Item 1 - Business
Our History and Overview
Eastern Insurance Holdings, Inc. (“EIHI”) is an insurance holding company offering workers’ compensation insurance and reinsurance products through its direct and indirect wholly-owned subsidiaries, Global Alliance Holdings, Ltd. (“Global Alliance”), Eastern Alliance Insurance Company (“Eastern Alliance”), Allied Eastern Indemnity Company (“Allied Eastern”), Eastern Advantage Assurance Company (“Eastern Advantage”), Employers Security Insurance Company (“Employers Security”), Employers Alliance, Inc. (“Employers Alliance”), Eastern Re, Ltd., S.P.C. (“Eastern Re”), and Eastern Services Corporation (“Eastern Services”), collectively referred to as the “Company”, “we” and/or “our”.
The following provides a brief description of EIHI’s direct and indirect wholly-owned subsidiaries:
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Global Alliance is a holding company domiciled in the Commonwealth of Pennsylvania;
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Eastern Alliance, Allied Eastern and Eastern Advantage are stock property/casualty insurance companies domiciled in the Commonwealth of Pennsylvania and, along with Employers Security, conduct business as Eastern Alliance Insurance Group (“EAIG”). The four insurance companies provide EAIG with increased underwriting flexibility through the use of a tiered rating structure;
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Employers Security is a stock property/casualty insurance company domiciled in the State of Indiana;
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Employers Alliance is a Pennsylvania corporation offering claims administration and risk management services to self-insured property/casualty customers;
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Eastern Re is a segregated portfolio cell reinsurance company domiciled in the Cayman Islands; and
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Eastern Services is a Pennsylvania corporation that provides management services to EAIG and Employers Alliance.
On December 9, 2010, EIHI completed the sale of Eastern Atlantic RE (“Atlantic RE”). Atlantic RE was a Cayman Islands reinsurance company formed for the purpose of transferring certain assets and liabilities related to EIHI’s run-off specialty reinsurance segment. The run-off specialty reinsurance segment reported net premiums earned totaling $1,000, $1.1 million and $9.7 million and revenue totaling 4.2 million, $1.0 million and $10.6 million for the years ended December 31, 2010, 2009 and 2008, respectively. Total revenue for the year ended December 31, 2010 excludes the loss on the sale of Atlantic RE of $14.0 million.
On June 21, 2010, EIHI completed the sale of Eastern Life and Health Insurance Company (“Eastern Life”), its group benefits insurance subsidiary. Eastern Life’s net premiums earned and revenue, prior to the sale, totaled $18.3 million and $20.6 million, respectively, for the year end December 31, 2010. Eastern Life’s net premiums earned and revenue totaled $35.9 million and $40.7 million and $36.7 million and $33.5 million, respectively, for the years ended December 31, 2009 and 2008, respectively.
On September 29, 2008, EIHI acquired all of the outstanding stock of Employers Security Holding Company and its wholly-owned subsidiaries, Employers Security and Affinity Management Services, Inc.
The Company currently operates in three business segments: workers’ compensation insurance, segregated portfolio cell reinsurance, and corporate/other. Prior to the sale of Atlantic RE and Eastern Life, the Company’s operations included a run-off specialty reinsurance segment and a group benefits insurance segment. The components of the run-off specialty reinsurance segment that were not transferred to Atlantic RE have been included in the corporate/other segment for the years ended December 31, 2010, 2009 and 2008.
Overview of Business Segments
The following discussion provides information on each of our business segments:
Workers’ Compensation Insurance. The Company offers traditional workers’ compensation insurance coverage to employers, generally with 500 employees or less, primarily in the Mid-Atlantic, Southeast, and Midwest regions of the continental United States. The Company’s workers’ compensation products include guaranteed cost policies, policyholder dividend policies, retrospectively-rated policies, deductible policies and alternative market programs.
Segregated Portfolio Cell Reinsurance. Workers’ compensation insurance coverage is also underwritten through the Company’s alternative markets business unit and ceded 100% to the segregated portfolio cell reinsurance segment. The Company receives a fronting fee generally based upon a percentage of direct premiums written, a segregated portfolio cell
rental fee, which is also based on a percentage of direct premiums written, and fees for claims administration and risk management services. As of December 31, 2010, the segregated portfolio cells and dividend participants provided $48.6 million of irrevocable, unconditional letters of credit to secure unfunded liabilities and collateralize reserves for unpaid losses and loss adjustment expenses (“LAE”) and unearned premiums.
Corporate/Other The corporate/other segment primarily includes the expenses of the holding company, the third party administration activities of the Company, and the non-segregated portfolio cell reinsurance results of operations of Eastern Re, as well as certain eliminations necessary to reconcile the segment information to the consolidated statements of operations and comprehensive income (loss). The corporate/other segment also includes the Company’s 10% interest in a segregated portfolio cell with an unaffiliated primary carrier that writes insurance coverage for sprinkler contractors. The Company cancelled the non-segregated portfolio cell reinsurance contracts in 1999 and the Company non-renewed the contract for its 10% interest in the segregated portfolio cell on a run-off basis effective April 1, 2009.
Products
Workers’ Compensation Insurance
The Company offers a complete line of workers’ compensation products including guaranteed cost policies, policyholder dividend policies, retrospectively-rated policies, deductible policies, and alternative market products. Direct premiums written in the workers’ compensation insurance segment totaled $126.8 million for the year ended December 31, 2010.
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Guaranteed cost policies. Guaranteed cost policies charge a fixed premium, which does not increase or decrease based upon loss experience during the policy period. For the year ended December 31, 2010, 56.0% of direct premiums written in the workers’ compensation insurance segment were derived from guaranteed cost policies.
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Policyholder dividend policies. Policyholder dividend policies charge a fixed premium, but the customer may receive a dividend in the event of favorable loss experience during the policy period. Policyholder dividend plans are generally restricted to accounts with minimum annual premiums in excess of $20,000. For the year ended December 31, 2010, 12.3% of direct premiums written in the workers’ compensation insurance segment were derived from policyholder dividend policies.
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Retrospectively-rated policies. Retrospectively-rated policies charge an initial premium that is subject to adjustment after the policy period expires, based upon the insured’s actual loss experience incurred during the policy period, subject to a minimum and maximum premium. These policies are typically subject to annual adjustment until all claims related to the policy year are closed. Retrospectively-rated policies are generally offered to employers with minimum annual premiums in excess of $150,000. For the year ended December 31, 2010, 2.3% of direct premiums written in the workers’ compensation insurance segment were derived from retrospectively-rated policies.
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Deductible policies. Deductible policies generally result in a lower premium; however, the insured retains a greater share of the underwriting risk than under guaranteed cost or dividend paying policies, which reduces the risk to the Company and further encourages loss control practices by the insured. The policyholder is contractually obligated to pay its own losses up to the amount of the deductible for each occurrence, subject to an aggregate retention. For the year ended December 31, 2010, 4.2% of direct premiums written in the workers’ compensation insurance segment were derived from deductible policies.
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Alternative market products. Alternative market products are offered to individual companies, groups, and trade associations. As described above in “Overview of Business Segments-Segregated Portfolio Cell Reinsurance” a policy is issued to an insured and 100% of the premium written, less a ceding commission, is ceded to a segregated portfolio cell. For the year ended December 31, 2010, 25.2% of direct premiums written in the workers’ compensation insurance segment were derived from alternative market products.
Segregated Portfolio Cell Reinsurance
Segregated portfolio cells, or segregated cells or rent-a-captives, are all referred to as alternative market programs or products. The Company provides a variety of products to this marketplace, including program design, fronting, claims administration, risk management, segregated portfolio cell rental, asset management and segregated portfolio management services. The Company outsources the asset management and segregated portfolio cell management services to a third party. Direct premiums written in the segregated portfolio cell reinsurance segment totaled $28.8 million for the year ended December 31, 2010. The segregated portfolio cell reinsurance segment generated fee revenue to the Company’s workers’ compensation insurance and corporate/other segments totaling $4.5 million for the year ended December 31, 2010.
Marketing and Distribution
Workers’ Compensation Insurance
The Company distributes its workers’ compensation products and services primarily in the Mid-Atlantic, Southeast and Midwest regions of the continental United States through a network of carefully chosen independent insurance agents. The following table provides direct premiums written, by state, for the year ended December 31, 2010 (dollars in thousands):
The Company has its greatest agency representation and largest workers’ compensation premium volume in central Pennsylvania.
The Company’s agents are compensated through a fixed base commission plan with an opportunity for profit sharing depending on the agent’s premium volume and loss experience.
The Company proactively manages its valued relationships with agents through a detailed management process. The process is driven by regular interaction and strong relationships between senior management of the Company and the principals of each agent. The primary components of the agency management process are as follows:
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The Company carefully selects agents through a process that assesses financial results, market potential, business philosophy and reputation of the agent and its staff. Senior management of the Company approves all agent appointments following extensive meetings with the agent’s principals. Following the agreement to appoint, the Company’s Senior Vice President of Marketing and Field Operations and other key personnel conduct a formal orientation process focusing on the Company’s workers’ compensation products and services, dedicated service team and the joint business objectives of the Company and the agent.
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The Company’s senior management team conducts annual business planning meetings with the agents’s principals to mutually agree upon the agent’s financial goals for the following year. Senior management and the underwriting staff conduct regular visits to monitor results and build relationships.
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The Company has established an Agency Advisory Council to promote an active dialogue between the Company and its agents. The Agency Advisory Council is comprised of experienced insurance agency professionals. The Council meets twice a year to discuss such topics as market conditions, customer service, products, competition and areas of opportunity. In addition to the Agency Advisory Council, the Company has established a Select Business Focus Group with its agents. This group meets once a year to concentrate on issues that impact small workers’ compensation clients (under $20,000 in annual premium).
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Agency management reports are distributed on a monthly basis, providing the agent with the data necessary to manage its relationship with the Company.
The Company attempts to optimize the franchise value of a workers’ compensation agency appointment by limiting the number of appointments in identified marketing territories. As a result of this agency management strategy, the average direct premiums written per agency contract was $1.2 million for the year ended December 31, 2010.
The Company’s ten largest agents in its workers’ compensation insurance segment accounted for 57.1% of its direct premiums written for the year ended December 31, 2010. The Company’s two largest agents, The Alliance of Central PA, Inc. and E.K. McConkey, accounted for 11.4% and 10.3% of its direct premiums written, respectively, for the year ended December 31, 2010. These agents are subject to the terms and conditions of the Company’s Agency Agreement, which sets forth binding authority, premium remittance and collection and termination provisions, among other things. No other agent accounted for more than 10.0% of the Company’s direct premiums written in its workers’ compensation insurance segment for the year ended December 31, 2010.
Segregated Portfolio Cell Reinsurance
The distribution of policies that may be submitted for consideration for reinsurance are substantially the same as that of the workers’ compensation insurance segment. The Company’s independent agents market the products to potential customer groups within the Company’s geographic target markets.
Underwriting, Risk Management and Pricing
Workers’ Compensation Insurance
The Company’s workers’ compensation insurance segment is committed to an individual account underwriting strategy that is focused on selecting quality accounts. The goal of the workers’ compensation underwriting professionals is to select a diverse book of business with respect to risk classification, hazard level and geographic location. The Company expects to remain a rural underwriter focusing on territories, accounts and agencies that generate acceptable underwriting margins.
The workers’ compensation underwriting strategy is focused on accounts with strong return to work and safety programs and low to middle hazard levels such as clerical office, light manufacturing, healthcare, auto dealers and service industries.
For the year ended December 31, 2010, the average annual workers’ compensation traditional premium per policy was $17,672.
Within the workers’ compensation underwriting operation, the Company operates a risk management unit, which delivers loss consulting services to the Company’s underwriters, agents and policyholders. The objective of the risk management operation is to protect the Company from catastrophic loss, reduce claims frequency and provide value added consulting services to policyholders. These services are provided at no additional cost to the policyholder. The quality of the services differentiates the Company’s workers’ compensation offerings from its competitors. The risk management unit also provides risk pre-screening in support of the underwriting selection process.
Segregated Portfolio Cell Reinsurance
Underwriting and risk management services for the segregated portfolio cell reinsurance segment are substantially the same as the workers’ compensation insurance segment, although a separate alternative markets unit has been formed for the delivery of services on a group program basis. The independent agents’ knowledge of the Company’s workers’ compensation product offerings is an important component in the offering of different product proposals to customers, including the alternative market option. After successful completion of the underwriting process, if the risk is deemed to be an appropriate candidate for the alternative market, the risk is submitted for consideration of intercompany reinsurance. In general, a pool of risks such as a trade group, or for similarly situated customers of an agency, are most appropriate for submission to the alternative markets unit. If a pool of risks is accepted, reinsurance agreements and dividend participant agreements are executed, external reinsurance is bound and a segregated portfolio cell is established and presented to the Cayman Islands Monetary Authority for approval.
Claims
Workers’ Compensation Insurance
Workers’ compensation claims management focuses on early intervention and aggressive disability management, utilizing the professional services of third-party medical case managers to supplement the expertise of in-house claims professionals when appropriate.
The Company believes in thorough education of its insureds and their employees regarding the workers’ compensation law and workplace safety. The Company utilizes frequent communication with all parties as a means to maintain control of claims and to minimize the influence of factors that increase costs such as attorney involvement and “doctor shopping.” The Company provides assistance and support to its insureds in the implementation of physician panels and return to work programs.
The Company utilizes strategic vendor relationships rather than in-house personnel for services such as legal representation, private investigation, vocational rehabilitation and medical case management.
Medical cost management initiatives have been implemented with strategic vendors to reduce claim costs. Medical cost management services include catastrophic medical management, medical case management, preferred provider networks, physical therapy networks and a prescription drug program.
The Company attempts to aggressively achieve final resolution of and close claims from prior accident years as expeditiously as possible. The table below shows the total number of workers’ compensation claims received and open and closed claims, by accident year, as of December 31, 2010.
Traditional Business
(Exclusive of Alternative Markets)
Open Lost Time Claims (1)
(1) Excludes claims for medical only claims because such claims are opened and closed in a short period of time.
The table below shows the number of open lost time claims for accident years 2009 and prior as of December 31, 2010 and 2009:
Traditional Business
(Exclusive of Alternative Markets)
Open Lost Time Claims (1)
(1) Excludes claims for medical only claims because such claims are opened and closed in a short period of time.
Segregated Portfolio Cell Reinsurance
The claims administration strategy for the alternative market programs is consistent with the workers’ compensation insurance segment.
Reinsurance
The Company’s insurance subsidiaries reinsure a portion of their loss exposure and pay to the reinsurers a portion of the premiums received on all policies reinsured. Insurance policies written by the Company’s insurance subsidiaries are reinsured with other insurance companies principally to:
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reduce net liability on individual risks;
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mitigate the effect of individual loss occurrences (including catastrophic losses);
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stabilize underwriting results; and
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decrease leverage and, accordingly, increase underwriting capacity.
Reinsurance does not legally discharge the Company from primary liability for the full amount due under the reinsured policies. However, the assuming reinsurer is obligated to reimburse the Company to the extent of the coverage ceded. As of December 31, 2010, the Company’s reinsurance recoverables, by segment, were as follows (in thousands):
The Company determines the amount and scope of reinsurance coverage to purchase each year based on a number of factors, including the evaluation of the risks accepted, consultations with reinsurance representatives and a review of market conditions, including the availability and pricing of reinsurance.
The Company monitors the solvency of its reinsurers on an annual basis, at a minimum, through review of their financial statements and, if available, their A.M. Best financial strength ratings. The Company has not experienced difficulty collecting amounts due from reinsurers; however, the insolvency or inability of any reinsurer to meet its obligations could have a material adverse effect on the Company’s financial condition and results of operations.
Workers’ Compensation Insurance
The Company’s workers’ compensation traditional business is reinsured under an excess of loss arrangement with Lloyd’s of London and Aspen Insurance UK, Ltd., under which the Company retains the first $500,000 on each loss occurrence. Loss occurrences in excess of $500,000 are covered up to a maximum of $39.5 million per claim.
The following table sets forth the amounts recoverable from reinsurers for the workers’ compensation insurance segment as of December 31, 2010 (dollars in thousands):
(1) Rating assigned to companies that are not rated by A.M. Best.
Segregated Portfolio Cell Reinsurance
Intercompany Reinsurance Structure. Intercompany reinsurance agreements are the mechanisms by which premiums paid by alternative markets customers are ceded to the segregated portfolio cells. Each segregated portfolio cell has the following reinsurance agreements:
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100% Quota Share Reinsurance Agreements-Under this reinsurance agreement, all premiums received from the specific customer are ceded to the respective segregated portfolio cell, net of a ceding commission. As with any reinsurance arrangement, the ultimate liability for the payment of claims resides with the primary insurance company. The ceding commission paid by the segregated portfolio cell consists of charges customary to such arrangements including fronting fees, external reinsurance, agent’s commissions, premium taxes and assessments, claims administration and risk management services and segregated portfolio cell rental fees. In addition, the ceding commission includes the risk assumed under the aggregate excess reinsurance agreement described directly below.
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Aggregate Excess Reinsurance Agreements-An aggregate excess reinsurance agreement exists for each respective segregated portfolio cell whereby the Company assumes 100% of aggregate losses over an aggregate attachment point (expressed as a percentage of direct premiums written), with a maximum loss limit of $100,000. The attachment points for the aggregate excess reinsurance agreements average 89.0% of direct premiums written. For example, in the case of a segregated portfolio cell with $1.0 million in assumed premium and an 89.0% attachment point, the segregated portfolio cell pays the first $890,000 in net losses and LAE, the Company pays the next $100,000 in net losses and LAE and the external aggregate reinsurer (as described below) pays net losses and LAE beyond the initial $990,000 covered by the segregated portfolio cell and the Company.
External Reinsurance. Each segregated portfolio cell purchases external reinsurance coverage directly from Lloyd’s of London. The segregated portfolio cell purchases per occurrence coverage to cover severity of claims and aggregate reinsurance coverage to cover frequency of claims on its segregated portfolio cell business.
Per Occurrence Reinsurance Agreements. Per occurrence reinsurance agreements cover each segregated portfolio cell for a catastrophic claim resulting from one event with respect to its segregated portfolio cell business. The specific retentions for per occurrence coverage for segregated portfolio cells range from $250,000 to $350,000, with limits ranging from $39.75 million to $39.65 million. For example, in the case of a segregated portfolio cell with a $300,000 retention that has a $3.0 million claim relating to the injury and/or death of a covered employee, the segregated portfolio cell would cover the first $300,000 of the claim with the third party reinsurer paying the remaining $2.7 million in claims.
Aggregate Reinsurance Coverage. Aggregate reinsurance agreements cover the segregated portfolio cells for losses and LAE beyond the $100,000 aggregate coverage provided by the Company. The need for this coverage would arise in the event of a series of losses as opposed to a single, catastrophic event. Aggregate reinsurance coverage purchased through Lloyd’s has ultimate loss limits of $1.0 million or $2.0 million, depending on the underlying risks. This external reinsurance combined with the aggregate coverage provided by the Company provides aggregate loss limits for each segregated portfolio cell ranging from $1.1 million to $2.1 million.
In addition to the reinsurance coverage on the segregated portfolio cell business, the dividend participants of each segregated portfolio cell provide a letter of credit to the Company that is equal to the difference between the loss fund (amount of funds available to pay losses after deduction of ceding commission) and the aggregate attachment point of the reinsurance. This is sometimes called the GAP, or unfunded liability. As an example, if a program has $1.0 million of assumed premiums, a 40% ceding commission and a 90% aggregate attachment point, the letter of credit amount is $300,000 calculated as follows:
The difference between the premium and the ceding commission is deposited in each respective segregated portfolio cell’s Cayman Island bank account to create the loss fund.
The following table sets forth the amounts recoverable from reinsurers for the segregated portfolio cell reinsurance segment as of December 31, 2010 (dollars in thousands):
(1) Rating assigned to companies that are not rated by A.M. Best.
Loss and LAE Reserves
The Company estimates its reserves for unpaid losses and LAE as of the balance sheet date. The adequacy of the Company’s reserves is inherently uncertain and represents a significant risk to the business. The Company attempts to mitigate the uncertainty inherent in its reserves by continually reviewing loss cost trends, attempting to set premium rates that are adequate to cover anticipated future costs, and by professionally managing its claims administration function. Additionally, the Company attempts to minimize the estimation risk inherent in its reserves by employing actuarial techniques on a quarterly basis. Significant judgment is required in actuarial estimation to ascertain the relevance of historical payment and claim settlement patterns under current facts and circumstances. No assurance can be given as to whether the ultimate liability for unpaid losses and LAE will be more or less than the Company’s current estimates. While management believes that the assumptions underlying the amounts recorded for the reserves for unpaid losses and LAE as of December 31, 2010 are reasonable, the ultimate net liability may differ materially from the amount provided.
The following table provides a summary of the activity in the Company’s reserves for unpaid losses and LAE for the years ended December 31, 2010, 2009 and 2008. The 2008 activity related to Employers Security’s reserves for unpaid losses and LAE is for the period from October 1, 2008 to December 31, 2008 (in thousands).
Incurred losses by segment were as follows for the year ended December 31, 2010 (in thousands):
Incurred losses by segment were as follows for the year ended December 31, 2009 (in thousands):
Incurred losses by segment were as follows for the year ended December 31, 2008 (in thousands):
For the years ended December 31, 2010, 2009 and 2008, the Company increased (decreased) its workers’ compensation insurance and segregated portfolio cell reinsurance reserves for unpaid losses and LAE, including the accretion of prior period discount, by the following amounts (in thousands):
Workers’ Compensation Insurance
For the years ended December 31, 2010, 2009 and 2008, the Company increased (decreased) its workers’ compensation insurance reserves for unpaid losses and LAE by the following amounts by accident year (in thousands):
For the year ended December 31, 2010, the Company did not recognize any development on prior accident year workers’ compensation reserves.
For the year ended December 31, 2009, the Company recognized net favorable development on prior accident year workers’ compensation reserves of $3.7 million, representing 6.8% of the Company’s estimated workers’ compensation reserves as of December 31, 2008 and 5.1% of the Company’s workers’ compensation net premiums earned for the year ended December 31, 2009. The favorable development arose primarily from accident years 2006 and 2007, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting include greater availability and use of employers’ return to work programs. Furthermore, the Company was able to settle a large amount of Pennsylvania claims via compromise and release, which is a lump sum cash payment in exchange for a full and final claim settlement. Management attributes the large amount of compromise and release claim closures to the difficult economic conditions and the claimants’ choosing a lump sum cash settlement over the continuation of a workers’ compensation annuity payment.
For the year ended December 31, 2008, the Company recognized net favorable development on prior accident year workers’ compensation reserves of $2.7 million, representing 6.3% of the Company’s estimated workers’ compensation reserves as of December 31, 2007 and 4.1% of the Company’s workers’ compensation net premiums earned for the year ended December 31, 2008. The favorable development arose primarily from accident year 2007, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting the continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting include greater availability and use of employers’ return to work programs and an improved economy in the Company’s underwriting territories during the first nine months of 2008.
Segregated Portfolio Cell Reinsurance
For the years ended December 31, 2010, 2009 and 2008, the Company increased (decreased) its segregated portfolio cell reinsurance reserves for unpaid losses and LAE by the following amounts by accident year (in thousands):
The Company estimates and records reserves for its segregated portfolio cell reinsurance segment in the same manner as for its workers’ compensation insurance segment. Furthermore, the Company’s underwriting, claim administration and risk management services are consistent between its workers’ compensation insurance and segregated portfolio cell reinsurance segments. This is because the workers’ compensation insurance and segregated portfolio cell reinsurance segments derive their books of business from the same general business demographics and geography. Prior period reserve development in the segregated portfolio cell reinsurance segment results in an increase or decrease in the segment’s losses and LAE incurred and a corresponding decrease or increase in the segregated portfolio cell dividend expense.
For the year ended December 31, 2010, the Company recognized net favorable development on prior accident year segregated portfolio cell reinsurance reserves of $1.4 million, representing 5.6% of the Company’s estimated segregated portfolio cell reinsurance reserves as of December 31, 2009 and 5.8% of the Company’s segregated portfolio cell reinsurance net premiums earned for the year ended December 31, 2009. The favorable development arose primarily from accident years 2008 and 2009, but was generally prevalent in most prior accident years, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting continued improvements in loss mitigation and underwriting. The unfavorable development recorded in 2010 related to accident year 2007 was driven by limited return to work options in one specific segregated portfolio cell program.
For the year ended December 31, 2009, the Company recognized net favorable development on prior accident year segregated portfolio cell reinsurance reserves of $2.8 million, representing 12.6% of the Company’s estimated segregated portfolio cell reinsurance reserves as of December 31, 2008 and 11.1% of the Company’s segregated portfolio cell reinsurance net premiums earned for the year ended December 31, 2008. The favorable development arose primarily from accident years 2006 and 2008, but was generally prevalent in most prior accident years, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting include greater availability and use of employers’ return to work programs.
For the year ended December 31, 2008, the Company recognized net favorable development on prior accident year segregated portfolio cell reinsurance reserves of $2.0 million, representing 9.4% of the Company’s estimated segregated portfolio cell reinsurance reserves as of December 31, 2007 and 8.4% of the Company’s segregated portfolio cell reinsurance net premiums earned for the year ended December 31, 2008. The favorable development arose primarily from accident years 2006 and 2007, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting include greater availability and use of employers’ return to work programs and an improved economy in the Company’s underwriting territories during the first nine months of 2008.
