<PAGE>
INDEX
<TABLE>
<CAPTION>
PART I PAGE
<S> <C> <C>
Item 1. Business 1
Item 2. Properties 34
Item 3. Legal Proceedings 34
Item 4. Submission of Matters to a Vote of Security Holders 34
Executive Officers of the Registrant 34
PART II
Item 5. Market for the Registrant's Common Equity and Related Shareholder Matters 35
Item 6. Selected Financial Data 35
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations 35
Item 7A. Quantitative and Qualitative Disclosure About Market Risk 35
Item 8. Financial Statements and Supplementary Data 36
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 36
PART III
Item 10. Directors and Executive Officers of the Registrant 36
Item 11. Executive Compensation 36
Item 12. Security Ownership of Certain Beneficial Owners and Management 36
Item 13. Certain Relationships and Related Transactions 36
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K 36
</TABLE>
<PAGE>
The Business Section and other parts of this Form 10-K contain forward-looking
statements that involve risks and uncertainties. The Company's actual results
may differ significantly from the results discussed in the forward-looking
statements. Factors that might cause such differences include, but are not
limited to, those discussed in the subsection entitled "Forward-Looking
Statements" in the Company's Management's Discussion and Analysis that has been
incorporated by reference into Part II, Item 7 of this Form 10-K.
ITEM 1. BUSINESS
COMPANY OVERVIEW
Pennsylvania Manufacturers Corporation (the "Company" or "PMC"), headquartered
in Blue Bell, Pennsylvania, is a Pennsylvania insurance holding company.
Presently, the Company operates in two principal segments, property and casualty
reinsurance through PMA Reinsurance Corporation ("PMA Re"), and workers'
compensation and standard property and casualty primary insurance through
Pennsylvania Manufacturers' Association Insurance Company ("PMAIC") and other
affiliated insurance companies (the "Property and Casualty Group"). PMA Re
emphasizes risk-exposed, excess of loss reinsurance and operates in the domestic
brokered market. The Property and Casualty Group offers workers' compensation
products and services and certain other standard lines of commercial insurance
primarily in nine contiguous jurisdictions in the Mid-Atlantic and Southern
regions of the United States, utilizing the PMA Group trade name. The domestic
insurance subsidiaries through which the Property and Casualty Group writes its
insurance products and who share results through an intercompany pooling
agreement are referred to herein as the "Pooled Companies."
During 1997, the Company established a separate specialty insurance operation
focusing on excess and surplus lines, Caliber One Management Company (Caliber
One). Caliber One did not write any business during 1997. Management
anticipates that Caliber One will primarily write multi-line business consisting
of primary and excess commercial general liability, professional liability,
excess automobile and certain property exposures beginning in 1998. Because
Caliber One's operating revenues and results were not significant in 1997, its
data was included in the Corporate and Other segment in the foregoing
discussions.
PMA Re and the Property and Casualty Group are sometimes collectively referred
to herein as the "Insurance Subsidiaries." A.M. Best & Company ("A.M. Best")
has currently assigned an "A+ (Superior)" rating to PMA Re, an "A- (Excellent)"
rating to the Pooled Companies and an "A" (Excellent) to Caliber One Indemnity
Company.
At December 31, 1997, the Company had total assets of $3.1 billion and
shareholders' equity of $478.3 million. Unless otherwise specified in this Form
10-K, dollar amounts set forth herein with respect to the Company are presented
in accordance with generally accepted accounting principles ("GAAP").
After a period of rapid growth in the late 1980's, the Company's consolidated
total net premiums written declined from $552.0 million in 1992 to $418.3
million in 1997. Between 1993 and 1997, PMA Re's premium volume expanded as a
result of the increased demand for reinsurance in the markets in which PMA Re
participates as well as trends towards ceding companies restricting the number
of reinsurers with which they will do business. Those trends have facilitated
PMA Re's increased participation on reinsurance treaties with its existing
clients, the writing of additional layers and programs with existing clients,
and to a lesser extent, the addition of business from new ceding companies.
During this period, the market for the products written by the Property and
Casualty Group was very competitive. The Property and Casualty Group restricted
its premium volume, rather than write business at rates that were not
commensurate with the risks assumed, and introduced loss-sensitive coverages and
large-deductible programs, under which insureds pay less premium but bear a
greater portion of loss exposure. Beginning in 1992, premiums written were also
reduced as a result of the Property and Casualty Group's re-underwriting of its
book of business and, commencing in 1993, rate reductions associated with
workers' compensation benefit reform laws. Management believes that recent
initiatives undertaken and workers' compensation reforms enacted in recent years
afford the Property and Casualty Group an opportunity to increase its core
business, workers' compensation insurance, on terms acceptable to it. See "The
Property and Casualty Group -- Background and Recent Developments" below.
1
<PAGE>
The composition of the Company's net premiums written for 1997 was as follows:
(dollar amounts in thousands)
<TABLE>
<CAPTION>
Net premiums
written % of total
------------ ----------
<S> <C> <C>
PMA Re................................ $177,934 42.5%
-------- ----
The Property and Casualty Group:
Workers' Compensation............. 175,301 41.9%
Other commercial lines............ 65,047 15.6%
-------- -----
Total............................. 240,348 57.5%
-------- -----
Total................................. $418,282 100.0%
======== =====
PMA RE
</TABLE>
BACKGROUND
PMA Re is primarily a treaty reinsurer of domestic property and casualty
business that operates in the brokered market. The Reinsurance Association of
America (the "RAA") reported that as of September 30, 1997, PMA Re was the
eighteenth largest professional reinsurer in the brokered market and the twenty-
second largest professional reinsurer in the United States market based upon
statutory capital and surplus.
In the brokered reinsurance market, the products (reinsurance coverages) are
distributed to the ultimate customer (ceding companies) through reinsurance
intermediaries, known as brokers. In exchange for providing such distribution
services, the brokers are paid commissions, known as brokerage, which is
typically based upon a percentage of the premiums ceded under a particular
contract. The brokered reinsurance market differs from the direct reinsurance
market in which reinsurers maintain their own sales forces and distribute their
products directly to their ceding company clients.
In the five-year period ended December 31, 1997, PMA Re has expanded its premium
base without changing its underwriting standards. From 1992 to 1997, PMA Re
reported premium volume growth which exceeded that of the overall reinsurance
industry. During such period, PMA Re's compound annual growth rate for net
premiums written was 13.2%, while it is estimated that the reinsurance
industry's compound annual growth rate was 8.2% for the same period based upon
information published by the RAA. Management believes that the expansion of PMA
Re's premium base has been attributable to several factors. First, PMA Re's
volume has been impacted by industry trends that have tended to increase the
demand for reinsurance. Specifically, much of the growth that has occurred in
the primary insurance market in recent years has been attributable to regional
and niche companies. Typically, these companies demand more reinsurance than
their larger counterparts. Second, there has been growth in primary industry
segments in which PMA Re specializes, such as excess and surplus lines. Third,
management believes that PMA Re has benefited from the greater selectivity by
ceding companies which have restricted the number of reinsurers with which they
will transact business. Additionally, commencing in 1996, PMA Re initiated a
target marketing program, under which certain existing accounts and new accounts
were identified as having certain desirable characteristics (such as quality
management and underwriting) and such accounts were pursued for additional or
new business. This program, as well as fallout from consolidation in the
reinsurance industry has enabled PMA Re to grow faster than the industry in 1996
and 1997. These factors have more than offset the recent trends of ceding
companies retaining more of their business and highly competitive conditions
which caused PMA Re to non-renew certain accounts and not accept certain new
business opportunities for underwriting or pricing reasons.
PMA Re's premium volume increases have largely taken the form of increased
participation levels on clients' existing programs, as well as writing of
additional layers and programs with current clients. To a lesser extent, volume
growth has been attributable to business written with new ceding company
clients.
2
<PAGE>
REINSURANCE PRODUCTS
The following table indicates PMA Re's gross and net premiums written by major
category of business:
(dollar amounts in thousands)
<TABLE>
<CAPTION>
1997 1996 1995 1994 1993
-------- -------- --------- -------- --------
<S> <C> <C> <C> <C> <C>
Gross premiums written (1)
Casualty................................ $151,901 $143,991 $128,736 $107,001 $ 94,482
Property................................ 72,625 63,325 63,693 36,592 28,217
Other................................... 795 842 (63) 837 1,854
-------- -------- -------- -------- --------
Total................................... $225,321 $208,158 $192,366 $144,430 $124,553
======== ======== ======== ======== ========
Net premiums written (2)
Casualty................................ $118,889 $122,008 $107,383 $ 88,585 $ 82,016
Property................................ 58,257 41,240 45,440 23,929 18,407
Other................................... 788 805 (63) 837 1,854
-------- -------- -------- -------- --------
Total................................... $177,934 $164,053 $152,760 $113,351 $102,277
======== ======== ======== ======== ========
</TABLE>
(1) In 1997 and 1996, gross premiums written include $5.8 million and $3.5
million of facultative reinsurance, respectively, comprised of the
following: property, $2.4 million and $1.1 million, respectively; casualty,
$3.4 million and $2.3 million, respectively; and other lines, $0.1 million
in 1996.
(2) In 1997 and 1996, net premiums written include $2.5 million and $1.0 Million
of facultative reinsurance, respectively, comprised of the following:
property, $1.7 million and $0.5 million, respectively; casualty, $0.8
million and $0.5 million, respectively; and other lines, less than $0.1
million in 1996.
CASUALTY BUSINESS
In terms of net premiums written, casualty business has increased at a compound
annual growth rate of 7.2% in the five-year period ended December 31, 1997, and
casualty business accounted for 66.8% of net premiums written in 1997. The
following table indicates the mix of casualty business by class on the basis of
net premiums written:
(dollar amounts in thousands)
<TABLE>
<CAPTION>
1997 1996 1995 1994 1993
-------- -------- -------- ------- -------
<S> <C> <C> <C> <C> <C>
Umbrella.................. $ 30,967 $ 40,307 $ 51,558 $38,743 $34,189
Errors and Omissions...... 13,813 19,866 7,149 7,281 4,033
General Liability......... 15,174 11,702 7,460 8,936 8,665
Medical Malpractice....... 7,373 7,411 6,835 6,355 6,657
Directors' and Officers'.. 5,897 6,210 4,586 4,156 1,815
Miscellaneous Liability... 16,431 12,811 10,350 6,006 3,690
Auto Liability............ 22,268 17,056 13,032 10,134 12,616
Workers' Compensation..... 6,966 6,645 6,412 6,974 10,351
-------- -------- -------- ------- -------
Total..................... $118,889 $122,008 $107,382 $88,585 $82,016
======== ======== ======== ======= =======
</TABLE>
Due to the competitive conditions in the casualty market, management has
maintained a relatively conservative growth posture for casualty business in the
five-year period. PMA Re has generally focused on other liability coverages
(which include general liability, products liability, professional liability and
other more specialized liability coverages), while maintaining a relatively
stable level of auto liability premiums, and de-emphasizing workers'
compensation coverages. The decrease in 1997 casualty net premiums was
primarily attributable to
3
<PAGE>
increased retrocessional protection purchased (see "The Company's Reinsurance
Ceded"), which offset increases in gross casualty premiums relating to new
business with existing clients and larger lines taken on existing programs. In
1997, 1996 and 1995, PMA Re decreased the amount of its excess and umbrella
business, as rates and terms for this type of business were no longer as
attractive as they had been. Much of the growth in 1995 and 1996 related to the
expansion and addition of several programs covering specialty business (which
includes professional liability, directors' and officers' liability,
environmental impairment liability, employment practices liability and other
miscellaneous specialized coverages). Such specialty business now accounts for
approximately 53.1% of in force casualty treaty business. In 1994, the growth in
other liability was mainly attributable to excess and umbrella business, as PMA
Re added several significant programs.
PROPERTY BUSINESS
Property business has increased at a compound annual growth rate of 40.4% in the
five-year period ended December 31, 1997, and accounted for 32.7% of net
premiums written in 1997. The increase in net property premiums written in 1997
was primarily the result of additional property underwriting expertise that PMA
Re added to its underwriting staff in late 1996 to broaden its product
offerings. Such expertise enabled PMA Re to increase cross-selling
opportunities with its existing treaty reinsurance clients by offering
additional and/or expanded property coverages. In addition, property premiums
ceded decreased primarily related to changes in PMA Re's property retrocessional
coverages in terms of premiums and ceding commissions (see "The Company's
Reinsurance Ceded"). The decrease in net premiums written in 1996 was primarily
attributable to higher ceding company retentions, competitive pricing conditions
and higher ceded property premiums. The growth in net property business in 1995
and 1994, of 89.9% and 30.0%, respectively, was attributable to the expansion of
several programs covering auto physical damage, inland marine risks and certain
specialty property coverages written on a surplus lines basis.
PMA Re has generally de-emphasized catastrophe coverages. As of December 31,
1997, catastrophe business accounted for approximately 4.0% of property premiums
in force. The property programs written by PMA Re generally contain per
occurrence limits and/or are not considered significantly catastrophe exposed,
either because of the locations of the insured values or the nature of the
underlying properties insured. However, as is common in property reinsurance,
PMA Re is exposed to the possibility of loss from catastrophic events due to the
aggregation of per occurrence limits and similar issues. PMA Re actively
manages this exposure through aggregate management, avoidance of catastrophe
business and retrocessional protection. As of January 1, 1998, PMA Re
maintained catastrophe retrocessional protection of $46.0 million excess of $2.0
million. Management believes that its catastrophe retrocessional coverage is
adequate to protect PMA Re against its probable maximum loss from a significant
catastrophe. See "Underwriting" and "The Company's Reinsurance Ceded" below.
FACULTATIVE REINSURANCE
Facultative reinsurance is a form of reinsurance coverage which is placed on a
risk-by-risk basis, and the reinsurer retains the right to accept or reject each
individual risk submitted by the ceding company.
Facultative differs from treaty reinsurance in that treaty reinsurance typically
covers multiple risks within a particular classification, the reinsurer does not
retain the right to accept or reject individual risks as long as such risks
conform to the contract stipulations, and the ceding company is obligated to
cede the risks to the reinsurer. Companies typically purchase facultative
reinsurance for several reasons, including: (i) to cover unusual risks; (ii) to
cover high hazard risks; (iii) to protect a ceding company's net retention
and/or treaty reinsurers; (iv) to obtain additional capacity beyond that
provided by a company's treaty reinsurers; (v) to cover risks excluded under a
company's treaties; and (vi) to cover risks under a company's new line of
business.
There are some facultative products which are variations of the above general
concept, such as automatic and semi-automatic facultative contracts. Under
automatic facultative arrangements (sometimes known as facultative obligatory
treaties), the cession is not obligatory from the ceding company's point of
view, but the acceptance of the risk is automatic from the reinsurer's
standpoint. For semi-automatic facultative contracts, the cession is not
obligatory, but the acceptance of the risk is obligatory, unless the risk falls
outside certain stipulated criteria. If the risk falls outside such criteria,
the reinsurer has the option of either: (i) accepting the risk, (ii) declining
the risk, or (iii) repricing the risk.
4
<PAGE>
In 1997, PMA Re recorded $2.5 million of net facultative reinsurance premiums
which represented 1.4% of total net premiums written for the year, compared to
$1.0 million, or 0.6%, in 1996. PMA Re will offer facultative products as a
complement to existing treaty business, as well as offering such products to
companies with whom PMA Re does not presently have a relationship. The products
offered include traditional facultative certificates and automatic or semi-
automatic programs for both property and casualty exposures. PMA Re commenced
writing facultative reinsurance in November 1995.
MARKETING AND DISTRIBUTION
PMA Re operates primarily through the domestic brokered reinsurance market in
which it has developed relationships with major reinsurance brokers enabling it
to gain access to a wide range of ceding companies with varying reinsurance and
related service needs. PMA Re's brokers that accounted for more than 10% of the
gross premiums in force as of December 31, 1997 were as follows:
(dollar amounts in thousands)
<TABLE>
<CAPTION>
Broker Gross Premiums in Force Percentage of Total
- ------ ----------------------- --------------------
<S> <C> <C>
Aon Reinsurance............. $99,151 35.7%
Guy Carpenter & Company..... 64,803 23.3%
E. W. Blanch................ 38,267 13.8%
</TABLE>
The above brokers are among the largest brokers in the reinsurance industry.
Beginning in 1996, PMA Re began a target marketing program designed to identify
companies in the smaller and medium company segments with whom PMA Re presently
has either no or an insignificant relationship, but meet desired risk profiles.
After such identification, marketing and underwriting personnel work with the
ceding company's broker to enable PMA Re to have an opportunity to participate
in the reinsurance coverage.
As of December 31, 1997, PMA Re had approximately 200 unaffiliated clients, with
no individual client accounting for more than 7.4% of gross premiums in force.
UNDERWRITING
PMA Re's underwriting process has two principal aspects: underwriting the
specific program to be reinsured and underwriting the ceding company.
Underwriting the specific program to be reinsured involves, in addition to
pricing, a review of the type of program, the total risk and the ceding
company's policy forms. Underwriting the ceding company involves an evaluation
of the expected future performance of the ceding company through an examination
of that company's management, financial strength, claims handling and
underwriting abilities. PMA Re generally conducts underwriting and claim
reviews at the offices of prospective ceding companies before entering into a
major treaty, as well as throughout the life of the reinsurance contract.
In underwriting excess-of-loss business, PMA Re has typically sought to write
treaties that are exposed to loss on a per occurrence basis within the original
policy limits of the ceding company. Management believes these layers in
general lend themselves more effectively to actuarial pricing techniques.
PMA Re's underwriters and actuaries work closely together to evaluate the
particular reinsurance program. Using the information provided by the broker,
the actuaries employ pricing models to estimate the ultimate exposure to the
treaty. The pricing models that are utilized employ various experience rating
and exposure rating techniques and are tailored in each case to the risk
exposures underlying each treaty. The underwriters then weigh the results of
the pricing models with the terms and conditions being offered to determine PMA
Re's selected price.
5
<PAGE>
As noted above, PMA Re typically requires per occurrence limits for property
coverages and requires that the underlying insured values not be catastrophe
exposed. Also, PMA Re does not emphasize catastrophe reinsurance coverages and
has historically maintained sufficient retrocessional protection. Recent
natural catastrophes did not have a significant adverse impact on PMA Re's
combined ratio and earnings inasmuch as PMA Re has not focused on assuming
catastrophe reinsurance business or catastrophe-exposed coverages and it has had
sufficient retrocessional arrangements.
The following table indicates PMA Re's gross, ceded and net losses from recent
catastrophes as of December 31, 1997:
(dollar amounts in thousands)
<TABLE>
<CAPTION>
Incurred PMA Re PMA Re PMA Re
Catastrophe Year Loss(1) Gross Loss Ceded Loss Net Loss
- ----------- ---- -------- ---------- ---------- --------
<S> <C> <C> <C> <C> <C>
Hurricane Hugo................. 1989 $ 4,200,000 $13,200 $11,400 $1,800
San Francisco Earthquake....... 1989 1,000,000 2,300 1,000 1,300
Oakland Fires.................. 1991 1,700,000 2,700 1,400 1,300
Hurricane Andrew............... 1992 15,500,000 22,800 20,700 2,100
Hurricane Iniki................ 1992 1,600,000 4,100 2,900 1,200
Northridge, CA Earthquake...... 1994 12,500,000 17,600 11,700 5,900
Hurricane Fran................. 1996 1,500,000 1,300 900 400
</TABLE>
(1) Source: Property Claims Services.
PMA Re has no significant obligations to its reinsurers as a result of the above
catastrophes.
CLAIMS ADMINISTRATION
PMA Re's claims department evaluates loss exposures, establishes individual
claim reserves, pays claims, provides claims-related services to PMA Re's
clients, audits the claims activities of current clients and assists in the
underwriting process by evaluating the claims departments of prospective
clients. PMA Re's claims department's evaluation of loss exposure includes
reviewing loss reports received from ceding companies to confirm that claims are
covered under the terms of the relevant reinsurance contract, establishing
reserves on an individual case basis and monitoring the adequacy of those
reserves. The claims department monitors the progress and ultimate outcome of
the claims to determine that subrogation, salvage and other cost recovery
opportunities have been adequately explored. The claims department performs
these functions in coordination with PMA Re's actuarial and underwriting
departments.
In addition to evaluating and adjusting claims, the claims department conducts
claims audits at the offices of prospective ceding companies. Satisfactory audit
results are required in order for reinsurance coverage to be written by PMA Re.
Also, the claims department conducts annual claims audits for many current and
former client ceding companies.
THE PROPERTY AND CASUALTY GROUP
BACKGROUND AND RECENT DEVELOPMENTS
The Property and Casualty Group provides workers' compensation insurance, other
commercial property and casualty insurance coverages, and related services to
entities located primarily in nine contiguous jurisdictions in the Mid-Atlantic
and Southern regions of the United States, utilizing the PMA Group trade name.
As a result primarily of the Property and Casualty Group's underwriting
decisions, the introduction of loss-sensitive coverages and large deductible
programs, competition and the impact of workers' compensation benefit reform
laws, the Property and Casualty Group's statutory net premiums written declined
from $434.7 million in 1993 to $240.3 million in 1997.
6
<PAGE>
In 1997, the Property and Casualty Group completed a commutation program, in
which it paid approximately $118.9 million, of which $17.8 million was paid in
the fourth quarter of 1996, to injured workers in exchange for a release from
any future indemnity payments. Commutations are agreements with claimants
whereby the claimants, in exchange for a lump sum payment, release their rights
to future indemnity payments from the Property and Casualty Group. Under
Pennsylvania law, all such commutation agreements must be approved by the
individual claimant, who is generally represented by outside legal counsel, and
the Pennsylvania Workers' Compensation Board. Savings associated with these
claims were consistent with management's expectations. The number of open claims
for accident years 1991 and prior was substantially reduced as a result of the
commutation program. This reduction in open claims is expected to reduce the
possibility of any further adverse development on such reserves, although there
can be no assurances that the level of commutations will have a significant
impact on the future development of such reserves.
The operating results of the Property and Casualty Group improved in 1997
relative to 1996, largely as a result of reserve strengthening that these
companies incurred in 1996, and also as a result of expense initiatives
instituted by the Property and Casualty Group in 1997. In 1996, the Property and
Casualty Group strengthened its loss reserves by $191.4 million. Of this amount,
$110.0 million related to workers' compensation, $60.4 million related to
asbestos and environmental claims, and $21.0 million related to other lines and
loss adjustment expenses ("LAE"). The adverse development arising from workers'
compensation had reduced earnings by a cumulative $251.6 million between 1992
and 1995. The reform legislation enacted in Pennsylvania, the Property and
Casualty Group's principal marketing territory, in 1993 and 1996 has introduced
various controls and limitations on disability and medical benefits. Management
believes that the reforms and more stringent underwriting standards adopted
since 1991 have had and continue to have a beneficial effect on the Company's
accident year loss ratios. The strengthening recorded for asbestos and
environmental claims is based upon a detailed loss analysis that examined data
on an account-by-account and site-by-site basis for asbestos, and an actuarial
calendar year aggregate loss development technique for environmental claims. The
Property and Casualty Group's net survival ratio is 7.4 years at December 31,
1997 (8.2 years at December 31, 1996). See "Loss Reserves" below. In 1997, the
Property and Casualty Group did not record any adverse loss reserve development
(see "Loss Reserves"), and additionally, the impact of a lower expense base has
contributed to improved operating results for the Property and Casualty Group.
The Property and Casualty Group continues to emphasize its traditional core
business, workers' compensation. Management believes that it can capitalize on
the recent regulatory reforms, attract additional business based upon the
Property and Casualty Group's expertise in workers' compensation and reduce
expenses, because acquisition costs are lower for workers' compensation than
other lines of commercial insurance. Additionally, the Property and Casualty
Group has aligned itself with network health care providers in an attempt to
offer medical cost containment practices to its insureds. In Pennsylvania, the
Property and Casualty Group will seek to expand and retain more of its premium
base in territories which meet the Property and Casualty Group's underwriting
and actuarial criteria. Recent regulatory reforms in Pennsylvania (Acts 44 and
57) have made workers' compensation business more attractive from an
underwriting perspective than it had been in the early 1990's. The workers'
compensation system in certain other existing marketing territories
(specifically, New Jersey, North Carolina and Virginia) has also improved in
recent years. In addition, the Property and Casualty Group intends to expand
into certain new territories. In 1997, the Property and Casualty Group began
writing business in Georgia, and in 1996, in New York and South Carolina. In
all new territories, the Property and Casualty Group will undertake a target
marketing effort by identifying profiles of entities that it desires to insure.
These profiles will be communicated to the key producers in the territories. It
is also contemplated that the Property and Casualty Group will seek to expand
its relationships with larger national and regional brokerage operations in both
its existing and new territories. However, no assurance can be given that the
Property and Casualty Group will be able to accomplish the above marketing plan.
The Property and Casualty Group intends to continue writing other lines of
property and casualty insurance, but generally only if such writings are
supported by its core workers' compensation business. Effective January 1, 1997,
the Property and Casualty Group reduced its retention on commercial casualty
lines of business to $175,000 per risk from $500,000 per risk.
The Property and Casualty Group has established two internal run-off operations
to reinsure certain obligations associated with workers' compensation claims for
the years 1991 and prior of the Pooled Companies for statutory accounting
purposes. The results of the internal run-off operations are included in the
GAAP financial results of the Property and Casualty Group. See "PMA Insurance,
Cayman Ltd." and "MASCCO" below. Additionally,
7
<PAGE>
during 1997, PMA Life Insurance Company reinsured the majority of its in force
annuity business with a third party reinsurer via a quota-share reinsurance
agreement for approximately $15.4 million. The transaction effectively makes PMA
Life Insurance Company a dormant company.
BUSINESS WRITTEN
The following table sets forth certain information on the Property and Casualty
Group's net premiums written for the years ended December 31:
(dollar amounts in thousands)
<TABLE>
<CAPTION>
1997 1996 1995 1994 1993
--------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
Workers' Compensation............ $175,301 $198,198 $236,742 $267,033 $342,184
Commercial Auto.................. 28,938 35,224 39,834 38,984 48,108
Commercial Multi-Peril........... 41,713 35,108 40,659 31,123 27,306
General Liability & Umbrella..... 8,751 8,204 11,370 12,691 16,788
Other............................ (14,355) 6,245 8,511 3,320 324
-------- -------- -------- -------- --------
Total............................ $240,348 $282,979 $337,116 $353,151 $434,710
======== ======== ======== ======== ========
WORKERS' COMPENSATION INSURANCE
</TABLE>
Workers' compensation is a statutory system that requires employers to provide
workers' compensation benefits to their employees and their employees'
dependents for injuries and occupational diseases arising out of employment,
regardless of whether such injuries result from the employer's or the employee's
negligence. Employers may insure their workers' compensation obligations or,
subject to regulatory approval, self-insure such liabilities. State workers'
compensation statutes require that a policy cover three types of benefits:
medical expenses, disability (indemnity) benefits and death benefits. The
amounts of disability and death benefits payable for various types of claims are
established by statute, but no maximum dollar limitation exists for medical
benefits.
Workers' compensation benefits vary among states, and insurance rates are
subject to differing forms of state regulation. Based upon direct written
premium information published by A.M. Best for the most recently available year
(1996), the Property and Casualty Group is the third largest private writer of
workers' compensation insurance in Pennsylvania and between the third and
twenty-third largest writer of workers' compensation insurance in the remaining
named jurisdictions listed in the table below. The Property and Casualty Group
has focused on these jurisdictions based upon its knowledge of their workers'
compensation systems and the Property and Casualty Group's assessment of their
business, economic and regulatory climates. Rate adequacy, regulatory climate,
economic conditions and other factors in each state are closely monitored and
taken into consideration in the underwriting process. Management intends to
employ similar analyses in determining whether and to what extent the Property
and Casualty Group will sell its products in additional jurisdictions. See
"Underwriting" below. The following table sets forth statutory direct workers'
compensation business written by jurisdiction for the years ended December 31:
8
<PAGE>
(dollar amounts in thousands)
<TABLE>
<CAPTION>
1997 1996 1995 1994 1993
-------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
Pennsylvania $ 91,126 $134,171 $142,234 $169,448 $224,067
New Jersey 26,327 17,995 24,388 31,287 47,745
Virginia 19,552 17,449 26,395 29,938 31,545
Maryland 16,538 11,406 17,993 14,391 15,318
North Carolina 9,501 8,195 14,035 11,649 21,216
Delaware 7,041 7,545 5,763 4,831 4,274
Other 11,470 5,403 7,889 4,864 7,165
-------- -------- -------- -------- --------
Total $181,555 $202,164 $238,697 $266,408 $351,330
======== ======== ======== ======== ========
</TABLE>
Management of the Property and Casualty Group believes that conditions in the
workers' compensation market have been improving in the last several years. In
addition, several states, including Pennsylvania, have enacted reforms to the
workers' compensation benefit system.
In 1993, Pennsylvania enacted Act 44, which introduced medical cost containment
measures to the workers' compensation benefit system and expanded the period of
time during which the insurer may require an employee to accept medical
treatment from the employer's list of designated health care providers. The law
also reduced the minimum wage replacement benefit to injured workers, introduced
a credit for unemployment compensation benefits, restored the right of
subrogation against tort recoveries in work-related automobile accidents and
created new anti-fraud measures. In June 1996, Pennsylvania enacted Act 57,
which further reformed the workers' compensation system in the state. Among its
provisions, Act 57: (i) imposes application of American Medical Association
Impairment Guidelines for the assessment of permanent and total claims after the
first two years of total disability compensation payments and limits indemnity
benefits to an additional 500 weeks for workers who are not at least 50%
disabled (as measured by those guidelines); (ii) contains certain Social
Security and pension benefit offsets; (iii) further increases the time frame for
directed medical treatment; (iv) addresses certain inequities in the average
weekly wage calculation; and (v) increases the ability of employers to
demonstrate that injured workers have earning capacity.
To date, Act 44 has had a favorable impact on medical loss costs in Pennsylvania
and Act 57 has had a favorable impact on indemnity loss costs. In recognition of
these developments, in the respective first years following the enactments of
Act 44 and Act 57, the average manual rate level in Pennsylvania decreased
approximately 10% in 1994 and approximately 25% in 1997. The benefit reforms,
management's re-underwriting of the Property and Casualty Group's book of
business and the use of loss-sensitive and alternative market products have had
a favorable impact on the Property and Casualty Group's accident year loss
ratios, as evidenced below:
Property and Casualty Group's Workers' Compensation Undiscounted Accident Year
- ------------------------------------------------------------------------------
Pure Loss Ratios As Of December 31, 1997
----------------------------------------
Accident
Year Loss Ratio
---- ----------
1990 100%
1991 86%
1992 80%
1993 64%
1994 64%
1995 63%
1996 63%
1997 66%
WORKERS' COMPENSATION PRODUCTS
The Property and Casualty Group offers a variety of workers' compensation
products to its customers. Certain of these products are based on rates filed
and approved by state insurance departments ("rate-sensitive products"), while
others are priced to a certain extent on the basis of the insured's own loss
experience ("loss-sensitive
9
<PAGE>
products"). In the last five years, the Property and Casualty Group has also
developed and sold large deductible products and other programs and services to
customers who agree to assume an even greater exposure to loss than under more
traditional loss-sensitive products ("alternative market products"). The
Property and Casualty Group decides which type of product to offer a customer
based upon the customer's needs and the underwriting review. See "Underwriting"
below. Set forth below is percentage information on the voluntary workers'
compensation direct premiums written by product type for the policy years
indicated:
<TABLE>
<CAPTION>
1997 1996 1995 1994 1993 1992 1991 1990 1989
----- ----- ----- ----- ----- ----- ----- ----- -----
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Rate-sensitive products 62% 57% 52% 50% 54% 53% 54% 60% 73%
Loss-sensitive products 27% 30% 34% 39% 40% 46% 46% 40% 27%
Alternative market products 11% 13% 14% 11% 6% 1% 0% 0% 0%
---- ---- ---- ---- ---- ---- ---- ---- ----
Total 100% 100% 100% 100% 100% 100% 100% 100% 100%
==== ==== ==== ==== ==== ==== ==== ==== ====
</TABLE>
RATE-SENSITIVE WORKERS' COMPENSATION PRODUCTS
Rate-sensitive products include fixed-cost policies and dividend paying
policies. The premium charged on a fixed-cost policy is based upon the manual
rates filed with and approved by the state insurance department and does not
increase or decrease based upon the losses incurred during the policy period.
Under policies that are subject to dividend plans, the customer may receive a
dividend based upon loss experience during the policy period. Since the late
1980s, the Property and Casualty Group has reduced its proportion of rate-
sensitive products from over 70% to approximately 62% in 1997. With the
enactment of regulatory reform in several jurisdictions in the Property and
Casualty Group's marketing territory, the Property and Casualty Group has become
more interested in this type of business and increased its writings of rate-
sensitive accounts in such jurisdictions in 1997.
LOSS-SENSITIVE WORKERS' COMPENSATION PRODUCTS
The Property and Casualty Group's loss-sensitive products adjust the amount of
the insured's premiums after the policy period expires based upon the insured's
actual losses incurred during the policy period. These loss-sensitive products
are generally subject to less price regulation than rate-sensitive products and
reduce, but do not eliminate, risk to the insurer. Under these types of
policies, claims professionals and actuaries periodically evaluate the reserves
on losses after the policy period expires to determine whether additional
premiums or refunds are owed under the policy. Such policies are typically open
for adjustments for an average of five years after policy expiration. The
Property and Casualty Group generally restricts such loss-sensitive products to
accounts developing annual minimum premiums in excess of $100,000.
ALTERNATIVE MARKET WORKERS' COMPENSATION PRODUCTS
Since 1992, the Property and Casualty Group has developed a variety of
alternative market products for larger accounts, including large deductible
policies and off-shore captive programs. Typically, the Property and Casualty
Group receives a lower up-front premium for these types of alternative market
product plans. However, under this type of business, the insured retains a
greater share of the underwriting risk than under rate-sensitive or loss-
sensitive products, which reduces the potential for unfavorable claim activity
on the accounts and encourages loss control on the part of the insured. For
example, under a large deductible policy, the customer is responsible for paying
its own losses up to the amount of the deductible for each occurrence. The
deductibles under such policies generally range from $250,000 to $1.0 million.
In addition to these products, the Property and Casualty Group offers certain
workers' compensation services to its clients unbundled from the insurance
products. See "PMA Management Corp."
WORKERS' COMPENSATION RESIDUAL MARKET BUSINESS
Workers' compensation insurers doing business in certain states are required to
provide insurance for risks which are not otherwise written on a voluntary basis
by the private market ("residual market business"). This system exists in all of
the Property and Casualty Group's current marketing jurisdictions, except
Pennsylvania and Maryland. In these two states, separate governmental entities
write all of the workers' compensation residual
10
<PAGE>
market business. In 1997, the Property and Casualty Group wrote $5.2 million of
residual market business, which constituted approximately 3% of its voluntary
net workers' compensation premiums written. Based upon data for policy year 1997
reported by the National Council on Compensation Insurance, the percentage for
the industry as a whole, in all states, was 9.7%.
COMMERCIAL LINES
The Property and Casualty Group writes property and liability coverages for
larger and middle market accounts which satisfy its underwriting standards. See
"Underwriting" below. These coverages feature package, umbrella and commercial
automobile business. During the present soft market, prices for commercial
coverages have been particularly competitive. The Property and Casualty Group
intends to continue offering these products, but generally only if they support
the core workers' compensation business. In addition, effective January 1, 1997,
the Property and Casualty Group has reduced its retention on commercial casualty
lines of business to $175,000 per risk from $500,000 per risk. See "The
Company's Reinsurance Ceded" below.
HOME OFFICE AND FIELD OPERATIONS
As of December 31, 1997, approximately 220 employees worked in the home office
located in Blue Bell, Pennsylvania, and approximately 660 employees were
assigned to field offices located throughout the Property and Casualty Group's
marketing territory.
Senior executives, financial operations, management information systems, human
resources, actuarial services and legal services are headquartered in the home
office. The definition of overall underwriting standards and major account and
alternative market underwriting support also take place in the home office. The
home office works in conjunction with senior managers from the field to
establish the Property and Casualty Group's business plan and underwriting
standards, which are then implemented by the field organization.
The field organization currently consists of three regional offices in Valley
Forge, Pennsylvania, Harrisburg, Pennsylvania, and Richmond, Virginia, as
well as branch offices in each of Georgia, Maryland, New Jersey, Pennsylvania,
Virginia and North Carolina. Additionally, the Property and Casualty Group
operates smaller satellite offices in Ohio and New York. The branch offices
deliver a full range of services directly to customers located in their service
territory, and the satellite offices offer primarily underwriting and claim
adjustment services.
DISTRIBUTION
The Property and Casualty Group distributes its products through approximately
20 direct sales employees and approximately 240 independent brokers and agents.
The direct sales employees are generally responsible for certain business
located in Pennsylvania. For the year ended December 31, 1997, these employees
produced $39.2 million in direct premiums written, constituting 13% of the
Property and Casualty Group's direct written business. The brokers and agents
write business throughout the marketing territory. In 1997, the top ten brokers
and agents accounted for 22% of the Property and Casualty Group's business, the
largest of which accounted for not more than 4% of its business. All brokers and
agents are required to submit business to the Property and Casualty Group's
underwriting process before business may be accepted.
The Property and Casualty Group monitors several statistics with respect to its
producer force, including the number of years the producer has been associated
with the Property and Casualty Group, the percentage of the producer's business
that is underwritten by the Property and Casualty Group, the ranking of the
Property and Casualty Group within the producer's business, and the
profitability of the producer's business. Since 1989, the Property and Casualty
Group has reduced the number of its producers by approximately 35%. The
relationships with former brokers and agents were terminated for a variety of
reasons, including lack of profitability of a terminated producer's book of
business, absence of the types of accounts that the Property and Casualty Group
wants to write and lack of commitment by the producer to the Property and
Casualty Group's customer service program. The current distribution network
generally consists of large regional agents and brokers, local agents and
national brokers that specialize in larger to middle market accounts that
require the variety of workers' compensation, commercial lines and alternative
market products offered by the Property and Casualty Group.
11
<PAGE>
UNDERWRITING
Home office underwriters, in consultation with casualty actuaries, determine the
general types of business to be written using a number of criteria, including
past performance, relative exposure to hazard, premium size, type of business
and other indicators of potential loss. The home office underwriting team also
establishes classes of business that the Property and Casualty Group generally
will not write, such as most coastal property exposures, certain hazardous
products and activities and certain environmental coverages. The home office
establishes the overall business goals and the underwriting authority for each
regional and branch office. It also identifies specific types of business that
must be referred to home office underwriting specialists and actuaries for
individual pricing, including large accounts over a specified dollar limit and
alternative market workers' compensation products. Underwriters and risk-control
professionals in the field report functionally to the Chief Underwriting
Officer, but also work as a team with the field marketing force to identify
business that meets prescribed underwriting standards and to develop specific
strategies to write the desired business. In performing this assessment, the
field office professionals also consult with actuaries who have been assigned to
the specific field office regarding loss trends and pricing and utilize
actuarial loss rating models to assess the projected underwriting results of
accounts.
The Property and Casualty Group also employs credit analysts. These employees
review the financial strength and stability of customers whose business is
written on loss-sensitive and alternative market products and specify the type
and amount of collateral that customers must provide under these arrangements.
REHABILITATION AND MANAGED CARE
The Property and Casualty Group uses a variety of managed care techniques to
reduce costs and losses. Disability management coordinators and point-of-service
case managers, all of whom are registered nurses, work together with claims
professionals to provide expeditious medical and disability management to
injured workers and to investigate injuries. The case managers and professionals
also help employers identify opportunities that allow injured employees to make
a gradual transition to full-time, full-duty jobs. The Property and Casualty
Group also has contracts with preferred provider networks consisting of medical
practitioners selected for their expertise in treating injured workers.
Specialties include occupational medicine, physical medicine, orthopedics and
neurology. There are also preferred pharmacy networks to reduce the cost of
medication. Finally, an automated program is used to check medical bills for
accuracy, duplication, unrelated charges and overcharges. Questionable bills are
forwarded to the Cost Containment Unit, which is staffed by registered nurses
and resolves disputed or suspect charges.
CLAIMS ADMINISTRATION
Claims services are delivered to customers primarily through employees in the
field offices. Certain specialized matters, such as asbestos and environmental
claims, are referred to a special unit in the home office. The Property and
Casualty Group also employs in-house attorneys who represent customers in
workers' compensation cases and other insurance matters.
The Property and Casualty Group has a separate, formal anti-fraud unit. The
anti-fraud unit investigates suspected false claims and other irregularities and
cooperates with regulatory and law enforcement officials in prosecuting
violators.
PMA MANAGEMENT CORP.
PMA Management Corp. offers claims, risk management and related services
primarily to self-insureds on an unbundled basis. In addition, PMA Management
Corp. offers "rent-a-captive" products for certain insureds and associations.
The purpose of a rent-a-captive program is to offer a customer an alternative
method of managing its loss exposures by obtaining many of the benefits of a
captive insurer without establishing and capitalizing its own captive; in
effect, the insured is "renting" a captive facility that the Company has already
established. Under this arrangement, the client purchases an insurance policy
from the Pooled Companies and chooses a participation level. The Pooled
Companies then cede this portion of the premium and loss exposures to a Bermuda
subsidiary of PMC. The client participates in the loss and investment
experience of the portion ceded to the Bermuda subsidiary through a dividend
mechanism. The client is responsible for any loss that may arise within its
participation level,
12
<PAGE>
and such potential obligation is typically secured through a letter of credit or
similar arrangement. The Company's principal sources of income from its rent-a-
captive program are the premium income on the excess risk retained by the Pooled
Companies and captive management fees earned by PMA Management Corp.
PMA INSURANCE, CAYMAN LTD.
PMA Insurance, Cayman Ltd. ("PMA Cayman"), a wholly owned subsidiary of the
Company, was incorporated in Grand Cayman, and had no material operations until
1996. At December 31, 1997, PMA Cayman has $260.5 million in total assets and
$256.2 million in total reserves. Substantially all of PMA Cayman's assets are
held in trust for the benefit of the Pooled Companies. PMA Cayman is included in
the Property and Casualty Group's GAAP results.
MID-ATLANTIC STATES CASUALTY COMPANY
Mid-Atlantic States Casualty Company ("MASCCO") is a Pennsylvania insurance
company and a wholly owned subsidiary of the Company. Prior to December 31,
1996, MASCCO was a party to a pooling agreement with the Pooled Companies.
Effective December 31, 1996, and with the approval of the Pennsylvania Insurance
Commissioner (the "Commissioner"), MASCCO withdrew from the pool and ceased
writing any new business. The Pooled Companies also ceded to MASCCO the
indemnity portion of Pennsylvania workers' compensation claims for accident
years 1991 and prior. At December 31, 1997, MASCCO had $111.6 million in total
assets and $96.2 million in total reserves. Substantially all of MASCCO's assets
are held in trust for the benefit of the Pooled Companies. MASCCO is also
included in the Property and Casualty Group's GAAP results.
Pursuant to a surplus maintenance agreement between PMC and the Commissioner,
MASCCO is required to discount its reserves at no more than 5%, maintain a
reserve to surplus ratio not in excess of 8:1 and continue to invest its assets
only in investment grade securities. At December 31, 1997, MASCCO's level of
reserves to surplus was 6.6:1.
CALIBER ONE
In 1997, the Company established a specialty insurance operation, Caliber One.
In starting Caliber One, the Company's intention is to expand PMC's access to
the insurance market by offering products and marketing to classes of business
that the neither PMA Re nor the Property and Casualty Group presently does. The
Company has hired an experienced senior underwriting professional to be the
Chief Operating Officer of this unit (see "Executive Officers of the
Registrant"), as well as other individuals with experience in underwriting and
claims management for specialty insurance.
PRODUCTS, UNDERWRITING AND DISTRIBUTION
Caliber One's initial focus will be on excess and surplus lines of insurance for
difficult risks that are typically declined by the standard market. Caliber One
plans to offer liability coverages for low frequency/high severity classes,
including pharmaceuticals, chemicals, machinery manufacturers, toy makers,
medical product manufacturers, and other difficult-to-insure product liability
risks. In addition, Caliber One plans to market environmental impairment
liability coverages, clinical trials coverage for emerging biotechnology
products, intellectual property rights liability coverages, as well as property
coverages for unprotected and vacant buildings. Caliber One's policy forms will
contain appropriate and flexible manuscript endorsements and exclusions, and in
some cases, will contain defense costs within the policy limits rather than
offering such coverage on an unlimited basis.
The underwriting of these specialty products involves a significant amount of
judgment. The senior underwriters that Caliber One has hired and those that it
intends to hire have a significant amount of experience in dealing with esoteric
high severity risks. The underwriting process involves reviewing the claim
experience of an account (if any), the claim experience of the particular class
or similar classes, and responding to special risks that an account has through
the use of policy features that can be changed for the circumstances, such as
retentions, exclusions, and endorsements. Caliber One's underwriting teams for
casualty products have been divided into three regions
13
<PAGE>
within the U.S., each led by a regional underwriting vice president who reports
to the Chief Operating Officer. For property products, one underwriting team
will support the activities of the three regions.
Caliber One will distribute its excess and surplus lines products, on a
nationwide basis, through approximately 30 appointed surplus lines brokers. For
most product offerings, Caliber One will not grant underwriting or binding
authority to its brokers.
ACQUISITION OF CALIBER ONE INDEMNITY COMPANY
In December 1997, PMA Re acquired 100% of the common stock of Lincoln Insurance
Company ("Lincoln"), a Delaware domiciled insurance company, which was
subsequently renamed Caliber One Indemnity Company. PMA Re paid $16.0 million
to acquire the company and made an $11.3 million capital contribution to bring
Caliber One Indemnity Company's statutory surplus to $25.0 million, the minimum
surplus level required by several states to be an authorized excess and surplus
lines carrier. Caliber One Indemnity Company was essentially a shell company,
as affiliates of the former parent had taken over the business that had been
previously written by Lincoln. Additionally, an affiliate of the former parent
entered into a reinsurance transaction with Lincoln immediately prior to the
acquisition whereby such company assumed all of Lincoln's existing loss reserves
and is providing protection against adverse loss reserve development and
uncollectible reinsurance of up to $68.5 million. Also, PMA Re has entered into
a surplus maintenance agreement with Caliber One Indemnity Company whereby PMA
Re will maintain Caliber One Indemnity Company's statutory surplus such that
the amount is not less than $25.0 million and so that the net premiums written
to surplus ratio does not exceed 1.0 to 1.0.
Caliber One Indemnity Company is presently authorized as an excess and surplus
lines carrier in 32 states, and it is management's intention to be authorized in
49 states so that products can be offered on a national basis. Caliber One
Indemnity Company has obtained an "A" (Excellent) rating from A.M. Best.
THE COMPANY'S REINSURANCE CEDED
The Company follows the customary insurance practice of reinsuring with other
insurance companies a portion of the risks under the policies written by the
Insurance Subsidiaries. This reinsurance is maintained to protect the Insurance
Subsidiaries against the severity of losses on individual claims and unusually
serious occurrences in which a number of claims produce an aggregate
extraordinary loss. Although reinsurance does not discharge the Insurance
Subsidiaries from their primary maximum liabilities to their policyholders for
the full amount of the losses insured under the insurance policies, it does make
the assuming reinsurer liable to the Insurance Subsidiaries for the reinsured
portion of the risk.
The Insurance Subsidiaries' reinsurance ceded agreements generally may be
terminated at their annual anniversary by either party upon 30 to 90 days'
notice. In general, the reinsurance agreements are of the treaty variety, which
cover all underwritten risks of the types specified in the treaties. Presently,
the maximum gross lines that PMA Re will write are $5.0 million for property
covers, $1.0 million for property catastrophe covers and $7.5 million for
casualty covers. Net retentions on any one claim are $750,000 for property
covers and $1.5 million for casualty covers.
PMA Re maintains property catastrophe retrocession programs in an aggregate
amount of $46.0 million in excess of $2.0 million for multiple claims arising
from two or more risks in a single occurrence or event.
PMA Re also maintains casualty retrocession programs. PMA Re has a casualty
retrocession contract, written on a funds withheld basis, which covers
individual casualty losses and provides low-layer clash protection. For
individual losses, the contract covers $6.0 million in excess of $1.5 million on
a per occurrence basis. The contract has clash limits for losses arising from
two or more risks of $1.25 million in excess of $1.5 million. The term of the
contract is three years, and the term aggregate limit is $25.0 million plus the
amount of funds withheld.
In addition to the above programs, PMA Re maintains casualty clash protection of
$12.5 million in excess of $2.75 million per occurrence and a workers'
compensation retrocession program with limits of $53.0 million in excess of $2.0
million per occurrence.
14
<PAGE>
Also, PMA Re maintains aggregate protection up to $22.3 million in excess of
$178.0 million for the current accident year. Effective January 1, 1998, PMA Re
added a new workers' compensation program which includes coverage of $98.0
million excess of $2.0 million per occurrence, $98.5 million excess of $1.5
million per program per occurrence and $18.5 million excess of $1.5 million per
person per occurrence.
The Property and Casualty Group has its own ceded reinsurance program, and
carries excess-of-loss per occurrence reinsurance for $103.5 million over a net
retention of $1.5 million on workers' compensation. The Property and Casualty
Group also carries excess-of-loss per risk reinsurance for $4.8 million ($49.8
million per occurrence) over a net retention of $175,000 on other casualty
lines; $2.0 million on automobile physical damage and $19.5 million ($48.5
million per occurrence) on property claims over its combined net retention of
$500,000. A property catastrophe program with a per occurrence limit of $27.7
million in excess of an $850,000 retention is maintained to provide protection
for multiple property losses involved in one occurrence. The Property and
Casualty Group also maintains reinsurance protection for its umbrella risks at
$9.0 million over a net retention of $1.0 and purchases facultative reinsurance
for certain other risks.
Effective January 1, 1998, Caliber One maintains reinsurance protection of $4.5
million excess of $500,000 per policy. For primary coverages, the reinsurance
is written on an excess of loss basis, and for excess coverages, the reinsurance
is written on a surplus share basis. Caliber One Indemnity Company is also
reinsured by an affiliate of its former parent relating to all business written
prior to its acquisition by PMA Re in December 1997 (see "Caliber One").
The Company actively manages its exposure to catastrophic events. In the
underwriting process, the Company generally avoids the accumulation of insurable
values in catastrophe prone regions. Also, in writing property reinsurance
coverages, PMA Re typically requires per occurrence loss limitations for
contracts that could have catastrophe exposure. Through per risk reinsurance,
the Company also manages its net retention in each exposure. As a result, the
Company's loss ratios have not been significantly impacted by catastrophes, and
management believes that the Company has adequate reinsurance to protect against
the estimated probable maximum gross loss from a catastrophic event; however,
though management believes it is unlikely, an especially severe catastrophic
event could exceed the Company's reinsurance and/or retrocessional protection,
and adversely impact the Company's financial position, perhaps materially.
The Company performs extensive credit reviews on its reinsurers, focusing on,
among other things, financial capacity, stability, trends, and commitment to the
reinsurance business. Prospective and existing reinsurers failing to meet the
Company's standards are excluded from the Company's reinsurance programs. In
addition, the Company requires letters of credit to support balances due from
reinsurers not authorized to transact business in the applicable jurisdictions.
LOSS RESERVES
In many cases significant periods of time, ranging up to several years or more,
may elapse between the occurrence of an insured loss, the reporting of the loss
to the insurer and the insurer's payment of that loss. Liabilities for
reinsurers generally become known more slowly than for primary insurers and are
generally subject to more unforeseen development.
To recognize liabilities for unpaid losses, insurers establish reserves, which
are balance sheet liabilities representing estimates of future amounts needed to
pay claims with respect to insured events which have occurred, including events
that have not been reported to the insurer. Reserves are also established for
LAE representing the estimated expenses of settling claims, including legal and
other fees, and general expenses of administering the claims adjustment process.
When a claim is reported, claims personnel establish a case reserve for the
estimated amount of the ultimate payment. The estimate reflects the informed
judgment of such personnel, based on general corporate reserving practices and
the experience and knowledge of such personnel regarding the nature and value of
the specific type of claim. Reserves are also established on an aggregate basis
to provide for losses incurred but not yet reported to the insurer, for the
overall adequacy of case reserves and the estimated expenses of settling claims.
Such reserves are estimated using various generally accepted actuarial
techniques.
15
<PAGE>
As part of the reserving process, historical data is reviewed and consideration
is given to the anticipated impact of various factors such as legal
developments, changes in social attitudes and economic conditions, including the
effects of inflation. This process relies on the basic assumption that past
experience, adjusted for the effect of current developments and likely trends,
is an appropriate basis for predicting future events. The reserving process
provides implicit recognition of the impact of inflation and other factors
affecting claims payments by taking into account changes in historic payment
patterns and perceived probable trends. There is generally no precise method,
however, for subsequently evaluating the adequacy of the consideration given to
inflation or to any other specific factor, since the eventual deficiency or
redundancy of reserves is affected by many factors, some of which are
interdependent.
Estimating the Company's ultimate claims liability is necessarily a complex and
judgmental process as the amounts are based on management's informed estimates
and judgments using data currently available. As additional experience and data
become available regarding claims payment and reporting patterns, legislative
developments and economic conditions, the estimates are revised accordingly. If
the Company's ultimate net losses prove to be substantially greater than the
amounts recorded at December 31, 1997, the related adjustments could have a
material adverse impact on the Company's financial condition and results of
operations.
In 1997, the Company had favorable loss and LAE development (of which $51.8
million has offsetting impacts to earned premiums as more fully described in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" incorporated herein by reference). The Company's losses
and LAE were impacted by significant loss reserve strengthening for the Property
and Casualty Group in 1996, partially offset by favorable development for PMA
Re. The components of the Company's incurred losses and LAE for prior accident
years, excluding accretion of discount, are as follows:
(dollar amounts in millions)
<TABLE>
<CAPTION>
1997 1996 1995
------- ------- -------
<S> <C> <C> <C>
PMA Re............................ $(32.1) $(35.3) $(15.0)
------ ------ ------
The Property and Casualty Group:
Workers' compensation............ (44.1) 110.0 54.7
Asbestos and environmental....... -- 60.4 23.4
Other losses and LAE............. 5.0 21.0 (11.6)
------ ------ ------
Total............................ (39.1) 191.4 66.5
------ ------ ------
Other............................. (14.8) -- --
------ ------ ------
Total............................. $(86.0) $156.1 $ 51.5
====== ====== ======
</TABLE>
In 1997, the Property and Casualty Group recorded a reserve release of
approximately $53.9 million on prior year losses and LAE, excluding the
accretion of discount. The release primarily relates to favorable reserve
development of $9.0 million related to retrospectively rated policies for
accident years 1991 and prior and favorable development of $28.0 million related
to retrospectively rated policies pertaining to accident years 1992 through
1996. The Property and Casualty Group also recorded favorable development on
guaranteed cost workers' compensation reserves for accident years 1991 and prior
of $7.1 million, partially offset by reserve strengthening in commercial multi-
peril business for accident year 1996 of $5.0 million. Furthermore, incurred
losses on prior accident years were also affected by the cession of prior year
reserves included in the PMA Life Insurance Company transaction of $14.8
million. In 1996 and 1995, the loss ratio included $191.4 million and $66.5
million, respectively, of strengthening of unpaid losses and loss adjustment
expenses of prior accident years.
