UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended June 30, 2017
OR
For the transition period from to .
Commission file number 0-15341
Donegal Group Inc.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
1195 River Road, P.O. Box 302, Marietta, PA 17547
(Address of principal executive offices) (Zip code)
(717) 426-1931
(Registrant’s telephone number, including area code)
Not applicable
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether 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 (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically and posted on its Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 21,745,343 shares of Class A Common Stock, par value $0.01 per share, and 5,576,775 shares of Class B Common Stock, par value $0.01 per share, outstanding on August 1, 2017.
DONEGAL GROUP INC.
INDEX TO FORM 10-Q REPORT
Signatures
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements.
Donegal Group Inc. and Subsidiaries
Consolidated Balance Sheets
Assets
Investments
Fixed maturities
Held to maturity, at amortized cost
Available for sale, at fair value
Equity securities, available for sale, at fair value
Investment in affiliate
Short-term investments, at cost, which approximates fair value
Total investments
Cash
Accrued investment income
Premiums receivable
Reinsurance receivable
Deferred policy acquisition costs
Deferred tax asset, net
Prepaid reinsurance premiums
Property and equipment, net
Accounts receivable - securities
Federal income taxes receivable
Due from affiliate
Goodwill
Other intangible assets
Other
Total assets
Liabilities and Stockholders’ Equity
Liabilities
Unpaid losses and loss expenses
Unearned premiums
Accrued expenses
Reinsurance balances payable
Borrowings under lines of credit
Cash dividends declared to stockholders
Subordinated debentures
Accounts payable - securities
Due to affiliate
Total liabilities
Stockholders’ Equity
Preferred stock, $.01 par value, authorized 2,000,000 shares; none issued
Class A common stock, $.01 par value, authorized 40,000,000 shares, issued 24,722,276 and 24,483,377 shares and outstanding 21,719,688 and 21,480,789 shares
Class B common stock, $.01 par value, authorized 10,000,000 shares, issued 5,649,240 shares and outstanding 5,576,775 shares
Additional paid-in capital
Accumulated other comprehensive loss
Retained earnings
Treasury stock, at cost
Total stockholders’ equity
Total liabilities and stockholders’ equity
See accompanying notes to consolidated financial statements.
1
Consolidated Statements of Income
(Unaudited)
Revenues:
Net premiums earned
Investment income, net of investment expenses
Net realized investment gains (includes $1,097,306 and $715,177 accumulated other comprehensive income reclassifications)
Lease income
Installment payment fees
Equity in earnings of Donegal Financial Services Corporation
Total revenues
Expenses:
Net losses and loss expenses
Amortization of deferred policy acquisition costs
Other underwriting expenses
Policyholder dividends
Interest
Other expenses
Total expenses
(Loss) income before income tax (benefit) expense
Income tax (benefit) expense (includes $384,057 and $250,312 income tax expense from reclassification items)
Net (loss) income
(Loss) earnings per common share:
Class A common stock - basic
Class A common stock - diluted
Class B common stock - basic and diluted
Consolidated Statements of Comprehensive Income
Other comprehensive income, net of tax
Unrealized gain on securities:
Unrealized holding gain during the period, net of income tax expense of $575,754 and $2,068,136
Reclassification adjustment for gains included in net income, net of income tax expense of $384,057 and $250,312
Other comprehensive income
Comprehensive (loss) income
2
Net realized investment gains (includes $3,646,281 and $1,186,118 accumulated other comprehensive income reclassifications)
Income before income tax expense
Income tax expense (includes $1,276,198 and $415,141 income tax expense from reclassification items)
Net income
Earnings per common share:
Unrealized holding gain during the period, net of income tax expense of $1,654,622 and $4,364,683
Reclassification adjustment for gains included in net income, net of income tax expense of $1,276,198 and $415,141
Comprehensive income
3
Consolidated Statement of Stockholders’ Equity
Six Months Ended June 30, 2017
Balance, December 31, 2016
Issuance of common stock
Share-based compensation
Cash dividends declared
Grant of stock options
Balance, June 30, 2017
4
Consolidated Statements of Cash Flows
Cash Flows from Operating Activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation, amortization and other non-cash items
Net realized investment gains
Changes in assets and liabilities:
Losses and loss expenses
Deferred acquisition costs
Deferred income taxes
Current income taxes
Other, net
Net adjustments
Net cash provided by operating activities
Cash Flows from Investing Activities:
Purchases of fixed maturities, held to maturity
Purchases of fixed maturities, available for sale
Purchases of equity securities, available for sale
Maturity of fixed maturities:
Held to maturity
Available for sale
Sales of fixed maturities, available for sale
Sales of equity securities, available for sale
Net purchases of property and equipment
Net (purchases) sales of short-term investments
Net cash used in investing activities
Cash Flows from Financing Activities:
Cash dividends paid
Payment on lines of credit
Net cash used in financing activities
Net increase in cash
Cash at beginning of period
Cash at end of period
Cash paid during period - Interest
Net cash paid during period - Taxes
5
DONEGAL GROUP INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
1 - Organization
Donegal Mutual Insurance Company (“Donegal Mutual”) organized us as an insurance holding company on August 26, 1986. Our insurance subsidiaries, Atlantic States Insurance Company (“Atlantic States”), Southern Insurance Company of Virginia (“Southern”), Le Mars Insurance Company (“Le Mars”), the Peninsula Insurance Group (“Peninsula”), which consists of Peninsula Indemnity Company and The Peninsula Insurance Company, Sheboygan Falls Insurance Company (“Sheboygan”) and Michigan Insurance Company (“MICO”), write personal and commercial lines of property and casualty coverages exclusively through independent insurance agents in certain Mid-Atlantic, Midwestern, New England and Southern states. We also own 48.2% of the outstanding stock of Donegal Financial Services Corporation (“DFSC”), a grandfathered unitary savings and loan holding company that owns Union Community Bank (“UCB”), a state savings bank. Donegal Mutual owns the remaining 51.8% of the outstanding stock of DFSC.
We have four segments: our investment function, our personal lines of insurance, our commercial lines of insurance and our investment in DFSC. The personal lines products of our insurance subsidiaries consist primarily of homeowners and private passenger automobile policies. The commercial lines products of our insurance subsidiaries consist primarily of commercial automobile, commercial multi-peril and workers’ compensation policies.
At June 30, 2017, Donegal Mutual held approximately 45% of our outstanding Class A common stock and approximately 83% of our outstanding Class B common stock. That ownership provides Donegal Mutual with approximately 73% of the combined voting power of our outstanding shares of Class A common stock and our outstanding shares of Class B common stock. We believe Donegal Mutual’s voting control of us benefits us for the reasons we describe in our Annual Reports on Form 10-K and in our proxy statements. Our insurance subsidiaries and Donegal Mutual have interrelated operations due to a pooling agreement and other intercompany agreements and transactions. While each company maintains its separate corporate existence, Donegal Mutual and our insurance subsidiaries conduct business together as the Donegal Insurance Group. As such, Donegal Mutual and our insurance subsidiaries share the same business philosophy, the same management, the same employees and the same facilities and offer the same types of insurance products.
Atlantic States, our largest subsidiary, participates in a pooling agreement with Donegal Mutual. Under the pooling agreement, Donegal Mutual and Atlantic States pool their insurance business and each company receives an allocated percentage of the pooled business. Atlantic States has an 80% share of the results of the pooled business, and Donegal Mutual has a 20% share of the results of the pooled business. Pooled business represents the predominant percentage of the net underwriting activity of both Donegal Mutual and Atlantic States.
Donegal Mutual completed the merger of Mountain States Mutual Casualty Company (“Mountain States”) with and into Donegal Mutual effective May 25, 2017. Donegal Mutual is the surviving company in the merger, and Mountain States’ insurance subsidiaries, Mountain States Indemnity Company and Mountain States Commercial Insurance Company, became insurance subsidiaries of Donegal Mutual as a result of the merger. As of the effective date of the merger, Donegal Mutual assumed all of the policy obligations of Mountain States and began to market its products together with its insurance subsidiaries as the Mountain States Insurance Group in certain Southwestern states. For an indefinite period of time, Donegal Mutual will exclude the business of the Mountain States Insurance Group from the pooling agreement with Atlantic States. As a result, our consolidated financial results will exclude the results of Donegal Mutual’s operations in those Southwestern states.
