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
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ________ TO ________.
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001
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 the number of shares outstanding of each of the issuer's classes of
common stock, as of October 31, 2001.
2,217,852 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 2000 2001
------ ---- ----
(unaudited)
Investments:
Fixed maturities:
Held to maturity at amortized cost (fair value
$13,576 in 2000 and $14,271 in 2001) $ 12,874 $ 13,020
Available for sale at fair value (amortized cost
$183,392 in 2000 and $190,238 in 2001) 183,283 193,453
Preferred stock at fair value 13,911 11,878
Other long-term investments at fair value 1,036 1,553
Short-term investments 4,550 9,715
--------- ---------
Total investments 215,654 229,619
Cash 5 22
Interest due and accrued 2,816 2,193
Premiums receivable, net of allowance for doubtful
accounts of $395 in 2000 and $426 in 2001 19,843 21,446
Receivable from affiliate - 164
Deferred policy acquisition costs 12,331 12,482
Ceded reinsurance balances receivable 13,089 16,922
Prepaid reinsurance premiums 4,326 4,101
Deferred income taxes 6,263 4,634
Other assets 7,537 8,093
----------- -----------
Total assets $281,864 $299,676
=========== ===========
See Notes to the Consolidated Financial Statements
2
MERCHANTS GROUP, INC.
CONSOLIDATED BALANCE SHEET
(in thousands except share amounts)
December 31, September 30,
2000 2001
---- ----
(unaudited)
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Reserve for losses and loss adjustment expenses $ 145,075 $ 149,774
Unearned premiums 50,857 51,204
Payable for securities -- 12,597
Payable to affiliate 608 --
Other liabilities 15,202 15,453
--------- ---------
Total liabilities 211,742 229,028
--------- ---------
Stockholders' equity:
Common stock, 10,000,000 shares authorized, 2,430,752 shares issued and
outstanding at December 31, 2000 and 2,313,852 shares issued and
outstanding
at September 30, 2001 32 32
Additional paid in capital 35,680 35,680
Treasury stock, 811,100 shares at December 31, 2000
and 928,000 shares at September 30, 2001 (16,063) (18,224)
Accumulated other comprehensive income (loss) (875) 1,897
Accumulated earnings 51,348 51,263
--------- ---------
Total stockholders' equity 70,122 70,648
--------- ---------
Commitments and contingent liabilities -- --
Total liabilities and stockholders' equity $ 281,864 $ 299,676
========= =========
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,
2000 2001 2000 2001
---- ---- ---- ----
(unaudited)
Revenues:
Net premiums earned $23,822 $ 23,230 $70,461 $69,737
Net investment income 3,481 3,244 10,325 10,279
Net realized investment gains 104 30 109 112
Other revenues 81 161 163 415
------- -------- ------- -------
Total revenues 27,488 26,665 81,058 80,543
------- -------- ------- -------
Expenses:
Net losses and loss adjustment
expenses 17,387 20,298 51,583 56,679
Amortization of deferred policy
acquisition costs 6,313 6,156 18,672 18,480
Other underwriting expenses 1,171 1,441 4,131 4,374
------- -------- ------- -------
Total expenses 24,871 27,895 74,386 79,533
------- -------- ------- -------
Income (loss) before income taxes 2,617 (1,230) 6,672 1,010
Income tax provision (benefit) 947 (421) 2,384 391
------- -------- ------- -------
Net income (loss) $ 1,670 $ (809) $ 4,288 $ 619
======= ======== ======= =======
Basic and diluted earnings (loss)
per share $ .68 $ (.35) $ 1.71 $ .26
======= ======== ======= =======
Weighted average shares outstanding:
Basic 2,457 2,317 2,501 2,365
Diluted 2,459 2,321 2,503 2,367
See Notes to the Consolidated Financial Statements
4
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (LOSS)
(in thousands)
Three Months Nine Months
Ended September 30, Ended September 30,
2000 2001 2000 2001
------- ------- ------- -------
(unaudited)
Net income (loss) $ 1,670 $ (809) $ 4,288 $ 619
------- ------- ------- -------
Other comprehensive income (loss)
before taxes:
Unrealized gains (losses)
