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, 2003
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). [ ]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of October 31, 2003: 2,110,152 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 2002 2003
------------- -------------
(unaudited)
Investments:
Fixed maturities:
Held to maturity at amortized cost (fair value
$4,259 in 2002) $ 4,092 $ -
Available for sale at fair value (amortized cost
$186,302 in 2002 and $191,507 in 2003) 189,476 194,026
Preferred stock at fair value 7,367 5,880
Other long-term investments at fair value 2,042 2,135
Short-term investments 6,420 5,038
------------- -------------
Total investments 209,397 207,079
Cash 9 5,024
Interest due and accrued 1,594 1,512
Premiums receivable, net of allowance for doubtful
accounts of $288 in 2002 and $346 in 2003 14,496 17,156
Deferred policy acquisition costs 8,817 8,850
Ceded reinsurance balances receivable 19,086 19,074
Prepaid reinsurance premiums 1,091 879
Receivable from affiliate - 294
Receivable for securities - 491
Deferred income taxes 4,195 5,256
Other assets 10,031 10,970
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Total assets $ 268,716 $ 276,585
============= =============
See Notes to the Consolidated Financial Statements
2
MERCHANTS GROUP, INC.
CONSOLIDATED BALANCE SHEET
(in thousands except share amounts)
December 31, September 30,
2002 2003
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(unaudited)
Liabilities and Stockholders' Equity
Liabilities:
Reserve for losses and loss adjustment expenses $ 147,136 $ 146,856
Unearned premiums 35,119 34,863
Payable to affiliate 3,237 -
Payable for securities - 8,020
Other liabilities 15,300 16,455
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Total liabilities 200,792 206,194
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Stockholders' equity:
Common stock, 10,000,000 shares authorized, 2,110,152
shares issued and outstanding at December 31, 2002
and September 30, 2003 32 32
Additional paid in capital 35,795 35,795
Treasury stock, 1,139,700 shares at December 31, 2002
and September 30, 2003 (22,766) (22,766)
Accumulated other comprehensive income 1,937 1,470
Accumulated earnings 52,926 55,860
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Total stockholders' equity 67,924 70,391
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Commitments and contingent liabilities - -
Total liabilities and stockholders' equity $ 268,716 $ 276,585
============= =============
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,
2002 2003 2002 2003
---------- ---------- ---------- ----------
(unaudited)
Revenues:
Net premiums earned $ 20,198 $ 16,341 $ 64,897 $ 48,697
Net investment income 2,593 2,201 7,890 6,715
Net realized investment gains - 44 1,383 2,210
Other revenues 128 127 565 284
---------- ---------- ---------- ----------
Total revenues 22,919 18,713 74,735 57,906
---------- ---------- ---------- ----------
Expenses:
Net losses and loss adjustment
expenses 14,752 11,972 48,501 37,240
Amortization of deferred policy
acquisition costs 5,552 4,258 17,398 12,689
Other underwriting expenses 1,523 1,382 4,664 3,746
---------- ---------- ---------- ----------
Total expenses 21,827 17,612 70,563 53,675
---------- ---------- ---------- ----------
Income before income taxes 1,092 1,101 4,172 4,231
Income tax provision 442 273 1,676 664
---------- ---------- ---------- ----------
Net income $ 650 $ 828 $ 2,496 $ 3,567
========== ========== ========== ==========
Basic and diluted earnings per share $ .31 $ .39 $ 1.17 $ 1.69
========== ========== ========== ==========
Weighted average shares outstanding:
Basic 2,110 2,110 2,130 2,110
Diluted 2,114 2,110 2,134 2,111
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,
2002 2003 2002 2003
---------- ---------- ---------- ----------
(unaudited)
Net income $ 650 $ 828 $ 2,496 $ 3,567
---------- ---------- ---------- ----------
Other comprehensive income (loss)
before taxes:
Unrealized gains (losses) on securities 849 (852) 1,392 1,489
Reclassification adjustment
for gains and losses included
in net income - (32) (1,383) (2,198)
---------- ---------- ---------- ----------
Other comprehensive income (loss)
before taxes 849 (884) 9 (709)
Income tax provision (benefit) related to
items of other comprehensive income 325 (301) 8 (242)
---------- ---------- ---------- ----------
Other comprehensive income (loss) 524 (583) 1 (467)
---------- ---------- ---------- ----------
Comprehensive income (loss) $ 1,174 ($ 245) $ 2,497 $ 3,100
========== ========== ========== ==========
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,
2002 2003
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(unaudited)
Common stock, beginning and end $ 32 $ 32
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Additional paid in capital, beginning and end: 35,795 35,795
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Treasury stock:
Beginning of period (20,332) (22,766)
Purchase of treasury shares (2,434) -
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End of period (22,766) (22,766)
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Accumulated other comprehensive income:
Beginning of period 1,812 1,937
Other comprehensive income (loss) 1 (467)
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End of period 1,813 1,470
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Accumulated earnings:
Beginning of period 51,244 52,926
Net income 2,496 3,567
Cash dividends (644) (633)
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End of period 53,096 55,860
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Total stockholders' equity $ 67,970 $ 70,391
============= =============
See Notes to the Consolidated Financial Statements
6
MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands)
Nine Months
Ended September 30,
2002 2003
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(unaudited)
Cash flows from operations:
Collection of premiums $ 60,522 $ 46,958
Payment of losses and loss adjustment expenses (50,410) (39,604)
Payment of other underwriting expenses (20,707) (16,759)
Investment income received 8,625 6,756
Investment expenses paid (242) (218)
Income taxes (paid) recovered (1,158) 154
Other 565 284
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Net cash used in operations (2,805) (2,429)
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Cash flows from investing activities:
Proceeds from fixed maturities sold or matured 103,184 110,103
Purchase of fixed maturities (99,567) (110,864)
Net decrease in preferred stock 1,048 1,500
Net (increase) decrease in other long-term investments (370) 1,958
Net decrease in short-term investments 970 1,382
Increase in receivable for securities - (491)
Increase in payable for securities 1,455 8,020
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Net cash provided by investing activities 6,720 11,608
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Cash flows from financing activities:
Settlement of affiliate balances, net (1,809) (3,531)
Decrease in demand loan, net (200) -
Purchase of treasury stock (2,434) -
Cash dividends (644) (633)
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Net cash used in financing activities (5,087) (4,164)
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Increase (decrease) in cash (1,172) 5,015
Cash:
Beginning of period 1,197 9
------------- -------------
End of period $ 25 $ 5,024
============= =============
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,
2002 2003
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(unaudited)
Net income $ 2,496 $ 3,567
Adjustments:
Accretion 12 (257)
Realized investment gains (1,383) (2,210)
(Increase) decrease in assets:
Interest due and accrued 481 82
Premiums receivable 6,680 (2,660)
Deferred policy acquisition costs 3,014 (33)
Ceded reinsurance balances receivable (504) 12
Prepaid reinsurance premiums 2,097 212
Deferred income taxes (143) (820)
Other assets 68 (941)
Increase (decrease) in liabilities:
Reserve for losses and loss adjustment expenses (1,643) (280)
Unearned premiums (12,718) (256)
Other liabilities (1,262) 1,155
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Net cash used in operations $ (2,805) $ (2,429)
============= =============
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, 2003 and the related
consolidated statements of operations and comprehensive income for the three and
nine month periods ended September 30, 2003, and changes in stockholders' equity
and cash flows for the nine month periods ended September 30, 2002 and 2003,
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, 2002.
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
With the exception of the individual who serves as both the President of the
Company and the Chief Operating Officer of MNH, the Company and MNH have no paid
employees. Under a management agreement dated September 26, 1986 (the Management
Agreement), Merchants Mutual Insurance Company (Mutual), which owned 12.1% of
the Company's common stock at September 30, 2003, provided the Company and MNH
with the facilities, management and personnel required to manage their
day-to-day business through December 31, 2002. All underwriting, administrative,
claims and investment expenses incurred on behalf of Mutual and MNH were shared
on an allocated cost basis. Effective January 1, 2003, the Company, MNH and
Mutual entered into a new agreement (the Services Agreement) for Mutual to
provide underwriting, administrative, claims and investment services to the
Company and MNH and to manage the traditional property and casualty insurance
business of MNH on substantially the same terms as under the Management
Agreement. 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 in the Company's Annual Report on Form 10-K for the year ended
December 31, 2002.
