<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
Form 10-Q
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QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998
COMMISSION FILE NUMBER 1-9640
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MERCHANTS GROUP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE
(State or other jurisdiction of incorporation or organization)
16-1280763
(I.R.S. Employer Identification No.)
250 MAIN STREET, BUFFALO, NEW YORK
(Address of principal executive offices)
14202
(Zip Code)
716-849-3333
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months, and (2) has been subject to such filing requirements
for the past 90 days. Yes [ x ] No [ ]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of October 30, 1998:
2,864,952 SHARES OF COMMON STOCK.
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
MERCHANTS GROUP, INC.
CONSOLIDATED BALANCE SHEET
(in thousands)
<TABLE>
<CAPTION>
December 31, September 30,
Assets 1997 1998
------ ------------ ------------
(unaudited)
<S> <C> <C>
Investments:
Fixed maturities:
Held to maturity at amortized cost (fair value
$20,327 in 1997 and $16,620 in 1998) $ 19,631 $ 15,938
Available for sale at fair value (amortized cost
$172,996 in 1997 and $175,334 in 1998) 174,927 177,792
Preferred stock at fair value 10,582 10,709
Other long-term investments at fair value 634 686
Short-term investments 4,470 12,070
------------ ------------
Total investments 210,244 217,195
Cash 10 30
Interest due and accrued 1,858 1,715
Premiums receivable, net of allowance for
doubtful accounts of $543 in 1997 and $454 in 1998 21,084 20,019
Deferred policy acquisition costs 12,597 12,138
Ceded reinsurance balances receivable 11,132 11,358
Prepaid reinsurance premiums 2,871 2,834
Receivable from affiliate 527 375
Deferred federal income taxes 6,319 4,978
Other assets 7,332 7,459
------------ ------------
Total assets $ 273,974 $ 278,101
============ ============
</TABLE>
See Notes to the Consolidated Financial Statements
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MERCHANTS GROUP, INC.
CONSOLIDATED BALANCE SHEET
(in thousands except share amounts)
<TABLE>
<CAPTION>
December 31, September 30,
1997 1998
-------------- --------------
(unaudited)
<S> <C> <C>
Liabilities and Stockholders' Equity
------------------------------------
Liabilities:
Reserve for losses and loss adjustment expenses $ 141,205 $ 140,165
Unearned premiums 50,406 48,636
Other liabilities 14,901 17,483
-------------- --------------
Total liabilities 206,512 206,284
-------------- --------------
Stockholders' equity:
Common stock, 10,000,000 shares authorized,issued
and outstanding 2,906,502 shares at December 31, 1997
and 2,881,752 shares at September 30, 1998 32 32
Additional paid in capital 35,455 35,511
Treasury stock, 319,600 shares at December 31, 1997
and 348,100 shares at September 30, 1998 (5,906) (6,495)
Accumulated other comprehensive income 1,061 2,035
Accumulated earnings 36,820 40,734
-------------- --------------
Total stockholders' equity 67,462 71,817
-------------- --------------
Commitments and contingent liabilities -- --
Total liabilities and stockholders' equity $ 273,974 $ 278,101
============== ==============
</TABLE>
See Notes to the Consolidated Financial Statements
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MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF OPERATIONS
(in thousands except per share amounts)
<TABLE>
<CAPTION>
Three Months Nine Months
Ended September 30, Ended September 30,
1997 1998 1997 1998
---------- ---------- ---------- ----------
(unaudited)
<S> <C> <C> <C> <C>
Revenues:
Net premiums earned $ 23,764 $ 23,448 $ 70,922 $ 71,063
Net investment income 3,223 3,317 9,442 9,938
Net realized investment gains
(losses) 9 (2) 112 (2)
Other revenues 77 51 163 135
---------- ---------- ---------- ----------
Total revenues 27,073 26,814 80,639 81,134
---------- ---------- ---------- ----------
Expenses:
Net losses and loss adjustment
expenses 17,488 16,344 53,152 49,980
Amortization of deferred policy
acquisition costs 6,297 6,214 18,794 18,832
Other underwriting expenses 1,599 2,215 4,992 6,337
---------- ---------- ---------- ----------
Total expenses 25,384 24,773 76,938 75,149
---------- ---------- ---------- ----------
Income before income taxes 1,689 2,041 3,701 5,985
Income tax provision 400 558 872 1,636
---------- ---------- ---------- ----------
Net income $ 1,289 $ 1,483 $ 2,829 $ 4,349
---------- ---------- ---------- ----------
Earnings per share:
Basic $ .44 $ .51 $ .94 $ 1.50
========== ========== ========== ==========
Diluted $ .43 $ .51 $ .94 $ 1.49
========== ========== ========== ==========
Weighted average shares outstanding:
Basic 2,959 2,900 2,995 2,905
Diluted 2,966 2,911 3,002 2,919
</TABLE>
See Notes to the Consolidated Financial Statements
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MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
(in thousands)
<TABLE>
<CAPTION>
Three Months Nine Months
Ended September 30, Ended September 30,
1997 1998 1997 1998
-------- -------- -------- --------
(unaudited)
<S> <C> <C> <C> <C>
Net income $ 1,289 $ 1,483 $ 2,829 $ 4,349
-------- -------- -------- --------
Other comprehensive income before tax:
Unrealized gains
on securities 1,826 849 2,363 1,489
