FORM 10-Q
UNITED STATESSECURITIES AND EXCHANGE COMMISSION
(Mark One)
For the quarterly period ended June 30, 2004
OR
For the transition period from to .
Commission file number 0-15341
Donegal Group Inc.
1195 River Road, P.O. Box 302, Marietta, PA 17547-0302
(717) 426-1931
Not applicable
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 [x]. No [ ].
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes [ ]. No [x].
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 10,124,548 shares of Class A Common Stock, par value $0.01 per share, and 3,100,398 shares of Class B Common Stock, par value $0.01 per share, outstanding on August 3, 2004.
Part I. Financial Information
Item 1. Financial Statements.
Donegal Group Inc. and Subsidiaries
See accompanying notes to consolidated financial statements.
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Consolidated Statements of Comprehensive Income
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[Continued from above table, first column(s) repeated]
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DONEGAL GROUP INC. AND SUBSIDIARIES(Unaudited)
1 - Organization
We were organized as a regional insurance holding company by Donegal Mutual Insurance Company (the “Mutual Company”) on August 26, 1986. We operate predominantly as an underwriter of personal and commercial lines of property and casualty insurance through our subsidiaries. Our personal lines products consist primarily of homeowners and private passenger automobile insurance policies. Our commercial lines products consist primarily of commercial automobile, commercial multiple peril and workers’ compensation insurance policies. We distribute our products exclusively through a network of independent insurance agents in the Mid-Atlantic, Midwest and Southeastern states. Our wholly owned insurance subsidiaries include Atlantic States Insurance Company (“Atlantic States”), Southern Insurance Company of Virginia (“Southern”), and, since January 1, 2004, Le Mars Insurance Company (“Le Mars”) and the Peninsula Insurance Group (“Peninsula”), which consists of Peninsula Indemnity Company and The Peninsula Insurance Company. We also own 47.5% of the outstanding stock of Donegal Financial Services Corporation (“DFSC”), a thrift holding company. The Mutual Company owns the remaining 52.5% of the outstanding stock of DFSC.
At June 30, 2004, the Mutual Company held approximately 41% of our outstanding Class A common stock and approximately 63% of our outstanding Class B common stock. We refer to the Mutual Company and our insurance subsidiaries as the Donegal Insurance Group.
Atlantic States, our largest subsidiary, and the Mutual Company have a pooling agreement under which both companies are allocated a given percentage of their combined underwriting results, excluding certain reinsurance assumed by the Mutual Company from our insurance subsidiaries. Atlantic States has a 70% share of the results of the pool, and the Mutual Company has a 30% share of the results of the pool.
In addition to the pooling agreement and third-party reinsurance, Atlantic, Southern and Le Mars have various reinsurance arrangements with the Mutual Company. These agreements include:
The retrocessional agreements are intended to ensure that Southern and Le Mars receive the same A.M. Best rating, currently A (Excellent), as the Mutual Company. The retrocessional agreements do not otherwise provide for pooling or reinsurance with or by the Mutual Company and do not transfer insurance risk.
In June 2002, the Mutual Company consummated an affiliation with Le Mars. As part of the affiliation, the Mutual Company entered into a management agreement with and made a $4.0 million surplus note investment in Le Mars. During 2003, Le Mars’ board of directors adopted a plan of conversion to convert to a stock insurance company. Following policyholder and regulatory approval of the plan of conversion, we acquired all of the outstanding stock of Le Mars as of January 1, 2004 for approximately $12.9 million in cash, including payment of the surplus note ($4.0 million) and accrued interest ($392,740) to the Mutual Company. The results of Le Mars have been included in our consolidated financial statements since January 1, 2004.
