| MERCER INSURANCE GROUP INC ITEM 1A RISK FACTORS Risks Relating to Our Industry Catastrophic Events As a property and casualty insurer, we are subject to claims from catastrophes that may have a significant negative impact on 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, hurricanes, earthquakes, tornadoes, wind, hail, fires, and other natural or man-made disasters |
| We also face exposure to losses resulting from acts of war, acts of terrorism and political instability |
| 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 |
| We attempt to mitigate catastrophe risk by reinsuring a portion of our exposure |
| However, reinsurance may prove inadequate if: • A major catastrophic loss exceeds the reinsurance limit • A number of small catastrophic losses occur which individually fall below the retention level |
| In addition, because accounting regulations do not permit insurers to reserve for catastrophic events until they occur, claims from catastrophic events 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 |
| Our ability to write new business also could be adversely affected |
| Loss Reserves 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 |
| Estimates are based on management assessment of the known facts and circumstances, prediction of future events, claims severity and frequency and other subjective 29 _________________________________________________________________ [80]Table of Contents factors |
| We regularly review our reserving techniques and our overall amount of reserves |
| We review historical data and consider the impact of various factors such as: • trends in claim frequency and severity; • information regarding each claim for losses; • legislative enactments, judicial decisions and legal developments regarding damages; and • trends in general economic conditions, including inflation |
| Our estimated loss reserves could be incorrect and potentially inadequate |
| 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 operation |
| There is no precise way to determine the ultimate liability for losses and loss settlements prior to final settlement of the claim |
| Terrorism The threat of terrorism, both within the United States and abroad, and military and other actions and heightened security measures in response to these types of threats, may cause significant volatility and declines in the equity markets in the United States, Europe and elsewhere, as well as loss of life, property damage, additional disruptions to commerce and reduced economic activity |
| Actual terrorist attacks could cause losses from insurance claims related to the property and casualty insurance operations of the Company as well as a decrease in our stockholders’ equity, net income and/or revenue |
| The Terrorism Risk Insurance Act of 2002 requires that some coverage for terrorist loss be offered by primary property insurers and provides Federal assistance for recovery of claims through 2007 |
| In addition, some of the assets in our investment portfolio may be adversely affected by declines in the equity markets and economic activity caused by the continued threat of terrorism, ongoing military and other actions and heightened security measures |
| We cannot predict at this time whether and the extent to which industry sectors in which we maintain investments may suffer losses as a result of potential decreased commercial and economic activity, or how any such decrease might impact the ability of companies within the affected industry sectors to pay interest or principal on their securities, or how the value of any underlying collateral might be affected |
| We can offer no assurances that the threats of future terrorist-like events in the United States and abroad or military actions by the United States will not have a material adverse effect on our business, financial condition or results of operations |
| Reinsurance 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 |
| The potential exists in a hard market cycle for reinsurance costs to rise |
| If this occurs, reinsurance could become more difficult to obtain and the Company may have to further increase its retention levels |
| Any increase in our retention levels 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 |
| 30 _________________________________________________________________ [81]Table of Contents If our reinsurers do not pay our claims in a timely manner, 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 |
| Investments Our investment portfolio contains a significant amount of fixed-income securities, including at different times bonds, mortgage-backed securities (MBSs) and other securities |
| The market values of all of our investments fluctuate depending on economic conditions and other factors |
| The market values of our fixed-income securities are particularly sensitive to changes in interest rates |
| We may not be able to prevent or minimize the negative impact of interest rate changes |
| Additionally, we may, from time to time, for business, regulatory or other reasons, elect or be required to sell certain of our invested assets at a time when their market values are less than their original cost, resulting in realized capital losses, which would reduce net income |
| Regulation If we fail to comply with insurance industry regulations, or if those regulations become more burdensome, we may not be able to operate profitably |
| Our insurance companies are regulated by government agencies in the states in which we do business, as well as by the federal government |
| Most insurance regulations are designed to protect the interests of policyholders rather than shareholders and other investors |
| These regulations are generally administered by a department of insurance in each state in which we do business |
| State insurance departments conduct periodic examinations of the affairs of insurance companies and require 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 |
| In addition, regulatory authorities have relatively broad discretion to deny or revoke licenses for various reasons, including the violation of regulations |
| In some instances, we follow practices based on our interpretations of regulations or practices that we believe may be generally followed by the industry |
| These practices may turn out to be different from the interpretations of regulatory authorities |
| If we do not have the requisite licenses and approvals or do not comply with applicable regulatory requirements, insurance regulatory authorities could preclude or temporarily suspend us from carrying on some or all of our activities or otherwise penalize us |
| This could adversely affect our ability to operate our business |
| 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 |
| We are also subject to various accounting and financial requirements established by the National Association of Insurance Commissioners (NAIC) |
| If we fail to comply with these laws, regulations and requirements, it could result in consequences ranging from a regulatory examination to a regulatory takeover of one or more of our insurance companies |
| In addition, state regulators and the NAIC continually re-examine existing laws and regulations, with an emphasis on insurance company solvency issues and fair treatment of policyholders |
| Insurance laws and regulations could change or additional restrictions could be imposed that are more burdensome and make our business less profitable |