The analysis in the following table presents the development of the Company’s reserves for unpaid losses and LAE from December 31, 2000 to December 31, 2010 for both workers’ compensation and segregated portfolio cell insurance segments. The first line in the table shows the reserves for unpaid losses and LAE, net of reinsurance, as estimated at the end of each calendar year. The first section below that line shows the cumulative actual payments of losses and LAE, net of reinsurance, that relate to each year-end liability as they were paid at the end of subsequent annual periods. The next section shows revised estimates of the original unpaid amounts, net of reinsurance, that are based on the subsequent payments and re-estimates of the remaining unpaid liabilities. The next line shows the favorable or unfavorable development of the original estimates, net of reinsurance. Loss reserve development in this table is cumulative, the estimated favorable or unfavorable development for a particular year represents the cumulative amount by which all previous liabilities are currently estimated to have been over- or under-estimated. The “cumulative redundancy/(deficiency)” is as of December 31, 2010, which represents the difference between the latest re-estimated liability and the amounts as originally estimated. A redundancy means the original estimate was higher than the current estimate; a deficiency means that the current estimate is higher than the original estimate (in thousands).
(1) The reserves for unpaid losses and LAE as of December 31, 2010, 2009, 2008, 2007 and 2006 are reflected before the impact of purchase accounting adjustments of $330, $537, $1,037, $1,049 and $1,895, respectively.
(2) The above table excludes reserves for unpaid losses and LAE of $862 as of December 31, 2010 related to the Company’s previous run-off specialty reinsurance segment that is now reported in the corporate/other segment.
A.M. Best Rating
A.M. Best rates insurance companies based on factors of concern to policyholders. In evaluating a company’s financial and operating performance, A.M. Best reviews the company’s profitability, leverage and liquidity, its book of business, the adequacy and soundness of its reinsurance programs, the quality and estimated fair value of its investments, the adequacy of its reserves and surplus, its capital structure, the experience and competence of its management, and its marketing presence. A.M. Best ratings are intended to provide an independent opinion of an insurer’s ability to meet its obligations to its policyholders. Their evaluation is not directed at investors. As of December 31, 2010, Eastern Alliance Insurance Group had
a financial strength rating of “A” (Excellent) with a stable outlook. An “A” (Excellent) financial strength rating is the third highest out of 16 rating classifications. Eastern Re had a financial strength rating of “A-” (Excellent) with a stable outlook. An “A-” (Excellent) financial strength rating is the fourth highest out of 16 rating classifications.
The financial strength ratings assigned by A.M. Best to the Company’s insurance subsidiaries are subject to periodic review and may be upgraded or downgraded by A.M. Best as a result of changes in the views of the rating agency or positive or adverse developments in the insurance subsidiaries’ financial conditions or results of operations.
Competition
The Company’s ability to compete successfully in its principal markets is dependent upon a number of factors, many of which are outside its control. Workers’ compensation insurance is subject to significant price competition. In addition to price, competition in the workers’ compensation line of business is based on quality of the products, quality and delivery of service, financial strength, ratings, distribution systems and technical expertise.
The property and casualty insurance market is highly competitive. The Company competes with stock insurance companies, mutual companies, local cooperatives and other underwriting organizations. The Company considers its principal competitors to be Old Republic Insurance Company, Travelers Insurance, Liberty Mutual Insurance Company, Erie Insurance Group, Guard Insurance Group, Penn National Insurance Company, Selective Insurance Group, Cincinnati Insurance Company, Lackawanna Insurance Group, Accident Fund Insurance Company of America, and the Highmark Casualty Insurance Company.
Investments
The Company’s investment portfolio consists of fixed income securities, convertible bonds, equity securities, and other long-term investments in various limited partnerships. The management and accounting for the Company’s investment function is outsourced to third parties. The Company has established an investment policy, approved by the Finance/Investment Committee of the Board of Directors, which has been communicated to the Company’s external investment managers. In addition, the Company has hired an independent investment consultant to oversee the Company’s investment managers and to assist the Company in setting and monitoring its investment policy.
The Company’s investment objectives are:
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to meet insurance regulatory requirements;
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to maintain adequate liquidity in its insurance subsidiaries;
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to preserve capital through a well diversified, high quality investment portfolio; and
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to maximize after tax income while generating competitive after tax total rates of return.
The Company evaluates the performance of its investments through the use of various industry benchmarks. Benchmarks have been selected for each investment manager and/or portfolio and are reviewed on a quarterly basis by management and the Company’s Finance/Investment Committee. For the year ended December 31, 2010, the Company’s taxable equivalent total return, net of management fees, was 6.11%, compared to the composite benchmark return of 7.72%.
The Company’s investments in fixed income and equity securities are classified as “available for sale” and are reported at estimated fair value, with changes in fair value reported as a component of accumulated other comprehensive income (loss), net of applicable taxes. The Company’s convertible bonds are considered hybrid financial instruments and are reported at estimated fair value, with changes in fair value reported as a realized gain or loss in the consolidated statements of operations and comprehensive income (loss). The Company periodically evaluates its investments for other-than-temporary impairment. At the time an investment is determined to be other-than-temporarily impaired, the Company records a realized loss in the consolidated statements of operations and comprehensive income (loss). Any subsequent increase in the investment’s market value would be reported as an unrealized gain.
The Company’s other long-term investments include interests in various limited partnerships. The Company accounts for its limited partnership investments under the equity method, with changes in the Company’s interest in the limited partnerships recorded in the change in equity interest in limited partnerships in the consolidated statements of operations and comprehensive income (loss).
The following table sets forth consolidated information concerning the Company’s investments as of December 31, 2010 and 2009 (in thousands).
Other structured securities include other asset-backed securities collateralized by home equity loans, auto loan receivables and manufactured homes.
As of December 31, 2010 and 2009, the estimated fair values of the Company’s other long-term investments, by investment strategy, were as follows (in thousands):
The gross unrealized losses and estimated fair value of fixed income securities, excluding those securities in the segregated portfolio cell reinsurance segment, classified as available-for-sale by category and length of time an individual security is in a continuous unrealized loss position as of December 31, 2010 were as follows (in thousands):
Note: The Company has excluded the segregated portfolio cell reinsurance segment’s gross unrealized losses from the above table because changes in the estimated fair value of the segregated portfolio cell reinsurance segment’s fixed income and equity securities inures to the segregated portfolio cell dividend participant and, accordingly, is included in the segregated portfolio cell dividend payable and the related segregated portfolio dividend expense in the Company’s consolidated balance sheet and consolidated statement of operations, respectively. Management believes the exclusion of the segregated portfolio cell reinsurance segment from this disclosure provides a more transparent understanding of gross unrealized losses in the Company’s fixed income and equity security portfolios that could impact its consolidated financial position or results of operations.
As of December 31, 2010, the Company held 51 fixed income securities with gross unrealized losses totaling $328,000. Management has evaluated the unrealized losses related to those fixed income securities and determined that they are primarily due to a fluctuation in interest rates and not to credit issues of the issuer or the underlying assets in the case of asset-backed securities. The Company does not intend to sell the fixed income securities and it is not more likely than not that the Company will be required to sell the fixed income securities before recovery of their amortized cost bases, which may be maturity; therefore, management does not consider the fixed income securities to be other-than-temporarily impaired as of December 31, 2010.
For the years ended December 31, 2010, the Company recorded other-than-temporary impairments, excluding impairments in the segregated portfolio cell reinsurance segment, totaling $6,000. The impairment related to a fixed income security for which management determined a credit loss had occurred. There were no other-than-temporary impairments related to the Company’s equity securities.
As of December 31, 2010, the Company held asset-backed securities with an estimated fair value of $34.0 million. The types of underlying assets collateralizing these securities, the weighted average issuance date, average credit rating and the estimated fair values as of December 31, 2010 are as follows:
The Company held 39 RMBS securities as of December 31, 2010, all of which were rated AAA. These securities were all issued by government agencies.
The Company held 21 CMO securities as of December 31, 2010 all of which were rated AAA, except for two securities with a CC rating. The amortized cost and estimated fair value of the two CC-rated securities totaled $777,000 and 722,000 as of December 31, 2010, respectively.
The Company held 6 CMBS securities as of December 31, 2010, all of which were rated AAA.
The Company held 2 sub-prime home equity loan securities as of December 31, 2010, one rated BBB+ and the other rated CCC.
The Company held one security collateralized by auto loan receivables and one security collateralized by manufactured home loans. These securities were both rated AAA.
As of December 31, 2010, the Company held insurance enhanced securities, net of pre-refunded municipal bonds that are escrowed in U.S. government obligations, with an estimated fair value of $16.5 million, which represents approximately 9.2% of the Company’s total investments as of December 31, 2010. Municipal bonds made up 100% of the insurance enhanced securities.
The following table provides a breakdown of the ratings for these insurance enhanced securities, net of pre-refunded municipal bonds, with and without insurance (in thousands):
These securities had an average credit rating of AA+ as of December 31, 2010 (average credit rating of AA without the benefit of insurance).
The Company’s indirect exposure to third party insurers, by percent of estimated fair value as of December 31, 2010 was as follows:
The following table shows the ratings distribution of the Company’s fixed income securities and convertible bonds, excluding fixed income securities of the segregated portfolio cell reinsurance segment, as a percentage of the estimated fair value of the fixed income portfolio as of December 31, 2010 (dollars in thousands).
Note: The Company has excluded the segregated portfolio cell reinsurance segment’s investment credit ratings from the above table because management believes the exclusion of the credit ratings of the segregated portfolio cell reinsurance segment’s fixed income securities provides a more transparent understanding of the underlying risk in the Company’s fixed income portfolio.
The amortized cost and estimated fair value of fixed income securities and convertible bonds as of December 31, 2010, by contractual maturity, are shown below. Expected maturities could differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties (in thousands).
Company Web Sites
The Company operates two Web sites. The Company’s Corporate Web site (www.eihi.com) provides investor relations information and news. EAIG’s Web site (www.eains.com) provides information and news regarding workers’ compensation products and services, in addition to secured content accessible to agents and insureds. The secured sections include a risk management library that allows EAIG’s risk management personnel to disseminate safety information quickly and effectively to agents and insureds.
Employees
As of December 31, 2010, the Company had 171 employees. The Company’s employees are not represented by a union. The Company considers its relationship with its employees to be excellent.
Regulation
General
Insurance companies are subject to supervision and regulation in the jurisdictions in which they conduct business. Insurance authorities in each jurisdiction have broad administrative powers to administer statutes and regulations with respect to all aspects of the insurance business, including:
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licensing of insurers and their agents;
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approval of policy forms and premium rates;
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mandating certain insurance benefits;
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standards of solvency, including establishing statutory and risk-based capital requirements for statutory surplus;
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classifying assets as admissible for purposes of determining statutory surplus;
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regulating unfair trade and claim practices, including through the imposition of restrictions on marketing and sales practices, distribution arrangements and payment of inducements;
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restrictions on the nature, quality and concentration of investments;
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assessments by guaranty and other associations;
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restrictions on the ability of insurance companies to pay dividends;
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restrictions on transactions between insurance companies and their affiliates;
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restrictions on acquisitions and dispositions of insurance companies;
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restrictions on the size of risks insurable under a single policy;
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requiring deposits for the benefit of policyholders;
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requiring certain methods of accounting;
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periodic examinations of insurance company operations and finances;
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reviewing claims administration practices;
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prescribing the form and content of records of financial condition required to be filed; and
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requiring reserves for unearned premiums, losses and other purposes.
State insurance laws and regulations require insurance companies to file financial statements with insurance departments everywhere they do business, and the operations of insurance companies are subject to examination by those departments at any time. EIHI’s domestic insurance subsidiaries prepare statutory financial statements in accordance with accounting practices and procedures prescribed or permitted by these departments.
Examinations
Examinations of EIHI’s insurance subsidiaries are conducted by the domiciliary insurance department every three to five years. The Pennsylvania Insurance Department’s most recent examinations of Eastern Alliance and Allied Eastern for which a report was issued were as of December 31, 2006. The Indiana Insurance Department is in the process of completing an examination of Employers Security as of December 31, 2009. The final examination report is expected to be issued in March 2011. These examinations did not result in any adjustments to the financial position of the insurance companies. In addition, there were no substantive qualitative matters indicated in the examination reports that had a material adverse impact on the Company’s operations. The Pennsylvania Insurance Department conducted an organizational examination of Eastern Advantage as of October 24, 2007.
Risk-Based Capital Requirements
Pennsylvania and Indiana impose the NAIC risk-based capital requirements that require insurance companies to calculate and report information under a risk-based formula. These risk-based capital requirements attempt to measure statutory capital and surplus needs based on the risks in an insurance company’s mix of products and investment portfolio.
Under the formula, a company first determines its “authorized control level” risk-based capital. This authorized control level takes into account (i) the risk with respect to the insurer’s assets; (ii) the risk of adverse insurance experience with respect to the insurer’s liabilities and obligations; (iii) the interest rate risk with respect to the insurer’s business; and (iv) all other business and other relevant risks as are set forth in the risk-based capital instructions. As of December 31, 2010, the capital levels of EIHI’s insurance subsidiaries exceeded risk-based capital requirements.
Market Conduct Regulation
State insurance laws and regulations include numerous provisions governing trade practices and the marketplace activities of insurers, including provisions governing the form and content of disclosure to consumers, illustrations, advertising, sales practices and complaint handling. State regulatory authorities generally enforce these provisions through periodic market conduct examinations. To our knowledge, the Company is currently in compliance with these provisions.
Sarbanes-Oxley Act of 2002
The Company is subject to the Sarbanes-Oxley Act of 2002, which implemented legislative reforms intended to address corporate and accounting fraud. Among other reforms, the Sarbanes-Oxley Act requires chief executive officers and chief financial officers, or their equivalent, to certify to the accuracy of periodic reports filed with the SEC, subject to civil and criminal penalties if they knowingly or willfully violate this certification requirement. The Sarbanes-Oxley Act also increases the oversight of, and codifies, certain requirements relating to audit committees of public companies and how they interact with the company’s auditors. Audit committee members must be independent and are barred from accepting consulting, advisory or other compensatory fees from the Company. In addition, companies must disclose whether at least one member of the committee is a “financial expert,” as such term is defined by the SEC, and if not, why not. Pursuant to the Sarbanes-Oxley Act, the SEC has adopted rules requiring inclusion of an internal control report and assessment by management in the annual report to shareholders. The Sarbanes-Oxley Act requires the auditor that issues the audit report to attest to and report on management’s assessment of the company’s internal controls.
Insurance Guaranty Funds
Almost all states have guaranty fund laws under which insurers doing business in the state can be assessed to fund policyholder liabilities of insolvent insurance companies. Pennsylvania, Indiana and the other states in which our insurance companies do business have such laws. Under these laws, an insurer is subject to assessment depending upon its market share in the state of a given line of business. The most significant assessment fund to which the Company is subject is the Pennsylvania Workers’ Compensation Security Fund (the “Security Fund”), which assesses workers’ compensation insurers doing business in Pennsylvania for the purpose of providing funds to cover obligations to policyholders of insolvent insurance companies. The maximum assessment the Security Fund can impose is equal to 1.0% of the Company’s net workers’ compensation premiums written in Pennsylvania in the year of assessment. The Company establishes reserves relating to specific insurance company insolvencies upon notification of an assessment by the respective state guaranty association. We cannot predict the amount or timing of any future assessments under these laws.
Cayman Islands Regulation
Eastern Re is organized and licensed as a Cayman Islands unrestricted Class B insurance company and is subject to regulation by the Cayman Islands Monetary Authority. Applicable laws and regulations govern the types of policies that the Company can insure or reinsure, the amount of capital that it must maintain and the way it can be invested, and the payment of dividends without approval by the Cayman Islands Monetary Authority. Eastern Re is required to maintain minimum capital of $120,000.
Holding Company Regulation
EIHI is registered as an insurance holding company under the Insurance Holding Company Act amendments to the Pennsylvania Insurance Code of 1921, as amended, and is subject to regulation and supervision by the Pennsylvania Insurance Department. EIHI is required to annually file a report of its operations with, and is subject to examination by, the Pennsylvania Insurance Department.
Each insurance company in a holding company system is required to register with the insurance supervisory agency of its state of domicile and furnish certain information. This includes information concerning the operations of companies within the holding company system that may materially affect the operations, management or financial condition of the
insurers within the system. Pursuant to these laws, the respective insurance departments may examine insurance companies and their holding companies at any time, require disclosure of material transactions by insurance companies and their holding companies and require prior notice or approval of certain transactions, such as “extraordinary dividends” distributed by insurance companies.
All transactions within the holding company system affecting insurance companies and their holding companies must be fair and equitable. Notice of certain material transactions between insurance companies and any person or entity in their holding company system will be required to be given to the applicable insurance commissioner. In some states, certain transactions cannot be completed without the prior approval of the insurance commissioner.
Approval by the state insurance commissioner is required prior to any transaction affecting the control of an insurer domiciled in that state. In Pennsylvania, the acquisition of 10% or more of the outstanding capital stock of an insurer or its holding company is presumed to be a change in control. Pennsylvania law also prohibits any person from (i) making a tender offer for, or a request or invitation for tenders of, or seeking to acquire or acquiring any voting security of a Pennsylvania insurer if, after the acquisition, the person would be in control of the insurer, or (ii) effecting or attempting to effect an acquisition of control of or merger with a Pennsylvania insurer, unless the offer, request, invitation, acquisition, effectuation or attempt has received the prior approval of the Insurance Department.
Dividend Restrictions
EIHI’s ability to declare and pay dividends will depend in part on dividends received from its insurance subsidiaries. Our domestic insurance subsidiaries’ ability to pay dividends to the Company is limited by the insurance laws and regulations of Pennsylvania and Indiana. The maximum annual dividends that the domestic insurance entities may pay without prior approval from the Pennsylvania or Indiana Insurance Departments is limited to the greater of 10% of statutory surplus or 100% of statutory net income for the most recently filed annual statement.
Eastern Re must receive approval from the Cayman Islands Monetary Authority before it can pay any dividend to EIHI.
Note on Forward-Looking Statements
This document contains forward-looking statements, which can be identified by the use of such words as “estimate,” “project,” “believe,” “intend,” “anticipate,” “plan,” “seek,” “expect” and similar expressions. These forward-looking statements include:
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statements of goals, intentions and expectations;
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statements regarding prospects and business strategy; and
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estimates of future costs, benefits and results.
These forward-looking statements are subject to significant risks, assumptions and uncertainties, including, among other things, the factors discussed under the heading “Risk Factors” that could affect the actual outcome of future events.
All of these factors are difficult to predict and many are beyond our control. These important factors include those discussed under “Risk Factors” and those listed below:
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the ability to carry out our business plans;
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future economic conditions in the regional and national markets in which we compete that are less favorable than expected;
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the effect of legislative, judicial, economic, demographic and regulatory events in the states in which we do business;
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the ability to obtain licenses and enter new markets successfully and capitalize on growth opportunities either through mergers or the expansion of our agency network;
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financial market conditions, including, but not limited to, changes in interest rates and the credit and equity markets causing a reduction of investment income or investment gains, an acceleration of the amortization of deferred policy acquisition costs, reduction in the value of our investment portfolio or a reduction in the demand for our products;
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the impact of acts of terrorism and acts of war;
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the effects of terrorist related insurance legislation and laws;
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changes in general economic conditions, including inflation, unemployment, interest rates and other factors;
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the cost, availability and collectibility of reinsurance;
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estimates and adequacy of loss reserves and trends in losses and LAE;
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heightened competition, including specifically the intensification of price competition, increased underwriting capacity and the entry of new competitors and the development of new products by new and existing competitors;
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the effects of mergers, acquisitions and dispositions;
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changes in the coverage terms selected by insurance customers, including higher deductibles and lower limits;
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changes in the underwriting criteria that we use resulting from competitive pressures;
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our inability to obtain regulatory approval of, or to implement, premium rate increases;
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the potential impact on our reported earnings that could result from the adoption of future accounting standards issued by the Financial Accounting Standards Board or other standard-setting bodies;
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our inability to carry out marketing and sales plans, including, among others, development of new products or changes to existing products and acceptance of the new or revised products in the market;
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unanticipated changes in industry trends and ratings assigned by nationally recognized rating organizations;
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adverse litigation or arbitration results; and
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adverse changes in applicable laws, regulations or rules governing insurance holding companies and insurance companies, and tax or accounting matters including limitations on premium levels, increases in minimum capital and reserves, and other financial viability requirements, and changes that affect the cost of, or demand for our products.
Because forward-looking information is subject to various risks and uncertainties, actual results may differ materially from that expressed or implied by the forward-looking information. Therefore, we caution you not to place undue reliance on this forward-looking information.
All subsequent written and oral forward-looking information attributable to the Company or any person acting on our behalf is expressly qualified in its entirety by the cautionary statements contained or referred to in this section. We do not undertake any obligation to publicly release any revisions that may be made to any forward-looking statements.
Because of these and other uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements. The Company has no obligation to update or revise any forward-looking statements to reflect any changed assumptions, any unanticipated events or any changes in the future.
Item 1A
Item 1A - Risk Factors
Our business is subject to numerous risks and uncertainties, the outcome of which may impact future results of operations and financial condition. These risks are as follows:
Risk Factors Relating to Our Business
Our results may be adversely affected if our actual losses exceed our loss reserves.
The Company maintains loss reserves to cover estimated amounts needed to pay for insured losses and for the LAE necessary to settle claims with respect to insured events that have occurred, including events that have not yet been reported to us. Estimating the reserves for unpaid losses and LAE is a difficult and complex process involving many variables and subjective judgments; reserves do not represent an exact measure of liability. Accordingly, our loss reserves may prove to be inadequate to cover our actual losses. We regularly review our reserving techniques and our overall amount of reserves. We review historical data and consider the impact of various factors such as:
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trends in claim frequency and severity;
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information regarding each claim for losses;
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legislative enactments, judicial decisions and legal developments regarding damages; and
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trends in general economic conditions, including inflation and levels of employment.
If we determine that our reserves for unpaid losses and LAE are inadequate, we will have to increase them. This adjustment would reduce income during the period in which the adjustment is made, which could have a material adverse impact on our financial condition and results of operations. For additional information, see “Item 1 - Business, Loss and LAE Reserves” and “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations, Critical Accounting Polices and Estimates.”
If we do not accurately establish our premium rates, our results of operations may be adversely affected.
In general, the premium rates for our insurance policies are established when coverage is initiated and therefore, before all of the underlying costs are known. Like other insurance companies, we rely on estimates and assumptions in setting our premium rates. Establishing adequate rates is necessary, together with investment income, to generate sufficient revenue to offset losses, LAE and other underwriting expenses and to earn a profit. If we fail to accurately assess the risks that we assume, we may fail to charge adequate premium rates to cover our losses and expenses, which could reduce income and cause us to become unprofitable. As a result, our actual costs for providing insurance coverage to our policyholders may be significantly higher than our premiums.
In order to set premium rates accurately, we must collect and properly analyze a substantial volume of data; develop, test, and apply appropriate rating formulae; closely monitor and recognize changes in trends; project both severity and frequency of losses with reasonable accuracy; and estimate customer retention. Customer retention represents the amount of exposure a policyholder retains on any one risk or group of risks. The term may apply to an insurance policy, where the policyholder is an individual, family or business, or a reinsurance policy, where the policyholder is an insurance company. We must also implement our pricing accurately in accordance with our assumptions. For example, as we expand the geographic market in which we offer our workers’ compensation insurance products we may not price these products accurately or adequately. Our ability to undertake these efforts successfully, and as a result set premium rates accurately, is subject to a number of risks and uncertainties, including:
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inaccurate assessment of new markets in which we have little or no prior experience;
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insufficient or unreliable data;
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incorrect or incomplete analysis of available data;
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uncertainties generally inherent in estimates and assumptions;
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our inability to implement appropriate rating formulae or other pricing methodologies;
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costs of ongoing medical treatment;
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our inability to accurately estimate customer retention, investment yields and the duration of our liability for losses and LAE; and
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unanticipated court decisions, legislation or regulatory action.
Consequently, we could set our premium rates too low, which could negatively affect our results of operations and our profitability, or we could set our premium rates too high, which could reduce our ability to obtain new or retain existing business and lead to lower net premiums earned.
If we do not effectively manage the growth of our operations we may not be able to compete or operate profitably.
Our growth strategy includes enhancing our market share in our existing markets, entering new geographic markets, introducing new insurance products and programs, further developing our agency relationships, and pursuing merger and acquisition opportunities. Our strategy is subject to various risks, including risks associated with our ability to:
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identify profitable new geographic markets to enter;
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obtain licenses in new states in which we wish to market and sell our products;
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successfully implement our underwriting, pricing, claims management, and product strategies over a larger operating region;
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properly design and price new and existing products and programs and reinsurance facilities;
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identify, train and retain qualified employees;
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identify, recruit and integrate new independent agents;
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formulate and execute a merger and acquisition strategy; and
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augment our internal monitoring and control systems as we expand our business.
We also may encounter difficulties in the implementation of our growth strategies, including unanticipated expenditures. In addition, our growth strategies may result in us entering into markets or product lines in which we have little or no prior experience. Any such difficulties could result in diversion of senior management time and adversely affect our financial results.