The acquisition of Le Mars enables us to conduct our insurance business in four Midwest states. Le Mars, which was organized under the laws of Iowa in 1901, operates as a property and casualty insurer in Iowa, Nebraska, Oklahoma and South Dakota. Personal lines coverages represent a majority of Le Mars’ premiums written, with the balance coming from farmowners and mercantile and service businesses. Le
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Mars’ largest lines of business are private passenger automobile liability and physical damage; its other principal lines are homeowners and commercial multiple peril. Le Mars had net premiums earned of $20.5 million in 2002 and $17.9 million in 2003. Le Mars’ surplus and total admitted assets on a statutory basis as of December 31, 2003 were $12.0 million and $37.0 million, respectively. The purchase price of Le Mars was based upon an independent valuation as of July 31, 2003. In applying GAAP purchase accounting standards as of January 1, 2004, we recognized an extraordinary gain in the amount of $5.4 million related to unallocated negative goodwill resulting from this acquisition. A substantial portion of this unallocated negative goodwill was generated by the recognition of anticipated federal income tax benefits that we expect to realize over the allowable twenty-year carryover period by offsetting the net operating loss carryover obtained as part of the acquisition of Le Mars against taxable income generated by our other consolidated affiliates. We have determined that a valuation allowance is required for a portion of the acquired net operating loss carryover, because federal tax laws limit the amount of such carryover that can be utilized. Other factors that generated negative goodwill include favorable operating results and increases in the market values of invested assets in the period between the valuation date and the acquisition date.
As of January 1, 2004, we purchased all of the outstanding stock of Peninsula Indemnity Company and The Peninsula Insurance Company, both of which are organized under Maryland law, with headquarters in Salisbury, Maryland, from Folksamerica Holding Company, Inc. (“Folksamerica”), a part of the White Mountains Insurance Group, Ltd., for a price in cash equal to 107.5% of Peninsula’s GAAP stockholders’ equity as of the closing of the acquisition, or approximately $23.4 million. The results of Peninsula have been included in our consolidated financial statements since January 1, 2004.
Peninsula expands our presence in existing markets, operating primarily in Maryland, Delaware and Virginia. Peninsula specializes in private passenger automobile coverages and also writes homeowners, commercial multiple peril, workers’ compensation and commercial automobile coverages. For the years ended December 31, 2002 and 2003, Peninsula had net premiums earned of $29.7 million and $32.7 million, respectively. Peninsula’s surplus and total admitted assets on a statutory basis as of December 31, 2003 were $19.5 million and $52.6 million, respectively. We recorded goodwill of $374,968 related to this acquisition, none of which is expected to be deductible for federal income tax purposes. Pursuant to terms of the purchase agreement, Folksamerica has guaranteed us against any deficiency in the loss and loss expense reserves of Peninsula as of January 1, 2004 in excess of $1.5 million. Any such deficiency will be based on a final actuarial review of the development of such reserves to be conducted four years after January 1, 2004. The maximum obligation of Folksamerica to us under this guarantee is $4.0 million.
The following table presents financial information related to the results of operations of Le Mars and Peninsula for the three and six months ended June 30, 2004. Prior to our acquisition of Le Mars and Peninsula, their quarterly financial statements were prepared in accordance with statutory accounting practices (SAP). Therefore, financial information prepared in accordance with generally accepted accounting principles (GAAP) necessary to prepare supplemental pro forma information was unavailable for the three and six months ended June 30, 2003.
2 - Basis of Presentation
The financial information for the interim periods included herein is unaudited; however, such information reflects all adjustments, consisting only of normal recurring adjustments, that, in the opinion of management, are necessary for a fair presentation of our financial position, results of operations and cash
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flows for the interim periods included herein. Our results of operations for the three and six months ended June 30, 2004 are not necessarily indicative of our results of operations to be expected for the twelve months ending December 31, 2004.
These interim financial statements should be read in conjunction with the financial statements and notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2003.
3 - Earnings Per Share
The computation of basic and diluted earnings per share is as follows:
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The following options to purchase shares of Class A common stock were not included in the computation of diluted earnings per share because the exercise price of the options was greater than the average market price during the relevant period:
4 - Segment Information
We evaluate the performance of our personal lines and commercial lines based upon underwriting results as determined under SAP, which is used by management to measure performance for our total business. Financial data by segment is as follows:
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5- Subordinated Debentures
On May 15, 2003, we received $15.0 million in net proceeds from the issuance of subordinated debentures. The debentures mature on May 15, 2033 and are callable at our option, at par, after five years. The debentures carry an interest rate equal to the three-month LIBOR rate plus 4.10%, which is adjustable quarterly. At June 30, 2004, the interest rate on the debentures was 5.35%.
