American Family Mutual Insurance Company

Report of the Examination of American Family Mutual Insurance Company Madison, Wisconsin As of December 31, 2006 TABLE OF CONTENTS Page I. INTRODUCTION ............................................................................................................... 2 II. HISTORY AND PLAN OF OPERATION ........................................................................... 4 III. MANAGEMENT AND CONTROL ..................................................................................... 6 IV. AFFILIATED COMPANIES ............................................................................................. 10 V. REINSURANCE .............................................................................................................. 16 VI. FINANCIAL DATA ........................................................................................................... 20 VII. SUMMARY OF EXAMINATION RESULTS .................................................................... 31 VIII. CONCLUSION................................................................................................................. 34 IX. SUMMARY OF COMMENTS AND RECOMMENDATIONS........................................... 35 X. ACKNOWLEDGMENT .................................................................................................... 36 State of Wisconsin / OFFICE OF THE COMMISSIONER OF INSURANCE Jim Doyle, Governor Sean Dilweg, Commissioner Wisconsin.gov September 28, 2007 125 South Webster Street • P.O. Box 7873 Madison, Wisconsin 53707-7873 Phone: (608) 266-3585 • Fax: (608) 266-9935 E-Mail: information@oci.state.wi.us Web Address: oci.wi.gov Honorable Sean Dilweg Commissioner of Insurance State of Wisconsin 125 South Webster Street Madison, Wisconsin 53703 Honorable Alfred W. Gross Chair, Financial Condition (E) Committee, NAIC Commissioner of Insurance Commonwealth of Virginia 1300 East Main Street Richmond, Virginia 23219 Honorable Morris J. Chavez Secretary, Western Zone, NAIC Superintendent of Insurance State of New Mexico 1120 Paseo de Paralta Santa Fe, New Mexico 87504 Honorable Merle Scheiber Secretary, Midwestern Zone, NAIC Director of Insurance State of South Dakota 445 East Capitol Avenue Pierre, South Dakota 57501-3185 Commissioners: In accordance with the instructions of the Wisconsin Commissioner of Insurance, a compliance examination has been made of the affairs and financial condition of: AMERICAN FAMILY MUTUAL INSURANCE COMPANY Madison, Wisconsin and this report is respectfully submitted. I. INTRODUCTION The previous examination of American Family Mutual Insurance Company (hereinafter also the company or AFMIC) was conducted in 2002 as of December 31, 2001. The current examination covered the intervening period ending December 31, 2006, and included a review of such 2007 transactions as deemed necessary to complete the examination. The examination consisted of a review of all major phases of the company's operations and included the following areas: History Management and Control Corporate Records Conflict of Interest Fidelity Bonds and Other Insurance Employees' Welfare and Pension Plans Territory and Plan of Operations Affiliated Companies Growth of Company Reinsurance Financial Statements Accounts and Records Data Processing Emphasis was placed on the audit of those areas of the company's operations accorded a high priority by the examiner-in-charge when planning the examination. Special attention was given to the action taken by the company to satisfy the recommendations and comments made in the previous examination report. The company is annually audited by an independent public accounting firm as prescribed by s. Ins 50.05, Wis. Adm. Code. An integral part of this compliance examination was the review of the independent accountant's work papers. Based on the results of the review of these work papers, alternative or additional examination steps deemed necessary for the completion of this examination were performed. The examination work papers contain documentation with respect to the alternative or additional examination steps performed during the course of the examination. 2 Independent Actuary's Review An independent actuarial firm was engaged under a contract with the Office of the Commissioner of Insurance. The actuary reviewed the adequacy of the company’s loss and loss adjustment expense reserves. The actuary’s results were reported to the examiner-in-charge. As deemed appropriate, reference is made in this report to the actuary’s conclusion. 3 II. HISTORY AND PLAN OF OPERATION American Family Mutual Insurance Company is a mutual property and casualty insurer organized in 1927 under the provisions of ch. 611, Wis. Stat., as the Farmers’ Mutual Automobile Insurance Company. The company changed its name to that presently used effective in 1963. The company is currently licensed in 23 states. During the five-year period under examination, the company obtained a license to write business in Wyoming during 2005 and commenced writing business in Washington in 2006. In 2006, the company wrote business in 18 of the 23 jurisdictions in which it was licensed. The distribution of direct premiums written in 2006 by state was as follows: Wisconsin Missouri Minnesota Illinois Colorado Arizona Kansas Indiana All others Total $ 888,229,647 816,314,883 628,505,278 521,401,161 480,555,912 429,013,692 327,170,199 257,702,027 900,519,417 $5,249,412,216 16.9% 15.6 12.0 9.9 9.2 8.2 6.2 4.9 17.1 100.0% The company is currently licensed in the following states: Arizona Illinois Kansas Montana New Mexico Ohio South Dakota Wisconsin Colorado Indiana Minnesota Nebraska North Carolina Oregon Utah Wyoming Idaho Iowa Missouri Nevada North Dakota South Carolina Washington In the state of Wisconsin, the company is licensed to transact the following lines of business as defined by s. Ins 6.75 (2), Wis. Adm. Code: (a) Fire, Inland Marine, and Other Property (b) Ocean Marine (c) Casualty Disability (d) Liability and Non Auto Incidental Medical Expense (e) Automobile and Aircraft (f) Fidelity (g) Surety (k) Worker’s Compensation (n) Miscellaneous 4 The company primarily writes personal lines insurance policies, which makes up over 80% of its direct business writings. The company’s products are marketed through a captive agency force of 4,045 agents, as of November 13, 2007. Agents are compensated by commissions with rates ranging from 6% to 15% based on the type of business written and other variables. According to