<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
Form 10-Q
-------------
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 1999
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 May 1, 1999:
2,757,652 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, March 31,
Assets 1998 1999
------ -------- --------
(unaudited)
<S> <C> <C>
Investments:
Fixed maturities:
Held to maturity at amortized cost (fair value
$17,756 in 1998 and $16,775 in 1999) $ 17,000 $16,224
Available for sale at fair value (amortized cost
$178,641 in 1998 and $174,906 in 1999) 180,784 176,297
Preferred stock at fair value 10,373 10,409
Other long-term investments at fair value 735 615
Short-term investments 6,280 8,675
-------- --------
Total investments 215,172 212,220
Cash 16 17
Interest due and accrued 1,923 1,850
Premiums receivable, net of allowance for doubtful
accounts of $454 in 1998 and $427 in 1999 20,629 19,662
Deferred policy acquisition costs 12,390 11,983
Ceded reinsurance balances receivable 9,741 10,064
Prepaid reinsurance premiums 2,629 2,713
Deferred federal income taxes 5,055 4,978
Other assets 6,968 6,289
-------- --------
Total assets $274,523 $269,776
======== ========
</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, March 31,
1998 1999
--------- ---------
(unaudited)
Liabilities and Stockholders' Equity
------------------------------------
<S> <C> <C>
Liabilities:
Reserve for losses and loss adjustment expenses $ 136,685 $ 134,897
Unearned premiums 49,382 47,930
Payable to affiliate 1,321 258
Other liabilities 15,352 14,472
--------- ---------
Total liabilities 202,740 197,557
--------- ---------
Stockholders' equity:
Common stock, 10,000,000 shares authorized, 2,851,452
shares issued and outstanding at December 31, 1998
and 2,822,702 shares issued at March 31, 1999 32 32
Additional paid in capital 35,511 35,577
Treasury stock, 378,400 shares at December 31, 1998
and 412,900 shares at March 31, 1999 (7,097) (7,848)
Accumulated other comprehensive income 1,173 1,111
Accumulated earnings 42,164 43,347
--------- ---------
Total stockholders' equity 71,783 72,219
--------- ---------
Commitments and contingent liabilities - -
Total liabilities and stockholders' equity $ 274,523 $ 269,776
========= =========
</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
Ended March 31,
1998 1999
------- -------
<S> <C> <C>
Revenues:
Net premiums earned $23,740 $23,662
Net investment income 3,290 3,271
Net realized investment gains - 1
Other revenues 42 142
------- -------
Total revenues 27,072 27,076
------- -------
Expenses:
Net losses and loss adjustment expenses 16,847 16,327
Amortization of deferred policy acquisition costs 6,291 6,270
Other underwriting expenses 2,088 2,154
------- -------
Total expenses 25,226 24,751
------- -------
Income before income taxes 1,846 2,325
Income tax provision 500 676
------- -------
Net income $ 1,346 $ 1,649
======= =======
Basic and diluted earnings per share $ .46 $ .58
======= =======
Weighted average shares outstanding:
Basic 2,907 2,846
Diluted 2,916 2,854
</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
Ended March 31,
1998 1999
------- -------
<S> <C> <C>
Net income $ 1,346 $ 1,649
------- -------
Other comprehensive income before tax:
Unrealized gains (losses)
on securities 359 (78)
Reclassification adjustment
for gains and losses included
in net income - (16)
------- -------
Other comprehensive income (loss)
before tax 359 (94)
Income tax provision (benefit) related to
items of other comprehensive income 122 (32)
------- -------
Other comprehensive income, net of tax 237 (62)
------- -------
Comprehensive income $ 1,583 $ 1,587
======= =======
</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>
Three Months
Ended March 31,
1998 1999
-------- --------
<S> <C> <C>
Common stock, beginning and end $ 32 $ 32
-------- --------
Additional paid in capital:
Beginning of period 35,455 35,511
Exercise of common stock options 48 66
-------- --------
End of period 35,503 35,577
-------- --------
Treasury stock:
Beginning of period (5,906) (7,097)
Purchase of treasury shares (18) (751)
-------- --------
End of period (5,924) (7,848)
-------- --------
Accumulated other comprehensive income:
Beginning of period 1,061 1,173
Other comprehensive income (loss) 237 (62)