On October 29, 2003, we received $10.0 million in net proceeds from the issuance of subordinated debentures. The debentures mature on October 29, 2033 and are callable at our option, at par, after five years. The debentures carry an interest rate equal to the three-month LIBOR rate plus 3.85%, which is adjustable quarterly. At June 30, 2004, the interest rate on the debentures was 5.02%.
On May 24, 2004, we received $5.0 million in net proceeds from the issuance of subordinated debentures. The debentures mature on May 24, 2034 and are callable at our option, at par, after five years. The debentures carry an interest rate equal to the three-month LIBOR rate plus 3.85%, which is adjustable quarterly. At June 30, 2004, the interest rate on the debentures was 5.02%.
6- Stock–Based Compensation Plans
We account for stock-based compensation plans under the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. During 2001, we adopted an Equity Incentive Plan for key employees that made 1,500,000 shares of Class A common stock available. The plan provides for the granting of awards by our board of directors in the form of stock options, stock appreciation rights, restricted stock or any combination of the above. During 2001, we also adopted an Equity Incentive Plan for Directors that made 200,000 shares of Class A common stock available. Awards may be made in the form of stock options, and the plan further provides for the issuance of 175 shares of restricted stock to each director on the first business day of January in each year. No stock-based employee compensation is reflected in income, except for expense associated with restricted stock issued, as all options granted under those plans had an exercise price equal to, or greater than, the market value of the underlying common stock on the date of the grant. The following table illustrates the effect on net income and earnings per share as if we had applied the provisions of Statement of Financial Accounting Standards (SFAS) No. 123 (as amended by SFAS No. 148), “Accounting for Stock-Based Compensation.”
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Results of Operations - Three Months Ended June 30, 2004 Compared to Three Months Ended June 30, 2003
Net Premiums Written. Net premiums written for the three months ended June 30, 2004 were $73.8 million, compared to $53.2 million for the same period in 2003. Commercial lines net premiums written increased $9.2 million, or 47.7%, in the second quarter of 2004 compared to the comparable period in 2003. Personal lines net premiums written increased $11.4 million, or 33.6%, in the second quarter of 2004 compared to the comparable period in 2003. The acquisition of Le Mars and Peninsula as of January 1, 2004 accounted for approximately $14.8 million of net premiums written in the second quarter of 2004, or approximately 71.8% of the increase from the comparable period in 2003. We have also benefited during these periods, and expect to continue to benefit, from premium increases by our insurance subsidiaries that have resulted from rate filings approved by insurance regulatory authorities. These increases related primarily to private passenger automobile, commercial multiple peril, workers’ compensation and homeowners lines of business realized in most of the states in which we operate. In addition to the acquisitions and pricing increases, we have also benefited from organic growth in most of the states in which we operate.
Net Premiums Earned. Net premiums earned increased to $65.5 million for the second quarter of 2004, an increase of $17.1 million, or 35.2%, over the second quarter of 2003. Premiums are earned, or recognized as revenue, over the terms of our policies, which are one year or less in duration. Therefore, increases or decreases in net premiums earned will generally reflect increases or decreases in net premiums written in the preceding twelve-month period compared to the comparable period one year earlier. Earned premiums have grown during the 2004 period due to the acquisition of Le Mars and Peninsula as well as due to the increase in written premiums in the past year. Net premiums earned and amortization of deferred policy acquisition costs decreased $1.0 million during the second quarter of 2004 because of the application of purchase accounting methodology in the acquisition of Le Mars and Peninsula. Acquired deferred acquisition costs were netted from unearned premiums as of January 1, 2004. Since these costs were incurred prior to January 1, 2004, they were netted from the associated deferred revenues in estimating the fair value of the unearned premiums assumed in the acquisitions. As a result, the normal amortization of these costs was shown as a reduction of net premiums earned in the three months ended June 30, 2004. The amortization of deferred acquisition costs was correspondingly reduced, so that there was no impact on net income for the period.
