<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, 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 October 29, 1999:
2,617,452 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 1998 1999
------ ---------- ------------
(unaudited)
<S> <C> <C>
Investments:
Fixed maturities:
Held to maturity at amortized cost (fair value
$17,756 in 1998 and $15,560 in 1999) $ 17,000 $ 15,267
Available for sale at fair value (amortized cost
$178,641 in 1998 and $175,909 in 1999) 180,784 175,228
Preferred stock at fair value 10,373 13,153
Other long-term investments at fair value 735 659
Short-term investments 6,280 10,015
-------- --------
Total investments 215,172 214,322
Cash 16 7
Interest due and accrued 1,923 1,994
Premiums receivable, net of allowance for doubtful
accounts of $454 in 1998 and $429 in 1999 20,629 19,774
Deferred policy acquisition costs 12,390 12,364
Ceded reinsurance balances receivable 9,741 5,654
Prepaid reinsurance premiums 2,629 3,072
Receivable from affiliate -- 2,477
Deferred federal income taxes 5,055 6,104
Other assets 6,968 6,573
-------- --------
Total assets $274,523 $272,341
======== ========
</TABLE>
See Notes to the Consolidated Financial Statements
2
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MERCHANTS GROUP, INC.
CONSOLIDATED BALANCE SHEET
(in thousands except share amounts)
<TABLE>
<CAPTION>
December 31, September 30,
1998 1999
--------- ---------
(unaudited)
<S> <C> <C>
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Reserve for losses and loss adjustment expenses $ 136,685 $ 132,747
Unearned premiums 49,382 49,728
Payable for securities -- 4,946
Demand loan -- 500
Payable to affiliate 1,321 --
Other liabilities 15,352 14,940
--------- ---------
Total liabilities 202,740 202,861
--------- ---------
Stockholders' equity:
Common stock, 10,000,000 shares authorized,
2,851,452 shares issued and outstanding at
December 31, 1998 and 2,620,952 shares issued
and outstanding at September 30, 1999 32 32
Additional paid in capital 35,511 35,680
Treasury stock, 378,400 shares at December 31, 1998
and 620,900 shares at September 30, 1999 (7,097) (12,580)
Accumulated other comprehensive income (loss) 1,173 (273)
Accumulated earnings 42,164 46,621
--------- ---------
Total stockholders' equity 71,783 69,480
--------- ---------
Commitments and contingent liabilities -- --
Total liabilities and stockholders' equity $ 274,523 $ 272,341
========= =========
</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,
1998 1999 1998 1999
-------- -------- ------- ----------
(unaudited)
<S> <C> <C> <C> <C>
Revenues:
Net premiums earned $ 23,448 $ 24,040 $ 71,063 $ 71,226
Net investment income 3,317 3,280 9,938 9,759
Net realized investment gains (losses) (2) 53 (2) 60
Other revenues 51 95 135 361
-------- -------- -------- --------
Total revenues 26,814 27,468 81,134 81,406
-------- -------- -------- --------
Expenses:
Net losses and loss adjustment
expenses 16,344 16,646 49,980 49,204
Amortization of deferred policy
acquisition costs 6,214 6,371 18,832 18,875
Other underwriting expenses 2,215 2,084 6,337 6,022
-------- -------- -------- --------
Total expenses 24,773 25,101 75,149 74,101
-------- -------- -------- --------
Income before income taxes 2,041 2,367 5,985 7,305
Income tax provision 558 717 1,636 2,156
-------- -------- -------- --------
Net income $ 1,483 $ 1,650 $ 4,349 $ 5,149
======== ======== ======== ========
Earnings per share:
Basic $ .51 $ .61 $ 1.50 $ 1.85
======== ======== ======== ========
Diluted $ .51 $ .61 $ 1.49 $ 1.85
======== ======== ======== ========
Weighted average shares outstanding:
Basic 2,900 2,715 2,905 2,780
Diluted 2,911 2,722 2,919 2,785
</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,
1998 1999 1998 1999
------- ------- ------- -------
(unaudited)
<S> <C> <C> <C> <C>
Net income $ 1,483 $ 1,650 $ 4,349 $ 5,149
------- ------- ------- -------
Other comprehensive income before taxes:
Unrealized gains (losses)
on securities 849 (980) 1,489 (2,153)
Reclassification adjustment
for gains and losses included
in net income (13) (53) (13) (38)
------- ------- ------- -------
Other comprehensive income (loss)
before taxes 836 (1,033) 1,476 (2,191)
Income tax provision (benefit) related to
items of other comprehensive income 284 (351) 502 (745)
------- ------- ------- -------
Other comprehensive income (loss) 552 (682) 974 (1,446)
------- ------- ------- -------
Comprehensive income $ 2,035 $ 968 $ 5,323 $ 3,703
