The Farmers Automobile Insurance Association Report on Audits of Financial Statements - Statutory Basis For the Years Ended December 31, 2012 and 2011
Table of Contents Page(s) Independent Auditor s Report... 1-2 Financial Statements: Statutory Balance Sheets as of December 31, 2012 and 2011... 3 Statutory Statements of Operations and Changes in Policyholders Surplus for the Years Ended December 31, 2012 and 2011... 4 Statutory Statements of Cash Flow for the Years Ended December 31, 2012 and 2011... 5 Notes to Statutory Basis Financial Statements... 6-26 Independent Auditor s Report on the Supplementary Information... 27 Summary Investment Schedule... 28 Investment Risks Interrogatories...29-32 Reinsurance Interrogatories...33-34
INDEPENDENT AUDITOR S REPORT To the Board of Directors The Farmers Automobile Insurance Association Pekin, Illinois We have audited the accompanying statutory balance sheets of The Farmers Automobile Insurance Association (the Association) as of December 31, 2012 and 2011, and the related statutory statements of operations, changes in policyholders surplus, and cash flow for the years then ended, and the related notes to the statutory financial statements. Management s Responsibilities for the Statutory Financial Statements Management is responsible for the preparation and fair presentation of these financial statements in accordance with the accounting practices prescribed or permitted by the Illinois Department of Insurance. Management is also responsible for the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error. Auditor s Responsibility Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor s judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the Association s preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Association s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinions. 1
Basis for Adverse Opinion on U.S. Generally Accepted Accounting Principles As described in Note 1 to the financial statements, the financial statements are prepared by the Association in accordance with accounting practices prescribed or permitted by the Illinois Department of Insurance, which is a basis of accounting other than accounting principles generally accepted in the United States of America, to meet the requirements of the state of Illinois. The effects on the statutory financial statements of the variances between the statutory basis of accounting described in Note 1 and accounting principles generally accepted in the United States of America have not been determined but are presumed to be material. Adverse Opinion on U.S. Generally Accepted Accounting Principles In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion on U.S. Generally Accepted Accounting Principles paragraph, the financial statements referred to above do not present fairly, in accordance with accounting principles generally accepted in the United States of America, the financial position of the Association as of December 31, 2012 and 2011, and the results of its operations and its cash flow for the years then ended. Opinion on Regulatory Basis of Accounting In our opinion, the statutory financial statements referred to above present fairly, in all material respects, the financial position of the Association as of December 31, 2012 and 2011, and the results of its operations, changes in policyholders surplus, and its cash flow for the years then ended, in accordance with the accounting practices prescribed or permitted by the Illinois Department of Insurance described in Note 1. Madison, Wisconsin May 15, 2013 Strohm Ballweg, LLP 2
Statutory Balance Sheets December 31, 2012 and 2011 2012 2011 Admitted Assets: Bonds $ 600,474,918 $ 578,566,670 Common Stocks: Affiliates 195,096,920 184,966,168 Other than Affiliates 28,546,741 25,362,541 Real Estate (Net of Accumulated Depreciation of $9,458,340 and $9,082,802) 7,446,329 6,382,683 Cash and Short-Term Investments 29,967,538 23,560,399 Securities Lending Reinvested Collateral Assets 39,763,541 48,978,557 Notes Receivable from Affiliate 425,000 425,000 Other Invested Assets 93,282 131,078 Cash and Invested Assets 901,814,269 868,373,096 Investment Income Accrued 6,623,985 6,832,213 Uncollected Premiums 140,648,826 120,808,458 Current Federal Income Tax Recoverable 4,464,365 5,567,898 Net Deferred Tax Asset 19,913,139 25,555,224 EDP Equipment (Net of Accumulated Depreciation of $5,955,684 and $5,287,619) 924,886 1,195,523 Intangible Pension Asset 453,656 - Recoverable from Reinsurers 4,815,697 3,210,770 Total Admitted Assets $ 1,079,658,823 $ 1,031,543,182 Liabilities: Unpaid Losses $ 245,133,767 $ 235,237,683 Unpaid Loss Adjustment Expenses 56,395,830 58,564,584 Unearned Premiums 196,409,548 178,236,641 Commissions, Expenses, Fees, and Taxes 28,066,808 24,104,505 Drafts Outstanding 20,508,476 20,678,698 Remittances and Items Not Allocated 1,369,563 1,770,122 Advance Premiums 4,891,581 5,986,067 Payable for Securities Lending 39,763,541 48,978,557 Other Liabilities 15,864,911 10,548,973 Total Liabilities 608,404,025 584,105,830 Policyholders Surplus: Guaranty Fund 872,500 872,500 Unassigned Surplus 470,382,298 446,564,852 Total Policyholders Surplus 471,254,798 447,437,352 Total Liabilities and Policyholders Surplus $ 1,079,658,823 $ 1,031,543,182 The accompanying notes are an integral part of the statutory financial statements. -3-