Investment Income. For the three months ended June 30, 2004, our net investment income increased 15.9% to $3.8 million, compared to $3.3 million for the comparable period one year ago. An increase in average invested assets from $352.0 million in the second quarter of 2003 to $484.3 million in the second quarter of 2004 was offset by a decrease in the annualized average return on investments from 3.8% for the second quarter of 2003 to 3.2% for the second quarter of 2004. The decrease in our annualized average return reflects higher levels of short-term investments in our investment portfolio during
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the second quarter of 2004 compared to the comparable period a year earlier and a declining interest rate environment in both periods.
Net Realized Investment Gains/Losses. Net realized investment gains in the second quarter of 2004 were $175,555, compared to $216,370 for the comparable period in 2003. No impairment charges were recognized in the second quarter of 2004, compared to impairment charges of $14,225 recognized in the second quarter of 2003. The impairment charges in 2003 were the result of declines in the market value of equity securities that we determined to be other than temporary. The remaining net realized investment gains and losses in both periods resulted from normal turnover within our investment portfolio.
Losses and Loss Expenses. Our loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, in the second quarter of 2004 was 61.0%, compared to 61.2% in the second quarter of 2003. The commercial lines loss ratio improved to 53.0% in the second quarter of 2004, compared to 57.2% in the second quarter of 2003 due to favorable experience in our commercial automobile and workers’ compensation lines of business. The personal lines loss ratio increased from 63.2% in the second quarter of 2003 to 66.2% in the second quarter of 2004, primarily due to an increase in our homeowners loss ratio that was largely attributable to claims from a severe weather event in the Midwest. Our loss ratios were also impacted in the second quarter of 2004 by the reduction in earned premiums during the second quarter of 2004 related to the application of purchase accounting methodology in the acquisition of Le Mars and Peninsula discussed above.
Underwriting Expenses. Our expense ratio, which is the ratio of policy acquisition costs and other underwriting expenses to premiums earned, for the second quarter of 2004 was 30.7%, compared to 30.6% in the second quarter of 2003. The increase in the second quarter of 2004 expense ratio reflects increased underwriting-based incentive costs, offset by a decrease in expenses related to the application of purchase accounting methodology in the acquisition of Le Mars and Peninsula discussed above. The acquired deferred acquisition costs were netted from unearned premiums as of the purchase date and, as a result, the amortization of these costs was shown as a reduction of earned premiums instead of being shown as a component of expenses in the current period.
Combined Ratio. The combined ratio was 91.8% and 92.3% for the three months ended June 30, 2004 and 2003, respectively. The combined ratio represents the sum of the loss ratio, expense ratio and dividend ratio, which is the ratio of workers’ compensation policy dividends incurred to premiums earned. The improvement in the combined ratio was largely attributable to the decreases in the loss and dividend ratios for the 2004 period compared to the 2003 period.
Interest Expense. Interest expense for the second quarter of 2004 was $360,031, compared to $306,790 for the second quarter of 2003, and reflected an increase in interest expense related to the issuance of $15.5 million of subordinated debentures in October 2003 and May 2004, offset by the fact that no borrowings were outstanding under our line of credit for the 2004 period compared to average borrowings of $17.5 million for the 2003 period.
Income Taxes. Income tax expense was $3.0 million for the second quarter of 2004, representing an effective tax rate of 30.5%, compared to $2.2 million for the second quarter of 2003, representing an effective tax rate of 29.5%. The change in effective tax rates is due to tax-exempt interest income representing a smaller proportion of net income before taxes in the 2004 period compared to the 2003 period.
Net Income and Earnings Per Share. Our net income for the second quarter of 2004 was $6.8 million, or $.50 per share on a diluted basis, an increase of 28.5% over the net income of $5.3 million, or $.56 per share on a diluted basis, reported for the second quarter of 2003. Our fully diluted shares outstanding for the second quarter of 2004 increased to 13.6 million, compared to 9.4 million for the second quarter of 2003, due primarily to a public stock offering of 3.45 million shares of Class A common stock that was completed in December 2003.