Less: reclassification adjustment
for gains and losses included
in net income 4 (13) (68) (13)
-------- -------- -------- --------
Other comprehensive income
before tax 1,830 836 2,295 1,476
Income tax provision related to
items of other comprehensive income 622 284 780 502
-------- -------- -------- --------
Other comprehensive income, net of tax 1,208 552 1,515 974
-------- -------- -------- --------
Comprehensive income $ 2,497 $ 2,035 $ 4,344 $ 5,323
======== ======== ======== ========
</TABLE>
See Notes to the Consolidated Financial Statements
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MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(in thousands)
<TABLE>
<CAPTION>
Nine Months
Ended September 30,
1997 1998
---------- ----------
(unaudited)
<S> <C> <C>
Common stock, beginning and end $ 32 $ 32
---------- ----------
Additional paid in capital:
Beginning of period 35,372 35,455
Exercise of common stock options 83 56
---------- ----------
End of period 35,455 35,511
---------- ----------
Treasury stock:
Beginning of period (2,983) (5,906)
Purchase of treasury shares (2,883) (589)
---------- ----------
End of period (5,866) (6,495)
---------- ----------
Accumulated other comprehensive income (loss):
Beginning of period (603) 1,061
Other comprehensive income 1,515 974
---------- ----------
End of period 912 2,035
---------- ----------
Accumulated earnings:
Beginning of period 33,211 36,820
Net income 2,829 4,349
Cash dividends (446) (435)
---------- ----------
End of period 35,594 40,734
---------- ----------
Total stockholders' equity $ 66,127 $ 71,817
========== ==========
</TABLE>
See Notes to the Consolidated Financial Statements
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MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
INCREASE (DECREASE) IN CASH
(in thousands)
<TABLE>
<CAPTION>
Nine Months
Ended September 30,
1997 1998
------------ ------------
(unaudited)
<S> <C> <C>
Cash flows from operations:
Collection of premiums $ 70,394 $ 70,822
Payment of losses and loss adjustment
expenses (50,426) (51,599)
Payment of other underwriting expenses (23,246) (21,789)
Investment income received 9,747 10,044
Investment expenses paid (229) (237)
Income taxes paid (250) (1,337)
Other cash receipts 163 135
------------ ------------
Net cash provided by operations 6,153 6,039
------------ ------------
Cash flows from investing activities:
Proceeds from fixed maturities sold or matured 60,450 74,034
Purchase of fixed maturities (59,523) (71,584)
Net increase in preferred stock (2,067) --
Net (increase) decrease in other long-term investments 714 (53)
Net increase in short-term investments (11,962) (7,600)
Purchase of equipment, net (108) --
------------ ------------
Net cash used in investing activities (12,496) (5,203)
------------ ------------
Cash flows from financing activities:
Settlement of affiliate balances (1,483) 152
Proceeds from exercise of common stock options 83 56
Cash borrowed to purchase securities 11,068 --
Purchase of treasury stock (2,883) (589)
Cash dividends (446) (435)
------------ ------------
Net cash provided by (used in) financing activities 6,339 (816)
------------ ------------
Increase (decrease) in cash and cash equivalents (4) 20
Cash:
Beginning of period 11 10
------------ ------------
End of period $ 7 $ 30
============ ============
</TABLE>
See Notes to the Consolidated Financial Statements
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MERCHANTS GROUP, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
RECONCILIATION OF NET INCOME TO NET CASH
PROVIDED BY OPERATIONS
(in thousands)
<TABLE>
<CAPTION>
Nine Months
Ended September 30,
1997 1998
---------- ----------
(unaudited)
<S> <C> <C>
Net income $ 2,829 $ 4,349
Adjustments:
Depreciation and amortization (accretion) 17 (109)
Realized investment (gains) losses (112) 2
(Increase) decrease in assets:
Interest due and accrued 228 143
Premiums receivable (420) 1,065
Deferred policy acquisition costs (232) 459
Ceded reinsurance balances receivable (849) (226)
Prepaid reinsurance premiums 101 37
Federal income tax receivable 760 --
Deferred federal income taxes (138) 840
Other assets (489) (293)
Increase (decrease) in liabilities:
Reserve for losses and loss adjustment expenses 2,600 (1,040)
Unearned premiums 775 (1,770)
Other liabilities 1,083 2,582
---------- ----------
Net cash provided by operations $ 6,153 $ 6,039
========== ==========
</TABLE>
See Notes to the Consolidated Financial Statements
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MERCHANTS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. PRINCIPLES OF CONSOLIDATION, BASIS OF PRESENTATION AND NEW ACCOUNTING
PRONOUNCEMENTS
The consolidated balance sheet as of September 30, 1998, the related
consolidated statements of operations and of comprehensive income for the three
months and nine months ended September 30, 1997 and 1998 and of changes in
stockholders' equity and of cash flows for the nine months ended September 30,
1997 and 1998 are unaudited. In the opinion of management, the interim financial
statements reflect all adjustments necessary for a fair presentation of
financial position and results of operations. Such adjustments consist only of
normal recurring items. Interim results are not necessarily indicative of
results for a full year.