| We are subject to the application of US generally accepted accounting principles (GAAP), which is periodically revised and/or expanded |
| As such, we are periodically required to adopt new or revised accounting standards issued by recognized authoritative bodies, including the Financial Accounting Standards Board |
| It is possible that future changes required to be adopted could change the current accounting treatment that we apply and such changes could result in a material adverse impact on our results of operations and financial condition |
| 31 _________________________________________________________________ [82]Table of Contents Risks Relating to Our Business Geographic Due to the geographic concentration of our business (principally, New Jersey, Pennsylvania, California, Oregon, Nevada, and Arizona) catastrophe and natural peril losses may have a greater adverse effect on us than they would on a more geographically diverse property and casualty insurer |
| We could be significantly affected by legislative, judicial, economic, regulatory, demographic and other events and conditions in these states |
| In addition, we have significant exposure to property losses caused by severe weather that affects any of these states |
| Those losses could adversely affect our results |
| Competition The property and casualty insurance market in which we operate is highly competitive |
| 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 produce 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 on independent producers |
| Increased competition could adversely affect our ability to attract and retain business and thereby reduce our profits from operations |
| Rating A reduction in our AM Best rating could affect our ability to write new business or renew our existing business |
| Ratings assigned by the AM Best Company, Inc |
| are an important factor influencing the competitive position of insurance companies |
| AM Best ratings represent independent opinions of financial strength and ability to meet obligations to policyholders and are not directed toward the protection of investors |
| If our financial position deteriorates, we may not maintain our favorable financial strength rating from AM Best |
| A downgrade of our rating could severely limit or prevent us from writing desirable business or from renewing our existing business |
| Key Producers Our results of operations may be adversely affected by any loss of business from key producers |
| Our products are 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 |
| Our two largest producers, Davis Insurance Agency and Brown & Brown, Inc, accounted for approximately 17prca of our direct premiums written for the year ended December 31, 2005 |
| H Thomas Davis, Jr, a director and executive officer of the Company, is the owner of the Davis Insurance Agency, while Brown & Brown, Inc, is not affiliated with us |
| If we experienced a significant decrease in business from, or lost entirely, either of our two largest producers or several of our other large producers, it would have a material adverse effect on us |
| Dividends Subsidiaries of the Company may declare and pay dividends to the Company only if they are permitted to do so under the insurance regulations of their respective state of domicile |
| All of the states in which the Company’s subsidiaries are domiciled regulate the payment of dividends |
| States, including New Jersey, Pennsylvania, and California require that the Company give notice to the relevant state insurance commissioner prior to its subsidiaries declaring any dividends and distributions payable to the parent |
| During the 32 _________________________________________________________________ [83]Table of Contents notice period, the state insurance commissioner may disallow all or part of the proposed dividend upon determination that: (i) the insurer’s surplus is not reasonable in relation to its liabilities and adequate to its financial needs and those of the policyholders, or (ii) in the case of New Jersey, the insurer is otherwise in a hazardous financial condition |
| In addition, insurance regulators may block dividends or other payments to affiliates that would otherwise be permitted without prior approval upon determination that, because of the financial condition of the insurance subsidiary or otherwise, payment of a dividend or any other payment to an affiliate would be detrimental to an insurance subsidiary’s policyholders or creditors |
| Technology We may not be able to successfully implement our technology initiative |
| We are changing the portion of our information system supported by an outside service bureau platform to one using an internal software package |
| Our new platform may allow a producer to produce business through the Internet or through the method he or she has historically used |
| Business processed and maintained in this system through the Internet will provide efficiency because information for all users is entered only once |
| Conversion to the new platform is scheduled to be completed in the latter part of 2006 |
| We may not be able to successfully re-engineer our internal processes to allow for implementation of this new system to the extent we desire |
| Further, during the transition period our producers’ ability to transact business with us may be interrupted, and we and our producers may not be able to provide our customers with the level of service to which they are accustomed |
| We believe that the ability to produce business through the Internet will increase our revenues by making it easier for us and our producers to exchange information, and should lower expenses by increasing ease of use |
| However, our producers may not be willing to use the Internet feature of this system |
| In addition, our short-term expenses have increased because of costs associated with the implementation of the new system and the need to maintain two systems during the transition |
| Acquisitions The Company made an acquisition in 2005 and intends to grow its business in part through acquisitions in the future as part of its long term business strategy |
| These type of transactions involve significant challenges and risks that the business transactions do not advance our business strategy, that we don’t realize a satisfactory return on the investment we make, or that we may experience difficulty in the integration of new employees, business systems, and technology or diversion of management’s attention from our other businesses |
| These factors could adversely affect our operating results and financial condition |
| Key Personnel We could be adversely affected by the loss of our key personnel |
| The success of our business is dependent, to a large extent, on the efforts of certain key management personnel, and the loss of key personnel could prevent us from fully implementing our business strategy and could significantly and negatively affect our financial condition and results of operations |
| As we continue to grow, we will need to recruit and retain additional qualified management personnel, and our ability to do so will depend upon a number of factors, such as our results of operations and prospects and the level of competition then prevailing in the market for qualified personnel |
| Presently, competition to attract and retain key personnel is intense |