Results of Operations - Six Months Ended June 30, 2004 Compared to Six Months Ended June 30, 2003
Net Premiums Written. Net premiums written for the six months ended June 30, 2004 were $142.2 million, compared to $103.5 million for the comparable period in 2003. Commercial lines net premiums
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written increased $16.8 million, or 42.4%, in the first half of 2004 compared to the comparable period in 2003. Personal lines net premiums written increased $21.9 million, or 34.2%, in the first half of 2004 compared to the comparable period in 2003. The acquisition of Le Mars and Peninsula as of January 1, 2004 accounted for approximately $29.1 million of net premiums written in 2004, or approximately 75.2% of the increase from the comparable period in 2003. We have also benefited during these periods, and expect to continue to benefit, from premium increases by our insurance subsidiaries that have resulted from rate filings approved by insurance regulatory authorities. These increases related primarily to private passenger automobile, commercial multiple peril, workers’ compensation and homeowners lines of business realized in most of the states in which we operate. In addition to the acquisitions and pricing increases, we have also benefited from organic growth in most of the states in which we operate.
Net Premiums Earned. Net premiums earned increased to $128.2 million for the first half of 2004, an increase of $31.8 million, or 33.0%, over the first half of 2003. Premiums are earned, or recognized as revenue, over the terms of our policies, which are one year or less in duration. Therefore, increases or decreases in net premiums earned will generally reflect increases or decreases in net premiums written in the preceding twelve-month period compared to the comparable period one year earlier. Earned premiums have grown during the 2004 period due to the acquisition of Le Mars and Peninsula as well as due to the increase in written premiums in the past year. Net premiums earned and amortization of deferred policy acquisition costs decreased $2.7 million during the first half of 2004 because of the application of purchase accounting methodology in the acquisition of Le Mars and Peninsula. Acquired deferred acquisition costs were netted from unearned premiums as of January 1, 2004. Since these costs were incurred prior to January 1, 2004, they were netted from the associated deferred revenues in estimating the fair value of the unearned premiums assumed in the acquisitions. As a result, the normal amortization of these costs was shown as a reduction of net premiums earned in the first half of 2004. The amortization of deferred acquisition costs was correspondingly reduced, so that there was no impact on net income for the period.
Investment Income. For the six months ended June 30, 2004, our net investment income increased 14.1% to $7.6 million, compared to $6.7 million for the comparable period one year ago. An increase in average invested assets from $346.9 million in the first half of 2003 to $451.4 million in the first half of 2004 was offset by a decrease in the annualized average return on investments from 3.9% for the first half of 2003 to 3.4% for the first half of 2004. The decrease in our annualized average return reflects higher levels of short-term investments in our investment portfolio during the first half of 2004 compared to the comparable period a year earlier and a declining interest rate environment in both periods.
Net Realized Investment Gains/Losses. Net realized investment gains in the first half of 2004 were $643,998, compared to $85,890 for the comparable period in 2003. Impairment charges of $6,650 were recognized in the first half of 2004, compared to impairment charges of $267,724 recognized in the first half of 2003. The impairment charges for both periods were the result of declines in the market value of equity securities that we determined to be other than temporary. The remaining net realized investment gains and losses in both periods resulted from normal turnover within our investment portfolio.
Losses and Loss Expenses. Our loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, in the first half of 2004 was 62.7%, compared to 63.8% in the first half of 2003. The commercial lines loss ratio increased to 57.0% in the first half of 2004, compared to 54.9% in the first half of 2003. The personal lines loss ratio improved from 68.7% in the first half of 2003 to 66.1% in the first half of 2004. An increase in our workers’ compensation loss ratio was offset by favorable experience in our commercial automobile, commercial multiple peril, personal automobile and homeowners lines of business. Our loss ratios were also impacted in the first half of 2004 by the reduction in earned premiums during the first half of 2004 related to the application of purchase accounting methodology in the acquisition of Le Mars and Peninsula discussed above.