16
<PAGE>
The following table shows the composition of changes in the reserves for losses
and LAE for the past three years:
(dollar amounts in thousands)
<TABLE>
<CAPTION>
1997 1996 1995
----------- ---------- ----------
<S> <C> <C> <C>
Balance at January 1............................................ $2,091,072 $2,069,986 $2,103,714
Less: Reinsurance recoverable on unpaid losses and LAE.......... 256,576 261,492 247,856
---------- ---------- ----------
Net balance at January 1...................................... 1,834,496 1,808,494 1,855,858
---------- ---------- ----------
Losses and LAE incurred, net:
Current year.................................................. 341,880 323,069 357,787
Prior years................................................... (86,006) 156,074 51,491
Accretion of discount (includes ($35,000) effect of the
change in the discount rate for the Property and
Casualty Group's workers' compensation unpaid
losses from 4% to 5% in 1995)................................. 51,407 57,480 13,300
---------- ---------- ----------
Total losses and LAE incurred, net.............................. 307,281 536,623 422,578
---------- ---------- ----------
Losses and LAE paid, net:
Current year.................................................. (72,399) (72,194) (71,126)
Prior years................................................... (398,475) (438,427) (398,816)
---------- ---------- ----------
Total losses and LAE paid, net.................................. (470,874) (510,621) (469,942)
---------- ---------- ----------
Net balance at December 31...................................... 1,670,903 1,834,496 1,808,494
Reinsurance recoverable on unpaid losses and LAE................ 332,284 256,576 261,492
---------- ---------- ----------
Balance at December 31.......................................... $2,003,187 $2,091,072 $2,069,986
========== ========== ==========
</TABLE>
The following table shows how the Company's losses have been paid and reserves
re-estimated over time, compared to the liability initially estimated:
17
<PAGE>
CONSOLIDATED LOSS AND LOSS ADJUSTMENT EXPENSE DEVELOPMENT
(dollar amounts in millions)
<TABLE>
<CAPTION>
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
I. Initial estimated
liability for unpaid
losses and LAE net
of reinsurance
recoverables $1,246.1 $1,457.4 $1,632.2 $1,734.6 $1,824.3 $1,941.0 $1,932.0 $1,855.9 $1,808.5 $1,834.5 $1,670.9
II. Amount of reserve paid, net of reinsurance through:
- - one year later........ 305.2 322.3 444.6 470.8 490.5 442.4 407.8 398.9 437.6 398.8 --
- - two years later....... 504.4 601.1 771.5 842.0 848.8 779.1 746.1 763.7 780.0
- - three years later..... 691.8 825.9 1,042.6 1,133.8 1,127.0 1,066.8 1,055.9 1,072.9
- - four years later...... 834.0 1,011.4 1,258.0 1,353.1 1,364.9 1,329.2 1,330.6
- - five years later...... 955.8 1,165.8 1,421.4 1,539.4 1,585.4 1,573.8
- - six years later....... 1,063.1 1,283.8 1,553.1 1,715.1 1,788.9
- - seven years later..... 1,143.3 1,380.1 1,684.6 1,882.1
- - eight years later..... 1,214.0 1,478.9 1,817.3
- - nine years later...... 1,288.2 1,584.2
- - ten years later....... 1,366.9
III. Reestimated liability, net of
reinsurance as of:
- - one year later........ 1,280.1 1,468.3 1,696.0 1,795.3 1,966.8 1,998.1 1,932.3 1,907.4 1,964.6 1,748.5 --
- - two years later....... 1,303.9 1,511.9 1,742.5 1,949.9 2,067.5 2,006.5 1,982.5 2,073.4 1,866.8
- - three years later..... 1,339.1 1,553.3 1,876.0 2,034.1 2,081.5 2,060.6 2,163.9 1,986.7
- - four years later...... 1,358.5 1,607.3 1,938.2 2,040.8 2,134.8 2,258.2 2,078.3
- - five years later...... 1,368.4 1,651.5 1,935.1 2,123.0 2,302.0 2,170.3
- - six years later....... 1,391.1 1,648.7 1,985.3 2,273.3 2,209.3
- - seven years later..... 1,392.8 1,684.2 2,098.2 2,205.4
- - eight years later..... 1,425.4 1,783.6 2,052.2
- - nine years later...... 1,503.9 1,751.8
- - ten years later....... 1,484.7
IV. Indicated deficiency
(redundancy) $ 238.6 $ 294.4 $ 420.0 $ 470.8 $ 385.0 $ 229.3 $ 146.3 $ 130.8 $ 58.3 $ (86.0) $ --
V. Net liability -
December 31, $1,932.0 $1,855.9 $1,808.5 $1,834.5 $1,670.9
Reinsurance recoverables 218.7 247.9 261.5 256.6 332.3
Gross liability -
December 31, $2,150.7 $2,103.8 $2,070.0 $2,091.1 $2,003.2
VI. Re-estimated net
liability $2,078.3 $1,986.7 $1,866.8 $1,748.5 $1,670.9
Re-estimated reinsurance
recoverables 178.1 221.3 253.5 250.8 332.3
Re-estimated gross
liability $2,256.4 $2,208.0 $2,120.3 $1,999.3 $2,003.2
</TABLE>
The columns in the above exhibit are not mutually exclusive. For example, if a
reserve established in 1987 for a claim incurred during that year had been re-
estimated during 1989, the re-estimate would be reflected in the table for each
of the statement years from 1987 and 1988 during calendar years 1989 through
1997. Conditions and trends that have affected the reserve development reflected
in the table may change and care should be exercised in making conclusions about
the relative adequacy of reserves from such development.
The 1996 aggregate workers' compensation adverse development was allocated
$102.0 million to Pennsylvania and $8.0 million to all other states in the
Company's marketing territory. Of the $102.0 million, the allocation by year is
as follows: prior to 1987: $16.0 million; 1987 to 1991: $101.0 million; and 1992
and subsequent years: ($15.0 million). In 1995, substantially all of the
workers' compensation adverse development related to accident years 1987 to 1991
in Pennsylvania. For accident years prior to 1992, the traditional paid loss
development schedules for workers' compensation had begun to exhibit an
increasing trend in loss development factors by 1993. This trend was initially
attributed to an increase in commutation activity. In 1995, management began to
question whether loss data was developing in a manner that was consistent with
the conclusion that the loss development trends were impacted solely by
commutation activity. As a result, management began to accumulate additional
data in order to determine whether there were additional causes of the increase
in the paid loss development data;
18
<PAGE>
management obtained claim count data that was far more detailed than had been
historically utilized in the reserve setting process. This data indicated that
the paid loss development factors were not only impacted by commutation
activity, but also by a decline in the claims closure rate in Pennsylvania.
Management believes that the decline of the closure rates was due to several
interrelated factors. One factor related to the fact that efforts to
rehabilitate claimants and return them to work were not as successful as
anticipated. For accident years 1987 to 1991, in particular, extensive efforts
were made by the Company to rehabilitate claimants and return them to work at
either full or modified duty. By late 1995 and into 1996, it was recognized, by
a review of a slow down in the claims closure pattern that these rehabilitation
efforts were not impacting the closure rates as expected. Another factor
negatively impacting claims closure rates related to the economic conditions in
Pennsylvania in the early 1990's. During the period from 1990 to 1994, economic
conditions in Pennsylvania were considered to be depressed in the Company's
major industry niches for workers' compensation insurance (construction, heavy
manufacturing). Payrolls in these industries were stagnant, and in many cases,
employment was flat or declining. The Company believes that in periods of
declining employment opportunities, there is a tendency for indemnity periods to
increase, which occurred for workers who suffered injuries in these industries.
The above factors, when considered with the fact that the benefits period in
Pennsylvania was unlimited, caused the Company to believe that a substantial
portion of claimants from the pre-1992 period, who had already been out of work
five to nine years, would not return to work in any capacity. In late 1995 and
during 1996, management undertook an effort to quantify the impact of the
declining closure rates versus the increase in commutation activity. During the
fourth quarter of 1995, management strengthened the Property and Casualty
Group's workers' compensation reserves by $54.7 million; however, the
quantification of the effect of the claims closure rate was an extremely complex
process, and as such, the data was not fully understood at that time. As the
data under analysis was more mature and refined in 1996, management determined
that the workers' compensation loss reserves for Pennsylvania in the pre-1992
accident years needed to be increased substantially; therefore, the Property and
Casualty Group increased its workers' compensation reserves by $110.0 million.
Benefit reforms enacted by states in which the Property and Casualty Group
transacts business, most significantly Pennsylvania, have had a beneficial
impact on more recent accident year loss ratios. Prior to 1996, the principal
revisions of the Pennsylvania system included medical cost containment measures
and an expansion of the period of time during which the insurer may require an
employee to accept medical treatment from the employer's list of designated
health care providers. In July 1996, Pennsylvania enacted Act 57, a workers'
compensation reform bill which is expected to substantially reduce indemnity
benefit periods in Pennsylvania. In addition to regulatory reforms, the loss
ratios have been favorably impacted by the conversion to loss sensitive and
alternative market products. Such a trend is evidenced by the fact that
accident year pure loss ratios (losses recorded for the year in which the event
occurred expressed as a percentage of the earned premiums for that year) for
workers' compensation have been generally lower in more recent accident years,
as the following chart indicates:
Property and Casualty Group's Workers' Compensation Undiscounted Accident Year
------------------------------------------------------------------------------
Pure Loss Ratios as of December 31, 1997
----------------------------------------
Accident Years Loss Ratio
-------------- ----------
1990 100%
1991 86%
1992 80%
1993 64%
1994 64%
1995 63%
1996 63%
1997 66%
In addition, management took several steps to reduce the outstanding claims
associated with the Pennsylvania workers' compensation business written through
1991. A formal commutation program was initiated in the fourth quarter 1996 and
continued into late 1997. Commutations are agreements with claimants whereby
the claimants, in exchange for a lump sum payment, will forego their rights to
future indemnity payments from the Property and Casualty Group. Under
Pennsylvania workers' compensation laws, all such commutation arrangements must
be approved by the claimant and the Pennsylvania Workers' Compensation Board.
The Property and Casualty Group paid $101.1 million and $17.8 million in 1997
and the fourth quarter of 1996, respectively, to commute workers'
19
<PAGE>
compensation indemnity claims. Savings associated with these claims were
consistent with management's expectations. The number of open claims for
accident years 1991 and prior was substantially reduced as a result of the
commutation program. This reduction in open claims is expected to reduce the
possibility of any further adverse development on such reserves, although there
can be no assurances that the level of commutations will have a significant
impact on the future development of such reserves.
Estimating reserves for workers' compensation claims can be more difficult than
many other lines of property and casualty insurance for several reasons,
including (i) the long payment 'tail' associated with the business; (ii) the
impact of social, political and regulatory trends on benefit levels for both
medical and indemnity payments; (iii) the impact of economic trends; and (iv)
the impact of changes in the mix of business. At various times, one or a
combination of such factors can make the interpretation of actuarial data
associated with workers' compensation loss development more difficult, and it
can take additional time to recognize changes in loss development patterns.
Under such circumstances, adjustments will be made to such reserves as loss
patterns develop and new information becomes available and such adjustments may
be material.
The adverse development in reserves associated with asbestos and environmental
claims is the result of a detailed analysis of loss and LAE reserves associated
with asbestos and environmental liability claims completed in 1996. The
reserving for asbestos and environmental claims has undergone change at both the
Company and in the insurance industry in general. For environmental and
asbestos liability claims, reserving methodology has been evolving into accepted
industry practice in the recent past; the Company's actuaries were able to apply
these methods to its loss reserves in 1997 and 1996. To reserve for
environmental claims, the Company currently utilizes a calendar year development
technique known as aggregate loss development. This technique focuses on the
aggregate losses paid as of a particular date and aggregate payment patterns
associated with such claims. Several elements including remediation studies,
remediation, defense, declaratory judgment, and third party bodily injury claims
were considered in estimating the costs and payment patterns of the
environmental and toxic tort losses. Prior to the development of these
techniques, there was a substantial range in the nature of reserving for
environmental and toxic tort liabilities. The methods employed by the Company
prior to the review performed in 1996 included a review of aggregate loss and
loss adjustment paid and case incurred data along with resulting "survival
ratios" to establish IBNR for environmental and toxic tort claims. For asbestos
claims, the Company had previously reserved costs to defend, and any
indemnification payments anticipated on, claims for which it had received notice
that it was a responsible party, plus a bulk factor applied to the estimated
case reserves to provide for potential development of indemnification and
defense cost related to such claims. In 1996, the Company performed a ground up
analysis of asbestos loss reserves using an actuarially accepted modeling
technique. Using historical information as a base and information obtained from
a review of open claims files, assumptions were made about future claims
activity in order to estimate ultimate losses. For each individual major
account, projections were made regarding new plaintiffs per year, the number of
years new claims will be reported, the average loss severity per plaintiff and
the ratio of loss adjustment expense to loss. In many cases involving larger
asbestos claims, the Company reserved up to the policy limits for the applicable
loss coverage parts for the affected accounts. Policy terms and reinsurance
treaties were applied in the modeling of future losses. Estimation of
obligations for asbestos and environmental exposures continues to be more
difficult than for other loss reserves because of several factors, including:
(i) evolving methodologies for the estimation of the liabilities; (ii) lack of
reliable historical claim data; (iii) uncertainties with respect to insurance
and reinsurance coverage related to these obligations; (iv) changing judicial
interpretations; and (v) changing government standards.
20
<PAGE>
The Company's asbestos-related loss reserves for the years ended December 31,
were as follows:
(dollar amounts in thousands)
<TABLE>
<CAPTION>
1997 1996 1995
---------- --------- ---------
<S> <C> <C> <C>
Gross of reinsurance:
Beginning reserves.......................... $ 80,055 $ 27,611 $ 13,969
Incurred losses and LAE..................... 2,435 62,854 22,482
Calendar year payments for losses and LAE... (5,764) (10,410) (8,840)
-------- -------- --------
Ending reserves............................. $ 76,726 $ 80,055 $ 27,611
======== ======== ========
Net of reinsurance:
Beginning reserves.......................... $ 53,300 $ 23,443 $ 8,168
Incurred losses and LAE..................... (36) 39,427 21,826
Calendar year payments for losses and LAE.. (4,686) (9,570) (6,551)
-------- -------- --------
Ending reserves............................. $ 48,578 $ 53,300 $ 23,443
======== ======== ========
</TABLE>
The Company's environmental-related loss reserves for the years ended December
31, were as follows:
(dollar amounts in thousands)
<TABLE>
<CAPTION>
1997 1996 1995
---------- --------- ---------
<S> <C> <C> <C>
Gross of reinsurance:
Beginning reserves........................... $ 35,626 $ 20,134 $ 20,952
Incurred losses and LAE...................... 1,130 22,143 3,516
Reserves acquired through purchase of Caliber
One Indemnity Company (1).................... 13,060 - -
Calendar year payments for losses and LAE..... (4,708) (6,651) (4,334)
-------- -------- --------
Ending reserves.............................. $ 45,108 $ 35,626 $ 20,134
======== ======== ========
Net of reinsurance:
Beginning reserves............................ $ 34,592 $ 20,134 $ 20,952
Incurred losses and LAE....................... 1,068 21,109 3,516
Calendar year payments for losses and LAE.... (3,965) (6,651) (4,334)
-------- -------- --------
Ending reserves............................... $ 31,695 $ 34,592 $ 20,134
======== ======== ========
</TABLE>
(1) Such acquired reserves have been reinsured by an affiliate of the former
parent (see "Caliber One" for further discussion).
Of the total net asbestos reserves, $6.7 million, $6.8 million, and $6.7 million
related to established claims reserves at December 31, 1997, 1996, and 1995,
respectively, and $41.9 million, $46.5 million, and $16.7 million related to
incurred but not reported losses at December 31, 1997, 1996, and 1995,
respectively. Of the total net environmental reserves, $11.2 million, $12.5
million, and $10.3 million related to established claims reserves at December
31, 1997, 1996, and 1995, respectively, and $20.5 million, $22.1 million, and
$9.8 million related to incurred but not reported losses at December 31, 1997,
1996, and 1995, respectively. All incurred asbestos and environmental losses
were for accident years 1986 and prior.
Management believes that its reserves for asbestos and environmental claims are
appropriately established based upon known facts, existing case law and
generally accepted actuarial methodologies. However, due to changing
interpretations by courts involving coverage issues, the potential for changes
in federal and state standards for clean-up and liability and other factors, the
ultimate exposure to the Property and Casualty Group for these claims may vary
significantly from the amounts currently recorded, resulting in a potential
future adjustment in the claims reserves recorded. Additionally, issues
involving policy provisions, allocation of liability among participating
insurers, proof of coverage and other factors make quantification of liabilities
exceptionally difficult and subject to adjustment based upon newly available
data.
21
<PAGE>
In 1996, Commercial Lines experienced reserve strengthening of $21.0 million, as
compared to a reserve release of $11.6 million in 1995. The reserve
strengthening in 1996 was principally due to a re-estimation of loss adjustment
costs associated with general liability claims. Through 1991, the Property and
Casualty Group's mix of general liability insurance policies were weighted
towards the manufacturing classes of business. Subsequent to 1991, the Property
and Casualty Group's mix of business became more heavily weighted towards the
construction and contracting classes of business. These particular classes of
business have experienced losses due to construction defects and similar
matters, that have taken longer to emerge than the classes of business
previously written by the Property and Casualty Group. Defense costs associated
with these claims have also exceeded the original estimate of the Property and
Casualty Group's management, which was based on the patterns of indemnification
payments associated with the earlier classes of business written. When this
issue was discovered, the Property and Casualty Group factored the increased
defense costs and the emergence pattern in determining a more appropriate
reserve amount for loss handling costs. The release of reserves in 1995 was
primarily due to favorable loss experience in commercial automobile business.
PMA Re has reported net favorable development of unpaid losses and LAE of $23.3
in 1997, $28.6 million in 1996 and $15.0 million in 1995. Such favorable
development is attributable to losses emerging at a lower rate than was
anticipated when the initial accident year reserves were established.
At December 31, 1997, the Company's loss reserves were stated net of $59.9
million of salvage and subrogation, of which $50.8 million related to the
Property and Casualty Group, which was comprised of $46.0 million related to
workers' compensation and $4.8 million related to Commercial Lines. The
anticipated salvage and subrogation was $9.1 million for PMA Re. Incurred
salvage and subrogation (increased) reduced losses and LAE by ($18.5) million,
($0.6) million and $9.5 million in 1997, 1996 and 1995, respectively. The
Company's policy with respect to estimating the amounts and realizability of
salvage and subrogation is to develop accident year schedules of historic paid
salvage and subrogation by line of business, which are then projected to an
ultimate basis using actuarial projection techniques. The anticipated salvage
and subrogation is the estimated ultimate salvage and subrogation less any
amounts received by the Company. The realizability of anticipated salvage and
subrogation is reflected in the historical data that is used to complete the
projection, as historic paid data implicitly considers realization and
collectibility.
INVESTMENTS
The Company's investment policy objectives are to (i) seek competitive after-tax
income and total return, (ii) maintain very high grade asset quality and
marketability, (iii) maintain maturity distribution commensurate with the
Company's business objectives, (iv) provide portfolio flexibility for changing
business and investment climates and (v) provide liquidity to meet operating
objectives. The Company has established strategies, asset quality standards,
asset allocations and other relevant criteria for its fixed maturity and equity
portfolios. In addition, maturities are structured after projecting liability
cash flows with actuarial models. The Company also does not invest in various
types of investments, including speculative derivatives. The Company's
portfolio does not contain any significant concentrations in single issuers
(other than U.S. treasury and agency obligations), industry segments or
geographic regions.
The Company's Board of Directors is responsible for the Company's investment
policy objectives. The Company retains outside investment advisers to provide
investment advice and guidance, supervise the Company's portfolio and arrange
securities transactions through brokers and dealers. The Company's Executive
and Finance Committees of the Board of Directors meet periodically with the
investment advisers to review the performance of the investment portfolio and to
determine what actions should be taken with respect to the Company's
investments. Investments by the Pooled Companies, MASCCO and PMA Re must comply
with the insurance laws and regulations of the Commonwealth of Pennsylvania and
investments for Caliber One Indemnity Company must comply with the insurance
laws and regulations of Delaware. The Company's capital not allocated to the
Pooled Companies, MASCCO, PMA Re and Caliber One Indemnity Company may be
invested in securities and other investments that are not subject to such
insurance laws, but nonetheless conform to the Company's investment policy.
22
<PAGE>
The following table summarizes the Company's investments by carrying value as of
December 31, 1997, and 1996:
(dollar amounts in millions)
<TABLE>
<CAPTION>
1997 1996
------------------- -----------------
Carrying Carrying
Investment Value Percent Value Percent
- ---------- -------- ------- -------- -------
<S> <C> <C> <C> <C>
U.S. Treasury securities and
obligations of U.S. Government
agencies......................... $1,119.5 51.0% $1,602.8 70.8%
Obligations of states and political
subdivisions..................... -- -- 76.5 3.4%
Corporate debt securities............ 687.7 31.3% 372.8 16.5%
Mortgage backed securities........... 122.3 5.6% 74.0 3.3%
Equity securities.................... -- -- 0.3 --
Short-term investments............... 265.2 12.1% 135.0 6.0%
-------- ----- -------- ------
Total (1)............................ $2,194.7 100.0% $2,261.4 100.0%
======== ===== ======== ======
</TABLE>
(1) As of December 31, 1997, the market value of the Company's total investments
was $2,194.7 million.
The following table indicates the composition of the Company's fixed maturities
portfolio at carrying value, excluding short-term investments, by rating as of
December 31, 1997, and 1996:
(dollar amounts in millions)
<TABLE>
<CAPTION>
1997 1996
------------------- -----------------
Carrying Carrying
Ratings (1) Value Percent Value Percent
- ---------- -------- ------- -------- -------
<S> <C> <C> <C> <C>
Total (1)............................ $2,194.7 100.0% $2,261.4 100.0%
U.S. Treasury securities and AAA.. $1,449.0 75.1% $1,882.4 88.5%
AA................................ 150.0 7.8% 95.8 4.5%
A................................. 282.2 14.6% 147.9 7.0%
BBB............................... 48.3 2.5% -- --
-------- ----- -------- ------
Total............................. $1,929.5 100.0% $2,126.1 100.0%
======== ===== -------- ------
</TABLE>
(1) Ratings as assigned by Standard and Poor's. Such ratings are generally
assigned at the issuance of the securities, subject to revision on the basis
of ongoing evaluations. Ratings in the table are as of December 31 of the
years indicated.
The following table sets forth scheduled maturities for the Company's
investments in fixed maturities, excluding short-term investments, based on
stated maturity dates as of December 31, 1997. Expected maturities will differ
from contractual maturities because the issuers may have the right to call or
prepay obligations with or without call or prepayment penalties:
(dollar amounts in millions)
<TABLE>
<CAPTION>
Carrying Value Percent
-------------- -------
<S> <C> <C>
1 year or less................. $ 128.9 6.7%
Over 1 year through 5 years.... 633.6 32.8%
Over 5 years through 10 years.. 396.5 20.6%
Over 10 years.................. 648.2 33.6%
Mortgage backed securities..... 122.3 6.3%
-------- -----
Total.......................... $1,929.5 100.0%
======== =====
</TABLE>
23
<PAGE>
The following table reflects the Company's investment results for each year in
the three-year period ended December 31, 1997:
(dollar amounts in millions)
<TABLE>
<CAPTION>
1997 1996 1995
--------- --------- ---------
<S> <C> <C> <C>
Average invested assets (1).... $2,247.7 $2,366.8 $2,395.8
Net investment income (2)...... $ 136.7 $ 133.9 $ 139.4
Net effective yield (3)........ 6.09% 5.66% 5.82%
Net realized investment gains.. $ 8.6 $ 3.0 $ 31.9
</TABLE>
(1) Average of beginning and ending amounts of cash and investments for the
period at carrying value.
(2) After investment expenses, excluding net realized investment gains.
(3) Net investment income for the period divided by average invested assets for
the same period.
As of December 31, 1997, the duration of the Company's investments was
approximately 5.3 years and the duration of its liabilities was approximately
5.1 years.
During 1997, the Company established a securities lending program through which
securities are loaned from the Company's portfolio to qualifying third parties,
subject to certain limits, via a lending agent for short periods of time.
Borrowers of these securities must provide collateral equal to a minimum of 102%
of the market value and accrued interest of the loaned securities. Acceptable
collateral may be in the form of either cash or securities. Cash received as
collateral is invested in short-term investments, and all securities received as
collateral are of similar quality to those securities lent by the Company.
Additionally, the Company limits securities lending to 40% of statutory admitted
assets of its insurance subsidiaries, with a 2% limit on statutory admitted
assets to any individual borrower. The Company receives either a fee from the
borrower or retains a portion of the income earned on the collateral. Under the
terms of the securities lending program, the Company is indemnified against
borrower default, with the lending agent responsible to the Company for any
deficiency between the cost of replacing a security that was not returned and
the amount of collateral held by the Company. In 1997, the Company recognized
income from securities lending transactions of approximately $524,000, net of
lending fees, which was included in investment income. The Company had
approximately $175.0 million of securities on loan as of December 31, 1997.
COMPETITION
The domestic property-casualty insurance industry consists of many companies,
with no one company dominating the market. In addition, the degree and nature
of competition varies from state to state for a variety of reasons, including
the regulatory climate and other market participants in each state. In addition
to competition from other insurance companies, the Property and Casualty Group
and Caliber One compete with certain alternative market arrangements, such as
captive insurers, risk-sharing pools and associations, risk retention groups,
and self-insurance programs. PMA Re competes with other reinsurers in the
brokered market as well as reinsurers that directly underwrite reinsurance
business. Many of the Company's competitors are larger and have greater
financial resources than the Company.
The main factors upon which entities in the Company's markets compete are price,
service, product capabilities and financial security. The Property and Casualty
Group, PMA Re and Caliber One attempt to price their products in such a way that
the prices charged to their clients are commensurate with the overall
marketplace while still meeting return targets. Given the present soft pricing
environment, competing solely on the basis of price has become increasingly
difficult for the Property and Casualty Group and PMA Re, and both have had to
reject risks submitted and non-renew certain accounts in recent years, as the
market rates for such risks did not provide the opportunity to achieve what
management considers to be an acceptable return.
In terms of service, management maintains service standards to ensure that
clients are satisfied with the products and services provided by the Company.
Such standards concern turn-around time for underwriting submissions,
information flow, claims handling and the quality of other services. Management
periodically participates in surveys of intermediaries and clients to gain an
understanding of the perceptions of the Company's service as compared to its
competitors.
24
<PAGE>
Management attempts to design products which meet the needs of clients in the
Company's markets. In recent years, the Property and Casualty Group has
developed products which reflect the evolving nature of the workers'
compensation market. Specifically, management has increased its focus on
rehabilitation and managed care to keep workers' compensation costs lower for
the employers. Additionally, the Property and Casualty Group has introduced and
refined alternative market products, as well as unbundled risk management and
claims administration services. See "The Property and Casualty Group." PMA Re
has also expanded its product line in recent years to satisfy the needs of its
client base. Products introduced by PMA Re in the last two years include:
facultative reinsurance, finite risk reinsurance, and integrated capital
management (which involves providing reinsurance as well as some type of direct
investment in a ceding company). See "PMA Re." For Caliber One, it is
management's intention to design products that meet the needs of new classes of
business and that cover emerging risks. See "Caliber One." Management
continues to review new product opportunities for the Property and Casualty
Group, PMA Re and Caliber One.
For many intermediaries and clients, financial security is measured by the
ratings assigned by independent rating agencies. Therefore, management believes
that the ratings assigned by independent rating agencies, particularly A.M.
Best, are material to the Company's operations. A.M. Best has currently
assigned an "A+" (Superior) rating to PMA Re, an "A-" (Excellent) rating to the
Pooled Companies and an "A" (Excellent) to Caliber One Indemnity Company (see
"Caliber One"). According to A.M. Best, its ratings are based on an analysis of
the financial condition and operating performance of an insurance company as
they relate to the industry in general. These ratings represent an independent
opinion of a company's financial strength and ability to meet its obligations to
policyholders. These ratings are not shareholder ratings, however, and do not
represent an opinion as to the value of the Company's stock. No assurance can
be given that these ratings can be maintained by PMA Re, the Pooled Companies
and Caliber One Indemnity Company.
YEAR 2000 ISSUE
The unprecedented advances in computer technology over the past several decades
have resulted in dramatic changes in the way companies do business. Most of
these developments have been beneficial, but some have proven costly, as
businesses have struggled to adapt to various features of the new technological
landscape. One such well-publicized problem has arisen out of the worldwide use
of the so-called "Year 2000" programming convention, in which two digit numbers
were generally used instead of four digit numbers to identify the years used in
dates. As a consequence, most computers require relatively costly reprogramming
to enable them to correctly perform date operations involving years 2000 or
later, a problem anticipated to have substantial repercussions on the business
world, since computer operations involving date calculations are pervasive.
With the assistance of outside consulting groups, the Company began evaluating
and reprogramming its own computer systems to address the Year 2000 issue in
late 1995. Management anticipates that by year-end 1998, it will have
substantially completed all necessary programming work so that Year 2000 issues
are not likely to result in any material adverse disruptions in the Company's
computer systems or its internal business operations. The cost of this work
through year-end 1997 has been approximately $3.8 million. The Company
estimates that the total remaining cost will be approximately $1.3 million,
which will be expensed in 1998.
Many experts now believe that Year 2000 problem may have a material adverse
impact on the national and global economy generally. In addition, it seems
likely that if businesses are materially damaged as a result of Year 2000
problems, at least some such businesses may attempt to recoup their losses by
claiming coverage under various types of insurance policies. Although
management has concluded that under a fair reading of the various policies of
insurance issued by it no coverage for Year 2000 problems should be considered
to exist, it is not possible to predict whether or to what extent any such
coverage could ultimately be found to exist by courts in various jurisdictions.
Accordingly, important factors which could cause actual results to differ
materially from those expressed in the forward looking statements include, but
are not limited to, the inability of the Company to accurately estimate the
impact of the Year 2000 problem on the insurance issued by, or other business
operations of, the Company.
25
<PAGE>
REGULATORY MATTERS
GENERAL
PMA Re is licensed or accredited to transact its reinsurance business in, and is
subject to regulation and supervision by 50 states and the District of Columbia.
The Pooled Companies are licensed to transact insurance business in, and are
subject to regulation and supervision by 45 states and the District of Columbia.
Caliber One Indemnity Company is licensed in one state and is an eligible excess
and surplus lines carrier in 32 states. The Insurance Subsidiaries are
authorized and regulated in all jurisdictions where they conduct insurance
business. Inasmuch as PMA Re and the Pooled Companies are domiciled in
Pennsylvania, however, the Pennsylvania Insurance Department exercises principal
regulatory jurisdiction over them, and Delaware exercises principal jurisdiction
over Caliber One Indemnity Company. The extent of regulation by the states
varies, but in general, most jurisdictions have laws and regulations governing
standards of solvency, adequacy of reserves, reinsurance, capital adequacy and
standards of business conduct. In addition, statutes and regulations usually
require the licensing of insurers and their agents, the approval of policy forms
and related material and, for certain lines of insurance, the approval of rates.
Property and casualty reinsurers and excess and surplus lines carriers are
generally not subject to filing or other regulatory requirements applicable to
primary standard lines insurers with respect to rates, policy forms or contract
wording. The form and content of statutory financial statements are regulated.
State insurance departments in jurisdictions in which the Insurance Subsidiaries
do business also conduct periodic examinations of their respective operations
and accounts and require the filing of annual and other reports relating to
their financial condition. The Pennsylvania Department of Insurance last
conducted examinations of PMA Re and the Pooled Companies as of December 31,
1992, and the Delaware Department of Insurance last conducted an examination of
Caliber One Indemnity Company as of December 31, 1996. No adjustments to
previously filed statutory financial statements were required as a result of
such examinations. In addition, there were no substantive qualitative matters
indicated in the examination reports that had or are expected to have a material
adverse impact on the operations of PMA Re, the Pooled Companies or Caliber One
Indemnity Company. In supervising and regulating insurance companies, including
reinsurers, state insurance departments, charged primarily with protecting
policyholders and the public rather than investors, enjoy broad authority and
discretion in applying applicable insurance laws and regulations for the
protection of policyholders and the public.
INSURANCE HOLDING COMPANY REGULATION
The Company and the Insurance Subsidiaries are subject to regulation pursuant to
the insurance holding company laws of Pennsylvania and Delaware. These state
insurance holding company laws generally require an insurance holding company
and insurers and reinsurers that are members of such insurance holding company's
system to register with the state regulatory authorities, to file with those
authorities certain reports disclosing information including their capital
structure, ownership, management, financial condition, certain intercompany
transactions including material transfers of assets and intercompany business
agreements, and to report material changes in such information. Such laws also
require that intercompany transactions be fair and reasonable and that an
insurer's surplus as regards policyholders following any dividends or
distributions to shareholder affiliates be reasonable in relation to the
insurer's outstanding liabilities and adequate for its financial needs.
Under Pennsylvania and Delaware law, no person may acquire, directly or
indirectly, a controlling interest in the capital stock of the Company unless
such person, corporation or other entity has obtained prior approval from the
Commissioner(s) for such acquisition of control. Pursuant to the Pennsylvania
and Delaware law, any person acquiring, controlling or holding with the power to
vote, directly or indirectly, ten percent or more of the voting securities of an
insurance company, is presumed to have "control" of such company. This
presumption may be rebutted by a showing that control does not exist in fact.
The respective Commissioner(s), however, may find that "control" exists in
circumstances in which a person owns or controls a smaller amount of voting
securities. To obtain approval from the Commissioner(s) of any acquisition of
control of an insurance company, the proposed acquirer must file with the
Commissioner(s) an application containing information regarding the identity and
background of the acquirer and its affiliates, the nature, source and amount of
funds to be used to effect the acquisition, the financial statements of the
acquirer and its affiliates, any potential plans for disposition of the
26
<PAGE>
securities or business of the insurer, the number and type of securities to be
acquired, any contracts with respect to the securities to be acquired, any
agreements with broker-dealers and other matters.
Other jurisdictions in which the Insurance Subsidiaries are licensed to transact
business may have requirements for prior approval of any acquisition of control
of an insurance or reinsurance company licensed or authorized to transact
business in such jurisdictions. Additional requirements in such jurisdictions
may include re-licensing or subsequent approval for renewal of existing licenses
upon an acquisition of control. As further described below, laws also govern
the holding company structure payment of dividends by the Insurance Subsidiaries
to the Company.
RESTRICTIONS ON INSURANCE SUBSIDIARIES DIVIDENDS
The principal source of funds for servicing debt of the Company and paying
dividends to shareholders of the Company is derived from receipt of dividends
from the subsidiaries. Under the Pennsylvania insurance laws, PMA Re and the
Pooled Companies may pay dividends only from unassigned funds (surplus), as
reported in the statutory financial statement filed by them with the Insurance
Department for the most recent annual period. As of December 31, 1997, PMA Re
and the Pooled Companies reported unassigned funds (surplus) in the amount of
$294.2 million. Caliber One Indemnity Company had an unassigned deficit of $6.4
million as of December 31, 1997, and therefore, cannot pay non-extraordinary
dividends; also, Caliber One Indemnity Company is directly owned by PMA Re, and
as such, its dividends may not be paid directly to PMC. Subject to such
constraints, PMA Re, any of the Pooled Companies and Caliber One Indemnity
Company may declare and pay non-extraordinary dividends subject to certain
notice requirements to the Commissioner and extraordinary dividends to
stockholders subject to certain notice and approval requirements by the
Commissioner. Under Pennsylvania law, an "extraordinary" dividend is any
dividend or other distribution which, together with other dividends and
distributions made within the preceding twelve months, exceeds the greater of
(i) 10% of such insurer's surplus as regards policyholders as shown on its last
annual statement on file with the Commissioner; or (ii) statutory net income for
the previous year. Payment of extraordinary dividends is permissible only if
the Commissioner has approved the payment of such extraordinary dividends, or if
the Commissioner has not disapproved the payment of such extraordinary dividend
within thirty days from the date the Commissioner receives notice of the
declaration of such dividend. In addition to the foregoing standards, following
the payment of any dividends, the policyholders' surplus of the insurance
company must be reasonable in relation to its outstanding liabilities and
adequate for its financial needs. The Commissioner may bring an action to
enjoin or rescind the payment of a dividend or distribution by any insurance
company that would cause its statutory surplus to be unreasonable or inadequate
under this standard.
For the years ended December 31, 1997, 1996 and 1995, the aggregate cash
dividends paid by PMA Re and the Pooled Companies were $20.0 million, $53.6
million, and $71.5 million, respectively. None of the dividends paid was
"extraordinary" for purposes of the Pennsylvania insurance laws. For 1998, PMA
Re and the Pooled Companies collectively are permitted to declare and pay
dividends to the Company in the aggregate amount of $51.2 million, subject to
the notice requirements on dividend declarations and payments. In accordance
with its plan of operation filed with the Pennsylvania Insurance Department,
MASCCO must maintain a ratio of unpaid losses and LAE to policyholders' surplus
of no more than 8:1. As of December 31, 1997, MASCCO was in compliance with
such requirements.
RISK-BASED CAPITAL
The National Association of Insurance Commissioners (the "NAIC") has adopted
risk-based capital ("RBC") requirements for property/casualty insurance
companies to evaluate the adequacy of statutory capital and surplus in relation
to investment and insurance risks such as asset quality, asset and liability
matching, loss reserve adequacy and other business factors.
Under RBC requirements, regulatory compliance is determined by the ratio of a
Company's total adjusted capital, as defined by the NAIC, to its authorized
control level, also as defined by the NAIC. Companies below prescribed trigger
points in terms of such ratio are classified as follows:
27
<PAGE>
Company action level......... 200%
Regulatory action level...... 150%
Authorized control level..... 100%
Mandatory control level...... 70%
At December 31, 1997, the ratios of the domestic insurance subsidiaries of the
Property and Casualty Group ranged from 293% to 324%, PMA Re's ratio was 355%
and Caliber One Indemnity Company's ratio was 1,922%.
RBC requirements for property/casualty insurance companies allow a discount for
workers' compensation reserves to be included in the adjusted surplus
calculation. However, the calculation for RBC requires the phase-out of non-
tabular reserve discounts previously taken for workers' compensation reserves.
The discount phase-out has increased by 20% in each year since 1994, ultimately
phasing out 100% of such discount by 1998. As a result, this phase-out
negatively impacts the RBC ratios of companies which write workers' compensation
insurance and discount such reserves on a non-tabular basis relative to
companies which write other types of property/casualty insurance. Management
believes that it will be able to maintain the Pooled Companies' RBC in excess of
regulatory requirements through prudent underwriting and claims handling,
investing and capital management. However, no assurances can be given that
developments affecting the Property and Casualty Group, many of which could be
outside of management's control, including but not limited to changes in the
regulatory environment, economic conditions and competitive conditions in the
jurisdictions in which the Property and Casualty Group writes business, will
cause the Pooled Companies' RBC to fall below required levels resulting in a
corresponding regulatory response.
EMPLOYEES
As of March 31, 1998, the Company had approximately 1,020 full-time employees.
None of the employees of the Company is represented by a labor union and the
Company is not a party to any collective bargaining agreements. The Company
considers its employee relations to be good.
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GLOSSARY OF SELECTED INSURANCE TERMS
Actuarial analysis..................Evaluation of risks in order to attempt to
assure that premiums and loss reserves
adequately reflect expected future loss
experience and claims payments; in
evaluating risks, mathematical models are
used to predict future loss experience and
claims payments based on past loss ratios
and loss development patterns and other
relevant data and assumptions.
Adverse loss development............Increases in losses and ALAE exceeding
anticipated loss and ALAE experience over a
given period of time.
Aggregate excess reinsurance
arrangements........................Reinsurance arrangements under which a
reinsurer assumes the risks and/or loss
reserves of certain business of a ceding
company in their entirety.
Allocated loss adjustment
expenses ("ALAE")...................Allocated loss adjustment expenses include
all legal expenses and other expenses
incurred by a company in connection with the
investigation, adjustment, settlement or
litigation of claims or losses under
business covered. ALAE does not include
costs of "in-house" counsel, claims staff or
other overhead or general expense of the
reinsured.
Attachment point....................The amount of losses above which excess of
loss reinsurance becomes operative.
Automatic facultative
arrangements........................Facultative insurance contracts whereby the
ceding company has the right, but not the
obligation, to cede risks to a reinsurer and
the reinsurer is obligated to accept such
risks pursuant to the contract terms.
Broker; intermediary................One who negotiates contracts of reinsurance
between a primary insurer or other reinsured
and a reinsurer on behalf of the primary
insurer or reinsured. The broker receives
from the reinsurer a commission for
placement and other services rendered.
Broker reinsurer....................A reinsurer that markets and sells
reinsurance through brokers rather than
through its own employees.
Case reserves.......................Loss reserves established with
respect to individual reported claims.
Casualty insurance and/or
reinsurance.........................Insurance and/or reinsurance that is
concerned primarily with the losses caused
by injuries to third persons (in other
words, persons other than the policyholder)
and the legal liability imposed on the
insured resulting therefrom.
Catastrophe reinsurance.............A form of excess of loss property
reinsurance that, subject to a specified
limit, indemnifies the ceding company for
the amount of loss in excess of a specified
retention with respect to an accumulation of
losses resulting from a catastrophic event.
The actual reinsurance document is called a
"catastrophe cover."
Cede; ceding company;
cedent..............................When a company reinsures its risk with
another, it "cedes" business and is referred
to as the "ceding company" or the "cedent".
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Claim closure rate..................The number of closed lost time workers'
compensation claims divided by total
reported lost time workers' compensation
claims by accident year as of a given
evaluation date.
Clash cover.........................A form of excess of loss casualty
reinsurance policy covering losses arising
from a single set of circumstances covered
by more than one primary policy. For
example, if an insurer covers both motorists
involved in an accident, a clash cover would
protect the insurer from suffering a net
loss in the full amount of both parties. The
clash cover would pay to the insurer a
portion of the loss in excess of the
coverage of one of the two parties.
Combined ratio......................A combination of the underwriting expense
ratio, the loss and LAE ratio, and the
policyholder dividend ratio. The loss and
LAE ratio measures the ratio of net incurred
losses and LAE to net earned premiums. The
underwriting expense ratio measures the
ratio of underwriting expenses to net
premiums written. The policyholder dividend
ratio measures policyholder dividends as a
percent of net premiums earned. Generally,
companies which write predominately long-
tailed liability risks will have a higher
combined ratio than those companies writing
predominately property risks.
Direct reinsurer, direct
underwriter, direct writer..........A reinsurer that markets and sells
reinsurance directly to its reinsureds
without the assistance of brokers.
Excess and surplus lines............Surplus lines risks are those risks not
fitting normal underwriting patterns,
involving a degree of risk that is not
commensurate with standard rates and/or
policy forms, or that will not be written by
standard carriers because of general market
conditions. Excess insurance refers to
coverage that attaches for an insured over
the limits of a primary policy or a
stipulated self-insured retention. Policies
are bound or accepted by carriers not
licensed in the jurisdiction where the risk
is located, and generally are not subject to
regulations governing premium rates or
policy language.
Excess of loss reinsurance..........The generic term describing reinsurance that
indemnifies the reinsured against all or a
specified portion of losses on underlying
insurance policies in excess of a specified
dollar amount, called a "layer" or
"retention." Also known as nonproportional
reinsurance or stop loss coverage.
Facultative reinsurance.............The reinsurance of all or a portion of the
insurance provided by a single policy. Each
policy reinsured is separately negotiated.
Gross premiums written..............Total premiums for direct insurance and
reinsurance assumed during a given period.
Incurred but not reported
("IBNR") reserves...................Loss reserves for estimated losses that have
been incurred but not yet reported to the
insurer or reinsurer.
Incurred losses.....................The total losses sustained by an insurance
company under a policy or policies, whether
paid or unpaid. Incurred losses include a
provision for claims that have occurred but
have not yet been reported to the insurer
("IBNR").
IRIS ratios.........................Financial ratios annually calculated by the
NAIC to assist state insurance departments
in monitoring the financial condition of
insurance companies.
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Layers..............................The division of a particular reinsurance
program delineated by an attachment point
and a maximum limit. Often, a reinsurance
program will be divided into several layers,
with the lower layers (See "Low or working
layer excess of loss reinsurance") typically
having higher premiums and higher claim
frequency and the higher layers typically
having lower premiums and claim frequency.
Loss adjustment expenses
("LAE").............................The expenses of settling claims, including
legal and other fees and the portion of
general expenses allocated to claim
settlement costs.
Loss ratio/pure loss ratio..........Loss ratio is equal to losses and LAE
divided by earned premiums. The pure loss
ratio refers to losses divided by earned
premiums. Undiscounted loss ratios refer to
loss ratios that do not consider the net
effect of discounting of loss reserves; the
Company's current practice is to discount
loss reserves for workers' compensation
insurance.
Loss reserves.......................Liabilities established by insurers and
reinsurers to reflect the estimated cost of
claims payments that the insurer or
reinsurer ultimately will be required to pay
in respect of insurance or reinsurance it
has written. Reserves are established for
losses and for LAE and consist of case
reserves and IBNR reserves.
Low or working layer excess of
loss reinsurance....................Reinsurance that absorbs the losses
immediately above the reinsured's retention
layer. A low layer excess of loss reinsurer
will pay up to a certain dollar amount at
which point a higher layer reinsurer (or the
ceding company) will be liable for
additional losses.
Manual rates........................Refers to insurance rates for lines and
classes of business approved and published
by state insurance departments.
Manual rate level or average
manual rate level...................Refers to the manual rates for lines and
classes of business relative to a benchmark;
within this document, the term refers to the
manual rates, as compared to other periods,
such as a prior policy year.
Net premiums earned.................The portion of net premiums written that is
recognized for accounting purposes as income
during a period.
Net premiums written................Gross premiums written for a given period
less premiums ceded to reinsurers during
such period.
Operating ratio.....................The combined ratio, reduced by the net
investment income ratio. The net investment
income ratio is the ratio of net investment
income to net premiums earned. The ratio
measures a company's operating
profitability, exclusive of realized gains
and federal income taxes.
Per occurrence......................A form of insurance or reinsurance under
which the date of the loss event is deemed
to be the date of the occurrence, regardless
of when reported and permits all losses
arising out of one event to be aggregated
instead of being handled on a risk-by-risk
basis.
Primary insurer.....................An insurance company that issues insurance
policies to the general public or to certain
non-insurance entities.
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Pro rata reinsurance................A generic term describing all forms of
reinsurance in which the reinsurer shares a
proportional part of the original premiums
and losses of the reinsured. Pro rata
reinsurance also is known as proportional
reinsurance, quota share reinsurance and
participating reinsurance.
Property insurance
and/or reinsurance..................Insurance and/or reinsurance that
indemnifies a person with an insurable
interest in tangible property for his
property loss, damage or loss of use.
Pure loss ratio.....................See "Loss ratio/pure loss
ratio" above.
Reinsurance.........................The practice whereby one party, called the
reinsurer, in consideration of a premium
paid to it, agrees to indemnify another
party, called the reinsured, for part or all
of the liability assumed by the reinsured
under a policy or policies of insurance that
it has issued. The reinsured may be referred
to as the original or primary insurer, the
direct writing company or the ceding
company.
Retention, retention layer..........The amount or portion of risk that an
insurer or reinsurer retains for its own
account. Losses in excess of the retention
layer are paid by the reinsurer or
retrocessionaire. In proportional treaties,
the retention may be a percentage of the
original policy's limit. In excess of loss
business, the retention is a dollar amount
of loss, a loss ratio or a percentage.
Retrocession;
retrocessionaire....................A transaction whereby a reinsurer cedes to
another reinsurer (the "retrocessionaire")
all or part of the reinsurance it has
assumed. Retrocession does not legally
discharge the ceding reinsurer from its
liability with respect to its obligations to
the reinsured.
Semi-automatic facultative
arrangements........................Facultative reinsurance contracts where the
ceding company has the right, but not the
obligation to cede risks to a reinsurer and
the reinsurer is obligated to accept such
risks as long as they are within stated
criteria. If a risk falls outside such
criteria, the reinsurer has the option of
either: (i) accepting the risk, (ii)
declining the risk, or (iii) repricing the
risk.
Statutory accounting
principles ("SAP")..................Recording transactions and preparing
financial statements in accordance with the
rules and procedures prescribed or permitted
by state insurance regulatory authorities
including the NAIC, which in general reflect
a liquidating, rather than going concern,
concept of accounting.
Statutory or policyholder's
surplus; statutory capital
& surplus...........................The excess of admitted assets over total
liabilities (including loss reserves),
determined in accordance with SAP.
Stop loss...........................See "Excess of loss reinsurance".
Survival ratio......................For asbestos and environmental (A&E) claims,
the survival ratio is equal to the average
normalized loss and LAE payments for A&E
over three years divided by loss reserves
established for A&E.
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Treaty reinsurance..................The reinsurance of a specified type or
category of risks defined in a reinsurance
agreement (a "treaty") between a primary
insurer or other reinsured and a reinsurer.
Typically, in treaty reinsurance, the
primary insurer or reinsured is obligated to
offer and the reinsurer is obligated to
accept a specified portion of all such type
or category of risks originally written by
the primary insurer or reinsured.
Underwriting........................The reinsurer's process of reviewing
applications submitted for insurance
coverage, deciding whether to accept all or
part of the coverage requested and
determining the applicable premiums.
Underwriting cycle..................An historical pattern in which property and
casualty insurance and reinsurance premiums,
profits and availability of coverage rise
and fall with some regularity over time.
Underwriting expenses...............The aggregate of policy acquisition costs,
including commissions, and the portion of
administrative, general and other expenses
attributable to underwriting operations.
Unearned premiums...................The portion of a premium representing the
unexpired portion of the exposure period as
of a certain date.
Unearned premium reserve............Liabilities established by insurers and
reinsurers to reflect unearned premiums
which are refundable to policyholders if an
insurance or reinsurance contract is
canceled prior to expiration of the contract
term.
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ITEM 2. PROPERTIES
The Company's headquarters are located in a four story, 110,000 square foot
building in Blue Bell, Pennsylvania. PMA Re's headquarters are located in
78,000 square feet of leased space in Mellon Bank Center, Philadelphia,
Pennsylvania.
Through various wholly owned subsidiaries, the Company also owns and occupies
additional office facilities in three other locations and rents additional
office space for its insurance operations in 15 other locations. The Company
believes that such owned properties are suitable and adequate for its current
business operations.
Subsidiaries of the Company also own various real estate properties that are not
used by the Company in its insurance operations but are leased to third parties.
These properties are one to eight story buildings that are generally located in
Philadelphia.
ITEM 3. LEGAL PROCEEDINGS
The Insurance Subsidiaries are defendants in actions arising out of their
insurance business and from time to time are involved in various governmental
and administrative proceedings. These actions include lawsuits seeking coverage
for alleged damages relating to exposure to asbestos and other toxic substances
and environmental clean-up actions under federal and state law. See "Item 1.
Business - Loss Reserves" and "Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations."
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the fourth
quarter of 1997.
EXECUTIVE OFFICERS OF THE REGISTRANT
The executive officers of the Company are as follows:
<TABLE>
<CAPTION>
Name Age Position
---- --- --------------------------------------
<S> <C> <C>
Frederick W. Anton III.... 64 Chairman of the Board
John W. Smithson.......... 52 President and Chief Executive Officer
Francis W. McDonnell...... 41 Senior Vice President, Chief
Financial Officer
and Treasurer
Vincent T. Donnelly....... 45 President and Chief Operating Officer -
The Property and Casualty Group
Stephen G. Tirney......... 44 President and Chief Operating Officer -
PMA Re
Ronald S. Austin.......... 40 President and Chief Operating Officer -
Caliber One
</TABLE>
Frederick W. Anton III has served as Chairman of the Board since 1995 and as a
director of the Company since 1972. Mr. Anton's current term as a director of
the Company expires in 2000. Mr. Anton served as Chairman of the Board and
Chief Executive Officer from 1995 to May 1997, as President and Chief Executive
Officer from 1981 to 1995, as President of the Property and Casualty Group from
1972 to 1989 and as Secretary and General Counsel of PMAIC from 1962 to 1972.
John W. Smithson has served as President and Chief Executive Officer of the
Company since May 1997, and as a director of the Company since 1987. Mr.
Smithson's current term as a director of the Company expires in 1999. Mr.
Smithson served as President and Chief Operating Officer of the Company from
1995 to May 1997, as Chairman and Chief Executive Officer of PMA Re from 1984 to
1997 and as Chairman and Chief Executive Officer of the Property and Casualty
Group from April 1995 to 1997, and was employed by PMAIC from 1972 to 1984. Mr.
Smithson is a designated Chartered Property-Casualty Underwriter.
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<PAGE>
Francis W. McDonnell has served as Senior Vice President and Chief Financial
Officer of the Company since 1995 and as Treasurer since 1997, and has served as
Senior Vice President and Chief Financial Officer of PMA Re since 1995. From
1993 to 1995, Mr. McDonnell served as Vice President Finance of PMA Re. Prior
to joining PMA Re in 1993, Mr. McDonnell served in various controllership
positions with Reliance Insurance Company from 1985 to 1993. Mr. McDonnell is a
Certified Public Accountant and a designated Chartered Property-Casualty
Underwriter.
Vincent T. Donnelly has served as President and Chief Operating Officer of the
Property and Casualty Group since February 1997. Mr. Donnelly served as Senior
Vice President - Finance and Chief Actuary of the Property and Casualty Group
from 1992 to 1997. Prior to joining the Property and Casualty Group, Mr.
Donnelly served as Vice President and Corporate Actuary of Continental Insurance
Company from 1987 to 1992 and as an actuary for American International Group
from 1978 to 1987. Mr. Donnelly is a Fellow of the Casualty Actuarial Society
and a member of the American Academy of Actuaries.
Stephen G. Tirney has served as President and Chief Operating Officer of PMA Re
since 1997. Mr. Tirney served as Executive Vice President of PMA Re from 1993
to 1997, as Senior Vice President of PMA Re from 1989 to 1993 and has been an
employee of PMA Re since 1976.
Ronald S. Austin was hired in 1997 as the President and Chief Operating Officer
of Caliber One. From 1988 to 1997, Mr. Austin served as an officer and director
of General Star Management Company, a member of the General Re Group.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER
MATTERS
Footnote number 20 on pages 85 through 87 of PMC's 1997 Annual Report to
Shareholders is incorporated herein by reference.
RECENT SALES OF UNREGISTERED SECURITIES
During the years ended December 31, 1997, 1996 and 1995, the Company sold shares
of Class A Common Stock in connection with the exercise of employee stock
options pursuant to the terms of the Company's stock option plans. In 1997, an
aggregate of 162,248 shares were sold to fourteen officers and employees of the
Company pursuant to such options at exercise prices ranging from $8.00 to $15.00
per share for an aggregate price of $1,424,349. Additionally, in 1997, the
Company sold 1,000 shares to employees at $18.00 per share. In 1996, an
aggregate of 97,150 shares were sold to five officers of the Company pursuant to
such options at exercise prices ranging from $6.60 to $10.00 per share for an
aggregate price of $806,000. In 1995, an aggregate of 205,199 shares were sold
to six officers and employees of the Company pursuant to such options at
exercise prices ranging from $6.60 to $11.50 per share for an aggregate price of
$1,776,288. The Company believes that these sales were made pursuant to the
exemption afforded by Section 4(2) of the Securities Act inasmuch as the sales
were made to a limited number of sophisticated investors in transactions not
involving a public offering.
ITEM 6. SELECTED FINANCIAL DATA
Selected Financial Data on pages 24 through 25 of PMC's 1997 Annual Report to
Shareholders is incorporated herein by reference.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Management's Discussion and Analysis of Financial Condition and Results of
Operations on pages 26 through 51 of PMC's 1997 Annual Report to Shareholders is
incorporated herein by reference.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Not applicable.
35
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See Item 14a below
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
See "Executive Officers of the Registrant" under Item 4. Director information
is incorporated by reference to the caption "Directors and Executive Officers"
in the definitive proxy statement involving the election of directors and other
matters (the "Proxy Statement") which PMC intends to file with the Commission
pursuant to Regulation 14A under the Securities Exchange Act of 1934 not later
than 120 days after December 31, 1997.
ITEM 11. EXECUTIVE COMPENSATION
Incorporated by reference to the caption "Compensation of Directors and
Executive Officers" in the Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Incorporated by reference to the caption "Security Ownership of Certain
Beneficial Owners and Management" in the Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Incorporated by reference to the caption "Certain Transactions" and
"Compensation Committee Interlocks and Insider Participation" in the Proxy
Statement.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
FINANCIAL STATEMENTS AND SCHEDULES
(a)(1) The following consolidated financial statements of PMC and its subsidiary
companies, included on pages 52 through 88 of PMC's 1997 Annual Report to
Shareholders, are incorporated herein by reference:
. Consolidated Balance Sheets at December 31, 1997 and 1996.
. Consolidated Statements of Operations for the years ended December 31, 1997,
1996 and 1995.
. Consolidated Statements of Shareholders' Equity for the years ended December
31, 1997, 1996 and 1995.
. Consolidated Statements of Cash Flows for the years ended December 31, 1997,
1996 and 1995.
. Notes to the Consolidated Financial Statements
. Report of Independent Accountants
36
<PAGE>
(a)(2) SCHEDULES SUPPORTING FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
Schedule No. Description Page
- -------------- ----------- ----
<S> <C> <C>
I Summary of Investments - Other Than S-1
Investments in Related Parties at
December 31, 1997
II Condensed Financial Information of S-2 - S-4
Registrant as of December 31, 1997 and
1996 and for the years ended December 31,
1997, 1996 and 1995
III Supplementary Insurance Information for the S-5
years ended December 31, 1997, 1996 and 1995
IV Reinsurance for the years ended December 31, S-6
1997, 1996 and 1995
V Valuation and Qualifying Accounts for the S-7
years ended December 31, 1997, 1996 and 1995
VI Supplementary Information Concerning S-8
Property & Casualty Insurance Operations
for the years ended December 31, 1997, 1996
and 1995
Report of Independent Accountants S-9
</TABLE>
All other schedules specified by Article 7 of Regulation S-X are not required
pursuant to the related instructions or are inapplicable and, therefore, have
been omitted.
(a)(3) See Exhibits listed on pages 38 through 39.
(b) Reports on Form 8-K filed in the fourth quarter of 1997
None.
37
<PAGE>
<TABLE>
<CAPTION>
PENNSYLVANIA MANUFACTURERS CORPORATION
SCHEDULE I
SUMMARY OF INVESTMENTS-OTHER THAN INVESTMENTS IN RELATED PARTIES
DECEMBER 31, 1997
Amount at
which shown in
Type of investment Cost Value the balance sheet
- ------------------------------------------------------------------ --------------- ----------------
<S> <C> <C> <C>
(Dollar amounts in thousands)
Fixed maturities:
Bonds:
U.S. Treasury Securities and obligations of U.S.
