UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

 

Commission File Number 001-34496

PENN MILLERS HOLDING CORPORATION

(Exact name of registrant as specified in its charter)

 

 

72 North Franklin Street, Wilkes-Barre, PA 18773

(Address of principal executive offices) (Zip Code)

 

Registrant’s telephone number, including area code: (800) 233-8347

 

Securities Registered Pursuant to Section 12(b) of the Act:

 

 

Securities Registered Pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (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 þ     No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or other information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

Yes o     No þ

 

At June 30, 2010 the aggregate market value of the voting and non-voting common stock held by non-affiliates of the registrant (based on the closing sales price on that date) was $56,618,964.

 

At February 28, 2011, 5,080,252 shares of common stock, $0.01 par value, of Penn Millers Holding Corporation were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s Definitive Proxy Statement for the 2011 Annual Meeting of Shareholders to be held on May 11, 2011 are incorporated by reference into Part III of this Report.

 

 

PENN MILLERS HOLDING CORPORATION AND SUBSIDIARY

 

FORM 10-K

 

For the Year Ended December 31, 2010

 

Table of Contents

 

 

 

Background

 

Our lead insurance company is Penn Millers Insurance Company, which is a Pennsylvania stock insurance company originally incorporated as a mutual insurance company in 1887. In 1999, Penn Millers Insurance Company converted from a mutual to a stock insurance company within a mutual holding company structure. This conversion created Penn Millers Mutual Holding Company (Penn Millers Mutual), a Pennsylvania mutual holding company, and established a “mid-tier” stock holding company, PMHC Corp. (PMHC), to hold all of the outstanding shares of Penn Millers Insurance Company. American Millers Insurance Company is a wholly owned subsidiary of Penn Millers Insurance Company that provides Penn Millers Insurance Company with excess of loss reinsurance.

 

On April 22, 2009, Penn Millers Mutual adopted a plan of conversion to convert Penn Millers Mutual from the mutual to the stock form of organization, which was approved by its eligible members on October 15, 2009. Upon its conversion, Penn Millers Mutual was renamed PMMHC Corp. and PMHC was subsequently merged with and into PMMHC Corp., thereby terminating PMHC’s existence and making PMMHC Corp. the stock holding company for Penn Millers Insurance Company and a wholly owned subsidiary of Penn Millers Holding Corporation. The historical consolidated financial statements of Penn Millers Mutual prior to the conversion became the consolidated financial statements of Penn Millers Holding Corporation upon completion of the conversion. Neither PMMHC Corp. nor Penn Millers Holding Corporation engages in any business operations. After the conversion, the outstanding capital stock of Penn Millers Insurance Company and proceeds derived from the public stock offering are the primary assets of PMMHC Corp. and Penn Millers Holding Corporation, respectively.

 

The references herein to “the Company,” “we,” “us,” “our” and “Penn Millers” refer to Penn Millers Holding Corporation and its direct and indirect subsidiaries.

 

On October 16, 2009, the Company completed the sale of 5,444,022 shares of Penn Millers Holding Corporation common stock, par value $0.01 per share, at an initial offering price of $10.00 per share in a concurrently-held subscription and community offering.

 

Prior to the completion of the offering, in accordance with the provisions of the Plan of Conversion of PMMHC Corp., our Employee Stock Ownership Plan (ESOP) purchased 539,999 of the shares in the offering, which was funded by a loan from Penn Millers Holding Corporation.

 

Our common stock is traded on the Nasdaq Global Market under the symbol “PMIC.”

 

On February 2, 2009, we completed the sale of substantially all of the net assets of Eastern Insurance Group, which was a wholly owned subsidiary insurance agency of PMHC. In July 2008, we completed the sale of substantially all of the net assets of Penn Software and Technology Services, Inc. (Penn Software), a Pennsylvania corporation specializing in providing information technology consulting for small businesses. Penn Software was a wholly owned subsidiary of PMHC. Both Eastern Insurance Group and Penn Software were accounted for as discontinued operations. In late 2010 we formally dissolved both Eastern Insurance Group and Penn Software.

 

Penn Millers Insurance Company has been assigned an “A−” (Excellent) rating by A.M. Best Company, Inc., (A.M. Best) which is the fourth highest out of fifteen possible ratings. The latest rating evaluation by A.M. Best occurred on June 22, 2010.

 

Business Segments

 

We provide a variety of property and casualty insurance products designed to meet the insurance needs of certain segments of the agricultural industry and the needs of small and middle market commercial businesses. We are licensed in 40 states, but we currently target the sales of our insurance products to 33 states. We discontinued writing personal insurance products in 2003 and now offer only commercial products. We report our operating results in three operating segments: agribusiness insurance, commercial business insurance, and our “other” segment. However, assets are not allocated to segments and are reviewed in the aggregate for decision-making purposes.

Our agribusiness insurance segment product includes property (fire and allied lines and inland marine), liability (general, products and umbrella), commercial automobile, and workers’ compensation insurance. We specialize in writing coverage for manufacturers, processors, and distributors of products for the agricultural industry. We do not write property or liability insurance for farms or farming operations unless written in conjunction with an eligible agribusiness operation; and we do not write any crop or weather insurance. We market our agribusiness lines through independent producers and our employees. We have been writing agribusiness policies for over 123 years. We believe we have an excellent industry reputation provided by experienced underwriting, marketing and loss control staff, supported by knowledgeable and easily accessible claims staff and senior management.

 

We market our agribusiness insurance product to agricultural businesses such as grain storage and elevators, flour mills, livestock feed manufacturers, fertilizer blending and application, cotton gins, livestock feed lots, mushroom growers, farm supply stores, produce packing, and seed merchants.

 

The annual premium size of our agribusiness accounts range from approximately $800 to $2.2 million with an average annual premium of approximately $45,000. Our product is sold through approximately 250 specialty agribusiness producers and also on a direct basis. The primary competitors in our agribusiness marketplace are Nationwide Agribusiness, Continental Western Insurance Company, and Westfield Insurance Company. We seek to compete with other agribusiness insurance companies primarily on service rather than on price.

 

Our commercial business segment provides insurance coverage to small and middle market commercial businesses. We target select low to medium hazard businesses such as retailers, including beverage stores, floor covering stores, florists, grocery stores, office equipment and supplies stores, dry cleaners, printers, and shopping centers; hospitality, such as restaurants and hotels; artisan contractor businesses, such as electrical, plumbing, and landscaping; professional services, such as accountants, insurance agencies, medical offices, and optometrists; office buildings; and select manufacturing and wholesale businesses.

 

Our commercial business insurance segment product consists of a business owner’s policy called Solutions that combines the following: property, liability, business interruption, and crime coverage for small businesses; workers’ compensation; commercial automobile; and umbrella liability coverage. The types of businesses we target under our Solutions offering include retail, service, hospitality, wholesalers, and printers. These lines within our Solutions product are sold through approximately 260 independent agents in Pennsylvania, New Jersey, Connecticut, Massachusetts, Tennessee, Virginia, New York, and Maryland.

 

In early 2009, we introduced an insurance product called PennEdge that allows us to write customized coverages on mid-size commercial accounts. PennEdge provides property and liability coverage to accounts that currently do not meet the eligibility requirements for our traditional business owner’s Solutions policy or our agribusiness products. PennEdge is specifically tailored to unique business and industry segments, including wholesalers, manufacturers, hospitality, printers, commercial laundries and dry cleaners. In 2010, we added hunting and fishing lodges, clubs, guides and outfitters, and metal recyclers to our target classes of insureds. We choose our targeted segments based on the experience of our underwriting staff, the market opportunities available to our existing producers and where we believe there are opportunities to reach producers that have not traditionally carried our products. Currently, the PennEdge product is available in twenty-four states and is marketed through both our agribusiness and commercial business producers. For segment reporting purposes, and consistent with how we manage our business, the results of PennEdge are included in our commercial business segment.

 

The premium size of our commercial business accounts (Solutions and PennEdge) range from approximately $250 to approximately $193,000, with an average annual premium of approximately $6,000. A large number of regional and national insurance companies compete for our small and mid-size business customers. We seek to compete with other commercial lines insurance companies primarily on service rather than on price.

 

Our third business segment, which we refer to as our “other” segment, includes the runoff of discontinued lines of insurance business and the results of mandatory assigned risk reinsurance programs that we must participate in as a condition of doing business in the states in which we operate. The discontinued lines of business include personal lines business that we used to write on a voluntary direct basis, but discontinued in 2003; and business we assumed from various reinsurance and pooling agreements in which we voluntarily participated until 1993.

The following table provides net premiums earned by business segment (dollars in thousands):

 

 

Financial information about our three business segments is contained in this report in Item 7 — “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 15 to the consolidated financial statements “Segment Information” under Part II Item 8 — “Financial Statements and Supplementary Data.”

 

Geographic Distribution

 

We primarily market our products through a network of over 500 independent producers in 33 states. The following table shows the geographic distribution of our direct written premiums on a consolidated basis and for the agribusiness and commercial business segments for the year ended December 31, 2010:

 

 

 

 

Our Products

 

We provide a variety of property and casualty insurance products designed to meet the insurance needs of certain segments of the agricultural industry and the needs of small and middle market commercial businesses. The following table provides net premiums earned by product line for the periods indicated (dollars in thousands):

 

 

 

 

Property coverage protects businesses against the loss or loss of use, including its income-producing ability, of business property.

 

Liability insurance includes commercial general liability, products liability, and professional liability covering our insureds’ operations.

 

Workers’ compensation coverage protects employers against specified benefits payable under state law for workplace injuries to employees. We consider our workers’ compensation business to be a companion product, so we rarely write stand-alone workers’ compensation policies.

 

Commercial auto coverage protects businesses against liability to others for both bodily injury and property damage, medical payments to insureds and occupants of their vehicles, physical damage to an insured’s own vehicle from collision and various other perils, and damages caused by uninsured motorists. Commercial automobile policies are generally marketed only in conjunction with other supporting lines.

 

Other lines of business include umbrella liability, boiler and machinery, and employment practices liability coverages offered by both our agribusiness and commercial business segments.

 

Our Business Strategies

 

Competitive pressures in the marketplace are exerting downward pressure on our prices, which is currently affecting our writing of new and renewal business. Our focus on underwriting discipline and rate adequacy in the midst of this soft market has resulted in a decline in premium revenue. We believe we are positioning the Company to take advantage of profitable growth opportunities that we anticipate will occur in the future. Our ability to successfully implement these strategies is subject to several risks, which are set forth in Item 1A — “Risk Factors.”