Our ability to manage our exposure to underwriting risks depends on the availability and cost of reinsurance coverage.
We use reinsurance arrangements to limit and manage the amount of risk we retain, to stabilize our underwriting results and to increase our underwriting capacity. Although we have not recently experienced difficulty in obtaining reinsurance at reasonable prices, the availability and cost of reinsurance is subject to current market conditions and may vary significantly over time. Any decrease in the amount of our reinsurance will increase our risk of loss. We may be unable to maintain our desired reinsurance coverage or to obtain other reinsurance coverage in adequate amounts and at favorable rates. If we are unable to renew our expiring coverage or obtain new coverage, it will be difficult for us to manage our underwriting risks and operate our business profitably.
It is also possible that the losses we experience on insured risks for which we have obtained reinsurance will exceed the coverage limits of the reinsurance. If the amount of our reinsurance coverage is insufficient, our insurance losses could increase substantially.
If our reinsurers do not pay our claims in a timely manner, we may incur losses.
We are subject to credit risk with respect to the reinsurers with whom we deal because buying reinsurance does not relieve us of our liability to policyholders. The Company had net reinsurance recoverables of $12.3 million as of December 31, 2010. For example, some of our reinsurers have been adversely impacted by the current economic environment and deterioration in the investment markets and, as a result, have been downgraded by A.M. Best, which could negatively impact the reinsurers’ results of operations or financial condition. If our reinsurers are not capable of fulfilling their financial obligations to us, including the inability to secure the necessary collateral provided under the reinsurance agreements, our insurance losses would increase, which would negatively affect our financial condition and results of operations.
Our investment performance may suffer as a result of adverse capital market developments, which may affect our financial results and ability to conduct business.
We invest the premiums we receive from policyholders until cash is needed to pay insured claims or other expenses. As of December 31, 2010, the Company had investments of $177.9 million. For the year ended December 31, 2010, the Company had $3.4 million of net investment income, representing 2.9% of its total revenues. Our investments are subject to a variety of investment risks, including risks relating to general economic conditions, market volatility, interest rate fluctuations, liquidity risk and credit risk. In particular, an unexpected increase in the volume or severity of claims may force us to liquidate securities, which may cause us to incur capital losses. If we do not structure the duration of our investments to match our insurance and reinsurance liabilities, we may be forced to liquidate investments prior to maturity at a significant loss to cover such payments. Investment losses could significantly decrease our asset base and statutory surplus, thereby affecting our ability to conduct business.
Our fixed income securities include investments in state and municipal bonds with an estimated fair value of $32.6 million as of December 31, 2010. Most states and many municipalities are experiencing financial difficulties and budget deficits as a result of the current economic environment and, as a result, the risks associated with our state and municipal bond portfolio have increased. Negative publicity surrounding state and municipality bond issues has resulted in reduced liquidity in the state and municipal bond market. The reduced market liquidity, as well as rising interest rates, has negatively impacted the estimated fair value of state and municipal bonds. If the liquidity in the state and municipal bond market does not improve, or worsens, the estimated fair value of the Company’s state and municipal bonds could decline further. Furthermore, the Company may experience an other-than-temporary impairment if a state or municipality in which the Company has an investment defaults on its obligations under the terms of the bond.
Our revenues may fluctuate with changes in interest rates.
Our investment portfolio contains a significant amount of fixed income securities, including bonds, mortgage-backed securities (“MBSs”), collateralized mortgage obligations (“CMOs”), and other asset-backed securities. The market values of all of our investments fluctuate depending on economic and political conditions and other factors beyond our control. The market values of our fixed income securities are particularly sensitive to changes in interest rates.
For example, if interest rates rise, fixed income securities generally will decrease in value. If interest rates decline, these securities generally will increase in value, except for MBSs, which may decline due to higher prepayments on the mortgages underlying the securities.
As of December 31, 2010, MBSs, including CMOs, constituted 18.7% of the market value of the Company’s investment portfolio. MBSs and CMOs are subject to prepayment risks that vary with, among other things, interest rates. During periods of declining interest rates, MBSs generally prepay faster as the underlying mortgages are prepaid and/or refinanced by the borrowers in order to take advantage of lower interest rates. MBSs that have an amortized cost that is greater than par (i.e., purchased at a premium) may incur a reduction in yield or a loss as a result of prepayments. In addition, during such periods, we generally will be unable to reinvest the proceeds of any prepayment at comparable yields. Conversely, during periods of rising interest rates, the frequency of prepayments generally decreases, and we may receive interest payments that are below the then prevailing interest rate for longer than expected. MBSs that have an amortized cost that is less than par (i.e., purchased at a discount) may incur a decrease in yield or a loss as a result of slower prepayments.
If we fail to comply with insurance industry regulations, or if those regulations become more burdensome, we may not be able to operate profitably.
Our insurance subsidiaries are regulated by government agencies in the states in which we conduct business, and we must comply with a number of state and federal laws and regulations. Most insurance regulations are intended to protect the interests of insureds rather than those of shareholders and other investors.
If we fail to comply with these laws and regulations, state insurance departments can exercise a range of remedies from the imposition of fines to being placed in rehabilitation or liquidation. State insurance departments also conduct periodic examinations of the affairs of insurance companies and require the filing of annual and other reports relating to financial condition, holding company issues and other matters. These regulatory requirements may adversely affect or inhibit our ability to achieve some or all of our business objectives.
Part of our strategy includes expanded licensing and product filings for the Company. Regulatory authorities, however, have broad discretion to deny or revoke licenses for various reasons, including the violation of regulations. If we do not have or obtain the requisite licenses and approvals or do not comply with applicable regulatory requirements, insurance regulatory authorities could preclude or temporarily suspend us from carrying on some or all of our activities, including our expansion objectives, or otherwise penalize us. Furthermore, changes in the level of regulation of the insurance industry or changes in laws or regulations or interpretations of such laws and regulations by regulatory authorities could adversely affect our ability to operate our business.
We are subject to various accounting and financial requirements established by the NAIC. Eastern Re is subject to the laws of the Cayman Islands and regulations promulgated by the Cayman Islands Monetary Authority. Failure to comply with these laws, regulations and requirements could result in consequences ranging from a regulatory examination to a regulatory takeover of one or more of our insurance subsidiaries. This would make our business less profitable. In addition, state regulators and the NAIC continually re-examine existing laws and regulations, with an emphasis on insurance company solvency issues and fair treatment of policyholders. Insurance laws and regulations could change or additional restrictions could be imposed that are more burdensome and make our business less profitable. Because these laws and regulations are for the protection of policyholders, any changes may not be in your best interest as a shareholder.
Compliance with applicable laws and regulations is time consuming and personnel-intensive, and changes in these laws and regulations may materially increase our direct and indirect compliance and other expenses of doing business, thus adversely affecting our financial condition and results of operations.
Workers’ compensation insurance markets in which we operate are highly competitive.
Competition in these markets is based on many factors. These factors include the perceived financial strength of the insurer, premiums charged, policy terms and conditions, services provided, reputation, financial ratings assigned by independent rating agencies and the experience of the insurer in the line of insurance to be written. The Company’s insurance
subsidiaries compete with stock insurance companies, mutual companies, local cooperatives and other underwriting organizations. Our principal competitors in the workers’ compensation insurance market include Old Republic Insurance Company, Travelers Insurance, Liberty Mutual Insurance Company, Erie Insurance Group, Guard Insurance Group, Penn National Insurance Company, Selective Insurance Group, Cincinnati Insurance Company, Lackawanna Insurance Group, Accident Fund Insurance Company of America, and Highmark Casualty Insurance Company. The workers’ compensation line of insurance is subject to significant price competition. If competitors price their products aggressively, our ability to grow or renew our business may be adversely affected. We pay agents on a commission basis to produce business. Some competitors may offer higher commissions to independent agents or offer insurance at lower premium rates through the use of salaried personnel or other distribution methods that do not rely on independent agents. Increased competition could adversely affect our ability to attract and retain business and thereby reduce our profits from operations.
We could be adversely affected by the loss of our key personnel.
The success of our business is dependent, to a large extent, on the efforts of certain key personnel, in particular, Michael L. Boguski, our President and Chief Executive Officer, Kevin M. Shook, our Executive Vice President, Treasurer and Chief Financial Officer, Robert A. Gilpin, our Senior Vice President of Marketing and Field Operations, and Suzanne M. Emmet, our Senior Vice President of Claims and Corporate Compliance. We have employment agreements with each of Messrs. Boguski, Shook, Gilpin, and Ms. Emmet, which contain covenants not to compete. We do not maintain key man life insurance on any of these executives. The loss of key personnel could prevent us from fully implementing our business strategy and could significantly and negatively affect our financial condition and results of operations. As we continue to grow, we will need to recruit and retain additional qualified management personnel, and our ability to do so will depend upon a number of factors, such as our results of operations and prospects and the level of competition then prevailing in the market for qualified personnel. The current market for qualified insurance personnel is highly competitive.
Our results of operations may be adversely affected by any loss of business from key agents and by the creditworthiness of our agents.
Our products are marketed by independent agents. Other insurance companies compete with the Company for the services and allegiance of these agents. Because they are independent, these agents are not obligated to direct business to the Company and may choose to direct business to our competitors, or may direct less desirable risks to us. The Company’s ten largest agents in its workers’ compensation insurance segment accounted for 57.1% of its direct premiums written for the year ended December 31, 2010. The Company’s two largest agents, The Alliance of Central PA, Inc. and E. K. McConkey, accounted for 11.4% and 10.3% of direct premiums written, respectively, for the year ended December 31, 2010. No other agent accounted for more than 10.0% of direct premiums written in the Company’s workers’ compensation insurance segment for the year ended December 31, 2010. If premium volume produced by any of the Company’s large agents were to decrease significantly, it would have a material adverse effect on us.
In addition, in accordance with industry practice, our customers sometimes pay the premiums for their policies to agents for payment to us. These premiums are considered paid when received by the agent and, thereafter, the customer is no longer liable to us for those amounts, whether or not we have actually received the premiums from the agent. Consequently, we assume a degree of credit risk associated with our reliance on agents in connection with the collection of insurance premiums.
If we are unable to collect receivables created as a result of our sale of Atlantic RE and Eastern Life, we could recognize a loss.
In connection with the sale of Atlantic RE, a portion of the purchase price consisted of a contingent profit commission of $3.0 million, payable upon the earlier of extinguishment of all Atlantic RE’s reinsurance obligations, commutation of those obligations, or ten years from the date of closing (December 9, 2020). The amount of the contingent profit commission is based upon the adequacy of the Company’s loss and LAE reserves as of September 30, 2010 compared to a predetermined targeted amount of loss and LAE reserves. The Company has recorded a receivable for the contingent profit commission on its consolidated balance sheet as of December 31, 2010. However, the ultimate amount of the contingent profit commission payment is dependent upon the amount of future claims incurred and the ability of the purchaser to manage the outstanding claims, both of which are outside the control of the Company. Accordingly, no assurance can be given that the Company will be collect all or any of the contingent profit commission in the future. If the Company determines at any future date that all or any portion of the contingent profit commission will not be collected, the Company will recognize a loss in the period in which such determination is made.
In connection with the sale of Eastern Life to Security Life Insurance Company of America (“Security Life”), a portion of the purchase price was payable by the delivery to Eastern Life by Security Life’s parent corporation, Security American Financial Enterprises, Inc. (“Security American”), of a three-year $1.75 million promissory note payable in full at maturity in 2013. The ability of Security American to repay the promissory note will be dependent upon its financial condition and the financial condition of Security Life when the note matures. If Security American is unable to repay the note at maturity, or if Security American’s financial condition deteriorates prior to the maturity date and it is more likely than not that they will be unable to repay the note, the Company will incur a loss.
Because the Company’s workers’ compensation insurance business is concentrated in Pennsylvania, the Company is subject to local economic risks as well as to changes in the regulatory and legal climate in Pennsylvania.
For the year ended December 31, 2010, 74.1% of the Company’s workers’ compensation premium was written in Pennsylvania. The Company’s workers’ compensation insurance business is affected by the economic health of Pennsylvania for two principal reasons. First, premium growth is dependent upon payroll growth, which, in turn, is affected by economic conditions. Second, losses and LAE can increase in weak economic conditions because it is more difficult to return injured workers to the job when employers are otherwise reducing payrolls. Finally, as a result of the Company’s high concentration of Pennsylvania business, the Company can be adversely affected by any material change in Pennsylvania law or regulation or any Pennsylvania court decision affecting workers’ compensation carriers generally.
Future changes in financial accounting standards or practices or existing tax laws may adversely affect our reported results of operations.
Financial accounting standards in the United States are constantly under review and may be changed from time to time. We would be required to apply these changes when adopted. Once implemented, these changes could materially affect our results of operations and/or the way in which such results of operations are reported. Similarly, we are subject to taxation in the United States and a number of state jurisdictions. Rates of taxation, definitions of income, exclusions from income, and other tax policies are subject to change over time. Eastern Re is domiciled in the Cayman Islands. Changes in Cayman Islands tax laws could have a material impact on our consolidated results of operations.
Proposals to federally regulate the insurance business could affect our business.
Currently, the U.S. federal government does not directly regulate the insurance business. However, federal legislation and administrative policies in several areas can significantly and adversely affect insurance companies. These areas include financial services regulation, securities regulation, pension regulation, privacy, tort reform legislation and taxation. In addition, various forms of direct federal regulation of insurance have been proposed. These proposals include the State Modernization and Regulatory Transparency Act, which would maintain state-based regulation of insurance but would affect state regulation of certain aspects of the insurance business, including rates, agency and company licensing, and market conduct examinations, and the National Insurance Act of 2007, which would provide for optional federal charters for insurance companies. We cannot predict whether this or other proposals will be adopted, or what impact, if any, such proposals or, if enacted, such laws may have on our business, financial condition or results of operations.
Risk Factors Relating to Our Common Stock
Directors and management could effectively control certain situations that may be viewed as contrary to your interests.
The extent of management’s control over the Company is related to the following factors:
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Directors and management owned approximately 19.5% of the Company’s outstanding stock as of December 31, 2010.
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The employee stock ownership plan (“ESOP”) owns 7.8%, or 702,017 shares, of the Company’s outstanding stock as of December 31, 2010. The shares held by the ESOP will be voted in the manner directed by the ESOP participants.
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We have implemented a stock compensation plan pursuant to which shares of restricted stock and stock options have been issued to certain of our directors, officers and employees.
As a result of these factors, the Company’s directors and management, directly or indirectly, hold a substantial equity interest in the Company. If all members of management were to act together as a group, they could have a significant influence over the outcome of the election of directors and any other shareholder vote. Therefore, management might have the power to take actions that nonaffiliated shareholders may deem to be contrary to the shareholders’ best interests.
Provisions in our articles and bylaws and statutory provisions may serve to entrench management and also may discourage takeover attempts that you may believe are in your best interests.
We are subject to provisions of Pennsylvania corporate and insurance law that hinder a change of control. Pennsylvania law requires the Pennsylvania Insurance Department’s prior approval of a change of control of an insurance holding company. Under Pennsylvania law, the acquisition of 10% or more of the outstanding capital stock of an insurer or its holding company is presumed to be a change in control. Approval by the Pennsylvania Insurance Department may be withheld even if the transaction would be in the shareholders’ best interest if, among other things, the Pennsylvania Insurance Department determines that the transaction would be detrimental to policyholders.
Our articles of incorporation and bylaws also contain provisions that may discourage a change in control. These provisions include:
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a classified Board of Directors divided into three classes serving for successive terms of three years each;
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a provision that the Board of Directors has the authority to issue shares of authorized but unissued common stock and preferred stock and to establish the terms of any one or more series of preferred stock, including voting rights, without additional shareholder approval;
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the prohibition of cumulative voting in the election of directors;
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the requirement that nominations for the election of directors made by shareholders and any shareholder proposals for inclusion on the agenda at any annual meeting must be made by notice (in writing) delivered or mailed to us not less than 90 days or more than 120 days prior to the meeting;
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the prohibition of shareholder action without a meeting and the prohibition of shareholders being able to call a special meeting;
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the requirement that certain provisions of our articles of incorporation can only be amended by an affirmative vote of shareholders entitled to cast at least 80% of all votes that shareholders are entitled to cast, unless approved by an affirmative vote of at least 80% of the members of the Board of Directors; and
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the requirement that certain provisions of our bylaws can only be amended by an affirmative vote of shareholders entitled to cast at least 66 2/3%, or in certain cases 80%, of all votes that shareholders are entitled to cast.
These provisions may serve to entrench management and may discourage a takeover attempt that you may consider to be in your best interest or in which you would receive a substantial premium over the current market price. These provisions may make it extremely difficult for any one person or group of affiliated persons to acquire voting control of the Company, with the result that it may be extremely difficult to bring about a change in the Board of Directors or management. Some of these provisions also may perpetuate present management because of the additional time required to cause a change in the control of the board. Other provisions make it difficult for shareholders owning less than a majority of the voting stock to be able to elect even a single director.
Provisions of the Pennsylvania Business Corporation Law, which we refer to as the PBCL, that are applicable to publicly traded companies provide, among other things, that we may not engage in a business combination with an “interested shareholder” during the five-year period after the interested shareholder became such, except under certain specified circumstances. Under the PBCL, an interested shareholder is generally a holder of 20% or more of our voting stock. The PBCL also contains provisions providing for the ability of shareholders to object to the acquisition by a person, or group of persons acting in concert, of 20% or more of our outstanding voting securities and to demand that they be paid a cash payment for the fair value of their shares from the controlling person or group.
If our insurance subsidiaries are not sufficiently profitable, our ability to pay dividends will be limited by regulatory restrictions.
Our domestic insurance subsidiaries’ ability to pay dividends to the Company is limited by the insurance laws and regulations of Pennsylvania and Indiana. The maximum dividend that the domestic insurance entities may pay without prior approval from the Pennsylvania Insurance Department and the Indiana Insurance Department is limited to the greater of 10% of statutory surplus or 100% of statutory net income for the most recently filed annual statement.
Eastern Re must receive approval from the Cayman Islands Monetary Authority before it can pay any dividend. Furthermore, any dividends paid in excess of Eastern Re’s cumulative earnings and profits subsequent to June 16, 2006 would be subject to U.S. federal income tax.
Item 1B
Item 1B - Unresolved Staff Comments
Not applicable.
Item 2
Item 2 - Properties
The Company’s corporate headquarters are located at 25 Race Avenue in Lancaster, Pennsylvania. The Company leases its home office building under a 15-year, non-cancelable lease through February 2017. The annual base rent is subject to an annual increase based upon the consumer price index at the end of each preceding calendar year. In addition to the base rent, the Company is responsible for its proportionate share of expenses related to the building including, but not limited to, utilities, maintenance, real estate taxes, and insurance. The Company has a 5% interest in the limited partnership that owns the building.
The Company also has regional offices in Charlotte, North Carolina, Indianapolis, Indiana, Brentwood, Tennessee and Wexford, Pennsylvania and leases office space in each of these locations under multi-year operating leases.
The home office building is used by the workers’ compensation insurance and corporate/other segments. The regional office space in North Carolina, Indiana, Tennessee and Western Pennyslvania is primarily used by the workers’ compensation insurance segment.
Item 3
Item 3 - Legal Proceedings
The Company is, from time to time, involved in legal proceedings that arise in the ordinary course of business. We believe we have sufficient loss reserves and reinsurance to cover claims under insurance policies issued by us. Although there can be no assurance as to the ultimate disposition of these matters, we do not believe, based upon the information available at this time, that any current pending legal proceedings, individually or in the aggregate, will have a material adverse effect on our business, financial condition, or results of operations.
Item 4
Item 4 - Submission of Matters to a Vote of Security Holders
We did not submit any matters to a vote of the holders of our common stock during the fourth quarter of 2010.
PART II
Item 5
Item 5 - Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The no par value common stock trades on the NASDAQ National Market under the symbol “EIHI”. As of March 3, 2011, there were 512 registered holders of record of our common stock.
During 2010, the Company paid four quarterly dividends of $0.07/share. Any payment of dividends in the future on the common stock is subject to determination and declaration by the Company’s Board of Directors, who will take into consideration the Company’s financial condition, results of operations and future prospects.
The table below sets forth information with respect to the amount and frequency of dividends declared on our common stock for the years ended December 31, 2010 and 2009. It is currently expected that cash dividends will continue to be paid in the future.
Information regarding restrictions and limitations on the payment of cash dividends can be found in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the “Financial Condition, Liquidity and Capital Resources” section.
The table below sets forth the high and low sales prices of our common stock for each quarterly period as reported by the NASDAQ for the years ended December 31, 2010 and 2009.
Equity Compensation Plan Information
The Company adopted the Eastern Insurance Holdings, Inc. 2006 Stock Incentive Plan (the “Stock Incentive Plan”) on December 18, 2006. Under the terms of the Stock Incentive Plan, stock awards may be made in the form of incentive stock options, non-qualified stock options or restricted stock. The following table provides the total number of stock awards outstanding, including the weighted average exercise price, as of December 31, 2010:
(1) Beginning with calendar year 2008, the number of securities available for future issuance under the Stock Incentive Plan is automatically increased on January 1 by an amount equal to 1.0% of the total outstanding common shares on the last trading day of December of the immediately preceding calendar year. The number of securities available for future issuance can be in the form of stock options or restricted stock.
Performance Graph
Set forth below is a line graph comparing the dollar change in the cumulative total shareholder return on the Company’s common stock for the year ended December 31, 2010 compared to the cumulative total return of the NASDAQ Composite Index and the cumulative total return of the SNL Insurance Underwriter Index. The chart depicts the value on December 31, 2010 of a $100 investment made on June 19, 2006.
Unregistered Sales of Equity Securities and Use of Proceeds
Issuer Purchases of Equity Securities
As of December 31, 2010, the Company’s Board of Directors has authorized repurchases of the Company’s issued and outstanding shares of common stock equal to 2,046,500 shares plus additional shares not to exceed $10.0 million. The share repurchases will be held as treasury stock and are available for issuance in connection with the Company’s Stock Incentive Plan.
The Company repurchased 728,413 shares of our common stock during the year ended December 31, 2010. As of December 31, 2010, the Company has repurchased 2,820,170 shares, and has approximately $1.5 million authorized for future repurchases. There were no share repurchases in 2009.
The following table presents information with respect to those purchases of our common stock made during the year ended December 31, 2010:
(a) As of December 31, 2010, the Company may repurchase shares of its common stock with an aggregate cost of $1.5 million. On January 12, 2011, the Company’s Board of Directors authorized the repurchase of an additional 1,000,000 shares after the remaining $1.5 million in authorized repurchases has been used.
Item 6
Item 6 - Selected Financial Data
The following table sets forth selected historical financial information for the Company for the years ended and as of the dates indicated. This information is derived from the Company’s consolidated financial statements. You should read the following selected financial information along with the information contained in this annual report, including Part II, Item 7
Item 7 of this annual report entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes and the reports of the independent registered public accounting firm included in Part II, Item 8 and elsewhere in this report. These historical results are not necessarily indicative of results to be expected from any future period (in thousands, except per share and share amounts).
(1) Includes Employers Security Holding Company’s results of operations for the period from October 1, 2008 to December 31, 2008.
(2) Includes the results of operations of Eastern Holding Company, Ltd. and its subsidiaries for the period from June 17, 2006 to December 31, 2006.
(3) The net income of the segregated portfolio cell reinsurance segment is recorded as a segregated portfolio dividend expense, which represents the dividend earned by the segregated portfolio dividend participants during the period.
(4) Total assets as of December 31, 2009, 2008, 2007 and 2006 include assets reclassified to discontinued operations totaling $115,207, $116,445, $155,319 and $151,835, respectively.
(5) Total liabilities as of December 31, 2009, 2008, 2007 and 2006 include liabilities reclassified to discontinued operations totaling $65,054, $77,048, $72,428 and $69,013, respectively.
(6) Calculated by dividing losses and LAE incurred by net premiums earned.
(7) Calculated by dividing the sum of acquisition and other underwriting expenses, other expenses and amortization of intangibles by net premiums earned.
(8) Calculated by dividing the policyholder dividend expense by net premiums earned.
(9) The sum of the loss and LAE ratio, expense ratio and the policyholder dividend expense ratio.
Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
During 2010, the Company sold its group benefits insurance business and the majority of its run-off specialty reinsurance business. As a result of these transactions, the Company has reported the results of operations of its group benefits insurance and run-off specialty reinsurance business as discontinued operations. The Company reported a net loss of $9.2 million for the year ended December 31, 2010, of which $12.1 million was attributed to discontinued operations.
The Company reported net income from continuing operations of $2.9 million for the year ended December 31, 2010, compared to net income of $5.9 million for the year ended December 31, 2009. The decrease in net income primarily reflects an increase in the loss ratio from 60.0% in 2009 to 71.1% in 2010, premiums returned to customers as a result of premium audits, and a decrease in net investment income. These items, which contributed to the decrease in the Company’s operating results, were partially offset by an increase in net premiums earned, an increase in realized gains from the sale of investments, a decrease in other-than-temporary investment impairments, and a decrease in the expense ratio from 35.1% in 2009 to 31.7% in 2010.