Underwriting Expenses. Our expense ratio, which is the ratio of policy acquisition costs and other underwriting expenses to premiums earned, for the first half of 2004 was 29.2%, compared to 30.4% for the first half of 2003. The improvement in our expense ratio reflects a decrease in expenses during the first half of 2004 related to the application of purchase accounting methodology in the acquisition of Le Mars and Peninsula discussed above. The acquired deferred acquisition costs were netted from unearned premiums as of January 1, 2004 and, as a result, the amortization of these costs was shown as a reduction of earned premiums instead of being shown as a component of expenses in the first half of 2004.
Combined Ratio. The combined ratio was 92.2% and 94.7% for the six months ended June 30, 2004 and 2003, respectively. The combined ratio represents the sum of the loss ratio, expense ratio and
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dividend ratio, which is the ratio of workers’ compensation policy dividends incurred to premiums earned. The improvement in the combined ratio was largely attributable to the decreases in the loss and expense ratios for the 2004 period compared to the 2003 period.
Interest Expense. Interest expense for the first half of 2004 was $697,426, compared to $521,531 for the first half of 2003, and reflected an increase in interest expense related to the issuance of $15.5 million of subordinated debentures in October 2003 and May 2004, offset by the fact that no borrowings were outstanding under our line of credit for the 2004 period compared to average borrowings of $18.6 million for the 2003 period.
Income Taxes. Income tax expense was $5.6 million for the first half of 2004, representing an effective tax rate of 30.1%, compared to $3.4 million for the first half of 2003, representing an effective tax rate of 27.4%. The change in effective tax rates is due to tax-exempt interest income representing a smaller proportion of net income before taxes in the 2004 period compared to the 2003 period.
Net Income and Earnings Per Share. Our net income for the first half of 2004 was $18.5 million, or $1.36 per share on a diluted basis. The first half of 2004 net income included an extraordinary gain of $5.4 million related to unallocated negative goodwill associated with the Le Mars acquisition. Income before this extraordinary item was $13.1 million, or $.96 per share on a diluted basis, an increase of 43.3% over the net income of $9.1 million, or $.97 per share on a diluted basis, reported for the first half of 2003. Our fully diluted shares outstanding for the first half of 2004 increased to 13.6 million, compared to 9.4 million for the first half of 2003, due primarily to a public stock offering of 3.45 million shares of Class A common stock that was completed in December 2003.
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 they arise. Our major sources of funds from operations are the net cash flows generated from our insurance subsidiaries’ underwriting results, investment income and maturing investments.
We generate sufficient net positive cash flow from our operations to fund our commitments and build our investment portfolio, thereby increasing future investment returns. We maintain a high degree of liquidity in our investment portfolio in the form of readily marketable fixed maturities, equity securities and short-term investments. Net cash flows provided by operating activities in the first six months of 2004 and 2003 were $16.1 million and $14.3 million, respectively.
On November 25, 2003, we entered into a credit agreement with Manufacturers and Traders Trust Company (“M&T”) relating to a four-year $35.0 million unsecured, revolving line of credit. As of June 30, 2004, we may borrow up to $35.0 million at interest rates equal to M&T’s current prime rate or the then current LIBOR rate plus between 1.50% and 1.75%, depending on our leverage ratio. In addition, we pay a fee of 0.15% per annum on the loan commitment amount, regardless of usage. The agreement requires our compliance with certain covenants, which include minimum levels of our net worth, leverage ratio and statutory surplus and A.M. Best ratings of our subsidiaries. As of June 30, 2004, there were no borrowings outstanding under the credit agreement, and we were in compliance with all requirements of the credit agreement.
On May 26, 2004, we received $5.0 million in net proceeds from the issuance of subordinated debentures. The debentures mature on May 26, 2034 and are callable at our option, at par, after five years. The debentures carry an interest rate equal to the three-month LIBOR rate plus 3.85%, which is adjustable quarterly. At June 30, 2004, the interest rate on the debentures was 5.02%.
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The following table shows our significant contractual obligations as of June 30, 2004.
