in full by a related liability (in the case of assets) or asset (in the case of liabilities) properly reflected in or reserved against in the Closing Date Statement. 3.8 Undisclosed Liabilities. As of the date of this Agreement, the Company does not have any material liability or obligation of any nature, whether known or unknown, absolute, accrued, contingent or otherwise and whether due or to become due, except (i) as and to the extent reflected or reserved against in its December 31, 1996 balance sheet included within the SAP Financial Statements, (ii) for liabilities and obligations incurred after the date of such balance sheet in the ordinary course of business, or (iii) the existence of which does not constitute a breach of any representations, warranties or covenants of the Seller hereunder; provided that this representation shall not be deemed to be -------- breached by reason of the development of Reserves for Losses and Loss Adjustment Expenses and Reserves for Uncollectible Reinsurance after the date hereof. At the Closing, the Company will have no liability or obligation of any nature, whether known or unknown, absolute, accrued, contingent or otherwise and whether due or to become due, except for Non-Statement Liabilities. 3.9 Tax Matters. Since Seller's acquisition of the Company on May 26, 1995 (the "Acquisition Date"), the Company has timely filed (or has had filed on its behalf), or will cause to be timely filed, all Tax Returns required to be filed by it (or on its behalf). All such Tax Returns were true, correct and complete in all material respects. - -------------------------------------------------------------------------------- Confidential page 7 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- 3.9.1 Since the Acquisition Date, the Company has timely paid all Taxes owed by or with respect to the Company. No penalties or other charges are or will become due with respect to the late filing of any Tax Return of the Company required to be filed since the Acquisition Date and on or before the Closing Date. Since the Acquisition Date, the Company has withheld and paid all Taxes required to have been withheld and paid in connection with amounts paid or owing to any employee, independent contractor, creditor or other Person. 3.9.2 Schedule 3.9 sets forth the states in which the Company (or any consolidated, combined or unitary group of which the Company is a member) files Tax Returns, indicates to the Knowledge of the Seller the Tax Returns in such states that have been audited since the Acquisition Date, and indicates those Tax Returns in such states that currently are the subject of audit. 3.9.3 There are no waivers or extensions of any applicable statute of limitations, or agreements to any extension of time, for the assessment or collection of taxes with respect to any tax returns, which waivers, extensions or agreements currently are in effect. No claim has been made in writing since the Acquisition Date, by an authority in a jurisdiction where the Company does not file Tax Returns that it is or may be subject to taxation by that jurisdiction. 3.9.4 Since the Acquisition Date, the Company has not received a Tax Ruling or entered into a Tax Closing Agreement with any taxing authority. For purposes of the preceding sentence, the term "Tax Ruling" shall mean written rulings of a taxing authority relating to Taxes, and the term "Tax Closing Agreement" shall mean a written and legally binding agreement with a taxing authority relating to Taxes. 3.9.5 To the Knowledge of the Seller, no action, suit, proceeding, investigation, audit, claim or assessment is presently pending or threatened with regard to any Taxes that relate to the Company for which it could be liable. - -------------------------------------------------------------------------------- Confidential page 8 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- 3.9.6 Except as set forth on Schedule 3.9, the Company is not required to make any adjustment pursuant to Section 481 of the Code by reason of a change in accounting method or otherwise. 3.9.7 The Buyer will not be required to deduct and withhold any amount pursuant to Section 1445 of the Code, upon the consummation of the transactions contemplated hereby (the "Contemplated Transactions"), and the Seller will cause the necessary documents to be provided to the Buyer at the Closing to support such nondeduction and non-withholding, including appropriate affidavits referred to in Section 1445(b)(3) of the Code. 3.9.8 There are no Liens for Taxes (other than for Taxes not yet due and payable) upon the assets of the Company. 3.9.9 The Seller and the Company have been included in a consolidated return for Federal income tax purposes filed by Seller on behalf of itself, the Company, and other subsidiaries of Seller (or its predecessors) since 1995 (with respect to a stub period from May 26, 1995, to December 31, 1995), as common parent corporation of an "affiliated group" (within the meaning of Section 1504(a) of the Code) of which the Company is an "includible corporation" (within the meaning of Section 1504(b) of the Code). Such affiliated group has filed all income Tax Returns that it was required to file for each taxable period during which the Company was a member of the group. All such income Tax Returns were correct and complete in all respects. All income Taxes owed by such affiliated groups have been paid for each taxable period during which the Company was a member of the group. 3.9.10 Since the Acquisition Date, the Company has not filed a consent under Section 341(f) (1) of the Code or agreed under Section 341(f) (3) of the Code to have the provisions of Section 341(f) (2) of the Code applied to the sale of its capital stock. The Company has not made any payment, is not obligated to make any payment, and is not a party to any agreement that could obligate it to make any payments, that will not be deductible in full by reason of Code section 280G. - -------------------------------------------------------------------------------- Confidential page 9 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- 3.10 Compliance with Laws. The Company is not in violation, nor to the Knowledge of the Seller has there been a violation by the Company that has not been corrected, of any applicable Order, or any applicable Law, of any Governmental Body, which violation could reasonably be expected to have a material adverse effect on the financial condition, results of operations or business of the Company. 3.10.1 The Seller has heretofore delivered to the Buyer true and complete copies of the triennial report for the Company covering the three (3) year period ended December 31, 1993 prepared by the Delaware Insurance Department. The foregoing triennial report is the most recent report of examination of the Company by the Delaware Insurance Department that has been provided to the Company. No understandings, agreements or stipulations exist between the Delaware Insurance Department and the Seller or the Company relating to the conduct of the Company except to the extent expressly contained in the Examination Report, and except that Seller has an understanding with the Department that Statutory Capital and Surplus will not be reduced by reason of dividends below an amount equal to 25% of Company reserves. To the Knowledge of the Seller, the Delaware Insurance Department has not since the Acquisition Date notified the Company of any deficiencies or concerns material to the financial condition or operations of the Company. 3.11 Licenses. The Company is duly qualified and licensed as an insurance company in the State of Delaware and is in good standing as such in such State. Schedule 3.11 lists and provides a description of (i) the jurisdictions in which the Company currently possesses licenses or other approvals to conduct an insurance business, including any approvals or authorization necessary to conduct a surplus lines business (collectively, "Insurance Licenses"), and (ii) the jurisdictions in which the Company possessed an Insurance License at May 30, 1995, which License has since been terminated, withdrawn, suspended, abandoned, or revoked, whether voluntarily or involuntarily, and describes the circumstances of such termination, withdrawal, suspension, abandonment, or revocation. The Company is not required by applicable law to have any other Insurance Licenses for the legal and valid conduct of its business as presently conducted. The Company has heretofore made available to the Buyer true and complete copies of all of such - -------------------------------------------------------------------------------- Confidential page 10 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- Insurance Licenses as are currently in effect. To Seller's Knowledge, all Licenses and Insurance Licenses are valid and in good standing and are in full force and effect, except as otherwise noted on Schedule 3.11. 3.12 No Breach. The execution, delivery and performance of this Agreement by the Seller and the consummation of the Contemplated Transactions will not (i) violate any provision of the Articles of Incorporation or By-laws (or comparable instruments) of the Company or the Seller; (ii) require the Company or the Seller to obtain any consent, approval or action of, or make any filing with or give any notice to, any Person, except as set forth on Schedule 3.12 (the "Required Consents"); (iii) if the Required Consents are obtained, except as set forth on Schedule 3.12, violate, result with the passage of time or the giving of notice, or both, in the breach of any of the terms of, result in a modification of the effect of, otherwise cause the termination of or constitute a default under, any contract, agreement, understanding, indenture, note, bond, loan, instrument, lease, conditional sale contract, mortgage, license, franchise, commitment or other binding arrangement (collectively, the "Contracts") to which the Company or the Seller is a party or by or to which either of them or any of their Properties (including the Shares) may be bound or subject, or result in the creation of any Lien upon the Properties of the Company or the Seller (including the Shares) pursuant to the terms of any such Contract, other than Liens arising under this Agreement; (iv) if the Required Consents are obtained, except as set forth on Schedule 3.12, violate any Order of any Governmental Body against, or binding upon, the Company or the Seller or upon any of their Properties (including the Shares) or upon their respective businesses; or (v) if the Required Consents are obtained, except as set forth on Schedule 3.12, violate any Law; other than, in the case of clauses (iii) through (v) above, where such violation, conflict, breach, modification, termination or Lien may arise or have arisen as a result of actions taken by the Buyer, or would not have a material adverse effect on the financial condition, results of operations or business of the Company or the Seller, as the case may be. 3.13 Claims and Proceedings. Except as set forth on Schedule 3.13, there are no outstanding Orders of any Governmental Body against or involving, or to the Knowledge of the Seller threatened against, the Company. Other than as may arise in the ordinary course of the Company's business with respect to claims made under insurance policies written by the Company - -------------------------------------------------------------------------------- Confidential page 11 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- or reinsurance agreements entered into by the Company, there are no actions, suits, claims or legal, administrative or arbitral proceedings or investigations (collectively, "Claims") pending, or to the Knowledge of the Seller threatened, against or involving the Company or any of its Properties, except for audits in connection with reinsurance agreements. 3.14 Contracts. Other than intercompany agreements between Seller or its affiliates and the Company, there are no material contracts to which the Company is a party on the date hereof, including but not limited to: (i) partnership or joint venture agreements; (ii) contracts containing covenants of the Company not to compete in any line of business or with any Person in any geographical area or covenants of any other Person not to compete with the Company in any line of business or in any geographical area; (iii) contracts relating to the borrowing of money; (iv) management contracts and other similar agreements; (v) contracts with any other insurance company, managing general agent, underwriting manager or any other Person, pursuant to which the Company has delegated underwriting and/or claims settlement authority; (vi) agency, brokerage or other similar insurance sales or marketing contracts; (vii) any contract, other than insurance contracts issued in the ordinary course of business, with Seller or any subsidiary of Seller or any officer, director or Affiliate of Seller; (viii) guaranties; and (ix) any other contracts. 3.15 Real Estate. There do not exist (i) any real property owned by the Company, (ii) any leases or subleases under which the Company is the lessor or lessee of any real property, or (iii) any options held by the Company or contractual obligations on its part to purchase, acquire, sell or dispose any material interest in real property. 3.16 Third Party Rights. No third Person has any rights to any property or asset of the Company, tangible or intangible, in whole or in part (including without limitation, any patent, copyright, trade secret, business name, trade name, trademark or proprietary information), which shall materially impair Buyer's interest in the Company. 3.17 Reinsurance. To the Knowledge of the Seller, Schedule 3.17 contains a complete and correct list of all Contracts entered into since 1976 regarding reinsurance, coinsurance, excess insurance, ceding of insurance, assumption of insurance or indemnification with respect to insurance to which the Company is a party (as either a ceding or assuming party) (individually a - -------------------------------------------------------------------------------- Confidential page 12 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- "Reinsurance Agreement" and collectively the "Reinsurance Agreements"). To the Knowledge of the Seller, except to the extent of a commutation of either (i) an entire Reinsurance Agreement or (ii) that portion of such Reinsurance Agreement associated with any particular reinsurer, all such treaties or agreements are in full force and effect. To the Knowledge of the Seller, no other party to any such Reinsurance Agreement has given written, or to the Knowledge of the Seller oral, notice of termination or cancellation of any such Reinsurance Agreement other than in accordance with the terms of such Reinsurance Agreement. 3.18 Policies of Insurance Written by the Company. Except for any failures to comply or file which did not and are not reasonably expected to result in the imposition of a material fine or penalty against the Company, all policies and contracts of insurance or reinsurance issued by the Company since the Acquisition Date are in compliance, and at their respective dates of issuance were in compliance, in all material respects with all applicable Laws and, to the extent required under applicable Law, (i) are on forms approved by the appropriate Governmental Bodies in the jurisdictions where issued or (ii) were filed with and not objected to by such Governmental Bodies within the period provided for objection. The Company has issued no policies of insurance since November 30, 1995. 3.19 Certain Business Practices. To the Knowledge of the Seller, all material insurance or reinsurance Claims that have become payable by the Company have been paid, reserved against, or provided for in the Company's accounts, in accordance with the terms of the insurance or reinsurance policy or contract under which they arose. 3.20 Title to Properties At the Closing, the Company will own outright all of the assets reflected in the Closing Date Statement, subject only to Liens on statutory deposits with state insurance departments. 3.21 Employee Benefits. Since the Acquisition Date, the Company has not been a party to any employee benefit plan subject to section 3(3) of the Employee Retirement Income Security Act of 1974, as amended, and the regulations thereunder, under which the Company has any liability with respect to any current or former employee of the Company. - -------------------------------------------------------------------------------- Confidential page 13 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- 3.22 Employees. The Company does not now, and at Closing will not, employ any employees. The Company is not a party to or bound by any collective bargaining agreement, and there are no labor unions or other organizations representing, or, to the Knowledge of the Seller, purporting to represent or attempting to represent any such employees. 3.23 Operations of the Company. Except as set forth on Schedule 3.23, since December 31, 1996 the Company has not: 3.23.1 incurred any indebtedness for borrowed money; 3.23.2 amended its Certificate of Incorporation or By-laws (or comparable instruments) or merged with or into or consolidated with any other Person, subdivided or in any way reclassified any shares of its capital stock or changed or agreed to change in any manner the rights of its outstanding capital stock or the character of its business; 3.23.3 issued or sold any shares of any class of its capital stock, or any securities convertible into or exchangeable for any such shares; or issued, sold, granted or entered into any subscriptions, options, warrants, conversion or other rights agreements to purchase or acquire any such securities; 3.23.4 adopted or amended any employment, collective bargaining, bonus, profit-sharing, compensation, pension, retirement, vacation, severance, deferred compensation or other plan, agreement, trust, fund or arrangement for the benefit of any officer, director, employee, agent or consultant; 3.23.5 mortgaged or pledged any of its real property or other Properties or assets, whether tangible or intangible, except for Liens on statutory deposits with state insurance departments; or 3.23.6 taken any action or, to the Knowledge of Seller, omitted to take any action that would result in the occurrence of any of the foregoing. Article 4. Representations and Warranties of the Buyer. - -------------------------------------------------------------------------------- Confidential page 14 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- The Buyer represents and warrants to the Seller as follows: 4.1 Due Incorporation and Authority. The Buyer is a corporation duly organized, validly existing and in good standing under the laws of the Commonwealth of Pennsylvania. 4.2 Authority to Execute and Perform Agreement; Enforceability. The Buyer has the full legal right and power and all corporate authority and approvals required to execute and deliver this Agreement and to perform fully its obligations hereunder. This Agreement has been duly executed and delivered by the Buyer and is a valid and binding obligation of the Buyer enforceable in accordance with its terms, except as enforceability may be limited by (i) bankruptcy, insolvency, reorganization, moratorium and other such laws of general application affecting the rights and remedies of creditors and (ii) general principles of equity, as such may be applied by courts of competent jurisdiction. 4.3 No Breach. The execution, delivery and performance of this Agreement by the Buyer and the consummation of the Contemplated Transactions will not (i) violate any provision of the Articles of Incorporation or By-laws (or comparable instruments) of the Buyer; (ii) require the Buyer to obtain any consent, approval or action of, or make any filing with or give any notice to, any Person, except as set forth on Schedule 4.3 (the "Buyer's Consents"); (iii) if the Buyer's Consents are obtained, violate any Order of any Governmental Body against, or binding upon, the Buyer or upon any of its Properties or upon its business; or (iv) if the Buyer's Consents are obtained, violate any Law; other than, in the case of clauses (iii) and (iv), where such violation would not have a material adverse effect on the financial condition, results of operations or business of the Buyer. 4.4 Claims and Proceedings. There are no outstanding Orders of any Governmental Body against or involving, or to the knowledge of the Buyer threatened against, the Buyer, and no Claims pending against or involving the Buyer which would have a material adverse effect on the ability of the Buyer to consummate the Contemplated Transactions. 4.5 Financing. The Buyer has on the date of execution of this Agreement and will have at the Closing sufficient immediately available funds, in cash or pursuant to credit agreements in effect on the date of this Agreement, to pay the Purchase Price. - -------------------------------------------------------------------------------- Confidential page 15 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- 4.6 Purchase for Investment. The Buyer is purchasing the Shares for its own account for investment and not for resale or distribution, and will not sell or otherwise transfer the Shares except in accordance with all applicable federal and state securities laws. For purposes hereof, the foregoing representation shall not be deemed breached by reason of Buyer's subsequent transfer of the Company to an affiliate of Buyer. Article 5. Covenants and Agreements. 5.1 Conduct of Business. From the date hereof through the Closing Date without the prior written consent of the Buyer, the Seller shall cause the Company not to issue any policies of insurance or undertake any of the actions specified in Section 3.23. The Seller shall give the Buyer prompt notice of any event, condition or circumstance occurring from the date hereof through the Closing Date that would constitute a material violation or breach of any representation or warranty, or cause such representation or warranty to be materially untrue as of the Closing Date (assuming such event, condition or circumstance existed on the Closing Date), or that would constitute a material violation or breach of any covenant of the Seller contained in this Agreement. 5.2 Corporate Examinations and Investigations. Prior to the Closing Date, the Seller will, and will cause the Company to, give to the Buyer and its employees and representatives, access to all of the Company's Properties, books and records, to make such examination of the business, operations and financial condition of the Company as the Buyer wishes. Any such investigation and examination shall be conducted at reasonable times and under reasonable circumstances, and the Seller shall, and shall cause the Company to, cooperate fully therein. In order that the Buyer may have full opportunity to make such physical, business, accounting and legal review, examination or investigation as it may wish of the affairs of the Company, the Seller shall make available and shall cause the Company to make available to the representatives of the Buyer during such period all such information and copies of such documents concerning the affairs of the Company as such representatives may reasonably request, permit the representatives of the Buyer access to the Properties of the Company and all parts thereof, and cause its officers, employees, consultants, agents, accountants and attorneys to cooperate fully with such - -------------------------------------------------------------------------------- Confidential page 16 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- representatives in connection with such review and examination. If this Agreement terminates, (i) the Buyer shall keep confidential and shall not use in any manner any information or documents obtained from the Company concerning its Properties, businesses and operations, unless readily ascertainable from public or published information, or trade sources, or already known or subsequently developed by the Buyer independently of any investigation of the Company, and (ii) any documents obtained from the Company and all copies or extracts thereof shall be returned. 5.3 Publicity. Except as required by law, regulation or stock exchange requirements, neither of the parties hereto shall, without the consent of the other, make any public announcement or issue any press release with respect to the Contemplated Transactions. Prior to making any such public announcement or issuing any such press release the parties hereto shall, to the extent possible, consult with the other party as to the content of such public announcement or press release. 5.4 Indemnification for Broker's Fees. The Seller represents and warrants to the Buyer that no broker, finder, agent or similar intermediary (a "Broker") has acted on behalf of the Company or the Seller in connection with this Agreement or the Contemplated Transactions, and that there are no brokerage commissions, finders' fees or similar fees or commissions payable in connection therewith based on any agreement, arrangement or understanding with the Company or the Seller, or any action taken by the Company or the Seller. The Seller agrees to indemnify and hold the Buyer harmless from any claim or demand for commission or other compensation by any Broker claiming to have been employed by or on behalf of the Company or the Seller, and to bear the cost of legal expenses incurred in defending against any such claim. The Buyer represents and warrants to the Seller that no Broker has acted on behalf of the Buyer in connection with this Agreement or the Contemplated Transactions, and that there are no brokerage commissions, finders' fees or similar fees or commissions payable in connection therewith based on any agreement, arrangement or understanding with the Buyer, or any action taken by the Buyer. The Buyer agrees to indemnify and hold the Seller and its Affiliates harmless from and against any claim or demand for commission or other compensation by any Broker claiming to have been employed by or on behalf of the Buyer, and to bear the cost of legal expenses incurred in defending against any such claim. - -------------------------------------------------------------------------------- Confidential page 17 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- 5.5 Tax Matters. 5.5.1 Seller shall prepare and file, or cause to be prepared and filed, all Consolidated Returns required to be filed by or on behalf of the Company for the period ending on or before the Closing Date and, without limiting the Buyer's obligations set forth in Section 5.5.3, shall pay, or cause to be paid, all Taxes shown as due on such Consolidated Returns. Seller shall include the income of the Company on the Seller Consolidated Returns for all periods through the close of business the day before the Closing Date and pay any federal income Taxes attributable to such income. 5.5.2 Subject to the provisions of Section 5.5.5, the Seller shall be liable to the Buyer for, and shall hold the Buyer and the Company harmless from and against, any and all Taxes due or payable by the Company for any taxable year or tax period ending on or before the Closing Date. Taxes for which the Seller shall be liable and shall hold the Buyer and the Company harmless from and against under the preceding sentence shall include, without limitation, Taxes (i) the liability for which arises under Treasury Regulations 1.1502-6 and 1.1502-78 or comparable provisions of state or local law as a result of the Company having been included in a group filing Consolidated Returns, (ii) the liability for which arises because the Company ceases on the Closing Date to be a member of a group filing Consolidated Returns, and (iii) that are due or payable by the Buyer or the Company and result from or arise out of the Contemplated Transactions or resulting from elections by the Seller and the Buyer (express or deemed) under Section 338(h)(10) of the Code (or comparable provisions of state or local tax laws). 5.5.3 Subject to the provisions of Section 5.5.5, the Buyer and the Company shall be liable for, and shall hold the Seller harmless from and against, any and all Taxes due or payable by the Company with respect to the Company for any taxable year or tax period beginning after the Closing Date except, in accordance with Section 5.5.4, to the extent that such Taxes result from elections by the Seller and the Buyer (express or deemed) under Section 338(h)(10) of the Code (or comparable provisions of state or local tax law). 5.5.4 Buyer and Seller agree that both parties shall make an election under Section 338(h)(10) of the Code (or comparable provision of state or local tax laws) with respect - -------------------------------------------------------------------------------- Confidential page 18 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- to the acquisition of the Company, but that any Taxes resulting from such election shall be paid by the Seller and Seller shall indemnify and hold Buyer harmless from and against such Taxes. Buyer shall be responsible for preparing all forms and documents in connection with such election. Seller shall execute and deliver to Buyer such forms and documents as are responsibly required to complete such election. 5.5.5 Any Taxes for a tax period beginning before the Closing Date and ending after the Closing Date shall be apportioned between the Seller and the Buyer, in the case of real and personal property taxes and franchise taxes not based on gross or net income, on a per diem basis and, in the case of other Taxes, shall be determined by (i) assuming that the Company's taxable year (including the taxable year of organizations in which it owns a partnership interest or other equity interest) ends as of the close of business on the Closing Date; (ii) closing on an actual basis the Company's books as of the close of business on such date; and (iii) preparing a Tax return based on the income, gain, deduction, losses and credits as so determined under an accurate and appropriate accounting method and, to the extent permissible, on a basis consistent with the methodology and elections employed in prior years. Each such portion of such period shall be deemed to be a tax period subject to the provisions of Sections 5.5.2 and 5.5.3 above. 5.5.6 The Buyer shall cause the Company to file any federal, state, local or foreign Tax Return (other than any Consolidated Return) required to be filed after the Closing Date with respect to the business, activities or assets of the Company (the "Post-Closing Returns") and, without limiting the Seller's obligations set forth in Section 5.5.2, the Company shall pay or cause its subsidiaries or Affiliates to pay all Taxes shown as due on any Post-Closing Returns. Any Post-Closing Returns that relate (in whole or in part) to tax periods beginning before the Closing Date (the "Straddle Returns") shall be prepared as promptly as possible after the Closing Date, but in no event later than three weeks prior to the due dates thereof, as such dates may be extended. Immediately after preparation of the Straddle Returns, the Buyer shall provide the Seller with copies of the Straddle Returns. Not less than five days before the due dates of such returns the Seller shall forward to the Buyer or the Company any comments it may have relating to such returns. - -------------------------------------------------------------------------------- Confidential page 19 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- 5.5.7 Any refunds of Taxes that were paid in respect of a taxable year or tax period (including a period deemed to be a tax period under Section 5.5.5) of the Company ending on or before the Closing Date shall be for the account of the Seller, and any refund of Taxes that were paid in respect of a taxable year or tax period (including a period deemed to be a tax period under Section 5.5.5) of the Company beginning on or after the Closing Date shall be for the account of the Buyer. 5.5.8 If the Buyer or the Company becomes aware of any assessment, official inquiry, examination or proceeding that could reasonably result in an official determination with respect to any Tax for which the Seller could be liable pursuant to Section 5.5.2, the Buyer shall promptly so notify the Seller in writing. If the Seller becomes aware of any official inquiry, examination or proceeding that could reasonably result in an official determination with respect to any Taxes related to the business, activities or assets of the Company (including, without limitation, any assessment, official inquiry, examination or proceeding with respect to any Consolidated Return), the Seller shall promptly so notify the Buyer, in writing. 5.5.9 The Seller shall have the right to exercise control over the contest and/or settlement of any issue raised in any official inquiry, examination or proceeding with respect to any Consolidated Return for federal income taxes or any inquiry, examination or proceeding that relates to Taxes for which the Seller is liable to the Buyer under Section 5.5.2, and the Seller shall pay any expenses incurred in connection therewith, provided that (i) the Seller shall keep the Buyer informed of all material developments with respect to such inquiry, examination or proceeding if it relates to any Tax for which the Buyer could be liable under Section 5.5.3 and (ii) the Seller shall not settle or compromise any such inquiry, examination or proceeding that relates to any Tax for which the Buyer could be liable under Section 5.5.3 without the consent of the Buyer, which consent shall not be unreasonably withheld. The Buyer shall cooperate with the Seller at Seller's expense, as the Seller may reasonably request, in any such inquiry, examination or proceeding. - -------------------------------------------------------------------------------- Confidential page 20 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- 5.5.10 Except as provided in Section 5.5.9, the Buyer shall have the right to exercise control over the contest and/or settlement of any issue raised in any official inquiry, examination or proceeding with respect to Taxes related to the business, activities or assets of the Company that relates only to Taxes for which the Buyer is liable to the Seller under Section 5.5.3; provided that (i) the Buyer shall keep the Seller informed of all -------- material developments with respect to such inquiry, examination or proceeding if it relates to any Tax for which the Seller could be liable under Section 5.5.2 and (ii) the Buyer shall not settle or compromise any such inquiry, examination or proceeding that relates to any Tax for which the Seller could be liable under Section 5.5.2 without the consent of the Seller, which consent shall not be unreasonably withheld. The Seller shall cooperate with the Buyer at the Buyer's expense, as the Buyer may reasonably request, in any such inquiry, examination or proceeding. 5.5.11 As used in this Agreement, the following terms shall have the following meanings: (i) "Code" means the Internal Revenue Code of 1986, as amended, and the applicable final Treasury Regulations promulgated thereunder, or corresponding provisions of future laws. (ii) "Consolidated Returns" means any consolidated federal income tax return or similar return with respect to any other Tax on behalf of an affiliated group of corporations of which the Company was or is includible as a member for any portion of such taxable period of the Company beginning before the Closing Date. (iii) "Taxes" (or "Tax" where the context requires) means all federal, state, county, local, foreign and other taxes (including, without limitation, income, profits, premium, estimated, excise, sales, use, occupancy, gross receipts, franchise, ad valorem, severance, capital levy, production, transfer, withholding, employment, unemployment compensation, payroll-related and property taxes, import duties and other governmental charges and assessments), whether or not - -------------------------------------------------------------------------------- Confidential page 21 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- measured in whole or in part by net income, and including deficiencies, interest, additions to tax or interest and penalties with respect thereto. (iv) "Tax Return" means all returns, declarations, reports, forms, estimates, information returns and statements required to be filed in respect of any Taxes to be supplied to a taxing authority in connection with any Taxes. (v) "Treasury Regulations" means the final Regulations promulgated under the Internal Revenue Code of 1986, as amended (or corresponding future law), or corresponding future final regulations. 5.6 Management Agreements. The Seller and the Company will cause all Management Agreements to be terminated at or prior to the Closing with no further liability on the part of the Company. 5.7 Reinsurance Agreement. At or prior to the Closing the Seller will cause Essex Insurance Company ("Essex"), a wholly-owned subsidiary of the Seller, and the Company to execute and deliver a reinsurance agreement, dated as of the Closing Date, in substantially the form of Schedule 5.7 (the "Essex Reinsurance Agreement"), with such changes therein as may be made in response to regulatory comments and which are mutually acceptable to the parties. 5.8 Further Assurances. 5.8.1 Each of the parties shall execute, at its expense, such documents and take such commercially reasonable actions as may be required or desirable to carry out the provisions hereof and the Contemplated Transactions, including without limitation: promptly after the date hereof preparing and filing a Form A Statement with the Delaware Insurance Department and any other Insurance Department where such filing is required, and any other filings required to be made to obtain the Required Consents; and the furnishing of all information as may be required by the Delaware Commissioner of Insurance or the Delaware Department of Insurance, any other state regulatory agency asserting jurisdiction, in order that the requisite approvals for the purchase and sale of the - -------------------------------------------------------------------------------- Confidential page 22 Shares and the Contemplated Transactions be obtained or to cause any applicable waiting periods to expire. 5.8.2 Each party will use commercially reasonable efforts to implement the provisions of this Agreement, and for such purpose, at the request of the other party will, at or after the Closing, without further consideration, promptly execute and deliver, or cause to be executed and delivered, such additional documents, instruments, conveyances and assurances and take such other actions as the other party may reasonably deem necessary or desirable to implement any provision of this Agreement and to render effective the consummation of the Contemplated Transactions, including, without limitation, the transfer to the Buyer of the ownership of the Company. In addition, the Seller and Buyer will use best efforts to ensure to the extent practicable that all existing Insurance Licenses are retained by the Company through the Closing Date. 5.9 Books and Records of the Company. 5.9.1 The Seller agrees to deliver to the Buyer at or as soon as practicable after the Closing, all books and records relating to the corporate governance or Insurance Licenses of the Company (including but not limited to, correspondence, memoranda, and the like). 5.9.2 For a period of seven (7) years following the Closing, or for such longer periods as may be required to satisfy applicable Laws, the parties shall retain all books and records in their respective possessions (a) relating to Taxes, including, without limitation, accounting and tax records and information pertaining to events occurring prior to the Closing Date, and (b) required to be retained pursuant to obligations imposed by any Law (such books and records of the business of the Company collectively, the "Records"). During such period, each party shall provide the other with reasonable access to the Records for review and copying. 5.9.3 If original documents are required to respond to legal process in connection with the conduct by either party of any litigation, arbitration, audit, settlement proceedings or negotiations with third parties with respect to its conduct of the business of the Company ("Legal Proceedings"), such party, subject to applicable laws, regulations or agreements, shall be permitted to remove such Records temporarily from the other party's premises; - -------------------------------------------------------------------------------- Confidential page 23 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- provided that such party shall return such original documents to such -------- other party as promptly as practicable after such time when such original documents are no longer required in connection with such Legal Proceedings. 5.9.4 If, in connection with Legal Proceedings, the Buyer or the Seller shall require the assistance of the other party's employees, such party shall provide such employees to the requesting party as are reasonably required by such requesting party. The requesting party shall pay such other party's out-of-pocket costs incurred in connection with such use of such party's employees and shall reimburse such party for the number of whole business days spent by each such employee in providing such services at the rate equal to the average daily gross pay (excluding the value of employee benefits) of such employee during each calendar month in which such services are performed. 5.10 Confidentiality Agreement. Except to the extent inconsistent with the express terms hereof, the terms and conditions of that certain Confidentiality Agreement dated as of June 2, 1997 between Buyer and Seller shall continue to apply to the transactions contemplated hereby and is incorporated herein by reference and made a part hereof. 5.11 Negotiations with Others. From the date hereof until the Closing, the Seller will not, and shall cause the Company not to, directly or indirectly, without the written consent of the Buyer, (i) initiate discussions or engage in negotiations concerning any sale of the Shares or of any merger, sale of assets or similar transaction involving the Company with, or (ii) furnish or cause to be furnished any non-public information concerning the Company to, any Person other than the Buyer and its agents and representatives. The Seller agrees to disclose to the Buyer the existence and content of any formal inquiries by or discussions with a third party relating to an acquisition of the stock or assets of the Company as soon as practicable after they take place. Article 6. Conditions Precedent to the Obligation of the Buyer to Close. The obligation of the Buyer to enter into and complete the Closing is subject, at the option of the Buyer, to the fulfillment on or prior to the Closing Date of the following conditions, any one or more of which (other than Section 6.2, insofar as it relates to the Delaware Commissioner - -------------------------------------------------------------------------------- Confidential page 24 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- of Insurance or the Delaware Department of Insurance, and Section 6.3) may be waived by the Buyer in its sole discretion: 6.1 Representations and Covenants. The representations and warranties of the Seller contained in this Agreement shall be true and correct in all material respects at and as of the Closing with the same force and effect as though made on and as of the Closing. The Seller shall have performed and complied in all material respects with all covenants and agreements required by this Agreement to be performed or complied with by the Seller on or prior to the Closing Date. The Seller shall have executed and delivered to the Buyer a certificate, dated the date of the Closing, to the foregoing effect and stating that all conditions to the Buyer's obligations hereunder have been satisfied. 6.2 Consents and Approvals; Insurance Licenses. All consents or approvals required for the consummation of the sale of the Shares and the Contemplated Transactions from the Delaware Commissioner of Insurance or the Delaware Department of Insurance or any other Governmental Body having jurisdiction over the Company or the consummation of the Contemplated Transactions shall have been obtained and be in full force and effect. All Insurance Licenses listed as being valid and in good standing and in full force and effect in Schedule 3.11 shall continue to so remain at the Closing. 6.3 Litigation. No Claim shall have been instituted before any Governmental Body, or instituted or threatened by any Governmental Body, to restrain, modify or prevent the carrying out of the Contemplated Transactions. 