UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
Form 10-Q
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[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ________ TO ________.
COMMISSION FILE NUMBER 1-9640
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MERCHANTS GROUP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE
(State or other jurisdiction of incorporation or organization)
16-1280763
(I.R.S. Employer Identification No.)
250 MAIN STREET, BUFFALO, NEW YORK
(Address of principal executive offices)
14202
(Zip Code)
716-849-3333
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months, and (2) has been subject to such filing requirements
for the past 90 days. Yes [x] No [ ]
Indicate by checkmark whether the registrant is an accelerated filer (as defined
in Rule 12b-2 of the Act). Yes [ ] No [x]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of October 29, 2004: 2,114,152 SHARES OF COMMON STOCK.
1
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
MERCHANTS GROUP, INC.
CONSOLIDATED BALANCE SHEET
(in thousands)
December 31, September 30,
Assets 2003 2004
------ ------------ -------------
(unaudited)
Investments:
Fixed maturities:
Available for sale at fair value (amortized cost
$192,315 in 2003 and $179,910 in 2004) $ 193,805 $ 180,002
Preferred stock at fair value 5,797 3,494
Other long-term investments at fair value 2,167 3,149
Short-term investments 1,118 10,886
------------ -------------
Total investments 202,887 197,531
Cash 23 5
Interest due and accrued 1,260 1,114
Premiums receivable, net of allowance for doubtful
accounts of $278 in 2003 and $292 in 2004 16,677 15,300
Deferred policy acquisition costs 8,623 7,774
Reinsurance recoverable on paid and unpaid losses 22,715 20,779
Prepaid reinsurance premiums 3,066 4,823
Receivable from affiliate - 425
Income taxes receivable 881 -
Deferred income taxes 4,497 5,350
Other assets 11,637 10,858
------------ -------------
Total assets $ 272,266 $ 263,959
============ =============
See Notes to the Consolidated Financial Statements
2
MERCHANTS GROUP, INC.
CONSOLIDATED BALANCE SHEET
(in thousands except share amounts)
December 31, September 30,
Liabilities and Stockholders' Equity 2003 2004
------------------------------------ ------------ -------------
(unaudited)
Liabilities:
Reserve for losses and loss adjustment expenses $ 146,474 $ 136,317
Unearned premiums 36,176 34,700
Payable to affiliate 2,090 -
Payable for securities - 3,867
Income taxes payable - 110
Other liabilities 17,267 16,871
------------ -------------
Total liabilities 202,007 191,865
------------ -------------
Stockholders' equity:
Common stock, 10,000,000 shares authorized, 2,110,152 shares issued and
outstanding at December 31, 2003 and 2,114,152 shares issued and
outstanding at September 30, 2004 32 33
Additional paid in capital 35,795 35,878
Treasury stock, 1,139,700 shares at December 31, 2003
and September 30, 2004 (22,766) (22,766)
Accumulated other comprehensive income (loss) 750 (390)
Accumulated earnings 56,448 59,339
------------ -------------
Total stockholders' equity 70,259 72,094
------------ -------------
Commitments and contingent liabilities - -
Total liabilities and stockholders' equity $ 272,266 $ 263,959
============ =============
See Notes to the Consolidated Financial Statements
3
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF OPERATIONS
(in thousands except per share amounts)
Three Months Nine Months
Ended September 30, Ended September 30,
2003 2004 2003 2004
--------- ------- --------- -------
(unaudited)
Revenues:
Net premiums earned $ 16,341 $14,161 $ 48,697 $42,594
Net investment income 2,201 1,935 6,715 5,954
Net realized investment gains 44 - 2,210 470
Other revenues 127 185 284 448
--------- ------- --------- -------
Total revenues 18,713 16,281 57,906 49,466
--------- ------- --------- -------
Expenses:
Net losses and loss adjustment expenses 11,972 8,941 37,240 28,182
Amortization of deferred policy acquisition
costs 4,258 3,677 12,689 11,074
Other underwriting expenses 1,382 2,354 3,746 5,813
--------- ------- --------- -------
Total expenses 17,612 14,972 53,675 45,069
--------- ------- --------- -------
Income before income taxes 1,101 1,309 4,231 4,397
Income tax provision 273 146 664 873
--------- ------- --------- -------
Net income $ 828 $ 1,163 $ 3,567 $ 3,524
========= ======= ========= =======
Earnings per share:
Basic $ .39 $ .55 $ 1.69 $ 1.67
--------- ------- --------- -------
Diluted $ .39 $ .55 $ 1.69 $ 1.66
========= ======= ========= =======
Weighted average shares outstanding:
Basic 2,110 2,114 2,110 2,113
Diluted 2,110 2,119 2,111 2,118
See Notes to the Consolidated Financial Statements
4
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
(in thousands)
Three Months Nine Months
Ended September 30, Ended September 30,
2003 2004 2003 2004
------ ------ ------ -------
(unaudited)
Net income $ 828 $1,163 $3,567 $ 3,524
------ ------ ------ -------
Other comprehensive income (loss) before taxes:
Unrealized gains (losses) on securities (852) 2,812 1,489 (1,257)
Reclassification adjustment
for gains included in net income (32) - (2,198) (470)
------ ------ ------ -------
Other comprehensive income (loss) before taxes (884) 2,812 (709) (1,727)
Income taxes (benefit) related to items
of other comprehensive income (loss) (301) 956 (242) (587)
------ ------ ------ -------
Other comprehensive income (loss) (583) 1,856 (467) (1,140)
------ ------ ------ -------
Comprehensive income $ 245 $3,019 $3,100 $ 2,384
====== ====== ====== =======
See Notes to the Consolidated Financial Statements
5
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(in thousands)
Nine Months
Ended September 30,
2003 2004
---------- --------
(unaudited)
Common stock:
Beginning of period $ 32 $ 32
Exercise of common stock options - 1
---------- --------
End of period 32 33
---------- --------
Additional paid in capital:
Beginning of period 35,795 35,795
Exercise of common stock options - 83
---------- --------
End of period 35,795 35,878
---------- --------