Government agencies $1,105,689 $1,119,566 $1,119,566
Corporate debt securities 675,218 687,671 687,671
Mortgage-backed securities 119,687 122,281 122,281
--------------- --------------- ----------------
Total fixed maturities 1,900,594 1,929,518 1,929,518
--------------- --------------- ----------------
Equity securities:
Common Stocks:
Industrial, miscellaneous and all other 5 13 13
--------------- --------------- ----------------
Total equity securities 5 13 13
--------------- --------------- ----------------
Short-term investments 265,207 265,207 265,207
--------------- --------------- ----------------
Total investments $2,165,806 $2,194,738 $2,194,738
============== ============== ===============
</TABLE>
S-1
<PAGE>
PENNSYLVANIA MANUFACTURERS CORPORATION
SCHEDULE II
BALANCE SHEETS
(PARENT COMPANY ONLY)
<TABLE>
<CAPTION>
as of December 31 (in thousands, except share data) 1997 1996
- -----------------------------------------------------------------------------------------------------------
<S> <C> <C>
ASSETS
Cash $ 253 $ -
Investments in subsidiaries 632,680 584,608
Deferred tax asset, net 29,163 36,602
Related party receivables 7,074 727
Other assets 22,545 21,096
--------- --------
Total assets $691,715 $643,033
========= ========
LIABILITIES
Long term debt $203,000 $204,571
Related party payables - 1,605
Dividends payable to shareholders 2,008 1,983
Other liabilities 8,360 9,046
--------- --------
Total liabilities 213,368 217,205
--------- --------
SHAREHOLDERS' EQUITY
Common stock, $5 par value (40,000,000 shares authorized;
15,286,263 shares issued and 14,850,789 outstanding - 1997
16,095,416 shares issued and 15,670,052 outstanding - 1996) 76,431 80,477
Class A common stock, $5 par value (40,000,000 shares authorized;
9,156,682 shares issued and 9,117,735 outstanding - 1997
8,247,804 shares issued and 8,173,023 outstanding - 1996) 45,783 41,239
Additional paid-in capital - Class A common stock 339 -
Retained earnings 343,368 336,921
Unrealized gain (loss) on investments of subsidiaries (net of
deferred income taxes: 1997 - $(10,126); 1996 - $13,394) 18,806 (24,874)
Notes receivable from officers (198) (1,162)
Treasury stock, at cost:
Common stock (1997 - 435,474 shares; 1996 - 425,364 shares (5,572) (5,408)
Class A common stock (1997 - 38,947 shares; 1996 - 74,781
shares) (610) (1,365)
--------- --------
Total shareholders' equity 478,347 425,828
--------- --------
Total liabilities and shareholders' equity $691,715 $643,033
========= ========
</TABLE>
These financial statements should be read in conjunction with the Consolidated
Financial Statements and the notes thereto.
S-2
<PAGE>
PENNSYLVANIA MANUFACTURERS CORPORATION
SCHEDULE II
STATEMENTS OF OPERATIONS
(PARENT COMPANY ONLY)
<TABLE>
<CAPTION>
for the years ended December 31, (in thousands) 1997 1996 1995
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
REVENUES:
Net investment income $ 263 $ 354 $ 217
Net realized investment gains - 35 4
Management fees 8,977 5,974 350
Other related party income - 263 1,642
--------------------------------
Total revenues 9,240 6,626 2,213
--------------------------------
EXPENSES:
General expenses 9,375 7,082 6,982
Interest expense 15,764 17,039 18,712
--------------------------------
Total expenses 25,139 24,121 25,694
--------------------------------
Loss before income taxes and equity in earnings (losses) of subsidiaries (15,899) (17,495) (23,481)
Benefit for income taxes (14,271) (60,345) (13,210)
--------------------------------
(Loss) income before equity in earnings (losses) of subsidiaries and
extraordinary item (1,628) 42,850 (10,271)
Equity in earnings (losses) of subsidiaries 21,381 (178,184) 34,401
--------------------------------
Income (loss) before extraordinary item 19,753 (135,334) 24,130
Extraordinary loss from early extinguishment of debt
(net of income tax benefit of $2,549) (4,734) - -
--------------------------------
Net income (loss) $ 15,019 $(135,334) $ 24,130
================================
</TABLE>
These financial statements should be read in conjunction with the Consolidated
Financial Statements and the notes thereto.
S-3
<PAGE>
PENNSYLVANIA MANUFACTURERS CORPORATION
SCHEDULE II
STATEMENTS OF CASH FLOWS
(PARENT COMPANY ONLY)
<TABLE>
<CAPTION>
for the years ended December 31, (in thousands) 1997 1996 1995
- ------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 15,019 $(135,334) $ 24,130
Adjustments to reconcile net income to net cash flows provided
by operating activities:
Equity in (earnings) losses of subsidiaries (21,381) 178,184 (34,401)
Net realized investment gains - (35) (4)
Provision (benefit) for deferred income taxes 9,614 (19,822) 7,000
Extraordinary loss from early extingusihment of debt (4,734) - -
Dividends received from subsidiaries 22,500 53,634 103,213
Other, net 5,331 (33,283) (20,384)
---------------------------------
Net cash flows provided by operating activities 26,349 43,344 79,554
---------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Cash contributions to subsidiaries (11,000) (50,000) (61,000)
Sales of fixed maturity investments, net - 45 2,122
Sales (purchases) of equity investments, net - 70 (16)
---------------------------------
Net cash flows used by investing activities (11,000) (49,885) (58,894)
---------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Change in related party receivables and payables (7,952) 10,863 (12,939)
Proceeds from issuance of long-term debt 210,000 26,000 125,000
Repayments of long-term debt (211,571) (25,000) (125,000)
Dividends paid to shareholders (7,965) (7,926) (7,885)
Proceeds from exercised stock options and
issuance of Class A common stock 837 - -
Treasury stock transactions, net 591 (929) 480
Repayments of notes receivable from officers 964 2,734 478
---------------------------------
Net cash flows (used) provided by financing activities (15,096) 5,742 (19,866)
---------------------------------
Net increase (decrease) in cash 253 (799) 794
Cash January 1 - 799 5
---------------------------------
Cash December 31 253 $ - $ 799
=================================
</TABLE>
These financial statements should be read in conjunction with the Consolidated
Financial Statements and the notes thereto.
S-4
<PAGE>
PENNSYLVANIA MANUFACTURERS CORPORATION
SCHEDULE III
SUPPLEMENTARY INSURANCE INFORMATION
<TABLE>
<CAPTION>
Future policy Benefits, Amortization
Deferred benefits, claims, of deferred Other
Policy losses, Net losses and policy oparting Net
(in thousands) Acquistion claims, and Unearned Premium investment settlement acquisition expenses premiums
Costs lost expenses premiums revenue income(1) expenses costs (2) written
- --------------------------- ----------- ------------- ---------- ---------- ----------- ----------- ----------- --------- ---------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Year ended December 31, 1997:
The Property and Casualty
Group $20,010 $1,353,917 $115,998 $212,348 $ 82,098 $ 193,530 $48,343 $57,206 $240,348
PMA Re 25,278 622,484 95,457 163,603 52,270 113,931 45,158 11,982 177,934
Corporate and Other - 26,786 - - 2,330 (180) - 5,951 -
- --------------------------- ----------- ------------- ---------- ---------- ----------- ----------- ----------- --------- ---------
Total $45,288 $2,003,187 $211,455 $375,951 $136,698 $ 307,281 $93,501 $75,139 $418,282
=========================== =========== ============= ========== ========== =========== =========== =========== ========= =========
Year ended December 31, 1996
The Property and Casualty
Group $23,488 $1,501,897 $127,986 $268,601 $ 82,455 $ 424,900 $52,706 $86,003 $279,422
PMA Re 20,518 589,175 77,996 151,974 48,676 111,937 37,586 8,344 164,053
Corporate and Other - - - - 2,805 (214) - 3,509 -
- --------------------------- ----------- ------------- ---------- ---------- ----------- ----------- ----------- --------- ---------
Total $44,006 $2,091,072 $205,982 $420,575 $133,936 $ 536,623 $90,292 $97,856 $443,475
======================================= ============= ========== ========== =========== =========== =========== ========= =========
Year ended December 31, 1995
The Property and Casualty
Group $20,747 $1,518,163 $124,988 $345,607 $ 92,275 $ 319,644 $53,420 $57,486 $337,116
PMA Re 17,154 551,823 67,734 139,345 45,166 103,947 33,787 7,334 152,760
Corporate and Other - - - - 1,914 (1,013) - 16,341 -
- --------------------------- ----------- ------------- ---------- ---------- ----------- ----------- ----------- --------- ---------
Total $37,901 $2,069,986 $192,722 $484,952 $139,355 $ 422,578 $87,207 $81,161 $489,876
======================================= ============= ========== ========== =========== =========== =========== ========= =========
</TABLE>
(1) Net investment income is based on each segment's invested assets.
(2) Other operating expenses are allocated primarily on the specific
identification basis. When indirect expenses cannot be directly
related to a segment, these expenses are allocated depending on
the nature of the expense.
S-5
<PAGE>
PENNSYLVANIA MANUFACTURERS CORPORATION
SCHEDULE IV
REINSURANCE
<TABLE>
<CAPTION>
ASSUMED
CEDED TO FROM PERCENTAGE OF
DIRECT OTHER OTHER NET AMOUNT ASSUMED
(dollar amounts in thousands) AMOUNT COMPANIES COMPANIES AMOUNT TO NET
- -------------------------------------- ----------- ----------- ------------- ------------ --------------
<S> <C> <C> <C> <C> <C>
Year Ended December 31, 1997:
Premiums:
Property and liability insurance $277,871 $118,277 $216,357 $375,951 58%
=========== =========== ============= ============ ==============
Year Ended December 31, 1996:
Premiums:
Property and liability insurance $299,386 $88,499 $209,688 $420,575 50%
=========== =========== ============= ============ ==============
Year Ended December 31, 1995:
Premiums:
Property and liability insurance $370,590 $35,476 $149,838 $484,952 31%
=========== =========== ============= ============ ==============
</TABLE>
S-6
<PAGE>
PENNSYLVANIA MANUFACTURERS CORPORATION
SCHEDULE V
VALUATION AND QUALIFYING ACCOUNTS
<TABLE>
<CAPTION>
Deductions -
Balance at Charged to write-offs of Balance at
beginning of costs and uncollectible end of
Description period expenses accounts period
------------------------------------- ------------- ------------ ----------------- ----------------
<S> <C> <C> <C> <C>
Year ended December 31, 1997:
Allowance for uncollectible accounts:
Uncollected premiums $18,877 - 471 $18,406
------------------------------------- ------------- ------------ ----------------- ----------------
Year ended December 31, 1996:
Allowance for uncollectible accounts:
Uncollected premiums $16,330 19,532 16,985 $18,877
------------------------------------- ------------- ------------ ----------------- ----------------
Year ended December 31, 1995:
Allowance for uncollectible accounts:
Uncollected premiums $22,402 - 6,072 $16,330
------------------------------------- ------------- ------------ ----------------- ----------------
</TABLE>
S-7
<PAGE>
PENNSYLVANIA MANUFACTURERS CORPORATION
SCHEDULE VI
SUPPLEMENTAL INFORMATION CONCERNING PROPERTY AND CASUALTY INSURANCE OPERATIONS
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------------
Discounts
on Reserves
Reserves for Unpaid Claim and claim
for Unpaid Claims and adjustment expenses
Deferred Claims and Claim incurred related to
policy Claim Adjustment Net ------------------------
Affiliation with acquisition Adjustment Expenses Unearned Earned Investment Current Prior
Registrant costs Expenses (1) Premiums Premiums Income Year Years(2)
- ---------------------- ----------- ------------ ---------- ---------- ---------- ---------- ---------- ---------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Consolidated property-
casualty subsidiaries
Year Ended
December 31, 1997 $45,288 $2,033,187 $460,230 $211,455 $375,951 $134,368 $141,880 $(86,036)
Year Ended
December 31, 1996 44,086 2,091,072 514,248 205,982 420,979 131,130 323,069 156,074
Year Ended
December 31, 1995 37,901 2,069,986 581,025 192,722 484,952 137,441 157,787 51,491
- ---------------------- ----------- ------------ ---------- ---------- ---------- ---------- ---------- ---------
Amortization of
deferred policy Paid claims and Net Premium
acquisition costs adjustment expenses Written
----------------- ------------------- ----------
Year Ended
December 31, 1997 93,501 470,874 418,282
Year Ended
December 31, 1996 90,292 510,620 443,475
Year Ended
December 31, 1995 87,207 469,942 489,876
----------------- ------------------- ----------
</TABLE>
(1) - Workers' compensation reserves discounted at approximately 5%.
(2) - Excludes accretion of less reserve discount of $51,407, $857,480 and
$13,300 in 1997, 1996 and 1995, respectively.
S-8
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders
Pennsylvania Manufacturers Corporation:
Our report on the consolidated financial statements of Pennsylvania
Manufacturers Corporation has been incorporated by reference in this Form 10-K
from page 88 of the 1997 Annual Report to Shareholders. In connection with our
audits of such financial statements, we have also audited the related financial
statement schedules listed in the index on page 37 of this Form 10-K.
In our opinion, the financial statements schedules referred to above, when
considered in relation to the basic financial statements taken as a whole,
present fairly, in all material respects, the information required to be
included therein.
/s/ Coopers & Lybrand L.L.P.
One South Market Square
Harrisburg, Pennsylvania
February 6, 1998
S-9
<PAGE>
EXHIBITS
<TABLE>
<CAPTION>
Exhibit No. Description of Exhibit
<S> <C>
(3) Article of incorportion and bylaws:
*3.1 Amended and Restated Artilce of Incorporation of the Company.
*3.2 Amended and Restated Bylaws of the Company.
(10) Material contracts:
*10.1 Employment Agreement dated April 1, 1995 between the Company and
Frederick W. Anton III.
*10.2 Employment Agreement dated May 1, 1995 between the Company and
John W. Smithson.
*10.3 The PMC EDC Plan Trust Agreement dated as of 1994.
*10.4 The PMC Supplemental Executive Retirement Plan (SERP) dated July
1995.
*10.5 The Company's Amended and Restated 1987 Incentive Stock Option
Plan
*10.6 The Company's Amended and Restated 1991 Equity Incentive Plan.
*10.7 The Company's Amended and Restated 1993 Equity Incentive Plan.
*10.8 The Company's Amended and Restated 1994 Equity Incentive Plan.
*10.9 The Company's 1995 Equity Incentive Plan.
*10.10 The Company's 1996 Equity Incentive Plan.
*10.11 Federal Tax Allocation Agreement.
*10.12 Office lease between Nine Penn Center Associates, L.P., as
Landlord, and Lorjo Corp., as Tenant, covering premises located
at Mellon Bank Center, 1735 Market Street, Philadelphia,
Pennsylvania, dated May 26, 1994.
*10.13 Credit Agreement dated as of March 14, 1997 by and among the
Company, The Bank of New York, First Union National Bank of
North Carolina, Fleet National Bank, PNC Bank, National
Association, Mellon Bank, N.A., CoreStates Bank, N.A. and
Dresdener Bank AG, New York Branch and Grand Cayman Branch.
*10.14 Master Agreement dated as of February 7, 1997 between the
Company and First Union National Bank of North Carolina.
*10.15 First Amended and Restated Letter of Credit Agreement by and
among the Company, the Bank of New York, Mellon Bank, N.A.,
Fleet Bank, National Association, PNC Bank, National Association
and First Union Bank of North Carolina.
10.16 Amendment No. 1 to Tax Allocation Agreement dated January 7,
1998.
10.17 Caliber One Indemnity Company Purchase Agreement dated December
15, 1997.
</TABLE>
38
<PAGE>
<TABLE>
<CAPTION>
<S> <C>
(11) Statement regarding computation of per share earnings.
(13) PMC's 1997 Annual Report to Shareholders only those portions
thereof which are expressly incorporated by reference in PMC's
Annual report on Form 10-K for 1997, are "filed" as part of this
Annual Report on Form 10-K
(21) Subsidiaries of the Company.
(23) Consents of experts and counsel
(27) Financial Data Schedule.
</TABLE>
* Incorporated by reference to initial filing of Registrant's Registration
Statement on Form 10, filed June 26, 1997.
39
<PAGE>
Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
PENNSYLVANIA MANUFACTURERS
CORPORATION
Date: March 23, 1998 By: /s/ John W. Smithson
-------------- ------------------------
John W. Smithson, President
and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
Signature Title Date
- --------- ----- ----
<S> <C> <C>
/s/ Frederick W. Anton III
_________________________ Chairman of the Board and March 23, 1998
Frederick W. Anton III a Director
/s/ John W. Smithson
_________________________ President, Chief Executive March 23, 1998
John W. Smithson Officer and a Director
/s/ Francis W. McDonnell
_________________________ Senior Vice President, Chief March 23, 1998
Francis W. McDonnell Financial Officer and
Treasurer (principal financial
and accounting officer)
_________________________ Director March __, 1998
Paul I Detwiler, Jr.
/s/ Joseph H. Foster
_________________________ Director March 23, 1998
Joseph H. Foster
/s/ Anne S. Genter
_________________________ Director March 23, 1998
Anne S. Genter
/s/ James F. Malone III
_________________________ Director March 23, 1998
James F. Malone III
/s/ A. John May
_________________________ Director March 23, 1998
A. John May
/s/ Louis N. McCarter III
_________________________ Director March 23, 1998
Louis N. McCarter III
</TABLE>
40
<PAGE>
<TABLE>
<CAPTION>
Signature Title Date
- --------- ----- ----
<S> <C> <C>
/s/ John W. Miller, Jr.
_________________________ Director March 23, 1998
John W. Miller, Jr.
/s/ Edward H. Owlett
_________________________ Director March 23, 1998
Edward H. Owlett
/s/ Louis I. Pollock
_________________________ Director March 23, 1998
Louis I. Pollock
_________________________ Director March __, 1998
Roderic H. Ross
/s/ L.J. Rowell, Jr.
_________________________ Director March 23, 1998
L.J. Rowell, Jr.
</TABLE>
41
<PAGE>
EXHIBITS
<TABLE>
<CAPTION>
<S> <C>
Exhibit No. Description of Exhibit
(3) Articles of incorporation and bylaws:
*3.1 Amended and Restated Articles of Incorporation of the Company.
*3.2 Amended and Restated Bylaws of the Company.
(10) Material contracts:
*10.1 Employment Agreement dated April 1, 1995 between the Company and
Frederick W. Anton III.
*10.2 Employment Agreement dated May 1, 1995 between the Company and
John W. Smithson.
*10.3 The PMC EDC Plan Trust Agreement dated as of 1994.
*10.4 The PMC Supplemental Executive Retirement Plan (SERP) dated July
1995.
*10.5 The Company's Amended and Restated 1987 Incentive Stock Option
Plan
*10.6 The Company's Amended and Restated 1991 Equity Incentive Plan.
*10.7 The Company's Amended and Restated 1993 Equity Incentive Plan.
*10.8 The Company's Amended and Restated 1994 Equity Incentive Plan.
*10.9 The Company's 1995 Equity Incentive Plan.
*10.10 The Company's 1996 Equity Incentive Plan.
*10.11 Federal Tax Allocation Agreement.
*10.12 Office lease between Nine Penn Center Associates, L.P., as
Landlord, and Lorjo Corp., as Tenant, covering premises located
at Mellon Bank Center, 1735 Market Street, Philadelphia,
Pennsylvania, dated May 26, 1994.
*10.13 Credit Agreement dated as of March 14, 1997 by and among the
Company, The Bank of New York, First Union National Bank of
North Carolina, Fleet National Bank, PNC Bank, National
Association, Mellon Bank, N.A., CoreStates Bank, N.A. and
Dresdener Bank AG, New York Branch and Grand Cayman Branch.
*10.14 Master Agreement dated as of February 7, 1997 between the
Company and First Union National Bank of North Carolina.
*10.15 First Amended and Restated Letter of Credit Agreement by and
among the Company, the Bank of New York, Mellon Bank, N.A.,
Fleet Bank, National Association, PNC Bank, National Association
and First Union Bank of North Carolina.
10.16 Amendment No. 1 to Tax Allocation Agreement dated January 7,
1998.
10.17 Caliber One Indemnity Company Purchase Agreement dated December
15, 1997.
</TABLE>
42
<PAGE>
<TABLE>
<CAPTION>
<S> <C>
(11) Statement regarding computation of per share earnings.
(13) PMC's 1997 Annual Report to Shareholders only those portions
thereof which are expressly incorporated by reference in PMC's
Annual report on Form 10-K for 1997, are "filed" as part of this
Annual Report on Form 10-K
(21) Subsidiaries of the Company.
(23) Consents of experts and counsel
(27) Financial Data Schedule.
</TABLE>
* Incorporated by reference to initial filing of Registrant's Registration
Statement on Form 10, filed June 26, 1997.
43
<PAGE>
Exhibit 10.16
AMENDMENT NO. 1
TO
TAX ALLOCATION AGREEMENT
BETWEEN
PENNSYLVANIA MANUFACTURERS CORPORATION
(HEREINAFTER REFERRED TO AS "PMC")
AND
THE VARIOUS SUBSIDIARIES OF PMC
Whereas, PMC is the Common Parent, as discussed in Section 1504 of the
Internal Revenue Code of 1986 (Code), of the corporations party to this
Agreement;
Whereas, the following companies are subsidiaries (hereafter referred to
collectively as "Subsidiaries") of PMC:
Pennsylvania Manufacturers' Association Ajon, Inc.
Insurance Company Rosemarie, Inc.
PMA Reinsurance Corporation Cris-Jen, Inc.
Manufacturers Alliance Insurance Company Aud-Evad, Inc.
Pennsylvania Manufacturers Indemnity Company Walprop, Inc.
Mid-Atlantic States Casualty Company DP Corp.
Lee-Ward, Inc. REM Corp.
Sarfred, Inc. Gulph Industries, Inc.
Syl-Bar, Inc. Dauphin Equities, Inc.
PMA Services, Inc. Pennsylvania Manufacturers
Wisteve, Inc. Association Finance Co.
Marpan, Inc. 925 Chestnut, Inc.
Lorjo Corp. Mid-Atlantic States
Presque, Inc. Investment Company
PMA Management Corporation
Whereas, PMC and the Subsidiaries entered into a Tax Allocation Agreement
(the "Agreement") effective September 24, 1996 to cover all tax allocations
beginning January 1, 1996 and after and until this Agreement is canceled or
otherwise terminated;
Whereas, Caliber One Management Company Inc. ("Management") has become a
subsidiary of PMC and PMC's Consolidated Group and wishes to become a party to
this Agreement effective July 8, 1997;
<PAGE>
Whereas, Caliber One Indemnity Company ("Indemnity") (formerly, "Lincoln
Insurance Company) has become a subsidiary of PMC and PMC' s Consolidated Group
and wishes to become a party to this Agreement effective December 16, 1997; and
Whereas, the Board of Directors of Management and Indemnity have adopted a
resolution accepting the provisions of this Agreement.
Now, therefore, in consideration of the premises and the mutual covenants
hereinafter contained, the Agreement is amended as follows:
1. Management is added as a party to the Agreement effective July 8, 1997.
The term "Subsidiary"/"Subsidiaries" as used in the Agreement shall include
Management.
2. Indemnity is added as a party to the Agreement effective December 16, 1997.
The term "Subsidiary"/"Subsidiaries" as used in the Agreement shall include
Indemnity.
3. The second "Whereas" clause of the Agreement is restated to read as
follows:
Whereas, the following companies are subsidiaries (hereafter
referred to collectively as "Subsidiaries") of PMC:
Pennsylvania Manufacturers' Association Rosemarie, Inc.
Insurance Company Cris-Jen, Inc.
PMA Reinsurance Corporation Aud-Evad, Inc.
Manufacturers Alliance Insurance Company Walprop, Inc.
Pennsylvania Manufacturers Indemnity Company DP Corp.
Mid-Atlantic States Casualty Company REM Corp.
Lee-Ward, Inc. Gulph Industries, Inc.
Sarfred, Inc. Dauphin Equities, Inc.
Syl-Bar, Inc. Pennsylvania Manufacturers
PMA Services, Inc. Association Finance Co.
Wisteve, Inc. 925 Chestnut, Inc.
Marpan, Inc. Mid-Atlantic States
Lorjo Corp. Investment Company
Presque, Inc. Caliber One Management
PMA Management Corporation Company, Inc.
Ajon, Inc. Caliber One Indemnity
Company
4. This Amendment shall not amend or otherwise modify any of the terms or
provisions of the Agreement except as stated herein.
<PAGE>
In witness whereof, Management and Indemnity have caused this Amendment No.
1 to the Agreement to be duly executed and attested as of the 7th day of
January, 1998.
Attest: Caliber One Management
Company, Inc.
By:/s/ Edward S. Hochberg By:/s/ Francis W. McDonnell
----------------------- -------------------------
Attest: Caliber One Indemnity
Company
By:/s/ Edward S. Hochberg By:/s/ Francis W. McDonnell
----------------------- -------------------------
<PAGE>
STOCK PURCHASE AGREEMENT
This AGREEMENT is made as of October , 1997, by and between MARKEL
CORPORATION, a Virginia corporation (the "Seller") and PMA REINSURANCE
CORPORATION, a Pennsylvania corporation (the "Buyer").
Preamble
The Seller is the beneficial and record owner of all of the issued and
outstanding shares of the common stock, $100.00 par value per share (the
"Shares"), of Lincoln Insurance Company, a Delaware domestic insurance
corporation (the "Company"). The Seller wishes to sell, and the Buyer wishes to
purchase, all of the Shares upon the terms and subject to the conditions of this
Agreement.
Accordingly, in consideration of the premises and the mutual promises
contained herein, the parties hereto, each intending to be legally bound
hereby, agree as follows:
Article 1. Sale and Purchase of Shares.
1.1 Sale and Purchase of Shares. At the closing provided for in Section 2 (the
"Closing") and upon the terms and subject to the conditions of this Agreement,
the Seller shall sell to the Buyer, and the Buyer shall purchase from the
Seller, all of the Shares. In consideration thereof and the covenants of the
Seller hereunder, the Buyer shall pay to the Seller an amount (the "Purchase
Price") equal to $2.2 million in excess of the Statutory Capital and Surplus of
the Company (hereinafter defined) existing at the close of business on the day
immediately preceding the Closing (defined in Section 2.1), subject to any
Unrealized Adjustment (hereinafter defined).
1.1.1 "Statutory Capital and Surplus" of the Company at any time means the
aggregate amount of capital and surplus of the Company for a period ending
at such time as would be shown on page 3, line 25 of the Company's annual
statement, prepared in accordance with Law for filing with the Delaware
Department of Insurance in accordance with Statutory Accounting Principles
(defined in Section 3.6), consistently applied with the principles applied
to the preparation of the financial statement of the Company referred to in
Section 3.6. Seller will prepare such a statement reflecting capital and
surplus as of the Closing Date (the "Closing Date Statement").
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Lincoln Insurance Company Stock Purchase Agreement
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1.1.2 "Unrealized Adjustment" shall mean an adjustment for the difference
between the aggregate market value of the Company's bonds and cash or cash
equivalents (as reported at the close of business on the day immediately
preceding the Closing by Bloomberg or a similar service mutually acceptable
to the parties) and the amount at which such amounts would be reported on
such date on page 2, lines 1 and 6 of the Company's annual statement.
1.2 Payment of Purchase Price. The Purchase Price shall be determined and paid
as follows:
1.2.1 Earnest Money Deposit. Prior to the execution hereof, Buyer
deposited with Seller $50,000 as earnest money toward the purchase of the
Shares (the "Earnest Money Deposit").
1.2.2 Purchase Price Payable at Closing. At least two business days
before the Closing, the Seller will deliver to the Buyer a reasonable
estimate of the amount of the Company's Statutory Capital and Surplus which
will exist at the Closing Date ("Seller's Estimated Statutory Capital and
Surplus") and the amount of the Purchase Price based thereon (the
"Estimated Purchase Price"), together with such details of the basis for
such Estimated Purchase Price as the Seller shall have relied upon in
making such estimate or as the Buyer shall reasonably request. At the
Closing, the Buyer shall pay to Seller, in cash by interbank wire transfer
of immediately available funds to an account previously designated by the
Seller, an amount equal to the excess of the Estimated Purchase Price over
the Earnest Money Deposit.
1.2.3 Adjustment of Estimated Purchase Price. Within ten days after the
Closing, the Buyer and Seller will agree upon the amount of the Company's
Capital and Surplus (determined in accordance with Sections 3.6 and 3.7),
the amount of any Unrealized Adjustment, and the amount of the Purchase
Price based thereon. Promptly thereafter, Buyer shall pay to the Seller
any shortfall, or the Seller shall pay to the Buyer any excess, as the case
may be, of the Estimated Purchase Price compared to the Purchase Price as
so determined.
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Lincoln Insurance Company Stock Purchase Agreement
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1.3 Delivery of Shares. At the Closing, the Seller shall deliver to the Buyer
stock certificates representing all of the Shares, duly endorsed in blank or
accompanied by stock powers duly executed in blank, in proper form for transfer,
and with all appropriate stock transfer stamps affixed.
Article 2. Closing.
2.1 Closing Date and Location. The Closing of the sale and purchase of the
Shares contemplated hereby shall take place at the offices of Seller in Glen
Allen, Virginia at 10:00 a.m. local time, on the fifth full Business Day after
satisfaction or waiver of all of the conditions set forth in Articles 7 and 8,
or such other time or date as the Buyer and the Seller may otherwise agree in
writing. The time and date upon which the Closing occurs is herein called the
"Closing Date."
Article 3 Representations, Warranties and Covenants of the Seller.
The Seller represents, warrants and covenants to the Buyer as follows:
3.1 Due Incorporation and Authority. The Seller is a corporation duly
organized, validly existing and in good standing under the laws of the State of
Virginia, and is not a foreign person within the meaning of Section 1. 1445-
2(b)(2)(i) of the Treasury Regulations (hereinafter defined), or any other
applicable Treasury Regulations. The Company is a corporation duly organized,
validly existing and in good standing under the laws of the State of Delaware
and has all requisite corporate power and authority to own, lease and operate
its Properties and to carry on its business as now and heretofore conducted.
Neither the character of the properties currently owned or leased by the Company
nor the current nature of its business makes necessary qualification by it to do
business as a foreign corporation in any jurisdiction.
3.2 Subsidiaries and Other Affiliates. The Company does not directly or
indirectly own or have the power to vote shares of any capital stock or other
ownership interests of any corporation or other Person such that it has voting
power to elect a majority of the directors of such corporation or other Persons
performing similar functions for such Person, as the case may be.
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Lincoln Insurance Company Stock Purchase Agreement
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Except for readily marketable securities held in its investment portfolio, the
Company does not directly or indirectly own any interest in any other Person.
3.3 Outstanding Capital Stock and Title to the Shares. The Company is
authorized to issue (i) thirty-five thousand (35,000) shares of common stock,
par value $100.00 per share, all of which shares are issued and outstanding, and
(ii) five thousand (5,000) shares of Adjustable Rate Cumulative Redeemable
Preferred Stock, par value $0.01 per share, none of which is currently
outstanding. There are no other authorized, issued or outstanding shares
(including treasury shares) of capital stock or other equity securities of the
Company, no securities of the Company convertible directly or indirectly into or
exchangeable directly or indirectly for any capital stock or other equity
security of the Company, no options, warrants, puts, calls or other rights
(including any preemptive rights) to acquire directly or indirectly from the
Company or Seller any capital stock or other equity security of the Company, and
no other contracts, understandings, arrangements or obligations (whether or not
contingent) by which the Company is or may be bound to issue or repurchase any
capital stock or other equity security of the Company.
3.3.1 All of the Shares are owned beneficially and of record by the Seller
free and clear of any lien, pledge, mortgage, security interest, claim,
lease, charge, option, right of first or last refusal or offer, easement,
servitude, transfer restriction under any shareholder or similar agreement,
encumbrance or any other restriction or limitation whatsoever, other than
any applicable state and federal securities and insurance laws
(collectively, "Liens"). Upon delivery of and payment for the Shares as
herein provided, the Seller will convey to the Buyer good and valid title
thereto, free and clear of any Lien, except for Liens arising through the
Buyer or as a result of the Buyer's actions.
3.3.2 All of the Shares are duly authorized and validly issued, fully paid
and nonassessable.
3.3.3 Except as provided in Section 3.12 (Required Consents), there are no
restrictions on the sale by Seller of the Shares to Buyer, and no approval
or consent of any Person is required for Seller to validly effect the sale
of the Shares. The Company is not a party to any agreement concerning any
or all of the Shares other than this Agreement.
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Lincoln Insurance Company Stock Purchase Agreement
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3.3.4 To the Knowledge of the Seller, any securities issued by the Company
were issued in compliance with, or pursuant to available exemptions under,
the Securities Act of 1933 ("1933 Act") and applicable state securities
laws. To the Knowledge of the Seller, the Company has not failed to file
any documents or failed to take any action required to be filed or taken
under the 1933 Act or applicable state securities laws, and to the
Knowledge of the Seller neither the Company nor any affiliate thereof is or
has been subject to any action, proceeding, inquiry or investigation under
any federal or state securities laws.
3.4 Authority to Execute and Perform Agreement; Enforceability. The Seller has
the full legal right and power and all corporate authority and approvals
required to execute and deliver this Agreement and the Related Agreements to
which it is a party (defined in Section 8.3) and to perform fully its
obligations hereunder. This Agreement and the Related Agreements to which
Seller is a party have been duly executed and delivered by the Seller and each
is a valid and binding obligation of the Seller enforceable against it in
accordance with its terms, except as enforceability may be limited by (i)
bankruptcy, insolvency, reorganization, moratorium and other such laws of
general application affecting the rights and remedies of creditors and (ii)
general principles of equity, as such may be applied by courts of competent
jurisdiction.
3.5 Charter Documents and Corporate Records. The Seller has heretofore
delivered to the Buyer true and complete copies of the Certificate of
Incorporation and Bylaws, or comparable instruments, of the Company as in effect
on the date hereof, and no amendments thereto shall be made from the date hereof
through the Closing Date.
3.5.1 Minute Books and Stock Certificate Books and Records. The minute
books of the Company now contain, and on the Closing Date will contain, a
true and complete record of all such records received by Seller from the
previous owner of the Company, and all corporate action taken by Company
since its acquisition by Seller prior to the date hereof, or hereafter
taken on or prior to the Closing Date, at the meetings or by written
consents of shareholders and directors and committees thereof. The stock
certificate books and records of the Company accurately reflect the capital
ownership of the Company.
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Lincoln Insurance Company Stock Purchase Agreement
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3.6 Statutory Financial Statements. The Seller has heretofore delivered to the
Buyer true and complete copies of the Annual Statements of the Company as filed
with the Delaware Department of Insurance for the years ended December 31, 1995
and 1996, and will deliver before the Closing, a true and complete copy of the
Quarterly Statement of the Company as filed with the Delaware Department of
Insurance for the quarter ended September 30, 1997 (the "Quarterly Statement").
The balance sheet of the Company as of December 31, 1996, and the related
statement of income and cash flow for the year then ended, included in the
Annual Statement for the year ended December 31, 1996, were prepared in
conformity with the insurance laws of Delaware applicable to such reports of the
Company and related regulations of the Delaware Department of Insurance
("Statutory Accounting Principles" or "SAP") consistently applied, except as
otherwise noted therein, for the period covered thereby, and fairly present, in
accordance with SAP, the statutory financial position of the Company as at the
date thereof and the results of operations and cash flow of the Company for the
period then ended; provided that this representation shall not be deemed to be
--------
breached by reason of the development of Reserves for Losses and Loss Adjustment
Expenses and Reserves for Uncollectible Reinsurance after the date of such
financial statement. The balance sheet of the Company as of September 30, 1997,
and the related statement of income and cash flow for the period then ended,
included in the Quarterly Statement were prepared in conformity with Statutory
Accounting Principles applicable to interim financial statements consistently
applied during the period involved, except as otherwise noted therein, subject
to normal year-end adjustments, and fairly present, in accordance with SAP, the
statutory financial position of the Company as at the date thereof and the
results of operations and cash flow of the Company for the period then ended;
provided that this representation shall not be deemed to be breached by reason
- --------
of the development of Reserves for Losses and Loss Adjustment Expenses and
Reserves for Uncollectible Reinsurance after the date of such financial
statement.
3.7 Statutory Capital and Surplus. At the Closing:
(a) the assets of the Company will consist solely of (i) cash and
bonds and other obligations which are not voting securities of the
kind described on Schedule
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Lincoln Insurance Company Stock Purchase Agreement
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3.7, having a fair market value reflected therefor on the Closing
Date Statement and (ii) Non-Statement Assets (hereinafter defined)
and
(b) the liabilities of the Company, including any contingent
liabilities, will consist solely of Non-Statement Liabilities
(hereinafter defined).
3.7.1 "Non-Statement Assets and Liabilities" are assets and liabilities,
respectively, of the Company:
(a) the existence of which does not breach any representation,
warranty or covenant herein of the Seller, and
(b) either (i) is not an asset or liability which would properly be
reflected in, reserved against or disclosed by the Closing Date
Statement or (ii) is offset in full by a related liability (in the
case of assets) or asset (in the case of liabilities) properly
reflected in or reserved against in the Closing Date Statement.
3.8 Undisclosed Liabilities. As of the date of this Agreement, the Company
does not have any material liability or obligation of any nature, whether known
or unknown, absolute, accrued, contingent or otherwise and whether due or to
become due, except (i) as and to the extent reflected or reserved against in its
December 31, 1996 balance sheet included within the SAP Financial Statements,
(ii) for liabilities and obligations incurred after the date of such balance
sheet in the ordinary course of business, or (iii) the existence of which does
not constitute a breach of any representations, warranties or covenants of the
Seller hereunder; provided that this representation shall not be deemed to be
--------
breached by reason of the development of Reserves for Losses and Loss Adjustment
Expenses and Reserves for Uncollectible Reinsurance after the date hereof. At
the Closing, the Company will have no liability or obligation of any nature,
whether known or unknown, absolute, accrued, contingent or otherwise and whether
due or to become due, except for Non-Statement Liabilities.
3.9 Tax Matters. Since Seller's acquisition of the Company on May 26, 1995
(the "Acquisition Date"), the Company has timely filed (or has had filed on its
behalf), or will cause to be timely filed, all Tax Returns required to be filed
by it (or on its behalf). All such Tax Returns were true, correct and complete
in all material respects.
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Lincoln Insurance Company Stock Purchase Agreement
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3.9.1 Since the Acquisition Date, the Company has timely paid all Taxes
owed by or with respect to the Company. No penalties or other charges are
or will become due with respect to the late filing of any Tax Return of the
Company required to be filed since the Acquisition Date and on or before
the Closing Date. Since the Acquisition Date, the Company has withheld and
paid all Taxes required to have been withheld and paid in connection with
amounts paid or owing to any employee, independent contractor, creditor or
other Person.
3.9.2 Schedule 3.9 sets forth the states in which the Company (or any
consolidated, combined or unitary group of which the Company is a member)
files Tax Returns, indicates to the Knowledge of the Seller the Tax Returns
in such states that have been audited since the Acquisition Date, and
indicates those Tax Returns in such states that currently are the subject
of audit.
3.9.3 There are no waivers or extensions of any applicable statute of
limitations, or agreements to any extension of time, for the assessment or
collection of taxes with respect to any tax returns, which waivers,
extensions or agreements currently are in effect. No claim has been made
in writing since the Acquisition Date, by an authority in a jurisdiction
where the Company does not file Tax Returns that it is or may be subject to
taxation by that jurisdiction.
3.9.4 Since the Acquisition Date, the Company has not received a Tax
Ruling or entered into a Tax Closing Agreement with any taxing authority.
For purposes of the preceding sentence, the term "Tax Ruling" shall mean
written rulings of a taxing authority relating to Taxes, and the term "Tax
Closing Agreement" shall mean a written and legally binding agreement with
a taxing authority relating to Taxes.
3.9.5 To the Knowledge of the Seller, no action, suit, proceeding,
investigation, audit, claim or assessment is presently pending or
threatened with regard to any Taxes that relate to the Company for which it
could be liable.
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Lincoln Insurance Company Stock Purchase Agreement
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3.9.6 Except as set forth on Schedule 3.9, the Company is not required to
make any adjustment pursuant to Section 481 of the Code by reason of a
change in accounting method or otherwise.
3.9.7 The Buyer will not be required to deduct and withhold any amount
pursuant to Section 1445 of the Code, upon the consummation of the
transactions contemplated hereby (the "Contemplated Transactions"), and the
Seller will cause the necessary documents to be provided to the Buyer at
the Closing to support such nondeduction and non-withholding, including
appropriate affidavits referred to in Section 1445(b)(3) of the Code.
3.9.8 There are no Liens for Taxes (other than for Taxes not yet due and
payable) upon the assets of the Company.
3.9.9 The Seller and the Company have been included in a consolidated
return for Federal income tax purposes filed by Seller on behalf of itself,
the Company, and other subsidiaries of Seller (or its predecessors) since
1995 (with respect to a stub period from May 26, 1995, to December 31,
1995), as common parent corporation of an "affiliated group" (within the
meaning of Section 1504(a) of the Code) of which the Company is an
"includible corporation" (within the meaning of Section 1504(b) of the
Code). Such affiliated group has filed all income Tax Returns that it was
required to file for each taxable period during which the Company was a
member of the group. All such income Tax Returns were correct and complete
in all respects. All income Taxes owed by such affiliated groups have been
paid for each taxable period during which the Company was a member of the
group.
3.9.10 Since the Acquisition Date, the Company has not filed a consent
under Section 341(f) (1) of the Code or agreed under Section 341(f) (3) of
the Code to have the provisions of Section 341(f) (2) of the Code applied
to the sale of its capital stock. The Company has not made any payment, is
not obligated to make any payment, and is not a party to any agreement that
could obligate it to make any payments, that will not be deductible in full
by reason of Code section 280G.
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Lincoln Insurance Company Stock Purchase Agreement
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3.10 Compliance with Laws. The Company is not in violation, nor to the
Knowledge of the Seller has there been a violation by the Company that has not
been corrected, of any applicable Order, or any applicable Law, of any
Governmental Body, which violation could reasonably be expected to have a
material adverse effect on the financial condition, results of operations or
business of the Company.
3.10.1 The Seller has heretofore delivered to the Buyer true and complete
copies of the triennial report for the Company covering the three (3) year
period ended December 31, 1993 prepared by the Delaware Insurance
Department. The foregoing triennial report is the most recent report of
examination of the Company by the Delaware Insurance Department that has
been provided to the Company. No understandings, agreements or
stipulations exist between the Delaware Insurance Department and the Seller
or the Company relating to the conduct of the Company except to the extent
expressly contained in the Examination Report, and except that Seller has
an understanding with the Department that Statutory Capital and Surplus
will not be reduced by reason of dividends below an amount equal to 25% of
Company reserves. To the Knowledge of the Seller, the Delaware Insurance
Department has not since the Acquisition Date notified the Company of any
deficiencies or concerns material to the financial condition or operations
of the Company.
3.11 Licenses. The Company is duly qualified and licensed as an insurance
company in the State of Delaware and is in good standing as such in such State.
Schedule 3.11 lists and provides a description of (i) the jurisdictions in which
the Company currently possesses licenses or other approvals to conduct an
insurance business, including any approvals or authorization necessary to
conduct a surplus lines business (collectively, "Insurance Licenses"), and (ii)
the jurisdictions in which the Company possessed an Insurance License at May 30,
1995, which License has since been terminated, withdrawn, suspended, abandoned,
or revoked, whether voluntarily or involuntarily, and describes the
circumstances of such termination, withdrawal, suspension, abandonment, or
revocation. The Company is not required by applicable law to have any other
Insurance Licenses for the legal and valid conduct of its business as presently
conducted. The Company has heretofore made available to the Buyer true and
complete copies of all of such
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Lincoln Insurance Company Stock Purchase Agreement
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Insurance Licenses as are currently in effect. To Seller's Knowledge, all
Licenses and Insurance Licenses are valid and in good standing and are in full
force and effect, except as otherwise noted on Schedule 3.11.
3.12 No Breach. The execution, delivery and performance of this Agreement by
the Seller and the consummation of the Contemplated Transactions will not (i)
violate any provision of the Articles of Incorporation or By-laws (or comparable
instruments) of the Company or the Seller; (ii) require the Company or the
Seller to obtain any consent, approval or action of, or make any filing with or
give any notice to, any Person, except as set forth on Schedule 3.12 (the
"Required Consents"); (iii) if the Required Consents are obtained, except as set
forth on Schedule 3.12, violate, result with the passage of time or the giving
of notice, or both, in the breach of any of the terms of, result in a
modification of the effect of, otherwise cause the termination of or constitute
a default under, any contract, agreement, understanding, indenture, note, bond,
loan, instrument, lease, conditional sale contract, mortgage, license,
franchise, commitment or other binding arrangement (collectively, the
"Contracts") to which the Company or the Seller is a party or by or to which
either of them or any of their Properties (including the Shares) may be bound or
subject, or result in the creation of any Lien upon the Properties of the
Company or the Seller (including the Shares) pursuant to the terms of any such
Contract, other than Liens arising under this Agreement; (iv) if the Required
Consents are obtained, except as set forth on Schedule 3.12, violate any Order
of any Governmental Body against, or binding upon, the Company or the Seller or
upon any of their Properties (including the Shares) or upon their respective
businesses; or (v) if the Required Consents are obtained, except as set forth on
Schedule 3.12, violate any Law; other than, in the case of clauses (iii) through
(v) above, where such violation, conflict, breach, modification, termination or
Lien may arise or have arisen as a result of actions taken by the Buyer, or
would not have a material adverse effect on the financial condition, results of
operations or business of the Company or the Seller, as the case may be.
3.13 Claims and Proceedings. Except as set forth on Schedule 3.13, there are
no outstanding Orders of any Governmental Body against or involving, or to the
Knowledge of the Seller threatened against, the Company. Other than as may
arise in the ordinary course of the Company's business with respect to claims
made under insurance policies written by the Company
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Lincoln Insurance Company Stock Purchase Agreement
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or reinsurance agreements entered into by the Company, there are no actions,
suits, claims or legal, administrative or arbitral proceedings or investigations
(collectively, "Claims") pending, or to the Knowledge of the Seller threatened,
against or involving the Company or any of its Properties, except for audits in
connection with reinsurance agreements.
3.14 Contracts. Other than intercompany agreements between Seller or its
affiliates and the Company, there are no material contracts to which the Company
is a party on the date hereof, including but not limited to: (i) partnership or
joint venture agreements; (ii) contracts containing covenants of the Company not
to compete in any line of business or with any Person in any geographical area
or covenants of any other Person not to compete with the Company in any line of
business or in any geographical area; (iii) contracts relating to the borrowing
of money; (iv) management contracts and other similar agreements; (v) contracts
with any other insurance company, managing general agent, underwriting manager
or any other Person, pursuant to which the Company has delegated underwriting
and/or claims settlement authority; (vi) agency, brokerage or other similar
insurance sales or marketing contracts; (vii) any contract, other than insurance
contracts issued in the ordinary course of business, with Seller or any
subsidiary of Seller or any officer, director or Affiliate of Seller; (viii)
guaranties; and (ix) any other contracts.
3.15 Real Estate. There do not exist (i) any real property owned by the
Company, (ii) any leases or subleases under which the Company is the lessor or
lessee of any real property, or (iii) any options held by the Company or
contractual obligations on its part to purchase, acquire, sell or dispose any
material interest in real property.
3.16 Third Party Rights. No third Person has any rights to any property or
asset of the Company, tangible or intangible, in whole or in part (including
without limitation, any patent, copyright, trade secret, business name, trade
name, trademark or proprietary information), which shall materially impair
Buyer's interest in the Company.
3.17 Reinsurance. To the Knowledge of the Seller, Schedule 3.17 contains a
complete and correct list of all Contracts entered into since 1976 regarding
reinsurance, coinsurance, excess insurance, ceding of insurance, assumption of
insurance or indemnification with respect to insurance to which the Company is a
party (as either a ceding or assuming party) (individually a
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Lincoln Insurance Company Stock Purchase Agreement
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"Reinsurance Agreement" and collectively the "Reinsurance Agreements"). To the
Knowledge of the Seller, except to the extent of a commutation of either (i) an
entire Reinsurance Agreement or (ii) that portion of such Reinsurance Agreement
associated with any particular reinsurer, all such treaties or agreements are in
full force and effect. To the Knowledge of the Seller, no other party to any
such Reinsurance Agreement has given written, or to the Knowledge of the Seller
oral, notice of termination or cancellation of any such Reinsurance Agreement
other than in accordance with the terms of such Reinsurance Agreement.
3.18 Policies of Insurance Written by the Company. Except for any failures to
comply or file which did not and are not reasonably expected to result in the
imposition of a material fine or penalty against the Company, all policies and
contracts of insurance or reinsurance issued by the Company since the
Acquisition Date are in compliance, and at their respective dates of issuance
were in compliance, in all material respects with all applicable Laws and, to
the extent required under applicable Law, (i) are on forms approved by the
appropriate Governmental Bodies in the jurisdictions where issued or (ii) were
filed with and not objected to by such Governmental Bodies within the period
provided for objection. The Company has issued no policies of insurance since
November 30, 1995.
3.19 Certain Business Practices. To the Knowledge of the Seller, all material
insurance or reinsurance Claims that have become payable by the Company have
been paid, reserved against, or provided for in the Company's accounts, in
accordance with the terms of the insurance or reinsurance policy or contract
under which they arose.
3.20 Title to Properties At the Closing, the Company will own outright all of
the assets reflected in the Closing Date Statement, subject only to Liens on
statutory deposits with state insurance departments.
3.21 Employee Benefits. Since the Acquisition Date, the Company has not been a
party to any employee benefit plan subject to section 3(3) of the Employee
Retirement Income Security Act of 1974, as amended, and the regulations
thereunder, under which the Company has any liability with respect to any
current or former employee of the Company.
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3.22 Employees. The Company does not now, and at Closing will not, employ any
employees. The Company is not a party to or bound by any collective bargaining
agreement, and there are no labor unions or other organizations representing,
or, to the Knowledge of the Seller, purporting to represent or attempting to
represent any such employees.
3.23 Operations of the Company. Except as set forth on Schedule 3.23, since
December 31, 1996 the Company has not:
3.23.1 incurred any indebtedness for borrowed money;
3.23.2 amended its Certificate of Incorporation or By-laws (or comparable
instruments) or merged with or into or consolidated with any other Person,
subdivided or in any way reclassified any shares of its capital stock or
changed or agreed to change in any manner the rights of its outstanding
capital stock or the character of its business;
3.23.3 issued or sold any shares of any class of its capital stock, or any
securities convertible into or exchangeable for any such shares; or issued,
sold, granted or entered into any subscriptions, options, warrants,
conversion or other rights agreements to purchase or acquire any such
securities;
3.23.4 adopted or amended any employment, collective bargaining, bonus,
profit-sharing, compensation, pension, retirement, vacation, severance,
deferred compensation or other plan, agreement, trust, fund or arrangement
for the benefit of any officer, director, employee, agent or consultant;
3.23.5 mortgaged or pledged any of its real property or other Properties or
assets, whether tangible or intangible, except for Liens on statutory
deposits with state insurance departments; or
3.23.6 taken any action or, to the Knowledge of Seller, omitted to take
any action that would result in the occurrence of any of the foregoing.
Article 4. Representations and Warranties of the Buyer.
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The Buyer represents and warrants to the Seller as follows:
4.1 Due Incorporation and Authority. The Buyer is a corporation duly
organized, validly existing and in good standing under the laws of the
Commonwealth of Pennsylvania.
4.2 Authority to Execute and Perform Agreement; Enforceability. The Buyer has
the full legal right and power and all corporate authority and approvals
required to execute and deliver this Agreement and to perform fully its
obligations hereunder. This Agreement has been duly executed and delivered by
the Buyer and is a valid and binding obligation of the Buyer enforceable in
accordance with its terms, except as enforceability may be limited by (i)
bankruptcy, insolvency, reorganization, moratorium and other such laws of
general application affecting the rights and remedies of creditors and (ii)
general principles of equity, as such may be applied by courts of competent
jurisdiction.
4.3 No Breach. The execution, delivery and performance of this Agreement by
the Buyer and the consummation of the Contemplated Transactions will not (i)
violate any provision of the Articles of Incorporation or By-laws (or comparable
instruments) of the Buyer; (ii) require the Buyer to obtain any consent,
approval or action of, or make any filing with or give any notice to, any
Person, except as set forth on Schedule 4.3 (the "Buyer's Consents"); (iii) if
the Buyer's Consents are obtained, violate any Order of any Governmental Body
against, or binding upon, the Buyer or upon any of its Properties or upon its
business; or (iv) if the Buyer's Consents are obtained, violate any Law; other
than, in the case of clauses (iii) and (iv), where such violation would not have
a material adverse effect on the financial condition, results of operations or
business of the Buyer.
4.4 Claims and Proceedings. There are no outstanding Orders of any
Governmental Body against or involving, or to the knowledge of the Buyer
threatened against, the Buyer, and no Claims pending against or involving the
Buyer which would have a material adverse effect on the ability of the Buyer to
consummate the Contemplated Transactions.
4.5 Financing. The Buyer has on the date of execution of this Agreement and
will have at the Closing sufficient immediately available funds, in cash or
pursuant to credit agreements in effect on the date of this Agreement, to pay
the Purchase Price.
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4.6 Purchase for Investment. The Buyer is purchasing the Shares for its own
account for investment and not for resale or distribution, and will not sell or
otherwise transfer the Shares except in accordance with all applicable federal
and state securities laws. For purposes hereof, the foregoing representation
shall not be deemed breached by reason of Buyer's subsequent transfer of the
Company to an affiliate of Buyer.
Article 5. Covenants and Agreements.
5.1 Conduct of Business. From the date hereof through the Closing Date without
the prior written consent of the Buyer, the Seller shall cause the Company not
to issue any policies of insurance or undertake any of the actions specified in
Section 3.23. The Seller shall give the Buyer prompt notice of any event,
condition or circumstance occurring from the date hereof through the Closing
Date that would constitute a material violation or breach of any representation
or warranty, or cause such representation or warranty to be materially untrue as
of the Closing Date (assuming such event, condition or circumstance existed on
the Closing Date), or that would constitute a material violation or breach of
any covenant of the Seller contained in this Agreement.
5.2 Corporate Examinations and Investigations. Prior to the Closing Date, the
Seller will, and will cause the Company to, give to the Buyer and its employees
and representatives, access to all of the Company's Properties, books and
records, to make such examination of the business, operations and financial
condition of the Company as the Buyer wishes. Any such investigation and
examination shall be conducted at reasonable times and under reasonable
circumstances, and the Seller shall, and shall cause the Company to, cooperate
fully therein. In order that the Buyer may have full opportunity to make such
physical, business, accounting and legal review, examination or investigation as
it may wish of the affairs of the Company, the Seller shall make available and
shall cause the Company to make available to the representatives of the Buyer
during such period all such information and copies of such documents concerning
the affairs of the Company as such representatives may reasonably request,
permit the representatives of the Buyer access to the Properties of the Company
and all parts thereof, and cause its officers, employees, consultants, agents,
accountants and attorneys to cooperate fully with such
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representatives in connection with such review and examination. If this
Agreement terminates, (i) the Buyer shall keep confidential and shall not use in
any manner any information or documents obtained from the Company concerning its
Properties, businesses and operations, unless readily ascertainable from public
or published information, or trade sources, or already known or subsequently
developed by the Buyer independently of any investigation of the Company, and
(ii) any documents obtained from the Company and all copies or extracts thereof
shall be returned.
5.3 Publicity. Except as required by law, regulation or stock exchange
requirements, neither of the parties hereto shall, without the consent of the
other, make any public announcement or issue any press release with respect to
the Contemplated Transactions. Prior to making any such public announcement or
issuing any such press release the parties hereto shall, to the extent possible,
consult with the other party as to the content of such public announcement or
press release.
5.4 Indemnification for Broker's Fees. The Seller represents and warrants to
the Buyer that no broker, finder, agent or similar intermediary (a "Broker") has
acted on behalf of the Company or the Seller in connection with this Agreement
or the Contemplated Transactions, and that there are no brokerage commissions,
finders' fees or similar fees or commissions payable in connection therewith
based on any agreement, arrangement or understanding with the Company or the
Seller, or any action taken by the Company or the Seller. The Seller agrees to
indemnify and hold the Buyer harmless from any claim or demand for commission or
other compensation by any Broker claiming to have been employed by or on behalf
of the Company or the Seller, and to bear the cost of legal expenses incurred in
defending against any such claim. The Buyer represents and warrants to the
Seller that no Broker has acted on behalf of the Buyer in connection with this
Agreement or the Contemplated Transactions, and that there are no brokerage
commissions, finders' fees or similar fees or commissions payable in connection
therewith based on any agreement, arrangement or understanding with the Buyer,
or any action taken by the Buyer. The Buyer agrees to indemnify and hold the
Seller and its Affiliates harmless from and against any claim or demand for
commission or other compensation by any Broker claiming to have been employed by
or on behalf of the Buyer, and to bear the cost of legal expenses incurred in
defending against any such claim.