The same executive management and underwriting personnel administer products, classes of business underwritten, pricing practices and underwriting standards of Donegal Mutual and our insurance subsidiaries. In addition, as the Donegal Insurance Group, Donegal Mutual and our insurance subsidiaries share a combined business plan to achieve market penetration and underwriting profitability objectives. The products our insurance subsidiaries and Donegal Mutual market are generally complementary, thereby allowing the Donegal Insurance Group to offer a broader range of products to a given market and to expand the Donegal Insurance Group’s ability to service entire personal lines or commercial lines accounts. Distinctions within the products Donegal Mutual and our insurance subsidiaries offer relate generally to specific risk profiles targeted within similar classes of business, such as preferred tier products versus standard tier products, but we do not allocate all of the standard risk gradients to one company. Therefore, the underwriting profitability of the business the individual companies write directly will vary. However, because the risk characteristics of all business Donegal Mutual and Atlantic States write directly are homogenized within the underwriting pool, Donegal Mutual and Atlantic States share the underwriting results in proportion to their respective participation in the underwriting pool.
6
On July 18, 2013, our board of directors authorized a share repurchase program pursuant to which we have the authority to purchase up to 500,000 shares of our Class A common stock at prices prevailing from time to time in the open market subject to the provisions of applicable rules of the SEC and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program during the six months ended June 30, 2017 or 2016 . We have purchased a total of 57,658 shares of our Class A common stock under this program from its inception through June 30, 2017.
2 - Basis of Presentation
Our financial information for the interim periods included in this Form 10-Q Report is unaudited; however, our financial information we include in this Form 10-Q Report reflects all adjustments, consisting only of normal recurring adjustments that, in the opinion of our management, are necessary for a fair presentation of our financial position, results of operations and cash flows for those interim periods. Our results of operations for the six months ended June 30, 2017 are not necessarily indicative of the results of operations we expect for the year ending December 31, 2017.
We recommend you read the interim financial statements we include in this Form 10-Q Report in conjunction with the financial statements and the notes to our financial statements contained in our Annual Report on Form 10-K for the year ended December 31, 2016.
3 - Earnings Per Share
We have two classes of common stock, which we refer to as our Class A common stock and our Class B common stock. Our certificate of incorporation provides that whenever our board of directors declares a dividend on our Class B common stock, our board of directors shall simultaneously declare a dividend on our Class A common stock that is payable to the holders of our Class A common stock at the same time and as of the same record date at a rate that is at least 10% greater than the rate at which our board of directors declared a dividend on our Class B common stock. Accordingly, we use the two-class method to compute our earnings per common share. The two-class method is an earnings allocation formula that determines earnings per share separately for each class of common stock based on dividends we have declared and an allocation of our remaining undistributed earnings using a participation percentage that reflects the dividend rights of each class. The table below presents for the periods indicated a reconciliation of the numerators and denominators we used to compute basic and diluted net (loss) income per share for each class of our common stock:
Basic net (loss) income per share:
Numerator:
Allocation of net (loss) income
Denominator:
Weighted-average shares outstanding
Basic net (loss) income per share
Diluted net (loss) income per share:
Number of shares used in basic computation
Weighted-average shares effect of dilutive securities
Add: Director and employee stock options
Number of shares used in diluted computation
Diluted net (loss) income per share
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Basic net income per share:
Allocation of net income
Basic net income per share
Diluted net income per share:
Diluted net income per share
We did not include outstanding options to purchase the following number of shares of Class A common stock in our computation of diluted earnings per share because the exercise price of the options exceeded the average market price of our Class A common stock during the applicable periods:
Number of options to purchase Class A shares excluded
4 - Reinsurance
Atlantic States and Donegal Mutual have participated in a pooling agreement since 1986 under which each company places all of its direct written premiums into the pool the pooling agreement established, and Atlantic States and Donegal Mutual then share the underwriting results of the pool in accordance with the terms of the pooling agreement. Atlantic States has an 80% share of the results of the pool, and Donegal Mutual has a 20% share of the results of the pool.
Our insurance subsidiaries and Donegal Mutual purchase certain third-party reinsurance on a combined basis. Le Mars, MICO, Peninsula and Sheboygan also purchase separate third-party reinsurance that provides coverage that we believe is commensurate with their relative size and risk exposures. Our insurance subsidiaries use several different reinsurers, all of which, consistent with the requirements of our insurance subsidiaries and Donegal Mutual, have an A.M. Best rating of A- (Excellent) or better or, with respect to foreign reinsurers, have a financial condition that, in the opinion of our management, is equivalent to a company with at least an A- rating from A.M. Best. The following information describes the external reinsurance our insurance subsidiaries have in place for 2017:
8
Our insurance subsidiaries and Donegal Mutual also purchase facultative reinsurance to cover exposures in excess of the covered limits of their third-party reinsurance agreements.
In addition to the pooling agreement and third-party reinsurance, our insurance subsidiaries have various reinsurance agreements with Donegal Mutual.
We have made no significant changes to our third-party reinsurance or the reinsurance agreements between our insurance subsidiaries and Donegal Mutual during the six months ended June 30, 2017.
5 - Investments
The amortized cost and estimated fair values of our fixed maturities and equity securities at June 30, 2017 were as follows:
Held to Maturity
U.S. Treasury securities and obligations of U.S. government corporations and agencies
Obligations of states and political subdivisions
Corporate securities
Mortgage-backed securities
Totals
Available for Sale
Equity securities
At June 30, 2017, our holdings of obligations of states and political subdivisions included general obligation bonds with an aggregate fair value of $209.9 million and an amortized cost of $199.7 million. Our holdings at June 30, 2017 also included special revenue bonds with an aggregate fair value of $96.1 million and an amortized cost of $90.5 million. With respect to both categories of those bonds at June 30, 2017, we held no securities of any issuer that comprised more than 10% of our holdings of either bond category. Education bonds and water and sewer utility bonds represented 58% and 23%, respectively, of our total investments in special revenue bonds based on the carrying values of these investments at June 30, 2017. Many of the issuers of the special revenue bonds we held at June 30, 2017 have the authority to impose ad valorem taxes. In that respect, many of the special revenue bonds we held at June 30, 2017 were similar to general obligation bonds.
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The amortized cost and estimated fair values of our fixed maturities and equity securities at December 31, 2016 were as follows:
At December 31, 2016, our holdings of obligations of states and political subdivisions included general obligation bonds with an aggregate fair value of $220.1 million and an amortized cost of $211.0 million. Our holdings at December 31, 2016 also included special revenue bonds with an aggregate fair value of $96.8 million and an amortized cost of $91.7 million. With respect to both categories of those bonds at December 31, 2016, we held no securities of any issuer that comprised more than 10% of that category. Education bonds and water and sewer utility bonds represented 62% and 23%, respectively, of our total investments in special revenue bonds based on their carrying values at December 31, 2016. Many of the issuers of the special revenue bonds we held at December 31, 2016 have the authority to impose ad valorem taxes. In that respect, many of the special revenue bonds we held are similar to general obligation bonds.
We made reclassifications from available for sale to held to maturity of certain fixed maturities at fair value on November 30, 2013. We segregated within accumulated other comprehensive loss the net unrealized losses of $15.1 million arising prior to the November 30, 2013 reclassification date for fixed maturities we reclassified from available for sale to held to maturity. We are amortizing this balance over the remaining life of the related securities as an adjustment to yield in a manner consistent with the accretion of discount on the same fixed maturities. We recorded amortization of $604,812 and $694,613 in other comprehensive income during the six months ended June 30, 2017 and 2016, respectively. At June 30, 2017 and December 31, 2016, net unrealized losses of $10.4 million and $11.0 million, respectively, remained within accumulated other comprehensive loss.
10
We show below the amortized cost and estimated fair value of our fixed maturities at June 30, 2017 by contractual maturity. Expected maturities may differ from contractual maturities because issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties.
Due in one year or less
Due after one year through five years
Due after five years through ten years
Due after ten years
Total held to maturity
Total available for sale
Gross realized gains and losses from investments before applicable income taxes for the three and six months ended June 30, 2017 and 2016 were as follows:
Gross realized gains:
Gross realized losses:
Net realized gains
We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at June 30, 2017 as follows:
11
We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at December 31, 2016 as follows:
We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, we write down the investment to its fair value, and we reflect the amount of the write-down as a realized loss in our results of operations when we consider the decline in value of an individual equity security investment to be other than temporary. We monitor all investments individually for other-than-temporary declines in value. Generally, we assume there has been an other-than-temporary decline in value if an individual equity security has depreciated in value by more than 20% of our original cost and has been in such an unrealized loss position for more than six months. We held eight equity securities that were in an unrealized loss position at June 30, 2017. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we considered these declines in value to be temporary. With respect to a debt security that is in an unrealized loss position, we first assess if we intend to sell the debt security. If we determine we intend to sell the debt security, we recognize the impairment loss in our results of operations. If we do not intend to sell the debt security, we determine whether it is more likely than not that we will be required to sell the debt security prior to recovery. If we determine it is more likely than not that we will be required to sell the debt security prior to recovery, we recognize the impairment loss in our results of operations. If we determine it is more likely than not that we will not be required to sell the debt security prior to recovery, we then evaluate whether a credit loss has occurred with respect to that security. We determine whether a credit loss has occurred by comparing the amortized cost of the debt security to the present value of the cash flows we expect to collect. If we expect a cash flow shortfall, we consider that a credit loss has occurred. If we determine that a credit loss has occurred, we consider the impairment to be other than temporary. We then recognize the amount of the impairment loss related to the credit loss in our results of operations, and we recognize the remaining portion of the impairment loss in our other comprehensive income, net of applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including when the fair value of an investment is significantly below its cost, when the financial condition of the issuer of a security has deteriorated, the occurrence of industry, issuer or geographic events that have negatively impacted the value of a security and rating agency downgrades. We held 207 debt securities that were in an unrealized loss position at June 30, 2017. Based upon our analysis of general market conditions and underlying factors impacting these debt securities, we considered these declines in value to be temporary.
