Item 1 of this Part I;
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references to our “predecessor,” for periods prior to the date of the Acquisition, refer collectively to PointSure Insurance Services, Inc, Eagle Pacific Insurance Company and Pacific Eagle Insurance Company;
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references to the “Company,” “we,” “us” or “our” refer to SeaBright Insurance Holdings, Inc. and its subsidiaries, SeaBright Insurance Company and PointSure Insurance Services, Inc., and prior to the date of the Acquisition, include references to our predecessor;
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the term “our business” refers to the business conducted by the Company since October 1, 2003 and with respect to periods prior to October 1, 2003, to the business conducted by our predecessor; and
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references to “SeaBright” refer solely to SeaBright Insurance Holdings, Inc., unless the context suggests otherwise.
Item 1. Business.
Overview
We are a specialty provider of multi-jurisdictional workers’ compensation insurance. We are domiciled in Illinois, commercially domiciled in California and headquartered in Seattle, Washington. We are licensed in 45 states and the District of Columbia to write workers’ compensation insurance. Traditional providers of workers’ compensation insurance provide coverage to employers under one or more state workers’ compensation laws, which prescribe benefits that employers are obligated to provide to their employees who are injured arising out of or in the course of employment. We focus on employers with complex workers’ compensation exposures, and provide coverage under multiple state and federal acts, applicable common law or negotiated agreements. We also provide traditional state act coverage in select markets. Our workers’ compensation policies are issued to employers who also pay the premiums. The policies provide payments to covered, injured employees of the policyholder for, among other things, temporary or permanent disability benefits, death benefits and medical and hospital expenses. The benefits payable and the duration of such benefits are set by statute, and vary by jurisdiction and with the nature and severity of the injury or disease and the wages, occupation and age of the employee.
SeaBright Insurance Holdings, Inc. was formed in 2003 by members of our current management and entities affiliated with Summit Partners, a leading private equity and venture capital firm, for the purpose of completing a management-led buyout that closed on September 30, 2003, which we refer to as the Acquisition. In the Acquisition, we acquired the renewal rights and substantially all of the operating assets and employees of Eagle Pacific Insurance Company and Pacific Eagle Insurance Company, which we collectively refer to as Eagle or the Eagle Entities. Eagle Pacific began writing specialty workers’ compensation insurance over 20 years ago. The Acquisition gave us renewal rights to an existing portfolio of business, representing a valuable asset given the renewal nature of our business, and a fully-operational infrastructure that would have taken many years to develop. These renewal rights gave us access to Eagle’s customer lists and the right to seek to renew Eagle’s continuing in-force insurance contracts. These renewal rights were valued at the date of Acquisition.
Industry Background
Workers’ compensation is a statutory system under which an employer is required to pay for its employees’ medical, disability, vocational rehabilitation and death benefits costs for work-related injuries or illnesses. Most employers comply with this requirement by purchasing workers’ compensation insurance. The principal concept underlying workers’ compensation laws is that an employee injured in the course of his or her employment has only the legal remedies available under workers’ compensation law and does not have
any other recourse against his or her employer. Generally, workers are covered for injuries that occur in the course and within the scope of their employment. An employer’s obligation to pay workers’ compensation does not depend on any negligence or wrongdoing on the part of the employer and exists even for injuries that result from the negligence or wrongdoings of another person, including the employee.
Workers’ compensation insurance policies generally provide that the carrier will pay all benefits that the insured employer may become obligated to pay under applicable workers’ compensation laws. Each state has a regulatory and adjudicatory system that quantifies the level of wage replacement to be paid, determines the level of medical care required to be provided and the cost of permanent impairment and specifies the options in selecting healthcare providers available to the injured employee or the employer. Coverage under the United States Longshore and Harbor Workers’ Compensation Act (“USL&H” or the “USL&H Act”) is similar to the state statutory system, but is administered on a federal level by the U.S. Department of Labor. This coverage is required for maritime employers with employees working on or near the waterfront in coastal areas of the United States and its inland waterways. As benefits under the USL&H Act are generally more generous than in the individual state systems, the rates charged for this coverage are higher than those charged for comparable land-based employment. These state and federal laws generally require two types of benefits for injured employees: (1) medical benefits, which include expenses related to diagnosis and treatment of the injury, as well as any required rehabilitation and (2) indemnity payments, which consist of temporary wage replacement, permanent disability payments and death benefits to surviving family members. To fulfill these mandated financial obligations, virtually all employers are required to purchase workers’ compensation insurance or, if permitted by state law or approved by the U.S. Department of Labor, to self-insure. The employers may purchase workers’ compensation insurance from a private insurance carrier, a state-sanctioned assigned risk pool or a self-insurance fund (an entity that allows employers to obtain workers’ compensation coverage on a pooled basis, typically subjecting each employer to joint and several liability for the entire fund).
Our History
On July 14, 2003, SeaBright entered into a purchase agreement with Kemper Employers Group, Inc. (“KEG”), Lumbermens Mutual Casualty Company (“LMC”) and the Eagle Entities. Pursuant to the purchase agreement, we acquired 100% of the issued and outstanding capital stock of Kemper Employers Insurance Company (“KEIC”) and PointSure Insurance Services, Inc. (“PointSure”), a wholesale insurance broker and third party claims administrator, and acquired tangible assets, specified contracts, renewal rights and intellectual property rights from LMC and the Eagle Entities. We acquired KEIC, a shell company with no in-force policies or employees, solely for the purpose of acquiring its workers’ compensation licenses in 43 states and the District of Columbia and for its certification with the United States Department of Labor. SeaBright paid approximately $6.5 million for KEIC’s insurance licenses, Eagle’s renewal rights, internally developed software and other assets and PointSure and approximately $9.2 million for KEIC’s statutory surplus and capital, for a total purchase price of $15.7 million. In September 2004 we paid to LMC a purchase price adjustment in the amount of $771,116.
The Acquisition was completed on September 30, 2003, at which time entities affiliated with Summit Partners, certain co-investors and members of our management team invested approximately $45.0 million in SeaBright and received convertible preferred stock in return. See “Certain Relationships and Related Transactions, and Director Independence” in Part III, Item 13. These proceeds were used to pay for the assets under the purchase agreement and to contribute additional capital to KEIC, which was renamed “SeaBright Insurance Company.” SeaBright Insurance Company received an “A−” (Excellent) rating from A.M. Best Company (“A.M. Best”) following the completion of the Acquisition.
On January 26, 2005, we closed the initial public offering of 8,625,000 shares of our common stock at a price of $10.50 per share for net proceeds of approximately $80.8 million, after deducting underwriters’ fees, commissions and offering costs totaling approximately $9.8 million. Approximately $74.8 million of the net proceeds were contributed to SeaBright Insurance Company. In connection with the initial public offering, all 508,365.25 outstanding shares of our Series A preferred stock were converted into 7,777,808 shares of common stock.
On February 1, 2006, we closed a follow-on public offering of 3,910,000 shares of common stock at a price of $15.75 per share for net proceeds of approximately $57.7 million, after deducting underwriters’ fees, commissions and offering costs totaling approximately $3.9 million. Following the closing of this offering, we contributed $50.0 million of the net proceeds to SeaBright Insurance Company, which intends to use the capital to expand its business in its core markets and to new territories.
Corporate Structure
Following the completion of the Acquisition, our corporate structure is as follows:
SeaBright Insurance Company is our insurance company subsidiary and a specialty provider of multi-jurisdictional workers’ compensation insurance. PointSure acts primarily as an in-house wholesale broker and third party administrator for SeaBright Insurance Company.
Arrangements to Minimize Exposure
Prior to the Acquisition, KEIC had a limited operating history in California writing small business workers’ compensation policies with an average annual premium size of approximately $4,100 per customer. KEIC had established loss reserves in the amount of approximately $16.0 million for these policies at September 30, 2003. In light of the deteriorating financial condition of LMC and its affiliates, we entered into a number of protective arrangements in connection with the Acquisition for the purpose of minimizing our exposure to this past business underwritten by KEIC and any adverse developments to KEIC’s loss reserves as they existed at the date of the Acquisition. One of our primary objectives in establishing these arrangements was to create security at the time of the Acquisition with respect to LMC’s potential obligations to us as opposed to having a mere future contractual right against LMC with respect to these obligations. The protective arrangements we established included a commutation agreement, an adverse development cover, a collateralized reinsurance trust and a $4.0 million escrow.
Commutation Agreement. Prior to the Acquisition, LMC and KEIC had entered into a reinsurance agreement requiring LMC to reinsure 80% of certain risks insured by KEIC in exchange for a premium paid to LMC. To help insulate us from the effects of a potential insolvency of LMC and the possibility that LMC may not continue to have the ability to make reinsurance payments to KEIC in the future, in connection with the Acquisition, KEIC entered into a commutation agreement with LMC to terminate the previously established reinsurance agreement. Under the commutation agreement, LMC paid KEIC approximately $13.0 million in cash in exchange for being released from its obligations under the reinsurance agreement, and KEIC reassumed all of the risks previously reinsured by LMC.
Adverse Development Cover. At the time of the Acquisition and after the commutation agreement, KEIC had loss reserves in the amount of approximately $16.0 million. In connection with the Acquisition, we entered into an agreement with LMC under which we both agreed to indemnify each other with respect to developments in these loss reserves over a period of approximately eight years. December 31, 2011 is the date to which the parties will look to determine whether the loss reserves with respect to KEIC’s insurance policies in effect at the date of the Acquisition have increased or decreased from the $16.0 million amount existing at the date of the Acquisition. If the loss reserves have increased, LMC must indemnify us in the amount of the increase. If they have decreased, we must indemnify LMC in the amount of the decrease.
Collateralized Reinsurance Trust. Because of the poor financial condition of LMC and its affiliates, we required LMC to fund a trust account in connection with the Acquisition. The funds in the trust account serve as current security for potential future obligations of LMC under the adverse development cover. The minimum amount that must be maintained in the trust account is equal to the greater of (a) $1.6 million or (b) 102% of the then-existing quarterly estimate of LMC’s total obligations under the adverse development cover, requiring LMC to fund additional amounts into the trust account on a quarterly basis, if necessary, based on a quarterly review of LMC’s obligations. We are entitled to access the funds in the trust account from time to time to satisfy LMC’s obligations under the adverse development cover in the event that LMC fails to satisfy its obligations.
As of December 31, 2006, we had recorded a receivable of approximately $2.8 million for adverse loss development under the adverse development cover since the date of the Acquisition. In September 2004, we and LMC retained an independent actuary to determine the appropriate amount of loss reserves that are subject to the adverse development cover as of September 30, 2004. In accordance with the terms of the adverse development cover and the collateralized reinsurance trust, on December 23, 2004, LMC deposited into the trust account an additional approximately $3.2 million, resulting in a total balance in the trust account of approximately $4.8 million. The balance in the trust account, including accumulated interest, totaled approximately $5.2 million at December 31, 2006. In February 2007, LMC submitted a request to withdraw approximately $1.8 million of excess funds on deposit in the trust account. After due evaluation, we complied with LMC’s request, resulting in a balance in the trust account of approximately $3.4 million immediately following the withdrawal. We continue to assess the reasonableness of reserves related to this business and believe that reserve amounts are reasonable at December 31, 2006.
$4.0 Million Escrow. In connection with the Acquisition, $4.0 million of the purchase price was placed into escrow in an account at Wells Fargo Bank for a period of two years. These funds were available to us as security for the obligations of LMC and its affiliates under the commutation agreement, the adverse development cover, the collateralized reinsurance trust and the indemnification provisions of the purchase agreement. The $4.0 million escrow fund was closed in 2006 after the escrow amount, including accumulated interest, was returned to KEG.
Services Arrangements
In addition to these arrangements, we also entered into services agreements with LMC and certain of its affiliates that require us to provide certain service functions for the Eagle Entities in exchange for fee income. The services that we are required to provide to the Eagle Entities under these agreements include administrative services, such as underwriting services, billing and collections services, safety services and accounting services, and claims services, including claims administration, claims investigation and loss adjustment and settlement services. For the years ended December 31, 2006, 2005, and 2004 we received approximately $1.4 million, $2.1 million, and $3.5 million respectively, in service fee income from LMC and its affiliates under these services arrangements.
We have entered into a service agreement with Broadspire Services, Inc., a third-party claims administrator and former subsidiary of LMC, pursuant to which Broadspire provides us with claims services for the claims that we acquired from KEIC in connection with the Acquisition. Fees for services with Broadspire were prepaid by LMC prior to the Acquisition and will continue until all claims are closed.