======= ======= ======= =======
</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,
1998 1999
-------- --------
(unaudited)
<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 56 169
-------- --------
End of period 35,511 35,680
-------- --------
Treasury stock:
Beginning of period (5,906) (7,097)
Purchase of treasury shares (589) (5,483)
-------- --------
End of period (6,495) (12,580)
------ -------
Accumulated other comprehensive income (loss):
Beginning of period 1,061 1,173
Other comprehensive income (loss) 974 (1,446)
-------- --------
End of period 2,035 (273)
-------- --------
Accumulated earnings:
Beginning of period 36,820 42,164
Net income 4,349 5,149
Cash dividends (435) (692)
-------- --------
End of period 40,734 46,621
-------- --------
Total stockholders' equity $ 71,817 $ 69,480
======== ========
</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,
1998 1999
-------- --------
(unaudited)
<S> <C> <C>
Cash flows from operations:
Collection of premiums $ 70,822 $ 72,143
Payment of losses and loss adjustment expenses (51,599) (49,525)
Payment of other underwriting expenses (21,789) (25,549)
Investment income received 10,044 9,813
Investment expenses paid (237) (265)
Income taxes paid (1,337) (2,183)
Other cash receipts 135 362
-------- --------
Net cash provided by operations 6,039 4,796
-------- --------
Cash flows from investing activities:
Proceeds from fixed maturities sold or matured 74,034 75,074
Purchase of fixed maturities (71,584) (69,767)
Net increase in preferred stock -- (2,790)
Net (increase) decrease in other long-term investments (53) 75
Net increase in short-term investments (7,600) (3,735)
Disposition of equipment -- 696
-------- --------
Net cash provided by (used in) investing activities (5,203) (447)
-------- --------
Cash flows from financing activities:
Settlement of affiliate balances 152 (3,798)
Cash borrowed to purchase securities -- 4,946
Increase in demand loan -- 500
Proceeds from exercise of common stock options 56 169
Purchase of treasury stock (589) (5,483)
Cash dividends (435) (692)
-------- --------
Net cash provided by (used in) financing activities (816) (4,358)
-------- --------
Increase (decrease) in cash and cash equivalents 20 (9)
Cash:
Beginning of period 10 16
-------- --------
End of period $ 30 $ 7
======== ========
</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,
1998 1999
------- -------
(unaudited)
<S> <C> <C>
Net income $ 4,349 $ 5,149
Adjustments:
Depreciation and amortization (accretion) (109) (90)
Realized investment gains (losses) 2 (60)
(Increase) decrease in assets:
Interest due and accrued 143 (71)
Premiums receivable 1,065 855
Deferred policy acquisition costs 459 26
Ceded reinsurance balances receivable (226) 4,087
Prepaid reinsurance premiums 37 (443)
Deferred federal income taxes 840
Other assets (293) (351)
Increase (decrease) in liabilities:
Reserve for losses and loss adjustment expenses (1,040) (3,938)
Unearned premiums (1,770) 346
Other liabilities 2,582 (412)
------- -------
Net cash provided by operations $ 6,039 $ 4,796
======= =======
</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 September 30, 1999, the related
consolidated statements of operations and of comprehensive income for the three
months and nine months ended September 30, 1998 and 1999 and of changes in
stockholders' equity and of cash flows for the nine months ended September 30,
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 29, 1986 (the Management Agreement), Merchants Mutual Insurance
Company (Mutual), which owns 9.7% of the Company's common stock at September 30,
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
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.
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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 49,000 and 75,500 shares of common
stock options for the three and nine month periods in 1999 and 1998,
respectively, which would have resulted in 6,868 and 11,254 additional shares
outstanding for the three month periods, respectively, and 4,913 and 13,366
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 period.
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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, 1999 AS COMPARED
TO THE NINE MONTHS ENDED SEPTEMBER 30, 1998
Total revenues for the nine months ended September 30, 1999 were $81,406,000,
substantially unchanged from $81,134,000 for the nine months ended September 30,
1998.