the agency contracts, agents are eligible to participate in a bonus program, which is based on performance criteria being met during a calendar year relating to net profit base, premium grown and policy retention. Agents are also eligible to participate in various promotional bonus programs that are awarded to agents that meet specific performance criteria, which are different for each promotion. The following table is a summary of the net insurance premiums written by the company in 2006. The growth of the company is discussed in the “Financial Data” section of this report. Direct Premium $ 7,075,964 17,796,157 86,077,533 1,381,372,782 407,169,356 2,681,003 11,097,145 11,070,136 198,300,710 86,926,095 96,028,362 2,735,036 289,254 1,589,944,885 43,284,379 1,307,462,325 82,545 18,549 0 $5,249,412,216 Reinsurance Assumed $ 3,775,611 102,097 0 49,711,850 538,665 2,946 78,924 0 2,095,731 2,705,930 1,199,987 0 521 425,270,877 411,163 242,417,364 0 0 188 $728,311,854 Reinsurance Ceded $ 270,412 10,891,707 2,050,542 31,925,550 8,207,432 91,907 373,088 0 0 165,591 2,582,333 0 0 0 0 16,192,145 0 0 0 $72,750,707 $ Net Premium 10,581,163 7,006,547 84,026,991 1,399,159,082 399,500,589 2,592,042 10,802,981 11,070,136 200,396,441 89,466,434 94,646,016 2,735,036 289,775 2,015,215,762 43,695,542 1,533,687,544 82,545 18,549 188 $5,904,973,36 3 Line of Business Fire Allied lines Farmowner’s multiple peril Homeowner’s multiple peril Commercial multiple peril Inland marine Earthquake Group accident and health Other accident and health Worker’s compensation Other liability – occurrence Other liability – claims made Products liability – occurrence Private passenger auto liability Commercial auto liability Auto physical damage Fidelity Burglary and theft Reinsurance – nonproportional assumed liability Total All Lines 5 III. MANAGEMENT AND CONTROL Board of Directors The board of directors consists of 13 members, 10 of whom are outside directors. Directors are grouped into 2 groups of 4 and 1 group of 5. One group is elected annually with each director serving for a three-year term. Officers are elected at the annual board meeting and are to hold those positions until the earlier of their resignation or removal by the board of directors. Inside board members receive no additional compensation for their service. The outside board members currently receive $30,000 a year as a retainer and $1,500 per meeting attended for serving on the board or board-appointed committee. Currently the board of directors consists of the following persons: Name and Residence David Ralph Anderson Madison, WI Craig C. Culver Prairie du Sac, WI Leslie Ann Howard Madison, WI Ted Douglas Kellner Milwaukee, WI Thomas James Mohs Madison, WI Walter Maurice Oliver McLean, VA Harvey Randall Pierce Middleton, WI Eliot George Protsch Cedar Rapids, IA Richard Raymond Renk Sun Prairie, WI Jack Charles Salzwedel Waunakee, WI Principal Occupation Chairman and Chief Executive Officer of the American Family Mutual Insurance Group President and Owner of Culver Franchising Systems, Inc. President and Chief Executive Officer of United Way of Dane County Chairman and Chief Executive Officer of Fiduciary Management, Inc. Chairman of Placon Corporation Senior Vice President, Human Resources and Administration of General Dynamics Corporation Retired Chairman and Chief Executive Officer of the American Family Mutual Insurance Group Senior Executive Vice President and Chief Financial Officer of Alliant Energy Corporation Chairman of Wm F. Renk & Sons Co., Inc. President and Chief Operations Officer of the American Family Mutual Insurance Group Term Expires 2009 2008 2008 2010 2010 2008 2010 2008 2008 2010 6 Name and Residence Jerry Sue Thornton Moreland Hills, OH John Duncan Wiley Madison, WI Thomas John Zimbrick Madison, WI Officers of the Company Principal Occupation President of Cuyahoga Community College Chancellor of the University of Wisconsin Madison Chief Executive Officer of Zimbrick, Inc. Term Expires 2009 2009 2009 The officers serving as of December 31, 2006 are as follows: 2006 Compensation $2,035,621 835,571 1,028,169 653,182 892,983 587,761 803,289 1,030,543 502,231 587,279 434,220 484,765 736,175 517,236 421,869 213,435 210,183 776,418 263,534 404,390 219,750 299,130 345,216 468,851 165,289 172,030 350,504 481,801 403,131 218,865 611,198 248,259 158,126 Name David Ralph Anderson Jack Charles Salzwedel James Francis Eldridge Daniel Robert Schultz Vicki Lee Chvala Bradley James Gleason Alan Edward Meyer Darnell Moore Mark Valdez Afable Donald David Alfermann Gerry William Benusa Michael Jeffrey Bosco Byrne William Chapman Michael Ranger Duran Richard Alan Fetherston Carolyn Sue Gilb Kari Elizabeth Grasee Thomas Syme King Annette Suzanne Knapstein Richard Louis LaVeer Chris Robert Listau Dennis James Loper Steve Guy Maxwell Jerome Gilbert Rekowski Mary Lynn Schmoeger Scott Joseph Seymour Paulette Lynn Siebers Christopher Shippee Spencer Richard Martin Steffen William Boyd Westrate Joseph Jay Zwettler James Walter Behrens Ann Marie Demerath Office Chairman and Chief Executive Officer President and Chief Operations Officer Secretary and Chief Legal Officer Treasurer and Chief Financial Officer Executive Vice President Executive Vice President Executive Vice President Executive Vice President Vice President, Claims Vice President, Senior Sales Vice President, Marketing Vice President, Life/Health Vice President, Information Services Vice President, Sales – Mountain Region Vice President, Public Relations Vice President, Northwest Region Vice President, Controller Vice President, Investments Vice President, Office Administration Vice President, Sales – Valley Region Vice President, Sales – Midland Region Vice President, P&C Loss Reserves Vice President, Human Resources Vice President, Commercial Lines Vice President, Education Vice President, Government Affairs and Communications Vice President, Broker/Dealer Vice President, Legal Vice President, Sales – Great Lakes Region Vice President, Actuarial Vice President, Personal Lines Assistant Secretary Assistant Treasurer 7 Committees of the Board Article III, Section 13 of the company's bylaws allow for the formation of certain committees by the board of directors. The committees at the time of the examination are listed below: Executive Committee David Anderson, Chair Ted Kellner Walter Oliver Eliot Protsch Richard Renk Jack Salzwedel Officer Compensation Committee Walter Oliver, Chair David Anderson Craig Culver Jack Salzwedel Jerry Sue