-------- --------
End of period 1,298 1,111
-------- --------
Accumulated earnings:
Beginning of period 36,820 42,164
Net income 1,346 1,649
Dividends (145) (466)
-------- --------
End of period 38,021 43,347
-------- --------
Total stockholders' equity $ 68,930 $ 72,219
======== ========
</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>
Three Months
Ended March 31,
1998 1999
-------- --------
<S> <C> <C>
Cash flows from operations:
Collection of premiums $ 22,585 $ 22,050
Payment of losses and loss adjustment expenses (16,936) (17,361)
Payment of other underwriting expenses (9,262) (9,513)
Investment income received 3,511 3,374
Investment expenses paid (79) (91)
Income taxes paid (336) (2)
Other cash receipts 42 142
-------- --------
Net cash used in operations (475) (1,401)
-------- --------
Cash flows from investing activities:
Proceeds from fixed maturities sold or matured 19,988 32,276
Purchase of fixed maturities (15,642) (27,082)
Net (increase) decrease in other long-term investments (15)120
Net increase in short-term investments (15,806) (2,395)
Sale (purchase) of equipment, net (7) 697
-------- --------
Net provided by (used in) investing activities (11,482) 3,616
-------- --------
Cash flows from financing activities:
Settlement of affiliate balances 1,882 (1,063)
Proceeds from exercise of common stock options 48 66
Cash borrowed to purchase securities 10,182 -
Purchase of treasury stock (18) (751)
Dividends (145) (466)
-------- --------
Net cash provided by (used in) financing activities 11,949 (2,214)
-------- --------
Increase (decrease) in cash (8) 1
Cash:
Beginning of period 10 16
-------- --------
End of period $ 2 $ 17
======== ========
</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>
Three Months
Ended March 31,
1998 1999
------- -------
<S> <C> <C>
Net income $ 1,346 $ 1,649
Adjustments:
Depreciation and amortization (36) (11)
Realized investment gains - (1)
(Increase) decrease in assets:
Interest due and accrued 232 73
Premiums receivable 663 967
Deferred policy acquisition costs 488 407
Ceded reinsurance balances receivable 451 (323)
Prepaid reinsurance premiums 97 (84)
Federal income tax receivable - 47
Deferred federal income taxes (20) 109
Other assets (122) (114)
Increase (decrease) in liabilities:
Reserve for losses and loss adjustment expenses (560) (1,788)
Unearned premiums (1,936) (1,452)
Other liabilities (1,078) (880)
------- -------
Net cash used in operations $ (475) $(1,401)
======= =======
</TABLE>
See Notes to the Consolidated Financial Statements
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MERCHANTS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Principles of Consolidation and Basis of Presentation
-----------------------------------------------------
The consolidated balance sheet as of March 31, 1999 and the related consolidated
statements of operations, of comprehensive income, of changes in stockholders'
equity and of cash flows for the three months ended March 31, 1998 and 1999 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, 1998.
The consolidated financial statements have been prepared in conformity with
generally accepted accounting principles (GAAP) which differ in some respects
from those followed in reports to insurance regulatory authorities. All
significant intercompany balances and transactions have been eliminated.
2. Related Party Transactions
--------------------------
The Company and MNH have no paid employees. Under a management agreement dated
September 26, 1986 (the Management Agreement), Merchants Mutual Insurance
Company (Mutual), which owns 9.0% of the Company's common stock at March 31,
1999, provides the Company and MNH with the facilities, management and personnel
required to manage their day-to-day business. All underwriting, administrative,
claims and investment expenses incurred on behalf of Mutual and MNH are shared
on an allocated cost basis, determined as follows: for underwriting and
administrative expenses, the respective share of total direct premiums written
for Mutual and MNH serves as the basis of allocation; for claims expenses, the
average number of outstanding claims is used; investment expenses are shared
based on each company's share of total invested assets.