Niche Strategies

 

 

 

We are a well established niche player in the agribusiness insurance market with over 123 years in this specialty segment. We have a significant market position in the agribusiness insurance market, writing business in 33 states. This is a specialized niche market with a limited number of competitors where we believe we have expertise and strong growth opportunities.

 

 

 

 

 

Growth Strategies

 

The property and casualty insurance industry is cyclical, with periods of rising and falling premiums known as hard and soft markets, respectively. The industry has been experiencing soft market conditions. We believe that the property and casualty insurance industry’s profits will decline to the point where pricing will start to increase and the underwriting cycle will move into a hard market phase.

 

The primary purpose of our October 2009 public offering was to increase our capital to permit us to take advantage of growth opportunities when, and if, a hard market cycle returns. The capital derived from our public offering will provide us the leverage necessary to support our future growth in net premiums written, expand our producer network and successfully market and underwrite our agribusiness and PennEdge products. We have historically performed well in periods of significant premium increases. In the last hard market cycle that we believe began in 2000 and ended in 2004, our commercial lines direct premiums written in our core business segments increased by 148% (a compound annual growth rate of 25%), which exceeded the commercial lines industry growth of 63% (a compound annual growth rate of 13%) during that period.

 

Because we cannot determine with any certainty when and if we will see a hard market return in the near future, we have developed our growth strategies to increase direct premiums written and reduce our costs without relying on improved market conditions and economic upswings. We are licensed in 40 states and currently write business in 33 states. We believe that we have the right mix of underwriting capacity, diverse product offerings, and management experience to increase penetration in states we now serve and to enlarge our footprint overall.

 

 

 

Profit Improvement Strategies

 

 

 

 

 

Balance Sheet Management

 

 

 

 

 

 

Alignment of the Interests of Our Employees with Those of Our Shareholders

 

During 2010, we took actions to more closely align the interests of our management and employees with those of our shareholders by instituting incentive based compensation systems (both cash and stock) for our executive officers and employees, and stock ownership requirements for our directors and officers. These compensation programs and stock ownership requirements are set forth in greater detail in our 2010 proxy statement.

 

Marketing and Distribution

 

We market our agricultural insurance product through approximately 250 producers in 33 states, and by our employees. Our Solutions business owner’s commercial insurance offering is sold through approximately 260 producers in 8 states. Our PennEdge offering is currently marketed in twenty-four states through our commercial business and agribusiness producers. We primarily market our products through this select group of more than 500 independent producers. All of these producers represent multiple insurance companies and are established businesses in the communities in which they operate. We consider our relationships with these producers to be positive. We also have two employees that are engaged in the direct marketing of our agribusiness insurance products, which accounted for approximately $3.1 million in direct premiums written for that segment in 2010.

 

One producer, Arthur J. Gallagher Risk Management Services, which places business with us through nine of their offices, accounted for $11.2 million, or approximately 13%, of our direct premiums written in 2010. Only one other producer accounted for more than 5% of our 2010 direct premiums written.

 

For the year ended December 31, 2010, our top 10 producers accounted for approximately 43% of our direct premiums written.

We emphasize personal contact between our producers and the policyholders. We believe that our producers’ responsive and efficient service and reputation, as well as our policyholders’ loyalty to and satisfaction with their agent or broker are the principal sources of new customer referrals, cross-selling of additional insurance products and policyholder retention for Penn Millers.

 

We depend upon our independent producers to produce new business and to provide front line customer service. Our network of independent producers also serves as an important source of information about the needs of the insureds we serve. We utilize this information to develop new products, such as PennEdge, and new product features, and to enter into strategic relationships to offer new products such as equipment breakdown, employment practices liability and environmental impairment coverages.

 

Our producers are monitored and supported by our marketing representatives and production underwriters, who are our employees. These employees also have principal responsibility for recruiting and training new producers. We periodically hold meetings for producers and conduct programs that provide both technical training about our products and sales training about how to effectively market our products.

 

Producers are compensated through a fixed base commission with an opportunity for profit sharing depending on the producer’s premiums written and profitability. Because we rely heavily on independent producers, we utilize a contingent compensation plan as an incentive for producers to place high-quality business with us and to support our loss control efforts. We believe that the contingent compensation paid to our producers is competitive with other insurance companies, subject to the producer directing high-quality and profitable business to us.

 

Our marketing efforts are further supported by our claims philosophy, which is designed to provide prompt and efficient service and claims processing, and aims to result in a positive experience for producers and policyholders. We believe that these positive experiences result in higher policyholder retention and new business opportunities when communicated by producers and policyholders to potential customers.

 

Underwriting, Risk Assessment and Pricing

 

Our competitive strategy in underwriting is to provide very high-quality service to our producers and insureds by responding quickly and effectively to information requests and policy submissions. Our production underwriters are compensated based upon the profitability of the business that they sell and underwrite. Accordingly, they originate and approve coverage for customers that will be priced appropriately for the underwriting risk assumed. We underwrite our agricultural and commercial lines accounts by evaluating each risk with consistently applied standards. We maintain information on all aspects of our business, which is regularly reviewed to determine product line profitability. Specific information regarding individual insureds is monitored to assist us in making decisions about policy renewals or modifications.

 

Our underwriting philosophy aims to consistently generate underwriting profits through sound risk selection and pricing discipline. One key element in sound risk selection is our use of loss control inspections. During the underwriting process, we rely to a significant extent on information provided by our staff of loss control representatives located throughout the continental United States. Our staff of ten loss control representatives is supported by a network of third party loss control providers to cover more remote areas. Our loss control representatives assess the risk of loss by evaluating the insured’s hazards and related controls through interviews with the insured and inspections of their premises. If the business has risk management deficiencies, the inspector will offer recommendations for improvement. If significant risk management deficiencies are not corrected, we will decline the business or move to cancel, or elect not to renew policies already in force. Each new agribusiness customer is visited by a loss control representative, and most agribusiness customers are visited annually thereafter. Most of our commercial business customers are also inspected. Whether an inspection is required is based primarily on the type and amount of insurance coverage that is requested. These loss control inspections allow us to more effectively evaluate and mitigate risks, thereby improving our profitability.

 

We strive to be disciplined in our pricing by pursuing rate increases to maintain or improve our underwriting profitability while still being able to attract and retain customers. We utilize pricing reviews that we believe will help us price risks more accurately, improve account retention, and support the production of profitable new business. Our pricing reviews involve evaluating our claims experience and loss trends on a periodic basis to

identify changes in the frequency and severity of our claims. We then consider whether our premium rates are adequate relative to the level of underwriting risk as well as the sufficiency of our underwriting guidelines.

 

Claims Management

 

Claims on insurance policies are received directly from the insured or through our independent producers. Our claims department supports our producer relationship strategy by working to provide a consistently responsive level of service to our policyholders. Our experienced, knowledgeable claims staff provides timely, good faith investigation and settlement of meritorious claims for appropriate amounts, maintenance of adequate case reserves for claims, and control of external claims adjustment expenses.

 

Loss costs are controlled through a variety of programs and external partnerships unique to each line of business. For instance, we engage in medical fee reviews, service provider networks, nurse case management and other specialized services to significantly reduce the cost of workers’ compensation claims. We choose to partner with law firms, independent adjusters and other experts based on their particular skills and effectiveness in providing high levels of service and the most favorable outcomes to the Company and our policyholders.

 

In 2011, we will contract independent services to assist with reducing our legal expenses and to promote greater efficiency in complex litigation. We also plan to install a new web-based product to assist our auto and liability claims teams with real time information on state laws specific to the particular claims they are managing in order to improve outcomes on third party claims.

 

Technology

 

Our technology efforts are focused on supporting our competitive strategy of differentiating ourselves from our competitors through our relationships with our producers and our responsiveness to their needs, and on making us as efficient and cost effective as possible.

 

Our producers access our systems through a proprietary portal on our public website. Through this portal our producers can quote new business, submit applications and change requests, and access policyholder billing and claims information. The portal also provides information on our products and services and contains sales and marketing materials for the producers.

 

We have streamlined internal processes to achieve operational efficiencies through the implementation of a policy and claim imaging and workflow system. This system provides online access to electronic copies of policy files, enabling our underwriters to respond to our producers’ inquiries more quickly and efficiently. The imaging system also automates internal workflows through electronic routing of underwriting and processing work tasks. This system allows our claims staff to access and process reported claims in an electronic claim file.

 

To address our disaster recovery preparedness, we have contracted with a third-party provider that specializes in disaster recovery and business continuity systems support in order to allow us to continue to provide high quality service to our insureds and producers should a prolonged disruption to our operations occur.

 

Reinsurance

 

Reinsurance Ceded.  In accordance with insurance industry practice, we reinsure a portion of our exposure and pay to the reinsurers a portion of the premiums received on all policies reinsured. Insurance policies written by us are reinsured with other insurance companies principally to:

 

 

We use a variety of reinsurance formats to manage our exposure to large losses and protect our capital:

 

 

Regardless of type, reinsurance does not legally discharge us from primary liability for the full amount due under the reinsured policies. However, the assuming reinsurer is obligated to reimburse us to the extent of the coverage ceded.

 

We determine the amount and scope of reinsurance coverage to purchase each year based on a number of factors. These factors include the evaluation of the risks accepted, consultations with reinsurance representatives, and a review of market conditions, including the availability and pricing of reinsurance. We monitor our exposure to catastrophic losses and attempt to manage such exposure. Catastrophic events include windstorms, hail, tornadoes, hurricanes, earthquakes, riots, blizzards, terrorist activities and freezing temperatures. Sophisticated computer modeling techniques are used to evaluate underwriting risks in hurricane-prone and earthquake-prone areas in which we do business. We then use reinsurance to manage our aggregate exposures to catastrophes.

 

A primary factor in the selection of reinsurers from whom we purchase reinsurance is their financial strength. Our reinsurance arrangements are generally renegotiated annually. For the year ended December 31, 2010, we ceded to reinsurers $19.1 million of written premiums compared to $15.6 million of written premiums for the year ended December 31, 2009. At December 31, 2010 and 2009, we had reinsurance amounts due to us of $24.9 million and $19.5 million, respectively.

 

Property Excess of Loss Reinsurance

 

For 2010, individual property risks in excess of $500,000 are covered on an excess of loss basis pursuant to various reinsurance treaties up to $20 million. Any exposure over $20 million is covered by facultative reinsurance. All property lines of business, including commercial automobile physical damage, are reinsured under the same treaties. In 2011, we increased our retention on any one risk to $1.0 million.