6.4 Affiliate Transactions. The Seller shall have delivered to the Buyer evidence reasonably satisfactory to the Buyer that, except as set forth on Schedule 6.4, all agreements between the Company, on the one hand, and Seller and/or any Affiliate of Seller, on the other hand, shall have terminated without any continuing obligations of the Company remaining thereunder. 6.5 Resignations. The Company shall have caused the current Officers and Directors of the Company to resign, and shall have obtained written resignations of such Directors and Officers - -------------------------------------------------------------------------------- Confidential page 25 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- which provide that all such persons waive and generally release the Company from any and all damages, claims, causes of action, liabilities and obligations of which they are or later become aware, and in particular release any claims for indemnification they may have under the Company Bylaws. Article 7. Conditions Precedent to the Obligation of the Seller to Close. The obligation of the Seller to enter into and complete the Closing is subject, at the option of the Seller, to the fulfillment on or prior to the Closing Date of the following conditions, any one or more of which (other than Section 7.2, insofar as it relates to the Delaware Commissioner of Insurance or the Delaware Department of Insurance, and Section 7.3) may be waived by the Seller in its sole discretion: 7.1 Representations and Covenants. The representations and warranties of the Buyer contained in this Agreement shall be true and correct in all material respects at and as of the Closing Date with the same force and effect as though made on and as of the Closing Date. The Buyer shall have performed and complied in all material respects with all covenants and agreements required by this Agreement to be performed or complied with by the Buyer on or prior to the Closing Date. The Buyer shall have executed and delivered to the Seller a certificate, dated the date of the Closing, to the foregoing effect and stating that all conditions to the Seller's obligations hereunder have been satisfied. 7.2 Consents and Approvals. All consents or approvals required for the consummation of the sale of the Shares and the Contemplated Transactions from the Delaware Commissioner of Insurance or the Delaware Department of Insurance or any other Governmental Body having jurisdiction over the Company and the consummation of the Contemplated Transactions shall have been obtained and be in full force and effect. 7.3 Litigation. No Claim shall have been instituted before any Governmental Body, or instituted or threatened by any Governmental Body, to restrain, modify or prevent the carrying out of the Contemplated Transactions. Article 8. Indemnification and Remedies - -------------------------------------------------------------------------------- Confidential page 26 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- 8.1 Definition of "Representations and Warranties." The "Representations and Warranties" of the Seller means all of the representations and warranties of the Seller set forth in Article 3 and the statements set forth in any certificate referred to in Section 6.1. The "Representations and Warranties" of Buyer means all of the representations and warranties of the Buyer set forth in Article 4 and the statements set forth in any certificate referred to in Section 7.1. 8.2 Survival of Representations, Warranties and Covenants; Right to Indemnification Not Affected by Knowledge. All Representations and Warranties of each of the parties hereto, and all Covenants of each of the parties set forth in this Agreement, will survive the Closing. The right of a party to indemnification pursuant hereto will not be affected by any investigation conducted or any knowledge acquired (or capable of being acquired) at any time, whether before or after the Closing Date, with respect to the accuracy of or compliance with any Representation, Warranty or Covenant of another party hereto. The waiver by a party hereto of any condition based on the accuracy of any Representation or Warranty, or on the performance of or compliance with any Covenant or condition hereunder, will not affect the right of such party to indemnification pursuant hereto by reason of such breach of Representation, Warranty or Covenant, except to the extent expressly set forth in a writing executed by such party. 8.3 Exclusive Remedies. With the exception of any indemnification obligations set forth in sections 5.4 and 5.5 (which shall be governed thereby), the rights and obligations with respect to indemnification set forth in this Article will be the exclusive rights and obligations of the respective parties hereto with respect to the Representations and Warranties of such parties, and a claim for indemnification pursuant to this Article shall be the exclusive remedy for any breach of any such Representation and Warranty. The rights and obligations of the respective parties set forth in this Article 8, and any claims or causes of action by a party under this Agreement, the Essex Reinsurance Agreement, or the Confidentiality Agreement (the "Related Agreements") to enforce any covenant of a party hereto set forth in this Agreement or any Related Agreement will be the exclusive rights and obligations of the Seller and the Buyer with respect to the business or ownership of the Company, the Shares, the events giving rise to this Agreement and the transactions provided for in or contemplated by this Agreement or by any of the Related Agreements. Without limiting the generality or effect of the foregoing, each of the Seller and the - -------------------------------------------------------------------------------- Confidential page 27 Lincoln Insurance Company Stock Purchase Agreement6 - -------------------------------------------------------------------------------- Buyer, hereby waives any claim or cause of action which it might be entitled to assert against the other, or any director, officer, employee, controlling person or Affiliate of such other party (including without limiting any claim or cause of action for fraud, misrepresentation or other cause under the common law, any securities, trade regulation, environmental or other law) by reason of this Agreement, the events giving rise to this Agreement and the transactions provided for or contemplated by this Agreement or any of the Related Agreements, except for claims or causes of action that may be made or brought under this Agreement or any of the Related Agreements to enforce the covenants of any party set forth herein or therein. 8.4 Indemnification by the Seller. The Seller will indemnify and hold the Buyer and the Company harmless from and against any damage deficiency, cost, expense, or Diminution of Value (hereinafter defined), whether or not involving a third-party claim (a "Loss") resulting from (i) the material breach of any Representation or Warranty of the Seller or any failure to materially perform any covenant of the Seller contained herein and (ii) any claims, actions, judgments, costs and expenses incident to the foregoing (including without limitation costs of investigation and reasonable attorneys' fees). For purposes hereof, a Diminution of Value shall not include any diminution in value of the Company (i) arising from loss of an Insurance License after the date hereof, or (ii) the financial impact of which is less than a hundred thousand Dollars ($100,000); provided, that if such diminution in value exceeds a hundred -------- thousand Dollars ($100,000), the entire amount of such diminution of value (including the portion not exceeding a hundred thousand Dollars ($100,000)) shall be included as part of the Indemnifying Party's indemnification obligation hereunder. 8.5 Indemnification by Buyer. The Buyer will indemnify and hold the Seller harmless from and against any Loss resulting from (i) the material breach of any Representation or Warranty of the Buyer or the failure to materially perform any covenant of the Buyer set forth herein and (ii) any claims, actions, judgments, costs and expenses incident to the foregoing (including without limitation costs of investigation and reasonable attorneys' fees). 8.6 Determination of Losses. Losses shall be determined taking into account the actual amount of damage, deficiency, cost or expense incurred or suffered or the diminution of value of any property by reason of the event or condition giving rise to the obligation to indemnify as well - -------------------------------------------------------------------------------- Confidential page 28 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- as any insurance proceeds actually received by the indemnified party (otherwise than from an insurer who is an Affiliate thereof), after adjustment for tax benefits and burdens arising therefrom or from the indemnification thereof (to the extent that such tax effects can reasonably be quantified). Upon payment by the indemnifying party, such party shall receive from the indemnified party an assignment of the indemnified party's rights and claims against insurers and others with respect to the event or condition giving rise to the obligation to indemnify. 8.7 Certain Limitations on Claims. The following limitations shall apply to claims for indemnification under Section 8.4 or 8.5: 8.7.1 No such claim based upon the breach of a Representation or Warranty may be asserted unless notice shall have been given on or before the date specified below to the Person from whom such indemnification may be sought that a breach of such a Representation or Warranty has or may have occurred (identifying such Representation or Warranty with reasonable particularity): (a) If such claim relates to the matters referred to in Section 3.3; no time limit shall apply; (b) If such claim relates to the matters referred to in Sections 3.10 and 5.5, the applicable statute of limitations; and (c) If such claim relates to any other Representation or Warranty; eighteen months from the Closing Date. 8.7.2 The Seller shall not be obligated to pay any amounts for indemnification under this Agreement by reason of the development of Reserves for Losses and Loss Adjustment Expenses and Reserves for Uncollectible Reinsurance after the date hereof (the foregoing shall not be deemed to alter or affect the terms of the Essex Reinsurance Agreement); 8.7.3 The amount of any indemnification required to be paid by an indemnifying party pursuant to this Article (the "Indemnifying Party") shall be reduced by any amount received by the party claiming indemnification hereunder (the "Indemnitee") with respect to the Loss which is the subject of such claim thereto under any insurance coverage (net of - -------------------------------------------------------------------------------- Confidential page 29 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- any costs, including reasonable legal fees, incurred by such Indemnitee in enforcing its rights to such coverage) or from any other Person responsible therefor. The Indemnitee shall use commercially reasonable efforts to collect any amounts available under such insurance coverage and from such other Person responsible. If an Indemnitee receives an amount under insurance coverage or from such other Person with respect to any Losses at any time subsequent to any indemnification provided by the Indemnifying Party pursuant to this Article, then such Indemnitee shall promptly reimburse the Indemnifying Party, as the case may be, for any payment made or expense incurred by the Indemnifying Party in connection with providing such indemnification up to such amount received by the Indemnitee (net of any costs of such coverage or of obtaining such amount incurred by such Indemnitee). Article 9. Restrictive Covenant 9.1 Non-Competition. Buyer agrees that, for a period of 18 months from and after the Closing Date, Buyer shall cause the Company to refrain from offering the insurance products listed on Schedule 9.1 to any current customers or accounts of Markel Insurance Company, Shand/Evanston Group, Essex Insurance Company, Markel American (American Underwriting Managers) or Investors Insurance Group. Article 10. Termination of Agreement. 10.1 Termination. This Agreement may be terminated prior to the Closing as follows: 10.1.1 at the election of the Seller, if a material breach of the Representations, Warranties or Covenants of the Buyer has occurred, which breach is not cured by Buyer within ten (10) days after receiving notice thereof from Seller; 10.1.2 at the election of the Buyer, if a material breach of the Representations, Warranties or Covenants of the Seller has occurred, which breach is not cured by Seller within ten (10) days after receiving notice thereof from Buyer; - -------------------------------------------------------------------------------- Confidential page 30 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- 10.1.3 at any time on or prior to the Closing Date, by mutual written consent of the Seller and the Buyer; or 10.1.4 on June 1, 1998, if the Closing has not occurred prior to such date. 10.2 Return of Deposit. 10.2.1 In the event of termination pursuant to Section 10.1.1, the Earnest Money Deposit shall be retained by Seller; 10.2.2 In the event of termination pursuant to Section 10.1.2, the Earnest Money Deposit shall be refunded to Buyer, in full; and 10.2.3 In the event of any other termination, Seller will be entitled to retain $25,000 of the Earnest Money Deposit, and the remainder shall be refunded to Buyer. 10.3 Remedies After Termination. If this Agreement terminates, each party shall retain such rights as it may then have for damages or other relief by reason of any breach by the other party of such other party's representations, warranties or covenants. Article 11. Definitions. 11.1 Certain Definitions. As used in this Agreement, the following terms have the following meanings: 11.1.1 "Affiliate" means, with respect to any Person, any other Person controlling, controlled by or under common control with, or the parents, spouse, lineal descendants or beneficiaries of, such Person. The term "control" (including the terms "controlling," "controlled by" and "under common control with" ) means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a Person, whether through the ownership of voting securities, by contract or otherwise. 11.1.2 "Business Day" means any day other than a Saturday or Sunday or upon which banks in New York, New York or Richmond, Virginia are authorized or required by law to close. - -------------------------------------------------------------------------------- Confidential page 31 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- 11.1.3 "Dollars" means U.S. Dollars. 11.1.4 "GAAP" means generally accepted accounting principles in the United States of America. 11.1.5 "Governmental Body" means any government or political subdivision thereof, whether federal, state, local or foreign, or any agency or instrumentality thereof. 11.1.6 "Law" means any law, statute, code, ordinance, regulation, rule or other requirement. 11.1.7 "Order" means any order, civil investigative demand, judgment, injunction, award, decree or writ. 11.1.8 "Person" means any individual, corporation, limited liability corporation, partnership, limited liability partnership, joint venture, association, joint-stock company, trust, unincorporated organization, Governmental Body or other entity. 11.1.9 "Property" or "Properties" means real, personal or mixed property, tangible or intangible. 11.1.10 "Reserves for Losses and Loss Adjustment Expenses" means an amount equal to the allowance, determined in accordance with Statutory Accounting Principles, with respect to the financial statements of the Company for (a) case reserve estimates for reported losses and loss adjustment expenses plus (b) incurred but not reported losses and loss adjustment expenses less (c) amounts representing estimated net realizable salvage, subrogation and deductibles, and in the case of clauses (a), (b) and (c), net of applicable reinsurance recoverables. 11.1.11 "Reserves for Uncollectible Reinsurance" means an amount, determined in accordance with GAAP, equal to the total of reinsurance recoverables owed to the Company, that have been determined to be uncollectible (including collection expenses and any amount determined to be uncollectible in accordance with GAAP resulting from a commutation with a reinsurer). - -------------------------------------------------------------------------------- Confidential page 32 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- 11.1.12 "Sellers Knowledge" or the phrase "to the best of Seller's Knowledge" means the actual knowledge of Steven Markel, Darrell D. Martin, Gregory B. Nevers, Richard R. Whitt, Paul Chucle or Paula Francis. Article 12. Dispute Resolution 12.1 Arbitration; selection of panel. As a condition precedent to any right of action hereunder, any and all disputes or disagreements arising between the parties pertaining to or relating in any manner to this Agreement (any "Controversy") which shall include but not be limited to any disputes or disagreements as to the meaning or interpretation of this Agreement or any portion thereof or the relationship of the parties created under this Agreement or any breach of this Agreement, upon which an amicable understanding cannot be reached shall be submitted to arbitration in the location of the party not seeking to arbitrate (i.e., Philadelphia in the case of Buyer, and Richmond in the case of Seller). One arbiter shall be chosen by the Buyer, the other by the Seller, and an umpire shall be chosen by the two arbiters before they enter upon arbitration, all of whom shall be active or retired disinterested executive officers of insurance or reinsurance companies. In the event that either party shall fail to choose an arbiter within thirty (30) days following a written request to do so, the requesting party may choose two arbiters who shall in turn choose an umpire before entering into arbitration. If the two arbiters fail to agree upon the selection of an umpire within thirty (30) days following their appointment, each arbiter shall name three nominees, of whom the other party shall decline two, and the decision between the remaining two nominees shall be made by drawing lots. 12.2 Arbitration; proceedings and award. Each party shall present its case to the arbiters and the umpire within thirty (30) following the appointment of the umpire. The arbiters shall consider this Agreement as an honorable engagement rather than merely as a legal obligation and they shall be relieved of all judicial formalities and may abstain from following the strict rules of law; however, there shall be no ex parte contacts between either party and any arbiter or the umpire, and cross examination and rebuttal shall be allowed if requested by either party. The decision of the arbiters shall be in writing giving the reasons for the award and shall be final and binding on both parties but, failing to agree, they shall call in the umpire and the decision of the majority shall - -------------------------------------------------------------------------------- Confidential page 33 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- be final and binding upon both parties, except that an appeal may be taken from such decision as provided in the Federal Arbitration Act. 12.3 Arbitration; expenses. Except as provided below, each party shall bear the expense of its own arbiter, and shall jointly and equally bear with the other the expense of the umpire and of the arbitration. In the event that the two arbiters are chosen by one party, as above provided, the expense of the arbiters, the umpire and the arbitration shall be equally divided between the two parties. Provided, however, that if in the opinion of the arbiters any claim hereunder or any defense or objection thereto was unreasonable, the arbiters may assess, as part of the award, all or any part of the expenses of the arbitration against the party raising such unreasonable claim, defense or objections. 12.3.1 At the commencement of the arbitration, each party must specify its position as to the precise amounts it considers are properly payable with respect to any amounts which are at issue in the Controversy ("Amounts at Issue"), and the Arbiters and Umpire shall be instructed that any award or awards rendered must lie within such range or ranges between the Amounts at Issue specified by the parties. At the time any award or awards are issued by the Arbiters, if any party has specified Amounts at Issue which are, in the aggregate, twice or more as far apart in amount from the aggregate amount of such award or awards than are the Amounts at Issue specified by the other party, such farther party shall be considered the "Losing Party" for purposes hereof. In the event a party becomes a Losing Party as so defined, such Losing Party will be responsible for all witness fees, attorney's expenses and all other expenses related to the arbitration process incurred by either party in connection with the arbitration, unless the arbitration panel determines that such an allocation of fees and expenses would be unjust. 12.3.2 Prior to proceeding with any arbitration hereunder, each party must first pay to the other any Amounts at Issue which are undisputed. In the event a party fails to do so, the Arbiters shall be directed, pursuant hereto, to enter an award in the full amount of the Amounts at Issue specified by the opposing party. 12.4 Specific Enforcement. This Agreement to arbitrate shall be specifically enforceable. Should any party to this Agreement be required to seek relief from a court of competent jurisdiction in order to - -------------------------------------------------------------------------------- Confidential page 34 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- enforce the requirement that all Controversies be settled by arbitration, the moving party, if its motion is successful, will be entitled to recover all of its costs and expenses, including attorneys' fees, in connection with such enforcement action. 12.5 Alternative Resolution. In the event that arbitration may not be legally permitted hereunder or the parties mutually agree not to submit a dispute to arbitration, any party may commence a civil action in a court of appropriate jurisdiction to solve disputes hereunder. Nothing contained in this Article shall prevent the parties from settling any dispute by mutual agreement at any time. 12.6 Consent to Jurisdiction and Service of Process. Any legal action, suit or proceeding arising out of or relating to this Agreement or the Contemplated Transactions may be instituted only in any federal court or any state court located either in Virginia or Pennsylvania. Article 13 Notices. 13.1 Any notice or other communication required or permitted hereunder shall be in writing and shall be delivered personally or by express courier or delivery service, telegraphed, telexed, sent by facsimile transmission or sent by certified, registered or express mail, postage prepaid. Any such notice shall be deemed given when so delivered personally or by express courier or delivery service, telegraphed, telexed or sent by facsimile transmission or, if mailed, five (5) days after the date of deposit in the United States mails, as follows: 13.1.1 if to the Seller, to: Steve Markel, Vice Chairman with a copy to: Markel Corporation Gregory B. Nevers, Corporate Counsel 4551 Cox Road Markel Corporation Glen Allen, Virginia 23060 4551 Cox Road telephone 804.965.1675 Glen Allen, Virginia 23060 facsimile 804.527. 3810 telephone 804.965.1673 facsimile 804.527. 3810
- -------------------------------------------------------------------------------- Confidential page 35 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- 13.1.2 if to the Buyer to: Ron Austin, President with a copy to: Caliber One Management Co. Frank McDonnell, Senior Vice President 380 Sentry Parkway PMA Reinsurance Corporation Blue Bell, PA. 19422 The Mellon Bank Center telephone 610.397.5091 1735 Market Street, Suite 2800 facsimile 610.397.5334 Philadelphia, PA 19103 telephone 215.665.5070 facsimile 215.665.5061
13.2 Any party may by notice given in accordance with this Section to the other parties designate another address or Person for receipt of notices hereunder. Article 14. Interpretation 14.1 Entire Agreement. This Agreement (including the Exhibits and Schedules) and any collateral agreements executed in connection with the consummation of the Contemplated Transactions contain the entire agreement among the parties with respect to the purchase of the Shares and supersede all prior agreements, written or oral, with respect thereto; provided that the Confidentiality Agreement between the Seller and Buyer dated June 2, 1997, shall survive the execution and delivery hereof and the Closing. 14.2 Waivers and Amendments: Non-Contractual Remedies; Preservation of Remedies. This Agreement may be amended, superseded, canceled, renewed or extended, and the terms hereof may be waived, only by a written instrument signed by the Buyer and the Seller or, in the case of a waiver, by the party waiving compliance. 14.3 Governing Law. This Agreement shall be governed and construed in accordance with the laws of the Commonwealth of Pennsylvania applicable to agreements made and to be performed entirely within such Commonwealth. 14.4 Binding Effect; No Third Party Beneficiary. This Agreement shall be binding upon and inure to the benefit of the parties and their respective successors, legal representatives and - -------------------------------------------------------------------------------- Confidential page 36 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- Permitted Assigns. For purposes of this section, "Permitted Assigns" shall mean corporate affiliates of any party, or other parties specifically consented to by the party not seeking assignment. Nothing expressed or implied in this Agreement is intended or shall be construed to confer upon or give any Person other than the Seller or the Buyer any rights or remedies under or by reason of this Agreement or any of the Contemplated Transactions. 14.5 Variations in Pronouns. All pronouns and any variations thereof refer to the masculine, feminine or neuter, singular or plural, as the context may require. 14.6 Counterparts. This Agreement may be executed by the parties hereto in separate counterparts, each of which when so executed and delivered shall be an original, but all such counterparts shall together constitute one and the same instrument. Each counterpart may consist of a number of copies hereof each signed by less than all, but together signed by all of the parties hereto. 14.7 Exhibits and Schedules. The Exhibits and Schedules are a part of this Agreement as if fully set forth herein. All references herein to Sections, Exhibits and Schedules shall be deemed references to such parts of this Agreement, unless the context shall otherwise require. 14.8 Headings. The headings in this Agreement are for reference only, and shall not affect the interpretation of this Agreement. 14.9 Interpretation. The parties acknowledge and agree that: (i) each party and its counsel reviewed and negotiated the terms and provisions of this Agreement and have contributed to its revision, (ii) the rule of construction to the effect that any ambiguities are resolved against the drafting party shall not be employed in the interpretation of this Agreement; and (iii) the terms and provisions of this Agreement shall be construed fairly as to all parties hereto, regardless of which party was generally responsible for the preparation of this Agreement. - -------------------------------------------------------------------------------- Confidential page 37 Lincoln Insurance Company Stock Purchase Agreement - -------------------------------------------------------------------------------- IN WITNESS WHEREOF, the parties hereto have duly executed and delivered this Agreement as of the date first above written. Markel Corporation By: /s/ Steven A. Markel -------------------------------- Title: Vice Chairman PMA Reinsurance Corporation By: /s/ Francis W. McDonnell -------------------------------- Title: Senior Vice President, Chief Financial Officer and Treasurer - -------------------------------------------------------------------------------- Confidential page 38 List of Schedules Schedule 3.7 Schedule of Company Assets Schedule 3.9 Schedule of Tax Return States Schedule 3.11 Schedule of Insurance Licenses Schedule 3.12 Schedule of Required Consents Schedule 3.13 Schedule of Governmental Orders Schedule 3.17 Schedule of Reinsurance Agreements Schedule 3.23 Schedule of Company Operations Schedule 4.3 Schedule of Buyer's Consents Schedule 5.7 Essex Reinsurance Agreement Schedule 6.4 Schedule of Affiliate Transactions. Schedule 9.1 Schedule of Non-Competition insurance products Schedule 3.7 Permissible Assets Cash Treasury bills, bonds or other securities pledged or placed on deposit as part of statutory deposit requirements. Money market mutual funds Other securities approved in writing by Buyer Accrued interest and/or dividends on any of the foregoing. SCHEDULE 3.9 Taxes States in which the Company files tax returns CURRENTLY STATE TYPE OF TAX AUDITED BEGIN AUDITED - ----- ----------- ------- ------------- Delaware Privilege No No Delaware Franchise No No The Company is not required to make adjustments pursuant to Section 431 of the Code Schedule 3.11 Insurance Licenses or Approvals STATES WITH EXISTING SURPLUS LINES ELIGIBILITY Alabama Arizona Arkansas District of Columbia Florida Georgia Hawaii Idaho Indiana Iowa Kansas Kentucky Massachusetts Michigan Minnesota Mississippi Missouri Montana Nebraska North Dakota Ohio Oklahoma Oregon Pennsylvania Puerto Rico South Dakota Tennessee Utah Virgin Islands West Virginia Wyoming STATES WITH PENDING NEGOTIATIONS South Carolina (cannot withdraw until all business is runoff) STATES WE HAVE VOLUNTARILY WITHDRAWN FROM ELIGIBILITY Alaska California Colorado Connecticut (removed from eligibility list) Illinois Louisiana Maryland (no renewal application in 1996) New Jersey New Mexico New York North Carolina Texas Virginia Washington Wisconsin (removed from eligibility list) STATES IN WHICH LINCOLN WAS NOT ELIGIBLE TO WRITE Maine Nevada New Hampshire Rhode Island Vermont Schedule 3.12 Required Consents The Contemplated Transactions require the prior approval of the Delaware Department of Insurance. States in which the Company is listed as an approved surplus/excess lines carrier may need to be informed of the Contemplated Transactions and any preconditions met with respect to continued listing and/or eligibility. An amendment to the Insurance Holding Company Registration Statement related to the Company must be filed in Delaware and in any other state in which a registration statement has been filed. Schedule 3.13 Outstanding Orders NONE Schedule 3.17 Reinsurance ----------- See attached Schedule 3.17 Attachment P.1 THE LINCOLN INSURANCE GROUP (including LIC and GIC) CASUALTY X/S of LOSS TREATIES TERM LAYER LG# BROKER/REF# - -------------------------------------------------------------------------------- 07/01/76 - 06/30/78 200,000 XS 50,000 3035 (PRORATED EXPENSES) 250,000 XS 250,000 3036 500,000 XS 500,000 3037 07/01/78 - 06/30/79 100,000 XS 50,000 3046 150,000 XS 150,000 3047 700,000 XS 300,000 3048 07/01/79 - 06/30/80 150,000 XS 150,000 3902 800,000 XS 300,000 3903 1,000,000 XS 1,100,000 3904 07/01/80 - 06/30/81 150,000 XS 150,000 4009 800,000 XS 300,000 4010 1,000,000 XS 1,100,000 4011 BEP INT'L 4035-1 07/01/81 - 09/30/82 400,000 XS 100,000 4107 500,000 XS 500,000 4108 07/01/81 - 06/30/82 4,000,000 XS 1,000,000 4109 10/01/82 - 09/30/83 350,000 XS 150,000 4122 500,000 XS 500,000 4123 07/01/82 - 06/30/83 4,000,000 XS 1,000,000 4119 10/01/83 - 09/30/84 350,000 XS 150,000 4129 500,000 XS 500,000 4130 07/01/83 - 06/30/84 2,000,000 XS 1,000,000 4128 10/01/84 - 09/30/85 350,000 XS 150,000 4132 500,000 XS 500,000 4133 07/01/84 - 09/30/85 2,000,000 XS 1,000,000 4134 10/01/85 - 09/30/86 350,000 XS 150,000 4135 500,000 XS 500,000 4136 80% 1,000,000 XS 1,000,000 4137 TPF&C P85-19512 10/01/86 - 09/30/87 350,000 XS 150,000 5135 TPF&C P86-19601 500,000 XS 500,000 5136 TPF&C P86-19682 1,000,000 XS 1,000,000 5137 TPF&C P86-19512 10/01/87 - 09/30/88 350,000 XS 150,000 5145 TPF&C P87-19681 500,000 XS 500,000 5146 TPF&C P87-19682 2,000,000 XS 1,000,000 5147 TPF&C P87-19512 10/01/88 - 09/30/89 250,000 XS 150,000 5155 TPF&C P88-19681 600,000 XS 400,000 5156 TPF&C P88-19682 2,000,000 XS 1,000,000 5157 TPF&C P88-19512 10/01/89 - 09/30/90 250,000 XS 150,000 5165 TPF&C P89-19681 600,000 XS 400,000 5166 TPF&C P89-19682 1,000,000 XS 1,000,000 5167 TPF&C P89-19512 1,000,000 XS 2,000,000 5168 TPF&C P89-20081 Schedule 3.17 Attachment P.2 THE LINCOLN INSURANCE GROUP (including LIC and GIC) CASUALTY X/S of LOSS TREATIES TERM LAYER LG# BROKER/REF# - -------------------------------------------------------------------------------- 10/01/90 - 09/30/91 100,000 XS 150,000 5175 TPF&C G90-19681 750,000 XS 250,000 5176 TPF&C G90-19682 1,000,000 XS 1,000,000 5177 TPF&C G90-19512 1,000,000 XS 2,000,000 5178 TPF&C G90-20081 10/01/91 - 09/30/92 100,000 XS 150,000 5185 TPF&C G91-19681 750,000 XS 250,000 5186 TPF&C G91-19682 1,000,000 XS 1,000,000 5187 TPF&C G91-19512 1,000,000 XS 2,000,000 5188 TPF&C G91-20081 10/01/92 - 09/30/93 750,000 XS 250,000 5196 TPF&C G92-19682 1,000,000 XS 1,000,000 5197 TPF&C G92-19512 1,000,000 XS 2,000,000 5198 TPF&C G92-20081 10/01/93 - 09/30/94 750,000 XS 250,000 6106 TPR G93-19682 1,000,000 XS 1,000,000 6107 TPR G93-19512 1,000,000 XS 2,000,000 6108 TPR G93-20001 THE LINCOLN INSURANCE GROUP (including LIC and GIC) PROPERTY X/S of LOSS TREATIES TERM LAYER LG# BROKER/REF# - -------------------------------------------------------------------------------- 07/01/85 - 06/30/86 300,000 XS 200,000 5101 07/01/86 - 09/30/87 750,000 XS 250,000 5111 TPF&C P86-19655 10/01/87 - 09/30/88 750,000 XS 250,000 5121 TPF&C P87-19655 10/01/88 - 09/30/89 400,000 XS 100,000 5131 TPF&C P88-19655 10/01/89 - 10/31/89 400,000 XS 100,000 5141A TPF&C P89-19655 11/01/89 - 09/30/90 450,000 XS 50,000 5141B TPF&C P89-19655 10/01/90 - 09/30/91 450,000 XS 50,000 5151 TPF&C G90-19655 10/01/91 - 09/30/92 400,000 XS 100,000 5161 TPF&C G91-19655 10/01/92 - 09/30/93 400,000 XS 100,000 5171 TPF&C G92-19655 10/01/93 - 09/30/94 400,000 XS 100,000 5181 TPR G93-19655 Schedule 3.17 Attachment P.3 THE LINCOLN INSURANCE GROUP (including LIC and GIC) - --------------------------- QUOTA SHARE REINSURANCE: - ------------------------ TERM QUOTA SHARE % LG# BROKER ---- ------------- --- ------ CASUALTY: - --------- 10/1/82 - 9/30/83 35% 4121 PNI 10/1/83 - 9/30/84 36% 4121-1 PNI PROPERTY: - --------- 7/1/85 - 6/30/86 50% 5104 N/A 7/1/86 - 6/30/87 50% 5115 N/A 7/1/87 - 6/30/88 50% 5125 N/A OTHER REINSURANCE AGREEMENTS: - ----------------------------- TERM LAYER LG# BROKER ---- ----- --- ------ SPORTS LEISURE: - --------------- 1980 900,000 XS 100,000 4004 EWB 1980 2,000,000 XS 1,000,000 4005 EWB 1981 400,000 XS 100,000 4015 EWB 1981 500,000 XS 500,000 4016 EWB 1981 4,000,000 XS 1,000,000 4017 EWB Schedule 3.17 Attachment P.4 Term Layer LG # Broker/Ref # ---- ----- Casualty -------- 10/1/94-9/30/95 750,000 XS 250,000 6109 TPR, G-19682-94 10/1/94-9/30/95 1,000,000 XS 1,000,000 6110 TPR, G-19512-94 10/1/94-9/30/95 1,000,000 XS 2,000,000 6110 TPR, G-20081-94 10/1/94-9/30/95 2,000,000 XS 3,000,000 6112 TPR, G-20070-94 Property XS of Loss - ------------------- 10/1/94-9/30/95 400,000 XS 100,000 5191 TPR, G-19655-94 Catastrophe Treaties - -------------------- 10/1/94-9/30/95 95% of 600,000 XS 400,000 5192 TPR, G-19656-94 10/1/94-9/30/95 95% of 1,000,000 XS 1,000,000 5193 TPR, G-19657-94 10/1/94-9/30/95 95% of 2,000,000 XS 2,000,000 5194 TPR, G-19658-94 These treaties were extended through 9/30/96. Schedule 3.23 Operations of the Company NONE Schedule 4.3 Schedule of Buyer's Consents None, other than as described in Schedule 3.12 Schedule 5.7 Essex Reinsurance Agreement See attached, labeled Exhibit B EXHIBIT B REINSURANCE AGREEMENT --------------------- THIS REINSURANCE AGREEMENT is made and entered into by and between LINCOLN INSURANCE COMPANY, a Delaware insurance company (the "Ceding Company"), and ESSEX INSURANCE COMPANY, a Delaware insurance company (the "Reinsurer"). WITNESSETH: ----------- WHEREAS, the Ceding Company issues, amends and cancels binders, certificates, cover notes, policies and endorsements of certain kinds of property and casualty insurance; WHEREAS, except as otherwise provided herein, the Ceding Company desires to reinsure its remaining unexpired liability under direct and assumed insurance business previously produced, underwritten and issued by the Ceding Company; WHEREAS, except as otherwise provided herein, the Ceding Company is willing to cede, and the Reinsurer is willing to accept as liability reinsurance, the Ceding Company's Ultimate Net Loss on all binders, certificates, cover notes, policies and endorsements of direct and assumed insurance produced, underwritten and issued by the Ceding Company. NOW, THEREFORE, in consideration of the premises, the reinsurance premium and the mutual covenants and promises hereinafter contained, and for other good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged, the Ceding Company and the Reinsurer agree as follows: ARTICLE I --------- LIABILITY REINSURANCE: - --------------------- 1. The Ceding Company hereby cedes, and the Reinsurer hereby accepts, as liability reinsurance, 100% of the Ceding Company's Ultimate Net Loss (hereinafter defined) under all Policies issued by the Ceding Company prior to the effective date of this Agreement up to an aggregate limit (the "Reinsurance Limit") in an amount equal to (i) the Ceding Company's reserves for losses and loss adjustment expenses as recorded on page 3, lines 1 and 2 of the Ceding Company's statutory report for the quarter ended September 30, 1997 filed with the Delaware Department of Insurance, less $1.1 million representing the unallocated loss adjustment expense reserve (the "Ceded Reserves"), plus (ii) $68.5 million. 2. For purposes of this Agreement, the term "Policies" means all policies of direct or assumed insurance, binders, certificates, cover notes, and endorsements underwritten, issued or produced by the Ceding Company prior to the effective date of this Agreement giving rise to liabilities reinsured by the Reinsurer hereunder. 3. The Reinsurer's obligations hereunder are subject to any and all available defenses, claims and actions against or arising under the terms of the Policies. ARTICLE II ---------- ULTIMATE NET LOSS - ----------------- 1. The Ultimate Net Loss of the Ceding Company means the sum of (i) all Losses (hereinafter defined) and (ii) all Allocated Loss Adjustment Expenses (hereinafter defined). (a) "Loss" or "Losses" shall mean any amount or amounts incurred in respect of any settlements, awards or judgments (including interest where classified as loss), including any compensatory or punitive damages or fines incurred or arising out of claims under the Policies, after deduction for all reinsurance recoveries, salvage and subrogation actually recovered; provided however, that there shall be no deduction for any reinsurance placed by the Ceding Company after the date of this Agreement for its own account. (b) "Allocated Loss Adjustment Expense" or "ALAE" shall mean all costs and expenses allocable to a specific claim that are incurred in the investigation, appraisal, adjustment, settlement, litigation, defenses or appeal of a specific claim, including court costs and costs of supersedeas and appeal bonds, and including (i) pre-judgment interest, unless included as part of the award or judgment; (ii) post-judgment interest, (iii) legal expenses and costs incurred in connection with coverage questions and legal actions connected thereto; and (iv) supervisory expenses and all other loss adjustment expenses. 2. In no event will the Reinsurer's total obligation to the Ceding Company exceed the lesser of amounts actually paid by the Reinsurer on behalf of the Ceding Company to fulfill the Ceding Company's obligations under the Policies or the Reinsurance Limit. 3. Ultimate Net Loss shall not include any unpaid or uncollectible reinsurance balances due from PMA Reinsurance Corporation, any other affiliate or member of the PMA Group and/or their predecessors, successors or assigns. ARTICLE III ----------- EFFECTIVE DATE OF REINSURANCE: - ----------------------------- The Effective Date of Reinsurance, as that term is used herein, shall be ___________________. -2- ARTICLE IV ---------- DURATION OF AGREEMENT: - --------------------- This Agreement shall not be terminated except as follows: 1. By written agreement of the Ceding Company and the Reinsurer on the date indicated in such agreement; 2. upon the expiration of all liability on the Policies and the complete performance by the Ceding Company and the Reinsurer of all obligations and duties arising under this Agreement; 3. upon the payment by the Reinsurer of the Reinsurance Limit. ARTICLE V --------- ADMINISTRATION, LOSSES AND LOSS SETTLEMENTS: - ------------------------------------------- 1. From and after the Effective Date of Reinsurance and until this Agreement is terminated as provided in Article IV, the Reinsurer shall be solely responsible for the administration of all aspects of the Policies, including but not limited to the billing and collection of premiums and the collection of reinsurance recoverables, if any, and any other amounts due under the Policies, and the defense, adjustment, settlement and payment of all claims and losses arising under or in connection with the Policies, all at the Reinsurer's sole expense and discretion. In the event that the Agreement is so terminated (or in the event that the Reinsurer becomes insolvent or becomes similarly unable to meet its financial obligations hereunder), the Reinsurer shall cease being responsible for the administration of the policies, and all claims and underwriting files, and any other documents relating to such administration shall be promptly transferred to the Ceding Company, with the expense of any such file transfer to be equally divided between the parties. 2. The Reinsurer may, in its sole discretion and without any notice to the Ceding Company, delegate all or part of it's administrative duties and obligations relating to the Policies to any entity designated by Reinsurer to act in its place, and the Ceding Company hereby consents to such delegation, subject to such entity's holding any required license, certificate or approval to act in such capacity. 3. The Reinsurer shall pay all Losses and ALAE payable under the Policies directly to claimants and shall not expect or be entitled to await the prior payment of such amounts by the Ceding Company. -3- ARTICLE VI ---------- COOPERATION AMONG PARTIES: - ------------------------- 1. The parties hereto agree to act in good faith and cooperate with each other in effecting the cession and reinsurance of liabilities provided for in this Agreement. The parties shall take all actions necessary to assist each other in responding to requests for information by any insurance regulatory authorities asserting jurisdiction over the transactions herein described. 2. Whenever the Ceding Company receives any premiums, other payments, communications or documents, including notices of claims, proofs of loss, actions, summons and complaints and other information pertaining to the Policies, the Reinsurance Agreements (as defined in Article VIII (3) herein) and the liabilities ceded and reinsured hereunder, the Ceding Company will forward such premiums, payments, communications, documents and information promptly to the Reinsurer, its successors or assigns, or the designees thereof. The Ceding Company shall execute and deliver promptly any and all additional powers of attorney, assignments, instruments and documents reasonably requested by the Reinsurer which are necessary for the performance by the Reinsurer of its obligations hereunder. ARTICLE VII ----------- REINSURANCE PREMIUM: - -------------------- 1. As Reinsurance Premium, and in consideration of the Reinsurer's agreement to reinsure the Ceding Company's liability under the Policies, the Ceding Company shall transfer to the Reinsurer on or prior to the Effective Date of Reinsurance all of Ceding Company's net assets except for cash, cash equivalents, accrued but unpaid interest or dividends and assets subject to statutory deposits in an amount equal to the Ceding Company's Statutory Capital and Surplus. 