We amortize premiums and discounts on debt securities over the life of the security as an adjustment to yield using the effective interest method. We compute realized investment gains and losses using the specific identification method.
We amortize premiums and discounts on mortgage-backed debt securities using anticipated prepayments.
12
Our investment in affiliate represents our 48.2% ownership interest in DFSC. We account for our investment in affiliate using the equity method of accounting. Under this method, we record our investment at cost, with adjustments for our share of DFSC’s earnings and losses as well as changes in the equity of DFSC due to unrealized gains and losses. We include our share of DFSC’s net income in our results of operations. We have compiled the following summary financial information for DFSC at June 30, 2017 and December 31, 2016 and for the three and six months ended June 30, 2017 and 2016, respectively, from the financial statements of DFSC. The financial information of DFSC at June 30, 2017 and 2016 and for the three and six months then ended is unaudited.
Stockholders’ equity
13
6 - Segment Information
We evaluate the performance of our personal lines and commercial lines segments based upon the underwriting results of our insurance subsidiaries using statutory accounting principles (“SAP”) that various state insurance departments prescribe or permit. Our management uses SAP to measure the performance of our insurance subsidiaries instead of United States generally accepted accounting principles (“GAAP”). Financial data by segment for the three and six months ended June 30, 2017 and 2016 is as follows:
Premiums earned
Commercial lines
Personal lines
GAAP premiums earned
Net investment income
Realized investment gains
Equity in earnings of DFSC
(Loss) income before income taxes:
Underwriting (loss) income:
SAP underwriting (loss) income
GAAP adjustments
GAAP underwriting (loss) income
(Loss) income before income taxes
14
Income before income taxes:
Income before income taxes
7 - Borrowings
Lines of Credit
In July 2017, we renewed our existing credit agreement with Manufacturers and Traders Trust Company (“M&T”) relating to a $60.0 million unsecured, revolving line of credit. The line of credit expires in July 2020. We have the right to request a one-year extension of the credit agreement as of each anniversary date of the credit agreement. At June 30, 2017, we had $34.0 million in outstanding borrowings from M&T and had the ability to borrow an additional $26.0 million at interest rates equal to M&T’s current prime rate or the then current LIBOR rate plus 2.25%. The interest rate on our outstanding borrowings from M&T is adjustable quarterly, and, at June 30, 2017, that interest rate was 3.48%. We pay a fee of 0.2% per annum on the loan commitment amount regardless of usage. The credit agreement requires our compliance with certain covenants. These covenants include minimum levels of our net worth, leverage ratio, statutory surplus and the A.M. Best ratings of our insurance subsidiaries. We were in compliance with all requirements of the credit agreement during the six months ended June 30, 2017.
MICO is a member of the Federal Home Loan Bank (“FHLB”) of Indianapolis. Through its membership, MICO has the ability to issue debt to the FHLB of Indianapolis in exchange for cash advances. MICO had no outstanding borrowings with the FHLB of Indianapolis at June 30, 2017. The table below presents the amount of FHLB of Indianapolis stock MICO purchased, collateral pledged and assets related to MICO’s membership in the FHLB of Indianapolis at June 30, 2017.
FHLB of Indianapolis stock purchased and owned
Collateral pledged, at par (carrying value $2,750,395)
Borrowing capacity currently available
15
Atlantic States is a member of the FHLB of Pittsburgh. Through its membership, Atlantic States has the ability to issue debt to the FHLB of Pittsburgh in exchange for cash advances. Atlantic States had $35.0 million in outstanding advances at June 30, 2017. The interest rate on the advances was 1.25% at June 30, 2017. The table below presents the amount of FHLB of Pittsburgh stock Atlantic States purchased, collateral pledged and assets related to Atlantic States’ membership in the FHLB of Pittsburgh at June 30, 2017.
FHLB of Pittsburgh stock purchased and owned
Collateral pledged, at par (carrying value $36,267,678)
Subordinated Debentures
Donegal Mutual holds a $5.0 million surplus note that MICO issued to increase MICO’s statutory surplus. The surplus note carries an interest rate of 5.00%, and any repayment of principal or payment of interest on the surplus note requires prior approval of the Michigan Department of Insurance and Financial Services.
8 - Share–Based Compensation
We measure all share-based payments to employees, including grants of stock options, and use a fair-value-based method for the recording of related compensation expense in our consolidated statements of income. In determining the expense we record for stock options granted to directors and employees of our subsidiaries and affiliates, we estimate the fair value of each option award on the date of grant using the Black-Scholes option pricing model. The significant assumptions we utilize in applying the Black-Scholes option pricing model are the risk-free interest rate, the expected term, the dividend yield and the expected volatility.
We charged compensation expense related to our stock compensation plans against income before income taxes of $602,380 and $807,252 for the three months ended June 30, 2017 and 2016, respectively, with a corresponding income tax benefit of $210,833 and $282,538, respectively. We charged compensation expense related to our stock compensation plans against income before income taxes of $1.2 million and $1.6 million for the six months ended June 30, 2017 and 2016, respectively, with a corresponding income tax benefit of $420,068 and $565,441, respectively. At June 30, 2017, we had $2.5 million of unrecognized compensation expense related to nonvested share-based compensation granted under our stock compensation plans that we expect to recognize over a weighted average period of approximately 1.7 years.
We received cash from option exercises under all stock compensation plans during the three months ended June 30, 2017 and 2016 of $652,027 and $3.4 million, respectively. We received cash from option exercises under all stock compensation plans during the six months ended June 30, 2017 and 2016 of $2.2 million and $4.1 million, respectively.We realized actual tax benefits for the tax deductions related to option exercises of $70,822 and $243,600 for the three months ended June 30, 2017 and 2016, respectively. We realized actual tax benefits for the tax deductions related to option exercises of $178,356 and $278,196 for the six months ended June 30, 2017 and 2016, respectively.
9 - Fair Value Measurements
We account for financial assets using a framework that establishes a hierarchy that ranks the quality and reliability of the inputs, or assumptions, we use in the determination of fair value, and we classify financial assets and liabilities carried at fair value in one of the following three categories:
Level 1 - quoted prices in active markets for identical assets and liabilities;
Level 2 - directly or indirectly observable inputs other than Level 1 quoted prices; and
Level 3 - unobservable inputs not corroborated by market data.
For investments that have quoted market prices in active markets, we use the quoted market price as fair value and include these investments in Level 1 of the fair value hierarchy. We classify publicly-traded equity securities as Level 1. When quoted market prices in active markets are not available, we base fair values on quoted market prices of comparable instruments or price estimates we obtain from independent pricing services and include these investments in Level 2 of the fair value hierarchy. We classify our fixed maturity investments as Level 2. Our fixed maturity investments consist of U.S. Treasury securities and obligations of U.S. government corporations and agencies, obligations of states and political subdivisions, corporate securities and mortgage-backed securities.
16
We present our investments in available-for-sale fixed maturity and equity securities at estimated fair value. The estimated fair value of a security may differ from the amount that could be realized if we sold the security in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values or obtain market quotations for substantially all of our fixed maturity and equity investments. These pricing services utilize market quotations for fixed maturity and equity securities that have quoted prices in active markets. For fixed maturity securities that generally do not trade on a daily basis, the pricing services prepare estimates of fair value measurements based predominantly on observable market inputs. The pricing services do not use broker quotes in determining the fair values of our investments. Our investment personnel review the estimates of fair value the pricing services provide to determine if the estimates we obtain from the pricing services are representative of fair values based upon our investment personnel’s general knowledge of the market, their research findings related to unusual fluctuations in value and their comparison of such values to execution prices for similar securities. Our investment personnel regularly monitor the market, current trading ranges for similar securities and the pricing of specific investments. Our investment personnel review all pricing estimates that we receive from the pricing services against their expectations with respect to pricing based on fair market curves, security ratings, coupon rates, security types and recent trading activity. Our investment personnel review documentation with respect to the pricing services’ pricing methodology that they obtain periodically to determine if the primary pricing sources, market inputs and pricing frequency for various security types are reasonable. At June 30, 2017, we received two estimates per security from the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided at June 30, 2017, we did not identify any material discrepancies, and we did not make any adjustments to the estimates the pricing services provided.