Statutory Statements of Operations and Changes in Policyholders Surplus Years Ended December 31, 2012 and 2011 2012 2011 Underwriting Income: Premiums Written $ 401,990,633 $ 368,508,420 Increase in Unearned Premiums (18,172,907) (15,665,125) Premiums Earned 383,817,726 352,843,295 Losses and Expenses Incurred: Losses 255,489,709 261,799,513 Loss Adjustment Expenses 32,618,847 32,887,085 Underwriting Expenses 109,440,766 100,942,000 Total Losses and Expenses Incurred 397,549,322 395,628,598 Underwriting Loss (13,731,596) (42,785,303) Net Investment Income Earned 27,047,315 28,591,127 Realized Capital Gains 11,196,332 5,253,245 Other Income 2,952,878 2,894,677 Net Income (Loss) Before Federal Income Tax 27,464,929 (6,046,254) Federal Income Tax Expense (Benefit) 4,713,763 (11,092,620) Net Income $ 22,751,166 $ 5,046,366 Statement of Changes in Policyholders' Surplus: Policyholders' Surplus - Beginning of Year $ 447,437,352 $ 417,770,470 Changes in Policyholders' Surplus: Net Income 22,751,166 5,046,366 Net Unrealized Capital Gains (Losses): Affiliates 7,206,270 8,717,456 Other than Affiliates 1,597,098 (1,863,927) Non-Admitted Assets 840,294 563,208 Provision for Reinsurance (76,979) (87,172) Net Deferred Income Tax (5,642,085) (243,080) Cumulative Effect of Changes in Accounting Principles - 11,232,203 Adoption of Statutory Accounting Principle No. 10R 6,301,828 Additional Minimum Pension Liability (2,858,318) - Net Increase 23,817,446 29,666,882 Policyholders' Surplus - End of Year $ 471,254,798 $ 447,437,352 The accompanying notes are an integral part of the statutory financial statements. -4-
Statutory Statements of Cash Flow Years Ended December 31, 2012 and 2011 2012 2011 Cash from Operations: Net Premiums Collected $ 381,870,530 $ 353,813,579 Net Investment Income Received 29,482,756 31,066,843 Other Income Received 2,952,880 2,894,677 Total Cash Received 414,306,166 387,775,099 Benefits and Loss Related Payments 247,198,552 253,954,886 Commissions, Expenses Paid and Other Deductions 140,017,413 133,211,961 Federal Income Taxes Paid (Recovered) 3,610,230 (3,741,143) Total Cash Disbursed 390,826,195 383,425,704 Net Cash from Operations 23,479,971 4,349,395 Cash from Investments: Proceeds from Investments Sold, Matured or Repaid: Bonds 158,716,016 134,960,461 Stocks 20,510,873 20,192,864 Other Invested Assets 150,968 689,144 Miscellaneous 9,327,741 14,331,710 Total Investment Proceeds 188,705,598 170,174,179 Cost of Investments Acquired: Bonds 172,964,579 135,616,816 Stocks 23,337,485 23,478,562 Real Estate 1,439,183 398,129 Other Invested Assets 4,191 588,544 Total Investments Acquired 197,745,438 160,082,051 Net Cash from Investments (9,039,840) 10,092,128 Cash from Financing and Miscellaneous Sources: Other Cash Applied (8,032,992) (7,311,796) Net Cash from Financing and Miscellaneous Sources (8,032,992) (7,311,796) Net Change in Cash and Short-Term Investments 6,407,139 7,129,727 Cash and Short-Term Investments at Beginning of Year 23,560,399 16,430,672 Cash and Short-Term Investments at End of Year $ 29,967,538 $ 23,560,399 The accompanying notes are an integral part of the statutory financial statements. -5-
1. Nature of Operations and Summary of Significant Accounting Practices The Farmers Automobile Insurance Association (the Association ) is a regional Midwest property and casualty insurance company domiciled in the State of Illinois. The Association sells insurance through independent agents. Insurance products primarily include private passenger and commercial automobile, homeowners, workers compensation, commercial multi-peril, general liability and business owners policies. Approximately 52 percent of the direct premium was written in the state of Illinois in 2012 and 2011. The accompanying financial statements have been prepared principally for filing with regulatory agencies and, as such, are prepared in conformity with accounting practices prescribed or permitted by the Illinois Department of Insurance (statutory accounting practices). Prescribed statutory accounting practices include the National Association of Insurance Commissioners (NAIC) Accounting Practices and Procedures Manual, as well as state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed when such practices are approved by the insurance department of the insurer s state of domicile. The Association does not use any permitted practices. Accounting Estimates The preparation of statutory financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Estimates that are particularly susceptible to significant change in the near term relate to: 1) the estimated unpaid losses and loss adjustment expenses, 2) the assumptions regarding the other than temporary impairment analysis of the investment portfolio, 3) the assumptions, including the discount rate, used to determine the benefit obligations for the defined benefit pension plan and post-retirement benefit plan, and 4) the amount of deferred tax assets expected to be realized in future years. Subsequent Events The Association adopted Statements of Statutory Accounting Principles (SSAP) No. 102, Accounting for Pensions effective January 1, 2013. The Association elects to phase-in the surplus impact by recognizing the entire surplus impact from applying paragraph 84 of SSAP 102, on an individual plan basis, over a period not to exceed ten (10) years. The reduction to surplus on January 1, 2013 was $1,460,056. Additionally, the Association adopted Statements of Statutory Accounting Principles No. 92, Accounting for Postretirement Benefits Other than Pensions effective January 1, 2013. The Association elects to phase-in the impact to surplus over a period not to exceed ten (10) years. The reduction to surplus on January 1, 2013 was $1,701,548. Subsequent events were evaluated through May 15, 2013, which is the date the financial statements were available to be issued. -6-