Issues Relating to a Potential LMC Receivership
LMC and its affiliates had traditionally offered a wide array of personal, risk management and commercial property and casualty insurance products. However, due to the distressed financial situation of LMC and its affiliates, LMC is no longer writing new business and is now operating under a voluntary run off plan which has been approved by the Illinois Department of Financial and Professional Regulation, Division of Insurance (the “Illinois Division of Insurance”). “Run off” is the professional management of an insurance company’s discontinued, distressed or non-renewed lines of insurance and associated liabilities outside of a
judicial proceeding. Under the run off plan, LMC has instituted aggressive expense control measures in order to reduce its future loss exposure and allow it to meet its obligations to current policyholders.
In the event that LMC is placed into receivership, a receiver may seek to recover certain payments made by LMC to us in connection with the Acquisition under applicable voidable preference and fraudulent transfer laws. However, we believe that there are factors that would mitigate the risk to us resulting from a potential voidable preference or fraudulent conveyance action brought by a receiver of LMC, including the fact that we believe LMC and KEIC were solvent at the time of the Acquisition and that the Acquisition was negotiated at arms length and for fair value, the fact that the Director of the Illinois Division of Insurance approved the Acquisition notwithstanding LMC’s financial condition and the fact that a substantial period of time has elapsed since the date of the Acquisition.
In addition, if LMC is placed into receivership, various arrangements that we established with LMC in connection with the Acquisition, including the servicing arrangements, the commutation agreement, the adverse development cover, and the collateralized reinsurance trust could be adversely affected. For a discussion of the risks relating to a potential LMC receivership, see the risks described under “Risks Related to Our Business - In the event LMC is placed into receivership, we could lose our rights to fee income and protective arrangements that were established in connection with the Acquisition, our reputation and credibility could be adversely affected and we could be subject to claims under applicable voidable preference and fraudulent transfer laws” in Item 1A.
Item 1A.
The net reserves as of December 31, 2006 of $6.9 million are subject to the various protective arrangements that we entered into in connection with the Acquisition. These protective arrangements were established specifically for the purpose of minimizing our exposure to past business underwritten by KEIC and any adverse developments to KEIC’s loss reserves as they existed at the date of the Acquisition. One of our primary objectives in establishing these arrangements was to create security at the time of the Acquisition with respect to LMC’s potential obligations to us as opposed to having a mere future contractual right against LMC with respect to these obligations in the event that LMC was subsequently placed into receivership or was otherwise unwilling or unable to satisfy its obligations to us. The protective arrangements we established include a commutation agreement, an adverse development cover, a collateralized reinsurance trust and a $4.0 million escrow, the balance of which had been returned to KEG as of December 31, 2006. These protective arrangements are described in detail under the heading “Our History - Arrangements to Minimize Exposure” in this Item 1.
Due to the distressed financial condition of LMC and its affiliates, LMC is no longer writing new business and is now operating under a voluntary run off plan which has been approved by the Illinois Division of Insurance. If LMC is placed into receivership, various of the protective arrangements, including the adverse development cover, the collateralized reinsurance trust and the commutation agreement, could be adversely affected. If LMC is placed into receivership and the amount held in the collateralized reinsurance trust is inadequate to satisfy the obligations of LMC to us under the adverse development cover, it is unlikely that we would recover any future amounts owed by LMC to us under the adverse development cover in excess of the amounts currently held in trust because the director of the Illinois Division of Insurance would have control of the assets of LMC. In addition, it is possible that a receiver or creditor could assert a claim seeking to unwind or recover the $13.0 million payment made by LMC to us under the commutation agreement or the funds deposited by LMC into the collateralized reinsurance trust under applicable voidable preference or fraudulent transfer laws. See “Risks Related to Our Business - In the event LMC is placed into receivership, we could lose our rights to fee income and protective arrangements that were established in connection with the Acquisition, our reputation and credibility could be adversely affected and we could be subject to claims under applicable voidable preference and fraudulent transfer laws” in Item 1A.
If LMC is placed into receivership in the near future, we will be responsible for the amount of any adverse development of KEIC’s loss reserves in excess of the collateral that is currently available to us, including the $3.4 million on deposit as of March 2, 2007 under the collateralized reinsurance trust. For example, if LMC is placed into receivership at a time when the amount on deposit in the collateralized reinsurance trust is deficient by $1.0 million, we would have to absorb that amount. Because the $13.0 million that we received under the commutation agreement was not discounted for present value at the time of payment, the earnings on these funds, if any, will help us to absorb any adverse development on KEIC’s loss reserves in excess of amounts on deposit under the collateralized reinsurance trust. We believe that there are several factors that would mitigate the risk to us resulting from a potential voidable preference or fraudulent conveyance action brought by a receiver, but if a receiver is successful under applicable voidable preference and fraudulent transfer laws in recovering from us the collateral that we received in connection with the Acquisition, those funds would not be available to us to offset any adverse development in KEIC’s loss reserves. See “Our History - Issues Relating to a Potential LMC Receivership” in this Item 1.
Investments
We derive investment income from our invested assets. We invest our statutory surplus and funds to support our loss reserves and our unearned premiums. As of December 31, 2006, the amortized cost of our investment portfolio was $400.2 million and the fair value of the portfolio was $399.9 million.
The following table shows the fair values of various categories of invested assets, the percentage of the total fair value of our invested assets represented by each category and the tax equivalent book yield based on the fair value of each category of invested assets as of December 31, 2006.
Equity securities consist of investments in exchange traded funds designed to correspond to the performance of certain indexes based on domestic or international stocks. We had no direct investments in equity securities at December 31, 2006 or 2005. The average credit rating for our fixed maturity portfolio at December 31, 2006, using ratings assigned by Standard and Poor’s, was AA+. The following table shows the ratings distribution of our fixed income portfolio as of December 31, 2006, as a percentage of total fair value.
The following table shows the composition of our fixed income securities by remaining time to maturity at December 31, 2006. For securities that are redeemable at the option of the issuer and have a market price that is greater than par value, the maturity used for the table below is the earliest redemption date. For securities that are redeemable at the option of the issuer and have a market price that is less than par value, the maturity used for the table below is the final maturity date. For mortgage-backed securities, mortgage prepayment assumptions are utilized to project the expected principal redemptions for each security, and the maturity used in the table below is the average life based on those projected redemptions.
Our investment strategy is to conservatively manage our investment portfolio by investing primarily in readily marketable, investment grade fixed income securities. Prior to March 2005, we did not invest in common equity securities and we had no exposure to foreign currency risk. In November 2006, our investment policy was revised to allow for investment in domestic and international equities of up to 4% and 1%, respectively, of our statutory consolidated capital and surplus. Our investment portfolio is managed by a registered investment advisory firm. We pay a variable fee based on assets under management. Our Board of Directors has established investment guidelines and periodically reviews portfolio performance for compliance with our guidelines.
We regularly review our portfolio for declines in value. In general, we focus on those securities whose fair values were less than 80% of their amortized cost or cost, as appropriate, for six or more consecutive months. We also analyze the entire portfolio for other factors that might indicate a risk of impairment, including credit ratings and interest rates. If a decline in value is deemed temporary, we record the decline as an unrealized loss in other comprehensive income (loss) on our consolidated statement of changes in stockholders’ equity and comprehensive income and in accumulated other comprehensive income (loss) on our consolidated balance sheet. As of December 31, 2006, no security had a fair value less than 80% of its amortized cost or cost. As of December 31, 2006, we had a net unrealized loss on our invested assets of $303,000. If the decline is deemed “other than temporary,” we write down the carrying value of the investment and record a realized loss in our consolidated statement of operations. Significant changes in the factors considered when evaluating investments for impairment losses could result in a significant change in impairment losses reported in the financial statements. There were no other-than-temporary declines in the fair value of our securities at December 31, 2006.
Reinsurance
We purchase reinsurance to reduce our net liability on individual risks and to protect against possible catastrophes. Reinsurance involves an insurance company transferring, or “ceding,” a portion of its exposure on a risk to another insurer, the reinsurer. The reinsurer assumes the exposure in return for a portion of the premium. The cost and limits of reinsurance we purchase can vary from year to year based upon the availability of quality reinsurance at an acceptable price and our desired level of retention. Retention refers to the amount of risk that we retain for our own account. In excess of loss reinsurance, losses in excess of the retention level up to the upper limit of the program, if any, are paid by the reinsurer.
Regardless of type, reinsurance does not legally discharge the ceding insurer from primary liability for the full amount due under the reinsured policies. However, the assuming reinsurer is obligated to indemnify the ceding company to the extent of the coverage ceded. To reduce our risk of the possibility of a reinsurer becoming unable to fulfill its obligations under the reinsurance contracts, we attempt to select financially strong reinsurers with an A.M. Best rating of “A−” (Excellent) or better and continue to evaluate their financial condition and monitor various credit risks to minimize our exposure to losses from reinsurer insolvencies.
Our Excess of Loss Reinsurance Treaty Program
Excess of loss reinsurance is reinsurance that indemnifies the reinsured against all or a specified portion of losses on underlying insurance policies in excess of a specified amount, which is called an “attachment level” or “retention.” Excess of loss reinsurance may be written in layers, in which a reinsurer or group of reinsurers accepts a band of coverage up to a specified amount. Any liability exceeding the upper limit of the program reverts to the ceding company, or the company seeking reinsurance. The ceding company also bears the credit risk of a reinsurer’s insolvency. In the ordinary course of our business, we entered into a new workers’ compensation and employers’ liability excess of loss reinsurance treaty program effective October 1, 2006, whereby our reinsurers are liable for the ultimate net losses in excess of $1.0 million for the business we write, up to a $75.0 million limit and subject to additional exclusions and limits, including those described below. We increased the maximum amount recoverable under this new program to $75.0 million from the $50.0 million maximum amount recoverable under the program that expired October 1, 2006 primarily due to the availability of additional reinsurance at reasonable rates. We have reviewed the terms of our excess of loss
reinsurance agreements and have concluded that they provide sufficient transfer of risk and meet other requirements necessary to qualify them for reinsurance accounting under Statement of Financial Accounting Standards (“SFAS”) No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts, and related pronouncements. The agreements for the current reinsurance program expire on October 1, 2007, at which time we expect to renew the program. We have the right to terminate the reinsurers’ shares in the program under various circumstances including a downgrade in a reinsurer’s A.M. Best rating below “A−”. The program provides coverage in several layers.
We retain losses of $1.0 million for each loss occurrence. The first reinsurance layer affords coverage up to $1.0 million for each loss occurrence in excess of $1.0 million for each loss occurrence and applies to in force policies written or renewed through us and classified by us as workers’ compensation and employers’ liability business (including USL&H Act, Jones Act and Federal Employers’ Liability Act business) and maritime employers’ liability. The aggregate limit for all claims under the first layer is $8.0 million. In addition, under the first layer of reinsurance, there is a sub-limit of $1.0 million per occurrence, and $2.0 million for two or more losses caused by any act of terrorism, as defined in the Terrorism Risk Insurance Act of 2002, as extended and amended by the Terrorism Risk Insurance Extension Act of 2005 (collectively referred to in this annual report as the “Terrorism Risk Act”); a sub-limit of $1.0 million for losses caused by occupational disease or other disease or cumulative trauma; and a maximum employer’s liability policy limit of $1.0 million ($2.0 million in Hawaii). Under the first layer, our reinsurers will not be liable for losses with respect to biological, chemical, radioactive or nuclear explosion, pollution, contamination or fire. Under the first layer, we are required to pay our reinsurers a deposit premium of $2.5 million for the term of the agreement, to be paid in the amount of approximately $636,000 on the first day of each calendar quarter. In order for coverage to attach under the first layer, we must report all losses to our reinsurers before October 1, 2014.
The second layer affords coverage up to $3.0 million for each loss occurrence in excess of $2.0 million for each loss occurrence and applies to in force policies written or renewed through us and classified by us as workers’ compensation and employers’ liability business (including USL&H Act, Jones Act and Federal Employers’ Liability Act business) and maritime employers’ liability. The aggregate limit for all claims under the second layer is $12.0 million. In addition, under the second layer of reinsurance, there is a sub-limit of $3.0 million per occurrence, and $6.0 million for two or more losses caused by any act of terrorism, as defined in the Terrorism Risk Act; a sub-limit of $3.0 million for losses caused by occupational disease or other disease or cumulative trauma; and a maximum employer’s liability policy limit of $1.0 million ($2.0 million in Hawaii). Under the second layer, our reinsurers will not be liable for losses with respect to biological, chemical, radioactive or nuclear explosion, pollution, contamination or fire. Under the second layer, we are required to pay our reinsurers a deposit premium of $1.9 million for the term of the agreement, to be paid in the amount of $482,250 on the first day of each calendar quarter. In order for coverage to attach under the second layer, we must report all losses to our reinsurers before October 1, 2014.