We present our cash and short-term investments at estimated fair value. We classify these items as Level 1.
The carrying values we report in our balance sheet for premium receivables and reinsurance receivables and payables for premiums and paid losses and loss expenses approximate their fair values. The carrying amounts we report in our balance sheet for our subordinated debentures and borrowings under lines of credit approximate their fair values. We classify these items as Level 3.
We evaluate our assets and liabilities on a recurring basis to determine the appropriate level at which to classify them for each reporting period.
The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities at June 30, 2017:
Total investments in the fair value hierarchy
Investment measured at net asset value
We did not transfer any investments between Levels 1 and 2 during the six months ended June 30, 2017.
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The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities at December 31, 2016:
10 - Income Taxes
At June 30, 2017 and December 31, 2016, respectively, we had no material unrecognized tax benefits or accrued interest and penalties. Tax years 2013 through 2016 remained open for examination at June 30, 2017. We provide a valuation allowance when we believe it is more likely than not that we will not realize some portion of our tax assets. We established a valuation allowance of $440,778 related to a portion of the net operating loss carryforward of Le Mars at January 1, 2004. We have determined that we are not required to establish a valuation allowance for our other deferred tax assets of $45.6 million and $43.1 million at June 30, 2017 and December 31, 2016, respectively, because it is more likely than not that we will realize these deferred tax assets through reversals of existing temporary differences, future taxable income and the implementation of tax planning strategies. Our deferred tax assets include a net operating loss carryforward of $2.0 million related to Le Mars, which will begin to expire in 2020 if not previously utilized. This carryforward is subject to an annual limitation in the amount that we can use in any one year of approximately $376,000. Our deferred tax assets also include an alternative minimum tax credit carryforward of $7.7 million with an indefinite life.
11 - Liability for Losses and Loss Expenses
The establishment of an appropriate liability for losses and loss expenses is an inherently uncertain process, and we can provide no assurance that our insurance subsidiaries’ ultimate liability will not exceed their loss and loss expense reserves and have an adverse effect on our results of operations and financial condition. Furthermore, we cannot predict the timing, frequency and extent of adjustments to our insurance subsidiaries’ estimated future liabilities, because the historical conditions and events that serve as a basis for our insurance subsidiaries’ estimates of ultimate claim costs may change. As is the case for substantially all property and casualty insurance companies, our insurance subsidiaries have found it necessary in the past to increase their estimated future liabilities for losses and loss expenses in certain periods, and, in other periods, their estimated future liabilities for losses and loss expenses have exceeded their actual liabilities. Changes in our insurance subsidiaries’ estimate of their liability for losses and loss expenses generally reflect actual payments and their evaluation of information received subsequent to the prior reporting date.
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We summarize activity in our insurance subsidiaries’ liability for losses and loss expenses as follows:
Balance at January 1
Less reinsurance recoverable
Net balance at January 1
Incurred related to:
Current year
Prior years
Total incurred
Paid related to:
Total paid
Net balance at end of period
Plus reinsurance recoverable
Balance at end of period
Our insurance subsidiaries recognized an increase in their liability for losses and loss expenses of prior years of $8.4 million and $3.7 million for the six months ended June 30, 2017 and 2016, respectively. Our insurance subsidiaries made no significant changes in their reserving philosophy, key reserving assumptions or claims management personnel, and our insurance subsidiaries have made no significant offsetting changes in estimates that increased or decreased their loss and loss expense reserves in those periods. The 2017 development represented 2.4% of the December 31, 2016 net carried reserves and resulted primarily from higher-than-expected severity in the commercial multi-peril and commercial automobile liability lines of business, offset by lower-than-expected severity in the workers’ compensation line of business, in accident years prior to 2017. The majority of the 2017 development related to increases in the liability for losses and loss expenses of prior years for Atlantic States and Peninsula. The 2016 development represented 1.2% of the December 31, 2015 net carried reserves and resulted primarily from higher-than-expected severity in the commercial multi-peril and commercial automobile liability lines of business, offset by lower-than-expected severity in the workers’ compensation line of business, in accident years prior to 2016. The majority of the 2016 development related to increases in the liability for losses and loss expenses of prior years for Atlantic States and Peninsula.
Short-duration contracts are contracts for which our insurance subsidiaries receive premiums that they recognize as revenue over the period of the contract in proportion to the amount of insurance protection our insurance subsidiaries provide. Our insurance subsidiaries consider the policies they issue to be short-duration contracts. We consider our insurance subsidiaries’ material lines of business to be personal automobile, homeowners, commercial automobile, commercial multi-peril and workers’ compensation.
Our insurance subsidiaries determine incurred but not reported (“IBNR”) reserves by subtracting the cumulative loss and loss expense amounts our insurance subsidiaries have paid and the case reserves our insurance subsidiaries have established at the balance sheet date from their actuaries’ estimate of the ultimate cost of losses and loss expenses. Accordingly, our insurance subsidiaries’ IBNR reserves include their actuaries’ projections of the cost of unreported claims as well as their actuaries’ projected development of case reserves on known claims and reopened claims. Our insurance subsidiaries’ methodology for estimating IBNR reserves has been in place for many years, and their actuaries made no significant changes to that methodology during the six months ended June 30, 2017.
The actuaries for our insurance subsidiaries generally prepare an initial estimate for ultimate losses and loss expenses for the current accident year by multiplying earned premium by an expected loss ratio for each line of business our insurance subsidiaries write. Expected loss ratios represent the actuaries’ expectation of losses at the time our insurance subsidiaries price and write their policies and before the emergence of any actual claims experience. The actuaries determine an expected loss ratio by analyzing historical experience and adjusting for loss cost trends, loss frequency and severity trends, premium rate level changes, reported and paid loss emergence patterns and other known or observed factors.
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The actuaries use a variety of actuarial methods to estimate the ultimate cost of losses and loss expenses. These methods include paid loss development, incurred loss development and the Bornhuetter-Ferguson method. The actuaries base their selection of a point estimate on a judgmental weighting of the estimates each of these methods produce.
The actuaries consider loss frequency and severity trends when they develop expected loss ratios and point estimates. Loss frequency is a measure of the number of claims per unit of insured exposure, and loss severity is a measure of the average size of claims. Factors that affect loss frequency include changes in weather patterns and economic activity. Factors that affect loss severity include changes in policy limits, reinsurance retentions, inflation rates and judicial interpretations.
Our insurance subsidiaries create a claim file when they receive notice of an actual demand for payment, an event that may lead to a demand for payment or when they otherwise determine that a demand for payment could potentially lead to a future demand for payment on another coverage under the same policy or another policy they have issued. In recent years, our insurance subsidiaries have noted an increase in the period of time between the occurrence of a casualty loss event and the date on which they receive notice of a liability claim. Changes in the length of time between the loss occurrence date and the claim reporting date affect the actuaries’ ability to accurately predict loss frequency and the amount of IBNR reserves our insurance subsidiaries require.
Our insurance subsidiaries generally create a claim file for a policy at the claimant level by type of coverage and generally recognize one count for each claim event. In certain lines of business where it is common for multiple parties to claim damages arising from a single claim event, our insurance subsidiaries recognize one count for each claimant involved in the event. Atlantic States recognizes one count for each claim event, or claimant involved in a multiple-party claim event, related to losses Atlantic States assumes through its participation in its pooling agreement with Donegal Mutual. Our insurance subsidiaries accumulate the claim counts and report them by line of business.
12 - Impact of New Accounting Standards
In May 2014, the Financial Accounting Standards Board (the “FASB”) issued guidance that requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. While the guidance will replace most existing GAAP revenue recognition guidance, the scope of the guidance excludes insurance contracts. The new standard is effective on January 1, 2018. The standard permits the use of either the retrospective or the cumulative effect transition method. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows.
In January 2016, the FASB issued guidance that generally requires entities to measure equity investments at fair value and recognize changes in fair value in their results of operations. The guidance also simplifies the impairment assessment of equity investments without readily determinable fair values by requiring entities to perform a qualitative assessment to identify impairment. The FASB issued other disclosure and presentation improvements related to financial instruments within the guidance. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017. As a result of this guidance, we will reflect changes in the fair value of our equity investments in our results of operations beginning January 1, 2018.
In February 2016, the FASB issued guidance that requires lessees to recognize leases, including operating leases, on the lessee’s balance sheet, unless a lease is considered a short-term lease. The guidance also requires entities to make new judgments to identify leases. The guidance is effective for annual and interim reporting periods beginning after December 15, 2018 and permits early adoption. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows.
