10-Q 1 r3q_10q.txt 3RD QTR 10Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q Quarterly Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934 (x) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended SEPTEMBER 30, 2000 --------------------------------------- OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _________________ to____________________ Commission File Number: 0-10956 EMC INSURANCE GROUP INC. ---------------------------------------------------- (Exact name of registrant as specified in its charter) Iowa 42-6234555 ------------------------------- ----------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 717 Mulberry Street, Des Moines, Iowa 50309 --------------------------------------- ---------- (Address of principal executive office) (Zip Code) (515) 280-2902 -------------------------------------------------- (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 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 the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class Outstanding at October 31, 2000 ----- ------------------------------- Common stock, $1.00 par value 11,293,509 Total pages 20 PART I. FINANCIAL INFORMATION ------- --------------------- ITEM 1. FINANCIAL STATEMENTS ------- -------------------- EMC INSURANCE GROUP INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS September 30, December 31, 2000 1999 ------------ ------------ ASSETS Investments: Fixed maturities: Securities held-to-maturity, at amortized cost (fair value $119,628,799 and $126,679,065) $118,789,773 $127,204,160 Securities available-for-sale, at fair value (amortized cost $286,967,854 and $263,720,333) .............................. 283,051,725 256,181,429 Equity securities available-for-sale, at fair value (cost $28,511,816 and $28,494,631) ..... 35,325,488 32,408,272 Short-term investments, at cost ................ 16,448,135 20,164,210 ------------ ------------ Total investments ..................... 453,615,121 435,958,071 Cash ............................................. 2,441,692 1,508,678 Indebtedness of related party .................... 1,415,252 - Accrued investment income ........................ 6,269,432 6,886,939 Accounts receivable (net of allowance for uncollectible accounts of $634,000 and $633,000) 766,552 3,293,537 Income taxes recoverable ......................... 841,250 1,537,000 Reinsurance receivables .......................... 12,805,859 11,129,365 Deferred policy acquisition costs ................ 16,582,105 13,619,192 Deferred income taxes ............................ 17,697,458 18,121,317 Intangible assets, including goodwill, at cost less accumulated amortization of $2,448,093 and $2,347,208 ................................. 1,109,727 1,210,612 Prepaid reinsurance premiums ..................... 2,452,528 1,280,564 Securities lending collateral (note 2) ........... 52,397,543 45,818,533 Other assets ..................................... 1,111,186 2,030,703 ------------ ------------ Total assets .......................... $569,505,705 $542,394,511 ============ ============ See accompanying Notes to Interim Consolidated Financial Statements. EMC INSURANCE GROUP INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS September 30, December 31, 2000 1999 ------------ ------------ LIABILITIES Losses and settlement expenses ................... $275,147,791 $266,514,024 Unearned premiums ................................ 78,442,065 64,991,129 Other policyholders' funds ....................... 759,480 1,093,254 Indebtedness to related party .................... - 3,886,559 Postretirement benefits .......................... 7,458,897 6,768,219 Deferred income .................................. 95,289 158,831 Securities lending obligation (note 2) ........... 52,397,543 45,818,533 Other liabilities ................................ 9,576,272 11,247,685 ------------ ------------ Total liabilities ......................... 423,877,337 400,478,234 ------------ ------------ STOCKHOLDERS' EQUITY Common stock, $1 par value, authorized 20,000,000 shares; issued and outstanding, 11,293,509 shares in 2000 and 11,265,232 shares in 1999 ... 11,293,509 11,265,232 Additional paid-in capital ....................... 65,539,981 65,333,686 Accumulated other comprehensive income (loss) .... 1,912,380 (3,625,263) Retained earnings ................................ 66,882,498 68,942,622 ------------ ------------ Total stockholders' equity ................ 145,628,368 141,916,277 ------------ ------------ Total liabilities and stockholders' equity $569,505,705 $542,394,511 ============ ============ See accompanying Notes to Interim Consolidated Financial Statements. EMC INSURANCE GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME Three months ended Nine months ended September 30, September 30, ----------------------- ------------------------- 2000 1999 2000 1999 ----------- ----------- ------------ ------------ REVENUES: Premiums earned ..........$58,617,746 $52,596,314 $167,177,512 $153,295,867 Investment income, net ... 7,328,475 6,669,304 21,508,117 19,030,740 Realized investment gains 574,984 1,313,608 904,237 1,559,775 Other income ............. 271,702 705,520 1,264,753 1,982,028 ----------- ----------- ------------ ------------ 66,792,907 61,284,746 190,854,619 175,868,410 ----------- ----------- ------------ ------------ LOSSES AND EXPENSES: Losses and settlement expenses ............... 46,971,850 44,080,785 135,845,029 126,844,057 Dividends to policyholders 630,354 729,623 1,147,760 1,711,209 Amortization of deferred policy acquisition costs 12,561,548 11,458,397 36,759,123 34,573,674 Other underwriting expenses ............... 4,852,337 4,675,398 12,846,085 13,520,600 Other expenses ........... 347,890 254,815 1,117,982 1,198,793 ----------- ----------- ------------ ------------ 65,363,979 61,199,018 187,715,979 177,848,333 ----------- ----------- ------------ ------------ Income (loss) before income tax expense (benefit) ............ 1,428,928 85,728 3,138,640 (1,979,923) ----------- ----------- ------------ ------------ INCOME TAX EXPENSE (BENEFIT): Current ................ 