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5.5 Tax Matters.
5.5.1 Seller shall prepare and file, or cause to be prepared and filed,
all Consolidated Returns required to be filed by or on behalf of the
Company for the period ending on or before the Closing Date and, without
limiting the Buyer's obligations set forth in Section 5.5.3, shall pay, or
cause to be paid, all Taxes shown as due on such Consolidated Returns.
Seller shall include the income of the Company on the Seller Consolidated
Returns for all periods through the close of business the day before the
Closing Date and pay any federal income Taxes attributable to such income.
5.5.2 Subject to the provisions of Section 5.5.5, the Seller shall be
liable to the Buyer for, and shall hold the Buyer and the Company harmless
from and against, any and all Taxes due or payable by the Company for any
taxable year or tax period ending on or before the Closing Date. Taxes for
which the Seller shall be liable and shall hold the Buyer and the Company
harmless from and against under the preceding sentence shall include,
without limitation, Taxes (i) the liability for which arises under Treasury
Regulations 1.1502-6 and 1.1502-78 or comparable provisions of state or
local law as a result of the Company having been included in a group filing
Consolidated Returns, (ii) the liability for which arises because the
Company ceases on the Closing Date to be a member of a group filing
Consolidated Returns, and (iii) that are due or payable by the Buyer or the
Company and result from or arise out of the Contemplated Transactions or
resulting from elections by the Seller and the Buyer (express or deemed)
under Section 338(h)(10) of the Code (or comparable provisions of state or
local tax laws).
5.5.3 Subject to the provisions of Section 5.5.5, the Buyer and the
Company shall be liable for, and shall hold the Seller harmless from and
against, any and all Taxes due or payable by the Company with respect to
the Company for any taxable year or tax period beginning after the Closing
Date except, in accordance with Section 5.5.4, to the extent that such
Taxes result from elections by the Seller and the Buyer (express or deemed)
under Section 338(h)(10) of the Code (or comparable provisions of state or
local tax law).
5.5.4 Buyer and Seller agree that both parties shall make an election
under Section 338(h)(10) of the Code (or comparable provision of state or
local tax laws) with respect
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to the acquisition of the Company, but that any Taxes resulting from such
election shall be paid by the Seller and Seller shall indemnify and hold
Buyer harmless from and against such Taxes. Buyer shall be responsible for
preparing all forms and documents in connection with such election. Seller
shall execute and deliver to Buyer such forms and documents as are
responsibly required to complete such election.
5.5.5 Any Taxes for a tax period beginning before the Closing Date and
ending after the Closing Date shall be apportioned between the Seller and
the Buyer, in the case of real and personal property taxes and franchise
taxes not based on gross or net income, on a per diem basis and, in the
case of other Taxes, shall be determined by (i) assuming that the Company's
taxable year (including the taxable year of organizations in which it owns
a partnership interest or other equity interest) ends as of the close of
business on the Closing Date; (ii) closing on an actual basis the Company's
books as of the close of business on such date; and (iii) preparing a Tax
return based on the income, gain, deduction, losses and credits as so
determined under an accurate and appropriate accounting method and, to the
extent permissible, on a basis consistent with the methodology and
elections employed in prior years. Each such portion of such period shall
be deemed to be a tax period subject to the provisions of Sections 5.5.2
and 5.5.3 above.
5.5.6 The Buyer shall cause the Company to file any federal, state, local
or foreign Tax Return (other than any Consolidated Return) required to be
filed after the Closing Date with respect to the business, activities or
assets of the Company (the "Post-Closing Returns") and, without limiting
the Seller's obligations set forth in Section 5.5.2, the Company shall pay
or cause its subsidiaries or Affiliates to pay all Taxes shown as due on
any Post-Closing Returns. Any Post-Closing Returns that relate (in whole
or in part) to tax periods beginning before the Closing Date (the "Straddle
Returns") shall be prepared as promptly as possible after the Closing Date,
but in no event later than three weeks prior to the due dates thereof, as
such dates may be extended. Immediately after preparation of the Straddle
Returns, the Buyer shall provide the Seller with copies of the Straddle
Returns. Not less than five days before the due dates of such returns the
Seller shall forward to the Buyer or the Company any comments it may have
relating to such returns.
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5.5.7 Any refunds of Taxes that were paid in respect of a taxable year or
tax period (including a period deemed to be a tax period under Section
5.5.5) of the Company ending on or before the Closing Date shall be for the
account of the Seller, and any refund of Taxes that were paid in respect of
a taxable year or tax period (including a period deemed to be a tax period
under Section 5.5.5) of the Company beginning on or after the Closing Date
shall be for the account of the Buyer.
5.5.8 If the Buyer or the Company becomes aware of any assessment,
official inquiry, examination or proceeding that could reasonably result in
an official determination with respect to any Tax for which the Seller
could be liable pursuant to Section 5.5.2, the Buyer shall promptly so
notify the Seller in writing. If the Seller becomes aware of any official
inquiry, examination or proceeding that could reasonably result in an
official determination with respect to any Taxes related to the business,
activities or assets of the Company (including, without limitation, any
assessment, official inquiry, examination or proceeding with respect to any
Consolidated Return), the Seller shall promptly so notify the Buyer, in
writing.
5.5.9 The Seller shall have the right to exercise control over the contest
and/or settlement of any issue raised in any official inquiry, examination
or proceeding with respect to any Consolidated Return for federal income
taxes or any inquiry, examination or proceeding that relates to Taxes for
which the Seller is liable to the Buyer under Section 5.5.2, and the Seller
shall pay any expenses incurred in connection therewith, provided that (i)
the Seller shall keep the Buyer informed of all material developments with
respect to such inquiry, examination or proceeding if it relates to any Tax
for which the Buyer could be liable under Section 5.5.3 and (ii) the Seller
shall not settle or compromise any such inquiry, examination or proceeding
that relates to any Tax for which the Buyer could be liable under Section
5.5.3 without the consent of the Buyer, which consent shall not be
unreasonably withheld. The Buyer shall cooperate with the Seller at
Seller's expense, as the Seller may reasonably request, in any such
inquiry, examination or proceeding.
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5.5.10 Except as provided in Section 5.5.9, the Buyer shall have the right
to exercise control over the contest and/or settlement of any issue raised
in any official inquiry, examination or proceeding with respect to Taxes
related to the business, activities or assets of the Company that relates
only to Taxes for which the Buyer is liable to the Seller under Section
5.5.3; provided that (i) the Buyer shall keep the Seller informed of all
--------
material developments with respect to such inquiry, examination or
proceeding if it relates to any Tax for which the Seller could be liable
under Section 5.5.2 and (ii) the Buyer shall not settle or compromise any
such inquiry, examination or proceeding that relates to any Tax for which
the Seller could be liable under Section 5.5.2 without the consent of the
Seller, which consent shall not be unreasonably withheld. The Seller shall
cooperate with the Buyer at the Buyer's expense, as the Buyer may
reasonably request, in any such inquiry, examination or proceeding.
5.5.11 As used in this Agreement, the following terms shall have the
following meanings:
(i) "Code" means the Internal Revenue Code of 1986, as amended,
and the applicable final Treasury Regulations promulgated thereunder,
or corresponding provisions of future laws.
(ii) "Consolidated Returns" means any consolidated federal
income tax return or similar return with respect to any other Tax on
behalf of an affiliated group of corporations of which the Company was
or is includible as a member for any portion of such taxable period of
the Company beginning before the Closing Date.
(iii) "Taxes" (or "Tax" where the context requires) means all
federal, state, county, local, foreign and other taxes (including,
without limitation, income, profits, premium, estimated, excise,
sales, use, occupancy, gross receipts, franchise, ad valorem,
severance, capital levy, production, transfer, withholding,
employment, unemployment compensation, payroll-related and property
taxes, import duties and other governmental charges and assessments),
whether or not
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measured in whole or in part by net income, and including
deficiencies, interest, additions to tax or interest and penalties
with respect thereto.
(iv) "Tax Return" means all returns, declarations, reports,
forms, estimates, information returns and statements required to be
filed in respect of any Taxes to be supplied to a taxing authority in
connection with any Taxes.
(v) "Treasury Regulations" means the final Regulations
promulgated under the Internal Revenue Code of 1986, as amended (or
corresponding future law), or corresponding future final regulations.
5.6 Management Agreements. The Seller and the Company will cause all
Management Agreements to be terminated at or prior to the Closing with no
further liability on the part of the Company.
5.7 Reinsurance Agreement. At or prior to the Closing the Seller will cause
Essex Insurance Company ("Essex"), a wholly-owned subsidiary of the Seller, and
the Company to execute and deliver a reinsurance agreement, dated as of the
Closing Date, in substantially the form of Schedule 5.7 (the "Essex Reinsurance
Agreement"), with such changes therein as may be made in response to regulatory
comments and which are mutually acceptable to the parties.
5.8 Further Assurances.
5.8.1 Each of the parties shall execute, at its expense, such documents
and take such commercially reasonable actions as may be required or
desirable to carry out the provisions hereof and the Contemplated
Transactions, including without limitation: promptly after the date hereof
preparing and filing a Form A Statement with the Delaware Insurance
Department and any other Insurance Department where such filing is
required, and any other filings required to be made to obtain the Required
Consents; and the furnishing of all information as may be required by the
Delaware Commissioner of Insurance or the Delaware Department of Insurance,
any other state regulatory agency asserting jurisdiction, in order that the
requisite approvals for the purchase and sale of the
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Shares and the Contemplated Transactions be obtained or to cause any
applicable waiting periods to expire.
5.8.2 Each party will use commercially reasonable efforts to implement the
provisions of this Agreement, and for such purpose, at the request of the
other party will, at or after the Closing, without further consideration,
promptly execute and deliver, or cause to be executed and delivered, such
additional documents, instruments, conveyances and assurances and take such
other actions as the other party may reasonably deem necessary or desirable
to implement any provision of this Agreement and to render effective the
consummation of the Contemplated Transactions, including, without
limitation, the transfer to the Buyer of the ownership of the Company. In
addition, the Seller and Buyer will use best efforts to ensure to the
extent practicable that all existing Insurance Licenses are retained by the
Company through the Closing Date.
5.9 Books and Records of the Company.
5.9.1 The Seller agrees to deliver to the Buyer at or as soon as
practicable after the Closing, all books and records relating to the
corporate governance or Insurance Licenses of the Company (including but
not limited to, correspondence, memoranda, and the like).
5.9.2 For a period of seven (7) years following the Closing, or for such
longer periods as may be required to satisfy applicable Laws, the parties
shall retain all books and records in their respective possessions (a)
relating to Taxes, including, without limitation, accounting and tax
records and information pertaining to events occurring prior to the Closing
Date, and (b) required to be retained pursuant to obligations imposed by
any Law (such books and records of the business of the Company
collectively, the "Records"). During such period, each party shall provide
the other with reasonable access to the Records for review and copying.
5.9.3 If original documents are required to respond to legal process in
connection with the conduct by either party of any litigation, arbitration,
audit, settlement proceedings or negotiations with third parties with
respect to its conduct of the business of the Company ("Legal
Proceedings"), such party, subject to applicable laws, regulations or
agreements, shall be permitted to remove such Records temporarily from the
other party's premises;
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provided that such party shall return such original documents to such
--------
other party as promptly as practicable after such time when such original
documents are no longer required in connection with such Legal
Proceedings.
5.9.4 If, in connection with Legal Proceedings, the Buyer or the Seller
shall require the assistance of the other party's employees, such party
shall provide such employees to the requesting party as are reasonably
required by such requesting party. The requesting party shall pay such
other party's out-of-pocket costs incurred in connection with such use of
such party's employees and shall reimburse such party for the number of
whole business days spent by each such employee in providing such services
at the rate equal to the average daily gross pay (excluding the value of
employee benefits) of such employee during each calendar month in which
such services are performed.
5.10 Confidentiality Agreement. Except to the extent inconsistent with the
express terms hereof, the terms and conditions of that certain Confidentiality
Agreement dated as of June 2, 1997 between Buyer and Seller shall continue to
apply to the transactions contemplated hereby and is incorporated herein by
reference and made a part hereof.
5.11 Negotiations with Others. From the date hereof until the Closing, the
Seller will not, and shall cause the Company not to, directly or indirectly,
without the written consent of the Buyer, (i) initiate discussions or engage in
negotiations concerning any sale of the Shares or of any merger, sale of assets
or similar transaction involving the Company with, or (ii) furnish or cause to
be furnished any non-public information concerning the Company to, any Person
other than the Buyer and its agents and representatives. The Seller agrees to
disclose to the Buyer the existence and content of any formal inquiries by or
discussions with a third party relating to an acquisition of the stock or assets
of the Company as soon as practicable after they take place.
Article 6. Conditions Precedent to the Obligation of the Buyer to Close.
The obligation of the Buyer to enter into and complete the Closing is
subject, at the option of the Buyer, to the fulfillment on or prior to the
Closing Date of the following conditions, any one or more of which (other than
Section 6.2, insofar as it relates to the Delaware Commissioner
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of Insurance or the Delaware Department of Insurance, and Section 6.3) may be
waived by the Buyer in its sole discretion:
6.1 Representations and Covenants. The representations and warranties of the
Seller contained in this Agreement shall be true and correct in all material
respects at and as of the Closing with the same force and effect as though made
on and as of the Closing. The Seller shall have performed and complied in all
material respects with all covenants and agreements required by this Agreement
to be performed or complied with by the Seller on or prior to the Closing Date.
The Seller shall have executed and delivered to the Buyer a certificate, dated
the date of the Closing, to the foregoing effect and stating that all conditions
to the Buyer's obligations hereunder have been satisfied.
6.2 Consents and Approvals; Insurance Licenses. All consents or approvals
required for the consummation of the sale of the Shares and the Contemplated
Transactions from the Delaware Commissioner of Insurance or the Delaware
Department of Insurance or any other Governmental Body having jurisdiction over
the Company or the consummation of the Contemplated Transactions shall have been
obtained and be in full force and effect. All Insurance Licenses listed as
being valid and in good standing and in full force and effect in Schedule 3.11
shall continue to so remain at the Closing.
6.3 Litigation. No Claim shall have been instituted before any Governmental
Body, or instituted or threatened by any Governmental Body, to restrain, modify
or prevent the carrying out of the Contemplated Transactions.
6.4 Affiliate Transactions. The Seller shall have delivered to the Buyer
evidence reasonably satisfactory to the Buyer that, except as set forth on
Schedule 6.4, all agreements between the Company, on the one hand, and Seller
and/or any Affiliate of Seller, on the other hand, shall have terminated without
any continuing obligations of the Company remaining thereunder.
6.5 Resignations. The Company shall have caused the current Officers and
Directors of the Company to resign, and shall have obtained written resignations
of such Directors and Officers
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which provide that all such persons waive and generally release the Company from
any and all damages, claims, causes of action, liabilities and obligations of
which they are or later become aware, and in particular release any claims for
indemnification they may have under the Company Bylaws.
Article 7. Conditions Precedent to the Obligation of the Seller to Close.
The obligation of the Seller to enter into and complete the Closing is
subject, at the option of the Seller, to the fulfillment on or prior to the
Closing Date of the following conditions, any one or more of which (other than
Section 7.2, insofar as it relates to the Delaware Commissioner of Insurance or
the Delaware Department of Insurance, and Section 7.3) may be waived by the
Seller in its sole discretion:
7.1 Representations and Covenants. The representations and warranties of the
Buyer contained in this Agreement shall be true and correct in all material
respects at and as of the Closing Date with the same force and effect as though
made on and as of the Closing Date. The Buyer shall have performed and complied
in all material respects with all covenants and agreements required by this
Agreement to be performed or complied with by the Buyer on or prior to the
Closing Date. The Buyer shall have executed and delivered to the Seller a
certificate, dated the date of the Closing, to the foregoing effect and stating
that all conditions to the Seller's obligations hereunder have been satisfied.
7.2 Consents and Approvals. All consents or approvals required for the
consummation of the sale of the Shares and the Contemplated Transactions from
the Delaware Commissioner of Insurance or the Delaware Department of Insurance
or any other Governmental Body having jurisdiction over the Company and the
consummation of the Contemplated Transactions shall have been obtained and be in
full force and effect.
7.3 Litigation. No Claim shall have been instituted before any Governmental
Body, or instituted or threatened by any Governmental Body, to restrain, modify
or prevent the carrying out of the Contemplated Transactions.
Article 8. Indemnification and Remedies
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8.1 Definition of "Representations and Warranties." The "Representations
and Warranties" of the Seller means all of the representations and warranties of
the Seller set forth in Article 3 and the statements set forth in any
certificate referred to in Section 6.1. The "Representations and Warranties" of
Buyer means all of the representations and warranties of the Buyer set forth in
Article 4 and the statements set forth in any certificate referred to in Section
7.1.
8.2 Survival of Representations, Warranties and Covenants; Right to
Indemnification Not Affected by Knowledge. All Representations and Warranties
of each of the parties hereto, and all Covenants of each of the parties set
forth in this Agreement, will survive the Closing. The right of a party to
indemnification pursuant hereto will not be affected by any investigation
conducted or any knowledge acquired (or capable of being acquired) at any time,
whether before or after the Closing Date, with respect to the accuracy of or
compliance with any Representation, Warranty or Covenant of another party
hereto. The waiver by a party hereto of any condition based on the accuracy of
any Representation or Warranty, or on the performance of or compliance with any
Covenant or condition hereunder, will not affect the right of such party to
indemnification pursuant hereto by reason of such breach of Representation,
Warranty or Covenant, except to the extent expressly set forth in a writing
executed by such party.
8.3 Exclusive Remedies. With the exception of any indemnification
obligations set forth in sections 5.4 and 5.5 (which shall be governed thereby),
the rights and obligations with respect to indemnification set forth in this
Article will be the exclusive rights and obligations of the respective parties
hereto with respect to the Representations and Warranties of such parties, and a
claim for indemnification pursuant to this Article shall be the exclusive remedy
for any breach of any such Representation and Warranty. The rights and
obligations of the respective parties set forth in this Article 8, and any
claims or causes of action by a party under this Agreement, the Essex
Reinsurance Agreement, or the Confidentiality Agreement (the "Related
Agreements") to enforce any covenant of a party hereto set forth in this
Agreement or any Related Agreement will be the exclusive rights and obligations
of the Seller and the Buyer with respect to the business or ownership of the
Company, the Shares, the events giving rise to this Agreement and the
transactions provided for in or contemplated by this Agreement or by any of the
Related Agreements. Without limiting the generality or effect of the
foregoing, each of the Seller and the
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Buyer, hereby waives any claim or cause of action which it might be entitled
to assert against the other, or any director, officer, employee, controlling
person or Affiliate of such other party (including without limiting any claim or
cause of action for fraud, misrepresentation or other cause under the common
law, any securities, trade regulation, environmental or other law) by reason of
this Agreement, the events giving rise to this Agreement and the transactions
provided for or contemplated by this Agreement or any of the Related Agreements,
except for claims or causes of action that may be made or brought under this
Agreement or any of the Related Agreements to enforce the covenants of any party
set forth herein or therein.
8.4 Indemnification by the Seller. The Seller will indemnify and hold the
Buyer and the Company harmless from and against any damage deficiency, cost,
expense, or Diminution of Value (hereinafter defined), whether or not involving
a third-party claim (a "Loss") resulting from (i) the material breach of any
Representation or Warranty of the Seller or any failure to materially perform
any covenant of the Seller contained herein and (ii) any claims, actions,
judgments, costs and expenses incident to the foregoing (including without
limitation costs of investigation and reasonable attorneys' fees). For purposes
hereof, a Diminution of Value shall not include any diminution in value of the
Company (i) arising from loss of an Insurance License after the date hereof, or
(ii) the financial impact of which is less than a hundred thousand Dollars
($100,000); provided, that if such diminution in value exceeds a hundred
--------
thousand Dollars ($100,000), the entire amount of such diminution of value
(including the portion not exceeding a hundred thousand Dollars ($100,000))
shall be included as part of the Indemnifying Party's indemnification obligation
hereunder.
8.5 Indemnification by Buyer. The Buyer will indemnify and hold the Seller
harmless from and against any Loss resulting from (i) the material breach of any
Representation or Warranty of the Buyer or the failure to materially perform any
covenant of the Buyer set forth herein and (ii) any claims, actions, judgments,
costs and expenses incident to the foregoing (including without limitation costs
of investigation and reasonable attorneys' fees).
8.6 Determination of Losses. Losses shall be determined taking into
account the actual amount of damage, deficiency, cost or expense incurred or
suffered or the diminution of value of any property by reason of the event or
condition giving rise to the obligation to indemnify as well
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Lincoln Insurance Company Stock Purchase Agreement
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as any insurance proceeds actually received by the indemnified party (otherwise
than from an insurer who is an Affiliate thereof), after adjustment for tax
benefits and burdens arising therefrom or from the indemnification thereof (to
the extent that such tax effects can reasonably be quantified). Upon payment by
the indemnifying party, such party shall receive from the indemnified party an
assignment of the indemnified party's rights and claims against insurers and
others with respect to the event or condition giving rise to the obligation to
indemnify.
8.7 Certain Limitations on Claims. The following limitations shall apply
to claims for indemnification under Section 8.4 or 8.5:
8.7.1 No such claim based upon the breach of a Representation or Warranty
may be asserted unless notice shall have been given on or before the date
specified below to the Person from whom such indemnification may be sought
that a breach of such a Representation or Warranty has or may have occurred
(identifying such Representation or Warranty with reasonable
particularity):
(a) If such claim relates to the matters referred to in Section 3.3;
no time limit shall apply;
(b) If such claim relates to the matters referred to in Sections
3.10 and 5.5, the applicable statute of limitations; and
(c) If such claim relates to any other Representation or Warranty;
eighteen months from the Closing Date.
8.7.2 The Seller shall not be obligated to pay any amounts for
indemnification under this Agreement by reason of the development of
Reserves for Losses and Loss Adjustment Expenses and Reserves for
Uncollectible Reinsurance after the date hereof (the foregoing shall not be
deemed to alter or affect the terms of the Essex Reinsurance Agreement);
8.7.3 The amount of any indemnification required to be paid by an
indemnifying party pursuant to this Article (the "Indemnifying Party")
shall be reduced by any amount received by the party claiming
indemnification hereunder (the "Indemnitee") with respect to the Loss which
is the subject of such claim thereto under any insurance coverage (net of
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any costs, including reasonable legal fees, incurred by such Indemnitee in
enforcing its rights to such coverage) or from any other Person responsible
therefor. The Indemnitee shall use commercially reasonable efforts to
collect any amounts available under such insurance coverage and from such
other Person responsible. If an Indemnitee receives an amount under
insurance coverage or from such other Person with respect to any Losses at
any time subsequent to any indemnification provided by the Indemnifying
Party pursuant to this Article, then such Indemnitee shall promptly
reimburse the Indemnifying Party, as the case may be, for any payment made
or expense incurred by the Indemnifying Party in connection with providing
such indemnification up to such amount received by the Indemnitee (net of
any costs of such coverage or of obtaining such amount incurred by such
Indemnitee).
Article 9. Restrictive Covenant
9.1 Non-Competition. Buyer agrees that, for a period of 18 months from and
after the Closing Date, Buyer shall cause the Company to refrain from offering
the insurance products listed on Schedule 9.1 to any current customers or
accounts of Markel Insurance Company, Shand/Evanston Group, Essex Insurance
Company, Markel American (American Underwriting Managers) or Investors Insurance
Group.
Article 10. Termination of Agreement.
10.1 Termination. This Agreement may be terminated prior to the Closing as
follows:
10.1.1 at the election of the Seller, if a material breach of the
Representations, Warranties or Covenants of the Buyer has occurred, which
breach is not cured by Buyer within ten (10) days after receiving notice
thereof from Seller;
10.1.2 at the election of the Buyer, if a material breach of the
Representations, Warranties or Covenants of the Seller has occurred, which
breach is not cured by Seller within ten (10) days after receiving notice
thereof from Buyer;
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Lincoln Insurance Company Stock Purchase Agreement
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10.1.3 at any time on or prior to the Closing Date, by mutual written
consent of the Seller and the Buyer; or
10.1.4 on June 1, 1998, if the Closing has not occurred prior to such
date.
10.2 Return of Deposit.
10.2.1 In the event of termination pursuant to Section 10.1.1, the
Earnest Money Deposit shall be retained by Seller;
10.2.2 In the event of termination pursuant to Section 10.1.2, the
Earnest Money Deposit shall be refunded to Buyer, in full; and
10.2.3 In the event of any other termination, Seller will be entitled to
retain $25,000 of the Earnest Money Deposit, and the remainder shall be
refunded to Buyer.
10.3 Remedies After Termination. If this Agreement terminates, each party shall
retain such rights as it may then have for damages or other relief by reason of
any breach by the other party of such other party's representations, warranties
or covenants.
Article 11. Definitions.
11.1 Certain Definitions. As used in this Agreement, the following terms have
the following meanings:
11.1.1 "Affiliate" means, with respect to any Person, any other Person
controlling, controlled by or under common control with, or the parents,
spouse, lineal descendants or beneficiaries of, such Person. The term
"control" (including the terms "controlling," "controlled by" and "under
common control with" ) means the possession, direct or indirect, of the
power to direct or cause the direction of the management and policies of a
Person, whether through the ownership of voting securities, by contract or
otherwise.
11.1.2 "Business Day" means any day other than a Saturday or Sunday or
upon which banks in New York, New York or Richmond, Virginia are authorized
or required by law to close.
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11.1.3 "Dollars" means U.S. Dollars.
11.1.4 "GAAP" means generally accepted accounting principles in the
United States of America.
11.1.5 "Governmental Body" means any government or political subdivision
thereof, whether federal, state, local or foreign, or any agency or
instrumentality thereof.
11.1.6 "Law" means any law, statute, code, ordinance, regulation, rule
or other requirement.
11.1.7 "Order" means any order, civil investigative demand, judgment,
injunction, award, decree or writ.
11.1.8 "Person" means any individual, corporation, limited liability
corporation, partnership, limited liability partnership, joint venture,
association, joint-stock company, trust, unincorporated organization,
Governmental Body or other entity.
11.1.9 "Property" or "Properties" means real, personal or mixed
property, tangible or intangible.
11.1.10 "Reserves for Losses and Loss Adjustment Expenses" means an
amount equal to the allowance, determined in accordance with Statutory
Accounting Principles, with respect to the financial statements of the
Company for (a) case reserve estimates for reported losses and loss
adjustment expenses plus (b) incurred but not reported losses and loss
adjustment expenses less (c) amounts representing estimated net realizable
salvage, subrogation and deductibles, and in the case of clauses (a), (b)
and (c), net of applicable reinsurance recoverables.
11.1.11 "Reserves for Uncollectible Reinsurance" means an amount,
determined in accordance with GAAP, equal to the total of reinsurance
recoverables owed to the Company, that have been determined to be
uncollectible (including collection expenses and any amount determined to
be uncollectible in accordance with GAAP resulting from a commutation with
a reinsurer).
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11.1.12 "Sellers Knowledge" or the phrase "to the best of Seller's
Knowledge" means the actual knowledge of Steven Markel, Darrell D. Martin,
Gregory B. Nevers, Richard R. Whitt, Paul Chucle or Paula Francis.
Article 12. Dispute Resolution
12.1 Arbitration; selection of panel. As a condition precedent to any right of
action hereunder, any and all disputes or disagreements arising between the
parties pertaining to or relating in any manner to this Agreement (any
"Controversy") which shall include but not be limited to any disputes or
disagreements as to the meaning or interpretation of this Agreement or any
portion thereof or the relationship of the parties created under this Agreement
or any breach of this Agreement, upon which an amicable understanding cannot be
reached shall be submitted to arbitration in the location of the party not
seeking to arbitrate (i.e., Philadelphia in the case of Buyer, and Richmond in
the case of Seller). One arbiter shall be chosen by the Buyer, the other by the
Seller, and an umpire shall be chosen by the two arbiters before they enter upon
arbitration, all of whom shall be active or retired disinterested executive
officers of insurance or reinsurance companies. In the event that either party
shall fail to choose an arbiter within thirty (30) days following a written
request to do so, the requesting party may choose two arbiters who shall in turn
choose an umpire before entering into arbitration. If the two arbiters fail to
agree upon the selection of an umpire within thirty (30) days following their
appointment, each arbiter shall name three nominees, of whom the other party
shall decline two, and the decision between the remaining two nominees shall be
made by drawing lots.
12.2 Arbitration; proceedings and award. Each party shall present its case to
the arbiters and the umpire within thirty (30) following the appointment of the
umpire. The arbiters shall consider this Agreement as an honorable engagement
rather than merely as a legal obligation and they shall be relieved of all
judicial formalities and may abstain from following the strict rules of law;
however, there shall be no ex parte contacts between either party and any
arbiter or the umpire, and cross examination and rebuttal shall be allowed if
requested by either party. The decision of the arbiters shall be in writing
giving the reasons for the award and shall be final and binding on both parties
but, failing to agree, they shall call in the umpire and the decision of the
majority shall
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Lincoln Insurance Company Stock Purchase Agreement
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be final and binding upon both parties, except that an appeal may be taken from
such decision as provided in the Federal Arbitration Act.
12.3 Arbitration; expenses. Except as provided below, each party shall bear the
expense of its own arbiter, and shall jointly and equally bear with the other
the expense of the umpire and of the arbitration. In the event that the two
arbiters are chosen by one party, as above provided, the expense of the
arbiters, the umpire and the arbitration shall be equally divided between the
two parties. Provided, however, that if in the opinion of the arbiters any
claim hereunder or any defense or objection thereto was unreasonable, the
arbiters may assess, as part of the award, all or any part of the expenses of
the arbitration against the party raising such unreasonable claim, defense or
objections.
12.3.1 At the commencement of the arbitration, each party must specify its
position as to the precise amounts it considers are properly payable with
respect to any amounts which are at issue in the Controversy ("Amounts at
Issue"), and the Arbiters and Umpire shall be instructed that any award or
awards rendered must lie within such range or ranges between the Amounts at
Issue specified by the parties. At the time any award or awards are issued
by the Arbiters, if any party has specified Amounts at Issue which are, in
the aggregate, twice or more as far apart in amount from the aggregate
amount of such award or awards than are the Amounts at Issue specified by
the other party, such farther party shall be considered the "Losing Party"
for purposes hereof. In the event a party becomes a Losing Party as so
defined, such Losing Party will be responsible for all witness fees,
attorney's expenses and all other expenses related to the arbitration
process incurred by either party in connection with the arbitration, unless
the arbitration panel determines that such an allocation of fees and
expenses would be unjust.
12.3.2 Prior to proceeding with any arbitration hereunder, each party
must first pay to the other any Amounts at Issue which are undisputed. In
the event a party fails to do so, the Arbiters shall be directed, pursuant
hereto, to enter an award in the full amount of the Amounts at Issue
specified by the opposing party.
12.4 Specific Enforcement. This Agreement to arbitrate shall be specifically
enforceable. Should any party to this Agreement be required to seek relief from
a court of competent jurisdiction in order to
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enforce the requirement that all Controversies be settled by arbitration, the
moving party, if its motion is successful, will be entitled to recover all of
its costs and expenses, including attorneys' fees, in connection with such
enforcement action.
12.5 Alternative Resolution. In the event that arbitration may not be legally
permitted hereunder or the parties mutually agree not to submit a dispute to
arbitration, any party may commence a civil action in a court of appropriate
jurisdiction to solve disputes hereunder. Nothing contained in this Article
shall prevent the parties from settling any dispute by mutual agreement at any
time.
12.6 Consent to Jurisdiction and Service of Process. Any legal action, suit or
proceeding arising out of or relating to this Agreement or the Contemplated
Transactions may be instituted only in any federal court or any state court
located either in Virginia or Pennsylvania.
Article 13 Notices.
13.1 Any notice or other communication required or permitted hereunder shall be
in writing and shall be delivered personally or by express courier or delivery
service, telegraphed, telexed, sent by facsimile transmission or sent by
certified, registered or express mail, postage prepaid. Any such notice shall
be deemed given when so delivered personally or by express courier or delivery
service, telegraphed, telexed or sent by facsimile transmission or, if mailed,
five (5) days after the date of deposit in the United States mails, as follows:
13.1.1 if to the Seller, to:
<TABLE>
<S> <C>
Steve Markel, Vice Chairman with a copy to:
Markel Corporation Gregory B. Nevers, Corporate Counsel
4551 Cox Road Markel Corporation
Glen Allen, Virginia 23060 4551 Cox Road
telephone 804.965.1675 Glen Allen, Virginia 23060
facsimile 804.527. 3810 telephone 804.965.1673
facsimile 804.527. 3810
</TABLE>
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Lincoln Insurance Company Stock Purchase Agreement
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13.1.2 if to the Buyer to:
<TABLE>
<S> <C>
Ron Austin, President with a copy to:
Caliber One Management Co. Frank McDonnell, Senior Vice President
380 Sentry Parkway PMA Reinsurance Corporation
Blue Bell, PA. 19422 The Mellon Bank Center
telephone 610.397.5091 1735 Market Street, Suite 2800
facsimile 610.397.5334 Philadelphia, PA 19103
telephone 215.665.5070
facsimile 215.665.5061
</TABLE>
13.2 Any party may by notice given in accordance with this Section to the other
parties designate another address or Person for receipt of notices hereunder.
Article 14. Interpretation
14.1 Entire Agreement. This Agreement (including the Exhibits and Schedules)
and any collateral agreements executed in connection with the consummation of
the Contemplated Transactions contain the entire agreement among the parties
with respect to the purchase of the Shares and supersede all prior agreements,
written or oral, with respect thereto; provided that the Confidentiality
Agreement between the Seller and Buyer dated June 2, 1997, shall survive the
execution and delivery hereof and the Closing.
14.2 Waivers and Amendments: Non-Contractual Remedies; Preservation of Remedies.
This Agreement may be amended, superseded, canceled, renewed or extended, and
the terms hereof may be waived, only by a written instrument signed by the Buyer
and the Seller or, in the case of a waiver, by the party waiving compliance.
14.3 Governing Law. This Agreement shall be governed and construed in
accordance with the laws of the Commonwealth of Pennsylvania applicable to
agreements made and to be performed entirely within such Commonwealth.
14.4 Binding Effect; No Third Party Beneficiary. This Agreement shall be
binding upon and inure to the benefit of the parties and their respective
successors, legal representatives and
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Permitted Assigns. For purposes of this section, "Permitted Assigns" shall mean
corporate affiliates of any party, or other parties specifically consented to by
the party not seeking assignment. Nothing expressed or implied in this Agreement
is intended or shall be construed to confer upon or give any Person other than
the Seller or the Buyer any rights or remedies under or by reason of this
Agreement or any of the Contemplated Transactions.
14.5 Variations in Pronouns. All pronouns and any variations thereof refer to
the masculine, feminine or neuter, singular or plural, as the context may
require.
14.6 Counterparts. This Agreement may be executed by the parties hereto in
separate counterparts, each of which when so executed and delivered shall be an
original, but all such counterparts shall together constitute one and the same
instrument. Each counterpart may consist of a number of copies hereof each
signed by less than all, but together signed by all of the parties hereto.
14.7 Exhibits and Schedules. The Exhibits and Schedules are a part of this
Agreement as if fully set forth herein. All references herein to Sections,
Exhibits and Schedules shall be deemed references to such parts of this
Agreement, unless the context shall otherwise require.
14.8 Headings. The headings in this Agreement are for reference only, and shall
not affect the interpretation of this Agreement.
14.9 Interpretation. The parties acknowledge and agree that: (i) each party and
its counsel reviewed and negotiated the terms and provisions of this Agreement
and have contributed to its revision, (ii) the rule of construction to the
effect that any ambiguities are resolved against the drafting party shall not be
employed in the interpretation of this Agreement; and (iii) the terms and
provisions of this Agreement shall be construed fairly as to all parties hereto,
regardless of which party was generally responsible for the preparation of this
Agreement.
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IN WITNESS WHEREOF, the parties hereto have duly executed and delivered
this Agreement as of the date first above written.
Markel Corporation
By: /s/ Steven A. Markel
--------------------------------
Title: Vice Chairman
PMA Reinsurance Corporation
By: /s/ Francis W. McDonnell
--------------------------------
Title: Senior Vice President,
Chief Financial Officer
and Treasurer
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<PAGE>
List of Schedules
Schedule 3.7 Schedule of Company Assets
Schedule 3.9 Schedule of Tax Return States
Schedule 3.11 Schedule of Insurance Licenses
Schedule 3.12 Schedule of Required Consents
Schedule 3.13 Schedule of Governmental Orders
Schedule 3.17 Schedule of Reinsurance Agreements
Schedule 3.23 Schedule of Company Operations
Schedule 4.3 Schedule of Buyer's Consents
Schedule 5.7 Essex Reinsurance Agreement
Schedule 6.4 Schedule of Affiliate Transactions.
Schedule 9.1 Schedule of Non-Competition insurance products
<PAGE>
Schedule 3.7
Permissible Assets
Cash
Treasury bills, bonds or other securities pledged or placed on deposit as part
of statutory deposit requirements.
Money market mutual funds
Other securities approved in writing by Buyer
Accrued interest and/or dividends on any of the foregoing.
<PAGE>
SCHEDULE 3.9
Taxes
States in which the Company files tax returns
CURRENTLY
STATE TYPE OF TAX AUDITED BEGIN AUDITED
- ----- ----------- ------- -------------
Delaware Privilege No No
Delaware Franchise No No
The Company is not required to make adjustments pursuant to Section 431 of the
Code
<PAGE>
Schedule 3.11
Insurance Licenses or Approvals
STATES WITH EXISTING SURPLUS LINES ELIGIBILITY
Alabama
Arizona
Arkansas
District of Columbia
Florida
Georgia
Hawaii
Idaho
Indiana
Iowa
Kansas
Kentucky
Massachusetts
Michigan
Minnesota
Mississippi
Missouri
Montana
Nebraska
North Dakota
Ohio
Oklahoma
Oregon
Pennsylvania
Puerto Rico
South Dakota
Tennessee
Utah
Virgin Islands
West Virginia
Wyoming
STATES WITH PENDING NEGOTIATIONS
South Carolina (cannot withdraw until
all business is runoff)
<PAGE>
STATES WE HAVE VOLUNTARILY WITHDRAWN FROM ELIGIBILITY
Alaska
California
Colorado
Connecticut (removed from eligibility list)
Illinois
Louisiana
Maryland (no renewal application in 1996)
New Jersey
New Mexico
New York
North Carolina
Texas
Virginia
Washington
Wisconsin (removed from eligibility list)
STATES IN WHICH LINCOLN WAS NOT ELIGIBLE TO WRITE
Maine
Nevada
New Hampshire
Rhode Island
Vermont
<PAGE>
Schedule 3.12
Required Consents
The Contemplated Transactions require the prior approval of the Delaware
Department of Insurance.
States in which the Company is listed as an approved surplus/excess lines
carrier may need to be informed of the Contemplated Transactions and any
preconditions met with respect to continued listing and/or eligibility.
An amendment to the Insurance Holding Company Registration Statement related to
the Company must be filed in Delaware and in any other state in which a
registration statement has been filed.
<PAGE>
Schedule 3.13
Outstanding Orders
NONE
<PAGE>
Schedule 3.17
Reinsurance
-----------
See attached
<PAGE>
Schedule 3.17
Attachment P.1
THE LINCOLN INSURANCE GROUP (including LIC and GIC)
CASUALTY X/S of LOSS TREATIES
TERM LAYER LG# BROKER/REF#
- --------------------------------------------------------------------------------
07/01/76 - 06/30/78 200,000 XS 50,000 3035
(PRORATED EXPENSES) 250,000 XS 250,000 3036
500,000 XS 500,000 3037
07/01/78 - 06/30/79 100,000 XS 50,000 3046
150,000 XS 150,000 3047
700,000 XS 300,000 3048
07/01/79 - 06/30/80 150,000 XS 150,000 3902
800,000 XS 300,000 3903
1,000,000 XS 1,100,000 3904
07/01/80 - 06/30/81 150,000 XS 150,000 4009
800,000 XS 300,000 4010
1,000,000 XS 1,100,000 4011 BEP INT'L 4035-1
07/01/81 - 09/30/82 400,000 XS 100,000 4107
500,000 XS 500,000 4108
07/01/81 - 06/30/82 4,000,000 XS 1,000,000 4109
10/01/82 - 09/30/83 350,000 XS 150,000 4122
500,000 XS 500,000 4123
07/01/82 - 06/30/83 4,000,000 XS 1,000,000 4119
10/01/83 - 09/30/84 350,000 XS 150,000 4129
500,000 XS 500,000 4130
07/01/83 - 06/30/84 2,000,000 XS 1,000,000 4128
10/01/84 - 09/30/85 350,000 XS 150,000 4132
500,000 XS 500,000 4133
07/01/84 - 09/30/85 2,000,000 XS 1,000,000 4134
10/01/85 - 09/30/86 350,000 XS 150,000 4135
500,000 XS 500,000 4136 80%
1,000,000 XS 1,000,000 4137 TPF&C P85-19512
10/01/86 - 09/30/87 350,000 XS 150,000 5135 TPF&C P86-19601
500,000 XS 500,000 5136 TPF&C P86-19682
1,000,000 XS 1,000,000 5137 TPF&C P86-19512
10/01/87 - 09/30/88 350,000 XS 150,000 5145 TPF&C P87-19681
500,000 XS 500,000 5146 TPF&C P87-19682
2,000,000 XS 1,000,000 5147 TPF&C P87-19512
10/01/88 - 09/30/89 250,000 XS 150,000 5155 TPF&C P88-19681
600,000 XS 400,000 5156 TPF&C P88-19682
2,000,000 XS 1,000,000 5157 TPF&C P88-19512
10/01/89 - 09/30/90 250,000 XS 150,000 5165 TPF&C P89-19681
600,000 XS 400,000 5166 TPF&C P89-19682
1,000,000 XS 1,000,000 5167 TPF&C P89-19512
1,000,000 XS 2,000,000 5168 TPF&C P89-20081
<PAGE>
Schedule 3.17
Attachment P.2
THE LINCOLN INSURANCE GROUP (including LIC and GIC)
CASUALTY X/S of LOSS TREATIES
TERM LAYER LG# BROKER/REF#
- --------------------------------------------------------------------------------
10/01/90 - 09/30/91 100,000 XS 150,000 5175 TPF&C G90-19681
750,000 XS 250,000 5176 TPF&C G90-19682
1,000,000 XS 1,000,000 5177 TPF&C G90-19512
1,000,000 XS 2,000,000 5178 TPF&C G90-20081
10/01/91 - 09/30/92 100,000 XS 150,000 5185 TPF&C G91-19681
750,000 XS 250,000 5186 TPF&C G91-19682
1,000,000 XS 1,000,000 5187 TPF&C G91-19512
1,000,000 XS 2,000,000 5188 TPF&C G91-20081
10/01/92 - 09/30/93 750,000 XS 250,000 5196 TPF&C G92-19682
1,000,000 XS 1,000,000 5197 TPF&C G92-19512
1,000,000 XS 2,000,000 5198 TPF&C G92-20081
10/01/93 - 09/30/94 750,000 XS 250,000 6106 TPR G93-19682
1,000,000 XS 1,000,000 6107 TPR G93-19512
1,000,000 XS 2,000,000 6108 TPR G93-20001
THE LINCOLN INSURANCE GROUP (including LIC and GIC)
PROPERTY X/S of LOSS TREATIES
TERM LAYER LG# BROKER/REF#
- --------------------------------------------------------------------------------
07/01/85 - 06/30/86 300,000 XS 200,000 5101
07/01/86 - 09/30/87 750,000 XS 250,000 5111 TPF&C P86-19655
10/01/87 - 09/30/88 750,000 XS 250,000 5121 TPF&C P87-19655
10/01/88 - 09/30/89 400,000 XS 100,000 5131 TPF&C P88-19655
10/01/89 - 10/31/89 400,000 XS 100,000 5141A TPF&C P89-19655
11/01/89 - 09/30/90 450,000 XS 50,000 5141B TPF&C P89-19655
10/01/90 - 09/30/91 450,000 XS 50,000 5151 TPF&C G90-19655
10/01/91 - 09/30/92 400,000 XS 100,000 5161 TPF&C G91-19655
10/01/92 - 09/30/93 400,000 XS 100,000 5171 TPF&C G92-19655
10/01/93 - 09/30/94 400,000 XS 100,000 5181 TPR G93-19655
<PAGE>
Schedule 3.17
Attachment P.3
THE LINCOLN INSURANCE GROUP (including LIC and GIC)
- ---------------------------
QUOTA SHARE REINSURANCE:
- ------------------------
TERM QUOTA SHARE % LG# BROKER
---- ------------- --- ------
CASUALTY:
- ---------
10/1/82 - 9/30/83 35% 4121 PNI
10/1/83 - 9/30/84 36% 4121-1 PNI
PROPERTY:
- ---------
7/1/85 - 6/30/86 50% 5104 N/A
7/1/86 - 6/30/87 50% 5115 N/A
7/1/87 - 6/30/88 50% 5125 N/A
OTHER REINSURANCE AGREEMENTS:
- -----------------------------
TERM LAYER LG# BROKER
---- ----- --- ------
SPORTS LEISURE:
- ---------------
1980 900,000 XS 100,000 4004 EWB
1980 2,000,000 XS 1,000,000 4005 EWB
1981 400,000 XS 100,000 4015 EWB
1981 500,000 XS 500,000 4016 EWB
1981 4,000,000 XS 1,000,000 4017 EWB
<PAGE>
Schedule 3.17
Attachment P.4
Term Layer LG # Broker/Ref #
---- -----
Casualty
--------
10/1/94-9/30/95 750,000 XS 250,000 6109 TPR, G-19682-94
10/1/94-9/30/95 1,000,000 XS 1,000,000 6110 TPR, G-19512-94
10/1/94-9/30/95 1,000,000 XS 2,000,000 6110 TPR, G-20081-94
10/1/94-9/30/95 2,000,000 XS 3,000,000 6112 TPR, G-20070-94
Property XS of Loss
- -------------------
10/1/94-9/30/95 400,000 XS 100,000 5191 TPR, G-19655-94
Catastrophe Treaties
- --------------------
10/1/94-9/30/95 95% of
600,000 XS 400,000 5192 TPR, G-19656-94
10/1/94-9/30/95 95% of
1,000,000 XS 1,000,000 5193 TPR, G-19657-94
10/1/94-9/30/95 95% of
2,000,000 XS 2,000,000 5194 TPR, G-19658-94
These treaties were extended through 9/30/96.
<PAGE>
Schedule 3.23
Operations of the Company
NONE
<PAGE>
Schedule 4.3
Schedule of Buyer's Consents
None, other than as described in Schedule 3.12
<PAGE>
Schedule 5.7
Essex Reinsurance Agreement
See attached, labeled Exhibit B
<PAGE>
EXHIBIT B
REINSURANCE AGREEMENT
---------------------
THIS REINSURANCE AGREEMENT is made and entered into by and between
LINCOLN INSURANCE COMPANY, a Delaware insurance company (the "Ceding Company"),
and ESSEX INSURANCE COMPANY, a Delaware insurance company (the "Reinsurer").
WITNESSETH:
-----------
WHEREAS, the Ceding Company issues, amends and cancels binders,
certificates, cover notes, policies and endorsements of certain kinds of
property and casualty insurance;
WHEREAS, except as otherwise provided herein, the Ceding Company
desires to reinsure its remaining unexpired liability under direct and assumed
insurance business previously produced, underwritten and issued by the Ceding
Company;
WHEREAS, except as otherwise provided herein, the Ceding Company is
willing to cede, and the Reinsurer is willing to accept as liability
reinsurance, the Ceding Company's Ultimate Net Loss on all binders,
certificates, cover notes, policies and endorsements of direct and assumed
insurance produced, underwritten and issued by the Ceding Company.
NOW, THEREFORE, in consideration of the premises, the reinsurance
premium and the mutual covenants and promises hereinafter contained, and for
other good and valuable consideration, the receipt and sufficiency of which is
hereby acknowledged, the Ceding Company and the Reinsurer agree as follows:
ARTICLE I
---------
LIABILITY REINSURANCE:
- ---------------------
1. The Ceding Company hereby cedes, and the Reinsurer hereby accepts,
as liability reinsurance, 100% of the Ceding Company's Ultimate Net Loss
(hereinafter defined) under all Policies issued by the Ceding Company prior to
the effective date of this Agreement up to an aggregate limit (the "Reinsurance
Limit") in an amount equal to (i) the Ceding Company's reserves for losses and
loss adjustment expenses as recorded on page 3, lines 1 and 2 of the Ceding
Company's statutory report for the quarter ended September 30, 1997 filed with
the Delaware Department of Insurance, less $1.1 million representing the
unallocated loss adjustment expense reserve (the "Ceded Reserves"), plus (ii)
$68.5 million.
2. For purposes of this Agreement, the term "Policies" means all
policies of direct or assumed insurance, binders, certificates, cover notes, and
endorsements underwritten, issued or produced by the Ceding Company prior to the
effective date of this Agreement giving rise to liabilities reinsured by the
Reinsurer hereunder.
<PAGE>
3. The Reinsurer's obligations hereunder are subject to any and all
available defenses, claims and actions against or arising under the terms of the
Policies.
ARTICLE II
----------
ULTIMATE NET LOSS
- -----------------
1. The Ultimate Net Loss of the Ceding Company means the sum of (i)
all Losses (hereinafter defined) and (ii) all Allocated Loss Adjustment Expenses
(hereinafter defined).
(a) "Loss" or "Losses" shall mean any amount or amounts incurred in
respect of any settlements, awards or judgments (including interest where
classified as loss), including any compensatory or punitive damages or fines
incurred or arising out of claims under the Policies, after deduction for all
reinsurance recoveries, salvage and subrogation actually recovered; provided
however, that there shall be no deduction for any reinsurance placed by the
Ceding Company after the date of this Agreement for its own account.
(b) "Allocated Loss Adjustment Expense" or "ALAE" shall mean all costs
and expenses allocable to a specific claim that are incurred in the
investigation, appraisal, adjustment, settlement, litigation, defenses or appeal
of a specific claim, including court costs and costs of supersedeas and appeal
bonds, and including (i) pre-judgment interest, unless included as part of the
award or judgment; (ii) post-judgment interest, (iii) legal expenses and costs
incurred in connection with coverage questions and legal actions connected
thereto; and (iv) supervisory expenses and all other loss adjustment expenses.
2. In no event will the Reinsurer's total obligation to the Ceding
Company exceed the lesser of amounts actually paid by the Reinsurer on behalf of
the Ceding Company to fulfill the Ceding Company's obligations under the
Policies or the Reinsurance Limit.
3. Ultimate Net Loss shall not include any unpaid or uncollectible
reinsurance balances due from PMA Reinsurance Corporation, any other affiliate
or member of the PMA Group and/or their predecessors, successors or assigns.
ARTICLE III
-----------
EFFECTIVE DATE OF REINSURANCE:
- -----------------------------
The Effective Date of Reinsurance, as that term is used herein, shall be
___________________.
-2-
<PAGE>
ARTICLE IV
----------
DURATION OF AGREEMENT:
- ---------------------
This Agreement shall not be terminated except as follows:
1. By written agreement of the Ceding Company and the Reinsurer on the
date indicated in such agreement;
2. upon the expiration of all liability on the Policies and the
complete performance by the Ceding Company and the Reinsurer of all obligations
and duties arising under this Agreement;
3. upon the payment by the Reinsurer of the Reinsurance Limit.
ARTICLE V
---------
ADMINISTRATION, LOSSES AND LOSS SETTLEMENTS:
- -------------------------------------------
1. From and after the Effective Date of Reinsurance and until this
Agreement is terminated as provided in Article IV, the Reinsurer shall be solely
responsible for the administration of all aspects of the Policies, including but
not limited to the billing and collection of premiums and the collection of
reinsurance recoverables, if any, and any other amounts due under the Policies,
and the defense, adjustment, settlement and payment of all claims and losses
arising under or in connection with the Policies, all at the Reinsurer's sole
expense and discretion. In the event that the Agreement is so terminated (or in
the event that the Reinsurer becomes insolvent or becomes similarly unable to
meet its financial obligations hereunder), the Reinsurer shall cease being
responsible for the administration of the policies, and all claims and
underwriting files, and any other documents relating to such administration
shall be promptly transferred to the Ceding Company, with the expense of any
such file transfer to be equally divided between the parties.
2. The Reinsurer may, in its sole discretion and without any notice to
the Ceding Company, delegate all or part of it's administrative duties and
obligations relating to the Policies to any entity designated by Reinsurer to
act in its place, and the Ceding Company hereby consents to such delegation,
subject to such entity's holding any required license, certificate or approval
to act in such capacity.
3. The Reinsurer shall pay all Losses and ALAE payable under the
Policies directly to claimants and shall not expect or be entitled to await the
prior payment of such amounts by the Ceding Company.
-3-
<PAGE>
ARTICLE VI
----------
COOPERATION AMONG PARTIES:
- -------------------------
1. The parties hereto agree to act in good faith and cooperate with
each other in effecting the cession and reinsurance of liabilities provided for
in this Agreement. The parties shall take all actions necessary to assist each
other in responding to requests for information by any insurance regulatory
authorities asserting jurisdiction over the transactions herein described.
2. Whenever the Ceding Company receives any premiums, other payments,
communications or documents, including notices of claims, proofs of loss,
actions, summons and complaints and other information pertaining to the
Policies, the Reinsurance Agreements (as defined in Article VIII (3) herein) and
the liabilities ceded and reinsured hereunder, the Ceding Company will forward
such premiums, payments, communications, documents and information promptly to
the Reinsurer, its successors or assigns, or the designees thereof. The Ceding
Company shall execute and deliver promptly any and all additional powers of
attorney, assignments, instruments and documents reasonably requested by the
Reinsurer which are necessary for the performance by the Reinsurer of its
obligations hereunder.
ARTICLE VII
-----------
REINSURANCE PREMIUM:
- --------------------
1. As Reinsurance Premium, and in consideration of the Reinsurer's
agreement to reinsure the Ceding Company's liability under the Policies, the
Ceding Company shall transfer to the Reinsurer on or prior to the Effective Date
of Reinsurance all of Ceding Company's net assets except for cash, cash
equivalents, accrued but unpaid interest or dividends and assets subject to
statutory deposits in an amount equal to the Ceding Company's Statutory Capital
and Surplus.
2. "Statutory Capital and Surplus" of the Ceding Company means the
aggregate amount of capital and surplus of the Company for a period ending on
the date of execution of this Agreement, as would be shown on page 3, line 25 of
the Company's annual statement, prepared in accordance with the Law for filing
with the Delaware Department of Insurance in accordance with Statutory
Accounting Principles, consistently applied with the principles applied to the
preparation of the financial statement of the Ceding Company.
-4-
<PAGE>
ARTICLE VIII
------------
TRANSFER, ASSIGNMENT AND VESTING OF CERTAIN RIGHTS:
- --------------------------------------------------
1. The Ceding Company and the Reinsurer hereby acknowledge that other
reinsurers have previously reinsured certain liabilities of the Ceding Company
under the Policies pursuant to one or more Reinsurance Agreements. The risks
ceded under the Reinsurance Agreements have not completely expired as the
reinsurers under such Reinsurance Agreements are still obligated on such
unexpired risks. It is understood and agreed that as of the Effective Date of
Reinsurance, the Ceding Company hereby assigns to the Reinsurer, and the
Reinsurer shall be vested with, all rights the Ceding Company may have now or in
the future under such Reinsurance Agreements, including the right to receive and
benefit from (a) any reinsurance recoverables, ceding commissions or other
consideration or compensation due or to become due to the Ceding Company as
ceding company under the Reinsurance Agreements, and (b) any letters of credit,
trust accounts or other accounts, funds held by or deposited with the Ceding
Company, or any other security established for the protection and benefit of the
Ceding Company in connection with the Reinsurance Agreements as the same may be
adjusted from time to time (collectively referred to herein as the
"Collateral"). It is expressly acknowledged and agreed that Reinsurer's
obligations under Article I are conditioned upon Reinsurer receiving the legal
rights and benefits contemplated by this Article VIII.
2. In addition to the Reinsurance Premium, the Ceding Company shall
transfer and assign to the Reinsurer all rights the Ceding Company may have now
or in the future under the Policies including, without limitations, all gross
premiums, premium adjustments and any other consideration due or to become due
the Ceding Company under the Policies. The Reinsurer shall be obligated to
perform and hereby assumes any and all obligations and duties of the Ceding
Company as ceding company under the Reinsurance Agreements.
3. For purposes of this Agreement, "Reinsurance Agreements" shall mean
all reinsurance agreements which were arranged by the Ceding Company prior to
the effective date of this Agreement and which have been entered into by and
between the Ceding Company on the one hand and those reinsurers providing for
the reinsurance of liabilities arising under the Policies, and all placement
slips and binding agreements related thereto.