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 number of shares
outstanding was increased by the assumed exercise of options for 35,500 shares
of common stock in the nine month period in 2003 and in the three and nine month
periods in 2002, which would have resulted in 439 additional shares outstanding
for the nine month period ended September 30, 2003 and 3,641 and 3,887
additional shares outstanding for the three and nine month periods in 2002,
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 applicable period. 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 insurance companies. This change eliminated state income
taxes for all non-life insurance companies and increased the premium tax rate
from 1.3% to 2.0%. 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, 2003 As Compared
to the Nine Months Ended September 30, 2002
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 the Notes to
Consolidated Financial Statements contained in Item 1 of this Form 10-Q, which
is incorporated herein by reference.
Results of operations for the nine months ended September 30, 2003 reflect the
effects of the Services Agreement and the Reinsurance Pooling Agreement between
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 2003 in
accordance with the Reinsurance Pooling Agreement is 40%. In addition to
comparisons of the Company's share of pooled premiums for 2003 to its unpooled
premiums for the same period in 2002, this item includes comparisons of the
pooled, or combined Mutual and MNH, premiums written for 2003 to the combined
business of Mutual and MNH for the same period in 2002, even though the
companies were not party to a reinsurance pooling agreement in 2002.
Total combined Mutual and MNH or "group-wide" direct premiums (DWP) written for
the nine months ended September 30, 2003 were $131,264,000, an increase of
$1,637,000 or 1% from $129,627,000 for the nine months ended September 30, 2002.
The Company's share of combined direct premiums written for the nine months
ended September 30, 2003, in accordance with the Reinsurance Pooling Agreement,
was $52,506,000. The Company recorded $56,036,000 of direct premiums written for
the nine months ended September 30, 2002. The table below shows a comparison of
direct premiums written by major category for the nine months ended September
30, 2003 and 2002:
MNH
Pooled MNH
Group-wide DWP Share DWP
-------------------------- ---------- ----------
Nine months ended Nine months ended
September 30, September 30,
-------------------------- --------------------------
2003 2002 Variance 2003 2002
---------- ---------- ---------- ---------- ----------
(000's omitted)
Voluntary Personal Lines $ 48,350 $ 51,086 (5%) $ 19,340 $ 29,676
Voluntary Commercial Lines 78,527 73,328 7% 31,411 21,861
Involuntary 4,387 5,213 (16%) 1,755 4,499
---------- ---------- ---------- ----------
Total Direct Written Premiums $ 131,264 $ 129,627 1% $ 52,506 $ 56,036
========== ========== ========== ==========
11
The 5% decrease in group-wide voluntary personal lines direct premiums written,
which represented 37% and 39% of total group-wide direct premiums written for
the nine month periods ended September 30, 2003 and 2002, respectively, resulted
from an 8% decrease in private passenger automobile (PPA) direct premiums
written, somewhat offset by a 3% increase in homeowners direct premiums written.
The decrease in PPA direct premiums written is primarily the result of the
group's policy, 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.
The 7% increase in group-wide voluntary commercial lines direct premiums
written, which comprised 60% and 57% of total group-wide direct premiums written
for the nine month periods ended September 30, 2003 and 2002, respectively,
primarily resulted from higher average premiums per commercial lines policy.
Group-wide pooled net premiums written for the nine months ended September 30,
2003 were $122,873,000, a decrease of $684,000, or less than 1% from
$123,557,000 for the nine months ended September 30, 2002. The Company's share
of pooled net premiums written in accordance with the Reinsurance Pooling
Agreement for the nine months ended September 30, 2003 was $48,653,000. Net
premiums written for the nine months ended September 30, 2002 were $54,277,000.
Total revenues for the nine months ended September 30, 2003 were $57,906,000, a
decrease of $16,829,000 or 23% from $74,735,000 for the nine months ended
September 30, 2003.
The Company's share of pooled net premiums earned in accordance with the
Reinsurance Pooling Agreement for the nine months ended September 30, 2003 was
$48,697,000. Net premiums earned for the nine months ended September 30, 2002
were $64,897,000. The decrease in net premiums earned was due to the allocation
of group-wide net premiums earned pursuant to the Reinsurance Pooling Agreement.
Net investment income was $6,715,000 for the nine months ended September 30,
2003, a decrease of 15% from $7,890,000 for the nine months ended September 30,
2002. The average pre-tax yield associated with the investment portfolio
decreased 105 basis points to 4.5% for the nine months ended September 30, 2003
compared to the nine months ended September 30, 2002. Average invested assets
for the nine months ended September 30, 2003 decreased 3% compared to the year
earlier period.