574,237 157,457 682,711 (860,930) Deferred ............... (349,525) (864,387) (561,305) (1,961,227) ----------- ----------- ------------ ------------ 224,712 (706,930) 121,406 (2,822,157) ----------- ----------- ------------ ------------ Net income .........$ 1,204,216 $ 792,658 $ 3,017,234 $ 842,234 =========== =========== ============ ============ Net income per common share - basic and diluted $ .11 $ .07 $ .27 $ .07 =========== =========== ============ ============ Dividends per common share $ .15 $ .15 $ .45 $ .45 =========== =========== ============ ============ Average number of common shares outstanding - basic and diluted .............. 11,290,979 11,259,339 11,281,968 11,352,828 =========== =========== ============ ============ See accompanying Notes to Interim Consolidated Financial Statements. EMC INSURANCE GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Three months ended Nine months ended September 30, September 30, ----------------------- ----------------------- 2000 1999 2000 1999 ----------- ----------- ----------- ----------- Net income ................. $ 1,204,216 $ 792,658 $ 3,017,234 $ 842,234 ----------- ----------- ----------- ----------- OTHER COMPREHENSIVE INCOME: Unrealized holding gains (losses) arising during the period, before deferred income tax expense (benefit) .. 4,639,391 (5,582,204) 7,427,043 (12,836,451) Deferred income tax expense (benefit) ...... 1,180,658 (1,168,027) 1,292,604 (3,634,473) ----------- ----------- ----------- ----------- 3,458,733 (4,414,177) 6,134,439 (9,201,978) ----------- ----------- ----------- ----------- Reclassification adjustment for gains included in net income, before income tax expense ............ (574,984) (1,305,677) (904,237) (1,551,844) Income tax expense ....... 195,495 443,930 307,441 527,627 ----------- ----------- ----------- ----------- (379,489) (861,747) (596,796) (1,024,217) ----------- ----------- ----------- ----------- Other comprehensive income (loss) .... 3,079,244 (5,275,924) 5,537,643 (10,226,195) ----------- ----------- ----------- ----------- Total comprehensive income (loss) .... $ 4,283,460 $(4,483,266)$ 8,554,877 $(9,383,961) =========== =========== =========== =========== See accompanying Notes to Interim Consolidated Financial Statements. EMC INSURANCE GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Nine months ended September 30, -------------------------- 2000 1999 ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income .................................... $ 3,017,234 $ 842,234 ------------ ------------ Adjustments to reconcile net income to net cash provided by operating activities: Losses and settlement expenses ............ 8,633,767 10,764,945 Unearned premiums ......................... 13,450,936 9,436,164 Other policyholders' funds ................ (333,774) 69,081 Deferred policy acquisition costs ......... (2,962,913) (2,259,428) Indebtedness of related party ............. (5,301,811) 730,765 Accrued investment income ................. 617,507 (36,864) Accrued income taxes: Current ................................. 695,750 2,006,000 Deferred ................................ (561,304) (1,961,227) Realized investment gains ................. (904,237) (1,559,775) Postretirement benefits ................... 690,678 566,795 Reinsurance receivables ................... (1,676,494) (1,045,812) Prepaid reinsurance premiums .............. (1,171,964) (681,938) Amortization of deferred income ........... (63,542) (93,217) Other, net ................................ 1,778,802 (4,219,194) ------------ ------------ 12,891,401 11,716,295 ------------ ------------ Net cash provided by operating activities .................. $ 15,908,635 $ 12,558,529 ------------ ------------ EMC INSURANCE GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED Nine months ended September 30, -------------------------- 2000 1999 ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of fixed maturity securities held-to-maturity ............................ $ - $(13,459,276) Maturities of fixed maturity securities held-to-maturity ............................ 8,442,086 34,723,949 Purchases of fixed maturity securities available-for-sale .......................... (39,542,271) (100,878,679) Disposals of fixed maturity securities available-for-sale .......................... 16,882,174 79,616,230 Purchases of equity securities available-for-sale .......................... (16,781,588) (17,742,273) Disposals of equity securities available-for-sale .......................... 17,150,692 17,852,208 Net sales (purchases) of short-term investments 3,716,072 (5,086,957) ------------ ------------ Net cash used in investing activities ....... (10,132,835) (4,974,798) ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES: Issuance of common stock ...................... 234,572 248,129 Repurchase of common stock .................... - (2,998,677) Dividends paid to stockholders ................ (5,077,358) (5,103,276) ------------ ------------ Net cash used in financing activities ..... (4,842,786) (7,853,824) ------------ ------------ NET INCREASE (DECREASE) IN CASH ................. 933,014 (270,093) Cash at beginning of year ....................... 1,508,678 2,133,056 ------------ ------------ Cash at end of quarter .......................... $ 2,441,692 $ 1,862,963 ============ ============ Income taxes recovered .......................... $ (13,122) $ (2,877,492) Interest paid ................................... $ 12,587 $ 107,895 See accompanying Notes to Interim Consolidated Financial Statements. EMC INSURANCE GROUP INC. AND SUBSIDIARIES NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS September 30, 2000 Note 1 ------ The results of operations for the interim periods reported are not necessarily indicative of the results to be expected for the year. The information reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the interim periods. Certain amounts previously reported in prior years' consolidated financial statements have been reclassified to conform to current year presentation. In reading these financial statements, reference should be made to the Company's 1999 Form 10-K or the 1999 Annual Report to Shareholders for more detailed footnote information. Note 2 ------ The Company participates in a securities lending program whereby certain fixed maturity securities from the investment portfolio are loaned to other institutions for short periods of time. The Company receives a fee for each security loaned out under this program and requires initial collateral, primarily cash, equal to 102 percent of the market value of the loaned securities. This collateral is recorded as an asset, along with a corresponding liability, on the Company's balance sheet. Note 3 ------ In June 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) 133, "Accounting for Derivative Instruments and Hedging Activities", effective for fiscal years beginning after June 15, 1999. In June 1999, the FASB issued SFAS 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of Effective Date of FASB Statement No. 133", which defers the effective date of SFAS 133 until fiscal years beginning after June 15, 2000. In June 2000, the FASB issued SFAS 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities - an amendment of FASB Statement No. 133". SFAS 138 addresses a limited number of Statement 133 implementation issues, and is effective for fiscal years beginning after June 15, 2000. Currently, the Company's investment strategy does not include investments in derivative instruments or hedging activities. Adoption of these statements is not expected to have any effect on the operating results of the Company. In September 2000, the FASB issued SFAS 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities - a replacement of FASB Statement No. 125". SFAS 140 is effective for transfers and servicing of financial assets and extinguishment of liabilities occurring after March 31, 2001 and for recognition and reclassification of collateral and disclosures relating to securitization transactions and collateral for fiscal years ending after December 15, 2000. Adoption of this statement is not expected to have any effect on the operating results of the Company. EMC INSURANCE GROUP INC. AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL ------- ------------------------------------------------- CONDITION AND RESULTS OF OPERATIONS ----------------------------------- OVERVIEW EMC Insurance Group Inc., an approximately 76 percent-owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance and reinsurance. Property and casualty insurance is the most significant segment, representing 81.5 percent of consolidated premiums earned. For purposes of this discussion, the term "Company" is used interchangeably to describe EMC Insurance Group Inc. (Parent Company only) and EMC Insurance Group Inc. and its subsidiaries. The Company's four property and casualty insurance subsidiaries and two subsidiaries and an affiliate of Employers Mutual are parties to reinsurance pooling agreements with Employers Mutual (collectively the "pooling agreement"). Under the terms of the pooling agreement, each company cedes to Employers Mutual all of its insurance business, with the exception of any voluntary reinsurance business assumed from nonaffiliated insurance companies, and assumes from Employers Mutual an amount equal to its participation in the pool. All losses, settlement expenses and other underwriting and administrative expenses, excluding the voluntary reinsurance business assumed by Employers Mutual from nonaffiliated insurance companies, are prorated among the parties on the basis of participation in the pool. Operations of the pool give rise to inter-company balances with Employers Mutual, which are settled on a quarterly basis. The investment and income tax activities of the pool participants are not subject to the pooling agreement. The purpose of the pooling agreement is to spread the risk of an exposure insured by any of the pool participants among all the companies. The pooling agreement produces a more uniform and stable underwriting result from year to year for all companies in the pool than might be experienced individually. In addition, each company benefits from the capacity of the entire pool, rather than being limited to policy exposures of a size commensurate with its own assets, and from the wide range of policy forms, lines of insurance written, rate filings and commission plans offered by each of the companies. A single set of reinsurance treaties is maintained for the protection of all companies in the pool. The Company's reinsurance subsidiary assumes a 100 percent quota share portion of Employers Mutual's assumed reinsurance business, exclusive of certain reinsurance contracts. This includes all premiums and related losses and settlement expenses of this business, subject to a maximum loss of $1,500,000 per event. The reinsurance subsidiary does not reinsure any of Employers Mutual's direct insurance business, nor any "involuntary" facility or pool business that Employers Mutual assumes pursuant to state law. In addition, the reinsurance subsidiary is not liable for credit risk in connection with the insolvency of any reinsurers of Employers Mutual. Operations of the quota share agreement give rise to inter-company balances with Employers Mutual, which are settled on a quarterly basis. The results of operations for the interim periods reported are not necessarily indicative of results to be expected for the year. The information reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the interim periods. EMC INSURANCE GROUP INC. AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL ------- ------------------------------------------------- CONDITION AND RESULTS OF OPERATIONS, CONTINUED ---------------------------------------------- CONSOLIDATED RESULTS OF OPERATIONS Operating results for the three months and nine months ended September 30, 2000 and 1999 are as follows: Three months ended Nine months ended September 30, September 30, ----------------- ----------------- ($ in thousands) 2000 1999 2000 1999 -------- -------- -------- -------- Premiums earned ..................... $ 58,618 $ 52,596 $167,178 $153,296 Losses and settlement expenses ...... 46,972 44,081 135,845 126,844 Acquisition and other expenses ...... 