 

The chart below illustrates the reinsurance coverage under our 2010 and 2011 excess of loss treaties for individual property risks:

 

Losses are subject to the following reinstatements and annual aggregate limits:

 

 

Property Automatic Facultative Treaty

 

For both 2010 and 2011, individual property risks with insured values in excess of $20 million up to $50 million, as identified in the policy, are reinsured under an automatic facultative treaty. Outside the treaty, any exposure over $50 million is approved by the reinsurer on an exception basis.

 

Property Catastrophe Excess of Loss Reinsurance

 

Catastrophic reinsurance protects us from significant aggregate loss exposure. For 2010 and 2011, we retain the first $3 million on any one event and reinsure 95% of losses per event in excess of $3 million, up to a maximum of $45 million total for one event.

 

The treaty provides one reinstatement per layer resulting in $79.8 million in an annual aggregate limit after our 5% co-participation.

 

Casualty Excess of Loss Reinsurance

 

For 2010, individual casualty risks that are in excess of $500,000 are covered on an excess of loss basis up to $10 million per occurrence, pursuant to various reinsurance treaties. In 2011, we increased our retention on any one risk to $1.0 million. The chart below illustrates the reinsurance coverage under our 2010 and 2011 excess of loss treaties for individual casualty risks:

 

 

For 2010 and 2011, our maximum coverage arising from workers’ compensation claims for any one life was $10 million.

 

Losses are subject to the following reinstatements and annual aggregate limits:

 

 

Umbrella Treaty Reinsurance

 

For 2010, umbrella liability losses are reinsured on a 75% quota share basis up to $1 million and a 100% quota share basis in excess of $1 million up to $5 million. Any exposure over $5 million up to $10 million is covered by

facultative reinsurance. In 2011, umbrella reinsurance remained the same except that the facultative coverage for exposures over $5 million up to $10 million was replaced by a 100% quota share treaty. Although the level of reinsurance coverage in this layer is essentially unchanged, using a quota share treaty will enable us to offer customers more competitive rates for umbrella coverage and allow us to underwrite more efficiently.

 

Accident Year Aggregate Excess of Loss Reinsurance (Stop Loss Reinsurance)

 

We maintain a whole account, accident year aggregate excess of loss reinsurance (stop loss) contract for accident years 2008 and 2009. The purpose of the contract was to provide additional protection for our capital above our underlying reinsurance program. This stop loss reinsurance contract provides coverage in the event that the total company’s accident year loss and LAE ratios for 2008 or 2009 exceed 72%.

 

The minimum ceded premiums paid under the stop loss approximated $2.4 million for 2008 and 2009. If losses are ceded, additional ceded premiums are accrued at 20% of the ceded losses. The contract includes a funds withheld provision whereby we withhold a significant amount of the ceded premiums minus ceded losses, thereby providing us protection from credit risk. The contract provides for an interest accrual for the reinsurer on the balance of the funds that we have withheld.

 

The contract also contains a profit sharing provision such that if the net profit to the reinsurers for the two years combined exceeds approximately $1.6 million, any profit above that amount will be returned to us provided that on or before January 1, 2015 we agree to a commutation whereby the reinsurers are released from any and all past, current and future liabilities under the stop loss contract.

 

In 2008, an unusually high level of property losses, both catastrophe and non-catastrophe related, resulted in losses and additional reinsurance premiums being ceded to the reinsurers under the stop loss contract. For 2008, premiums ceded under the stop loss contract totaled $3.3 million; ceded losses totaled $4.3 million; and interest accrued on the funds withheld account totaled $86,000, for a net benefit under the stop loss contract to Penn Millers of approximately $884,000 at December 31, 2008.

 

In 2009, we experienced a reduction in the estimated ultimate losses for the 2008 accident year; and losses ceded to the stop loss contract were reduced. In addition, the estimated accident year 2009 ultimate loss experience was below the stop loss contract’s trigger loss ratio of 72%; and therefore, no losses were ceded for 2009. When the $2.4 million of ceded premiums for 2009 were added to the improved estimated experience for the 2008 accident year, the profit to the reinsurers for 2008 and 2009 combined was estimated to be $2.0 million. Accordingly, we are carrying a profit sharing refund due us of approximately $0.4 million at December 31, 2009 and at December 31, 2010, which represents the excess over the $1.6 million profit sharing provision in the contract.

 

To receive this estimated profit sharing, we will have to release the reinsurers from any and all past, current and future liabilities under the stop loss contract on or before January 1, 2015. Therefore, the accounting for this anticipated profit sharing and commutation reverses the losses and additional premiums ceded recorded in 2008, and accrues the profit sharing as reduced ceded premiums in 2009. This outcome has resulted in some significant fluctuations between earned premiums and incurred losses between 2008 and 2009 and has adversely impacted our loss ratio and slightly improved the expense ratio for 2009. Based on the 2008 and 2009 accident year incurred loss development we experienced in 2010, we still have not triggered the stop loss contract. As a result, there are no ceded premiums or losses related to the stop loss contract recognized in 2010.

The experience and accounting under the stop loss reinsurance contract is as follows (in thousands):

 

 

This reinsurance contract has been accounted for at December 31, 2009 and at December 31, 2010 as if it has been commuted because the estimated experience under the contract at this point in time would lead us to execute a commutation to recognize profit sharing under that contract. However, the contract does not require us to execute the commutation until on or before January 1, 2015. Therefore, we will keep the contract in effect until a later date to continue the stop loss reinsurance protection for possible future adverse development of reserves for the accident years 2008 and 2009.

 

The stop loss contract was not renewed for the 2010 accident year because the reinsurance protection was no longer necessary as we have raised additional capital through our stock offering in October 2009.

 

The insolvency or inability of any reinsurer to meet its obligations to us could have a material adverse effect on our results of operations or financial condition. Our reinsurance providers, the majority of whom are longstanding partners who understand our business, are all carefully selected with the assistance of our reinsurance brokers. We monitor the solvency of reinsurers through regular review of their financial statements and, if available, their A.M. Best ratings. All of our significant reinsurance partners that A.M. Best follows have at least an “A−” A.M. Best rating. According to A.M. Best, companies with a rating of “A−” or better “have an excellent ability to meet their ongoing obligations to policyholders.” In certain instances, we may partner with a reinsurer who is not rated by A.M. Best. However, in such instances the reinsurer must be well capitalized and have a strong credit rating from Standard and Poor’s or Moody’s rating agencies. We will generally only make exceptions for property related reinsurance in which there is typically little or no delay in the reporting of losses by insureds and the settlement of the claims. We have experienced no significant difficulties collecting amounts due from reinsurers.

 

The following table sets forth the largest amounts of losses and loss expenses recoverable from reinsurers as of December 31, 2010 (dollars in thousands) and the A.M. Best rating of each:

 

 

 

Reinsurance Assumed.  We generally do not assume risks from other insurance companies. However, we are required by statute to participate in certain residual market pools. This participation requires us to assume business for workers’ compensation and for property exposures that are not insured in the voluntary marketplace. We participate in these residual markets pro rata on a market share basis, and as of December 31, 2010, our participation was not material. Prior to 1994 we participated in various voluntary insurance pools that are currently in runoff. We no longer participate in any voluntary assumed reinsurance contracts.

 

Losses and LAE Reserves

 

We are required by applicable insurance laws and regulations to maintain reserves for payment of losses and loss adjustment expenses (LAE). These reserves are established for both reported claims and for claims incurred but not reported (IBNR), arising from the policies we have issued. The laws and regulations require that provision be made for the ultimate cost of those claims without regard to how long it takes to settle them or the time value of money. The determination of reserves involves actuarial and statistical projections of what we expect to be the cost of the ultimate settlement and administration of such claims. The reserves are set based on facts and circumstances then known, estimates of future trends in claims severity, and other variable factors such as inflation and changing judicial theories of liability.

 

Estimating the ultimate liability for losses and LAE is an inherently uncertain process. Therefore, the reserve for losses and LAE does not represent an exact calculation of that liability. We recognize this uncertainty by maintaining reserves at a level providing for the possibility of adverse development relative to the estimation process. We do not discount our reserves to recognize the time value of money.

 

When a claim is reported to us, our claims personnel establish a “case reserve” for the estimated amount of the ultimate payment. This estimate reflects an informed judgment based upon general insurance reserving practices and on the experience and knowledge of our claims staff. In estimating the appropriate reserve, our claims staff considers the nature and value of the specific claim, the severity of injury or damage, and the policy provisions relating to the type of loss. Case reserves are adjusted by our claims staff as more information becomes available. It is our policy to settle each claim as expeditiously as possible.

 

We maintain IBNR reserves to provide for already incurred claims that have not yet been reported to us, plus developments on reported claims. The IBNR reserve is determined by estimating our ultimate net liability for both reported and IBNR claims and then subtracting the case reserves and paid losses and LAE for reported claims.

 

Each quarter, we compute our estimated ultimate liability using actuarial principles and procedures applicable to the lines of business written. However, because the establishment of loss reserves is an inherently uncertain process, we cannot assure you that ultimate losses will not exceed the established loss reserves. We reflect adjustments to reserves in the operating results of the periods in which the estimates are changed.

 

Our estimated liability for asbestos and environmental claims was $2.4 million at December 31, 2010 and at December 31, 2009; a substantial portion of which results from our participation in assumed reinsurance pools. The estimation of the ultimate liability for these claims is difficult due to outstanding issues such as whether coverage exists, the definition of an occurrence, the determination of ultimate damages, and the allocation of such damages to financially responsible parties. Therefore, any estimation of these liabilities is subject to significantly greater-than-normal variation and uncertainty.

The following table provides a reconciliation of beginning and ending unpaid losses and LAE reserve balances for the years ended December 31, 2010 and 2009, prepared in accordance with U.S. GAAP:

 

 

The estimation process for determining the liability for unpaid losses and LAE inherently results in adjustments each year for claims incurred (but not paid) in preceding years. Negative amounts reported for claims incurred related to prior years are a result of claims being settled for amounts less than originally estimated (favorable development). Positive amounts reported for claims incurred related to prior years are a result of claims being settled for amounts greater than originally estimated (unfavorable or adverse development).

 

The losses and LAE incurred in 2010 for prior accident years shows a negative amount of $2.1 million, which indicates that we had over-estimated our losses and LAE reserves at December 31, 2009.