Net realized investment gains were $2,210,000 for the nine months ended
September 30, 2003 compared to $1,383,000 for the nine months ended September
30, 2002. The majority of the net realized gains for 2003 resulted from the
Company taking advantage of a share repurchase program related to an otherwise
illiquid equity security. Equity securities comprised less than 1% of the
Company's investment portfolio at September 30, 2003.
Other revenues decreased $281,000 or 50% to $284,000 for the nine months ended
September 30, 2003 from $565,000 for the nine months ended September 30, 2002.
This decrease resulted primarily from a 19% decrease in service fee income,
which in turn was due to the allocation of service fee income pursuant to the
Reinsuance Pooling Agreement.
12
Net losses and LAE, which include the Company's share of pooled 2003 accident
year losses, were $37,240,000 for the nine months ended September 30, 2003, a
decrease of $11,261,000, or 23%, from $48,501,000 for the nine months ended
September 30, 2002. The loss and LAE ratio increased to 76.5% for the nine
months ended September 30, 2003 from 74.7% for the nine months ended September
30, 2002.
The ratio of amortized deferred policy acquisition costs and other underwriting
expenses to net premiums earned decreased to 33.7% for the nine months ended
September 30, 2003 from 34.0% for the nine months ended September 30, 2002. An
increase in the premium tax rate in New York State, which is discussed in the
following paragraph, added .5 percentage points to the Company's ratio of
amortized deferred policy acquisition costs and other underwriting expenses to
net premiums earned for the 2003 period. Other underwriting expenses for the
2003 period included $253,000 of retrospective commission income to be received
from Mutual in accordance with the Reinsurance Pooling Agreement. This
retrospective commission income reduced the ratio of deferred policy acquisition
costs and other underwriting expenses to net premiums earned by .5 percentage
points. Commissions, premium taxes and other state assessments that vary
directly with the Company's premium volume represented 20.9% of net premiums
earned in the nine months ended September 30, 2003 compared to 20.2% in the nine
months ended September 30, 2002.
The provision for income taxes for the nine months ended September 30, 2003
includes the effect of a May 2003 change in New York State law with respect to
the taxation of insurance companies. This change eliminated state income taxes
for all non-life insurance companies and increased the premium tax rate from
1.3% to 2.0%. 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 months 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.
Results of Operations for the Three Months Ended September 30, 2003 As Compared
to the Three Months Ended September 30, 2002
Total combined Mutual and MNH direct premiums written for the three months ended
September 30, 2003 were $44,865,000, an increase of $882,000 or 2% from
$43,983,000 for the three months ended September 30, 2002. The Company's share
of combined direct premiums written for the three months ended September 30,
2003, in accordance with the Reinsurance Pooling Agreement was $17,946,000. The
Company recorded $17,915,000 of direct premiums written for the three months
ended September 30, 2002. The table below shows a comparison of direct premiums
written by major category for the three months ended September 30, 2003 and
2002:
13
MNH
Pooled MNH
Group-wide DWP Share DWP
-------------------------- ---------- ----------
Three months ended Three months ended
September 30, September 30,
2003 2002 Variance 2003 2002
---------- ---------- ---------- ---------- ----------
(000's omitted)
Voluntary Personal Lines $ 16,897 $ 18,747 (10%) $ 6,759 $ 11,094
Voluntary Commercial Lines 26,892 23,258 16% 10,757 5,192
Involuntary 1,076 1,978 (46%) 430 1,629
---------- ---------- ---------- ----------
Total Direct Written Premiums $ 44,865 $ 43,983 2% $ 17,946 $ 17,915
========== ========== ========== ==========
The 10% decrease in group-wide voluntary personal lines direct premiums written
resulted primarily from a 14% decrease in PPA direct premiums written. The
decrease in PPA direct premiums written is primarily the result of the group's
policy, 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.
The 16% increase in group-wide voluntary commercial lines direct premiums
written primarily resulted from higher average premiums per commercial lines
policy.
Group-wide pooled net premiums written for the three months ended September 30,
2003 were $41,772,000, a decrease of $564,000, or 1% from $42,336,000 for the
three months ended September 30, 2002. The Company's share of pooled net
premiums written in accordance with the Reinsurance Pooling Agreement for the
three months ended September 30, 2003 was $16,709,000. Net premiums written for
the three months ended September 30, 2002 were $17,757,000.