4. In order to further evidence the transfer and assignment to the
Reinsurer of the Ceding Company's rights under the Policies, the Reinsurance
Agreements and the Collateral, the Ceding Company shall execute the Assignment
of Rights attached hereto as Exhibit "A' concurrently with the execution of this
Agreement. The Ceding Company shall execute such additional instruments,
acknowledgments and documents as may be reasonably necessary to more completely
evidence such transfer and assignment and the vesting of rights in the Reinsurer
contemplated thereby, including, without limitation, instruments,
acknowledgments, documents and other communications to reinsurers under the
Reinsurance Agreements and to banks and other financial institutions which have
issued letters of credit, or are holding funds or other collateral security, in
connection with
-5-
<PAGE>
the Reinsurance Agreements. The parties acknowledge and agree that the amount of
Collateral may change over time and that the Ceding Company shall assign to the
Reinsurer all of the Ceding Company's right and interest in the full amount of
said Collateral, as the same may be adjusted from time to time.
5. It is expressly understood and agreed that the assignment of rights
contemplated by this Article is conditioned upon the Reinsurer meeting its
direct claims payment obligations hereunder. In the event that the Reinsurer
fails to meet such obligations, or in the event this Agreement is terminated as
provided herein, all remaining rights transferred to Reinsurer under this
Article shall immediately revert to the Ceding Company, and the Assignment of
Rights and the appointment of the Reinsurer as the Ceding Company's
Attorney-In-Fact provided for in Article XII shall be void and of no further
force or effect.
ARTICLE IX
----------
NO CEDING COMMISSION:
- --------------------
No ceding commission shall be payable to the Ceding Company by the
Reinsurer for the cession provided under this Agreement.
ARTICLE X
---------
REPORTS:
- -------
Within sixty (60) days after the end of each calendar quarter, the
Reinsurer shall furnish the Ceding Company with a quarterly summary loss report
relating to the Policies in a form mutually agreed upon. The Reinsurer shall
also furnish to the Ceding Company such information and details regarding the
Policies as may be necessary for the Ceding Company to prepare its statutory
financial statements and to comply with the requirements of the regulatory
authorities having jurisdiction over the Ceding Company.
The reporting obligations of the Reinsurer under this Article X shall exist
for as long as the Ceding Company is a valid and existing insurer required to
provide statutory financial statements and other information to regulatory
authorities having jurisdiction over the Ceding Company.
-6-
<PAGE>
ARTICLE XI
----------
RECORDS AND INSPECTION:
The Ceding Company shall deliver to the Reinsurer (or its delegatee)
copies of such documents, records, papers or information as the Reinsurer may
reasonably request which are necessary for the Reinsurer's performance of its
obligations under the terms of this Agreement. Without limiting the generality
of the foregoing, the Ceding Company hereby authorizes the Reinsurer (or its
delegatee) to retain possession of all documents, records, papers or information
relating to the Policies during the term of this Agreement. Each party shall
place at the disposal of the other party during normal business hours, and the
other party shall have the right to inspect, through its duly authorized
representatives, and make copies of all books, records, and papers pertaining to
any matter under this Agreement or any claims or losses incurred under the
Policies.
ARTICLE XII
-----------
APPOINTED ATTORNEY-IN-FACT:
In order to more fully evidence the Reinsurer's right to (a) service
and administer any and all aspects of the Policies; (b) exercise any and all
rights of the Ceding Company under the Reinsurance Agreements (including,
without limitation, the collection of reinsurance recoverables and ceding
commissions and the negotiation, compromise, settlement, arbitration, litigation
or commutation of any claims or liabilities arising thereunder); and (c)
exercise any and all rights of the Ceding Company with respect to the
Collateral, the Ceding Company shall execute the Power of Attorney attached
hereto as Exhibit "B" concurrently with the execution of this Agreement. The
Reinsurer as Attorney-In-Fact under such Power of Attorney shall indemnify and
hold the Ceding Company harmless from and against any act, error or omission of
the Reinsurer in its exercise of authority under such Power of Attorney.
ARTICLE XIII
------------
INSOLVENCY OF CEDING COMPANY:
In the event of the Ceding Company's insolvency, the reinsurance under
this Agreement shall be payable by the Reinsurer, without diminution because of
the Ceding Company's insolvency, to the Ceding Company or its liquidator,
receiver, conservator or statutory successor. It is agreed that the liquidator,
receiver or statutory successor of the Ceding Company will give written notice
to the Reinsurer of the pending of a claim against the Ceding Company covered
under this Agreement within a reasonable time after such claim is filed in the
insolvency proceeding and that during the pendency of such claim, the Reinsurer
may investigate such claim and interpose, at its own expense, in the proceeding
where such claim is to be adjudicated any defense or defenses which it may deem
-7-
<PAGE>
available to the Ceding Company or its liquidator, receiver or statutory
successor. The expense thus incurred by the Reinsurer shall be chargeable,
subject to court approval, against the Ceding Company as a part of the expense
of liquidation to the extent of a proportionate share of the benefits which may
accrue to the Ceding Company solely as a result of the defense undertaken by the
Reinsurer.
ARTICLE XIV
-----------
ERRORS AND OMISSIONS:
- --------------------
Inadvertent delays, errors or omissions by either the Ceding Company
or the Reinsurer made in connection with this Agreement or any transactions
hereunder whether in respect to cessions, or claims, or otherwise, shall not
relieve either party from any liability which would have attached had such
delay, error or omission not occurred, provided always that such error or
omission be rectified as soon as possible after discovery.
ARTICLE XV
----------
REINSURER'S REPRESENTATIONS AND WARRANTIES:
- ------------------------------------------
The Reinsurer represents and warrants to the Ceding Company that as of
both the Effective Date of Reinsurance and the date of execution of this
Agreement:
1. The Reinsurer is duly organized and validly existing in the State
of Delaware and authorized and empowered under its Articles of
Incorporation, its By-Laws and the laws of the State of Delaware to
enter into and perform this Agreement.
2. The Reinsurer is an approved or authorized insurer in good standing
in the State of Delaware.
3. This Agreement constitutes an obligation binding on the Reinsurer.
ARTICLE XVI
-----------
CEDING COMPANY'S REPRESENTATION AND WARRANTIES:
The Ceding Company represents and warrants to the Reinsurer that as of
both the Effective Date of Reinsurance and the date of execution of this
Agreement:
1. The Ceding Company is duly organized and validly existing in the
State of Delaware and authorized and empowered under its Articles
of Incorporation, its By-Laws and the laws of the State of Delaware
to enter into and perform this Agreement.
-8-
<PAGE>
2. The execution and performance of the Agreement by the Ceding
Company is subject to approval by the Delaware Commissioner of
Insurance but, to the best of the Ceding Company's knowledge, not
by the insurance regulatory official of any other state.
3. This Agreement constitutes an obligation binding on the Ceding
Company.
ARTICLE XVII
------------
INDEMNIFICATION:
- ---------------
The Ceding Company and Reinsurer agree to hold each other harmless
from, and indemnify each other against, any and all claims, losses, expenses,
including reasonable attorney's fees, causes of action and judgments incurred by
the other as a result of their own (or that of any agents acting on their
behalf) gross negligence or wilful misconduct in the performance of the
respective obligations under this Agreement, the Assignment of Rights Agreement,
or the Power of Attorney.
ARTICLE XVIII
-------------
DISPUTE RESOLUTION:
- ------------------
1. Arbitration; selection of panel. As a condition precedent to any
right of action hereunder, any and all disputes or disagreements arising between
the parties pertaining to or relating in any manner to this Agreement (any
"Controversy")--which shall include but not limited to any disputes or
disagreements as to the meaning or interpretation of this Agreement or any
portion thereof or the relationship of the parties created under this Agreement
or any breach of this Agreement, upon which an amicable understanding cannot be
reached--shall be submitted to arbitration in the location of the party not
seeking to arbitrate (i.e., Philadelphia, Pennsylvania in the case of the Ceding
Company, and Richmond, Virginia in the case of the Reinsurer). One arbiter shall
be chosen by the Ceding Company, the other by the Reinsurer, and an umpire shall
be chosen by the two arbiters before they enter upon arbitration, all of whom
shall be active or retired disinterested executive officers of insurance or
reinsurance companies. In the event that either party should fail to choose an
arbiter within thirty (30) days following a written request to do so, the
requesting party may choose two arbiters who shall in turn choose an umpire
before entering upon arbitration. If the two arbiters fail to agree upon the
selection of an umpire within thirty (30) days following their appointment, each
arbiter shall name three nominees, of whom the other party shall decline two,
and the decision between the remaining two nominees shall be made by drawing
lots.
2. Arbitration; proceedings and award. Each party shall present its
case to the arbiters and the umpire within thirty (30) days following the date
of appointment of the umpire. The arbiters shall consider this Agreement as an
honorable engagement rather
-9-
<PAGE>
than merely as a legal obligation and they are relieved of all judicial
formalities and may abstain from following the strict rules of law; however,
there shall be no ex parte contacts between either party and any arbiter or the
umpire, and cross examination and rebuttal should be allowed if requested by
either party. The decision of the arbiters shall be in writing giving the
reasons for the award and shall be final and binding on both parties, but,
failing to agree, they shall call in the umpire and the decision of the majority
shall be final and binding upon both parties, except that an appeal may be taken
from such decision as provided in the Federal Arbitration Act.
3. Arbitration; expenses. Each party shall bear the expense of its own
arbiter, and shall jointly and equally bear with the other the expense of the
umpire and of the arbitration. In the event that the two arbiters are chosen by
one party, as above provided, the expense of the arbiters, the umpire and the
arbitration shall be equally divided between the two parties. Provided, however,
that, if in the opinion of the arbiters, any claim hereunder or any defense or
objection thereto was unreasonable, the arbiters may assess, as part of the
award, all or any part of the expenses of the arbitration against the party
raising such unreasonable claim, defense or objections.
4. Specific Enforcement. This Agreement to arbitrate shall be
specifically enforceable. Should any party to this Agreement be required to seek
relief from a court of competent jurisdiction in order to enforce the
requirement that all Controversies be settled by arbitration, the moving party,
if its motion is successful, will be entitled to recover all of its costs and
expenses, including reasonable attorneys' fees, in connection with such
enforcement action.
5. Alternative Resolution. In the event that arbitration may not be
legally permitted hereunder or the parties mutually agree not to submit a
dispute to arbitration, any party may commence a civil action in a court of
competent jurisdiction to solve disputes hereunder. Nothing contained in this
Article shall prevent the parties from settling any dispute by mutual agreement
at any time.
ARTICLE XIX
-----------
MISCELLANEOUS:
- -------------
1. The Ceding Company hereby covenants and agrees that it will not
pledge, encumber, mortgage, hypothecate, transfer, deliver or assign any rights
under the Policies, the Reinsurance Agreements or Collateral except for the
assignment to the Reinsurer contemplated by this Agreement.
2. This Agreement and all exhibits hereto constitute the entire
contract between the parties relating to the subject matter hereof and may, by
mutual consent be altered in any of its terms and conditions only by a signed
addendum hereto or thereto.
-10-
<PAGE>
3. All representations and warranties of the Reinsurer and the Ceding
Company set forth in Articles XV and XVI of this Agreement shall expire as of
the Effective date of Reinsurance.
4. This Agreement shall be governed by the laws of the State of
Delaware.
5. This Agreement and all exhibits hereto may be executed in multiple
counterparts, each of which shall be an original.
6. This Agreement and exhibits hereto shall inure to the benefit of
and bind the Ceding Company and the Reinsurer and their respective successors
and assigns whether by acquisition, merger or otherwise.
IN WITNESS WHEREOF, the parties hereto have caused this Agreement to
be duly executed by their respective corporate officers on the ___ day of ___,
199__.
Attest: LINCOLN INSURANCE COMPANY
- --------------------------------- By:
-------------------------------------
Its:
------------------------------------
Attest: ESSEX INSURANCE COMPANY
- --------------------------------- By:
-------------------------------------
Its:
------------------------------------
-11-
<PAGE>
EXHIBIT "A"
ASSIGNMENT AND TRANSFER OF RIGHTS
BY
LINCOLN INSURANCE COMPANY
TO
ESSEX INSURANCE COMPANY
MADE IN CONNECTION WITH THE REINSURANCE AGREEMENT
BETWEEN
LINCOLN INSURANCE COMPANY
("Ceding Company")
AND
ESSEX INSURANCE COMPANY
("Reinsurer")
Effective
------------------------------
In accordance with the provisions of the Agreement between the Ceding
Company and the Reinsurer effective _____________________, (hereinafter the
"Essex Cover") and for value received, the Ceding Company hereby assigns,
grants, transfers, sells, conveys and sets over to the Reinsurer, and its
successors and assigns all of the Ceding Company's right, title and interest in
the assets, accounts, rights and property interests listed below. Terms
capitalized but not defined herein shall have the meanings ascribed to them in
the Essex Cover.
1. All of the gross premiums, premium adjustments, commissions
and other consideration of any kind which is now due or is to
become due the Ceding Company on the Policies from the Ceding
Company's insureds, claimants, brokers, agents or others under
or in connection with any and all the Policies.
2. All of the payments, reinsurance recoverables, ceding
commissions, and any other consideration of any kind which is
now due or is to become due the Ceding Company under the
Reinsurance Agreements from the Ceding Company's reinsurers,
retrocessionaires and others under or in connection with any
and all the Reinsurance Agreements.
3. Any and all other rights of the Ceding Company under the
Reinsurance Agreements, including but not limited to any right
to defend, negotiate, compromise, settle, litigate, arbitrate
or commute any liabilities or obligations arising under the
Reinsurance Agreements and to receive reports regarding the
Collateral.
4. All of the rights and interests of the Ceding Company with
respect to the Collateral, including but not limited to any
and all rights to draw on letters of credit, to receive and
use payments under letters of credit or from trust or other
accounts, to obtain possession of and use funds
<PAGE>
held by or deposited with the Ceding Company or to obtain
possession of and use any other funds, money, security or other
asset or interest established from the protection or benefit of
the Ceding Company in connection with the Reinsurance Agreements
and any and all rights to obtain possession of and use or dispose
of the Collateral.
The Ceding Company hereby authorizes the Reinsurer, at the cost of the
Reinsurer, in the name of the Ceding Company or otherwise, (a) to ask, demand,
collect, receive and furnish receipts for such consideration or any part thereof
due or become due on or in connection with the Policies and the Reinsurance
Agreements; (b) to ask, demand, collect, receive or furnish any information or
perform any lawful acts in connection with the Policies, the Reinsurance
Agreements and any Collateral established in connection with the Reinsurance
Agreements; or (c) to settle or discontinue any proceedings pertaining to the
Policies, the Reinsurance Agreements or otherwise involving the subject matter
of this assignment. The Ceding Company further agrees that if any payment or
other consideration is received by the Ceding Company which is to be credited on
or attributable to any of the Policies, the Reinsurance Agreements or
Collateral, the Ceding Company will immediately endorse and deliver to the
Reinsurer such checks, drafts, money or other consideration, and that until
delivery of such items to the Reinsurer, the Ceding Company shall treat any such
checks, drafts, money or other consideration as the property of the Reinsurer
held in trust for the Reinsurer. The Reinsurer shall be liable for any remaining
or unexpired obligations of the Ceding Company, if any, under the Reinsurance
Agreements.
The Ceding Company agrees to execute and deliver to the Reinsurer any
further instruments or assurances that the Reinsurer may reasonably request for
the more effectual perfecting of the Reinsurer's interests in any of the
foregoing assets, property rights or interest herein assigned.
IN WITNESS WHEREOF, Lincoln Insurance Company and Essex Insurance
Company have executed this instrument effective as of the ______ day of
____________________, 19____.
Attest: LINCOLN INSURANCE COMPANY
- -----------------------------------
By:
----------------------------------
Its:
---------------------------------
ESSEX INSURANCE COMPANY
By:
----------------------------------
Attest: Its:
---------------------------------
- ---------------------------------
<PAGE>
EXHIBIT "B"
POWER OF ATTORNEY
County of ___________ )
State of_____________ )
KNOW ALL MEN BY THESE PRESENTS, that Lincoln Insurance Company, a
Delaware insurance company ("Lincoln"), does hereby irrevocably make, constitute
and appoint Essex Insurance Company, a Delaware insurance company ("Essex") or
any entity designated by Essex to act in its place, as its true and lawful
attorney-in-fact for it and in its name, place and stead for the following
purposes:
To do all lawful acts as said Attorney-In-Fact may deem desirable,
appropriate or necessary in connection with, arising out of or relating in any
way to any and all policies issued by Lincoln and defined as the Policies in the
Essex Cover dated ____________________________ by and between Lincoln and Essex,
including without limitation amending, modifying, endorsing, canceling and
non-renewing any or all of the Policies.
To assess, invoice, collect, refund, sue for, receive and do any and
all other lawful acts relating to any payments, premiums, premium adjustments,
monies or other consideration of any kind due or to become due at any time under
the Policies and to endorse in Lincoln's name any check, draft and other form of
payment made in connection with the Policies and to commence, defend, settle
and/or compromise any litigation or arbitration proceeding, with respect to such
payments, premiums, premium adjustments, monies or other consideration of any
kind, all as said Attorney-In-Fact may deem desirable, appropriate or necessary.
To service, administer and perform all functions in connection with
the Policies and to fully handle all claims matters arising under the Policies,
including without limitation, determining liability and the amount thereof,
compromising, settling, paying and defending all claims or suits, all as said
Attorney-In-Fact may deem desirable, appropriate or necessary.
To assess, invoice, collect, refund, sue for, receive and do any and
all other lawful acts relating to any payments, recoverables, ceding
commissions, monies or other consideration of any kind due or becoming due under
the Reinsurance Agreements, as that term is defined in the Essex Cover, to
endorse in Lincoln's name any check, draft and other form of payment made in
connection with the Reinsurance Agreements and to commence, defend, settle
and/or compromise any litigation or arbitration proceeding with respect to such
payments, recoverables, ceding commissions, monies or other
1
<PAGE>
consideration of any kind due or becoming due under the Reinsurance Agreements,
all as said Attorney-In-Fact may deem desirable, appropriate or necessary.
To exercise, enforce, waive or abandon any and all rights of Lincoln
under the Reinsurance Agreements including, without limitation, the rights to
negotiate, compromise, settle, arbitrate, litigate or commute any claims or
liabilities arising under the Reinsurance Agreements and the right to exercise,
enforce, waive or abandon any and all rights of Lincoln to letters of credit,
amounts held in trust accounts or other accounts, or any other assets,
collateral or security established for the protection and benefit of Lincoln in
connection with the Reinsurance Agreements.
To exercise, enforce, waive, settle and abandon any and all claims and
rights of subrogation and contribution under or with respect to any of the
Policies or Reinsurance Agreements and to commence, defend, settle and
compromise any litigation and arbitration proceeding and do any and all other
lawful acts in any way relating to any claims and rights of subrogation and
contribution under or arising out of or with respect to the Policies or
Reinsurance Agreements.
In connection with any power, right or authority provided for herein,
engage the services of and discharge any counsel, experts and others, and, in
case of any litigation or arbitration, to accept service of process and papers,
and to take any and all appeals therefrom, all as said Attorney-In-Fact may deem
desirable, appropriate or necessary.
To do any and all other lawful acts with respect to the Policies or
Reinsurance Agreements which Lincoln has or had the right to do, it being the
intention that said Attorney-In-Fact shall have the broadest possible power and
authority to make all decisions and do all lawful acts as said Attorney-In-Fact
in its sole discretion may deem desirable, appropriate or necessary in
connection with any of the Policies or Reinsurance Agreements.
That said Attorney-in-Fact shall have full power of substitution and
full power to appoint and discharge any subagent or subagents without any
consent or approval of Lincoln or any of its successors or assigns with respect
to the Attorney-In-Fact's authority hereunder. The said Attorney-In-Fact is
assignee of all of the Lincoln's rights and interest in the Policies and
Reinsurance Agreements, and, therefore, it is agreed that this Power of Attorney
is coupled with an interest and irrevocable. This Power of Attorney shall
survive any dissolution, liquidation, merger or consolidation of Lincoln and
shall be binding upon all successors and assigns of Lincoln, each of which
together with Lincoln hereby forever waives any and all rights to revoke this
Power of Attorney or any of the powers conferred upon said Attorney-In-Fact
hereby or to appoint any other person to execute the said power and also waives
and renounces all rights to do any of the lawful acts which the said
Attorney-In-Fact is authorized to perform by this Power of Attorney.
This Power of Attorney shall remain in full force and effect for such
period of time as said Attorney-In-Fact may, in its sole discretion, deem
desirable, appropriate or
2
<PAGE>
necessary to do any and all acts, in connection with any such Policies or
Reinsurance Agreements, and may be terminated only upon written notice of
termination given by said Attorney-In-Fact to Lincoln or its successors or
assigns. Notwithstanding any provision to the contrary, this Power of Attorney
shall terminate automatically upon termination of the Essex Cover.
Effective as of _____________, 19__
Attest: LINCOLN INSURANCE COMPANY
By:
- ------------------------------ ----------------------------------
Secretary (or Assistant Secretary)
Its:
---------------------------------
State of Delaware )
County of__________ )
Personally came before me this ______ day of _______________, 19__, the
above-named ________________ and ___________________, Secretary (or Assistant
Secretary) respectively, of Lincoln Insurance Company.
-------------------------------------
Notary Public
3
<PAGE>
Schedule 6.4
Continuing Agreements
The Essex Reinsurance Agreement will continue
The Tax Allocation Agreement will not continue but as between Lincoln Insurance
Company and Markel Corporation obligations shall be determined in accordance
with the Tax Allocation Agreement as in effect until its date of termination
<PAGE>
Schedule 9.1
Restricted Lines of Insurance
Alarm Installation & Schools/Clubs Private Horse Owners'
Monitoring Contractors Liability
Health Clubs
Amusement Centers Restaurants, Bars &
Homeowners' Taverns
Architects & Engineers Associations
Service & Maintenance
Automobile Lenders Horse Farm Packages Contractors
Automobile Parts Horse Mortality Show Animal Club
Manufacturers
Insurance Agents and Special Property
Bicycle Manufacturers Brokers
Special Risk Accident
Boy's & Girl's Clubs Insurance Company & Medical
E&O/D&O
Children's Camps Sporting Goods
Lawyers Professional Manufacturers
Child Care Centers Liability
Sports Camps
College Student Low Value Dwelling
Accident and Health Tanning & Toning
Martial Arts Schools Salons
Commercial Auto
Medical Malpractice Toy Manufacturers
Comm. Equine Liability
Medical Malpractice: Vacant Property
Contract Surety Hard-to-Place Doctors
Watercraft
Dance/Exercise Schools Mobile Homeowners (Commercial)
Detective & Security Mobile Home Parks Watercraft (Personal)
Guards
Motorcycles
Directors & Officers
Liability Mutual Funds and
lnvestment
Employment Practices Advisors E&O/D&O
Liability
Nursing Homes
Family Entertainment
Ctrs. Pawn Shops
General Contractors Performing Arts Groups
Gymnastics
<PAGE>
Pennsylvania Manufacturers Corporation
Exhibit 11
Computation of Earnings Per Share
(Unaudited)
<TABLE>
<CAPTION>
Years ended December 31,
(in thousands, except per share data) 1997 1996 1995
---------------------------------------------
<S> <C> <C> <C>
Basic:
Weighted average shares outstanding 23,855,031 23,800,791 23,816,088
Net income (loss) before extraordinary item $ 19,753 $ (135,334) $ 24,130
Extraordinary loss (4,734) -- --
---------------------------------------------
Net income (loss) $ 15,019 $ (135,334) $ 24,130
=============================================
Net income (loss) per common and equivalent share
before extraordinary item $ 0.83 $ (5.68) $ 1.01
Extraordinary item (0.20) -- --
---------------------------------------------
Net income (loss) per common and equivalent share $ 0.63 $ (5.68) $ 1.01
=============================================
Diluted:
Weighted average shares outstanding 23,855,031 23,800,791 23,816,088
Net effect of dilutive stock options - based
on the treasury stock method using average
market price 712,347 -- 965,861
---------------------------------------------
Total diluted common shares 24,567,378 23,800,791 24,781,949
=============================================
Net income (loss) before extraordinary item $ 19,753 $ (135,334) $ 24,130
Extraordinary loss (4,734) -- --
---------------------------------------------
Net income (loss) $ 15,019 $ (135,334) $ 24,130
=============================================
Net income (loss) per common and equivalent share
before extraordinary item $ 0.80 $ (5.68) $ 0.97
Extraordinary item (0.19) -- --
---------------------------------------------
Net income (loss) per common and equivalent share $ 0.61 $ (5.68) $ 0.97
=============================================
</TABLE>
<PAGE>
Exhibit 13
Selected Financial Data
<TABLE>
<CAPTION>
(dollars in thousands, except share and per share data) 1997 (1) 1996 (1) 1995 (1) 1994 (1) 1993
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Consolidated Revenues
Net premiums written ..................................... $ 418,282 $ 443,475 $ 489,876 $ 466,502 $ 536,987
============ ============ ============ ============ ============
Net premiums earned ...................................... 375,951 420,575 484,952 466,534 547,407
Net investment income .................................... 136,698 133,936 139,355 138,719 153,842
Net realized investment gains ............................ 8,598 2,984 31,923 47,521 69,798
Service revenues ......................................... 10,311 9,189 5,106 3,380 1,321
------------ ------------ ------------ ------------ ------------
Total revenues ...................................... $ 531,558 $ 566,684 $ 661,336 $ 656,154 $ 772,368
============ ============ ============ ============ ============
- -----------------------------------------------------------------------------------------------------------------------------------
Components of Net Income
Pre-tax operating income (loss) (2):
PMA Re .............................................. $ 44,802 $ 42,783 $ 39,443 $ 33,703 $ 33,511
The Property and Casualty Group .................... (9,038) (219,619) (4,305) 3,893 (1,153)
Corporate operations ................................ (3,441) (490) (13,414) (6,686) (885)
------------ ------------ ------------ ------------ ------------
Total pre-tax operating income (loss) before
interest expense .................................... 32,323 (177,326) 21,724 30,910 31,473
Net realized investment gains ............................ 8,598 2,984 31,923 47,521 69,798
Interest expense ......................................... 15,768 17,052 18,734 13,051 11,650
------------ ------------ ------------ ------------ ------------
Income (loss) before income taxes, cumulative effect of
accounting changes and extraordinary item ........... 25,153 (191,394) 34,913 65,380 89,621
Provision (benefit) for income taxes ..................... 5,400 (56,060) 10,783 8,130 21,324
------------ ------------ ------------ ------------ ------------
Income (loss) before cumulative effect of
accounting changes and extraordinary item ........... 19,753 (135,334) 24,130 57,250 68,297
Cumulative effect of accounting changes,
net of related tax effects (3) ...................... -- -- -- -- 14,119
Extraordinary loss from early estinguishment of debt,
net of related tax effects (4) ...................... (4,734) -- -- -- --
------------ ------------ ------------ ------------ ------------
Net income (loss) ........................................ $ 15,019 $ (135,334) $ 24,130 $ 57,250 $ 82,416
============ ============ ============ ============ ============
- -----------------------------------------------------------------------------------------------------------------------------------
Per Share Data
Weighted average shares:
Basic (5), (6) ...................................... 23,855,031 23,800,791 23,816,088 23,897,263 24,231,071
Diluted (5), (6) .................................... 24,567,378 23,800,791 24,781,949 24,650,741 24,470,024
Income (loss) before cumulative effect of accounting
changes and extraordinary item, net of related
tax effects:
Basic (5), (6) ...................................... $ 0.83 $ (5.68) $ 1.01 $ 2.40 $ 2.82
Diluted (5), (6) .................................... 0.80 (5.68) 0.97 2.32 2.79
Net income (loss) per share:
Basic (5), (6) ...................................... 0.63 (5.68) 1.01 2.40 3.40
Diluted (5), (6) .................................... 0.61 (5.68) 0.97 2.32 3.37
Dividends paid per common share .......................... 0.32 0.32 0.32 0.32 0.28
Dividend paid per Class A common share ................... 0.36 0.36 0.36 0.36 0.32
Shareholders' equity per share (7) ....................... 19.96 17.86 25.53 22.10 22.23
- -----------------------------------------------------------------------------------------------------------------------------------
Financial Position
Total investments ........................................ $ 2,194,738 $ 2,261,353 $ 2,455,949 $ 2,313,261 $ 2,374,208
Total assets ............................................. 3,057,258 3,117,516 3,258,572 3,181,979 3,197,909
Reserves for unpaid losses and LAE ....................... 2,003,187 2,091,072 2,069,986 2,103,714 2,150,665
Long-term debt ........................................... 203,000 204,699 203,848 203,975 194,836
Shareholders' equity (7) ................................. 478,347 425,828 609,668 524,862 534,383
- -----------------------------------------------------------------------------------------------------------------------------------
GAAP Ratios for Insurance Subsidiaries
PMA Re
Loss ratio .......................................... 69.6% 73.7% 74.6% 74.7% 80.6%
Expense ratio ....................................... 34.9% 30.2% 29.5% 33.3% 29.4%
------------ ------------ ------------ ------------ ------------
Combined ratio (8) .................................. 104.5% 103.9% 104.1% 108.0% 110.0%
============ ============ ============ ============ ============
The Property and Casualty Group:
Loss ratio .......................................... 91.1% 158.2% 92.5% 90.1% 96.3%
Expense ratio ....................................... 45.3% 48.6% 30.6% 31.4% 25.0%
Policyholder dividend ratio ......................... 6.9% 6.1% 4.8% 4.6% 3.5%
------------ ------------ ------------ ------------ ------------
Combined ratio (8) .................................. 143.3% 212.9% 127.9% 126.1 124.8%
============ ============ ============ ============ ============
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
24
<PAGE>
(1) Operating results in 1997, 1996 and 1995 were impacted by approximately
$12,100, $223,100 and $8,400, respectively, of restructuring and other
special charges. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations" for further discussion. In addition,
1994 operating results included a charge of approximately 4,900 to write
down certain real estate properties.
(2) Pre-tax operating income (loss) excludes net realized investment gains.
(3) In 1993, the Company recognized an after-tax net benefit of $14,119
resulting from the adoption of SFAS No. 109, "Accounting for Income Taxes,"
($21,500 benefit), and SFAS No. 106. "Employers' Accounting for
Postretirement Benefits Other Than Pensions," ($7,381 after-tax charge).
(4) In 1997, the Company refinanced substantially all of its long-term debt
which resulted in a $4,734 extraordinary loss, net of tax effects. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" below.
(5) For the year ended December 31, 1996, common stock equivalents were not
taken into consideration in the computation of weighted-average shares as
these common stock equivalents would have an anti-dilutive effect on the net
loss per share.
(6) In 1997, the Company adopted SFAS No. 128, "Earnings Per Share," which
requires the presentation of basic and diluted earnings per share (see Notes
1-I and 16 to the Consolidated Financial Statements). All prior periods'
presentation of earnings per share data has been restated to conform with
SFAS No. 128.
(7) In 1994, shareholders' equity was increased $45,343 related to the adoption
of SFAS No. 115, "Accounting for Certain Investments and Debt and Equity
Securities."
(8) The combined ratio computed on a GAAP basis is equal to losses and LAE, plus
amortization of deferred acquisition costs, plus operating expenses, plus
policyholders' dividends (where applicable), all divided by net premiums
earned.
25
<PAGE>
Management's Discussion and Analysis of Financial Condition and Results of
Operations
The following section provides a discussion of the financial results and
material changes in financial position for the Company for the years ended
December 31, 1997, 1996 and 1995. The balance sheet information presented below
is as of December 31 for each respective year. The statement of operations
information is for the years ended December 31 for each respective year. The
term "SAP" refers to the statutory accounting practices prescribed or permitted
by applicable state insurance departments, and the term "GAAP" refers to
generally accepted accounting principles.
Results of Operations
The Company consists of PMC, an insurance holding company, and its subsidiaries.
PMC operates in two principal segments, property and casualty reinsurance and
property and casualty primary insurance. PMA Reinsurance Corporation (PMA Re)
emphasizes risk-exposed, excess of loss reinsurance and operates in the brokered
market. PMA Re's business is predominantly in casualty lines of reinsurance. The
Property and Casualty Group writes workers' compensation and other standard
lines of commercial insurance primarily in the Mid-Atlantic and Southern regions
of the United States, utilizing The PMA Group trade name.
During 1997, the Company established a separate specialty insurance operation
focusing in excess and surplus lines, Caliber One Management Company (Caliber
One). Caliber One did not write any business during 1997. Management anticipates
that Caliber One will primarily write multi-line business consisting of primary
and excess commercial general liability, professional liability, excess
automobile and certain property exposures beginning in 1998. Because Caliber
One's operating revenues and results were not significant in 1997, its data was
included in the Corporate and Other segment in the following discussions.
In the discussion below, pre-tax operating income (loss) is defined as income
(loss) from continuing operations before income taxes, but excluding net
realized investment gains. Operating revenues consist of all of the Company's
revenues, except net realized investment gains.
Consolidated Results
The table below presents the major components of net income (loss):
<TABLE>
<CAPTION>
(dollar amounts in thousands, except per share data)
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Pre-tax operating income (loss) ............. $16,555 $(194,378) $ 2,990
Net realized investment gains ............... 8,598 2,984 31,923
------- --------- -------
Income (loss) before income taxes ........... 25,153 (191,394) 34,913
Provision (benefit) for income taxes ........ 5,400 (56,060) 10,783
------- --------- -------
Income (loss) before extraordinary loss ..... 19,753 (135,334) 24,130
Extraordinary loss, net of related taxes .... (4,734) -- --
------- --------- -------
Net income (loss) ........................... $15,019 $(135,334) $24,130
======= ========= =======
Per basic share:
Income (loss) before extraordinary loss $ .83 $ (5.68) $ 1.01
Extraordinary loss .................... (.20) -- --
------- --------- -------
Net income (loss) ..................... $ .63 $ (5.68) $ 1.01
======= ========= =======
Per diluted share:
Income (loss) before extraordinary loss $ .80 $ (5.68) $ .97
Extraordinary loss .................... (.19) -- --
------- --------- -------
Net income (loss) ..................... $ .61 $ (5.68) $ .97
======= ========= =======
</TABLE>
26
<PAGE>
The following table indicates the Company's pre-tax operating income (loss) by
principal business segment:
(dollar amounts in thousands)
1997 1996 1995
---- ---- ----
PMA Re .................................... $44,802 $ 42,783 $ 39,443
The Property and Casualty Group ........... (9,038) (219,619) (4,305)
Corporate and Other ....................... (3,441) (490) (13,414)
------- --------- --------
Pre-tax operating income (loss) before
interest expense ..................... 32,323 (177,326) 21,724
Interest expense .......................... 15,768 17,052 18,734
------- --------- --------
Pre-tax operating income (loss) ........... $16,555 $(194,378) $ 2,990
======= ========= ========
In 1997, the Company reported consolidated pre-tax operating income of $16.6
million ($0.69 and $0.67 per basic and diluted share, respectively) versus a
pre-tax operating loss of $194.4 million ($8.17 per basic and diluted share) in
1996. After-tax operating income for 1997 was $14.2 million ($0.59 and $0.58 per
basic and diluted share, respectively) as compared to an after-tax operating
loss of $137.3 million ($5.77 per basic and diluted share) in 1996. The
improvement in the 1997 results was due primarily to special charges recorded in
1996 (see below), increased pre-tax operating income generated by PMA Re and
improved underwriting results by the Property and Casualty Group. The increase
in PMA Re's pre-tax operating income to $44.8 million, as compared to $42.8
million in 1996, was due to higher premium volume, improved underwriting results
and higher investment income. The Property and Casualty Group decreased its
pre-tax operating loss in 1997 to $9.0 million, as compared to $219.6 million in
1996, due primarily to special charges recorded in 1996 (see below), as well as
the impact of cost savings initiatives implemented in late 1996 and in 1997.
Corporate and Other operations reported a pre-tax operating loss of $3.4 million
in 1997 versus a pre-tax operating loss of $0.5 million in 1996. The higher
operating loss for Corporate and Other operations was due mainly to increased
operating costs related to certain corporate properties disposed of during the
third quarter of 1997. Interest expense decreased in 1997 by $1.3 million, due
to the refinancing of the Company's debt with a new $235.0 million revolving
credit facility (the "New Credit Facility"). See "Liquidity and Capital
Resources" herein for further discussion.
On a consolidated basis, the Company reported pre-tax operating income of $3.0
million ($0.13 and $0.12 per basic and diluted share, respectively) in 1995 as
compared to the $194.4 million pre-tax operating loss discussed above for 1996.
After-tax operating income was $3.4 million ($0.14 per basic and diluted share)
in 1995 as compared to the $137.3 million after-tax operating loss in 1996
mentioned above. The decrease from 1995 to 1996 was due primarily to special
charges recorded in 1996 (see below) at the Property and Casualty Group. In
1995, PMA Re reported pre-tax operating income of $39.4 million, the Property
and Casualty Group had a pre-tax operating loss of $4.3 million and Corporate
and Other operations recorded a pre-tax operating loss of $13.4 million. The
improvement in the operating results of Corporate and Other from 1995 to 1996
was due mainly to the fact that 1995 was impacted by an $8.4 million write-down
of certain real estate properties owned by the Company as well as higher
overhead expenses. Interest expense decreased in 1996 by approximately $1.7
million as compared to 1995, mainly reflecting lower average debt balances and
the pay-down of higher coupon debt.
Net income on a consolidated basis, before extraordinary items, was $19.8
million, or $0.83 per basic share and $0.80 per diluted share, in 1997 compared
to a net loss of $135.3 million, or $5.68 per basic and diluted share in 1996.
On March 14, 1997, the Company refinanced substantially all of its outstanding
credit agreements not already maturing in 1997 with the New Credit Facility. In
connection with this refinancing, the Company recognized an extraordinary loss
from the early extinguishment of debt of $4.7 million, or $0.20 and $0.19 per
basic and diluted share, respectively, net of tax.
Over the past three years, the Company's operating results have been impacted by
restructuring charges and other special items. During 1997, the Company recorded
$7.0 million of severance and other restructuring charges, primarily related to
the Property and Casualty Group and Corporate and Other
27
<PAGE>
operations. In addition, the Company recorded $2.2 million of operating costs
for certain corporate properties which were disposed of during 1997 (see
"Corporate and Other") and $2.0 million of year 2000 expenses (see "Liquidity
and Capital Resources" for further discussion). In 1996, the Company's operating
results included a pre-tax charge of $221.3 million ($143.8 million after tax),
recorded by the Property and Casualty Group in order to strengthen its loss and
LAE reserves, to recognize restructuring costs in connection with staff
reductions and to write off certain accounts receivable. In addition, pre-tax
Year 2000 costs in 1996 were $1.8 million. In 1995, the Company recorded a
charge of $8.4 million to write down the Company's former headquarters building
and certain adjacent properties to their fair market values less costs to carry
and sell the properties. The charges over the three-year period consisted of the
following:
<TABLE>
<CAPTION>
(dollar amounts in millions)
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Severance and other restructuring charges ........ $ 7.0 $ 7.6 $ --
Year 2000 costs .................................. 2.0 1.8 --
Costs related to corporate properties ............ 2.2 -- --
Write-down of corporate properties ............... -- -- 8.4
Caliber One pre-opening costs .................... 0.9 -- --
Loss reserve strengthening ....................... -- 191.4 --
Receivables write-down ........................... -- 17.5 --
Equipment write-down ............................. -- 4.8 --
------ ------ ----
Total pre-tax charge ............................. $ 12.1 $223.1 $8.4
====== ====== ====
</TABLE>
PMA Re Results of Operations
Summarized financial results of PMA Re for the years ended December 31, 1997,
1996 and 1995, are as follows:
<TABLE>
<CAPTION>
(dollar amounts in thousands)
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Net premiums written .................... $177,934 $164,053 $152,760
======== ======== ========
Net premiums earned ..................... $163,603 $151,974 $139,345
Net investment income ................... 52,270 48,676 45,166
-------- -------- --------
Operating revenues ...................... 215,873 200,650 184,511
-------- -------- --------
Losses and LAE incurred ................. 113,931 111,937 103,947
Acquisition and operating expenses ...... 57,140 45,930 41,121
-------- -------- --------
Total losses and expenses ............... 171,071 157,867 145,068
-------- -------- --------
Pre-tax operating income ................ $ 44,802 $ 42,783 $ 39,443
======== ======== ========
GAAP loss ratio ......................... 69.6% 73.7% 74.6%
GAAP combined ratio ..................... 104.5% 103.9% 104.1%
SAP loss ratio .......................... 69.5% 73.7% 74.6%
SAP combined ratio ...................... 103.8% 104.4% 105.5%
</TABLE>
Premium Revenues
In 1997 and 1996, net premiums written increased 8.5% and 7.4%, respectively.
The increases in 1997 and 1996 were primarily the result of increased
participation on reinsurance treaties and the writing of additional layers and
programs with existing clients. An increased number of programs added for
property lines during the second half of 1996 and during 1997 also contributed
to the aforementioned increases in net premiums written. These increases were
partially offset by the trend toward large ceding companies increasing their
retentions, which decreases PMA Re's subject premium. Additionally, highly
competitive pricing conditions in the U.S. reinsurance market caused PMA Re to
non-renew certain existing business and to decline certain new business
opportunities.
The following table indicates PMA Re's gross and net premiums written by major
category of business:
(dollar amounts in thousands)
28
<PAGE>
<TABLE>
<CAPTION>
1997 1996
1997 1996 1995 Change % Change %
---- ---- ---- -------- --------
<S> <C> <C> <C> <C> <C>
Gross premiums written:
Casualty lines ...... $151,901 $143,991 $128,736 5.5% 11.9%
Property lines ...... 72,625 63,325 63,693 14.7% (0.6)%
Other lines ......... 795 842 (63) (5.6)% --
-------- -------- -------- ---- ----
Total ..................... $225,321 $208,158 $192,366 8.2% 8.2%
======== ======== ======== ==== ====
Net premiums written:
Casualty lines ...... $118,889 $122,008 $107,383 (2.6)% 13.6%
Property lines ...... 58,257 41,240 45,440 41.3% (9.2)%
Other lines ......... 788 805 (63) (2.1)% --
-------- -------- -------- ---- ----
Total ..................... $177,934 $164,053 $152,760 8.5% 7.4%
======== ======== ======== ==== ====
</TABLE>
PMA Re's net casualty premiums written decreased 2.6% in 1997 and increased
13.6% in 1996. The decrease in 1997 was primarily attributable to increased
retrocessional protection purchased, which offset increases in gross casualty
premiums relating to new business with existing clients and larger lines taken
on existing programs. The growth in 1996 was attributable to the expansion of
several programs covering specialty business, which included professional
liability, directors' and officers' liability, and other coverages written on a
surplus lines basis.
PMA Re's net property business increased 41.3% during 1997 and decreased 9.2%
during 1996. The increase in net property premiums written in 1997 was primarily
the result of additional property underwriting expertise that PMA Re added to
its underwriting staff in late 1996 to broaden its product offerings. Such
expertise enabled PMA Re to increase cross-selling opportunities with its
existing treaty reinsurance clients by offering additional and/or expanded
property coverages. In addition, property premiums ceded decreased primarily
related to changes in PMA Re's property retrocessional coverages in terms of
premiums and ceding commissions. The decrease in net premiums written in 1996
was primarily attributable to higher ceding company retentions, competitive
pricing conditions and higher ceded property premiums.
The property programs written by PMA Re generally contain per occurrence limits
and/or are not considered significantly catastrophe exposed, either because of
the locations of the insured values or the nature of the underlying properties
insured. However, as is common in property reinsurance, PMA Re is exposed to the
possibility of loss from catastrophic events due to the aggregation of per
occurrence limits and similar issues. PMA Re actively manages this exposure
through aggregate management, avoidance of catastrophe business and
retrocessional protection (see "Capital Resources").
In 1997, PMA Re recorded $2.5 million of net facultative reinsurance premiums
which represented 1.4% of total net premiums written for the year, compared to
$1.0 million, or 0.6%, in 1996. PMA Re commenced writing facultative reinsurance
in November 1995.
Net premiums earned increased 7.7% and 9.1% in 1997 and 1996, respectively.
These increases both correspond to the increases in net premiums written, as net
premiums earned generally follow growth patterns similar to net premiums written
adjusted for the customary lag related to the timing of premium writings within
the year.
Losses and Expenses
PMA Re's combined ratios have remained relatively stable from 1995 through 1997,
ranging from 103.9% to 104.5% during the three-year period. This relative
stability is attributable to (i) consistently favorable development of unpaid
losses and LAE; (ii) prudent management of catastrophe exposures; and (iii)
lower loss ratios offsetting generally increased acquisition costs related to
writing more business with ceding commissions.
29
<PAGE>
The following table indicates the components of PMA Re's combined ratios, as
computed on a GAAP basis (1):
1997 1996 1995
---- ---- ----
Loss ratio ....................................... 69.6% 73.7% 74.6%
------ ------ ------
Expense ratio:
Amortization of deferred acquisition costs .. 27.6% 24.7% 24.2%
Operating expenses .......................... 7.3% 5.5% 5.3%
------ ------ ------
Total expense ratio .............................. 34.9% 30.2% 29.5%
------ ------ ------
Combined ratio-GAAP .............................. 104.5% 103.9% 104.1%
------ ------ ------
(1) The combined ratio computed on a GAAP basis is equal to losses and LAE,
plus amortization of deferred acquisition costs, plus operating expenses,
plus policyholders' dividends (where applicable), all divided by net
premiums earned.
For the past three years, PMA Re's loss ratios have declined primarily as a
result of increased ceding commissions and favorable loss reserve development.
PMA Re's loss ratio decreased to 69.6% in 1997 from 73.7% and 74.6% in 1996 and
1995, respectively. For contracts written on a pro rata basis and other
contracts containing ceding commissions, premiums tend to be higher relative to
the losses when compared to contracts that do not contain ceding commissions. In
the past three years, PMA Re has written more contracts containing ceding
commissions which has contributed to the decreases in loss ratios. For such
contracts, PMA Re pays the ceding company a commission, but in return, PMA Re
receives a higher proportion of the subject premium. In addition, net favorable
development on prior years' unpaid losses and LAE was $23.3 million in 1997, and
$28.6 million and $15.0 million in 1996 and 1995, respectively.
The ratio of amortization of deferred acquisition costs to net premiums earned
("Acquisition Expense Ratio") increased 2.9 points to 27.6% in 1997 compared to
1996, and 0.5 points in 1996 versus 1995. These increases predominantly relate
to the fact that PMA Re continues to write more contracts with ceding
commissions. Additionally, the ceding commissions that PMA Re received related
to its retrocessional catastrophe cover were higher in 1996 than in 1997, which
contributed to the lower Acquisition Expense Ratio in 1996.
The ratio of operating expenses to net premiums earned (the "Operating Expense
Ratio") increased 1.8 points to 7.3% in 1997 compared to 5.5% in 1996. This
increase was attributable to increases in certain expenses, such as salary and
facility expenses, in connection with the addition of staff and expansion of
office facilities during 1997. During the three-year period ended December 31,
1997, PMA Re has continued to add staff in response to increased premium volume
and to increase the level of specialized services provided to customers.
Accordingly, the Operating Expense Ratio has increased from 5.3% in 1995 to 7.3%
in 1997.
Certain of the Company's computer systems are not presently equipped to
recognize the year 2000 due to system constraints (the "Year 2000 Issue"). The
Company is presently undertaking a project to upgrade all of its computer
systems to be able to process records with dates beyond December 31, 1999.
During 1997, PMA Re incurred costs amounting to approximately $400,000 related
to the Year 2000 Project (the "Year 2000 Project"). Management expects that PMA
Re will incur approximately $600,000 in 1998 related to the Year 2000 Project .
Management expects that such project will be completed in 1998 (see "Liquidity
and Capital Resources" for further discussion of the Year 2000 Issue).
Net Investment Income
Net investment income increased 7.4% to $52.3 million in 1997 from $48.7 million
in 1996, which represented a 7.8% increase from $45.2 million in 1995. Such
increases were primarily attributable to the overall increase in PMA Re's
invested assets, as well as changes in portfolio holdings. During 1997, PMA Re
shifted some of its holdings from government securities to high-quality
corporate securities, which generally yield higher levels of investment income.
Additionally, the 1996 increase was due to a decrease in holdings of tax-exempt
securities for which pre-tax yields tend to be lower than other investment
30
<PAGE>
vehicles. At amortized cost, PMA Re's cash and invested assets increased $49.0
million, or 5.9%, and $34.9 million, or 4.4%, during 1997 and 1996,
respectively.
Comparison of SAP and GAAP Results
The difference between the combined ratios presented on a GAAP basis versus on a
SAP basis is primarily attributable to the different accounting treatment of
acquisition costs. As PMA Re has grown in terms of premium volume during 1997
and 1996, PMA Re has incurred additional acquisition costs, which are deferred
for GAAP. For SAP purposes, PMA Re is required to expense such costs as
incurred, resulting in an incremental expense recorded on a SAP basis compared
to GAAP.
The Property and Casualty Group Results of Operations
Summarized financial results of the Property and Casualty Group for the years
ended December 31, 1997, 1996 and 1995, are as follows:
(dollar amounts in thousands)
1997 1996 1995
---- ---- ----
Net premiums written:
Workers' compensation ........... $ 175,301 $ 189,338 $ 233,145
Commercial Lines ................ 65,047 90,084 103,971
--------- --------- ---------
Total ........................... $ 240,348 $ 279,422 $ 337,116
========= ========= =========
Net premiums earned:
Workers' compensation ........... $ 152,773 $ 176,380 $ 243,175
Commercial Lines ................ 59,575 92,221 102,432
--------- --------- ---------
Total ........................... 212,348 268,601 345,607
Net investment income ................ 82,098 82,455 92,275
Service revenues ..................... 10,311 9,189 5,106
--------- --------- ---------
Operating revenues ................... 304,757 360,245 442,988
--------- --------- ---------
Losses and LAE incurred .............. 193,530 424,900 319,644
Acquisition and operating expenses ... 105,549 138,709 110,906
Policyholder dividends ............... 14,716 16,255 16,743
--------- --------- ---------
Total losses and expenses ............ 313,795 579,864 447,293
--------- --------- ---------
Pre-tax operating loss ............... $ (9,038) $(219,619) $ (4,305)
--------- --------- ---------
GAAP loss ratio ...................... 91.1% 158.2% 92.5%
GAAP combined ratio .................. 143.3% 212.9% 127.9%
SAP loss ratio (1) ................... 84.0% 125.7% 77.3%
SAP combined ratio (1) ............... 119.0% 175.6% 115.1%
(1) The SAP loss and combined ratios above relate to the operations of the
Pooled Companies only and do not include the results of other statutory
entities within the Property and Casualty Group.
Premium Revenues
Premiums for the Property and Casualty Group have decreased in the three-year
period ended December 31, 1997. Between 1997 and 1996, net premiums written
decreased 14.0%, and between 1996 and 1995, net premiums written decreased
17.1%. Direct premiums written for workers' compensation decreased $20.6 million
and $36.5 million in 1997 and 1996, respectively. Direct premiums written for
commercial lines of business other than workers' compensation, such as
commercial auto, general liability, umbrella, multi-peril and commercial
property lines (collectively "Commercial Lines") increased $11.7 million in 1997
compared to 1996, and decreased $11.6 million in 1996 relative to 1995.
Reinsurance premiums assumed decreased $4.4 million between 1997 and 1996 and
increased $0.8 million between 1996 and 1995. Reinsurance premiums ceded
increased $25.8 million in 1997 compared to 1996 and $10.4 million in 1996
relative to 1995. Net premiums earned decreased $56.3 million between 1997 and
1996 and $77.0 million between 1996 and 1995.
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<PAGE>
The decline in premiums from 1995 to 1997 is due to a number of factors
discussed below, including the Property and Casualty Group's underwriting
decisions, competition, and the impact of workers' compensation benefit reform
laws.
During the past three years, competition and manual rate levels affected
workers' compensation premium volume. During this period, the Property and
Casualty Group did not renew certain accounts due to inadequate profit
potential. Intense competition caused rates for certain accounts to be
unattractive relative to the risks assumed. Rather than match the price merely
to retain the volume, the Property and Casualty Group declined to write the
accounts. In terms of manual rates, average rate levels declined 25.0%, 7.0%,
and 3.0% in 1997, 1996, and 1995, respectively. The rate decreases had a
substantially lower proportional impact on premiums written during 1996 and
1995, as the Property and Casualty Group had reduced its dependence on
rate-sensitive business. The Property and Casualty Group increased its focus on
rate sensitive small account business in 1997, as it believes that the impact of
recently passed legislation in its principal marketing states, including Act 57
in Pennsylvania, may make loss experience on such business more predictable than
it has recently been.
Workers' compensation premiums also declined during the three-year period as a
result of the enactment of workers' compensation benefit reform laws. The
decline in workers' compensation premiums has been concentrated primarily in
Pennsylvania. Direct workers' compensation premiums for all other jurisdictions
increased in 1997 compared to 1996, including an increase of $3.8 million from
new jurisdictions in 1997. The number of workers' compensation policies
increased in 1997 compared to 1996, from 2,757 to 3,184. However, the increase
in policies was offset by the rate decreases related to the benefit reform laws.
These benefit reform laws also have had a favorable impact on loss and LAE
reserves for business written on policies subject to such reform laws. See
"Losses and Expenses" below. The changes in workers' compensation benefits that
were promulgated under Act 57 in Pennsylvania were accompanied by a change in
the basic premium rate structure for workers' compensation insurance, which
lowered the rates charged to insureds by approximately 25% effective February
1997. This change in rate structure was reviewed by an independent actuarial
firm on behalf of the Commonwealth of Pennsylvania in connection with the
approval of rates under Act 57. In addition, the Company's actuaries reviewed
the effect that the reforms would have on workers' compensation benefits paid in
relation to the changes in premiums charged. It was the opinion of both groups
of actuaries that the rate changes mandated by Act 57 were consistent with the
changes in benefits allowed under Act 57, and the effect of the rate changes
would be minimal with respect to the profitability of the business. The premium
charged on a fixed-cost policy is based upon the manual rates filed with and
approved by the state insurance department and does not increase or decrease
based upon the losses incurred during the policy period. Under policies that are
subject to dividend plans, the customer may receive a dividend based upon loss
experience during the policy period. Since the late 1980s, the Property and
Casualty Group has reduced its proportion of rate-sensitive products from over
70% to approximately 62%. With the enactment of regulatory reform in several
jurisdictions in the Property and Casualty Group's marketing territory, the
Property and Casualty Group is more interested in this type of business and may
write more rate-sensitive accounts in such jurisdictions in the future.
Direct workers' compensation premiums were also impacted by changes in the level
of premium adjustments, primarily related to audit premiums and retrospective
policies. In 1997, such adjustments decreased premiums written by $4.4 million
($15.8 million in audit premiums billed and $20.2 million in retrospective
premiums returned), while in 1996, such adjustments reduced premiums written by
$6.1 million ($17.1 million in audit premiums billed and $23.2 million in
retrospective premiums returned) and in 1995, such adjustments increased
premiums written by $13.1 million ($26.9 million in audit premiums billed and
$13.8 million in retrospective premiums returned). The slightly lower impact of
premium adjustments in 1997 relative to 1996 was due primarily to a decrease in
retrospectively rated premiums returned to insureds, resulting from a lower
volume of workers' compensation business written during the past three years.
The decrease in 1996 relative to 1995 was due primarily to two factors: (i) the
lower amount of billed audit premiums, which is attributable to better
estimating of the ultimate exposure base (generally, payroll) on such risks by
the Property and Casualty Group's underwriters; and (ii) the
32
<PAGE>
increase in retrospectively rated premiums returned to insureds, resulting from
the favorable loss experience in more recent accident years in workers'
compensation. As the Property and Casualty Group has expanded retrospectively
rated business since 1989, proportionately more policies had mature loss data,
resulting in more premium adjustments. Changes in actuarial estimates of future
premium adjustments on retrospective policies are recorded directly in net
premiums earned (see below for further discussion), and therefore, such
retrospective adjustments returned to insureds do not impact net premiums
earned.
Under retrospectively rated policies, the Property and Casualty Group receives
an up-front provisional premium which is adjusted based upon loss experience of
the insured. If losses are lower than expected, the insured receives a refund,
subject to a minimum premium and if losses are higher than expected, the insured
owes additional premium, subject to a maximum premium. Between the minimum and
maximum premiums, the net impact on the Company's operating results is
negligible, because changes in loss estimates pertaining to retrospectively
rated contracts are offset by changes in premium estimates, net of changes in
estimates for accrued premium taxes and other loss-based costs. While the
premium is adjusted based upon loss experience, the Company's profit load (or
margin) portion of the premium is fixed at the policy's inception and is not
adjusted based upon loss experience, although the margin would be impaired in
the event losses exceed the maximum premium amount. Approximately $50.1 million,
$59.0 million and $85.0 million of the Property and Casualty Group's workers'
compensation premiums were derived from loss sensitive products in 1997, 1996,
and 1995, respectively. The audit premiums referred to above were derived from
the Company's workers' compensation insurance policies. An insured's workers'
compensation premiums are determined by two factors: aggregate payroll and
employer business classification. The Company determines its initial estimate of
annual premium based on payroll records and business classification data
submitted to it by the insured. An audit of this data is performed after the
policy year ends, and an adjustment to the premium is then made and billed to
the insured.