18,044 16,863 50,753 49,806 -------- -------- -------- -------- Underwriting loss ................... (6,398) (8,348) (19,420) (23,354) Net investment income ............... 7,328 6,669 21,508 19,031 Other (loss) income ................. (76) 451 147 783 -------- -------- -------- -------- Operating income (loss) before income tax expense (benefit) ...... 854 (1,228) 2,235 (3,540) Realized investment gains ........... 575 1,314 904 1,560 -------- -------- -------- -------- Income (loss) before income tax expense (benefit) ................. 1,429 86 3,139 (1,980) Income tax expense (benefit) ........ 225 (707) 122 (2,822) -------- -------- -------- -------- Net income .......................... $ 1,204 $ 793 $ 3,017 $ 842 ======== ======== ======== ======== Incurred losses and settlement expenses: Insured events of current year .. $ 48,053 $ 47,235 $140,080 $134,135 Decrease in provision for insured events of prior years (1,081) (3,154) (4,235) (7,291) -------- -------- -------- -------- Total losses and settlement expenses ....... $ 46,972 $ 44,081 $135,845 $126,844 ======== ======== ======== ======== Catastrophe and storm losses ........ $ 2,252 $ 2,117 $ 7,683 $ 8,211 ======== ======== ======== ======== Operating results before income taxes improved for both the three months and nine months ended September 30, 2000 as compared to the same periods in 1999, but continue to be constrained by inadequate premium rate levels that have resulted from several years of intense rate competition within the insurance industry. The improvement in the 2000 operating results is attributed to a moderate improvement in overall premium rate adequacy, a slight decline in loss frequency and a sizable increase in investment income. Overall premium rate adequacy continued to show moderate improvement during the third quarter of 2000 and this trend is expected to continue; however, it will take time for premium rates to return to adequate levels due to the competitive rate environment that persists in the insurance industry. The improvement in premium rate adequacy will have a positive impact on future operating results, but the unpredictable nature of catastrophe and storm losses will remain. In the meantime, management continues to work toward improving profitability through re-underwriting programs for both the existing book of business and the agency force. EMC INSURANCE GROUP INC. AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL ------- ------------------------------------------------- CONDITION AND RESULTS OF OPERATIONS, CONTINUED ---------------------------------------------- Premiums earned increased 11.4 percent for the three months and 9.1 percent for the nine months ended September 30, 2000 from the same periods in 1999. This growth in premium income, which is well above the industry average of approximately 2.0 percent, is primarily associated with the property and casualty insurance segment. Applications for insurance coverage have increased significantly in the first nine months of 2000 as some of the Company's competitors have withdrawn from certain markets or implemented large, mandatory across-the-board rate increases regardless of loss experience. The Company has been selective in the insurance risks it has accepted and has been able to price both new and renewal business at more adequate levels. The combination of these factors has contributed to the strong growth rate. Losses and settlement expenses increased 6.6 percent for the three months and 7.1 percent for the nine months ended September 30, 2000 from the same periods in 1999. Overall loss frequency has declined in the property and casualty insurance segment during the first nine months of 2000, but this improvement has been partially offset by increased loss experience in the reinsurance segment. Active storm patterns have kept catastrophe and storm losses at an elevated level, compounding the impact of inadequate premium rates. The benefit provided by the development of prior years' reserves declined for both the three months and nine months ended September 30, 2000, but remained positive. The Company has historically experienced favorable development in its reserves and reserving practices have not been changed; however, the amount of development experienced will fluctuate from quarter to quarter and from year to year as individual claims are settled. Acquisition and other expenses increased 7.0 percent for the three months and 1.9 percent for the nine months ended September 30, 2000 from the same periods in 1999. These increases, which are less than the increases in premium income noted above, reflect a decline in profit sharing expenses due to the recent deterioration in the profitability of the underlying insurance policies. The increase for the first nine months of 2000 was further limited by $839,000 of commission income recorded by the reinsurance subsidiary during the second quarter of 2000 and a modest increase in the estimate of deferrable acquisition expenses recorded by the property and casualty insurance segment during the first half of 2000. Net investment income increased 9.9 percent for the three months and 13.0 percent for the nine months ended September 30, 2000 from the same periods in 1999. These increases reflect the combination of a higher average invested balance in fixed-maturity securities and an increase in the average rate of return earned on the fixed-maturity portfolio. During 2000 and 1999 the Company sold approximately $14,000,000 and $55,000,000, respectively, of tax- exempt securities and reinvested the proceeds into taxable securities in order to achieve a better rate of return after taxes. The Company reported income tax expense for both the three months and nine months ended September 30, 2000 compared to an income tax benefit for the same periods in 1999. This change in tax status is primarily due to the Company's improved operating results, but also reflects the change in asset allocation from tax-exempt securities to taxable securities noted above. Also contributing to the increase in income tax expense for the nine months ended September 30, 2000 is $176,000 of income tax expense generated by a required change in the tax method used to recognize installment premiums. EMC INSURANCE GROUP INC. AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL ------- ------------------------------------------------- CONDITION AND RESULTS OF OPERATIONS, CONTINUED ---------------------------------------------- SEGMENT RESULTS Property and Casualty Insurance Operating results for the three months and nine months ended September 30, 2000 and 1999 are as follows: Three months ended Nine months ended September 30, September 30, ------------------------------------ ($ in thousands) 2000 1999 2000 1999 -------- -------- -------- -------- Premiums earned ..................... $ 47,112 $ 42,628 $136,179 $124,044 Losses and settlement expenses ...... 