Total revenues for the three months ended September 30, 2003 were $18,713,000, a
decrease of $4,206,000 or 18% from $22,919,000 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, 2003 was
$16,341,000. Net premiums earned for the three months ended September 30, 2002
were $20,198,000. The decrease in net premiums earned was a result of the
Company's allocated share of group-wide net premiums earned under the
Reinsurance Pooling Agreement.
Net investment income was $2,201,000 for the three months ended September 30,
2003, a decrease of 15% from $2,593,000 for the three months ended September 30,
2002. The average pre-tax yield associated with the investment portfolio
decreased 109 basis points to 4.2% for the three months ended September 30, 2003
when compared to the three months ended September 30, 2002. Average invested
assets for the three months ended September 2003 decreased 2% compared to the
year earlier period.
Net realized investment gains were $44,000 for the three months ended September
30, 2003. There were no realized gains or losses in the three months ended
September 30, 2002.
14
Net losses and LAE, which include the Company's share of pooled 2003 accident
year losses, were $11,972,000 for the three months ended September 30, 2003, a
decrease of $2,780,000, or 19%, from $14,752,000 for the three months ended
September 30, 2002. The loss and LAE ratio increased to 73.3% for the three
months ended September 30, 2003 from 73.0% for the three months ended September
30, 2002.
The ratio of amortized deferred policy acquisition costs and other underwriting
expenses to net premiums earned decreased to 34.5% for the three months ended
September 30, 2003 from 35.0% for the three months ended September 30, 2002. The
aforementioned increase in the New York State premium tax rate added .5
percentage points to the ratio of amortized deferred policy acquisition costs
and other underwriting expenses to net premiums earned. Commissions, premium
taxes and other state assessments that vary directly with the Company's premium
volume represented 21.3% of net premiums earned in the three months ended
September 30, 2003 compared to 20.4% in the three months ended September 30,
2002.
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. The reduction in the
Company's share of net premiums written under 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 sale 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. 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 is 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 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, 2003, the
Company recorded as accumulated other comprehensive income in its Consolidated
Balance Sheet $1,470,000 of unrealized gains, net of taxes, associated with its
investments classified as available for sale. During the nine months ended
September 30, 2003 the Company recorded $467,000 of unrealized losses, net of
tax, associated with its available for sale investments as other comprehensive
income (loss).
At September 30, 2003, the Company's portfolio of fixed maturity investments
represented 93.7% 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, investment income and
15
cash flows from the portion of the Company's bond portfolio invested in
mortgage-backed and other asset-backed securities which, in addition to interest
income, provide monthly paydowns of bond principal, will enable the Company to
satisfy its cash obligations.
At September 30, 2003, $96,129,000 or 49.5%, 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 derivative types 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, 2003 $3,383,000, or 1.6%, of the Company's investment portfolio
was invested in non-investment grade securities compared to $4,965,000, or 2.4%,
at December 31, 2002.
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 working capital purposes and for repurchases of the Company's common
stock. At September 30, 2003 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 2003 without the prior approval of the New Hampshire Insurance
Commissioner is $5,492,000. MNH paid $3,700,000 of dividends to the Company in
2002. Dividends were paid in February 2002, May 2002 and November 2002, of
$2,300,000, $900,000 and $500,000, respectively. MNH paid dividends to the
Company of $600,000 in April of 2003. On October 30, 2003, the Board of
Directors of MNH authorized a $600,000 cash dividend to be paid to the Company
on November 26, 2003. The Company paid cash dividends to its common stockholders
of $.10 per share in the first, second and third quarters of 2003 amounting to
$633,000. On October 30, 2003 the Company declared a quarterly cash dividend of
$.10 per share payable on December 3, 2003 to shareholders of record as of the
close of business on November 19, 2003.
Under the Management Agreement and the Services Agreement, Mutual has provided
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 by Mutual to the Company, or owed by the
Company to Mutual, for the difference between premiums collected and payments
made for losses, 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
16
would allow it to meet this 3 to 1 regulatory guideline. For the first nine
months of 2003, MNH's ratio of net premiums written to statutory surplus,
annualized for a full year, was 1.1 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 Management
Agreement, which was effective from 1986 through December 31, 2002, Mutual
provided the Company and MNH with facilities and personnel to conduct the
traditional Merchants insurance business and other services. With the exception
of the individual who serves as both the President of the Company and the Chief
Operating Officer of MNH, the officers of the Company and MNH are paid full time
employees of Mutual whose services are provided under the Services Agreement.