3. Earnings Per Share
------------------
Basic and diluted earnings per share were computed by dividing net income by the
weighted average number of shares of common stock outstanding during each
period, increased by the assumed exercise of 65,750 and 25,915 shares of common
stock options in 1999 and 1998, respectively, which would have resulted in 8,128
and 8,757 additional shares outstanding, 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 quarter.
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Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Results of Operations for the Three Months Ended March 31, 1999 As Compared to
- ------------------------------------------------------------------------------
the Three Months Ended March 31, 1998
- -------------------------------------
Total revenues for the three months ended March 31, 1999 were $27,076,000,
virtually unchanged from $27,072,000 for the three months ended March 31, 1998.
Direct premiums written for the three months ended March 31, 1999 were
$23,281,000, a decrease of $319,000 or 1%, from $23,600,000 for the three months
ended March 31, 1998. Voluntary direct premiums written for the three months
ended March 31, 1999 were $22,824,000, an increase of $855,000 or 4%, from
$21,969,000 for the three months ended March 31, 1998. Net premiums written for
the three months ended March 31, 1999 were $22,127,000, an increase of $226,000
or 1% from $21,901,000 for the three months ended March 31, 1998.
Net premiums earned for the three months ended March 31, 1999 were $23,662,000,
substantially unchanged from $23,740,000 for the three months ended March 31,
1998.
Voluntary personal lines direct premiums written for the three months ended
March 31, 1999 were $9,085,000, a decrease of $232,000 or 2% from $9,317,000 for
the three months ended March 31, 1998. Private passenger automobile (PPA) direct
premiums written, which represented 80% and 81% of total voluntary personal
lines direct premiums written for the three months ended March 31, 1999 and
1998, respectively, decreased 4% from the year earlier period. Homeowners direct
premiums written for the three months ended March 31, 1999 increased 2% compared
to the three months ended March 31, 1998.
The decrease in PPA direct premiums written was primarily the result of a 7%
decrease in policies in force at March 31, 1999, compared to policies in force
at March 31, 1998. Average premium per PPA policy at March 31, 1999 was
relatively unchanged compared to March 31, 1998. Average premium per homeowners
policy at March 31, 1999 increased 5% compared to the year earlier period. This
increase in homeowners average premium per policy was partially offset by a 3%
decrease in homeowners policies in force at March 31, 1999, compared to March
31, 1998.
Voluntary commercial lines direct premiums written for the three months ended
March 31, 1999 were $13,739,000, an increase of $1,087,000 or 9% from
$12,652,000 for the three months ended March 31, 1998, primarily due to
increases in commercial automobile (19%), contractors coverall (14%), and
commercial package premiums written (10%).
The increase in commercial auto direct written premiums was primarily due to a
6.1 percentage point improvement in the commercial auto policy retention rate
during the first three months of 1999 as compared to the year earlier period.
The increase in contractors coverall direct written premiums resulted primarily
from a 17 percentage point increase in new business units during the three
months ended March 31, 1999 as compared to the three months ended March 31,
1998. The increase in commercial package policy direct premiums written was
primarily due to an 8% increase in policies in force at March 31, 1999 compared
to policies in force at March 31, 1998.
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Involuntary direct premiums written, primarily PPA insurance, which comprised 2%
and 7% of all direct premiums written during the three months ended March 31,
1999 and 1998, respectively, decreased by $1,174,000 or 72% to $457,000 in the
three months ended March 31, 1999 from $1,631,000 for the three months ended
March 31, 1998 because the New York Automobile Insurance Plan (NYAIP) continues
to adjust assignments as a result of having over-assigned policies to the
Company in 1997 and due to an overall decrease in the NYAIP pool of business.