The third layer affords coverage up to $5.0 million for each loss occurrence in excess of $5.0 million for each loss occurrence and applies to in force policies written or renewed through us and classified by us as workers’ compensation and employers’ liability business (including USL&H Act, Jones Act and Federal Employers’ Liability Act business) and maritime employers’ liability, except when classified by us as ocean marine. The third layer has a sub-limit of $5.0 million for one or more losses caused by any act of terrorism, as defined in the Terrorism Risk Act. Under the third layer, our reinsurers will not be liable for losses with respect to biological, chemical, radioactive or nuclear explosion, pollution, contamination or fire. Under the third layer, we are required to pay our reinsurers a deposit premium of $1.8 million for the term of the agreement, to be paid in the amount of $450,500 on the first day of each calendar quarter. Our reinsurers’ liability under the third layer will never exceed $5.0 million in respect of any one loss occurrence and is further limited to $15.0 million during the term of the agreement by reason of any and all claims arising under the agreement. In order for coverage to attach under the third layer, we must report all losses to our reinsurers before October 1, 2014.
The fourth layer affords coverage up to $10.0 million for each loss occurrence in excess of $10.0 million for each loss occurrence and applies to in force policies written or renewed through us and classified by us as
workers’ compensation and employers’ liability business (including USL&H Act, Jones Act and Federal Employers’ Liability Act business) and maritime employers’ liability, except when classified by us as ocean marine. The fourth layer has a sub-limit of $10.0 million for one or more losses caused by any act of terrorism, as defined in the Terrorism Risk Act. Under the fourth layer, our reinsurers will not be liable for losses with respect to biological, chemical, radioactive or nuclear explosion, pollution, contamination or fire. In addition, the fourth layer does not cover commercial airline flight exposures involving four or more flight crew at any one time or loss arising from major league sports teams. Under the fourth layer, we are required to pay our reinsurers a deposit premium of $1.4 million for the term of the agreement, to be paid in the amount of $344,500 on the first day of each calendar quarter. Our reinsurers’ liability under the fourth layer will never exceed $10.0 million in respect of any one loss occurrence and is further limited to $20.0 million during the term of the agreement by reason of any and all claims arising under the agreement. In addition, under the fourth layer, the maximum amount applicable to the ultimate net loss for any one loss suffered by any one employee is $7.5 million. In order for coverage to attach under the fourth layer, we must report all losses to our reinsurers before October 1, 2014.
The fifth layer in our excess of loss reinsurance treaty program affords coverage up to $55.0 million for each loss occurrence in excess of $20.0 million for each loss occurrence and applies to in force policies written or renewed through us and classified by us as workers’ compensation and employers’ liability business (including USL&H Act, Jones Act and Federal Employers’ Liability Act business) and maritime employers’ liability, except when classified by us as ocean marine. The fifth layer is divided into two sub-layers. The first sub-layer affords coverage up to $30.0 million for each loss occurrence in excess of $20.0 million for each loss occurrence, subject to an aggregate limit of $60.0 million. The first sub-layer has a sub-limit of $30 million for one or more losses caused by any act of terrorism, as defined in the Terrorism Risk Act. Under the first sub-layer, we are required to pay our reinsurers a deposit premium of $1.7 million for the term of the agreement, to be paid in the amount of $418,500 on the first day of each calendar quarter. The second sub-layer affords coverage up to $25.0 million for each loss occurrence in excess of $50.0 million for each loss occurrence, subject to an aggregate limit of $50.0 million. The second sub-layer has a sub-limit of $25.0 million for one or more losses caused by any act of terrorism, as defined in the Terrorism Risk Act. Under the second sub-layer, we are required to pay our reinsurers a deposit premium of $650,000 for the term of the agreement, to be paid in the amount of $162,500 on the first day of each calendar quarter. Under the fifth layer, our reinsurers will not be liable for losses with respect to biological, chemical, radioactive or nuclear explosion, pollution, contamination or fire. Under both sub-layers of the fifth layer, the maximum amount applicable to the ultimate net loss for any one loss suffered by any one employee is $5.0 million. In addition, the fifth layer does not cover commercial airline flight exposures involving four or more flight crew at any one time or loss arising from major league sports teams. In order for coverage to attach under the fifth layer, we must report all losses to our reinsurers before October 1, 2014.
The agreements for the first, second and third layers in our excess of loss reinsurance treaty program have profit-sharing provisions requiring the reinsurers to make payments to SeaBright Insurance Company if the reinsurers experience favorable loss experience under these contracts.
Under each layer of our reinsurance treaty program, we may terminate any reinsurer’s share under the applicable agreement at any time by giving written notice to the reinsurer in the event certain specified circumstances occur, including (1) if the reinsurer’s policyholders’ surplus at the inception of the agreement has been reduced by more than 25% of the amount of surplus 12 months prior to that date, (2) if the reinsurer’s A.M. Best rating is downgraded below “A−” and/or its Standard & Poor’s rating is downgraded below “BBB+” or (3) if the reinsurer voluntarily ceases assuming new and renewal property and casualty treaty reinsurance business. Each layer of our reinsurance treaty program includes various exclusions in addition to the specific exclusions described above, including an exclusion for war in specified circumstances and an exclusion for reinsurance assumed. Under each layer of our reinsurance treaty program, we are required to pay to our reinsurers the pro rata share of the amount, if any, by which any financial assistance paid to us under the Terrorism Risk Act for acts of terrorism occurring during any one program year, combined with our total private-sector reinsurance recoveries for those acts of terrorism, exceeds the amount of insured losses paid by us for those acts of terrorism.
Our current excess of loss reinsurance treaties are placed with Allied World Assurance Company Ltd., rated “A” (Excellent) by A.M. Best; Aspen Insurance UK Limited, rated “A” (Excellent) by A.M. Best; Endurance Specialty Insurance Ltd., rated “A−” (Excellent) by A.M. Best; Flagstone Reinsurance Limited, rated “A−” (Excellent) by A.M. Best; Hannover Rueckversicherung AG, rated “A” (Excellent) by A.M. Best; syndicates from Lloyd’s of London, rated “A” (Excellent) by A.M. Best; Hannover Re (Bermuda) Limited, rated “A” (Excellent) by A.M. Best; Max Re Ltd., rated “A−” (Excellent) by A.M. Best; Munich Re America (American Re), rated “A” (Excellent) by A.M. Best; Odyssey America Reinsurance Corporation, rated “A” (Excellent) by A.M. Best; Partner Reinsurance Company of the U.S., rated “A+” (Excellent) by A.M. Best; and Tokio Millennium Reinsurance Limited, rated “A+” (Excellent) by A.M. Best.
The following is a summary of our top ten reinsurers, based on net amount recoverable, as of December 31, 2006.
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Participant in current excess of loss reinsurance treaty program or individual risk reinsurance placements.
Reinsurance Arrangements Established in Connection with Past Transactions
In addition to the reinsurance program described above, we have existing reinsurance arrangements which were established in connection with past transactions into which we have entered. In March 2002, KEIC sold the assets and business of its commercial compensation specialty operation to Argonaut Insurance Company. In connection with the sale, KEIC entered into a reinsurance agreement effective March 31, 2002 with Argonaut pursuant to which KEIC ceded and Argonaut assumed a 100% quota share participation in the transferred insurance policies. Certain reinsurance-type arrangements, including the commutation agreement and the adverse development cover, were also established with LMC in connection with the Acquisition. See “Our History” in this Item 1.
Terrorism Reinsurance
As extended, the Terrorism Risk Act is effective through December 31, 2007. The Terrorism Risk Act may provide us with reinsurance protection under certain circumstances and subject to certain limitations. The Secretary of the Treasury must declare the act to be a “certified act of terrorism” for it to be covered under this federal program. The definition of terrorism for purposes of the Terrorism Risk Act excludes domestic acts of terrorism or acts of terrorism committed in the course of a war declared by Congress. No federal compensation will be paid under the Terrorism Risk Act unless aggregate insured losses from the act for the entire insurance industry exceed certain threshold amounts ($5.0 million for terrorism losses occurring prior to
April 1, 2006, $50.0 million for terrorism losses occurring from April 1, 2006 to December 31, 2006, and $100.0 million for terrorism losses occurring in 2007). Each insurance company is responsible for a deductible based on a percentage of the direct earned premiums of its affiliated group in the previous calendar year for commercial lines policies (except for certain excluded lines such as commercial auto) covering risks in the United States. This deductible amount is 17.5% of such premiums for losses occurring in 2006 and 20.0% of such premiums for losses occurring in 2007. For losses in excess of the deductible, the federal government will reimburse 90% of the insurer’s loss occurring in 2006 and 85% of the insurer’s loss occurring in 2007. As stated above, all layers of our reinsurance program contain sublimits for losses caused by an act of terrorism, as defined in the Terrorism Risk Act, subject to certain absolute exclusions.
Competition
We operate in niche markets where we believe we have few competitors with a similar focus. The insurance industry in general is highly competitive and there is significant competition in the national workers’ compensation industry. Competition in the insurance business is based on many factors, including perceived market strength of the insurer, pricing and other terms and conditions, services provided, the speed of claims payment, the reputation and experience of the insurer and ratings assigned by independent rating organizations such as A.M. Best. Most of the insurers with which we compete have significantly greater financial, marketing and management resources and experience than we do. We may also compete with new market entrants in the future.
While more than 300 insurance companies participate in the national workers’ compensation market, our competitors are relatively few in number because we operate in niche markets. Our primary competitors vary slightly based on the type of product and by region. We have a number of competitors that limit their writings on a geographic basis. For our maritime product, our primary competitors are American International Group (“AIG”), American Longshore Mutual Association and Signal Mutual Indemnity Association Ltd. (based in Bermuda) in all of our regions. Additional competitors by region are Alaska National Insurance Company and Liberty Northwest in our Western Region; Gray Insurance Group, Amerisafe and Louisiana Workers Compensation Company (“LWCC”) in our Southern Region; and Travelers in our Midwestern Region. For our state act construction product, our primary competitors are AIG, Zurich and Liberty Mutual in all of our regions. Additional competitors by region are State Compensation Insurance Fund of California (“SCIF”), Arizona State Fund, Travelers and Construction Program Group in our Western Region; Texas Mutual, LWCC and Amerisafe in our Southern Region; and Acuity Group, ACE and Amerisafe in our Midwestern Region. For our ADR product, our primary competitors are AIG, Zurich and SCIF. In Alaska, our primary competition is Alaska National Insurance Company and Liberty Northwest. In Hawaii, our primary competition is AIG, Hawaii Employers Mutual Insurance Company and First Insurance.
We believe our competitive advantages are our strong reputation in our niche markets, our local knowledge in the markets where we operate, our specialized underwriting expertise, our client-driven claims and loss control service capabilities, our focus on niche markets, our loyal brokerage distribution, our low operating expense ratio and our customized systems. In addition to these competitive advantages, as discussed above, we offer our maritime customers regulated insurance coverage without the joint-and-several liability associated with coverage provided by offshore mutual organizations.
Ratings
Many insurance buyers, agents and brokers use the ratings assigned by A.M. Best and other rating agencies to assist them in assessing the financial strength and overall quality of the companies from which they are considering purchasing insurance. We have been rated “A−” (Excellent) by A.M. Best since the completion of the Acquisition. An “A−” rating is the fourth highest of 15 rating categories used by A.M. Best. In evaluating a company’s financial and operating performance, A.M. Best reviews the company’s profitability, indebtedness and liquidity, as well as its book of business, the adequacy and soundness of its reinsurance, the quality and estimated fair value of its assets, the adequacy of its loss reserves, the adequacy of its surplus, its capital structure, the experience and competence of its management and its market presence. This rating is
intended to provide an independent opinion of an insurer’s ability to meet its obligations to policyholders and is not an evaluation directed at investors.
Regulation
Holding Company Regulation
As a member of an insurance holding company, SeaBright Insurance Company, our insurance company subsidiary, is subject to regulation by the states in which it is domiciled or transacts business. SeaBright Insurance Company is domiciled in Illinois and is considered to be commercially domiciled in California. An insurer is deemed “commercially domiciled” in California if, during the three preceding fiscal years, or a lesser period of time if the insurer has not been licensed in California for three years, the insurer has written an average of more gross premiums in California than it has written in its state of domicile, and such gross premiums written constitute 33% or more of its total gross premiums written in the United States for such period. Pursuant to the insurance holding company laws of Illinois and California, SeaBright Insurance Company is required to register with the Illinois Division of Insurance and the California Department of Insurance. In addition, SeaBright Insurance Company is required to periodically report certain financial, operational and management data to the Illinois Division of Insurance and the California Department of Insurance. All transactions within a holding company system affecting an insurer must have fair and reasonable terms, charges or fees for services performed must be reasonable, and the insurer’s policyholder surplus following any transaction must be both reasonable in relation to its outstanding liabilities and adequate for its needs. Notice to, and in some cases approval from, insurance regulators in Illinois and California is required prior to the consummation of certain affiliated and other transactions involving SeaBright Insurance Company.