Thornton John Wiley Thomas Zimbrick Audit Committee Eliot Protsch, Chair Thomas Mohs Leslie Howard Jerry Sue Thornton John Wiley Thomas Zimbrick Finance Committee Ted D. Kellner, Chair David R. Anderson Craig Culver Leslie Howard Harvey Pierce Richard Renk Jack Salzwedel Daniel Schultz (non-voting member) Nominating and Governance Committee Thomas Zimbrick, Chair David Anderson Leslie Howard Thomas Mohs Harvey Pierce Eliot Protsch Jack Salzwedel John Wiley 8 The company’s board has also formed committees to manage certain employeerelated activities of the organization. These committees are composed of executive officers appointed by the board. These committees report directly to the board and don’t have authority to make decisions on behalf of the board. The committees at the time of the examination are listed below: Incentive & Thrift Administrative Committee James Eldridge, Chair Vicki Chvala Brad Gleason Steve Maxwell Alan Meyer Julie Minix (non-voting member) Darnell Moore Daniel Schultz Personnel Committee Jack Salzwedel, Chair Vicki Chvala James Eldridge Brad Gleason Steve Maxwell Alan Meyer Darnell Moore Daniel Schultz Employee and District Manager Retirement Committee Daniel Schultz, Chair Vicki Chvala James Eldridge Brad Gleason Steve Maxwell Alan Meyer Julie Minix (non-voting member) Darnell Moore 9 IV. AFFILIATED COMPANIES American Family Mutual Insurance Company is the parent of a holding company system referred to as the “American Family Mutual Insurance Group.” The organizational chart below depicts the relationships among the affiliates in the group. A brief description of the affiliates follows the organizational chart. Organizational Chart As of December 31, 2006 American Family Mutual Insurance Company American Family Securities, LLC AmFam, Incorporated American Family Brokerage, Incorporated American Family Life Insurance Company American Standard Insurance Company of Wisconsin American Family Financial Services, Incorporated American Family Insurance Company American Standard Insurance Company of Ohio AmFam, Incorporated AmFam, Incorporated, was incorporated in 1981 to serve as a downstream holding company for the American Family Mutual Insurance Group. As of December 31, 2006, the company’s consolidated GAAP basis audited financial statement reported assets of $5,569,851,000, liabilities of $4,417,535,000 and stockholder’s equity of $1,152,316,000. Of that amount, all but approximately $18,950,000 was derived from the value of its insurance subsidiaries. American Family Brokerage, Incorporated American Family Brokerage, Incorporated, was incorporated in 1985 as an insurance agency and operates within the same states as its parent AFMIC. Its primary objective is to assist American Family agents in securing coverage for their clients when the coverage or limits are not available through the American Family Insurance Group. As of December 31, 2006, the company’s 10 GAAP basis audited financial statement reported assets of $3,961,000, liabilities of $2,449,000, and stockholder’s equity of $1,512,000. Operations for 2006 produced a net income of $982,000. American Family Securities, LLC American Family Securities, LLC, (hereinafter also AFS) was incorporated on July 14, 2000, with a capital contribution of $250,000 from AFMIC, as a limited liability company whose sole member is AFMIC. AFS, a non-clearing, registered broker dealer, is the principal underwriter for American Family Life Insurance Company’s (hereinafter also AFLIC) variable life and annuity products. On March 23, 2001, AFS was admitted into the National Association of Securities Dealers (NASD) to sell AFLIC’s variable products. As of December 31, 2006, the company’s GAAP basis audited financial statement reported assets of $292,000, liabilities of $5,000 and member’s equity of $287,000. Operations for 2006 produced a net income of $9,000. American Family Financial Services, Incorporated American Family Financial Services, Incorporated, (hereinafter also AFFS) was acquired by American Family Insurance Group in 1969. Its original business purpose was to provide direct loans and leases, primarily to policyholders, through AFMIC's multi-line exclusive agency force. However, during the period under examination AFFS’s business environment has changed and so has its purpose. The company has been making fewer loans to policyholders. This was due to the fact that other lenders (banks, credit unions, etc.) could offer lower lending rates than AFFS because they have a lower cost of money. AFFS’s borrowing costs, derived primarily from the issuance of commercial paper and a demand note, is considerably higher than banks which use checking, savings, and certificate of deposit accounts to fund loans. At the same time AFFS expanded its lending to its exclusive agency force, since its agents found it hard to borrow money from other lenders due to their commission-based compensation. These trends are evident when comparing the commercial mortgage loan receivable balance as a ratio to total loans outstanding at year-end 2001 to year-end 2006, which was 7.9% and 35.7%, respectively. At year-end 2006 approximately 80% of AFFS’s commercial mortgage loans were to its agents. 11 As noted above, AFFS finances its loan portfolio primarily through the sale of commercial paper. AFMIC has agreed to guarantee the debt of AFFS, in order to allow the company to receive the best possible interest rates. In 1998 the board of directors of AFMIC authorized an increase in the guarantee limit to $375 million, as approved by this office. As of December 31, 2006, AFFS outstanding guaranteed debt totaled $79,973,206. In addition, AFMIC, American Standard Insurance Company of Wisconsin (hereinafter also ASIC), and American Family Life Insurance Company (hereinafter also AFLIC) may lend AFFS additional funds through the use of short-term notes not to exceed at any one time $100,000,000, $10,000,000 and $20,000,000, respectively, as approved by this office. At December 31, 2006, there were no outstanding short-term notes issued by AFFS owed to an affiliate. As of December 31, 2006, the company’s GAAP basis audited financial statement reported assets of $160,215,000, liabilities of $141,526,000, and stockholder’s equity of $18,689,000. Operations for 2006 produced net loss of $43,000. As of November 1, 2007, AFFS has discontinued writing new loans of any kind and is considering various options for the servicing and run off its existing loan portfolio. American Family Life Insurance Company