Summary of Significant Differences Between Statutory Accounting and GAAP A description of the significant accounting practices used by the Association and significant variances from accounting principles generally accepted in the United States of America (GAAP) are as follows: A. Investments Bonds and stocks are valued in accordance with rules prescribed by the NAIC. Investment grade bonds (i.e., NAIC designation 1 or 2) not backed by other loans are stated at amortized cost using a scientific method. Below investment grade bonds (i.e., NAIC designation 3 or higher) not backed by other loans are stated at the lesser of fair value or amortized cost with any change in the carrying value of the bond being treated as an unrealized gain/loss and credited/charged directly to surplus. Common stocks of nonaffiliated companies are carried at market value and common stocks of insurance company affiliates are accounted for using the statutory equity method in which undistributed earnings are reported as unrealized gains and losses; under GAAP, the financial statements of wholly owned subsidiaries would be consolidated with those of the parent. Loan-backed securities (mortgage-backed and asset-backed securities) are stated at amortized cost using a prospective basis. The prospective approach recognizes, through the recalculation of the effective yield to be applied to future periods, the effects of all cash flow whose amounts differ from those estimated earlier. Changes in amortization and amortized cost will occur in future periods. Assumptions for loan-backed securities are updated on a quarterly basis. Agency pass-through and collateralized mortgage obligations use the three-month generic prepayment speed assumption. Non-agency collateralized mortgage obligations and asset-backed securities are updated using projected principal payment windows. Investment income is recorded when earned. Realized gains and losses on sale or maturity of investments are determined on the basis of specific identification. Aggregate unrealized capital gains and losses are credited or charged directly to unassigned surplus without income tax effect. Statutory accounting requires that unrealized capital losses on investments that are determined to be other than temporary declines in value must be recognized as realized capital losses. The Association reviews its investment portfolio on a periodic basis to determine other than temporary declines in value. In evaluating whether a decline in value is other than temporary, management considers several factors including, but not limited to: 1) the Association s ability and intent to retain the security for a sufficient amount of time for it to recover, 2) the extent and duration of the decline in value, 3) the probability of collecting all cash flows according to contractual terms in effect at acquisition or restructuring, 4) relevant industry conditions and trends, and 5) the financial condition and current and future business prospects of the issuer. The amount of declines deemed other than temporary was $0 and $9,257 for the years ended December 31, 2012 and 2011, respectively. Under GAAP, equity securities that have readily determinable fair values and debt securities would be classified into three categories: held-to-maturity, trading, and available-for-sale. Held-to-maturity securities would be reported at amortized cost. Trading securities would be reported at fair value, with unrealized gains and losses included in earnings. Availablefor-sale securities would be reported at fair value, with unrealized gains and losses, net of applicable taxes, reported as a separate component of unassigned surplus. An occupancy rental charge on home office real estate owned is recorded as investment income and as offsetting rental expense; under GAAP, no such rental charge would be recognized. -7-
B. Unpaid Losses and Loss Adjustment Expenses The liabilities for unpaid losses and loss adjustment expenses are based upon management s estimates of reported and unreported losses determined on the basis of claim evaluation and past statistical experience. These liabilities are reported net of estimated salvage and subrogation receivable. Reinsurance recoverables related to unpaid losses and loss adjustment expenses are netted with the respective liabilities; under GAAP, these reinsurance recoverables would be shown on a separate gross basis. C. Policy Acquisition Costs The costs of acquiring premium income are immediately charged against operations, whereas premium income is deferred over the periods covered by the policies. Under GAAP, costs which vary directly with the production of new and renewal business would be capitalized and amortized as premium is earned D. Pension Under GAAP, net periodic pension expense would be based on the cost of incremental benefits for employee service during the period, interest on the projected benefit obligation, actual return on plan assets and amortization of actuarial gains and losses. Statutory accounting adopts a similar actuarial approach to estimate pension costs; however, costs related to non-vested participants are excluded. A liability has been recorded only for employees who are fully vested in the defined benefit retirement plan, and the funded status of the plan was determined using the accumulated benefit obligation; under GAAP, a liability would be recorded for vested and non-vested employees, and the funded status of the plan would be determined using the projected benefit obligation. E. Income Taxes Deferred income taxes are provided for differences between the financial statement and the tax bases of assets and liabilities and are reduced by a valuation allowance when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Additionally, under statutory accounting practices, limitations are placed on the admissibility of deferred tax assets. Most changes in deferred tax assets and liabilities are reported as changes in surplus, and state income taxes are not included in deferred tax calculations; under GAAP, there is no admissibility concept, and changes in deferred tax assets and liabilities would be reported through operations and/or surplus depending on their characteristics. F. Guaranty Fund The guaranty fund is an appropriation of unassigned surplus established to meet Wisconsin statutory requirements G. Non-Admitted Assets Certain assets designated as non-admitted assets, aggregating $6,270,472 and $7,110,766 at December 31, 2012 and 2011, respectively, are not recognized by statutory accounting practices. These assets are excluded from the balance sheet, and the net change in such assets is charged or credited directly to unassigned surplus. Non-admitted deferred tax assets are not included in the amounts above. The change in the non-admitted deferred tax asset is charged or credited directly to unassigned surplus. Under GAAP, such assets would be recognized at the lower of cost or net realizable value. -8-