 

The losses and LAE incurred in 2009 for prior accident years shows a positive amount of $1.6 million which indicates that we under-estimated our reserves at December 31, 2008. This situation results from the accounting for the stop loss contract assuming the liabilities will be commuted. To receive an estimated profit sharing under the stop loss contract, we will have to release the reinsurers from any and all past, current and future liabilities under the stop loss contract on or before January 1, 2015. The accounting for this anticipated profit sharing and commutation reverses the losses ceded and part of the premiums ceded under the contract. In return for taking back the $4.3 million of 2008 losses ceded under the contract at December 31, 2008, which were re-estimated to be $3.9 million at December 31, 2009, $4.0 million of premiums ceded under the contract will be returned to us.

 

This return of the 2008 ceded losses could be interpreted as adverse loss reserve development in the above schedule. The loss development experience in 2009 excluding the effects of the accounting for the stop loss contract is net favorable development (in thousands):

 

 

For additional information concerning the stop loss reinsurance contract, see Item 1 — “Business — Reinsurance.”

Reconciliation of Reserve for Losses and Loss Adjustment Expenses

 

The following table shows the development of our reserves for unpaid losses and LAE from 2000 through 2010 on a U.S. GAAP basis. The top line of the table shows the liabilities at the balance sheet date, including losses incurred but not yet reported. The upper portion of the table shows the cumulative amounts subsequently paid as of successive years with respect to the liability. The lower portion of the table shows the re-estimated amount of the previously recorded liability based on experience as of the end of each succeeding year. The estimates change as more information becomes known about the frequency and severity of claims for individual years. The redundancy (deficiency) exists when the re-estimated liability for each reporting period is less (greater) than the prior liability estimate. The “cumulative redundancy (deficiency)” depicted in the table, for any particular calendar year, represents the aggregate change in the initial estimates over all subsequent calendar years.

 

Gross deficiencies and redundancies may be significantly more or less than net deficiencies and redundancies due to the nature and extent of applicable reinsurance.

 

The adverse development for the years 2000 through 2003 is primarily attributable to changes in estimates as we had better information about the frequency and severity of claims and the adequacy of premium pricing levels, particularly in the commercial multi-peril line of business. Beginning in 2003, actuarial consultants were engaged to provide an additional reserve analysis three times per year. In 2009, we began utilizing an independent actuary to perform detailed reserve analyses on a quarterly basis. In addition, new policies and procedures were introduced to the claims function and more rigorous analysis of pricing data was undertaken. The resulting improvements to the claims reserving and underwriting and pricing processes have helped reduce the levels of gross and net reserve volatility in more recent years.

 

The net cumulative deficiency for those early years (2000 to 2003), while still high, is significantly lower than the gross deficiency, while in more recent years, the variance between gross and net is not as pronounced. This is primarily attributable to the fact that we purchased more reinsurance protection during those early years. Our maximum retained loss for any one risk was $200,000 in 2000. From 2001 to 2003, the maximum retention was $250,000. The maximum retention was $300,000 in 2004 and 2005 and $500,000 in 2006 and 2007. For 2008, we continued to retain $500,000 on any individual property and casualty risk, however, we retained 75% of losses in excess of $500,000 to $1 million, and 25% of losses in excess of $1 million to $5 million. As a complement to this increased retention, we entered into a whole account, accident year aggregate excess of loss (stop loss) contract that covers accident years 2008 and 2009 to provide coverage in the event that the 2008 or 2009 accident year loss ratio exceeds 72%. In 2009, we retained $500,000 on any individual property and casualty risk, and we lowered our retention to 52.5% of losses in excess of $500,000 to $1 million and 0% of losses in excess of $1 million to $5 million. In order to reduce our reinsurance costs, in 2010 we raised our retention to 60% in the $500,000 to $1 million layer.

 

Because of these and other factors, it is difficult to develop a meaningful extrapolation of estimated future redundancies or deficiencies in loss reserves from the data in the table.

 

 

Investments

 

Our investments in fixed maturity and equity securities are classified as available for sale, and are carried at fair value with unrealized gains and losses reflected as a component of accumulated other comprehensive income (loss), net of taxes. The goal of our investment activities is to complement and support our strategies. As such, the investment portfolio’s goal is to maximize after-tax investment income and price appreciation while maintaining the portfolio’s target risk profile.

 

An important component of our operating results has been the return on invested assets. Our investment objectives are (i) accumulation and preservation of capital, (ii) optimization, within accepted risk levels, of after-tax returns, (iii) assuring proper levels of liquidity, (iv) providing for an acceptable and stable level of current income, (v) managing the maturities of our investment securities to reflect the maturities of our liabilities, and (vi) maintaining a quality portfolio which will help attain the highest possible rating from A.M. Best. In addition to any investments prohibited by the insurance laws and regulations of Pennsylvania and any other applicable states, our investment policy prohibits the following investments and investing activities:

 

 

 

Our board of directors and company management review the investment policy at least annually. Our fixed maturity investment portfolio is managed by a registered independent investment advisor specializing in the management of insurance company investments.

 

We use quoted values and other data provided by a nationally recognized independent pricing service as inputs in our process for determining fair values of our investments. The pricing service covers substantially all of the securities in our portfolio. The pricing service’s evaluations represent an exit price, a good faith opinion as to what a buyer in the marketplace would pay for a security in a current sale. The pricing is based on observable inputs either directly or indirectly, such as quoted prices in markets that are active, quoted prices for similar securities at the measurement date, or other inputs that are observable.

 

Our fixed maturity investment manager provides us with pricing information that we utilize, together with information obtained from an independent pricing service, to determine the fair value of our fixed maturity securities.

 

The following table sets forth information concerning our investments (in thousands):

 

 

 

 

The following table summarizes the distribution of our portfolio of fixed maturity investments and equity securities (a high-yield bond mutual fund) as a percentage of total estimated fair value based on credit ratings assigned by Standard & Poor’s (S&P) at December 31, 2010 (dollars in thousands):

 

 

 

 

The table below sets forth the maturity profile of our fixed maturity securities at December 31, 2010. Expected maturities could differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties (in thousands):

 

 

 

 

At December 31, 2010, the average effective duration of our mortgage-backed securities was 3.7 years. The average effective duration of our total fixed maturity investment portfolio was 3.2 years. The fair value of our investments may fluctuate significantly in response to changes in interest rates. In addition, we may experience investment losses to the extent our liquidity needs require the disposition of fixed maturity securities in unfavorable interest rate environments.

 

Our fixed maturity portfolio held $22.9 million and $28.3 million of United States Agency-guaranteed residential mortgage-backed securities (RMBS) at December 31, 2010 and 2009, respectively. The RMBS had an

average credit rating of AAA for both years ended 2010 and 2009, and we held no non-agency guaranteed RMBS during the years ended 2010 and 2009.

 

Approximately 12% of our investments in fixed maturity securities at December 31, 2010 are guaranteed by third party monoline insurers. As of December 31, 2010 and 2009, the fixed maturity securities guaranteed by these monoline insurers were comprised entirely of municipal bonds with a fair value of $20.1 million and $22.7 million, and an average credit rating of AA and AA+, respectively. We hold no securities issued by any third party insurer.

 

The following table sets forth information with respect to the fair value at December 31, 2010, and December 31, 2009, of the fixed maturity securities that are guaranteed by each of the third party insurers (in thousands):

 

 

The following table sets forth the ratings of the security, with and without consideration of guarantee, for the fixed maturity securities that are guaranteed by third party insurers at December 31, 2010, and with the guarantee as of December 31, 2009 (in thousands):

 

 

Competition

 

The property and casualty insurance market is highly competitive. We compete with stock insurance companies, mutual companies, local cooperatives and other underwriting organizations. Certain of these competitors have substantially greater financial, technical and operating resources than we do. Our ability to compete successfully in our principal markets is dependent upon a number of factors, many of which are outside our control. These factors include market and competitive conditions. Many of our lines of insurance are subject to significant price competition. Some companies may offer insurance at lower premium rates through the use of salaried personnel or other distribution methods, rather than through independent producers paid on a commission basis (as we do). In addition to price, competition in our lines of insurance is based on quality of the products, quality and speed of service, financial strength and ratings, distribution systems and technical expertise. The primary competitors in our agribusiness marketplace are Nationwide Agribusiness, Continental Western Insurance Company and Westfield Insurance Company. A large number of regional and national insurance companies compete for small business and middle market customers.

 

Regulation

 

Insurance Company Regulation

Insurance companies are subject to supervision and regulation in the states in which they do business. State insurance authorities have broad administrative powers with respect to all aspects of the insurance business including:

 

 

Some of the state insurance laws, regulations and practices that an insurance company is subject to are described in greater detail below.

 

Accounting and Financial Reporting.  Penn Millers Insurance Company is required to file financial statements with state insurance departments everywhere it does business, and the operations of Penn Millers Insurance Company and its accounts are subject to examination by those departments at any time. Penn Millers prepares statutory financial statements in accordance with accounting practices and procedures prescribed or permitted by these departments.

 

Examinations.  Examinations are conducted by the Pennsylvania Insurance Department every three to five years. The Pennsylvania Insurance Department’s last completed examination of Penn Millers Insurance Company was as of December 31, 2009. Although the results of the examination have not been formally issued by the Pennsylvania insurance Department, the examination did not result in any adjustments to our financial position. In addition, we are not aware of any substantive matters arising out of the examination that we believe would have a material adverse impact on our operations.

 

NAIC Risk-Based Capital Requirements.  In addition to state-imposed insurance laws and regulations, the NAIC has adopted risk-based capital requirements that require insurance companies to calculate and report information under a risk-based formula. These risk-based capital requirements attempt to measure statutory capital and surplus needs based on the risks in a company’s mix of products and investment portfolio. Under the formula, a company first determines its “authorized control level” risk-based capital. This authorized control level takes into account (i) the risk with respect to the insurer’s assets; (ii) the risk of adverse insurance experience with respect to the insurer’s liabilities and obligations; (iii) the interest rate risk with respect to the insurer’s business; and (iv) all other business risks and such other relevant risks as are set forth in the risk-based capital instructions. A company’s “total adjusted capital” is the sum of statutory capital and surplus and such other items as the risk-based capital instructions may provide. The formula is designed to allow state insurance regulators to identify weakly capitalized

companies. The capital levels of Penn Millers Insurance Company have never triggered any of these regulatory capital levels, however, the capital requirements applicable to Penn Millers Insurance Company could increase in the future.