Treasury stock beginning and end: (22,766) (22,766)
---------- --------
Accumulated other comprehensive income (loss):
Beginning of period 1,937 750
Other comprehensive income (loss) (467) (1,140)
---------- --------
End of period 1,470 (390)
---------- --------
Accumulated earnings:
Beginning of period 52,926 56,448
Net income 3,567 3,524
Cash dividends (633) (633)
---------- --------
End of period 55,860 59,339
---------- --------
Total stockholders' equity $ 70,391 $ 72,094
========== ========
See Notes to the Consolidated Financial Statements
6
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands)
Nine Months
Ended September 30,
2003 2004
--------- ---------
(unaudited)
Cash flows from operations:
Collection of premiums $ 46,958 $ 40,843
Payment of losses and loss adjustment expenses (39,604) (36,628)
Payment of other underwriting expenses (16,759) (16,200)
Investment income received 6,756 6,258
Investment expenses paid (218) (211)
Income taxes (paid) recovered 154 (376)
Other 284 447
--------- ---------
Net cash used in operations (2,429) (5,867)
--------- ---------
Cash flows from investing activities:
Proceeds from fixed maturities sold or matured 110,103 35,470
Purchase of fixed maturities (110,864) (22,567)
Net decrease in preferred stock 1,500 2,000
Net (increase) decrease in other long-term investments 1,958 (982)
Net (increase) decrease in short-term investments 1,382 (9,768)
Increase in payable for securities 8,020 3,867
(Increase) decrease in receivable for securities (491) 893
--------- ---------
Net cash provided by investing activities 11,608 8,913
--------- ---------
Cash flows from financing activities:
Settlement of affiliate balances, net (3,531) (2,515)
Exercise of common stock options - 84
Cash dividends (633) (633)
--------- ---------
Net cash used by financing activities (4,164) (3,064)
--------- ---------
Increase (decrease) in cash 5,015 (18)
Cash:
Beginning of period 9 23
--------- ---------
End of period $ 5,024 $ 5
========= =========
See Notes to the Consolidated Financial Statements
7
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
RECONCILIATION OF NET INCOME TO NET CASH
USED IN OPERATIONS
(in thousands)
Nine Months
Ended September 30,
2003 2004
--------- ---------
(unaudited)
Net income 3,567 $ 3,524
Adjustments:
Amortization (accretion), net (257) (53)
Realized investment gains (2,210) (470)
(Increase) decrease in assets:
Interest due and accrued 82 146
Premiums receivable (2,660) 1,377
Deferred policy acquisition costs (33) 849
Reinsurance recoverable on paid and unpaid losses 12 1,936
Prepaid reinsurance premiums 212 (1,757)
Income taxes receivable - 881
Deferred income taxes (820) (266)
Other assets (941) (115)
Increase (decrease) in liabilities:
Reserve for losses and loss adjustment expenses (280) (10,157)
Unearned premiums (256) (1,476)
Income taxes payable - 110
Other liabilities 1,155 (396)
-------- ---------
Net cash used in operations (2,429) $ (5,867)
======== =========
See Notes to the Consolidated Financial Statements
8
MERCHANTS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Principles of Consolidation and Basis of Presentation
The consolidated balance sheet as of September 30, 2004 and the related
consolidated statements of operations and comprehensive income for the three and
nine month periods ended September 30, 2003 and 2004, and changes in
stockholders' equity and cash flows for the nine month periods ended September
30, 2003 and 2004, respectively, are unaudited. In the opinion of management,
the interim financial statements reflect all adjustments necessary for a fair
presentation of financial position and results of operations. Such adjustments
consist only of normal recurring items. Interim results are not necessarily
indicative of results for a full year.
The consolidated financial statements include the accounts of Merchants Group,
Inc. (the Company), its wholly-owned subsidiary, Merchants Insurance Company of
New Hampshire, Inc. (MNH), and M.F.C. of New York, Inc., an inactive premium
finance company which is a wholly-owned subsidiary of MNH. The accompanying
consolidated financial statements should be read in conjunction with the
following notes and the Notes to Consolidated Financial Statements included in
the Company's Annual Report on Form 10-K for the year ended December 31, 2003.
The consolidated financial statements have been prepared in conformity with
generally accepted accounting principles (GAAP) which differ in some respects
from those followed in reports to insurance regulatory authorities. All
significant intercompany balances and transactions have been eliminated.
2. Related Party Transactions
The Company and MNH operate and manage their business in conjunction with
Merchants Mutual Insurance Company (Mutual), under a services agreement (the
Services Agreement) effective January 1, 2003. At September 30, 2004, Mutual
owned 12.1% of the Company's issued and outstanding common stock. The Company
and MNH do not have any operating assets and MNH has only one employee. Under
the Services Agreement, Mutual provides the Company and MNH with the facilities,
management and personnel required to operate their day-to-day business. The
Services Agreement covers substantially the same services previously provided
under a management agreement amongst the Company, MNH and Mutual from 1986 to
2002. The Services Agreement provides for negotiated fees (subject to periodic
adjustment) for administrative, underwriting, claims and investment management
services.
As of January 1, 2003 MNH and Mutual entered into a reinsurance pooling
agreement (the Reinsurance Pooling Agreement) that provides for the pooling, or
sharing, of the insurance business traditionally written by Mutual and MNH. The
Reinsurance Pooling Agreement applies to premiums earned and losses incurred on
or after its effective date. The terms of these agreements are more fully
described under the heading "Administration" in Part I, Item 1, Business, in the
Company's Annual Report of Form 10-K for the year ended December 31, 2003.