H. Premium Income Recognition Premiums are earned over the terms of the related insurance policies and reinsurance contracts on a daily pro rata basis. Unearned premium reserves are established to cover the unexpired portion of premiums written and are computed on a pro rata basis. The Association determined that a premium deficiency reserve was not necessary for the years ended December 31, 2012 and 2011. The Association does not anticipate investment income as a factor in the calculation of a potential premium deficiency reserve. I. Cash and Short-Term Investments For purposes of reporting cash flows, the Association follows statutory accounting practices and considers cash in checking accounts, certain money market funds, and highly liquid debt instruments purchased with an original maturity of one year or less to be cash and short-term investments. The Association has on deposit in a financial institution a balance in excess of amounts insured by the Federal Deposit Insurance Corporation. The Association does not believe it is exposed to any significant credit risks on this account. J. Other Real estate consists of home office properties. Depreciation of real estate and other admitted and non-admitted assets is computed using the straight-line method over the estimated useful or class life. Commissions on reinsurance ceded are credited to income at the time the premium is ceded; under GAAP, commissions on ceded premium would be deferred and recognized as income over the periods covered by the policies. Statutory financial statements are prepared in a form using language and groupings substantially the same as the annual statement filed with the NAIC and state regulatory authorities which differ from the presentation and disclosure of financial statements that would be presented under GAAP. Necessary reclassifications are made in prior period financial statements, whenever appropriate, to conform to the current presentation. 2. Affiliated Entity Transactions The Association and its wholly owned subsidiary, Pekin Insurance Company, owned 77.62 percent and 76.02 percent of Pekin Life Insurance Company (PLIC) at December 31, 2012 and 2011, respectively. Specifically, the Association owned 70.04 percent and 68.44 percent of PLIC as of these dates. The Association and Pekin Insurance Company occupy the same building, and, along with PLIC, utilize many common facilities, management, administrative and office personnel, and services. Since 1966, the Association and Pekin Insurance Company have had a reinsurance pooling agreement under which underwriting income and expense and other administrative expenses are prorated to the Association (80%) and to Pekin Insurance Company (20%). The proration does not include provisions for federal income taxes or results of investment transactions. In addition, the Association and PLIC allocate related expenses to one another. Intercompany balances are paid periodically throughout the year based on estimates and settled within 45 days after year-end based on actual allocated expenses. Such net expenses allocated to PLIC, and therefore not included in the accompanying statements of income, were $6,321,250 in 2012 and $5,483,669 in 2011. -9-
In connection with structured settlements, the Association purchased 20 annuities from PLIC in 2012 and 35 annuities in 2011, of which the Association s claimant is the payee, but for which the Association is contingently liable. The single premium for these annuities totaled $650,500 and $1,241,196 in 2012 and 2011, respectively. The reserve carried by PLIC at December 31, 2012 and 2011, is $4,779,670 and $4,568,830, respectively. 3. Bonds and Common Stocks The admitted value, unrealized gain and loss, and market value of investments in bonds as of December 31, 2012, are as follows: 2012 Admitted Unrealized Unrealized Market Obligation Value Gain Loss Value U.S. Government $ 2,142,954 $ 50,615 $ - $ 2,193,569 Other Government 2,733,483 338,134-3,071,617 U.S. States, Territories and Possessions 15,625,816 2,006,952-17,632,768 U.S. Political Subdivisions of States and Territories 30,691,890 2,931,524-33,623,414 U.S. Special Revenue and Special Assessment 103,253,257 11,759,338-115,012,595 Industrial and Miscellaneous 307,763,254 30,975,519 237,245 338,501,528 Loan-Backed Securities 138,264,264 8,710,541 3,118 146,971,687 Total $ 600,474,918 $ 56,772,623 $ 240,363 $ 657,007,178 The admitted value, unrealized gain and loss, and market value of investments in bonds as of December 31, 2011 are as follows: 2011 Admitted Unrealized Unrealized Market Obligation Value Gain Loss Value U.S. Government $ 2,163,311 $ 92,086 $ - $ 2,255,397 Other Government 3,064,932 138,914-3,203,846 U.S. States, Territories and Possessions 15,738,945 2,180,722-17,919,667 U.S. Political Subdivisions of States and Territories 36,579,167 3,169,664 256,585 39,492,246 U.S. Special Revenue and Special Assessment 104,485,402 11,956,389-116,441,791 Industrial and Miscellaneous 266,439,458 25,425,771 1,030,515 290,834,714 Loan-Backed Securities 150,095,455 7,909,048 4,246 158,000,257 Total $ 578,566,670 $ 50,872,594 $ 1,291,346 $ 628,147,918-10-