Changes of Control
In addition, the insurance holding company laws of Illinois and California require advance approval by the Illinois Division of Insurance and the California Department of Insurance of any change in control of SeaBright Insurance Company. “Control” is generally presumed to exist through the direct or indirect ownership of 10% or more of the voting securities of a domestic insurance company or of any entity that controls a domestic insurance company. In addition, insurance laws in many states contain provisions that require prenotification to the insurance commissioners of a change in control of a non-domestic insurance company licensed in those states. Any future transactions that would constitute a change in control of SeaBright Insurance Company, including a change of control of us, would generally require the party acquiring control to obtain the prior approval of the Illinois Division of Insurance and the California Department of Insurance and may require pre-acquisition notification in applicable states that have adopted pre-acquisition notification provisions. Obtaining these approvals may result in a material delay of, or deter, any such transaction.
These laws may discourage potential acquisition proposals and may delay, deter or prevent a change of control of SeaBright, including through transactions, and in particular unsolicited transactions, that some or all of the stockholders of SeaBright might consider to be desirable.
State Insurance Regulation
Insurance companies are subject to regulation and supervision by the department of insurance in the state in which they are domiciled and, to a lesser extent, other states in which they conduct business. SeaBright Insurance Company is primarily subject to regulation and supervision by the Illinois Division of Insurance and the California Department of Insurance. These state agencies have broad regulatory, supervisory and administrative powers, including, among other things, the power to: grant and revoke licenses to transact business; license agents; set the standards of solvency to be met and maintained; determine the nature of, and limitations on, investments and dividends; approve policy forms and rates in some states; periodically examine an insurance company’s financial condition; determine the form and content of required financial statements; and periodically examine market conduct. For example in January 2006, the California Department of Industrial
Relations, Division of Workers’ Compensation audited selected claims from our 2003 - 2005 claims logs. On April 21, 2006, the Division issued formal findings that we passed the audit with no administrative penalties assessed.
Detailed annual and quarterly financial statements and other reports are required to be filed with the departments of insurance of the states in which we are licensed to transact business. The financial statements and condition of SeaBright Insurance Company are subject to periodic examination by the Illinois Division of Insurance and the California Department of Insurance. In October 2006, the Illinois Division of Insurance began a routine comprehensive examination of our 2005 statutory annual statement.
In addition, many states have laws and regulations that limit an insurer’s ability to withdraw from a particular market. For example, states may limit an insurer’s ability to cancel or not renew policies. Furthermore, certain states prohibit an insurer from withdrawing one or more lines of business from the state, except pursuant to a plan that is approved by the state insurance department. The state insurance department may disapprove a plan that may lead to market disruption. Laws and regulations that limit cancellation and non-renewal and that subject program withdrawals to prior approval requirements may restrict our ability to exit unprofitable markets.
Federal Laws and Regulations
As a provider of maritime workers’ compensation insurance, we are subject to the USL&H Act, which generally covers exposures on the navigable waters of the United States and in adjoining waterfront areas, including exposures resulting from loading and unloading vessels, and the Jones Act, which covers exposures at sea. We are also subject to regulations related to the USL&H Act and the Jones Act.
The USL&H Act, which is administered by the U.S. Department of Labor, provides medical benefits, compensation for lost wages and rehabilitation services to longshoremen, harbor workers and other maritime workers who are injured during the course of employment or suffer from diseases caused or worsened by conditions of employment. The Department of Labor has the authority to require us to make deposits to serve as collateral for losses incurred under the USL&H Act. Several other statutes extend the provisions of the USL&H Act to cover other classes of private-industry workers. These include workers engaged in the extraction of natural resources from the outer continental shelf, employees on American defense bases, and those working under contracts with the U.S. government for defense or public-works projects, outside of the continental United States. Our authorizations to issue workers’ compensation insurance from the various state departments of insurance regulating SeaBright Insurance Company are augmented by our U.S. Department of Labor certificates of authority to ensure payment of compensation under the USL&H Act and extensions of the USL&H Act, including the OCSLA and the Nonappropriated Fund Instrumentalities Act. This coverage, which we write as an endorsement to workers’ compensation and employers liability insurance policies, provides employment-injury and occupational disease protection to workers who are injured or contract occupational diseases occurring on the navigable waters of the United States, or in adjoining areas, and for certain other classes of workers covered by the extensions of the USL&H Act.
The Jones Act is a federal law, the maritime employer provisions of which provide injured offshore workers, or seamen, with the right to seek compensation for injuries resulting from the negligence of their employers or co-workers during the course of their employment on a ship or vessel. In addition, an injured offshore worker may make a claim against a vessel owner on the basis that the vessel was not seaworthy. Our authorizations to issue workers’ compensation insurance from the various state departments of insurance regulating SeaBright Insurance Company allow us to write Jones Act coverage for our maritime customers. We are not required to have a certificate from the U.S. Department of Labor to write Jones Act coverage.
We also offer extensions of coverage under the OCSLA, a federal workers’ compensation act that provides workers’ compensation coverage for the death or disability of an employee resulting from any injury occurring as a result of working on an off-shore drilling platform on the Outer Continental Shelf, where required by a prospective policyholder.
As a condition of authorization effective August 25, 2005, the U.S. Department of Labor implemented new regulations requiring insurance carriers authorized to write insurance under the USL&H Act or any of its extensions to deposit security to secure compensation payment obligations. The Department of Labor determines the amount of this deposit annually by calculating the carrier’s USL&H and extension Act obligation by state and by the percentage of those obligations deemed unsecured by those states’ guaranty funds. SeaBright’s current deposit obligation is approximately $1.4 million.
Privacy Regulations
In 1999, the United States Congress enacted the Gramm-Leach-Bliley Act, which, among other things, protects consumers from the unauthorized dissemination of certain personal information. Subsequently, a majority of states have implemented additional regulations to address privacy issues. These laws and regulations apply to all financial institutions, including insurance and finance companies, and require us to maintain appropriate procedures for managing and protecting certain personal information of our customers and to fully disclose our privacy practices to our customers. We may also be exposed to future privacy laws and regulations, which could impose additional costs and impact our financial condition or results of operations. A recent National Association of Insurance Commissioners, or NAIC, initiative that impacted the insurance industry in 2001 was the adoption in 2000 of the Privacy of Consumer Financial and Health Information Model Regulation, which assisted states in promulgating regulations consistent with the Gramm-Leach-Bliley Act. In 2002, to further facilitate the implementation of the Gramm-Leach-Bliley Act, the NAIC adopted the Standards for Safeguarding Customer Information Model Regulation. Several states have now adopted similar provisions regarding the safeguarding of customer information. Our insurance subsidiary has established procedures to comply with Gramm-Leach-Bliley privacy requirements.
Federal and State Legislative and Regulatory Changes
From time to time, various regulatory and legislative changes have been proposed in the insurance industry. Among the proposals that have in the past been or are at present being considered are the possible introduction of federal regulation in addition to, or in lieu of, the current system of state regulation of insurers and proposals in various state legislatures (some of which proposals have been enacted) to conform portions of their insurance laws and regulations to various model acts adopted by the NAIC. We are unable to predict whether any of these laws and regulations will be adopted, the form in which any such laws and regulations would be adopted, or the effect, if any, these developments would have on our operations and financial condition.
On November 26, 2002, in response to the tightening of supply in certain insurance and reinsurance markets resulting from, among other things, the September 11, 2001 terrorist attacks, the Terrorism Risk Insurance Act of 2002 was enacted. In 2005, this law was extended and amended. The Terrorism Risk Act is designed to ensure the availability of insurance coverage for losses resulting from certain acts of terror in the United States of America. As extended, the law establishes a federal assistance program through the end of 2007 to help the property and casualty insurance industry cover claims related to future terrorism-related losses and requires such companies to offer coverage for certain acts of terrorism. By law, SeaBright Insurance Company may not exclude coverage for terrorism losses from its workers’ compensation policies. Although SeaBright Insurance Company is protected by federally funded terrorism reinsurance to the extent provided for in the Terrorism Risk Act, there are limitations and restrictions on this protection, including a substantial deductible that must be met, which could have an adverse effect on our financial condition or results of operations. Potential future changes to the Terrorism Risk Act, including a decision by Congress not to extend it past December 31, 2007, could also adversely affect us by causing our reinsurers to increase prices or withdraw from certain markets where terrorism coverage is required.
Collectively bargained workers’ compensation insurance programs in California were enabled by S.B. 983, the workers’ compensation reform bill passed in 1993, and greatly expanded by the passage of S.B. 228 in 2003. Among other things, this legislation amended the California Labor Code to include the specific requirements for the creation of an ADR program for the delivery of workers’ compensation benefits. The
passage of S.B. 228 made these programs available to all unionized employees, where previously they were available only to unionized employees in the construction industry.
Our workers’ compensation operations are subject to legislative and regulatory actions. In California, where we have our largest concentration of business, significant workers’ compensation legislation was enacted twice in recent years. Effective January 1, 2003, legislation became effective which provides for increases in indemnity benefits to injured workers. In September 2003 and April 2004, workers’ compensation legislation was enacted in California with the principal objective of reducing costs. The legislation contains provisions which primarily seek to reduce medical costs and does not directly impact indemnity payments to injured workers. The principal changes in the legislation that impact medical costs are as follows: 1) a reduction in the reimbursable amount for certain physician fees, outpatient surgeries, pharmaceutical products and certain durable medical equipment; 2) a limitation on the number of chiropractor or physical therapy office visits; 3) the introduction of medical utilization guidelines; 4) a requirement for second opinions on certain spinal surgeries; and 5) a repeal of the presumption of correctness afforded to the treating physician, except where the employee has pre-designated a treating physician.
On March 24, 2006, the California Workers’ Compensation Insurance Rating Bureau (the “WCIRB”), an industry-backed private organization that provides statistical analysis, submitted a filing with the California Insurance Commissioner recommending a 16.4% decrease in advisory pure premium rates on new and renewal policies effective July 1, 2006. Pure premium is that portion of an insurance premium necessary to cover the cost of paying claims, such as medical and indemnity costs and allocated and unallocated loss adjustment expenses. The filing was based on an analysis of loss experience valued as of December 31, 2005 and was made in response to continued reductions in workers’ compensation claim costs in California as a result of reform legislation enacted primarily in 2003 and 2004. On May 31, 2006, the California Insurance Commissioner recommended a 16.4% decrease in rates effective July 1, 2006. The California Insurance Commissioner’s decision is advisory only and insurance companies may choose whether or not to adopt the new rates. On May 31, 2006, after completing a study of our California loss data, we filed with the California Department of Insurance our rates for new and renewal workers’ compensation insurance policies written in California on or after July 1, 2006, reflecting an average reduction of 5.8% from prior rates, for new and renewal workers’ compensation insurance policies written in California on or after July 1, 2006. The filing was approved on June 21, 2006.
On September 14, 2006, the WCIRB amended a previous filing with the California Insurance Commissioner to recommend a 6.3% decrease in advisory pure premium rates on new and renewal policies effective on or after January 1, 2007. The filing was based on a review of loss and loss adjustment experience through June 30, 2006 and was made in response to continued reductions in California workers’ compensation claim costs. On November 2, 2006, the California Insurance Commissioner recommended a 9.5% decrease in workers’ compensation advisory pure premium rates for policies incepting on or after January 1, 2007. On November 22, 2006, we filed with the California Department of Insurance our rates for new and renewal workers’ compensation insurance policies written in California on or after January 1, 2007. The filing was approved on December 19, 2006. The new rates reflect an average reduction of 9.5% from prior rates and are in response to emerging favorable trends in loss costs resulting from reform legislation. If any of our competitors adopt premium rate reductions that are greater than ours, we may be unable to compete effectively and our business, financial condition and results of operations could be materially adversely affected.
The National Association of Insurance Commissioners
The NAIC is a group formed by state insurance commissioners to discuss issues and formulate policy with respect to regulation, reporting and accounting of insurance companies. Although the NAIC has no legislative authority and insurance companies are at all times subject to the laws of their respective domiciliary states and, to a lesser extent, other states in which they conduct business, the NAIC is influential in determining the form in which such laws are enacted. Model Insurance Laws, Regulations and Guidelines (the “Model Laws”) have been promulgated by the NAIC as a minimum standard by which state regulatory systems and regulations are measured. Adoption of state laws which provide for substantially similar regulations to those described in certain of the Model Laws is a requirement for accreditation by the NAIC.
The NAIC provides authoritative guidance to insurance regulators on current statutory accounting issues by promulgating and updating a codified set of statutory accounting practices in its Accounting Practices and Procedures Manual. The Illinois Division of Insurance and the California Department of Insurance have adopted these codified statutory accounting practices.