The consolidated financial statements include the accounts of Merchants Group,
Inc. (the "Company"), its wholly-owned subsidiary, Merchants Insurance Company
of New Hampshire, Inc. ("MNH"), and M.F.C. of New York, Inc., an inactive
premium finance company which is a wholly-owned subsidiary of MNH. The
accompanying consolidated financial statements should be read in conjunction
with the following notes and the Notes to Consolidated Financial Statements
included in the Company's Annual Report on Form 10-K for the year ended December
31, 1997.
The consolidated financial statements have been prepared in conformity with
generally accepted accounting principles ("GAAP") which differ in some respects
from those followed in reports to insurance regulatory authorities. All
significant intercompany balances and transactions have been eliminated.
During 1998, the Company adopted Statement of Financial Accounting Standards No.
130 ("SFAS No. 130") "Reporting Comprehensive Income" and restated prior period
financial statements to conform to the new standard. SFAS No. 130 establishes
standards for reporting comprehensive income in a full set of general purpose
financial statements. Comprehensive income includes all changes to stockholders'
equity during a period except those resulting from investments by and
distributions to owners. The adoption of SFAS No. 130 resulted in revised and
additional disclosures but had no effect on the financial position, results of
operations or liquidity of the Company.
In June 1998, the FASB issued Statement of Financial Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No.
133"). SFAS No. 133 is effective for all fiscal quarters of all fiscal years
beginning after June 15, 1999 (January 1, 2000 for the Company). SFAS No. 133
requires that all derivative instruments be recorded on the balance sheet at
their fair value. Changes in the fair value of derivatives are recorded each
period in current earnings or other comprehensive income, depending on whether a
derivative is designated as part of a hedge transaction and, if it is, the type
of hedge transaction. The Company does not invest in the types of derivative
instruments
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covered by SFAS No. 133. As a result, the adoption of SFAS No. 133 will not have
an effect on the Company's results of operations or its financial position.
2. RELATED PARTY TRANSACTIONS
The Company and MNH do not have any paid employees. Under a Management Agreement
dated September 29, 1986 between the Company, MNH and Merchants Mutual Insurance
Company ("Mutual") (the "Management Agreement"), Mutual, which owns 8.8% of the
Company's common stock at September 30, 1998, provides the Company and MNH with
the facilities, management and personnel required to manage their day-to-day
business. On July 23, 1998, the Company gave notice of termination of the
Management Agreement which, under its terms, terminates five years after the
date of notice. All underwriting, administrative, claims and investment expenses
incurred on behalf of Mutual and MNH are shared under the Management Agreement
on an allocated cost basis, determined as follows: for underwriting and
administrative expenses, the respective share of total direct premiums written
for Mutual and MNH serves as the basis of allocation; for claims expenses, the
average number of outstanding claims is used; investment expenses are shared
based on each company's share of total invested assets.
3. EARNINGS PER SHARE
Basic and diluted earnings per share were computed by dividing net income for
each period by the weighted average number of shares of common stock outstanding
during each period, increased by the assumed exercise of 75,500 and 34,250
shares of common stock options for the three and nine month periods in 1998 and
1997, respectively, which would have resulted in 11,254 and 6,704 additional
shares outstanding for the three month periods, respectively and 13,366 and
6,879 additional shares outstanding for the nine month periods, respectively,
assuming the proceeds to the Company from exercise were used to purchase shares
of the Company's common stock at its average market value per share during the
periods ended September 30, 1998.
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Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1998 AS COMPARED
TO THE NINE MONTHS ENDED SEPTEMBER 30, 1997
Total revenues for the nine months ended September 30, 1998 were $81,134,000, up
1% from $80,639,000 for the nine months ended September 30, 1997.
Net premiums earned for the nine months ended September 30, 1998 were
$71,063,000, substantially unchanged from $70,922,000 for the nine months ended
September 30, 1997. Direct premiums written for the nine months ended September
30, 1998 were $73,722,000, a decrease of $1,482,000 (2%) from $75,204,000 for
the nine months ended September 30, 1997.