on securities 593 1,276 (3) 4,578
Reclassification adjustment
for gains and losses included
in net income (100) (28) (100) (110)
------- ------- ------- -------
Other comprehensive income (loss)
before taxes 493 1,248 (103) 4,468
Income tax provision (benefit) related to
items of other comprehensive income 186 464 (108) 1,696
------- ------- ------- -------
Other comprehensive income (loss) 307 784 5 2,772
------- ------- ------- -------
Comprehensive income (loss) $ 1,977 $ (25) $ 4,293 $ 3,391
======= ======= ======= =======
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,
2000 2001
---- ----
(unaudited)
Common stock, beginning and end $ 32 $ 32
-------- --------
Additional paid in capital beginning and end: 35,680 35,680
-------- --------
Treasury stock:
Beginning of period (13,139) (16,063)
Purchase of treasury shares (2,695) (2,161)
-------- --------
End of period (15,834) (18,224)
-------- --------
Accumulated other comprehensive income (loss):
Beginning of period (1,188) (875)
Other comprehensive income 5 2,772
-------- --------
End of period (1,183) 1,897
-------- --------
Accumulated earnings:
Beginning of period 48,002 51,348
Net income 4,288 619
Cash dividends (749) (704)
-------- --------
End of period 51,541 51,263
-------- --------
Total stockholders' equity $ 70,236 $ 70,648
======== ========
See Notes to the Consolidated Financial Statements
6
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands)
Nine Months
Ended September 30,
2000 2001
---- ----
(unaudited)
Cash flows from operations:
Collection of premiums $ 70,333 $ 69,102
Payment of losses and loss adjustment expenses (50,443) (56,144)
Payment of other underwriting expenses (23,845) (22,926)
Investment income received 9,850 10,282
Investment expenses paid (304) (228)
Income taxes paid (2,059) (906)
Other 163 410
-------- --------
Net cash provided by (used in) operations 3,695 (410)
-------- --------
Cash flows from investing activities:
Proceeds from fixed maturities sold or matured 50,975 75,248
Purchase of fixed maturities (46,057) (80,696)
Net (increase) decrease in preferred stock (961) 2,597
Net (increase) decrease in other long-term investments (64) (517)
Net (increase) decrease in short-term investments (2,216) (5,165)
-------- --------
Net cash provided by (used in) investing activities 1,677 (8,533)
-------- --------
Cash flows from financing activities:
Settlement of affiliate balances (897) (772)
Cash borrowed to purchase securities -- 12,597
Decrease in demand loan, net (1,025) --
Purchase of treasury stock (2,695) (2,161)
Cash dividends (749) (704)
-------- --------
Net cash provided by (used in) financing activities (5,366) 8,960
-------- --------
Increase in cash 6 17
Cash:
Beginning of period 2 5
-------- --------
End of period $ 8 $ 22
======== ========
See Notes to the Consolidated Financial Statements
7
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
RECONCILIATION OF NET INCOME TO NET CASH
PROVIDED BY (USED IN) OPERATIONS
(in thousands)
Nine Months
Ended September 30,
2000 2001
---- ----
(unaudited)
Net income $ 4,288 $ 619
Adjustments:
Accretion of bond discount (382) (853)
Realized investment gains (109) (112)
(Increase) decrease in assets:
Interest due and accrued (397) 623
Premiums receivable (627) (1,603)
Deferred policy acquisition costs (236) (151)
Ceded reinsurance balances receivable (1,856) (3,833)
Prepaid reinsurance premiums (2,386) 225
Deferred income taxes 157 (66)
Other assets 97 (556)
Increase (decrease) in liabilities:
Reserve for losses and loss adjustment expenses 2,713 4,699
Unearned premiums 3,277 347
Other liabilities (844) 251
------- -------
Net cash provided by (used in) operations $ 3,695 $ (410)
======= =======
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, 2001 and the related
consolidated statements of operations, of comprehensive income, of changes in
stockholders' equity and of cash flows for the three and nine month periods
ended September 30, 2000 and 2001, 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, 2000.