The increase in the loss ratio primarily reflects a higher accident period loss ratio in both the workers’ compensation insurance and segregated portfolio cell reinsurance segments as a result of an increase in severity-related claims in the workers’ compensation insurance segment.
The Company returned premium to customers as a result of premium audits in 2010, reflecting the impact of the economy on customers’ payroll. Premiums returned to customers totaled $1.4 million in 2010, compared to additional premium from customers totaling $6,000 in 2009. In addition to the impact of changes in audit premium, the Company decreased its estimate of earned but unbilled premium by $750,000 in 2010. While the audit premium had a negative impact on net premiums earned, the Company wrote new business of $32.7 million in 2010 and experienced an increase in the renewal retention rate, resulting in an 11.5% increase in premium revenue from 2009 to 2010.
The decrease in the expense ratio primarily reflects the impact of the premium revenue increase. The Company experienced growth in each of its geographical markets during 2010, and particularly in its Southeast market. The expense ratio was also positively impacted by the release of the 2009 and 2010 accruals related to the Pennsylvania Workers’ Compensation Security Fund assessment.
Principal Revenue and Expense Items
The Company derives its revenue primarily from net premiums earned, including assumed premiums earned, net investment income and net realized investment gains.
Direct and net premiums written. Direct premiums written is the sum of both direct premiums and assumed premiums before the effect of ceded reinsurance. Direct premiums written include all premiums billed during a specified policy period. Net premiums written is the difference between direct premiums written and premiums ceded or paid to reinsurers (ceded premiums written). In the segregated portfolio cell reinsurance segment, assumed premiums are derived from insurance contracts written by the Company and ceded to the segregated portfolio cells.
Net premiums earned. Net premiums earned represent the earned portion of the Company’s net premiums written. Premiums are earned over the term of the related policies. At the end of each accounting period, the portion of the premiums that are not yet earned are included in unearned premiums and are realized as revenue in subsequent periods over the remaining term of the policy. The Company’s workers’ compensation policies typically have a term of twelve months. Thus, for example, for a policy that is written on July 1, 2010, one-half of the premiums would be earned in 2010 and the other half would be earned in 2011. Workers’ compensation premiums are determined based upon the payroll of the insured, the applicable premium rates and, where applicable, an experience based modification factor. An audit of the policyholders’ records is conducted after policy expiration to make a final determination of applicable premiums. Included with net premiums earned is an estimate for earned but unbilled final audit premiums. The Company can estimate earned but unbilled premiums because it keeps track, by policy, of how much additional premium is billed in final audit invoices as a percentage to estimate the probable additional amount that it has earned but not yet billed as of the balance sheet date.
Net investment income and realized gains and losses on investments. The Company invests its surplus and the funds supporting its insurance liabilities (including unearned premiums and unpaid losses and LAE) in cash, cash equivalents, fixed income securities, convertible bonds and equity securities. Investment income includes interest earned on invested assets, including the impacts of premium amortization and discount accretion. Realized gains and losses on invested assets are
reported separately from net investment income. The Company recognizes realized gains when invested assets are sold for an amount greater than their cost or amortized cost (in the case of fixed income securities) and recognizes realized losses when investment securities are written down as a result of an other than temporary impairment or sold for an amount less than their cost or amortized cost. Realized gains and losses also include the change in fair value of convertible bonds.
Other revenue. Other revenue includes claim administration, risk management, and cell rental fees earned. There are other revenue items that the Company recognizes on a segmental basis that are eliminated in consolidation. Such items consist primarily of fees paid by the segregated portfolio cells to other entities within the consolidated group. The segregated portfolio cells recognize an expense for such items (included as part of its ceding commission) and a corresponding revenue item is recognized by the affiliate providing the service. For segment reporting purposes, such revenue items primarily include claims administration, risk management, and cell rental fees. Fronting fees are included in acquisition and other underwriting expenses as an offset to the direct costs incurred. For segment reporting purposes, such fees are recognized ratably over the period in which the service is provided, which generally corresponds to the earned portion of net premiums written for the underlying policies.
The Company’s expenses consist primarily of losses and LAE, acquisition and other underwriting expenses, policyholder dividends, other expenses, and income taxes.
Losses and LAE. Losses and LAE represent the largest expense item and include: (1) claim payments made, (2) estimates for future claim payments and changes in those estimates for prior periods, and (3) costs associated with investigating, defending and adjusting claims.
Acquisition and other underwriting expenses. In the workers’ compensation insurance segment, expenses incurred to underwrite risks are referred to as acquisition and other underwriting expenses, which consist primarily of commissions, premium taxes, assessments and fees and other underwriting expenses incurred in acquiring, writing and administering the Company’s business. In the segregated portfolio cell reinsurance, acquisition and other underwriting expenses consist of ceding commissions earned under the respective reinsurance agreements. Ceding commissions received are netted against acquisition and other underwriting expenses.
Other expenses. Other expenses consist of general administrative expenses such as salaries, rent, office supplies, depreciation and all other operating expenses not otherwise classified separately.
Policyholder dividend expense. Policyholder dividends represent the amount of dividends incurred during the period that are expected to be returned to policyholders. The dividend expense is based on the loss experience of the underlying workers’ compensation insurance policy.
Income tax expense. EIHI and certain of its subsidiaries pay federal, state and local income taxes. Income tax expense includes an amount for both current and deferred income taxes. Current income tax expense includes an amount for the Company’s current year federal income tax liability and any adjustments related to differences between the prior year federal income tax estimate and the actual income tax expense reported in the federal income tax return. Deferred tax expense represents the change in the Company’s net deferred tax asset, exclusive of the tax effect related to changes in unrealized gains and losses in the Company’s investment portfolio and changes in the unrecognized amounts related to the Company’s benefit plan liabilities.
Key Financial Measures
The Company evaluates its insurance operations by monitoring certain key measures of growth and profitability. The Company measures growth by monitoring changes in direct premiums written and net premiums written. The Company measures underwriting profitability by examining loss, expense, policyholder dividend expense and combined ratios. On a segmental basis, the Company measures a segment’s operating results by examining net income, diluted earnings per share, and return on average equity.
Loss ratio. The loss ratio is the ratio (expressed as a percentage) of losses and LAE incurred to net premiums earned and measures the underwriting profitability of a company’s insurance business. The Company measures the loss ratio on an accident year and calendar year loss basis to measure underwriting profitability. An accident year loss ratio measures losses and LAE for insured events occurring in a particular policy year, regardless of when they are reported, as a percentage of net premiums earned during that year. A calendar year loss ratio measures losses and LAE for insured events occurring during a particular policy year and the change in loss reserves from prior accident years as a percentage of net premiums earned during that year.
Expense ratio. The expense ratio is the ratio (expressed as a percentage) of the sum of the acquisition and other underwriting expenses, other expenses and amortization of intangibles to net premiums earned, and measures the Company’s operational efficiency in producing, underwriting and administering its insurance business.
Policyholder dividend expense ratio. The policyholder dividend expense ratio is the ratio (expressed as a percentage) of policyholder dividend expense to net premiums earned and measures the impact of the Company’s policyholder dividend policies on its workers’ compensation insurance segment.
Combined ratio. The combined ratio is the sum of the loss ratio, expense ratio and policyholder dividend expense ratio and measures the Company’s overall underwriting profit. If the combined ratio is below 100%, the Company is making an underwriting profit. If the Company’s combined ratio is at or above 100%, the Company is not profitable without investment income and may not be profitable if investment income is insufficient.
Net premiums written to statutory surplus ratio. The net premiums written to statutory surplus ratio represents the ratio of net premiums written to statutory surplus. This ratio measures the Company’s insurance subsidiaries’ exposure to pricing errors in its current book of business. The higher the ratio, the greater the impact on surplus should pricing prove inadequate.
Net income, diluted earnings per share, and return on average equity. The Company uses net income and diluted earnings per share to measure its profits and return on average equity to measure its effectiveness in utilizing shareholders’ equity to generate net income. In determining return on average equity for a given year, net income is divided by the average of the beginning and ending shareholders’ equity for that year.
Critical Accounting Policies and Estimates
The preparation of financial statements in accordance with U.S. GAAP requires both the use of estimates and judgment relative to the application of appropriate accounting policies. The Company is required to make estimates and assumptions in certain circumstances that affect amounts reported in the consolidated financial statements and related footnotes. The Company evaluates these estimates and assumptions on an on-going basis based on historical developments, market conditions, industry trends and other information that is believed to be reasonable under the circumstances. There can be no assurance that actual results will conform to the estimates and assumptions and that reported results of operations will not be materially adversely affected by the need to make accounting adjustments to reflect changes in these estimates and assumptions from time to time. The Company believes the following policies are the most sensitive to estimates and judgments.
Reserves for Unpaid Losses and LAE
The Company establishes reserves for unpaid losses and LAE for its workers’ compensation insurance and segregated portfolio cell reinsurance products, which are estimates of future payments of reported and unreported claims for losses and related expenses. The adequacy of the Company’s reserves for unpaid losses and LAE are inherently uncertain because the ultimate amount that the Company may pay under many of the claims incurred as of the balance sheet date will not be known for many years. Establishing reserves is an imprecise process, requiring the use of informed estimates and judgments. The Company’s estimates and judgments may be revised as additional experience and other data becomes available and are reviewed as new or improved methodologies are developed, or as current laws change. Any such revisions could result in future changes in estimates of losses or reinsurance recoverables and would be reflected in the Company’s results of operations in the period in which the estimates are changed. Estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates and judgments using data currently available. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded as of December 31, 2010, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.
Workers’ Compensation Insurance
On a quarterly basis, the Company prepares actuarial analyses to assess the reasonableness of the recorded reserves for unpaid losses and LAE in its workers’ compensation insurance segment. These actuarial analyses incorporate various methodologies, including paid loss development, incurred loss development and a combination of other actuarial methodologies that incorporate characteristics of incurred and paid methodologies combined with a review of the Company’s exposure base. The recorded amount in each accident year is then compared to the results of these methodologies, with consideration being given to the age of the accident year. As accident years mature, the various methodologies generally
produce consistent loss estimates. For more recent accident years, the methodologies produce results that are not as consistent. Accordingly, more emphasis is placed on supplementing the methodologies in more recent accident years with trends in exposure base, medical expense inflation, general inflation, severity, and claim counts, among other things.
The Company’s reserves for unpaid losses and LAE in its workers’ compensation insurance segment as of December 31, 2010 and 2009 are summarized below (in thousands):
In its workers’ compensation insurance segment, the Company records reserves for estimated losses under insurance policies and for LAE related to the investigation and settlement of policy claims. The Company’s reserves for unpaid losses and LAE represent the estimated cost of reported and unreported losses and LAE incurred and unpaid at a given point in time. In establishing its workers’ compensation reserves, the Company uses loss discounting, which involves recognizing the time value of money and offsetting estimates of future payments by future expected investment income.
When a claim is reported, the Company’s claims adjusters establish a case reserve, which consists of anticipated medical costs, indemnity costs and certain defense and cost containment expenses that the Company refers to as allocated loss adjustment expenses, or ALAE. At any point in time, the amount paid on a claim, plus the case reserve for future amounts to be paid, represents the claims adjuster’s estimate at that time of the total cost of the claim, or the case incurred amount. The case reserve for each reported claim is based upon various factors, including:
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type of loss;
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severity of the injury or damage;
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age and occupation of the injured employee;
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estimated length of temporary disability;
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anticipated permanent disability;
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expected medical procedures, costs and duration;
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knowledge of the circumstances surrounding the claim;
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insurance policy provisions, including coverage, related to the claim;
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jurisdiction of the occurrence; and
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other benefits defined by applicable statute.
The case incurred amount can vary over time due to changes in expectations with respect to medical treatment and outcome, length and degree of disability, employment availability and wage levels and judicial determinations. As changes occur, the case incurred amount is adjusted. The initial estimate of the case incurred amount can vary significantly from the amount ultimately paid, especially in circumstances involving severe injuries with comprehensive medical treatment. Changes in case incurred amounts, or case incurred development, is an important component of the Company’s historical claim data.
In addition to case reserves, the Company establishes loss and ALAE reserves on an aggregate basis for case incurred development and IBNR claims. Case incurred development and IBNR reserves are primarily intended to provide for aggregate changes in preexisting case incurred amounts and, secondarily, to provide for the unpaid cost of IBNR claims for which an initial case reserve has not been established.
The third component of the Company’s reserves for unpaid losses and LAE is unallocated loss adjustment expense, or ULAE. The Company’s ULAE reserve is established for the costs of future unallocated loss adjustment expenses for known and unknown claims. The Company’s ULAE reserve covers primarily the estimated cost of administering claims.
In estimating case incurred development and IBNR reserves, the Company performs most of its detailed analysis on a net of reinsurance basis, and then considers expected recoveries in arriving at its recorded amounts for unpaid losses and LAE. To estimate such reserves, the Company relies primarily on the historical claim data and trends from its workers’ compensation book of business. Using standard actuarial methods, the Company estimates reserves based on historical patterns of case development, payment patterns, mix of business, premium rates charged, case reserving adequacy, operational changes, adjustment philosophy and severity and duration trends. However, the number of variables and judgments involved in establishing reserve estimates, combined with some random variation in loss development patterns, results in uncertainty regarding projected ultimate losses.
To estimate reserves, the Company stratifies its data using variations of the following different categorizations of claims:
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All loss and LAE data developed together;
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Lost time claims developed independently;
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Medical only claims developed independently;
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The indemnity portion of lost time claims developed independently;
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The medical portion of a lost time claim and medical only claims developed together; and
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LAE developed independently.
The term “developed together” refers to the summation of the claims data for a particular data stratification. For example, “All loss and LAE data developed together” represents all loss and LAE data of the Company, regardless of medical, indemnity or expense components, developed together using the historical data for this particular data stratification. The term “developed independently” refers to a specific data element. For example, “The indemnity portion of lost time claims developed independently” represents the development of the indemnity portion of a claim separately using historical data for this particular type of claim. Developing claims using different data stratifications allows the Company to identify trends for a specific group of claims that would not necessarily be readily identifiable if the data were included with other types of claim information. For example, developing the medical portion of a claim separately may allow the Company to identify a medical inflation trend that may not have been evident if it had been included with indemnity claim information. The combination of the different data stratifications and standard actuarial methods, including the following, produce different actuarial indications for the Company to evaluate:
Incurred Loss Development Method. The incurred (case incurred) loss development method relies on the assumption that, at any given state of maturity, ultimate losses can be predicted by multiplying cumulative reported losses (paid losses plus case reserves) by a cumulative development factor. The validity of the results of this method depends on the stability of claim reporting and settlement rates, as well as the consistency of case reserve levels. Case reserves do not have to be adequately stated for this method to be effective; they only need to have a fairly consistent level of adequacy at all stages of maturity. “Age-to-age” loss development factors (“LDFs”) are calculated to measure the relative development of an accident year from one maturity point to the next.
Paid Loss Development Method. The paid loss development method relies on paid losses to estimate ultimate losses and is mechanically identical to the incurred loss development method described above. The paid method does not rely on case reserves or claim reporting patterns in making projections. The validity of the results from using a paid loss development approach can be affected by many conditions, such as internal claim department processing changes, legal changes or variations in a company’s mix of business from one year to the next. Also, since the percentage of losses paid for immature years is often low, development factors are more volatile. A small variation in the number of claims paid can have a leveraging effect that can lead to significant changes in estimated ultimate liability for losses and LAE. Therefore, ultimate values for immature accident years are often based on alternative estimation techniques.
Bornhuetter-Ferguson Methodology. The Bornhuetter-Ferguson expected loss projection method based on reported loss data relies on the assumption that remaining unreported losses are a function of the total expected ultimate losses rather than a function of the currently reported losses. The expected ultimate losses in this analysis are based on historical results, adjusted for known pricing changes and inflationary trends. The expected ultimate losses are multiplied by the unreported percentage to produce expected unreported losses. The unreported percentage is calculated as one minus the reciprocal of the selected cumulative incurred LDFs. Finally, the unreported losses are added to the current reported losses to produce ultimate losses. The Bornhuetter-Ferguson method is most useful as an alternative to other models for immature accident years. For these immature accident years, the amounts reported or paid may be small and unstable and therefore not predictive of future development. Therefore, future development is assumed to follow an expected pattern that is supported by more stable historical data or by emerging trends. This method is also useful when changing reporting patterns distort historical development of losses.
The Bornhuetter-Ferguson method can also be applied with paid losses.
In estimating ULAE reserves, the Company reviews past loss adjustment expenses in relation to paid claims and estimated future costs based on expected claims activity and duration. The sum of the Company’s net loss and ALAE reserve and ULAE reserves represents its total net reserve for unpaid losses and LAE.
In determining management’s best estimate, the Company considers the various accident year loss indications produced by the actuarial methods. Considering the results of the methods, the inherent strengths and weaknesses of each method as described above, as well as other statistical information such as ultimate loss ratios, ultimate loss to exposure ratios and average ultimate claim values, the Company determines and records its best estimate of unpaid losses and ALAE. Management believes its best estimate of recorded reserves for unpaid losses and LAE is representative of the inherent uncertainty surrounding reserving for a long-tail line of business such as workers’ compensation as well as the relative immature accident year historical experience of its workers’ compensation insurance segment, which completed its first full year of operations in 1998.
As of December 31, 2010, the Company’s best estimate of its ultimate liability for losses and LAE, net of amounts recoverable from reinsurers and before purchase accounting adjustments, for its workers’ compensation insurance segment was $64.1 million.
For each of the methods described above that are used to estimate reserves for losses and LAE, the estimated paid and incurred loss development factors are key assumptions. Loss development factors are estimated based on the Company’s historical paid and incurred loss development patterns, and an estimate of the “tail factor”, or a factor to account for development beyond the maturity of the historical data. In addition, for the Bornhuetter-Ferguson methods, a key assumption is an estimate of the expected loss ratio. The expected loss ratio is determined based on estimated historical loss ratios adjusted to reflect current underwriting and rate change activity. The assumptions used in these methods by the Company over time have reflected a consistent application of the Company’s estimating processes to emerging experience. The tail factors used in the calculation of loss development factors requires considerable judgment. Selecting representative tail factors requires substantially more judgment than the historical loss development factors. While loss development factors are based on the historical claim payment and reserving patterns of the Company over a period of time, tail factors are estimated based on loss development trends in more mature accident years and industry information, and therefore are estimated in the absence of direct historical loss development history.
Management believes that changes in tail factors are reasonably likely considering the impact that changing economic conditions and medical inflation may have on the loss and LAE estimation process. There are loss and LAE risk factors that affect workers’ compensation claims that can change over time and also cause the Company’s loss reserves to fluctuate. Some examples of these risk factors include, but are not limited to, the following:
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recovery time from the injury;
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degree of patient responsiveness to treatment;
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use of pharmaceutical drugs;
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type and effectiveness of medical treatments;
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frequency of visits to healthcare providers;
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changes in costs of medical treatments;
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availability of new medical treatments and equipment;
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types of healthcare providers used;
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availability of light duty for early return to work;
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attorney involvement;
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wage inflation in states that index benefits; and
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changes in administrative policies of second injury funds.
Although many factors influence the actual cost of claims and the corresponding reserves for unpaid losses and LAE estimates, we do not measure and estimate values for all of these variables individually. This is due to the fact that many of the factors that are known to impact the cost of claims cannot be measured directly. In most instances, we rely on historical
experience and tail factors to estimate values for the variables that are explicitly used in the unpaid loss and LAE analysis. For the most recent accident year, we rely on selecting an expected loss ratio to estimate the reserves for unpaid losses and LAE. In addition to the examples above that represent reasonably likely changes in our tail factor, another example of potential variability in our loss and LAE estimation process involves selecting an expected loss ratio for the most recent accident year. For example, if our expected loss ratio for the 2010 accident year were to increase by 5 percentage points, our reserves for unpaid losses and LAE as of December 31, 2010 would increase by $4.2 million, which would result in an after-tax reduction in our earnings of $2.7 million. Management believes that changes in the most recent year accident year loss ratio are reasonably likely due to variability in underwriting and rate changes. It is important to note that actual claims costs will vary from our estimate of ultimate claim costs, perhaps by substantial amounts, due to the inherent variability of the business written, the potentially significant claim settlement lags and the fact that not all events affecting future claim costs can be estimated.
In the event that our estimates of ultimate reserves for unpaid losses and LAE prove to be greater or less than the ultimate liability, our future earnings and financial position could be positively or negatively impacted. Future earnings would be reduced by the amount of any deficiencies in the year(s) in which the claims are paid or the reserves for unpaid losses and LAE are increased. For example, if we determined our reserves for unpaid losses and LAE, net of reinsurance, of $64.1 million as of December 31, 2010 to be 5% inadequate, this would result in an after-tax reduction in our earnings of approximately $2.1 million. This reduction could be realized in one year or multiple years, depending on when the deficiency is identified. The deficiency would also impact our financial position because our statutory surplus would be reduced by an amount equivalent to the reduction in net income. Any deficiency is typically recognized in the reserves for unpaid losses and LAE and, accordingly, it typically does not have a material effect on our liquidity because the claims have not been paid. Since the claims will typically be paid out over a multi-year period, we have generally been able to adjust our investments to match the anticipated future claim payments. Conversely, if our estimates of ultimate reserves for unpaid losses and LAE prove to be redundant, our future earnings and financial position would be improved.
The Company has utilized the following tail factors for the years ended December 31, 2010, 2009, and 2008:
Following is a sensitivity analysis of the Company’s workers’ compensation reserves to reasonably likely changes in the tail factors used to project actual current losses to ultimate losses (dollars in thousands):
The estimates above rely on substantial judgment. There is inherent uncertainty in estimating reserves for unpaid losses and LAE. It is possible that the actual losses and LAE incurred may vary significantly from the Company’s estimates.
Segregated Portfolio Cell Reinsurance
The Company’s reserves for unpaid losses and LAE in its segregated portfolio cell reinsurance segment as of December 31, 2010 and 2009 are summarized below (in thousands):
The Company estimates and records reserves for its segregated portfolio cell reinsurance segment in the same manner as for its workers’ compensation insurance segment.
The reporting and paid loss development patterns in the segregated portfolio cell reinsurance segment are also consistent with that of the workers’ compensation insurance segment. Accordingly, the tail factors used to project actual current losses to ultimate losses for claims covered in the Company’s segregated portfolio cell reinsurance segment require considerable judgment. The difference between total revenue for the segregated portfolio cell reinsurance segment for each period and the sum of losses and LAE, acquisition and other underwriting expenses, policyholder dividend expense and other expenses is accrued as a segregated portfolio dividend expense. Accordingly, any change in the reserve for unpaid losses and LAE is recorded to the segregated portfolio dividend payable/receivable account and would only impact the Company’s net income or shareholders’ equity if the Company were a segregated portfolio cell dividend participant.
“Other Than Temporary” Investment Impairments
Unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in shareholders’ equity as a component of comprehensive income (loss) and, accordingly, have no effect on net income. When, in the opinion of management, a decline in the fair value of an investment below its cost or amortized cost is considered to be “other-than- temporary,” such investment is written down to its fair value. The amount written down is recorded in earnings as a realized loss on investments. Generally, the determination of other-than-temporary impairment includes, in addition to other relevant factors, a presumption that if the market value is below cost by a significant amount for a period of time, a write-down is necessary. Notwithstanding this presumption, the determination of other-than-temporary impairment requires judgment about future prospects for an investment and is therefore a matter of inherent uncertainty. For the years ended December 31, 2010, 2009 and 2008, the Company recorded other-than-temporary impairments, excluding impairments in the segregated portfolio cell reinsurance segment, of $6,000, $1.9 million and $3.6 million, respectively. Other-than-temporary impairments in the segregated portfolio cell reinsurance segment totaled $80,000, $749,000 and $1.2 million for the years ended December 31, 2010, 2009 and 2008, respectively. As of December 31, 2010, the Company held fixed income securities, excluding fixed income securities in the segregated portfolio cell reinsurance segment, with gross unrealized losses of $328,000, of which $55,000 were in an unrealized loss position for more than twelve months. There were no equity securities in an unrealized loss position as of December 31, 2010. Adverse investment market conditions, or poor operating results of underlying investments, could result in impairment charges in the future. The Company generally applies the following standards in determining whether the decline in fair value of an investment is other-than-temporary:
Equity securities. An equity security is considered impaired when one of the following conditions exist: 1) an equity security’s market value is less than 80% of its cost for a continuous period of 6 months, 2) an equity security’s market value is less than 50% of its cost, regardless of the amount of time the security’s market value has been below cost, and 3) an equity security’s market value has been less than cost for a continuous period of 12 months or more, regardless of the magnitude of the decline in market value. Equity securities that are in an unrealized loss position, but do not meet the above quantitative thresholds are evaluated to determine if the decline in market value is other than temporary.
For the years ended December 31, 2010, 2009 and 2008, the Company recorded other-than-temporary impairments of $0, $1.7 million, and $3.0 million, respectively, related to its equity security portfolio. The securities were impaired because they had been in an unrealized loss position for more than 12 months.