Voluntary personal lines direct premiums written for the nine months ended
September 30, 1998 were $29,582,000, a decrease of 1% from $29,773,000 for the
nine months ended September 30, 1997. Voluntary personal lines direct premiums
written represented 43% and 44% of total voluntary direct premiums written for
the nine months ended September 30, 1998 and 1997, respectively.
Voluntary commercial lines direct premiums written for the nine months ended
September 30, 1998 were $39,805,000, an increase of 6% from $37,620,000 for the
nine months ended September 30, 1997. The increase in voluntary commercial lines
direct premiums written resulted from increases in workers' compensation,
commercial auto and commercial package premiums written.
Involuntary direct premiums written, primarily private passenger automobile
insurance, decreased by 45% to $4,335,000 for the nine months ended September
30, 1998 from $7,811,000 for the nine months ended September 30, 1997 as the New
York Automobile Insurance Plan ("NYAIP") continues to adjust 1998 assignments
for having over-assigned policies to the Company in 1997. Involuntary direct
premiums written comprised 6% and 10% of all direct premiums written during the
nine months ended September 30, 1998 and 1997, respectively.
Net investment income was $9,938,000 for the nine months ended September 30,
1998, an increase of 5% from $9,442,000 for the nine months ended September 30,
1997, due to a 5% increase in average invested assets.
The Company recorded $2,000 of net realized losses on the sale of investments
for the nine months ended September 30, 1998 compared to $112,000 of net
realized gains for the nine months ended September 30, 1997.
Other revenues were $135,000 for the nine months ended September 30, 1998, a
decrease of 17% from $163,000 for the nine months ended September 20, 1997. This
decrease resulted from an unusually high level of charge-offs related to
business assumed from certain involuntary market facilities.
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Losses and loss adjustment expenses ("LAE") were $49,980,000 for the nine months
ended September 30, 1998, a decrease of 6% from $53,152,000 for the nine months
ended September 30, 1997. The ratio of losses and LAE to premiums earned
decreased to 70.3% for the nine months ended September 30, 1998 from 74.9% for
the nine months ended September 30, 1997, due to a lower accident year loss
ratio in 1998 compared to 1997 and the fact that in 1998 there were no increases
recorded in reserves for prior accident year losses.
The ratio of amortized policy acquisition costs and other underwriting expenses
to net premiums earned increased to 35.4% for the nine months ended September
30, 1998 from 33.5% for the nine months ended September 30, 1997, primarily due
to increased agency incentive commissions related to the improved underwriting
results. Commissions, premium taxes and other state assessments that vary
directly with the Company's premium volume represented 21.4% of net premiums
earned in the nine months ended September 30, 1998 compared to 20.3% of net
premiums earned in the nine months ended September 30, 1997.
The Company's effective federal income tax rate for the nine months ended
September 30, 1998 was 27.3%. This rate was calculated based upon the Company's
estimate of its effective federal income tax rate for all of 1998. Non-taxable
investment income, primarily tax-exempt bond income, reduced the Company's
effective tax rate by approximately 6 percentage points.
RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 1998 AS COMPARED
TO THE THREE MONTHS ENDED SEPTEMBER 30, 1997
Total revenues for the three months ended September 30, 1998 were $26,814,000,
down 1% from $27,073,000 for the three months ended September 30, 1997.
Net premiums earned for the three months ended September 30, 1998 were
$23,448,000, a decrease of 1%, from $23,764,000 for the three months ended
September 30, 1997. The decrease in net premiums earned resulted primarily from
a 2% decrease in direct premiums written, somewhat offset by a higher
contribution to 1998 earnings from unearned premiums at June 30, 1998 compared
to the contribution to 1997 earnings from unearned premiums at June 30, 1997.
Voluntary personal lines direct premiums written for the three months ended
September 30, 1998 were $10,238,000, a decrease of 4% from $10,611,000 for the
three months ended September 30, 1997. This decrease in voluntary personal lines
direct premiums written resulted primarily from a 5% decline in voluntary
private passenger auto direct premiums written due to intensified price based
market competition.
Voluntary commercial lines direct premiums written for the three months ended
September 30, 1998 were $12,807,000, an increase of 2% from $12,560,000 for the
three months ended September 30, 1997.
Involuntary direct premiums written were $1,343,000, a decrease of 59% from
$3,270,000 for the three months ended September 30, 1997. Involuntary direct
premiums written were affected by adjustments made by the NYAIP after having
over-assigned policies to the Company in 1997.
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Net investment income was $3,317,000 for the three months ended September 30,
1998, an increase of 3% from $3,223,000 for the three months ended September 30,
1997, primarily due to a 5% increase in average invested assets.