37,124 35,625 108,935 104,214 Acquisition and other expenses ...... 14,050 13,775 41,601 40,413 -------- -------- -------- -------- Underwriting loss ................... (4,062) (6,772) (14,357) (20,583) Net investment income ............... 5,290 4,711 15,354 13,425 Other (loss) income ................. (24) 491 389 1,013 -------- -------- -------- -------- Operating income (loss) before income taxes ............... $ 1,204 $ (1,570) $ 1,386 $ (6,145) ======== ======== ======== ======== Incurred losses and settlement expenses: Insured events of current year .. $ 37,203 $ 38,883 $114,671 $112,308 Decrease in provision for insured events of prior years.. (79) (3,258) (5,736) (8,094) -------- -------- -------- -------- Total losses and settlement expenses ....... $ 37,124 $ 35,625 $108,935 $104,214 ======== ======== ======== ======== Catastrophe and storm losses ........ $ 2,233 $ 1,969 $ 7,062 $ 7,060 ======== ======== ======== ======== Premiums earned increased 10.5 percent for the three months and 9.8 percent for the nine months ended September 30, 2000 from the same periods in 1999. These increases reflect an increase in policy count and exposure base in the commercial lines of business, as well as rate increases in both the commercial and personal lines of business. Overall premium rate adequacy continued to improve during the third quarter of 2000 as the Company implemented rate increases in both the personal and commercial lines of business. Management expects premium rate adequacy to improve further during the remainder of 2000 as the rate increases implemented in 1999 and 2000 become more fully recognized. Losses and settlement expenses increased 4.2 percent for the three months and 4.5 percent for the nine months ended September 30, 2000 from the same periods in 1999. These increases, which are less than the increases in premium income noted above, reflect a decline in overall loss frequency from the elevated levels experienced during 1999. Catastrophe and storm losses continue to have a significant impact on operating results due to the persistence of active storm patterns. Acquisition and other expenses increased 2.0 percent for the three months and 2.9 percent for the nine months ended September 30, 2000 from the same periods in 1999. Profit sharing expenses, which take the form of policyholder dividends and contingent commissions, have declined as a result of the recent deterioration in the profitability of the underlying insurance policies. As a result, acquisition and other expenses have not increased at the same pace as premium income. Results for the first nine months of 2000 also reflect a moderate increase in the estimate of deferrable acquisition expenses. EMC INSURANCE GROUP INC. AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL ------- ------------------------------------------------- CONDITION AND RESULTS OF OPERATIONS, CONTINUED ---------------------------------------------- Underwriting results for the three months and nine months ended September 30, 2000 improved from the same periods in 1999, but continue to be constrained by the competitive rate environment of the insurance industry. Premium rate levels are showing improvement, but this improvement has been moderate and it will take time for rates to return to adequate levels. Underwriting results are expected to improve gradually, but steadily, as the Company realizes the positive impact of various initiatives implemented during the past couple of years and as additional rate increases are implemented. The Company continues to work toward improving profitability through re- underwriting programs for both the existing book of business and the agency force. Reinsurance Operating results for the three months and nine months ended September 30, 2000 and 1999 are as follows: Three months ended Nine months ended September 30, September 30, ----------------- ----------------- ($ in thousands) 2000 1999 2000 1999 -------- -------- -------- -------- Premiums earned ..................... $ 11,506 $ 9,968 $ 30,999 $ 29,252 Losses and settlement expenses ...... 9,848 8,456 26,910 22,630 Acquisition and other expenses ...... 3,994 3,088 9,152 9,393 -------- -------- -------- -------- Underwriting loss ................... (2,336) (1,576) (5,063) (2,771) Net investment income ............... 1,949 1,847 5,895 5,302 Other income ........................ 19 28 64 93 -------- -------- -------- -------- Operating (loss) income before income taxes ...................... $ (368)$ 299 $ 896 $ 2,624 ======== ======== ======== ======== Incurred losses and settlement expenses: Insured events of current year .. $ 10,850 $ 8,352 $ 25,409 $ 21,827 (Decrease) increase in provision for insured events of prior years ................ (1,002) 104 1,501 803 -------- -------- -------- -------- Total losses and settlement expenses ....... $ 9,848 $ 8,456 $ 26,910 $ 22,630 ======== ======== ======== ======== Catastrophe losses .................. $ 19 $ 148 $ 621 $ 1,151 ======== ======== ======== ======== EMC INSURANCE GROUP INC. AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL ------- ------------------------------------------------- CONDITION AND RESULTS OF OPERATIONS, CONTINUED ---------------------------------------------- Premiums earned increased 15.4 percent for the three months and 6.0 percent for the nine months ended September 30, 2000 from the same periods in 1999. The increase for the three months ended September 30, 2000 includes approximately $750,000 associated with a change in the estimate of "earned but not reported" premium income from foreign reinsurance contracts. Due to the time lag in reporting of foreign reinsurance contracts, estimated amounts of premium income and related losses and expenses are booked on quarterly basis. These estimates are adjusted when the reported amounts deviate from the estimates. The remainder of the increase for 2000 is attributed to the addition of several new contracts and growth on existing contracts. The increase for the first nine months of 2000 is distorted by the delayed reporting of several foreign reinsurance contracts written in 1998 that were included in the results of the first quarter of 1999. The majority of the reinsurance subsidiary's reinsurance contracts renew on January 1 and premium rates for those renewals were relatively flat. However, industry premium rates have improved during the first nine months of 2000 and premium rate increases have been implemented on the reinsurance contracts that renewed during the second and third quarters. Despite these rate increases, which have varied from very modest to significant depending on prior loss experience, overall premium rate adequacy is not expected to improve significantly during 2000. This is due to the fact that a large portion of the assumed book of business will not receive rate increases in 2000 and those implemented during 2000 will not be fully recognized. Losses and settlement expenses increased 16.5 percent for the three months and 18.9 percent for the nine months ended September 30, 2000 from the same periods in 1999. These increases reflect the increase in production noted above. Results for 2000 have been negatively impacted by an unusually large increase in loss severity, particularly on aggregate treaties and property contracts. Additional losses from 1999 storms and increased loss activity in the workers' compensation line of business also contributed to the large increases. Results for the first nine months of 2000 have also been negatively impacted by adverse development on prior years' reserves, including $800,000 related to December 1999 storms in Europe and $1,600,000 related to other 1999 property losses. Acquisition and other expenses increased 29.3 percent for the three months and decreased 2.6 percent for the nine months ended September 30, 2000 from the same periods in 1999. The increase for the three months ended September 30, 2000 reflects the large increase in premium income and an increase in the reserve for contingent commissions. The decrease for the first nine months of 2000 is attributed to $839,000 of commission income recorded during the second quarter of 2000. This commission income includes $420,000 of profit share commission associated with an outside reinsurance contract that the reinsurance subsidiary pays for to protect Employers Mutual from catastrophic losses on the assumed book of business and $419,000 of contingent commission that was returned to a reinsurance pool by a ceding company client because of loss experience on a treaty. The underwriting results of the reinsurance subsidiary continue to be negatively impacted by reduced premium rate levels and increased loss severity. Industry premium rate levels have improved during the first nine months of 2000; however, the excess capacity that led to the reduction in premium rate levels continues to exist. Underwriting results of the reinsurance subsidiary are not expected to improve significantly during the last three months of 2000 since the majority of the contracts were renewed in January at flat rates, but underwriting results for 2001 should benefit from the improving rate environment. Employers Mutual will continue to work toward improving profitability on the assumed book of business by accepting a larger share of coverage on desirable programs, strengthening its relationships with reinsurance intermediaries and monitoring premium growth. EMC INSURANCE GROUP INC. AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL ------- ------------------------------------------------- CONDITION AND RESULTS OF OPERATIONS, CONTINUED ---------------------------------------------- Parent Company Operating results before income taxes totaled $18,000 and ($47,000) for the three months and nine months ended September 30, 2000 compared to $43,000 and ($19,000) for the same periods in 1999. The decline in operating results is primarily due to a reduction in investment income that has resulted from a decline in the invested asset balance. LIQUIDITY AND CAPITAL RESOURCES The Company maintains a portion of the investment portfolio in relatively short-term and highly liquid investments to ensure the availability of funds to meet claims and expenses. The remainder of the investment portfolio, excluding investments in equity securities, is invested in securities with maturity dates that approximate the anticipated liabilities of the insurance issued. The Company considers itself to be a long-term investor and generally purchases fixed maturity investments with the intent to hold them to maturity. The Company has previously classified a portion of its investments in fixed maturity securities, primarily bonds issued by municipalities and corporations, as available-for-sale securities to provide flexibility in the management of the portfolio. Beginning in the third quarter of 1999, all newly acquired securities are being classified as available-for-sale to provide increased management flexibility. Unrealized holding losses on fixed maturity securities available-for-sale totaled $3,916,000 at September 30, 2000 compared to $7,539,000 at December 31, 1999. The decline in the market value of these investments is primarily due to an increase in interest rates. Since the Company does not actively trade in the bond market, such fluctuations in the fair value of these investments are not expected to have a material impact on the operations of the Company, as forced liquidations of investments are not anticipated. The Company closely monitors the bond market and makes appropriate adjustments in investment policy as changing conditions warrant. At December 31, 1999 