Direct premiums written for the nine months ended September 30, 1999 were
$75,097,000, an increase of $1,375,000 or 2%, from $73,722,000 for the nine
months ended September 30, 1998. Voluntary direct premiums written for the nine
months ended September 30, 1999 were $73,455,000, an increase of $4,068,000 or
6%, from $69,387,000 for the nine months ended September 30, 1998. Involuntary
direct premiums written for the nine months ended September 30, 1999 were
$1,642,000, a decrease of $2,693,000 or 62%, from $4,335,000 for the nine months
ended September 30, 1998. Net premiums written for the nine months ended
September 30, 1999 were $71,129,000, an increase of $1,799,000 or 3%, from
$69,330,000 for the nine months ended September 30, 1998.
Voluntary personal lines direct premiums written for the nine months ended
September 30, 1999 were $28,948,000, a decrease of $634,000 or 2%, from
$29,582,000 for the nine months ended September 30, 1998. Private passenger
automobile (PPA) direct premiums written, which represented 77% and 78% of total
voluntary personal lines direct premiums written for the nine months ended
September 30, 1999 and 1998, respectively, decreased 4% from the year earlier
period. Homeowners direct premiums written for the nine months ended September
30 ,1999 increased 6% compared to the nine months ended September 30, 1998.
The decrease in PPA direct premiums written was primarily the result of a 6%
decrease in policies in force at September 30, 1999 compared to policies in
force at September 30, 1998. The decrease in PPA direct written premiums related
primarily to the Company's Long Island, New York and New Hampshire markets and
resulted from the Company's decision not to price its PPA products competitively
in these intensely competitive markets. Average premium per PPA policy at
September 30, 1999 was relatively unchanged compared to September 30, 1998. The
increase in homeowners direct premiums written resulted primarily from a 3%
increase in policies in force at September 30, 1999 compared to policies in
force at September 30, 1998. Average premium per homeowners policy was unchanged
compared to September 30, 1998.
Voluntary commercial lines direct premiums written for the nine months ended
September 30, 1999 were $44,507,000, an increase of $4,702,000 or 12%, from
$39,805,000 for the nine months ended September 30, 1998, primarily due to
increases in commercial automobile (23%) and contractors coverall (20%) premiums
written.
The increase in commercial auto direct premiums written was primarily due to a
19% increase in policies in force at September 30, 1999 compared to policies in
force at September 30, 1998. The increase in commercial auto policies in force
resulted primarily from a 25% improvement in the retention rate for this line of
business as compared to the year earlier period. The increase in
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contractors coverall direct written premiums resulted primarily from a 17%
increase in policies in force at September 30, 1999 compared to September 30,
1998. The increase in contractors coverall policies in force resulted primarily
from a 69% increase in new business units (policies written for the first time)
compared to the year earlier period.
Involuntary direct premiums written, primarily PPA insurance, which comprised 2%
and 6% of all direct premiums written during the nine months ended September 30,
1999 and 1998, respectively, decreased 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 premiums earned for the nine months ended September 30, 1999 were
$71,226,000, substantially unchanged from $71,063,000 for the nine months ended
September 30, 1998. A 4% increase in voluntary net earned premiums was offset by
a 41% decrease in involuntary net earned premiums. The decrease in involuntary
earned premiums resulted from the decrease in involuntary direct premiums
written.
Net investment income was $9,759,000 for the nine months ended September 30,
1999, a decrease of 2% from $9,938,000 for the nine months ended September 30,
1998. The average pre-tax yield associated with the investment portfolio
decreased 8 basis points to 6.36%. Average invested assets for the nine months
ended September 30, 1999 were substantially unchanged compared to the year
earlier period.
Losses and loss adjustment expenses (LAE) were $49,204,000 for the nine months
ended September 30, 1999, a decrease of $776,000 or 2%, from $49,980,000 for the
nine months ended September 30, 1998. The loss and LAE ratio decreased to 69.1%
for the nine months ended September 30, 1999 from 70.3% for the nine months
ended September 30, 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 amortized deferred policy acquisition costs and other underwriting
expenses to net premiums earned decreased to 35.0% for the nine months ended
September 30, 1999 from 35.4% for the nine months ended September 30, 1998.