The admitted value and market value of bonds at December 31, 2012, by contractual maturity, are shown below: Admitted Market Value Value Due in One Year or Less $ 5,000,141 $ 5,002,190 Due After One Year Through Five Years 90,055,780 95,290,169 Due After Five Years Through Ten Years 310,146,790 344,772,637 Due After Ten Years 57,007,943 64,970,495 Total 462,210,654 510,035,491 Loan-Backed Securities 138,264,264 * 146,971,687 Total $ 600,474,918 $ 657,007,178 * The admitted value of loan-backed securities includes $1,902,574 and $2,570,981 of U.S. Government Guaranteed Securities for 2012 and 2011, respectively. The Association does not engage in direct subprime residential mortgage lending. The Association s minimal exposure to subprime lending is limited to investments within the fixed maturity investment portfolio which contain securities collateralized by mortgages that have characteristics of subprime lending such as adjustable rate mortgages and alternative documentation mortgages. These investments are in the form of asset-backed securities collateralized by subprime mortgages and collateralized mortgage obligations backed by alternative documentation mortgages. The total carrying value of these investments is $298,131 as of December 31, 2012 and 2011, comprising 0.05 percent of the Association s total bond portfolio. The adjusted cost, unrealized gain and loss, and statement value of investments in common stock as of December 31, 2012 are as follows: 2012 Adjusted Unrealized Unrealized Statement Common Stocks Cost Gain Loss Value Other Than Affiliates $ 24,320,217 $ 4,931,971 $ 705,447 $ 28,546,741 Affiliates 62,723,856 132,373,064-195,096,920 Total $ 87,044,073 $ 137,305,035 $ 705,447 $ 223,643,661 The adjusted cost, unrealized gain and loss, and statement value of investments in common stock as of December 31, 2011 are as follows: 2011 Adjusted Unrealized Unrealized Statement Common Stocks Cost Gain Loss Value Other Than Affiliates $ 22,733,118 $ 3,818,816 $ 1,189,393 $ 25,362,541 Affiliates 59,799,374 125,166,794-184,966,168 Total $ 82,532,492 $ 128,985,610 $ 1,189,393 $ 210,328,709-11-
Securities with unrealized losses based on estimated market values as of December 31, 2012 are shown below: Less Than 12 Months 12 Months or More Total Market Unrealized Market Unrealized Market Unrealized Description of Securities Value Losses Value Losses Value Losses Industrial and Miscellaneous 36,374,760 237,245 - - 36,374,760 237,245 Loan-Backed Securities 873,568 388 328,060 2,730 1,201,628 3,118 Subtotal Debt Securities 37,248,328 237,633 328,060 2,730 37,576,388 240,363 Common Stock - Unaffiliated 5,065,159 342,406 3,125,809 363,041 8,190,968 705,447 Total Securities With Unrealized Losses $ 42,313,487 $ 580,039 $ 3,453,869 $ 365,771 $ 45,767,356 $ 945,810 Securities with unrealized losses based on estimated market values as of December 31, 2011 are shown below: Less Than 12 Months 12 Months or More Total Market Unrealized Market Unrealized Market Unrealized Description of Securities Value Losses Value Losses Value Losses U.S. Political Subdivisions of States and Territories $ 3,334,019 $ 256,585 $ - $ - $ 3,334,019 $ 256,585 Industrial and Miscellaneous 16,095,035 869,554 4,872,740 160,961 20,967,775 1,030,515 Loan-Backed Securities 720,999 4,246 - - 720,999 4,246 Subtotal Debt Securities 20,150,053 1,130,385 4,872,740 160,961 25,022,793 1,291,346 Common Stock - Unaffiliated 6,255,770 897,290 1,164,278 292,103 7,420,048 1,189,393 Total Securities With Unrealized Losses $ 26,405,823 $ 2,027,675 $ 6,037,018 $ 453,064 $ 32,442,841 $ 2,480,739 Proceeds from sales of bonds, excluding calls and maturities, during 2012 and 2011 were $154,236,016 and $99,594,173, respectively. Gross gains of $9,551,394 and $4,204,688 and gross losses of $40,032 and $256,756 were realized on those sales, respectively. Bonds carried at $2,035,004 and $2,053,277 at December 31, 2012 and 2011, respectively, were on deposit with the Illinois Department of Insurance as required by law. A certificate of deposit in the amount of $100,000 was on deposit with the Arizona Department of Insurance at December 31, 2012 and 2011 as required by law. -12-
Securities Lending The Association lends securities to agreed upon borrowers through an agreement with its custodian. The Association s policy is to require initial collateral from the borrower in an amount not less than 102 percent and 105 percent of the fair value of the domestic and foreign securities loaned at the outset of the contract as collateral. All collateral so received is held either in the physical custody of the custodian or for the account of the custodian by their agent or a central bank. The offsetting collateral liability is included in Payable for Securities Lending. At December 31, 2012 and 2011, the amount of securities loaned was $38,977,363 and $47,812,122, respectively, and the related collateral was $39,590,854 and $46,868,621. At December 31, 2012, collateral assets valued at $3,404,813 had maturity dates beyond one year. The aggregate amount of cash collateral received as of December 31, 2012 and 2011, is shown below by maturity date: 2012 2011 Maturity Date Fair Value Fair Value Open $ 6,001,973 $ 14,173,071 30 Days or Less 6,429,554 4,729,044 31 to 60 Days 6,116,787 7,034,980 61 to 90 Days 7,553,935 5,352,397 Greater Than 90 Days 13,488,605 15,579,129 Total Collateral Received $ 39,590,854 $ 46,868,621 The aggregate amount of cash collateral reinvested as of December 31, 2012 and 2011, is shown below by maturity date: 2012 2011 Amortized Fair Amortized Fair Cost Value Cost Value 30 Days or Less $ 11,153,884 $ 11,153,982 $ 15,957,881 $ 15,957,967 31 to 60 Days 6,072,394 6,072,732 5,962,473 5,962,830 61 to 90 Days 3,660,207 3,660,498 2,343,338 2,343,455 91 to 120 Days 3,336,902 3,338,162 1,425,649 1,425,914 121 to 180 Days 4,885,307 4,886,611 3,402,463 3,401,644 181 to 365 Days 4,007,565 4,009,674 6,036,152 6,038,480 1 to 2 Years 1,547,798 1,547,893 4,612,788 4,616,420 2 to 3 Years 1,593 1,593 563,137 562,990 Greater Than 3 Years 5,097,891 5,091,120 8,674,676 8,649,519 Total Collateral Reinvested $ 39,763,541 $ 39,762,265 $ 48,978,557 $ 48,959,219-13-