Other revenues were $51,000 for the three months ended September 30, 1998 a
decrease of 34% from $77,000 for the three months ended September 30, 1997, due
to an unusually high level of charge-offs related to business assumed from
certain involuntary market facilities.
Net losses and LAE were $16,344,000 for the three months ended September 30,
1998, a decrease of 7% from $17,488,000 for the three months ended September 30,
1997. The ratio of losses and LAE to premiums earned decreased to 69.7% for the
three months ended September 30, 1998 from 73.6% for the three months ended
September 30, 1997, due to a lower accident year loss ratio in 1998 compared to
1997 and the fact that in the third quarter of 1998 there were no increases
recorded in reserves for prior accident year losses.
The ratio of amortized policy acquisition costs and other underwriting expenses
to net premiums earned increased to 35.9% for the three months ended September
30, 1998 from 33.2% for the three months ended September 30, 1997, primarily due
to increased agency incentive commissions related to the improved underwriting
results. Commissions, premium taxes and other state assessments that vary
directly with the Company's premium volume represented 20.7% of net premiums
earned in the three months ended September 30, 1998 compared to 18.7% of net
premiums earned in the three months ended September 30, 1997.
LIQUIDITY AND CAPITAL RESOURCES
In developing its investment strategy, the Company determines a level of cash
and short-term investments which, when combined with expected cash flow, is
estimated to be adequate to meet expected cash obligations. Historically, the
excess of premiums collected over payments on claims, combined with cash flow
from investments, has provided the Company with short-term funds in excess of
normal operating demands for cash.
Net cash provided by operations decreased $114,000 (2%) from $6,153,000 for the
nine months ended September 30, 1997 to $6,039,000 for the nine months ended
September 30, 1998.
Net cash used in investing activities decreased $7,293,000 from $12,496,000 in
the nine months ended September 30, 1997 to $5,203,000 in the nine months ended
September 30, 1998. This decrease in net cash used in investing activities
resulted primarily from a $1,523,000 increase in net cash provided by
investments in fixed maturities, a $2,067,000 decrease in cash used to acquire
preferred stock, and a $4,362,000 decrease in net cash used to acquire
short-term investments.
Net cash provided by financing activities decreased $7,155,000 from a $6,339,000
source of cash in the nine months ended September 30, 1997 to an $816,000 use of
cash in the nine months ended September 30, 1998. This change resulted primarily
from an $11,068,000 decrease in cash borrowed to purchase securities, which was
partially offset by a $2,294,000 decrease in cash used
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to purchase treasury stock and a $1,635,000 net decrease in funds used to settle
balances owing to affiliates.
The Company's objectives with respect to its investment portfolio include
maximizing total return while protecting policyholders' surplus, maintaining
flexibility and liquidity, and maintaining a reasonable duration match between
assets and liabilities. Like other property and casualty insurers, the Company
relies on premiums as a major source of cash, and therefore liquidity. Cash
flows from the Company's investment portfolio, either in the form of interest or
principal payments, are an additional source of liquidity. Because the duration
of the Company's investment portfolio and liabilities are closely managed,
increases or decreases in market interest rates are not expected to have a
material effect on the Company's liquidity or its results of operations.
The Company generally designates newly acquired fixed maturity investments as
available for sale and carries these investments at fair value. Unrealized gains
and losses related to these investments are recorded as a component of
accumulated other comprehensive income within stockholders' equity. During the
nine months ended September 30, 1998 the Company recorded $974,000 of unrealized
gains, net of tax, associated with its fixed maturity investments. At September
30, 1998, the Company recorded $2,035,000 of unrealized gains, net of tax,
related to its investment portfolio. This amount is shown as accumulated other
comprehensive income in the accompanying balance sheet.
At September 30, 1998, the Company's portfolio of fixed maturities represented
89.2% of invested assets. Management believes that this level of bond holdings
is consistent with the Company's liquidity needs because it anticipates that
cash receipts from net premiums written and investment income will enable the
Company to satisfy its cash obligations. Furthermore, a portion of the Company's
bond portfolio is invested in mortgage-backed and other asset-backed securities
which, in addition to interest income, provide monthly paydowns of bond
principal.
At September 30, 1998, $127,928,000 or 66.0% of the Company's fixed maturity
portfolio was invested in mortgage-backed and other asset backed securities. The
Company invests in a variety of collateralized mortgage obligation ("CMO")
products but has not invested in the derivative type of CMO products such as
interest only, principal only or inverse floating rate securities. All of the
Company's CMO investments have an active secondary market and their effect on
the Company's liquidity does not differ from that of other fixed maturity
investments. The Company does not own any other derivative financial
instruments.
At September 30, 1998, $4,203,000, or 1.9%, of the Company's investment
portfolio was invested in non-investment grade securities.
During the nine months ended September 30, 1998, the Company repurchased 28,500
shares of its common stock. The Company is holding 348,100 shares of its common
stock in treasury at September 30, 1998.