9
3. Earnings Per Share
Basic and diluted earnings per share were computed by dividing net income by the
weighted average number of shares of common stock outstanding during each
period. For diluted earnings per share, the weighted average number of shares
outstanding was increased by the assumed exercise of options for each period.
The effect on the number of shares outstanding assumes the proceeds to the
Company from exercise were used to purchase shares of the Company's common stock
at its average market value per share during the period. The number of options
assumed to be exercised and the incremental effect on average shares outstanding
for purposes of calculating diluted earnings per share are shown below:
Three Months Nine Months
Ended September 30, Ended September 30,
-------------------------- -----------------------
2003 2004 2003 2004
---- ------ ------ ------
Options assumed exercised - 31,500 35,500 31,500
Incremental shares outstanding - 4,542 439 4,911
Options to purchase 35,500 shares of common stock at $21.00 per share were
outstanding during the three months ended September 30, 2003 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 common shares.
4. Income Taxes
The provision for income taxes for the nine month period ended September 30,
2003 includes the effect of a May 2003 change in New York State law with respect
to the taxation of property and casualty insurance companies. As a result of
this change, the Company reduced its deferred tax liability with respect to New
York State income taxes to $0, and recorded a one-time benefit, net of federal
income taxes, to its income tax provision of $505,000 during the nine month
period ended September 30, 2003. This one time benefit reduced the Company's
effective income tax rate for the nine month period ended September 30, 2003 by
12 percentage points.
10
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Results of Operations for the Nine Months Ended September 30, 2004 As Compared
to the Nine Months Ended September 30, 2003
The following discussion should be considered in light of the statements under
the heading "Safe Harbor Statement under the Securities Litigation Reform Act of
1995," at the end of this Item. All capitalized terms used in this Item that are
not defined in this Item have the meanings given to them in Notes to
Consolidated Financial Statements contained in Item 1 of this Form 10-Q, which
is incorporated herein by reference.
Total revenues for the nine months ended September 30, 2004 were $49,466,000, a
decrease of $8,440,000 or 15% from $57,906,000 for the nine months ended
September 30, 2003.
Results of operations for the nine months ended September 30, 2004 and 2003
reflect the effects of the Services Agreement and the Reinsurance Pooling
Agreement among the Company and its wholly-owned insurance subsidiary, Merchants
Insurance Company of New Hampshire, Inc. (MNH) and Merchants Mutual Insurance
Company (Mutual), effective January 1, 2003. The Services Agreement calls for
Mutual to provide underwriting, administrative, claims and investment services
to the Company and MNH. The Reinsurance Pooling Agreement provides for the
pooling, or sharing, of insurance business traditionally written by Mutual and
MNH on or after the effective date. MNH's share of pooled (combined Mutual and
MNH) premiums earned and losses and loss adjustment expenses (LAE) for 2004 in
accordance with the Reinsurance Pooling Agreement is 35%. MNH's share of pooled
premiums earned and losses and LAE was 40% in 2003. The Reinsurance Pooling
Agreement pertains to premiums earned and incurred losses and LAE. Direct
premiums written by MNH and Mutual are not pooled.
Total combined Mutual and MNH or "group-wide" direct premiums written (DWP) for
the nine months ended September 30, 2004 were $145,921,000, an increase of
$14,657,000 or 11% from $131,264,000 in 2003. The Company's pro-forma share of
combined direct premiums written in 2004, in accordance with the Reinsurance
Pooling Agreement, was $51,072,000 compared to $52,506,000 in 2003. The table
below shows a comparison of direct premiums written by major category in 2004
and 2003:
Group-wide DWP MNH Pro-forma Share
--------------------- --------------------
Nine months ended Nine months ended
September 30, September 30,
--------------------- --------------------
2003 2004 Change 2003 2004 Change
-------- -------- ------ ------- ------- ------
(000's omitted) (000's omitted)
Voluntary Personal Lines $ 48,350 $ 38,982 (19%) $19,340 $13,643 (29%)
Voluntary Commercial Lines 78,527 89,905 14% 31,411 31,467 -
Umbrella Program - 14,241 - - 4,984 -
Involuntary 4,387 2,793 (36%) 1,755 978 (44%)
-------- -------- ------- -------
Total Direct Written Premiums $131,264 $145,921 11% $52,506 $51,072 (3%)
======== ======== ======= =======
The 19% (or $9,368,000) decrease in group-wide voluntary personal lines direct
premiums written resulted from a 26% (or $9,004,000) decrease in private
passenger automobile (PPA) direct premiums written and a 2% (or $258,000)
decrease in homeowners direct premiums written. The decrease in PPA direct
premiums
11
written is the result of the companies' decision, implemented in 2002, not to
write new policies in certain jurisdictions and of the approval of the
companies' plan to withdraw from the New Jersey PPA market by the New Jersey
Department of Banking and Insurance, which was effective in June 2003. As a
result, voluntary PPA policies in force at September 30, 2004 were 21,945, a
decrease of 8,654, or 28%, from 30,599 at September 30, 2003.
Mutual introduced a monoline commercial umbrella program in the fourth quarter
of 2003 (the Umbrella Program). The Umbrella Program is marketed exclusively
through one independent agent and approximately 95% of the premiums related to
Umbrella Program Policies are reinsured with an "A+" rated national reinsurer
through a quota share reinsurance treaty. There were no similar direct premiums
written in the nine months ended September 30, 2003, because the program was
initiated during the fourth quarter of 2003.
