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Deteriorating underwriting results preceded merger agreement for NM mutual

A deal announced Dec. 16 will afford Donegal Mutual Insurance Co. an opportunity to pursue a strategy it regards as a core competency while providing it entry to a new region of the country.

"Donegal Mutual has had success affiliating with underperforming mutual insurance companies," Donegal Group Inc., a downstream holding company in which the mutual is the controlling stockholder, said in its most recent annual report on Form 10-K.

In Albuquerque, N.M.-based Mountain States Mutual Casualty Co., Donegal Mutual will affiliate with an independent agent-focused entity that has been challenged from an underwriting profitability perspective in recent years.

The Mountain States group, as consolidated by S&P Global Market Intelligence to include Mountain States Commercial Insurance Co. and Mountain States Indemnity Co. in addition to the top-tier mutual, produced a net underwriting loss of more than $11.2 million during the first nine months of 2016 as compared with a loss of $5.2 million in the year-earlier period. Its combined ratio of 141.6% for that year-to-date period marked an increase from 114.4% in the first nine months of 2015. The group's expense ratio in both nine-month periods topped 40%, and its loss and loss adjustment expense ratio widened to 97.3% in the first nine months of 2016 from 74.4% in the year-earlier period.

With the group having generated a net loss of nearly $7 million during the first nine months of 2016, its policyholders' surplus slumped to $72.3 million as of Sept. 30 from $80.1 million at year-end 2015.

The Mountain States group last reported a net underwriting gain for a full calendar year in 2007. It attributed increasing losses and LAE in 2015 to factors that included adverse prior-year reserve development, severe hailstorms and windstorms, and pressure on auto insurance results.

A.M. Best, in revising its issuer credit ratings outlook for Mountain States group members to negative in May, said it was concerned about the execution risk associated with efforts to return to profitability.

"The group has suffered poor results since 2008, with losses in more recent years driven by frequent, small hailstorms that have fallen below its catastrophe protection," A.M. Best said at the time. Plus, the agency said, the group's expense ratio remained high, driven in part by fees associated with fronting arrangements.

Mountain States Mutual Casualty assumed more than $26 million in premiums in 2015 from the combination of two carriers: James River Group Holdings Ltd.'s Falls Lake National Insurance Co. and State National Insurance Co. Inc.'s National Specialty Insurance Co. The mutual assumes business written by the fronting companies under quota share agreements.

Although A.M. Best listed a number of items that offset those concerns, including management's implementation of tighter underwriting standards, it cautioned that it could take negative ratings actions if operating earnings remained weak.

In announcing the agreement, the parties said Donegal Mutual would enter quota share, services and technology license agreements with Mountain States Mutual Casualty's subsidiaries at the time of closing such that they would become eligible for A.M. Best's assignment of Donegal Mutual's group rating of A. The top-tier mutual will merge with and into Donegal Mutual.

Mountain States President William Davis said in a release that the various transactions would have the effect of enhancing the group's competitive position, and it stands to benefit from "enhanced opportunities" to improve underwriting profitability.

Donegal Group is not party to the Mountain States agreement. But the company said in the 10-K that it has benefited from the mutual's past M&A pursuits either through the targets' mutual-to-stock conversions or as a result of the placement of their assumed business into the intercompany pooling arrangement through the mutual's entry of 100% quota share reinsurance agreements with them. In this case, however, the business of the Mountain States group will be excluded from Donegal Mutual's pooling agreement with Donegal Group unit Atlantic States Insurance Co. "[f]or an indefinite period of time."

Donegal Mutual and Atlantic States pool substantially all their premiums and losses and LAE and share the underwriting results in proportion to their respective rates of participation.

The merger promises significant benefits to Donegal Mutual from a geographic diversity perspective. All the $22.5 million in direct premiums written attributable to Mountain States group members during the first nine months of 2016 came from states in which Donegal Mutual group members wrote no business on a direct basis, including $18.3 million from New Mexico, $2.9 million from Texas and $715,000 from Utah.

Pennsylvania was the Donegal Mutual group's largest state, accounting for $251.2 million of its $661.2 million in direct premiums written during the first nine months of 2016. Nebraska and South Dakota represented its westernmost states.

Donegal Group said in the 10-K that its unique organizational structure affords it with flexibility to pursue a range of transactions.

"We also believe our historic record clearly demonstrates our ability to acquire control of an underperforming insurance company, re-underwrite its book of business, reduce its cost structure and return it to sustained profitability," the company added.