Commissions, premium taxes and other state assessments that vary with the
Company's premium volume represented 21.3% of net premiums earned in the nine
months ended September 30, 1999 compared to 21.4% for the nine months ended
September 30, 1998.
The Company's effective federal income tax rate for the nine months ended
September 30, 1999 was 29.5%. This rate was calculated based upon the Company's
estimate of its effective income tax rate for all of 1999. Non-taxable
investment income, primarily tax-exempt income, reduced the Company's effective
tax rate by approximately 5 percentage points.
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RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 1999 AS COMPARED
TO THE THREE MONTHS ENDED SEPTEMBER 30, 1998
Total revenues for the three months ended September 30, 1999 were $27,468,000,
an increase of $654,000, or 2%, from $26,814,000 for the three months ended
September 30, 1998. The increase in total revenues earned resulted primarily
from an increase in net earned premiums. Direct premiums written for the three
months ended September 30, 1999 were $25,392,000, an increase of $1,004,000 or
4%, from $24,388,000 for the three months ended September 30, 1998.
Voluntary personal lines direct premiums written for the three months ended
September 30, 1999 were $10,347,000, an increase of $109,000 or 1%, from
$10,238,000 for the three months ended September 30, 1998. Private passenger
automobile direct premiums written decreased 1% from the year earlier period.
Homeowners direct premiums written for the three months ended September 30, 1999
increased 8% compared to the three months ended September 30, 1998.
Voluntary commercial lines direct premiums written for the three months ended
September 30, 1999 were $14,444,000, an increase of $1,637,000, or 13%, from
$12,807,000 for the three months ended September 30, 1998, primarily due to
increases in commercial automobile (25%) and contractors coverall (22%) premiums
written.
Involuntary direct premiums written for the three months ended September 30,
1999 were $600,000, a decrease of $743,000, or 55%, from $1,343,000 for the
three months ended September 30, 1998. Involuntary written premiums were
affected by the adjustments in policy assignments made to the Company by the
NYAIP and an overall decrease in the NYAIP pool of business.
Net investment income was $3,280,000 for the three months ended September 30,
1999, a $37,000, or 1%, decrease from $3,317,000 for the three months ended
September 30, 1998, primarily due to a 1% decrease in average invested assets.
Losses and LAE were $16,646,000 for the three months ended September 30, 1999, a
decrease of $302,000, or 2%, from $16,344,000 for the three months ended
September 30, 1998. The loss and LAE ratio decreased to 69.2% for the three
months ended September 30, 1999 from 69.7% for the three months ended September
30, 1998.
The ratio of amortized deferred policy acquisition costs and other underwriting
expenses to net premiums earned decreased to 35.2% for the three months ended
September 30, 1999 from 35.9% for the three months ended September 30, 1998.
Commissions, premium taxes and other state assessments that vary with the
Company's premium volume represented 21.7% of net premiums earned in the three
months ended September 30, 1999 compared to 20.9% for the three months ended
September 30, 1998.
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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.
The Company's objectives with respect to its investment portfolio include
maximizing total return while protecting policyholders' surplus and maintaining
flexibility. Like other property and casualty insurers, the Company relies on
premiums as a major source of cash, and therefore liquidity. Cash flows from the
Company's investment portfolio, either in the form of interest or principal
payments, are an additional source of liquidity. Because the duration of the
Company's investment portfolio 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, 1999 the Company recorded $1,446,000 of
unrealized losses, net of tax, associated with its fixed maturity investments.
At September 30, 1999, the Company recorded $273,000 of unrealized losses, net
of tax, as accumulated other comprehensive income related to its investment
portfolio.
At September 30, 1999, the Company's portfolio of fixed maturities represented
88.9% of invested assets. Management believes that this level of bond holdings
is consistent with the Company's liquidity needs because it anticipates that
cash receipts from net premiums written and investment income will enable the
Company to satisfy its cash obligations. Furthermore, a portion of the Company's
bond portfolio is invested in mortgage-backed and other asset-backed securities
which, in addition to interest income, provide monthly paydowns of bond
principal.
At September 30, 1999, $112,685,000, or 59.2%, of the Company's fixed maturity
portfolio was invested in mortgage-backed and other asset backed securities. The
Company invests in a variety of collateralized mortgage obligation ("CMO")
products but has not invested in the derivative type of CMO products such as
interest only, principal only or inverse floating rate securities. All of the
Company's CMO investments have an active secondary market and their effect on
the Company's liquidity does not differ from that of other fixed maturity
investments. The Company does not own any other derivative financial
instruments.