Group-wide voluntary commercial lines direct premiums written increased
$11,378,000, or 14%, to $89,905,000 for the nine months ended September 30,
2004, from $78,527,000 for the nine months ended September 30, 2003. This
increase resulted from period to period increases in every group-wide commercial
line of business. The average premium per group-wide, non-Umbrella Program
commercial lines policy increased 8% from the year earlier period. Total
non-Umbrella Program commercial lines policies in force at September 30, 2004
were 32,647, an increase of 3% from 31,830 at September 30, 2003.
The 36% decrease in group-wide involuntary direct premiums written resulted
primarily from a decrease in assignments from the New York Automobile Insurance
Plan (NYAIP). Direct premiums written related to policies assigned from the
NYAIP decreased to $1,674,000 for the nine months ended September 30, 2004,
compared to $2,352,000 for the nine months ended September 30, 2003. The NYAIP
provides coverage for individuals who are unable to obtain auto insurance in the
voluntary market. Assignments from the NYAIP vary depending upon a company's PPA
market share and the size of the NYAIP. The Company is unable to predict the
volume of future assignments from the NYAIP.
In order to minimize the adverse impact of assignments from the NYAIP, the
Company purchased territorial credits from an unaffiliated insurance company
pursuant to Section 6.A.7. of the NYAIP Manual. The credits against NYAIP
assignments were generated by the other insurance company for writing PPA
business in certain localities in New York with PPA market availability
problems. The other insurance company, by nature of its concentration in PPA
business in "credit" territories, generated more credits than it required to
offset its NYAIP assignments. The credits purchased reduced the Company's share
of the NYAIP. The credits purchased decreased direct premiums written related to
NYAIP assignments during the nine months ended September 30, 2004 by
approximately $1,900,000 compared to approximately $1,800,000 for the nine
months ended September 30, 2003.
Group-wide pooled net premiums written for 2004 were $124,283,000, an increase
of $1,410,000, or 1% from $122,873,000 for the nine months ended September 30,
2003. This 1% increase in group-wide net premiums written is consistent with the
increase in group wide non-Umbrella Program direct premiums written. The
Company's share of 2004 pooled net premiums written was $39,360,000, a decrease
of $9,293,000, or 19%, from $48,653,000 in 2003. The decrease in the Company's
share of net premiums
12
written resulted primarily from the 5 percentage point decrease in the Company's
participation in the Reinsurance Pooling Agreement for 2004 as compared to 2003.
The Company's share of pooled net premiums earned in accordance with the
Reinsurance Pooling Agreement for the nine months ended September 30, 2004 was
$42,594,000, compared to $48,697,000 for the nine months ended September 30,
2003. This $6,103,000, or 13%, decrease in net premiums earned resulted
primarily from the 5 percentage point decrease in the Company's participation in
the Reinsurance Pooling Agreement.
Net investment income was $5,954,000 for the nine months ended September 30,
2004, a decrease of 11% from $6,715,000 for the nine months ended September 30,
2003. The average pre-tax yield on the investment portfolio decreased 26 basis
points to 4.2% for the nine months ended September 30, 2004, reflecting the
lower interest rate environment. Average invested assets for the nine months
ended September 30, 2004 decreased 2% from the year earlier period.
Net losses and LAE were $28,182,000 for the nine months ended September 30,
2004, a decrease of $9,058,000, or 24%, from $37,240,000 for the nine months
ended September 30, 2003. The decrease in net losses and LAE was due to the 13%
decrease in net premiums earned and a 10.3 percentage point decrease in the loss
and LAE ratio to 66.2% for the nine months ended September 30, 2004 from 76.5%
for the nine months ended September 30, 2003. Substantially all of the decrease
in the loss and LAE ratio related to an improvement in the loss and LAE ratio
for the 2004 accident year (losses occurring in the first nine months of 2004)
compared to the 2003 accident year (losses occurring in the first nine months of
2003).
Involuntary automobile insurance business increased the Company's calendar year
loss and LAE ratio by approximately .5 and 2.5 percentage points for the nine
months ended September 30, 2004 and 2003, respectively.
The ratio of amortized deferred policy acquisition costs and other underwriting
expenses to net premiums earned increased to 39.6% for the nine months ended
September 30, 2004 from 33.7% for the nine months ended September 30, 2003.
Other underwriting expenses included $1,325,000 (3.1 percentage points of the
expense ratio) of retrospective commissions related to the Reinsurance Pooling
Agreement which provides for retrospective commission income or expense based on
actual experience compared to a targeted loss and LAE ratio. The commission is
owed to Mutual based on a decrease during 2004 in the estimated cumulative loss
and LAE ratio on the "pooled" business since the inception of the Reinsurance
Pooling Agreement. During the first nine months of 2003 the Company recorded
$253,000 retrospective commission income related to the Reinsurance Pooling
Agreement. This amount reduced the 2003 ratio of amortized deferred policy
acquisition costs and other underwriting expenses to net premiums earned by .5
percentage points. During 2004 the Company also recorded as other underwriting
expenses $333,000 of amortization related to the purchase of NYAIP territorial
credits (described above), compared to $124,000 of such amortization in 2003.
Commissions (other than retrospective commissions under the Reinsurance Pooling
Agreement), premium taxes and other state assessments that vary directly with
the Company's premium volume represented 19.9% of net premiums earned in the
nine month period ended September 30, 2004 compared to 20.9% of net premiums
earned in the nine months ended September 30, 2003.
13
The provision for income taxes for the nine months ended September 30, 2003
included the effect of a May 2003 change in New York State law governing the
taxation of property and casualty insurance companies. As a result of this
change the Company recorded a $505,000 one time benefit, net of federal income
taxes, to its income tax provision during the nine months ended September 30,
2003. This one time benefit reduced the Company's effective income tax rate for
the nine months ended September 30, 2003 by 12 percentage points.