In March 2016, the FASB issued guidance that simplifies and improves several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities and classification on the statement of cash flows. The guidance is effective for annual and interim reporting periods beginning after December 15, 2016. The adoption of this guidance did not have a significant impact on our financial position, results of operations or cash flows.
In June 2016, the FASB issued guidance that amends previous guidance on the impairment of financial instruments by adding an impairment model that requires an entity to recognize expected credit losses as an allowance rather than impairments as credit losses are incurred. The intent of the guidance is to reduce complexity and result in a more timely recognition of expected credit losses. The guidance is effective for annual and interim reporting periods beginning after December 15, 2019. We do not expect the adoption of this guidance to have a significant impact on our financial position, results of operations or cash flows.
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In March 2017, the FASB issued guidance that amends previous guidance on the amortization period for certain purchased callable debt securities held at a premium. The new guidance shortens the amortization period to the earliest call date. The intent of the new guidance is to align interest income recognition with the expectations incorporated in the market pricing on the underlying securities. The new standard is effective for annual and interim reporting periods beginning after December 15, 2018, with early adoption permitted. The adoption of this new guidance did not have a significant impact on our financial position, results of operations or cash flows.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
We recommend that you read the following information in conjunction with the historical financial information and the footnotes to that financial information we include in this Quarterly Report on Form 10-Q. We also recommend you read Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2016.
Critical Accounting Policies and Estimates
We combine our financial statements with those of our insurance subsidiaries and present our financial statements on a consolidated basis in accordance with GAAP.
Our insurance subsidiaries make estimates and assumptions that can have a significant effect on amounts and disclosures we report in our financial statements. The most significant estimates relate to the reserves of our insurance subsidiaries for property and casualty insurance unpaid losses and loss expenses, the valuation of investments and the determination of other-than-temporary investment impairments and the policy acquisition costs of our insurance subsidiaries. While we believe our estimates and the estimates of our insurance subsidiaries are appropriate, the ultimate amounts of these liabilities may differ from the estimates we provided. We regularly review our methods for making these estimates and we reflect any adjustment we consider necessary in our current consolidated results of operations.
Liability for Unpaid Losses and Loss Expenses
Liabilities for losses and loss expenses are estimates at a given point in time of the amounts an insurer expects to pay with respect to incurred policyholder claims based on facts and circumstances the insurer knows at that point in time. At the time of establishing its estimates, an insurer recognizes that its ultimate liability for losses and loss expenses will exceed or be less than such estimates. Our insurance subsidiaries base their estimates of liabilities for losses and loss expenses on assumptions as to future loss trends, expected claims severity, judicial theories of liability and other factors. However, during the loss adjustment period, our insurance subsidiaries may learn additional facts regarding individual claims, and, consequently, it often becomes necessary for our insurance subsidiaries to refine and adjust their estimates for these liabilities. We reflect any adjustments to the liabilities for losses and loss expenses of our insurance subsidiaries in our consolidated results of operations in the period in which our insurance subsidiaries make adjustments to their estimates.
Our insurance subsidiaries maintain liabilities for the payment of losses and loss expenses with respect to both reported and unreported claims. Our insurance subsidiaries establish these liabilities for the purpose of covering the ultimate costs of settling all losses, including investigation and litigation costs. Our insurance subsidiaries base the amount of their liability for reported losses primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss the policyholder incurred. Our insurance subsidiaries determine the amount of their liability for unreported claims and loss expenses on the basis of historical information by line of insurance. Our insurance subsidiaries account for inflation in the reserving function through analysis of costs and trends and reviews of historical reserving results. Our insurance subsidiaries monitor their liabilities closely and recompute them periodically using new information on reported claims and a variety of statistical techniques. Our insurance subsidiaries do not discount their liabilities for losses and loss expenses.
Reserve estimates can change over time because of unexpected changes in assumptions related to our insurance subsidiaries’ external environment and, to a lesser extent, assumptions related to our insurance subsidiaries’ internal operations. For example, our insurance subsidiaries have experienced a decrease in claims frequency on workers’ compensation claims during the past several years while the severity of these claims has gradually increased. These trend
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changes give rise to greater uncertainty as to the pattern of future loss settlements on workers’ compensation claims. Related uncertainties regarding future trends include the cost of medical technologies and procedures and changes in the utilization of medical procedures. Assumptions related to our insurance subsidiaries’ external environment include the absence of significant changes in tort law and the legal environment that increase liability exposure, consistency in judicial interpretations of insurance coverage and policy provisions and the rate of loss cost inflation. Internal assumptions include consistency in the recording of premium and loss statistics, consistency in the recording of claims, payment and case reserving methodology, accurate measurement of the impact of rate changes and changes in policy provisions, consistency in the quality and characteristics of business written within a given line of business and consistency in reinsurance coverage and collectability of reinsured losses, among other items. To the extent our insurance subsidiaries determine that underlying factors impacting their assumptions have changed, our insurance subsidiaries make adjustments in their reserves that they consider appropriate for such changes. Accordingly, our insurance subsidiaries’ ultimate liability for unpaid losses and loss expenses will likely differ from the amount recorded at June 30, 2017. For every 1% change in our insurance subsidiaries’ estimate for loss and loss expense reserves, net of reinsurance recoverable, the effect on our pre-tax results of operations would be approximately $3.7 million.
The establishment of appropriate liabilities is an inherently uncertain process and we can provide no assurance that our insurance subsidiaries’ ultimate liability will not exceed our insurance subsidiaries’ loss and loss expense reserves and have an adverse effect on our results of operations and financial condition. Furthermore, we cannot predict the timing, frequency and extent of adjustments to our insurance subsidiaries’ estimated future liabilities, because the historical conditions and events that serve as a basis for our insurance subsidiaries’ estimates of ultimate claim costs may change. As is the case for substantially all property and casualty insurance companies, our insurance subsidiaries have found it necessary in the past to increase their estimated future liabilities for losses and loss expenses in certain periods and, in other periods, their estimated future liabilities for losses and loss expenses have exceeded their actual liabilities. Changes in our insurance subsidiaries’ estimates of their liability for losses and loss expenses generally reflect actual payments and their evaluation of information received subsequent to the prior reporting date.
Excluding the impact of severe weather events, our insurance subsidiaries have noted stable amounts in the number of claims incurred and a slight downward trend in the number of claims outstanding at period ends relative to their premium base in recent years across most of their lines of business. However, the amount of the average claim outstanding has increased gradually over the past several years as the United States property and casualty insurance industry has experienced increased litigation trends and economic conditions that have extended the estimated length of disabilities and contributed to increased medical loss costs. We have also experienced a general slowing of settlement rates in litigated claims. Our insurance subsidiaries could have to make further adjustments to their estimates in the future. However, on the basis of our insurance subsidiaries’ internal procedures, which analyze, among other things, their prior assumptions, their experience with similar cases and historical trends such as reserving patterns, loss payments, pending levels of unpaid claims and product mix, as well as court decisions, economic conditions and public attitudes, we believe that our insurance subsidiaries have made adequate provision for their liability for losses and loss expenses.
Atlantic States’ participation in the pool with Donegal Mutual exposes Atlantic States to adverse loss development on the business of Donegal Mutual that the pool includes. However, pooled business represents the predominant percentage of the net underwriting activity of both companies, and Donegal Mutual and Atlantic States share proportionately any adverse risk development relating to the pooled business. The business in the pool is homogeneous and each company has a pro-rata share of the entire pool. Since substantially all of the business of Atlantic States and Donegal Mutual is pooled and the results shared by each company according to its participation level under the terms of the pooling agreement, the intent of the underwriting pool is to produce a more uniform and stable underwriting result from year to year for each company than either would experience individually and to spread the risk of loss between the companies.