Net investment income was $3,271,000 for the three months ended March 31, 1999,
a decrease of less than 1% from $3,290,000 for the three months ended March 31,
1998. The average pre-tax yield associated with the investment portfolio
decreased 17 basis points to 6.32%. Average invested assets for the three months
ended March 31, 1999 increased 1% compared to the year earlier period.
Losses and loss adjustment expenses (LAE) were $16,327,000 for the three months
ended March 31, 1999, a decrease of $520,000 or 3% from $16,847,000 for the
three months ended March 31, 1998. The loss and LAE ratio decreased to 69.0% for
the three months ended March 31, 1999 from 71.0% for the three months ended
March 31, 1998. This decrease resulted from lower losses associated with private
passenger and commercial automobile business in 1999 compared to 1998, partially
offset by higher losses related to homeowners and businessowners premiums, due
to the severe winter weather that occurred in Western New York in early January
1999.
The ratio of deferred amortized policy acquisition costs and other underwriting
expenses to net premiums earned increased to 35.6% for the three months ended
March 31, 1999 from 35.3% for the three months ended March 31, 1998.
Commissions, premium taxes and other state assessments that vary directly with
the Company's premium volume represented 22.0% of net premiums earned in the
three months ended March 31, 1999 compared to 22.2% of net premiums earned in
the three months ended March 31, 1998.
The Company's effective federal income tax rate for the three months ended March
31, 1999 was 29.1%. This rate was calculated based upon the Company's estimate
of its effective federal income tax rate for all of 1999. Non-taxable investment
income, primarily tax-exempt bond income, reduced the Company's effective tax
rate by approximately 5 percentage points.
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 income
from investments, has provided the Company with short-term funds in excess of
normal operating demands for cash.
Net cash used in operations increased $926,000 from $475,000 in the three months
ended March 31, 1998 to $1,401,000 in the three months ended March 31, 1999.
This increase was primarily due to a $535,000 decrease in the collection of
premiums and a $425,000 increase in paid losses and LAE.
Net cash provided by investing activities increased $15,098,000, from a
$11,482,000 use of cash in the three months ended March 31, 1998 to a $3,616,000
source of cash in the three months ended March 31, 1999.
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This increase in net cash provided by investing activities resulted primarily
from a $13,411,000 decrease in net cash used to purchase short-term investments.
Net cash used in financing activities increased $14,163,000 from a $11,949,000
source of cash in the three months ended March 31, 1998 to a $2,214,000 use of
cash in the three months ended March 31, 1999. This increase resulted primarily
from a $10,182,000 decrease in cash borrowed to purchase securities, and a
$733,000 increase in cash used to purchase treasury stock, somewhat offset by a
$2,945,000 decrease in cash provided by the settlement of amounts owed to
Mutual.
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 relative to the duration of its
liabilities are closely managed, increases or decreases in market interest rates
are not expected to have a material effect on the Company's liquidity, or its
results of operations.
The Company generally designates newly acquired fixed maturity investments as
available for sale and carries these investments at fair value. Unrealized gains
and losses related to these investments are recorded as a component of
accumulated other comprehensive income within stockholders' equity. During the
three months ended March 31, 1999 the Company recorded $62,000 of unrealized
losses, net of tax, associated with its fixed maturity investments. At March 31,
1999, the Company recorded $1,111,000 of unrealized gains, net of tax, as
accumulated other comprehensive income related to its investment portfolio.
At March 31, 1999, the Company's portfolio of fixed maturities represented 90.7%
of invested assets. Management believes that this level of bond holdings is
consistent with the Company's liquidity needs because it anticipates that cash
receipts from net premiums written 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 March 31, 1999, $115,473,000 or 60.0% 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 March 31, 1999, $5,663,000, or 2.7%, of the Company's investment portfolio
was invested in non-investment grade securities.
During the three months ended March 31, 1999, the Company repurchased 34,500
shares of its common stock. The Company is holding 412,900 shares of its common
stock in treasury at March 31, 1999.