Also reducing net premiums written is the fact that, since 1992, the Property
and Casualty Group has been increasing its focus on alternative market workers'
compensation products. These products include large-deductible policies,
offshore rent-a-captive programs and individual self-insurance programs.
Typically, the Property and Casualty Group receives a lower net premium for
these types of plans. However, under this type of business, the insured retains
a greater share of the underwriting risk than under rate-sensitive or
loss-sensitive products, which reduces the potential for unfavorable claim
activity on the accounts and encourages loss control on the part of the insured.
A substantial portion of related revenues are recorded as service revenues
rather than premiums. Such service revenues increased $1.1 million in 1997 as
compared to 1996, and $4.1 million in 1996 relative to 1995.
Companies writing workers' compensation in certain states generally must share
in the risk of insuring entities that cannot obtain insurance in the voluntary
market. Typically, an insurer's share of this residual market is dependent upon
its market share in terms of direct premiums in the voluntary market, and the
assignments are accomplished either by direct assignment or by assumption from
pools. In 1997, the Property and Casualty Group's direct assignments, which are
included in direct written premiums, decreased $3.1 million relative to 1996,
and decreased $15.3 million in 1996 as compared to 1995. These decreases reflect
generally lower premium volume in workers' compensation for the Property and
Casualty Group, as well as increasingly competitive conditions in the voluntary
workers' compensation market, which has led to lower amounts of residual market
business.
During 1997, direct writings of Commercial Lines increased $11.7 million
compared to 1996, assumed Commercial Lines premiums decreased $8.5 million and
ceded Commercial Lines premiums increased $28.2 million in 1997 compared to
1996. The growth in direct writings for Commercial Lines in 1997 was due
primarily to rate increases on existing business, as well as additional
companion commercial business associated with new workers' compensation
customers. The Property and Casualty Group is continuing to review the
profitability of these lines, and the net growth in such lines has been limited
as a result of this review and the new reinsurance treaty discussed below. Also,
market conditions have been extremely competitive in these lines, and management
has refused to compromise underwriting standards
33
<PAGE>
merely to increase volume. During 1996, direct writings of Commercial Lines
decreased $11.6 million compared to 1995, assumed Commercial Lines premiums
increased $0.8 million and ceded Commercial Lines premiums increased $3.1
million in 1996 compared to 1995.
In 1997, the Property and Casualty Group entered into a new reinsurance treaty
that covers substantially all of the Commercial Lines casualty business at a
$175,000 per risk attachment point, compared to a $500,000 per risk attachment
point in 1996 which accounted for the increase in ceded Commercial Lines
premiums.
Ceded premiums increased $25.8 million in 1997 compared to 1996, and increased
$10.4 million in 1996 compared to 1995. The increase in 1997 as compared to 1996
was due primarily to a reinsurance treaty effected at December 31, 1997, ceding
$15.4 million of annuity reserves held by its domestic life insurance company to
a third party (the "PMA Life Insurance Company transaction"). Ceded premiums
also increased approximately $6.6 million due to the aforementioned lower
attachment point of the Commercial Lines casualty reinsurance treaty the
Property and Casualty Group entered into effective January 1, 1997. Finally,
ceded reinsurance premiums increased an additional $6.2 million, due to the
increased direct writings of Commercial Lines business in 1997 as compared to
1996. In 1996 as compared to 1995, ceded premiums decreased, although the rate
of decrease was less than the rate of decrease in direct premiums, due to the
increased use of facultative reinsurance for specific risks in Commercial Lines.
Fluctuations in net premiums earned were primarily attributable to changes in
net premiums written. In addition to the impact of fluctuations in premiums
written, premiums earned were also impacted by the change in accrued
retrospective premiums. Accrued retrospective premiums, which are a component of
uncollected premiums, are based upon actuarial estimates of expected ultimate
losses and resulting estimated premium adjustments relating to retrospectively
rated policies. The estimated ultimate premium adjustments under retrospectively
rated policies are recorded in the initial policy year based upon estimated loss
experience on the underlying policies and adjusted in subsequent periods in
conjunction with revisions of the estimated underlying losses on such policies.
In addition, accrued retrospective premiums are increased or decreased based
upon retrospective policy adjustments paid or billed. Such adjustments actually
billed or paid do not impact premium revenues because the Company records an
offsetting amount through net premiums written. The following sets forth the
components of the change in accrued retrospective premiums for each of the three
years in the period ended December 31, 1997:
(dollar amounts in thousands)
1997 1996 1995
---- ---- ----
Estimated retrospective policy
adjustments related to the current
accident year ......................... ($12,460) ($18,767) ($12,941)
Revision of estimate of retrospective
policy adjustments related to
prior accident years .................. (44,719) (9,888) (4,845)
Retrospective policy adjustments paid ...... 20,179 23,155 13,786
Uncollectible write-off .................... -- (5,000) --
-------- -------- --------
Total ...................................... ($37,000) ($10,500) ($ 4,000)
======== ======== ========
In 1997, 1996 and 1995, the Property and Casualty Group reduced accrued
retrospective premiums by $37.0 million, $10.5 million and $4.0 million,
respectively. The primary reason for the additional reduction in 1997 relative
to 1996 was a $44.7 million revision of estimate of accrued retrospective
premiums, primarily due to the favorable development of claims liabilities for
more recent accident years ($35.7 million) and the commutation of claims for
accident years 1991 and prior in 1997 ($9.0 million). The reduction for policy
years 1991 and prior primarily relates to the commutation program for such years
initiated in late 1996. In July 1997, the Property and Casualty Group completed
a formal program under which it commuted a large number of claims associated
with workers' compensation claims from accident years 1991 and prior, including
loss reserves associated with retrospective policies. The commutation
34
<PAGE>
program resulted in current payments to claimants which were less than the
carried reserves. As a result of the differences between the current commutation
payments to claimants and carried reserves on such claims, management reduced
its estimate of amounts recoverable under retrospectively rated policies and
also recognized a reduction in losses and LAE associated with such policies (see
"Losses and Expenses" below). The reduction related to 1992 through 1996 policy
years was related primarily to a corresponding amount of favorable development
on underlying loss reserves for such years. The effects of the commutations on
these prior loss reserves, as well as the intent of the Property and Casualty
Group to continue utilizing early intervention techniques such as commutations
on claims from more recent accident years, have led to a re-estimation of policy
liabilities for these more recent accident years, and a re-estimation of amounts
due under retrospectively rated policies for these more recent accident years.
The reduction in amounts due under retrospectively rated policies and the
corresponding reduction in loss reserves resulting from commutation of the
carried loss reserves and re-estimation of more recent accident years resulted
in a reduction of the GAAP loss ratio for 1997 (as more fully described in
"Losses and Expenses," below), compared to 1996 and 1995. Additionally, the
reduction of earned premiums caused both the GAAP expense ratio and the
policyholder dividend ratio to increase for 1997, compared to 1996 and 1995.
However, the impact of the reduction of the accrued retrospective premiums (net
of the adjustment to underlying loss reserves) on the Company's results of
operations was negligible.
The increased adjustment to prior accident years recorded in 1996 as compared to
1995 reflects additional favorable loss reserve development in the prior three
accident years.
Management believes that it has made a reasonable estimate of the Company's
accrued retrospective premiums. While the eventual ultimate receivable may
differ from the current estimates, management does not believe that the
difference will have a material effect, either adversely or favorably, on the
Company's financial position or results of operations.
Losses and Expenses
The following table reflects the components of the Property and Casualty Group's
combined ratios, as computed under GAAP:
1997 1996 1995
---- ---- ----
Loss ratio ........................................ 91.1% 158.2% 92.5%
----- ------ ------
Expense ratio:
Amortization of deferred acquisition costs .. 22.7% 19.7% 15.5%
Operating expenses (1) ...................... 22.6% 28.9% 15.1%
------ ------ ------
Total expense ratio ............................... 45.3% 48.6% 30.6%
------ ------ ------
Policyholders' dividend ........................... 6.9% 6.1% 4.8%
------ ------ ------
Combined ratio-GAAP ............................... 143.3% 212.9% 127.9%
------ ------ ------
(1) The GAAP Operating Expense Ratio excludes $9.3 million, $8.2 million and
$5.3 million in 1997, 1996 and 1995, respectively, of PMA Management Corp.
direct expenses related to service revenues, which are not included in
premiums earned.
The components of the loss and LAE ratio for the Property and Casualty Group are
as follows:
1997 1996 1995
---- ---- ----
Current accident year - undiscounted .............. 81.3% 81.4% 83.8%
Accretion of discount for prior
accident years and discounting of
current accident year ....................... 12.0% 5.5% (0.7%)
Adjustments to retrospectively rated
business and net effect of PMA Life
reinsurance transaction ..................... (1.5%) -- --
Change in discount rate ........................... -- -- (9.8%)
Reserve (release) strengthening ................... (0.7%) 71.3% 19.2%
------ ------ -----
Loss and LAE ratio ................................ 91.1% 158.2% 92.5%
----- ------ -----
In 1997, the calendar year loss ratio was impacted by a $31.7 million net
charge, which represented the accretion of discount on workers' compensation
loss reserves for prior accident years, partially offset by
35
<PAGE>
discounting of current accident year reserves, while the 1996 calendar-year loss
ratio was impacted by a $15.0 million net charge for accretion of discount on
prior accident year workers' compensation loss reserves and discounting of
current accident year reserves. The increase in the net charge for discount
accretion is due primarily to higher overall reserve levels in 1997 and lower
levels of current accident year reserves being discounted in 1997 as compared to
1996. The Property and Casualty Group expects lower levels of discount
associated with current accident year reserves to continue, due to benefit
reforms that reduce claims duration which have been enacted in many of the
states in which it does business. Management also expects that the net charge
associated with accretion of discount of prior years' reserves to decrease in
1998 and forward, as the accelerated payment of claims due to commutations is
expected to lower the level of discount in the Property and Casualty Group's
loss reserves. The increase in the loss ratio in 1996 compared to 1995 from the
accretion of discount was due primarily to higher overall reserves in 1996 and
to lower levels of earned premium in 1996 as compared to 1995. Discounting of
reserves for workers' compensation claims is established in accordance with
applicable state laws, which permit discounting the estimated claim payments on
certain claims at various rates (the Property and Casualty Group uses a discount
rate of approximately 5% per year, which is within the range of permitted rates
in the states in which it does business). Loss reserves on other lines of
business as well as loss adjustment expense reserves for all lines of business
are not discounted.
In 1997, the Property and Casualty Group recorded a reserve release of
approximately $53.9 million on prior year losses and LAE, excluding the
accretion of discount. The release primarily relates to favorable reserve
development of $9.0 million related to retrospectively rated policies for
accident years 1991 and prior and favorable development of $28.0 million related
to retrospectively rated policies pertaining to accident years 1992 through
1996. The Property and Casualty Group also recorded favorable development on
guaranteed cost workers' compensation reserves for accident years 1991 and prior
of $7.1 million, partially offset by reserve strengthening in commercial
multi-peril business for accident year 1996 of $5.0 million. Furthermore,
incurred losses on prior accident years were also affected by the cession of
prior year reserves included in the PMA Life Insurance Company transaction of
$14.8 million. In 1996 and 1995, the loss ratio included $191.4 million and
$66.5 million, respectively, of strengthening of unpaid losses and loss
adjustment expenses of prior accident years. The loss reserve (release)
strengthening was associated with the following lines of business:
(dollar amounts in millions)
1997 1996 1995
---- ---- ----
Pre-1992 workers' compensation ............. $(7.1) $110.0 $ 54.7
Asbestos and environmental ................. -- 60.4 23.4
Other lines of business .................... 5.0 21.0 (11.6)
----- ------ ------
Total reserve (release) strengthening ...... $(2.1) $191.4 $ 66.5
------ ------ ------
The 1996 aggregate workers' compensation adverse development was allocated
$102.0 million to Pennsylvania and $8.0 million to all other states in the
Property and Casualty Group's marketing territory. Of the $102.0 million, the
allocation by year is as follows: prior to 1987: $16.0 million; 1987 to 1991:
$101.0 million; and 1992 and subsequent years: ($15.0 million). In 1995,
substantially all of the workers compensation adverse development related to
accident years 1987 to 1991 in Pennsylvania. For accident years prior to 1992,
the traditional paid loss development schedules for workers' compensation had
begun to exhibit an increasing trend in loss development factors by 1993. This
trend was initially attributed to an increase in commutation activity. In 1995,
management began to question whether loss data was developing in a manner that
was consistent with the conclusion that the loss development trends were
impacted solely by commutation activity. As a result, management began to
accumulate additional data in order to determine whether there were additional
causes of the increase in the paid loss development data; management obtained
claim count data that was far more detailed than had been historically utilized
in the reserve setting process. This data indicated that the paid loss
development factors were not only impacted by commutation activity, but also by
a decline in the claims closure rate in Pennsylvania. Management believes that
the decline of the closure rates was due to several interrelated factors. One
factor related to the fact that efforts to rehabilitate claimants and return
them to work were not as
36
<PAGE>
successful as anticipated. For accident years 1987 to 1991, in particular,
extensive efforts were made by the Company to rehabilitate claimants and return
them to work at either full or modified duty. By late 1995 and into 1996, it was
recognized, by a review of a slow down in the claims closure pattern that these
rehabilitation efforts were not impacting the closure rates as expected. Another
factor negatively impacting claims closure rates related to the economic
conditions in Pennsylvania in the early 1990's. During the period from 1990 to
1994, economic conditions in Pennsylvania were considered to be depressed in the
Company's major industry niches for workers' compensation insurance
(construction, heavy manufacturing). Payrolls in these industries were stagnant,
and in many cases, employment was flat or declining. The Company believes that
in periods of declining employment opportunities, there is a tendency for
indemnity periods to increase, which occurred for workers who suffered injuries
in these industries.
The above factors, when considered with the fact that the benefits period in
Pennsylvania was unlimited, caused the Company to believe that a substantial
portion of claimants from the pre-1992 period, who had already been out of work
five to nine years, would not return to work in any capacity. In late 1995 and
during 1996, management undertook an effort to quantify the impact of the
declining closure rates versus the increase in commutation activity. During the
fourth quarter of 1995, management strengthened the Property and Casualty
Group's workers' compensation reserves by $54.7 million; however, the
quantification of the effect of the claims closure rate was an extremely complex
process, and as such, the data was not fully understood at that time. As the
data under analysis was more mature and refined in 1996, management determined
that the workers' compensation loss reserves for Pennsylvania in the pre-1992
accident years needed to be increased substantially; therefore, the Property and
Casualty Group increased its workers' compensation reserves by $110.0 million.
Benefit reforms enacted by states in which the Property and Casualty Group
transacts business, most significantly Pennsylvania, have had a beneficial
impact on more recent accident year loss ratios. Prior to 1996, the principal
revisions of the Pennsylvania system included medical cost containment measures
and an expansion of the period of time during which the insurer may require an
employee to accept medical treatment from the employer's list of designated
healthcare providers. In July 1996, Pennsylvania enacted Act 57, a workers'
compensation reform bill which is expected to substantially reduce indemnity
benefit periods in Pennsylvania. In addition to regulatory reforms, the loss
ratios have been favorably impacted by the conversion to loss sensitive and
alternative market products. Such a trend is evidenced by the fact that accident
year loss ratios (losses recorded for the year the event occurred expressed as a
percentage of the earned premiums for that year) for workers' compensation have
been generally lower in more recent accident years, as the following chart
indicates:
Property and Casualty Group Workers' Compensation Undiscounted Accident Year
- ----------------------------------------------------------------------------
Pure Loss Ratios as of December 31, 1997
----------------------------------------
Accident Years Loss Ratio
-------------- ----------
1990 100%
1991 86%
1992 80%
1993 64%
1994 64%
1995 63%
1996 63%
1997 66%
In addition, management took several steps to reduce the outstanding claims
associated with the Pennsylvania workers' compensation business written through
1991. A formal commutation program was initiated in the fourth quarter 1996 and
continued into late 1997. Commutations are agreements with claimants whereby the
claimants, in exchange for a lump sum payment, will forego their rights to
future indemnity payments from the Property and Casualty Group. Under
Pennsylvania workers' compensation
37
<PAGE>
laws, all such commutation arrangements must be approved by the claimant and the
Pennsylvania Workers' Compensation Board. The Property and Casualty Group paid
$101.1 million and $17.8 million in 1997 and the fourth quarter of 1996,
respectively, to commute workers' compensation indemnity claims. Savings
associated with these claims were consistent with management's expectations. The
number of open claims for accident years 1991 and prior was substantially
reduced as a result of the commutation program. This reduction in open claims is
expected to reduce the possibility of any further adverse development on such
reserves, although there can be no assurances that the level of commutations
will have a significant impact on the future development of such reserves.
Estimating reserves for workers' compensation claims can be more difficult than
many other lines of property and casualty insurance for several reasons,
including (i) the long payment `tail' associated with the business; (ii) the
impact of social, political and regulatory trends on benefit levels for both
medical and indemnity payments; (iii) the impact of economic trends; and (iv)
the impact of changes in the mix of business. At various times, one or a
combination of such factors can make the interpretation of actuarial data
associated with workers' compensation loss development more difficult, and it
can take additional time to recognize changes in loss development patterns.
Under such circumstances, adjustments will be made to such reserves as loss
patterns develop and new information becomes available and such adjustments may
be material.
The adverse development in reserves associated with asbestos and environmental
claims is the result of a detailed analysis of loss and LAE reserves associated
with asbestos and environmental liability claims completed in 1996. The
reserving for asbestos and environmental claims has undergone change at both the
Company and in the insurance industry in general. For environmental and asbestos
liability claims, reserving methodology has been evolving into accepted industry
practice in the recent past; the Company has applied these methods to its loss
reserves in 1997 and 1996. To reserve for environmental claims, the Company
currently utilizes a calendar year development technique known as aggregate loss
development. This technique focuses on the aggregate losses paid as of a
particular date and aggregate payment patterns associated with such claims.
Several elements including remediation studies, remediation, defense,
declaratory judgment, and third party bodily injury claims were considered in
estimating the costs and payment patterns of the environmental and toxic tort
losses. Prior to the development of these techniques, there was a substantial
range in the nature of reserving for environmental and toxic tort liabilities.
The methods employed by the Company prior to the review performed in 1996
included a review of aggregate loss and loss adjustment paid and case incurred
data along with resulting "survival ratios" to establish IBNR for environmental
and toxic tort claims. For asbestos claims, the Company had previously reserved
costs to defend, and any indemnification payments anticipated on, claims for
which it had received notice that it was a responsible party, plus a bulk factor
applied to the estimated case reserves to provide for potential development of
indemnification and defense cost related to such claims. In 1996, the Company
performed a ground up analysis of asbestos loss reserves using an actuarially
accepted modeling technique. Using historical information as a base and
information obtained from a review of open claims files, assumptions were made
about future claims activity in order to estimate ultimate losses. For each
individual major account, projections were made regarding new plaintiffs per
year, the number of years new claims will be reported, the average loss severity
per plaintiff and the ratio of loss adjustment expense to loss. In many cases
involving larger asbestos claims, the Company reserved up to the policy limits
for the applicable loss coverage parts for the affected accounts. Policy terms
and reinsurance treaties were applied in the modeling of future losses.
Estimation of obligations for asbestos and environmental exposures continues to
be more difficult than for other loss reserves because of several factors,
including: (i) evolving methodologies for the estimation of the liabilities;
(ii) lack of reliable historical claim data; (iii) uncertainties with respect to
insurance and reinsurance coverage related to these obligations; (iv) changing
judicial interpretations; and (v) changing government standards.
The Company's asbestos-related loss reserves for the years ended December 31,
were as follows:
(dollar amounts in thousands)
1997 1996 1995
---- ---- ----
38
<PAGE>
Gross of reinsurance:
Beginning reserves ........................ $ 80,055 $ 27,611 $ 13,969
Incurred losses and LAE ................... 2,435 62,854 22,482
Calendar year payments for losses and LAE.. (5,764) (10,410) (8,840)
------- -------- -------
Ending reserves ........................... $ 76,726 $ 80,055 $ 27,611
======== ======== ========
Net of reinsurance:
Beginning reserves ........................ $ 53,300 $ 23,443 $ 8,168
Incurred losses and LAE ................... (36) 39,427 21,826
Calendar year payments for losses and LAE.. (4,686) (9,570) (6,551)
------- ------- -------
Ending reserves ........................... $ 48,578 $ 53,300 $ 23,443
======== ======== ========
(Included in such reserves are reserves for PMA Re of $0.3 million, $0.3 million
and $0.6 million [gross and net] at December 31, 1997, 1996 and 1995,
respectively.)
The Company's environmental-related loss reserves for the years ended December
31, were as follows:
(dollar amounts in thousands)
1997 1996 1995
---- ---- ----
Gross of reinsurance:
Beginning reserves ........................... $ 35,626 $ 20,134 $ 20,952
Incurred losses and LAE ...................... 1,130 22,143 3,516
Reserves acquired through purchase of
Caliber One Indemnity Company (1).......... 13,060 - -
Calendar year payments for losses and LAE..... (4,708) (6,651) (4,334)
------- ------- --------
Ending reserves .............................. $ 45,108 $ 35,626 $ 20,134
======== ======== ========
Net of reinsurance:
Beginning reserves ........................... $ 34,592 $ 20,134 $ 20,952
Incurred losses and LAE ...................... 1,068 21,109 3,516
Calendar year payments for losses and LAE..... (3,965) (6,651) (4,334)
-------- -------- --------
Ending reserves .............................. $ 31,695 $ 34,592 $ 20,134
======== ======== ========
(1) Such acquired reserves have been reinsured by an affiliate of the former
parent (see "Liquidity and Capital Resources" for further discussion).
(Included in such reserves are reserves for PMA Re of $3.8 million, $2.9 million
and $2.6 million [gross and net] at December 31, 1997, 1996 and 1995,
respectively, and $13.1 million gross and zero net for Caliber One Indemnity
Company at December 31, 1997.)
Of the total net asbestos reserves, $6.7 million, $6.8 million, and $6.7 million
related to established claims reserves at December 31, 1997, 1996, and 1995,
respectively, and $41.9 million, $46.5 million, and $16.7 million related to
incurred but not reported losses at December 31, 1997, 1996, and 1995,
respectively. Of the total net environmental reserves, $11.2 million, $12.5
million, and $10.3 million related to established claims reserves at December
31, 1997, 1996, and 1995, respectively, and $20.5 million, $22.1 million, and
$9.8 million related to incurred but not reported losses at December 31, 1997,
1996, and 1995, respectively. All incurred asbestos and environmental losses
were for accident years 1986 and prior.
Management believes that its reserves for asbestos and environmental claims are
appropriately established based upon known facts, existing case law and
generally accepted actuarial methodologies. However, due to changing
interpretations by courts involving coverage issues, the potential for changes
in federal and state standards for clean-up and liability and other factors, the
ultimate exposure to the Property and Casualty Group for these claims may vary
significantly from the amounts currently recorded, resulting in a potential
future adjustment in the claims reserves recorded. Additionally, issues
involving policy provisions, allocation of liability among participating
insurers, proof of coverage and other factors make quantification of liabilities
exceptionally difficult and subject to adjustment based upon newly available
data.
39
<PAGE>
In 1996, Commercial Lines experienced reserve strengthening of $21.0 million, as
compared to a reserve release of $11.6 million in 1995. The reserve
strengthening in 1996 was principally due to a re-estimation of loss adjustment
costs associated with general liability claims. Through 1991, the Property and
Casualty Group's mix of general liability insurance policies was weighted
towards the manufacturing classes of business. Subsequent to 1991, the Property
and Casualty Group's mix of business became more heavily weighted towards the
construction and contracting classes of business. These particular classes of
business have experienced losses due to alleged construction defects and similar
matters, that have taken longer to emerge than the classes of business
previously written by the Property and Casualty Group. Defense costs associated
with these claims have also exceeded the original estimate of the Property and
Casualty Group's management, which was based on the patterns of indemnification
payments associated with the earlier classes of business written. When this
issue was discovered, the Property and Casualty Group factored the increased
defense costs and the emergence pattern in determining a more appropriate
reserve amount for loss handling costs. The release of reserves in 1995 was due
primarily to favorable loss experience in commercial automobile business.
The 1997 expense ratio declined by 3.3 points as compared to the 1996 expense
ratio. The 1997 Acquisition Expense Ratio increased by 3.0 points compared to
1996, primarily due to a 4.2 point increase related to the aforementioned
adjustment to accrued retrospective premiums in 1997 ($37.0 million) and by the
1997 cession of premiums associated with the PMA Life Insurance Company
transaction ($15.4 million), offset by the write-off in 1996 of $5.0 million in
retrospectively rated premiums. These actions reduced earned premiums without a
commensurate decrease in acquisition expenses. Such increase was partially
offset by ceding commission received by the Property and Casualty Group on its
reinsurance arrangement for Commercial Lines casualty losses. Such commissions
are recorded as a reduction of acquisition expenses. In 1996, the Acquisition
Expense Ratio increased 4.2 points compared to 1995 primarily due to a change in
the mix of business to a greater proportion of alternative market products and
self-insured services, which have much lower, in any, net premium which caused
acquisition expenses to represent a larger proportion of net premiums earned.
The 1997 Operating Expense Ratio was 22.6%, a decrease of 6.3 points as compared
to 28.9% in 1996. After adjusting for the reduction in accrued retrospective
premiums and the PMA Life Insurance Company transaction, the adjusted Operating
Expense Ratio would have been 18.1% in 1997. The lower adjusted Operating
Expense Ratio is primarily attributable to expense containment programs begun at
the Property and Casualty Group, and the higher levels of restructuring charges
and valuation adjustments in 1996. Operating expenses in 1997 decreased by $31.0
million as compared to 1996, despite an increase of $1.1 million in expenses
associated with the Property and Casualty Group's service revenues. The 1996
Operating Expense Ratio was adversely impacted by several factors, including an
accrual of $7.6 million for a voluntary early retirement program ("VERIP"), a
$4.8 million charge associated with a change in depreciable lives of computer
equipment and a $10.1 million increase in premium balances written off. In 1997,
the Property and Casualty Group recorded $5.2 million for severance and related
costs associated with the continued restructuring and cost reduction
initiatives. These initiatives have lowered payroll and related expenses in 1997
by $4.9 million. The 1996 Operating Expense Ratio increased 13.8 points in
comparison to 1995 primarily related to the aforementioned factors that
adversely impacted the 1996 ratio.
In 1997 and 1996, respectively, the Property and Casualty Group incurred
approximately $1.6 million and $1.8 million associated with the Year 2000 Issue.
Management anticipates that the Property and Casualty Group will incur
approximately $700,000 in 1998 as a result of this conversion; it is expected
that this conversion will be completed by the end of 1998 (see "Liquidity and
Capital Resources" for further discussion of the Year 2000 Issue).
The policyholder dividend ratios were 6.9%, 6.1% and 4.8% for the years ended
December 31, 1997, 1996 and 1995, respectively. The policyholder dividend ratio
increased by 1.3 points in 1997 as a result of the adjustment to retrospectively
rated premiums and the PMA Life Insurance Company transaction. The ratios have
generally increased over the three-year period mainly because of sliding-scale
dividend plans.
40
<PAGE>
Under such plans, the insured receives a dividend based upon the collective loss
experience of the plan. As the loss experience for the most recent three
underwriting years has improved relative to the years prior to this period, the
Property and Casualty Group has incurred higher policyholder dividends.
Net Investment Income
Net investment income was relatively flat in 1997 as compared to 1996, as lower
average investment balances resulting from the pay-down of loss reserves from
prior accident years primarily related to the commutation program and decreasing
premium volume were offset by higher yields associated with the purchase of high
grade corporate bonds and asset-backed securities. Net investment income
decreased 10.6% in 1996 as compared to 1995, primarily due to lower average
investment balances.
Comparison of SAP and GAAP Results
The results presented under SAP are those of the domestic insurance subsidiaries
of the Property and Casualty Group that share their results through a pooling
arrangement (the Pooled Companies). Prior to December 31, 1996, the Pooled
Companies were comprised of four domestic insurance companies: Pennsylvania
Manufacturers' Association Insurance Company, Manufacturers Alliance Insurance
Company, Pennsylvania Manufacturers Indemnity Company and Mid-Atlantic States
Casualty Company (MASCCO). As part of a plan to reduce the amount of indemnity
reserves from accident years 1991 and prior in the Pooled Companies, MASCCO was
removed from the pooling arrangement effective December 31, 1996, and indemnity
reserves from accident years 1991 and prior were transferred to MASCCO. The
other significant difference relates to various reinsurance agreements between
the Pooled Companies and certain foreign insurance subsidiaries. Prior to
December 31, 1996, Chestnut Insurance Company, Ltd. (Chestnut) was the reinsurer
under these agreements. At December 31, 1996, these reinsurance arrangements
were novated, and the assets and liabilities associated with such contracts were
sold to PMA Insurance Cayman, Limited (Cayman), a foreign affiliate. At December
31, 1997, the Pooled Companies had reinsurance recoverables from MASCCO and
Cayman of $96.2 million and $284.9 million, respectively.
In addition to the above and the different accounting treatment of acquisition
costs (see "PMA Re Results of Operations" for further discussion of SAP to GAAP
differences related to acquisition costs), the GAAP results for the Property and
Casualty Group include the results of other entities within the Property and
Casualty Group, but excluded from the aforementioned pooling agreement,
including PMA Life Insurance Company and other affiliated reinsurers and
non-insurance companies utilized in providing certain products and services to
the Property and Casualty Group's clients. The exclusion of such entities tends
to decrease the SAP combined ratio relative to the GAAP combined ratio.
Corporate and Other
The Corporate and Other segment is primarily comprised of corporate overhead and
the operations of the Company's properties. Corporate and Other operations
reported a pre-tax operating loss of $3.4 million in 1997 versus a pre-tax
operating loss of $0.5 million in 1996. The decline in the operating results of
Corporate and Other operations was due mainly to an incremental $2.2 million
increase in operating costs related to certain corporate properties disposed of
during the third quarter of 1997. No material gain or loss was recorded in
connection with the disposal of such properties.
In 1995, management determined that the fair market values of the Company's
former headquarters building, which was disposed of in 1997, and certain
adjacent properties were less than the carrying values plus the costs to carry
and sell the properties. The Company recorded a charge of $8.4 million in 1995
to write down these properties to their fair market values less costs to carry
and sell the properties. No such charge was recorded during 1996.
During 1997, the Company incurred pre-operating charges of approximately $0.9
million in establishing Caliber One. The Corporate segment also incurred $1.8
million of severance and related restructuring costs in 1997.
41
<PAGE>
Net Realized Investment Gains
Net realized investment gains amounted to $8.6 million, $3.0 million and $31.9
million in 1997, 1996 and 1995, respectively. During the three-year period ended
December 31, 1997, the Company realized gains from investment sales related to
the following: (i) transactions to move holdings between taxable and tax-exempt
fixed maturity investments in order to maximize after-tax yields; (ii)
transactions to expand the asset classes in which the Company invests to
capitalize on favorable yield spreads between such instruments and U.S. Treasury
securities; (iii) transactions based upon an assessment of the interest rate
environment and the shape of the yield curve; and (iv) sales of equity
securities, as the Company has substantially reduced its holdings of this asset
class over the last three years. Gains and losses on the sale of investments are
recognized as a component of net income, but the timing and recognition of such
gains and losses are unpredictable and are not indicative of future results.
In 1997, the Company repositioned its investment portfolio to improve its
pre-tax investment yield, while maintaining the maturity matching structure
between investments and liability cash flow projections. As interest rates
declined in the latter part of the year, these transactions resulted in a net
$8.6 million gain for 1997.
During 1996 and 1995, most of the investment sales activity resulted from
reducing the Company's holdings of tax-advantaged securities. Based upon an
assessment of the Company's position with respect to alternative minimum tax
("AMT"), the Company reduced its tax-advantaged securities positions beginning
in late 1995 and throughout 1996. In 1996, these sales resulted in a net loss of
$0.9 million, versus 1995 when such transactions resulted in a net gain of $12.1
million. In addition to gains and losses arising from the sales of fixed
maturity investments, sales of equity securities generated net realized gains of
$3.9 million and $0.9 million in 1996 and 1995, respectively.
Interest Expense and Income Taxes
Interest expense decreased $1.3 million in 1997, from $17.1 million in 1996 to
$15.8 million in 1997 due to the refinancing of the Company's debt with the New
Credit Facility. See "Liquidity and Capital Resources" below. In 1996, interest
expense decreased to $17.1 million from $18.7 million in 1995. Such reduction
related to slightly lower average debt balances in 1996. In addition, principal
payments on the Company's higher coupon senior notes (average coupon rate of
amounts paid was 9.49%) were funded with drawdowns on the Company's revolving
credit facility, which had an average interest rate of 6.08% in 1996.
The Company's effective tax rates were 21.5%, (29.3)% and 30.9% in 1997, 1996
and 1995, respectively. The Company recorded a net deferred tax asset of $70.4
million and $101.6 million in 1997 and 1996, respectively (see "Capital
Resources" for further discussion). In the normal course of business the Company
is examined by various taxing authorities, including the Internal Revenue
Service. Federal tax return examinations have been completed for the years 1992
and 1993. The examinations for years 1994 and 1995 are currently in progress. In
management's opinion, the ultimate resolution of these matters will not have an
adverse impact on the Company's financial position or results of operations.
Liquidity and Capital Resources
Liquidity
Liquidity is a measure of an entity's ability to secure enough cash to meet its
contractual obligations and operating needs. At the holding company level, the
Company requires cash to pay debt obligations, dividends to shareholders and
taxes to the Federal government, as well as to capitalize subsidiaries from time
to time. PMC's primary sources of liquidity are dividends from subsidiaries, net
tax payments received from subsidiaries and borrowings.
The Company paid interest of $19.8 million, $16.6 million and $15.1 million in
1997, 1996 and 1995, respectively. The Company made scheduled debt repayments in
1997, 1996 and 1995 of $7.3 million, $25.1 million and $125.1 million,
respectively, and paid dividends to shareholders of $8.0 million in 1997
42
<PAGE>
and $7.9 million in 1996 and 1995. PMC also made cash capital contributions to
its subsidiaries totaling $11.0 million, $50.0 million and $61.0 million in
1997, 1996 and 1995, respectively. In 1995, PMC also utilized cash to settle
intercompany balances with its domestic insurance subsidiaries.
Dividends from subsidiaries were $22.5 million, $53.6 million and $103.2 million
in 1997, 1996 and 1995, respectively. Net tax cash flows were $20.0 million,
$12.0 million and $11.4 million in 1997, 1996 and 1995, respectively.
In addition to dividends and tax payments from subsidiaries, the Company
utilized the following sources to generate liquidity for the above needs. During
the first quarter of 1997, the Company made debt repayments of $8.0 million on
the revolving credit agreement before refinancing all of its credit agreements
not already maturing in 1997 with the New Credit Facility (See "Capital
Resources" below for further discussion). During 1996, the Company financed
scheduled repayments on its senior note facilities of $25.0 million through
drawdowns on its revolving credit facility. In 1995, the Company repaid its
expiring revolving credit agreement by issuing $107.0 million of 7.62% privately
placed senior notes. Additionally, in 1995, the Company funded the scheduled
debt repayments on its existing senior notes by drawing down $18.0 million on a
new $50.0 million revolving credit agreement with a banking syndicate. At
December 31, 1997, the Company had $32.0 million available on the New Credit
Facility. In addition to the New Credit Facility, the Company maintains a
committed facility of $50.0 million for letters of credit (the "Letter of Credit
Facility"). The Letter of Credit Facility is utilized primarily for securing
reinsurance obligations of the Company's insurance subsidiaries. As of December
31, 1997, the Company had $46.9 million outstanding in letters of credit under
the Letter of Credit Facility.
The Company's domestic insurance subsidiaries' ability to pay dividends to the
holding company is limited by the insurance laws and regulations of
Pennsylvania. Under such laws and regulations, dividends may not be paid without
prior approval of the Commissioner in excess of the greater of (i) 10% of
surplus as regards to policyholders as of the end of the preceding year or (ii)
SAP net income for the preceding year, but in no event to exceed unassigned
funds.
Under this standard, the Pooled Companies and PMA Re can pay an aggregate of
$51.2 million of dividends without the prior approval of the Commissioner during
1998. Caliber One Indemnity Company had an unassigned deficit of $6.4 million as
of December 31, 1997, and therefore, cannot pay non-extraordinary dividends;
also, Caliber One Indemnity Company is directly owned by PMA Re, and as such,
its dividends may not be paid directly to PMC. Under its plan of operation filed
with the Pennsylvania Insurance Department, MASCCO must maintain a ratio of
unpaid losses and loss adjustment expenses to surplus of no more than eight to
one; as of December 31, 1997, MASCCO was in compliance with such requirement. In
addition, the New Credit Facility requires the Company's insurance subsidiaries
to maintain combined statutory capital and surplus of $450.0 million. At
December 31, 1997, the Company's insurance subsidiaries had combined statutory
capital and surplus of $552.2 million. Additionally, the New Credit Facility
requires the domestic insurance subsidiaries of the Property and Casualty Group
to maintain an adjusted surplus to authorized control level ratio (as calculated
under risk based capital rules) of not less than 220% as of December 31, 1997,
230% as of December 31, 1998, and 240% as of December 31, 1999, and thereafter,
and requires PMA Re to maintain such ratio at 300%. At December 31, 1997, the
ratios of the domestic insurance subsidiaries of the Property and Casualty Group
ranged from 293% to 324%, PMA Re's ratio was 355% and Caliber One Indemnity
Company's ratio was 1,922%.
In December 1997, PMA Re acquired 100% of the outstanding common stock of
Caliber One Indemnity Company (formerly known as Lincoln Insurance Company) for
approximately $16.0 million and made a capital contribution of $11.3 million to
Caliber One Indemnity Company. In conjunction with this purchase, all of Caliber
One Indemnity Company's acquired loss reserves were reinsured by an affiliate of
Caliber One Indemnity Company's former parent for adverse development and
uncollectible reinsurance in the amount of the stated reserves plus $68.5
million (see Note 1 to the Consolidated Financial Statements). Management
believes that the reinsurance obtained as part of the purchase will be adequate
43
<PAGE>
to cover any future reserve development or uncollectible reinsurance on the
acquired reserves. PMA Re intends to maintain Caliber One Indemnity Company's
surplus at not less than $25.0 million, the minimum capital and surplus required
by many states in order to be an eligible surplus lines carrier.
PMC's dividends to shareholders are restricted by its debt agreements. Based
upon the terms of the New Credit Facility, on a pro forma basis, under the most
restrictive debt covenant, PMC would be able to pay dividends of approximately
$14.5 million in 1998 (See "Capital Resources" for further discussion).
Management believes that the Company's sources of funds will provide sufficient
liquidity to meet short-term and long-term obligations.
Investments
The Company's investment policy objectives are to (i) seek competitive after-tax
income and total return, (ii) maintain very high grade asset quality and
marketability, (iii) maintain maturity distribution commensurate with the
Company's business objectives, (iv) provide portfolio flexibility for changing
business and investment climates and (v) provide liquidity to meet operating
objectives. The Company has established strategies, asset quality standards,
asset allocations and other relevant criteria for its fixed maturity and equity
portfolios. In addition, maturities are structured after projecting liability
cash flows with actuarial models. The Company also does not invest in various
types of investments, including speculative derivatives. The Company's portfolio
does not contain any significant concentrations in single issuers (other than
U.S. treasury and agency obligations), industry segments or geographic regions.
The Company's Board of Directors is responsible for the Company's investment
policy objectives. The Company retains outside investment advisers to provide
investment advice and guidance, supervise the Company's portfolio and arrange
securities transactions through brokers and dealers. The Company's Executive and
Finance Committees of the Board of Directors meet periodically with the
investment advisers to review the performance of the investment portfolio and to
determine what actions should be taken with respect to the Company's
investments. Investments by the Pooled Companies, MASCCO and PMA Re must comply
with the insurance laws and regulations of the Commonwealth of Pennsylvania and
investments for Caliber One Indemnity Company must comply with the insurance
laws and regulations of Delaware. The Company's capital not allocated to the
Pooled Companies, MASCCO, PMA Re and Caliber One Indemnity Company may be
invested in securities and other investments that are not subject to such
insurance laws, but nonetheless conform to the Company's investment policy.
The following table summarizes the Company's investments by carrying value as of
December 31, 1997, and 1996:
(dollar amounts in millions)
1997 1996
---- ----
Carrying Carrying
Investment Value Percent Value Percent
- ---------- ----- ------- ----- -------
U.S. Treasury securities and
obligations of U.S. Government
agencies ........................ $1,119.5 51.0% $1,602.8 70.8%
Obligations of states and political
subdivisions ................... -- -- 76.5 3.4%
Corporate debt securities ............ 687.7 31.3% 372.8 16.5%
Mortgage backed securities ........... 122.3 5.6% 74.0 3.3%
Equity securities .................... -- -- 0.3 --
Short-term investments ............... 265.2 12.1% 135.0 6.0%
-------- ------ -------- ------
Total (1) ............................ $2,194.7 100.0% $2,261.4 100.0%
======== ====== ======== ======
(1) As of December 31, 1997, the market value of the Company's total
investments was $2,194.7 million.
The following table indicates the composition of the Company's fixed maturities
portfolio at carrying value, excluding short-term investments, by rating as of
December 31, 1997, and 1996:
44
<PAGE>
(dollar amounts in millions)
1997 1996
---- ----
Carrying Carrying
Ratings (1) Value Percent Value Percent
- ----------- ----- ------- ----- -------
U.S. Treasury securities and AAA.... $1,449.0 75.1% $1,882.4 88.5%
AA.................................. 150.0 7.8% 95.8 4.5%
A................................... 282.2 14.6% 147.9 7.0%
BBB................................. 48.3 2.5% -- --
------- ------ ------- ------
Total............................... $1,929.5 100.0% $2,126.1 100.0%
======== ====== ======== ======
(1) Ratings as assigned by Standard and Poor's. Such ratings are generally
assigned at the issuance of the securities, subject to revision on the
basis of ongoing evaluations. Ratings in the table are as of December 31
of the years indicated.
The following table sets forth scheduled maturities for the Company's
investments in fixed maturities, excluding short-term investments, based on
stated maturity dates as of December 31, 1997. Expected maturities will differ
from contractual maturities because the issuers may have the right to call or
prepay obligations with or without call or prepayment penalties:
(dollar amounts in millions)
Carrying Value Percent
-------------- -------
1 year or less............................. $ 128.9 6.7%
Over 1 year through 5 years................ 633.6 32.8%
Over 5 years through 10 years.............. 396.5 20.6%
Over 10 years.............................. 648.2 33.6%
Mortgage-backed securities................. 122.3 6.3%
----- ----
Total...................................... $1,929.5 100.0%
======== ======
The following table reflects the Company's investment results for each year in
the three-year period ended December 31, 1997:
(dollar amounts in millions)
1997 1996 1995
---- ---- ----
Average invested assets (1).......... $2,247.7 $2,366.8 $2,395.8
Net investment income (2)............ $ 136.7 $ 133.9 $ 139.4
Net effective yield (3).............. 6.09% 5.66% 5.82%
Net realized investment gains........ $ 8.6 $ 3.0 $ 31.9
(1) Average of beginning and ending amounts of cash and investments for the
period at carrying value.
(2) After investment expenses, excluding net realized investment gains.
(3) Net investment income for the period divided by average invested assets for
the same period.
As of December 31, 1997, the duration of the Company's investments was
approximately 5.3 years and the duration of its liabilities was approximately
5.1 years.
During 1997, the Company established a securities lending program through which
securities are loaned from the Company's portfolio to qualifying third parties,
subject to certain limits, via a lending agent for short periods of time.
Borrowers of these securities must provide collateral equal to a minimum of 102%
of the market value and accrued interest of the loaned securities. Acceptable
collateral may be in the form of either cash or securities. Cash received as
collateral is invested in short-term investments, and all securities received as
collateral are of similar quality to those securities lent by the Company.
Additionally, the Company limits securities lending to 40% of statutory admitted
assets of its insurance subsidiaries, with a 2% limit on statutory admitted
assets to any individual borrower. The Company receives either a fee from the
borrower or retains a portion of the income earned on the collateral. Under the
terms of the securities lending program, the Company is indemnified against
borrower default, with the lending agent responsible to the Company for any
deficiency between the cost of replacing a security that was not returned and
the amount of collateral held by the Company. In 1997, the Company recognized
income from securities lending transactions of approximately $524,000, net of
lending fees,
45
<PAGE>
which was included in investment income. The Company had approximately $175.0
million of securities on loan as of December 31, 1997.
Capital Resources
The Company's total assets decreased to $3,057.3 million at December 31, 1997
from $3,117.5 million at December 31, 1996. Total investments decreased $66.6
million to $2,194.7 million at December 31, 1997. The decrease in investments is
primarily attributable to the Property and Casualty Group's pay-down of loss
reserves from prior accident years as part of the formal commutation program
which was initiated in the fourth quarter 1996 and continued into late 1997. All
other assets increased $6.4 million in 1997, mainly due to increases in
reinsurance recoverables of $74.4 million and cash of $25.0 million. The
reinsurance recoverables increase primarily relates to the purchase of Caliber
One Indemnity Company during 1997 (see Note 1 to the Consolidated Financial
Statements) and the PMA Life Insurance Company transaction (see "The Property
and Casualty Group Results of Operations"), which included approximately $32.7
million and $15.4 million, respectively, of ceded loss reserves. The increase in
cash relates to investment security purchases which did not settle until January
1, 1998, causing a large cash balance at year-end. The above asset increases
were partially offset by a $33.6 million decrease in uncollected premiums
primarily related to the reduction in accrued retrospective premiums by the
Property and Casualty Group (see "The Property and Casualty Group Results of
Operations"), a $31.2 million decrease in deferred income taxes (see below) and
a $12.2 million decrease in fixed assets primarily related to the disposal of
certain corporate properties during the third quarter of 1997. No material gain
or loss was recorded in connection with the disposal of such properties.
The Company's deferred income tax asset decreased to $70.4 million at December
31, 1997 from $101.6 million at December 31, 1996. The $31.2 million decrease
from 1996 to 1997 resulted primarily from the $23.5 million charge related to
the fair value of Company's investments that is recorded as a component of the
deferred tax asset. The net deferred tax asset of $70.4 million reflects
management's estimate of the amounts that the Company expects to recover in
future years primarily through the utilization of net operating losses and AMT
credit carryforwards. Under SFAS No. 109, a valuation allowance should be
provided to offset the effects of a deferred tax asset if management believes
that it is more likely than not that the benefit of a deferred tax item will not
be realized. Management believes that the benefit of its deferred tax asset will
be fully realized, and therefore has not provided for a valuation allowance. At
December 31, 1997, the Company had approximately $109.6 million of net operating
carryforwards (expiring in 2011), approximately $7.5 million of AMT credit
carryforwards (which do not expire) and approximately $188,000 of general
business credit carryforwards (expiring in 2010 and 2011).
Unpaid losses and loss adjustment expenses decreased $87.9 million to $2,003.2
million at December 31, 1997. This decrease reflects the Property and Casualty
Group's pay-down of loss reserves from prior accident years as part of the
formal commutation program which was initiated in the fourth quarter 1996 and
continued into late 1997, partially offset by loss reserves acquired in
connection with the purchase of Caliber One Indemnity Company (see Note 1 to the
Consolidated Financial Statements).
Estimating future claims costs is necessarily a complex and judgmental process
inasmuch as reserve amounts are based on management's informed estimates and
judgments using data currently available. As such, management reviews a variety
of information, and uses a number of actuarial methods applied to historical
claims data, which often produces a range of possible results. As additional
experience and other data are reviewed, these estimates and judgments are
revised, at which point reserves may be increased or decreased accordingly. Such
increases or decreases are reflected in operating results for the time period in
which the adjustments are made. While the estimate for unpaid losses and loss
adjustment expenses is subject to many uncertainties, management believes that
it has made adequate provision for its claims liabilities. However, if actual
losses exceed the amounts recorded in the financial statement, the Company's
financial condition and results of operations could be adversely affected.
At December 31, 1997, the Company's loss reserves were stated net of $59.9
million of salvage and subrogation. $50.8 million of salvage and subrogation
related to the Property and Casualty Group, $46.0
46
<PAGE>
million of which related to workers' compensation and $4.8 million related to
Commercial Lines. The anticipated salvage and subrogation was $9.1 million for
PMA Re. Incurred salvage and subrogation (increased) reduced losses and LAE by
($18.5) million, ($0.6) million and $9.5 million in 1997, 1996 and 1995,
respectively. The Company's policy with respect to estimating the amounts and
realizability of salvage and subrogation is to develop accident year schedules
of historic paid salvage and subrogation by line of business, which are then
projected to an ultimate basis using actuarial projection techniques. The
anticipated salvage and subrogation is the estimated ultimate salvage and
subrogation less any amounts received by the Company. The realizability of
anticipated salvage and subrogation is reflected in the historical data that is
used to complete the projection, as historic paid data implicitly considers
realization and collectibility.
The Company actively manages its exposure to catastrophic events. In the
underwriting process, the Company generally avoids the accumulation of insurable
values in catastrophe prone regions. Also, in writing property reinsurance
coverages, PMA Re typically requires per occurrence loss limitations for
contracts that could have catastrophe exposure. Through per risk reinsurance,
the Company also manages its net retention in each exposure. In addition, PMA Re
maintains retrocessional protection of $46.0 million excess of $2.0 million per
occurrence, and the Property and Casualty Group maintains catastrophe
reinsurance protection of $27.7 million excess of $850,000. As a result, the
Company's loss ratios have not been significantly impacted by catastrophes, and
management believes that the Company has adequate reinsurance to protect against
the estimated probable maximum gross loss from a catastrophic event; however,
though management believes it is unlikely, an especially severe catastrophic
event could exceed the Company's reinsurance and/or retrocessional protection,
and adversely impact the Company's financial position, perhaps materially.
The Company also maintains reinsurance and retrocessional protection for other
lines of business at December 31, 1997, as follows:
Retention Limits
--------- ------
The Property and Casualty Group:
Per Occurrence:
Workers' compensation...... $ 1.5 million $ 103.5 million
Per Risk:
Property lines............. $ 0.5 million (1) $ 19.5 million
Auto physical damage....... $ 0.5 million $ 2.0 million
Other casualty lines....... $ 0.2 million (2) $ 4.8 million
PMA Re:
Per Occurrence:
Casualty lines............. $ 2.8 million $ 12.5 million
Workers' compensation...... $ 2.0 million $ 53.0 million
Property lines............. $ 2.0 million $ 46.0 million
Per Risk:
Property lines............. $ 0.8 million $ 4.2 million
Casualty lines............. $ 1.5 million $ 6.0 million
(1) This coverage also provides protection of $48.5 million per occurrence over
its combined net retention of $0.5 million.
(2) This coverage also provides protection of $49.8 million per occurrence over
its combined net retention of $0.2 million.
Also, PMA Re maintains aggregate protection up to $22.3 million in excess of
$178.0 million for the current accident year. Effective January 1, 1998, PMA Re
added a new workers' compensation program which includes coverage of $98.0
million excess of $2.0 million per occurrence, $98.5 million excess of $1.5
million per program per occurrence and $18.5 million excess of $1.5 million per
person per occurrence.
The Company performs extensive credit reviews on its reinsurers, focusing on,
among other things, financial capacity, stability, trends, and commitment to the
reinsurance business. Prospective and existing
47
<PAGE>
reinsurers failing to meet the Company's standards are excluded from the
Company's reinsurance programs. In addition, the Company requires letters of
credit to support balances due from reinsurers not authorized to transact
business in the applicable jurisdictions.
At December 31, 1997, the Company had reinsurance recoverables due from the
following unaffiliated single reinsurers in excess of 3% of shareholders'
equity:
Gross amount
due to the Company A.M. Best
Reinsurer (in thousands) Rating
- --------- -------------- ------
United States Fidelity and Guaranty Company....... $ 74,041 A
Essex Insurance Company........................... $ 36,807 A
American Re-Insurance Corporation................. $ 35,411 A+
Kemper Reinsurance Corporation.................... $ 21,853 A
London Life International Reinsurance Corporation. $ 16,212 A+
Continental Casualty Company...................... $ 15,209 A
The Company maintained funds held to collateralize the above balances in the
amount of $66.2 million at December 31, 1997. The Company believes that it would
have the right to offset the funds withheld from a reinsurer against the
balances due from such reinsurer in the event of insolvency. Funds held under
reinsurance treaties decreased $17.3 million in 1997, primarily due to the
commutation of a prior underwriting year for one of the reinsurance covers at
the Property and Casualty Group as well as one of the retrocessional covers at
PMA Re, partially offset by retrocessional activity at PMA Re for the current
underwriting year.
Long-term debt remained essentially constant between 1997 and 1996. As noted
previously, management refinanced its existing credit agreements on March 14,
1997 under the New Credit Facility, replacing the following debt which was
outstanding at that time:
(dollar amounts in thousands)
Senior notes 9.60%, due 2001.................... $ 46,428
Senior notes 7.62%, due 2001, Series A.......... 71,000
Senior notes 7.62%, due 2000, Series B.......... 36,000
Revolving credit agreement, expiring in 1998.... 36,000
--------
Total........................................... $189,428
--------
The early extinguishment of the senior note agreements resulted in an
extraordinary loss of $4.7 million ($7.3 million pre-tax) which was recorded in
the first quarter of 1997. The New Credit Facility bears interest at LIBOR plus
0.70% on the utilized portion, and carries a 0.275% facility fee on the
unutilized portion. The margin over LIBOR is adjustable downward based upon
future reductions in the Company's debt to capitalization ratio. As of December
31, 1997, the interest rate on the New Credit Facility was 6.61% on the utilized
portion. The final expiration of the New Credit Facility will be December 31,
2002, maturing in an installment of $15.5 million in 1999 and annual
installments of $62.5 million commencing in 2000 through 2002. Management also
entered into an interest rate swap agreement which manages the impact of the
potential volatility of the interest rate associated with the floating rates on
the New Credit Facility. The interest rate swap covers a notional principal
amount of $150.0 million and effectively converts the floating rate on such
portion of the New Credit Facility to a fixed 7.24%.
Other liabilities, including taxes, licenses and fees, decreased $9.1 million in
1997 to $81.5 million compared to 1996 primarily due to lower operating expenses
at the Property and Casualty Group during 1997.
Consolidated shareholders' equity at December 31, 1997, totaled $478.3 million
or $19.96 per share compared to $425.8 million or $17.86 per share at December
31, 1996. As a result of changes in market
48
<PAGE>
interest rates, the unrealized appreciation of investments, net of tax, was
$18.8 million at December 31, 1997, compared to an unrealized depreciation of
investments, net of tax, of $24.9 million at December 31, 1996, resulting in an
increase in shareholders' equity of $43.7 million or $1.82 per share.
Consolidated shareholders' equity decreased to $425.8 million or $17.86 per
share at December 31, 1996, from $609.7 million or $25.53 per share at December
31, 1995. This decrease was due primarily to the net loss of $135.3 million in
1996, a decrease in shareholders' equity of $42.4 million, net of tax, or $1.78
per share, related to unrealized depreciation of investments and dividends
declared of $7.9 million.
At December 31, 1997, the Company's capital structure consisted of $203.0
million of long-term debt and $478.3 million of shareholders' equity. The
Company utilizes long-term debt in its capital structure to fund internal
expansion through capital contributions to subsidiaries, to pursue investment
opportunities, and to refinance existing debt. Due to the inherent risks
associated with the insurance industry, management strives to maintain a
relatively conservative capital structure. Management believes that a certain
amount of debt is necessary in order to enhance returns on shareholders' equity;
however, the level of debt must be appropriate in terms of the availability of
dividends from subsidiaries, operating income, and the overall capital
structure. In determining the appropriate level of long-term debt, management
focuses on the following statistics: statutory dividends to interest expense,
earnings (loss) before interest and taxes to interest expense, pre-tax operating
income (loss) before interest to interest expenses, and debt to capitalization
ratio. The following table indicates the Company's status with respect to these
statistics:
1997 1996 1995
---- ---- ----
Statutory dividends to interest expense (times)... 1.4 3.1 3.8
Earnings (loss) before interest and taxes to
interest expense (times)........................ 2.6 (10.2) 2.9
Pre-tax operating income (loss) before interest
to interest expense (times)..................... 2.0 (10.4) 1.2
Debt to total capitalization (excluding SFAS
No. 115 adjustment)............................. 30.6% 31.2% 25.6%
Presently, management believes that the existing capital structure is
appropriate for the Company. However, management continually monitors the
capital structure in light of developments in the business, and the present
assessment could change as management becomes aware of new opportunities and
challenges in the Company's business.
Year 2000 Issue
The unprecedented advances in computer technology over the past several decades
have resulted in dramatic changes in the way companies do business. Most of
these developments have been beneficial, but some have proven costly, as
businesses have struggled to adapt to various features of the new technological
landscape. One such well-publicized problem has arisen out of the worldwide use
of the so-called "Year 2000" programming convention, in which two digit numbers
were generally used instead of four digit numbers to identify the years used in
dates. As a consequence, most computers require relatively costly reprogramming
to enable them to correctly perform date operations involving years 2000 or
later, a problem anticipated to have substantial repercussions on the business
world, since computer operations involving date calculations are pervasive.