Results of Operations for the Three Months Ended September 30, 2004 As Compared
to the Three Months Ended September 30, 2003
Total combined Mutual and MNH direct premiums written for the three months ended
September 30, 2004 were $48,553,000, an increase of $3,688,000 or 8% from
$44,865,000 for the three months ended September 30, 2003. The Company's share
of combined direct premiums written for the three months ended September 30,
2004, in accordance with the Reinsurance Pooling Agreement was $16,994,000. The
Company recorded $17,946,000 of direct premiums written for the three months
ended September 30, 2003. The table below shows a comparison of direct premiums
written by major category for the three months ended September 30, 2004 and
2003:
Group-wide DWP MNH Pro-Forma Share
-------------- -------------------
Three months ended Three months ended
September 30, September 30,
2003 2004 Change 2003 2004 Change
---- ---- ------ ---- ---- ------
(000's omitted)
Voluntary Personal Lines $16,897 $13,054 (23%) $ 6,759 $ 4,569 (32%)
Voluntary Commercial Lines 26,892 30,436 13% 10,757 10,653 (1%)
Umbrella Program - 4,102 - - 1,436 -
Involuntary 1,076 961 (11%) 430 336 (22%)
------- ------- -------- --------
Total Direct Written Premiums $44,865 $48,553 8% $ 17,946 $ 16,994 (5%)
======= ======= ======== ========
The 23% (or $3,843,000) decrease in group-wide voluntary personal lines direct
premiums written resulted primarily from a 33% (or $3,846,000) decrease in PPA
direct premiums written. The decrease in PPA direct premiums written is
primarily the result of the group's decision, implemented in 2002, not to write
new PPA policies in certain jurisdictions and, the approval of the group's plan
to withdraw from the New Jersey PPA market by the New Jersey Department of
Banking and Insurance which was effective in June 2003 and provided for the
non-renewal of policies beginning in June 2004.
Group-wide voluntary commercial lines direct premiums written increased
$3,544,000, or 13%, to $30,436,000 for the three months ended September 30, 2004
from $26,892,000 for the three months ended September 30, 2003. This increase
resulted from period to period increases in every group-wide commercial line of
business. The average premium per group-wide voluntary commercial lines policy
increased 8% compared to the year earlier period. Total voluntary commercial
lines policies in force at September 30, 2004 increased 3% from September 30,
2003.
Umbrella Program direct premiums written relate to the monoline commercial
umbrella program introduced by Mutual in the fourth quarter of 2003 which was
discussed earlier in this Item. There were no similar direct premiums written in
the three months ended September 30, 2003.
14
Group-wide pooled net premiums written for the three months ended September 30,
2004 were $41,812,000, substantially unchanged from $41,772,000 for the three
months ended September 30, 2003. The Company's share of pooled net premiums
written in accordance with the Reinsurance Pooling Agreement for the three
months ended September 30, 2004 was $14,634,000 compared to $16,709,000 for the
three months ended September 30, 2003.
Total revenues for the three months ended September 30, 2004 were $16,281,000, a
decrease of $2,432,000 or 13% from $18,713,000 for the three months ended
September 30, 2003.
The Company's share of pooled net premiums earned in accordance with the
Reinsurance Pooling Agreement for the three months ended September 30, 2004 was
$14,161,000 a decrease of $2,180,000 or 13% from $16,341,000 for the three
months ended September 30, 2003. The decrease in net premiums earned was a
result of the reduction in the Company's share of group-wide net premiums earned
under the Reinsurance Pooling Agreement from 40% in 2003 to 35% in 2004.
Net investment income was $1,935,000 for the three months ended September 30,
2004, a decrease of 12% from $2,201,000 for the three months ended September 30,
2003. The average pre-tax yield associated with the investment portfolio
decreased 13 basis points to 4.1% for the three months ended September 30, 2004
reflecting the lower interest rate environment Average invested assets for the
three months ended September 2004 decreased 4% compared to the year earlier
period.
There were no net realized investment gains in the three months ended September
30, 2004 compared to $2,210,000 for the three months ended September 30, 2003.
The 2003 amount related primarily to the sale of an otherwise illiquid security
to its issuer through a share repurchase program.
Net losses and LAE were $8,941,000 for the three months ended September 30,
2004, a decrease of $3,031,000, or 25%, from $11,972,000 for the three months
ended September 30, 2003. This decrease in net losses and LAE was due to the 13%
decrease in net premiums earned and a 10.2 percentage point decrease in the loss
and LAE ratio to 63.1% for the three months ended September 30, 2004 from 73.3%
for the three months ended September 30, 2003. The decrease in the loss and LAE
ratio was due to improvement in claims experience for the 2004 accident year
compared to the 2003 accident year.
The ratio of amortized deferred policy acquisition costs and other underwriting
expenses to net premiums earned increased to 42.6% for the three months ended
September 30, 2004 from 34.5% for the three months ended September 30, 2003.
Other underwriting expenses included $576,000 (4.1 percentage points of the
expense ratio) of retrospective commissions related to the Reinsurance Pooling
Agreement. No expense related to Reinsurance Pooling Agreement retrospective
commissions was recorded during the three months ended September 30, 2003.
During the three months ended September 30, 2004, the Company also recorded as
other underwriting expenses $106,000 of amortization expense related to the
purchase of AIP territorial credits as compared to $76,000 of such expense
recorded in the three months ended September 30, 2003. Commissions, premium
taxes and other state assessments that vary directly with the Company's premium
volume represented 21.4% of net premiums earned in the three months ended
September 30, 2004 compared to 21.3% in the three months ended September 30,
2003.