 

NAIC Ratios.  The NAIC also has developed a set of 13 financial ratios referred to as the Insurance Regulatory Information System (IRIS). On the basis of statutory financial statements filed with state insurance regulators, the NAIC annually calculates these IRIS ratios to assist state insurance regulators in monitoring the financial condition of insurance companies. The NAIC has established an acceptable range for each of the IRIS financial ratios. If four or more of its IRIS ratios fall outside the range deemed acceptable by the NAIC, an insurance company may receive inquiries from individual state insurance departments. For the year ended December 31, 2010, Penn Millers Insurance Company did not have four or more results fall outside the acceptable IRIS range.

 

Market Conduct Regulation.  State insurance laws and regulations include numerous provisions governing trade practices and the marketplace activities of insurers, including provisions governing the form and content of disclosure to consumers, illustrations, advertising, sales practices and complaint handling. State regulatory authorities generally enforce these provisions through periodic market conduct examinations.

 

Property and Casualty Regulation.  Our property and casualty operations are subject to rate and policy form approval, as well as laws and regulations covering a range of trade and claim settlement practices. State insurance regulatory authorities have broad discretion in approving an insurer’s proposed rates. The extent to which a state restricts underwriting and pricing of a line of business may adversely affect an insurer’s ability to operate that business profitably in that state on a consistent basis.

 

Mandatory Pooling Arrangements.  State insurance laws and regulations require us to participate in mandatory property-liability “shared market,” “pooling” or similar arrangements that provide certain types of insurance coverage to individuals or others who otherwise are unable to purchase coverage voluntarily provided by private insurers. Shared market mechanisms include assigned risk plans and fair access to insurance requirement or “FAIR” plans. In addition, some states require insurers to participate in reinsurance pools for claims that exceed specified amounts. Our participation in these mandatory shared market or pooling mechanisms generally is related to the amount of our direct writings for the type of coverage written by the specific arrangement in the applicable state.

 

Guaranty Fund Laws.  All states have guaranty fund laws under which insurers doing business in the state can be assessed to fund policyholder liabilities of insolvent insurance companies. Under these laws, an insurer is subject to assessment depending upon its market share of a given line of business in that state. For the years ended December 31, 2010 and 2009, we incurred approximately $(49,000) and $114,000, respectively, in assessments pursuant to state insurance guaranty association laws. We establish reserves relating to insurance companies that are subject to insolvency proceedings when we are notified of assessments by the guaranty associations. We cannot predict the amount and timing of any future assessments under these laws.

 

Dividends.  Pennsylvania law sets the maximum amount of dividends that may be paid by Penn Millers Insurance Company during any twelve-month period after notice to, but without prior approval of, the Pennsylvania Insurance Department. This amount cannot exceed the greater of 10% of the insurance company’s surplus as regards policyholders as reported on the most recent annual statement filed with the Pennsylvania Insurance Department, or the insurance company’s statutory net income for the period covered by the annual statement as reported on such statement. As of December 31, 2010, the amount available for payment of dividends by Penn Millers Insurance Company in 2011 without the prior approval of the Pennsylvania Insurance Department is approximately $6.8 million. “Extraordinary dividends” in excess of the foregoing limitations may only be paid with prior notice to, and approval of, the Pennsylvania Insurance Department.

 

Holding Company Laws.  Most states have enacted legislation that regulates insurance holding company systems. Each insurance company in a holding company system is required to register with the insurance supervisory agency of its state of domicile and furnish certain information. This includes information concerning the operations of companies within the holding company group that may materially affect the operations, management or financial condition of the insurers within the group. Pursuant to these laws, the Pennsylvania Insurance Department requires disclosure of material transactions involving Penn Millers Insurance Company and its affiliates, and requires prior notice and/or approval of certain transactions, such as “extraordinary dividends”

distributed by Penn Millers Insurance Company. Under these laws, the Pennsylvania Insurance Department also has the right to examine us and Penn Millers Insurance Company at any time.

 

All transactions within our consolidated group affecting Penn Millers Insurance Company must be fair and equitable. Notice of certain material transactions between Penn Millers Insurance Company and any person or entity in our holding company system will be required to be given to the Pennsylvania Insurance Department. Certain transactions cannot be completed without the prior approval of the Pennsylvania Insurance Department.

 

Approval of the state insurance commissioner is required prior to any transaction affecting the control of an insurer domiciled in that state. In Pennsylvania, the acquisition of 10% or more of the outstanding voting securities of an insurer or its holding company is presumed to be a change in control. Pennsylvania law also prohibits any person or entity from (i) making a tender offer for, or a request or invitation for tenders of, or seeking to acquire or acquiring any voting security of a Pennsylvania insurer if, after the acquisition, the person or entity would be in control of the insurer, or (ii) effecting or attempting to effect an acquisition of control of or merger with a Pennsylvania insurer, unless the offer, request, invitation, acquisition, effectuation or attempt has received the prior approval of the Pennsylvania Insurance Department.

 

Other Regulation

 

Sarbanes-Oxley Act of 2002.  On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002, (the SOA). The stated goals of the SOA are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies, and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. The SOA resulted in the implementation of very specific additional disclosure requirements and corporate governance rules, and compliance with the SOA imposes large costs on public companies like us.

 

Terrorism Risk Insurance Act of 2002.  On November 26, 2002, President Bush signed the Terrorism Risk Insurance Act of 2002. Under this law, coverage provided by an insurer for losses caused by certified acts of terrorism is partially reimbursed by the United States under a formula by which the government pays 85% of covered terrorism losses, exceeding a prescribed deductible. Therefore, the act limits an insurer’s exposure to “certified” terrorist acts (as defined by the act) to the prescribed deductible amount. The deductible is based upon a percentage of direct earned premiums for commercial property and casualty policies. Coverage under the act must be offered to all property, casualty and surety insureds.

 

The immediate effect of the act was to nullify terrorism exclusions previously permitted by state regulators to the extent they exclude losses that would otherwise be covered under the act. The act, as amended by the Risk Insurance Program Reauthorization Act of 2007, further states that until December 31, 2014, rates and forms for terrorism risk insurance covered by the act are not subject to prior approval or a waiting period under any applicable state law. Rates and forms of terrorism exclusions and endorsements are subject to subsequent review.

 

Privacy.  As mandated by the Gramm-Leach-Bliley Act, states continue to promulgate and refine laws and regulations that require financial institutions, including insurance companies, to take steps to protect the privacy of certain consumer and customer information relating to products or services primarily for personal, family or household purposes. A recent NAIC initiative that affected the insurance industry was the adoption in 2000 of the Privacy of Consumer Financial and Health Information Model Regulation, which assisted states in promulgating regulations to comply with the Gramm-Leach-Bliley Act. In 2002, to further facilitate the implementation of the Gramm-Leach-Bliley Act, the NAIC adopted the Standards for Safeguarding Customer Information Model Regulation. Several states have now adopted similar provisions regarding the safeguarding of customer information. Penn Millers has implemented procedures to comply with the Gramm-Leach-Bliley Act’s related privacy requirements.

 

OFAC.  The Treasury Department’s Office of Foreign Asset Control (OFAC) maintains a list of “Specifically Designated Nationals and Blocked Persons” (the SDN List). The SDN List identifies persons and entities that the government believes are associated with terrorists, rogue nations or drug traffickers. OFAC’s regulations prohibit insurers, among others, from doing business with persons or entities on the SDN List. If the insurer finds and confirms a match, the insurer must take steps to block or reject the transaction, notify the affected person and file a

report with OFAC. The focus on insurers’ responsibilities with respect to the SDN List has increased significantly since September 11, 2001.

 

New and Proposed Legislation and Regulations.  The property and casualty insurance industry has recently received a considerable amount of publicity because of rising insurance costs and the unavailability of insurance. New regulations and legislation are being proposed to limit damage awards, to control plaintiffs’ counsel fees, to bring the industry under regulation by the federal government and to control premiums, policy terminations and other policy terms. We are unable to predict whether, in what form, or in what jurisdictions, any regulatory proposals might be adopted or their effect, if any, on us.

 

On July 21, 2010, the President signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). Among other things, the Dodd-Frank Act establishes a Federal Insurance Office within the U.S. Department of the Treasury. The Federal Insurance Office initially has limited regulatory authority and is empowered to gather data and information regarding the insurance industry and insurers, including conducting a study for submission to the U.S. Congress on how to modernize and improve insurance regulation in the U.S. Further, the Dodd-Frank Act gives the Federal Reserve supervisory authority over a number of financial services companies, including insurance companies, if they are designated by a two-thirds vote of a Financial Stability Oversight Council as “systemically important.” The Dodd-Frank Act, or other additional federal regulation that is adopted in the future, could impose significant burdens on us, including impacting the ways in which we conduct our business, increasing compliance costs and duplicating state regulation. At this time, we cannot conclude with any degree of certainty what impact these reforms will have on our business.

 

Many of the states in which we operate have passed or are considering legislation restricting or banning the use of “credit scoring” in the rating and risk selection process. The Fair and Accurate Credit Transactions Act, passed by the U.S. Congress in 2003, directed the Federal Trade Commission (“FTC”) to consult with the Office of Fair Housing and Equal Opportunity on, among other things, how the use of credit information may affect the availability and affordability of property and casualty insurance, and whether the use of certain factors by credit scoring systems could have a disparate impact on minorities. In July of 2007, the FTC released a report on credit scoring and its impact on automobile insurance. The FTC concluded that credit-based scoring is an effective predictor of risk with respect to the issuance of automobile insurance policies to consumers, but has little effect as an indicator of racial or ethnic status of consumers. Despite the FTC’s conclusions, some consumer groups and certain regulatory and legislative entities continue to resist the use of credit scoring in the rating and risk selection process. In 2008, the FTC asked nine of the nation’s largest homeowners insurance companies to provide information that the FTC says will allow it to determine how consumer credit data is used by the companies in underwriting and rate setting in this line of business. The results of the study could affect the future use of credit scoring. Banning or restricting this practice or other data mining would limit our ability, and the ability of other carriers, to take advantage of the predictive value of this information.

 

Employees

 

As of December 31, 2010, we had 114 employees. None of these employees are covered by a collective bargaining agreement. We believe that our relationship with our employees remains positive. On February 10, 2011 we announced a reduction in staffing of nearly 10% of our workforce in order to more effectively align our staffing levels with our current business needs.

 

Available Information

 

The Company maintains a website at www.pennmillers.com. Our annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports, filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, are available free of charge on our website as soon as practicable after filing of such material with, or furnishing it to, the Securities and Exchange Commission. The information on our website is not part of this Form 10-K.