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 have no paid employees. Under a management agreement dated
September 29, 1986 (the Management Agreement), Merchants Mutual Insurance
Company (Mutual), which owned 11.0% of the Company's common stock at September
30, 2001, provides the Company and MNH with the facilities, management and
personnel required to manage their day-to-day business. All underwriting,
administrative, claims and investment expenses incurred on behalf of Mutual and
MNH are shared on an allocated cost basis, determined as follows: for
underwriting and administrative expenses, the respective share of total direct
premiums written for Mutual and MNH serves as the basis of allocation; for
claims expenses, the average number of outstanding claims is used; investment
expenses are shared based on each company's share of total invested assets.
3. EARNINGS PER SHARE
Basic and diluted earnings per share were computed by dividing net income or
loss by the weighted average number of shares of common stock outstanding during
each period, increased by the assumed exercise of 8,000 shares of common stock
options for the three and nine month periods in 2000 and the nine month period
in 2001 and by the assumed exercise of 43,500 shares of common stock options for
the three month period in 2001. The common stock options assumed to be exercised
would have resulted in
9
3,953 and 1,489 additional shares outstanding for the three month periods ended
September 30, 2001 and 2000, respectively, and 2,229 and 1,432 additional shares
outstanding for the nine month periods ending September 30, 2001 and 2000,
respectively, assuming 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 respective period.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2001 AS COMPARED
TO THE NINE MONTHS ENDED SEPTEMBER 30, 2000
Total revenues for the nine months ended September 30, 2001 were $80,543,000, a
decrease of $515,000 or less than 1%, from $81,058,000 for the nine months ended
September 30, 2000.
Direct premiums written for the nine months ended September 30, 2001 were
$75,872,000, a decrease of $6,420,000 or 8%, from $82,292,000 for the nine
months ended September 30, 2000. Voluntary direct premiums written for the nine
months ended September 30, 2001 were $72,770,000, a decrease of $8,602,000 or
11%, from $81,372,000 for the nine months ended September 30, 2000.
Voluntary personal lines direct premiums written for the nine months ended
September 30, 2001 were $29,614,000, an increase of $1,104,000 or 4%, from
$28,510,000 for the nine months ended September 30, 2000. Private passenger
automobile (PPA) direct premiums written, which represented 74% and 75% of total
voluntary personal lines direct premiums written for the nine months ended
September 30, 2001 and 2000, respectively, increased 3% from the year earlier
period. Homeowners direct premiums written for the nine months ended September
30, 2001 increased 7% compared to the nine months ended September 30, 2000
primarily due to a 7% increase in policies in force at September 30, 2001 as
compared to September 30, 2000.
The Company implemented a program to underwrite specialized commercial auto
insurance (the Auto Program) during the quarter ended June 30, 2000. All
policies issued under the Auto Program were 100% reinsured through certain
Lloyds syndicates and therefore had no impact on net premiums written, net
premiums earned or net losses and loss adjustment expenses (LAE) incurred by the
Company. The Company recorded all direct underwriting expenses incurred,
including commissions with respect to the acquisition of these policies, which
were offset by reinsurance commission income. The Auto Program was discontinued
in 2001 and had no impact on current year net income.
Voluntary commercial lines direct premiums written for the nine months ended
September 30, 2001 were $43,156,000, a decrease of $9,705,000 or 18%, from
$52,861,000 for the nine months ended September 30, 2000. This decrease was
attributable in part to the aforementioned discontinuation of the Auto Program,
which produced $5,235,000 of direct written premiums in the nine months ended
September 30, 2000.