15
Liquidity and Capital Resources
In developing its investment strategy the Company determines a level of cash and
short-term investments which, when combined with expected cash flow, is
estimated to be adequate to meet expected cash obligations. Due to declining
written premiums however, the Company's operating activities have resulted in a
use of cash each year since 2001. The Company's decreasing participation
percentage in the pooled business over the remaining years of the Reinsurance
Pooling Agreement will likely result in continued negative cash flows from
operations. The Company believes that careful management of the relationship
between assets and liabilities will minimize the likelihood that investment
portfolio sales will be necessary to fund insurance operations, and that the
effect of any such sales, if any, on the Company's stockholders' equity will not
be material.
The Company's objectives with respect to its investment portfolio include
maximizing total return within investment guidelines while protecting
policyholders' surplus and maintaining flexibility. The Company relies on
premiums as a major source of cash, and therefore liquidity. Cash flows from the
Company's investment portfolio, in the form of interest or principal payments as
well as from the maturity of fixed income investments, are an additional source
of liquidity.
The Company designates newly acquired fixed maturity investments as available
for sale and carries these investments at fair value. Unrealized gains and
losses related to these investments are recorded as accumulated other
comprehensive income within stockholders' equity. At September 30, 2004, the
Company recorded as accumulated other comprehensive income in its Consolidated
Balance Sheet $390,000 of unrealized losses, net of taxes, associated with its
investments classified as available for sale.
At September 30, 2004, the Company's portfolio of fixed maturity investments
represented 91.1% of invested assets. Management believes that this level of
fixed maturity investments is consistent with the Company's liquidity needs
because it anticipates that cash receipts from net premiums written, investment
income and maturing securities will enable the Company to satisfy its cash
obligations. Furthermore, a portion of the Company's fixed maturity investments
are invested in mortgage-backed and other asset-backed securities which, in
addition to interest income, provide monthly paydowns of bond principal.
At September 30, 2004, $107,327,000, or 54.3%, of the Company's fixed maturity
portfolio was invested in mortgage-backed and other asset-backed securities. The
Company invests in a variety of collateralized mortgage obligation ("CMO")
products but has not invested in the derivative type of CMO products such as
interest only, principal only or inverse floating rate securities. All of the
Company's CMO investments have a secondary market and their effect on the
Company's liquidity does not differ from that of other fixed maturity
investments.
At September 30, 2004 $413,000, or less than 1%, of the Company's investment
portfolio was invested in non-investment grade securities compared to
$2,496,000, or 1%, at December 31, 2003.
The Company has arranged for a $2,000,000 unsecured credit facility from a bank.
Any borrowings under this facility are payable on demand and carry an interest
rate which can be fixed or variable and is
16
negotiated at the time of each advance. This facility is available for general
working capital purposes and for repurchases of the Company's common stock. At
September 30, 2004 no amount was outstanding on this loan.
As a holding company, the Company is dependent on cash dividends from MNH to
meet its obligations and to pay any cash dividends. MNH is subject to New
Hampshire insurance laws which place certain restrictions on its ability to pay
dividends without the prior approval of state regulatory authorities. These
restrictions limit dividends to those that, when added to all other dividends
paid within the preceding twelve months, would not exceed 10% of the insurer's
statutory policyholders' surplus as of the preceding December 31st. The maximum
amount of dividends that MNH could pay during any twelve month period ending in
2004 without the prior approval of the New Hampshire Insurance Commissioner is
$5,767,000. MNH paid $1,200,000 of dividends to the Company in 2003. Since
October 1, 2003 MNH has made dividend payments to the Company of $600,000 and
$1,200,000 in November 2003, and August 2004, respectively. The Company paid
cash dividends to its common stockholders of $.10 per share in the first, second
and third quarters of 2004 amounting to $633,000. On October 28, 2004 the
Company declared a quarterly cash dividend of $.10 per share payable on December
3, 2004 to shareholders of record as of the close of business on November 19,
2004.
Under the Services Agreement, Mutual has provided services and facilities for
MNH to conduct its insurance business. The balance in the payable to or
receivable from affiliate account represents the amount owing to or owed by
Mutual by or to the Company for the difference between premiums collected and
payments made for losses, commissions (including retrospective commissions),
employees, services and facilities by Mutual on behalf of MNH.
Regulatory guidelines suggest that the ratio of a property-casualty insurer's
annual net premiums written to its statutory surplus should not exceed 3 to 1.
MNH has consistently followed a business strategy that would allow it to meet
this 3 to 1 regulatory guideline. For the first nine months of 2004, MNH's ratio
of net premiums written to statutory surplus, annualized for a full year, was .9
to 1.
Relationship with Mutual
The Company's and MNH's business and day-to-day operations are closely aligned
with those of Mutual. This is the result of a combination of factors. Mutual has
had a historical ownership interest in the Company and MNH. Prior to November
1986 MNH was a wholly-owned subsidiary of Mutual. Following the Company's
initial public offering in November 1986 and until a secondary stock offering in
July 1993 the Company was a majority-owned subsidiary of Mutual. Mutual
currently owns 12.1% of the Company's common stock. Under the Services
Agreement, Mutual provides the Company and MNH with all facilities and personnel
to operate their business. With the exception of the individual who serves as
President of the Company and as the Chief Operating Officer of MNH, the only
other officers of the Company or MNH are employees of Mutual whose services are
provided to, and paid for by, the Company and MNH through the Services
Agreement. Also, the operation of MNH's insurance business, which offers
substantially the same lines of insurance as Mutual through the same independent
insurance agents, creates a very close relationship among the Companies.
17
"Safe Harbor" Statement under the Private Securities Litigation Reform Act of
1995:
With the exception of historical information, the matters and statements
discussed, made or incorporated by reference in this Quarterly Report on Form
10-Q constitute forward-looking statements and are discussed, made or
incorporated by reference, as the case may be, pursuant to the safe harbor
provisions of the Private Securities Litigation Reform Act of 1995.