As a holding company, the Company is dependent on cash dividends from MNH to
meet its obligations and pay any cash dividends. MNH is subject to New Hampshire
insurance laws which
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place certain restrictions on its ability to pay dividends without the prior
approval of state regulatory authorities. These restrictions limit dividends to
those that, when added to all other dividends paid within the preceding twelve
months, would not exceed 10% of the insurer's statutory policyholders' surplus
as of the preceding December 31. The maximum amount of dividends that MNH could
pay during any twelve month period ending in 1998 without the prior approval of
the New Hampshire Insurance Commissioner is $4,601,000. MNH paid $2,600,000 in
dividends to the Company during the nine months ended September 30, 1998.
Under the Management Agreement, Mutual provides employees, services and
facilities for MNH to conduct its insurance business on a cost reimbursed basis.
The balance in the payable to or receivable from affiliate account represents
the amount owing to or owed by Mutual to the Company for the difference between
premiums collected and payments made for losses, employees, services and
facilities by Mutual on behalf of MNH.
MNH, like many other property-casualty insurance companies, is subject to
environmental damage claims asserted by or against its insureds. Management of
the Company is of the opinion that, based on various court decisions throughout
the country, such claims should not be recoverable under the terms of MNH's
insurance policies because of either specific or general coverage exclusions
contained in the policies. However, there is no assurance that the courts will
agree with MNH's position in every case, nor can there by assurance that
material claims will not be asserted under policies which a court will find do
not explicitly or implicitly exclude claims for environmental damages.
Management, however, is not aware of any pending claim or group of claims which
would result in a liability that would have a material adverse effect on the
financial condition of the Company or MNH.
Industry and regulatory guidelines suggest that the ratio of a property-casualty
insurer's annual net premiums written to its statutory surplus should not exceed
3 to 1. MNH has consistently followed a business strategy that would allow it to
meet this 3 to 1 regulatory guideline. For the first nine months of 1998 MNH's
ratio of net premiums written to statutory surplus, annualized for a full year,
was 1.9 to 1.
YEAR 2000
The Year 2000 issue relates to the way in which information systems distinguish
date data between the twentieth and twenty-first centuries. Also, many systems
and equipment that are not typically thought of as relating to computers contain
embedded hardware or software ("non-IT") that may have a time element.
Under the Management Agreement, Mutual is responsible for the Company's being
Year 2000 compliant. The Company is relying upon the expertise of Mutual's
employees for assuring that the necessary precautions for Year 2000 compliance
are taken. Mutual has advised the Company that the process of preparing all of
its computer systems to be Year 2000 compliant is substantially completed.
Mutual began work on becoming Year 2000 compliant in 1996. The scope of the
project includes: ensuring the compliance of all computer software applications
and operating systems, mainframe, mid-range and personal computers, local and
wide-area networks, and
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telecommunications equipment; addressing issues related to non-IT embedded
software and equipment; remediation of affected systems and equipment; and
addressing the compliance of key suppliers.
The project has three phases: assessment of systems, equipment and business
relationships affected by the Year 2000 issue; definition of strategies
necessary to address affected systems and relationships; and remediation or
replacement of affected systems, equipment and relationships.
Mutual's target for completing all phases of the project is the fourth quarter
of 1999. Mutual has completed the assessment and strategy phases for all
systems. Mutual began converting to a mid-range computer based policywriting and
claims paying system known as "MOST" (Merchants Optimum Services & Technology)
in 1994. The final phase of the conversion to MOST was completed in October
1998. All new business and policy renewals for all products are now processed on
the MOST system. Mutual has advised the Company that it believes the MOST
system, the mainframe, mid-range and personal computers, and local area networks
are substantially Year 2000 compliant.
Mutual and the Company depend upon a number of key business partners and
suppliers. As part of its Year 2000 project, Mutual has identified key business
partners, vendors, suppliers, and service providers with whom it and the Company
conduct business, and has made substantial progress in contacting these
organizations to determine their Year 2000 readiness. Based upon the responses
to Mutual's inquiries to these organizations, Mutual has and will continue to
take appropriate actions. For organizations that are not compliant, or where
Mutual determines that a significant risk may be involved, Mutual has engaged or
is in the process of engaging another organization that is Year 2000 compliant.
Currently, Mutual has identified one supplier, for which there is no viable
alternative, that is currently not Year 2000 compliant, but which expects to
become compliant by December 31, 1998. In certain instances where it may not be
possible to verify with certainty a supplier's Year 2000 compliance (for
example, it may not be possible for Mutual to test the operational ability of
its telecommunications, electricity or gas service suppliers in a Year 2000
environment) and where alternate sources of supply are not feasible, Mutual and
the Company may have to rely on the assurances of the supplier.