With the assistance of outside consulting groups, the Company began evaluating
and reprogramming its own computer systems to address the Year 2000 problem in
late 1995. Management anticipates that by year-end 1998, it will have
substantially completed all necessary programming work so that Year 2000 issues
are not likely to result in any material adverse disruptions in the Company's
computer systems or its internal business operations. The cost of this work
through year-end 1997 has been approximately $3.8 million. The Company estimates
that the total remaining cost will be approximately $1.3 million, which will be
expensed in 1998.
49
<PAGE>
Many experts now believe that Year 2000 problem may have a material adverse
impact on the national and global economy generally. In addition, it seems
likely that if businesses are materially damaged as a result of Year 2000
problems, at least some such businesses may attempt to recoup their losses by
claiming coverage under various types of insurance policies. Although management
has concluded that under a fair reading of the various policies of insurance
issued by it no coverage for Year 2000 problems should be considered to exist,
it is not possible to predict whether or to what extent any such coverage could
ultimately be found to exist by courts in various jurisdictions. Accordingly,
important factors which could cause actual results to differ materially from
those expressed in the forward looking statements include, but are not limited
to, the inability of the Company to accurately estimate the impact of the Year
2000 problem on the insurance issued by or other business operations of the
Company.
Regulation
The National Association of Insurance Commissioners (NAIC) has adopted
risk-based capital ("RBC") requirements for property/casualty insurance
companies to evaluate the adequacy of statutory capital and surplus in relation
to investment and insurance risks such as underwriting, asset quality, loss
reserve adequacy and other business factors.
Under RBC requirements, regulatory compliance is determined by the ratio of a
Company's total adjusted capital, as defined by the NAIC, to its authorized
control level, also as defined by the NAIC. Companies below prescribed trigger
points in terms of such ratio are classified as follows:
Company action level 200%
Regulatory action level 150%
Authorized control level 100%
Mandatory control level 70%
At December 31, 1997, the ratios of the domestic insurance subsidiaries of the
Property and Casualty Group ranged from 293% to 324%, PMA Re's ratio was 355%
and Caliber One Indemnity Company's ratio was 1,922%.
RBC requirements for property/casualty insurance companies allow a discount for
workers' compensation reserves to be included in the adjusted surplus
calculation. However, the calculation for RBC requires the phase-out of
non-tabular reserve discounts previously taken for workers' compensation
reserves. The discount phase-out has increased by 20% in each year since 1994,
ultimately phasing out 100% of such discount by December 1998. As a result, this
phase-out negatively impacts the RBC ratios of companies which write workers'
compensation insurance and discount such reserves on a non-tabular basis
relative to companies which write other types of property/casualty insurance.
Management believes that it will be able to maintain the Pooled Companies' RBC
in excess of regulatory requirements through prudent underwriting and claims
handling, investing and capital management. However, no assurances can be given
that developments affecting the Property and Casualty Group will not occur, many
of which could be outside of management's control, including but not limited to
changes in the regulatory environment, economic conditions and competitive
conditions in the jurisdictions in which the Property and Casualty Group writes
business, which will cause the Pooled Companies' RBC to fall below required
levels resulting in a corresponding regulatory response.
In addition, the NAIC has developed a series of twelve ratios (the "IRIS
ratios") designed to further assist regulators in assessing the financial
condition of insurers. These ratio results are computed annually and reported to
the NAIC and the insurer's state of domicile. In 1997, two of the three Pooled
Companies reported unusual values in three ratios, and the remaining Pooled
Company reported unusual values in two ratios, relating to reserve development,
directly as a result of the reserve strengthening that occurred in 1996. In
addition, Caliber One Indemnity Company reported an unusual value in one ratio
relating to the change in surplus as a result of the $11.3 million capital
contribution from PMA Re in 1997 (see Note 1 to the Consolidated Financial
Statements for further discussion). In 1996, each of the Pooled Companies
reported unusual values in three ratios relating to reserve development and two
ratios, all of
50
<PAGE>
which related to historical profitability, directly as a result of the reserve
strengthening and asset valuations that occurred in 1996. MASCCO reported
unusual values in three historical profitability ratios, directly as a result of
a large intercompany reinsurance transaction that occurred at year end 1996.
New Accounting Pronouncements
In June 1996, the Financial Accounting Standards Board ("FASB") issued SFAS No.
125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities." SFAS No. 125, which is effective for transfers
and extinguishments occurring after December 31, 1996, provides consistent
standards for distinguishing transfers of financial assets that are sales from
transfers that are secured borrowings. The Property and Casualty Group's
domestic insurance subsidiaries currently participate in a transfer arrangement
of certain accounts receivable. Such arrangement has been restructured as a
result of the adoption of SFAS No. 125. The restructuring of such arrangement
did not have a material impact on the Company's financial condition or results
of operations.
In February 1997, the FASB issued SFAS No. 128, "Earnings Per Share," which
supersedes Accounting Principles Board Opinion No. 15, "Earnings Per Share" and
related interpretations. SFAS No. 128, which is effective for financial
statements for both interim and annual periods ending after December 15, 1997,
requires presentation of earnings per share by all entities that have issued
common stock or potential common stock if those securities trade in a public
market either on a stock exchange or in the over-the-counter market, including
securities quoted only locally or regionally. SFAS No. 128 establishes a new
calculation for earnings per share showing both basic and diluted earnings per
share. As a result, basic earnings per share was calculated using only weighted
average shares outstanding with no dilutive impact from common stock equivalents
while diluted earnings per share was calculated similar to the current fully
diluted earnings per share calculation. All prior period earnings per share
amounts were restated to be consistent with the new requirements.
During 1997, the FASB issued SFAS No. 130, "Comprehensive Income," which
establishes standards for the reporting and disclosure of comprehensive income
and its components (revenues, expenses, gains and losses). SFAS No. 130 requires
that all items that are required to be recognized under accounting standards as
components of comprehensive income be reported in a financial statement that is
displayed with the same prominence as other financial statements. In addition,
the FASB issued SFAS No. 131, "Disclosures About Segments of an Enterprise and
Related Information," which establishes standards for the way that public
business enterprises report information about operating segments in annual
financial statements and interim financial reports issued to shareholders. SFAS
No. 131 also establishes standards for related disclosures about products and
services, geographic areas and major customers. The Company will adopt the
provisions of these pronouncements in 1998. The adoption of these pronouncements
will not have an impact on the Company's financial position and results of
operations, but may change the presentation of certain of the Company's
financial statements and related notes and data thereto.
Forward-Looking Statements
This Management's Discussion and Analysis and other statements made throughout
this report contain forward-looking statements that involve risks and
uncertainties. The Company's actual results could differ materially from those
expected by the Company. The factors that could cause actual results to vary
materially, some of which are described with the forward-looking statements,
include, but are not limited to, the following: changes in general economic
conditions, including the performance of financial markets and interest rates;
regulatory or tax changes, including changes in risk-based capital or other
regulatory standards that affect the ability of the Company to conduct its
business; competitive or regulatory changes that affect the cost of or demand
for the Company's products; the effect of changes in workers' compensation
statutes and the administration thereof; the Company's ability to predict and
effectively manage claims related to insurance and reinsurance policies;
reliance on key management; adequacy of claim liabilities; adequacy and
collectibility of reinsurance purchased by the Company; and natural disasters.
Investors should not place undue reliance on any such forward-looking
statements.
51
<PAGE>
PENNSYLVANIA MANUFACTURERS CORPORATION
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
December 31, December 31,
(in thousands, except share data) 1997 1996
- ------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Assets
Investments:
Fixed maturities available for sale, at fair value (amortized cost:
1997-$1,900,594; 1996-$2,164,391) $ 1,929,518 $ 2,126,120
Equity securities, at fair value (cost: 1997-$5; 1996-$259) 13 262
Short-term investments, at amortized cost which approximates fair value 265,207 134,971
-----------------------------------
Total investments 2,194,738 2,261,353
Cash 32,148 7,176
Investment income due and accrued 23,818 30,268
Uncollected premiums (net of allowance for uncollectible accounts:
1997-$18,406; 1996-$18,877) 252,425 285,982
Reinsurance receivables (net of allowance for
uncollectible reinsurance: 1997-$2,096; 1996-$3,901) 332,406 257,983
Property and equipment (net of accumulated depreciation:
1997-$42,771; 1996-$41,219) 38,621 50,861
Deferred income taxes, net 70,391 101,642
Deferred acquisition costs 45,288 44,006
Other assets 67,423 78,245
-----------------------------------
Total assets $ 3,057,258 $ 3,117,516
===================================
Liabilities
Unpaid losses and loss adjustment expenses $ 2,003,187 $ 2,091,072
Unearned premiums 211,455 205,982
Long-term debt 203,000 204,699
Dividends to policyholders 10,200 12,524
Funds held under reinsurance treaties 69,545 86,804
Taxes, licenses and fees, and other expenses 49,410 39,226
Other liabilities 32,114 51,381
-----------------------------------
Total liabilities 2,578,911 2,691,688
===================================
Commitments and contingencies (Note 13)
Shareholders' Equity
Common stock, $5 par value (40,000,000 shares authorized;
15,286,263 shares issued and 14,850,789 outstanding - 1997;
16,095,416 shares issued and 15,670,052 outstanding - 1996) 76,431 80,477
Class A common stock, $5 par value (40,000,000 shares authorized;
9,156,682 shares issued and 9,117,735 outstanding - 1997;
8,247,804 shares issued and 8,173,023 outstanding - 1996) 45,783 41,239
Additional paid-in capital - Class A common stock 339 -
Retained earnings 343,368 336,921
Unrealized gain (loss) on investments (net of deferred income taxes:
1997-$(10,126); 1996-$13,394) 18,806 (24,874)
Notes receivable from officers (198) (1,162)
Treasury stock, at cost:
Common stock (1997-435,474 shares; 1996-425,364 shares) (5,572) (5,408)
Class A common stock (1997-38,947 shares; 1996-74,781 shares) (610) (1,365)
-----------------------------------
Total shareholders' equity 478,347 425,828
-----------------------------------
Total liabilities and shareholders' equity $ 3,057,258 $ 3,117,516
===================================
</TABLE>
See accompanying notes to the consolidated financial statements.
52
<PAGE>
PENNSYLVANIA MANUFACTURERS CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
for the years ended December 31,
(in thousands, except per share data) 1997 1996 1995
- -----------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Revenues:
Net premiums written $ 418,282 $ 443,475 $ 489,876
Change in net unearned premiums (5,331) (12,400) (924)
Change in accrued retrospective premiums (37,000) (10,500) (4,000)
-------------------------------------------
Net premiums earned 375,951 420,575 484,952
Net investment income 136,698 133,936 139,355
Net realized investment gains 8,598 2,984 31,923
Service revenues 10,311 9,189 5,106
-------------------------------------------
Total revenues 531,558 566,684 661,336
-------------------------------------------
Losses and Expenses:
Losses and loss adjustment expenses (includes $(35,000) effect of
the change in discount rate on the Property and Casualty Group's
workers' compensation unpaid losses from 4% to 5% in 1995) 307,281 536,623 422,578
Amortization of deferred acquisition costs 93,501 90,292 87,207
Operating expenses 75,139 97,856 81,161
Dividends to policyholders 14,716 16,255 16,743
Interest expense 15,768 17,052 18,734
-------------------------------------------
Total losses and expenses 506,405 758,078 626,423
-------------------------------------------
Income (loss) before income taxes and extraordinary item 25,153 (191,394) 34,913
-------------------------------------------
Provision (benefit) for income taxes:
Current (4,506) (44,572) (4,570)
Deferred 9,906 (11,488) 15,353
-------------------------------------------
Total 5,400 (56,060) 10,783
-------------------------------------------
Income (loss) before extraordinary item 19,753 (135,334) 24,130
Extraordinary loss from early extinguishment
of debt (net of income tax benefit of $2,549) (4,734) - -
-------------------------------------------
Net income (loss) $ 15,019 $(135,334) $ 24,130
-------------------------------------------
Earnings (loss) per common and equivalent share Basic:
Earnings (loss) before extraordinary item $ 0.83 $ (5.68) $ 1.01
Extraordinary item (0.20) - -
-------------------------------------------
Net earnings (loss) $ 0.63 $ (5.68) $ 1.01
-------------------------------------------
Diluted:
Earnings (loss) before extraordinary item $ 0.80 $ (5.68) $ 0.97
Extraordinary item (0.19) - -
-------------------------------------------
Net earnings (loss) $ 0.61 $ (5.68) $ 0.97
-------------------------------------------
</TABLE>
See accompanying notes to the consolidated financial statements.
53
<PAGE>
PENNSYLVANIA MANUFACTURERS CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
<TABLE>
<CAPTION>
Additional
Common Stock Class A Common Stock paid-in capital
--------------------------------------------- Class A
(in thousands, except share and per share data) Shares Amounts Shares Amounts Common Stock
- ----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Balance-January 1, 1995 17,606,850 $ 88,034 6,736,370 $ 33,682 $ -
Net income
Common stock dividends declared ($.32 per share)
Class A common stock dividends declared ($.36 per share)
Conversion of common stock into Class A common stock (562,270) (2,811) 562,270 2,811
Unrealized gain on investments available for sale (net of
tax effect of $(36,063))
Repayment of notes
Purchase of treasury shares, net
Effect of other treasury stock transactions
- ----------------------------------------------------------------------------------------------------------------------------------
Balance-December 31, 1995 17,044,580 85,223 7,298,640 36,493 -
Net loss
Common stock dividends declared ($.32 per share)
Class A common stock dividends declared ($.36 per share)
Conversion of common stock into Class A common stock (949,164) (4,746) 949,164 4,746
Unrealized loss on investments available for sale (net of
tax effect of $22,823)
Repayment of notes
Purchase of treasury shares, net
- ----------------------------------------------------------------------------------------------------------------------------------
Balance-December 31, 1996 16,095,416 80,477 8,247,804 41,239 -
Net income
Common stock dividends declared ($.32 per share)
Class A common stock dividends declared ($.36 per share)
Conversion of common stock into Class A common stock (809,153) (4,046) 809,153 4,046
Class A common stock issued under stock option plans
and other issuances of Class A common stock 99,725 498 339
Unrealized gain on investments available for sale (net of
tax effect of $(23,520))
Repayment of notes
(Purchase) reissuance of treasury shares, net
- ----------------------------------------------------------------------------------------------------------------------------------
Balance-December 31, 1997 15,286,263 $ 76,431 9,156,682 $ 45,783 $ 339
==================================================================================================================================
</TABLE>
See accompanying notes to the consolidated financial statements.
54
<PAGE>
<TABLE>
<CAPTION>
Unrealized
Retained gain (loss) on Notes receivable
(in thousands, except share and per share data) earnings investments from officers
- -----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Balance-January 1, 1995 $ 463,952 $ (49,465) $ (4,374)
Net income 24,130
Common stock dividends declared ($.32 per share) (5,396)
Class A common stock dividends declared ($.36 per share) (2,505)
Conversion of common stock into Class A common stock
Unrealized gain on investments available for sale (net of
tax effect of $(36,063)) 66,976
Repayment of notes 478
Purchase of treasury shares, net
Effect of other treasury stock transactions
- -----------------------------------------------------------------------------------------------------------------------------
Balance-December 31, 1995 480,181 17,511 (3,896)
Net loss (135,334)
Common stock dividends declared ($.32 per share) (5,138)
Class A common stock dividends declared ($.36 per share) (2,788)
Conversion of common stock into Class A common stock
Unrealized loss on investments available for sale (net of
tax effect of $22,823) (42,385)
Repayment of notes 2,734
Purchase of treasury shares, net
- -----------------------------------------------------------------------------------------------------------------------------
Balance-December 31, 1996 336,921 (24,874) (1,162)
Net income 15,019
Common stock dividends declared ($.32 per share) (4,842)
Class A common stock dividends declared ($.36 per share) (3,147)
Conversion of common stock into Class A common stock
Class A common stock issued under stock option plans and other
issuances of Class A common stock
Unrealized gain on investments available for sale (net of
tax effect of $(23,520)) 43,680
Repayment of notes 964
(Purchase) reissuance of treasury shares, net (583)
- -----------------------------------------------------------------------------------------------------------------------------
Balance-December 31, 1997 $ 343,368 $ 18,806 $ (198)
=============================================================================================================================
<CAPTION>
Treasury stock, at cost
----------------------------------------------
Common Stock Class A Common Stock
----------------------------------------------
(in thousands, except share and per share data) Shares Amounts Shares Amounts Total
- ----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Balance-January 1, 1995 388,514 $ (4,706) 200,498 $ (2,261) $ 524,862
Net income 24,130
Common stock dividends declared ($.32 per share) (5,396)
Class A common stock dividends declared ($.36 per share) (2,505)
Conversion of common stock into Class A common stock -
Unrealized gain on investments available for sale (net of
tax effect of $(36,063)) 66,976
Repayment of notes 478
Purchase of treasury shares, net 4,050 (63) 150,442 (2,355) (2,418)
Effect of other treasury stock transactions (277,532) 3,541 3,541
- ----------------------------------------------------------------------------------------------------------------------------------
Balance-December 31, 1995 392,564 (4,769) 73,408 (1,075) 609,668
Net loss (135,334)
Common stock dividends declared ($.32 per share) (5,138)
Class A common stock dividends declared ($.36 per share) (2,788)
Conversion of common stock into Class A common stock -
Unrealized loss on investments available for sale (net of
tax effect of $22,823) (42,385)
Repayment of notes 2,734
Purchase of treasury shares, net 32,800 (639) 1,373 (290) (929)
- ----------------------------------------------------------------------------------------------------------------------------------
Balance-December 31, 1996 425,364 (5,408) 74,781 (1,365) 425,828
Net income 15,019
Common stock dividends declared ($.32 per share) (4,842)
Class A common stock dividends declared ($.36 per share) (3,147)
Conversion of common stock into Class A common stock -
Class A common stock issued under stock option plans
and other issuances of Class A common stock 837
Unrealized gain on investments available for sale (net of
tax effect of $(23,520)) 43,680
Repayment of notes 964
(Purchase) reissuance of treasury shares, net 10,110 (164) (35,834) 755 8
- ----------------------------------------------------------------------------------------------------------------------------------
Balance-December 31, 1997 435,474 $ (5,572) 38,947 $ (610) $ 478,347
==================================================================================================================================
</TABLE>
55
<PAGE>
PENNSYLVANIA MANUFACTURERS CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
for the years ended December 31,
(in thousands) 1997 1996 1995
- ------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income (loss) $ 15,019 $ (135,334) $ 24,130
Adjustments to reconcile net income (loss) to net cash flows
(used) provided by operating activities:
Depreciation 8,672 12,511 7,652
Amortization 4,054 7,243 35
Provision (benefit) for deferred income taxes 9,906 (11,488) 15,353
Extraordinary loss from early extinguishment of debt (4,734) - -
Net realized investment gains (8,598) (2,984) (31,923)
Change in uncollected premiums and unearned premiums, net 39,030 17,983 22,381
Change in dividends to policyholders (2,324) (632) 910
Change in unpaid losses and loss adjustment expenses (87,885) 21,086 (33,728)
Change in investment income due and accrued 6,577 5,188 4,961
Change in deferred acquisition costs (1,282) (6,105) (5,665)
Other, net (85,795) (23,413) 11,807
--------------------------------------------------
Net cash flows (used) provided by operating activities (107,360) (115,945) 15,913
--------------------------------------------------
Cash flows from investing activities:
Fixed maturity investments held to maturity:
Maturities or calls - - 3,809
Fixed maturity investments available for sale:
Purchases (1,963,492) (1,227,173) (2,147,600)
Maturities or calls 168,304 52,280 75,861
Sales 2,072,842 1,210,114 2,085,864
Equity securities:
Purchases - (5,196) (18,104)
Sales 254 16,984 28,793
Net (purchases) sales of short-term investments (130,391) 78,935 (35,445)
Sale of corporate properties 7,145 - -
Net purchases of property and equipment (3,577) (6,723) (6,017)
Purchase of Caliber One Indemnity Company (15,990) - -
Cash acquired in purchase of Caliber One Indemnity Company 4,509 - -
--------------------------------------------------
Net cash flows provided (used) by investing activities 139,604 119,221 (12,839)
--------------------------------------------------
Cash flows from financing activities:
Proceeds from long-term debt 210,000 26,000 125,000
Repayments of long-term debt (211,699) (25,149) (125,127)
Dividends paid to shareholders (7,965) (7,926) (7,885)
Proceeds from exercised stock options and issuance of Class A
common stock 837 - -
Treasury stock transactions, net 591 (929) 480
Repayments of notes receivable from officers 964 2,734 478
--------------------------------------------------
Net cash flows used by financing activities (7,272) (5,270) (7,054)
--------------------------------------------------
Net increase (decrease) in cash 24,972 (1,994) (3,980)
Cash January 1 7,176 9,170 13,150
--------------------------------------------------
Cash December 31 $ 32,148 $ 7,176 $ 9,170
--------------------------------------------------
Supplementary cash flow information:
Amounts (received) paid for income taxes $ (19,112) $ 5,525 $ (951)
Amounts paid for interest $ 19,776 $ 16,622 $ 15,062
Fair value of securities transferred from held to maturity
classification to available for sale classification $ - $ - $ 1,238,077
</TABLE>
See accompanying notes to the consolidated financial statements.
56
<PAGE>
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except share and per share data)
1. Summary of Significant Accounting Policies
The accompanying consolidated financial statements include the accounts of
Pennsylvania Manufacturers Corporation (PMC) and its wholly and majority owned
subsidiaries (the Company). PMC is an insurance holding company that sells
property and casualty reinsurance and insurance through its insurance
subsidiaries. PMC's insurance subsidiaries are domiciled in Pennsylvania,
except for its newly established excess and surplus lines writer, discussed
below, which is domiciled in Delaware, and certain foreign subsidiaries.
Reinsurance -- PMC's reinsurance subsidiary, PMA Reinsurance Corporation (PMA
Re), emphasizes risk-exposed, excess of loss reinsurance and operates in the
brokered market. PMA Re's business is predominantly in casualty lines of
reinsurance.
Workers' Compensation and Primary Standard Insurance -- PMC's property and
casualty insurance subsidiaries (the Property and Casualty Group) write workers'
compensation and other standard lines of commercial insurance primarily in the
Mid-Atlantic and Southern regions of the U.S.
Specialty Property and Casualty -- During 1997, the Company established a
separate specialty insurance operation focusing on excess and surplus lines,
Caliber One Management Company (Caliber One). In December 1997, PMA Re acquired
100% of the outstanding common stock of Caliber One Indemnity Company (formerly
known as Lincoln Insurance Company) for approximately $16,000 and made a capital
contribution of approximately $11,300 to Caliber One Indemnity Company. All of
Caliber One Indemnity Company's acquired loss reserves were reinsured by an
affiliate of Caliber One Indemnity Company's former parent in conjunction with
the purchase. The reinsurance obtained in conjunction with the purchase covers
adverse development and uncollectible reinsurance in an amount equal to the
stated amount of the reserves acquired, plus an additional $68,500. Management
believes that the reinsurance obtained as part of the purchase will be adequate
to cover any future reserve development or uncollectible insurance on the
acquired reserves. PMA Re intends to maintain Caliber One Indemnity Company's
surplus at not less than $25,000, the minimum capital and surplus required for
many states in order to be an eligible surplus lines carrier. Management
anticipates that Caliber One will primarily write multi-line business consisting
of primary and excess commercial general liability, professional liability,
excess automobile and certain property exposures. Because Caliber One's results
were not significant in 1997, Caliber One's financial information has been
included within the Corporate and Other segment, including pre-opening costs of
approximately $900, which have been expensed as incurred.
The Company's significant accounting policies and practices are as follows:
A. Basis of Presentation -- The consolidated financial statements have been
prepared in accordance with generally accepted accounting principles (GAAP).
All significant intercompany accounts and transactions have been eliminated in
consolidation. The preparation of consolidated financial statements in
conformity with GAAP requires management to make certain estimates and
assumptions that affect the amounts reported in its consolidated financial
statements and accompanying notes. Actual results may differ from those
estimates.
These consolidated financial statements vary in certain respects from statutory
accounting practices prescribed or permitted by the Pennsylvania Insurance
Department and the Delaware Insurance Department, (collectively SAP).
Prescribed SAP includes state laws, regulations and general administrative
rules, as well as a variety of NAIC publications. Permitted SAP encompasses all
accounting practices that are not prescribed. The NAIC has a project to codify
SAP, the result of which is expected to constitute the only source of prescribed
SAP. The project, when completed, will change the definitions of what comprises
prescribed versus permitted SAP and may result in changes to the accounting
policies that insurance
57
<PAGE>
companies use to prepare SAP financial statements. See Note 18 for additional
SAP information and a reconciliation of SAP net income and surplus to GAAP net
income and shareholders' equity.
B. Investments -- Fixed maturity investments include U.S. Treasury securities
and obligations of U.S. Government agencies, obligations of states and political
subdivisions, where applicable, corporate debt securities and mortgage-backed
securities. Under SFAS No. 115, "Accounting for Certain Investments in Debt and
Equity Securities," fixed maturities which the Company may hold for an
indefinite period of time are classified as available-for-sale and, accordingly,
are carried at fair value with changes in fair value, net of income tax effects,
reflected in shareholders' equity. Fixed maturities which the Company has the
positive intent and ability to hold to maturity are carried at amortized cost.
In 1995, the Company re-evaluated the classifications of its fixed maturity
investments. As a result, effective June 30, 1995, the Company reclassified its
entire held-to-maturity portfolio, which had an amortized cost of $1,241,774, to
the available-for-sale designation in order to match more closely the Company's
investment strategy. This reclassification resulted in a $1,238,077 increase in
available-for-sale securities and a $2,403 unrealized loss (net of deferred
taxes), with no impact on net income. As of December 31, 1997, the Company's
entire fixed income portfolio remains designated as available for sale.
Equity securities for all periods are stated at fair value with changes in fair
value, net of income tax effects, reflected in shareholders' equity.
Realized gains and losses, determined by specific identification, are reflected
in income in the period in which the sale transaction occurs.
C. Premiums -- Premiums, including estimates of additional premiums resulting
from audits of insureds' records, are earned principally on a pro rata basis
over the terms of the policies. Premiums applicable to the unexpired terms of
policies in-force are reported as unearned premiums. Estimated premiums
receivable on retrospectively rated policies are reported as a component of
uncollected premiums (See Note 1-P).
The Company follows Emerging Issues Task Force Consensus Position No. 93-6,
"Accounting for Multiple Year Retrospectively Rated Contracts by Ceding and
Assuming Enterprises" (EITF 93-6). EITF 93-6 requires that the Company reflect
adjustments to future premiums, as the result of past experience under multiple
year reinsurance contracts, in earnings currently. The impact of EITF 93-6 has
been immaterial.
D. Unpaid Losses and Loss Adjustment Expenses -- Unpaid losses and loss
adjustment expenses are stated net of estimated salvage and subrogation and are
determined using claims adjusters' evaluations, estimates of losses and loss
adjustment expenses on known claims, and estimates of losses and loss adjustment
expenses incurred but not reported (IBNR). IBNR reserves are calculated
utilizing various actuarial methods. Unpaid losses on certain workers'
compensation claims are discounted to present value using the Company's payment
experience and SAP mortality and interest assumptions (See Note 3). The methods
of making such estimates and establishing the resulting reserves are continually
reviewed and updated and any adjustments resulting therefrom are reflected in
earnings currently.
E. Deferred Acquisition Costs -- The costs of acquiring new and renewal
business are deferred and amortized over the period during which the related
premiums are earned. Such costs include direct acquisition costs, including
commissions, brokerage, and premium taxes as well as other policy issuance costs
and underwriting expenses that directly relate to and vary with the production
of business. The Company determines whether deferred acquisition costs are
recoverable considering future losses and loss adjustment expenses, maintenance
costs, and anticipated investment income. To the extent that deferred
acquisition costs are not recoverable, the deficiency is charged to income
currently.
F. Dividends to Policyholders -- The Property and Casualty Group issues certain
workers' compensation insurance policies with dividend payment features. These
policyholders share in the operating results in the form of dividends declared
at the discretion of the Company's board of directors. Dividends to
policyholders are accrued during the period in which the related premiums are
earned and are determined based on the terms of the individual policies.
58
<PAGE>
G. Income Taxes -- The Company accounts for income taxes under SFAS No. 109,
"Accounting for Income Taxes." SFAS No. 109 is an asset and liability approach,
whereby deferred tax assets and liabilities are recorded to the extent of the
tax effect of differences between the financial statement carrying values and
tax bases of assets and liabilities. A valuation allowance is recorded for
deferred tax assets where it appears more likely than not that the Company will
not be able to recover the deferred tax asset. In addition, PMC and a majority
of its subsidiaries have a written tax-sharing agreement which allocates to each
entity subject to the agreement its Federal income taxes on a separate return
basis. The benefit of any net operating losses is retained by PMC.
H. Property and Equipment -- Property and equipment are stated at cost, less
accumulated depreciation. Depreciation is calculated on the straight-line
method utilizing useful lives ranging from 3 to 40 years. During 1996, the
Property and Casualty Group changed the depreciable lives for its mainframe
computer equipment from five years to three years. The effect of this adjustment
was to increase 1996 depreciation expense by approximately $4,800.
I. Per Share Information -- In February 1997, the Financial Accounting
Standards Board issued SFAS No. 128, "Earnings Per Share", which supersedes
Accounting Principles Board Opinion No. 15, "Earnings Per Share," and Related
Interpretations, and which the Company adopted during 1997. In accordance with
SFAS No. 128, all prior period data presented has been restated to conform with
the provisions of this statement. SFAS No. 128 replaces the presentation of
primary earnings per share with a presentation of basic earnings per share and
requires the presentation of both basic and diluted earnings per share on the
face of the income statement. SFAS No. 128 also requires a reconciliation of
the numerators and denominators used in the basic earnings per share calculation
to the numerators and denominators used in the diluted earnings per share
calculation. Such reconciliation is provided in Note 16.
Basic earnings per share: For years 1997, 1996 and 1995, basic earnings per
share was based upon the weighted average number of common and Class A common
shares outstanding for the period.
Diluted earnings per share: For years 1997 and 1995, diluted earnings per share
was based upon the weighted average number of common and Class A common shares
outstanding during the year and the assumed exercise price of dilutive stock
options, less the number of treasury shares assumed to be purchased from the
proceeds using the average market price of the Company's Class A common stock.
In 1996, diluted earnings per share was based upon the weighted average common
and Class A common shares outstanding during the year; the assumed exercise
price of stock options using the average market price of the Company's Class A
common stock was not taken into consideration as these stock options would have
had an anti-dilutive effect on the net loss per share (See Note 16).
J. Stock-Based Compensation -- The Company has chosen to continue to account
for stock-based compensation using the intrinsic value method prescribed in
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees," and related Interpretations. Accordingly, compensation cost for
stock options is measured as the excess, if any, of the quoted market price of
the Company's Class A common stock at the date of the grants over the amount an
employee must pay to acquire the Class A common stock.
K. Computer Software Costs Related to the Year 2000 -- In 1996, the Company
adopted Emerging Issues Task Force Consensus Position No. 96-14, "Accounting for
the Costs Associated with Modifying Computer Software for the Year 2000" (EITF
96-14). EITF 96-14 states that external and internal costs specifically
associated with modifying internal-use software for the Year 2000 should be
charged to expense as incurred. In accordance with EITF 96-14, the Company
charged approximately $2,000 and $1,800 to operating expenses during the years
ended December 31, 1997 and 1996, respectively, for costs associated with
modifying internal-use software.
L. Service Revenues -- Service revenues are earned over the term of the related
contracts in proportion to the actual services rendered.
59
<PAGE>
M. Reclassifications -- Certain prior year amounts have been reclassified to
conform to the current year presentation. Additionally, in 1995, the Company
elected to change its method of reporting cash flows from the direct method to
the indirect method.
N. Recently Issued Accounting Standards -- In June 1996, the Financial
Accounting Standards Board issued SFAS No. 125, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities." SFAS No.
125, which is effective for transfers and extinguishments occurring after
December 31, 1996, provides consistent standards for distinguishing transfers of
financial assets that are sales from transfers that are secured borrowings. The
Property and Casualty Group's domestic insurance subsidiaries participated in a
transfer arrangement of certain accounts receivable. This arrangement has been
terminated as a result of SFAS No. 125. The termination did not have a material
impact on the Company's financial condition or results of operations.
During 1997, the FASB issued SFAS No. 130, "Comprehensive Income," which
establishes standards for the reporting and disclosure of comprehensive income
and its components (revenues, expenses, gains and losses). SFAS No. 130
requires that all items that are required to be recognized under accounting
standards as components of comprehensive income be reported in a financial
statement that is displayed with the same prominence as other financial
statements. In addition, the FASB issued SFAS No. 131, "Disclosures About
Segments of an Enterprise and Related Information," which establishes standards
for the way that public business enterprises report information about operating
segments in annual financial statements and interim financial reports issued to
shareholders. SFAS No. 131 also establishes standards for related disclosures
about products and services, geographic areas and major customers. The Company
will adopt the provisions of these pronouncements in 1998. The adoption of
these pronouncements will not have an impact on the Company's financial position
and results of operations, but may change the presentation of certain of the
Company's financial statements and related notes and data thereto.
O. Long-Lived Assets -- It is management's policy to review long-lived assets,
such as the Company's properties, for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. Such changes in circumstances include such things as significant
decline in market value or change in use of the asset. Periodically, management
reviews appraisals and/or cash flow projections from properties and other long-
lived assets and compares such amounts to the carrying values to determine
whether or not there has been an impairment. If such an impairment exists, it
is management's policy to write down the carrying value of the asset to fair
value less costs to carry and dispose of the asset, where applicable.
P. Accrued Retrospective Premiums -- Accrued retrospective premiums, which are
a component of uncollected premiums, are based upon actuarial estimates of
expected ultimate losses and resulting estimated premium adjustments relating to
retrospectively rated policies. The change in accrued retrospective premiums is
a component of net premiums earned. The estimated ultimate premium adjustments
under retrospectively rated policies are recorded in the initial accident year
based upon estimated loss experience on the underlying policies and adjusted in
subsequent periods in conjunction with revisions of the estimated underlying
losses on such policies. In addition, accrued retrospective premiums are
increased (decreased) based upon retrospective policy adjustments paid (billed);
such adjustments actually billed or paid do not impact premium revenues as the
Company records an offsetting amount through net premiums written.
60
<PAGE>
The following sets forth the components of the change in accrued retrospective
premiums for each of the past three years:
<TABLE>
<CAPTION>
For the years ended December 31,
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Estimated retrospective policy
adjustments related to current
accident year.......................... $(12,460) $(18,767) $(12,941)
Revision of estimate of retrospective
policy adjustments related to
prior accident years................... (44,719) (9,888) (4,845)
Retrospective policy adjustments paid.... 20,179 23,155 13,786
Uncollectible write-off.................. -- (5,000) --
-------- -------- -------
Total.................................... $(37,000) $(10,500) $(4,000)
======== ======== =======
</TABLE>
In 1997, 1996 and 1995, the Property and Casualty Group reduced accrued
retrospective premiums by $37,000, $10,500 and $4,000, respectively. The
primary reason for the additional reduction in 1997 relative to 1996 was a
$44,719 revision of estimate of accrued retrospective premiums, primarily due to
the favorable development of claims liabilities for more recent accident years
($35,719) and the commutation of claims for accident years 1991 and prior in
1997 ($9,000). The reduction for policy years 1991 and prior primarily relates
to the commutation program for such years initiated in late 1996. In July 1997,
the Property and Casualty Group completed a formal program where it commuted a
large number of claims associated with workers' compensation claims from
accident years 1991 and prior, including loss reserves associated with
retrospective policies (See Note 3). The commutation program resulted in
current payments to claimants which were less than the carried reserves. As a
result of the differences between the current commutation payments to claimants
and carried reserves on such claims, management reduced its estimate of amounts
recoverable under retrospectively rated policies and also recognized a reduction
in losses and LAE associated with such policies. The reduction related to 1992
through 1996 policy years was primarily related to a corresponding amount of
favorable development on underlying loss reserves for such years (See Note 3).
The effects of the commutations on these prior loss reserves, as well as the
intent of the Property and Casualty Group to continue utilizing early
intervention techniques such as commutations on claims from more recent accident
years, have led to a re-estimation of policy liabilities for these more recent
accident years, and a re-estimation of amounts due under retrospectively rated
policies for these more recent accident years.
Management believes that it has made a reasonable estimate of the Company's
accrued retrospective premiums. While the eventual ultimate receivable may
differ from the current estimates, management does not believe that the
difference will have a material effect, either adversely or favorably, on the
Company's financial position or results of operations.
2. Investments
The Company's investment portfolio is well diversified and contains no
significant concentrations in any specific industry, business segment, or
individual issuer. The Company principally invests in U.S. Treasury securities
and obligations of U.S. Government agencies, high-quality obligations of states
and political subdivisions and corporations, and mortgage backed securities.
Equity securities consist entirely of common stocks of financial institutions,
public utilities, and industrial and service entities.
61
<PAGE>
The amortized cost and fair value of the Company's investment portfolio are as
follows:
<TABLE>
<CAPTION>
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
---- ----- ------ -----
<S> <C> <C> <C> <C>
December 31, 1997
Fixed maturities available for sale:
U.S. Treasury securities and obligations of
U.S. Government agencies....................... $1,105,689 $17,267 $ 3,390 $1,119,566
Corporate debt securities....................... 675,218 12,845 392 687,671
Mortgage backed securities...................... 119,687 2,657 63 122,281
---------- ------- ------- ----------
Total fixed maturities available for sale......... 1,900,594 32,769 3,845 1,929,518
Equity securities................................. 5 8 -- 13
Short-term investments............................ 265,207 -- -- 265,207
---------- ------- ------- ----------
Total investments................................. $2,165,806 $32,777 $ 3,845 $2,194,738
========== ======= ======= ==========
DECEMBER 31, 1996
Fixed maturities available for sale:
U.S. Treasury securities and obligations of
U.S. Government agencies....................... $1,640,881 $ 4,045 $42,182 $1,602,744
Obligations of states and political subdivisions 77,562 194 1,229 76,527
Corporate debt securities....................... 372,620 3,203 2,977 372,846
Mortgage backed securities...................... 73,328 728 53 74,003
---------- ------- ------- ----------
Total fixed maturities available for sale......... 2,164,391 8,170 46,441 2,126,120
Equity securities................................. 259 3 -- 262
Short-term investments............................ 134,971 -- -- 134,971
---------- ------- ------- ----------
Total investments................................. $2,299,621 $ 8,173 $46,441 $2,261,353
========== ======= ======= ==========
</TABLE>
The amortized cost and estimated fair value of fixed maturities at December 31,
1997, by contractual maturity, are shown below. Expected maturities will differ
from contractual maturities because the issuers may have the right to call or
prepay obligations with or without call or prepayment penalties.
<TABLE>
<CAPTION>
Amortized Fair
Cost Value
---- -----
<S> <C> <C>
1998.......................................... $ 129,047 $ 128,919
1999-2002..................................... 634,888 633,643
2003-2007..................................... 394,704 396,459
2008 and thereafter........................... 622,268 648,216
Mortgage backed securities.................... 119,687 122,281
---------- ----------
$1,900,594 $1,929,518
========== ==========
</TABLE>
Net investment income consists of the following:
<TABLE>
<CAPTION>
For the years ended December 31,
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Fixed maturities......................... $128,400 $131,530 $129,883
Equity securities........................ -- 148 503
Short-term investments................... 7,282 7,711 11,764
Other.................................... 4,422 3,251 4,303
-------- -------- --------
Total investment income................ 140,104 142,640 146,453
Investment expenses...................... 3,406 8,704 7,098
-------- -------- --------
Net investment income.................. $136,698 $133,936 $139,355
======== ======== ========
</TABLE>
62
<PAGE>
Net realized investment gains consist of the following:
<TABLE>
<CAPTION>
For the years ended December 31,
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Realized gains:
Fixed maturities......................... $20,899 $12,762 $37,900
Equity securities........................ -- 4,351 3,117
Other.................................... -- 4 --
------- ------- -------
20,899 17,117 41,017
------- ------- -------
Realized losses:
Fixed maturities......................... 12,203 12,861 5,956
Equity securities........................ -- 436 2,200
Other.................................... 98 836 938
------- ------- -------
12,301 14,133 9,094
------- ------- -------
Total net realized investment gains........ $ 8,598 $ 2,984 $31,923
======= ======= =======
</TABLE>
On December 31, 1997, the Company had securities with a total amortized cost and
fair value of $30,925 and $31,105, respectively, on deposit with various
governmental authorities, as required by law. In addition, at December 31,
1997, securities with a total amortized cost and fair value of $11,603 and
$11,547, respectively, were pledged as collateral for letters of credit issued
on behalf of the Company.
Change in unrealized appreciation (depreciation) of investments consists of the
following:
<TABLE>
<CAPTION>
For the years ended December 31,
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Fixed maturities available for sale........ $67,195 $(62,457) $ 99,874
Equity securities.......................... 5 (2,751) 3,165
------- -------- --------
Change in unrealized appreciation
(depreciation) of investments....... $67,200 $(65,208) $103,039
======= ======== ========
</TABLE>
During 1997, the Company established a securities lending program through which
securities are loaned from the Company's portfolio to qualifying third parties,
subject to certain limits, via a lending agent for short periods of time.
Borrowers of these securities must provide collateral equal to a minimum of 102%
of the market value and accrued interest of the loaned securities. Acceptable
collateral may be in the form of either cash or securities. Cash received as
collateral is invested in short-term investments, and all securities received as
collateral are of similar quality to those securities lent by the Company.
Additionally, the Company limits securities lending to 40% of statutory admitted
assets of its insurance subsidiaries, with a 2% limit on statutory admitted
assets to any individual borrower. The Company receives either a fee from the
borrower or retains a portion of the income earned on the collateral. Under the
terms of the securities lending program, the Company is indemnified against
borrower default, with the lending agent responsible to the Company for any
deficiency between the cost of replacing a security that was not returned and
the amount of collateral held by the Company. In 1997, the Company recognized
income from securities lending transactions of $524, net of lending fees, which
was included in investment income. The Company had approximately $175,000 of
securities on loan as of December 31, 1997.
63
<PAGE>
3. Unpaid Losses and Loss Adjustment Expenses
Activity in the liability for unpaid losses and loss adjustment expenses (LAE)
is summarized as follows:
<TABLE>
<CAPTION>
For the years ended December 31,
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Balance at January 1......................................... $2,091,072 $2,069,986 $2,103,714
Less: reinsurance recoverable on unpaid losses and LAE....... 256,576 261,492 247,856
---------- ---------- ----------
Net balance at January 1..................................... 1,834,496 1,808,494 1,855,858
---------- ---------- ----------
Losses and LAE incurred, net:
Current year............................................... 341,880 323,069 357,787
Prior years................................................ (86,006) 156,074 51,491
Accretion of discount (includes ($35,000) effect of the
change in the discount rate for the Property and Casualty
Group's workers' compensation unpaid losses from 4% to 5%
in 1995).................................................. 51,407 57,480 13,300
---------- ---------- ----------
Total losses and LAE incurred, net........................... 307,281 536,623 422,578
---------- ---------- ----------
Losses and LAE paid, net:
Current year............................................... (72,399) (72,194) (71,126)
Prior years................................................ (398,475) (438,427) (398,816)
---------- ---------- ----------
Total losses and LAE paid, net............................... (470,874) (510,621) ( 469,942)
---------- ---------- ----------
Net balance at December 31................................... 1,670,903 1,834,496 1,808,494
Reinsurance recoverable on unpaid losses and LAE............. 332,284 256,576 261,492
---------- ---------- ----------
Balance at December 31....................................... $2,003,187 $2,091,072 $2,069,986
========== ========== ==========
</TABLE>
The Company's results of operations included a decrease in estimated incurred
losses and LAE related to prior accident years of $86,006 in 1997, and an
increase of $156,074 and $51,491 in 1996 and 1995, respectively.
During 1997, PMA Re recorded favorable reserve development on prior accident
years of approximately $32,100. PMA Re has consistently recorded favorable
reserve development on prior accident years for the past several years. The
remaining decrease in estimated losses and LAE on prior accident years during
calendar year 1997 can be attributed primarily to the following: the cession of
prior year reserves by PMA Life Insurance Company to a third party reinsurer of
approximately $14,800 (See Note 5); favorable reserve development at the
Property and Casualty Group in conjunction with the formal commutation program,
discussed below, of approximately $9,000 pertaining to retrospectively rated
policies for accident years 1991 and prior; favorable reserve development at the
Property and Casualty Group of approximately $28,000 related to retrospectively
rated policies pertaining to accident years 1992 through 1996; and favorable
development on pre-1992 workers' compensation reserves of $7,100, partially
offset by reserve strengthening in commercial multi-peril business for accident
year 1996 of $5,000.
The increase in estimated incurred losses and LAE during 1996 is primarily due
to a loss reserve strengthening charge of $191,400. This loss reserve
strengthening was associated with the following lines of business:
1996
----
Workers' compensation..................... $110,000
Asbestos and environmental................ 60,400
Other lines of business................... 21,000
--------
$191,400
========
The 1996 aggregate workers' compensation adverse development was allocated
$102,000 to Pennsylvania and $8,000 to all other states in the Company's
marketing territory. Of the $102,000, the allocation by accident year is as
follows: prior to 1987: $16,000; 1987 to 1991: $101,000; and 1992 and subsequent
64
<PAGE>
years: $(15,000). In 1995, substantially all of the workers' compensation
adverse development related to accident years 1987 to 1991 in Pennsylvania. For
accident years prior to 1992, the traditional paid loss development schedules
for workers' compensation had begun to exhibit an increasing trend in loss
development factors by 1993. This trend was initially attributed to an increase
in commutation activity. In 1995, management began to question whether loss
data was developing in a manner that was consistent with the conclusion that the
loss development trends were impacted solely by commutation activity. As a
result, management began to accumulate additional data in order to determine
whether there were additional causes of the increase in the paid loss
development data; management obtained claim count data that was far more
detailed than had been historically utilized in the reserve setting process.
This data indicated that the paid loss development factors were not only
impacted by commutation activity, but also by a decline in the claims closure
rate in Pennsylvania. Management believes that the decline of the closure rates
was due to several interrelated factors. One factor related to the fact that
efforts to rehabilitate claimants and return them to work were not as successful
as anticipated. For accident years 1987 to 1991, in particular, extensive
efforts were made by the Company to rehabilitate claimants and return them to
work at either full or modified duty. By late 1995 and into 1996, it was
recognized, by a review of a slow down in the claims closure pattern that these
rehabilitation efforts were not impacting the closure rates as expected.
Another factor negatively impacting claims closure rates related to the economic
conditions in Pennsylvania in the early 1990's. During the period from 1990 to
1994, economic conditions in Pennsylvania were considered to be depressed in the
Company's major industry niches for workers' compensation insurance
(construction, heavy manufacturing). Payrolls in these industries were
stagnant, and in many cases, employment was flat or declining. The Company
believes that in periods of declining employment opportunities, there is a
tendency for indemnity periods to increase, which occurred for workers who
suffered injuries in these industries.
The above factors, when considered with the fact that the benefits period in
Pennsylvania was unlimited, caused the Company to believe that a substantial
portion of claimants from the pre-1992 period, who had already been out of work
five to nine years, would not return to work in any capacity. In late 1995 and
during 1996, management undertook an effort to quantify the impact of the
declining closure rates versus the increase in commutation activity. During the
fourth quarter of 1995, management strengthened the Property and Casualty
Group's workers' compensation reserves by $54,700; however, the quantification
of the effect of the claims closure rate was an extremely complex process, and
as such, the data was not fully understood at that time. As the data under
analysis was more mature and refined in 1996, management determined that the
workers' compensation loss reserves for Pennsylvania in the pre-1992 accident
years needed to be increased substantially; therefore, the Property and Casualty
Group increased its workers' compensation reserves by $110,000 in 1996.
Workers' compensation reform legislation enacted in Pennsylvania in 1993 and
1996 introduced various controls and limitations on medical and disability
benefits. Management believes that these reforms have had and will continue to
have a favorable impact on workers' compensation loss ratios for accident years
1993 and subsequent. In addition, management took several steps to reduce the
outstanding claims associated with the Pennsylvania workers' compensation
business written through 1991. A formal commutation program was initiated in
the fourth quarter 1996 and continued into late 1997. Commutations are
agreements with claimants whereby the claimants, in exchange for a lump sum
payment, will forego their rights to future indemnity payments from the Property
and Casualty Group. Under Pennsylvania workers' compensation laws, all such
commutation arrangements must be approved by the claimant and the Pennsylvania
Workers' Compensation Board. The Property and Casualty Group paid approximately
$101,100 and $17,800 in 1997 and the fourth quarter of 1996, respectively, to
commute workers' compensation indemnity claims. Savings associated with these
claims were consistent with management's expectations. The number of open
claims for accident years 1991 and prior was substantially reduced as a result
of the commutation program. This reduction in open claims is expected to reduce
the possibility of any further adverse development on such reserves, although
there can be no assurances that the level of commutations will have a
significant impact on the future development of such reserves.
Estimating reserves for workers' compensation claims can be more difficult than
many other lines of property and casualty insurance for several reasons,
including (i) the long payment `tail' associated with the
65
<PAGE>
business; (ii) the impact of social, political and regulatory trends on benefit
levels; (iii) the impact of economic trends; and (iv) the impact of changes in
the mix of business. At various times, one or a combination of such factors can
make the interpretation of actuarial data associated with workers' compensation
loss development more difficult, and it can take additional time to recognize
changes in loss development patterns. Under such circumstances, adjustments
will be made to such reserves as loss patterns develop and new information
becomes available and such adjustments may be material.
The adverse development in reserves associated with asbestos and environmental
claims during 1996 was due to the completion of a detailed analysis of loss and
LAE reserves associated with asbestos and environmental liability claims in
1996. The reserving for asbestos and environmental claims has undergone change
at both the Company and in the insurance industry in general. For environmental
and asbestos liability claims, reserving methodology has been evolving into
accepted industry practice in the recent past; the Company's actuaries were able
to apply these methods to its loss reserves in 1997 and 1996. To reserve for
environmental claims, the Company currently utilizes a calendar year development
technique known as aggregate loss development. This technique focuses on the
aggregate losses paid as of a particular date and aggregate payment patterns
associated with such claims. Several elements including remediation studies,
remediation, defense, declaratory judgment, and third party bodily injury claims
were considered in estimating the costs and payment patterns of the
environmental and toxic tort losses. Prior to the development of these
techniques, there was a substantial range in the nature of reserving for
environmental and toxic tort liabilities. The methods employed by the Company
prior to the review performed in 1996 included a review of aggregate loss and
loss adjustment paid and case incurred data along with resulting "survival
ratios" to establish IBNR for environmental and toxic tort claims. For asbestos
claims, the Company had previously reserved costs to defend, and any
indemnification payments anticipated on, claims for which it had received notice
that it was a responsible party, plus a bulk factor applied to the estimated
case reserves to provide for potential development of indemnification and
defense costs related to such claims. In 1996, the Company performed a ground
up analysis of asbestos loss reserves using an actuarially accepted modeling
technique. Using historical information as a base and information obtained from
a review of open claims files, assumptions were made about future claims
activity in order to estimate ultimate losses. For each individual major
account, projections were made regarding new plaintiffs per year, the number of
years new claims will be reported, the average loss severity per plaintiff, and
the ratio of loss adjustment expense to loss. In many cases involving larger
asbestos claims, the Company reserved up to the policy limits for the applicable
loss coverage parts for the affected accounts. Policy terms and reinsurance
treaties were applied in the modeling of future losses. Estimation of
obligations for asbestos and environmental exposures continues to be more
difficult than other loss reserves because of several factors, including: (i)
evolving methodologies for the estimation of the liabilities; (ii) lack of
reliable historical claim data; (iii) uncertainties with respect to insurance
and reinsurance coverage related to these obligations; (iv) changing judicial
interpretations; and (v) changing government standards.
The Company's asbestos-related losses were as follows:
<TABLE>
<CAPTION>
For the years ended December 31,
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Gross of reinsurance:
Beginning reserves............................... $ 80,055 $ 27,611 $ 13,969
Incurred losses and LAE.......................... 2,435 62,854 22,482
Calendar year payments for losses and LAE........ (5,764) (10,410) (8,840)
-------- -------- --------
Ending reserves.................................. $ 76,726 $ 80,055 $ 27,611
======== ======== ========
</TABLE>
66
<PAGE>
<TABLE>
<CAPTION>
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Net of reinsurance:
Beginning reserves............................... $53,300 $23,443 $ 8,168
Incurred losses and LAE.......................... (36) 39,427 21,826
Calendar year payments for losses and LAE....... (4,686) (9,570) (6,551)
------- ------- -------
Ending reserves.................................. $48,578 $53,300 $23,443
======= ======= =======
</TABLE>
The Company's environmental-related losses were as follows:
<TABLE>
<CAPTION>
For the years ended December 31,
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Gross of reinsurance:
Beginning reserves............................... $35,626 $20,134 $20,952
Incurred losses and LAE.......................... 1,130 22,143 3,516
Reserves acquired through purchase of Caliber
One Indemnity Company/(1)/................... 13,060 -- --
Calendar year payments for losses and LAE........ (4,708) (6,651) (4,334)
------- ------- -------
Ending reserves.................................. $45,108 $35,626 $20,134
======= ======= =======
Net of reinsurance:
Beginning reserves............................... $34,592 $20,134 $20,952
Incurred losses and LAE.......................... 1,068 21,109 3,516
Calendar year payments for losses and LAE....... (3,965) (6,651) (4,334)
------- ------- -------
Ending reserves.................................. $31,695 $34,592 $20,134
======= ======= =======
</TABLE>
(1) Such acquired reserves have been reinsured by an affiliate of the former
parent (See Note 1).
Of the total net asbestos reserves, approximately $6,700, $6,800, and $6,700
related to established claims reserves at December 31, 1997, 1996, and 1995,
respectively, and $41,900, $46,500, and $16,700 related to incurred but not
reported losses at December 31, 1997, 1996, and 1995, respectively. Of the
total net environmental reserves, approximately $11,200, $12,500, and $10,300
related to established claims reserves at December 31, 1997, 1996, and 1995,
respectively, and $20,500, $22,100, and $9,800 related to incurred but not
reported losses at December 31, 1997, 1996, and 1995, respectively. All
incurred asbestos and environmental losses were for accident years 1986 and
prior.
Management believes that its reserves for asbestos and environmental claims are
appropriately established based upon known facts, existing case law, and
generally accepted actuarial methodologies. However, due to changing
interpretations by courts involving coverage issues, the potential for changes
in federal and state standards for clean-up and liability and other factors, the
ultimate exposure to the Company for these claims may vary significantly from
the amounts currently recorded, resulting in a potential adjustment in the
claims reserves recorded. Additionally, issues involving policy provisions,
allocation of liability among participating insurers, proof of coverage, and
other factors make quantification of liabilities exceptionally difficult and
subject to adjustment based upon newly available data.
In 1996, other commercial lines for the Property and Casualty Group experienced
reserve strengthening of $21,000, as compared to a reserve release of $11,600 in
1995. The reserve strengthening was principally due to a re-estimation of loss
adjustment costs associated with general liability claims. Through 1991, the
Property and Casualty Group's mix of general liability insurance policies were
weighted towards the manufacturing classes of business. Subsequent to 1991, the
Property and Casualty Group's mix of business became more heavily weighted
towards the construction and contracting classes of business. These particular
classes of business have experienced losses due to construction defects and
similar matters, that have taken longer to emerge than the classes of business
previously written by the Property and Casualty Group. Defense costs associated
with these claims have also exceeded the original estimate of the Property and
Casualty Group's management, which was based on the patterns of indemnification
payments associated
67
<PAGE>
with the earlier classes of business written. When this issue was discovered,
the Property and Casualty Group factored the increased defense costs and the
emergence pattern in determining a more appropriate reserve amount for loss
handling costs. The release of reserves in 1995 was primarily due to favorable
loss experience in commercial automobile business.
Unpaid losses on workers' compensation claims for the Company include
approximately $816,000 and $1,012,000, net of discount of $460,230 and $514,248,
at December 31, 1997 and 1996, respectively. The approximate discount rate used
was 5% at December 31, 1997 and 1996. In 1995, the Property and Casualty Group
changed its discount rate with respect to its workers' compensation unpaid
losses from approximately 4% to 5% for SAP and GAAP purposes. This change was
approved and is permitted by the Pennsylvania Insurance Department. The effect
on net income (net of tax effect of $12,250) in 1995 was $22,750 ($0.96 per
basic share and $0.92 per diluted share).
The Company's loss reserves were stated net of salvage and subrogation of
approximately $59,900 and $75,000 at December 31, 1997 and 1996, respectively.