The Company continues to experience higher loss frequency for certain of its
commercial lines of business not adequately covered by premiums collected from
those lines of business. As a response to these higher
10
losses, the Company has filed for and received approval of rate increases in
certain lines of business, revised its underwriting guidelines, and removed
discretionary pricing credits where warranted. As a consequence of these
actions, voluntary commercial lines direct premiums written, excluding Auto
Program premiums written, for the nine months ended September 30, 2001 decreased
$4,486,000 or 9%, to $43,140,000 from $47,626,000 for the nine months ended
September 30, 2000. Direct premiums written for all of the Company's commercial
lines of business, except commercial package policies, decreased in the nine
months ended September 30, 2001 compared to the nine months ended September 30,
2000. Commercial lines policies in force at September 30, 2001 decreased 17%
compared to commercial lines policies in force at September 30, 2000.
The Company intends to continue to reduce direct written premiums in business
segments that it believes can no longer provide the opportunity to earn a
satisfactory return for its shareholders. The Company estimates that its
voluntary direct written premiums will decline in 2002 with further reductions
possible thereafter.
Involuntary direct premiums written, primarily PPA insurance, which comprised 4%
and 1% of all direct premiums written during the nine months ended September 30,
2001 and 2000, respectively, increased by $2,182,000, or 237%, to $3,102,000 for
the nine months ended September 30, 2001 from $920,000 for the nine months ended
September 30, 2000. The Company believes it is likely that, due to a decrease in
the willingness of several major competitors to insure non-standard business
voluntarily, the number of policies written by the New York Automobile Insurance
Plan (NYAIP) will continue to increase and therefore the amount of the Company's
involuntary direct written premiums will also continue to increase. However, the
Company is unable to predict the volume of future assignments from the NYAIP.
Net premiums written decreased $1,043,000, or 1%, to $70,309,000 for the nine
months ended September 30, 2001 from $71,352,000 for the nine months ended
September 30, 2000, due to a 2% decrease in non-Auto Program direct premiums
written.
Net premiums earned for the nine months ended September 30, 2001 were
$69,737,000, a decrease of 1% from $70,461,000 for the nine months ended
September 30, 2000. This decrease is attributable to the 1% decrease in net
premiums written.
Net investment income was $10,279,000 for the nine months ended September 30,
2001, a decrease of $46,000 or less than 1% from $10,325,000 for the nine months
ended September 30, 2000. A 1% increase in average invested assets for the nine
months ended September 30, 2001 was more than offset by a decrease in the
average pre-tax investment portfolio yield to 6.67% for the nine months ended
September 30, 2001.
Other revenues were $415,000 for the nine months ended September 30, 2001, an
increase of $252,000, or 155%, from $163,000 for the nine months ended September
30, 2000. This increase resulted from an increase in installment fee income and
a decrease in charge-offs related to uncollectible premiums receivable. The
reduction in charge-offs related to a decline in the average age of the
Company's premium receivable.
11
Losses and LAE were $56,679,000 for the nine months ended September 30, 2001, an
increase of $5,096,000 or 10%, from $51,583,000 for the nine months ended
September 30, 2000. The loss and LAE ratio increased to 81.3% for the nine
months ended September 30, 2001 from 73.2% for the nine months ended September
30, 2000. Losses and LAE for the nine months ended September 30, 2001 include
$1,990,000 of losses and LAE related to the September 11, 2001 terrorist attacks
on the World Trade Center ("WTC") in New York City. The Company had written 27
policies, primarily businessowners policies in the WTC and in lower Manhattan.
The Company's estimate for losses related to the WTC event was derived using
various actuarial techniques, as well as analyses of the claims received to date
and of the policies in force in the affected area for which no claims have been
received. The WTC event added 2.9 percentage points to the loss and LAE ratio
for the nine months ended September 30, 2001.
Excluding the effect of the WTC event, the loss and LAE ratio increased 5.2
percentage points to 78.4 for the nine months ended September 30, 2001 from 73.2
for the nine months ended September 30, 2000. This increase in the loss and LAE
ratio resulted from increased claim frequency and severity experienced in 2001,
primarily for private passenger automobile, commercial automobile and workers'
compensation policies.
The ratio of amortized deferred policy acquisition costs and other underwriting
expenses to net premiums earned were 32.8% and 32.4% for the nine month periods
ended September 30, 2001 and 2000, respectively. Commissions, premium taxes and
other state assessments that vary directly with the Company's premium volume
represented 20.3% of net premiums earned in the nine months ended September 30,
2001 compared to 20.0% for the nine months ended September 30, 2000.