2. "Statutory Capital and Surplus" of the Ceding Company means the aggregate amount of capital and surplus of the Company for a period ending on the date of execution of this Agreement, as would be shown on page 3, line 25 of the Company's annual statement, prepared in accordance with the Law for filing with the Delaware Department of Insurance in accordance with Statutory Accounting Principles, consistently applied with the principles applied to the preparation of the financial statement of the Ceding Company. -4- ARTICLE VIII ------------ TRANSFER, ASSIGNMENT AND VESTING OF CERTAIN RIGHTS: - -------------------------------------------------- 1. The Ceding Company and the Reinsurer hereby acknowledge that other reinsurers have previously reinsured certain liabilities of the Ceding Company under the Policies pursuant to one or more Reinsurance Agreements. The risks ceded under the Reinsurance Agreements have not completely expired as the reinsurers under such Reinsurance Agreements are still obligated on such unexpired risks. It is understood and agreed that as of the Effective Date of Reinsurance, the Ceding Company hereby assigns to the Reinsurer, and the Reinsurer shall be vested with, all rights the Ceding Company may have now or in the future under such Reinsurance Agreements, including the right to receive and benefit from (a) any reinsurance recoverables, ceding commissions or other consideration or compensation due or to become due to the Ceding Company as ceding company under the Reinsurance Agreements, and (b) any letters of credit, trust accounts or other accounts, funds held by or deposited with the Ceding Company, or any other security established for the protection and benefit of the Ceding Company in connection with the Reinsurance Agreements as the same may be adjusted from time to time (collectively referred to herein as the "Collateral"). It is expressly acknowledged and agreed that Reinsurer's obligations under Article I are conditioned upon Reinsurer receiving the legal rights and benefits contemplated by this Article VIII. 2. In addition to the Reinsurance Premium, the Ceding Company shall transfer and assign to the Reinsurer all rights the Ceding Company may have now or in the future under the Policies including, without limitations, all gross premiums, premium adjustments and any other consideration due or to become due the Ceding Company under the Policies. The Reinsurer shall be obligated to perform and hereby assumes any and all obligations and duties of the Ceding Company as ceding company under the Reinsurance Agreements. 3. For purposes of this Agreement, "Reinsurance Agreements" shall mean all reinsurance agreements which were arranged by the Ceding Company prior to the effective date of this Agreement and which have been entered into by and between the Ceding Company on the one hand and those reinsurers providing for the reinsurance of liabilities arising under the Policies, and all placement slips and binding agreements related thereto. 4. In order to further evidence the transfer and assignment to the Reinsurer of the Ceding Company's rights under the Policies, the Reinsurance Agreements and the Collateral, the Ceding Company shall execute the Assignment of Rights attached hereto as Exhibit "A' concurrently with the execution of this Agreement. The Ceding Company shall execute such additional instruments, acknowledgments and documents as may be reasonably necessary to more completely evidence such transfer and assignment and the vesting of rights in the Reinsurer contemplated thereby, including, without limitation, instruments, acknowledgments, documents and other communications to reinsurers under the Reinsurance Agreements and to banks and other financial institutions which have issued letters of credit, or are holding funds or other collateral security, in connection with -5- the Reinsurance Agreements. The parties acknowledge and agree that the amount of Collateral may change over time and that the Ceding Company shall assign to the Reinsurer all of the Ceding Company's right and interest in the full amount of said Collateral, as the same may be adjusted from time to time. 5. It is expressly understood and agreed that the assignment of rights contemplated by this Article is conditioned upon the Reinsurer meeting its direct claims payment obligations hereunder. In the event that the Reinsurer fails to meet such obligations, or in the event this Agreement is terminated as provided herein, all remaining rights transferred to Reinsurer under this Article shall immediately revert to the Ceding Company, and the Assignment of Rights and the appointment of the Reinsurer as the Ceding Company's Attorney-In-Fact provided for in Article XII shall be void and of no further force or effect. ARTICLE IX ---------- NO CEDING COMMISSION: - -------------------- No ceding commission shall be payable to the Ceding Company by the Reinsurer for the cession provided under this Agreement. ARTICLE X --------- REPORTS: - ------- Within sixty (60) days after the end of each calendar quarter, the Reinsurer shall furnish the Ceding Company with a quarterly summary loss report relating to the Policies in a form mutually agreed upon. The Reinsurer shall also furnish to the Ceding Company such information and details regarding the Policies as may be necessary for the Ceding Company to prepare its statutory financial statements and to comply with the requirements of the regulatory authorities having jurisdiction over the Ceding Company. The reporting obligations of the Reinsurer under this Article X shall exist for as long as the Ceding Company is a valid and existing insurer required to provide statutory financial statements and other information to regulatory authorities having jurisdiction over the Ceding Company. -6- ARTICLE XI ---------- RECORDS AND INSPECTION: The Ceding Company shall deliver to the Reinsurer (or its delegatee) copies of such documents, records, papers or information as the Reinsurer may reasonably request which are necessary for the Reinsurer's performance of its obligations under the terms of this Agreement. Without limiting the generality of the foregoing, the Ceding Company hereby authorizes the Reinsurer (or its delegatee) to retain possession of all documents, records, papers or information relating to the Policies during the term of this Agreement. Each party shall place at the disposal of the other party during normal business hours, and the other party shall have the right to inspect, through its duly authorized representatives, and make copies of all books, records, and papers pertaining to any matter under this Agreement or any claims or losses incurred under the Policies. ARTICLE XII ----------- APPOINTED ATTORNEY-IN-FACT: In order to more fully evidence the Reinsurer's right to (a) service and administer any and all aspects of the Policies; (b) exercise any and all rights of the Ceding Company under the Reinsurance Agreements (including, without limitation, the collection of reinsurance recoverables and ceding commissions and the negotiation, compromise, settlement, arbitration, litigation or commutation of any claims or liabilities arising thereunder); and (c) exercise any and all rights of the Ceding Company with respect to the Collateral, the Ceding Company shall execute the Power of Attorney attached hereto as Exhibit "B" concurrently with the execution of this Agreement. The Reinsurer as Attorney-In-Fact under such Power of Attorney shall indemnify and hold the Ceding Company harmless from and against any act, error or omission of the Reinsurer in its exercise of authority under such Power of Attorney. ARTICLE XIII ------------ INSOLVENCY OF CEDING COMPANY: In the event of the Ceding Company's insolvency, the reinsurance under this Agreement shall be payable by the Reinsurer, without diminution because of the Ceding Company's insolvency, to the Ceding Company or its liquidator, receiver, conservator or statutory successor. It is agreed that the liquidator, receiver or statutory successor of the Ceding Company will give written notice to the Reinsurer of the pending of a claim against the Ceding Company covered under this Agreement within a reasonable time after such claim is filed in the insolvency proceeding and that during the pendency of such claim, the Reinsurer may investigate such claim and interpose, at its own expense, in the proceeding where such claim is to be adjudicated any defense or defenses which it may deem -7- available to the Ceding Company or its liquidator, receiver or statutory successor. The expense thus incurred by the Reinsurer shall be chargeable, subject to court approval, against the Ceding Company as a part of the expense of liquidation to the extent of a proportionate share of the benefits which may accrue to the Ceding Company solely as a result of the defense undertaken by the Reinsurer. ARTICLE XIV ----------- ERRORS AND OMISSIONS: - -------------------- Inadvertent delays, errors or omissions by either the Ceding Company or the Reinsurer made in connection with this Agreement or any transactions hereunder whether in respect to cessions, or claims, or otherwise, shall not relieve either party from any liability which would have attached had such delay, error or omission not occurred, provided always that such error or omission be rectified as soon as possible after discovery. ARTICLE XV ---------- REINSURER'S REPRESENTATIONS AND WARRANTIES: - ------------------------------------------ The Reinsurer represents and warrants to the Ceding Company that as of both the Effective Date of Reinsurance and the date of execution of this Agreement: 1. The Reinsurer is duly organized and validly existing in the State of Delaware and authorized and empowered under its Articles of Incorporation, its By-Laws and the laws of the State of Delaware to enter into and perform this Agreement. 2. The Reinsurer is an approved or authorized insurer in good standing in the State of Delaware. 3. This Agreement constitutes an obligation binding on the Reinsurer. ARTICLE XVI ----------- CEDING COMPANY'S REPRESENTATION AND WARRANTIES: The Ceding Company represents and warrants to the Reinsurer that as of both the Effective Date of Reinsurance and the date of execution of this Agreement: 1. The Ceding Company is duly organized and validly existing in the State of Delaware and authorized and empowered under its Articles of Incorporation, its By-Laws and the laws of the State of Delaware to enter into and perform this Agreement. -8- 2. The execution and performance of the Agreement by the Ceding Company is subject to approval by the Delaware Commissioner of Insurance but, to the best of the Ceding Company's knowledge, not by the insurance regulatory official of any other state. 3. This Agreement constitutes an obligation binding on the Ceding Company. ARTICLE XVII ------------ INDEMNIFICATION: - --------------- The Ceding Company and Reinsurer agree to hold each other harmless from, and indemnify each other against, any and all claims, losses, expenses, including reasonable attorney's fees, causes of action and judgments incurred by the other as a result of their own (or that of any agents acting on their behalf) gross negligence or wilful misconduct in the performance of the respective obligations under this Agreement, the Assignment of Rights Agreement, or the Power of Attorney. ARTICLE XVIII ------------- DISPUTE RESOLUTION: - ------------------ 1. Arbitration; selection of panel. As a condition precedent to any right of action hereunder, any and all disputes or disagreements arising between the parties pertaining to or relating in any manner to this Agreement (any "Controversy")--which shall include but not limited to any disputes or disagreements as to the meaning or interpretation of this Agreement or any portion thereof or the relationship of the parties created under this Agreement or any breach of this Agreement, upon which an amicable understanding cannot be reached--shall be submitted to arbitration in the location of the party not seeking to arbitrate (i.e., Philadelphia, Pennsylvania in the case of the Ceding Company, and Richmond, Virginia in the case of the Reinsurer). One arbiter shall be chosen by the Ceding Company, the other by the Reinsurer, and an umpire shall be chosen by the two arbiters before they enter upon arbitration, all of whom shall be active or retired disinterested executive officers of insurance or reinsurance companies. In the event that either party should fail to choose an arbiter within thirty (30) days following a written request to do so, the requesting party may choose two arbiters who shall in turn choose an umpire before entering upon arbitration. If the two arbiters fail to agree upon the selection of an umpire within thirty (30) days following their appointment, each arbiter shall name three nominees, of whom the other party shall decline two, and the decision between the remaining two nominees shall be made by drawing lots. 2. Arbitration; proceedings and award. Each party shall present its case to the arbiters and the umpire within thirty (30) days following the date of appointment of the umpire. The arbiters shall consider this Agreement as an honorable engagement rather -9- than merely as a legal obligation and they are relieved of all judicial formalities and may abstain from following the strict rules of law; however, there shall be no ex parte contacts between either party and any arbiter or the umpire, and cross examination and rebuttal should be allowed if requested by either party. The decision of the arbiters shall be in writing giving the reasons for the award and shall be final and binding on both parties, but, failing to agree, they shall call in the umpire and the decision of the majority shall be final and binding upon both parties, except that an appeal may be taken from such decision as provided in the Federal Arbitration Act. 3. Arbitration; expenses. Each party shall bear the expense of its own arbiter, and shall jointly and equally bear with the other the expense of the umpire and of the arbitration. In the event that the two arbiters are chosen by one party, as above provided, the expense of the arbiters, the umpire and the arbitration shall be equally divided between the two parties. Provided, however, that, if in the opinion of the arbiters, any claim hereunder or any defense or objection thereto was unreasonable, the arbiters may assess, as part of the award, all or any part of the expenses of the arbitration against the party raising such unreasonable claim, defense or objections. 4. Specific Enforcement. This Agreement to arbitrate shall be specifically enforceable. Should any party to this Agreement be required to seek relief from a court of competent jurisdiction in order to enforce the requirement that all Controversies be settled by arbitration, the moving party, if its motion is successful, will be entitled to recover all of its costs and expenses, including reasonable attorneys' fees, in connection with such enforcement action. 5. Alternative Resolution. In the event that arbitration may not be legally permitted hereunder or the parties mutually agree not to submit a dispute to arbitration, any party may commence a civil action in a court of competent jurisdiction to solve disputes hereunder. Nothing contained in this Article shall prevent the parties from settling any dispute by mutual agreement at any time. ARTICLE XIX ----------- MISCELLANEOUS: - ------------- 1. The Ceding Company hereby covenants and agrees that it will not pledge, encumber, mortgage, hypothecate, transfer, deliver or assign any rights under the Policies, the Reinsurance Agreements or Collateral except for the assignment to the Reinsurer contemplated by this Agreement. 2. This Agreement and all exhibits hereto constitute the entire contract between the parties relating to the subject matter hereof and may, by mutual consent be altered in any of its terms and conditions only by a signed addendum hereto or thereto. -10- 3. All representations and warranties of the Reinsurer and the Ceding Company set forth in Articles XV and XVI of this Agreement shall expire as of the Effective date of Reinsurance. 4. This Agreement shall be governed by the laws of the State of Delaware. 5. This Agreement and all exhibits hereto may be executed in multiple counterparts, each of which shall be an original. 6. This Agreement and exhibits hereto shall inure to the benefit of and bind the Ceding Company and the Reinsurer and their respective successors and assigns whether by acquisition, merger or otherwise. IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be duly executed by their respective corporate officers on the ___ day of ___, 199__. Attest: LINCOLN INSURANCE COMPANY - --------------------------------- By: ------------------------------------- Its: ------------------------------------ Attest: ESSEX INSURANCE COMPANY - --------------------------------- By: ------------------------------------- Its: ------------------------------------ -11- EXHIBIT "A" ASSIGNMENT AND TRANSFER OF RIGHTS BY LINCOLN INSURANCE COMPANY TO ESSEX INSURANCE COMPANY MADE IN CONNECTION WITH THE REINSURANCE AGREEMENT BETWEEN LINCOLN INSURANCE COMPANY ("Ceding Company") AND ESSEX INSURANCE COMPANY ("Reinsurer") Effective ------------------------------ In accordance with the provisions of the Agreement between the Ceding Company and the Reinsurer effective _____________________, (hereinafter the "Essex Cover") and for value received, the Ceding Company hereby assigns, grants, transfers, sells, conveys and sets over to the Reinsurer, and its successors and assigns all of the Ceding Company's right, title and interest in the assets, accounts, rights and property interests listed below. Terms capitalized but not defined herein shall have the meanings ascribed to them in the Essex Cover. 1. All of the gross premiums, premium adjustments, commissions and other consideration of any kind which is now due or is to become due the Ceding Company on the Policies from the Ceding Company's insureds, claimants, brokers, agents or others under or in connection with any and all the Policies. 2. All of the payments, reinsurance recoverables, ceding commissions, and any other consideration of any kind which is now due or is to become due the Ceding Company under the Reinsurance Agreements from the Ceding Company's reinsurers, retrocessionaires and others under or in connection with any and all the Reinsurance Agreements. 3. Any and all other rights of the Ceding Company under the Reinsurance Agreements, including but not limited to any right to defend, negotiate, compromise, settle, litigate, arbitrate or commute any liabilities or obligations arising under the Reinsurance Agreements and to receive reports regarding the Collateral. 4. All of the rights and interests of the Ceding Company with respect to the Collateral, including but not limited to any and all rights to draw on letters of credit, to receive and use payments under letters of credit or from trust or other accounts, to obtain possession of and use funds held by or deposited with the Ceding Company or to obtain possession of and use any other funds, money, security or other asset or interest established from the protection or benefit of the Ceding Company in connection with the Reinsurance Agreements and any and all rights to obtain possession of and use or dispose of the Collateral. The Ceding Company hereby authorizes the Reinsurer, at the cost of the Reinsurer, in the name of the Ceding Company or otherwise, (a) to ask, demand, collect, receive and furnish receipts for such consideration or any part thereof due or become due on or in connection with the Policies and the Reinsurance Agreements; (b) to ask, demand, collect, receive or furnish any information or perform any lawful acts in connection with the Policies, the Reinsurance Agreements and any Collateral established in connection with the Reinsurance Agreements; or (c) to settle or discontinue any proceedings pertaining to the Policies, the Reinsurance Agreements or otherwise involving the subject matter of this assignment. The Ceding Company further agrees that if any payment or other consideration is received by the Ceding Company which is to be credited on or attributable to any of the Policies, the Reinsurance Agreements or Collateral, the Ceding Company will immediately endorse and deliver to the Reinsurer such checks, drafts, money or other consideration, and that until delivery of such items to the Reinsurer, the Ceding Company shall treat any such checks, drafts, money or other consideration as the property of the Reinsurer held in trust for the Reinsurer. The Reinsurer shall be liable for any remaining or unexpired obligations of the Ceding Company, if any, under the Reinsurance Agreements. The Ceding Company agrees to execute and deliver to the Reinsurer any further instruments or assurances that the Reinsurer may reasonably request for the more effectual perfecting of the Reinsurer's interests in any of the foregoing assets, property rights or interest herein assigned. IN WITNESS WHEREOF, Lincoln Insurance Company and Essex Insurance Company have executed this instrument effective as of the ______ day of ____________________, 19____. Attest: LINCOLN INSURANCE COMPANY - ----------------------------------- By: ---------------------------------- Its: --------------------------------- ESSEX INSURANCE COMPANY By: ---------------------------------- Attest: Its: --------------------------------- - --------------------------------- EXHIBIT "B" POWER OF ATTORNEY County of ___________ ) State of_____________ ) KNOW ALL MEN BY THESE PRESENTS, that Lincoln Insurance Company, a Delaware insurance company ("Lincoln"), does hereby irrevocably make, constitute and appoint Essex Insurance Company, a Delaware insurance company ("Essex") or any entity designated by Essex to act in its place, as its true and lawful attorney-in-fact for it and in its name, place and stead for the following purposes: To do all lawful acts as said Attorney-In-Fact may deem desirable, appropriate or necessary in connection with, arising out of or relating in any way to any and all policies issued by Lincoln and defined as the Policies in the Essex Cover dated ____________________________ by and between Lincoln and Essex, including without limitation amending, modifying, endorsing, canceling and non-renewing any or all of the Policies. To assess, invoice, collect, refund, sue for, receive and do any and all other lawful acts relating to any payments, premiums, premium adjustments, monies or other consideration of any kind due or to become due at any time under the Policies and to endorse in Lincoln's name any check, draft and other form of payment made in connection with the Policies and to commence, defend, settle and/or compromise any litigation or arbitration proceeding, with respect to such payments, premiums, premium adjustments, monies or other consideration of any kind, all as said Attorney-In-Fact may deem desirable, appropriate or necessary. To service, administer and perform all functions in connection with the Policies and to fully handle all claims matters arising under the Policies, including without limitation, determining liability and the amount thereof, compromising, settling, paying and defending all claims or suits, all as said Attorney-In-Fact may deem desirable, appropriate or necessary. To assess, invoice, collect, refund, sue for, receive and do any and all other lawful acts relating to any payments, recoverables, ceding commissions, monies or other consideration of any kind due or becoming due under the Reinsurance Agreements, as that term is defined in the Essex Cover, to endorse in Lincoln's name any check, draft and other form of payment made in connection with the Reinsurance Agreements and to commence, defend, settle and/or compromise any litigation or arbitration proceeding with respect to such payments, recoverables, ceding commissions, monies or other 1 consideration of any kind due or becoming due under the Reinsurance Agreements, all as said Attorney-In-Fact may deem desirable, appropriate or necessary. To exercise, enforce, waive or abandon any and all rights of Lincoln under the Reinsurance Agreements including, without limitation, the rights to negotiate, compromise, settle, arbitrate, litigate or commute any claims or liabilities arising under the Reinsurance Agreements and the right to exercise, enforce, waive or abandon any and all rights of Lincoln to letters of credit, amounts held in trust accounts or other accounts, or any other assets, collateral or security established for the protection and benefit of Lincoln in connection with the Reinsurance Agreements. To exercise, enforce, waive, settle and abandon any and all claims and rights of subrogation and contribution under or with respect to any of the Policies or Reinsurance Agreements and to commence, defend, settle and compromise any litigation and arbitration proceeding and do any and all other lawful acts in any way relating to any claims and rights of subrogation and contribution under or arising out of or with respect to the Policies or Reinsurance Agreements. In connection with any power, right or authority provided for herein, engage the services of and discharge any counsel, experts and others, and, in case of any litigation or arbitration, to accept service of process and papers, and to take any and all appeals therefrom, all as said Attorney-In-Fact may deem desirable, appropriate or necessary. To do any and all other lawful acts with respect to the Policies or Reinsurance Agreements which Lincoln has or had the right to do, it being the intention that said Attorney-In-Fact shall have the broadest possible power and authority to make all decisions and do all lawful acts as said Attorney-In-Fact in its sole discretion may deem desirable, appropriate or necessary in connection with any of the Policies or Reinsurance Agreements. That said Attorney-in-Fact shall have full power of substitution and full power to appoint and discharge any subagent or subagents without any consent or approval of Lincoln or any of its successors or assigns with respect to the Attorney-In-Fact's authority hereunder. The said Attorney-In-Fact is assignee of all of the Lincoln's rights and interest in the Policies and Reinsurance Agreements, and, therefore, it is agreed that this Power of Attorney is coupled with an interest and irrevocable. This Power of Attorney shall survive any dissolution, liquidation, merger or consolidation of Lincoln and shall be binding upon all successors and assigns of Lincoln, each of which together with Lincoln hereby forever waives any and all rights to revoke this Power of Attorney or any of the powers conferred upon said Attorney-In-Fact hereby or to appoint any other person to execute the said power and also waives and renounces all rights to do any of the lawful acts which the said Attorney-In-Fact is authorized to perform by this Power of Attorney. This Power of Attorney shall remain in full force and effect for such period of time as said Attorney-In-Fact may, in its sole discretion, deem desirable, appropriate or 2 necessary to do any and all acts, in connection with any such Policies or Reinsurance Agreements, and may be terminated only upon written notice of termination given by said Attorney-In-Fact to Lincoln or its successors or assigns. Notwithstanding any provision to the contrary, this Power of Attorney shall terminate automatically upon termination of the Essex Cover. Effective as of _____________, 19__ Attest: LINCOLN INSURANCE COMPANY By: - ------------------------------ ---------------------------------- Secretary (or Assistant Secretary) Its: --------------------------------- State of Delaware ) County of__________ ) Personally came before me this ______ day of _______________, 19__, the above-named ________________ and ___________________, Secretary (or Assistant Secretary) respectively, of Lincoln Insurance Company. ------------------------------------- Notary Public 3 Schedule 6.4 Continuing Agreements The Essex Reinsurance Agreement will continue The Tax Allocation Agreement will not continue but as between Lincoln Insurance Company and Markel Corporation obligations shall be determined in accordance with the Tax Allocation Agreement as in effect until its date of termination Schedule 9.1 Restricted Lines of Insurance Alarm Installation & Schools/Clubs Private Horse Owners' Monitoring Contractors Liability Health Clubs Amusement Centers Restaurants, Bars & Homeowners' Taverns Architects & Engineers Associations Service & Maintenance Automobile Lenders Horse Farm Packages Contractors Automobile Parts Horse Mortality Show Animal Club Manufacturers Insurance Agents and Special Property Bicycle Manufacturers Brokers Special Risk Accident Boy's & Girl's Clubs Insurance Company & Medical E&O/D&O Children's Camps Sporting Goods Lawyers Professional Manufacturers Child Care Centers Liability Sports Camps College Student Low Value Dwelling Accident and Health Tanning & Toning Martial Arts Schools Salons Commercial Auto Medical Malpractice Toy Manufacturers Comm. Equine Liability Medical Malpractice: Vacant Property Contract Surety Hard-to-Place Doctors Watercraft Dance/Exercise Schools Mobile Homeowners (Commercial) Detective & Security Mobile Home Parks Watercraft (Personal) Guards Motorcycles Directors & Officers Liability Mutual Funds and lnvestment Employment Practices Advisors E&O/D&O Liability Nursing Homes Family Entertainment Ctrs. Pawn Shops General Contractors Performing Arts Groups Gymnastics EX-11 4 COMPUTATION OF EARNINGS PER SHARE Pennsylvania Manufacturers Corporation Exhibit 11 Computation of Earnings Per Share (Unaudited)
Years ended December 31, (in thousands, except per share data) 1997 1996 1995 --------------------------------------------- Basic: Weighted average shares outstanding 23,855,031 23,800,791 23,816,088 Net income (loss) before extraordinary item $ 19,753 $ (135,334) $ 24,130 Extraordinary loss (4,734) -- -- --------------------------------------------- Net income (loss) $ 15,019 $ (135,334) $ 24,130 ============================================= Net income (loss) per common and equivalent share before extraordinary item $ 0.83 $ (5.68) $ 1.01 Extraordinary item (0.20) -- -- --------------------------------------------- Net income (loss) per common and equivalent share $ 0.63 $ (5.68) $ 1.01 ============================================= Diluted: Weighted average shares outstanding 23,855,031 23,800,791 23,816,088 Net effect of dilutive stock options - based on the treasury stock method using average market price 712,347 -- 965,861 --------------------------------------------- Total diluted common shares 24,567,378 23,800,791 24,781,949 ============================================= Net income (loss) before extraordinary item $ 19,753 $ (135,334) $ 24,130 Extraordinary loss (4,734) -- -- --------------------------------------------- Net income (loss) $ 15,019 $ (135,334) $ 24,130 ============================================= Net income (loss) per common and equivalent share before extraordinary item $ 0.80 $ (5.68) $ 0.97 Extraordinary item (0.19) -- -- --------------------------------------------- Net income (loss) per common and equivalent share $ 0.61 $ (5.68) $ 0.97 =============================================
EX-13 5 SELECTED FINANCIAL DATA Exhibit 13 Selected Financial Data
(dollars in thousands, except share and per share data) 1997 (1) 1996 (1) 1995 (1) 1994 (1) 1993 - ----------------------------------------------------------------------------------------------------------------------------------- Consolidated Revenues Net premiums written ..................................... $ 418,282 $ 443,475 $ 489,876 $ 466,502 $ 536,987 ============ ============ ============ ============ ============ Net premiums earned ...................................... 375,951 420,575 484,952 466,534 547,407 Net investment income .................................... 136,698 133,936 139,355 138,719 153,842 Net realized investment gains ............................ 8,598 2,984 31,923 47,521 69,798 Service revenues ......................................... 10,311 9,189 5,106 3,380 1,321 ------------ ------------ ------------ ------------ ------------ Total revenues ...................................... $ 531,558 $ 566,684 $ 661,336 $ 656,154 $ 772,368 ============ ============ ============ ============ ============ - ----------------------------------------------------------------------------------------------------------------------------------- Components of Net Income Pre-tax operating income (loss) (2): PMA Re .............................................. $ 44,802 $ 42,783 $ 39,443 $ 33,703 $ 33,511 The Property and Casualty Group .................... (9,038) (219,619) (4,305) 3,893 (1,153) Corporate operations ................................ (3,441) (490) (13,414) (6,686) (885) ------------ ------------ ------------ ------------ ------------ Total pre-tax operating income (loss) before interest expense .................................... 32,323 (177,326) 21,724 30,910 31,473 Net realized investment gains ............................ 8,598 2,984 31,923 47,521 69,798 Interest expense ......................................... 15,768 17,052 18,734 13,051 11,650 ------------ ------------ ------------ ------------ ------------ Income (loss) before income taxes, cumulative effect of accounting changes and extraordinary item ........... 25,153 (191,394) 34,913 65,380 89,621 Provision (benefit) for income taxes ..................... 5,400 (56,060) 10,783 8,130 21,324 ------------ ------------ ------------ ------------ ------------ Income (loss) before cumulative effect of accounting changes and extraordinary item ........... 19,753 (135,334) 24,130 57,250 68,297 Cumulative effect of accounting changes, net of related tax effects (3) ...................... -- -- -- -- 14,119 Extraordinary loss from early estinguishment of debt, net of related tax effects (4) ...................... (4,734) -- -- -- -- ------------ ------------ ------------ ------------ ------------ Net income (loss) ........................................ $ 15,019 $ (135,334) $ 24,130 $ 57,250 $ 82,416 ============ ============ ============ ============ ============ - ----------------------------------------------------------------------------------------------------------------------------------- Per Share Data Weighted average shares: Basic (5), (6) ...................................... 23,855,031 23,800,791 23,816,088 23,897,263 24,231,071 Diluted (5), (6) .................................... 24,567,378 23,800,791 24,781,949 24,650,741 24,470,024 Income (loss) before cumulative effect of accounting changes and extraordinary item, net of related tax effects: Basic (5), (6) ...................................... $ 0.83 $ (5.68) $ 1.01 $ 2.40 $ 2.82 Diluted (5), (6) .................................... 0.80 (5.68) 0.97 2.32 2.79 Net income (loss) per share: Basic (5), (6) ...................................... 0.63 (5.68) 1.01 2.40 3.40 Diluted (5), (6) .................................... 0.61 (5.68) 0.97 2.32 3.37 Dividends paid per common share .......................... 0.32 0.32 0.32 0.32 0.28 Dividend paid per Class A common share ................... 0.36 0.36 0.36 0.36 0.32 Shareholders' equity per share (7) ....................... 19.96 17.86 25.53 22.10 22.23 - ----------------------------------------------------------------------------------------------------------------------------------- Financial Position Total investments ........................................ $ 2,194,738 $ 2,261,353 $ 2,455,949 $ 2,313,261 $ 2,374,208 Total assets ............................................. 3,057,258 3,117,516 3,258,572 3,181,979 3,197,909 Reserves for unpaid losses and LAE ....................... 2,003,187 2,091,072 2,069,986 2,103,714 2,150,665 Long-term debt ........................................... 203,000 204,699 203,848 203,975 194,836 Shareholders' equity (7) ................................. 478,347 425,828 609,668 524,862 534,383 - ----------------------------------------------------------------------------------------------------------------------------------- GAAP Ratios for Insurance Subsidiaries PMA Re Loss ratio .......................................... 69.6% 73.7% 74.6% 74.7% 80.6% Expense ratio ....................................... 34.9% 30.2% 29.5% 33.3% 29.4% ------------ ------------ ------------ ------------ ------------ Combined ratio (8) .................................. 104.5% 103.9% 104.1% 108.0% 110.0% ============ ============ ============ ============ ============ The Property and Casualty Group: Loss ratio .......................................... 91.1% 158.2% 92.5% 90.1% 96.3% Expense ratio ....................................... 45.3% 48.6% 30.6% 31.4% 25.0% Policyholder dividend ratio ......................... 6.9% 6.1% 4.8% 4.6% 3.5% ------------ ------------ ------------ ------------ ------------ Combined ratio (8) .................................. 143.3% 212.9% 127.9% 126.1 124.8% ============ ============ ============ ============ ============ - -----------------------------------------------------------------------------------------------------------------------------------
24 (1) Operating results in 1997, 1996 and 1995 were impacted by approximately $12,100, $223,100 and $8,400, respectively, of restructuring and other special charges. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for further discussion. In addition, 1994 operating results included a charge of approximately 4,900 to write down certain real estate properties. (2) Pre-tax operating income (loss) excludes net realized investment gains. (3) In 1993, the Company recognized an after-tax net benefit of $14,119 resulting from the adoption of SFAS No. 109, "Accounting for Income Taxes," ($21,500 benefit), and SFAS No. 106. "Employers' Accounting for Postretirement Benefits Other Than Pensions," ($7,381 after-tax charge). (4) In 1997, the Company refinanced substantially all of its long-term debt which resulted in a $4,734 extraordinary loss, net of tax effects. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" below. (5) For the year ended December 31, 1996, common stock equivalents were not taken into consideration in the computation of weighted-average shares as these common stock equivalents would have an anti-dilutive effect on the net loss per share. (6) In 1997, the Company adopted SFAS No. 128, "Earnings Per Share," which requires the presentation of basic and diluted earnings per share (see Notes 1-I and 16 to the Consolidated Financial Statements). All prior periods' presentation of earnings per share data has been restated to conform with SFAS No. 128. (7) In 1994, shareholders' equity was increased $45,343 related to the adoption of SFAS No. 115, "Accounting for Certain Investments and Debt and Equity Securities." (8) The combined ratio computed on a GAAP basis is equal to losses and LAE, plus amortization of deferred acquisition costs, plus operating expenses, plus policyholders' dividends (where applicable), all divided by net premiums earned. 25 Management's Discussion and Analysis of Financial Condition and Results of Operations The following section provides a discussion of the financial results and material changes in financial position for the Company for the years ended December 31, 1997, 1996 and 1995. The balance sheet information presented below is as of December 31 for each respective year. The statement of operations information is for the years ended December 31 for each respective year. The term "SAP" refers to the statutory accounting practices prescribed or permitted by applicable state insurance departments, and the term "GAAP" refers to generally accepted accounting principles. Results of Operations The Company consists of PMC, an insurance holding company, and its subsidiaries. PMC operates in two principal segments, property and casualty reinsurance and property and casualty primary insurance. PMA Reinsurance Corporation (PMA Re) emphasizes risk-exposed, excess of loss reinsurance and operates in the brokered market. PMA Re's business is predominantly in casualty lines of reinsurance. The Property and Casualty Group writes workers' compensation and other standard lines of commercial insurance primarily in the Mid-Atlantic and Southern regions of the United States, utilizing The PMA Group trade name. During 1997, the Company established a separate specialty insurance operation focusing in excess and surplus lines, Caliber One Management Company (Caliber One). Caliber One did not write any business during 1997. Management anticipates that Caliber One will primarily write multi-line business consisting of primary and excess commercial general liability, professional liability, excess automobile and certain property exposures beginning in 1998. Because Caliber One's operating revenues and results were not significant in 1997, its data was included in the Corporate and Other segment in the following discussions. In the discussion below, pre-tax operating income (loss) is defined as income (loss) from continuing operations before income taxes, but excluding net realized investment gains. Operating revenues consist of all of the Company's revenues, except net realized investment gains. Consolidated Results The table below presents the major components of net income (loss):
(dollar amounts in thousands, except per share data) 1997 1996 1995 ---- ---- ---- Pre-tax operating income (loss) ............. $16,555 $(194,378) $ 2,990 Net realized investment gains ............... 8,598 2,984 31,923 ------- --------- ------- Income (loss) before income taxes ........... 25,153 (191,394) 34,913 Provision (benefit) for income taxes ........ 5,400 (56,060) 10,783 ------- --------- ------- Income (loss) before extraordinary loss ..... 19,753 (135,334) 24,130 Extraordinary loss, net of related taxes .... (4,734) -- -- ------- --------- ------- Net income (loss) ........................... $15,019 $(135,334) $24,130 ======= ========= ======= Per basic share: Income (loss) before extraordinary loss $ .83 $ (5.68) $ 1.01 Extraordinary loss .................... (.20) -- -- ------- --------- ------- Net income (loss) ..................... $ .63 $ (5.68) $ 1.01 ======= ========= ======= Per diluted share: Income (loss) before extraordinary loss $ .80 $ (5.68) $ .97 Extraordinary loss .................... (.19) -- -- ------- --------- ------- Net income (loss) ..................... $ .61 $ (5.68) $ .97 ======= ========= =======