Also, effective January 1, 2003, the Reinsurance Pooling Agreement between MNH
and Mutual provides for MNH to cede all of its net risk on its traditional
insurance business to Mutual and then to assume from Mutual an agreed percentage
(40% in 2003) of the combined traditional insurance business of both MNH and
Mutual. This will create a common underwriting result for MNH and Mutual under
the Reinsurance Pooling Agreement and further align the interests of the
parties.
"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.
17
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 $207,079,000 at September 30, 2003 is subject
to changes in interest rates and to a lesser extent on credit quality. Further,
certain mortgage-backed and asset-backed securities are exposed to accelerated
prepayment risk generally caused by interest rate movements. If interest rates
were to decline, mortgage holders would be more likely to refinance existing
mortgages at lower rates. Acceleration of future repayments could adversely
affect future investment income, if reinvestment of the accelerated receipts was
made in lower yielding securities.
The following table provides information related to the Company's fixed maturity
investments at September 30, 2003. The table presents cash flows of principal
amounts and related weighted average interest rates by expected maturity dates.
The cash flows are based upon the maturity date or, in the case of
mortgage-backed and asset-backed securities, expected payment patterns. Actual
cash flows could differ from those shown in the table.
18
Fixed Maturities
Expected Cash Flows of Principal Amounts ($ in 000's): TOTAL
--------
Esti-
Amor- mated
There- tized Market
2003 2004 2005 2006 2007 after Cost Value
-------- -------- -------- -------- -------- -------- -------- --------
Available for Sale
U.S. Treasury securities and
obligations of U.S.
Government corporations
and agencies $ 2,185 $ 0 $ 8,176 $ 0 $ 0 $ 3,008 $ 13,369 $ 13,741
Average interest rate 4.0% 0.0% 3.6% 0.0% 0.0% 3.2% --- ---
Obligations of states and
political subdivisions 3,471 1,390 8,558 9,697 3,898 17,707 44,721 45,175
Average interest rate 7.9% 4.1% 3.2% 3.4% 4.3% 3.9% --- ---
Corporate securities 9,083 5,600 17,733 0 0 5,464 37,880 38,981
Average interest rate 4.3% 5.3% 4.0% 0.0% 0.0% 8.1% --- ---
Mortgage & asset
backed securities 6,471 17,501 19,006 19,607 9,821 23,131 95,537 96,129
Average interest rate 5.4% 5.3% 5.2% 5.2% 5.3% 5.4% --- ---
-------- -------- -------- -------- -------- -------- -------- --------
Total $ 21,210 $ 24,491 $ 53,473 $ 29,304 $ 13,719 $ 49,310 $191,507 $194,026
======== ======== ======== ======== ======== ======== ======== ========
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-14(c) and 15d-14(c) 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
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).
(c) Reinsurance Pooling Agreement between Merchants Insurance
Company of New Hampshire, Inc. and Merchants Mutual Insurance
Company effective January 1, 2003
20
(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 September 29, 2003 (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 (incorporated by reference to Exhibit 10(g) to the
Company's 2002 Annual Report on Form 10-K filed on March 31,
2002).
(g) Endorsement to the 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 September 24, 2003
(filed herewith).
(h) 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).
(i) 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).
(j) 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).
(k) 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).
*(l) 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
*(m) 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).
*(n) 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).
*(o) 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).
*(p) 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).
*(q) 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.
*(r) Consulting Agreement between Stephen C. June and Merchants
Insurance Company of New Hampshire, Inc. dated as of May 7,
2001 (incorporated by reference to Exhibit 10t to the
Company's 2001 Annual Report on Form 10-K filed on March 27,
2002).
*(s) 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.
22
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)
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 August 1, 2003, the Company filed a Form 8-K reporting the issuance of a
press release announcing results for the quarter ended June 30, 2003.
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 12, 2003 By:/s/ Kenneth J. Wilson
---------------------------
Kenneth J. Wilson
Chief Financial Officer and
Treasurer (duly authorized
officer of the registrant and
chief accounting officer)
23