Fixed income securities. A fixed income security is considered to be other-than-temporarily impaired when the security’s fair value is less than its amortized cost basis and 1) the Company intends to sell the security, 2) it is more likely than not that the Company will be required to sell the security before recovery of the security’s amortized cost basis, or 3) the Company believes it will be unable to recover the entire amortized cost basis of the security (i.e., a credit loss has occurred). When the Company determines a credit loss has been incurred, but the Company does not intend to sell the security and it is not more likely than not that the Company will be required to sell the security before recovery of the security’s amortized cost basis, the portion of the other-than-temporary impairment that is credit related is recorded as a realized loss in the consolidated statements of operations and comprehensive income (loss), and the portion of the other-than-temporary impairment that is not credit related is included in other comprehensive income (loss). A fixed income security is reviewed for potential credit loss if any of the following situations occur:
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A review of the financial condition and prospects of the issuer indicates that the security should be evaluated;
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Moody’s or Standard & Poor’s rate the security below investment grade; or
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The security has a market value below 80% of amortized cost due to deterioration in credit quality.
For the years ended December 31, 2010, 2009 and 2008, the Company recorded other-than-temporary impairments of $6,000, $189,000, and $619,000, respectively, related to its fixed income security portfolio.
Limited partnerships. A limited partnership investment is generally written down if the Company is unable to hold or otherwise intends to sell its interest in the limited partnership at a loss, or if management has received information that suggests the Company will be unable to recover its original investment in the limited partnership. The amount written down is recorded in the change in equity interest in limited partnerships in the consolidated statement of operations and comprehensive income (loss).
There were no impairments related to the Company’s limited partnership investments in 2010 or 2009. For the year ended December 31, 2008, the Company recorded a permanent impairment of $1.4 million related to one of its limited partnership investments.
At the time a security is determined to be other-than-temporarily impaired, the cost or amortized cost is written down to market value at the balance sheet date and the impairment is recorded as a realized loss in the consolidated statement of operations.
Goodwill
In accordance with the requirements of ASC 350, Intangibles-Goodwill and Other, goodwill is not amortized but is tested for impairment at the reporting unit level, which is at the operating segment level or one level below an operating segment. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. Goodwill is required to be tested for impairment annually and between annual tests if events or circumstances change, such as adverse changes in the business climate, that would more likely than not reduce the fair value of the reporting unit below its carrying value.
Goodwill is assigned to one or more reporting units at the date of acquisition. The Company has allocated 100% of the goodwill recorded on its consolidated balance sheet as of December 31, 2010 to its workers’ compensation insurance segment. The goodwill impairment test, performed as of September 30 of each year, is a two-step test. The first step identifies whether there is potential impairment by comparing the fair value of a reporting unit to the carrying amount, including goodwill. If the fair value of a reporting unit is less than its carrying amount, the second step of the impairment test is required to measure the amount of any impairment loss.
For the 2010 annual impairment test, the fair value of the workers’ compensation insurance segment was estimated using a discounted cash flow analysis, a form of the income approach, using management’s internal four-year forecast for the workers’ compensation insurance segment and a terminal value estimated using a long-term growth rate of 5.0%, which is reflective of the segment’s historical growth rate, and a discount rate of 13.0%, which is reflective of the risks inherent in the segment. Cash flows were adjusted as necessary to maintain adequate capital requirements.
The discounted cash flow analysis resulted in the workers’ compensation insurance segment’s estimated fair value exceeding its carrying value as of September 30, 2010; therefore, goodwill was considered not impaired, and the second step of impairment testing was not necessary.
In the event the operating results of the Company’s workers’ compensation insurance segment were to be adversely impacted by a significant loss of business or higher than expected losses and LAE, management’s internal forecast may need to be re-evaluated, which could result in a fair value that is less than the carrying value of the workers’ compensation insurance segment and the need to recognize a goodwill impairment.
Deferred Income Taxes
The temporary differences between the tax and book bases of assets and liabilities are recorded as deferred income taxes. Management evaluates the recoverability of the net deferred tax asset based on historical trends of generating taxable income or losses, as well as expectations of future taxable income or loss. As of December 31, 2010, the Company recorded a net deferred tax asset of $721,000. Management expects that the net deferred tax asset is fully recoverable. If this assumption were to change, any amount of the net deferred tax asset that the Company could not expect to recover would be provided for as an allowance and would be reflected as an increase in income tax expense in the period in which it was established.
As of December 31, 2010, the Company recognized a deferred tax asset of $1.9 million related to other-than-temporary investment impairments. Under United States federal income tax rules and regulations, capital losses can only be utilized to offset income generated from capital gains. Capital losses can be carried back to offset capital gains reported in the three prior tax periods and can be carried forward for five tax periods. Management has determined, based on a review of its investment portfolio and giving consideration to capital gains reported in prior tax periods, that the Company’s deferred tax asset related to other-than-temporary investment impairments and net unrealized losses on investments is recoverable; therefore, a valuation allowance has not been recorded as of December 31, 2010. Due to the significant volatility in the investment markets, management’s conclusion on the recoverability of the deferred tax asset could change in future periods. Further declines in the estimated fair value of the Company’s investments may result in the need for a valuation allowance, which could have an adverse impact of the Company’s financial condition and/or results of operations.
Reinsurance Recoverables
Amounts recoverable from Company’s reinsurers are estimated in a manner consistent with the reserves for unpaid losses and LAE associated with the reinsured policy. Amounts paid for reinsurance contracts are expensed over the contract period during which insured events are covered by the reinsurance contracts. Reinsurance balances recoverable on paid and unpaid loss and LAE are reported separately as assets, instead of being netted with the appropriate liabilities, because reinsurance does not relieve the Company of its legal liability to its policyholders. Reinsurance balances recoverable are subject to credit risk associated with the particular reinsurer. Additionally, the same uncertainties associated with estimating unpaid losses and LAE affect the estimates for the ceded portion of these liabilities. The Company continually monitors the financial condition of its reinsurers and where necessary obtains collateral. As of December 31, 2010, the Company had reinsurance recoverables of $12.3 million.
Recent Accounting Pronouncements
Deferred Acquisition Costs
In October 2010, the Financial Accounting Standards Board (“FASB”) issued new accounting guidance related to the accounting for costs related to the acquisition or renewal of insurance contracts. The new guidance provides specific types of costs that should be capitalized in connection with the acquisition or renewal of insurance contracts. Those costs include incremental direct costs of contract acquisition incurred in connection with independent third parties and certain costs related to activities performed by the insurer for the contract, including underwriting, policy issuance and processing, medical and inspection, and sales force contract selling. Under the new guidance, costs incurred by an entity related to unsuccessful acquisition or renewal efforts must be charged to expense as incurred. The new guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011 and is to be applied prospectively. Retrospective application to all prior periods upon the date of adoption is permitted, but not required. Early adoption is permitted but only at the beginning of an entity’s annual reporting period. The Company currently capitalizes and defers commissions and related expenses, premium taxes and certain underwriting personnel salaries. The Company expects to adopt this new guidance effective January 1, 2012 and apply it retrospectively to prior periods for purposes of consistency across all periods presented. Upon adoption, the Company expects to reduce the amount of acquisition costs capitalized related to certain underwriting personnel salaries to give effect to unsuccessful acquisition or renewal activities. Management does not expect the adoption of the new guidance to have a material effect of the Company’s financial condition or results of operations.
Fair Value Measurements
In January 2010, the FASB issued new accounting guidance related to disclosures about fair value measurements. The new guidance requires the following new or enhanced disclosures: 1) details of significant transfers in and out of Level 1 and Level 2 measurements and the reasons for the transfers, 2) a gross presentation of activity within the Level 3 rollforward, presenting separately information about purchases, sales, issuances, and settlements, and 3) fair value disclosures must be presented by class of assets and liabilities rather than by major category. The new guidance was effective for the first interim or annual reporting period beginning after December 15, 2009, except for the gross presentation of the Level 3 rollforward information, which is required for annual reporting periods beginning after December 15, 2010 and for interim periods within those years. The Company adopted the new accounting guidance effective January 1, 2010. The adoption of the new guidance resulted in enhanced disclosures related to the Company’s fair value measurements of its investments.
Variable Interest Entities
In June 2009, the FASB issued new accounting guidance related to variable interest entities. The new guidance 1) replaces the quantitative-based risks and rewards calculation for determining whether an enterprise is the primary beneficiary in a variable interest entity with an approach that is primarily qualitative, 2) requires ongoing assessments of whether an enterprise is the primary beneficiary of a variable interest entity, and 3) requires additional disclosures about an enterprise’s involvement in variable interest entities. The new guidance was effective for financial statements issued for fiscal years beginning after November 15, 2009. The Company adopted the new accounting guidance effective January 1, 2010. The adoption of the new guidance had no impact on the Company’s consolidated financial statements.
YEAR ENDED DECEMBER 31, 2010 COMPARED TO YEAR ENDED DECEMBER 31, 2009
RESULTS OF OPERATIONS
The major components of consolidated revenue were as follows for the years ended December 31, 2010 and 2009 (in thousands):
The increase in consolidated revenue primarily reflects new business of $32.7 million, an increase in realized gains related to the sale of investments, and a decline in other-than-temporary investment impairments, partially offset by a decrease in net investment income.
The components of consolidated net income, by segment, for the years ended December 31, 2010 and 2009 were as follows (in thousands):
The decrease in consolidated net income primarily reflects an increase in the loss ratio from 60.0% in 2009 to 71.1% in 2010, audit premiums returned to customers, and a decrease in net investment income. These items, which contributed to the decrease in the Company’s operating results, were partially offset by a decrease in other-than-temporary investment impairments and a decrease in the expense ratio from 35.5% in 2009 to 32.7% in 2010.
WORKERS’ COMPENSATION INSURANCE
The following table represents the operations of the workers’ compensation insurance segment for the years ended December 31, 2010 and 2009 (in thousands).
(1) Ceded premiums written include premiums ceded to the segregated portfolio cell reinsurance segment of $28,798 and $28,661 for the years ended December 31, 2010 and 2009, respectively.
Net Income
The decrease in net income primarily reflects an increase in the severity-related claims, the impact of return premium to customers and a decrease in net investment income related to the current interest rate environment, partially offset by new business growth, particularly in the Company’s Southeast region, an increase in realized gains related to the sale of investments, and a reduction in other-than-temporary investment impairments.
The workers’ compensation insurance ratios were as follows for the years ended December 31, 2010 and 2009:
Premiums
The increase in direct premiums written primarily reflects new business of $32.7 million and an increase in the renewal retention rate, partially offset by the impact of audit premium returned and renewal rate decreases of 1.9%. Traditional and alternative market direct premiums written totaled $98.0 million and $28.8 million, respectively, for the year ended December 31, 2010. The renewal retention rate increased from 84.1% in 2009 to 87.0% in 2010. The Company returned $1.4 million in premium to customers as a result of premium audits in 2010, compared to $6,000 of additional premium from customers in 2009. In addition, the Company reduced its estimate of earned but unbilled (“EBUB”) premium in 2010 by $750,000. The decrease in audit premium and the related reduction in the EBUB estimate reflects the impact of lower payrolls in the Company’s geographic markets.
Net Investment Income
The decrease in net investment income primarily reflects a decline in the average yield on the fixed income portfolio and a decline in short-term interest rates from 2009 to 2010. The average yield on the fixed income portfolio was 3.52% as of December 31, 2010, compared to 3.61% as of December 31, 2009.
Net Realized Investment Gains (Losses)
Net realized investment gains for the year ended December 31, 2010 include an increase in the fair value of the Company’s convertible bond portfolio of $1.2 million, compared to an increase of $877,000 for the same period in 2009. The Company recognized other-than-temporary impairments of $6,000 in 2010, compared to $1.7 million in 2009.
Losses and LAE
The increase in the calendar period loss and LAE ratio reflects an increase in the accident period loss ratio and no development on prior accident period reserves. The accident period loss ratio was 70.4% and 65.6% for the years ended December 31, 2010 and 2009, respectively. The increase in the accident period loss ratio primarily reflects an increase in severity-related claims, specifically in the fourth quarter 2010, as well as the continuing impact of the current economic environment on the Company’s book of business. Favorable loss reserve development totaled $3.7 million for the year ended December 31, 2009. Severity-related claims for the year ended December 31, 2010 and 2009 were as follows:
Acquisition and Other Underwriting Expenses
Acquisition and other underwriting expenses as a percent of net premiums earned was 6.3% for the year ended December 31, 2010, compared to 8.5% for the same period in 2009. The decrease in acquisition and other underwriting expenses as a percent of net premiums earned primarily reflects the release of the 2009 and 2010 accruals related to the Pennsylvania Workers’ Compensation Security Fund assessment.
Other Expenses
Other expenses as a percent of net premiums earned was 18.3% for the year ended December 31, 2010, compared to 18.8% for the same period in 2009. The decrease primarily reflects the growth in premium revenue in the Company’s Southeast region.
Policyholder Dividend Expense
The increase in the policyholder dividend expense primarily reflects the loss experience of underlying policies related to policies with a 2010 policy effective date. As of December 31, 2010, approximately 12.3% of the Company’s policies were written on a participating basis, compared to approximately 10.0% as of December 31, 2009.
Tax Expense
The effective tax rate was 31.0% and 29.3% for the years ended December 31, 2010 and 2009, respectively. The primary difference between the statutory tax rate of 35.0% and the effective tax rate reflects tax exempt income on municipal bond securities.
SEGREGATED PORTFOLIO CELL REINSURANCE
The following table represents the operations of the segregated portfolio cell reinsurance segment for the years ended December 31, 2010 and 2009 (in thousands):
(1) The workers’ compensation insurance and corporate/other segments provide services to the segregated portfolio cell reinsurance segment. The fees paid by the segregated portfolio cell reinsurance segment for these services are included in the revenue of the segment providing the service. The segregated portfolio cell reinsurance segment records the fees associated with these services as ceding expense, which is included in its underwriting expenses. The difference between total revenue for the segregated portfolio cell reinsurance segment for each period and the sum of losses and loss adjustment expenses, underwriting expenses, policyholder dividend expenses and other expenses is accrued as a segregated portfolio dividend expense. As a result, the segregated portfolio cell reinsurance segment has no net income for the period presented in this table.
The segregated portfolio cell reinsurance ratios were as follows for the years ended December 31, 2010 and 2009:
Reinsurance Premiums Assumed
The increase in reinsurance premiums assumed primarily reflects new business of $5.2 million, partially offset by a decrease in the renewal retention rate, the impact of audit premium returned and renewal rate decreases of 0.3%. The renewal retention rate decreased from 89.1% in 2009 to 87.1% in 2010. The Company returned $974,000 in premium to customers as a result of premium audits in 2010, compared to $714,000 for the same period in 2009. The decrease in audit premium reflects the impact of lower payrolls in economically sensitive segregated portfolio cells.
Net Investment Income
The decrease in net investment income primarily reflects a reduction in short-term interest rates from 2009 to 2010.
Net Realized Investment Gains (Losses)
Net realized investment gains for the year ended December 31, 2010 include other-than-temporary impairments of $80,000 in 2010, compared to impairments of $749,000 in 2009.
Losses and LAE
The increase in the calendar period loss and LAE ratio reflects an increase in the accident period loss ratio and a decrease in favorable loss reserve development related to prior accident period reserves. The accident period loss ratio was 79.9% and 71.7% for the years ended December 31, 2010 and 2009, respectively. The increase in the accident period loss ratio primarily reflects management’s estimate of the impact of the current economic environment on the Company’s workers’ compensation book of business, including the impact of rising unemployment on management’s return to work controls and an increase in severity-related claims in 2010. Favorable loss reserve development totaled $1.4 million for the year ended December 31, 2010, compared to favorable loss reserve development of $2.8 million for the same period in 2009. The favorable loss reserve development relates primarily to a decrease in the prior accident period loss development factors used to estimate losses and LAE. The decrease in prior accident period loss development factors primarily reflects prior year claim settlements during 2010 for amounts at, or less than, previously established case and IBNR reserves. This decrease had the effect of lowering loss development factors as of December 31, 2010. In the aggregate, the claims were closed at amounts lower than the provision established for IBNR claims. Management believes that the realization of the benefits of its return-to-work controls enabled it to record losses and LAE that were lower than the amount reserved for claim settlements.
Acquisition and Other Underwriting Expenses
The expense ratios are consistent with the contractual ceding commissions for the years ended December 31, 2010 and 2009.
Segregated Portfolio Dividend Expense
The segregated portfolio dividend expense represents the amount of net income or loss in a specific period that may be payable to the segregated portfolio dividend participants.
CORPORATE/OTHER
The corporate/other segment reported a net loss of $3.4 million for the year ended December 31, 2010, compared to a net loss of $3.2 million for the same period in 2009. The change in equity interest in the Company’s investment in segregated portfolio cells decreased from 2009 to 2010, and was partially offset by a decrease in intangible asset amortization.
YEAR ENDED DECEMBER 31, 2009 COMPARED TO YEAR ENDED DECEMBER 31, 2008
RESULTS OF OPERATIONS
The major components of consolidated revenue were as follows for the years ended December 31, 2009 and 2008 (in thousands):
The increase in consolidated revenue from 2008 to 2009 primarily reflects an improvement in the Company’s investment portfolio and an increase in net premiums earned in the workers’ compensation insurance segment, partially offset by lower investment income. The Company’s limited partnership investments experienced an increase in value during 2009, compared to significant losses in 2008. Other-than-temporary impairments in the Company’s investment portfolio decreased from 2008 to 2009, which contributed to the improvement in net realized investment gains during 2009. The decrease in net investment income is reflective of a decrease in the Company’s fixed income security holdings, and lower interest rates on new fixed income security purchases and cash and short-term investment holdings. The increase in net premiums earned in the workers’ compensation insurance segment primarily reflects new business written and a full year of premium related to the acquisition of Employers Security.
The components of consolidated net income (loss), by segment, for the years ended December 31, 2009 and 2008 were as follows (in thousands):
The improvement in the Company’s net income from 2008 to 2009 primarily reflects the aforementioned improvement in the Company’s investment portfolio and a reduction in expenses in the corporate/other segment, partially offset by an increase in the workers’ compensation insurance combined ratio.
WORKERS’ COMPENSATION INSURANCE
The following table represents the operations of the workers’ compensation insurance segment for the years ended December 31, 2009 and 2008 (in thousands). The results of operations for the year ended December 31, 2008 include the operating results of Employers Security for the period from October 1, 2008 to December 31, 2008:
(1) Ceded premiums written include premiums ceded to the segregated portfolio cell reinsurance segment of $28,661 and $29,113 for the years ended December 31, 2009 and 2008, respectively.
Net Income
The increase in net income primarily reflects a decrease in net realized investment losses and an increase in the value of the segment’s limited partnership investments. The decrease in net realized investment losses primarily reflects a reduction in other-than-temporary impairments from 2008 to 2009. The improved investment results were partially offset by an increase in the combined ratio from 2008 to 2009. The increase in the loss and LAE ratio from 2008 to 2009 primarily reflects an increase in the 2009 accident year loss ratio reflecting management’s view of the expected impact of the then current economic environment on the Company’s workers’ compensation book of business. The increase in the expense ratio primarily reflects an increase in corporate expense allocations and the impact of premium rate decreases and audits of prior year policies that resulted in return premium to customers in 2009.
The workers’ compensation insurance ratios were as follows for the years ended December 31, 2009 and 2008:
Premiums
The increase in direct premiums written from 2008 to 2009 primarily reflects new business sales of $28.0 million and direct premiums written of $6.1 million related to the acquisition of Employers Security, partially offset by a reduction in the renewal retention rate from 87.6% in 2008 to 84.1% in 2009 and renewal rate decreases of 3.9%. Traditional and alternative market direct premiums written were $81.4 million and $28.7 million, respectively, for the year ended December 31, 2009, compared to $72.8 million and $29.1 million, respectively, for the same period in 2008.
Net Investment Income
The decrease in net investment income primarily reflects a decline in the average yield on the fixed income portfolio and a decline in short-term interest rates from 2008 to 2009. The average yield on the fixed income portfolio was 3.61% as of December 31, 2009, compared to 4.18% as of December 31, 2008.
Net Realized Investment Losses
The decrease in net realized investment losses from 2008 to 2009 primarily reflects a reduction in other-than-temporary impairments. Other-than-temporary impairments totaled $1.7 million in 2009, compared to $3.4 million in 2008. In addition, the convertible bond portfolio experienced an increase in fair value of $877,000 in 2009, compared to a decrease in fair value of $623,000 in 2008.
Losses and LAE
The increase in the calendar period loss and LAE ratio primarily reflects an increase in the accident period loss ratio, partially offset by an increase in favorable loss reserve development related to prior accident periods. The accident period loss ratio was 65.6% and 60.2% for the years ended December 31, 2009 and 2008, respectively. The increase in the accident period loss ratio primarily reflects management’s estimate of the impact of the then current economic environment on the Company’s workers’ compensation book of business, including the impact of rising unemployment on management’s return to work controls. Favorable loss reserve development totaled $3.7 million for the year ended December 31, 2009, compared to favorable loss reserve development of $2.7 million for the same period in 2008. The favorable development primarily reflects continued improvements in loss mitigation and underwriting, including greater availability and use of employers’ return to work programs. Furthermore, the Company was able to settle a large amount of Pennsylvania claims via compromise and release, which is a lump sum cash payment in exchange for a full and final claim settlement. Management attributes the large amount of compromise and release claim closures to the difficult economic conditions and the claimants’ choosing a lump sum cash settlement over the continuation of a workers’ compensation annuity payment.
Acquisition and Other Underwriting Expenses
The increase in acquisition and other underwriting expenses primarily reflects the impact of the Indiana state tax liability related to Employers Security’s operating results for the year ended December 31, 2009.
Other Expenses
The increase in other expenses as a percent of net premiums earned from 2008 to 2009 primarily reflects the impact of the lower net premiums earned and the increase in corporate expense allocations.
Policyholder Dividends
The decrease in policyholder dividend expense primarily reflects an increase in the aforementioned accident period loss ratio from 2008 to 2009. As of December 31, 2009 and 2008, approximately 10.0% of the Company’s workers’ compensation insurance policies were written on a participating basis.
Tax Expense
The effective tax rate was 29.3% and 31.6% for the years ended December 31, 2009 and 2008, respectively. The difference between the statutory tax rate of 35.0% and the effective tax rate primarily reflects tax exempt income on municipal bond securities. The decrease in the effective tax rate primarily reflects a prior year tax return adjustment that decreased income tax expense in 2009, compared to a prior year tax return adjustment that increase income tax expense in 2008.
SEGREGATED PORTFOLIO CELL REINSURANCE
The following table represents the operations of the segregated portfolio cell reinsurance segment for the years ended December 31, 2009 and 2008 (in thousands):
(1) The workers’ compensation insurance and corporate/other segments provide services to the segregated portfolio cell reinsurance segment. The fees paid by the segregated portfolio cell reinsurance segment for these services are included in the revenue of the segment providing the service. The segregated portfolio cell reinsurance segment records the fees associated with these services as ceding expense, which is included in its underwriting expenses. The difference between total revenue for the segregated portfolio cell reinsurance segment for each period and the sum of losses and loss adjustment expenses, underwriting expenses, policyholder dividend expenses and other expenses is accrued as a segregated portfolio dividend expense. As a result, the segregated portfolio cell reinsurance segment has no net income for the period presented in this table.
The segregated portfolio cell reinsurance ratios were as follows for the years ended December 31, 2009 and 2008:
Reinsurance Premiums Assumed
The decrease in reinsurance premiums assumed from 2008 to 2009 primarily reflects the impact of renewal rate decreases of 1.0% and return premium of $714,000 related to policy audits. New business sales totaled $4.1 million and the renewal retention rate increased from 87.7% in 2008 to 89.1% in 2009. In 2008, policy audits resulted in return premium of $383,000.
Net Investment Income
The decrease in net investment income primarily reflects a reduction in short-term interest rates from 2008 to 2009.
Net Realized Investment Losses
The decrease in net realized investment losses from 2008 to 2009 primarily reflects a reduction in other-than-temporary impairments. Other-than-temporary impairments totaled $749,000 in 2009, compared to $1.2 million in 2008.
Losses and LAE
The increase in the calendar period loss and LAE ratio primarily reflects an increase in the accident period loss ratio, partially offset by an increase in favorable loss reserve development related to prior accident periods. The accident period loss ratio was 71.7% and 64.9% for the years ended December 31, 2009 and 2008, respectively. The increase in the accident period loss ratio primarily reflects management’s estimate of the impact of the then current economic environment on the Company’s workers’ compensation book of business, including the impact of rising unemployment on management’s return to work controls. Favorable loss reserve development totaled $2.8 million for the year ended December 31, 2009, compared to favorable loss reserve development of $2.0 million for the same period in 2008. The favorable loss reserve development relates primarily to a decrease in the prior accident period loss development factors used to estimate losses and LAE. The decrease in prior accident period loss development factors primarily reflects prior year claim settlements during 2009 for amounts at, or less than, previously established case and IBNR reserves. This decrease had the effect of lowering loss development factors as of December 31, 2009. In the aggregate, the claims were closed at amounts lower than the provision established for IBNR claims. Management believes that the realization of the benefits of its return-to-work controls enabled it to record losses and LAE that were lower than the amount reserved for claim settlements.
Acquisition and Other Underwriting Expenses
The expense ratios are consistent with the contractual ceding commissions for the years ended December 31, 2009 and 2008.
Segregated Portfolio Dividend Expense
The segregated portfolio dividend expense represents the amount of net income or loss in a specific period that may be payable to the segregated portfolio dividend participants.