26 The following table indicates the Company's pre-tax operating income (loss) by principal business segment: (dollar amounts in thousands) 1997 1996 1995 ---- ---- ---- PMA Re .................................... $44,802 $ 42,783 $ 39,443 The Property and Casualty Group ........... (9,038) (219,619) (4,305) Corporate and Other ....................... (3,441) (490) (13,414) ------- --------- -------- Pre-tax operating income (loss) before interest expense ..................... 32,323 (177,326) 21,724 Interest expense .......................... 15,768 17,052 18,734 ------- --------- -------- Pre-tax operating income (loss) ........... $16,555 $(194,378) $ 2,990 ======= ========= ======== In 1997, the Company reported consolidated pre-tax operating income of $16.6 million ($0.69 and $0.67 per basic and diluted share, respectively) versus a pre-tax operating loss of $194.4 million ($8.17 per basic and diluted share) in 1996. After-tax operating income for 1997 was $14.2 million ($0.59 and $0.58 per basic and diluted share, respectively) as compared to an after-tax operating loss of $137.3 million ($5.77 per basic and diluted share) in 1996. The improvement in the 1997 results was due primarily to special charges recorded in 1996 (see below), increased pre-tax operating income generated by PMA Re and improved underwriting results by the Property and Casualty Group. The increase in PMA Re's pre-tax operating income to $44.8 million, as compared to $42.8 million in 1996, was due to higher premium volume, improved underwriting results and higher investment income. The Property and Casualty Group decreased its pre-tax operating loss in 1997 to $9.0 million, as compared to $219.6 million in 1996, due primarily to special charges recorded in 1996 (see below), as well as the impact of cost savings initiatives implemented in late 1996 and in 1997. Corporate and Other operations reported a pre-tax operating loss of $3.4 million in 1997 versus a pre-tax operating loss of $0.5 million in 1996. The higher operating loss for Corporate and Other operations was due mainly to increased operating costs related to certain corporate properties disposed of during the third quarter of 1997. Interest expense decreased in 1997 by $1.3 million, due to the refinancing of the Company's debt with a new $235.0 million revolving credit facility (the "New Credit Facility"). See "Liquidity and Capital Resources" herein for further discussion. On a consolidated basis, the Company reported pre-tax operating income of $3.0 million ($0.13 and $0.12 per basic and diluted share, respectively) in 1995 as compared to the $194.4 million pre-tax operating loss discussed above for 1996. After-tax operating income was $3.4 million ($0.14 per basic and diluted share) in 1995 as compared to the $137.3 million after-tax operating loss in 1996 mentioned above. The decrease from 1995 to 1996 was due primarily to special charges recorded in 1996 (see below) at the Property and Casualty Group. In 1995, PMA Re reported pre-tax operating income of $39.4 million, the Property and Casualty Group had a pre-tax operating loss of $4.3 million and Corporate and Other operations recorded a pre-tax operating loss of $13.4 million. The improvement in the operating results of Corporate and Other from 1995 to 1996 was due mainly to the fact that 1995 was impacted by an $8.4 million write-down of certain real estate properties owned by the Company as well as higher overhead expenses. Interest expense decreased in 1996 by approximately $1.7 million as compared to 1995, mainly reflecting lower average debt balances and the pay-down of higher coupon debt. Net income on a consolidated basis, before extraordinary items, was $19.8 million, or $0.83 per basic share and $0.80 per diluted share, in 1997 compared to a net loss of $135.3 million, or $5.68 per basic and diluted share in 1996. On March 14, 1997, the Company refinanced substantially all of its outstanding credit agreements not already maturing in 1997 with the New Credit Facility. In connection with this refinancing, the Company recognized an extraordinary loss from the early extinguishment of debt of $4.7 million, or $0.20 and $0.19 per basic and diluted share, respectively, net of tax. Over the past three years, the Company's operating results have been impacted by restructuring charges and other special items. During 1997, the Company recorded $7.0 million of severance and other restructuring charges, primarily related to the Property and Casualty Group and Corporate and Other 27 operations. In addition, the Company recorded $2.2 million of operating costs for certain corporate properties which were disposed of during 1997 (see "Corporate and Other") and $2.0 million of year 2000 expenses (see "Liquidity and Capital Resources" for further discussion). In 1996, the Company's operating results included a pre-tax charge of $221.3 million ($143.8 million after tax), recorded by the Property and Casualty Group in order to strengthen its loss and LAE reserves, to recognize restructuring costs in connection with staff reductions and to write off certain accounts receivable. In addition, pre-tax Year 2000 costs in 1996 were $1.8 million. In 1995, the Company recorded a charge of $8.4 million to write down the Company's former headquarters building and certain adjacent properties to their fair market values less costs to carry and sell the properties. The charges over the three-year period consisted of the following:
(dollar amounts in millions) 1997 1996 1995 ---- ---- ---- Severance and other restructuring charges ........ $ 7.0 $ 7.6 $ -- Year 2000 costs .................................. 2.0 1.8 -- Costs related to corporate properties ............ 2.2 -- -- Write-down of corporate properties ............... -- -- 8.4 Caliber One pre-opening costs .................... 0.9 -- -- Loss reserve strengthening ....................... -- 191.4 -- Receivables write-down ........................... -- 17.5 -- Equipment write-down ............................. -- 4.8 -- ------ ------ ---- Total pre-tax charge ............................. $ 12.1 $223.1 $8.4 ====== ====== ====
PMA Re Results of Operations Summarized financial results of PMA Re for the years ended December 31, 1997, 1996 and 1995, are as follows:
(dollar amounts in thousands) 1997 1996 1995 ---- ---- ---- Net premiums written .................... $177,934 $164,053 $152,760 ======== ======== ======== Net premiums earned ..................... $163,603 $151,974 $139,345 Net investment income ................... 52,270 48,676 45,166 -------- -------- -------- Operating revenues ...................... 215,873 200,650 184,511 -------- -------- -------- Losses and LAE incurred ................. 113,931 111,937 103,947 Acquisition and operating expenses ...... 57,140 45,930 41,121 -------- -------- -------- Total losses and expenses ............... 171,071 157,867 145,068 -------- -------- -------- Pre-tax operating income ................ $ 44,802 $ 42,783 $ 39,443 ======== ======== ======== GAAP loss ratio ......................... 69.6% 73.7% 74.6% GAAP combined ratio ..................... 104.5% 103.9% 104.1% SAP loss ratio .......................... 69.5% 73.7% 74.6% SAP combined ratio ...................... 103.8% 104.4% 105.5%
Premium Revenues In 1997 and 1996, net premiums written increased 8.5% and 7.4%, respectively. The increases in 1997 and 1996 were primarily the result of increased participation on reinsurance treaties and the writing of additional layers and programs with existing clients. An increased number of programs added for property lines during the second half of 1996 and during 1997 also contributed to the aforementioned increases in net premiums written. These increases were partially offset by the trend toward large ceding companies increasing their retentions, which decreases PMA Re's subject premium. Additionally, highly competitive pricing conditions in the U.S. reinsurance market caused PMA Re to non-renew certain existing business and to decline certain new business opportunities. The following table indicates PMA Re's gross and net premiums written by major category of business: (dollar amounts in thousands) 28
1997 1996 1997 1996 1995 Change % Change % ---- ---- ---- -------- -------- Gross premiums written: Casualty lines ...... $151,901 $143,991 $128,736 5.5% 11.9% Property lines ...... 72,625 63,325 63,693 14.7% (0.6)% Other lines ......... 795 842 (63) (5.6)% -- -------- -------- -------- ---- ---- Total ..................... $225,321 $208,158 $192,366 8.2% 8.2% ======== ======== ======== ==== ==== Net premiums written: Casualty lines ...... $118,889 $122,008 $107,383 (2.6)% 13.6% Property lines ...... 58,257 41,240 45,440 41.3% (9.2)% Other lines ......... 788 805 (63) (2.1)% -- -------- -------- -------- ---- ---- Total ..................... $177,934 $164,053 $152,760 8.5% 7.4% ======== ======== ======== ==== ====
PMA Re's net casualty premiums written decreased 2.6% in 1997 and increased 13.6% in 1996. The decrease in 1997 was primarily attributable to increased retrocessional protection purchased, which offset increases in gross casualty premiums relating to new business with existing clients and larger lines taken on existing programs. The growth in 1996 was attributable to the expansion of several programs covering specialty business, which included professional liability, directors' and officers' liability, and other coverages written on a surplus lines basis. PMA Re's net property business increased 41.3% during 1997 and decreased 9.2% during 1996. The increase in net property premiums written in 1997 was primarily the result of additional property underwriting expertise that PMA Re added to its underwriting staff in late 1996 to broaden its product offerings. Such expertise enabled PMA Re to increase cross-selling opportunities with its existing treaty reinsurance clients by offering additional and/or expanded property coverages. In addition, property premiums ceded decreased primarily related to changes in PMA Re's property retrocessional coverages in terms of premiums and ceding commissions. The decrease in net premiums written in 1996 was primarily attributable to higher ceding company retentions, competitive pricing conditions and higher ceded property premiums. The property programs written by PMA Re generally contain per occurrence limits and/or are not considered significantly catastrophe exposed, either because of the locations of the insured values or the nature of the underlying properties insured. However, as is common in property reinsurance, PMA Re is exposed to the possibility of loss from catastrophic events due to the aggregation of per occurrence limits and similar issues. PMA Re actively manages this exposure through aggregate management, avoidance of catastrophe business and retrocessional protection (see "Capital Resources"). In 1997, PMA Re recorded $2.5 million of net facultative reinsurance premiums which represented 1.4% of total net premiums written for the year, compared to $1.0 million, or 0.6%, in 1996. PMA Re commenced writing facultative reinsurance in November 1995. Net premiums earned increased 7.7% and 9.1% in 1997 and 1996, respectively. These increases both correspond to the increases in net premiums written, as net premiums earned generally follow growth patterns similar to net premiums written adjusted for the customary lag related to the timing of premium writings within the year. Losses and Expenses PMA Re's combined ratios have remained relatively stable from 1995 through 1997, ranging from 103.9% to 104.5% during the three-year period. This relative stability is attributable to (i) consistently favorable development of unpaid losses and LAE; (ii) prudent management of catastrophe exposures; and (iii) lower loss ratios offsetting generally increased acquisition costs related to writing more business with ceding commissions. 29 The following table indicates the components of PMA Re's combined ratios, as computed on a GAAP basis (1): 1997 1996 1995 ---- ---- ---- Loss ratio ....................................... 69.6% 73.7% 74.6% ------ ------ ------ Expense ratio: Amortization of deferred acquisition costs .. 27.6% 24.7% 24.2% Operating expenses .......................... 7.3% 5.5% 5.3% ------ ------ ------ Total expense ratio .............................. 34.9% 30.2% 29.5% ------ ------ ------ Combined ratio-GAAP .............................. 104.5% 103.9% 104.1% ------ ------ ------ (1) The combined ratio computed on a GAAP basis is equal to losses and LAE, plus amortization of deferred acquisition costs, plus operating expenses, plus policyholders' dividends (where applicable), all divided by net premiums earned. For the past three years, PMA Re's loss ratios have declined primarily as a result of increased ceding commissions and favorable loss reserve development. PMA Re's loss ratio decreased to 69.6% in 1997 from 73.7% and 74.6% in 1996 and 1995, respectively. For contracts written on a pro rata basis and other contracts containing ceding commissions, premiums tend to be higher relative to the losses when compared to contracts that do not contain ceding commissions. In the past three years, PMA Re has written more contracts containing ceding commissions which has contributed to the decreases in loss ratios. For such contracts, PMA Re pays the ceding company a commission, but in return, PMA Re receives a higher proportion of the subject premium. In addition, net favorable development on prior years' unpaid losses and LAE was $23.3 million in 1997, and $28.6 million and $15.0 million in 1996 and 1995, respectively. The ratio of amortization of deferred acquisition costs to net premiums earned ("Acquisition Expense Ratio") increased 2.9 points to 27.6% in 1997 compared to 1996, and 0.5 points in 1996 versus 1995. These increases predominantly relate to the fact that PMA Re continues to write more contracts with ceding commissions. Additionally, the ceding commissions that PMA Re received related to its retrocessional catastrophe cover were higher in 1996 than in 1997, which contributed to the lower Acquisition Expense Ratio in 1996. The ratio of operating expenses to net premiums earned (the "Operating Expense Ratio") increased 1.8 points to 7.3% in 1997 compared to 5.5% in 1996. This increase was attributable to increases in certain expenses, such as salary and facility expenses, in connection with the addition of staff and expansion of office facilities during 1997. During the three-year period ended December 31, 1997, PMA Re has continued to add staff in response to increased premium volume and to increase the level of specialized services provided to customers. Accordingly, the Operating Expense Ratio has increased from 5.3% in 1995 to 7.3% in 1997. Certain of the Company's computer systems are not presently equipped to recognize the year 2000 due to system constraints (the "Year 2000 Issue"). The Company is presently undertaking a project to upgrade all of its computer systems to be able to process records with dates beyond December 31, 1999. During 1997, PMA Re incurred costs amounting to approximately $400,000 related to the Year 2000 Project (the "Year 2000 Project"). Management expects that PMA Re will incur approximately $600,000 in 1998 related to the Year 2000 Project . Management expects that such project will be completed in 1998 (see "Liquidity and Capital Resources" for further discussion of the Year 2000 Issue). Net Investment Income Net investment income increased 7.4% to $52.3 million in 1997 from $48.7 million in 1996, which represented a 7.8% increase from $45.2 million in 1995. Such increases were primarily attributable to the overall increase in PMA Re's invested assets, as well as changes in portfolio holdings. During 1997, PMA Re shifted some of its holdings from government securities to high-quality corporate securities, which generally yield higher levels of investment income. Additionally, the 1996 increase was due to a decrease in holdings of tax-exempt securities for which pre-tax yields tend to be lower than other investment 30 vehicles. At amortized cost, PMA Re's cash and invested assets increased $49.0 million, or 5.9%, and $34.9 million, or 4.4%, during 1997 and 1996, respectively. Comparison of SAP and GAAP Results The difference between the combined ratios presented on a GAAP basis versus on a SAP basis is primarily attributable to the different accounting treatment of acquisition costs. As PMA Re has grown in terms of premium volume during 1997 and 1996, PMA Re has incurred additional acquisition costs, which are deferred for GAAP. For SAP purposes, PMA Re is required to expense such costs as incurred, resulting in an incremental expense recorded on a SAP basis compared to GAAP. The Property and Casualty Group Results of Operations Summarized financial results of the Property and Casualty Group for the years ended December 31, 1997, 1996 and 1995, are as follows: (dollar amounts in thousands) 1997 1996 1995 ---- ---- ---- Net premiums written: Workers' compensation ........... $ 175,301 $ 189,338 $ 233,145 Commercial Lines ................ 65,047 90,084 103,971 --------- --------- --------- Total ........................... $ 240,348 $ 279,422 $ 337,116 ========= ========= ========= Net premiums earned: Workers' compensation ........... $ 152,773 $ 176,380 $ 243,175 Commercial Lines ................ 59,575 92,221 102,432 --------- --------- --------- Total ........................... 212,348 268,601 345,607 Net investment income ................ 82,098 82,455 92,275 Service revenues ..................... 10,311 9,189 5,106 --------- --------- --------- Operating revenues ................... 304,757 360,245 442,988 --------- --------- --------- Losses and LAE incurred .............. 193,530 424,900 319,644 Acquisition and operating expenses ... 105,549 138,709 110,906 Policyholder dividends ............... 14,716 16,255 16,743 --------- --------- --------- Total losses and expenses ............ 313,795 579,864 447,293 --------- --------- --------- Pre-tax operating loss ............... $ (9,038) $(219,619) $ (4,305) --------- --------- --------- GAAP loss ratio ...................... 91.1% 158.2% 92.5% GAAP combined ratio .................. 143.3% 212.9% 127.9% SAP loss ratio (1) ................... 84.0% 125.7% 77.3% SAP combined ratio (1) ............... 119.0% 175.6% 115.1% (1) The SAP loss and combined ratios above relate to the operations of the Pooled Companies only and do not include the results of other statutory entities within the Property and Casualty Group. Premium Revenues Premiums for the Property and Casualty Group have decreased in the three-year period ended December 31, 1997. Between 1997 and 1996, net premiums written decreased 14.0%, and between 1996 and 1995, net premiums written decreased 17.1%. Direct premiums written for workers' compensation decreased $20.6 million and $36.5 million in 1997 and 1996, respectively. Direct premiums written for commercial lines of business other than workers' compensation, such as commercial auto, general liability, umbrella, multi-peril and commercial property lines (collectively "Commercial Lines") increased $11.7 million in 1997 compared to 1996, and decreased $11.6 million in 1996 relative to 1995. Reinsurance premiums assumed decreased $4.4 million between 1997 and 1996 and increased $0.8 million between 1996 and 1995. Reinsurance premiums ceded increased $25.8 million in 1997 compared to 1996 and $10.4 million in 1996 relative to 1995. Net premiums earned decreased $56.3 million between 1997 and 1996 and $77.0 million between 1996 and 1995. 31 The decline in premiums from 1995 to 1997 is due to a number of factors discussed below, including the Property and Casualty Group's underwriting decisions, competition, and the impact of workers' compensation benefit reform laws. During the past three years, competition and manual rate levels affected workers' compensation premium volume. During this period, the Property and Casualty Group did not renew certain accounts due to inadequate profit potential. Intense competition caused rates for certain accounts to be unattractive relative to the risks assumed. Rather than match the price merely to retain the volume, the Property and Casualty Group declined to write the accounts. In terms of manual rates, average rate levels declined 25.0%, 7.0%, and 3.0% in 1997, 1996, and 1995, respectively. The rate decreases had a substantially lower proportional impact on premiums written during 1996 and 1995, as the Property and Casualty Group had reduced its dependence on rate-sensitive business. The Property and Casualty Group increased its focus on rate sensitive small account business in 1997, as it believes that the impact of recently passed legislation in its principal marketing states, including Act 57 in Pennsylvania, may make loss experience on such business more predictable than it has recently been. Workers' compensation premiums also declined during the three-year period as a result of the enactment of workers' compensation benefit reform laws. The decline in workers' compensation premiums has been concentrated primarily in Pennsylvania. Direct workers' compensation premiums for all other jurisdictions increased in 1997 compared to 1996, including an increase of $3.8 million from new jurisdictions in 1997. The number of workers' compensation policies increased in 1997 compared to 1996, from 2,757 to 3,184. However, the increase in policies was offset by the rate decreases related to the benefit reform laws. These benefit reform laws also have had a favorable impact on loss and LAE reserves for business written on policies subject to such reform laws. See "Losses and Expenses" below. The changes in workers' compensation benefits that were promulgated under Act 57 in Pennsylvania were accompanied by a change in the basic premium rate structure for workers' compensation insurance, which lowered the rates charged to insureds by approximately 25% effective February 1997. This change in rate structure was reviewed by an independent actuarial firm on behalf of the Commonwealth of Pennsylvania in connection with the approval of rates under Act 57. In addition, the Company's actuaries reviewed the effect that the reforms would have on workers' compensation benefits paid in relation to the changes in premiums charged. It was the opinion of both groups of actuaries that the rate changes mandated by Act 57 were consistent with the changes in benefits allowed under Act 57, and the effect of the rate changes would be minimal with respect to the profitability of the business. The premium charged on a fixed-cost policy is based upon the manual rates filed with and approved by the state insurance department and does not increase or decrease based upon the losses incurred during the policy period. Under policies that are subject to dividend plans, the customer may receive a dividend based upon loss experience during the policy period. Since the late 1980s, the Property and Casualty Group has reduced its proportion of rate-sensitive products from over 70% to approximately 62%. With the enactment of regulatory reform in several jurisdictions in the Property and Casualty Group's marketing territory, the Property and Casualty Group is more interested in this type of business and may write more rate-sensitive accounts in such jurisdictions in the future. Direct workers' compensation premiums were also impacted by changes in the level of premium adjustments, primarily related to audit premiums and retrospective policies. In 1997, such adjustments decreased premiums written by $4.4 million ($15.8 million in audit premiums billed and $20.2 million in retrospective premiums returned), while in 1996, such adjustments reduced premiums written by $6.1 million ($17.1 million in audit premiums billed and $23.2 million in retrospective premiums returned) and in 1995, such adjustments increased premiums written by $13.1 million ($26.9 million in audit premiums billed and $13.8 million in retrospective premiums returned). The slightly lower impact of premium adjustments in 1997 relative to 1996 was due primarily to a decrease in retrospectively rated premiums returned to insureds, resulting from a lower volume of workers' compensation business written during the past three years. The decrease in 1996 relative to 1995 was due primarily to two factors: (i) the lower amount of billed audit premiums, which is attributable to better estimating of the ultimate exposure base (generally, payroll) on such risks by the Property and Casualty Group's underwriters; and (ii) the 32 increase in retrospectively rated premiums returned to insureds, resulting from the favorable loss experience in more recent accident years in workers' compensation. As the Property and Casualty Group has expanded retrospectively rated business since 1989, proportionately more policies had mature loss data, resulting in more premium adjustments. Changes in actuarial estimates of future premium adjustments on retrospective policies are recorded directly in net premiums earned (see below for further discussion), and therefore, such retrospective adjustments returned to insureds do not impact net premiums earned. Under retrospectively rated policies, the Property and Casualty Group receives an up-front provisional premium which is adjusted based upon loss experience of the insured. If losses are lower than expected, the insured receives a refund, subject to a minimum premium and if losses are higher than expected, the insured owes additional premium, subject to a maximum premium. Between the minimum and maximum premiums, the net impact on the Company's operating results is negligible, because changes in loss estimates pertaining to retrospectively rated contracts are offset by changes in premium estimates, net of changes in estimates for accrued premium taxes and other loss-based costs. While the premium is adjusted based upon loss experience, the Company's profit load (or margin) portion of the premium is fixed at the policy's inception and is not adjusted based upon loss experience, although the margin would be impaired in the event losses exceed the maximum premium amount. Approximately $50.1 million, $59.0 million and $85.0 million of the Property and Casualty Group's workers' compensation premiums were derived from loss sensitive products in 1997, 1996, and 1995, respectively. The audit premiums referred to above were derived from the Company's workers' compensation insurance policies. An insured's workers' compensation premiums are determined by two factors: aggregate payroll and employer business classification. The Company determines its initial estimate of annual premium based on payroll records and business classification data submitted to it by the insured. An audit of this data is performed after the policy year ends, and an adjustment to the premium is then made and billed to the insured. Also reducing net premiums written is the fact that, since 1992, the Property and Casualty Group has been increasing its focus on alternative market workers' compensation products. These products include large-deductible policies, offshore rent-a-captive programs and individual self-insurance programs. Typically, the Property and Casualty Group receives a lower net premium for these types of plans. However, under this type of business, the insured retains a greater share of the underwriting risk than under rate-sensitive or loss-sensitive products, which reduces the potential for unfavorable claim activity on the accounts and encourages loss control on the part of the insured. A substantial portion of related revenues are recorded as service revenues rather than premiums. Such service revenues increased $1.1 million in 1997 as compared to 1996, and $4.1 million in 1996 relative to 1995. Companies writing workers' compensation in certain states generally must share in the risk of insuring entities that cannot obtain insurance in the voluntary market. Typically, an insurer's share of this residual market is dependent upon its market share in terms of direct premiums in the voluntary market, and the assignments are accomplished either by direct assignment or by assumption from pools. In 1997, the Property and Casualty Group's direct assignments, which are included in direct written premiums, decreased $3.1 million relative to 1996, and decreased $15.3 million in 1996 as compared to 1995. These decreases reflect generally lower premium volume in workers' compensation for the Property and Casualty Group, as well as increasingly competitive conditions in the voluntary workers' compensation market, which has led to lower amounts of residual market business. During 1997, direct writings of Commercial Lines increased $11.7 million compared to 1996, assumed Commercial Lines premiums decreased $8.5 million and ceded Commercial Lines premiums increased $28.2 million in 1997 compared to 1996. The growth in direct writings for Commercial Lines in 1997 was due primarily to rate increases on existing business, as well as additional companion commercial business associated with new workers' compensation customers. The Property and Casualty Group is continuing to review the profitability of these lines, and the net growth in such lines has been limited as a result of this review and the new reinsurance treaty discussed below. Also, market conditions have been extremely competitive in these lines, and management has refused to compromise underwriting standards 33 merely to increase volume. During 1996, direct writings of Commercial Lines decreased $11.6 million compared to 1995, assumed Commercial Lines premiums increased $0.8 million and ceded Commercial Lines premiums increased $3.1 million in 1996 compared to 1995. In 1997, the Property and Casualty Group entered into a new reinsurance treaty that covers substantially all of the Commercial Lines casualty business at a $175,000 per risk attachment point, compared to a $500,000 per risk attachment point in 1996 which accounted for the increase in ceded Commercial Lines premiums. Ceded premiums increased $25.8 million in 1997 compared to 1996, and increased $10.4 million in 1996 compared to 1995. The increase in 1997 as compared to 1996 was due primarily to a reinsurance treaty effected at December 31, 1997, ceding $15.4 million of annuity reserves held by its domestic life insurance company to a third party (the "PMA Life Insurance Company transaction"). Ceded premiums also increased approximately $6.6 million due to the aforementioned lower attachment point of the Commercial Lines casualty reinsurance treaty the Property and Casualty Group entered into effective January 1, 1997. Finally, ceded reinsurance premiums increased an additional $6.2 million, due to the increased direct writings of Commercial Lines business in 1997 as compared to 1996. In 1996 as compared to 1995, ceded premiums decreased, although the rate of decrease was less than the rate of decrease in direct premiums, due to the increased use of facultative reinsurance for specific risks in Commercial Lines. Fluctuations in net premiums earned were primarily attributable to changes in net premiums written. In addition to the impact of fluctuations in premiums written, premiums earned were also impacted by the change in accrued retrospective premiums. Accrued retrospective premiums, which are a component of uncollected premiums, are based upon actuarial estimates of expected ultimate losses and resulting estimated premium adjustments relating to retrospectively rated policies. The estimated ultimate premium adjustments under retrospectively rated policies are recorded in the initial policy year based upon estimated loss experience on the underlying policies and adjusted in subsequent periods in conjunction with revisions of the estimated underlying losses on such policies. In addition, accrued retrospective premiums are increased or decreased based upon retrospective policy adjustments paid or billed. Such adjustments actually billed or paid do not impact premium revenues because the Company records an offsetting amount through net premiums written. The following sets forth the components of the change in accrued retrospective premiums for each of the three years in the period ended December 31, 1997: (dollar amounts in thousands) 1997 1996 1995 ---- ---- ---- Estimated retrospective policy adjustments related to the current accident year ......................... ($12,460) ($18,767) ($12,941) Revision of estimate of retrospective policy adjustments related to prior accident years .................. (44,719) (9,888) (4,845) Retrospective policy adjustments paid ...... 20,179 23,155 13,786 Uncollectible write-off .................... -- (5,000) -- -------- -------- -------- Total ...................................... ($37,000) ($10,500) ($ 4,000) ======== ======== ======== In 1997, 1996 and 1995, the Property and Casualty Group reduced accrued retrospective premiums by $37.0 million, $10.5 million and $4.0 million, respectively. The primary reason for the additional reduction in 1997 relative to 1996 was a $44.7 million revision of estimate of accrued retrospective premiums, primarily due to the favorable development of claims liabilities for more recent accident years ($35.7 million) and the commutation of claims for accident years 1991 and prior in 1997 ($9.0 million). The reduction for policy years 1991 and prior primarily relates to the commutation program for such years initiated in late 1996. In July 1997, the Property and Casualty Group completed a formal program under which it commuted a large number of claims associated with workers' compensation claims from accident years 1991 and prior, including loss reserves associated with retrospective policies. The commutation 34 program resulted in current payments to claimants which were less than the carried reserves. As a result of the differences between the current commutation payments to claimants and carried reserves on such claims, management reduced its estimate of amounts recoverable under retrospectively rated policies and also recognized a reduction in losses and LAE associated with such policies (see "Losses and Expenses" below). The reduction related to 1992 through 1996 policy years was related primarily to a corresponding amount of favorable development on underlying loss reserves for such years. The effects of the commutations on these prior loss reserves, as well as the intent of the Property and Casualty Group to continue utilizing early intervention techniques such as commutations on claims from more recent accident years, have led to a re-estimation of policy liabilities for these more recent accident years, and a re-estimation of amounts due under retrospectively rated policies for these more recent accident years. The reduction in amounts due under retrospectively rated policies and the corresponding reduction in loss reserves resulting from commutation of the carried loss reserves and re-estimation of more recent accident years resulted in a reduction of the GAAP loss ratio for 1997 (as more fully described in "Losses and Expenses," below), compared to 1996 and 1995. Additionally, the reduction of earned premiums caused both the GAAP expense ratio and the policyholder dividend ratio to increase for 1997, compared to 1996 and 1995. However, the impact of the reduction of the accrued retrospective premiums (net of the adjustment to underlying loss reserves) on the Company's results of operations was negligible. The increased adjustment to prior accident years recorded in 1996 as compared to 1995 reflects additional favorable loss reserve development in the prior three accident years. Management believes that it has made a reasonable estimate of the Company's accrued retrospective premiums. While the eventual ultimate receivable may differ from the current estimates, management does not believe that the difference will have a material effect, either adversely or favorably, on the Company's financial position or results of operations. Losses and Expenses The following table reflects the components of the Property and Casualty Group's combined ratios, as computed under GAAP: 1997 1996 1995 ---- ---- ---- Loss ratio ........................................ 91.1% 158.2% 92.5% ----- ------ ------ Expense ratio: Amortization of deferred acquisition costs .. 22.7% 19.7% 15.5% Operating expenses (1) ...................... 22.6% 28.9% 15.1% ------ ------ ------ Total expense ratio ............................... 45.3% 48.6% 30.6% ------ ------ ------ Policyholders' dividend ........................... 6.9% 6.1% 4.8% ------ ------ ------ Combined ratio-GAAP ............................... 143.3% 212.9% 127.9% ------ ------ ------ (1) The GAAP Operating Expense Ratio excludes $9.3 million, $8.2 million and $5.3 million in 1997, 1996 and 1995, respectively, of PMA Management Corp. direct expenses related to service revenues, which are not included in premiums earned. The components of the loss and LAE ratio for the Property and Casualty Group are as follows: 1997 1996 1995 ---- ---- ---- Current accident year - undiscounted .............. 81.3% 81.4% 83.8% Accretion of discount for prior accident years and discounting of current accident year ....................... 12.0% 5.5% (0.7%) Adjustments to retrospectively rated business and net effect of PMA Life reinsurance transaction ..................... (1.5%) -- -- Change in discount rate ........................... -- -- (9.8%) Reserve (release) strengthening ................... (0.7%) 71.3% 19.2% ------ ------ ----- Loss and LAE ratio ................................ 91.1% 158.2% 92.5% ----- ------ ----- In 1997, the calendar year loss ratio was impacted by a $31.7 million net charge, which represented the accretion of discount on workers' compensation loss reserves for prior accident years, partially offset by 35 discounting of current accident year reserves, while the 1996 calendar-year loss ratio was impacted by a $15.0 million net charge for accretion of discount on prior accident year workers' compensation loss reserves and discounting of current accident year reserves. The increase in the net charge for discount accretion is due primarily to higher overall reserve levels in 1997 and lower levels of current accident year reserves being discounted in 1997 as compared to 1996. The Property and Casualty Group expects lower levels of discount associated with current accident year reserves to continue, due to benefit reforms that reduce claims duration which have been enacted in many of the states in which it does business. Management also expects that the net charge associated with accretion of discount of prior years' reserves to decrease in 1998 and forward, as the accelerated payment of claims due to commutations is expected to lower the level of discount in the Property and Casualty Group's loss reserves. The increase in the loss ratio in 1996 compared to 1995 from the accretion of discount was due primarily to higher overall reserves in 1996 and to lower levels of earned premium in 1996 as compared to 1995. Discounting of reserves for workers' compensation claims is established in accordance with applicable state laws, which permit discounting the estimated claim payments on certain claims at various rates (the Property and Casualty Group uses a discount rate of approximately 5% per year, which is within the range of permitted rates in the states in which it does business). Loss reserves on other lines of business as well as loss adjustment expense reserves for all lines of business are not discounted. In 1997, the Property and Casualty Group recorded a reserve release of approximately $53.9 million on prior year losses and LAE, excluding the accretion of discount. The release primarily relates to favorable reserve development of $9.0 million related to retrospectively rated policies for accident years 1991 and prior and favorable development of $28.0 million related to retrospectively rated policies pertaining to accident years 1992 through 1996. The Property and Casualty Group also recorded favorable development on guaranteed cost workers' compensation reserves for accident years 1991 and prior of $7.1 million, partially offset by reserve strengthening in commercial multi-peril business for accident year 1996 of $5.0 million. Furthermore, incurred losses on prior accident years were also affected by the cession of prior year reserves included in the PMA Life Insurance Company transaction of $14.8 million. In 1996 and 1995, the loss ratio included $191.4 million and $66.5 million, respectively, of strengthening of unpaid losses and loss adjustment expenses of prior accident years. The loss reserve (release) strengthening was associated with the following lines of business: (dollar amounts in millions) 1997 1996 1995 ---- ---- ---- Pre-1992 workers' compensation ............. $(7.1) $110.0 $ 54.7 Asbestos and environmental ................. -- 60.4 23.4 Other lines of business .................... 5.0 21.0 (11.6) ----- ------ ------ Total reserve (release) strengthening ...... $(2.1) $191.4 $ 66.5 ------ ------ ------ The 1996 aggregate workers' compensation adverse development was allocated $102.0 million to Pennsylvania and $8.0 million to all other states in the Property and Casualty Group's marketing territory. Of the $102.0 million, the allocation by year is as follows: prior to 1987: $16.0 million; 1987 to 1991: $101.0 million; and 1992 and subsequent years: ($15.0 million). In 1995, substantially all of the workers compensation adverse development related to accident years 1987 to 1991 in Pennsylvania. For accident years prior to 1992, the traditional paid loss development schedules for workers' compensation had begun to exhibit an increasing trend in loss development factors by 1993. This trend was initially attributed to an increase in commutation activity. In 1995, management began to question whether loss data was developing in a manner that was consistent with the conclusion that the loss development trends were impacted solely by commutation activity. As a result, management began to accumulate additional data in order to determine whether there were additional causes of the increase in the paid loss development data; management obtained claim count data that was far more detailed than had been historically utilized in the reserve setting process. This data indicated that the paid loss development factors were not only impacted by commutation activity, but also by a decline in the claims closure rate in Pennsylvania. Management believes that the decline of the closure rates was due to several interrelated factors. One factor related to the fact that efforts to rehabilitate claimants and return them to work were not as 36 successful as anticipated. For accident years 1987 to 1991, in particular, extensive efforts were made by the Company to rehabilitate claimants and return them to work at either full or modified duty. By late 1995 and into 1996, it was recognized, by a review of a slow down in the claims closure pattern that these rehabilitation efforts were not impacting the closure rates as expected. Another factor negatively impacting claims closure rates related to the economic conditions in Pennsylvania in the early 1990's. During the period from 1990 to 1994, economic conditions in Pennsylvania were considered to be depressed in the Company's major industry niches for workers' compensation insurance (construction, heavy manufacturing). Payrolls in these industries were stagnant, and in many cases, employment was flat or declining. The Company believes that in periods of declining employment opportunities, there is a tendency for indemnity periods to increase, which occurred for workers who suffered injuries in these industries. The above factors, when considered with the fact that the benefits period in Pennsylvania was unlimited, caused the Company to believe that a substantial portion of claimants from the pre-1992 period, who had already been out of work five to nine years, would not return to work in any capacity. In late 1995 and during 1996, management undertook an effort to quantify the impact of the declining closure rates versus the increase in commutation activity. During the fourth quarter of 1995, management strengthened the Property and Casualty Group's workers' compensation reserves by $54.7 million; however, the quantification of the effect of the claims closure rate was an extremely complex process, and as such, the data was not fully understood at that time. As the data under analysis was more mature and refined in 1996, management determined that the workers' compensation loss reserves for Pennsylvania in the pre-1992 accident years needed to be increased substantially; therefore, the Property and Casualty Group increased its workers' compensation reserves by $110.0 million. Benefit reforms enacted by states in which the Property and Casualty Group transacts business, most significantly Pennsylvania, have had a beneficial impact on more recent accident year loss ratios. Prior to 1996, the principal revisions of the Pennsylvania system included medical cost containment measures and an expansion of the period of time during which the insurer may require an employee to accept medical treatment from the employer's list of designated healthcare providers. In July 1996, Pennsylvania enacted Act 57, a workers' compensation reform bill which is expected to substantially reduce indemnity benefit periods in Pennsylvania. In addition to regulatory reforms, the loss ratios have been favorably impacted by the conversion to loss sensitive and alternative market products. Such a trend is evidenced by the fact that accident year loss ratios (losses recorded for the year the event occurred expressed as a percentage of the earned premiums for that year) for workers' compensation have been generally lower in more recent accident years, as the following chart indicates: Property and Casualty Group Workers' Compensation Undiscounted Accident Year - ---------------------------------------------------------------------------- Pure Loss Ratios as of December 31, 1997 ---------------------------------------- Accident Years Loss Ratio -------------- ---------- 1990 100% 1991 86% 1992 80% 1993 64% 1994 64% 1995 63% 1996 63% 1997 66% In addition, management took several steps to reduce the outstanding claims associated with the Pennsylvania workers' compensation business written through 1991. A formal commutation program was initiated in the fourth quarter 1996 and continued into late 1997. Commutations are agreements with claimants whereby the claimants, in exchange for a lump sum payment, will forego their rights to future indemnity payments from the Property and Casualty Group. Under Pennsylvania workers' compensation 37 laws, all such commutation arrangements must be approved by the claimant and the Pennsylvania Workers' Compensation Board. The Property and Casualty Group paid $101.1 million and $17.8 million in 1997 and the fourth quarter of 1996, respectively, to commute workers' compensation indemnity claims. Savings associated with these claims were consistent with management's expectations. The number of open claims for accident years 1991 and prior was substantially reduced as a result of the commutation program. This reduction in open claims is expected to reduce the possibility of any further adverse development on such reserves, although there can be no assurances that the level of commutations will have a significant impact on the future development of such reserves. Estimating reserves for workers' compensation claims can be more difficult than many other lines of property and casualty insurance for several reasons, including (i) the long payment `tail' associated with the business; (ii) the impact of social, political and regulatory trends on benefit levels for both medical and indemnity payments; (iii) the impact of economic trends; and (iv) the impact of changes in the mix of business. At various times, one or a combination of such factors can make the interpretation of actuarial data associated with workers' compensation loss development more difficult, and it can take additional time to recognize changes in loss development patterns. Under such circumstances, adjustments will be made to such reserves as loss patterns develop and new information becomes available and such adjustments may be material. The adverse development in reserves associated with asbestos and environmental claims is the result of a detailed analysis of loss and LAE reserves associated with asbestos and environmental liability claims completed in 1996. The reserving for asbestos and environmental claims has undergone change at both the Company and in the insurance industry in general. For environmental and asbestos liability claims, reserving methodology has been evolving into accepted industry practice in the recent past; the Company has applied these methods to its loss reserves in 1997 and 1996. To reserve for environmental claims, the Company currently utilizes a calendar year development technique known as aggregate loss development. This technique focuses on the aggregate losses paid as of a particular date and aggregate payment patterns associated with such claims. Several elements including remediation studies, remediation, defense, declaratory judgment, and third party bodily injury claims were considered in estimating the costs and payment patterns of the environmental and toxic tort losses. Prior to the development of these techniques, there was a substantial range in the nature of reserving for environmental and toxic tort liabilities. The methods employed by the Company prior to the review performed in 1996 included a review of aggregate loss and loss adjustment paid and case incurred data along with resulting "survival ratios" to establish IBNR for environmental and toxic tort claims. For asbestos claims, the Company had previously reserved costs to defend, and any indemnification payments anticipated on, claims for which it had received notice that it was a responsible party, plus a bulk factor applied to the estimated case reserves to provide for potential development of indemnification and defense cost related to such claims. In 1996, the Company performed a ground up analysis of asbestos loss reserves using an actuarially accepted modeling technique. Using historical information as a base and information obtained from a review of open claims files, assumptions were made about future claims activity in order to estimate ultimate losses. For each individual major account, projections were made regarding new plaintiffs per year, the number of years new claims will be reported, the average loss severity per plaintiff and the ratio of loss adjustment expense to loss. In many cases involving larger asbestos claims, the Company reserved up to the policy limits for the applicable loss coverage parts for the affected accounts. Policy terms and reinsurance treaties were applied in the modeling of future losses. Estimation of obligations for asbestos and environmental exposures continues to be more difficult than for other loss reserves because of several factors, including: (i) evolving methodologies for the estimation of the liabilities; (ii) lack of reliable historical claim data; (iii) uncertainties with respect to insurance and reinsurance coverage related to these obligations; (iv) changing judicial interpretations; and (v) changing government standards. The Company's asbestos-related loss reserves for the years ended December 31, were as follows: (dollar amounts in thousands) 1997 1996 1995 ---- ---- ---- 38 Gross of reinsurance: Beginning reserves ........................ $ 80,055 $ 27,611 $ 13,969 Incurred losses and LAE ................... 2,435 62,854 22,482 Calendar year payments for losses and LAE.. (5,764) (10,410) (8,840) ------- -------- ------- Ending reserves ........................... $ 76,726 $ 80,055 $ 27,611 ======== ======== ======== Net of reinsurance: Beginning reserves ........................ $ 53,300 $ 23,443 $ 8,168 Incurred losses and LAE ................... (36) 39,427 21,826 Calendar year payments for losses and LAE.. (4,686) (9,570) (6,551) ------- ------- ------- Ending reserves ........................... $ 48,578 $ 53,300 $ 23,443 ======== ======== ======== (Included in such reserves are reserves for PMA Re of $0.3 million, $0.3 million and $0.6 million [gross and net] at December 31, 1997, 1996 and 1995, respectively.) The Company's environmental-related loss reserves for the years ended December 31, were as follows: (dollar amounts in thousands) 1997 1996 1995 ---- ---- ---- Gross of reinsurance: Beginning reserves ........................... $ 35,626 $ 20,134 $ 20,952 Incurred losses and LAE ...................... 1,130 22,143 3,516 Reserves acquired through purchase of Caliber One Indemnity Company (1).......... 13,060 - - Calendar year payments for losses and LAE..... (4,708) (6,651) (4,334) ------- ------- -------- Ending reserves .............................. $ 45,108 $ 35,626 $ 20,134 ======== ======== ======== Net of reinsurance: Beginning reserves ........................... $ 34,592 $ 20,134 $ 20,952 Incurred losses and LAE ...................... 1,068 21,109 3,516 Calendar year payments for losses and LAE..... (3,965) (6,651) (4,334) -------- -------- -------- Ending reserves .............................. $ 31,695 $ 34,592 $ 20,134 ======== ======== ======== (1) Such acquired reserves have been reinsured by an affiliate of the former parent (see "Liquidity and Capital Resources" for further discussion). (Included in such reserves are reserves for PMA Re of $3.8 million, $2.9 million and $2.6 million [gross and net] at December 31, 1997, 1996 and 1995, respectively, and $13.1 million gross and zero net for Caliber One Indemnity Company at December 31, 1997.) Of the total net asbestos reserves, $6.7 million, $6.8 million, and $6.7 million related to established claims reserves at December 31, 1997, 1996, and 1995, respectively, and $41.9 million, $46.5 million, and $16.7 million related to incurred but not reported losses at December 31, 1997, 1996, and 1995, respectively. Of the total net environmental reserves, $11.2 million, $12.5 million, and $10.3 million related to established claims reserves at December 31, 1997, 1996, and 1995, respectively, and $20.5 million, $22.1 million, and $9.8 million related to incurred but not reported losses at December 31, 1997, 1996, and 1995, respectively. All incurred asbestos and environmental losses were for accident years 1986 and prior. Management believes that its reserves for asbestos and environmental claims are appropriately established based upon known facts, existing case law and generally accepted actuarial methodologies. However, due to changing interpretations by courts involving coverage issues, the potential for changes in federal and state standards for clean-up and liability and other factors, the ultimate exposure to the Property and Casualty Group for these claims may vary significantly from the amounts currently recorded, resulting in a potential future adjustment in the claims reserves recorded. Additionally, issues involving policy provisions, allocation of liability among participating insurers, proof of coverage and other factors make quantification of liabilities exceptionally difficult and subject to adjustment based upon newly available data. 39 In 1996, Commercial Lines experienced reserve strengthening of $21.0 million, as compared to a reserve release of $11.6 million in 1995. The reserve strengthening in 1996 was principally due to a re-estimation of loss adjustment costs associated with general liability claims. Through 1991, the Property and Casualty Group's mix of general liability insurance policies was weighted towards the manufacturing classes of business. Subsequent to 1991, the Property and Casualty Group's mix of business became more heavily weighted towards the construction and contracting classes of business. These particular classes of business have experienced losses due to alleged construction defects and similar matters, that have taken longer to emerge than the classes of business previously written by the Property and Casualty Group. Defense costs associated with these claims have also exceeded the original estimate of the Property and Casualty Group's management, which was based on the patterns of indemnification payments associated with the earlier classes of business written. When this issue was discovered, the Property and Casualty Group factored the increased defense costs and the emergence pattern in determining a more appropriate reserve amount for loss handling costs. The release of reserves in 1995 was due primarily to favorable loss experience in commercial automobile business. The 1997 expense ratio declined by 3.3 points as compared to the 1996 expense ratio. The 1997 Acquisition Expense Ratio increased by 3.0 points compared to 1996, primarily due to a 4.2 point increase related to the aforementioned adjustment to accrued retrospective premiums in 1997 ($37.0 million) and by the 1997 cession of premiums associated with the PMA Life Insurance Company transaction ($15.4 million), offset by the write-off in 1996 of $5.0 million in retrospectively rated premiums. These actions reduced earned premiums without a commensurate decrease in acquisition expenses. Such increase was partially offset by ceding commission received by the Property and Casualty Group on its reinsurance arrangement for Commercial Lines casualty losses. Such commissions are recorded as a reduction of acquisition expenses. In 1996, the Acquisition Expense Ratio increased 4.2 points compared to 1995 primarily due to a change in the mix of business to a greater proportion of alternative market products and self-insured services, which have much lower, in any, net premium which caused acquisition expenses to represent a larger proportion of net premiums earned. The 1997 Operating Expense Ratio was 22.6%, a decrease of 6.3 points as compared to 28.9% in 1996. After adjusting for the reduction in accrued retrospective premiums and the PMA Life Insurance Company transaction, the adjusted Operating Expense Ratio would have been 18.1% in 1997. The lower adjusted Operating Expense Ratio is primarily attributable to expense containment programs begun at the Property and Casualty Group, and the higher levels of restructuring charges and valuation adjustments in 1996. Operating expenses in 1997 decreased by $31.0 million as compared to 1996, despite an increase of $1.1 million in expenses associated with the Property and Casualty Group's service revenues. The 1996 Operating Expense Ratio was adversely impacted by several factors, including an accrual of $7.6 million for a voluntary early retirement program ("VERIP"), a $4.8 million charge associated with a change in depreciable lives of computer equipment and a $10.1 million increase in premium balances written off. In 1997, the Property and Casualty Group recorded $5.2 million for severance and related costs associated with the continued restructuring and cost reduction initiatives. These initiatives have lowered payroll and related expenses in 1997 by $4.9 million. The 1996 Operating Expense Ratio increased 13.8 points in comparison to 1995 primarily related to the aforementioned factors that adversely impacted the 1996 ratio. In 1997 and 1996, respectively, the Property and Casualty Group incurred approximately $1.6 million and $1.8 million associated with the Year 2000 Issue. Management anticipates that the Property and Casualty Group will incur approximately $700,000 in 1998 as a result of this conversion; it is expected that this conversion will be completed by the end of 1998 (see "Liquidity and Capital Resources" for further discussion of the Year 2000 Issue). The policyholder dividend ratios were 6.9%, 6.1% and 4.8% for the years ended December 31, 1997, 1996 and 1995, respectively. The policyholder dividend ratio increased by 1.3 points in 1997 as a result of the adjustment to retrospectively rated premiums and the PMA Life Insurance Company transaction. The ratios have generally increased over the three-year period mainly because of sliding-scale dividend plans. 40 Under such plans, the insured receives a dividend based upon the collective loss experience of the plan. As the loss experience for the most recent three underwriting years has improved relative to the years prior to this period, the Property and Casualty Group has incurred higher policyholder dividends. Net Investment Income Net investment income was relatively flat in 1997 as compared to 1996, as lower average investment balances resulting from the pay-down of loss reserves from prior accident years primarily related to the commutation program and decreasing premium volume were offset by higher yields associated with the purchase of high grade corporate bonds and asset-backed securities. Net investment income decreased 10.6% in 1996 as compared to 1995, primarily due to lower average investment balances. Comparison of SAP and GAAP Results The results presented under SAP are those of the domestic insurance subsidiaries of the Property and Casualty Group that share their results through a pooling arrangement (the Pooled Companies). Prior to December 31, 1996, the Pooled Companies were comprised of four domestic insurance companies: Pennsylvania Manufacturers' Association Insurance Company, Manufacturers Alliance Insurance Company, Pennsylvania Manufacturers Indemnity Company and Mid-Atlantic States Casualty Company (MASCCO). As part of a plan to reduce the amount of indemnity reserves from accident years 1991 and prior in the Pooled Companies, MASCCO was removed from the pooling arrangement effective December 31, 1996, and indemnity reserves from accident years 1991 and prior were transferred to MASCCO. The other significant difference relates to various reinsurance agreements between the Pooled Companies and certain foreign insurance subsidiaries. Prior to December 31, 1996, Chestnut Insurance Company, Ltd. (Chestnut) was the reinsurer under these agreements. At December 31, 1996, these reinsurance arrangements were novated, and the assets and liabilities associated with such contracts were sold to PMA Insurance Cayman, Limited (Cayman), a foreign affiliate. At December 31, 1997, the Pooled Companies had reinsurance recoverables from MASCCO and Cayman of $96.2 million and $284.9 million, respectively. In addition to the above and the different accounting treatment of acquisition costs (see "PMA Re Results of Operations" for further discussion of SAP to GAAP differences related to acquisition costs), the GAAP results for the Property and Casualty Group include the results of other entities within the Property and Casualty Group, but excluded from the aforementioned pooling agreement, including PMA Life Insurance Company and other affiliated reinsurers and non-insurance companies utilized in providing certain products and services to the Property and Casualty Group's clients. The exclusion of such entities tends to decrease the SAP combined ratio relative to the GAAP combined ratio. Corporate and Other The Corporate and Other segment is primarily comprised of corporate overhead and the operations of the Company's properties. Corporate and Other operations reported a pre-tax operating loss of $3.4 million in 1997 versus a pre-tax operating loss of $0.5 million in 1996. The decline in the operating results of Corporate and Other operations was due mainly to an incremental $2.2 million increase in operating costs related to certain corporate properties disposed of during the third quarter of 1997. No material gain or loss was recorded in connection with the disposal of such properties. In 1995, management determined that the fair market values of the Company's former headquarters building, which was disposed of in 1997, and certain adjacent properties were less than the carrying values plus the costs to carry and sell the properties. The Company recorded a charge of $8.4 million in 1995 to write down these properties to their fair market values less costs to carry and sell the properties. No such charge was recorded during 1996. During 1997, the Company incurred pre-operating charges of approximately $0.9 million in establishing Caliber One. The Corporate segment also incurred $1.8 million of severance and related restructuring costs in 1997. 41 Net Realized Investment Gains Net realized investment gains amounted to $8.6 million, $3.0 million and $31.9 million in 1997, 1996 and 1995, respectively. During the three-year period ended December 31, 1997, the Company realized gains from investment sales related to the following: (i) transactions to move holdings between taxable and tax-exempt fixed maturity investments in order to maximize after-tax yields; (ii) transactions to expand the asset classes in which the Company invests to capitalize on favorable yield spreads between such instruments and U.S. Treasury securities; (iii) transactions based upon an assessment of the interest rate environment and the shape of the yield curve; and (iv) sales of equity securities, as the Company has substantially reduced its holdings of this asset class over the last three years. Gains and losses on the sale of investments are recognized as a component of net income, but the timing and recognition of such gains and losses are unpredictable and are not indicative of future results. In 1997, the Company repositioned its investment portfolio to improve its pre-tax investment yield, while maintaining the maturity matching structure between investments and liability cash flow projections. As interest rates declined in the latter part of the year, these transactions resulted in a net $8.6 million gain for 1997. During 1996 and 1995, most of the investment sales activity resulted from reducing the Company's holdings of tax-advantaged securities. Based upon an assessment of the Company's position with respect to alternative minimum tax ("AMT"), the Company reduced its tax-advantaged securities positions beginning in late 1995 and throughout 1996. In 1996, these sales resulted in a net loss of $0.9 million, versus 1995 when such transactions resulted in a net gain of $12.1 million. In addition to gains and losses arising from the sales of fixed maturity investments, sales of equity securities generated net realized gains of $3.9 million and $0.9 million in 1996 and 1995, respectively. Interest Expense and Income Taxes Interest expense decreased $1.3 million in 1997, from $17.1 million in 1996 to $15.8 million in 1997 due to the refinancing of the Company's debt with the New Credit Facility. See "Liquidity and Capital Resources" below. In 1996, interest expense decreased to $17.1 million from $18.7 million in 1995. Such reduction related to slightly lower average debt balances in 1996. In addition, principal payments on the Company's higher coupon senior notes (average coupon rate of amounts paid was 9.49%) were funded with drawdowns on the Company's revolving credit facility, which had an average interest rate of 6.08% in 1996. The Company's effective tax rates were 21.5%, (29.3)% and 30.9% in 1997, 1996 and 1995, respectively. The Company recorded a net deferred tax asset of $70.4 million and $101.6 million in 1997 and 1996, respectively (see "Capital Resources" for further discussion). In the normal course of business the Company is examined by various taxing authorities, including the Internal Revenue Service. Federal tax return examinations have been completed for the years 1992 and 1993. The examinations for years 1994 and 1995 are currently in progress. In management's opinion, the ultimate resolution of these matters will not have an adverse impact on the Company's financial position or results of operations. Liquidity and Capital Resources Liquidity Liquidity is a measure of an entity's ability to secure enough cash to meet its contractual obligations and operating needs. At the holding company level, the Company requires cash to pay debt obligations, dividends to shareholders and taxes to the Federal government, as well as to capitalize subsidiaries from time to time. PMC's primary sources of liquidity are dividends from subsidiaries, net tax payments received from subsidiaries and borrowings. The Company paid interest of $19.8 million, $16.6 million and $15.1 million in 1997, 1996 and 1995, respectively. The Company made scheduled debt repayments in 1997, 1996 and 1995 of $7.3 million, $25.1 million and $125.1 million, respectively, and paid dividends to shareholders of $8.0 million in 1997 42 and $7.9 million in 1996 and 1995. PMC also made cash capital contributions to its subsidiaries totaling $11.0 million, $50.0 million and $61.0 million in 1997, 1996 and 1995, respectively. In 1995, PMC also utilized cash to settle intercompany balances with its domestic insurance subsidiaries. Dividends from subsidiaries were $22.5 million, $53.6 million and $103.2 million in 1997, 1996 and 1995, respectively. Net tax cash flows were $20.0 million, $12.0 million and $11.4 million in 1997, 1996 and 1995, respectively. In addition to dividends and tax payments from subsidiaries, the Company utilized the following sources to generate liquidity for the above needs. During the first quarter of 1997, the Company made debt repayments of $8.0 million on the revolving credit agreement before refinancing all of its credit agreements not already maturing in 1997 with the New Credit Facility (See "Capital Resources" below for further discussion). During 1996, the Company financed scheduled repayments on its senior note facilities of $25.0 million through drawdowns on its revolving credit facility. In 1995, the Company repaid its expiring revolving credit agreement by issuing $107.0 million of 7.62% privately placed senior notes. Additionally, in 1995, the Company funded the scheduled debt repayments on its existing senior notes by drawing down $18.0 million on a new $50.0 million revolving credit agreement with a banking syndicate. At December 31, 1997, the Company had $32.0 million available on the New Credit Facility. In addition to the New Credit Facility, the Company maintains a committed facility of $50.0 million for letters of credit (the "Letter of Credit Facility"). The Letter of Credit Facility is utilized primarily for securing reinsurance obligations of the Company's insurance subsidiaries. As of December 31, 1997, the Company had $46.9 million outstanding in letters of credit under the Letter of Credit Facility. The Company's domestic insurance subsidiaries' ability to pay dividends to the holding company is limited by the insurance laws and regulations of Pennsylvania. Under such laws and regulations, dividends may not be paid without prior approval of the Commissioner in excess of the greater of (i) 10% of surplus as regards to policyholders as of the end of the preceding year or (ii) SAP net income for the preceding year, but in no event to exceed unassigned funds. Under this standard, the Pooled Companies and PMA Re can pay an aggregate of $51.2 million of dividends without the prior approval of the Commissioner during 1998. Caliber One Indemnity Company had an unassigned deficit of $6.4 million as of December 31, 1997, and therefore, cannot pay non-extraordinary dividends; also, Caliber One Indemnity Company is directly owned by PMA Re, and as such, its dividends may not be paid directly to PMC. Under its plan of operation filed with the Pennsylvania Insurance Department, MASCCO must maintain a ratio of unpaid losses and loss adjustment expenses to surplus of no more than eight to one; as of December 31, 1997, MASCCO was in compliance with such requirement. In addition, the New Credit Facility requires the Company's insurance subsidiaries to maintain combined statutory capital and surplus of $450.0 million. At December 31, 1997, the Company's insurance subsidiaries had combined statutory capital and surplus of $552.2 million. Additionally, the New Credit Facility requires the domestic insurance subsidiaries of the Property and Casualty Group to maintain an adjusted surplus to authorized control level ratio (as calculated under risk based capital rules) of not less than 220% as of December 31, 1997, 230% as of December 31, 1998, and 240% as of December 31, 1999, and thereafter, and requires PMA Re to maintain such ratio at 300%. At December 31, 1997, the ratios of the domestic insurance subsidiaries of the Property and Casualty Group ranged from 293% to 324%, PMA Re's ratio was 355% and Caliber One Indemnity Company's ratio was 1,922%. In December 1997, PMA Re acquired 100% of the outstanding common stock of Caliber One Indemnity Company (formerly known as Lincoln Insurance Company) for approximately $16.0 million and made a capital contribution of $11.3 million to Caliber One Indemnity Company. In conjunction with this purchase, all of Caliber One Indemnity Company's acquired loss reserves were reinsured by an affiliate of Caliber One Indemnity Company's former parent for adverse development and uncollectible reinsurance in the amount of the stated reserves plus $68.5 million (see Note 1 to the Consolidated Financial Statements). Management believes that the reinsurance obtained as part of the purchase will be adequate 43 to cover any future reserve development or uncollectible reinsurance on the acquired reserves. PMA Re intends to maintain Caliber One Indemnity Company's surplus at not less than $25.0 million, the minimum capital and surplus required by many states in order to be an eligible surplus lines carrier. PMC's dividends to shareholders are restricted by its debt agreements. Based upon the terms of the New Credit Facility, on a pro forma basis, under the most restrictive debt covenant, PMC would be able to pay dividends of approximately $14.5 million in 1998 (See "Capital Resources" for further discussion). Management believes that the Company's sources of funds will provide sufficient liquidity to meet short-term and long-term obligations. Investments The Company's investment policy objectives are to (i) seek competitive after-tax income and total return, (ii) maintain very high grade asset quality and marketability, (iii) maintain maturity distribution commensurate with the Company's business objectives, (iv) provide portfolio flexibility for changing business and investment climates and (v) provide liquidity to meet operating objectives. The Company has established strategies, asset quality standards, asset allocations and other relevant criteria for its fixed maturity and equity portfolios. In addition, maturities are structured after projecting liability cash flows with actuarial models. The Company also does not invest in various types of investments, including speculative derivatives. The Company's portfolio does not contain any significant concentrations in single issuers (other than U.S. treasury and agency obligations), industry segments or geographic regions. The Company's Board of Directors is responsible for the Company's investment policy objectives. The Company retains outside investment advisers to provide investment advice and guidance, supervise the Company's portfolio and arrange securities transactions through brokers and dealers. The Company's Executive and Finance Committees of the Board of Directors meet periodically with the investment advisers to review the performance of the investment portfolio and to determine what actions should be taken with respect to the Company's investments. Investments by the Pooled Companies, MASCCO and PMA Re must comply with the insurance laws and regulations of the Commonwealth of Pennsylvania and investments for Caliber One Indemnity Company must comply with the insurance laws and regulations of Delaware. The Company's capital not allocated to the Pooled Companies, MASCCO, PMA Re and Caliber One Indemnity Company may be invested in securities and other investments that are not subject to such insurance laws, but nonetheless conform to the Company's investment policy. The following table summarizes the Company's investments by carrying value as of December 31, 1997, and 1996: (dollar amounts in millions) 1997 1996 ---- ---- Carrying Carrying Investment Value Percent Value Percent - ---------- ----- ------- ----- ------- U.S. Treasury securities and obligations of U.S. Government agencies ........................ $1,119.5 51.0% $1,602.8 70.8% Obligations of states and political subdivisions ................... -- -- 76.5 3.4% Corporate debt securities ............ 687.7 31.3% 372.8 16.5% Mortgage backed securities ........... 122.3 5.6% 74.0 3.3% Equity securities .................... -- -- 0.3 -- Short-term investments ............... 265.2 12.1% 135.0 6.0% -------- ------ -------- ------ Total (1) ............................ $2,194.7 100.0% $2,261.4 100.0% ======== ====== ======== ====== (1) As of December 31, 1997, the market value of the Company's total investments was $2,194.7 million. The following table indicates the composition of the Company's fixed maturities portfolio at carrying value, excluding short-term investments, by rating as of December 31, 1997, and 1996: 44 (dollar amounts in millions) 1997 1996 ---- ---- Carrying Carrying Ratings (1) Value Percent Value Percent - ----------- ----- ------- ----- ------- U.S. Treasury securities and AAA.... $1,449.0 75.1% $1,882.4 88.5% AA.................................. 150.0 7.8% 95.8 4.5% A................................... 282.2 14.6% 147.9 7.0% BBB................................. 48.3 2.5% -- -- ------- ------ ------- ------ Total............................... $1,929.5 100.0% $2,126.1 100.0% ======== ====== ======== ====== (1) Ratings as assigned by Standard and Poor's. Such ratings are generally assigned at the issuance of the securities, subject to revision on the basis of ongoing evaluations. Ratings in the table are as of December 31 of the years indicated. The following table sets forth scheduled maturities for the Company's investments in fixed maturities, excluding short-term investments, based on stated maturity dates as of December 31, 1997. Expected maturities will differ from contractual maturities because the issuers may have the right to call or prepay obligations with or without call or prepayment penalties: (dollar amounts in millions) Carrying Value Percent -------------- ------- 1 year or less............................. $ 128.9 6.7% Over 1 year through 5 years................ 633.6 32.8% Over 5 years through 10 years.............. 396.5 20.6% Over 10 years.............................. 648.2 33.6% Mortgage-backed securities................. 122.3 6.3% ----- ---- Total...................................... $1,929.5 100.0% ======== ====== The following table reflects the Company's investment results for each year in the three-year period ended December 31, 1997: (dollar amounts in millions) 1997 1996 1995 ---- ---- ---- Average invested assets (1).......... $2,247.7 $2,366.8 $2,395.8 Net investment income (2)............ $ 136.7 $ 133.9 $ 139.4 Net effective yield (3).............. 6.09% 5.66% 5.82% Net realized investment gains........ $ 8.6 $ 3.0 $ 31.9 (1) Average of beginning and ending amounts of cash and investments for the period at carrying value. (2) After investment expenses, excluding net realized investment gains. (3) Net investment income for the period divided by average invested assets for the same period. As of December 31, 1997, the duration of the Company's investments was approximately 5.3 years and the duration of its liabilities was approximately 5.1 years. During 1997, the Company established a securities lending program through which securities are loaned from the Company's portfolio to qualifying third parties, subject to certain limits, via a lending agent for short periods of time. Borrowers of these securities must provide collateral equal to a minimum of 102% of the market value and accrued interest of the loaned securities. Acceptable collateral may be in the form of either cash or securities. Cash received as collateral is invested in short-term investments, and all securities received as collateral are of similar quality to those securities lent by the Company. Additionally, the Company limits securities lending to 40% of statutory admitted assets of its insurance subsidiaries, with a 2% limit on statutory admitted assets to any individual borrower. The Company receives either a fee from the borrower or retains a portion of the income earned on the collateral. Under the terms of the securities lending program, the Company is indemnified against borrower default, with the lending agent responsible to the Company for any deficiency between the cost of replacing a security that was not returned and the amount of collateral held by the Company. In 1997, the Company recognized income from securities lending transactions of approximately $524,000, net of lending fees, 45 which was included in investment income. The Company had approximately $175.0 million of securities on loan as of December 31, 1997. Capital Resources The Company's total assets decreased to $3,057.3 million at December 31, 1997 from $3,117.5 million at December 31, 1996. Total investments decreased $66.6 million to $2,194.7 million at December 31, 1997. The decrease in investments is primarily attributable to the Property and Casualty Group's pay-down of loss reserves from prior accident years as part of the formal commutation program which was initiated in the fourth quarter 1996 and continued into late 1997. All other assets increased $6.4 million in 1997, mainly due to increases in reinsurance recoverables of $74.4 million and cash of $25.0 million. The reinsurance recoverables increase primarily relates to the purchase of Caliber One Indemnity Company during 1997 (see Note 1 to the Consolidated Financial Statements) and the PMA Life Insurance Company transaction (see "The Property and Casualty Group Results of Operations"), which included approximately $32.7 million and $15.4 million, respectively, of ceded loss reserves. The increase in cash relates to investment security purchases which did not settle until January 1, 1998, causing a large cash balance at year-end. The above asset increases were partially offset by a $33.6 million decrease in uncollected premiums primarily related to the reduction in accrued retrospective premiums by the Property and Casualty Group (see "The Property and Casualty Group Results of Operations"), a $31.2 million decrease in deferred income taxes (see below) and a $12.2 million decrease in fixed assets primarily related to the disposal of certain corporate properties during the third quarter of 1997. No material gain or loss was recorded in connection with the disposal of such properties. The Company's deferred income tax asset decreased to $70.4 million at December 31, 1997 from $101.6 million at December 31, 1996. The $31.2 million decrease from 1996 to 1997 resulted primarily from the $23.5 million charge related to the fair value of Company's investments that is recorded as a component of the deferred tax asset. The net deferred tax asset of $70.4 million reflects management's estimate of the amounts that the Company expects to recover in future years primarily through the utilization of net operating losses and AMT credit carryforwards. Under SFAS No. 109, a valuation allowance should be provided to offset the effects of a deferred tax asset if management believes that it is more likely than not that the benefit of a deferred tax item will not be realized. Management believes that the benefit of its deferred tax asset will be fully realized, and therefore has not provided for a valuation allowance. At December 31, 1997, the Company had approximately $109.6 million of net operating carryforwards (expiring in 2011), approximately $7.5 million of AMT credit carryforwards (which do not expire) and approximately $188,000 of general business credit carryforwards (expiring in 2010 and 2011). Unpaid losses and loss adjustment expenses decreased $87.9 million to $2,003.2 million at December 31, 1997. This decrease reflects the Property and Casualty Group's pay-down of loss reserves from prior accident years as part of the formal commutation program which was initiated in the fourth quarter 1996 and continued into late 1997, partially offset by loss reserves acquired in connection with the purchase of Caliber One Indemnity Company (see Note 1 to the Consolidated Financial Statements). Estimating future claims costs is necessarily a complex and judgmental process inasmuch as reserve amounts are based on management's informed estimates and judgments using data currently available. As such, management reviews a variety of information, and uses a number of actuarial methods applied to historical claims data, which often produces a range of possible results. As additional experience and other data are reviewed, these estimates and judgments are revised, at which point reserves may be increased or decreased accordingly. Such increases or decreases are reflected in operating results for the time period in which the adjustments are made. While the estimate for unpaid losses and loss adjustment expenses is subject to many uncertainties, management believes that it has made adequate provision for its claims liabilities. However, if actual losses exceed the amounts recorded in the financial statement, the Company's financial condition and results of operations could be adversely affected. At December 31, 1997, the Company's loss reserves were stated net of $59.9 million of salvage and subrogation. $50.8 million of salvage and subrogation related to the Property and Casualty Group, $46.0 46 million of which related to workers' compensation and $4.8 million related to Commercial Lines. The anticipated salvage and subrogation was $9.1 million for PMA Re. Incurred salvage and subrogation (increased) reduced losses and LAE by ($18.5) million, ($0.6) million and $9.5 million in 1997, 1996 and 1995, respectively. The Company's policy with respect to estimating the amounts and realizability of salvage and subrogation is to develop accident year schedules of historic paid salvage and subrogation by line of business, which are then projected to an ultimate basis using actuarial projection techniques. The anticipated salvage and subrogation is the estimated ultimate salvage and subrogation less any amounts received by the Company. The realizability of anticipated salvage and subrogation is reflected in the historical data that is used to complete the projection, as historic paid data implicitly considers realization and collectibility. The Company actively manages its exposure to catastrophic events. In the underwriting process, the Company generally avoids the accumulation of insurable values in catastrophe prone regions. Also, in writing property reinsurance coverages, PMA Re typically requires per occurrence loss limitations for contracts that could have catastrophe exposure. Through per risk reinsurance, the Company also manages its net retention in each exposure. In addition, PMA Re maintains retrocessional protection of $46.0 million excess of $2.0 million per occurrence, and the Property and Casualty Group maintains catastrophe reinsurance protection of $27.7 million excess of $850,000. As a result, the Company's loss ratios have not been significantly impacted by catastrophes, and management believes that the Company has adequate reinsurance to protect against the estimated probable maximum gross loss from a catastrophic event; however, though management believes it is unlikely, an especially severe catastrophic event could exceed the Company's reinsurance and/or retrocessional protection, and adversely impact the Company's financial position, perhaps materially. The Company also maintains reinsurance and retrocessional protection for other lines of business at December 31, 1997, as follows: Retention Limits --------- ------ The Property and Casualty Group: Per Occurrence: Workers' compensation...... $ 1.5 million $ 103.5 million Per Risk: Property lines............. $ 0.5 million (1) $ 19.5 million Auto physical damage....... $ 0.5 million $ 2.0 million Other casualty lines....... $ 0.2 million (2) $ 4.8 million PMA Re: Per Occurrence: Casualty lines............. $ 2.8 million $ 12.5 million Workers' compensation...... $ 2.0 million $ 53.0 million Property lines............. $ 2.0 million $ 46.0 million Per Risk: Property lines............. $ 0.8 million $ 4.2 million Casualty lines............. $ 1.5 million $ 6.0 million (1) This coverage also provides protection of $48.5 million per occurrence over its combined net retention of $0.5 million. (2) This coverage also provides protection of $49.8 million per occurrence over its combined net retention of $0.2 million. Also, PMA Re maintains aggregate protection up to $22.3 million in excess of $178.0 million for the current accident year. Effective January 1, 1998, PMA Re added a new workers' compensation program which includes coverage of $98.0 million excess of $2.0 million per occurrence, $98.5 million excess of $1.5 million per program per occurrence and $18.5 million excess of $1.5 million per person per occurrence. The Company performs extensive credit reviews on its reinsurers, focusing on, among other things, financial capacity, stability, trends, and commitment to the reinsurance business. Prospective and existing 47 reinsurers failing to meet the Company's standards are excluded from the Company's reinsurance programs. In addition, the Company requires letters of credit to support balances due from reinsurers not authorized to transact business in the applicable jurisdictions. At December 31, 1997, the Company had reinsurance recoverables due from the following unaffiliated single reinsurers in excess of 3% of shareholders' equity: Gross amount due to the Company A.M. Best Reinsurer (in thousands) Rating - --------- -------------- ------ United States Fidelity and Guaranty Company....... $ 74,041 A Essex Insurance Company........................... $ 36,807 A American Re-Insurance Corporation................. $ 35,411 A+ Kemper Reinsurance Corporation.................... $ 21,853 A London Life International Reinsurance Corporation. $ 16,212 A+ Continental Casualty Company...................... $ 15,209 A The Company maintained funds held to collateralize the above balances in the amount of $66.2 million at December 31, 1997. The Company believes that it would have the right to offset the funds withheld from a reinsurer against the balances due from such reinsurer in the event of insolvency. Funds held under reinsurance treaties decreased $17.3 million in 1997, primarily due to the commutation of a prior underwriting year for one of the reinsurance covers at the Property and Casualty Group as well as one of the retrocessional covers at PMA Re, partially offset by retrocessional activity at PMA Re for the current underwriting year. Long-term debt remained essentially constant between 1997 and 1996. As noted previously, management refinanced its existing credit agreements on March 14, 1997 under the New Credit Facility, replacing the following debt which was outstanding at that time: (dollar amounts in thousands) Senior notes 9.60%, due 2001.................... $ 46,428 Senior notes 7.62%, due 2001, Series A.......... 71,000 Senior notes 7.62%, due 2000, Series B.......... 36,000 Revolving credit agreement, expiring in 1998.... 