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Donegal Mutual and our insurance subsidiaries operate together as the Donegal Insurance Group and share a combined business plan designed to achieve market penetration and underwriting profitability objectives. The products our insurance subsidiaries and Donegal Mutual offer are generally complementary, thereby allowing Donegal Insurance Group to offer a broader range of products to a given market and to expand Donegal Insurance Group’s ability to service an entire personal lines or commercial lines account. Distinctions within the products of Donegal Mutual and our insurance subsidiaries generally relate to specific risk profiles targeted within similar classes of business, such as preferred tier products compared to standard tier products, but we do not allocate all of the standard risk gradients to one company. Therefore, the underwriting profitability of the business the individual companies write directly will vary. However, because the pool homogenizes the risk characteristics of all business Donegal Mutual and Atlantic States write directly and each company shares the underwriting results according to each company’s participation percentage, each company realizes its percentage share of the underwriting results of the pool. Our insurance subsidiaries’ unpaid liability for losses and loss expenses by major line of business at June 30, 2017 and December 31, 2016 consisted of the following:
Commercial lines:
Automobile
Workers’ compensation
Commercial multi-peril
Total commercial lines
Personal lines:
Homeowners
Total personal lines
Total commercial and personal lines
Total liability for unpaid losses and loss expenses
We have evaluated the effect on our insurance subsidiaries’ unpaid loss and loss expense reserves and our stockholders’ equity in the event of reasonably likely changes in the variables we consider in establishing the loss and loss expense reserves of our insurance subsidiaries. We established the range of reasonably likely changes based on a review of changes in accident-year development by line of business and applied those changes to our insurance subsidiaries’ loss reserves as a whole. The range we selected does not necessarily indicate what could be the potential best or worst case or the most likely scenario. The following table sets forth the estimated effect on our insurance subsidiaries’ unpaid loss and loss expense reserves and our stockholders’ equity in the event of reasonably likely changes in the variables we considered in establishing the loss and loss expense reserves of our insurance subsidiaries:
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Statutory Combined Ratios
We evaluate our insurance operations by monitoring certain key measures of growth and profitability. In addition to using GAAP-based performance measurements, we also utilize certain non-GAAP financial measures that we believe are valuable in managing our business and for comparison to our peers. These non-GAAP measures are underwriting income, combined ratio and net premiums written. An insurance company’s statutory combined ratio is a standard measure of underwriting profitability. This ratio is the sum of the ratio of calendar-year incurred losses and loss expenses to premiums earned; the ratio of expenses incurred for commissions, premium taxes and underwriting expenses to net premiums written and the ratio of dividends to policyholders to premiums earned. The combined ratio does not reflect investment income, federal income taxes or other non-operating income or expense. A combined ratio of less than 100 percent generally indicates underwriting profitability. The statutory combined ratio differs from the GAAP combined ratio. In calculating the GAAP combined ratio, we do not deduct installment payment fees from incurred expenses, and we base the expense ratio on premiums earned instead of premiums written. Differences between our GAAP loss ratios reported in our financial statements and our insurance subsidiaries’ statutory loss ratios result from anticipating salvage and subrogation recoveries for the GAAP loss ratios but not for the statutory loss ratios. The following table sets forth our insurance subsidiaries’ statutory combined ratios by major line of business for the three and six months ended June 30, 2017 and 2016:
We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, we write down an individual investment to its fair value and we reflect the amount of the write-down as a realized loss in our results of operations when we consider the decline in value of the individual investment to be other than temporary. We monitor all investments individually for other-than-temporary declines in value. Generally, we assume there has been an other-than-temporary decline in value if an individual equity security has depreciated in value by more than 20% of our original cost and has been in such an unrealized loss position for more than six months. We held eight equity securities that were in an unrealized loss position at June 30, 2017. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we considered these declines in value to be temporary. With respect to a debt security that is in an unrealized loss position, we first assess if we intend to sell the debt security. If we determine we intend to sell the debt security, we recognize the impairment loss in our results of operations. If we do not intend to sell the debt security, we determine whether it is more likely than not that we will be required to sell the debt security prior to recovery. If we determine it is more likely than not that we will be required to sell the debt security prior to recovery, we recognize the impairment loss in our results of operations. If we determine it is more likely than not that we will not be required to sell the debt security prior to recovery, we then evaluate whether a credit loss has occurred. We determine whether a credit loss has occurred by comparing the amortized cost of the debt security to the present value of the cash flows we expect to collect on the debt security. If we expect a cash flow shortfall, we consider that a credit loss has occurred. If we determine that a credit loss has occurred, we consider the impairment to be other than temporary. We then recognize the amount of the impairment loss related to the credit loss in our results of operations, and we recognize the remaining portion of the impairment loss in our other comprehensive income, net of applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including when the fair value of an investment is significantly below its cost, when the financial condition of the issuer of a security has deteriorated, the occurrence of industry, company or geographic events that have negatively impacted the value of a security or rating agency downgrades. We held 207 debt securities that were in an unrealized loss position at June 30, 2017. Based upon our analysis of general market conditions and underlying factors impacting these debt securities, we considered these declines in value to be temporary. We did not recognize any impairment losses in our results of operations for the six months ended June 30, 2017 or 2016.
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We present our investments in available-for-sale fixed maturity and equity securities at estimated fair value. The estimated fair value of a security may differ from the amount we could realize if we sold the security in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values or obtain market quotations for substantially all of our fixed maturity and equity investments. The pricing services utilize market quotations for fixed maturity and equity securities that have quoted prices in active markets. For fixed maturity securities that generally do not trade on a daily basis, the pricing services prepare estimates of fair value measurements based predominantly on observable market inputs. The pricing services do not use broker quotes in determining the fair values of our investments. Our investment personnel review the estimates of fair value the pricing services provide to determine if the estimates we obtain from the pricing services are representative of fair values based upon the general market knowledge of our investment personnel, their research findings related to unusual fluctuations in value and their comparison of such values to execution prices for similar securities. Our investment personnel monitor the market and are familiar with current trading ranges for similar securities and pricing of specific investments. Our investment personnel review all pricing estimates that we receive from the pricing services against their expectations with respect to pricing based on fair market curves, security ratings, coupon rates, security types and recent trading activity. Our investment personnel review documentation with respect to the pricing services’ pricing methodology that they obtain periodically to determine if the primary pricing sources, market inputs and pricing frequency for various security types are reasonable. At June 30, 2017, we received two estimates per security from the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided at June 30, 2017, we did not identify any material discrepancies, and we did not make any adjustments to the estimates the pricing services provided.
Policy Acquisition Costs
Our insurance subsidiaries defer their policy acquisition costs, consisting primarily of commissions, premium taxes and certain other underwriting costs that relate directly to the successful acquisition of insurance policies. We amortize these costs over the period in which our insurance subsidiaries earn the related premiums. The method we follow in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. This method gives effect to the premiums to be earned, related investment income, losses and loss expenses and certain other costs we expect to incur as our insurance subsidiaries earn the premiums.
Results of Operations - Three Months Ended June 30, 2017 Compared to Three Months Ended June 30, 2016
Net Premiums Written. Our insurance subsidiaries’ net premiums written for the three months ended June 30, 2017 were $190.8 million, an increase of $12.5 million, or 7.0%, from the $178.2 million of net premiums written for the second quarter of 2016. We attribute the increase primarily to the impact of premium rate increases and an increase in the writing of new accounts in both personal and commercial lines of business. Personal lines net premiums written increased $8.7 million, or 8.9%, for the second quarter of 2017 compared to the second quarter of 2016. We attribute the increase in personal lines primarily to an increase in new business and premium rate increases our insurance subsidiaries implemented throughout 2016 and 2017. Commercial lines net premiums written increased $3.8 million, or 4.7%, for the second quarter of 2017 compared to the second quarter of 2016. We attribute the increase in commercial lines primarily to premium rate increases and increased writings of new commercial accounts.
Net Premiums Earned. Our insurance subsidiaries’ net premiums earned for the second quarter of 2017 were $175.0 million, an increase of $13.1 million, or 8.1%, compared to $161.9 million for the second quarter of 2016, reflecting increases in net premiums written during 2017 and 2016. Our insurance subsidiaries earn premiums and recognize them as revenue over the terms of their policies, which are one year or less in duration. Therefore, increases or decreases in net premiums earned generally reflect increases or decreases in net premiums written in the preceding 12-month period compared to the comparable period one year earlier.
Investment Income. Our net investment income increased to $5.6 million for the second quarter of 2017, compared to $5.3 million for the second quarter of 2016. We attribute the increase primarily to an increase in average invested assets.
Net Realized Investment Gains. Net realized investment gains for the second quarter of 2017 were $1.1 million, compared to $715,177 for the second quarter of 2016. The net realized investment gains for the second quarter of 2017 resulted primarily from strategic sales of equity securities within our investment portfolio and unrealized gains within a limited partnership that
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invests in equity securities. The net realized investment gains for the second quarter of 2016 resulted primarily from calls and strategic sales of fixed maturities and equity securities within our investment portfolio. We did not recognize any impairment losses in our investment portfolio during the second quarters of 2017 or 2016.
Equity in Earnings of DFSC. Our equity in the earnings of DFSC was $386,615 for the second quarter of 2017, compared to $305,475 for the second quarter of 2016.
Losses and Loss Expenses. Our insurance subsidiaries’ loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, for the second quarter of 2017 was 73.1%, an increase from our insurance subsidiaries’ loss ratio of 63.7% for the second quarter of 2016. We attribute this increase primarily to an increase in weather-related losses for the second quarter of 2017 to $20.1 million, compared to $11.2 million for the second quarter of 2016. On a statutory basis, our insurance subsidiaries’ commercial lines loss ratio was 62.1% for the second quarter of 2017, compared to 58.5% for the second quarter of 2016, primarily due to an increase in the commercial multi-peril loss ratio. The personal lines statutory loss ratio of our insurance subsidiaries increased to 81.8% for the second quarter of 2017, compared to 68.3% for the second quarter of 2016. We attribute this increase primarily to an increase in the homeowners and personal automobile loss ratios. Our insurance subsidiaries experienced unfavorable loss reserve development of approximately $5.8 million during the second quarter of 2017 in their reserves for prior accident years, compared to approximately $3.7 million during the second quarter of 2016. The development occurred primarily from higher-than-expected severity in the commercial multi-peril and commercial automobile liability lines of business, offset by lower-than-expected severity in the workers’ compensation line of business, in accident years prior to 2017.