At September 30, 1999, $10,889,000 of the Company's investment portfolio was
invested in non- investment grade securities, an increase of $4,183,000 from
$6,706,000 at December 31, 1998. Non investment grade securities represented
5.1% and 3.0% of the Company's investment portfolio at September 30, 1999 and
December 31, 1998, respectively.
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During the nine months ended September 30, 1999, the Company repurchased 242,500
shares of its common stock. The Company is holding 620,900 shares of its common
stock in treasury at September 30, 1999.
In August 1999, the Company arranged for a $2,000,000 credit facility from a
bank in the form of a master grid note. Any borrowings under this facility are
payable on demand and carry an interest rate which can be fixed or variable and
is negotiated at the time of each advance. This facility is available for
general working capital purposes and for repurchases of the Company's common
stock. At September 30, 1999, $500,000 was outstanding related to this loan.
As a holding company, the Company is dependent on cash dividends from MNH to
meet its obligations and to pay any cash dividends. 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 $5,000,000 in dividends to the Company during the nine
months ended September 30, 1999.
Under the Management Agreement, Mutual provides employees, services and
facilities for MNH to conduct its insurance business on a cost reimbursed basis.
The balance in the payable to or receivable from affiliate account represents
the amount owing to or owed by Mutual to the Company for the difference between
premiums collected and payments made for losses, employees, services and
facilities by Mutual on behalf of MNH.
Industry and regulatory guidelines suggest that the ratio of a property-casualty
insurer's annual net premiums written to its statutory surplus should not exceed
3 to 1. MNH has consistently followed a business strategy that would allow it to
meet this 3 to 1 regulatory guideline. For the first nine months of 1999 MNH's
ratio of net premiums written to statutory surplus, annualized for a full year,
was 1.8 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,
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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 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 is $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 such 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.
16
<PAGE> 17
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. Mutual contracts for the use of a disaster recovery site in Toronto,
Canada, where it maintains information system back-up facilities to be used in
the event of power outages or other causes of system failure. These facilities
are tested quarterly to insure compliance with their intended purpose. Further,
if circumstances such as a power outage at one of its five regional offices were
to occur, Mutual has developed a plan to transfer business normally processed at
that location to other locations.
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 uses 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.
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 9.7% 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
17
<PAGE> 18
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.
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 $214,615,000 at September 30, 1999 is subject
to changes in interest rates and to a lesser extent on credit quality. Further,
certain mortgage-backed and asset-backed securities are exposed to accelerated
prepayment risk generally caused by interest rate movements. If interest rates
were to decline, mortgage holders would be more likely to refinance existing
mortgages at lower rates. Acceleration of future repayments could adversely
affect future investment income, if reinvestment of the accelerated receipts was
made in lower yielding securities.
The table on the following page provides information related to the Company's
fixed maturity investments at September 30, 1999. The table presents cash flows
of principal amounts and related weighted average interest rates by expected
maturity dates. The cash flows are based upon the maturity date or, in the case
of mortgage-backed and asset-backed securities, expected payment patterns.
Actual cash flows could differ from those shown in the table.
18
<PAGE> 19
FIXED MATURITIES
Expected Cash Flows of Principal Amounts ($ in 000's):
<TABLE>
<CAPTION>
TOTAL
-------------------
Amor- Estimated
There- tized Market
HELD TO MATURITY 1999 2000 2001 2002 2003 After Cost Value
- ----------------- -------- -------- -------- -------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
U.S. Treasury securities and
obligations of U.S.
Government corporations
and agencies $ 0 $ 1,647 $ 0 $ 0 $ 0 $ 0 $ 1,647 $ 1,609
Average interest rate 0.0% 5.4% 0.0% 0.0% 0.0% 0.0%---- --
Mortgage & asset backed
securities 270 701 196 1,815 1,710 8,928 13,62013,951
Average interest rate 8.0% 8.0% 7.7% 7.7% 7.5% 7.3% -- --
-------- -------- -------- -------- -------- -------- -------- --------
Total $ 270 $ 2,348 $ 196 $ 1,815 $ 1,710 $ 8,928 $ 15,267 $ 15,560
======== ======== ======== ======== ======== ======== ======== ========
AVAILABLE FOR SALE
U.S. Treasury securities and
obligations of U.S.