Illinois and California have also adopted laws substantially similar to the NAIC’s “risk based capital” (“RBC”) laws, which require insurers to maintain minimum levels of capital based on their investments and operations. These RBC requirements provide a standard by which regulators can assess the adequacy of an insurance company’s capital and surplus relative to its operations. Among other requirements, an insurance company must maintain capital and surplus of at least 200% of the RBC computed by the NAIC’s RBC model (known as the “Authorized Control Level” of RBC). At December 31, 2006, the capital and surplus of SeaBright Insurance Company exceeded 200% of the Authorized Control Level of RBC.
The NAIC’s Insurance Regulatory Information System (“IRIS”) key financial ratios, developed to assist insurance departments in overseeing the financial condition of insurance companies, are reviewed by experienced financial examiners of the NAIC and state insurance departments to select those companies that merit highest priority in the allocation of the regulators’ resources. IRIS identifies twelve industry ratios and specifies “usual values” for each ratio. Departure from the usual values on four or more of the ratios can lead to inquiries from individual state insurance commissioners as to certain aspects of an insurer’s business.
The 2006 IRIS results for SeaBright Insurance Company showed one result outside the “usual” range for such ratios, as such ranges are determined by the NAIC. This result was attributable to one main factor. Upon completion of the follow-on public offering of our common stock in February of 2006, we contributed approximately $50.0 million to SeaBright Insurance Company’s surplus. The IRIS ratio that measures a company’s “Gross Change in Policyholders’ Surplus” is not considered “usual” if a company’s surplus is reduced by more than 10% or increased by more than 50% in any given year. Following the contribution to SeaBright Insurance Company’s surplus, we expected the “Gross Change in Policyholders’ Surplus” IRIS ratio to increase by more than 50%, and therefore fall outside of the “usual range.” As of December 31, 2005, SeaBright Insurance Company had a statutory policyholders’ surplus of $144.7 million. As of December 31, 2006, the statutory policyholders’ surplus was $222.3 million. This represents an increase of 53.6% over the statutory policyholders’ surplus from 2006.
Dividend Limitations
SeaBright Insurance Company’s ability to pay dividends is subject to restrictions contained in the insurance laws and related regulations of Illinois and California. The insurance holding company laws in these states require that ordinary dividends be reported to the Illinois Division of Insurance and the California Department of Insurance prior to payment of the dividend and that extraordinary dividends be submitted for prior approval. An extraordinary dividend is generally defined as a dividend that, together with all other dividends made within the past 12 months, exceeds the greater of 10% of its statutory policyholders’ surplus as of the preceding year end or the net income of the company for the preceding year. Statutory policyholders’ surplus, as determined under statutory accounting principles is the amount remaining after all liabilities, including loss and loss adjustment expenses, are subtracted from all admitted assets. Admitted assets are assets of an insurer prescribed or permitted by a state insurance regulator to be recognized on the statutory balance sheet. Insurance regulators have broad powers to prevent the reduction of statutory surplus to inadequate levels, and there is no assurance that extraordinary dividend payments will be permitted.
Statutory Accounting Practices
Statutory accounting practices (“SAP”) are a basis of accounting developed to assist insurance regulators in monitoring and regulating the solvency of insurance companies. SAP is primarily concerned with measuring an insurer’s surplus available for policyholders. Accordingly, statutory accounting focuses on valuing assets and liabilities of insurers at financial reporting dates in accordance with appropriate insurance law and regulatory provisions applicable in each insurer’s domiciliary state.
U.S. generally accepted accounting principles (“GAAP”) are concerned with a company’s solvency, but such principles are also concerned with other financial measurements, such as income and cash flows. Accordingly, GAAP gives more consideration to appropriate matching of revenue and expenses and accounting for management’s stewardship of assets than does SAP. As a direct result, different assets and liabilities and different amounts of assets and liabilities will be reflected in financial statements prepared in accordance with GAAP as opposed to SAP.
Statutory accounting practices established by the NAIC and adopted, in part, by the Illinois and California regulators, determine, among other things, the amount of statutory surplus and statutory net income or loss of SeaBright Insurance Company and thus determine, in part, the amount of funds it has available to pay dividends to us.
Guaranty Fund Assessments
In Illinois, California and in most of the states where SeaBright Insurance Company is licensed to transact business, there is a requirement that property and casualty insurers doing business within each such state participate in a guaranty association, which is organized to pay contractual benefits owed pursuant to insurance policies issued by impaired, insolvent or failed insurers. These associations levy assessments, up to prescribed limits, on all member insurers in a particular state on the basis of the proportionate share of the premium written by member insurers in the lines of business in which the impaired, insolvent or failed insurer is engaged. Some states permit member insurers to recover assessments paid through full or partial premium tax offsets or policy surcharges.
Property and casualty insurance company insolvencies or failures may result in additional security fund assessments to SeaBright Insurance Company at some future date. At this time we are unable to determine the impact, if any, such assessments may have on the financial position or results of operations of SeaBright Insurance Company. We have established liabilities for guaranty fund assessments with respect to insurers that are currently subject to insolvency proceedings.
PointSure
The brokerage and third party administrator activities of PointSure are subject to licensing requirements and regulation under the laws of each of the jurisdictions in which it operates. PointSure is authorized to act as an insurance broker under firm or officer licenses in 49 states and the District of Columbia. PointSure’s business depends on the validity of, and continued good standing under, the licenses and approvals pursuant to which it operates, as well as compliance with pertinent regulations. PointSure therefore devotes significant effort toward maintaining its licenses to ensure compliance with a diverse and complex regulatory structure.
Licensing laws and regulations vary from state to state. In all states, the applicable licensing laws and regulations are subject to amendment or interpretation by regulatory authorities. Generally such authorities are vested with relatively broad and general discretion as to the granting, renewing and revoking of licenses and approvals. Licenses may be denied or revoked for various reasons, including the violation of such regulations, conviction of crimes and the like. Possible sanctions which may be imposed include the suspension of individual employees, limitations on engaging in a particular business for specified periods of time, revocation of licenses, censures, redress to clients and fines. In some instances, PointSure follows practices based on interpretations of laws and regulations generally followed by the industry, which may prove to be different from the interpretations of regulatory authorities.
Employees
As of December 31, 2006, we had 178 full-time equivalent employees. We have employment agreements with some of our executive officers, which are described in our proxy statement for the 2007 annual meeting of stockholders and incorporated by reference into Part III, Item 11 of this annual report. We believe that our employee relations are good.
Corporate Website
Through our Internet website at www.sbic.com, we provide free access to our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission (the “SEC”). A copy of the materials will be mailed to you free of charge upon request to SeaBright Insurance Holdings, Inc., Investor Relations, 2101 4th Avenue, Suite 1600, Seattle, WA 98121. The following corporate governance materials are also available on our website.
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Audit Committee, Compensation Committee, and Nominating and Corporate Governance Committee charters;
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Code of Ethics for Senior Financial Employees;
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Conflict of Interest & Code of Conduct Policy; and
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Insider Trading Policy.
If we waive or substantially change any material provision of our Code of Ethics for Senior Financial Employees, we will disclose that fact on our website within four business days of the waiver or change.
Note on Forward-Looking Statements
Some of the statements in this Item 1, some of the statements in Item 1A, some of the statements under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operation” in Part II, Item 7 of this annual report and statements elsewhere in this annual report, may include forward-looking statements that reflect our current views with respect to future events and financial performance. These statements include forward-looking statements both with respect to us specifically and the insurance sector in general. Statements that include the words “expect,” “intend,” “plan,” “believe,” “project,” “estimate,” “may,” “should,” “anticipate,” “will” and similar statements of a future or forward-looking nature identify forward-looking statements for purposes of the federal securities laws or otherwise.
All forward-looking statements address matters that involve risks and uncertainties. Accordingly, there are or will be important factors that could cause our actual results to differ materially from those indicated in these statements. We believe that these factors include but are not limited to the following:
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ineffectiveness or obsolescence of our business strategy due to changes in current or future market conditions;
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increased competition on the basis of pricing, capacity, coverage terms or other factors;
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greater frequency or severity of claims and loss activity, including as a result of natural or man-made catastrophic events, than our underwriting, reserving or investment practices anticipate based on historical experience or industry data;
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the effects of acts of terrorism or war;
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developments in financial and capital markets that adversely affect the performance of our investments;
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changes in regulations or laws applicable to us, our subsidiaries, brokers or customers;
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our dependency on a concentrated geographic market;
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changes in the availability, cost or quality of reinsurance and failure of our reinsurers to pay claims timely or at all;
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decreased demand for our insurance products;
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loss of the services of any of our executive officers or other key personnel;
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the effects of mergers, acquisitions and divestitures that we may undertake;
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changes in rating agency policies or practices;
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changes in legal theories of liability under our insurance policies;
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changes in accounting policies or practices; and
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changes in general economic conditions, including inflation and other factors.
The foregoing factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are included in this annual report. We undertake no obligation to publicly update or review any forward-looking statement, whether as a result of new information, future developments or otherwise.
If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may vary materially from what we project. Any forward-looking statements you read in this annual report reflect our views as of the date of this annual report with respect to future events and are subject to these and other risks, uncertainties and assumptions relating to our operations, results of operations, growth strategy and liquidity. Before making an investment decision, you should carefully consider all of the factors identified in this annual report that could cause actual results to differ.
Item 1A.
Risk Factors.
You should carefully consider the risks described below, together with all of the other information included in this annual report. The risks and uncertainties described below are not the only ones facing our company. If any of the following risks actually occurs, our business, financial condition or operating results could be harmed. Any of the risks described below could result in a significant or material adverse effect on our financial condition or results of operations, and a corresponding decline in the market price of our common stock. You could lose all or part of your investment. The risks discussed below also include forward-looking statements and our actual results may differ substantially from those discussed in those forward-looking statements. Please refer to the discussion under the heading “Note on Forward-Looking Statements” in Item 1.
Risks Related to Our Business
Our loss reserves are based on estimates and may be inadequate to cover our actual losses.
If we fail to accurately assess the risks associated with the businesses that we insure, our loss reserves may be inadequate to cover our actual losses and we may fail to establish appropriate premium rates. We establish loss reserves in our financial statements that represent an estimate of amounts needed to pay and administer claims with respect to insured events that have occurred, including events that have not yet been reported to us. Loss reserves are estimates and are inherently uncertain; they do not and cannot represent an exact measure of liability. Accordingly, our loss reserves may prove to be inadequate to cover our actual losses. Any changes in these estimates are reflected in our results of operations during the period in which the changes are made, with increases in our loss reserves resulting in a charge to our earnings.
Our loss reserve estimates are based on estimates of the ultimate cost of individual claims and on actuarial estimation techniques. Several factors contribute to the uncertainty in establishing these estimates. Judgment is required in actuarial estimation to ascertain the relevance of historical payment and claim settlement patterns under current facts and circumstances. Key assumptions in the estimation process are the average cost of claims over time, which we refer to as severity trends, including the increasing level of medical, legal and rehabilitation costs, and costs associated with fraud or other abuses of the medical claim process. If there are unfavorable changes in severity trends, we may need to increase our loss reserves, as described above.
Our geographic concentration ties our performance to the business, economic and regulatory conditions in California, Illinois and Alaska. Any single catastrophe or other condition affecting losses in these states could adversely affect our results of operations.
Our business is concentrated in California (approximately 52.3% of direct premiums written for the year ended December 31, 2006), Alaska (approximately 10.3% of direct premiums written for the same period) and Illinois (approximately 9.2% of direct premiums written for the same period). Accordingly, unfavorable business, economic or regulatory conditions in those states could negatively impact our business. For example, California, Illinois, and Alaska are states that are susceptible to severe natural perils, such as tsunamis, earthquakes, tornados and hurricanes, along with the possibility of terrorist acts. Accordingly, we could suffer losses as a result of catastrophic events in those states. Although geographic concentration has not adversely affected our business in the past, we may in the future be exposed to economic and regulatory risks or risks from natural perils that are greater than the risks faced by insurance companies that conduct business over a greater geographic area. This concentration of our business could have a material adverse effect on our financial condition or results of operations.
If we are unable to obtain or collect on our reinsurance protection, our business, financial condition and results of operations could be materially adversely affected.
We buy reinsurance coverage to protect us from the impact of large losses. Reinsurance is an arrangement in which an insurance company, called the ceding company, transfers insurance risk by sharing premiums with another insurance company, called the reinsurer. Conversely, the reinsurer receives or assumes reinsurance from the ceding company. In the ordinary course of our business we participate in a workers’ compensation and employers’ liability excess of loss reinsurance treaty program covering all of the business that we write or renew pursuant to which our reinsurers are liable for varying percentages of the ultimate net losses in excess of $1.0 million for the business we write, up to a $75.0 million limit, subject to certain exclusions and limitations. The treaty program provides coverage in several layers. See the discussion under the heading “Reinsurance” in Item 1. The availability, amount and cost of reinsurance depend on market conditions and may vary significantly. As a result of catastrophic events, such as the events of September 11, 2001, we may incur significantly higher reinsurance costs, more restrictive terms and conditions, and decreased availability. For example, each layer of our reinsurance treaty program contains an aggregate limit for all claims under that layer over which our reinsurers will not be liable (e.g., $8.0 million under the first layer, $12.0 million under the second layer and $15.0 million under the third layer). In addition, each layer of our reinsurance treaty program covers acts of terrorism only up to a modest limit (e.g., $1.0 million per occurrence under the first layer, $3.0 million per occurrence under the second layer and $5.0 million under the third layer). Because of these sub-limits and terrorism exclusions included in our policies, which are common in the wake of the events of September 11, 2001, we have significantly greater exposure to losses resulting from acts of terrorism. The incurrence of higher reinsurance costs and more restrictive terms could materially adversely affect our business, financial condition and results of operations.