American Family Life Insurance Company was incorporated in 1957. The company is currently licensed in 26 states and writes primarily ordinary life insurance products, including traditional, universal life and to a lesser extent variable universal life and annuities. As of December 31, 2006, AFLIC reported assets of $3,685,060,233, liabilities of $3,252,832,866 (both amounts include $179,738,716 from separate accounts), and surplus of $432,227,367. Operations for 2006 produced net income of $61,131,953. AFLIC was examined concurrently with the AFMIC examination. The results of the examination are described within a separate report. American Standard Insurance Company of Wisconsin American Standard Insurance Company of Wisconsin was incorporated in 1961. The company is currently licensed in 23 states and is limited to providing insurance for motorcycles and for nonstandard private passenger automobile risks. ASIC’s direct writings are 100% ceded 12 to AFMIC under a quota share agreement approved by this office. As of December 31, 2006, ASIC reported assets of $355,217,394, liabilities of $116,618,918, and surplus of $238,598,476. Operations for 2006 produced net income of $11,767,890. ASIC was examined concurrently with the AFMIC examination. The results of the examination are described within a separate report. American Family Insurance Company American Family Insurance Company (hereinafter also AFIC) was incorporated in Ohio in 1995 and writes business only in that state. AFIC was founded for the purposes of operating efficiencies and state tax savings. AFIC cedes 100% of its direct writings to AFMIC under a quota share agreement approved by this office. AFIC writes lines of business identical to American Family Mutual Insurance Company and markets its business through AFMIC’s agents. As of December 31, 2006, AFIC reported assets of $73,695,175, liabilities of $62,659,779 and surplus of $11,035,396. Operations for 2006 produced net income of $996,245. AFIC was examined concurrently with AFMIC as of December 31, 2006, and the results of that examination were expressed in a separate report issued by the Ohio Department of Insurance. American Standard Insurance Company of Ohio American Standard Insurance Company of Ohio (hereinafter also ASICO) was incorporated in 1995 and writes business only in Ohio. ASICO was founded for the purposes of operating efficiencies and state tax savings. ASICO writes lines of business identical to ASIC’s and cedes 100% of these direct writings to AFMIC under a quota share agreement approved by this office. Insurance is sold through AFMIC’s agents. As of December 31, 2006, ASICO reported assets of $17,113,493, liabilities of $11,373,899 and surplus of $5,739,594. Operations for 2006 produced a net income of $360,817. ASICO was examined concurrently with AFMIC as of December 31, 2006, and the results of that examination were expressed in a separate report issued by the Ohio Department of Insurance. Agreements with Affiliates In addition to common staffing and management control, AFMIC’s relationship to its affiliates is affected by various written agreements and undertakings. Reinsurance agreements 13 are described in section V of the report titled “Reinsurance.” A brief summary of the other agreements and undertakings follows arranged by effective date. Effective December 12, 1995, AFMIC developed an inter-company cost allocation agreement for the reimbursement of expenses paid by AFMIC on behalf of its affiliates. Allocated cost is based on the actual cost of providing the service multiplied by the affiliate’s proportionate share of the benefit conferred. All cost allocations are determined by the group’s Controller Division and are considered final. All parties to this agreement are allowed to express their opinion to the group’s Controller Division of the allocation affecting each of them and the Controller Division is to consider such opinions carefully in determining cost allocation. In connection with the affiliated quota share reinsurance agreements as described in section V of this report titled “Reinsurance,” AFMIC (hereafter also Buyer) and each of its affiliated property and casualty subsidiary insurers, which includes ASIC, AFIC, and ASICO (hereinafter also Sellers), entered into an agreement for the sale of their respective premium receivable. These contracts were approved by this office and became effective on January 1, 2000. Under the terms of these agreements, the Buyer agrees to purchase the Sellers’ premium receivables at the end of the month, with no discount, beginning January 2000. Settlements are to be made within five days of the transfer. The motivation for the sale of premium receivables by the Sellers was that the routine intercompany balances were becoming so large that they could not settle them with AFMIC by using only their short-term investments, and the Sellers did not want to liquidate their long-term investments to settle intercompany accounts. Effective April 29, 2002, AFMIC and its affiliates entered into a restated tax allocation agreement for the purpose of filing federal income tax returns on a consolidated basis. Under this agreement, AFMIC prepares and files a consolidated U.S. federal income tax return that includes all affiliates of the holding company group. The agreement sets forth the rights and obligations of the parties to the agreement with respect to the determination and settlement of federal income tax liabilities as well as the allocation of American Family Mutual Insurance Group’s consolidated U.S. federal income tax liability and tax benefits in accordance with a rational, systematic formula. The agreement provides for computation of tax, settlement of balances between affiliates, tax 14 sharing, filing the return, audits and other adjustments, and other administrative requirements. The agreement calls for the settling of estimated U.S. federal tax payments within 30 days of filing of those payments. Final settlement is due within 30 days of the filing of the consolidated U.S. federal tax return. The agreement has a provision for members entering or departing the group and provides for successors. 