The following table presents the salvage and subrogation by segment and product
line:
<TABLE>
<CAPTION>
December 31,
1997 1996
---- ----
<S> <C> <C>
Property and Casualty Group:
Workers' compensation $46,000 $61,900
Other Commercial Lines 4,800 3,900
------- -------
Total Property and Casualty Group 50,800 65,800
PMA Re 9,100 9,200
------- -------
Total salvage and subrogation $59,900 $75,000
======= =======
</TABLE>
The Company's policy with respect to estimating the amounts and realizability of
salvage and subrogation is to develop historical accident year schedules of paid
salvage and subrogation by line of business, which are then projected to an
ultimate basis using actuarial projection techniques. The anticipated salvage
and subrogation is the estimated ultimate salvage and subrogation less any
amounts received by the Company. The realizability of anticipated salvage and
subrogation is reflected in the historical data that is used to complete the
projection, as historical paid data implicitly considers realization and
collectibility.
4. Deferred Acquisition Costs
The following represents the components of deferred acquisition costs and the
amounts that were charged to expense:
<TABLE>
<CAPTION>
For the years ended December 31,
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Balance at January 1........................... $ 44,006 $ 37,901 $ 32,236
Deferral of acquisition costs.................. 94,783 96,397 92,872
Amortization of deferred acquisition costs..... (93,501) (90,292) (87,207)
-------- -------- --------
Balance at December 31......................... $ 45,288 $ 44,006 $ 37,901
======== ======== ========
</TABLE>
5. Reinsurance
In the ordinary course of business, PMC's reinsurance and insurance subsidiaries
assume and cede reinsurance with other insurance companies and are members of
various pools and associations. The reinsurance and insurance subsidiaries cede
business, primarily on an excess of loss basis, in order to limit the maximum
net loss from large risks and limit the accumulation of many smaller losses from
a catastrophic event. The reinsurance and insurance subsidiaries remain
primarily liable to their clients in the event their reinsurers are unable to
meet their financial obligations.
68
<PAGE>
Amounts receivable from reinsurers related to paid and unpaid losses are
displayed separately on the consolidated balance sheets, net of an allowance for
uncollectible accounts.
The components of net premiums earned and losses and LAE incurred are as
follows:
<TABLE>
<CAPTION>
For the years ended December 31,
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Earned Premiums:
Direct.......................... $ 277,871 $299,386 $370,590
Assumed......................... 216,357 209,688 149,838
Ceded........................... (118,277) (88,499) (35,476)
--------- -------- --------
Net............................... $ 375,951 $420,575 $484,952
========= ======== ========
Losses and LAE Incurred:
Direct.......................... $ 244,429 $420,157 $317,552
Assumed......................... 166,202 163,799 127,910
Ceded........................... (103,350) (47,333) (22,884)
--------- -------- --------
Net............................... $ 307,281 $536,623 $422,578
========= ======== ========
</TABLE>
The Company performs extensive credit reviews on its reinsurers, focusing on,
among other things, financial capacity, stability, trends, and commitment to the
reinsurance business. Prospective and existing reinsurers failing to meet the
Company's standards are excluded from the Company's reinsurance programs. In
addition, the Company requires letters of credit to support balances due from
reinsurers not authorized to transact business in the applicable jurisdictions.
At December 31, 1997, the Company had reinsurance recoverables due from the
following unaffiliated single reinsurers in excess of 3% of shareholders'
equity:
<TABLE>
<CAPTION>
Gross amount due
Reinsurer to the Company A.M. Best Rating
- --------- -------------- ----------------
<S> <C> <C>
United States Fidelity and Guaranty Company......... $74,041 A
Essex Insurance Company............................. 36,807 A
American Re-Insurance Corporation................... 35,411 A+
Kemper Reinsurance Corporation...................... 21,853 A
London Life International Reinsurance Corporation... 16,212 A+
Continental Casualty Company........................ 15,209 A
</TABLE>
The Company maintained funds held to collateralize the above balances in the
amount of $66,891 at December 31, 1997. The Company believes that it would have
the right to offset the funds withheld from a reinsurer against the balances due
from such reinsurer in the event of insolvency.
During 1997, PMA Life Insurance Company reinsured the majority of its in force
annuity business with a third party reinsurer via a quota-share reinsurance
agreement for approximately $15,400. The transaction effectively makes PMA Life
Insurance Company a dormant company.
All of Caliber One Indemnity Company's acquired loss reserves were reinsured
with an affiliate of its former parent in conjunction with its purchase by PMA
Re, as discussed in Note 1. Management believes that such reinsurance is
adequate to cover any future reserve development or uncollectible reinsurance on
the acquired reserves.
69
<PAGE>
6. Long-Term Debt
Long-term debt consists of the following:
December 31,
1997 1996
---- ----
Senior notes 9.53%, due 1997...................... $ -- $ 7,143
Senior notes 9.60%, due 2001...................... -- 46,428
Senior notes 7.62%, due 2001, Series A............ -- 71,000
Senior notes 7.62%, due 2000, Series B............ -- 36,000
Revolving credit agreement, expiring in 1998...... -- 44,000
Revolving credit facility, expiring in 2002/(1)/.. 203,000 --
Mortgage notes.................................... -- 128
-------- --------
Long-term debt.................................... $203,000 $204,699
======== ========
(1) Maturing in an installment of $15,500 in 1999 and annual installments of
$62,500 commencing in 2000 through 2002.
On March 14, 1997, the Company refinanced substantially all of its existing
credit agreements not already maturing in 1997 through the completion of a new
$235,000 revolving credit facility (New Credit Facility). Utilizing the New
Credit Facility, the Company refinanced the following obligations:
Senior notes 9.60%, due 2001......................... $ 46,428
Senior notes 7.62%, due 2001, Series A............... 71,000
Senior notes 7.62%, due 2000, Series B............... 36,000
Revolving credit agreement, expiring in 1998/(1)/.... 36,000
--------
Total................................................ $189,428
========
(1) The Company repaid $8,000 of the revolving credit agreement prior to March
14, 1997.
The early extinguishment of the senior note agreements resulted in an
extraordinary loss of $4,734 ($7,283 pre-tax). The New Credit Facility bears
interest at LIBOR plus 0.70% on the utilized portion and carries a 0.275%
facility fee on the unutilized portion. The spread over LIBOR and the facility
fee are adjustable downward based upon the Company's debt to capitalization
ratios in the future. As of December 31, 1997, the interest rate on the
utilized portion of the New Credit Facility was 6.61%.
In November of 1996, the Company entered into a letter of credit agreement with
a group of banks, which currently extends through November of 1998. The
original agreement allowed the issuing bank to issue letters of credit having an
aggregate outstanding face amount up to $75,000. Effective March 14, 1997, this
facility was reduced to an aggregate outstanding face amount not to exceed
$50,000. The agreement requires the Company to pay a commitment fee during the
existence of the agreement equal to 0.1875% per annum on the average daily
available amount. At December 31, 1997 and 1996, the aggregate outstanding face
amount of letters of credit issued was $46,881 and $47,461, respectively. This
agreement primarily secures reinsurance liabilities of the insurance
subsidiaries of the Company.
The debt covenants supporting the revolving credit facility and the letter of
credit agreement contain provisions which, among other matters, limit the
Company's ability to incur additional indebtedness, merge, consolidate and
acquire or sell assets. The debt covenants also require the Company to satisfy
certain ratios related to net worth, debt-to-capitalization, and interest
coverage. Additionally, the debt covenants place restrictions on dividends to
shareholders (See Note 15).
The Company has entered into an interest rate swap agreement in its management
of its existing interest rate exposures. This transaction effectively changed
the Company's interest rate exposure on a portion the New Credit Facility, which
has a floating rate, to a fixed obligation as follows:
70
<PAGE>
<TABLE>
<CAPTION>
Notional Principal
Balance at
Debt Agreement December 31, 1997 Fixed Rate Floating Rate
- -------------- ----------------- ---------- -------------
<S> <C> <C> <C>
Revolving Credit Facility, 2002 $150,000 7.24% 6.61%
</TABLE>
The variable rate resets every three months. This agreement involves the
exchange of interest payment obligation without the exchange of underlying
principal. The differential to be paid or received is recognized as an
adjustment of interest expense. In the event that a counterparty fails to meet
the terms of the agreement, the Company's exposure is limited to the interest
rate differential on the notional principal amount ($150,000). Management
believes such credit risk is minimal and any loss would not be significant.
7. Stock Options
The Company currently has six stock option plans in place for options granted to
officers and other key employees for the purchase of the Company's Class A
common stock, under which 3,864,903 Class A common shares are reserved for
issuance. The stock options are granted under terms and conditions determined
by a committee appointed by the Company's board of directors. Granted stock
options have a maximum term of ten years, vest over periods ranging between zero
and five years, and are typically granted with an exercise price equal to the
fair market value of the stock. Information regarding these option plans for
1997, 1996, and 1995 are as follows:
<TABLE>
<CAPTION>
1997 1996 1995
---------------------------------------------------------------------------------------------
Weighted Weighted Weighted
Average Average Average
Shares Price Shares Price Shares Price
------ ----- ------ ----- ------ -----
<S> <C> <C> <C> <C> <C> <C>
Options outstanding,
beginning of year...... 3,242,160 $ 12.43 3,087,260 $ 11.80 2,926,000 $ 10.41
Options granted.......... 324,500 17.00 325,000 17.00 775,000 15.59
Options exercised........ (162,248) (8.78) (99,150) (8.33) (205,199) (8.66)
Options canceled......... (286,800) (11.53) (70,950) (11.55) (408,541) (10.65)
--------- ------- --------- ------- --------- -------
Options outstanding,
end of year............ 3,117,612 $ 13.18 3,242,160 $ 12.43 3,087,260 $ 11.80
========= ======= ========= ======= ========= =======
Option price range at
end of year............ $8.00 to $17.00 $8.00 to $17.00 $6.60 to $16.00
Option price range for
exercised shares....... $8.00 to $15.00 $6.60 to $10.00 $6.60 to $11.50
Options available for
grant at end of year... 747,291 921,566 425,616
</TABLE>
71
<PAGE>
Stock options outstanding at December 31, 1997 and related exercise price and
weighted average remaining life information is as follows:
<TABLE>
<CAPTION>
Weighted
Options Options Average
Outstanding at Exercisable at Remaining Life
Exercise Prices December 31, 1997 December 31, 1997 (in years)
- --------------- ----------------- ----------------- ----------
<S> <C> <C> <C>
$8.00............................. 254,357 246,857 3.49
10.00............................. 438,690 438,690 4.46
11.50............................. 799,000 799,000 5.65
12.75............................. 271,500 271,500 6.17
15.00............................. 296,580 287,580 7.45
16.00............................. 411,485 283,735 7.43
17.00............................. 646,000 228,725 9.15
--------- ---------
3,117,612 2,556,087
========= =========
</TABLE>
The fair value of options at date of grant was estimated using a binomial model
with the following weighted average assumptions:
1997 (1) 1996 (2) 1995(3) 1995(4)
-------- -------- ------- -------
Expected life (years)............. 10 10 10 10
Interest rate..................... 6.3% 6.3% 6.1% 6.2%
Volatility........................ 18% 18% 18% 18%
Dividend yield.................... 2.3% 2.3% 2.3% 2.3%
(1) Options granted on September 3, 1997
(2) Options granted on July 23, 1996
(3) Options granted on June 5, 1995
(4) Options granted on September 1, 1995
The Company has adopted the disclosure-only provision of SFAS No. 123,
"Accounting for Stock-Based Compensation". Accordingly, no compensation cost
has been recognized for the stock option plans. Had compensation costs for the
Company's stock option plans been determined based on the fair value at the
grant date for awards granted during the year, pretax income would have been
reduced by $1,878 ($1,221 after tax, or $0.05 per basic share), $2,079 ($1,352
after tax, or $0.06 per basic share), and $4,308 ($2,800 after tax, or $0.12 per
basic share) in 1997, 1996, and 1995, respectively.
8. Income Taxes
The components of income tax provision (benefit) from continuing operations are:
For the years ended December 31,
1997 1996 1995
---- ---- ----
Current:
Federal................................ $(4,506) $(44,572) $(4,570)
------- -------- -------
(4,506) (44,572) (4,570)
------- -------- -------
Deferred:
Federal................................ 9,906 (11,488) 15,353
------- -------- -------
9,906 (11,488) 15,353
------- -------- -------
Income tax provision (benefit) from
continuing operations................... $ 5,400 $(56,060) $10,783
======= ======== =======
72
<PAGE>
The components of income tax benefit from extraordinary item are:
For the years ended December 31,
1997 1996 1995
---- ---- ----
Current:
Federal................................ $ (374) $ -- $ --
------- ------- -------
(374) -- --
------- ------- -------
Deferred:
Federal................................ (2,175) -- --
------- ------- -------
(2,175) -- --
------- ------- -------
Income tax benefit from
extraordinary item...................... $(2,549) $ -- $ --
======= ======= =======
A reconciliation between the total provision (benefit) for income taxes and the
amounts computed at the Statutory Federal income tax rate of 35% for the years
1997, 1996 and 1995 is as follows:
<TABLE>
<CAPTION>
For the years ended December 31,
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Computed at the Statutory tax rate............. $ 8,804 $(66,988) $ 12,220
(Decrease) increase in taxes resulting from:
Excludable dividends......................... -- (36) (107)
Tax-exempt interest.......................... (61) (4,547) (12,917)
Losses of foreign reinsurance affiliate...... -- 16,060 8,469
Reversal of income tax accruals.............. (3,703) -- --
Other........................................ 360 (549) 3,118
------- -------- --------
Provision (benefit) for income taxes........... $ 5,400 $(56,060) $ 10,783
======= ======== ========
</TABLE>
The tax effects of significant temporary differences between the financial
statement carrying amounts and tax bases of assets and liabilities that
represent the net deferred tax asset are as follows:
December 31,
1997 1996
---- ----
Allowance for uncollectible accounts.......... $ 6,839 $ 9,037
Unearned premiums............................. 13,756 13,386
Discounting of unpaid losses and LAE.......... 63,743 51,086
Unrealized depreciation of investments........ -- 13,394
Depreciation.................................. -- 5,646
Postretirement benefit obligation............. 5,139 5,111
Tax carryforwards............................. 46,088 67,014
Other......................................... 18,919 9,458
-------- --------
Gross deferred tax asset...................... 154,484 174,132
-------- --------
Deferred acquisition costs.................... (15,723) (15,352)
Pension asset................................. (371) (1,348)
Depreciation.................................. (574) --
Unrealized appreciation of investments........ (10,126) --
Losses of foreign reinsurance affiliate....... (55,087) (55,790)
Other......................................... (2,212) --
-------- --------
Gross deferred tax liability.................. (84,093) (72,490)
-------- --------
Net deferred tax asset........................ $ 70,391 $101,642
======== ========
73
<PAGE>
At December 31, 1997, the Company had approximately $109,622 of net operating
loss carryforwards (expiring in 2011), approximately $7,532 of alternative
minimum tax credit carryforwards (which do not expire) and approximately $188 of
general business credit carryforwards (expiring in 2010 and 2011).
Under SFAS 109, a valuation allowance should be provided to offset the effects
of a deferred tax asset if management believes that it is more likely than not
that the benefit of a deferred tax item will not be realized. Management
believes that the benefit of its deferred tax asset will be fully realized, and
therefore has not provided for a valuation allowance.
U.S. Federal tax return examinations have been completed for the years 1992 and
1993. The examinations for years 1994 and 1995 are currently in progress. In
management's opinion, the ultimate resolution of these matters will not have an
adverse impact on the Company's financial position or results of operations.
9. Employee Retirement, Postretirement, and Postemployment Benefits
During 1996, the Property and Casualty Group initiated a Voluntary Early
Retirement Program ("VERIP"). Eligibility to participate in the VERIP was
contingent upon an employee's age and years of service with the Company. Of the
approximately 85 employees eligible to participate in the VERIP, approximately
50 employees opted to participate. At December 31, 1996, the Company accrued
$7,635 in connection with the VERIP. The components of this accrual are as
follows:
Pension costs................................................ $4,300
Postemployment costs......................................... 2,360
Postretirement costs......................................... 975
------
$7,635
======
The Company did not offer a VERIP in 1997, and as such, did not incur any VERIP
expenses. The Company did, however, incur certain restructuring and other
charges during 1997 (See Note 20).
A. Pension and Retirement Plans -- The Company sponsors a qualified non-
contributory defined benefit pension plan (Qualified Pension Plan) covering
substantially all employees. After meeting certain qualifications, an employee
acquires a vested right to future benefits. The benefits payable under the plan
are generally determined on the basis of an employee's length of employment and
career average salary. The Company's policy is to fund pension cost accrued in
accordance with the Employee Retirement Income Security Act of 1974. The
Company also maintains a non-qualified unfunded supplemental defined benefit
pension plan (Non-qualified Pension Plan) for the benefit of certain key
employees.
The following tables set forth the amounts recognized in the Company's financial
statements with respect to the Qualified and Non-qualified pension plans:
<TABLE>
<CAPTION>
For the year ended December 31, For the year ended December 31,
1997 1996
Non- Non-
Qualified Qualified Qualified Qualified
Plan Plan Total Plan Plan Total
---- ---- ----- ---- ---- -----
<S> <C> <C> <C> <C> <C> <C>
Service cost-benefits earned
during the period......... $ 1,375 93 $ 1,468 1,665 98 $ 1,763
Interest cost on projected
benefit obligation........ 3,034 166 3,200 2,948 150 3,098
Actual return on plan assets.. (2,490) -- (2,490) (2,830) -- (2,830)
Net amortization and
deferral.................. (884) 93 (791) (842) 94 (748)
VERIP......................... -- -- -- 4,300 -- 4,300
------- --- ------- ------ --- -------
Net pension cost.............. 1,035 352 $ 1,387 5,241 342 $ 5,583
======= === ======= ====== === =======
<CAPTION>
For the year ended December 31,
1995
Non-
Qualified Qualified
Plan Plan Total
---- ---- -----
<S> <C> <C> <C>
Service cost-benefits earned
during the period......... 1,132 108 $ 1,240
Interest cost on projected
benefit obligation........ 2,770 158 2,928
Actual return on plan assets.. (8,712) -- (8,712)
Net amortization and
deferral.................. 5,803 94 5,897
VERIP......................... -- -- --
------ --- -------
Net pension cost.............. 993 360 $ 1,353
====== === =======
</TABLE>
74
<PAGE>
<TABLE>
<CAPTION>
December 31, 1997 December 31, 1996
Non- Non-
Qualified Qualified Qualified Qualified
Plan Plan Total Plan Total
---- ---- ----- ---- -----
<S> <C> <C> <C> <C> <C> <C>
Actuarial present value of:
Vested benefit obligation......... $36,405 $ 1,238 $37,643 $41,932 $ 1,069 $43,001
Non-vested benefit obligation..... 3,919 79 3,998 3,487 68 3,555
------- ------- ------- ------- ------- -------
Accumulated benefit obligation........ $40,324 1,317 41,641 $45,419 1,137 46,556
======= ======= ======= ======= ======= =======
Projected benefit obligation.......... $44,653 2,472 47,125 $49,331 2,133 51,464
Fair value of Pension Plan assets..... 40,600 -- 40,600 46,739 -- 46,739
------- ------- ------- ------- ------- -------
Excess of projected benefit obligation
over Pension Plan assets........ (4,053) (2,472) (6,525) (2,592) (2,133) (4,725)
Unrecognized net loss (gain).......... 4,830 29 4,859 588 (63) 525
Unrecognized transition asset......... (810) 1,123 313 (1,081) 1,216 135
Unrecognized prior service benefit.... (1,101) -- (1,101) (1,199) -- (1,199)
------- ------- ------- ------- ------- -------
Pension liability..................... $(1,134) $(1,320) $(2,454) $(4,284) $ (980) $(5,264)
======= ======= ======= ======= ======= =======
</TABLE>
Qualified Pension Plan assets consist of equity securities, fixed maturity
securities, fixed income contracts, and the Company's common stock.
Actuarial assumptions utilized by the Qualified and Non-qualified Pension Plan
are as follows:
<TABLE>
<CAPTION>
For the years ended December 31,
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Discount rate..................................... 7.0% 7.5% 7.0%
Rate of compensation increase..................... 4.5% 5.0% 5.0%
Expected long-term rate of return on plan assets.. 8.0% 8.0% 8.0%
</TABLE>
The Company also maintains a voluntary defined contribution savings plan
covering all employees who work a minimum of 20 hours per week. The Company
matches employee contributions up to 5% of compensation. Contributions under
such plans charged to income were $1,735, $2,153 and $1,726 in 1997, 1996 and
1995, respectively.
B. Postretirement Benefits -- In addition to providing pension benefits, the
Company provides certain health care benefits for retired employees.
Substantially all of the Company's employees may become eligible for those
benefits if they have worked fifteen or more years with the Company and have
attained the age of fifty while in the service of the Company. For employees
who retire on or subsequent to January 1, 1993, the Company will pay a fixed
portion of medical insurance premiums. Retirees will absorb future increases in
medical premiums.
The funded status of this liability is as follows:
December 31,
1997 1996
---- ----
Accumulated postretirement benefit obligation:
Retirees and dependents.......................... $ 6,076 $ 6,931
Fully eligible active employees.................. 1,214 952
Active employees not fully eligible.............. 2,383 1,871
------- -------
Total............................................ 9,673 9,754
Unrecognized prior service cost.................. 1,317 1,436
Unrecognized net gain............................ 3,455 4,031
------- -------
Accrued postretirement benefit liability......... $14,445 $15,221
======= =======
75
<PAGE>
The components of postretirement benefit cost include the following:
For the years ended December 31,
1997 1996 1995
---- ---- ----
Service cost.......................... $ 237 $ 248 $ 330
Interest cost......................... 655 561 658
Amortization.......................... (242) (251) (209)
VERIP................................. -- 975 --
----- ------ -----
Postretirement benefit cost........... $ 650 $1,533 $ 779
===== ====== =====
Assumptions used in the computation of the funded status and postretirement
benefit cost are as follows:
For the years ended December 31,
1997 1996 1995
---- ---- ----
Discount rate......................... 7.5% 7.0% 7.0%
Health care inflation rate:
Next year........................... 7.5% 8.0% 8.5%
Ultimate............................ 5.5% 5.5% 5.5%
The assumed health care cost trend rate used to measure the expected cost of
benefits covered by the plan has been established at 7.5% for 1998 and is
expected to decline gradually to 5.5% in 2002 and remain at that level
thereafter. The health care cost trend rate assumption has a significant effect
on the amounts reported. A 1% increase in the trend rate for health care costs
would have increased the accumulated postretirement benefit obligation by $405
and the annual service and interest cost by $27.
C. Postemployment Benefits -- SFAS No. 112, "Employers' Accounting for
Postemployment Benefits," establishes the accounting standards for employers who
provide benefits to employees subsequent to their employment, but prior to
retirement. These benefits include severance, long-term and short-term
disability payments, salary continuation, postemployment health benefits,
supplemental unemployment benefits, and other related payments. SFAS No. 112
requires that benefit obligations attributable to prior service and/or that
relate to benefits that vest or accumulate must be accrued presently if the
payments are probable and reasonably estimable. Postemployment benefits that do
not meet such criteria are accrued when payments are probable and reasonably
estimable. In connection with the VERIP described above, the Company recorded
$2,360 of postemployment costs in 1996. While a VERIP was not offered in 1997,
the Company incurred approximately $7,000 of severance and other restructuring
charges during 1997 (See Note 20).
10. Fair Value of Financial Instruments
The following table represents the carrying amounts and estimated fair values of
the Company's financial instruments. Estimated fair value is defined as the
amount at which the instrument could be exchanged in a current transaction
between willing parties. Certain financial instruments, specifically amounts
relating to insurance contracts, are excluded from this disclosure.
76
<PAGE>
<TABLE>
<CAPTION>
December 31, 1997 December 31, 1996
Carrying Estimated Carrying Estimated
Amount Fair Value Amount Fair Value
------ ---------- ------ ----------
<S> <C> <C> <C> <C>
Financial assets:
Fixed maturities available for sale...... $1,929,518 $1,929,518 $2,126,120 $2,126,120
Equity securities........................ 13 13 262 262
Financial liabilities:
Long-term debt........................... 203,000 203,000 204,699 218,101
Interest rate swap agreements............ -- 3,388 -- 52
</TABLE>
The following methods and assumptions were used to estimate the fair value of
each class of financial instruments for which it is practicable to estimate
values:
Fixed maturities: The fair values are estimated based upon
quoted market prices.
Equity securities: The fair values are estimated based upon
quoted market prices.
Long-term debt: The fair value is estimated using
discounted cash flow calculations based
upon the Company's current incremental
borrowing rate for similar types of
borrowing facilities or the rate utilized
to prepay obligations, where applicable.
Interest rate swaps: The fair values are estimated by obtaining
quotes from dealers.
Guarantees: The fair values are determined based upon
the likelihood of the Company being
required to satisfy the underlying
obligations. Management believes that it is
a remote possibility that the Company would
have to act upon any guarantees. Therefore,
the fair value of the guarantees is zero.
Other financial instruments
(excluded from the above table): The carrying values approximate the fair
values.
11. Disclosure of Certain Risks and Uncertainties
A. Business Segments and Concentrations -- As stated in Note 1, PMC is an
insurance holding company that sells property and casualty reinsurance and
insurance through its insurance subsidiaries.
The following summarizes the relative importance of the segments and lines of
insurance in terms of net premiums written:
Percent of the Company's
Net Premiums Written
1997 1996 1995
---- ---- ----
PMA Re-total................................... 42.5% 37.0% 31.2%
PMA Re-casualty reinsurance lines.............. 28.4 27.5 21.9
The Property and Casualty Group-total.......... 57.5 63.0 68.8
The Property and Casualty Group-workers'
compensation................................. 43.2 45.6 42.8
PMA Re distributes its products through major reinsurance brokers. PMA Re's top
five such brokers accounted for 90.8% of PMA Re's gross premiums in force at
December 31, 1997.
The Property and Casualty Group's operations are concentrated in six contiguous
states in the Mid-Atlantic and Southern regions of the U.S. As such, economic
trends in individual states may not be independent of
77
<PAGE>
one another. Also, the Property and Casualty Group's products are highly
regulated by each of these states. For many of the Property and Casualty
Group's products, the insurance departments of the states in which it conducts
business must approve rates and policy forms. In addition, workers'
compensation benefits are determined by statutes and regulations in each of
these states. While the Property and Casualty Group considers factors such as
rate adequacy, regulatory climate, and economic factors in its underwriting
process, unfavorable developments in these factors could have an adverse impact
on the Company's financial condition and results of operations.
The Company actively manages its exposure to catastrophic events. In the
underwriting process, the Company generally avoids the accumulation of insurable
values in catastrophe prone regions. Also, in writing property reinsurance
coverages, PMA Re typically requires per occurrence loss limitations for
contracts that could have catastrophe exposure. Through per risk reinsurance,
the Company also manages its net retention in each exposure. In addition, PMA
Re maintains retrocessional protection of $46,000 excess of $2,000 per
occurrence, and the Property and Casualty Group maintains catastrophe
reinsurance protection of $27,700 excess of $850. As a result, the Company's
loss ratios have not been significantly impacted by catastrophes, and management
believes that the Company has adequate reinsurance to protect against the
estimated probable maximum gross loss from a catastrophic event; however, though
management believes it is unlikely, an especially severe catastrophic event
could exceed the Company's reinsurance and/or retrocessional protection, and
adversely impact the Company's financial position, perhaps materially.
B. Use of Estimates in the Preparation of the Financial Statements -- The
preparation of financial statements in conformity with GAAP requires management
to make estimates and assumptions that affect the reported amounts of assets and
liabilities, disclosure of contingent assets and liabilities at the date of the
financial statements, and the reported amounts of revenues and expenses during
the period. Actual results could differ from those estimates.
Unpaid Losses and Loss Adjustment Expenses -- At December 31, 1997, the Company
carried $2,003,187 of unpaid losses and loss adjustment expenses. Unpaid losses
and loss adjustment expenses reflect management's best estimate of future
amounts needed to pay claims and related settlement costs with respect to
insured events which have occurred, including events that have not been reported
to the Company. In many cases, significant periods of time, ranging up to
several years or more, may elapse between the occurrence of an insured loss, the
reporting of the loss to the Company and the Company's payment of that loss. In
general, liabilities for reinsurers become known more slowly than for primary
insurers and are subject to more unforeseen development. As part of the process
in determining these amounts, historical data is reviewed and consideration is
given to the impact of various factors, such as legal developments, changes in
social attitudes, and economic conditions. In addition, estimating reserves for
workers' compensation claims can be more difficult than many other lines of
property and casualty insurance for several reasons, including (i) the long
payment `tail' associated with the business; (ii) the impact of social,
political and regulatory trends on benefit levels for both medical and indemnity
payments; (iii) the impact of economic trends; and (iv) the impact of changes in
the mix of business. At various times, one or a combination of such factors can
make the interpretation of actuarial data associated with workers' compensation
loss development more difficult, and it can take additional time to recognize
changes in loss development patterns. Under such circumstances, adjustments
will be made to such reserves as loss patterns develop and new information
becomes available and such adjustments may be material.
Management believes that its unpaid losses and loss adjustment expenses are
fairly stated at December 31, 1997, in accordance with GAAP. However,
estimating the ultimate claims liability is necessarily a complex and judgmental
process inasmuch as the amounts are based on management's informed estimates and
judgments using data currently available. As additional experience and data
become available regarding claims payment and reporting patterns, legislative
developments, and economic conditions, the estimates are revised accordingly.
If the Company's ultimate net losses prove to be substantially greater than the
amounts recorded at December 31, 1997, the related adjustments could have a
material adverse impact on the Company's financial condition and results of
operations (See also Note 3).
78
<PAGE>
C. Year 2000 Issue -- The unprecedented advances in computer technology over
the past several decades have resulted in dramatic changes in the way companies
do business. Most of these developments have been tremendously beneficial, but
some have proven costly, as businesses have struggled to adapt to various
features of the new technological landscape. One such well-publicized problem
has arisen out of the worldwide use of the so-called "Year 2000" programming
convention, in which two digit numbers were generally used instead of four digit
numbers to identify the years used in dates. As a consequence, most computers
require relatively costly reprogramming to enable them to correctly perform date
operations involving years 2000 or later, a problem anticipated to have
substantial repercussions on the business world, since computer operations
involving date calculations are pervasive.
With the assistance of outside consulting groups, the Company began evaluating
and reprogramming its own computer systems to address the Year 2000 problem in
late 1995. Management anticipates that by no later than year end 1998, it will
have completed substantially all necessary programming work so that Year 2000
issues are not likely to result in any material adverse disruption in the
Company's computer systems or its internal business operations. The cost of
this work through year-end 1997 has been approximately $3,800. The Company
estimates that the total remaining cost will be approximately $1,300, and will
be expensed in 1998.
Many experts now believe that Year 2000 problem may have a material adverse
impact on the national and global economy generally. In addition, it seems
likely that if businesses are materially damaged as a result of Year 2000
problems, at least some such businesses may attempt to recoup their losses by
claiming coverage under various types of insurance policies. And, although
management has concluded that under a fair reading of the various policies of
insurance issued by it no coverage for Year 2000 problems should be considered
to exist, it is not possible to predict whether or to what extent any such
coverage could ultimately be found to exist by courts in the various
jurisdictions. Accordingly, important factors which could cause actual results
to differ materially from those expressed in the forward looking statements
include but are not limited to the inability of the Company to accurately
estimate the impact of the Year 2000 problem on the insurance, or other business
operations, of the Company.
12. Transactions With Related Parties
The Company's largest shareholder is PMA Foundation (the "Foundation"), formerly
known as Pennsylvania Manufacturers' Association, which is a not-for-profit
corporation qualified under Section 501(c)(6) of the Internal Revenue Code,
whose purposes include the promotion of the common business interests of its
members and the economic prosperity of the Commonwealth of Pennsylvania. As of
December 31, 1997, the Foundation owned 4,561,225 shares of common stock (30.7%
of the class) and 912,225 shares of Class A common stock (10.0% of the class),
which constitutes 29.5% of the total number of votes available to be cast in
matters brought before the Company's shareholders. All of the members of the
Company's Board of Directors currently serve as members of the Foundation's
Board of Trustees. Also, Frederick W. Anton III, Chairman of the Company,
serves as President and Chief Executive Officer of the Foundation. The Company
and certain of its subsidiaries provide certain administrative services to the
Foundation for which the Company and its subsidiaries receive reimbursement.
Total reimbursements amounted to $34, $82, and $269 for the years ended December
31, 1997, 1996, and 1995, respectively. The Foundation also leases its
Harrisburg, Pennsylvania headquarters facility from a subsidiary of the Company
under a monthly operating lease presently requiring rent payments of $20 per
month and reimburses a subsidiary of the Company for its use of office space in
the Blue Bell, Pennsylvania facility. Rent and related reimbursements paid to
the Company's affiliates by the Foundation amounted to $250, $247, and $294, for
the years ended December 31, 1997, 1996, and 1995, respectively.
In addition, the Company has arranged an executive loan program with a financial
institution whereby such institution will provide prime rate personal loans to
officers of the Company and its subsidiaries collateralized by common stock and
Class A common stock at a maximum 50% loan to value ratio. The Company has
agreed to purchase any loan made under this program from the financial
institution in the event that the borrower defaults on such loan. The amount of
loans outstanding at December 31, 1997 under this program was $4,642.
79
<PAGE>
The Company incurred legal and consulting fees aggregating approximately $6,506,
$7,917, and $6,279 in 1997, 1996 and 1995, respectively, from firms in which
directors of the Company are partners or principals.
The Company has notes receivable from officers which are accounted for as a
reduction of shareholders' equity in the accompanying balance sheets. Such
notes receivable had balances of $198 and $1,162 as of December 31, 1997 and
December 31, 1996, respectively. The interest rate on the notes range between
6.0% and 8.0%.
13. COMMITMENTS AND CONTINGENCIES
For the years ended December 31, 1997, 1996 and 1995, total rent expense was
$5,745, $6,114 and $4,536 respectively. At December 31, 1997, the Company was
obligated under noncancelable operating leases for office space with aggregate
minimum annual rentals as follows:
For the years ended December 31,
1998.................................. $ 3,972
1999.................................. 2,940
2000.................................. 1,811
2001.................................. 1,820
2002.................................. 1,566
Thereafter............................ 2,133
-------
Total................................. $14,242
=======
In the event a property and casualty insurer, operating in a jurisdiction where
the Company's insurance subsidiaries also operate becomes or is declared
insolvent state insurance regulations provide for the assessment of other
insurers to fund any capital deficiency of the insolvent insurer. Generally,
this assessment is based upon the ratio of an insurer's voluntary premiums
written to the total premiums written for all insurers in that particular
jurisdiction. The Company is not aware of any material potential assessments at
December 31, 1997.
The Company has provided guarantees of approximately $11,048 related to loans on
properties in which the Company has an interest.
The Company is named in various legal proceedings arising in the normal course
of business. In the opinion of management, the resolution of these matters will
not have a material adverse effect on the Company's financial condition, results
of operations, or cash flows.
14. SALE OF UNCOLLECTED PREMIUMS
Insurance subsidiaries of PMC, from time to time, engage in the practice of
selling uncollected premiums to a third-party financial institution. No such
sales were transacted during 1997. The proceeds received from such sales were
$10,628 and $19,509 in 1996 and 1995, respectively. These receivables were
excluded from uncollected premiums in the accompanying balance sheets. However,
the Company had recorded an allowance for doubtful accounts related to the
estimated uncollectible accounts since the Company had retained risk under the
recourse provisions. At December 31, 1997, the Company had no contingent
obligations outstanding related to the sale of uncollected premiums.
15. SHAREHOLDERS' EQUITY
The Company has two classes of common stock, Class A common stock and common
stock. The Company's common stock and Class A common stock generally vote
without regard to class on matters submitted to shareholders, with the common
stock having ten votes per share and the Class A common stock having one vote
per share.
80
<PAGE>
With respect to dividend rights, the Class A common stock is entitled to cash
dividends at least 10% higher than those declared and paid on the common stock.
The Company's bylaws limit the classes of persons who may own the common stock.
Holders of common stock may elect to convert any or all such shares into Class A
common stock on a share-for-share basis.
Under the insurance laws and regulations of Pennsylvania, PMC's insurance
subsidiaries may not pay dividends to PMC without prior regulatory approval,
over a twelve-month period in excess of the greater of (a) 10% of the preceding
year-end's policyholders surplus or (b) the preceding year's SAP net income, but
in no event to exceed unassigned funds. At December 31, 1997, the maximum
amount available to be paid as dividends from the Company's insurance
subsidiaries to PMC, without the prior consent of the Pennsylvania Insurance
Department, was $51,220.
PMC's dividends to shareholders are restricted by its debt agreements. On
March 14, 1997, the Company refinanced certain debt agreements through the
completion of the New Credit Facility (See Note 6). Under the terms of the New
Credit Facility under the most restrictive debt covenant, the Company could pay
dividends of approximately $14,500 in 1998.
PMA Re intends to maintain Caliber One Indemnity Company's surplus at not less
than $25,000, the minimum capital and surplus required for many states in order
to be an eligible surplus lines carrier (See Note 1).
16. Earnings Per Share
In accordance with SFAS No. 128 discussed in Note 1-I, the Company is required
to present a reconciliation of the numerators and denominators used in the basic
earnings per share calculation to the numerators and denominators used in the
diluted earnings per share calculation. The computation of diluted earnings per
share is similar to the computation of basic earnings per share except that the
denominator is increased to include the number of additional common shares that
would have been outstanding if all dilutive potential common shares, such as
outstanding stock options with exercise prices below the average market price,
had been issued. For all years presented, there were no differences in the
numerator for the basic and diluted earnings per share calculation. For
entities that report an extraordinary item, as the Company did in 1997, SFAS
No. 128 requires that income before extraordinary item be used as the control
number in determining whether or not potential common shares are dilutive. The
Company's income (loss) before extraordinary item, which was equal to net income
in 1996 and 1995, and a reconciliation of the denominator of the basic and
diluted earnings per share computations are presented below.
81
<PAGE>
<TABLE>
<CAPTION>
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Numerator:
Control number - income (loss)
before extraordinary item........... $19,753 $(135,334) $24,130
Denominator:
Basic shares - weighted
average common and
Class A common shares outstanding 23,855,031 23,800,791 23,816,088
Dilutive stock options................ 712,347 -- 965,861
---------- ---------- ----------
Total diluted shares.................. 24,567,378 23,800,791 24,781,949
========== ========== ==========
</TABLE>
Options to purchase 646,000 shares of Class A common stock at $17.00 per share
were outstanding at December 31, 1997, but were not included in the computation
of diluted earnings per share because the options' exercise price was greater
than the average market price of the Class A common shares. Options to purchase
3,242,160 shares of Class A common stock at prices ranging between $8.00 and
$17.00 were outstanding during at December 31, 1996, but were excluded from the
computation of diluted earnings per share as they would have been anti-dilutive.
82
<PAGE>
17. Business Segments
Operating revenues, income (loss) before income taxes, and identifiable assets
of the Company's business segments were as follows:
<TABLE>
<CAPTION>
For the year ending December 31,
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Operating revenues/(1)/
PMA Re
Net premiums earned................................... $163,603 $ 151,974 $139,345
Net investment income................................. 52,270 48,676 45,166
-------- --------- --------
215,873 200,650 184,511
-------- --------- --------
The Property and Casualty Group
Net premiums earned - workers' compensation........... 152,773 176,380 243,175
Net premiums earned - commercial lines................ 59,575 92,221 102,432
-------- --------- --------
Net premiums earned - total 212,348 268,601 345,607
Net investment income................................. 82,098 82,455 92,275
Service revenues...................................... 10,311 9,189 5,106
-------- --------- --------
304,757 360,245 442,988
-------- --------- --------
Corporate, Other and Consolidating Eliminations
Net investment income................................. 2,330 2,805 1,914
-------- --------- --------
2,330 2,805 1,914
-------- --------- --------
Total operating revenues.................................. $522,960 $ 563,700 $629,413
======== ========= ========
</TABLE>
(1) Operating revenues exclude net realized investment gains.
<TABLE>
<CAPTION>
For the years ended December 31,
1997 1996 1995
---- ---- ----
Income (loss) before income taxes
PMA Re.................................................... $ 44,802 $ 42,783 $ 39,443
The Property and Casualty Group........................... (9,038) (219,619) (4,305)
Corporate, Other and Consolidating Eliminations........... (3,441) (490) (13,414)
-------- --------- --------
Pre-tax operating income (loss) before interest expense... 32,323 (177,326) 21,724
Net realized investment gains............................. 8,598 2,984 31,923
Interest expense.......................................... (15,768) (17,052) (18,734)
-------- --------- --------
Total income (loss) before income taxes................... $ 25,153 $(191,394) $ 34,913
======== ========= ========
<CAPTION>
December 31,
1997 1996
---- ----
<S> <C> <C>
Identifiable assets
PMA Re................................................... $1,126,176 $1,031,149
The Property and Casualty Group.......................... 1,863,975 2,050,648
Corporate, Other and Consolidating Eliminations.......... 67,107 35,719
---------- ----------
Total identifiable assets................................ $3,057,258 $3,117,516
========== ==========
</TABLE>
83
<PAGE>
18. SAP Information
SAP net income (loss) and capital and surplus for PMC's domestic insurance
subsidiaries as reported to the Insurance Departments of Pennsylvania and
Delaware are as follows:
<TABLE>
<CAPTION>
For the years ended December 31,
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
SAP net income (loss)
PMA Re................................................... $ 25,752 $ 26,338 $ 36,854
The Property and Casualty Group.......................... 10,785 (191,640) 30,925
-------- --------- --------
Total/(1)/............................................... $ 36,537 $(165,302) $ 67,779
======== ========= ========
</TABLE>
(1) Caliber One Indemnity Company had no SAP net income or loss during 1997.
<TABLE>
<CAPTION>
December 31,
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
SAP capital and surplus
PMA Re/(1)/.............................................. $271,154 $ 260,853 $254,088
The Property and Casualty Group.......................... 281,071 279,764 402,968
-------- --------- --------
Total.................................................... $552,225 $ 540,617 $657,056
======== ========= ========
</TABLE>
(1) The SAP capital and surplus of PMA Re includes PMA Re's investment in
Caliber One Indemnity Company, equal to Caliber One Indemnity Company's SAP
capital and surplus of $25,039 at December 31, 1997.
A reconciliation of PMC's domestic insurance subsidiaries' SAP net income (loss)
and capital and surplus to the Company's GAAP net income (loss) and
shareholders' equity is as follows:
<TABLE>
<CAPTION>
For the years ended December 31,
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Net income (loss)
SAP net income (loss):
Domestic insurance subsidiaries......................... $ 36,537 $(165,302) $ 67,779
GAAP adjustments:
Change in deferred acquisition costs.................... 1,282 6,105 5,665
Benefit (provision) for deferred income taxes........... 4,725 11,488 (15,353)
Allowance for doubtful accounts......................... 307 (5,317) 4,105
Retirement accruals..................................... 275 (76) (3,613)
Other................................................... 549 (938) (306)
-------- --------- --------
GAAP net income (loss) - domestic insurance subsidiaries.. 43,675 (154,040) 58,277
Other entities and eliminations........................... (23,922) 18,706 (34,147)
Extraordinary loss........................................ (4,734) -- --
-------- --------- --------
GAAP net income (loss).................................... $ 15,019 $(135,334) $ 24,130
======== ========= ========
</TABLE>
84
<PAGE>
<TABLE>
<CAPTION>
December 31,
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Shareholders' equity
SAP capital and surplus:
Domestic insurance subsidiaries............................ $ 552,225 $ 540,617 $ 657,056
GAAP adjustments:
Deferred acquisition costs................................. 45,288 44,006 37,901
Deferred income taxes...................................... 52,571 101,642 67,331
Allowance for doubtful accounts............................ (19,700) (26,214) (20,897)
Retirement accruals........................................ (10,653) (14,571) (14,495)
Reversal of non-admitted assets............................ 21,330 25,599 32,841
Unrealized gain (loss) on fixed maturity investments
available for sale....................................... 19,380 (38,271) 24,186
Other...................................................... 3,254 (338) 958
--------- --------- ---------
GAAP shareholders' equity - domestic insurance subsidiaries.. 663,695 632,470 784,881
Other entities and eliminations.............................. (185,348) (206,642) (175,213)
--------- --------- ---------
GAAP shareholders' equity.................................... $ 478,347 $ 425,828 $ 609,668
========= ========= =========
</TABLE>
19. Subsequent Events
In February of 1998, the Company's Board of Directors authorized a plan to
repurchase, over the next two years, up to a maximum of 1,500,000 shares of
common stock and Class A common stock, in an amount not to exceed $25,000.
Repurchases may be made, from time to time, at the discretion of the Company in
the open market or directly from shareholders at prevailing market prices. The
1.5 million share limit equated to approximately 6.25% of the total common and
Class A common stock outstanding at December 31, 1997.
Effective February 5, 1998, the Company's Class A common stock began trading on
the Nasdaq National List under the ticker symbol, "PMFRA". Previously, the
Company's Class A common stock traded on the OTC Bulletin Board under the same
ticker symbol.
20. Quarterly Financial Information (Unaudited)
As noted in Note 19, the Company's Class A common stock began trading on the
Nasdaq National List during 1998. As of December 31, 1997 and 1996, neither
class of common equity was traded on an established exchange. Transactions in
the common stock were conducted privately among persons qualified to own the
common stock. No price information was available for such transactions.
Throughout 1997 and 1996, Class A common stock traded under the symbol, "PMFRA",
on the OTC Bulletin Board through approximately ten broker/dealers who
voluntarily made a market in Class A common stock. The stock price data
presented below for 1997 and 1996 for the Class A common stock are based upon
over-the-counter market bid quotations, which reflect interdealer prices,
without retail mark-up, mark-down or commission, and may not represent actual
transactions. As of February 28, 1998, the Company had 186 and 404 record
holders of common stock and Class A common stock, respectively.
Over the past two years, the Company's operating results have been impacted by
restructuring charges and other special items. During 1997, the Company
incurred restructuring and other charges of approximately $775, $3,500, $2,660
and $5,165 for the first, second, third and fourth quarter, respectively.
During 1996, the Company incurred approximately $31,700 of restructuring and
other charges, excluding loss reserve strengthening, during the fourth quarter.
The Company recorded $10,000 and $181,400 of loss reserve strengthening in the
third and fourth quarters of 1996, respectively (See Note 3).
85
<PAGE>
The following tables provide a summary of quarterly financial information:
<TABLE>
<CAPTION>
1997
- ----------------------------------------------------------------------------------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Income Statement Data:
Net premiums written $149,882 $ 98,389 $104,487 $ 65,524
======== ======== ======== ========
Net premiums earned $107,950 $114,451 $ 62,970 $ 90,580
Net investment income 35,847 32,612 34,353 33,886
Net realized investment (losses) gains (1,251) (680) 5,531 4,998
Service revenues 2,548 2,490 2,674 2,599
-------- -------- -------- --------
Total revenues 145,094 148,873 105,528 132,063
-------- -------- -------- --------
Losses and loss adjustment expenses 94,904 98,230 47,785 66,362
Operating expenses 35,281 48,093 38,858 46,408
Dividends to policyholders 3,257 3,360 3,566 4,533
Interest expense 4,334 3,888 3,803 3,743
-------- -------- -------- --------
Total losses and expenses 137,776 153,571 94,012 121,046
-------- -------- -------- --------
Income before income taxes and
extraordinary item 7,318 (4,698) 11,516 11,017
Provision (benefit) for income tax 2,561 (5,218) 4,172 3,885
-------- -------- -------- --------
Income before extraordinary item 4,757 520 7,344 7,132
Extraordinary item, net of tax (4,734) -- -- --
-------- -------- -------- --------
Net income $ 23 $ 520 $ 7,344 $ 7,132
======== ======== ======== ========
Supplemental Operating Income (Loss)
Data:
Operating income (loss) before interest
expenses and income taxes/(1)/ $ 12,903 $ (130) $ 9,788 $ 9,762
Operating income after interest
before income taxes/(1)/ 8,569 (4,018) 5,985 6,019
Operating income after income
taxes/(1)/ 5,570 962 3,749 3,883
- ----------------------------------------------------------------------------------------------------------
Per Share Data:
Basic:
Income before extraordinary
item $ 0.20 $ 0.02 $ 0.31 $ 0.30
Extraordinary item (0.20) -- -- --
-------- -------- -------- --------
Net income $ -- $ 0.02 $ 0.31 $ 0.30
======== ======== ======== ========
Operating income after income taxes/(1)/ $ 0.23 $ 0.04 $ 0.16 $ 0.16
======== ======== ======== ========
Diluted:
Income before extraordinary item $ 0.19 $ 0.02 $ 0.30 $ 0.29
Extraordinary item (.0.19) -- -- --
-------- -------- -------- --------
Net income $ -- $ 0.02 $ 0.30 $ 0.29
======== ======== ======== ========
Operating income after income taxes/(1)/ $ 0.23 $ 0.04 $ 0.15 $ 0.16
======== ======== ======== ========
- ----------------------------------------------------------------------------------------------------------
Class A Common Stock Prices:
High $ 16.125 $ 16.000 $ 16.750 $ 18.000
Low $ 15.625 $ 14.000 $ 15.000 $ 16.000
Close $ 16.000 $ 15.000 $ 16.750 $ 16.000
</TABLE>
(1) - Operating income (loss) excludes net realized investment (losses) gains.
86
<PAGE>
<TABLE>
<CAPTION>
1996
- ----------------------------------------------------------------------------------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Income Statement Data:
Net premiums written $147,444 $ 96,336 $116,745 $ 82,950
======== ======== ======== =========
Net premiums earned $117,937 $102,226 $106,034 $ 94,378
Net investment income 33,420 32,511 32,732 35,273
Net realized investment gains (losses) 943 (1,412) 5,972 (2,519)
Service revenues 1,748 2,264 2,642 2,535
-------- -------- -------- ---------
Total revenues 154,048 135,589 147,380 129,667
-------- -------- -------- ---------
Losses and loss adjustment expenses 99,943 85,512 97,013 254,155
Operating expenses 38,310 42,012 40,748 67,078
Dividends to policyholders 3,122 2,730 3,566 6,837
Interest expense 4,472 4,358 4,331 3,891
-------- -------- -------- ---------
Total losses and expenses 145,847 134,612 145,658 331,961
-------- -------- -------- ---------
Income before income taxes and
extraordinary item 8,201 977 1,722 (202,294)
Provision (benefit) for income tax 2,572 (139) (734) (57,759)
-------- -------- -------- ---------
Net income (loss) $ 5,629 $ 1,116 $ 2,456 $(144,535)
======== ======== ======== =========
Supplemental Operating Income (Loss)
Data:
Operating income (loss) before interest
expenses and income taxes/(1)/ $ 11,730 $ 6,747 $ 81 $(195,884)
Operating income (loss) after interest
before income taxes/(1)/ 7,258 2,389 (4,250) (199,775)
Operating income (loss) after income
taxes/(1)/ 5,016 2,034 (1,426) (142,898)
- ----------------------------------------------------------------------------------------------------------
Per Share Data:
Basic:
Net income (loss) $ 0.23 $ 0.05 $ 0.11 $ (6.07)
======== ======== ======== =========
Operating income (loss) after income
taxes/(1)/ $ 0.21 $ 0.09 $ (0.06) $ (6.01)
======== ======== ======== =========
Diluted:
Net income (loss) $ 0.22 $ 0.05 $ 0.10 $ (6.07)
======== ======== ======== =========
Operating income (loss) after income
taxes/(1)/ $ 0.20 $ 0.08 $ (0.06) $ (6.01)
======== ======== ======== =========
- ----------------------------------------------------------------------------------------------------------
Class A Common Stock Prices:
High $ 20.500 $ 18.500 $ 17.500 $ 17.500
Low $ 18.250 $ 16.500 $ 17.000 $ 15.625
Close $ 18.875 $ 17.000 $ 17.500 $ 15.750
</TABLE>
(1) - Operating income (loss) excludes net realized investment gains (losses).
87
<PAGE>
Report of Independent Accountants
To the Board of Directors and Shareholders
Pennsylvania Manufacturers Corporation:
We have audited the accompanying consolidated balance sheets of
Pennsylvania Manufacturers Corporation and subsidiaries as of December 31, 1997
and 1996, and the related consolidated statements of operations, shareholders'
equity and cash flows for each of the three years in the period ended
December 31, 1997. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Pennsylvania Manufacturers Corporation and subsidiaries as of December 31, 1997
and 1996, and the consolidated results of their operations and their cash flows
for each of the three years in the period ended December 31, 1997, in conformity
with generally accepted accounting principles.
/s/ Coopers & Lybrand L.L.P.
One South Market Square
Harrisburg, Pennsylvania
February 6, 1998
88
<PAGE>
Pennsylvania Manufacturers Corporation
Subsidiaries of Registrant
Exhibit 21.1
<TABLE>
<CAPTION>
PMC Direct PMC Indirect
Ownership Ownership
--------------------------------
<S> <C> <C>
Caliber One Management Company, Inc. 100%
DP Corp. 100%
Manufacturers Alliance Insurance Company 100%
Mid Atlantic States Investment Company 100%
Mid-Atlantic States Casualty Company 100%
PMA Holdings Cayman, Ltd. 100%
PMA Insurance Cayman, Ltd. 100%
Pennsylvania Manufacturers Association Insurance Company 100%
Ajon, Inc. 15% 85%
Aud-Evad, Inc. 15% 85%
Dauphin Equities, Inc. 15% 85%
Lorjo Corp. 15% 85%
Rosemarie, Inc. 15% 85%
Sarfred, Inc. 15% 85%
Wisteve, Inc. 15% 85%
Cris-Jen, Inc. 100%
Gulph Industries, Inc. 100%
Lee Ward, Inc. 100%
PMA Management Corp. 100%
PMA Services, Inc. 100%
Presque Enterprises, Inc. 100%
Syl-Bar, Inc. 100%
Walprop, Inc. 100%
Pennsylvania Manufacturers' Association Finance Company 100%
Pennsylvania Manufacturers Indemnity Company 100%
PMA Holdings Limited 100%
Pennsylvania Manufacturers International Insurance, Ltd. 100%
PMA Life Insurance Company 100%
PMA Reinsurance Corp. 100%
Caliber One Indemnity Company 100%
REM Corp. 100%
925 Chestnut, Inc. 100%
</TABLE>
<PAGE>
Exhibit 23
CONSENT OF INDEPENDENT ACCOUNTANTS
We consent to incorporation by reference in the Registration Statement on Form
S-8 (File No. 333-45949) of Pennsylvania Manufacturers Corporation of our report
dated February 6, 1998, appearing on page 88 of the Annual Report to
Shareholders which is incorporated in this Annual Report on Form 10-K. We also
consent to the incorporation by reference of our report on the Financial
Statement Schedules which appears on page S-9 of this Form 10-K.
/s/ Coopers & Lybrand L.L.P.
One South Market Square
Harrisburg, Pennsylvania
March 15, 1998
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 7
<S> <C> <C>
<PERIOD-TYPE> YEAR YEAR
<FISCAL-YEAR-END> DEC-31-1997 DEC-31-1996
<PERIOD-START> DEC-31-1996 DEC-31-1995
<PERIOD-END> DEC-31-1997 DEC-31-1996
<DEBT-HELD-FOR-SALE> 1,929,518 2,126,120
<DEBT-CARRYING-VALUE> 0 0
<DEBT-MARKET-VALUE> 0 0
<EQUITIES> 13 262
<MORTGAGE> 0 0
<REAL-ESTATE> 0 0
<TOTAL-INVEST> 2,194,738 2,261,353
<CASH> 32,148 7,176
<RECOVER-REINSURE> 332,406 257,983
<DEFERRED-ACQUISITION> 45,288 44,006
<TOTAL-ASSETS> 3,057,258 3,117,516
<POLICY-LOSSES> 2,003,187 2,091,072
<UNEARNED-PREMIUMS> 211,455 205,982
<POLICY-OTHER> 0 0
<POLICY-HOLDER-FUNDS> 10,200 12,524
<NOTES-PAYABLE> 203,000 204,699
0 0
0 0
<COMMON> 122,214 121,716
<OTHER-SE> 356,133 304,112
<TOTAL-LIABILITY-AND-EQUITY> 3,057,258 3,117,516
375,951 420,575
<INVESTMENT-INCOME> 136,698 133,936
<INVESTMENT-GAINS> 8,598 2,984
<OTHER-INCOME> 10,311 9,189
<BENEFITS> 307,281 536,623
<UNDERWRITING-AMORTIZATION> 93,501 90,292
<UNDERWRITING-OTHER> 89,855 114,111
<INCOME-PRETAX> 25,153 (191,394)
<INCOME-TAX> 5,400 (56,060)
<INCOME-CONTINUING> 0 0
<DISCONTINUED> 0 0
<EXTRAORDINARY> (4,734) 0
<CHANGES> 0 0
<NET-INCOME> 15,019 (135,334)
<EPS-PRIMARY> 0.63 (5.68)
<EPS-DILUTED> 0.61 (5.68)
<RESERVE-OPEN> 0 0
<PROVISION-CURRENT> 0 0
<PROVISION-PRIOR> 0 0
<PAYMENTS-CURRENT> 0 0
<PAYMENTS-PRIOR> 0 0
<RESERVE-CLOSE> 0 0
<CUMULATIVE-DEFICIENCY> 0 0
</TABLE>