4. Fair Value Measurement Statutory Accounting Practices establishes a framework for measuring fair value. That framework provides a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets (level one measurements) and the lowest priority to unobservable inputs (level three measurements). The three levels of the fair value hierarchy under statutory accounting are described below: Level 1 Inputs to the valuation methodology are unadjusted quoted prices for identical assets in active markets that the Association has the ability to access. Level 2 Inputs to the valuation methodology include quoted prices for similar assets in active markets; quoted prices for identical or similar assets in inactive markets; inputs other than quoted prices that are observable; or inputs that are derived principally from or corroborated by observable market data by correlation or other means. The fair values of the Level 2 securities are obtained from independent pricing services or from the Association s investment manager and are determined using quoted market prices from an orderly market at the reporting date for those or similar investments. Level 3 Inputs to the valuation methodology are unobservable and significant to the fair value measurement. The following tables set forth by level, within the fair value hierarchy, the Association s financial instruments that are reported at fair value as of December 31, 2012 and 2011: 2012 Description Level 1 Level 2 Level 3 Total Common Stock - Other Than Affiliates $ 25,851,483 $ 2,424,735 $ 270,523 $ 28,546,741 2011 Description Level 1 Level 2 Level 3 Total Common Stock - Other Than Affiliates $ 23,132,627 $ 1,843,720 $ 386,194 $ 25,362,541 The Association did not have any liabilities measured at fair value at December 31, 2012 and 2011. The Association did not have any transfers between levels in 2012 and 2011. -14-
Shown below are the fair value measurements in Level 3 of the fair value hierarchy as of December 31, 2012 and 2011: Description Amount Amount Total Monster Common Stock: IVANS Beverage Corp Beginning Balance January 1, 2012 $ 306,124 $ 80,070 $ 386,194 Transfers Into Level 3 - - - Transfers Out of Level 3 - (80,070) (80,070) Total Gains/(Losses) Included in Net Income - - - Total Gains/(Losses) Included in Surplus (35,601) - (35,601) Purchases, Issuance, Sales, and Settlements - - - Ending Balance December 31, 2012 $ 270,523 $ - $ 270,523 The aggregate fair value of all financial instruments as of December 31, 2012, is shown below. Aggregate Admitted Fair Value Assets (Level 1) (Level 2) (Level 3) Bonds $ 657,007,178 $ 600,474,918 $ 2,193,569 $ 651,871,212 $ 2,942,397 Common Stock: Affiliates 195,096,920 195,096,920-83,484,694 111,612,226 Other Than Affiliates 28,546,741 28,546,741 25,851,483 2,424,735 270,523 Short-Term Investments 8,113,846 8,113,846 8,113,846 - - The type of security included within each hierarchy in the above table is as follows: Level 1 Measurements Bonds: Comprised of actively traded U.S. Treasury notes. Common Stock: Comprised of actively traded exchange listed mutual funds and common stocks. Short-Term Investments: Comprised of money market mutual funds. Level 2 Measurements Bonds: Comprised primarily of Political Subdivisions, Special Revenue, Industrial and Miscellaneous, and Loan-Backed securities. Common Stock: Comprised of common stock of affiliate which is not actively traded and is recorded at the statutory equity method; and comprised of common stock other than affiliates with an NAIC market indicator of U for which the price given for a share of common stock is the price listed on any market or exchange, including a foreign exchange, other than the New York Stock Exchange, the American Stock Exchange or the NASDAQ National Market System. -15-
Level 3 Measurements Bonds: Certain asset-backed bonds comprised primarily of corporate pass-through bonds. Common Stock: Comprised of certain common stocks not actively traded on the national stock exchange and common stock of affiliates recorded at the statutory equity method for which no appraisal is available. 5. Liability for Unpaid Losses and Loss Adjustment Expenses Activity in the liability for loss and loss adjustment expense reserves is summarized as follows: 2012 2011 Balance at January 1 $ 307,630,397 $ 308,770,497 Less Reinsurance Recoverable (13,828,130) (14,235,567) Net Balance at January 1 293,802,267 294,534,930 Incurred Related to: Current Year 307,862,963 318,060,188 Prior Years (19,754,407) (23,373,590) Total Incurred 288,108,556 294,686,598 Paid Related to: Current Year 177,075,593 184,495,397 Prior Years 103,305,633 110,923,864 Total Paid 280,381,226 295,419,261 Net Balance at December 31 301,529,597 293,802,267 Plus Reinsurance Recoverable 22,897,394 13,828,130 Balance at December 31 $ 324,426,991 $ 307,630,397 As a result of actual claim payments varying from previous estimates of insured events and subsequent reserve changes, the provision for loss and loss adjustment expenses decreased by $19,754,407 and $23,373,590 in 2012 and 2011, respectively. The decrease in incurred loss and loss adjustment expenses in 2012 and 2011 is primarily attributable to favorable development of general liability, workers compensation, automobile liability, and homeowners estimated loss and loss adjustment expenses reserves. Estimates of anticipated salvage and subrogation recoveries on losses and loss adjustment expenses have been recorded as a reduction to the liabilities for unpaid loss and unpaid loss adjustment expenses amounting to $11,535,679 and $11,232,203 at December 31, 2012 and 2011, respectively. 6. Reinsurance The Association has reinsurance treaties in place for its property and casualty insurance business to reduce exposure to large losses. Although reinsurance does not relieve the Association of its legal liability to its policyholders, it provides a measure of protection against catastrophic losses and provides a means of risk reduction on individual losses. In order to maintain an appropriate balance between the cost of reinsurance and surplus growth, the Association periodically -16-