A.M. Best Rating

 

A.M. Best Company, Inc. (“A.M. Best”) rates insurance companies based on factors of concern to policyholders. A.M. Best currently assigns an “A-” (Excellent) rating with a stable outlook to Penn Millers Insurance Company. This rating is the fourth highest out of 15 rating classifications. The latest rating evaluation by A.M. Best occurred on June 22, 2010. According to the A.M. Best guidelines, A.M. Best assigns “A-” ratings to companies that have, on balance, very good balance sheet financial strength, operating performance and business profiles according to the standards established by A.M. Best. Companies rated “A-” are considered by A.M. Best to have “an excellent ability to meet their ongoing obligations to policyholders.” The rating evaluates the claims paying ability of a company, and is not a recommendation on the merits of an investment in our common stock.

 

 

As a “Smaller Reporting Company” we are not required to provide any disclosure under Item 1A. Risk factors are events and uncertainties over which the Company has limited or no control and which can have a material adverse impact on our financial condition or results of operations. We are subject to a variety of risk factors. The following information sets forth our evaluation of the risk factors we deem to be most material. We work to actively manage these risks, but the reader should be cautioned that we are only able to mitigate the impact of most risk factors, not eliminate the risk. Also, there may be other risks which we do not presently deem material that may become material in the future. You should carefully consider the following risk factors and all of the information set forth in this report, including our consolidated financial statements and notes thereto.

 

Catastrophic or other significant natural or man-made losses may negatively affect our financial results and liquidity.

 

As a property and casualty insurer, we are subject to claims from catastrophes that may have a significant negative impact on our operating and financial results. We have experienced catastrophe losses and can be expected to experience catastrophe losses in the future. Catastrophe losses can be caused by various events, including coastal storms, snow storms, ice storms, freezing temperatures, hurricanes, earthquakes, tornadoes, wind, hail, fires, and other natural or man-made disasters. The frequency, number and severity of these losses are unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event.

 

Longer-term natural catastrophe trends may be changing due to climate change, a phenomenon that has been associated with extreme weather events linked to rising temperatures, and includes effects on global weather patterns, greenhouse gases, sea, land and air temperatures, sea levels, rain and snow. Climate change, to the extent it produces rising temperatures and changes in weather patterns, could impact the frequency or severity of weather events, such as hurricanes. To the extent climate change does increase the frequency and severity of such weather events, we may face increased claims, including with respect to properties located in coastal areas.

 

We attempt to reduce our exposure to catastrophe losses through the underwriting process and by obtaining reinsurance coverage. However, in the event that we experience catastrophe losses, we cannot assure you that our unearned premiums, loss reserves and reinsurance will be adequate to cover these risks. In addition, because accounting rules do not permit insurers to reserve for catastrophic events until they occur, claims from catastrophic events have caused, and could continue to cause, substantial volatility in our financial results for any fiscal quarter or year and could have a material adverse affect on our financial condition or results of operations. Our ability to write new business also could be adversely affected.

 

We characterize as a “catastrophe” any event that is classified as such by the Property Claims Services (“PCS”) unit of Insurance Services Office, Inc. PCS defines industry catastrophes as events that cause $25 million or more in direct insured losses to property and that affect a significant number of policyholders and insurers. In 2010 and 2009, annual losses incurred by us from such events, net of reinsurance, were approximately $5.6 million and $2.0 million, respectively.

 

Our financial condition and results of operations also are affected periodically by losses caused by natural perils such as those described above that are not deemed a catastrophe. If a number of these events occur in a short

time period, it may materially affect our financial condition and results of operations. In 2010, we experienced an unusually high level of both catastrophe and non-catastrophe related weather losses from severe winter storm activity in the Mid-Atlantic and Northeast and from severe spring storm activity in the Midwest.

 

A reduction in our A.M. Best rating could affect our ability to write new business or renew our existing business.

 

Ratings assigned by A.M. Best are an important factor influencing the competitive position of insurance companies. A.M. Best ratings, which are reviewed at least annually, represent independent opinions of financial strength and ability to meet obligations to policyholders and are not directed toward the protection of investors. Therefore, our A.M. Best rating should not be relied upon as a basis for an investment decision to purchase our common stock.

 

Penn Millers Insurance Company holds a financial strength rating of “A-” (Excellent) by A.M. Best, the fourth highest rating out of 15 rating classifications. Penn Millers Insurance Company has held an A-rating for the past 17 years, and has been rated A- or higher every year since we were first rated in 1918. Our most recent evaluation by A.M. Best occurred on June 22, 2010. Financial strength ratings are used by producers and customers as a means of assessing the financial strength and quality of insurers. If our financial position deteriorates, we may not maintain our favorable financial strength rating from A.M. Best. A downgrade of our rating could severely limit or prevent us from writing desirable business or from renewing our existing business. In addition, a downgrade could negatively affect our ability to implement our strategies.

 

Turmoil in the capital markets and an economic downturn may impact our business activity level, results of operations, capital position and stock price.

 

Our business prospects, results of operations and capital position are affected by financial market conditions and general economic conditions. Pressures on the global economy and financial markets commenced in the third quarter of 2007, accelerated significantly in the third quarter of 2008, and continued into 2010. Rising unemployment, decreasing real estate and certain commodity prices, decreasing consumer spending and business investment, unprecedented stock price volatility and a significant slowdown in the economy have had a negative impact on the financial markets. It is not possible to predict whether conditions will deteriorate further or when the outlook will improve. As a result of such an economic downturn, the value of the securities we hold as investments may decline, negatively affecting our earnings and capital level through realized and unrealized investment losses. If adverse economic conditions negatively affect companies who issue the securities we hold, and reinsurers on whom we rely to help pay insurance claims, our liquidity level may suffer, we may experience insurance losses and it may be necessary to write-down securities we hold, due to issuer defaults or ratings downgrades. In the event of a protracted recession, we may experience significant challenges. These may include an increase in lapsed premiums and policies and a reduction of new business, declining premium revenues from our workers’ compensation products due to our insureds’ declining payrolls, and declining premiums as a result of business failures. In addition, increases in both legitimate and fraudulent claims may result from a protracted and deep recession. An adverse economic environment could affect the recovery of deferred policy acquisition costs, and deferred tax assets may not be realizable. Finally, if adverse economic conditions affect the ability of our reinsurers to pay claims, we could experience significant losses that could impair our financial condition.

 

Our municipal bond portfolio may be impacted by the effects of economic stress on state and local governments. Approximately 27.3% of our fixed maturity investment portfolio at December 31, 2010 is invested in obligations of states, municipalities and political subdivisions (collectively referred to as our municipal bond portfolio). Widespread concern currently exists regarding the stress on state and local governments emanating from: (i) declining revenues; (ii) large unfunded liabilities to government workers; and (iii) entrenched cost structures. Debt-to-gross domestic product ratios for the majority of states have been deteriorating due to, among other factors: (i) declines in federal monetary assistance provided as the United States is currently experiencing the largest deficit in its history; and (ii) lower levels of sales and property tax revenue as unemployment remains elevated and the housing market continues to remain unstable. This concern has led to speculation about the potential for a significant deterioration in the municipal bond market which could materially affect our results of operations, financial condition and liquidity. We may not be able to mitigate the exposure in our municipal portfolio if state and

local governments are unable to fulfill their obligations. The risk of widespread issuer defaults may also increase if there are changes in legislation that permit states, or additional municipalities and political subdivisions, to file for bankruptcy protection or if there are judicial interpretations that, in a bankruptcy or other proceeding, lessen the value of any structural protections.

 

Our investment performance may suffer as a result of adverse capital market developments, which may affect our financial results and ability to conduct business.

 

We invest the premiums we receive from policyholders until cash is needed to pay insured claims or other expenses. Our investments are subject to a variety of investment risks, including risks relating to general economic conditions, market volatility, interest rate fluctuations, liquidity risk and credit risk. An unexpected increase in the volume or severity of claims may force us to liquidate securities, which may cause us to incur capital losses. If we do not effectively structure the duration of our investments to match our insurance and reinsurance liabilities, we may be forced to liquidate investments prior to maturity at a significant loss to cover such payments. Investment losses could significantly decrease our asset base and statutory surplus, thereby affecting our ability to conduct business.

 

The geographic distribution of our business exposes us to significant natural disasters, which may negatively affect our financial and operating results.

 

Approximately 34% of our business is concentrated in the southeastern United States, which is prone to tornadoes and hurricanes. As of December 31, 2010, almost 20% of our direct premiums written originated from business written in Pennsylvania and New Jersey, and therefore, we have a greater exposure to catastrophic or other significant natural or man-made losses in that geographic region. The incidence and severity of such events are inherently unpredictable. In recent years, changing climate conditions have increased the unpredictability, severity and frequency of tornados, hurricanes, and other storms.

 

States and regulators from time to time have taken action that has the effect of limiting the ability of insurers to manage these risks, such as prohibiting insurers from reducing exposures or withdrawing from catastrophe-prone areas, or mandating that insurers participate in residual markets. Our ability or willingness to manage our exposure to these risks may be limited due to considerations of public policy, the evolving political environment, or social responsibilities. We may choose to write business in catastrophe-prone geographic areas that we might not otherwise write for strategic purposes, such as improving our access to other underwriting opportunities.

 

Our ability to properly estimate reserves related to hurricanes can be affected by the inability to access portions of the impacted areas, the complexity of factors contributing to the losses, the legal and regulatory uncertainties, and the nature of the information available to establish the reserves. These complex factors include, but are not limited to the following:

 

 

The estimates related to catastrophes are adjusted as actual claims are filed and additional information becomes available. This adjustment could reduce income during the period in which the adjustment is made, which could have a material adverse impact on our financial condition and results of operations.

Losses resulting from political instability, acts of war or terrorism may negatively affect our financial and operating results.

 

Numerous classes of business are exposed to terrorism related catastrophic risks. The frequency, number and severity of these losses are unpredictable. As a result, we have changed our underwriting protocols to address terrorism and the limited availability of terrorism reinsurance. However, given the uncertainty of the potential threats, we cannot be sure that we have addressed all the possibilities.