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As a holding company, the Company is dependent on cash dividends from MNH to
meet its obligations, pay any cash dividends and repurchase its shares. MNH is
subject to New Hampshire insurance laws which place certain restrictions on its
ability to pay dividends without the prior approval of state regulatory
authorities. These restrictions limit dividends to those that, when added to all
other dividends paid within the preceding twelve months, would not exceed 10% of
the insurer's statutory policyholders' surplus as of the preceding December 31.
The maximum amount of dividends that MNH could pay during any twelve month
period ending in 1999 without the prior approval of the New Hampshire Insurance
Commissioner is $5,058,000. MNH paid $2,000,000 in dividends to the Company
during the three months ended March 31, 1999.
Under a management agreement (Management Agreement) Mutual provides employees,
services and facilities for MNH to conduct its insurance business on a cost
reimbursed basis. The balance in the payable to or receivable from affiliate
account represents the amount owing to or owed by Mutual, to the Company for the
difference between premiums collected and payments made for losses, employees,
services and facilities by Mutual on behalf of MNH.
Industry and regulatory guidelines suggest that the ratio of a property-casualty
insurer's annual net premiums written to its statutory surplus should not exceed
3 to 1. MNH has consistently followed a business strategy that would allow it to
meet this 3 to 1 regulatory guideline. For the first three months of 1999 MNH's
ratio of net premiums written to statutory surplus, annualized for a full year,
was 1.7 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 Mutual 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
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 and testing 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 policy and claims
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
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believes the MOST system, its mainframe, mid-range and personal computers, and
its 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 taken and will continue
to take appropriate actions. 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 approximates $300,000. 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 $150,000 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 1999 to be $10,000, 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.
Because it is based on the successful implementation of the MOST system, Mutual
has notified the Company that it believes that critical systems are
substantially Year 2000 compliant and that to the best of Mutual's knowledge,
the likelihood that critical systems will have a failure that materially affects
operating results is remote. Mutual also informed the Company that testing will
continue as 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.
MNH continues to evaluate the complex issues related to insurance coverage for
losses arising from the various possible situations involving Year 2000 problems
and its potential liability to its insureds. The Company believes that the
coverages 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 certain classes of commercial risks, and has adopted
endorsements to its policies based on forms provided and filed for approval with
various regulatory authorities by the Insurance Services Office, Inc. Use of
these special endorsements is governed by the law and regulatory policies of
states in which MNH is authorized to do business.
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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 MNH's results of operations
and financial condition. It is also possible that MNH may incur expenses
defending claims for which it is ultimately determined there is no insurance
coverage. MNH has made no provision for reserves for losses or LAE on claims
based on potential Year 2000 problems.
Relationship with Mutual
- ------------------------
The Company's and MNH's business and day-to-day operations are closely
aligned with those of Mutual. This is the result of a combination of factors.
Mutual has had a historical ownership interest in the Company and MNH. Prior to
November 1986 MNH was a wholly-owned subsidiary of Mutual. Following the
Company's initial public offering in November 1986 and until a secondary stock
offering in July 1993 the Company was a majority-owned subsidiary of Mutual.
Mutual currently owns 9.0% of the Company's common stock. Under the Management
Agreement, Mutual provides the Company and MNH with all facilities and personnel
to operate their business. The only officers of the Company or MNH who are paid
full time employees are employees of Mutual whose services are purchased under
the Management Agreement. Also, the operation of the Company's insurance
business, which offers substantially the same lines of insurance as Mutual
through the same independent insurance agents, creates a very close relationship
among the companies.
During 1998, Mutual initiated discussions with the Company concerning
proposals for the acquisition of the Company by Mutual. The Company's Directors
who are not affiliated with Mutual (the Independent Directors) determined that
the terms proposed by Mutual were inadequate. The Independent Directors also
determined that the Management Agreement prevents the Company's shareholders
from realizing the Company's fair value in a sale or merger, and on July 23,
1998 the Company gave notice to Mutual of its intention to terminate the
Management Agreement.