The agreements for our current workers’ compensation excess of loss reinsurance treaty program expire on October 1, 2007. Although we currently expect to renew the program upon its expiration, any decrease in the amount of our reinsurance at the time of renewal, whether caused by the existence of more restrictive terms and conditions or decreased availability, will also increase our risk of loss and, as a result, could materially adversely affect our business, financial condition and results of operations. We have not experienced difficulty in qualifying for or obtaining sufficient reinsurance to appropriately cover our risks in the past. We currently have 12 reinsurers participating in our excess of loss reinsurance treaty program, and believe that this is a sufficient number of reinsurers to provide us with reinsurance in the volume that we require. However, it is possible that one or more of our current reinsurers could cancel participation, or we could find it necessary to cancel the participation of one of our reinsurers, in our excess of loss reinsurance treaty program. In either of those events, if our reinsurance broker is unable to spread the cancelled or terminated reinsurance among the remaining reinsurers in the program, we estimate that it could take approximately one to three weeks to identify and negotiate appropriate documentation with a replacement reinsurer. During this time, we
would be exposed to an increased risk of loss, the extent of which would depend on the volume of cancelled reinsurance.
In addition, we are subject to credit risk with respect to our reinsurers. Reinsurance protection that we receive does not discharge our direct obligations under the policies we write. We remain liable to our policyholders, even if we are unable to make recoveries to which we believe we are entitled under our reinsurance contracts. Losses may not be recovered from our reinsurers until claims are paid, and, in the case of long-term workers’ compensation cases, the creditworthiness of our reinsurers may change before we can recover amounts to which we are entitled. Although we have not experienced problems in the past resulting from the failure of a reinsurer to pay our claims in a timely manner, if we experience this problem in the future, our costs would increase and our revenues would decline. As of December 31, 2006, we had $13.7 million of amounts recoverable from our reinsurers, excluding the receivable on our adverse development cover, that we would be obligated to pay if our reinsurers failed to pay us.
The insurance business is subject to extensive regulation and legislative changes, which impact the manner in which we operate our business.
Our insurance business is subject to extensive regulation by the applicable state agencies in the jurisdictions in which we operate, perhaps most significantly by the Illinois Division of Insurance and the California Department of Insurance. These state agencies have broad regulatory powers designed to protect policyholders, not stockholders or other investors. These powers include, among other things, the ability to:
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place limitations on our ability to transact business with our affiliates;
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regulate mergers, acquisitions and divestitures involving our insurance company subsidiary;
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require SeaBright Insurance Company and PointSure to comply with various licensing requirements and approvals that affect our ability to do business;
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approve or reject our policy coverage and endorsements;
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place limitations on our investments and dividends;
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set standards of solvency to be met and maintained;
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regulate rates pertaining to our business;
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require assessments for the provision of funds necessary for the settlement of covered claims under certain policies provided by impaired, insolvent or failed insurance companies;
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require us to comply with medical privacy laws; and
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prescribe the form and content of, and examine, our statutory financial statements.
In October 2006, the Illinois Division of Insurance began a routine comprehensive examination of our 2005 statutory annual statement.
Our ability to transact business with our affiliates and to enter into mergers, acquisitions and divestitures involving our insurance company subsidiary is limited by the requirements of the insurance holding company laws of Illinois and California. To comply with these laws, we are required to file notices with the Illinois Division of Insurance and the California Department of Insurance to seek their respective approvals at least 30 days before engaging in any intercompany transactions, such as sales, purchases, exchanges of assets, loans, extensions of credit, cost sharing arrangements and extraordinary dividends or other distributions to stockholders. Under these holding company laws, any change of control transaction also requires prior notification and approval. Because these governmental agencies may not take action or give approval within the 30 day period, these notification and approval requirements may subject us to business delays and additional business expense. If we fail to give these notifications, we may be subject to significant fines and penalties and damaged working relations with these governmental agencies.
In addition, workers’ compensation insurance is statutorily provided for in all of the states in which we do business. State laws and regulations provide for the form and content of policy coverage and the rights and benefits that are available to injured workers, their representatives and medical providers. For example, in California, on January 1, 2003, workers’ compensation legislation became effective that provided for increases in the benefits payable to injured workers. Also, in California, workers’ compensation legislation intended to reduce certain costs was enacted in September 2003 and April 2004. Among other things, this legislation established an independent medical review process for resolving medical disputes, tightened standards for determining impairment ratings by applying specific medical treatment guidelines, capped temporary total disability payments to 104 weeks from first payment and enabled injured workers to access immediate medical care up to $10,000 but required them to get medical care through a network of doctors chosen by the employer. The implementation of these reforms affects the manner in which we coordinate medical care costs with employers and the manner in which we oversee treatment plans. However, the reforms are subject to continuing opposition in the California legislature, in the courts and by ballot initiatives, any of which could overturn or substantially amend the reforms and regulatory rules applicable to the legislation. We cannot predict the ultimate impact of the reforms.
Our business is also affected by federal laws, including the USL&H Act, which is administered by the Department of Labor, and the Merchant Marine Act of 1920, or Jones Act. The USL&H Act contains various provisions affecting our business, including the nature of the liability of employers of longshoremen, the rate of compensation to an injured longshoreman, the selection of physicians, compensation for disability and death and the filing of claims.
In addition, we are impacted by the Terrorism Risk Act and by the Gramm-Leach-Bliley Act of 2002 related to disclosure of personal information. The Terrorism Risk Act requires that commercial property and casualty insurance companies offer coverage for certain acts of terrorism and has established a federal assistance program through the end of 2007 to help insurers cover claims arising out of such acts. The Terrorism Risk Act only covers certified acts of terrorism, and the U.S. Secretary of the Treasury must declare the act to be a “certified act of terrorism” for it to be covered under this federal program. In addition, no federal compensation will be paid under the Terrorism Risk Act unless aggregate insured losses from the act for the entire insurance industry exceed certain threshold amounts ($5.0 million for terrorism losses occurring prior to April 1, 2006, $50.0 million for terrorism losses occurring from April 1, 2006 to December 31, 2006, and $100.0 million for terrorism losses occurring in 2007). Under this program, the federal government covers 90% of the losses from covered certified acts of terrorism (85% for terrorism losses occurring in 2007) on commercial risks in the United States only, in excess of the applicable deductible amount. This deductible is calculated based on a percentage of an affiliated insurance group’s prior year direct earned premiums on commercial lines policies (except for certain excluded lines such as commercial auto) covering risks in the United States. This deductible amount is 17.5% of such premiums for losses occurring in 2006 and 20.0% of such premiums for losses occurring in 2007. The Terrorism Risk Act is scheduled to expire on December 31, 2007 and may not be renewed, or if it is renewed, it may provide reduced protection against the financial impact of acts of terrorism by, among other things, increasing the aggregate loss event trigger and the amount of statutory deductible insurers would be required to pay.
This extensive regulation of our business may affect the cost or demand for our products and may limit our ability to obtain rate increases or to take other actions that we might desire to increase our profitability. In addition, we may be unable to maintain all required approvals or comply fully with the wide variety of applicable laws and regulations, which are continually undergoing revision, or the relevant authority’s interpretation of such laws and regulations.
A downgrade in the A.M. Best rating of our insurance subsidiary could reduce the amount of business we are able to write.
Rating agencies rate insurance companies based on each company’s ability to pay claims. Our insurance company subsidiary currently has a rating of “A−” (Excellent) from A.M. Best, which is the rating agency that we believe has the most influence on our business. The ratings of A.M. Best are subject to periodic review using, among other things, proprietary capital adequacy models, and are subject to revision or withdrawal at
any time. Insurance ratings are directed toward the concerns of policyholders and insurance agents and are not intended for the protection of investors or as a recommendation to buy, hold or sell any of our securities. Our competitive position relative to other companies is determined in part by our A.M. Best rating. We believe that our business is particularly sensitive to our A.M. Best rating because we focus on larger customers which tend to give substantial weight to the A.M. Best rating of their insurers. We expect that any reduction in our A.M. Best rating below “A−” would cause a reduction in the number of policies we write and could have a material adverse effect on our results of operations and our financial position.
The effects of emerging claim and coverage issues on our business are uncertain.
As industry practices and legal, judicial, social and other environmental conditions change, unexpected and unintended issues related to claims and coverage may emerge. These issues may adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the number or size of claims. In some instances, these changes may not become apparent until some time after we have issued insurance contracts that are affected by the changes. As a result, the full extent of liability under our insurance contracts may not be known for many years after a contract is issued. For example, the number or nature of existing occupational diseases may expand beyond our expectation. In addition, medical claims costs associated with permanent and partial disabilities may inflate more rapidly or higher than we currently expect. Expansions of this nature may expose us to more claims than we anticipated when we wrote the underlying policy.
Intense competition could adversely affect our ability to sell policies at rates we deem adequate.
In most of the states in which we operate, we face significant competition which, at times, is intense. If we are unable to compete effectively, our business and financial condition could be materially adversely affected. Competition in our businesses is based on many factors, including premiums charged, services provided, financial strength ratings assigned by independent rating agencies, speed of claims payments, reputation, perceived financial strength and general experience. We compete with regional and national insurance companies and state-sponsored insurance funds, as well as potential insureds that have decided to self-insure. Our principal competitors include AIG, Alaska National Insurance Company, Signal Mutual Indemnity Association Ltd., Zurich and the State Compensation Insurance Fund of California. Many of our competitors have substantially greater financial and marketing resources than we do, and some of our competitors, including the State Compensation Insurance Fund of California, benefit financially by not being subject to federal income tax. Intense competitive pressure on prices can result from the actions of even a single large competitor, such as the State Compensation Insurance Fund of California or AIG.
In addition, our competitive advantage may be limited due to the small number of insurance products that we offer. Some of our competitors, such as AIG, have additional competitive leverage because of the wide array of insurance products that they offer. For example, it may be more convenient for a potential customer to purchase numerous different types of insurance products from one insurance carrier. We do not offer a wide array of insurance products due to our targeted market niches, and we may lose potential customers to our larger, more diverse competitors as a result.
On March 24, 2006, the California Workers’ Compensation Insurance Rating Bureau (the “WCIRB”), an industry-backed private organization that provides statistical analysis, submitted a filing with the California Insurance Commissioner recommending a 16.4% decrease in advisory pure premium rates on new and renewal policies effective July 1, 2006. Pure premium is that portion of an insurance premium necessary to cover the cost of paying claims, such as medical and indemnity costs and allocated and unallocated loss adjustment expenses. The filing was based on an analysis of loss experience valued as of December 31, 2005 and was made in response to continued reductions in workers’ compensation claim costs in California as a result of reform legislation enacted primarily in 2003 and 2004. On May 31, 2006, the California Insurance Commissioner recommended a 16.4% decrease in rates effective July 1, 2006. The California Insurance Commissioner’s decision is advisory only and insurance companies may choose whether or not to adopt the new rates. On May 31, 2006, after completing a study of our California loss data, we filed with the California Department of Insurance our rates for new and renewal workers’ compensation insurance policies written in California on or
after July 1, 2006, reflecting an average reduction of 5.8% from prior rates, for new and renewal workers’ compensation insurance policies written in California on or after July 1, 2006. The filing was approved on June 21, 2006.
On September 14, 2006, the WCIRB amended a previous filing with the California Insurance Commissioner to recommend a 6.3% decrease in advisory pure premium rates on new and renewal policies effective on or after January 1, 2007. The filing was based on a review of loss and loss adjustment experience through June 30, 2006 and was made in response to continued reductions in California workers’ compensation claim costs. On November 2, 2006, the California Insurance Commissioner recommended a 9.5% decrease in workers’ compensation advisory pure premium rates for policies incepting on or after January 1, 2007. On November 22, 2006, we filed with the California Department of Insurance our rates for new and renewal workers’ compensation insurance policies written in California on or after January 1, 2007. The filing was approved on December 19, 2006. These current new rates reflect an average reduction of 9.5% from prior rates and are in response to emerging favorable trends in loss costs resulting from reform legislation. If any of our competitors adopt premium rate reductions that are greater than ours, we may be unable to compete effectively and our business, financial condition and results of operations could be materially adversely affected.