15 V. REINSURANCE The company’s reinsurance program consists primarily of assuming premium from affiliated companies and ceding catastrophe excess coverage through reinsurance agreements with unaffiliated foreign and U.S. reinsurance companies. The company's reinsurance portfolio and strategy is described below. A list of the companies that have a significant amount of reinsurance in force at the time of the examination follows. The contracts contained proper insolvency provisions. Affiliated Assuming Contract Assumed business is primarily intercompany reinsurance. As noted in the section of the report titled “Affiliated Companies,” AFMIC assumes 100% of the direct writings of ASIC, AFIC, and ASICO. These arrangements are represented by signed contracts, which include all necessary provisions and also contained a proper insolvency clause. Effective October 1, 1999, the contract was restated and signed by all parties due to changes made to its reporting, settlement and insolvency provisions. In 2006, this business represents 12% of AFMIC’s gross written premium. These writings are primarily personal and automobile lines of business. Mandatory pools and other 2006 nonaffiliated reinsurance assumptions represent approximately 0.1% of the company’s gross written premium. Nonaffiliated Ceding Contracts 1. Type: Reinsurer: Property Catastrophe Excess of Loss As of January 1, 2007, participation was as follows: First Layer 0.00% 0.00 1.00 1.50 3.00 3.10 4.00 5.00 0.75 1.75 Second Layer 1.67% 3.33 1.00 0.00 3.00 3.10 4.00 0.00 0.75 1.75 Reinsurer Employers Reinsurance Corporation Swiss Reinsurance America Corporation Ariel Reinsurance Company Limited Aspen Insurance Limited (on behalf of Aspen Insurance UK Limited) AXIS Specialty Limited Catlin Insurance Company Ltd. Endurance Specialty Insurance Ltd. Everest Reinsurance Company Flagstone Reinsurance Limited Folksamerica Reinsurance Company 16 Reinsurer Hannover RuckversicherungsAkiengesellschaft Harbor Point Re Limited Hiscox Insurance Company (Bermuda) Ltd. Mapfre Re Compania de Reaseguros, S.A. Montpelier Reinsurance Limited Munich Reinsurance America, Inc. New Castle Reinsurance Company Ltd. Odyssey America Reinsurance Corporation Partner Reinsurance Company Platinum Underwriters Bermuda, Ltd. Swiss Re Underwriters Agency, Inc. (on behalf of Swiss Reinsurance America Corporation) Tokio Millennium Re Ltd. Transatlantic Reinsurance Company XL Re Ltd. AXA RE Munchener Ruckversicherungs-Gesellschaft Lloyd’s Underwriters (21 Syndicates on First Layer and 20 Syndicates on Second Layer) W.R. Berkley Insurance (Europe) Limited Total Scope: First Layer 2.50% 2.50 1.00 0.40 3.00 2.25 1.00 1.00 3.00 3.00 8.50 2.00 0.00 4.00 4.00 3.75 32.2125 0.7875 95.00% Second Layer 5.00% 2.50 1.00 0.40 3.00 2.25 1.00 1.00 3.00 3.00 11.00 2.00 4.17 3.50 1.25 3.75 27.9646 0.6188 95.00% All business classified by the company as fire, allied lines, farmowner’s (property perils), homeowner’s (property perils), business owners (property perils), commercial package policies (property perils), or automobile physical damage with certain named exclusions First Layer - The first $300,000,000 in losses and ALAE for each occurrence and 5% of ultimate net losses of the next $200,000,000 Second Layer - The first $500,000,000 in losses and ALAE for each occurrence and 5% of ultimate net losses in excess of $500,000,000 not to exceed $30,000,000 Retention: Coverage: First Layer - 95% of the excess of the company’s retention, up to a limit of $200,000,000 each loss occurrence. The company may reinstate coverage in event that coverage under this layer is exhausted limited to $200,000,000 any one loss occurrence. The company shall pay an additional premium based upon the pro rata amount of the reinstatement. Second Layer - 95% of the excess of the company’s retention, up to a limit of $600,000,000 each loss occurrence. The company may reinstate coverage in event that coverage under this layer is exhausted limited to $600,000,000 any one loss occurrence. The company shall pay an additional premium based upon the pro rata amount of the reinstatement. 17 Premium: First Layer - Annual deposit premium of $23,000,000 paid in quarterly installments; annual minimum premium of $18,400,000, subject to adjustment at the rate of 1.3111% of subject net earned premium Second Layer - Annual deposit premium of $24,900,000 paid in quarterly installments; annual minimum premium of $19,920,000, subject to adjustment at the rate of 1.4194% of subject net earned premium Commissions: Effective date: Termination: None January 1, 2007 The contract is scheduled to expire on January 1, 2008. The company may terminate subscribing reinsurer’s percentage share at any time by giving written notice to the subscribing reinsurer in the event that certain named circumstances occur. Benfield is recognized as the intermediary, however, as of January 1, 2008, the property catastrophe intermediary will be Aon Reinsurance Services. Payments by the company to the intermediary shall be deemed to constitute payment to the reinsurer. Payments by the reinsurer to the intermediary shall be deemed to constitute payment to the company only to the extent that such payments are actually received by the company. Commercial Umbrella Liability Excess of Loss Munich Reinsurance America, Inc. All policies with limits greater than $5,000,000 and classified by the company as commercial liability umbrella or commercial blanket excess liability with certain named exclusions $5,000,000 each occurrence $10,000,000 excess of $5,000,000 each occurrence 100% of the subject gross net written premium 27.5% of the subject gross net written premium January 7, 2004, and is continuous Either party may terminate with 90 days’ prior written notice of cancellation to the other party Property Facultative General Reinsurance Corporation All business classified by the company as fire, allied lines, inland marine, or commercial multiple peril (property coverages) with certain named exclusions Additional comment: 2. Type: Reinsurer: Scope: Retention: Coverage: Premium: Commissions: Effective date: Termination: 3. Type: Reinsurers: Scope: 18 Retention: Coverage: Premium: $15,000,000 per risk $25, 000, 0000 in excess of the company’s retention of $15,000,000 per risk Rates range from 0.03 to 0.05 and are applied to each $100 of accepted coverage above $15,000,000 with a minimum premium of $250 per risk. Rates are based on the size of the risk and the type of construction of the property risk. None July 1, 2007 The contract is scheduled to expire on July 1, 2008. Either party may terminate with 90 days’ prior written notice of cancellation to the other party. Commissions: Effective date: Termination: 19 VI. FINANCIAL DATA The following financial statements reflect the financial condition of the company as reported to the Commissioner of Insurance in the December 31, 2006, annual statement. Also included in this section are schedules that reflect the growth of the company, NAIC Insurance Regulatory Information System (IRIS) ratio results for the period under examination, and the compulsory and security surplus calculation. Adjustments made as a result of the examination are noted at the end of this section in the area captioned "Reconciliation of Surplus per Examination." 