evaluates its retention levels correlated to specific types of property and casualty insurance policies. The Association is also a party to an intercompany pooling agreement with Pekin Insurance Company. All direct business written by the Company is subject to the intercompany pool. An immaterial portion of business is ceded to third parties. Under this agreement, underwriting income and expenses and other administrative expenses are prorated to the Association (80%) and to Pekin Insurance Company (20%). At December 31, 2012 Assumed Reinsurance Ceded Reinsurance Net Premium Commission Premium Commission Premium Commission Reserve Equity Reserve Equity Reserve Equity Intercompany Pooling Agreement $ 138,024,363 $ 22,222,208 $ 49,102,387 $ 7,185,231 $ 88,921,976 $ 15,036,977 All Other 559,083-5,324,781 297,510 (4,765,698) (297,510) At December 31, 2011 $ 138,583,446 $ 22,222,208 $ 54,427,168 $ 7,482,741 $ 84,156,278 $ 14,739,467 Intercompany Pooling Agreement $ 119,863,172 $ 19,443,929 $ 44,559,160 $ 6,502,826 $ 75,304,012 $ 12,941,103 All Other 388,480-4,860,797 264,068 (4,472,317) (264,068) $ 120,251,652 $ 19,443,929 $ 49,419,957 $ 6,766,894 $ 70,831,695 $ 12,677,035 The direct unearned premium reserve was $112,253,271 and $107,404,947 at December 31, 2012 and 2011, respectively. Commission equity is computed as the maximum amount of return commission which would be due to the reinsurer if all reinsurance contracts were cancelled at year-end. 7. Pension Plan, Post-Retirement Benefits, and Deferred Compensation Retirement Benefits The Association and its affiliates participate in a trusteed non-contributory defined benefit pension plan. This plan covers full-time employees who have completed one year of service and have reached the age of 21. Effective January 1, 2013, the Association adopted Amendment No. 2 to freeze participation in the Plan for employees hired or rehired on or after January 1, 2013. The Association s funding policy is to contribute annually an amount that represents the current cost of the benefits expected to be earned in the current year offset by the expected asset return higher than the discount rate, but no more than the maximum amount that can be deducted for federal income tax purposes. Each affiliate is charged for its applicable share of such contributions based on a percentage of the projected benefit obligation. Pursuant to a retirement plan for Directors elected prior to 2004, eligible Directors will receive a retirement benefit equal to the annual retainer in effect on the Directors retirement date. The benefits paid were $43,250 in 2012 and 2011, respectively. The liability for the Directors retirement benefit is $1,267,480 and $1,244,538 at December 31, 2012 and 2011, respectively. -17-
401(k) Savings Plan The Association and its affiliates participate in a voluntary 401(k) savings plan for eligible participants. New full-time employees are automatically enrolled in the Plan with instant entry after approximately 30 days of employment. The Association may elect, at its sole discretion, to contribute a matching contribution to the savings plan. The Association elected to match 25 percent of each employee s contribution up to a maximum match of $400 in 2012 and 2011. Employer contributions of $125,703 and $121,466 respectively, were made to this plan in 2012 and 2011. Employees hired or rehired on or after January 1, 2013, may receive, at the discretion of the Association, a contribution from the Association based on a percentage of eligible earnings and an Association match of the employee s percentage of contribution. For 2013, the Association will contribute 3.5 percent of an employee s eligible earnings and a 75.0 percent Association match of the employee s percentage of contribution not to exceed 6.0 percent. Post-Retirement Benefits In addition to providing pension benefits, the Association and its affiliates provide certain health care and life insurance benefits (post-retirement benefits) for retired employees. Substantially all employees may become eligible for these benefits if they reach retirement age while working for the Association. Net post-retirement benefit cost includes the expected cost of such benefits for newly eligible or vested employees, interest cost, gains and losses arising from differences between actuarial assumptions and actual experience, and amortization of the transition obligation. The unfunded post-retirement benefit obligation for retirees and other fully eligible or vested plan participants included in loss adjustment expense reserves and accrued expenses was $3,605,304 and $4,368,800 respectively, at December 31, 2012 and $2,999,809 and $4,648,727, respectively, at December 31, 2011. Deferred Compensation The Association maintains a deferred compensation plan for the Directors. This plan allows for voluntary deferral of all or any part of compensation to which a Director might otherwise be entitled to as Directors fees, in accordance with the plan provisions. During 2012 and 2011, respectively, $37,000 of Directors fees were deferred. The liability for Directors deferred compensation was $447,607 and $410,632 at December 31, 2012 and 2011, respectively. Expected Cash Flows The Association expects to contribute $3,914,500 to the Pension Plan and $1,304,700 to the Post-Retirement Benefit Plan in 2013. The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid: Pension Post-Retirement Year Benefits Benefits 2013 $ 3,951,296 $ 1,082,733 2014 3,387,608 1,275,735 2015 5,376,957 1,352,496 2016 5,264,220 1,417,261 2017 6,346,187 1,446,435 2018 to 2022 33,488,547 7,240,735-18-