 

The Terrorism Risk Insurance Act of 2002, as extended by the Terrorism Risk Insurance Program Reauthorization Act of 2007, is effective for the period from November 26, 2002 through December 31, 2014. Prior to the act, insurance coverage by private insurers for losses (other than workers’ compensation) arising out of acts of terrorism was severely limited. The act provides, among other things, that all licensed insurers must offer coverage on most commercial lines of business for acts of terrorism. Losses arising out of acts of terrorism that are certified as such by the Secretary of the Treasury of the United States and that exceed $100 million will be reimbursed by the federal government subject to a limit of $100 billion in any year and less a deductible calculated for each insurer. Each insurance company is responsible for a deductible based on a percentage of its direct earned premiums in the previous calendar year. For 2011, our deductible is approximately $13.8 million. For losses in excess of the deductible, the federal government will reimburse 85% of the insurer’s loss, up to the insurer’s proportionate share of the $100 billion.

 

Notwithstanding the protection provided by reinsurance and the Terrorism Risk Insurance Act of 2002, the risk of severe losses to us from acts of terrorism has not been eliminated. Our reinsurance contracts include various limitations or exclusions limiting the reinsurers’ obligation to cover losses caused by acts of terrorism. Accordingly, events constituting acts of terrorism may not be covered by, or may exceed the capacity of, our reinsurance and could adversely affect our business and financial condition.

 

Our results may fluctuate as a result of many factors, including cyclical changes in the insurance industry, and we are currently in a “soft market” phase of the insurance industry cycle, which may lead to reduced premium volume.

 

Results of companies in the insurance industry, and particularly the property and casualty insurance industry, historically have been subject to significant fluctuations and uncertainties. The industry’s profitability can be affected significantly by:

 

 

Historically, the financial performance of the insurance industry has fluctuated in cyclical periods of low premium rates and excess underwriting capacity resulting from increased competition (a so-called “soft market”), followed by periods of high premium rates and a shortage of underwriting capacity resulting from decreased competition (a so-called “hard market”). Fluctuations in underwriting capacity, demand and competition, and the impact on our business of the other factors identified above, could have a negative impact on our results of operations and financial condition. We believe that underwriting capacity and price competition in the current market are indicative of a “soft market” phase of the insurance industry cycle. This additional underwriting capacity has resulted in increased competition from other insurers seeking to expand the kinds or amounts of insurance coverage they offer and causes some insurers to seek to maintain market share at the expense of underwriting discipline. During the last four years, we have experienced increased price competition with regard to most of our product lines. This competitive environment may adversely affect our ability to increase revenues may adversely affect our profitability.

Because estimating future losses is difficult and uncertain, if our actual losses exceed our estimates of losses and loss reserves, our operating results may be adversely affected.

 

We maintain reserves to cover amounts we estimate will be needed to pay for insured losses and for the expenses necessary to settle claims. Estimating loss and loss expense reserves is a difficult and complex process involving many variables and subjective judgments. We regularly review our reserve estimate protocols and our overall amount of reserves. We review historical data and consider the impact of various factors such as:

 

 

Our actual losses could exceed our reserves. If we determine that our loss reserves are inadequate, we will have to increase them. This adjustment would reduce income during the period in which the adjustment is made, which could have a material adverse impact on our financial condition and results of operations. Such adjustments to loss reserve estimates are referred to as “loss development.” If existing loss reserves exceed the revised estimate, it is referred to as positive loss development. Negative (also called “unfavorable”) loss development occurs when the revised estimate of expected losses with respect to a calendar year exceeds existing loss reserves. For example, our loss and loss expense reserve for the 2000 calendar year has experienced a cumulative unfavorable loss reserve development of $9.2 million (a 30.1% deficiency) as of December 31, 2010, while our loss and loss expense reserve for the 2006 calendar year has experienced a cumulative positive (also called “favorable”) loss development of $6.8 million (a 9.8% reduction) as of December 31, 2010. For additional information, see Item 1 — “Business — Losses and LAE Reserves.”

 

If our reinsurers do not pay our claims in accordance with our reinsurance agreements, we may incur losses.

 

We are subject to loss and credit risk with respect to the reinsurers with whom we deal because buying reinsurance does not relieve us of our liability to policyholders. If our reinsurers are not capable of fulfilling their financial obligations to us, our insurance losses would increase. For the year ended December 31, 2010, we ceded 22.0% of our gross written premiums to our reinsurers. We secure reinsurance coverage from a number of reinsurers. The lowest A.M. Best rating issued to any of our reinsurers that A.M. Best follows is “A-” (Excellent), which is the fourth highest of fifteen ratings. For additional information, see Item 1 — “Business — Reinsurance.”

 

We may be unable to effectively develop and market new products, like PennEdge, which may negatively affect our operations.

 

Our ability to expand our business and to compete depends on our ability to successfully develop and market new products, like PennEdge. The success of new products such as PennEdge depends on many factors, including our ability to anticipate and satisfy customer needs, develop our products cost-effectively, differentiate our products from our competitors, and, where applicable, obtain the necessary regulatory approvals on a timely basis.

 

However, even if we successfully develop new products, the success of those products will be dependent upon market acceptance. Market acceptance could be affected by several factors, including, but not limited to:

 

 

The successful development and marketing of PennEdge and other products will require a significant investment. Our failure to effectively develop and market PennEdge and other products may have an adverse effect on our business and operating results.

 

The property and casualty insurance market in which we operate is highly competitive, which limits our ability to increase premiums for our products and recruit new producers.

 

Competition in the property and casualty insurance business is based on many factors. These factors include the perceived financial strength of the insurer, premiums charged, policy terms and conditions, services provided, reputation, financial ratings assigned by independent rating agencies and the experience of the insurer in the line of insurance to be written. We compete with stock insurance companies, mutual companies, local cooperatives and other underwriting organizations. Many of these competitors have substantially greater financial, technical and operating resources than we have. Many of the lines of insurance we write are subject to significant price competition. If our competitors price their products aggressively, our ability to grow or renew our business may be adversely affected. We pay producers on a commission basis to write our business. Some of our competitors may offer higher commissions or insurance at lower premium rates through the use of salaried personnel or other distribution methods that do not rely primarily on independent producers (as we do). Increased competition could adversely affect our ability to attract and retain business, and thereby, reduce our profits from operations.

 

Our results of operations may be adversely affected by any loss of business from key producers.

 

Our products are primarily marketed by independent producers. Other insurance companies compete with us for the services and allegiance of these producers. These producers may choose to direct business to our competitors, or may direct less desirable risks to us. One producer, Arthur J. Gallagher Risk Management Services, which writes business for us through nine of their offices, accounted for $11.2 million, or approximately 13%, of our direct premiums written in 2010. Only one other producer accounted for more than 5% of our 2010 direct premiums written. If we experience a significant decrease in business from, or lose entirely, our largest producers it would have a material adverse effect on us.

 

Assessments and premium surcharges for state guaranty funds, second injury funds and other mandatory pooling arrangements may reduce our profitability.

 

Most states require insurance companies licensed to do business in their state to participate in guaranty funds, which require the insurance companies to bear a portion of the unfunded obligations of impaired, insolvent or failed insurance companies. These obligations are funded by assessments, which are expected to continue in the future. State guaranty associations levy assessments, up to prescribed limits, on all member insurance companies in the state based on their proportionate share of premiums written in the lines of business in which the impaired, insolvent or failed insurance companies are engaged. Accordingly, the assessments levied on us may increase as we increase our written premiums. Some states also have laws that establish second injury funds to reimburse insurers and employers for claims paid to injured employees for aggravation of prior conditions or injuries. These funds are supported by either assessments or premium surcharges based on incurred losses.

 

In addition, as a condition to conducting business in some states, insurance companies are required to participate in residual market programs to provide insurance to those who cannot procure coverage from an insurance carrier on a negotiated basis. Insurance companies generally can fulfill their residual market obligations by, among other things, participating in a reinsurance pool where the results of all policies provided through the pool are shared by the participating insurance companies. Although we price our insurance to account for our potential obligations under these pooling arrangements, we may not be able to accurately estimate our liability for these obligations. Accordingly, mandatory pooling arrangements may cause a decrease in our profits. At December 31, 2010, we participated in mandatory pooling arrangements in the majority of the states in which we do business. As we write policies in new states that have mandatory pooling arrangements, we will be required to participate in additional pooling arrangements. Further, the impairment, insolvency or failure of other insurance companies in these pooling arrangements would likely increase the liability for other members in the pool. The effect of assessments and premium surcharges or increases in such assessments or surcharges could reduce our profitability

in any given period or limit our ability to grow our business. For more information, see Item 1 — “Business — Regulation.”

 

Our revenues may fluctuate with our investment results and changes in interest rates.

 

Our investment portfolio is comprised mostly of fixed maturity securities at December 31, 2010, including bonds, mortgage-backed securities (MBSs) and other securities. The fair values of these invested assets fluctuate depending upon economic conditions, particularly changes in interest rates.

 

MBSs are subject to prepayment risks that vary with, among other things, interest rates. MBSs represented approximately $24.6 million or approximately 14% of our investments at December 31, 2010. During periods of declining interest rates, MBSs generally return principal faster than expected as the underlying mortgages are prepaid and/or refinanced by the borrowers in order to take advantage of the lower rates. MBSs with an amortized cost that is greater than par (i.e., purchased at a premium) may incur a reduction in yield or a loss as a result of prepayments. In addition, during such periods, we generally will be unable to reinvest the proceeds of any prepayment at comparable yields. Conversely, during periods of rising interest rates, the frequency of prepayments generally decreases. MBSs that have an amortized value that is less than par (i.e., purchased at a discount) may incur a decrease in yield or a loss as a result of slower prepayments.

 

We may not be able to prevent or minimize the negative impact of interest rate changes. Additionally, unforeseen circumstances may force us to sell certain of our invested assets at a time when their fair values are less than their original cost, resulting in realized capital losses, which would reduce our net income.

 

Volatility in commodity and other prices could impact our financial results.

 

We provide insurance coverages to mills, silos, and other agribusinesses, which store large quantities of commodities such as corn, wheat, soybeans and fertilizer. Therefore, the amount of our losses is affected by the value of these commodities. Volatility in commodity prices may be a result of many factors, including, but not limited to, shortages or excess supply created by weather changes, catastrophes, changes in global or local demand, or the rise or fall of the U.S. dollar relative to other currencies. Unexpected increases in commodity prices could result in our losses exceeding our actual reserves for our agribusiness lines. Such volatility in commodity prices could cause substantial volatility in our financial results for any fiscal quarter or year and could have a material adverse affect on our financial condition or results of operations. In addition, the cost of construction materials and prevailing labor costs in areas affected by widespread storm damage can significantly impact our casualty losses. Higher costs for construction materials and shortages of skilled contractors such as electricians, plumbers and carpenters can increase the cost to repair or replace an insured property.