Government corporations
and agencies $ 0 $ 7,400 $ 18,612 $ 350 $ 0 $ 0 $ 26,362 $ 26,101
Average interest rate 0.0% 5.4% 5.5% 6.3% 0.0% 0.0
Obligations of states and
political subdivisions 0 4,597 8,723 1,710 0 10,050 16,035 16,123
Average interest rate 0.0% 4.8% 4.9% 5.6% 0.0% 5.4% -- --
Corporate securities 0 7,908 6,602 11,217 7,135 967 33,829 33,931
Average interest rate 0.0% 5.5% 6.3% 7.1% 7.6% 8.6% -- --
Mortgage & asset
backed securities 7,060 22,083 37,422 17,893 4,224 11,001 99,683 99,073
Average interest rate 6.8% 6.9% 6.9% 7.0% 7.1% 7.2% -- --
-------- -------- -------- -------- -------- -------- -------- --------
Total $ 7,060 $ 41,988 $ 71,359 $ 31,170 $ 11,359 $ 12,973 $175,909 $175,228
======== ======== ======== ======== ======== ======== ======== ========
</TABLE>
The above discussion and the amounts set forth in the table include
forward-looking statements of market risk which assume that certain adverse
market conditions may occur. Actual future market conditions may differ
materially from such assumptions. Accordingly, the forward-looking statements
should not be considered projections by the Company of future events.
19
<PAGE> 20
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.
20
<PAGE> 21
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
MERCHANTS GROUP, INC.
(Registrant)
Date: November 12, 1999 By:/s/ KENNETH J. WILSON
----------------------------
Kenneth J. Wilson
Chief Financial Officer and
Treasurer (duly authorized
officer of the registrant and
chief accounting officer)
21
<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,
1998 1999 1998 1999
------ ------ ------ ------
<S> <C> <C> <C> <C>
Net income for computing earnings per
common share - without dilution and
fully diluted $1,483 $1,650 $4,349 $5,149
====== ====== ====== ======
Weighted average number of common shares
outstanding - without dilution 2,900 2,715 2,905 2,780
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 11 7 14 5
------ ------ ------ ------
Weighted average number of common shares
and common share equivalents outstanding,
diluted 2,911 2,722 2,919 2,785
====== ====== ====== ======
Earnings per share:
Basic $ .51 $ .61 $ 1.50 $ 1.85
====== ====== ====== ======
Diluted $ .51 $ .61 $ 1.49 $ 1.85
====== ====== ====== ======
</TABLE>
22
<TABLE> <S> <C>
<ARTICLE> 7
<CURRENCY> U.S. DOLLARS
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> SEP-30-1999
<EXCHANGE-RATE> 1
<DEBT-HELD-FOR-SALE> 175,228,000
<DEBT-CARRYING-VALUE> 15,267,000
<DEBT-MARKET-VALUE> 15,560,000
<EQUITIES> 0
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 214,322,000
<CASH> 7,000
<RECOVER-REINSURE> 5,654,000
<DEFERRED-ACQUISITION> 12,364,000
<TOTAL-ASSETS> 272,341,000
<POLICY-LOSSES> 132,747,000
<UNEARNED-PREMIUMS> 49,728,000
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 0
0
0
<COMMON> 32,000
<OTHER-SE> 69,448,000
<TOTAL-LIABILITY-AND-EQUITY> 272,341,000
71,226,000
<INVESTMENT-INCOME> 9,759,000
<INVESTMENT-GAINS> 60,000
<OTHER-INCOME> 361,000
<BENEFITS> 49,204,000
<UNDERWRITING-AMORTIZATION> 18,875,000
<UNDERWRITING-OTHER> 6,022,000
<INCOME-PRETAX> 7,305,000
<INCOME-TAX> 2,156,000
<INCOME-CONTINUING> 5,149,000
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 5,149,000
<EPS-BASIC> 1.85
<EPS-DILUTED> 1,85
<RESERVE-OPEN> 126,869,000
<PROVISION-CURRENT> 49,204,000
<PROVISION-PRIOR> 0
<PAYMENTS-CURRENT> 24,079,000
<PAYMENTS-PRIOR> 25,446,000
<RESERVE-CLOSE> 126,548,000
<CUMULATIVE-DEFICIENCY> 0
</TABLE>