The provisions of the Management Agreement require five year's prior
written notice for its termination. The Company does not expect the notice of
termination to have any material, short-term effect on the Company's operations.
However, the Independent Directors believe that the Management Agreement, as
currently written, creates conflicts of interest between the Company and Mutual
in their joint operations and prevents the Company's shareholders from realizing
the fair value of their shares.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Market Risk
- -----------
Market risk represents the potential for loss due to changes in the fair value
of financial instruments. The market risk related to the Company's financial
instruments primarily relates to its investment portfolio. The value of the
Company's investment portfolio of $212,220,000 at March 31, 1998 is subject to
changes in interest rates and to a lesser extent on credit quality. Further,
certain mortgage-backed and asset-backed securities are exposed to accelerated
prepayment risk generally
15
<PAGE> 16
caused by interest rate movements. If interest rates were to decline, mortgage
holders would be more likely to refinance existing mortgages at lower rates.
Acceleration of future repayments could adversely affect future investment
income, if reinvestment of the accelerated receipts was made in lower yielding
securities.
The table below provides information related to the Company's fixed maturity
investments at March 31, 1999. The table presents cash flows of principal
amounts and related weighted average interest rates by expected maturity dates.
The cash flows are based upon the maturity date or, in the case of
mortgage-backed and asset-backed securities, expected payment patterns. Actual
cash flows could differ from those shown in the table.
Fixed Maturities
- ----------------
Expected Cash Flows of Principal Amounts ($ in 000's):
<TABLE>
<CAPTION>
TOTAL
--------------
Esti-
Amor- mated
There- tized Market
1999 2000 2001 2002 2003 after Cost Value
-------- -------- -------- -------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Held to Maturity
- ----------------
U.S. Treasury securities and
obligations of U.S.
Government corporations
and agencies $ 0 $ 1,647 $ 0 $ 0 $ 0 $ 0 $ 1,647 $ 1,623
Average interest rate 0.0% 5.4% 0.0% 0.0% 0.0% 0.0% --- ---
Mortgage & asset backed
securities 180 163 1,226 2,186 1,710 9,112 14,577 15,152
Average interest rate 8.0% 8.0% 7.7% 7.7% 7.5% 7.3% --- ---
-------- -------- -------- -------- -------- -------- -------- --------
Total $ 180 $ 1,810 $ 1,226 $ 2,186 $ 1,710 $ 9,112 $ 16,224 $ 16,775
======== ======== ======== ======== ======== ======== ======== ========
Available for Sale
- ------------------
U.S. Treasury securities and
obligations of U.S.
Government corporations
and agencies $ 0 $ 419 $ 0 $ 350 $ 0 $ 0 $ 769 $ 767
Average interest rate 0.0% 5.3% 0.0% 6.3% 0.0% 0.0% --- ---
Obligations of states and
political subdivisions 0 11,858 10,725 1,708 0 1,326 25,617 26,127
Average interest rate 0.0% 4.8% 4.9% 5.6% 0.0% 5.4% --- ---
Corporate securities 3,811 10,600 16,700 10,233 5,874 817 48,035 48,508
Average interest rate 5.8% 5.5% 5.6% 7.1% 7.6% 8.6% --- ---
Mortgage & asset
backed securities 20,578 24,093 26,136 16,774 3,453 9,451 100,485 100,895
Average interest rate 6.8% 6.9% 6.9% 7.0% 7.1% 7.2% --- ---
-------- -------- -------- -------- -------- -------- -------- --------
Total $ 24,389 $ 46,970 $ 53,561 $ 29,065 $ 9,327 $ 11,594 $174,906 $176,297
======== ======== ======== ======== ======== ======== ======== ========
</TABLE>
16
<PAGE> 17
PART II. OTHER INFORMATION
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.
No reports on Form 8-K were filed during the period
for which this report is filed.