 

Proposals to federally regulate the insurance business could affect our business.

 

Currently, the U.S. federal government does not directly regulate the insurance business. However, federal legislation and administrative policies in several areas can significantly and adversely affect insurance companies. These areas include financial services regulation, securities regulation, pension regulation, privacy, tort reform legislation and taxation. In addition, various forms of direct federal regulation of insurance have been proposed. These proposals generally would maintain state-based regulation of insurance, but would affect state regulation of certain aspects of the insurance business, including rates, producer and company licensing, and market conduct examinations. We cannot predict whether any of these proposals will be adopted, or what impact, if any, such proposals or, if enacted, such laws may have on our business, financial condition or results of operations.

 

If we fail to comply with insurance industry regulations, or if those regulations become more burdensome, we may not be able to operate profitably.

 

We are regulated by the Pennsylvania Insurance Department, as well as, to a more limited extent, the federal government and the insurance departments of other states in which we do business. As of December 31, 2010 almost 20% of our direct premiums written originated from business written in Pennsylvania and New Jersey. Therefore, the cancellation or suspension of our license in these states, as a result of any failure to comply with the applicable insurance laws and regulations, may negatively impact our operating results.

Most insurance regulations are designed to protect the interests of policyholders rather than shareholders and other investors. These regulations relate to, among other things:

 

 

The Pennsylvania Insurance Department also conducts periodic examinations of the affairs of insurance companies and requires the filing of annual and other reports relating to financial condition, holding company issues and other matters. These regulatory requirements may adversely affect or inhibit our ability to achieve some or all of our business objectives. Our last completed examination was as of December 31, 2009, the results of which have not been formally issued by the Pennsylvania Insurance Department.

 

In addition, regulatory authorities have relatively broad discretion to deny or revoke licenses for various reasons, including the violation of regulations. Further, changes in the level of regulation of the insurance industry or changes in laws or regulations themselves or interpretations by regulatory authorities could adversely affect our ability to operate our business.

 

Our ability to manage our exposure to underwriting risks depends on the availability and cost of reinsurance coverage.

 

Reinsurance is the practice of transferring part of an insurance company’s liability and premium under an insurance policy to another insurance company. We use reinsurance arrangements to limit and manage the amount of risk we retain, to stabilize our underwriting results and to increase our underwriting capacity. The availability and cost of reinsurance are subject to current market conditions and may vary significantly over time. Any decrease in the amount of our reinsurance will increase our risk of loss. We may be unable to maintain our desired reinsurance coverage or to obtain other reinsurance coverage in adequate amounts and at favorable rates. If we are unable to renew our expiring coverage or obtain new coverage, it will be difficult for us to manage our underwriting risks and operate our business profitably.

 

It is also possible that the losses we experience on risks we have reinsured will exceed the coverage limits on the reinsurance. If the amount of our reinsurance coverage is insufficient, our insurance losses could increase substantially.

We could be adversely affected by the loss of our existing management or key employees.

 

The success of our business is dependent, to a large extent, on our ability to attract and retain key employees, in particular our senior officers. These key officers have an average of over twenty years of experience in the property and casualty insurance industry. Our business may be adversely affected if labor market conditions make it difficult for us to replace our current key officers with individuals having equivalent qualifications and experience at compensation levels competitive for our industry. In particular, because of the shortage of experienced underwriters and claims personnel who have experience or training in the agribusiness sector of the insurance industry, replacing key employees in that line of our business could be challenging. While we have employment agreements with a number of key officers, we do not have agreements not to compete or employment agreements with most of our employees. Our employment agreements with our key officers have change of control provisions that provide for certain payments and the continuation of certain benefits in the event they are terminated without cause or they voluntarily quit for good reason after a change in control.

 

We could be adversely affected by any interruption to our ability to conduct business at our current location.

 

Our business operations are concentrated in one physical location in Wilkes-Barre, Pennsylvania, which is located on the Susquehanna River. Accordingly, our business operations could be substantially interrupted by flooding, snow, ice, and other weather-related incidents, or from fire, power loss, telecommunications failures, terrorism, or other such events. In such an event, we may not have sufficient redundant facilities to cover a loss or failure in all aspects of our business operations and to restart our business operations in a timely manner. Any damage caused by such a failure or loss may cause interruptions in our business operations that may adversely affect our service levels and business.

 

Statutory provisions and our articles and bylaws may discourage takeover attempts on Penn Millers that you may believe are in your best interests or that might result in a substantial profit to you.

 

We are subject to provisions of Pennsylvania corporate and insurance law that hinder a change of control. Pennsylvania law requires the Pennsylvania Insurance Department’s prior approval of a change of control of an insurance holding company. Under Pennsylvania law, the acquisition of 10% or more of the outstanding voting stock of an insurer or its holding company is presumed to be a change in control. Approval by the Pennsylvania Insurance Department may be withheld even if the transaction would be in the shareholders’ best interest if the Pennsylvania Insurance Department determines that the transaction would be detrimental to policyholders.

 

Our articles of incorporation and bylaws also contain provisions that may discourage a change in control. These provisions include:

 

 

 

These provisions may serve to entrench management and may discourage a takeover attempt that you may consider to be in your best interest or in which you would receive a substantial premium over the current market price. These provisions may make it extremely difficult for any one person, entity or group of affiliated persons or entities to acquire voting control of Penn Millers, with the result that it may be extremely difficult to bring about a change in the board of directors or management. Some of these provisions also may perpetuate present management because of the additional time required to cause a change in the control of the board. Other provisions make it difficult for shareholders owning less than a majority of the voting stock to be able to elect even a single director.

 

If Penn Millers Insurance Company is not sufficiently profitable, our ability to pay dividends will be limited.

 

We depend primarily on dividends paid by Penn Millers Insurance Company and proceeds from the initial public offering that are not contributed to Penn Millers Insurance Company to provide funds for the payment of dividends to our shareholders. We will receive dividends only after all of Penn Millers Insurance Company’s obligations and regulatory requirements with the Pennsylvania Insurance Department have been satisfied. During any twelve-month period, the amount of dividends paid by Penn Millers Insurance Company to us, without the prior approval of the Pennsylvania Insurance Department, may not exceed the greater of 10% of the insurance company’s surplus as regards policyholders as reported on its most recent annual statement filed with the Pennsylvania Insurance Department or the insurance company’s statutory net income as reported on such statement. We presently do not intend to pay dividends to our shareholders. If Penn Millers Insurance Company is not sufficiently profitable, our ability to pay dividends to you in the future will be limited.

 

If our controls to ensure compliance with legal and regulatory policies and guidelines are not effective, our business, financial results and reputation could be materially adversely affected.

 

A control system, regardless of how well designed and effective we consider it to be, can only provide reasonable assurance that the control systems’ objectives will be met. If we determine that our controls are not effective, including internal controls over financial reporting, this could have an adverse effect on our financial results, liquidity, and reputation; and possibly subject us to litigation.

 

 

None

 

 

Our headquarters are located at 72 North Franklin Street, Wilkes-Barre, Pennsylvania. We own this 39,963 square foot facility. We also rent office space in Indianapolis, IN. In the opinion of our management, the Company’s properties are adequate and suitable for its business as presently conducted and are adequately maintained.

 

 

The Company is, from time to time, involved in legal proceedings that arise in the ordinary course of business. We believe that we have sufficient loss reserves and reinsurance to cover claims under insurance policies issued by us. Although there can be no assurance as to the ultimate disposition of these matters, we do not believe, based upon the information available at this time, that any current pending legal proceedings, either individually or in the aggregate, will have a material adverse effect on our business, financial conditions, or results of operations.

 

 

On October 17, 2009, our common stock began trading on the Nasdaq Global Market under the symbol “PMIC.” The number of holders of record, including individual owners of our common stock was 329 as of February 28, 2011. This is not the actual number of beneficial owners of our common stock, as shares are held in “street name” by brokers and others on behalf of individual owners.

 

We do not currently pay dividends on our common stock. Payment of dividends in the future is at the discretion of our board of directors and will depend on a number of factors including our operating results, overall financial condition, capital requirements and general business conditions. We depend primarily on dividends paid by Penn Millers Insurance Company to us and proceeds from the initial public offering that were not contributed to Penn Millers Insurance Company to provide funds for the payment of dividends. If Penn Millers Insurance Company chooses to pay dividends to Penn Millers Holding Corporation, we will receive dividends only after Penn Millers Insurance Company provides notice to, and without objection from, the Pennsylvania Insurance Department. During any twelve-month period, the amount of dividends paid by Penn Millers Insurance Company to us, without the prior approval of the Pennsylvania Insurance Department, may not exceed the greater of 10% of the insurance company’s surplus as regards policyholders as reported on its most recent annual statement filed with the Pennsylvania Insurance Department or the insurance company’s statutory net income as reported on such statement. Information regarding the restrictions and limitations on the payment of cash dividends can be found in Item 1 “Business — Regulation.”

 

The following table sets forth the high and low closing sales prices of our common stock for the periods indicated that we were a publicly-traded company:

 

 

Issuer Purchases of Equity Securities

 

In the three months ended June 30, 2010, the 54,440 shares remaining under our October 27, 2009 stock repurchase program were purchased at an average cost of $14.60 per share.

 

On May 12, 2010, our board of directors authorized the repurchase of up to 5% of the issued and outstanding shares of our common stock. The repurchases are authorized to be made from time to time in open market or privately negotiated transactions as, in our management’s sole opinion, market conditions warrant. We have the right to repurchase issued and outstanding shares of common stock until 5% of the shares, or 258,591, are repurchased. In the year ended December 31, 2010, we repurchased under this second program 232,691 shares at an average cost of $14.44 per share.

 

All purchases were made in accordance with the safe harbor set forth in Exchange Act Rule 10-b-18. The repurchased shares will be held as treasury shares and will be used in connection with our stock-based incentive plan.

 

On August 11, 2010, our board of directors approved a third share repurchase plan, authorizing the repurchase of an additional 245,662 common shares in open market or privately negotiated transactions during a twelve month

period beginning August 18, 2010. For the year ended December 31, 2010, no shares were repurchased under the August 2010 program.

 

For more information on our stock repurchase programs, see “Liquidity and Capital Resources” in Item 7 of this Form 10-K.

 

Equity Compensation Plan Information

 

The following table summarizes the number of shares issuable pursuant to outstanding options and remaining available for issuance under the Company’s Stock Incentive Plan as of December 31, 2010:

 

 

 

Not applicable.