Forward-looking statements include, without limitation, statements relating to
the Company's plans, strategies, objectives, expectations and intentions. Words
such as "believes," "forecasts," "intends," "possible," "expects,"
"anticipates," "estimates," or "plans" and similar expressions are intended to
identify forward looking statements. Such forward-looking statements involve
certain assumptions, risks and uncertainties that include, but are not limited
to, those associated with factors affecting the property-casualty insurance
industry generally, including price competition, the Company's dependence on
state insurance departments for approval of rate increases; size and frequency
of claims, escalating damage awards, natural disasters, fluctuations in interest
rates and general business conditions; the Company's dependence on investment
income; the geographic concentration of the Company's business in the
northeastern United States and in particular in New York, New Hampshire, New
Jersey, Rhode Island, Pennsylvania and Massachusetts; the adequacy of the
Company's loss reserves; the Company's dependence on the general reinsurance
market; government regulation of the insurance industry; exposure to
environmental claims; dependence of the Company on its relationship with Mutual;
and the other risks and uncertainties discussed or indicated in all documents
filed by the Company with the Securities and Exchange Commission. The Company
expressly disclaims any obligation to update any forward-looking statements as a
result of developments occurring after the filing of this report.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Market Risk
Market risk represents the potential for loss due to changes in the fair value
of financial instruments. The market risk related to the Company's financial
instruments primarily relates to its investment portfolio. The value of the
Company's investment portfolio of $197,531,000 at September 30, 2004 is subject
to changes in interest rates and to a lesser extent on credit quality. Further,
certain mortgage-backed and asset-backed securities are exposed to accelerated
prepayment risk generally caused by interest rate movements. If interest rates
were to decline, mortgage holders would be more likely to refinance existing
mortgages at lower rates. Acceleration of future repayments could adversely
affect future investment income, if reinvestment of the accelerated receipts was
made in lower yielding securities.
The following table provides information related to the Company's fixed maturity
investments at September 30, 2004. The table presents cash flows of principal
amounts and related weighted average interest rates by expected maturity dates.
The cash flows are based upon the maturity date or, in the case of
mortgage-backed and asset-backed securities, expected payment patterns. Actual
cash flows could differ from those shown in the table.
18
Fixed Maturities
Expected Cash Flows of Principal Amounts ($ in 000's):
TOTAL
-----------------
Esti-
Amor- mated
There- tized Market
2004 2005 2006 2007 2008 after Cost Value
---- ---- ---- ---- ---- ----- ---- ------
Available for Sale
U.S. Treasury securities and
obligations of U.S. Government
corporations and agencies $ 0 $ 2,028 $ 0 $ 0 $ 3,007 $ 0 $ 5,035 $ 5,072
Average interest rate 0.0% 4.4% 0.0% 0.0% 3.2% 0.0% --- ---
Obligations of states and
political subdivisions 360 7,245 9,566 3,880 15,276 5,025 41,352 41,427
Average interest rate 3.5% 3.1% 3.4% 4.3% 3.9% 4.2% --- ---
Corporate securities 0 17,611 997 0 3,239 4,115 25,962 26,158
Average interest rate 0.0% 4.0% 3.2% 0.0% 3.7% 5.1% --- ---
Mortgage & asset
backed securities 5,496 22,266 23,912 18,039 9,650 28,198 107,561 107,345
Average interest rate 4.9% 4.9% 4.9% 5.0% 5.0% 5.1% --- --
-------- -------- -------- -------- -------- -------- -------- --------
Total $ 5,856 $ 49,150 $ 34,475 $ 21,919 $ 31,172 $ 37,338 $179,910 $180,002
======== ======== ======== ======== ======== ======== ======== ========
The discussion and the estimated amounts referred to above include
forward-looking statements of market risk which involve certain assumptions as
to market interest rates and the credit quality of the fixed maturity
investments. Actual future market conditions may differ materially from such
assumptions. Accordingly, the forward-looking statements should not be
considered projections of future events by the Company.
Item 4. Controls and Procedures
The Company's chief executive officer and chief financial officer, after
evaluating the effectiveness of the Company's "disclosure controls and
procedures" (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities
Exchange Act of 1934) as of the end of the period covered by this report,
concluded that the Company's disclosure controls and procedures were effective
to ensure that material information relating to the Company was being made known
to them by others within the Company in a timely manner, including the period
when this quarterly report was being prepared.
There was no change in the Company's internal control over financial
reporting identified in connection with the evaluation required by paragraph (d)
of Rules 13a-15 or 15d-15 under the Securities Exchange Act of 1934 that
occurred during the Company's last fiscal quarter that has materially affected,
or is reasonably likely to materially affect, the Company's internal control
over financial reporting.
19
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.
None.
Item 2. Changes in Securities and Use of Proceeds.
None.
Item 3. Defaults Upon Senior Securities.
None.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information.
None.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits.
Exhibits required by Item 601 of Regulation S-K.
3(a) Restated Certificate of Incorporation (incorporated by reference to
Exhibit No. 3C to Amendment No. 1 to the Company's Registration
Statement No. 33-9188 on Form S-1 Filed on November 7, 1986.
(b) Restated By-laws (incorporated by reference to Exhibit 3D to
Amendment No. 1 to the Company's Registration Statement No. 33-9188
on Form S-1 filed on November 7, 1986.
4 Instruments defining the rights of security holders, including
indentures - N/A.
5 Opinion re legality - N/A.
10(a) Management Agreement dated as of September 29, 1986 by and among
Merchants Mutual Insurance Company, Registrant and Merchants
Insurance Company of New Hampshire, Inc. (incorporated by reference
to Exhibit No. 10a to the Company's Registration Statement (No.
33-9188) on Form S-1 filed on September 30, 1986).