The Company's effective income tax rate for the nine months ended September 30,
2001 was 38.7%. This rate was calculated based upon the Company's estimate of
its effective income tax rate for all of 2001.
RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2001 AS COMPARED
TO THE THREE MONTHS ENDED SEPTEMBER 30, 2000
Total revenues for the three months ended September 30, 2001 were $26,665,000, a
decrease of $823,000, or 3%, from $27,488,000 for the three months ended
September 30, 2000.
Voluntary personal lines direct premiums written for the three months ended
September 30, 2001 were $11,009,000, an increase of $516,000, or 5%, from
$10,493,000 for the three months ended September 30, 2000. PPA direct premiums
written increased 4% from the year earlier period, primarily due to a 3%
increase in average premium per policy. Homeowners direct premiums written for
the three months ended September 30, 2001 increased 8% compared to the three
months ended September 30, 2000 primarily due to a 7% increase in policies in
force.
Voluntary commercial lines direct premiums written excluding Auto Program
premiums written for the three months ended September 30, 2001 were $13,549,000,
a decrease of $936,000, or 6%, from $14,485,000 for the three months ended
September 30, 2000. This decrease in commercial lines direct written premiums is
attributable to the same factors affecting voluntary commercial lines direct
premiums
12
written for the nine months ended September 30, 2001, and is expected to
continue as discussed earlier in this item.
Involuntary direct premiums written for the three months ended September 30,
2001 were $1,579,000, an increase of $1,215,000, or 334%, from $364,000 for the
three months ended September 30, 2000. Involuntary written premiums are affected
by the size of the involuntary markets in which the Company operates, primarily
the New York Automobile Insurance Plan.
Net investment income was $3,244,000 for the three months ended September 30,
2001, a decrease of $237,000 or 7% from $3,481,000 for the three months ended
September 30, 2000, primarily due to a 29 basis point decrease in the average
pre-tax investment portfolio yield to 6.51%.
Losses and LAE were $20,298,000 for the three months ended September 30, 2001,
an increase of $2,911,000, or 17%, from $17,387,000 for the three months ended
September 30, 2000. The loss and LAE ratio increased to 87.4% for the three
months ended September 30, 2001 from 73.0% for the three months ended September
30, 2000. The increase in the loss and LAE ratio is attributable to the same
factors affecting losses and LAE for the nine months ended September 30, 2001
discussed earlier in this item. Excluding the impact of the WTC event, the loss
and LAE ratio for the three months ended September 30, 2001 would have been
78.8%.
The ratio of amortized deferred policy acquisition costs and other underwriting
expenses to net premiums earned increased to 32.7% for the three months ended
September 30, 2001 from 31.4% for the three months ended September 30, 2000
primarily due to a $300,000 increase in accrued contingent commissions payable
related to the Company's profit sharing program with its agents. Commissions,
premium taxes and other state assessments that vary with the Company's premium
volume represented 20.1% of net premiums earned in the three months ended
September 30, 2001 compared to 19.6% for the three months ended September 30,
2000. This increase was attributable to the aforementioned increase in
contingent commissions.
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. Historically, the
excess of premiums collected over payments on claims, combined with cash flow
from investments, has provided the Company with short-term funds in excess of
normal operating demands for cash. However, the Company's intention to continue
to reduce direct written premiums in business segments where returns are
unsatisfactory will likely result in future 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
sale on the Company's surplus will not be material. Further, the Company
believes that the WTC event will not require any unplanned liquidation of its
investment portfolio.
13
The Company's objectives with respect to its investment portfolio include
maximizing total returns within investment guidelines while protecting
stockholders' equity and maintaining flexibility. Like other property and
casualty insurers, the Company relies on premiums as a major source of cash, and
therefore liquidity. Cash flows from the Company's investment portfolio, either
in the form of interest or principal payments, are an additional source of
liquidity. Because the duration of the Company's investment portfolio relative
to the duration of its liabilities are closely managed, increases or decreases
in market interest rates are not expected to have a material effect on the
Company's liquidity or its results of operations.