CORPORATE/OTHER
The corporate/other segment reported a net loss of $3.2 million for the year ended December 31, 2009, compared to a net loss of $4.8 million for the same period in 2008. The decrease in the net loss from 2008 to 2009 primarily reflects an increase in the equity interest in limited partnerships at Eastern Re, a reduction in audit and consulting fees related to Sarbanes Oxley outsourcing, a decrease in stock compensation expense related to the ESOP of $390,000 and an increase in the Company’s equity interest in the segregated portfolio cells of $676,000. The decrease in ESOP compensation expense reflects the decline in the Company’s stock price.
Financial Position
December 31, 2010 compared to December 31, 2009. Total assets were $322.7 million as of December 31, 2010, compared to $397.3 million as of December 31, 2009. The decrease in assets reflects the sale of the group benefits insurance and run-off specialty reinsurance segments. Cash and investments increased $29.2 million, primarily reflecting the purchase of investments during 2010. Premiums receivable increased $8.2 million, primarily reflecting the increase in direct premiums written. Net deferred income taxes decreased $622,000, primarily reflecting an increase in the estimated fair value of the Company’s convertible bond portfolio, and federal income taxes recoverable decreased $631,000, primarily reflecting the receipt of a carryback refund in 2010 related to capital losses carried back to prior tax years.
Total liabilities were $188.0 million as of December 31, 2010, compared to $243.4 million as of December 31, 2009. The decrease in liabilities reflects the sale of the group benefits insurance and run-off specialty reinsurance segments. Reserves for unpaid losses and LAE increased $6.5 million primarily reflecting the increase in the accident period loss ratio. Unearned premiums increased $7.5 million, primarily reflecting higher direct premiums written. The segregated portfolio cell dividend payable decreased $3.3 million, primarily reflecting a decrease in unrealized gains on investments and dividends paid to preferred segregated portfolio cell dividend participants.
Total shareholders’ equity was $134.7 million as of December 31, 2010, compared to $153.9 million as of December 31, 2009. The decrease in shareholders’ equity primarily reflects the 2010 consolidated net loss, treasury share repurchases, and a decrease in the fair value of the Company’s investment portfolio.
Liquidity and Capital Resources
Liquidity is a measure of an entity’s ability to secure sufficient cash to meet its contractual obligations and operating needs. The Company’s principal sources of funds are premiums, investment income and proceeds from sales and maturities of investments. The Company’s primary use of funds is to pay claims and operating expenses and to purchase investments. The Company’s investment portfolio is structured so that investments mature periodically over time in reasonable relation to current expectations of future claim payments. The Company’s fixed income investment portfolio as of December 31, 2010 had an effective duration of 3.81 years.
For the years ended December 31, 2010, 2009 and 2008, the Company’s cash inflows from premiums and investment activity were sufficient to support the Company’s cash outflows related to claims and operating expenses. Management expects future cash flows from operations in its workers’ compensation insurance and segregated portfolio cell reinsurance segments to be sufficient to cover claims and operating expenses. However, in the event cash flows from operations are not sufficient, the Company may have to liquidate investments to cover such costs. As of December 31, 2010, the Company’s investment portfolio included securities with gross unrealized gains totaling $8.2 million, excluding gross unrealized gains on investments in the segregated portfolio cell reinsurance segment of $1.1 million; therefore, based on current gross unrealized gains in the investment portfolio as of December 31, 2010, management does not believe it would have to sell securities at a loss in the event cash flows from operations proved insufficient to cover the Company’s operating needs.
The Company has a $2.6 million line of credit available to provide additional liquidity if needed.
The Company’s ability to manage liquidity results, in part, from the purchase of reinsurance to protect the Company against severe claims and catastrophic events. See “Item 1 - Business, Reinsurance.”
Our domestic insurance subsidiaries’ ability to pay dividends to EIHI is limited by the insurance laws and regulations of Pennsylvania and Indiana. The maximum annual dividends that the domestic insurance entities may pay without prior approval from the Pennsylvania Insurance Department and the Indiana Insurance Department is limited to the greater of 10% of statutory surplus or 100% of statutory net income for the most recently filed annual statement.
Eastern Re must receive approval from the Cayman Islands Monetary Authority before it can pay any dividend to the Company.
Cash Flows
The primary sources of cash flows for the Company are net premiums written, investment income, and proceeds from the sale or maturity of investments. The major components of cash flow from continuing operations are as follows for the years ended December 31, 2010, 2009, and 2008 (in thousands):
Cash Flows From Continuing Operations for the Years Ended December 31, 2010 and 2009. Cash flows from operating activities for the year ended December 31, 2010 primarily reflects the increase in direct premiums written and tax refunds related to the carryback of capital losses to prior tax years, partially offset by claim payments and a decrease in net investment income.
Cash flows used in investing activities for the year ended December 31, 2010 primarily reflects the investment of cash received from the sale of Eastern Life.
Cash flows from financing activities for the year ended December 31, 2010 reflect the Company’s stock buyback activity, shareholder dividends and the repayment of the outstanding loan.
Cash Flows From Continuing Operations for the Years Ended December 31, 2009 and 2008. The decrease in cash flows from operating activities from 2008 to 2009 primarily reflects the run-off of the specialty reinsurance segment and a reduction in net investment income.
Cash flows from investing activities for the year ended December 31, 2009 primarily reflects the sale of investments to fund the Eastern Re capital contribution in March 2009.
Cash flows from financing activities for the year ended December 31, 2009 primarily reflects the payment of the quarterly shareholder dividends and the semi-annual loan payments.
Contractual Commitments
The following table summarizes information about contractual obligations and commercial commitments before the impact of purchase accounting adjustments. The minimum payments under these agreements as of December 31, 2010 were as follows (in thousands):
(1) The payments related to the loss reserves are shown before purchase accounting adjustments of $330.
The loss reserves payments due by period in the table above are based upon the loss and LAE reserves estimates as of December 31, 2010 and actuarial estimates of expected payout patterns by line of business. As a result, our calculation of loss reserve payments due by period is subject to the same uncertainties associated with determining the level of reserves and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. For a discussion of our reserving process, see “Item 1 - Business, Loss and LAE Reserves.” Actual payments of loss and LAE by period will vary, perhaps materially, from the above table to the extent that current estimates of loss reserves vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns.
Off-Balance Sheet Arrangements
As of December 31, 2010, the Company has no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Item 7A
Item 7A - Quantitative and Qualitative Disclosures About Market Risk
Market risk is the potential economic loss principally arising from adverse changes in the fair value of financial instruments. The major components of market risk affecting the Company are credit risk, interest rate risk, and equity risk.
Credit Risk. Credit risk is the potential economic loss principally arising from adverse changes in the financial condition of a specific debt issuer. The Company addresses this risk by investing primarily in fixed-income securities which are rated “A” or higher by Standard & Poor’s. The Company also independently, and through the Company’s outside investment manager, monitors the financial condition of all of the issuers of fixed-income securities in the portfolio. To limit the Company’s exposure to risk, the Company employs diversification rules that limit the credit exposure to any single issuer or business sector.
Interest Rate Risk. Interest rate risk is the risk that we will incur economic loss due to adverse changes in interest rates. The Company had fixed-income investments, excluding convertible bonds and fixed income securities in the segregated portfolio cell reinsurance segment, with an estimated fair value of $106.0 million at December 31, 2010, that are subject to interest rate risk. The Company manages the exposure to interest rate risk through an asset/liability matching and capital management process. In the management of this risk, the characteristics of duration, credit and variability of cash flows are critical elements. These risks are assessed regularly and balanced within the context of the Company’s liability and capital position.
The table below summarizes the Company’s interest rate risk. It illustrates the sensitivity of the fair value of the Company’s fixed income portfolio, excluding the Company’s convertible bond portfolio and fixed income securities in the segregated cell reinsurance segment, to selected hypothetical changes in interest rates as of December 31, 2010. The selected scenarios are not predictions of future events, but rather illustrate the effect that such events may have on the fair value of the Company’s fixed income portfolio and shareholders’ equity (dollars in thousands).
Equity Risk. Equity risk is the risk that the Company may incur economic loss due to adverse changes in equity prices. The Company’s exposure to changes in equity prices primarily results from its holdings of exchange traded funds and other equities. The Company’s portfolio of equity securities is carried on the balance sheet at fair value.
Impact of Inflation
Inflation rates may impact the Company’s financial condition and operating results in several ways. Fluctuations in rates of inflation influence interest rates, which in turn affect the market value of the investment portfolio and yields on new investments. Inflation also affects the portion of losses and loss reserves that relates to hospital and medical expenses and property claims and loss adjustment expenses, but not the portion of losses and loss reserves that relates to workers’ compensation indemnity payments for lost wages, which are fixed by statute. Adjustments for inflationary effects are included as part of the continual review of loss reserve estimates. Increased costs are considered in setting premium rates, and this is particularly important in the health care area where hospital and medical inflation rates have exceeded general inflation rates. Operating expenses, including payrolls, are affected to a certain degree by the inflation rate.
Item 8
Item 8 - Financial Statements and Supplementary Data
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders
of Eastern Insurance Holdings, Inc.:
In our opinion, the consolidated financial statement listed in the index appearing under Item 15 a)(1) present fairly, in all material respects, the financial position of Eastern Insurance Holdings, Inc. and its subsidiaries (the “Company”) at December 31, 2010 and December 31, 2009, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2010 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15 a)(2) present fairly, in all material respects the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in “Management’s Report on Internal Control Over Financial Reporting” appearing under Item 9A - Controls and Procedures. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for the recognition and presentation of other-than-temporary impairments of debt securities as required by accounting guidance adopted on April 1, 2009.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ PricewaterhouseCoopers LLP
Philadelphia, Pennsylvania
March 8, 2011
EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
See accompanying notes to consolidated financial statements.
EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME (LOSS)
(In thousands, except per share data)
See accompanying notes to consolidated financial statements.
EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
For the Years Ended December 31, 2010, 2009 and 2008
(In thousands, except share data)
See accompanying notes to consolidated financial statements.
EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended December 31, 2010, 2009 and 2008
(In thousands)
See accompanying notes to consolidated financial statements.
Eastern Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands except share and per share data)
1. Background and Nature of Operations
Eastern Insurance Holdings, Inc. (“EIHI”) is an insurance holding company offering workers’ compensation and reinsurance products through its direct and indirect wholly-owned subsidiaries, Global Alliance Holdings, Ltd. (“Global Alliance”), Eastern Alliance Insurance Company (“Eastern Alliance”), Allied Eastern Indemnity Company (“Allied Eastern”), Eastern Advantage Assurance Company (“Eastern Advantage”), Employers Alliance, Inc. (“Employers Alliance”), Eastern Re Ltd., S.P.C. (“Eastern Re”), and Eastern Services Corporation (“Eastern Services”), collectively referred to as the “Company.”
On December 9, 2010, EIHI completed the sale of Eastern Atlantic RE (“Atlantic RE”). Atlantic RE was a Cayman Islands reinsurance company formed for the purpose of transferring certain assets and liabilities related to EIHI’s run-off specialty reinsurance segment as part of the sale. As a result of the sale, the results of operations for the portion of the run-off specialty reinsurance segment that was transferred to Atlantic RE have been reflected as discontinued operations in the accompanying consolidated financial statements. The portion of the run-off specialty reinsurance segment that was not sold has been reclassified to the corporate/other segment. See Note 4 for additional information related to the sale.
On June 21, 2010, EIHI completed the sale of Eastern Life and Health Insurance Company (“Eastern Life”). As a result of the sale, Eastern Life’s operations have been reflected as discontinued operations in the accompanying consolidated financial statements. See Note 4 for additional information related to the sale.
On September 29, 2008, EIHI acquired all of the outstanding stock of Employers Security Holding Company (“ESHC”) and its wholly-owned subsidiaries, Employers Security and Affinity Management Services (“AMS”) (See Note 3). Employers Security is an Indiana-domiciled, mono-line workers’ compensation insurance company licensed to write business in Indiana, Illinois and Missouri.
The Company currently operates in three segments: workers’ compensation insurance, segregated portfolio cell reinsurance, and corporate/other. Prior to the sale of Atlantic RE and Eastern Life, the Company’s operations included a run-off specialty reinsurance segment and a group benefits insurance segment. The components of the run-off specialty reinsurance segment that were not transferred to Atlantic RE have been included in the corporate/other segment for the years ended December 31, 2010, 2009 and 2008.
2. Significant Accounting Policies
Basis of Presentation
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”).
All inter-company transactions and related account balances have been eliminated in consolidation.
Certain amounts in the prior year consolidated financial statements have been reclassified to conform to the current year presentation.
Use of Estimates
The preparation of the consolidated financial statements requires management to make estimates and assumptions that affect the amount of reported assets and liabilities and disclosures of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. The most significant estimates in the consolidated financial statements include reserves for unpaid losses and loss adjustment expenses (“LAE”), earned but unbilled premium, deferred acquisition costs, return premiums under reinsurance contracts, and current and deferred income taxes. Actual results could differ from these estimates.
Cash and Cash Equivalents
The Company considers all investments with original maturity dates of three months or less to be cash equivalents for purposes of the consolidated statements of cash flows. The carrying amount of cash equivalents approximates their fair value.
Investments
Fixed Income Securities
The Company’s investments in fixed income securities are classified as available-for-sale and are carried at estimated fair value, with unrealized gains and losses reported in accumulated other comprehensive income (loss), net of tax. The estimated fair value of the Company’s fixed income securities are based on prices obtained from an independent pricing service. Prices obtained from the independent pricing service are determined based on quoted market prices or, in the absence of quoted market prices, dealer quotes or matrix pricing, all of which are based on observable market-based inputs when available. Adverse credit market conditions have caused some markets to become relatively illiquid, thus reducing the availability of certain data used by the independent pricing services and dealers. When prices provided by the independent pricing service vary significantly from week to week, management reviews and validates such prices with other recognized market information sources or independent broker/dealers. Other criteria used by management to determine whether a market has become inactive include price quotations not based on current information, price quotations varying among brokers, significant increases in the bid-ask spread of a security and a significant decline or absence of a market for new issuances.
Premiums or discounts are amortized using the effective interest method. Realized gains or losses are based on amortized cost and are computed using the specific identification method. The Company monitors its fixed income securities for unrealized losses that appear to be other-than-temporary. A fixed income security is considered to be other-than-temporarily impaired when the security’s fair value is less than its amortized cost basis and 1) the Company intends to sell the security, 2) it is more likely than not that the Company will be required to sell the security before recovery of the security’s amortized cost basis, or 3) the Company believes it will be unable to recover the entire amortized cost basis of the security (i.e., a credit loss has occurred). When the Company determines a credit loss has been incurred, but the Company does not intend to sell the security and it is not more likely than not that the Company will be required to sell the security before recovery of the security’s amortized cost basis, the portion of the other-than-temporary impairment that is credit related is recorded as a realized loss in the consolidated statements of operations and comprehensive income (loss), and the portion of the other-than-temporary impairment that is not credit related is included in other comprehensive income (loss). Any subsequent increase in the security’s estimated fair value would be reported as an unrealized gain.
As a result of adopting new accounting guidance related to the recognition and presentation of other-than-temporary investment impairments in 2009, the Company recorded a cumulative effect adjustment that increased retained earnings by $685 and decreased accumulated other comprehensive income (loss), net by $445, resulting in an increase to shareholders’ equity of $240. The increase in shareholders’ equity reflects the reversal of a prior period deferred tax valuation allowance, of which $240 was applied to the retained earnings cumulative effect adjustment.
Convertible Bond Securities
The Company’s investments in convertible bond securities are considered hybrid financial instruments and are carried at estimated fair value, with changes in estimated fair value reported as a realized gain or loss in the consolidated statement of operations and comprehensive income (loss).
Equity Securities
The Company’s investments in equity securities, which consist primarily of index and exchange-traded mutual funds, are classified as available-for-sale and are carried at estimated fair value, with unrealized gains and losses reported in accumulated other comprehensive income (loss), net of tax. The estimated fair value of equity securities is determined based on quoted market prices or independent broker quotes.
Realized gains or losses are based on cost and are computed using the specific identification method. The Company monitors its equity securities for unrealized losses that appear to be other-than-temporary. The Company performs a detailed review of these securities to determine the underlying cause of the unrealized loss and whether the security is impaired. At the time a security is determined to be other-than-temporarily impaired, the Company reduces the cost of the security to the current estimated fair value as of the balance sheet date and records a realized loss in the consolidated statements of operations and comprehensive income (loss). Any subsequent increase in the security’s estimated fair value would be reported as an unrealized gain.
Other Long-Term Investments
Other long-term investments consist of investments in limited partnerships. Investments in limited partnerships are reported in the consolidated financial statements using the equity method. The carrying value of the Company’s limited partnership investments are based on the Company’s allocable share of the limited partnerships’ net asset value. Changes in
the value of the Company’s proportionate share of its limited partnership investments are included in the change in equity interest in limited partnerships in the consolidated statements of operations and comprehensive income (loss). The Company reports changes in the value of its limited partnership investments on a month lag as a result of the timing of statements being received from the limited partnership.
The Company monitors its limited partnership investments for declines in value that may be other-than-temporary. When a limited partnership interest is determined to be other-than-temporarily impaired, the Company reduces its interest in the limited partnership to its current estimated fair value at the balance sheet date. The impairment is recorded in the change in equity interest in limited partnerships in the consolidated statements of operations and comprehensive income (loss).
Premiums
Premiums, including estimates of additional premiums resulting from audits of insureds’ records, are generally recognized as written upon inception of the policy. Premiums written are primarily earned on a daily pro rata basis over the terms of the policies to which they relate. Accordingly, unearned premiums represent the portion of premiums written which is applicable to the unexpired portion of the policies in force. Workers’ compensation premiums are determined based upon the payroll of the insured, the applicable premium rates and, where applicable, an experience based modification factor. An audit of the policyholders’ records is conducted after policy expiration to make a final determination of applicable premiums. Included in net premiums earned is an estimate for earned but unbilled final audit premiums. The Company estimates earned but unbilled premiums by tracking, by policy, how much additional premium is billed in final audit invoices as a percentage of payroll exposure to estimate the probable additional amount that it has earned, but not yet billed, as of the balance sheet date. Earned but unbilled premiums accrued as of December 31, 2010 and 2009, and included in net premiums earned, totaled $601 and $1,351, respectively.
Other Revenue
Other revenue primarily consists of service revenue related to claims adjusting and risk management services. Claims adjusting and risk management service revenue is earned over the term of the related contracts in proportion to the actual services rendered.
Losses and Loss Adjustment Expenses
A liability is established for the estimated unpaid losses and LAE under the terms of, and with respect to, its policies and agreements and includes amounts determined on the basis of claims adjusters’ evaluations and an amount based on past experience for losses incurred but not reported (“IBNR”).
The Company discounts its reserves for unpaid losses and LAE for workers’ compensation claims on a non-tabular basis, using a discount rate of 3.0%, based upon regulatory guidelines. The reserves for unpaid losses and LAE have been reduced for the effects of discounting by approximately $4,633 and $4,256 as of December 31, 2010 and 2009, respectively.
The methods used to estimate the reserves for unpaid losses and LAE are reviewed periodically and any adjustments resulting therefrom are reflected in current operations.
Management believes that its reserves for unpaid losses and LAE is adequate as of December 31, 2010. However, estimating the ultimate liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates and judgments using data currently available. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded as of December 31, 2010, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.
Reinsurance
In the ordinary course of business, the Company assumes and cedes reinsurance with other insurance companies. These arrangements provide greater diversification of business and minimize the net loss potential arising from large claims. Ceded reinsurance contracts do not relieve the Company of its obligation to its insureds. Premiums and claims under the Company’s reinsurance contracts are accounted for on a basis consistent with those used in accounting for the underlying policies reinsured and the terms of the reinsurance contracts. The Company has certain reinsurance contracts that provide for return premium based on the actual loss experience of the written and reinsured business. The Company estimates the amounts to be recorded for return premium based on the terms set forth in the reinsurance agreements and the expected loss experience.
The reinsurance recoverable for unpaid losses and LAE includes the balances due from reinsurance companies for unpaid losses and LAE that are expected to be recovered from reinsurers, based on contracts in force.
Policy Acquisition Costs
Policy acquisition costs consist primarily of commissions and premium taxes that vary with and are primarily related to the production of premium. Policy acquisition costs are deferred and amortized over the period in which the related premiums are earned. Deferred acquisition costs are limited to the estimated amounts recoverable after providing for losses and loss adjustment expenses that are expected to be incurred based upon historical and current experience. Anticipated investment income is considered in determining recoverability.
Amortization of policy acquisition costs totaled $6,487, $5,908, and $4,676 for the years ended December 31, 2010, 2009 and 2008, respectively.
Income Taxes
Deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured using enacted tax rates and laws that are expected to be in effect when the difference is reversed. A valuation allowance is recorded against gross deferred tax assets if it is more likely than not that all or some portion of the benefits related to the deferred tax assets will not be realized.
EIHI’s insurance subsidiaries are not generally subject to state income taxes; rather, they are subject to state premium tax in the jurisdictions in which they write business. Employers Alliance and Eastern Services are subject to state income tax in the states in which they operate.
Eastern Re is an exempt entity under the Companies Law of the Cayman Islands; however, Eastern Re’s earnings and profits are subject to federal income tax for earnings subsequent to June 16, 2006.
The Company includes income tax-related interest and penalties as a component of income tax expense. The Company did not incur any income tax-related interest or penalties during 2010, 2009 or 2008.
The Company’s federal income tax returns for tax years subsequent to December 31, 2006 are subject to examination by the Internal Revenue Service.
Policyholder Dividends
The Company issues certain workers’ compensation insurance policies with dividend payment features. These policyholders share in the operating results of their respective policies in the form of dividends. Dividends to policyholders are accrued during the period in which the related premiums are earned and are determined based on the terms of the individual policies. As of December 31, 2010 and 2009, the Company recorded accrued dividends payable of $1,590 and $1,157, respectively, which are included in accounts payable and accrued expenses on the consolidated balance sheets.
Property and Equipment
Property and equipment, including expenditures for significant improvements and purchased software, is carried at cost less accumulated depreciation and amortization. Maintenance, repairs and minor improvements are expensed as incurred. When property and equipment is retired or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is included in operations. Depreciation is computed under the straight-line method. The estimated useful lives of property and equipment range from 3-7 years. Accumulated depreciation and amortization expense totaled $2,754 and $2,263 as of December 31, 2010 and 2009, respectively. Depreciation and amortization expense totaled $691, $658, and $471 for the years ended December 31, 2010, 2009 and 2008, respectively.
Assessments
The Company is subject to state guaranty fund assessments in the states in which it is licensed, which provide for the payment of covered claims or to meet other insurance obligations from insurance company insolvencies. The Company’s assessments consist primarily of charges from the Workers’ Compensation Security Fund of Pennsylvania (“Security Fund”). The Security Fund serves as a guaranty fund to provide claim payments for those workers entitled to workers’ compensation benefits when the insurance company originally providing the benefits was placed into liquidation by a court. Security Fund
assessments are established on an actuarial basis to provide an amount sufficient to pay the outstanding and anticipated claims in a timely manner, to meet the costs of the Pennsylvania Insurance Department to administer the fund and to maintain a minimum balance in the fund of $500 million. If the Security Fund determines that the balance in the Security Fund is less than $500 million based on the actuarial study, then an assessment up to one percent of direct written premium is made to all companies licensed to write workers’ compensation in Pennsylvania. Eastern Alliance, Allied Eastern and Eastern Advantage recognize a liability and the related expense for the assessments when premiums covered under the Security Fund are written; when an assessment from the Security Fund has been imposed or it is probable that an assessment will be imposed; and the amount of the assessment is reasonably estimable. The Company accrued an assessment related to the Security Fund of $0 and $2,108 as of December 31, 2010 and 2009, respectively. The 2009 accrual included an amount related to the 2008 Security Fund assessment, which was paid in January 2010.
Goodwill and Intangible Assets
Goodwill represents the excess of cost over the fair value of net assets of businesses acquired. Goodwill and other intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but are instead tested for impairment at least annually. Intangible assets with estimable useful lives are amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with Accounting Standards Codification (“ASC”) 350, Intangibles-Goodwill and Other.
Goodwill is assigned to one or more reporting units at the date of acquisition. The goodwill reported by the Company has been allocated 100% to the workers’ compensation insurance segment, which is considered a reporting unit for goodwill purposes. The annual goodwill impairment test, performed as of September 30, each year, consists of a two-step process. The first step identifies whether potential impairment exists by comparing the fair value of the reporting unit to its carrying value, including goodwill. If the fair value of a reporting unit is less than its carrying amount, the second step is required to measure the amount of any impairment loss. There have been no historical impairments of goodwill.
Management tests goodwill for impairment annually as of September 30 and more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The Company’s goodwill is allocated 100% to the workers’ compensation insurance segment.
Management tested goodwill for impairment as of September 30, 2010 using a discounted cash flow analysis. The discounted cash flow analysis was based on management’s internal four-year forecast for the workers’ compensation insurance segment, assuming a long-term growth rate of 5.0% and a discount rate of 13.0%. Cash flows were adjusted, as necessary, to maintain adequate capital requirements. The discounted cash flow analysis resulted in the workers’ compensation insurance segment’s estimated fair value exceeding its carrying value as of September 30, 2010; therefore, goodwill was considered not impaired.