* * * * * * * *
"Safe Harbor" Statement under the Private Securities Litigation Reform Act of
1995:
With the exception of historical information, the matters and
statements discussed, made or incorporated by reference in this Quarterly Report
on Form 10-Q constitute forward-looking statements and are discussed, made or
incorporated by reference, as the case may be, pursuant to the safe harbor
provisions of the Private Securities Litigation Reform Act of 1995. Such
forward-looking statements involve certain assumptions, risks and uncertainties
that could cause actual results to differ materially from those included in or
contemplated by the statements. These assumptions, risks and uncertainties
include, but are not limited to, those associated with factors affecting the
property-casualty insurance industry generally, including price competition,
size and frequency of claims, increasing crime rates, escalating damage awards,
natural disasters, fluctuations in interest rates and general business
conditions; the Company's dependence on investment income; the geographic
concentration of the Company's business in the Northeastern United States and in
particular in New York, New Hampshire, New Jersey, Rhode Island, Pennsylvania
and Massachusetts; the adequacy of the Company's loss reserves; government
regulation of the insurance industry; exposure to environmental claims;
dependence of the Company on its relationship with Mutual; and the other risks
and uncertainties discussed or indicated in all documents filed by the Company
with the Commission. The Company expressly disclaims any obligation to update
any forward-looking statements as a result of developments occurring after the
date of this report.
17
<PAGE> 18
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: May 13, 1999 By: /s/ Kenneth J. Wilson
----------------------
Kenneth J. Wilson
Chief Financial Officer and
Treasurer (duly authorized
officer of the registrant and
chief accounting officer)
18
<PAGE> 1
EXHIBIT 11
MERCHANTS GROUP, INC.
Computation of Income Per Share
(in thousands except per share data)
<TABLE>
<CAPTION>
Three Months
Ended March 31,
1998 1999
--------------------
<S> <C> <C>
Net income (loss) for computing earnings per common
share - without dilution and fully diluted $1,346 $1,649
====== ======
Weighted average number of common shares
outstanding - without dilution 2,907 2,846
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 9 8
------ ------
Weighted average number of common shares and
common share equivalents outstanding, diluted 2,916 2,854
====== ======
Basic and diluted earnings per share $ .46 $ .58
====== ======
</TABLE>
19
<TABLE> <S> <C>
<ARTICLE> 7
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> MAR-31-1999
<DEBT-HELD-FOR-SALE> 176,297,000
<DEBT-CARRYING-VALUE> 16,224,000
<DEBT-MARKET-VALUE> 16,775,000
<EQUITIES> 0
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 212,220,000
<CASH> 17,000
<RECOVER-REINSURE> 10,064,000
<DEFERRED-ACQUISITION> 11,983,000
<TOTAL-ASSETS> 269,776,000
<POLICY-LOSSES> 134,897,000
<UNEARNED-PREMIUMS> 47,930,000
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 0
0
0
<COMMON> 32,000
<OTHER-SE> 72,187,000
<TOTAL-LIABILITY-AND-EQUITY> 269,776,000
23,662,000
<INVESTMENT-INCOME> 3,271,000
<INVESTMENT-GAINS> 1,000
<OTHER-INCOME> 142,000
<BENEFITS> 16,327,000
<UNDERWRITING-AMORTIZATION> 6,270,000
<UNDERWRITING-OTHER> 2,154,000
<INCOME-PRETAX> 2,325,000
<INCOME-TAX> 676,000
<INCOME-CONTINUING> 1,649,000
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,649,000
<EPS-PRIMARY> .58
<EPS-DILUTED> .58
<RESERVE-OPEN> 126,869,000
<PROVISION-CURRENT> 16,327,000
<PROVISION-PRIOR> 0
<PAYMENTS-CURRENT> 8,160,000
<PAYMENTS-PRIOR> 9,201,000
<RESERVE-CLOSE> 125,835,000
<CUMULATIVE-DEFICIENCY> 0
</TABLE>