Underwriting Expenses. The expense ratio for an insurance company is the ratio of policy acquisition costs and other underwriting expenses to premiums earned. The expense ratio of our insurance subsidiaries was 32.6% for the second quarter of 2017, compared to 32.8% for the second quarter of 2016.
Combined Ratio. The combined ratio represents the sum of the loss ratio, the expense ratio and the dividend ratio, which is the ratio of policyholder dividends incurred to premiums earned. Our insurance subsidiaries’ combined ratios were 106.4% and 97.0% for the three months ended June 30, 2017 and 2016, respectively. We attribute the increase in the combined ratio to an increase in the loss ratio for the second quarter of 2017 compared to the second quarter of 2016.
Interest Expense. Our interest expense for the second quarter of 2017 was $382,958, compared to $403,882 for the second quarter of 2016. We attribute the decrease to lower average borrowings during the second quarter of 2017 compared to the second quarter of 2016.
Income Taxes. Income tax benefit was $1.1 million for the second quarter of 2017. We recorded the the income tax benefit based upon our loss before income tax and tax-exempt interest income for the second quarter of 2017. Income tax expense was $3.5 million for the second quarter of 2016, representing an effective tax rate of 28.7% . The effective tax rate in both periods represented an estimate based on our projected annual taxable income.
Net (Loss) Income and (Loss) Earnings Per Share. Our net loss for the second quarter of 2017 was $2.3 million, or $.08 per share of Class A common stock on a diluted basis and $.08 per share of Class B common stock, compared to net income of $8.6 million, or $.32 per share of Class A common stock on a diluted basis and $.30 per share of Class B common stock, for the second quarter of 2016. We had 21.7 million and 20.9 million Class A shares outstanding at June 30, 2017 and 2016, respectively. We had 5.6 million Class B shares outstanding at the end of both periods.
Results of Operations - Six Months Ended June 30, 2017 Compared to Six Months Ended June 30, 2016
Net Premiums Written. Our insurance subsidiaries’ net premiums written for the six months ended June 30, 2017 were $375.3 million, an increase of $27.0 million, or 7.7%, from the $348.3 million of net premiums written for the first half of 2016. We attribute the increase primarily to the impact of premium rate increases and an increase in the writing of new accounts in both personal and commercial lines of business. Personal lines net premiums written increased $15.1 million, or 8.2%, for the first half of 2017 compared to the first half of 2016. The increase was attributable primarily to an increase in new business and premium rate increases our insurance subsidiaries implemented throughout 2016 and 2017. Commercial lines net premiums written increased $11.9 million, or 7.2%, for the first half of 2017 compared to the first half of 2016. The increase was primarily attributable to premium rate increases and increased writings of new commercial accounts.
Net Premiums Earned. Our insurance subsidiaries’ net premiums earned for the first half of 2017 were $344.2 million, an increase of $23.8 million, or 7.4%, compared to $320.4 million for the first half of 2016, reflecting increases in net premiums written during 2017 and 2016. Our insurance subsidiaries earn premiums and recognize them as revenue over the terms of their policies, which are one year or less in duration. Therefore, increases or decreases in net premiums earned generally reflect increases or decreases in net premiums written in the preceding 12-month period compared to the comparable period one year earlier.
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Investment Income. Our net investment income increased to $11.4 million for the first half of 2017, compared to $10.9 million for the first half of 2016. We attribute the increase primarily to an increase in average invested assets.
Net Realized Investment Gains. Net realized investment gains for the first half of 2017 were $3.6 million, compared to $1.2 million for the first half of 2016. The net realized investment gains for the first half of 2017 resulted primarily from strategic sales of equity securities within our investment portfolio and unrealized gains within a limited partnership that invests in equity securities. The net realized investment gains for the first half of 2016 resulted primarily from calls and strategic sales of fixed maturities and equity securities within our investment portfolio. We did not recognize any impairment losses in our investment portfolio during the first half of 2017 or 2016.
Equity in Earnings of DFSC. Our equity in the earnings of DFSC was $619,565 for the first half of 2017, compared to $340,702 for the first half of 2016. We attribute the increase in DFSC’s earnings primarily to higher net interest income related to loan portfolio growth that DFSC achieved during 2017.
Losses and Loss Expenses. Our insurance subsidiaries’ loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, for the first half of 2017 was 70.4%, an increase from our insurance subsidiaries’ loss ratio of 62.0% for the first half of 2016. We attribute this increase primarily to an increase in weather-related losses for the first half of 2017 to $34.3 million, compared to $18.1 million for the first half of 2016. On a statutory basis, our insurance subsidiaries’ commercial lines loss ratio was 62.7% for the first half of 2017, compared to 57.7% for the first half of 2016, primarily due to an increase in the commercial multi-peril and commercial automobile loss ratios. The personal lines statutory loss ratio of our insurance subsidiaries increased to 76.8% for the first half of 2017, compared to 65.6% for the first half of 2016, primarily due to an increase in the homeowners and personal automobile loss ratios. Our insurance subsidiaries experienced unfavorable loss reserve development of approximately $8.4 million during the first half of 2017 in their reserves for prior accident years, compared to approximately $3.7 million during the first half of 2016. The development occurred primarily from higher-than-expected severity in the commercial multi-peril and commercial automobile liability lines of business, offset by lower-than-expected severity in the workers’ compensation line of business, in accident years prior to 2017.
Underwriting Expenses. The expense ratio for an insurance company is the ratio of policy acquisition costs and other underwriting expenses to premiums earned. The expense ratio of our insurance subsidiaries was 32.9% for the first half of 2017, compared to 33.0% for the first half of 2016.
Combined Ratio. The combined ratio represents the sum of the loss ratio, the expense ratio and the dividend ratio, which is the ratio of policyholder dividends incurred to premiums earned. Our insurance subsidiaries’ combined ratios were 103.9% and 95.5% for the six months ended June 30, 2017 and 2016, respectively. We attribute the increase in the combined ratio to an increase in the loss ratio for the first half of 2017 compared to the first half of 2016.
Interest Expense. Our interest expense for the first half of 2017 was $746,633, compared to $812,362 for the first half of 2016. We attribute the decrease to lower average borrowings during the first half of 2017 compared to the first half of 2016.
Income Taxes. Income tax expense was $542,190 for the first half of 2017, representing an effective tax rate of 16.3%, compared to income tax expense of $7.6 million for the first half of 2016, representing an effective tax rate of 27.2% . The effective tax rate in both periods represented an estimate based on our projected annual taxable income. The decrease in our effective tax rate was primarily due to tax-exempt interest income representing a larger proportion of income before income tax expense for the first half of 2017 compared to the first half of 2016.
Net Income and Earnings Per Share. Our net income for the first half of 2017 was $2.8 million, or $.10 per share of Class A common stock on a diluted basis and $.09 per share of Class B common stock, compared to net income of $20.4 million, or $.78 per share of Class A common stock on a diluted basis and $.72 per share of Class B common stock, for the first half of 2016. We had 21.7 million and 20.9 million Class A shares outstanding at June 30, 2017 and 2016, respectively. We had 5.6 million Class B shares outstanding at the end of both periods.
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Liquidity and Capital Resources
Liquidity is a measure of an entity’s ability to secure enough cash to meet its contractual obligations and operating needs as such obligations and needs arise. Our major sources of funds from operations are the net cash flows we generate from our insurance subsidiaries’ underwriting results, investment income and investment maturities.
Our operations have historically generated sufficient net positive cash flow to fund our commitments and add to our investment portfolio, thereby increasing future investment returns and enhancing our liquidity. The impact of the pooling agreement between Donegal Mutual and Atlantic States has historically been cash-flow positive because of the consistent underwriting profitability of the pool. Donegal Mutual and Atlantic States settle their respective obligations to each other under the pool monthly, thereby resulting in cash flows substantially similar to the cash flows that would result from each company writing the business directly. We have not experienced any unusual variations in the timing of claim payments associated with the loss reserves of our insurance subsidiaries. We maintain significant liquidity in our investment portfolio in the form of readily marketable fixed maturities, equity securities and short-term investments. We structure our fixed-maturity investment portfolio following a “laddering” approach, so that projected cash flows from investment income and principal maturities are evenly distributed from a timing perspective, thereby providing an additional measure of liquidity to meet our obligations should an unexpected variation occur in the future. Our operating activities provided net cash flows in the first six months of 2017 and 2016 of $44.4 million and $27.5 million, respectively.