In the event the operating results of the Company’s workers’ compensation insurance segment were to be adversely impacted by a significant loss of business or higher than expected losses and LAE, management’s internal forecast may need to be re-evaluated, which could result in a fair value that is less than the carrying value of the workers’ compensation insurance segment and the need to recognize a goodwill impairment.
Treasury Stock
The Company records the repurchase of shares of its common stock using the cost method. Under the cost method, treasury stock is recorded based on the actual cost of the shares repurchased.
Stock-Based Compensation
The Company adopted the Eastern Insurance Holdings, Inc. 2006 Stock Incentive Plan (the “Stock Incentive Plan”) on December 18, 2006. Under the terms of the Stock Incentive Plan, stock awards may be made in the form of incentive stock options, non-qualified stock options or restricted stock. The Company records compensation expense based on the fair value of the stock award on the grant date using the straight-line attribution method.
Employee Stock Ownership Plan
The Company recognizes compensation expense related to its employee stock ownership plan (“ESOP”) equal to the product of the number of shares earned, or committed to be released, during the period, and the average price of the
Company’s common stock during the period. The estimated fair value of unearned ESOP shares is calculated based on the average price of the Company’s common stock for the period. For purposes of calculating earnings per share, the Company includes the weighted average of ESOP shares committed to be released for the period.
Concentrations of Credit Risk
Financial instruments, which potentially expose the Company to concentrations of credit risk, consist primarily of cash and cash equivalents, investments, premiums receivable, and amounts recoverable from reinsurers.
Comprehensive Income
Comprehensive income includes all changes in shareholders’ equity during the reporting period, net of tax. The components of accumulated other comprehensive income, net of tax, as of December 31, 2010 and 2009 were as follows (in thousands):
Cash Flow Information
Purchases and sales or maturities of short-term investments are recorded net for purposes of the consolidated statements of cash flows and are included with fixed income securities.
The issuance of the $1,750 promissory note related to the sale of Eastern Life and the recognition of the contingent profit commission of $3,018 related to the sale of Atlantic RE is considered a non-cash investing activity and has been excluded from the consolidated statement of cash flows for the year ended December 31, 2010.
The Company paid income taxes of $455, $3,175, and $4,875 for the years ended December 31, 2010, 2009 and 2008, respectively. Taxes paid for the year ended December 31, 2010 are net of refunds related to capital loss carrybacks to prior tax years totaling $1,795.
The Company paid interest of $33, $65, and $468 for the years ended December 31, 2010, 2009 and 2008, respectively.
Recent Accounting Pronouncements
Deferred Acquisition Costs
In October 2010, the Financial Accounting Standards Board (“FASB”) issued new accounting guidance related to the accounting for costs related to the acquisition or renewal of insurance contracts. The new guidance provides specific types of costs that should be capitalized in connection with the acquisition or renewal of insurance contracts. Those costs include incremental direct costs of contract acquisition incurred in connection with independent third parties and certain costs related to activities performed by the insurer for the contract, including underwriting, policy issuance and processing, medical and inspection, and sales force contract selling. Under the new guidance, costs incurred by an entity related to unsuccessful acquisition or renewal efforts must be charged to expense as incurred. The new guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011 and is to be applied prospectively. Retrospective application to all prior periods upon the date of adoption is permitted, but not required. Early adoption is permitted but only at the beginning of an entity’s annual reporting period. The Company currently capitalizes and defers commissions and related expenses, premium taxes and certain underwriting personnel salaries. The Company expects to adopt this new guidance effective January 1, 2012 and apply it retrospectively to prior periods for purposes of consistency across all periods presented. Upon adoption, the Company expects to reduce the amount of acquisition costs capitalized related to certain underwriting personnel salaries to give effect to unsuccessful acquisition or renewal activities. Management does not expect the adoption of the new guidance to have a material effect of the Company’s financial condition or results of operations.
Fair Value Measurements
In January 2010, the FASB issued new accounting guidance related to disclosures about fair value measurements. The new guidance requires the following new or enhanced disclosures: 1) details of significant transfers in and out of Level 1 and Level 2 measurements and the reasons for the transfers, 2) a gross presentation of activity within the Level 3 rollforward, presenting separately information about purchases, sales, issuances, and settlements, and 3) fair value disclosures must be presented by class of assets and liabilities rather than by major category. The new guidance was effective for the first interim or annual reporting period beginning after December 15, 2009, except for the gross presentation of the Level 3 rollforward information, which is required for annual reporting periods beginning after December 15, 2010 and for interim periods within those years. The Company adopted the new accounting guidance effective January 1, 2010. The adoption of the new guidance resulted in enhanced disclosures related to the Company’s fair value measurements of its investments.
Variable Interest Entities
In June 2009, the FASB issued new accounting guidance related to variable interest entities. The new guidance 1) replaces the quantitative-based risks and rewards calculation for determining whether an enterprise is the primary beneficiary in a variable interest entity with an approach that is primarily qualitative, 2) requires ongoing assessments of whether an enterprise is the primary beneficiary of a variable interest entity, and 3) requires additional disclosures about an enterprise’s involvement in variable interest entities. The new guidance was effective for financial statements issued for fiscal years beginning after November 15, 2009. The Company adopted the new accounting guidance effective January 1, 2010. The adoption of the new guidance had no impact on the Company’s consolidated financial statements.
3. Business Combinations
Acquisition of ESHC
On September 29, 2008, EIHI acquired all of the outstanding stock of ESHC in a transaction valued at $14,820, including the assumption of $2,650 in debt. The acquisition of ESHC resulted in the recognition of certain intangible assets and goodwill totaling $4,180 and $2,760, respectively. The intangible assets included renewal rights, agency relationships, and state insurance licenses of $1,841, $1,814, and $525, respectively. ESHC reported total assets and total liabilities of $25,856 and $19,203, respectively, on the date of the transaction. ESHC’s shareholders’ equity of $6,653 on the date of the transaction was reduced by $10 as a result of purchase accounting adjustments to reflect the fair value of certain acquired assets and liabilities. The most significant purchase accounting adjustments related to the elimination of deferred acquisition costs, an increase to reserves for losses and LAE, and a decrease to unearned premiums. Direct costs related to the acquisition totaling $107 were capitalized and included in goodwill.
4. Discontinued Operations
During the year ended December 31, 2010, the Company disposed of its group benefits insurance operations and the majority of its run-off specialty reinsurance operations. As a result of the disposals, the group benefits insurance and the run-off specialty reinsurance segments have been reflected in the consolidated financial statements as discontinued operations.
The following table provides the assets and liabilities of the group benefits insurance segment and run-off specialty reinsurance segment that are included in discontinued operations on the Company’s consolidated balance sheet as of December 31, 2009:
Sale of Eastern Life
On June 21, 2010, EIHI completed the sale of its wholly-owned group benefits insurance subsidiary, Eastern Life, to Security Life Insurance Company of America (“Security”). The agreement effected a statutory merger of Eastern Life into Security, with Security continuing as the surviving corporation. Total transaction consideration to EIHI was $34,102, which represented Eastern Life’s GAAP shareholder’s equity as of May 31, 2010 plus $250. The consideration consisted of cash and a $1,750 promissory note from Security’s parent. The note bears interest at 4.0%, payable quarterly, and is due in full on July 1, 2013.
The sale of Eastern Life resulted in the recognition of a gain totaling $564, which is included in discontinued operations. Transaction expenses related to the sale of Eastern Life totaled $873 ($567, net of tax) for the year ended December 31, 2010, and have been included in discontinued operations. Certain corporate expenses previously reported in the group benefits insurance segment were reclassified to continuing operations. The reclassification of these corporate expenses totaled $500 for each of the years ended December 31, 2010, 2009, and 2008.
For the years ended December 31, 2010, 2009, and 2008, the group benefits insurance segment reported net premiums earned of $18,262, $35,937, and $36,723, respectively, and total revenue of $20,563, $40,745, and $33,505, respectively. Income (loss) before income taxes in the group benefits insurance segment totaled $952, $4,157, and $(2,239) for the years ended December 31, 2010, 2009, and 2008, respectively.
Sale of Eastern Atlantic RE
On December 9, 2010, EIHI completed the sale of Eastern Atlantic RE (“Atlantic RE”) to an investor group advised by Dowling Advisors, Inc. (“Dowling”). Atlantic RE is a Cayman Islands reinsurance company and was part of EIHI’s run-off specialty reinsurance segment. Under the terms of the sale, Dowling purchased 100% of the outstanding stock of Atlantic RE for $2,300 of cash.
The sale of Atlantic RE resulted in the recognition of a loss totaling $14,029, which is included in discontinued operations. The loss includes the recognition of an estimated contingent profit commission of $3,018, which is based on the adequacy of the run-off specialty reinsurance segment’s reserves for losses and LAE as of September 30, 2010, compared to a predetermined targeted reserve for losses and LAE. Transaction expenses related to the sale of Atlantic RE totaled $510 for the year ended December 31, 2010, and have been included in discontinued operations.
For the years ended December 31, 2010, 2009, and 2008, the run-off specialty reinsurance segment reported net premiums earned of $1, $1,133, and $9,682, respectively, and total revenue of $4,180, $957, and $10,585, respectively. Total revenue for the year ended December 31, 2010 excludes the loss on the sale of Atlantic RE of $14,029. The loss before income taxes in the run-off specialty reinsurance segment totaled $(12,924), $(663), and $(18,609) for the years ended December 31, 2010, 2009, and 2008, respectively.
5. Intangible Assets
The Company’s acquisition of EHC and ESHC resulted in the identification of certain intangible assets. The renewal rights and agency relationships will be amortized over their estimated useful lives of 15 years. The state insurance licenses are considered to have an infinite life and will not be amortized.
As of December 31, 2010 and 2009, intangible assets consisted of the following (in thousands):
Amortization expense totaled $1,284, $1,732 and $1,373 for the years ended December 31, 2010, 2009 and 2008, respectively.
The estimated aggregated amortization expense for each of the next five years is as follows (in thousands):
6. Earnings Per Share
Basic earnings per share are computed by dividing net (loss) income by the weighted average number of shares outstanding for the respective period. Diluted earnings per share are computed by dividing net (loss) income by the weighted average number of shares outstanding for the period, including dilutive potential common shares outstanding for the period. For the years ended December 31, 2010, 2009 and 2008, there were 978,430, 784,361 and 834,757 stock options and restricted stock awards, respectively, that were not included in the Company’s earnings per share from continuing operations calculation because to do so would have been anti-dilutive.
Consolidated net (loss) income, basic shares outstanding, diluted shares outstanding, basic earnings per share, diluted earnings per share and cash dividends per share for the years ended December 31, 2010, 2009 and 2008 were as follows (in thousands, except share and per share data):
7. Exercise of Outstanding Warrants
As of January 1, 2009, contingent warrants to purchase 306,099 common shares of EIHI stock at an exercise price of $1.63 were outstanding. These warrants were awarded in 1999 as compensation to a Director of the Company who acted as the insurance broker for premium production in the Company’s run-off specialty reinsurance segment. The number of warrants ultimately earned was contingent upon achievement of predetermined direct premiums written thresholds. As of January 1, 2009, 244,879 warrants were earned. The remaining 61,220 warrants will not be earned because the specialty reinsurance segment was placed into run-off on July 1, 2008 and, therefore, there is no additional premium production. On March 10, 2009, the Director notified the Company that he was exercising the 244,879 earned warrants. Furthermore, as provided in the terms of the warrant, the Director instructed the Company to retain 64,588 shares in payment of the exercise price. Accordingly, on March 31, 2009, 180,291 shares of EIHI common stock were issued to the Director in full satisfaction of the 244,879 warrants earned. This was a non-cash transaction that had no impact on cash flows from operating or financing activities.
8. Share Repurchase
As of December 31, 2010, the Company’s Board of Directors has authorized repurchases of the Company’s issued and outstanding shares of common stock equal to 2,046,500 shares plus additional shares not to exceed $10.0 million. The share repurchases will be held as treasury stock and are available for issuance in connection with the Company’s Stock Incentive Plan.
On January 12, 2011, the Company’s Board of Directors authorized the repurchase of an additional 1,000,000 shares after the $10.0 million in share repurchases has been completed.
For the years ended December 31, 2010, 2009 and 2008, the Company repurchased 728,413, 1,400 and 1,073,492 shares, respectively, at a cost of $8,169, $11 and $17,066, respectively, representing a weighted average cost of $11.21, $8.03 and $15.90 per share, respectively.
9. Stock-Based Compensation
Awards under the Stock Incentive Plan may be made in the form of incentive stock options, nonqualified stock options, restricted stock or any combination to employees and non-employee directors. The Stock Incentive Plan limits the number of shares that may be initially awarded as restricted stock to 299,000, and the number of shares for which incentive stock
options may be granted to 500,000. The total number of shares initially authorized in the Stock Incentive Plan was 1,046,500 shares, with an annual increase equal to 1% of the shares outstanding at the end of each year. The Stock Incentive Plan provides that stock options and restricted stock awards may include vesting restrictions and performance criteria at the discretion of the Compensation Committee of the Board of Directors. The stock options and restricted stock awards vest over a five year period and are not subject to performance criteria. The term of options may not exceed ten years for incentive stock options, and ten years and one month for nonqualified stock options, and the option price may not be less than fair market value on the date of grant. During 2010, the Company granted 208,000 stock options and 1,500 restricted stock awards to employees. There were no stock options or restricted stock awards granted in 2009. During 2008, the Company granted 15,000 stock options and 5,000 restricted stock awards to employees. During 2001, 2009, and 2008, stock options totaling 8,522, 12,780, and 32,741, respectively, were forfeited. No stock options or restricted stock awards were exercised in 2010, 2009, or 2008.
Total stock-based compensation expense recognized in the consolidated statement of operations and comprehensive income for the years ended December 31, 2010 and 2009 is shown in the following table (in thousands):
As of December 31, 2010, there were 361,959 and 160,231 vested stock options and restricted stocks awards, respectively. As of December 31, 2009, there were 236,897 and 109,896 vested stock options and restricted stock awards, respectively. The total unrecognized stock compensation expense related to non-vested stock options was $1,593 and $1,173, respectively, and the total unrecognized stock compensation expense related to non-vested restricted stock awards was $689 and $1,395, respectively, as of December 31, 2010 and 2009. The unrecognized stock compensation expense related to the non-vested stock options and restricted stock awards is expected to be recognized over a weighted average period of approximately 28.1 months and 22.5 months, respectively.
The fair values of stock options granted in 2010 were determined on the dates of grant using a lattice-based binomial option valuation model with the following assumptions:
The expected life shown above was imputed based upon the combination of vesting provisions and the termination, retirement and early exercise assumptions input to the binomial option valuation model. As trading in the Company’s stock began in June 2006, the expected stock price volatility reflects a weighting of the average historical volatility over a 10-year period for 17 comparable companies and the average 6-month implied volatility for those comparable companies with listed options. A yield curve of risk free interest rates was developed for each valuation date based on quoted prices of US Treasury STRIPs.
The assumptions used to calculate the fair value of future options granted are evaluated and revised, as necessary, to reflect market conditions and the Company’s historical experience and future expectations. The calculated fair value is recognized as compensation expense in the Company’s consolidated statements of operations and comprehensive income (loss) over the requisite service period of the entire award. Compensation expense is recognized only for those options expected to vest, with forfeitures estimated at the date of grant and evaluated and adjusted periodically to reflect the Company’s historical experience and future expectations. Any change in the forfeiture assumption is accounted for as a change in estimate, with the cumulative effect of the change on periods previously reported being reflected in the financial statements of the period in which the change is made.
The following table summarizes stock option activity for the year ended December 31, 2010:
The aggregate intrinsic value of the stock options in the above table is $0 because the Company’s closing stock price of $11.90 on December 31, 2010 was below the weighted average exercise price of the stock options.
As of December 31, 2010, there were 291,949 shares of common stock available for issuance of future share-based awards. The following table presents additional information regarding options outstanding as of December 31, 2010:
The following table summarizes restricted stock activity for the year ended December 31, 2010.
10. Statutory Financial Information
The Company’s domestic insurance subsidiaries prepare statutory-basis financial statements in accordance with accounting practices prescribed or permitted by the insurance department in the subsidiaries’ domiciliary state. The Pennsylvania Insurance Department and the Indiana Insurance Department requires that insurance companies domiciled in their respective states prepare their statutory-basis financial statements in accordance with the National Association of Insurance Commissioners’ (“NAIC”) Accounting Practices and Procedures manual, subject to any deviations prescribed or permitted by domiciliary insurance commissioner (“SAP”).
Permitted statutory accounting practices encompass all accounting practices that are not prescribed; such practices differ from state to state, may differ from company to company within a state, and may change in the future. The Company’s domestic insurance subsidiaries did not have any permitted practices as of or for the year ended December 31, 2010.
The principal differences between GAAP and SAP relate to the carrying value of fixed income securities, deferred acquisition costs, deferred income taxes, dividends payable, benefit plan liabilities, the non-admissibility of certain assets for SAP purposes, and the reporting of reserves for unpaid losses and loss adjustment expenses and the related reinsurance recoverables on a gross versus net basis.
Financial Information
The statutory surplus and statutory net income (loss) of Eastern Alliance, Allied Eastern, Eastern Advantage and Employers Security as of December 31, 2010 and 2009 and for the years ended December 31, 2010, 2009, and 2008 was as follows (in thousands):
Risk-Based Capital/Minimum Capital Requirements
Risk-based capital is designed to measure the acceptable amount of capital an insurer should have based on the inherent risks of the insurer’s business. Insurers failing to meet adequate capital levels may be subject to insurance department scrutiny and ultimately rehabilitation or liquidation. Based on established standards, Eastern Alliance, Allied Eastern, Eastern Advantage, and Employers Security maintained statutory-basis surplus in excess of minimum prescribed risk-based capital requirements as of December 31, 2010.
Under Cayman Islands regulations, Eastern Re is required to maintain minimum capital of $120.
Dividend Restrictions
The ability of Eastern Alliance, Allied Eastern, Eastern Advantage, and Employers Security to pay dividends to EIHI is limited by the laws and regulations of Pennsylvania and Indiana. The maximum annual dividends that EIHI’s insurance subsidiaries may pay without the prior approval from the Pennsylvania Insurance Department and Indiana Insurance Department is limited to the greater of 10% of statutory surplus or 100% of statutory net income for the most recently filed annual statement. The maximum dividend that may be paid by Eastern Alliance, Allied Eastern and Eastern Advantage in 2011, without prior approval from the Pennsylvania Insurance Department, is $4,747, $840 and $855, respectively. The maximum dividend that may be paid by Employers Security in 2011, without prior approval from the Indiana Insurance Department, is $1,056.
11. Fair Value Measurements
The Company’s assets and liabilities that are measured at fair value on a recurring basis are segregated between those assets and liabilities that are valued based on quoted prices (unadjusted) in active markets for identical assets or liabilities, which the reporting entity can access at the measurement date (Level 1), direct or indirect observable inputs other than Level 1 quoted prices (Level 2), or unobservable inputs to the extent that observable inputs are not available (Level 3).
The following is a description of the Company’s categorization of the inputs used in the recurring fair value measurements of its financial assets included in its consolidated balance sheet as of December 31, 2010:
Level 1-Represents financial assets whose fair value is determined based upon observable unadjusted quoted market prices for identical financial assets in active markets that the Company has the ability to access. An example of a Level 1 input utilized to measure fair value includes the closing price of one share of common stock on an active exchange market. The Company considers U.S. Treasuries and equity securities as Level 1 assets.
Level 2-Represents financial assets whose fair value is determined based upon: quoted market prices for similar assets in active markets; quoted market prices for identical assets in inactive markets; inputs other than quoted market prices that are observable for the asset such as interest rates or yield curves; or other inputs derived principally from or corroborated from other observable market information. An example of a Level 2 input utilized to measure fair value, specifically for the Company’s fixed income portfolio, is “matrix pricing.” “Matrix pricing” relies on observable inputs from active markets other than quoted market prices including, but not limited to, benchmark securities and yields, latest reported trades, quotes from brokers or dealers, issuer spreads, bids, offers, and other relevant reference data to determine fair value. “Matrix pricing” is used to measure the fair value of fixed income securities where obtaining individual quoted market prices is impractical. The Company considers U.S. Government agencies, municipal bonds, mortgage-backed securities, collateralized mortgage obligations, asset-backed securities, corporate bonds, and convertible bonds as Level 2 assets.
Level 3-Represents financial assets whose fair value is determined based upon inputs that are unobservable, including the Company’s own determinations of the assumptions that a market participant would use in pricing the asset.
The following table provides a summary of the fair value measurements of the Company’s fixed income securities, convertible bonds, and equity securities, as of December 31, 2010 and 2009, excluding the segregated portfolio cell segment (in thousands):
There were no transfers between Level 1 and Level 2 securities for the year ended December 31, 2010.
The estimated fair values of the Company’s investments in fixed income securities, convertible bonds, and equity securities are based on prices provided by an independent, nationally recognized pricing service. Approximately 99.0% of the Company’s fixed income and equity security prices are obtained from the independent pricing service. The prices provided by the independent pricing service are based on quoted market prices, when available, non-binding broker quotes, or matrix pricing. The independent pricing service provides a single price or quote per security and the Company does not adjust security prices. The Company obtains an understanding of the methods, models and inputs, used by the independent pricing service, and has controls in place to validate that amounts provided represent current exit values. The Company’s controls
include, but are not limited to, initial and ongoing evaluation of the methodologies used by the independent pricing service as well as comparing the fair value estimates to the Company’s knowledge of the current market. Fixed income securities include U.S. Treasuries, agencies backed by the U.S. Government, municipal bonds, mortgage-backed securities, collateralized mortgage obligations, asset-backed securities, and corporate bonds.
The Company’s fixed income securities and convertible bonds consist primarily of publicly traded securities for which there are observable inputs and/or broker quotes. Most fixed income security prices provided by the independent pricing service are based on observable inputs and, therefore, are classified as Level 2 securities. The Company does not hold any fixed income securities, for which pricing was based on significant unobservable inputs; therefore, the Company has not classified any of its fixed income securities as Level 3 securities.
The Company’s equity securities consist primarily of mutual fund instruments for which there is an active market and quoted market prices; therefore, the Company has classified its mutual fund investments as Level 1 securities. The Company holds an investment in an international equity fund, which is included in equity securities on the consolidated balance sheets, that is considered a Level 2 security. The estimated fair value of the fund is based on the fund’s net asset value and the Company has the ability to redeem its investment at net asset value. Approximately 94.7% of the fund’s underlying investments were considered Level 1 securities as of December 31, 2009, the most recent date for which the Company has audited financial statements of the fund.
Other long-term investments include the Company’s interest in various limited partnerships, including a low volatility multi-strategy fund of funds, two natural resource limited partnerships, a structured finance opportunity fund, an open-ended investment fund and a real estate limited partnership. The Company records its investment in the limited partnerships using the equity method. The carrying value of the Company’s limited partnership investments are based on the Company’s allocable share of the limited partnerships’ net asset value. Changes in the Company’s investments are based on statements received directly from the limited partnership and/or the limited partnership’s administrator. The estimated fair values of the underlying investments in the limited partnerships may be based on Level 1, Level 2, or Level 3 inputs, or a combination thereof.
As of December 31, 2010 and 2009, the estimated fair values of the Company’s other long-term investments, by investment strategy, were as follows (in thousands):
Following is a summary of the investment objectives of each of the Company’s limited partnership investments, by investment strategy:
Multi-strategy fund of funds-The fund seeks to build and manage low volatility, multi-manager portfolios that have little or no correlation to the broader fixed income and equity security markets.
Natural resources-The Company invests in two separate natural resource funds. The investment objective of one of the funds is to achieve long-term capital appreciation primarily through investments in hard asset securities and hard asset commodities. The investment objective of the other fund is to provide an enhancement to an investor’s portfolio of investments and to provide a partial inflation hedge with an attractive risk/return profile as compared to other products using a commodity index or pool of commodities.
Structured finance opportunity fund-The fund seeks superior risk-adjusted absolute returns by acquiring and actively managing a diversified portfolio of debt securities, including bonds, loans, and other asset-backed instruments.
Open-ended investment fund-The fund seeks above-average capital growth through investment in domestic equity securities and equity related securities that are publicly traded in the United States.
Real estate partnership-The partnership was formed for the purpose of acquiring, rehabilitating, operating, leasing, and managing an apartment complex in Lancaster, Pennsylvania. The apartments are primarily marketed to low income individuals.
As of December 31, 2010, the only restrictions on the Company’s ability to redeem its interest in its limited partnership investments relate to the timing of redemption (i.e., monthly, quarterly). There are no restrictions related to the amount the Company can redeem, in the event it chooses to redeem all or a portion of its interest in its limited partnership investments. The Company has no unfunded commitments related to these investments as of December 31, 2010.
The activity in the Company’s limited partnership investments for the years ended December 31, 2010, 2009 and 2008 was as follows (in thousands):
The change in interest in the Company’s limited partnership investments is included in the change in equity interest in limited partnerships in the consolidated statements of operations and comprehensive income (loss).
12. Investments
The following tables provide the amortized cost and estimated fair value of the Company’s fixed income and equity securities as of December 31, 2010 and 2009 (in thousands):
Other structured securities include other asset-backed securities collateralized by home equity loans, auto loan receivables and manufactured homes.