On July 15, 2004, we declared regular quarterly cash dividends of 12 cents per share for our Class A common stock and 10.5 cents per share for our Class B common stock, payable August 16, 2004 to stockholders of record as of the close of business on August 2, 2004. There are no regulatory restrictions on the payment of dividends to our stockholders, although there are state law restrictions on the payment of dividends from our insurance subsidiaries to us. Our insurance subsidiaries are required by law to maintain certain minimum surplus on a statutory basis, and are subject to regulations under which payment of dividends from statutory surplus is restricted and may require prior approval of the applicable domiciliary insurance regulatory authorities. Our insurance subsidiaries are subject to risk-based capital (RBC) requirements. At December 31, 2003, our insurance subsidiaries’ capital levels were each substantially above RBC requirements. At January 1, 2004, amounts available for distribution as dividends to us from our insurance subsidiaries without prior approval of their domiciliary insurance regulatory authorities were $13.3 million from Atlantic States, $4.1 from Southern, $1.2 million from Le Mars and $1.9 million from Peninsula, all of which remained available at June 30, 2004.
As of June 30, 2004, we had no material commitments for capital expenditures.
Equity Price Risk
Our portfolio of marketable equity securities, which is carried 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 performing an analysis of prospective investments and through regular reviews of our portfolio by our investment staff.
Credit Risk
Our portfolio of fixed-maturity securities and, to a lesser extent, short-term investments is subject to credit risk. This risk is defined as the potential loss in market value resulting from adverse changes in the borrower’s ability to repay the debt. We manage this risk by performing an analysis of prospective investments and through regular reviews of our portfolio by our investment staff. We also limit the amount that any one security can constitute of our total investment portfolio.
We provide property and liability insurance coverages through independent insurance agencies located throughout our operating area. The majority of this business is billed directly to the insured, although a portion of our commercial business is billed through our agents who are extended credit in the normal course of business.
Because the pooling agreement does not relieve Atlantic States of primary liability as the originating insurer, we are subject to a concentration of credit risk arising from business ceded to the Mutual Company. Our insurance subsidiaries maintain reinsurance agreements in place with the Mutual Company and with a number of other major unaffiliated authorized reinsurers.
Impact of Inflation
Property and casualty insurance premium rates are established before the amount of losses and loss settlement expenses, or the extent to which inflation may impact such expenses, are known. Consequently, we 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 our investment portfolio as a result of fluctuations in prices and interest rates and,
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to a lesser extent, our debt obligations. We attempt to manage our interest rate risk by maintaining an appropriate relationship between the average duration of the investment portfolio and the approximate duration of our liabilities, i.e., policy claims and debt obligations.
We have maintained approximately the same duration of our investment portfolio to our liabilities from December 31, 2003 to June 30, 2004. In addition, we have maintained approximately the same investment mix during this period.
There have been no material changes to our quantitative or qualitative market risk exposure from December 31, 2003 through June 30, 2004.
Item 4. Controls and Procedures.
Evaluation of Disclosure Controls and Procedures
We conducted an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that information we (including our consolidated subsidiaries) are required to disclose in our periodic filings with the Securities and Exchange Commission is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms.
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 report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995
Certain forward-looking statements contained herein involve risks and uncertainties. These statements include certain discussions relating to underwriting, premium and investment income volume, business strategies and our business activities during 2004 and beyond. In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expect,” “plan,” “intend,” “anticipate,” “believe,” “estimate,” “project,” “predict,” “potential” and similar expressions. These forward-looking statements reflect our current views about future events, are based on assumptions and are subject to known and unknown risks and uncertainties that may cause our actual results to differ materially from those anticipated by these forward-looking statements. Many of the factors that will determine future events or our future results of operations are beyond our ability to control or predict.
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Part II. Other Information
Item 1. Legal Proceedings.
None.
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities.
Item 3. Defaults upon Senior Securities.
Item 4. Submission of Matters to a Vote of Security Holders.
Annual Stockholders meeting held April 19, 2004.
Item 5. Other Information.
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Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits
(b) Reports on Form 8-K:
On April 21, 2004, we filed a report on Form 8-K including as an exhibit our first quarter 2004 earnings press release.
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Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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