36,000 -------- Total........................................... $189,428 -------- The early extinguishment of the senior note agreements resulted in an extraordinary loss of $4.7 million ($7.3 million pre-tax) which was recorded in the first quarter of 1997. The New Credit Facility bears interest at LIBOR plus 0.70% on the utilized portion, and carries a 0.275% facility fee on the unutilized portion. The margin over LIBOR is adjustable downward based upon future reductions in the Company's debt to capitalization ratio. As of December 31, 1997, the interest rate on the New Credit Facility was 6.61% on the utilized portion. The final expiration of the New Credit Facility will be December 31, 2002, maturing in an installment of $15.5 million in 1999 and annual installments of $62.5 million commencing in 2000 through 2002. Management also entered into an interest rate swap agreement which manages the impact of the potential volatility of the interest rate associated with the floating rates on the New Credit Facility. The interest rate swap covers a notional principal amount of $150.0 million and effectively converts the floating rate on such portion of the New Credit Facility to a fixed 7.24%. Other liabilities, including taxes, licenses and fees, decreased $9.1 million in 1997 to $81.5 million compared to 1996 primarily due to lower operating expenses at the Property and Casualty Group during 1997. Consolidated shareholders' equity at December 31, 1997, totaled $478.3 million or $19.96 per share compared to $425.8 million or $17.86 per share at December 31, 1996. As a result of changes in market 48 interest rates, the unrealized appreciation of investments, net of tax, was $18.8 million at December 31, 1997, compared to an unrealized depreciation of investments, net of tax, of $24.9 million at December 31, 1996, resulting in an increase in shareholders' equity of $43.7 million or $1.82 per share. Consolidated shareholders' equity decreased to $425.8 million or $17.86 per share at December 31, 1996, from $609.7 million or $25.53 per share at December 31, 1995. This decrease was due primarily to the net loss of $135.3 million in 1996, a decrease in shareholders' equity of $42.4 million, net of tax, or $1.78 per share, related to unrealized depreciation of investments and dividends declared of $7.9 million. At December 31, 1997, the Company's capital structure consisted of $203.0 million of long-term debt and $478.3 million of shareholders' equity. The Company utilizes long-term debt in its capital structure to fund internal expansion through capital contributions to subsidiaries, to pursue investment opportunities, and to refinance existing debt. Due to the inherent risks associated with the insurance industry, management strives to maintain a relatively conservative capital structure. Management believes that a certain amount of debt is necessary in order to enhance returns on shareholders' equity; however, the level of debt must be appropriate in terms of the availability of dividends from subsidiaries, operating income, and the overall capital structure. In determining the appropriate level of long-term debt, management focuses on the following statistics: statutory dividends to interest expense, earnings (loss) before interest and taxes to interest expense, pre-tax operating income (loss) before interest to interest expenses, and debt to capitalization ratio. The following table indicates the Company's status with respect to these statistics: 1997 1996 1995 ---- ---- ---- Statutory dividends to interest expense (times)... 1.4 3.1 3.8 Earnings (loss) before interest and taxes to interest expense (times)........................ 2.6 (10.2) 2.9 Pre-tax operating income (loss) before interest to interest expense (times)..................... 2.0 (10.4) 1.2 Debt to total capitalization (excluding SFAS No. 115 adjustment)............................. 30.6% 31.2% 25.6% Presently, management believes that the existing capital structure is appropriate for the Company. However, management continually monitors the capital structure in light of developments in the business, and the present assessment could change as management becomes aware of new opportunities and challenges in the Company's business. Year 2000 Issue The unprecedented advances in computer technology over the past several decades have resulted in dramatic changes in the way companies do business. Most of these developments have been beneficial, but some have proven costly, as businesses have struggled to adapt to various features of the new technological landscape. One such well-publicized problem has arisen out of the worldwide use of the so-called "Year 2000" programming convention, in which two digit numbers were generally used instead of four digit numbers to identify the years used in dates. As a consequence, most computers require relatively costly reprogramming to enable them to correctly perform date operations involving years 2000 or later, a problem anticipated to have substantial repercussions on the business world, since computer operations involving date calculations are pervasive. With the assistance of outside consulting groups, the Company began evaluating and reprogramming its own computer systems to address the Year 2000 problem in late 1995. Management anticipates that by year-end 1998, it will have substantially completed all necessary programming work so that Year 2000 issues are not likely to result in any material adverse disruptions in the Company's computer systems or its internal business operations. The cost of this work through year-end 1997 has been approximately $3.8 million. The Company estimates that the total remaining cost will be approximately $1.3 million, which will be expensed in 1998. 49 Many experts now believe that Year 2000 problem may have a material adverse impact on the national and global economy generally. In addition, it seems likely that if businesses are materially damaged as a result of Year 2000 problems, at least some such businesses may attempt to recoup their losses by claiming coverage under various types of insurance policies. Although management has concluded that under a fair reading of the various policies of insurance issued by it no coverage for Year 2000 problems should be considered to exist, it is not possible to predict whether or to what extent any such coverage could ultimately be found to exist by courts in various jurisdictions. Accordingly, important factors which could cause actual results to differ materially from those expressed in the forward looking statements include, but are not limited to, the inability of the Company to accurately estimate the impact of the Year 2000 problem on the insurance issued by or other business operations of the Company. Regulation The National Association of Insurance Commissioners (NAIC) has adopted risk-based capital ("RBC") requirements for property/casualty insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks such as underwriting, asset quality, loss reserve adequacy and other business factors. Under RBC requirements, regulatory compliance is determined by the ratio of a Company's total adjusted capital, as defined by the NAIC, to its authorized control level, also as defined by the NAIC. Companies below prescribed trigger points in terms of such ratio are classified as follows: Company action level 200% Regulatory action level 150% Authorized control level 100% Mandatory control level 70% At December 31, 1997, the ratios of the domestic insurance subsidiaries of the Property and Casualty Group ranged from 293% to 324%, PMA Re's ratio was 355% and Caliber One Indemnity Company's ratio was 1,922%. RBC requirements for property/casualty insurance companies allow a discount for workers' compensation reserves to be included in the adjusted surplus calculation. However, the calculation for RBC requires the phase-out of non-tabular reserve discounts previously taken for workers' compensation reserves. The discount phase-out has increased by 20% in each year since 1994, ultimately phasing out 100% of such discount by December 1998. As a result, this phase-out negatively impacts the RBC ratios of companies which write workers' compensation insurance and discount such reserves on a non-tabular basis relative to companies which write other types of property/casualty insurance. Management believes that it will be able to maintain the Pooled Companies' RBC in excess of regulatory requirements through prudent underwriting and claims handling, investing and capital management. However, no assurances can be given that developments affecting the Property and Casualty Group will not occur, many of which could be outside of management's control, including but not limited to changes in the regulatory environment, economic conditions and competitive conditions in the jurisdictions in which the Property and Casualty Group writes business, which will cause the Pooled Companies' RBC to fall below required levels resulting in a corresponding regulatory response. In addition, the NAIC has developed a series of twelve ratios (the "IRIS ratios") designed to further assist regulators in assessing the financial condition of insurers. These ratio results are computed annually and reported to the NAIC and the insurer's state of domicile. In 1997, two of the three Pooled Companies reported unusual values in three ratios, and the remaining Pooled Company reported unusual values in two ratios, relating to reserve development, directly as a result of the reserve strengthening that occurred in 1996. In addition, Caliber One Indemnity Company reported an unusual value in one ratio relating to the change in surplus as a result of the $11.3 million capital contribution from PMA Re in 1997 (see Note 1 to the Consolidated Financial Statements for further discussion). In 1996, each of the Pooled Companies reported unusual values in three ratios relating to reserve development and two ratios, all of 50 which related to historical profitability, directly as a result of the reserve strengthening and asset valuations that occurred in 1996. MASCCO reported unusual values in three historical profitability ratios, directly as a result of a large intercompany reinsurance transaction that occurred at year end 1996. New Accounting Pronouncements In June 1996, the Financial Accounting Standards Board ("FASB") issued SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." SFAS No. 125, which is effective for transfers and extinguishments occurring after December 31, 1996, provides consistent standards for distinguishing transfers of financial assets that are sales from transfers that are secured borrowings. The Property and Casualty Group's domestic insurance subsidiaries currently participate in a transfer arrangement of certain accounts receivable. Such arrangement has been restructured as a result of the adoption of SFAS No. 125. The restructuring of such arrangement did not have a material impact on the Company's financial condition or results of operations. In February 1997, the FASB issued SFAS No. 128, "Earnings Per Share," which supersedes Accounting Principles Board Opinion No. 15, "Earnings Per Share" and related interpretations. SFAS No. 128, which is effective for financial statements for both interim and annual periods ending after December 15, 1997, requires presentation of earnings per share by all entities that have issued common stock or potential common stock if those securities trade in a public market either on a stock exchange or in the over-the-counter market, including securities quoted only locally or regionally. SFAS No. 128 establishes a new calculation for earnings per share showing both basic and diluted earnings per share. As a result, basic earnings per share was calculated using only weighted average shares outstanding with no dilutive impact from common stock equivalents while diluted earnings per share was calculated similar to the current fully diluted earnings per share calculation. All prior period earnings per share amounts were restated to be consistent with the new requirements. During 1997, the FASB issued SFAS No. 130, "Comprehensive Income," which establishes standards for the reporting and disclosure of comprehensive income and its components (revenues, expenses, gains and losses). SFAS No. 130 requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. In addition, the FASB issued SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information," which establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and interim financial reports issued to shareholders. SFAS No. 131 also establishes standards for related disclosures about products and services, geographic areas and major customers. The Company will adopt the provisions of these pronouncements in 1998. The adoption of these pronouncements will not have an impact on the Company's financial position and results of operations, but may change the presentation of certain of the Company's financial statements and related notes and data thereto. Forward-Looking Statements This Management's Discussion and Analysis and other statements made throughout this report contain forward-looking statements that involve risks and uncertainties. The Company's actual results could differ materially from those expected by the Company. The factors that could cause actual results to vary materially, some of which are described with the forward-looking statements, include, but are not limited to, the following: changes in general economic conditions, including the performance of financial markets and interest rates; regulatory or tax changes, including changes in risk-based capital or other regulatory standards that affect the ability of the Company to conduct its business; competitive or regulatory changes that affect the cost of or demand for the Company's products; the effect of changes in workers' compensation statutes and the administration thereof; the Company's ability to predict and effectively manage claims related to insurance and reinsurance policies; reliance on key management; adequacy of claim liabilities; adequacy and collectibility of reinsurance purchased by the Company; and natural disasters. Investors should not place undue reliance on any such forward-looking statements. 51 PENNSYLVANIA MANUFACTURERS CORPORATION CONSOLIDATED BALANCE SHEETS
December 31, December 31, (in thousands, except share data) 1997 1996 - ------------------------------------------------------------------------------------------------------------------------------ Assets Investments: Fixed maturities available for sale, at fair value (amortized cost: 1997-$1,900,594; 1996-$2,164,391) $ 1,929,518 $ 2,126,120 Equity securities, at fair value (cost: 1997-$5; 1996-$259) 13 262 Short-term investments, at amortized cost which approximates fair value 265,207 134,971 ----------------------------------- Total investments 2,194,738 2,261,353 Cash 32,148 7,176 Investment income due and accrued 23,818 30,268 Uncollected premiums (net of allowance for uncollectible accounts: 1997-$18,406; 1996-$18,877) 252,425 285,982 Reinsurance receivables (net of allowance for uncollectible reinsurance: 1997-$2,096; 1996-$3,901) 332,406 257,983 Property and equipment (net of accumulated depreciation: 1997-$42,771; 1996-$41,219) 38,621 50,861 Deferred income taxes, net 70,391 101,642 Deferred acquisition costs 45,288 44,006 Other assets 67,423 78,245 ----------------------------------- Total assets $ 3,057,258 $ 3,117,516 =================================== Liabilities Unpaid losses and loss adjustment expenses $ 2,003,187 $ 2,091,072 Unearned premiums 211,455 205,982 Long-term debt 203,000 204,699 Dividends to policyholders 10,200 12,524 Funds held under reinsurance treaties 69,545 86,804 Taxes, licenses and fees, and other expenses 49,410 39,226 Other liabilities 32,114 51,381 ----------------------------------- Total liabilities 2,578,911 2,691,688 =================================== Commitments and contingencies (Note 13) Shareholders' Equity Common stock, $5 par value (40,000,000 shares authorized; 15,286,263 shares issued and 14,850,789 outstanding - 1997; 16,095,416 shares issued and 15,670,052 outstanding - 1996) 76,431 80,477 Class A common stock, $5 par value (40,000,000 shares authorized; 9,156,682 shares issued and 9,117,735 outstanding - 1997; 8,247,804 shares issued and 8,173,023 outstanding - 1996) 45,783 41,239 Additional paid-in capital - Class A common stock 339 - Retained earnings 343,368 336,921 Unrealized gain (loss) on investments (net of deferred income taxes: 1997-$(10,126); 1996-$13,394) 18,806 (24,874) Notes receivable from officers (198) (1,162) Treasury stock, at cost: Common stock (1997-435,474 shares; 1996-425,364 shares) (5,572) (5,408) Class A common stock (1997-38,947 shares; 1996-74,781 shares) (610) (1,365) ----------------------------------- Total shareholders' equity 478,347 425,828 ----------------------------------- Total liabilities and shareholders' equity $ 3,057,258 $ 3,117,516 ===================================
See accompanying notes to the consolidated financial statements. 52 PENNSYLVANIA MANUFACTURERS CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS
for the years ended December 31, (in thousands, except per share data) 1997 1996 1995 - ----------------------------------------------------------------------------------------------------------------------- Revenues: Net premiums written $ 418,282 $ 443,475 $ 489,876 Change in net unearned premiums (5,331) (12,400) (924) Change in accrued retrospective premiums (37,000) (10,500) (4,000) ------------------------------------------- Net premiums earned 375,951 420,575 484,952 Net investment income 136,698 133,936 139,355 Net realized investment gains 8,598 2,984 31,923 Service revenues 10,311 9,189 5,106 ------------------------------------------- Total revenues 531,558 566,684 661,336 ------------------------------------------- Losses and Expenses: Losses and loss adjustment expenses (includes $(35,000) effect of the change in discount rate on the Property and Casualty Group's workers' compensation unpaid losses from 4% to 5% in 1995) 307,281 536,623 422,578 Amortization of deferred acquisition costs 93,501 90,292 87,207 Operating expenses 75,139 97,856 81,161 Dividends to policyholders 14,716 16,255 16,743 Interest expense 15,768 17,052 18,734 ------------------------------------------- Total losses and expenses 506,405 758,078 626,423 ------------------------------------------- Income (loss) before income taxes and extraordinary item 25,153 (191,394) 34,913 ------------------------------------------- Provision (benefit) for income taxes: Current (4,506) (44,572) (4,570) Deferred 9,906 (11,488) 15,353 ------------------------------------------- Total 5,400 (56,060) 10,783 ------------------------------------------- Income (loss) before extraordinary item 19,753 (135,334) 24,130 Extraordinary loss from early extinguishment of debt (net of income tax benefit of $2,549) (4,734) - - ------------------------------------------- Net income (loss) $ 15,019 $(135,334) $ 24,130 ------------------------------------------- Earnings (loss) per common and equivalent share Basic: Earnings (loss) before extraordinary item $ 0.83 $ (5.68) $ 1.01 Extraordinary item (0.20) - - ------------------------------------------- Net earnings (loss) $ 0.63 $ (5.68) $ 1.01 ------------------------------------------- Diluted: Earnings (loss) before extraordinary item $ 0.80 $ (5.68) $ 0.97 Extraordinary item (0.19) - - ------------------------------------------- Net earnings (loss) $ 0.61 $ (5.68) $ 0.97 -------------------------------------------
See accompanying notes to the consolidated financial statements. 53 PENNSYLVANIA MANUFACTURERS CORPORATION CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Additional Common Stock Class A Common Stock paid-in capital --------------------------------------------- Class A (in thousands, except share and per share data) Shares Amounts Shares Amounts Common Stock - ---------------------------------------------------------------------------------------------------------------------------------- Balance-January 1, 1995 17,606,850 $ 88,034 6,736,370 $ 33,682 $ - Net income Common stock dividends declared ($.32 per share) Class A common stock dividends declared ($.36 per share) Conversion of common stock into Class A common stock (562,270) (2,811) 562,270 2,811 Unrealized gain on investments available for sale (net of tax effect of $(36,063)) Repayment of notes Purchase of treasury shares, net Effect of other treasury stock transactions - ---------------------------------------------------------------------------------------------------------------------------------- Balance-December 31, 1995 17,044,580 85,223 7,298,640 36,493 - Net loss Common stock dividends declared ($.32 per share) Class A common stock dividends declared ($.36 per share) Conversion of common stock into Class A common stock (949,164) (4,746) 949,164 4,746 Unrealized loss on investments available for sale (net of tax effect of $22,823) Repayment of notes Purchase of treasury shares, net - ---------------------------------------------------------------------------------------------------------------------------------- Balance-December 31, 1996 16,095,416 80,477 8,247,804 41,239 - Net income Common stock dividends declared ($.32 per share) Class A common stock dividends declared ($.36 per share) Conversion of common stock into Class A common stock (809,153) (4,046) 809,153 4,046 Class A common stock issued under stock option plans and other issuances of Class A common stock 99,725 498 339 Unrealized gain on investments available for sale (net of tax effect of $(23,520)) Repayment of notes (Purchase) reissuance of treasury shares, net - ---------------------------------------------------------------------------------------------------------------------------------- Balance-December 31, 1997 15,286,263 $ 76,431 9,156,682 $ 45,783 $ 339 ==================================================================================================================================
See accompanying notes to the consolidated financial statements. 54
Unrealized Retained gain (loss) on Notes receivable (in thousands, except share and per share data) earnings investments from officers - ----------------------------------------------------------------------------------------------------------------------------- Balance-January 1, 1995 $ 463,952 $ (49,465) $ (4,374) Net income 24,130 Common stock dividends declared ($.32 per share) (5,396) Class A common stock dividends declared ($.36 per share) (2,505) Conversion of common stock into Class A common stock Unrealized gain on investments available for sale (net of tax effect of $(36,063)) 66,976 Repayment of notes 478 Purchase of treasury shares, net Effect of other treasury stock transactions - ----------------------------------------------------------------------------------------------------------------------------- Balance-December 31, 1995 480,181 17,511 (3,896) Net loss (135,334) Common stock dividends declared ($.32 per share) (5,138) Class A common stock dividends declared ($.36 per share) (2,788) Conversion of common stock into Class A common stock Unrealized loss on investments available for sale (net of tax effect of $22,823) (42,385) Repayment of notes 2,734 Purchase of treasury shares, net - ----------------------------------------------------------------------------------------------------------------------------- Balance-December 31, 1996 336,921 (24,874) (1,162) Net income 15,019 Common stock dividends declared ($.32 per share) (4,842) Class A common stock dividends declared ($.36 per share) (3,147) Conversion of common stock into Class A common stock Class A common stock issued under stock option plans and other issuances of Class A common stock Unrealized gain on investments available for sale (net of tax effect of $(23,520)) 43,680 Repayment of notes 964 (Purchase) reissuance of treasury shares, net (583) - ----------------------------------------------------------------------------------------------------------------------------- Balance-December 31, 1997 $ 343,368 $ 18,806 $ (198) ============================================================================================================================= Treasury stock, at cost ---------------------------------------------- Common Stock Class A Common Stock ---------------------------------------------- (in thousands, except share and per share data) Shares Amounts Shares Amounts Total - ---------------------------------------------------------------------------------------------------------------------------------- Balance-January 1, 1995 388,514 $ (4,706) 200,498 $ (2,261) $ 524,862 Net income 24,130 Common stock dividends declared ($.32 per share) (5,396) Class A common stock dividends declared ($.36 per share) (2,505) Conversion of common stock into Class A common stock - Unrealized gain on investments available for sale (net of tax effect of $(36,063)) 66,976 Repayment of notes 478 Purchase of treasury shares, net 4,050 (63) 150,442 (2,355) (2,418) Effect of other treasury stock transactions (277,532) 3,541 3,541 - ---------------------------------------------------------------------------------------------------------------------------------- Balance-December 31, 1995 392,564 (4,769) 73,408 (1,075) 609,668 Net loss (135,334) Common stock dividends declared ($.32 per share) (5,138) Class A common stock dividends declared ($.36 per share) (2,788) Conversion of common stock into Class A common stock - Unrealized loss on investments available for sale (net of tax effect of $22,823) (42,385) Repayment of notes 2,734 Purchase of treasury shares, net 32,800 (639) 1,373 (290) (929) - ---------------------------------------------------------------------------------------------------------------------------------- Balance-December 31, 1996 425,364 (5,408) 74,781 (1,365) 425,828 Net income 15,019 Common stock dividends declared ($.32 per share) (4,842) Class A common stock dividends declared ($.36 per share) (3,147) Conversion of common stock into Class A common stock - Class A common stock issued under stock option plans and other issuances of Class A common stock 837 Unrealized gain on investments available for sale (net of tax effect of $(23,520)) 43,680 Repayment of notes 964 (Purchase) reissuance of treasury shares, net 10,110 (164) (35,834) 755 8 - ---------------------------------------------------------------------------------------------------------------------------------- Balance-December 31, 1997 435,474 $ (5,572) 38,947 $ (610) $ 478,347 ==================================================================================================================================
55 PENNSYLVANIA MANUFACTURERS CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS
for the years ended December 31, (in thousands) 1997 1996 1995 - ------------------------------------------------------------------------------------------------------------------------------ Cash flows from operating activities: Net income (loss) $ 15,019 $ (135,334) $ 24,130 Adjustments to reconcile net income (loss) to net cash flows (used) provided by operating activities: Depreciation 8,672 12,511 7,652 Amortization 4,054 7,243 35 Provision (benefit) for deferred income taxes 9,906 (11,488) 15,353 Extraordinary loss from early extinguishment of debt (4,734) - - Net realized investment gains (8,598) (2,984) (31,923) Change in uncollected premiums and unearned premiums, net 39,030 17,983 22,381 Change in dividends to policyholders (2,324) (632) 910 Change in unpaid losses and loss adjustment expenses (87,885) 21,086 (33,728) Change in investment income due and accrued 6,577 5,188 4,961 Change in deferred acquisition costs (1,282) (6,105) (5,665) Other, net (85,795) (23,413) 11,807 -------------------------------------------------- Net cash flows (used) provided by operating activities (107,360) (115,945) 15,913 -------------------------------------------------- Cash flows from investing activities: Fixed maturity investments held to maturity: Maturities or calls - - 3,809 Fixed maturity investments available for sale: Purchases (1,963,492) (1,227,173) (2,147,600) Maturities or calls 168,304 52,280 75,861 Sales 2,072,842 1,210,114 2,085,864 Equity securities: Purchases - (5,196) (18,104) Sales 254 16,984 28,793 Net (purchases) sales of short-term investments (130,391) 78,935 (35,445) Sale of corporate properties 7,145 - - Net purchases of property and equipment (3,577) (6,723) (6,017) Purchase of Caliber One Indemnity Company (15,990) - - Cash acquired in purchase of Caliber One Indemnity Company 4,509 - - -------------------------------------------------- Net cash flows provided (used) by investing activities 139,604 119,221 (12,839) -------------------------------------------------- Cash flows from financing activities: Proceeds from long-term debt 210,000 26,000 125,000 Repayments of long-term debt (211,699) (25,149) (125,127) Dividends paid to shareholders (7,965) (7,926) (7,885) Proceeds from exercised stock options and issuance of Class A common stock 837 - - Treasury stock transactions, net 591 (929) 480 Repayments of notes receivable from officers 964 2,734 478 -------------------------------------------------- Net cash flows used by financing activities (7,272) (5,270) (7,054) -------------------------------------------------- Net increase (decrease) in cash 24,972 (1,994) (3,980) Cash January 1 7,176 9,170 13,150 -------------------------------------------------- Cash December 31 $ 32,148 $ 7,176 $ 9,170 -------------------------------------------------- Supplementary cash flow information: Amounts (received) paid for income taxes $ (19,112) $ 5,525 $ (951) Amounts paid for interest $ 19,776 $ 16,622 $ 15,062 Fair value of securities transferred from held to maturity classification to available for sale classification $ - $ - $ 1,238,077
See accompanying notes to the consolidated financial statements. 56 Notes to Consolidated Financial Statements (Dollar amounts in thousands, except share and per share data) 1. Summary of Significant Accounting Policies The accompanying consolidated financial statements include the accounts of Pennsylvania Manufacturers Corporation (PMC) and its wholly and majority owned subsidiaries (the Company). PMC is an insurance holding company that sells property and casualty reinsurance and insurance through its insurance subsidiaries. PMC's insurance subsidiaries are domiciled in Pennsylvania, except for its newly established excess and surplus lines writer, discussed below, which is domiciled in Delaware, and certain foreign subsidiaries. Reinsurance -- PMC's reinsurance subsidiary, PMA Reinsurance Corporation (PMA Re), emphasizes risk-exposed, excess of loss reinsurance and operates in the brokered market. PMA Re's business is predominantly in casualty lines of reinsurance. Workers' Compensation and Primary Standard Insurance -- PMC's property and casualty insurance subsidiaries (the Property and Casualty Group) write workers' compensation and other standard lines of commercial insurance primarily in the Mid-Atlantic and Southern regions of the U.S. Specialty Property and Casualty -- During 1997, the Company established a separate specialty insurance operation focusing on excess and surplus lines, Caliber One Management Company (Caliber One). In December 1997, PMA Re acquired 100% of the outstanding common stock of Caliber One Indemnity Company (formerly known as Lincoln Insurance Company) for approximately $16,000 and made a capital contribution of approximately $11,300 to Caliber One Indemnity Company. All of Caliber One Indemnity Company's acquired loss reserves were reinsured by an affiliate of Caliber One Indemnity Company's former parent in conjunction with the purchase. The reinsurance obtained in conjunction with the purchase covers adverse development and uncollectible reinsurance in an amount equal to the stated amount of the reserves acquired, plus an additional $68,500. Management believes that the reinsurance obtained as part of the purchase will be adequate to cover any future reserve development or uncollectible insurance on the acquired reserves. PMA Re intends to maintain Caliber One Indemnity Company's surplus at not less than $25,000, the minimum capital and surplus required for many states in order to be an eligible surplus lines carrier. Management anticipates that Caliber One will primarily write multi-line business consisting of primary and excess commercial general liability, professional liability, excess automobile and certain property exposures. Because Caliber One's results were not significant in 1997, Caliber One's financial information has been included within the Corporate and Other segment, including pre-opening costs of approximately $900, which have been expensed as incurred. The Company's significant accounting policies and practices are as follows: A. Basis of Presentation -- The consolidated financial statements have been prepared in accordance with generally accepted accounting principles (GAAP). All significant intercompany accounts and transactions have been eliminated in consolidation. The preparation of consolidated financial statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the amounts reported in its consolidated financial statements and accompanying notes. Actual results may differ from those estimates. These consolidated financial statements vary in certain respects from statutory accounting practices prescribed or permitted by the Pennsylvania Insurance Department and the Delaware Insurance Department, (collectively SAP). Prescribed SAP includes state laws, regulations and general administrative rules, as well as a variety of NAIC publications. Permitted SAP encompasses all accounting practices that are not prescribed. The NAIC has a project to codify SAP, the result of which is expected to constitute the only source of prescribed SAP. The project, when completed, will change the definitions of what comprises prescribed versus permitted SAP and may result in changes to the accounting policies that insurance 57 companies use to prepare SAP financial statements. See Note 18 for additional SAP information and a reconciliation of SAP net income and surplus to GAAP net income and shareholders' equity. B. Investments -- Fixed maturity investments include U.S. Treasury securities and obligations of U.S. Government agencies, obligations of states and political subdivisions, where applicable, corporate debt securities and mortgage-backed securities. Under SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," fixed maturities which the Company may hold for an indefinite period of time are classified as available-for-sale and, accordingly, are carried at fair value with changes in fair value, net of income tax effects, reflected in shareholders' equity. Fixed maturities which the Company has the positive intent and ability to hold to maturity are carried at amortized cost. In 1995, the Company re-evaluated the classifications of its fixed maturity investments. As a result, effective June 30, 1995, the Company reclassified its entire held-to-maturity portfolio, which had an amortized cost of $1,241,774, to the available-for-sale designation in order to match more closely the Company's investment strategy. This reclassification resulted in a $1,238,077 increase in available-for-sale securities and a $2,403 unrealized loss (net of deferred taxes), with no impact on net income. As of December 31, 1997, the Company's entire fixed income portfolio remains designated as available for sale. Equity securities for all periods are stated at fair value with changes in fair value, net of income tax effects, reflected in shareholders' equity. Realized gains and losses, determined by specific identification, are reflected in income in the period in which the sale transaction occurs. C. Premiums -- Premiums, including estimates of additional premiums resulting from audits of insureds' records, are earned principally on a pro rata basis over the terms of the policies. Premiums applicable to the unexpired terms of policies in-force are reported as unearned premiums. Estimated premiums receivable on retrospectively rated policies are reported as a component of uncollected premiums (See Note 1-P). The Company follows Emerging Issues Task Force Consensus Position No. 93-6, "Accounting for Multiple Year Retrospectively Rated Contracts by Ceding and Assuming Enterprises" (EITF 93-6). EITF 93-6 requires that the Company reflect adjustments to future premiums, as the result of past experience under multiple year reinsurance contracts, in earnings currently. The impact of EITF 93-6 has been immaterial. D. Unpaid Losses and Loss Adjustment Expenses -- Unpaid losses and loss adjustment expenses are stated net of estimated salvage and subrogation and are determined using claims adjusters' evaluations, estimates of losses and loss adjustment expenses on known claims, and estimates of losses and loss adjustment expenses incurred but not reported (IBNR). IBNR reserves are calculated utilizing various actuarial methods. Unpaid losses on certain workers' compensation claims are discounted to present value using the Company's payment experience and SAP mortality and interest assumptions (See Note 3). The methods of making such estimates and establishing the resulting reserves are continually reviewed and updated and any adjustments resulting therefrom are reflected in earnings currently. E. Deferred Acquisition Costs -- The costs of acquiring new and renewal business are deferred and amortized over the period during which the related premiums are earned. Such costs include direct acquisition costs, including commissions, brokerage, and premium taxes as well as other policy issuance costs and underwriting expenses that directly relate to and vary with the production of business. The Company determines whether deferred acquisition costs are recoverable considering future losses and loss adjustment expenses, maintenance costs, and anticipated investment income. To the extent that deferred acquisition costs are not recoverable, the deficiency is charged to income currently. F. Dividends to Policyholders -- The Property and Casualty Group issues certain workers' compensation insurance policies with dividend payment features. These policyholders share in the operating results in the form of dividends declared at the discretion of the Company's board of directors. Dividends to policyholders are accrued during the period in which the related premiums are earned and are determined based on the terms of the individual policies. 58 G. Income Taxes -- The Company accounts for income taxes under SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 is an asset and liability approach, whereby deferred tax assets and liabilities are recorded to the extent of the tax effect of differences between the financial statement carrying values and tax bases of assets and liabilities. A valuation allowance is recorded for deferred tax assets where it appears more likely than not that the Company will not be able to recover the deferred tax asset. In addition, PMC and a majority of its subsidiaries have a written tax-sharing agreement which allocates to each entity subject to the agreement its Federal income taxes on a separate return basis. The benefit of any net operating losses is retained by PMC. H. Property and Equipment -- Property and equipment are stated at cost, less accumulated depreciation. Depreciation is calculated on the straight-line method utilizing useful lives ranging from 3 to 40 years. During 1996, the Property and Casualty Group changed the depreciable lives for its mainframe computer equipment from five years to three years. The effect of this adjustment was to increase 1996 depreciation expense by approximately $4,800. I. Per Share Information -- In February 1997, the Financial Accounting Standards Board issued SFAS No. 128, "Earnings Per Share", which supersedes Accounting Principles Board Opinion No. 15, "Earnings Per Share," and Related Interpretations, and which the Company adopted during 1997. In accordance with SFAS No. 128, all prior period data presented has been restated to conform with the provisions of this statement. SFAS No. 128 replaces the presentation of primary earnings per share with a presentation of basic earnings per share and requires the presentation of both basic and diluted earnings per share on the face of the income statement. SFAS No. 128 also requires a reconciliation of the numerators and denominators used in the basic earnings per share calculation to the numerators and denominators used in the diluted earnings per share calculation. Such reconciliation is provided in Note 16. Basic earnings per share: For years 1997, 1996 and 1995, basic earnings per share was based upon the weighted average number of common and Class A common shares outstanding for the period. Diluted earnings per share: For years 1997 and 1995, diluted earnings per share was based upon the weighted average number of common and Class A common shares outstanding during the year and the assumed exercise price of dilutive stock options, less the number of treasury shares assumed to be purchased from the proceeds using the average market price of the Company's Class A common stock. In 1996, diluted earnings per share was based upon the weighted average common and Class A common shares outstanding during the year; the assumed exercise price of stock options using the average market price of the Company's Class A common stock was not taken into consideration as these stock options would have had an anti-dilutive effect on the net loss per share (See Note 16). J. Stock-Based Compensation -- The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related Interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company's Class A common stock at the date of the grants over the amount an employee must pay to acquire the Class A common stock. K. Computer Software Costs Related to the Year 2000 -- In 1996, the Company adopted Emerging Issues Task Force Consensus Position No. 96-14, "Accounting for the Costs Associated with Modifying Computer Software for the Year 2000" (EITF 96-14). EITF 96-14 states that external and internal costs specifically associated with modifying internal-use software for the Year 2000 should be charged to expense as incurred. In accordance with EITF 96-14, the Company charged approximately $2,000 and $1,800 to operating expenses during the years ended December 31, 1997 and 1996, respectively, for costs associated with modifying internal-use software. L. Service Revenues -- Service revenues are earned over the term of the related contracts in proportion to the actual services rendered. 59 M. Reclassifications -- Certain prior year amounts have been reclassified to conform to the current year presentation. Additionally, in 1995, the Company elected to change its method of reporting cash flows from the direct method to the indirect method. N. Recently Issued Accounting Standards -- In June 1996, the Financial Accounting Standards Board issued SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." SFAS No. 125, which is effective for transfers and extinguishments occurring after December 31, 1996, provides consistent standards for distinguishing transfers of financial assets that are sales from transfers that are secured borrowings. The Property and Casualty Group's domestic insurance subsidiaries participated in a transfer arrangement of certain accounts receivable. This arrangement has been terminated as a result of SFAS No. 125. The termination did not have a material impact on the Company's financial condition or results of operations. During 1997, the FASB issued SFAS No. 130, "Comprehensive Income," which establishes standards for the reporting and disclosure of comprehensive income and its components (revenues, expenses, gains and losses). SFAS No. 130 requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. In addition, the FASB issued SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information," which establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and interim financial reports issued to shareholders. SFAS No. 131 also establishes standards for related disclosures about products and services, geographic areas and major customers. The Company will adopt the provisions of these pronouncements in 1998. The adoption of these pronouncements will not have an impact on the Company's financial position and results of operations, but may change the presentation of certain of the Company's financial statements and related notes and data thereto. O. Long-Lived Assets -- It is management's policy to review long-lived assets, such as the Company's properties, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Such changes in circumstances include such things as significant decline in market value or change in use of the asset. Periodically, management reviews appraisals and/or cash flow projections from properties and other long- lived assets and compares such amounts to the carrying values to determine whether or not there has been an impairment. If such an impairment exists, it is management's policy to write down the carrying value of the asset to fair value less costs to carry and dispose of the asset, where applicable. P. Accrued Retrospective Premiums -- Accrued retrospective premiums, which are a component of uncollected premiums, are based upon actuarial estimates of expected ultimate losses and resulting estimated premium adjustments relating to retrospectively rated policies. The change in accrued retrospective premiums is a component of net premiums earned. The estimated ultimate premium adjustments under retrospectively rated policies are recorded in the initial accident year based upon estimated loss experience on the underlying policies and adjusted in subsequent periods in conjunction with revisions of the estimated underlying losses on such policies. In addition, accrued retrospective premiums are increased (decreased) based upon retrospective policy adjustments paid (billed); such adjustments actually billed or paid do not impact premium revenues as the Company records an offsetting amount through net premiums written. 60 The following sets forth the components of the change in accrued retrospective premiums for each of the past three years:
For the years ended December 31, 1997 1996 1995 ---- ---- ---- Estimated retrospective policy adjustments related to current accident year.......................... $(12,460) $(18,767) $(12,941) Revision of estimate of retrospective policy adjustments related to prior accident years................... (44,719) (9,888) (4,845) Retrospective policy adjustments paid.... 20,179 23,155 13,786 Uncollectible write-off.................. -- (5,000) -- -------- -------- ------- Total.................................... $(37,000) $(10,500) $(4,000) ======== ======== =======
In 1997, 1996 and 1995, the Property and Casualty Group reduced accrued retrospective premiums by $37,000, $10,500 and $4,000, respectively. The primary reason for the additional reduction in 1997 relative to 1996 was a $44,719 revision of estimate of accrued retrospective premiums, primarily due to the favorable development of claims liabilities for more recent accident years ($35,719) and the commutation of claims for accident years 1991 and prior in 1997 ($9,000). The reduction for policy years 1991 and prior primarily relates to the commutation program for such years initiated in late 1996. In July 1997, the Property and Casualty Group completed a formal program where it commuted a large number of claims associated with workers' compensation claims from accident years 1991 and prior, including loss reserves associated with retrospective policies (See Note 3). The commutation program resulted in current payments to claimants which were less than the carried reserves. As a result of the differences between the current commutation payments to claimants and carried reserves on such claims, management reduced its estimate of amounts recoverable under retrospectively rated policies and also recognized a reduction in losses and LAE associated with such policies. The reduction related to 1992 through 1996 policy years was primarily related to a corresponding amount of favorable development on underlying loss reserves for such years (See Note 3). The effects of the commutations on these prior loss reserves, as well as the intent of the Property and Casualty Group to continue utilizing early intervention techniques such as commutations on claims from more recent accident years, have led to a re-estimation of policy liabilities for these more recent accident years, and a re-estimation of amounts due under retrospectively rated policies for these more recent accident years. Management believes that it has made a reasonable estimate of the Company's accrued retrospective premiums. While the eventual ultimate receivable may differ from the current estimates, management does not believe that the difference will have a material effect, either adversely or favorably, on the Company's financial position or results of operations. 2. Investments The Company's investment portfolio is well diversified and contains no significant concentrations in any specific industry, business segment, or individual issuer. The Company principally invests in U.S. Treasury securities and obligations of U.S. Government agencies, high-quality obligations of states and political subdivisions and corporations, and mortgage backed securities. Equity securities consist entirely of common stocks of financial institutions, public utilities, and industrial and service entities. 61 The amortized cost and fair value of the Company's investment portfolio are as follows:
Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value ---- ----- ------ ----- December 31, 1997 Fixed maturities available for sale: U.S. Treasury securities and obligations of U.S. Government agencies....................... $1,105,689 $17,267 $ 3,390 $1,119,566 Corporate debt securities....................... 675,218 12,845 392 687,671 Mortgage backed securities...................... 119,687 2,657 63 122,281 ---------- ------- ------- ---------- Total fixed maturities available for sale......... 1,900,594 32,769 3,845 1,929,518 Equity securities................................. 5 8 -- 13 Short-term investments............................ 265,207 -- -- 265,207 ---------- ------- ------- ---------- Total investments................................. $2,165,806 $32,777 $ 3,845 $2,194,738 ========== ======= ======= ========== DECEMBER 31, 1996 Fixed maturities available for sale: U.S. Treasury securities and obligations of U.S. Government agencies....................... $1,640,881 $ 4,045 $42,182 $1,602,744 Obligations of states and political subdivisions 77,562 194 1,229 76,527 Corporate debt securities....................... 372,620 3,203 2,977 372,846 Mortgage backed securities...................... 73,328 728 53 74,003 ---------- ------- ------- ---------- Total fixed maturities available for sale......... 2,164,391 8,170 46,441 2,126,120 Equity securities................................. 259 3 -- 262 Short-term investments............................ 134,971 -- -- 134,971 ---------- ------- ------- ---------- Total investments................................. $2,299,621 $ 8,173 $46,441 $2,261,353 ========== ======= ======= ==========
The amortized cost and estimated fair value of fixed maturities at December 31, 1997, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because the issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
Amortized Fair Cost Value ---- ----- 1998.......................................... $ 129,047 $ 128,919 1999-2002..................................... 634,888 633,643 2003-2007..................................... 394,704 396,459 2008 and thereafter........................... 622,268 648,216 Mortgage backed securities.................... 119,687 122,281 ---------- ---------- $1,900,594 $1,929,518 ========== ==========
Net investment income consists of the following:
For the years ended December 31, 1997 1996 1995 ---- ---- ---- Fixed maturities......................... $128,400 $131,530 $129,883 Equity securities........................ -- 148 503 Short-term investments................... 7,282 7,711 11,764 Other.................................... 4,422 3,251 4,303 -------- -------- -------- Total investment income................ 140,104 142,640 146,453 Investment expenses...................... 3,406 8,704 7,098 -------- -------- -------- Net investment income.................. $136,698 $133,936 $139,355 ======== ======== ========
62 Net realized investment gains consist of the following:
For the years ended December 31, 1997 1996 1995 ---- ---- ---- Realized gains: Fixed maturities......................... $20,899 $12,762 $37,900 Equity securities........................ -- 4,351 3,117 Other.................................... -- 4 -- ------- ------- ------- 20,899 17,117 41,017 ------- ------- ------- Realized losses: Fixed maturities......................... 12,203 12,861 5,956 Equity securities........................ -- 436 2,200 Other.................................... 98 836 938 ------- ------- ------- 12,301 14,133 9,094 ------- ------- ------- Total net realized investment gains........ $ 8,598 $ 2,984 $31,923 ======= ======= =======
On December 31, 1997, the Company had securities with a total amortized cost and fair value of $30,925 and $31,105, respectively, on deposit with various governmental authorities, as required by law. In addition, at December 31, 1997, securities with a total amortized cost and fair value of $11,603 and $11,547, respectively, were pledged as collateral for letters of credit issued on behalf of the Company. Change in unrealized appreciation (depreciation) of investments consists of the following:
For the years ended December 31, 1997 1996 1995 ---- ---- ---- Fixed maturities available for sale........ $67,195 $(62,457) $ 99,874 Equity securities.......................... 5 (2,751) 3,165 ------- -------- -------- Change in unrealized appreciation (depreciation) of investments....... $67,200 $(65,208) $103,039 ======= ======== ========
During 1997, the Company established a securities lending program through which securities are loaned from the Company's portfolio to qualifying third parties, subject to certain limits, via a lending agent for short periods of time. Borrowers of these securities must provide collateral equal to a minimum of 102% of the market value and accrued interest of the loaned securities. Acceptable collateral may be in the form of either cash or securities. Cash received as collateral is invested in short-term investments, and all securities received as collateral are of similar quality to those securities lent by the Company. Additionally, the Company limits securities lending to 40% of statutory admitted assets of its insurance subsidiaries, with a 2% limit on statutory admitted assets to any individual borrower. The Company receives either a fee from the borrower or retains a portion of the income earned on the collateral. Under the terms of the securities lending program, the Company is indemnified against borrower default, with the lending agent responsible to the Company for any deficiency between the cost of replacing a security that was not returned and the amount of collateral held by the Company. In 1997, the Company recognized income from securities lending transactions of $524, net of lending fees, which was included in investment income. The Company had approximately $175,000 of securities on loan as of December 31, 1997. 63 3. Unpaid Losses and Loss Adjustment Expenses Activity in the liability for unpaid losses and loss adjustment expenses (LAE) is summarized as follows:
For the years ended December 31, 1997 1996 1995 ---- ---- ---- Balance at January 1......................................... $2,091,072 $2,069,986 $2,103,714 Less: reinsurance recoverable on unpaid losses and LAE....... 256,576 261,492 247,856 ---------- ---------- ---------- Net balance at January 1..................................... 1,834,496 1,808,494 1,855,858 ---------- ---------- ---------- Losses and LAE incurred, net: Current year............................................... 341,880 323,069 357,787 Prior years................................................ (86,006) 156,074 51,491 Accretion of discount (includes ($35,000) effect of the change in the discount rate for the Property and Casualty Group's workers' compensation unpaid losses from 4% to 5% in 1995).................................................. 51,407 57,480 13,300 ---------- ---------- ---------- Total losses and LAE incurred, net........................... 307,281 536,623 422,578 ---------- ---------- ---------- Losses and LAE paid, net: Current year............................................... (72,399) (72,194) (71,126) Prior years................................................ (398,475) (438,427) (398,816) ---------- ---------- ---------- Total losses and LAE paid, net............................... (470,874) (510,621) ( 469,942) ---------- ---------- ---------- Net balance at December 31................................... 1,670,903 1,834,496 1,808,494 Reinsurance recoverable on unpaid losses and LAE............. 332,284 256,576 261,492 ---------- ---------- ---------- Balance at December 31....................................... $2,003,187 $2,091,072 $2,069,986 ========== ========== ==========
The Company's results of operations included a decrease in estimated incurred losses and LAE related to prior accident years of $86,006 in 1997, and an increase of $156,074 and $51,491 in 1996 and 1995, respectively. During 1997, PMA Re recorded favorable reserve development on prior accident years of approximately $32,100. PMA Re has consistently recorded favorable reserve development on prior accident years for the past several years. The remaining decrease in estimated losses and LAE on prior accident years during calendar year 1997 can be attributed primarily to the following: the cession of prior year reserves by PMA Life Insurance Company to a third party reinsurer of approximately $14,800 (See Note 5); favorable reserve development at the Property and Casualty Group in conjunction with the formal commutation program, discussed below, of approximately $9,000 pertaining to retrospectively rated policies for accident years 1991 and prior; favorable reserve development at the Property and Casualty Group of approximately $28,000 related to retrospectively rated policies pertaining to accident years 1992 through 1996; and favorable development on pre-1992 workers' compensation reserves of $7,100, partially offset by reserve strengthening in commercial multi-peril business for accident year 1996 of $5,000. The increase in estimated incurred losses and LAE during 1996 is primarily due to a loss reserve strengthening charge of $191,400. This loss reserve strengthening was associated with the following lines of business: 1996 ---- Workers' compensation..................... $110,000 Asbestos and environmental................ 60,400 Other lines of business................... 21,000 -------- $191,400 ======== The 1996 aggregate workers' compensation adverse development was allocated $102,000 to Pennsylvania and $8,000 to all other states in the Company's marketing territory. Of the $102,000, the allocation by accident year is as follows: prior to 1987: $16,000; 1987 to 1991: $101,000; and 1992 and subsequent 64 years: $(15,000). In 1995, substantially all of the workers' compensation adverse development related to accident years 1987 to 1991 in Pennsylvania. For accident years prior to 1992, the traditional paid loss development schedules for workers' compensation had begun to exhibit an increasing trend in loss development factors by 1993. This trend was initially attributed to an increase in commutation activity. In 1995, management began to question whether loss data was developing in a manner that was consistent with the conclusion that the loss development trends were impacted solely by commutation activity. As a result, management began to accumulate additional data in order to determine whether there were additional causes of the increase in the paid loss development data; management obtained claim count data that was far more detailed than had been historically utilized in the reserve setting process. This data indicated that the paid loss development factors were not only impacted by commutation activity, but also by a decline in the claims closure rate in Pennsylvania. Management believes that the decline of the closure rates was due to several interrelated factors. One factor related to the fact that efforts to rehabilitate claimants and return them to work were not as successful as anticipated. For accident years 1987 to 1991, in particular, extensive efforts were made by the Company to rehabilitate claimants and return them to work at either full or modified duty. By late 1995 and into 1996, it was recognized, by a review of a slow down in the claims closure pattern that these rehabilitation efforts were not impacting the closure rates as expected. Another factor negatively impacting claims closure rates related to the economic conditions in Pennsylvania in the early 1990's. During the period from 1990 to 1994, economic conditions in Pennsylvania were considered to be depressed in the Company's major industry niches for workers' compensation insurance (construction, heavy manufacturing). Payrolls in these industries were stagnant, and in many cases, employment was flat or declining. The Company believes that in periods of declining employment opportunities, there is a tendency for indemnity periods to increase, which occurred for workers who suffered injuries in these industries. The above factors, when considered with the fact that the benefits period in Pennsylvania was unlimited, caused the Company to believe that a substantial portion of claimants from the pre-1992 period, who had already been out of work five to nine years, would not return to work in any capacity. In late 1995 and during 1996, management undertook an effort to quantify the impact of the declining closure rates versus the increase in commutation activity. During the fourth quarter of 1995, management strengthened the Property and Casualty Group's workers' compensation reserves by $54,700; however, the quantification of the effect of the claims closure rate was an extremely complex process, and as such, the data was not fully understood at that time. As the data under analysis was more mature and refined in 1996, management determined that the workers' compensation loss reserves for Pennsylvania in the pre-1992 accident years needed to be increased substantially; therefore, the Property and Casualty Group increased its workers' compensation reserves by $110,000 in 1996. Workers' compensation reform legislation enacted in Pennsylvania in 1993 and 1996 introduced various controls and limitations on medical and disability benefits. Management believes that these reforms have had and will continue to have a favorable impact on workers' compensation loss ratios for accident years 1993 and subsequent. In addition, management took several steps to reduce the outstanding claims associated with the Pennsylvania workers' compensation business written through 1991. A formal commutation program was initiated in the fourth quarter 1996 and continued into late 1997. Commutations are agreements with claimants whereby the claimants, in exchange for a lump sum payment, will forego their rights to future indemnity payments from the Property and Casualty Group. Under Pennsylvania workers' compensation laws, all such commutation arrangements must be approved by the claimant and the Pennsylvania Workers' Compensation Board. The Property and Casualty Group paid approximately $101,100 and $17,800 in 1997 and the fourth quarter of 1996, respectively, to commute workers' compensation indemnity claims. Savings associated with these claims were consistent with management's expectations. The number of open claims for accident years 1991 and prior was substantially reduced as a result of the commutation program. This reduction in open claims is expected to reduce the possibility of any further adverse development on such reserves, although there can be no assurances that the level of commutations will have a significant impact on the future development of such reserves. Estimating reserves for workers' compensation claims can be more difficult than many other lines of property and casualty insurance for several reasons, including (i) the long payment `tail' associated with the 65 business; (ii) the impact of social, political and regulatory trends on benefit levels; (iii) the impact of economic trends; and (iv) the impact of changes in the mix of business. At various times, one or a combination of such factors can make the interpretation of actuarial data associated with workers' compensation loss development more difficult, and it can take additional time to recognize changes in loss development patterns. Under such circumstances, adjustments will be made to such reserves as loss patterns develop and new information becomes available and such adjustments may be material. The adverse development in reserves associated with asbestos and environmental claims during 1996 was due to the completion of a detailed analysis of loss and LAE reserves associated with asbestos and environmental liability claims in 1996. The reserving for asbestos and environmental claims has undergone change at both the Company and in the insurance industry in general. For environmental and asbestos liability claims, reserving methodology has been evolving into accepted industry practice in the recent past; the Company's actuaries were able to apply these methods to its loss reserves in 1997 and 1996. To reserve for environmental claims, the Company currently utilizes a calendar year development technique known as aggregate loss development. This technique focuses on the aggregate losses paid as of a particular date and aggregate payment patterns associated with such claims. Several elements including remediation studies, remediation, defense, declaratory judgment, and third party bodily injury claims were considered in estimating the costs and payment patterns of the environmental and toxic tort losses. Prior to the development of these techniques, there was a substantial range in the nature of reserving for environmental and toxic tort liabilities. The methods employed by the Company prior to the review performed in 1996 included a review of aggregate loss and loss adjustment paid and case incurred data along with resulting "survival ratios" to establish IBNR for environmental and toxic tort claims. For asbestos claims, the Company had previously reserved costs to defend, and any indemnification payments anticipated on, claims for which it had received notice that it was a responsible party, plus a bulk factor applied to the estimated case reserves to provide for potential development of indemnification and defense costs related to such claims. In 1996, the Company performed a ground up analysis of asbestos loss reserves using an actuarially accepted modeling technique. Using historical information as a base and information obtained from a review of open claims files, assumptions were made about future claims activity in order to estimate ultimate losses. For each individual major account, projections were made regarding new plaintiffs per year, the number of years new claims will be reported, the average loss severity per plaintiff, and the ratio of loss adjustment expense to loss. In many cases involving larger asbestos claims, the Company reserved up to the policy limits for the applicable loss coverage parts for the affected accounts. Policy terms and reinsurance treaties were applied in the modeling of future losses. Estimation of obligations for asbestos and environmental exposures continues to be more difficult than other loss reserves because of several factors, including: (i) evolving methodologies for the estimation of the liabilities; (ii) lack of reliable historical claim data; (iii) uncertainties with respect to insurance and reinsurance coverage related to these obligations; (iv) changing judicial interpretations; and (v) changing government standards. The Company's asbestos-related losses were as follows:
For the years ended December 31, 1997 1996 1995 ---- ---- ---- Gross of reinsurance: Beginning reserves............................... $ 80,055 $ 27,611 $ 13,969 Incurred losses and LAE.......................... 2,435 62,854 22,482 Calendar year payments for losses and LAE........ (5,764) (10,410) (8,840) -------- -------- -------- Ending reserves.................................. $ 76,726 $ 80,055 $ 27,611 ======== ======== ========
66
1997 1996 1995 ---- ---- ---- Net of reinsurance: Beginning reserves............................... $53,300 $23,443 $ 8,168 Incurred losses and LAE.......................... (36) 39,427 21,826 Calendar year payments for losses and LAE....... (4,686) (9,570) (6,551) ------- ------- ------- Ending reserves.................................. $48,578 $53,300 $23,443 ======= ======= =======
The Company's environmental-related losses were as follows:
For the years ended December 31, 1997 1996 1995 ---- ---- ---- Gross of reinsurance: Beginning reserves............................... $35,626 $20,134 $20,952 Incurred losses and LAE.......................... 1,130 22,143 3,516 Reserves acquired through purchase of Caliber One Indemnity Company/(1)/................... 13,060 -- -- Calendar year payments for losses and LAE........ (4,708) (6,651) (4,334) ------- ------- ------- Ending reserves.................................. $45,108 $35,626 $20,134 ======= ======= ======= Net of reinsurance: Beginning reserves............................... $34,592 $20,134 $20,952 Incurred losses and LAE.......................... 1,068 21,109 3,516 Calendar year payments for losses and LAE....... (3,965) (6,651) (4,334) ------- ------- ------- Ending reserves.................................. $31,695 $34,592 $20,134 ======= ======= =======
(1) Such acquired reserves have been reinsured by an affiliate of the former parent (See Note 1). Of the total net asbestos reserves, approximately $6,700, $6,800, and $6,700 related to established claims reserves at December 31, 1997, 1996, and 1995, respectively, and $41,900, $46,500, and $16,700 related to incurred but not reported losses at December 31, 1997, 1996, and 1995, respectively. Of the total net environmental reserves, approximately $11,200, $12,500, and $10,300 related to established claims reserves at December 31, 1997, 1996, and 1995, respectively, and $20,500, $22,100, and $9,800 related to incurred but not reported losses at December 31, 1997, 1996, and 1995, respectively. All incurred asbestos and environmental losses were for accident years 1986 and prior. Management believes that its reserves for asbestos and environmental claims are appropriately established based upon known facts, existing case law, and generally accepted actuarial methodologies. However, due to changing interpretations by courts involving coverage issues, the potential for changes in federal and state standards for clean-up and liability and other factors, the ultimate exposure to the Company for these claims may vary significantly from the amounts currently recorded, resulting in a potential adjustment in the claims reserves recorded. Additionally, issues involving policy provisions, allocation of liability among participating insurers, proof of coverage, and other factors make quantification of liabilities exceptionally difficult and subject to adjustment based upon newly available data. In 1996, other commercial lines for the Property and Casualty Group experienced reserve strengthening of $21,000, as compared to a reserve release of $11,600 in 1995. The reserve strengthening was principally due to a re-estimation of loss adjustment costs associated with general liability claims. Through 1991, the Property and Casualty Group's mix of general liability insurance policies were weighted towards the manufacturing classes of business. Subsequent to 1991, the Property and Casualty Group's mix of business became more heavily weighted towards the construction and contracting classes of business. These particular classes of business have experienced losses due to construction defects and similar matters, that have taken longer to emerge than the classes of business previously written by the Property and Casualty Group. Defense costs associated with these claims have also exceeded the original estimate of the Property and Casualty Group's management, which was based on the patterns of indemnification payments associated 67 with the earlier classes of business written. When this issue was discovered, the Property and Casualty Group factored the increased defense costs and the emergence pattern in determining a more appropriate reserve amount for loss handling costs. The release of reserves in 1995 was primarily due to favorable loss experience in commercial automobile business. Unpaid losses on workers' compensation claims for the Company include approximately $816,000 and $1,012,000, net of discount of $460,230 and $514,248, at December 31, 1997 and 1996, respectively. The approximate discount rate used was 5% at December 31, 1997 and 1996. In 1995, the Property and Casualty Group changed its discount rate with respect to its workers' compensation unpaid losses from approximately 4% to 5% for SAP and GAAP purposes. This change was approved and is permitted by the Pennsylvania Insurance Department. The effect on net income (net of tax effect of $12,250) in 1995 was $22,750 ($0.96 per basic share and $0.92 per diluted share). The Company's loss reserves were stated net of salvage and subrogation of approximately $59,900 and $75,000 at December 31, 1997 and 1996, respectively. The following table presents the salvage and subrogation by segment and product line:
December 31, 1997 1996 ---- ---- Property and Casualty Group: Workers' compensation $46,000 $61,900 Other Commercial Lines 4,800 3,900 ------- ------- Total Property and Casualty Group 50,800 65,800 PMA Re 9,100 9,200 ------- ------- Total salvage and subrogation $59,900 $75,000 ======= =======
The Company's policy with respect to estimating the amounts and realizability of salvage and subrogation is to develop historical accident year schedules of paid salvage and subrogation by line of business, which are then projected to an ultimate basis using actuarial projection techniques. The anticipated salvage and subrogation is the estimated ultimate salvage and subrogation less any amounts received by the Company. The realizability of anticipated salvage and subrogation is reflected in the historical data that is used to complete the projection, as historical paid data implicitly considers realization and collectibility. 4. Deferred Acquisition Costs The following represents the components of deferred acquisition costs and the amounts that were charged to expense:
For the years ended December 31, 1997 1996 1995 ---- ---- ---- Balance at January 1........................... $ 44,006 $ 37,901 $ 32,236 Deferral of acquisition costs.................. 94,783 96,397 92,872 Amortization of deferred acquisition costs..... (93,501) (90,292) (87,207) -------- -------- -------- Balance at December 31......................... $ 45,288 $ 44,006 $ 37,901 ======== ======== ========
5. Reinsurance In the ordinary course of business, PMC's reinsurance and insurance subsidiaries assume and cede reinsurance with other insurance companies and are members of various pools and associations. The reinsurance and insurance subsidiaries cede business, primarily on an excess of loss basis, in order to limit the maximum net loss from large risks and limit the accumulation of many smaller losses from a catastrophic event. The reinsurance and insurance subsidiaries remain primarily liable to their clients in the event their reinsurers are unable to meet their financial obligations. 68 Amounts receivable from reinsurers related to paid and unpaid losses are displayed separately on the consolidated balance sheets, net of an allowance for uncollectible accounts. The components of net premiums earned and losses and LAE incurred are as follows:
For the years ended December 31, 1997 1996 1995 ---- ---- ---- Earned Premiums: Direct.......................... $ 277,871 $299,386 $370,590 Assumed......................... 216,357 209,688 149,838 Ceded........................... (118,277) (88,499) (35,476) --------- -------- -------- Net............................... $ 375,951 $420,575 $484,952 ========= ======== ======== Losses and LAE Incurred: Direct.......................... $ 244,429 $420,157 $317,552 Assumed......................... 166,202 163,799 127,910 Ceded........................... (103,350) (47,333) (22,884) --------- -------- -------- Net............................... $ 307,281 $536,623 $422,578 ========= ======== ========
The Company performs extensive credit reviews on its reinsurers, focusing on, among other things, financial capacity, stability, trends, and commitment to the reinsurance business. Prospective and existing reinsurers failing to meet the Company's standards are excluded from the Company's reinsurance programs. In addition, the Company requires letters of credit to support balances due from reinsurers not authorized to transact business in the applicable jurisdictions. At December 31, 1997, the Company had reinsurance recoverables due from the following unaffiliated single reinsurers in excess of 3% of shareholders' equity:
Gross amount due Reinsurer to the Company A.M. Best Rating - --------- -------------- ---------------- United States Fidelity and Guaranty Company......... $74,041 A Essex Insurance Company............................. 36,807 A American Re-Insurance Corporation................... 35,411 A+ Kemper Reinsurance Corporation...................... 21,853 A London Life International Reinsurance Corporation... 16,212 A+ Continental Casualty Company........................ 15,209 A
The Company maintained funds held to collateralize the above balances in the amount of $66,891 at December 31, 1997. The Company believes that it would have the right to offset the funds withheld from a reinsurer against the balances due from such reinsurer in the event of insolvency. During 1997, PMA Life Insurance Company reinsured the majority of its in force annuity business with a third party reinsurer via a quota-share reinsurance agreement for approximately $15,400. The transaction effectively makes PMA Life Insurance Company a dormant company. All of Caliber One Indemnity Company's acquired loss reserves were reinsured with an affiliate of its former parent in conjunction with its purchase by PMA Re, as discussed in Note 1. Management believes that such reinsurance is adequate to cover any future reserve development or uncollectible reinsurance on the acquired reserves. 69 6. Long-Term Debt Long-term debt consists of the following: December 31, 1997 1996 ---- ---- Senior notes 9.53%, due 1997...................... $ -- $ 7,143 Senior notes 9.60%, due 2001...................... -- 46,428 Senior notes 7.62%, due 2001, Series A............ -- 71,000 Senior notes 7.62%, due 2000, Series B............ -- 36,000 Revolving credit agreement, expiring in 1998...... -- 44,000 Revolving credit facility, expiring in 2002/(1)/.. 203,000 -- Mortgage notes.................................... -- 128 -------- -------- Long-term debt.................................... $203,000 $204,699 ======== ======== (1) Maturing in an installment of $15,500 in 1999 and annual installments of $62,500 commencing in 2000 through 2002. On March 14, 1997, the Company refinanced substantially all of its existing credit agreements not already maturing in 1997 through the completion of a new $235,000 revolving credit facility (New Credit Facility). Utilizing the New Credit Facility, the Company refinanced the following obligations: Senior notes 9.60%, due 2001......................... $ 46,428 Senior notes 7.62%, due 2001, Series A............... 71,000 Senior notes 7.62%, due 2000, Series B............... 36,000 Revolving credit agreement, expiring in 1998/(1)/.... 36,000 -------- Total................................................ $189,428 ======== (1) The Company repaid $8,000 of the revolving credit agreement prior to March 14, 1997. The early extinguishment of the senior note agreements resulted in an extraordinary loss of $4,734 ($7,283 pre-tax). The New Credit Facility bears interest at LIBOR plus 0.70% on the utilized portion and carries a 0.275% facility fee on the unutilized portion. The spread over LIBOR and the facility fee are adjustable downward based upon the Company's debt to capitalization ratios in the future. As of December 31, 1997, the interest rate on the utilized portion of the New Credit Facility was 6.61%. In November of 1996, the Company entered into a letter of credit agreement with a group of banks, which currently extends through November of 1998. The original agreement allowed the issuing bank to issue letters of credit having an aggregate outstanding face amount up to $75,000. Effective March 14, 1997, this facility was reduced to an aggregate outstanding face amount not to exceed $50,000. The agreement requires the Company to pay a commitment fee during the existence of the agreement equal to 0.1875% per annum on the average daily available amount. At December 31, 1997 and 1996, the aggregate outstanding face amount of letters of credit issued was $46,881 and $47,461, respectively. This agreement primarily secures reinsurance liabilities of the insurance subsidiaries of the Company. The debt covenants supporting the revolving credit facility and the letter of credit agreement contain provisions which, among other matters, limit the Company's ability to incur additional indebtedness, merge, consolidate and acquire or sell assets. The debt covenants also require the Company to satisfy certain ratios related to net worth, debt-to-capitalization, and interest coverage. Additionally, the debt covenants place restrictions on dividends to shareholders (See Note 15). The Company has entered into an interest rate swap agreement in its management of its existing interest rate exposures. This transaction effectively changed the Company's interest rate exposure on a portion the New Credit Facility, which has a floating rate, to a fixed obligation as follows: 70
Notional Principal Balance at Debt Agreement December 31, 1997 Fixed Rate Floating Rate - -------------- ----------------- ---------- ------------- Revolving Credit Facility, 2002 $150,000 7.24% 6.61%
The variable rate resets every three months. This agreement involves the exchange of interest payment obligation without the exchange of underlying principal. The differential to be paid or received is recognized as an adjustment of interest expense. In the event that a counterparty fails to meet the terms of the agreement, the Company's exposure is limited to the interest rate differential on the notional principal amount ($150,000). Management believes such credit risk is minimal and any loss would not be significant. 7. Stock Options The Company currently has six stock option plans in place for options granted to officers and other key employees for the purchase of the Company's Class A common stock, under which 3,864,903 Class A common shares are reserved for issuance. The stock options are granted under terms and conditions determined by a committee appointed by the Company's board of directors. Granted stock options have a maximum term of ten years, vest over periods ranging between zero and five years, and are typically granted with an exercise price equal to the fair market value of the stock. Information regarding these option plans for 1997, 1996, and 1995 are as follows:
1997 1996 1995 --------------------------------------------------------------------------------------------- Weighted Weighted Weighted Average Average Average Shares Price Shares Price Shares Price ------ ----- ------ ----- ------ ----- Options outstanding, beginning of year...... 3,242,160 $ 12.43 3,087,260 $ 11.80 2,926,000 $ 10.41 Options granted.......... 324,500 17.00 325,000 17.00 775,000 15.59 Options exercised........ (162,248) (8.78) (99,150) (8.33) (205,199) (8.66) Options canceled......... (286,800) (11.53) (70,950) (11.55) (408,541) (10.65) --------- ------- --------- ------- --------- ------- Options outstanding, end of year............ 3,117,612 $ 13.18 3,242,160 $ 12.43 3,087,260 $ 11.80 ========= ======= ========= ======= ========= ======= Option price range at end of year............ $8.00 to $17.00 $8.00 to $17.00 $6.60 to $16.00 Option price range for exercised shares....... $8.00 to $15.00 $6.60 to $10.00 $6.60 to $11.50 Options available for grant at end of year... 747,291 921,566 425,616
71 Stock options outstanding at December 31, 1997 and related exercise price and weighted average remaining life information is as follows:
Weighted Options Options Average Outstanding at Exercisable at Remaining Life Exercise Prices December 31, 1997 December 31, 1997 (in years) - --------------- ----------------- ----------------- ---------- $8.00............................. 254,357 246,857 3.49 10.00............................. 438,690 438,690 4.46 11.50............................. 799,000 799,000 5.65 12.75............................. 271,500 271,500 6.17 15.00............................. 296,580 287,580 7.45 16.00............................. 411,485 283,735 7.43 17.00............................. 646,000 228,725 9.15 --------- --------- 3,117,612 2,556,087 ========= =========
The fair value of options at date of grant was estimated using a binomial model with the following weighted average assumptions: 1997 (1) 1996 (2) 1995(3) 1995(4) -------- -------- ------- ------- Expected life (years)............. 10 10 10 10 Interest rate..................... 6.3% 6.3% 6.1% 6.2% Volatility........................ 18% 18% 18% 18% Dividend yield.................... 2.3% 2.3% 2.3% 2.3% (1) Options granted on September 3, 1997 (2) Options granted on July 23, 1996 (3) Options granted on June 5, 1995 (4) Options granted on September 1, 1995 The Company has adopted the disclosure-only provision of SFAS No. 123, "Accounting for Stock-Based Compensation". Accordingly, no compensation cost has been recognized for the stock option plans. Had compensation costs for the Company's stock option plans been determined based on the fair value at the grant date for awards granted during the year, pretax income would have been reduced by $1,878 ($1,221 after tax, or $0.05 per basic share), $2,079 ($1,352 after tax, or $0.06 per basic share), and $4,308 ($2,800 after tax, or $0.12 per basic share) in 1997, 1996, and 1995, respectively. 8. Income Taxes The components of income tax provision (benefit) from continuing operations are: For the years ended December 31, 1997 1996 1995 ---- ---- ---- Current: Federal................................ $(4,506) $(44,572) $(4,570) ------- -------- ------- (4,506) (44,572) (4,570) ------- -------- ------- Deferred: Federal................................ 9,906 (11,488) 15,353 ------- -------- ------- 9,906 (11,488) 15,353 ------- -------- ------- Income tax provision (benefit) from continuing operations................... $ 5,400 $(56,060) $10,783 ======= ======== ======= 72 The components of income tax benefit from extraordinary item are: For the years ended December 31, 1997 1996 1995 ---- ---- ---- Current: Federal................................ $ (374) $ -- $ -- ------- ------- ------- (374) -- -- ------- ------- ------- Deferred: Federal................................ (2,175) -- -- ------- ------- ------- (2,175) -- -- ------- ------- ------- Income tax benefit from extraordinary item...................... $(2,549) $ -- $ -- ======= ======= ======= A reconciliation between the total provision (benefit) for income taxes and the amounts computed at the Statutory Federal income tax rate of 35% for the years 1997, 1996 and 1995 is as follows:
For the years ended December 31, 1997 1996 1995 ---- ---- ---- Computed at the Statutory tax rate............. $ 8,804 $(66,988) $ 12,220 (Decrease) increase in taxes resulting from: Excludable dividends......................... -- (36) (107) Tax-exempt interest.......................... (61) (4,547) (12,917) Losses of foreign reinsurance affiliate...... -- 16,060 8,469 Reversal of income tax accruals.............. (3,703) -- -- Other........................................ 360 (549) 3,118 ------- -------- -------- Provision (benefit) for income taxes........... $ 5,400 $(56,060) $ 10,783 ======= ======== ========