At June 30, 2017, we had $34.0 million in outstanding borrowings under our line of credit with M&T and had the ability to borrow an additional $26.0 million at interest rates equal to M&T’s current prime rate or the then current LIBOR rate plus 2.25%. The interest rate on these borrowings was 3.48% at June 30, 2017. At June 30, 2017, Atlantic States had $35.0 million in outstanding advances with the FHLB of Pittsburgh. The interest rate on these advances was 1.25% at June 30, 2017.
The following table shows our expected payments for significant contractual obligations at June 30, 2017:
Net liability for unpaid losses and loss expenses of our insurance subsidiaries
Total contractual obligations
We estimate the date of payment for the net liability for unpaid losses and loss expenses of our insurance subsidiaries based on historical experience and expectations of future payment patterns. We show the liability net of reinsurance recoverable on unpaid losses and loss expenses to reflect expected future cash flows related to such liability. Amounts Atlantic States assumes pursuant to the pooling agreement with Donegal Mutual represent a substantial portion of our insurance subsidiaries’ gross liability for unpaid losses and loss expenses, and amounts Atlantic States cedes pursuant to the pooling agreement represent a substantial portion of our insurance subsidiaries’ reinsurance recoverable on unpaid losses and loss expenses. We include cash settlement of Atlantic States’ assumed liability from the pool in monthly settlements of pooled activity, as we net amounts ceded to and assumed from the pool. Although Donegal Mutual and we do not anticipate any changes in the pool participation levels in the foreseeable future, any such change would be prospective in nature and therefore would not impact the timing of expected payments by Atlantic States for its percentage share of pooled losses occurring in periods prior to the effective date of such change.
We discuss in Note 7 - Borrowings our estimate of the timing of the amounts payable for the borrowings under our lines of credit based on their contractual maturities. The borrowings under our lines of credit carry interest rates that vary as we discuss in Note 7 – Borrowings. Based upon the interest rates in effect at June 30, 2017, our annual interest cost associated with the borrowings under our lines of credit is approximately $1.7 million. For every 1% change in the interest rate associated with the borrowings under our lines of credit, the effect on our annual interest cost would be approximately $690,000.
We discuss in Note 7 - Borrowings our estimate of the timing of the amounts payable for the subordinated debentures based on their contractual maturity. The subordinated debentures carry an interest rate of 5%, and any repayment of principal or payment of interest on the subordinated debentures requires prior approval of the Michigan Department of Insurance and Financial Services. Our annual interest cost associated with the subordinated debentures is approximately $250,000.
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On July 18, 2013, our board of directors authorized a share repurchase program pursuant to which we have the authority to purchase up to 500,000 shares of our Class A common stock at prices prevailing from time to time in the open market subject to the provisions of applicable rules of the SEC and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program during the six months ended June 30, 2017 and 2016 . We have purchased a total of 57,658 shares of our Class A common stock under this program from its inception through June 30, 2017.
On July 20, 2017, our board of directors declared quarterly cash dividends of 14 cents per share of our Class A common stock and 12.25 cents per share of our Class B common stock, payable on August 15, 2017 to our stockholders of record as of the close of business on August 1, 2017. We are not subject to any restrictions on our payment of dividends to our stockholders, although there are state law restrictions on the payment of dividends by our insurance subsidiaries to us. Dividends from our insurance subsidiaries are our principal source of cash for payment of dividends to our stockholders. Our insurance subsidiaries are subject to regulations that restrict the payment of dividends from statutory surplus and may require prior approval of their domiciliary insurance regulatory authorities. Our insurance subsidiaries are also subject to risk based capital (“RBC”) requirements that limit their ability to pay dividends to us. Our insurance subsidiaries’ statutory capital and surplus at December 31, 2016 exceeded the amount of statutory capital and surplus necessary to satisfy regulatory requirements, including the RBC requirements, by a significant margin. Our insurance subsidiaries paid $5.5 million in dividends to us during the first six months of 2017. Amounts remaining available for distribution to us as dividends from our insurance subsidiaries without prior approval of their domiciliary insurance regulatory authorities in 2017 are $20.3 million from Atlantic States, $3.3 million from Southern, $2.6 million from Le Mars, $1.6 million from Peninsula, $643,035 from Sheboygan and $5.0 million from MICO, or a total of approximately $33.4 million.
At June 30, 2017, we had no material commitments for capital expenditures.
Equity Price Risk
Our portfolio of marketable equity securities, which we carry on our consolidated balance sheets at estimated fair value, has exposure to the risk of loss resulting from an adverse change in prices. We manage this risk by having our investment personnel perform an analysis of prospective investments and regular reviews of our portfolio of equity securities.
Credit Risk
Our portfolio of fixed-maturity securities and, to a lesser extent, our portfolio of short-term investments is subject to credit risk, which we define as the potential loss in market value resulting from adverse changes in the borrower’s ability to repay its debt. We manage this risk by having our investment personnel perform an analysis of prospective investments and regular reviews of our portfolio of fixed-maturity securities. We also limit the percentage and amount of our total investment portfolio that we invest in the securities of any one issuer.
Our insurance subsidiaries provide property and casualty insurance coverages through independent insurance agencies. We bill the majority of this business directly to the insured, although we bill a portion of our commercial business through licensed insurance agents to whom our insurance subsidiaries extend credit in the normal course of business.
Because the pooling agreement does not relieve Atlantic States of primary liability as the originating insurer, Atlantic States is subject to a concentration of credit risk arising from the business it cedes to Donegal Mutual. Our insurance subsidiaries maintain reinsurance agreements with Donegal Mutual and with a number of other major unaffiliated authorized reinsurers.
Impact of Inflation
We establish property and casualty insurance premium rates before we know the amount of unpaid losses and loss expenses or the extent to which inflation may impact such losses and expenses. Consequently, our insurance subsidiaries attempt, in establishing rates, to anticipate the potential impact of inflation.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
Our market risk generally represents the risk of gain or loss that may result from the potential change in the fair value of the securities we hold in our investment portfolio as a result of fluctuations in prices and interest rates and, to a lesser extent, our debt obligations. We manage our interest rate risk by maintaining an appropriate relationship between the average duration of our investment portfolio and the approximate duration of our liabilities, i.e., policy claims of our insurance subsidiaries and our debt obligations.
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There have been no material changes to our quantitative or qualitative market risk exposure from December 31, 2016 through June 30, 2017.
Item 4. Controls and Procedures.
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Based on such evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that, at June 30, 2017, our disclosure controls and procedures were effective in recording, processing, summarizing and reporting, on a timely basis, information we are required to disclose in the reports that we file or submit under the Exchange Act, and our disclosure controls and procedures were also effective to ensure that information we disclose in the reports we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, to allow timely decisions regarding required disclosure.
Changes in Internal Control Over Financial Reporting
There has been no change in our internal control over financial reporting during the quarter covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to affect materially, our internal control over financial reporting.
Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995
We base all statements contained in this Quarterly Report on Form 10-Q that are not historic facts on our current expectations. Such statements are forward-looking in nature (as defined in the Private Securities Litigation Reform Act of 1995) and necessarily involve risks and uncertainties. Forward-looking statements we make may be identified by our use of words such as “will,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “seeks,” “estimates” and similar expressions. Our actual results could vary materially from our forward-looking statements. The factors that could cause our actual results to vary materially from the forward-looking statements we have previously made include, but are not limited to, adverse and catastrophic weather events, our ability to maintain profitable operations, the adequacy of the loss and loss expense reserves of our insurance subsidiaries, business and economic conditions in the areas in which we and our insurance subsidiaries operate, interest rates, competition from various insurance and other financial businesses, terrorism, the availability and cost of reinsurance, legal and judicial developments, changes in regulatory requirements, our ability to integrate and manage successfully the companies we may acquire from time to time and the other risks that we describe from time to time in our filings with the SEC. We disclaim any obligation to update such statements or to announce publicly the results of any revisions that we may make to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.
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Part II. Other Information
Item 1. Legal Proceedings.
None.
Item 1A. Risk Factors.
Our business, results of operations and financial condition, and, therefore, the value of our Class A common stock and our Class B common stock, are subject to a number of risks. For a description of certain risks, we refer to “Risk Factors” in our 2016 Annual Report on Form 10-K we filed with the SEC on March 10, 2017. There have been no material changes in the risk factors we disclosed in that Form 10-K Report during the six months ended June 30, 2017.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
Item 3. Defaults upon Senior Securities.
Item 4. Removed and Reserved.
Item 5. Other Information.
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Item 6. Exhibits.
Exhibit No.
Description
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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.
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