Rate reductions have also been proposed in other states in which we operate. At this time, we are unable to predict the impact that the proposed rate reductions, if approved and adopted by us, might have on our future financial position and results of operations.
If we are unable to realize our investment objectives, our financial condition may be adversely affected.
Investment income is an important component of our revenues and net income. The ability to achieve our investment objectives is affected by factors that are beyond our control. For example, United States participation in hostilities with other countries and large-scale acts of terrorism may adversely affect the economy generally, and our investment income could decrease. Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic and international economic and political conditions. These and other factors also affect the capital markets, and, consequently, the value of the securities we own. The outlook for our investment income is dependent on the future direction of interest rates and the amount of cash flows from operations that are available for investment. The fair values of fixed maturity investments that are “available-for-sale” fluctuate with changes in interest rates and cause fluctuations in our stockholders’ equity. Any significant decline in our investment income as a result of rising interest rates or general market conditions would have an adverse effect on our net income and, as a result, on our stockholders’ equity and our policyholders’ surplus.
We could be adversely affected by the loss of one or more principal employees or by an inability to attract and retain staff.
Our success will depend in substantial part upon our ability to attract and retain qualified executive officers, experienced underwriting talent and other skilled employees who are knowledgeable about our business. We rely substantially upon the services of our senior management team and key employees, consisting of John G. Pasqualetto, Chairman, President and Chief Executive Officer; Richard J. Gergasko, Executive Vice President - Operations; Joseph S. De Vita, Senior Vice President, Chief Financial Officer and Assistant Secretary; D. Drue Wax - Senior Vice President, General Counsel and Corporate Secretary; Richard W. Seelinger, Senior Vice President - Policyholder Services; Marc B. Miller, M.D., Senior Vice President and Chief Medical Officer; Jeffrey C. Wanamaker, Senior Vice President - Underwriting; James L. Borland, III, Vice President and Chief Information Officer; M. Philip Romney, Vice President - Finance, Principal Accounting Officer and Assistant Secretary and Chris A. Engstrom, President - PointSure. Although we are not aware of any planned departures or retirements, if we were to lose the services of members of our management team, our business could be adversely affected. Many of our principal employees possess skills and extensive experience relating to our market niches. Were we to lose any of these employees, it may be challenging for us to attract a replacement employee with comparable skills and experience in our market niches. We have employment agreements with some of our executive officers, which are described in our
proxy statement for the 2007 annual meeting of stockholders and incorporated by reference into Part III, Item 11 of this annual report. We do not currently maintain key man life insurance policies with respect to any member of our senior management team or other employees.
We may require additional capital in the future, which may not be available or only available on unfavorable terms.
Our future capital requirements depend on many factors, including our ability to write new business successfully and to establish premium rates and loss reserves at levels sufficient to cover losses. To the extent that the funds generated by the initial public offering of 8,625,000 shares of our common stock in January 2005 and the follow-on offering of 3,910,000 shares of common stock in February 2006 are insufficient to support future operating requirements and/or cover claim losses, we may need to raise additional funds through financings or curtail our growth. We believe that the net proceeds to us from the above offerings will satisfy our capital requirements for the foreseeable future. However, because the timing and amount of our future needs for capital will depend on our growth and profitability, we cannot provide any assurance in that regard. If we had to raise additional capital, equity or debt financing may not be available at all or may be available only on terms that are not favorable to us. In the case of equity financings, dilution to our stockholders could result, and in any case such securities may have rights, preferences and privileges that are senior to those of the shares currently outstanding. If we cannot obtain adequate capital on favorable terms or at all, we may be unable to support future growth or operating requirements and, accordingly, our business, financial condition or results of operations could be materially adversely affected.
Our status as an insurance holding company with no direct operations could adversely affect our ability to pay dividends in the future.
We are a holding company that transacts our business through our operating subsidiaries, SeaBright Insurance Company and PointSure. Our primary assets are the stock of these operating subsidiaries. Our ability to pay expenses and dividends depends, in the long run, upon the surplus and earnings of our subsidiaries and the ability of our subsidiaries to pay dividends to us. Payment of dividends by SeaBright Insurance Company is restricted by state insurance laws, including laws establishing minimum solvency and liquidity thresholds, and could be subject to contractual restrictions in the future, including those imposed by indebtedness we may incur in the future. SeaBright Insurance Company is required to report any ordinary dividends to the Illinois Division of Insurance and the California Department of Insurance prior to the payment of the dividend. In addition, SeaBright Insurance Company is not authorized to pay any extraordinary dividends to us under Illinois or California insurance laws without prior regulatory approval from the Illinois Division of Insurance or the California Department of Insurance. See the discussion under the heading “Regulation - Dividend Limitations” in Item 1. As a result, at times, we may not be able to receive dividends from SeaBright Insurance Company and we may not receive dividends in amounts necessary to pay dividends on our capital stock. In addition, the payment of dividends by us is within the discretion of our Board of Directors and will depend on numerous factors, including our financial condition, our capital requirements and other factors that our Board of Directors considers relevant. Currently, we do not intend to pay dividends on our capital stock.
We rely on independent insurance brokers to distribute our products.
Our business depends in part on the efforts of independent insurance brokers to market our insurance programs successfully and produce business for us and on our ability to offer insurance programs and services that meet the requirements of the clients and customers of these brokers. The majority of the business in our workers’ compensation operations is produced by a group of licensed insurance brokers that totaled approximately 150 at December 31, 2006. Brokers are not obligated to promote our insurance programs and may sell competitors’ insurance programs. Several of our competitors, including AIG and Zurich, offer a broader array of insurance programs than we do. Accordingly, our brokers may find it easier to promote the broader range of programs of our competitors than to promote our niche selection of insurance products. If our brokers fail or choose not to market our insurance programs successfully or to produce business for us, our growth may be limited and our financial condition and results of operations may be negatively affected.
We have a limited operating history as a stand-alone entity and may experience difficulty in transitioning to an independent public company.
We commenced operations in October 2003 after acquiring KEIC, the renewal rights from, and substantially all of the operating assets, systems and employees of, the Eagle Entities and PointSure. See the discussion under the heading “Our History” in Item 1. Although our management team is primarily the same management team that operated the Eagle Entities and PointSure for approximately five years prior to the Acquisition, we have a limited operating history as a stand-alone entity and do not have the same resources available to us that the Eagle Entities and PointSure had prior to the Acquisition. Accordingly, our future results of operations or financial condition as a stand-alone entity may vary from the results realized by the Eagle Entities and PointSure prior to the Acquisition. An investor in our common stock should consider that our history as a stand-alone entity is relatively short and that there is a limited basis for evaluating our performance.
In addition, upon completion of our initial public offering in January 2005, we became a publicly-traded company and are now responsible for complying with the various federal and state legal and regulatory requirements applicable to public companies. We have incurred and will incur increased costs as a result of being a public company, particularly in light of recently enacted and proposed changes in laws, regulations and listing requirements, including those related to the Sarbanes-Oxley Act of 2002. Our business and financial condition may be adversely affected if we are unable to effectively manage these increased costs.
Assessments and other surcharges for guaranty funds and second injury funds and other mandatory pooling arrangements may reduce our profitability.
Virtually all states require insurers licensed to do business in their state to bear a portion of the unfunded obligations of impaired or insolvent insurance companies. These obligations are funded by assessments that are expected to continue in the future as a result of insolvencies. Assessments are levied by guaranty associations within the state, up to prescribed limits, on all member insurers in the state on the basis of the proportionate share of the premium written by member insurers in the lines of business in which the impaired, insolvent or failed insurer is engaged. See the discussion under the heading “Regulation” in Item 1. Accordingly, the assessments levied on us may increase as we increase our premiums written. Further, Washington state legislation enacted on April 20, 2005 created a separate account within the Guaranty Fund for USL&H Act claims and authorized prefunding of potential insolvencies in order to establish a cash balance. Many states also have laws that established second injury funds to provide compensation to injured employees for aggravation of a prior condition or injury, which are funded by either assessments based on paid losses or premium surcharge mechanisms. For example, Alaska requires insurers to contribute to its second injury fund annually an amount equal to the compensation the injured employee is owed multiplied by a contribution rate based on the fund’s reserve rate. In addition, as a condition of the ability to conduct business in some states, including California, insurance companies are required to participate in mandatory workers’ compensation shared market mechanisms or pooling arrangements, which provide workers’ compensation insurance coverage from private insurers. Although we price our products to account for the obligations that we may have under these pooling arrangements, we may not be successful in estimating our liability for these obligations. Accordingly, our prices may not fully account for our liabilities under pooling arrangements, which may cause a decrease in our profits. As we write policies in new states that have pooling arrangements, we will be required to participate in additional pooling arrangements. Further, the insolvency of other insurers in these pooling arrangements would likely increase the liability for other members remaining in the pool. The effect of these assessments and mandatory shared market mechanisms or changes in them could reduce our profitability in any given period or limit our ability to grow our business.
In the event LMC is placed into receivership, we could lose our rights to fee income and protective arrangements that were established in connection with the Acquisition, our reputation and credibility could be adversely affected and we could be subject to claims under applicable voidable preference and fraudulent transfer laws.
The assets that SeaBright acquired in the Acquisition were acquired from LMC and certain of its affiliates. LMC and its insurance company affiliates are currently operating under a voluntary “run off” plan approved by the Illinois Division of Insurance. “Run off” is the professional management of an insurance company’s discontinued, distressed or non-renewed lines of insurance and associated liabilities outside of a judicial proceeding. Under the run off plan, LMC has instituted aggressive expense control measures in order to reduce its future loss exposure and allow it to meet its obligations to current policyholders. According to LMC’s statutory financial statements as of and for the year ended December 31, 2006, LMC had a statutory surplus of $173.6 million (unaudited), an increase of approximately $5.3 million from its surplus of $168.3 million (audited) as of December 31, 2005. In connection with the Acquisition, we established various arrangements with LMC and certain of its affiliates, including (1) servicing arrangements entitling us to fee income for providing claims administration services for Eagle and (2) other protective arrangements designed to minimize our exposure to any past business underwritten by KEIC, the shell entity that we acquired from LMC for its insurance licenses, and any adverse developments in KEIC’s loss reserves as they existed at the date of the Acquisition. See the discussion under the heading “Our History” in Item 1. In the event LMC is placed into receivership, our business could be adversely affected in the following ways:
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A receiver could seek to reject or terminate one or more of the services agreements that were established in connection with the Acquisition between us and LMC or its affiliates, including Eagle. In that event, we could lose the revenue we currently receive under these services agreements.
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As discussed under “Our History” in Item 1, to minimize our exposure to any past business underwritten by KEIC, we entered into an arrangement with LMC at the time of the Acquisition requiring LMC to indemnify us in the event of adverse development of the loss reserves in KEIC’s balance sheet as they existed on the date of closing of the Acquisition. We refer to this arrangement as the adverse development cover. To support LMC’s obligations under the adverse development cover, LMC funded a trust account at the time of the Acquisition. The minimum amount that must be maintained in the trust account is equal to the greater of (a) $1.6 million or (b) 102% of the then existing quarterly estimate of LMC’s total obligations under the adverse development cover. We refer to this trust account as the collateralized reinsurance trust because the funds on deposit in the trust account serve as collateral for LMC’s potential future obligations to us under the adverse development cover. At December 31, 2006, the liability of LMC under the adverse development cover was approximately $2.8 million. LMC initially funded the trust account with $1.6 million to support its obligations under the adverse development cover. In September 2004, we and LMC retained an independent actuary to determine the appropriate amount of loss reserves that are subject to the adverse development cover as of September 30, 2004. In accordance with the terms of the protective arrangements that we have established with LMC, on December 23, 2004, LMC deposited into the collateralized reinsurance trust an additional $3.2 million, resulting in a total balance in the trust account of $4.8 million. In February 2007, LMC submitted a request to withdraw approximately $1.8 million of excess funds on deposit in the trust account. After due evaluation, we complied with LMC’s request, resulting in a balance in the trust account of approximately $3.4 million immediately following the withdrawal. If LMC is placed in receivership and the amount held in the collateralized reinsurance trust is inadequate to satisfy the obligations of LMC to us under the adverse development cover, it is unlikely that we would recover any future amounts owed by LMC to us under the adverse development cover in excess of the amounts currently held in trust because the director of the Illinois Division of Insurance would have control of the assets of LMC.
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Some of our customers are insured under Eagle insurance policies that we service pursuant to the claims administration servicing agreement described above. Although SeaBright is a separate legal entity from LMC and its affiliates, including Eagle, Eagle’s policyholders may not readily distinguish SeaBright from Eagle and LMC if those policies are not honored in the event LMC is found to be
insolvent and placed into court-ordered liquidation. If that were to occur, our market reputation, credibility and ability to renew the underlying policies could be adversely affected.