The Company generally 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 a component of
accumulated other comprehensive income within stockholders' equity. At September
30, 2001, the Company had recorded $1,897,000 of unrealized gains, net of taxes,
associated with its investments classified as "available for sale" as
accumulated other comprehensive income. During the nine months ended September
30, 2001 the Company recorded $2,772,000 of unrealized gains, net of tax,
associated with its available for sale investments as other comprehensive
income.
At September 30, 2001, the Company's portfolio of fixed maturities represented
89.9% of invested assets. Management believes that this level of bond holdings
is consistent with the Company's liquidity needs because it anticipates that
cash receipts from net premiums written and investment income will enable the
Company to satisfy its cash obligations. Furthermore, a portion of the Company's
bond portfolio is invested in mortgage-backed and other asset-backed securities
which, in addition to interest income, provide monthly paydowns of bond
principal.
At September 30, 2001, $76,402,000, or 33.2%, 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 an active secondary market and their effect on
the Company's liquidity does not differ from that of other fixed maturity
investments. The Company does not own any other derivative financial
instruments.
At September 30, 2001, $10,302,000, or 4.5% of the Company's investment
portfolio was invested in non-investment grade securities compared to
$9,480,000, or 4.5% at September 30, 2000. All of the Company's non-investment
grade securities are currently performing to the Company's purchase
expectations.
During the nine months ended September 30, 2001, the Company repurchased 116,900
shares of its common stock at an average price per share of $18.49. The Company
was holding 928,000 shares of its common stock in treasury at September 30,
2001.
The Company has arranged for a $2,000,000 unsecured credit facility from a bank
in the form of a master grid note. Any borrowings under this facility are
payable on demand and carry an interest rate which can be fixed or variable and
is negotiated at the time of each advance. This facility is available for
general
14
working capital purposes and for repurchases of the Company's common stock. At
September 30, 2001, no amount was outstanding on this loan.
As a holding company, the Company is dependent on cash dividends from MNH to
meet its obligations, pay any cash dividends and repurchase its shares. 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 2001 without the prior approval of the New Hampshire Insurance
Commissioner is $5,061,000. MNH has paid $5,060,000 of dividends to the Company
in 2001.
MNH paid dividends in February 2001, May 2001 and September 2001, of $2,200,000,
$1,350,000 and $1,510,000, respectively, and as such is restricted from paying
another dividend to the Company until February 2002. The Company has paid cash
dividends to its common stockholders of $.30 per share in 2001 amounting to
$704,000.
Under the Management Agreement, Mutual provides employees, services and
facilities for MNH to conduct its insurance business on a cost reimbursed basis.
The balance in the payable to or receivable from affiliate account represents
the amount owing to or owed by Mutual to the Company for the difference between
premiums collected and payments made for losses, employees, services and
facilities by Mutual on behalf of MNH.
Industry and 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 2001, MNH's
ratio of net premiums written to statutory surplus, annualized for a full year,
was 1.8 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 11.0% of the Company's common stock. Under the Management
Agreement, Mutual provides the Company and MNH with all facilities and personnel
to operate their business. The only officers of the Company or MNH who are paid
full time employees are employees of Mutual whose services are purchased under
the Management Agreement. Also, the operation of the Company'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.
During 1998, Mutual initiated discussions with the Company concerning proposals
for the acquisition of the Company by Mutual. The Company determined that the
terms proposed by Mutual were inadequate. The Company also determined that the
Management Agreement prevents the Company's shareholders
15
from realizing the Company's fair value in a sale or merger, and on July 23,
1998 the Company gave notice to Mutual of its intention to terminate the
Management Agreement. The provisions of the Management Agreement require five
year's prior written notice for its termination. The Company does not expect the
notice of termination to have any material, short-term effect on the Company's
operations. However, the Company believes that the Management Agreement, as
currently written, creates conflicts of interest between the Company and Mutual
in their joint operations and prevents the Company's shareholders from realizing
the fair value of their shares.