Assets, Obligations, and Assumptions A summary of assets, obligations, and assumptions of the Pension and Post-Retirement Benefit Plans of the Association is as follows at December 31: Pension Benefits Post-Retirement Benefits Change in Benefit Obligation: 2012 2011 2012 2011 Vested Benefit Obligation at Beginning of Year $ 69,459,340 $ 57,821,778 $ 26,773,865 $ 25,162,915 Net Benefits Accrued 4,097,231 3,411,114 1,362,743 1,637,388 Interest on Prior Liability 3,422,457 3,143,216 1,365,818 1,626,238 Actuarial Loss (Gain) 3,891,761 9,876,496 (5,944,617) (589,832) Benefits Paid (3,692,534) (4,793,264) (976,950) (1,062,844) Vested Benefit Obligation at End of Year $ 77,178,255 $ 69,459,340 $ 22,580,859 $ 26,773,865 Change in Plan Assets: Fair Value of Plan Assets at Beginning of Year $ 38,469,765 $ 37,207,683 $ 12,573,977 $ 11,356,037 Actual Return on Plan Assets 4,889,116 2,115,346 567,703 601,441 Employer Contribution 3,940,000 3,940,000 1,313,202 1,306,666 Benefits Paid (3,692,534) (4,793,264) (699,841) (690,167) Fair Value of Plan Assets at End of Year $ 43,606,347 $ 38,469,765 $ 13,755,041 $ 12,573,977 In 2012, the Association recognized an Additional Minimum Pension Liability of $3,311,974 and the related intangible asset of $453,656 resulting in a net charge to surplus of $2,858,318. The vested projected benefit obligation of the Association in relation to the total obligation of the Association and its affiliates (excluding inactive participants) is the basis for allocating the plan assets and the net periodic benefit cost. The net periodic benefit cost of the Post-Retirement Benefit Plan is measured on a seriatim basis that projects future benefit costs participant by participant based on demographic characteristics. The projected costs are discounted to a present value. -19-
A summary of the funded status and net periodic benefit cost of the Pension and Post-Retirement Benefit Plans for the Association is as follows for the years ended December 31: Pension Benefits Post-Retirement Benefits 2012 2011 2012 2011 Funded Status: Unamortized Prior Service Cost $ 15,833 $ 30,047 $ - $ - Unrecognized Net (Gain) Loss 21,167,368 21,024,602 (1,131,355) 3,772,453 Remaining Net Obligation at Initial Date of Application 457,840 525,470 - - Accrued Liabilities 5,134,492 3,088,400 8,192,013 7,822,190 Intangible Asset 453,656 - - - Accumulated Benefit Obligation for Vested Employees 53,831,449 49,688,117 22,580,859 26,773,865 Benefit Obligation for Non-Vested Employees: Projected Benefit Obligation 356,729 329,813 - - Accumulated Benefit Obligation - - 22,683,534 28,653,597 Components of Net Periodic Benefit Cost: Service Cost 3,106,932 2,539,865 1,090,194 1,309,910 Interest Cost 2,595,249 2,340,392 1,092,654 1,237,581 Actual Return on Plan Assets (2,025,314) (1,437,259) (467,168) (481,153) Amortization of Unrecognized Transition Obligation 67,630 66,839 - - Amortization of Unrecognized Prior Service Cost 13,289 13,134 - - Amortization of Net Loss from Earlier Period 1,137,468 679,290 161,122 417,337 Net Asset (Loss) Deferred for Later Recognition - (339,932) - - Total Net Periodic Benefit Cost $ 4,895,254 $ 3,862,329 $ 1,876,802 $ 2,483,675 Weighted average assumptions used to determine the projected benefit obligation at December 31: Pension Benefits Post-Retirement Benefits 2012 2011 2012 2011 Discount Rate 3.99% 4.94% 4.77% 4.94% Rate of Compensation Increase 3.5% to 7.0% 4.30% N/A N/A -20-
Weighted average assumptions used to determine net periodic benefit cost for the years ended December 31: Pension Benefits Post-Retirement Benefits 2012 2011 2012 2011 Discount Rate 4.94% 5.66% 4.94% 5.66% Rate of Compensation Increase 4.00% to 8.00% 4.30% N/A N/A Expected Long-Term Rate of Return on Plan Assets 6.50% 6.50% 6.50% 6.50% The health care portion of the Post-Retirement Benefit Plan is contributory, with participants contributions adjusted annually as determined by the Association; the life insurance portion of the Post-Retirement Benefit Plan is non-contributory. The health care cost trend rate in 2012 was assumed to be 7.0 percent for one year, graded to 6.0 percent for three years, then 5.5 percent thereafter. In 2011 the health care cost trend rate was 7.0 percent for two years, then 6.0 percent for three years, then 5.5 percent thereafter. Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care trend rates would have the following effects: One Percentage Point Increase One Percentage Point Decrease Effect on Total of Service and Interest $ 326,487 $ (269,020) Cost Components Effect on Post-Retirement Benefit Obligation $ 2,162,538 $ (1,817,303) The retirement plan assets are held in a deposit administration contract and equity securities. The Trustees of the Farmers Automobile Insurance Association Retirement Plan maintain a deposit administration contract with Pekin Life Insurance Company for pension benefits. The fund is a group annuity contract consisting of employer contributions with guaranteed interest, less annuities purchased to provide benefit payments to retirees and lump sum benefits paid directly to participants. The fair value of the account included in plan assets of the Association and its affiliates was $27,974,521 and $26,304,752 as of December 31, 2012 and 2011, respectively, or 50 and 51 percent of total plan assets. Equity securities comprise the remaining plan assets. At December 31, 2012 and 2011, equity securities amounted to $27,723,868 and $24,792,854, respectively, or 50 and 49 percent of total plan assets. The expected long-term rate of return on plan assets was selected based upon current market conditions, Association experience, and future Association expectations. The specific goal of the investment portfolio is to maintain a fully funded plan over time to ensure the benefit for the plan participants. New contributions are invested in equity securities until the amount in equities exceeds 45 percent of the plan s total assets. Additional amounts will be paid into the deposit administration fund, unless the equity portfolio falls under 45 percent. If the equity portfolio exceeds 60 percent of the plan s assets, part of the equity portfolio will be liquidated and proceeds moved into the deposit administration fund within a reasonable time frame. There are three return objectives. The primary benchmark is the projected annual rate of return used by the plan s actuary. The average annualized investment performance of the invested assets, net of investment related expenses, should be equal to or in excess of this benchmark. The secondary (equity) benchmark is the percent total rate of return -21-