The Company estimates that its share of the total expenses associated with
becoming Year 2000 compliant will total approximately $290,000. Approximately
$150,000 of the expenses have been for external costs which include
approximately $112,000 in outside consultant expenses and $38,000 for specific
upgrades of software to address Year 2000 compliance and $140,000 of the
expenses have been for internal resources dedicated to achieving Year 2000
compliance. It is estimated that any remaining external or internal costs will
not be material. The Company estimates its share of costs incurred in 1998 to be
$210,000, which has been expensed. There has not been a material impact on the
Company's results of operations or financial condition as a result of
Information Technology projects being deferred due to resource constraints
caused by the Year 2000 project.
With the successful implementation of the MOST system, Mutual has notified the
Company that it believes that critical systems are substantially Year 2000
compliant. Testing will continue as
16
<PAGE> 17
needed to assure that systems are Year 2000 compliant and that any situation
that develops which needs to be addressed will be corrected by January 1, 2000.
Mutual is continuing to work with third party vendors to assess their ability to
operate in the Year 2000, to assess third-party remediation plans, and to take
steps to identify and transfer support to third party vendors who are Year 2000
compliant. The Company will continue to monitor and assess the reasonably likely
worst case Year 2000 scenario and plans to have contingency plans, as required,
in place by mid-1999. If the Company does not complete its year 2000 program
prior to the commencement of the Year 2000, if it fails to identify and
remediate all critical Year 2000 problems, or if major suppliers or customers
experience material Year 2000 problems, the Company's results of operations or
financial condition could be materially affected. The Company is currently
assessing its most reasonably likely worst case Year 2000 scenario and the
possible effects thereof.
MNH continues to evaluate the complex issues related to insurance coverage for
losses arising form the various possible situations involving Year 2000
problems and its potential liability to its insureds. The Company believes that
the coverage MNH provides do not extend to the types of losses which are most
likely to occur as a result of Year 2000 problems. MNH plans to use coverage
exclusion endorsements based on its evaluation of the potential exposure to Year
2000 problems for classes of commercial risks, and has adopted endorsements to
its policies based on forms provided and filed for approval with various
regulatory authorities by Insurance Services Office, Inc. ("ISO"). Use of these
special endorsements is governed by the law and regulatory polices of state in
which MNH is authorized to do business.
It is possible, however, that future court interpretations of policy language
based on specific facts or legislation mandating coverage, could result in
coverage for losses attributable to Year 2000 problems. Such decisions or
legislation could have a material adverse impact on the Company's results of
operations and financial condition. It is also possible that the Company may
incur expenses defending claims for which it is ultimately determined there is
no insurance coverage. The Company had made no provision for reserves for losses
or loss adjustment expense payments on claims based on potential Year 2000
problems.
17
<PAGE> 18
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
-----------------
CHANNING T. LUSHBOUGH VS. MERCHANTS GROUP, INC., ET AL.
Since the date of the Company's last filing, this litigation has been resolved
favorably to the Company. During 1997, the New York State Supreme Court
dismissed a shareholder derivative lawsuit brought against the Company, Mutual,
MNH and certain directors of the Company and Mutual (the "defendants"). The
court held that the complaint failed to state a cause of action against any of
the defendants. The lawsuit was originally filed in 1993 as a purported class
action and was amended in 1995 to a derivative action after the court held that
the plaintiff's claims were derivative in nature. The plaintiff alleged that the
defendants breached their fiduciary obligations to the then minority
shareholders of the Company, and defrauded the minority shareholders by causing
MNH to purchase from the Federal Deposit Insurance Corporation (the "FDIC") a
surplus note issued by Mutual and simultaneously reducing the principal amounts
plus accrued return on such surplus note to $1,350,000, which is the amount MNH
paid to the FDIC for the note, and by approving the public sale of the Company's
common stock in July 1993 at what the plaintiff alleged was an inadequate price.
After the lawsuit was amended to a derivative action, the Company's Board of
Directors appointed a special committee composed of disinterested directors to
review the merits of the case. That committee determined that the Company's
Board had acted reasonably in approving the note restructuring and the public
offering, and decided that the plaintiff's lawsuit should be dismissed. The
court held that the case should be dismissed because the determination of the
special committee to discontinue the lawsuit was valid and appropriate under
Delaware law. The plaintiff appealed the court's decision and also filed a
motion with the court for permission to renew and reargue the defendants' motion
to dismiss. The plaintiff's motion to renew and reargue was argued on July 28,
1997 and was recently denied by the trial court. The plaintiff has not filed a
notice of appeal of that decision.
Item 6. Exhibits and Reports on Form 8-K
--------------------------------
(a) Exhibits
(11) Statement re computation of per share earnings (filed
herewith).
(27) Financial Data Schedule (filed herewith).
(b) Reports on Form 8-K.
In a report filed on Form 8-K dated July 23, 1998,
the Company reported that it had delivered Notice of
Termination of Management Agreement to Mutual.