20 American Family Mutual Insurance Company Assets As of December 31, 2006 Net Admitted Assets $ 5,909,657,803 2,726,881,720 260,137,158 10,218,246 10,061,917 96,279,381 248,657,555 32,674,331 85,773,547 15,820,806 1,076,446,926 21,305,169 90,300,234 210,810,543 17,140,013 98,120,424 0 97,008,002 0 0 0 1,830,657 779,962 $11,009,904,394 Assets Bonds Common stocks Real estate: Occupied by the company Properties held for the production of income Properties held for sale Cash, cash equivalents, and short-term investments Other invested assets Receivables for securities Investment income due and accrued Premiums and considerations: Uncollected premiums and agents' balances in course of collection Deferred premiums, agents' balances, and installments booked but deferred and not yet due Amounts recoverable from reinsurers Current federal and foreign income tax recoverable and interest thereon Net deferred tax asset Guaranty funds receivable or on deposit Electronic data processing equipment and software Furniture and equipment, including health care delivery assets Receivable from parent, subsidiaries, and affiliates Write-ins for other than invested assets: Cash items Advances Prepaid expenses Miscellaneous receivables Reinsurance receivable Total Assets $ 5,909,657,803 2,726,881,720 260,137,158 10,218,246 10,061,917 96,279,381 248,657,555 32,674,331 85,773,547 45,215,722 1,080,957,640 21,305,169 90,300,234 210,810,543 22,183,700 98,120,424 59,191,842 97,008,002 912,764 453,168 261,836 1,830,657 779,962 $11,109,673,321 Nonadmitted Assets $ 0 0 0 0 0 0 0 0 0 29,394,916 4,510,714 0 0 0 5,043,687 0 59,191,842 0 912,764 453,168 261,836 0 0 $99,768,927 21 American Family Mutual Insurance Company Liabilities, Surplus, and Other Funds As of December 31, 2006 Losses Reinsurance payable on paid loss and loss adjustment expenses Loss adjustment expenses Commissions payable, contingent commissions, and other similar charges Other expenses (excluding taxes, licenses, and fees) Taxes, licenses, and fees (excluding federal and foreign income taxes) Unearned premiums Advance premium Policyholders’ dividends declared and unpaid Ceded reinsurance premiums payable (net of ceding commissions) Amounts withheld or retained by company for account of others Remittances and items not allocated Drafts outstanding Payable to parent, subsidiaries, and affiliates Payable for securities Write-ins for liabilities: All other liabilities Capital contributions payable Total liabilities Write-ins for special surplus funds: Non-assessable guaranty fund Unassigned funds (surplus) Surplus as regards policyholders Total Liabilities and Surplus $ 1,250,000 4,190,319,561 4,191,569,561 $11,009,904,394 $ 2,718,312,427 70,942,074 751,080,564 24,957,391 637,405,062 52,994,970 2,174,011,980 44,814,622 639,307 (971,334) 8,899,043 18,017,615 176,442,646 52,124,057 3,155,796 36,333,901 49,174,712 6,818,334,833 22 American Family Mutual Insurance Company Summary of Operations For the Year 2006 Underwriting Income Premiums earned Deductions: Losses incurred Loss expenses incurred Other underwriting expenses incurred Total underwriting deductions Net underwriting gain (loss) Investment Income Net investment income earned Net realized capital gains (losses) Net investment gain (loss) Other Income Net gain (loss) from agents' or premium balances charged off Finance and service charges not included in premiums Write-ins for miscellaneous income: Net gain on sale of equipment Net billing plan write-offs Other income Premium rebate Total other income Net income (loss) before dividends to policyholders and before federal and foreign income taxes Dividends to policyholders Net income (loss) after dividends to policyholders but before federal and foreign income taxes Federal and foreign income taxes incurred Net Loss $4,291,324,042 774,816,398 1,448,282,788 6,514,423,228 (628,419,515) 296,976,249 95,593,064 392,569,313 $5,886,003,713 (420,774) 55,516,150 (101,885) (23,532,012) 4,179,917 4,954 35,646,350 (200,203,852) 2,817,790 (203,021,642) (99,452,979) $ (103,568,663) 23 American Family Mutual Insurance Company Cash Flow For the Year 2006 Premiums collected net of reinsurance Net investment income Miscellaneous income Total Benefit and loss related payments Commissions, expenses paid, and aggregate write-ins for deductions Dividends paid to policyholders Federal and foreign income taxes paid (recovered) Total deductions Net cash from operations Proceeds from investments sold, matured, or repaid: Bonds Stocks Real estate Other invested assets Net gains (losses) on cash, cash equivalents, and short-term investments Total investment proceeds Cost of investments acquired (long-term only): Bonds Stocks Real estate Other invested assets Miscellaneous applications Total investments acquired Net cash from investments Cash from financing and miscellaneous sources: Other cash provided (applied) Net cash from financing and miscellaneous sources Reconciliation: Net change in cash, cash equivalents, and short-term investments Cash, cash equivalents, and short-term investments: Beginning of year End of Year $5,857,158,160 322,508,935 35,646,357 6,215,313,452 $4,739,821,61 2 1,412,997,218 2,608,140 12,494,191 6,167,921,161 47,392,291 $655,456,286 458,418,213 4,546,754 28,444,268 5,611,547 1,152,477,068 630,087,622 431,608,875 33,297,305 55,624,209 44,109,473 1,194,727,484 (42,250,416) 17,779,736 17,779,736 22,921,612 73,357,769 $ 96,279,381 24 American Family Mutual Insurance Company Compulsory and Security Surplus Calculation December 31, 2006 This table is rounded to the nearest thousand. Assets Less security surplus of insurance subsidiaries Less liabilities Adjusted surplus Annual premium: Individual accident and health Factor Total Group accident and health Factor Total Lines other than accident and health Factor Total Compulsory surplus (subject to a minimum of $2 million) Compulsory Surplus Excess (or Deficit) Adjusted surplus (from above) Security surplus: (140% of compulsory surplus, factor reduced 1% for each $33 million in premium written in excess of $10 