the Company established a valuation allowance of $1,233,000 for the deferred tax asset associated with the unrealized holding losses on the Company's available-for-sale securities. This valuation allowance was established due to uncertainties concerning the future realization of the tax benefit. At September 30, 2000 the Company had a net unrealized holding gain on its available-for-sale securities, a related deferred tax liability, and no valuation allowance. The majority of the Company's assets are invested in fixed maturity securities. These investments provide a substantial amount of income which supplements underwriting results and contributes to net earnings. As these investments mature, the proceeds will be reinvested at current rates, which may be higher or lower than those now being earned; therefore, more or less investment income may be available to contribute to net earnings depending on the interest rate level. During the third quarter of 1999, the Company began participating in a securities lending program whereby certain fixed maturity securities from the investment portfolio are loaned to other institutions for short periods of time. The Company receives a fee for each security loaned out under this program and requires initial collateral, primarily cash, equal to 102 percent of the market value of the loaned securities. This collateral is recorded as an asset, along with a corresponding liability, on the Company's balance sheet. EMC INSURANCE GROUP INC. AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL ------- ------------------------------------------------- CONDITION AND RESULTS OF OPERATIONS, CONTINUED ---------------------------------------------- During 1999 and 2000 the Company disposed of approximately $55,000,000 and $14,000,000, respectively, of investments in tax-exempt fixed maturity securities and reinvested the proceeds in taxable fixed maturity securities. This change in asset allocation is not expected to have a material impact on the operations of the Company, as forced liquidations of investments are not anticipated. The major ongoing sources of the Company's liquidity are insurance premium income, investment income, and cash provided from maturing or liquidated investments. The principal outflows of cash are payments of claims, commissions, premium taxes, operating expenses, income taxes, dividends and investment purchases. During the first nine months of 2000, the Company generated positive cash flows from operations of $15,908,635 compared to $12,558,529 for the same period of 1999. During the second quarter of 1999 the Company completed a $3,000,000 stock repurchase plan that was approved by its Board of Directors on November 20, 1998. A total of 254,950 shares of common stock were repurchased under this plan at an average cost of $11.76 per share. IMPACT OF YEAR 2000 REMEDIATION ON OPERATIONS The Year 2000 issue presented both operational and underwriting risks to the Company. Operational risks included the failure of computer systems and equipment owned and operated by Employers Mutual, as well as those owned and operated by vendors and other parties with which the Company conducts business. Underwriting risks included, but were not limited to, potential claims by the Company's policyholders to recover losses due to interruption of business or liability to third parties that resulted from the failure of computer systems. To date, the Company has not encountered any problems as a result of the Year 2000 date rollover. All of the Company's systems are functioning normally. In addition, the Company has not encountered any problems with any vendor-supplied hardware or software. The Company continues to monitor the situation closely for any potential Year 2000 issues. The Company distributed a letter during 1999 to all of its commercial policyholders notifying them that their policies did not cover Year 2000 losses, but that coverage was available through an endorsement to the policy. A questionnaire was developed and provided to them to aid in the assessment of potential risks associated with Year 2000 noncompliance. Very few policyholders elected to purchase the additional coverage provided by this endorsement. The parties to the pooling agreement purchased reinsurance protection for potential third party liability claims against policyholders arising from Year 2000 issues. To date, no claims have been reported relating to Year 2000 losses. EMC INSURANCE GROUP INC. AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL ------- ------------------------------------------------- CONDITION AND RESULTS OF OPERATIONS, CONTINUED ---------------------------------------------- NEW ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board (FASB) issued SFAS 133, "Accounting for Derivative Instruments and Hedging Activities", effective for fiscal years beginning after June 15, 1999. In June 1999, the FASB issued SFAS 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of Effective Date of FASB Statement No. 133", which defers the effective date of SFAS 133 until fiscal years beginning after June 15, 2000. In June 2000, the FASB issued SFAS 138 "Accounting for Certain Derivative Instruments and Certain Hedging Activities - an amendment of FASB statement No. 133". SFAS 138 addresses a limited number of Statement 133 implementation issues, and is effective for fiscal years beginning after June 15, 2000. Currently, the Company's investment strategy does not include investments in derivative instruments or hedging activities. Accordingly, adoption of these statements is not expected to have any effect on the operating results of the Company. In September 2000, the FASB issued SFAS 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities - a replacement of FASB Statement No. 125". SFAS 140 is effective for transfers and servicing of financial assets and extinguishment of liabilities occurring after March 31, 2001 and for recognition and reclassification of collateral and disclosures relating to securitization transactions and collateral for fiscal years ending after December 15, 2000. Adoption of this statement is not expected to have any effect on the