The tax effects of significant temporary differences between the financial statement carrying amounts and tax bases of assets and liabilities that represent the net deferred tax asset are as follows: December 31, 1997 1996 ---- ---- Allowance for uncollectible accounts.......... $ 6,839 $ 9,037 Unearned premiums............................. 13,756 13,386 Discounting of unpaid losses and LAE.......... 63,743 51,086 Unrealized depreciation of investments........ -- 13,394 Depreciation.................................. -- 5,646 Postretirement benefit obligation............. 5,139 5,111 Tax carryforwards............................. 46,088 67,014 Other......................................... 18,919 9,458 -------- -------- Gross deferred tax asset...................... 154,484 174,132 -------- -------- Deferred acquisition costs.................... (15,723) (15,352) Pension asset................................. (371) (1,348) Depreciation.................................. (574) -- Unrealized appreciation of investments........ (10,126) -- Losses of foreign reinsurance affiliate....... (55,087) (55,790) Other......................................... (2,212) -- -------- -------- Gross deferred tax liability.................. (84,093) (72,490) -------- -------- Net deferred tax asset........................ $ 70,391 $101,642 ======== ======== 73 At December 31, 1997, the Company had approximately $109,622 of net operating loss carryforwards (expiring in 2011), approximately $7,532 of alternative minimum tax credit carryforwards (which do not expire) and approximately $188 of general business credit carryforwards (expiring in 2010 and 2011). Under SFAS 109, a valuation allowance should be provided to offset the effects of a deferred tax asset if management believes that it is more likely than not that the benefit of a deferred tax item will not be realized. Management believes that the benefit of its deferred tax asset will be fully realized, and therefore has not provided for a valuation allowance. U.S. Federal tax return examinations have been completed for the years 1992 and 1993. The examinations for years 1994 and 1995 are currently in progress. In management's opinion, the ultimate resolution of these matters will not have an adverse impact on the Company's financial position or results of operations. 9. Employee Retirement, Postretirement, and Postemployment Benefits During 1996, the Property and Casualty Group initiated a Voluntary Early Retirement Program ("VERIP"). Eligibility to participate in the VERIP was contingent upon an employee's age and years of service with the Company. Of the approximately 85 employees eligible to participate in the VERIP, approximately 50 employees opted to participate. At December 31, 1996, the Company accrued $7,635 in connection with the VERIP. The components of this accrual are as follows: Pension costs................................................ $4,300 Postemployment costs......................................... 2,360 Postretirement costs......................................... 975 ------ $7,635 ====== The Company did not offer a VERIP in 1997, and as such, did not incur any VERIP expenses. The Company did, however, incur certain restructuring and other charges during 1997 (See Note 20). A. Pension and Retirement Plans -- The Company sponsors a qualified non- contributory defined benefit pension plan (Qualified Pension Plan) covering substantially all employees. After meeting certain qualifications, an employee acquires a vested right to future benefits. The benefits payable under the plan are generally determined on the basis of an employee's length of employment and career average salary. The Company's policy is to fund pension cost accrued in accordance with the Employee Retirement Income Security Act of 1974. The Company also maintains a non-qualified unfunded supplemental defined benefit pension plan (Non-qualified Pension Plan) for the benefit of certain key employees. The following tables set forth the amounts recognized in the Company's financial statements with respect to the Qualified and Non-qualified pension plans:
For the year ended December 31, For the year ended December 31, 1997 1996 Non- Non- Qualified Qualified Qualified Qualified Plan Plan Total Plan Plan Total ---- ---- ----- ---- ---- ----- Service cost-benefits earned during the period......... $ 1,375 93 $ 1,468 1,665 98 $ 1,763 Interest cost on projected benefit obligation........ 3,034 166 3,200 2,948 150 3,098 Actual return on plan assets.. (2,490) -- (2,490) (2,830) -- (2,830) Net amortization and deferral.................. (884) 93 (791) (842) 94 (748) VERIP......................... -- -- -- 4,300 -- 4,300 ------- --- ------- ------ --- ------- Net pension cost.............. 1,035 352 $ 1,387 5,241 342 $ 5,583 ======= === ======= ====== === ======= For the year ended December 31, 1995 Non- Qualified Qualified Plan Plan Total ---- ---- ----- Service cost-benefits earned during the period......... 1,132 108 $ 1,240 Interest cost on projected benefit obligation........ 2,770 158 2,928 Actual return on plan assets.. (8,712) -- (8,712) Net amortization and deferral.................. 5,803 94 5,897 VERIP......................... -- -- -- ------ --- ------- Net pension cost.............. 993 360 $ 1,353 ====== === =======
74
December 31, 1997 December 31, 1996 Non- Non- Qualified Qualified Qualified Qualified Plan Plan Total Plan Total ---- ---- ----- ---- ----- Actuarial present value of: Vested benefit obligation......... $36,405 $ 1,238 $37,643 $41,932 $ 1,069 $43,001 Non-vested benefit obligation..... 3,919 79 3,998 3,487 68 3,555 ------- ------- ------- ------- ------- ------- Accumulated benefit obligation........ $40,324 1,317 41,641 $45,419 1,137 46,556 ======= ======= ======= ======= ======= ======= Projected benefit obligation.......... $44,653 2,472 47,125 $49,331 2,133 51,464 Fair value of Pension Plan assets..... 40,600 -- 40,600 46,739 -- 46,739 ------- ------- ------- ------- ------- ------- Excess of projected benefit obligation over Pension Plan assets........ (4,053) (2,472) (6,525) (2,592) (2,133) (4,725) Unrecognized net loss (gain).......... 4,830 29 4,859 588 (63) 525 Unrecognized transition asset......... (810) 1,123 313 (1,081) 1,216 135 Unrecognized prior service benefit.... (1,101) -- (1,101) (1,199) -- (1,199) ------- ------- ------- ------- ------- ------- Pension liability..................... $(1,134) $(1,320) $(2,454) $(4,284) $ (980) $(5,264) ======= ======= ======= ======= ======= =======
Qualified Pension Plan assets consist of equity securities, fixed maturity securities, fixed income contracts, and the Company's common stock. Actuarial assumptions utilized by the Qualified and Non-qualified Pension Plan are as follows:
For the years ended December 31, 1997 1996 1995 ---- ---- ---- Discount rate..................................... 7.0% 7.5% 7.0% Rate of compensation increase..................... 4.5% 5.0% 5.0% Expected long-term rate of return on plan assets.. 8.0% 8.0% 8.0%
The Company also maintains a voluntary defined contribution savings plan covering all employees who work a minimum of 20 hours per week. The Company matches employee contributions up to 5% of compensation. Contributions under such plans charged to income were $1,735, $2,153 and $1,726 in 1997, 1996 and 1995, respectively. B. Postretirement Benefits -- In addition to providing pension benefits, the Company provides certain health care benefits for retired employees. Substantially all of the Company's employees may become eligible for those benefits if they have worked fifteen or more years with the Company and have attained the age of fifty while in the service of the Company. For employees who retire on or subsequent to January 1, 1993, the Company will pay a fixed portion of medical insurance premiums. Retirees will absorb future increases in medical premiums. The funded status of this liability is as follows: December 31, 1997 1996 ---- ---- Accumulated postretirement benefit obligation: Retirees and dependents.......................... $ 6,076 $ 6,931 Fully eligible active employees.................. 1,214 952 Active employees not fully eligible.............. 2,383 1,871 ------- ------- Total............................................ 9,673 9,754 Unrecognized prior service cost.................. 1,317 1,436 Unrecognized net gain............................ 3,455 4,031 ------- ------- Accrued postretirement benefit liability......... $14,445 $15,221 ======= ======= 75 The components of postretirement benefit cost include the following: For the years ended December 31, 1997 1996 1995 ---- ---- ---- Service cost.......................... $ 237 $ 248 $ 330 Interest cost......................... 655 561 658 Amortization.......................... (242) (251) (209) VERIP................................. -- 975 -- ----- ------ ----- Postretirement benefit cost........... $ 650 $1,533 $ 779 ===== ====== ===== Assumptions used in the computation of the funded status and postretirement benefit cost are as follows: For the years ended December 31, 1997 1996 1995 ---- ---- ---- Discount rate......................... 7.5% 7.0% 7.0% Health care inflation rate: Next year........................... 7.5% 8.0% 8.5% Ultimate............................ 5.5% 5.5% 5.5% The assumed health care cost trend rate used to measure the expected cost of benefits covered by the plan has been established at 7.5% for 1998 and is expected to decline gradually to 5.5% in 2002 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. A 1% increase in the trend rate for health care costs would have increased the accumulated postretirement benefit obligation by $405 and the annual service and interest cost by $27. C. Postemployment Benefits -- SFAS No. 112, "Employers' Accounting for Postemployment Benefits," establishes the accounting standards for employers who provide benefits to employees subsequent to their employment, but prior to retirement. These benefits include severance, long-term and short-term disability payments, salary continuation, postemployment health benefits, supplemental unemployment benefits, and other related payments. SFAS No. 112 requires that benefit obligations attributable to prior service and/or that relate to benefits that vest or accumulate must be accrued presently if the payments are probable and reasonably estimable. Postemployment benefits that do not meet such criteria are accrued when payments are probable and reasonably estimable. In connection with the VERIP described above, the Company recorded $2,360 of postemployment costs in 1996. While a VERIP was not offered in 1997, the Company incurred approximately $7,000 of severance and other restructuring charges during 1997 (See Note 20). 10. Fair Value of Financial Instruments The following table represents the carrying amounts and estimated fair values of the Company's financial instruments. Estimated fair value is defined as the amount at which the instrument could be exchanged in a current transaction between willing parties. Certain financial instruments, specifically amounts relating to insurance contracts, are excluded from this disclosure. 76
December 31, 1997 December 31, 1996 Carrying Estimated Carrying Estimated Amount Fair Value Amount Fair Value ------ ---------- ------ ---------- Financial assets: Fixed maturities available for sale...... $1,929,518 $1,929,518 $2,126,120 $2,126,120 Equity securities........................ 13 13 262 262 Financial liabilities: Long-term debt........................... 203,000 203,000 204,699 218,101 Interest rate swap agreements............ -- 3,388 -- 52
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate values: Fixed maturities: The fair values are estimated based upon quoted market prices. Equity securities: The fair values are estimated based upon quoted market prices. Long-term debt: The fair value is estimated using discounted cash flow calculations based upon the Company's current incremental borrowing rate for similar types of borrowing facilities or the rate utilized to prepay obligations, where applicable. Interest rate swaps: The fair values are estimated by obtaining quotes from dealers. Guarantees: The fair values are determined based upon the likelihood of the Company being required to satisfy the underlying obligations. Management believes that it is a remote possibility that the Company would have to act upon any guarantees. Therefore, the fair value of the guarantees is zero. Other financial instruments (excluded from the above table): The carrying values approximate the fair values. 11. Disclosure of Certain Risks and Uncertainties A. Business Segments and Concentrations -- As stated in Note 1, PMC is an insurance holding company that sells property and casualty reinsurance and insurance through its insurance subsidiaries. The following summarizes the relative importance of the segments and lines of insurance in terms of net premiums written: Percent of the Company's Net Premiums Written 1997 1996 1995 ---- ---- ---- PMA Re-total................................... 42.5% 37.0% 31.2% PMA Re-casualty reinsurance lines.............. 28.4 27.5 21.9 The Property and Casualty Group-total.......... 57.5 63.0 68.8 The Property and Casualty Group-workers' compensation................................. 43.2 45.6 42.8 PMA Re distributes its products through major reinsurance brokers. PMA Re's top five such brokers accounted for 90.8% of PMA Re's gross premiums in force at December 31, 1997. The Property and Casualty Group's operations are concentrated in six contiguous states in the Mid-Atlantic and Southern regions of the U.S. As such, economic trends in individual states may not be independent of 77 one another. Also, the Property and Casualty Group's products are highly regulated by each of these states. For many of the Property and Casualty Group's products, the insurance departments of the states in which it conducts business must approve rates and policy forms. In addition, workers' compensation benefits are determined by statutes and regulations in each of these states. While the Property and Casualty Group considers factors such as rate adequacy, regulatory climate, and economic factors in its underwriting process, unfavorable developments in these factors could have an adverse impact on the Company's financial condition and results of operations. The Company actively manages its exposure to catastrophic events. In the underwriting process, the Company generally avoids the accumulation of insurable values in catastrophe prone regions. Also, in writing property reinsurance coverages, PMA Re typically requires per occurrence loss limitations for contracts that could have catastrophe exposure. Through per risk reinsurance, the Company also manages its net retention in each exposure. In addition, PMA Re maintains retrocessional protection of $46,000 excess of $2,000 per occurrence, and the Property and Casualty Group maintains catastrophe reinsurance protection of $27,700 excess of $850. As a result, the Company's loss ratios have not been significantly impacted by catastrophes, and management believes that the Company has adequate reinsurance to protect against the estimated probable maximum gross loss from a catastrophic event; however, though management believes it is unlikely, an especially severe catastrophic event could exceed the Company's reinsurance and/or retrocessional protection, and adversely impact the Company's financial position, perhaps materially. B. Use of Estimates in the Preparation of the 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, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates. Unpaid Losses and Loss Adjustment Expenses -- At December 31, 1997, the Company carried $2,003,187 of unpaid losses and loss adjustment expenses. Unpaid losses and loss adjustment expenses reflect management's best estimate of future amounts needed to pay claims and related settlement costs with respect to insured events which have occurred, including events that have not been reported to the Company. In many cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured loss, the reporting of the loss to the Company and the Company's payment of that loss. In general, liabilities for reinsurers become known more slowly than for primary insurers and are subject to more unforeseen development. As part of the process in determining these amounts, historical data is reviewed and consideration is given to the impact of various factors, such as legal developments, changes in social attitudes, and economic conditions. In addition, estimating reserves for workers' compensation claims can be more difficult than many other lines of property and casualty insurance for several reasons, including (i) the long payment `tail' associated with the business; (ii) the impact of social, political and regulatory trends on benefit levels for both medical and indemnity payments; (iii) the impact of economic trends; and (iv) the impact of changes in the mix of business. At various times, one or a combination of such factors can make the interpretation of actuarial data associated with workers' compensation loss development more difficult, and it can take additional time to recognize changes in loss development patterns. Under such circumstances, adjustments will be made to such reserves as loss patterns develop and new information becomes available and such adjustments may be material. Management believes that its unpaid losses and loss adjustment expenses are fairly stated at December 31, 1997, in accordance with GAAP. However, estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management's informed estimates and judgments using data currently available. As additional experience and data become available regarding claims payment and reporting patterns, legislative developments, and economic conditions, the estimates are revised accordingly. If the Company's ultimate net losses prove to be substantially greater than the amounts recorded at December 31, 1997, the related adjustments could have a material adverse impact on the Company's financial condition and results of operations (See also Note 3). 78 C. Year 2000 Issue -- The unprecedented advances in computer technology over the past several decades have resulted in dramatic changes in the way companies do business. Most of these developments have been tremendously beneficial, but some have proven costly, as businesses have struggled to adapt to various features of the new technological landscape. One such well-publicized problem has arisen out of the worldwide use of the so-called "Year 2000" programming convention, in which two digit numbers were generally used instead of four digit numbers to identify the years used in dates. As a consequence, most computers require relatively costly reprogramming to enable them to correctly perform date operations involving years 2000 or later, a problem anticipated to have substantial repercussions on the business world, since computer operations involving date calculations are pervasive. With the assistance of outside consulting groups, the Company began evaluating and reprogramming its own computer systems to address the Year 2000 problem in late 1995. Management anticipates that by no later than year end 1998, it will have completed substantially all necessary programming work so that Year 2000 issues are not likely to result in any material adverse disruption in the Company's computer systems or its internal business operations. The cost of this work through year-end 1997 has been approximately $3,800. The Company estimates that the total remaining cost will be approximately $1,300, and will be expensed in 1998. Many experts now believe that Year 2000 problem may have a material adverse impact on the national and global economy generally. In addition, it seems likely that if businesses are materially damaged as a result of Year 2000 problems, at least some such businesses may attempt to recoup their losses by claiming coverage under various types of insurance policies. And, although management has concluded that under a fair reading of the various policies of insurance issued by it no coverage for Year 2000 problems should be considered to exist, it is not possible to predict whether or to what extent any such coverage could ultimately be found to exist by courts in the various jurisdictions. Accordingly, important factors which could cause actual results to differ materially from those expressed in the forward looking statements include but are not limited to the inability of the Company to accurately estimate the impact of the Year 2000 problem on the insurance, or other business operations, of the Company. 12. Transactions With Related Parties The Company's largest shareholder is PMA Foundation (the "Foundation"), formerly known as Pennsylvania Manufacturers' Association, which is a not-for-profit corporation qualified under Section 501(c)(6) of the Internal Revenue Code, whose purposes include the promotion of the common business interests of its members and the economic prosperity of the Commonwealth of Pennsylvania. As of December 31, 1997, the Foundation owned 4,561,225 shares of common stock (30.7% of the class) and 912,225 shares of Class A common stock (10.0% of the class), which constitutes 29.5% of the total number of votes available to be cast in matters brought before the Company's shareholders. All of the members of the Company's Board of Directors currently serve as members of the Foundation's Board of Trustees. Also, Frederick W. Anton III, Chairman of the Company, serves as President and Chief Executive Officer of the Foundation. The Company and certain of its subsidiaries provide certain administrative services to the Foundation for which the Company and its subsidiaries receive reimbursement. Total reimbursements amounted to $34, $82, and $269 for the years ended December 31, 1997, 1996, and 1995, respectively. The Foundation also leases its Harrisburg, Pennsylvania headquarters facility from a subsidiary of the Company under a monthly operating lease presently requiring rent payments of $20 per month and reimburses a subsidiary of the Company for its use of office space in the Blue Bell, Pennsylvania facility. Rent and related reimbursements paid to the Company's affiliates by the Foundation amounted to $250, $247, and $294, for the years ended December 31, 1997, 1996, and 1995, respectively. In addition, the Company has arranged an executive loan program with a financial institution whereby such institution will provide prime rate personal loans to officers of the Company and its subsidiaries collateralized by common stock and Class A common stock at a maximum 50% loan to value ratio. The Company has agreed to purchase any loan made under this program from the financial institution in the event that the borrower defaults on such loan. The amount of loans outstanding at December 31, 1997 under this program was $4,642. 79 The Company incurred legal and consulting fees aggregating approximately $6,506, $7,917, and $6,279 in 1997, 1996 and 1995, respectively, from firms in which directors of the Company are partners or principals. The Company has notes receivable from officers which are accounted for as a reduction of shareholders' equity in the accompanying balance sheets. Such notes receivable had balances of $198 and $1,162 as of December 31, 1997 and December 31, 1996, respectively. The interest rate on the notes range between 6.0% and 8.0%. 13. COMMITMENTS AND CONTINGENCIES For the years ended December 31, 1997, 1996 and 1995, total rent expense was $5,745, $6,114 and $4,536 respectively. At December 31, 1997, the Company was obligated under noncancelable operating leases for office space with aggregate minimum annual rentals as follows: For the years ended December 31, 1998.................................. $ 3,972 1999.................................. 2,940 2000.................................. 1,811 2001.................................. 1,820 2002.................................. 1,566 Thereafter............................ 2,133 ------- Total................................. $14,242 ======= In the event a property and casualty insurer, operating in a jurisdiction where the Company's insurance subsidiaries also operate becomes or is declared insolvent state insurance regulations provide for the assessment of other insurers to fund any capital deficiency of the insolvent insurer. Generally, this assessment is based upon the ratio of an insurer's voluntary premiums written to the total premiums written for all insurers in that particular jurisdiction. The Company is not aware of any material potential assessments at December 31, 1997. The Company has provided guarantees of approximately $11,048 related to loans on properties in which the Company has an interest. The Company is named in various legal proceedings arising in the normal course of business. In the opinion of management, the resolution of these matters will not have a material adverse effect on the Company's financial condition, results of operations, or cash flows. 14. SALE OF UNCOLLECTED PREMIUMS Insurance subsidiaries of PMC, from time to time, engage in the practice of selling uncollected premiums to a third-party financial institution. No such sales were transacted during 1997. The proceeds received from such sales were $10,628 and $19,509 in 1996 and 1995, respectively. These receivables were excluded from uncollected premiums in the accompanying balance sheets. However, the Company had recorded an allowance for doubtful accounts related to the estimated uncollectible accounts since the Company had retained risk under the recourse provisions. At December 31, 1997, the Company had no contingent obligations outstanding related to the sale of uncollected premiums. 15. SHAREHOLDERS' EQUITY The Company has two classes of common stock, Class A common stock and common stock. The Company's common stock and Class A common stock generally vote without regard to class on matters submitted to shareholders, with the common stock having ten votes per share and the Class A common stock having one vote per share. 80 With respect to dividend rights, the Class A common stock is entitled to cash dividends at least 10% higher than those declared and paid on the common stock. The Company's bylaws limit the classes of persons who may own the common stock. Holders of common stock may elect to convert any or all such shares into Class A common stock on a share-for-share basis. Under the insurance laws and regulations of Pennsylvania, PMC's insurance subsidiaries may not pay dividends to PMC without prior regulatory approval, over a twelve-month period in excess of the greater of (a) 10% of the preceding year-end's policyholders surplus or (b) the preceding year's SAP net income, but in no event to exceed unassigned funds. At December 31, 1997, the maximum amount available to be paid as dividends from the Company's insurance subsidiaries to PMC, without the prior consent of the Pennsylvania Insurance Department, was $51,220. PMC's dividends to shareholders are restricted by its debt agreements. On March 14, 1997, the Company refinanced certain debt agreements through the completion of the New Credit Facility (See Note 6). Under the terms of the New Credit Facility under the most restrictive debt covenant, the Company could pay dividends of approximately $14,500 in 1998. PMA Re intends to maintain Caliber One Indemnity Company's surplus at not less than $25,000, the minimum capital and surplus required for many states in order to be an eligible surplus lines carrier (See Note 1). 16. Earnings Per Share In accordance with SFAS No. 128 discussed in Note 1-I, the Company is required to present a reconciliation of the numerators and denominators used in the basic earnings per share calculation to the numerators and denominators used in the diluted earnings per share calculation. The computation of diluted earnings per share is similar to the computation of basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if all dilutive potential common shares, such as outstanding stock options with exercise prices below the average market price, had been issued. For all years presented, there were no differences in the numerator for the basic and diluted earnings per share calculation. For entities that report an extraordinary item, as the Company did in 1997, SFAS No. 128 requires that income before extraordinary item be used as the control number in determining whether or not potential common shares are dilutive. The Company's income (loss) before extraordinary item, which was equal to net income in 1996 and 1995, and a reconciliation of the denominator of the basic and diluted earnings per share computations are presented below. 81
1997 1996 1995 ---- ---- ---- Numerator: Control number - income (loss) before extraordinary item........... $19,753 $(135,334) $24,130 Denominator: Basic shares - weighted average common and Class A common shares outstanding 23,855,031 23,800,791 23,816,088 Dilutive stock options................ 712,347 -- 965,861 ---------- ---------- ---------- Total diluted shares.................. 24,567,378 23,800,791 24,781,949 ========== ========== ==========
Options to purchase 646,000 shares of Class A common stock at $17.00 per share were outstanding at December 31, 1997, but were not included in the computation of diluted earnings per share because the options' exercise price was greater than the average market price of the Class A common shares. Options to purchase 3,242,160 shares of Class A common stock at prices ranging between $8.00 and $17.00 were outstanding during at December 31, 1996, but were excluded from the computation of diluted earnings per share as they would have been anti-dilutive. 82 17. Business Segments Operating revenues, income (loss) before income taxes, and identifiable assets of the Company's business segments were as follows:
For the year ending December 31, 1997 1996 1995 ---- ---- ---- Operating revenues/(1)/ PMA Re Net premiums earned................................... $163,603 $ 151,974 $139,345 Net investment income................................. 52,270 48,676 45,166 -------- --------- -------- 215,873 200,650 184,511 -------- --------- -------- The Property and Casualty Group Net premiums earned - workers' compensation........... 152,773 176,380 243,175 Net premiums earned - commercial lines................ 59,575 92,221 102,432 -------- --------- -------- Net premiums earned - total 212,348 268,601 345,607 Net investment income................................. 82,098 82,455 92,275 Service revenues...................................... 10,311 9,189 5,106 -------- --------- -------- 304,757 360,245 442,988 -------- --------- -------- Corporate, Other and Consolidating Eliminations Net investment income................................. 2,330 2,805 1,914 -------- --------- -------- 2,330 2,805 1,914 -------- --------- -------- Total operating revenues.................................. $522,960 $ 563,700 $629,413 ======== ========= ========
(1) Operating revenues exclude net realized investment gains.
For the years ended December 31, 1997 1996 1995 ---- ---- ---- Income (loss) before income taxes PMA Re.................................................... $ 44,802 $ 42,783 $ 39,443 The Property and Casualty Group........................... (9,038) (219,619) (4,305) Corporate, Other and Consolidating Eliminations........... (3,441) (490) (13,414) -------- --------- -------- Pre-tax operating income (loss) before interest expense... 32,323 (177,326) 21,724 Net realized investment gains............................. 8,598 2,984 31,923 Interest expense.......................................... (15,768) (17,052) (18,734) -------- --------- -------- Total income (loss) before income taxes................... $ 25,153 $(191,394) $ 34,913 ======== ========= ======== December 31, 1997 1996 ---- ---- Identifiable assets PMA Re................................................... $1,126,176 $1,031,149 The Property and Casualty Group.......................... 1,863,975 2,050,648 Corporate, Other and Consolidating Eliminations.......... 67,107 35,719 ---------- ---------- Total identifiable assets................................ $3,057,258 $3,117,516 ========== ==========
83 18. SAP Information SAP net income (loss) and capital and surplus for PMC's domestic insurance subsidiaries as reported to the Insurance Departments of Pennsylvania and Delaware are as follows:
For the years ended December 31, 1997 1996 1995 ---- ---- ---- SAP net income (loss) PMA Re................................................... $ 25,752 $ 26,338 $ 36,854 The Property and Casualty Group.......................... 10,785 (191,640) 30,925 -------- --------- -------- Total/(1)/............................................... $ 36,537 $(165,302) $ 67,779 ======== ========= ========
(1) Caliber One Indemnity Company had no SAP net income or loss during 1997.
December 31, 1997 1996 1995 ---- ---- ---- SAP capital and surplus PMA Re/(1)/.............................................. $271,154 $ 260,853 $254,088 The Property and Casualty Group.......................... 281,071 279,764 402,968 -------- --------- -------- Total.................................................... $552,225 $ 540,617 $657,056 ======== ========= ========
(1) The SAP capital and surplus of PMA Re includes PMA Re's investment in Caliber One Indemnity Company, equal to Caliber One Indemnity Company's SAP capital and surplus of $25,039 at December 31, 1997. A reconciliation of PMC's domestic insurance subsidiaries' SAP net income (loss) and capital and surplus to the Company's GAAP net income (loss) and shareholders' equity is as follows:
For the years ended December 31, 1997 1996 1995 ---- ---- ---- Net income (loss) SAP net income (loss): Domestic insurance subsidiaries......................... $ 36,537 $(165,302) $ 67,779 GAAP adjustments: Change in deferred acquisition costs.................... 1,282 6,105 5,665 Benefit (provision) for deferred income taxes........... 4,725 11,488 (15,353) Allowance for doubtful accounts......................... 307 (5,317) 4,105 Retirement accruals..................................... 275 (76) (3,613) Other................................................... 549 (938) (306) -------- --------- -------- GAAP net income (loss) - domestic insurance subsidiaries.. 43,675 (154,040) 58,277 Other entities and eliminations........................... (23,922) 18,706 (34,147) Extraordinary loss........................................ (4,734) -- -- -------- --------- -------- GAAP net income (loss).................................... $ 15,019 $(135,334) $ 24,130 ======== ========= ========
84
December 31, 1997 1996 1995 ---- ---- ---- Shareholders' equity SAP capital and surplus: Domestic insurance subsidiaries............................ $ 552,225 $ 540,617 $ 657,056 GAAP adjustments: Deferred acquisition costs................................. 45,288 44,006 37,901 Deferred income taxes...................................... 52,571 101,642 67,331 Allowance for doubtful accounts............................ (19,700) (26,214) (20,897) Retirement accruals........................................ (10,653) (14,571) (14,495) Reversal of non-admitted assets............................ 21,330 25,599 32,841 Unrealized gain (loss) on fixed maturity investments available for sale....................................... 19,380 (38,271) 24,186 Other...................................................... 3,254 (338) 958 --------- --------- --------- GAAP shareholders' equity - domestic insurance subsidiaries.. 663,695 632,470 784,881 Other entities and eliminations.............................. (185,348) (206,642) (175,213) --------- --------- --------- GAAP shareholders' equity.................................... $ 478,347 $ 425,828 $ 609,668 ========= ========= =========
19. Subsequent Events In February of 1998, the Company's Board of Directors authorized a plan to repurchase, over the next two years, up to a maximum of 1,500,000 shares of common stock and Class A common stock, in an amount not to exceed $25,000. Repurchases may be made, from time to time, at the discretion of the Company in the open market or directly from shareholders at prevailing market prices. The 1.5 million share limit equated to approximately 6.25% of the total common and Class A common stock outstanding at December 31, 1997. Effective February 5, 1998, the Company's Class A common stock began trading on the Nasdaq National List under the ticker symbol, "PMFRA". Previously, the Company's Class A common stock traded on the OTC Bulletin Board under the same ticker symbol. 20. Quarterly Financial Information (Unaudited) As noted in Note 19, the Company's Class A common stock began trading on the Nasdaq National List during 1998. As of December 31, 1997 and 1996, neither class of common equity was traded on an established exchange. Transactions in the common stock were conducted privately among persons qualified to own the common stock. No price information was available for such transactions. Throughout 1997 and 1996, Class A common stock traded under the symbol, "PMFRA", on the OTC Bulletin Board through approximately ten broker/dealers who voluntarily made a market in Class A common stock. The stock price data presented below for 1997 and 1996 for the Class A common stock are based upon over-the-counter market bid quotations, which reflect interdealer prices, without retail mark-up, mark-down or commission, and may not represent actual transactions. As of February 28, 1998, the Company had 186 and 404 record holders of common stock and Class A common stock, respectively. Over the past two years, the Company's operating results have been impacted by restructuring charges and other special items. During 1997, the Company incurred restructuring and other charges of approximately $775, $3,500, $2,660 and $5,165 for the first, second, third and fourth quarter, respectively. During 1996, the Company incurred approximately $31,700 of restructuring and other charges, excluding loss reserve strengthening, during the fourth quarter. The Company recorded $10,000 and $181,400 of loss reserve strengthening in the third and fourth quarters of 1996, respectively (See Note 3). 85 The following tables provide a summary of quarterly financial information:
1997 - ---------------------------------------------------------------------------------------------------------- First Second Third Fourth Quarter Quarter Quarter Quarter - ---------------------------------------------------------------------------------------------------------- Income Statement Data: Net premiums written $149,882 $ 98,389 $104,487 $ 65,524 ======== ======== ======== ======== Net premiums earned $107,950 $114,451 $ 62,970 $ 90,580 Net investment income 35,847 32,612 34,353 33,886 Net realized investment (losses) gains (1,251) (680) 5,531 4,998 Service revenues 2,548 2,490 2,674 2,599 -------- -------- -------- -------- Total revenues 145,094 148,873 105,528 132,063 -------- -------- -------- -------- Losses and loss adjustment expenses 94,904 98,230 47,785 66,362 Operating expenses 35,281 48,093 38,858 46,408 Dividends to policyholders 3,257 3,360 3,566 4,533 Interest expense 4,334 3,888 3,803 3,743 -------- -------- -------- -------- Total losses and expenses 137,776 153,571 94,012 121,046 -------- -------- -------- -------- Income before income taxes and extraordinary item 7,318 (4,698) 11,516 11,017 Provision (benefit) for income tax 2,561 (5,218) 4,172 3,885 -------- -------- -------- -------- Income before extraordinary item 4,757 520 7,344 7,132 Extraordinary item, net of tax (4,734) -- -- -- -------- -------- -------- -------- Net income $ 23 $ 520 $ 7,344 $ 7,132 ======== ======== ======== ======== Supplemental Operating Income (Loss) Data: Operating income (loss) before interest expenses and income taxes/(1)/ $ 12,903 $ (130) $ 9,788 $ 9,762 Operating income after interest before income taxes/(1)/ 8,569 (4,018) 5,985 6,019 Operating income after income taxes/(1)/ 5,570 962 3,749 3,883 - ---------------------------------------------------------------------------------------------------------- Per Share Data: Basic: Income before extraordinary item $ 0.20 $ 0.02 $ 0.31 $ 0.30 Extraordinary item (0.20) -- -- -- -------- -------- -------- -------- Net income $ -- $ 0.02 $ 0.31 $ 0.30 ======== ======== ======== ======== Operating income after income taxes/(1)/ $ 0.23 $ 0.04 $ 0.16 $ 0.16 ======== ======== ======== ======== Diluted: Income before extraordinary item $ 0.19 $ 0.02 $ 0.30 $ 0.29 Extraordinary item (.0.19) -- -- -- -------- -------- -------- -------- Net income $ -- $ 0.02 $ 0.30 $ 0.29 ======== ======== ======== ======== Operating income after income taxes/(1)/ $ 0.23 $ 0.04 $ 0.15 $ 0.16 ======== ======== ======== ======== - ---------------------------------------------------------------------------------------------------------- Class A Common Stock Prices: High $ 16.125 $ 16.000 $ 16.750 $ 18.000 Low $ 15.625 $ 14.000 $ 15.000 $ 16.000 Close $ 16.000 $ 15.000 $ 16.750 $ 16.000
(1) - Operating income (loss) excludes net realized investment (losses) gains. 86
1996 - ---------------------------------------------------------------------------------------------------------- First Second Third Fourth Quarter Quarter Quarter Quarter - ---------------------------------------------------------------------------------------------------------- Income Statement Data: Net premiums written $147,444 $ 96,336 $116,745 $ 82,950 ======== ======== ======== ========= Net premiums earned $117,937 $102,226 $106,034 $ 94,378 Net investment income 33,420 32,511 32,732 35,273 Net realized investment gains (losses) 943 (1,412) 5,972 (2,519) Service revenues 1,748 2,264 2,642 2,535 -------- -------- -------- --------- Total revenues 154,048 135,589 147,380 129,667 -------- -------- -------- --------- Losses and loss adjustment expenses 99,943 85,512 97,013 254,155 Operating expenses 38,310 42,012 40,748 67,078 Dividends to policyholders 3,122 2,730 3,566 6,837 Interest expense 4,472 4,358 4,331 3,891 -------- -------- -------- --------- Total losses and expenses 145,847 134,612 145,658 331,961 -------- -------- -------- --------- Income before income taxes and extraordinary item 8,201 977 1,722 (202,294) Provision (benefit) for income tax 2,572 (139) (734) (57,759) -------- -------- -------- --------- Net income (loss) $ 5,629 $ 1,116 $ 2,456 $(144,535) ======== ======== ======== ========= Supplemental Operating Income (Loss) Data: Operating income (loss) before interest expenses and income taxes/(1)/ $ 11,730 $ 6,747 $ 81 $(195,884) Operating income (loss) after interest before income taxes/(1)/ 7,258 2,389 (4,250) (199,775) Operating income (loss) after income taxes/(1)/ 5,016 2,034 (1,426) (142,898) - ---------------------------------------------------------------------------------------------------------- Per Share Data: Basic: Net income (loss) $ 0.23 $ 0.05 $ 0.11 $ (6.07) ======== ======== ======== ========= Operating income (loss) after income taxes/(1)/ $ 0.21 $ 0.09 $ (0.06) $ (6.01) ======== ======== ======== ========= Diluted: Net income (loss) $ 0.22 $ 0.05 $ 0.10 $ (6.07) ======== ======== ======== ========= Operating income (loss) after income taxes/(1)/ $ 0.20 $ 0.08 $ (0.06) $ (6.01) ======== ======== ======== ========= - ---------------------------------------------------------------------------------------------------------- Class A Common Stock Prices: High $ 20.500 $ 18.500 $ 17.500 $ 17.500 Low $ 18.250 $ 16.500 $ 17.000 $ 15.625 Close $ 18.875 $ 17.000 $ 17.500 $ 15.750
(1) - Operating income (loss) excludes net realized investment gains (losses). 87 Report of Independent Accountants To the Board of Directors and Shareholders Pennsylvania Manufacturers Corporation: We have audited the accompanying consolidated balance sheets of Pennsylvania Manufacturers Corporation and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pennsylvania Manufacturers Corporation and subsidiaries as of December 31, 1997 and 1996, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. /s/ Coopers & Lybrand L.L.P. One South Market Square Harrisburg, Pennsylvania February 6, 1998 88 EX-21 6 SUBSIDIARIES OF REGISTRANTS Pennsylvania Manufacturers Corporation Subsidiaries of Registrant Exhibit 21.1
PMC Direct PMC Indirect Ownership Ownership -------------------------------- Caliber One Management Company, Inc. 100% DP Corp. 100% Manufacturers Alliance Insurance Company 100% Mid Atlantic States Investment Company 100% Mid-Atlantic States Casualty Company 100% PMA Holdings Cayman, Ltd. 100% PMA Insurance Cayman, Ltd. 100% Pennsylvania Manufacturers Association Insurance Company 100% Ajon, Inc. 15% 85% Aud-Evad, Inc. 15% 85% Dauphin Equities, Inc. 15% 85% Lorjo Corp. 15% 85% Rosemarie, Inc. 15% 85% Sarfred, Inc. 15% 85% Wisteve, Inc. 15% 85% Cris-Jen, Inc. 100% Gulph Industries, Inc. 100% Lee Ward, Inc. 100% PMA Management Corp. 100% PMA Services, Inc. 100% Presque Enterprises, Inc. 100% Syl-Bar, Inc. 100% Walprop, Inc. 100% Pennsylvania Manufacturers' Association Finance Company 100% Pennsylvania Manufacturers Indemnity Company 100% PMA Holdings Limited 100% Pennsylvania Manufacturers International Insurance, Ltd. 100% PMA Life Insurance Company 100% PMA Reinsurance Corp. 100% Caliber One Indemnity Company 100% REM Corp. 100% 925 Chestnut, Inc. 100%
EX-23 7 CONSENT OF INDEPENDENT ACCOUNTANTS Exhibit 23 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to incorporation by reference in the Registration Statement on Form S-8 (File No. 333-45949) of Pennsylvania Manufacturers Corporation of our report dated February 6, 1998, appearing on page 88 of the Annual Report to Shareholders which is incorporated in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedules which appears on page S-9 of this Form 10-K. /s/ Coopers & Lybrand L.L.P. One South Market Square Harrisburg, Pennsylvania March 15, 1998 EX-27 8 FINANCIAL DATA SCHEDULE
7 YEAR YEAR DEC-31-1997 DEC-31-1996 DEC-31-1996 DEC-31-1995 DEC-31-1997 DEC-31-1996 1,929,518 2,126,120 0 0 0 0 13 262 0 0 0 0 2,194,738 2,261,353 32,148 7,176 332,406 257,983 45,288 44,006 3,057,258 3,117,516 2,003,187 2,091,072 211,455 205,982 0 0 10,200 12,524 203,000 204,699 0 0 0 0 122,214 121,716 356,133 304,112 3,057,258 3,117,516 375,951 420,575 136,698 133,936 8,598 2,984 10,311 9,189 307,281 536,623 93,501 90,292 89,855 114,111 25,153 (191,394) 5,400 (56,060) 0 0 0 0 (4,734) 0 0 0 15,019 (135,334) 0.63 (5.68) 0.61 (5.68) 0 0 0 0 0 0 0 0 0 0 0 0 0 0
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