(b) Services Agreement Among Merchants Mutual Insurance Company,
Merchants Insurance Company of New Hampshire, Inc. and Merchants
Group, Inc. dated January 1, 2003 (incorporated by reference to
Exhibit No. 10b to the Company's 2003 Quarterly Report on Form 10-Q
filed on May 14, 2003).
20
(c) Reinsurance Pooling Agreement between Merchants Insurance Company of
New Hampshire, Inc. and Merchants Mutual Insurance Company effective
January 1, 2003 (incorporated by reference to Exhibit No. 10c to the
Company's 2003 Quarterly Report on Form 10-Q filed on May 14, 2003).
(d) Casualty Excess of Loss Reinsurance Agreement between Merchants
Mutual Insurance Company, Merchants Insurance Company of New
Hampshire, Inc. and American Reinsurance Company (incorporated by
reference to Exhibit 10(f) to the Company's 2002 Annual Report on
Form 10-K filed on March 31, 2002).
(e) Endorsement to the Casualty Excess of Loss Reinsurance agreement
between Merchants Mutual Insurance Company, Merchants Insurance
Company of New Hampshire, Inc. and American Reinsurance Company
dated February 23, 2004 (filed herewith).
(f) Property Per Risk Excess of Loss Reinsurance Agreement between
Merchants Mutual Insurance Company, Merchants Insurance Company of
New Hampshire, Inc. and American Reinsurance Company dated April 16,
2004 (filed herewith).
(g) Property Catastrophe Excess of Loss Reinsurance Agreement between
Merchants Mutual Insurance Company, Merchants Insurance Company of
New Hampshire, Inc. and the various reinsurers as identified by the
Interest and Liabilities Agreements attaching to and forming part of
this Agreement (filed herewith).
(h) Quota Share Reinsurance Treaty Agreement between Merchants Insurance
Company of New Hampshire, Inc. and The Subscribing Underwriting
Members of Lloyd's, London specifically identified on the schedules
attached to this agreement dated January 1, 2000 (incorporated by
reference to Exhibit 10h to the Company's 2000 Annual Report on Form
10-K filed on March 28, 2001).
(i) Merchants Mutual Capital Accumulation Plan (incorporated by
reference to Exhibit No. 10g to the Company's Registration Statement
(No. 33-9188) on Form S-1 filed on September 30, 1986).
(j) Merchants Mutual Capital Accumulation Plan, fifth amendment,
effective January 1, 1999 (incorporated by reference to Exhibit 10j
to the Company's 2000 Annual Report on Form 10-K filed on March 28,
2001).
*(k) Form of Amended Indemnification Agreement entered into by Registrant
with each director and executive officer of Registrant (incorporated
by reference to Exhibit No. 10n to Amendment No. 1 to the Company's
Registration Statement on (No. 33-9188) Form S-1 filed on November
7, 1986).
21
*(l) Merchants Mutual Insurance Company Adjusted Return on Equity
Incentive Compensation Plan January 1, 2000 (incorporated by
reference to Exhibit 10p to the Company's 2000 Annual Report on Form
10-K filed on March 28, 2001).
*(m) Merchants Mutual Insurance Company Adjusted Return on Equity Long
Term Incentive Compensation Plan January 1, 2000 (incorporated by
reference to Exhibit 10q to the Company's 2000 Annual Report on Form
10-K filed on March 28, 2001).
*(n) Amendment No. 1 to Employee Retention Agreement between Robert M.
Zak and Merchants Mutual Insurance Company originally dated as of
May 1, 1999, dated February 6, 2002 (incorporated by reference to
Exhibit 10(s) to the Company's 2002 Annual Report on Form 10-K filed
on March 31, 2003).
*(o) Amendment No. 1 to Employee Retention Agreement between Edward M.
Murphy and Merchants Mutual Insurance Company originally dated as of
March 1, 1999, dated February 6, 2002 (incorporated by reference to
Exhibit 10(t) to the Company's 2002 Annual Report on Form 10-K filed
on March 31, 2003).
*(p) Amendment No. 1 to Employee Retention Agreement between Kenneth J.
Wilson and Merchants Mutual Insurance Company originally dated as of
March 1, 1999, dated February 6, 2002 incorporated by reference to
Exhibit 10(u) to the Company's 2002 Annual Report on Form 10-K filed
on March 31, 2003.
*(q) Employment Agreement between Stephen C. June and Merchants Insurance
Company of New Hampshire, Inc. dated as of April 1, 2002
(incorporated by reference to Exhibit 10u to the Company's 2001
Annual Report on Form 10-K filed on March 27, 2002).
11 Statement re computation of per share earnings - N/A.
12 Statement re computation of ratios - N/A.
15 Letter re unaudited interim financial information - N/A.
18 Letter re change in accounting principles - N/A.
19 Report furnished to security holder - N/A.
22 Published report regarding matters submitted to vote of security
holders - N/A.
23 Consents of experts and counsel - N/A.
24 Power of attorney - N/A.
31 Rule 13a-14(a)/15d-14(a) Certifications (filed herewith)
22
32(a) Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002 (Subsections (a) and (b) of Section 1350, Chapter 63 of Title
18, United States Code) (filed herewith).
* Indicates a management contract or compensation plan or arrangement.
(b) Reports on Form 8-K.
On October 28, 2004, the Company filed a Form 8-K reporting the issuance of a
press release announcing results for the quarter ended September 30, 2004 and
the declaration of the Company's regular quarterly common stock dividend.
SIGNATURES
Pursuant to the requirements 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.
MERCHANTS GROUP, INC.
(Registrant)
Date: November 10, 2004 By:/s/ Kenneth J. Wilson
------------------------
Kenneth J. Wilson
Chief Financial Officer and
Treasurer (duly authorized
officer of the registrant and
chief accounting officer)
23