million, with a minimum factor of 110%) Security Surplus Excess (or Deficit) $ 200,396 15% $ 11,070 10% 1,107 5,690,689 20% 1,138,138 1,169,304 $ 2,945,384 $ 4,114,688 30,059 $11,009,904 76,881 6,818,335 4,114,688 1,286,235 $ 2,828,453 25 American Family Mutual Insurance Company Reconciliation and Analysis of Surplus For the Five-Year Period Ending December 31, 2006 The following schedule is a reconciliation of total surplus during the period under examination as reported by the company in its filed annual statements: 2006 Surplus, beginning of year Net income Change in net unrealized capital gains/losses Change in net deferred income tax Change in non-admitted assets Change in provision for reinsurance Cumulative effect of changes in accounting principles Write-ins for gains and (losses) in surplus: SSAP 89 Pension adjustment SSAP 89 Termination benefits adjustment Surplus, end of year $4,021,987,141 (103,568,663) 215,648,467 57,193,423 (15,465,970) 5,021 0 2005 $3,286,482,301 573,131,594 93,080,296 23,126,443 40,713,897 (5,021) 5,003,274 2004 $2,686,296,997 479,852,608 105,211,412 10,179,264 21,157,382 0 0 2003 $2,084,336,187 62,434,812 345,792,895 35,919,385 155,269,643 0 0 2002 $2,600,780,463 (50,206,476) (303,624,110) 70,363,657 (232,626,458) 32,506 0 (6,989) 15,777,131 $4,191,569,561 (65,859) 520,216 $4,021,987,141 81,984 (16,297,346) $3,286,482,301 2,544,075 0 $2,686,296,997 (383,395) 0 $2,084,336,187 26 American Family Mutual Insurance Company Insurance Regulatory Information System For the Five-Year Period Ending December 31, 2006 The company’s NAIC Insurance Regulatory Information System (IRIS) results for the period under examination are summarized below. Unusual IRIS results are denoted with asterisks and discussed below the table. Ratio #1 #2 #3 #4 #5 #6 #7 #8 #9 #10 #11 #12 #13 Gross Premium to Surplus Net Premium to Surplus Change in Net Premiums Written Surplus Aid to Surplus Two-Year Overall Operating Ratio Investment Yield Gross Change in Surplus Net Change in Adjusted Surplus (established in 2005) Liabilities to Liquid Assets Agents’ Balances to Surplus One-Year Reserve Development to Surplus Two-Year Reserve Development to Surplus Estimated Current Reserve Deficiency to Surplus 2006 143% 141 (1) 0 96 3.3 4 4 71 0 2 (2) (9) 2005 150% 149 0 0 88 3.5 22 22 69 1 (3) (1) (3) 2004 183% 181 7 0 92 3.6* 21 NA 74 1 (1) 6 0 2003 208% 206 14 0 96 3.5* 27 NA 78 2 4 5 2 2002 236% 234 18 0 103* 3.4* (16)* NA 83 2 2 3 10 The Two-Year Operating Ratio (IRIS ratio #5) measures the company’s profitability over the previous two-year period and was exceptional in 2002. This is primarily due to the large catastrophic losses that were incurred by the company in 2001, which produced an underwriting loss of $601.7M. The company has a high retention before its excess of loss coverage, as described in section V of this report titled “Reinsurance.” However, the company’s management believes AFMIC’s capital/surplus position allows it to be more aggressive in terms of its reinsurance program and is sufficient to absorb the risk. The Investment Yield Ratio (IRIS ratio #6) measures the amount of the company’s net investment income as a percentage of the average amount of cash and invested assets. Exceptional investment yield ratios were noted in 2002, 2003 and 2004. This was primarily caused by low interest bearing bond holdings (large portion of the holdings are municipal special revenue bonds). Interest rates were fairly low during this period, which caused bond issuers to call higher-yielding bonds leaving investors a bond market that had lower returns. Also, the 27 company's unaffiliated stock portfolio is invested in stocks with lower dividend yields. Another factor contributing to AFMIC’s low dividend yield is that the company’s wholly owned affiliated stock companies (American Family Brokerage, Incorporated, American Family Securities, LLC, and AmFam, Incorporated), which comprises approximately 26% of its common stock portfolio, did not pay any dividends during those three years and therefore were not contributors towards AFMIC’s net investment income. Ratio #7 measures the change in gross surplus from the previous year. The gross change in surplus ratio was exceptional in 2002 due to a combination of continued underwriting losses from the development of the prior year’s catastrophe losses of about $134.7M, unrealized losses of $303M and realized capital losses of $137M from the market conditions at that time (market drop, burst of the "dot coms" bubble), and nonadmitted assets related to deferred taxes rose to $227.7M. 28 Growth of American Family Mutual Insurance Company Surplus As Regards Policyholders $4,191,569,561 4,021,987,141 3,286,482,301 2,686,296,996 2,084,336,159 2,600,780,461 Year 2006 2005 2004 2003 2002 2001 Admitted Assets $11,009,904,394 10,467,217,602 9,560,663,658 8,378,401,612 7,071,500,281 6,848,839,782 Liabilities $6,818,334,833 6,445,230,461 6,274,181,357 5,692,104,616 4,987,164,121 4,248,059,321 Net Income $(103,568,663) 573,131,594 479,852,608 62,434,812 (50,206,476) 11,304,684 Year 2006 2005 2004 2003 2002 2001 Gross Premium Written $5,977,724,070 6,029,576,358 6,008,603,245 5,593,566,264 4,918,660,859 4,145,682,416 Net Premium Written $5,904,973,363 5,975,594,688 5,955,846,020 5,541,868,797 4,877,645,480 4,120,837,347 Premium Earned $5,886,003,713 5,965,012,958 5,786,961,645 5,296,774,315 4,577,173,604 3,996,598,808 Loss and LAE Ratio 86.1% 68.5 71.7 77.3 79.3 91.6 Expense Ratio 23.9% 23.6 21.8 21.9 21.5 22.0 Combined Ratio 110.0% 92.1 93.5 99.2 100.8 113.6 The company has experienced surplus growth over the past five years of 61.2%. Gross and net premium growth was significant during the three-year period beginning in 2002; however, in 2005 and 2006 premium growth leveled off primarily due to fairly soft market conditions for personal line property casualty insurers, which caused competition to be strong and left very little room for companies to achieve market share growth. The significant surplus growth and the leveling off of premium writings over the period under examination has brought the company’s gross writings ratio back to below 1.5 to 1 as it was during the previous period under examination. The company’s combined ratio has fluctuated greatly over the five-year period under examination and has averaged 99.1% over that same period. Net investment gains over the period have negated some of the affects of the high combined ratios. 