16
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 $229,619,000 at September 30, 2001 is subject
to changes in interest rates and to a lesser extent on credit quality. Further,
certain mortgage-backed and asset-backed securities are exposed to accelerated
prepayment risk generally caused by interest rate movements. When interest rates
decline, mortgage holders are more likely to refinance existing mortgages at
lower rates. Acceleration of future repayments could adversely affect future
investment income, if reinvestment of the accelerated receipts was made in lower
yielding securities.
The following table provides information related to the Company's fixed maturity
investments at September 30, 2001. The table presents cash flows of principal
amounts and related weighted average interest rates by expected maturity dates.
The cash flows are based upon the maturity date or, in the case of
mortgage-backed and asset-backed securities, expected payment patterns. Actual
cash flows could differ from those shown in the table.
Fixed Maturities
----------------
Expected Cash Flows of Principal Amounts ($ in 000's): TOTAL
-----
Amor- Estimated
There - tized Market
Held to Maturity 2001 2002 2003 2004 2005 after Cost Value
---------------- ---- ----- ----- ----- ---- ------- ---- ------
Mortgage & asset backed
securities $ 0 $ 642 $ 1,644 $ 2,284 $ 2,083 $ 6,367 $ 13,020 $ 14,271
Average interest rate 0.0% 7.1% 7.0% 7.0% 7.0% 7.3 -- --
-------- -------- -------- -------- -------- -------- -------- --------
Total $ 0 $ 642 $ 1,644 $ 2,284 $ 2,083 $ 6,367 $ 13,020 $ 14,271
======== ======== ======== ======== ======== ======== ======== ========
Available for Sale
------------------
U.S. Treasury securities and
obligations of U.S.
Government corporations
and agencies $4, 994 $ 3,837 $ 4,201 $ 0 $ 0 $ 33,743 $ 46,775 $ 47,827
Average interest rate 5.3% 6.9% 4.1% 0.0% 0.0% 6.4% -- --
Obligations of states and
political subdivisions 600 1,484 5,386 0 0 50 7,520 7,759
Average interest rate 5.0% 5.6% 5.3% 0.0% 0.0% 5.1% -- --
Corporate securities 8,644 23,495 36,652 1,093 0 4,196 74,080 74,485
Average interest rate 6.6% 7.2% 5.5% 19.2% 0.0% 8.7% -- --
Mortgage & asset
backed securities 5,154 13,643 18,106 14,190 2,715 8,055 61,683 63,382
Average interest rate 6.3% 6.8% 6.0% 5.7% 5.9% 6.6% -- --
-------- -------- -------- -------- -------- -------- -------- --------
Total $ 19,392 $ 42,459 $ 64,345 $ 15,283 $ 2,715 $ 46,044 $190,238 $193,453
======== ======== ======== ======== ======== ======== ======== ========
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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.
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PART II. OTHER INFORMATION
Item 6. Exhibits and Reports On Form 8-K
--------------------------------
(b) Reports on Form 8-K.
No reports on Form 8-K were filed during the period for
which this report is filed.
* * * * * * *
"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. Such
forward-looking statements involve certain assumptions, risks and uncertainties
that could cause actual results to differ materially from those included in or
contemplated by the statements. These assumptions, risks and uncertainties
include, but are not limited to, those associated with factors affecting the
property-casualty insurance industry generally, including price competition,
size and frequency of claims, increasing crime rates, 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; government
regulation of the insurance industry; exposure to environmental claims;
dependence of the Company on its relationship with Mutual; the Company's
intention to reduce written premium in business segments that it believes no
longer provide a satisfactory return; and the other risks and uncertainties
discussed or indicated in all documents filed by the Company with the
Commission. The Company expressly disclaims any obligation to update any
forward-looking statements as a result of developments occurring after the date
of this report.
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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 13, 2001 By:/s/ Kenneth J. Wilson
---------------------
Kenneth J. Wilson
Chief Financial Officer and
Treasurer (duly authorized
officer of the registrant and
chief accounting officer)
20