Certain insurance departments in the states in which the Company is licensed to do business require a deposit to protect the Company’s policyholders should the Company become insolvent. In order to satisfy these requirements, the Company had fixed income securities with an estimated fair value of $11,442 and $10,699 on deposit with various insurance departments as of December 31, 2010 and 2009, respectively.
The amortized cost and estimated fair value of fixed income securities and convertible bonds as of December 31, 2010, by contractual maturity, are shown below (in thousands). Expected maturities could differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties.
The gross unrealized losses and estimated fair value of fixed income securities, excluding those securities in the segregated portfolio cell reinsurance segment, classified as available-for-sale by category and length of time an individual security has been in a continuous unrealized position as of December 31, 2010 and 2009 are as follows (in thousands):
Note: The Company has excluded the segregated portfolio cell reinsurance segment’s gross unrealized losses from the above table because changes in the estimated fair value of the segregated portfolio cell reinsurance segment’s fixed income and equity securities inures to the segregated portfolio cell dividend participant and, accordingly, is included in the segregated portfolio cell dividend payable and the related segregated portfolio dividend expense in the Company’s consolidated balance sheet and consolidated statement of operations, respectively. Management believes the exclusion of the segregated portfolio cell reinsurance segment from this disclosure provides a more transparent understanding of gross unrealized losses in the Company’s fixed income and equity security portfolios that could impact its consolidated financial position or results of operations.
As of December 31, 2010, the Company held 51 fixed income securities with gross unrealized losses totaling $328. Management has evaluated the unrealized losses related to those fixed income securities and determined that they are primarily due to a fluctuation in interest rates and not to credit issues of the issuer or the underlying assets in the case of asset-backed securities. The Company does not intend to sell the fixed income securities and it is not more likely than not that the Company will be required to see the fixed income securities before recovery of their amortized cost bases, which may be maturity; therefore, management does not consider the fixed income securities to be other-than-temporarily impaired as of December 31, 2010.
Proceeds from the sale of fixed income securities totaled $42,218, $36,511, and $16,130 for the years ended December 31, 2010, 2009 and 2008, respectively. Proceeds from the sale of equity securities totaled $8,293, $6,346, and
$2,858 for the years ended December 31, 2010, 2009, and 2008, respectively. Proceeds from the sale of other long-term investments totaled $0, $461, and $370 for the years ended December 31, 2010, 2009, and 2008, respectively.
The gross realized gains and gross realized losses recognized by the Company as a result of the sale of investments were as follows for the years ended December 31, 2010, 2009, and 2008 (in thousands):
For the years ended December 31, 2010, 2009 and 2008, the Company recorded other-than-temporary impairments, excluding the segregated portfolio cell reinsurance segment, related to its fixed income and equity securities totaling $6, $1,852 and $3,644, respectively. Other-than-temporary impairments in the segregated portfolio cell reinsurance segment totaled $80, $749, and $1,211 for the years ended December 31, 2010, 2009 and 2008, respectively.
For the years ended December 31, 2010, 2009 and 2008, the change in the estimated fair value of convertible bonds included in net realized investment (losses) gains in the consolidated statement of operations and comprehensive income totaled $1,166, $877 and $(623), respectively.
The change in the Company’s net unrealized gains and losses for the years ended December 31, 2010, 2009, and 2008 was as follows (in thousands):
Net investment income for the years ended December 31, 2010, 2009, and 2008 was as follows (in thousands):
For the years ended December 31, 2010, 2009 and 2008, the Company recognized an increase (decrease) of $1,052 and $1,066, and (3,540) respectively, related to its equity interest in limited partnerships. The Company’s limited partnership investments include a multi-strategy fund of funds, natural resource funds, a structured finance opportunity fund and open-ended investment fund and a real estate partnership. The Company obtains audited financial statements of its limited partnership investments on an annual basis. The total assets, total liabilities and results of operations of the limited partnerships in which the Company invests as of and for the year ended December 31, 2009, based on the limited partnerships’ audited financial statements, were as follows (in thousands):
13. Reserves for Unpaid Losses and LAE
The following table provides a summary of the activity in the Company’s reserves for unpaid losses and LAE for the years ended December 31, 2010, 2009, and 2008 (in thousands):
Incurred losses by segment were as follows for the year ended December 31, 2010 (in thousands):
Incurred losses by segment were as follows for the year ended December 31, 2009 (in thousands):
Incurred losses by segment were as follows for the year ended December 31, 2008 (in thousands):
For the years ended December 31, 2010, 2009 and 2008, the Company increased (decreased) its workers’ compensation and segregated portfolio cell reinsurance reserves for unpaid losses and LAE, including the accretion of prior period discount, by the following amounts (in thousands):
Workers’ Compensation Insurance
For the years ended December 31, 2010, 2009 and 2008, the Company increased (decreased) its workers’ compensation insurance reserves for unpaid losses and LAE by the following amounts by accident year (in thousands):
For the year ended December 31, 2010, the Company did not recognize any development on prior accident period workers’ compensation reserves.
For the year ended December 31, 2009, the Company recognized net favorable development on prior accident year workers’ compensation reserves of $3.7 million, representing 6.8% of the Company’s estimated workers’ compensation reserves as of December 31, 2008 and 5.1% of the Company’s workers’ compensation net premiums earned for the year ended December 31, 2009. The favorable development arose primarily from accident years 2006 and 2007, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting include greater availability and use of employers’ return to work programs. Furthermore, the Company was able to settle a large amount of Pennsylvania claims via compromise and release, which is a lump sum cash payment in exchange for a full and final claim settlement. Management attributes the large amount of compromise and release claim closures to the difficult economic conditions and the claimants’ choosing a lump sum cash settlement over the continuation of a workers’ compensation annuity payment.
For the year ended December 31, 2008, the Company recognized net favorable development on prior accident year workers’ compensation reserves of $2.7 million, representing 6.3% of the Company’s estimated workers’ compensation reserves as of December 31, 2007 and 4.1% of the Company’s workers’ compensation net premiums earned for the year ended December 31, 2008. The favorable development arose primarily from accident year 2007, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting the continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting include greater availability and use of employers’ return to work programs and an improved economy in the Company’s underwriting territories during the first nine months of 2008.
Segregated Portfolio Cell Reinsurance
For the years ended December 31, 2010, 2009 and 2008, the Company (decreased) increased its segregated portfolio cell reinsurance reserves for unpaid losses and LAE by the following amounts by accident year (in thousands):
The Company estimates and records reserves for its segregated portfolio cell reinsurance segment in the same manner as for its workers’ compensation insurance segment. Furthermore, the Company’s underwriting, claim administration and risk management services are consistent between its workers’ compensation insurance and segregated portfolio cell reinsurance segments. This is because the workers’ compensation and segregated portfolio cell reinsurance segments derive their books of business from the same general business demographics and geography. Prior period reserve development in the segregated portfolio cell reinsurance segment results in an increase or decrease in the segment’s losses and LAE incurred and a corresponding decrease or increase in the segregated portfolio cell dividend expense.
For the year ended December 31, 2010, the Company recognized net favorable development on prior accident year segregated portfolio cell reinsurance reserves of $1.4 million, representing 5.6% of the Company’s estimated segregated portfolio cell reinsurance reserves as of December 31, 2009 and 5.8% of the Company’s segregated portfolio cell reinsurance net premiums earned for the year ended December 31, 2009. The favorable development arose primarily from accident years 2008 and 2009, but was generally prevalent in most prior accident years, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting include greater availability and use of employers’ return to work programs.
For the year ended December 31, 2009, the Company recognized net favorable development on prior accident year segregated portfolio cell reinsurance reserves of $2.8 million, representing 12.6% of the Company’s estimated segregated portfolio cell reinsurance reserves as of December 31, 2008 and 11.1% of the Company’s segregated portfolio cell reinsurance net premiums earned for the year ended December 31, 2008. The favorable development arose primarily from accident years 2006 and 2008, but was generally prevalent in most prior accident years, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting include greater availability and use of employers’ return to work programs.
For the year ended December 31, 2008, the Company recognized net favorable development on prior accident year segregated portfolio cell reinsurance reserves of $2.0 million, representing 9.4% of the Company’s estimated segregated portfolio cell reinsurance reserves as of December 31, 2007 and 8.4% of the Company’s segregated portfolio cell reinsurance net premiums earned for the year ended December 31, 2008. The favorable development arose primarily from accident years 2006 and 2007, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting include greater availability and use of employers’ return to work programs and an improved economy in the Company’s underwriting territories during the first nine months of 2008.
14. Reinsurance
The Company purchases reinsurance to manage its loss exposure. Although reinsurance agreements contractually obligate the Company’s reinsurers to reimburse the Company for the agreed upon portion of its gross paid losses, they do not discharge the primary liability of the Company.
The following table provides a summary of the Company’s premiums on a direct, assumed, ceded, and net basis for the years ended December 31, 2010, 2009, and 2008 (in thousands):
The following table provides a summary of the Company’s losses and loss adjustment expenses incurred on a direct, assumed, ceded and net basis for the years ended December 31, 2010, 2009, and 2008 (in thousands):
15. Income Taxes
The components of the income tax provision from continuing operations for the years ended December 31, 2010, 2009, and 2008 are as follows (in thousands):
In addition to the income tax provision, the net deferred tax asset decreased $1,471 and $3,283 in 2010 and 2009, respectively, as a result of changes in the unrealized gains and losses related to the Company’s fixed income and equity securities portfolio. The net deferred tax asset was also increased by $179 in 2010 and decreased by $127 in 2009 related to changes in the unrecognized benefit plan gains. The tax effect of these items is recorded directly to accumulated other comprehensive income, which is a component of shareholders’ equity.
The provision for income taxes from continuing operations for the years ended December 31, 2010, 2009, and 2008 is as follows (in thousands):
The components of the net deferred tax asset as of December 31, 2010 and 2009 are as follows (in thousands):
As of December 31, 2010, the net deferred tax asset of $721 has not been reduced by a valuation allowance because management believes that, while it is not assured, it is more likely than not that the Company will generate sufficient future taxable income to utilize these net future tax deductions. The amount of the net deferred tax asset considered realizable, however, could be materially reduced in the near term if estimates of future taxable income in the years in which the differences are expected to reverse are decreased.
As of December 31, 2010, the Company has not recognized any future tax benefit related to its foreign operations at Eastern Re. The unrecognized tax benefit, which represents the excess of the tax basis over the amount for financial reporting (i.e., outside basis difference) of Eastern Re, was $11,545 as of December 31, 2010. The outside basis difference primarily arises from losses at Eastern Re recognized for financial statement purposes, which have not yet been recognized for tax purposes. Management presently believes that the Company will not be able to recognize these tax benefits in the foreseeable future and, therefore, has not recognized the future tax benefits as of December 31, 2010.
As of December 31, 2010, the Company has no tax positions for which management believes a provision for uncertainty is necessary. The Company’s federal income tax returns for tax years subsequent to December 31, 2006 are subject to examination by the Internal Revenue Service.
16. Employee Benefit Plans
ESOP
The Company sponsors an ESOP. Eligible employees generally include those employees who have reached the age of 21 and have completed one year of service. All employees that were employed by EHC or ELH on June 16, 2006 were determined to have met the eligibility requirements on that date. ESOP shares are allocated to participants based on the ratio of their individual compensation during the plan year to the total compensation of eligible employees during the plan year.
The Company issued 747,500 shares of its common stock to the ESOP on June 16, 2006, and the ESOP signed a promissory note in the amount of $7,475 for the purchase of the shares, which is due in ten equal installments, with interest accruing annually at 4%. Shares purchased are held in a suspense account for allocation among participating employees as the loan is repaid.
Suspense shares, allocated shares, shares committed to be released, average price per share and stock compensation expense as of and for the years ended December 31, 2010 and 2009 were as follows (in thousands, except share data):
Suspense shares represent shares held by the ESOP that have not been allocated to participant accounts. Allocated shares have been earned and allocated to participant accounts, while shares committed to be released have been earned, but have not yet been allocated to participant accounts.
As of December 31, 2010 and 2009, the estimated fair value of unearned ESOP shares were $4,259 and $4,256, respectively.
For the years ended December 31, 2010, 2009, and 2008 the Company made a cash contribution of $958, $937, and $858 to the ESOP, respectively. The ESOP used these contributions, along with dividends received on the unallocated shares of the Company’s stock held by the ESOP, to make the semi-annual principal and interest payments to the Company related to the outstanding balance of the promissory note. Dividends used by the ESOP to fund the semi-annual principal and interest payments totaled $142, $163, and $242 in 2010, 2009, and 2008, respectively. The transactions between the Company and the ESOP are considered non-cash transactions for purposes of the consolidated statements of cash flows.
Defined Contribution Plan
The Company sponsors a contributory defined contribution plan covering eligible employees. Employees are eligible to participate in the defined contribution plan upon the attainment of 21 years of age. The Company provides a matching
contribution up to 75% of the first 4% of an employee’s contributions. Employees are immediately vested in the employer matching contributions regardless of years of service. The Company’s contributions to the defined contribution plan for the years ended December 31, 2010, 2009, and 2008 totaled $297, $309, and $237, respectively.
Employees may invest the contributions to their account in a variety of mutual funds. The estimated fair values of the mutual fund investments are based on quoted net asset values; therefore, the estimated fair values are considered Level 1 fair value measurements.
Other Benefit Plans
The Company also sponsors a non-contributory defined benefit pension plan (the “pension plan”) and a defined benefit postretirement plan (the “postretirement plan”), both of which are frozen as to the earning of additional benefits.
As of December 31, 2010 and 2009, the projected benefit obligation, fair value of plan assets and funded status of the pension plan and the postretirement plan were as follows (in thousands):
Based on the funded status of the pension plan as of December 31, 2010, the Company does not anticipate making a contribution in 2011.
The assumptions used in the measurement of the Company’s benefit obligation are shown in the following table:
The net periodic benefit cost incurred by the Company for the years ended December 31, 2010, 2009 and 2008 totaled $17, $68, and $(59) for the pension plan and $(7), $(5), and $(3) for the postretirement plan.
The assumptions used in the measurement of the Company’s net periodic benefit cost for the pension plan and the postretirement plan are shown in the following table:
Benefits paid totaled $117, $39, and $234 for the pension plan and $2, $1, and $21 for the postretirement plan for the years ended December 31, 2010, 2009, and 2008, respectively. The estimated future benefits to be paid over the next ten years related to the pension plan are as follows (in thousands):
The estimated future benefits to be paid over the next ten years related to the postretirement plan are expected to be minimal. The only benefits currently being paid by the Company under the postretirement plan relate to life insurance premiums for certain retirees.
The pension plan’s assets were comprised of the following at December 31, 2010 and 2009 (in thousands):
The pension plan’s equity securities consist of a small-cap index mutual fund. The mutual fund’s estimated fair value is based on a quoted net asset value; therefore, the estimated fair value is considered a Level 1 fair value measurement. The pension plan’s fixed income securities consist of pooled separate accounts that are valued at the net participation value of participation units held by the pension plan. The value of the participation units is determined by the trustee based on the estimated fair values of the underlying assets of the pooled separate account; therefore, the estimated fair value of the pooled separate accounts is considered a Level 2 fair value measurement.
The primary investment objective of the pension plan is to achieve maximum rates of return commensurate with safety of principal. The pension plan asset allocation is reviewed annually to determine whether the portfolio mix is within an acceptable range of the target allocation. Target asset allocations are based on asset and liability studies with the goal to enhance the expected return of the pension plan portfolio while maintaining acceptable levels of risk. As of December 31, 2010 the target asset allocation for the portfolio is 10% equity securities and 90% fixed income securities.
Historical and future expected returns of multiple asset classes were analyzed to develop a risk-free real rate of return and risk premiums for each asset class. The overall rate for each asset class was developed by combining a long-term inflation component, the risk-free real rate of return, and the associated risk premium. A weighted average rate was developed based on those overall rates and the target asset allocation of the pension plan.
17. Segment Information
The Company currently operates in three business segments. Prior to the sale of Atlantic RE and Eastern Life, the Company’s operations included a run-off specialty reinsurance segment and a group benefits insurance segment. The components of the run-off specialty reinsurance segment that were not transferred to Atlantic RE have been included in the corporate/other segment for the years ended December 31, 2010, 2009 and 2008.
Workers’ Compensation Insurance
The Company offers traditional workers’ compensation insurance coverage to employers, primarily in the Mid-Atlantic, Southeast and Midwest regions of the continental United States. The Company’s workers’ compensation products include guaranteed cost policies, policyholder dividend policies, retrospectively-rated policies and deductible policies.
Segregated Portfolio Cell Reinsurance
The Company offers alternative market workers’ compensation solutions to individual companies, groups and associations (referred to as “segregated portfolio cell dividend participants”) through the creation of segregated portfolio cells. The segregated portfolio cells are segregated pools of assets that function as insurance companies within an insurance company. The pool of assets and associated liabilities of each segregated portfolio cell are solely for the benefit of the segregated portfolio cell dividend participants, and the pool of assets of one segregated portfolio cell are statutorily protected from the creditors of the others. This permits the Company to provide customers with a turn-key alternative markets solution that includes program design, fronting, claims administration, risk management, segregated portfolio cell rental, asset management and segregated portfolio management services. The Company outsources the asset management and segregated portfolio cell management services to a third party. The segregated portfolio cell structure provides dividend participants the opportunity to share in both underwriting profit and investment income derived from their respective segregated portfolio cell’s financial results. The segregated portfolio cell reinsurance segment generated fee revenue to the Company’s workers’ compensation insurance and corporate/other segments totaling approximately $4,469, $4,054 and $4,188 for the years ended December 31, 2010, 2009 and 2008, respectively.
Corporate/Other
The corporate/other segment primarily includes the expenses of the holding company, the third party administration activities of the Company, and the non-segregated portfolio cell reinsurance results of operations of Eastern Re, as well as certain eliminations necessary to reconcile the segment information to the consolidated statements of operations and comprehensive income (loss). The corporate/other segment also includes the Company’s 10% interest in a segregated
portfolio cell with an unaffiliated primary carrier that writes insurance coverage for sprinkler contractors. The Company cancelled the non-segregated portfolio cell reinsurance contracts in 1999 and the Company non-renewed the contract for its 10% interest in the segregated portfolio cell on a run-off basis effective April 1, 2009.
The following table represents the segment results for the year ended December 31, 2010 (in thousands):
The following table represents the segment results for the year ended December 31, 2009 (in thousands):
The following table represents the segment results for the year ended December 31, 2008 (in thousands):
18. Commitments and Contingencies
Lease Commitments
The Company’s corporate headquarters are located at 25 Race Avenue in Lancaster, Pennsylvania. The Company leases its home office building under a 15-year, non-cancelable lease through February 2017. The annual base rent is subject to an annual increase based upon the consumer price index at the end of each preceding calendar year. In addition to the base rent, the Company is responsible for its proportionate share of expenses related to the building including, but not limited to, utilities, maintenance, real estate taxes, and insurance. The Company has a 5% interest in the limited partnership that owns the building.
The Company maintains regional offices in North Carolina, Indiana, Tennessee and Pittsburgh, Pennsylvania and leases office space in each of these locations under multi-year operating leases.
Minimum monthly lease commitments for the remainder of the office lease terms are as follows (in thousands):
Rent expense totaled $918, $1,084, and $953 for the years ended December 31, 2010, 2009 and 2008, respectively.
19. Junior Subordinated Debentures
On May 15, 2008, the Company called its junior subordinated debentures at par. The Company paid cash of $8,400 to satisfy its outstanding obligation related to the debentures, including accrued interest of $253.
For the year ended December 31, 2008, the Company incurred interest expense of $468 related to the junior subordinated debentures.
20. Loan Payable
The Company repaid the loan during 2010. The Company incurred interest expense of $33 and $46 related to the loan for the years ended December 31, 2010, 2009 and 2008, respectively.
21. Related Party Transactions
The Company has an agreement with Alliance Impairment Management, Inc. (“AIM”), which provides case management services to certain of the Company’s insurance subsidiaries. For the years ended December 31, 2010, 2009, and 2008, the Company paid fees to AIM totaling approximately $3,200, $2,600 and $2,200, respectively. Bruce Eckert, the Company’s Vice Chairman (Chief Executive Officer as of December 31, 2010), is an investor in AIM.
22. Subsequent Events
Management performed an evaluation of subsequent events and determined there were no recognized or unrecognized subsequent events that would require an adjustment and/or additional disclosure in the consolidated financial statements as of December 31, 2010.
23. Quarterly Financial Data (Unaudited, in thousands, except per share data)
Item 9
Item 9 - Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None
Item 9A
Item 9A - Controls and Procedures
a) Evaluation of Disclosure Controls and Procedures.
Our disclosure controls and procedures, as that term is defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are designed with the objective of providing reasonable assurance that information required to be disclosed in our reports filed or submitted under the Exchange Act, such as this report, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission (the “SEC”). In designing and evaluating our disclosure controls and procedures, our management recognizes that any disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable, rather than absolute, assurance of achieving the desired control objectives.
An evaluation was performed by our management, with the participation of our chief executive officer (“CEO”) and chief financial officer (“CFO”), of the effectiveness of the design and operation of the our disclosure controls and procedures as of the end of the period covered by this report. Based on this evaluation, our CEO and CFO have concluded that, as of the end of such period, our disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms and made known to our management, including our CEO and CFO, as appropriate, to allow timely decisions regarding required disclosures.
b) Changes in Internal Controls.
There have been no changes in EIHI’s internal control over financial reporting identified in connection with the evaluation described in the above paragraph that have materially affected, or are reasonably likely to materially affect, EIHI’s internal control over financial reporting.
(c) Management’s Report on Internal Control Over Financial Reporting.
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) under the Securities Exchange Act of 1934. Under the supervision and with the participation of our management, including the principal executive officer and principal financial officer, we have conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation under the framework in Internal Control-Integrated Framework, we have concluded that the internal control over financial reporting was effective as of December 31, 2010.
Because of its inherent limitations, internal control over the financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
(d) The Report of Independent Registered Public Accounting Firm on internal control over financial reporting is included in this Annual Report on Form 10-K immediately before the consolidated financial statements.
Item 9B
Item 9B - Other Information
None
PART III
Item 10
Item 10 - Directors and Officers of the Registrant
Incorporated by reference from the Company’s 2011 Proxy Statement.
Item 11
Item 11 - Executive Compensation
Incorporated by reference from the Company’s 2011 Proxy Statement.
Item 12
Item 12 - Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Incorporated by reference from the Company’s 2011 Proxy Statement.
Item 13
Item 13 - Certain Relationships and Related Transactions
Incorporated by reference from the Company’s 2011 Proxy Statement.
Item 14
Item 14 - Principal Accountant Fees and Services
Incorporated by reference from the Company’s 2011 Proxy Statement.
Part IV
Item 15
Item 15 - Exhibits, Financial Statement Schedules
a) (1) Financial Statements.
The following consolidated financial statements are filed as part of this report in Item 8:
Consolidated Financial Statements
Consolidated Balance Sheets as of December 31, 2010 and 2009
Consolidated Statements of Operations and Comprehensive Income (Loss) for Years Ended December 31, 2010, 2009 and
Consolidated Statements of Changes in Shareholders’ Equity for Years Ended December 31, 2010, 2009 and 2008
Consolidated Statements of Cash Flows for Years Ended December 31, 2010, 2009 and 2008
Notes to Consolidated Financial Statements
(2) Financial Statement Schedules.
The following financial statement schedules for the years 2010, 2009 and 2008 are submitted herewith:
Schedule I-Summary of Investments
Schedule II-Condensed Financial Information of Parent Company
Schedule III-Supplementary Schedule Information
Schedule IV-Reinsurance
Schedule VI-Supplemental Information
The information required by Schedule V-Allowance for Uncollectible Premiums and Other Receivables has been included within the consolidated financial statements or notes thereto.
(3) Exhibits.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
EASTERN INSURANCE HOLDINGS, INC.
By:
/s/ KEVIN M. SHOOK
Kevin M. Shook, Executive Vice President, Treasurer and Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities indicated on the date indicated:
EXHIBIT INDEX
Eastern Insurance Holdings, Inc. and Subsidiaries
Schedule I-Summary of Investments-Other than
Investments in Related Parties as of December 31, 2010
Eastern Insurance Holdings, Inc.
Schedule II-Condensed Financial Information of Parent Company
Condensed Balance Sheets
December 31, 2010 and 2009
(In thousands, except share data)
See accompanying notes to consolidated financial statements.
Eastern Insurance Holdings, Inc.
Schedule II-Condensed Financial Information of Parent Company
Condensed Statement of Earnings
For the Years Ended December 31, 2010, 2009 and 2008
(In thousands)
See accompanying notes to consolidated financial statements.
Eastern Insurance Holdings, Inc.
Schedule II-Condensed Financial Information of Parent Company
Condensed Statements of Cash Flows
For the Years ended December 31, 2010, 2009 and 2008
(In thousands)
See accompanying notes to consolidated financial statements.
Eastern Insurance Holdings, Inc. and Subsidiaries
Schedule III-Supplementary Schedule Information
(In thousands)
Eastern Insurance Holdings, Inc. and Subsidiaries
Schedule IV-Reinsurance
For the years ended December 31, 2010, 2009 and 2008
(In thousands)
Eastern Insurance Holdings, Inc.
Schedule VI-Supplemental Information
For the year ended December 31, 2010