2002 and 2006 were the only years the company experienced net losses during the last five years, which were mainly attributable to large catastrophe wind and hail storms. 29 Reconciliation of Surplus per Examination No adjustments were made to surplus as a result of the examination. The amount of surplus of $4,191,569,561 reported by the company as of December 31, 2006, is accepted. 30 VII. SUMMARY OF EXAMINATION RESULTS Compliance with Prior Examination Report Recommendations There were ten specific comments and recommendations in the previous examination report. Comments and recommendations contained in the last examination report and actions taken by the company are as follows: 1. Management and Control—It is recommended that the company continue to maintain compliance with its conflict of interest disclosure requirements for its board of directors, officers and designated employees. Action—Compliance 2. Management and Control—It is recommended that the company comply with s. Ins 611.56 (1), Wis. Stat., and appoint only directors as members of board appointed committees. Action—Compliance 3. Schedule Y—It is recommended that the company report in Schedule Y of its statutory annual statements all transactions among affiliates relating to the cost sharing and income tax allocation agreements in compliance with s. Ins 40.03 (5), Wis. Adm. Code. Action—Compliance 4. Invested Assets—It is recommended that the company amend the custodial agreement to include the language recommended by the NAIC’s Financial Condition Examiners Handbook, to replace references to Midwest Securities with the current trust company and to replace the custodian with the current one. Action—Compliance 5. Remittances and Items not Allocated―It is recommended that the company comply with the NAIC’s Accounting Practices and Procedures Manual SSAP 67 and the NAIC’s Annual Statement Instructions – Property and Casualty for the reporting of Remittances and Items not Allocated. Action—Compliance 6. Amounts Withheld or Retained by Company for Account of Others―It is recommended that the company comply with the NAIC’s Accounting Practices and Procedures Manual SSAP 67 and the NAIC’s Annual Statement Instructions – Property and Casualty for the reporting unallocated cash receipts. Action—Compliance 7. Advance Premium Accounting―It is recommended that the company record only the payment portion to advance premium in compliance with the NAIC’s Accounting Practices and Procedures Manual SSAPs 6 and 53. Action—Compliance 31 8. Outstanding Drafts―It is recommended that the company comply with s. Ins 6.80 (4), Wis. Adm. Code, for the retention of outstanding and honored draft details. Action—Compliance 9. Affiliated Balances―It is recommended that the company report all affiliated reinsurance transactions on Schedule F and the appropriate lines on the balance sheet as prescribed by the NAIC Annual Statement Instructions – Property and Casualty. Action—Compliance 10. Internal Control―It is recommended that for all significant and/or critical data the company establish a process such that access to the data be reviewed periodically, but no less frequently than annually. Action—Compliance 32 Summary of Current Examination Results This section contains comments and elaboration on those areas where adverse findings were noted or where unusual situations existed. Comment on the remaining areas of the company's operations is contained in the examination work papers. Management and Control A sample of the company’s IT projects was selected to review the internal quality assurance testing. Projects included both implementation of new applications and changes to existing applications. The company was able to provide summary evidence that the quality assurance testing was performed, including test plans and tester sign-off. However, the company was not able to provide detailed evidence of testing performed to support the testing performed for all projects. This documentation is considered reasonably related to insurance operations as it supports the testing of applications moved to production. These applications ensure the security and integrity of the company’s data. It is therefore recommended that the company retain detailed evidence of quality assurance testing process for applications placed in production in accordance with s. Ins 6.80 (4), Wis. Adm. Code. 33 VIII. CONCLUSION Reported policyholders’ surplus has increased from $2,600,780,461 as of year-end 2001 to $4,191,569,561 as of year-end 2006. This represents an increase of 61.2% during the period under examination. Premium growth was fairly significant in 2002, 2003 and 2004; however, in the last couple of years premium writings have leveled off due to soft market conditions for personal line property and casualty insurers. Operating earnings were profitable three out of the last five years due to steady investment income coupled with very good underwriting results. Net operating losses in 2006 and 2002 were mainly attributable to large catastrophe wind and hail storm loss events. The examination of American Family Mutual Insurance Company resulted in one recommendation, which was not a repeat recommendation, no adjustments to surplus, and no reclassifications of account balances. The examination recommendation pertains to the retention of records of requested information made by this office’s Data Processing Audit Specialist while performing his examination of IT related controls. 34 IX. SUMMARY OF COMMENTS AND RECOMMENDATIONS 1. Page 33 - Management and Control—It is recommended that the company retain detailed evidence of quality assurance testing process for applications placed in production in accordance with s. Ins 6.80 (4), Wis. Adm. Code. 35 X. ACKNOWLEDGMENT The courtesy and cooperation extended during the course of the examination by the officers and employees of the company are acknowledged. In addition to the undersigned, the following representatives of the Office of the Commissioner of Insurance, State of Wisconsin, participated in the examination: Name Rick H. Anderson Jerry C. DeArmond Andy M. Fell David A. Grinnell Thomas R. Houston Randy F. Milquet Frederick H. Thornton Title Insurance Financial Examiner Insurance Financial Examiner Advanced Loss Reserve Specialist Insurance Financial Examiner Insurance Financial Examiner Insurance Financial Examiner Insurance Financial Examiner Advanced Data Processing Audit Specialist Insurance Financial Examiner Advanced Exam Planning & Quality Control Specialist Respectfully submitted, John E. Litweiler Examiner-in-Charge 36