operating results of the Company. CAUTIONARY STATEMENT REGARDING FORWARD LOOKING STATEMENTS The Private Securities Litigation Reform Act of 1995 provides issuers the opportunity to make cautionary statements regarding forward-looking statements. Accordingly, any forward-looking statement contained in this report is based on management's current expectations and actual results of the Company may differ materially from such expectations. The risks and uncertainties that may affect the actual results of the Company include but are not limited to the following: catastrophic events and the occurrence of significant severe weather conditions; state and federal legislation and regulations; changes in the demand for, pricing of, or supply of insurance or reinsurance; changes in interest rates and the performance of financial markets; the adequacy of loss and settlement expense reserves, including asbestos and environmental claims; and other risks and uncertainties inherent in the Company's business. EMC INSURANCE GROUP INC. AND SUBSIDIARIES ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ------- ---------------------------------------------------------- The main objectives in managing the investment portfolios of the Company are to maximize after-tax investment income and total investment return while minimizing credit risks, in order to provide maximum support for the underwriting operations. Investment strategies are developed based upon many factors including underwriting results and the Company's resulting tax position, regulatory requirements, fluctuations in interest rates and consideration of other market risks. Investment decisions are centrally managed by investment professionals and are supervised by an investment committee composed of representatives from each of the Company's subsidiary's board of directors. Market risk represents the potential for loss due to adverse changes in the fair value of financial instruments. The market risks of the financial instruments of the Company relate to the investment portfolio, which exposes the Company to interest rate and equity price risk, and to a lesser extent credit quality and prepayment risk. Monitoring systems and analytical tools are in place to assess each of these elements of market risk. Interest rate risk includes the price sensitivity of a fixed maturity security to changes in interest rates and the affect on future earnings from short-term investments and maturing long-term investments, given a change in interest rates. The following analysis illustrates the sensitivity of the Company's financial instruments to selected changes in market rates and prices. A hypothetical one percent increase in interest rates as of September 30, 2000 would result in a corresponding pre-tax decrease in the fair value of the fixed maturity portfolios of approximately $23,407,000 or 5.5 percent. In addition, a hypothetical one percent decrease in interest rates at September 30, 2000 would result in a corresponding decrease in pre-tax income over the next twelve months of approximately $339,000, assuming the current maturity and prepayment patterns. The Company monitors interest rate risk through the analysis of interest rate simulations, and adjusts the average duration of its fixed maturity portfolio by investing in either longer or shorter term instruments given the results of interest rate simulations and judgments of cash flow needs. The effective duration of the fixed maturity portfolio at September 30, 2000 was 5.31 years. The valuation of the Company's marketable equity portfolios is subject to equity price risk. In general, equities have more year-to-year price variability than bonds. However, returns from equity securities over longer time frames have been consistently higher. The Company invests in a diversified portfolio of readily marketable equity securities. A hypothetical 10 percent decrease in the S&P 500 as of September 30, 2000 would result in a corresponding pre-tax decrease in the fair value of the Company's equity portfolio of approximately $3,116,000. The Company invests in high quality fixed maturity securities, thus minimizing credit quality risk. At September 30, 2000 the portfolio of long- term fixed maturity securities consists of 12.8 percent U.S. Treasury, 12.9 percent government agency, 13.0 percent mortgage-backed, 19.5 percent municipal, and 41.8 percent corporate securities. At December 31, 1999 the portfolio of long-term fixed maturity securities consisted of 15.0 percent U.S. Treasury, 13.9 percent government agency, 15.2 percent mortgage-backed, 24.6 percent municipal, and 31.3 percent corporate securities. No securities are below investment grade. EMC INSURANCE GROUP INC. AND SUBSIDIARIES ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK, CONTINUED ------- --------------------------------------------------------------------- Prepayment risk refers to the changes in prepayment patterns that can either shorten or lengthen the expected timing of the principal repayments and thus the average life and the effective yield of a security. Such risk exists primarily within the portfolio of mortgage-backed securities. The prepayment risk analysis is monitored regularly through the analysis of interest rate simulations. At September 30, 2000 the effective duration of the mortgage- backed securities is 3.9 years with an average life and current yield of 7.0 years and 7.6 percent, respectively. At December 31, 1999 the effective duration of the mortgage-backed securities was 4.4 years with an average life and current yield of 7.5 years and 7.7 percent, respectively. PART II. OTHER INFORMATION -------- ----------------- Item 6. Exhibits and Reports on Form 8-K ------- -------------------------------- (a) None. (b) No Form 8-K was filed by the registrant during the quarter ended September 30, 2000. 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. EMC INSURANCE GROUP INC. Registrant /s/ Bruce G. Kelley ----------------------------------- Bruce G. Kelley President & Chief Executive Officer /s/ Mark Reese ----------------------------------- Mark Reese Vice President and Chief Financial Officer Date: November 14, 2000