* * * * * * * *
18
<PAGE> 19
"Safe Harbor" Statement under the Private Securities Litigation Reform Act of
1995:
With the exception of historical information, the matters and statements
discussed, made or incorporated by reference in this Quarterly Report on Form
10-Q constitute forward-looking statements and are discussed, made or
incorporated by reference, as the case may be, pursuant to the safe harbor
provisions of the Private Securities Litigation Reform Act of 1995. Such
forward-looking statements involve certain assumptions, risks and uncertainties
that could cause actual results to differ materially from those included in or
contemplated by the statements. These assumptions, risks and uncertainties
include, but are not limited to, those associated with factors affecting the
property-casualty insurance industry generally, including price competition,
size and frequency of claims, increasing crime rates, escalating damage awards,
natural disasters, fluctuations in interest rates and general business
conditions; the Company's dependence on investment income; the geographic
concentration of the Company's business in the Northeastern United States and in
particular in New York, New Hampshire, New Jersey, Rhode Island, Pennsylvania
and Massachusetts; the adequacy of the Company's loss reserves; government
regulation of the insurance industry; exposure to environmental claims; the
Company's ability to deal successfully with issues raised by the Year 2000;
dependence of the Company on its relationship with Mutual; the future of the
Company's relationship with Mutual as a result of the notice to terminate the
Management Agreement; and the other risks and uncertainties discussed or
indicated in all documents filed by the Company with the Commission. The Company
expressly disclaims any obligation to update any forward-looking statements as a
result of developments occurring after the filing of this report.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
MERCHANTS GROUP, INC.
(Registrant)
Date: November 13, 1998 By: /s/ Kenneth J. Wilson
---------------------------------
Kenneth J. Wilson
Chief Financial Officer and
Treasurer (duly authorized
officer of the registrant and
chief accounting officer)
<PAGE> 1
EXHIBIT 11
MERCHANTS GROUP, INC.
Computation of Income Per Share
(in thousands except per share data)
<TABLE>
<CAPTION>
Three Months Nine Months
Ended September 30, Ended September 30,
1997 1998 1997 1998
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Net income for computing earnings per
common share - without dilution and
fully diluted $ 1,289 $ 1,483 $ 2,829 $ 4,349
========== ========== ========== ==========
Weighted average number of common shares
outstanding - without dilution 2,959 2,900 2,995 2,905
Addition from assumed exercise as of the
beginning of the period of common stock
options outstanding as of the end of the
period, reduced by the number of shares
assumed to have been repurchased by the
company with the proceeds from exercise,
at the average market value per share
during the period 7 11 7 14
---------- ---------- ---------- ----------
Weighted average number of common shares
and common share equivalents outstanding,
basic and diluted 2,966 2,911 3,002 2,919
========== ========== ========== ==========
Earnings per share:
Basic $ .44 $ .51 $ .94 $ 1.50
========== ========== ========== ==========
Diluted $ .43 $ .51 $ .94 $ 1.49
========== ========== ========== ==========
</TABLE>
20
<TABLE> <S> <C>
<ARTICLE> 7
<CURRENCY> U.S. DOLLARS
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<EXCHANGE-RATE> 1
<DEBT-HELD-FOR-SALE> 177,792,000
<DEBT-CARRYING-VALUE> 15,938,000
<DEBT-MARKET-VALUE> 16,620,000
<EQUITIES> 0
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 217,195,000
<CASH> 30
<RECOVER-REINSURE> 11,358,000
<DEFERRED-ACQUISITION> 12,138,000
<TOTAL-ASSETS> 278,101,000
<POLICY-LOSSES> 140,165,000
<UNEARNED-PREMIUMS> 48,636,000
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 0
0
0
<COMMON> 32,000
<OTHER-SE> 71,785,000
<TOTAL-LIABILITY-AND-EQUITY> 206,284,000
71,063,000
<INVESTMENT-INCOME> 9,938,000
<INVESTMENT-GAINS> (2,000)
<OTHER-INCOME> 135,000
<BENEFITS> 49,980,000
<UNDERWRITING-AMORTIZATION> 18,832,000
<UNDERWRITING-OTHER> 6,337,000
<INCOME-PRETAX> 5,985,000
<INCOME-TAX> 1,636,000
<INCOME-CONTINUING> 4,349,000
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 4,349,000
<EPS-PRIMARY> 1.50
<EPS-DILUTED> 1.49
<RESERVE-OPEN> 130,833,000
<PROVISION-CURRENT> 51,475,000
<PROVISION-PRIOR> (1,495,000)
<PAYMENTS-CURRENT> 20,742,000
<PAYMENTS-PRIOR> 30,856,000
<RESERVE-CLOSE> 129,215,000
<CUMULATIVE-DEFICIENCY> 0
</TABLE>