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In connection with the Acquisition, LMC and its affiliates made various transfers and payments to SeaBright, including approximately $13.0 million under the commutation agreement and an initial amount of approximately $1.6 million to fund the collateralized reinsurance trust. In the event that LMC is placed into receivership, it is possible that a receiver or creditor could assert a claim seeking to unwind or recover these payments under applicable voidable preference and fraudulent transfer laws.
Risks Related to Our Industry
We may face substantial exposure to losses from terrorism for which we are required by law to provide coverage.
Under our workers’ compensation policies, we are required to provide workers’ compensation benefits for losses arising from acts of terrorism. The impact of any terrorist act is unpredictable, and the ultimate impact on us would depend upon the nature, extent, location and timing of such an act. Notwithstanding the protection provided by the reinsurance we have purchased and any protection provided by the Terrorism Risk Act, the risk of severe losses to us from acts of terrorism has not been eliminated because, as discussed above, our excess of loss reinsurance treaty program contains various sub-limits and exclusions limiting our reinsurers’ obligation to cover losses caused by acts of terrorism. Furthermore, the Terrorism Risk Act is scheduled to expire on December 31, 2007 and may not be renewed, or if it is renewed, it may provide reduced protection against the financial impact of acts of terrorism. Accordingly, events may not be covered by, or may exceed the capacity of, our reinsurance protection and any protection offered by the Terrorism Risk Act or any successor legislation. Thus, any acts of terrorism could materially adversely affect our business and financial condition.
The threat of terrorism and military and other actions may result in decreases in our net income, revenue and assets under management and may adversely affect our investment portfolio.
The threat of terrorism, both within the United States and abroad, and military and other actions and heightened security measures in response to these types of threats, may cause significant volatility and declines in the equity markets in the United States and abroad, as well as loss of life, property damage, additional disruptions to commerce and reduced economic activity. Actual terrorist attacks could cause a decrease in our stockholders’ equity, net income and/or revenue. The effects of these changes may result in a decrease in our stock price. In addition, some of the assets in our investment portfolio may be adversely affected by declines in the bond markets and declines in economic activity caused by the continued threat of terrorism, ongoing military and other actions and heightened security measures.
We cannot predict at this time whether and the extent to which industry sectors in which we maintain investments may suffer losses as a result of potential decreased commercial and economic activity, or how any such decrease might impact the ability of companies within the affected industry sectors to pay interest or principal on their securities, or how the value of any underlying collateral might be affected.
We can offer no assurances that terrorist attacks or the threat of future terrorist events in the United States and abroad or military actions by the United States will not have a material adverse effect on our business, financial condition or results of operations.
Our results of operations and revenues may fluctuate as a result of many factors, including cyclical changes in the insurance industry, which may cause the price of our common stock to be volatile.
The results of operations of companies in the insurance industry historically have been subject to significant fluctuations and uncertainties. Our profitability can be affected significantly by:
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competition;
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rising levels of loss costs that we cannot anticipate at the time we price our products;
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volatile and unpredictable developments, including man-made, weather-related and other natural catastrophes or terrorist attacks;
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changes in the level of reinsurance capacity and capital capacity;
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changes in the amount of loss reserves resulting from new types of claims and new or changing judicial interpretations relating to the scope of insurers’ liabilities; and
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fluctuations in interest rates, inflationary pressures and other changes in the investment environment, which affect returns on invested assets and may impact the ultimate payout of losses.
The availability of insurance is related to prevailing prices, the level of insured losses and the level of industry surplus which, in turn, may fluctuate in response to changes in rates of return on investments being earned in the insurance industry. As a result, the insurance business historically has been a cyclical industry characterized by periods of intense price competition due to excessive underwriting capacity as well as periods when shortages of capacity permitted favorable premium levels. During 1998, 1999 and 2000, the workers’ compensation insurance industry experienced substantial pricing competition, and this pricing competition greatly affected the ability of our predecessor to increase premiums. Beginning in 2001, we witnessed a decrease in pricing competition in the industry, which enabled us to raise our rates. Although rates for many products increased from 2000 to 2003, legislative reforms caused premium rates in certain states, including California, to decrease in 2004, 2005 and 2006, and rates may continue to decrease. In addition, the availability of insurance has and may continue to increase, either by capital provided by new entrants or by the commitment of additional capital by existing insurers, which may perpetuate rate decreases. Any of these factors could lead to a significant reduction in premium rates, less favorable policy terms and fewer submissions for our underwriting services. In addition to these considerations, changes in the frequency and severity of losses suffered by insureds and insurers may affect the cycles of the insurance business significantly, and we expect to experience the effects of such cyclicality. This cyclicality may cause the price of our securities to be volatile.
Risks Related to Our Common Stock
The price of our common stock may decrease.
The trading price of shares of our common stock may decline for many reasons, some of which are beyond our control, including, among others:
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quarterly variations in our results of operations;
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changes in expectations as to our future results of operations, including financial estimates by securities analysts and investors;
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announcements of claims against us by third parties;
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changes in law and regulation;
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results of operations that vary from those expected by securities analysts and investors; and
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future sales of shares of our common stock.
In addition, the stock market in recent years has experienced substantial price and volume fluctuations that sometimes have been unrelated or disproportionate to the operating performance of companies whose shares are traded. As a result, the trading price of shares of our common stock may decrease and you may not be able to sell your shares at or above the price you pay to purchase them.
Future sales of shares of our common stock may affect their market price and the future exercise of options may depress our stock price and result in dilution of your investment.
We cannot predict what effect, if any, future sales of shares of our common stock, or the availability of shares for future sale, will have on the market price of our common stock. Future sales of substantial amounts of our common stock in the public market, or the perception that such sales could occur, could adversely
affect the market price of our common stock and may make it more difficult for you to sell your shares at a time and price which you deem appropriate.
As of March 13, 2007, there were 20,557,704 shares of our common stock outstanding. Moreover, 931,350 additional shares of our common stock will be issuable upon the full exercise or conversion of options outstanding at that date. In the event that any outstanding options are exercised, you will suffer dilution of your investment.
Applicable insurance laws may make it difficult to effect a change of control of our company.
Our insurance company subsidiary is domiciled in the state of Illinois and commercially domiciled in the state of California. The insurance holding company laws of Illinois and California require advance approval by the Illinois Division of Insurance and the California Department of Insurance of any change in control of SeaBright Insurance Company. “Control” is generally presumed to exist through the direct or indirect ownership of 10% or more of the voting securities of a domestic insurance company or of any entity that controls a domestic insurance company. In addition, insurance laws in many states contain provisions that require prenotification to the insurance commissioners of a change in control of a non-domestic insurance company licensed in those states. Any future transactions that would constitute a change in control of SeaBright Insurance Company, including a change of control of us, would generally require the party acquiring control to obtain the prior approval of the Illinois Division of Insurance and the California Department of Insurance and may require pre-acquisition notification in applicable states that have adopted pre-acquisition notification provisions. Obtaining these approvals may result in a material delay of, or deter, any such transaction. See the discussion under the heading “Regulation” in Item 1.
These laws may discourage potential acquisition proposals and may delay, deter or prevent a change of control of us, including through transactions, and in particular unsolicited transactions, that some or all of our stockholders might consider to be desirable.
Anti-takeover provisions in our amended and restated certificate of incorporation and by-laws and under the laws of the State of Delaware could impede an attempt to replace or remove our directors or otherwise effect a change of control of our company, which could diminish the value of our common stock.
Our amended and restated certificate of incorporation and by-laws contain provisions that may make it more difficult for stockholders to replace directors even if the stockholders consider it beneficial to do so. In addition, these provisions could delay or prevent a change of control that a stockholder might consider favorable. For example, these provisions may prevent a stockholder from receiving the benefit from any premium over the market price of our common stock offered by a bidder in a potential takeover. Even in the absence of an attempt to effect a change in management or a takeover attempt, these provisions may adversely affect the prevailing market price of our common stock if they are viewed as discouraging takeover attempts in the future. In addition, Section 203 of the Delaware General Corporation Law may limit the ability of an “interested stockholder” to engage in business combinations with us. An interested stockholder is defined to include persons owning 15% or more of any class of our outstanding voting stock.
Our amended and restated certificate of incorporation and by-laws contain the following provisions that could have an anti-takeover effect:
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stockholders have limited ability to call stockholder meetings and to bring business before a meeting of stockholders;
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stockholders may not act by written consent; and
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our Board of Directors may authorize the issuance of preferred stock with such rights, powers and privileges as the board deems appropriate.
These provisions may make it difficult for stockholders to replace management and could have the effect of discouraging a future takeover attempt which is not approved by our Board of Directors but which individual stockholders might consider favorable.
Item 1B.
Item 1B.
Unresolved Staff Comments.
None.
Item 2.
Item 2.
Properties.
Our principal executive offices are located in approximately 20,100 square feet of leased office space in Seattle, Washington. We also lease office space consisting of approximately 2,650 square feet in Honolulu, Hawaii; 2,500 square feet in Anchorage, Alaska; 8,300 square feet in Orange, California; 3,400 square feet in Houston, Texas; 700 square feet in San Francisco, California; 300 square feet in Camarillo, California; 3,000 square feet in Chicago, Illinois; 3,900 square feet in Radnor, Pennsylvania; and 1,800 square feet in Tampa, Florida. We conduct claims and underwriting operations in our branch offices, with the exception of our Honolulu office, where we conduct only claims and loss control operations, and our Camarillo office, where we conduct only underwriting operations. We do not own any real property. We consider our leased facilities to be adequate for our current operations.
Item 3.
Item 3.
Legal Proceedings.
We are, from time to time, involved in various legal proceedings in the ordinary course of business. We believe we have sufficient loss reserves and reinsurance to cover claims under policies issued by us. Accordingly, we do not believe that the resolution of any currently pending legal proceedings, either individually or taken as a whole, 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.
None.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
On January 19, 2005, the SEC declared effective our Registration Statement on Form S-1 (Registration No. 333-119111), as filed with the SEC in connection with the initial public offering of 8,625,000 shares of our common stock. We have used substantially all of the offering proceeds. We intend to use any remaining proceeds for general corporate purposes, including supporting the growth of PointSure, as described in the registration statement.
Our common stock has been quoted on the NASDAQ Global Select Market (formerly the Nasdaq National Market) under the symbol “SEAB” since our initial public offering on January 21, 2005. Prior to that time, there was no public market for our common stock.
The following table sets forth, for the periods indicated, the high and low sales prices for our common stock as quoted on the NASDAQ Global Select Market.
As of March 13, 2007, there were approximately 29 holders of record of our common stock.
Dividend Policy
We do not expect to pay any cash dividends on our common stock for the foreseeable future. We currently intend to retain any additional future earnings to finance our operations and growth. Any future determination to pay cash dividends on our common stock will be at the discretion of our Board of Directors and will be dependent on our earnings, financial condition, operating results, capital requirements, any contractual restrictions, regulatory and other restrictions on the payment of dividends by our subsidiaries to us, and other factors that our Board of Directors deems relevant.
We are a holding company and have no direct operations. Our ability to pay dividends in the future depends on the ability of our operating subsidiaries to pay dividends to us. Our subsidiary, SeaBright Insurance Company, is a regulated insurance company and therefore is subject to significant regulatory restrictions limiting its ability to declare and pay dividends.
SeaBright Insurance Company’s ability to pay dividends is subject to restrictions contained in the insurance laws and related regulations of Illinois and California. The insurance holding company laws in these states require that ordinary dividends be reported to the Illinois Division of Insurance and the California Department of Insurance prior to payment of the dividend and that extraordinary dividends be submitted for prior approval. See “Regulation” in Part I, Item 1 of this annual report.
For information regarding restrictions on the payment of dividends by us and SeaBright Insurance Company, see the discussion under the heading “Liquidity and Capital Resources” in Part II, Item 7 and the discussion under the heading “Business” in Part I, Item 1 of this annual report.
Purchases of Equity Securities
We did not purchase any of our equity securities during 2006.
Performance Graph
The following graph and table compare the total return on $100 invested in SeaBright common stock for the period commencing on January 21, 2005 (the date of our initial public offering) and ending on December 31, 2006 with the total return on $100 invested in each of the Nasdaq Stock Market (U.S.) Index and in the Nasdaq Insurance Index. The closing market price for SeaBright common stock at the end of fiscal year 2006 was $18.01.
Comparison of 23 Month Cumulative Total Return*
Among SeaBright Insurance Holdings, Inc., The NASDAQ Composite Index
And The NASDAQ Insurance Index
*
$100 invested on 11/21/05 in stock or on 10/31/05 in index-including reinvestment of dividends. Fiscal year ending December 31.
The information in the graph and table above is not “soliciting material,” is not deemed “filed” with the SEC and is not to be incorporated by reference in any of our filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended (the “Exchange Act”), whether made before or after the date of this annual report and irrespective of any general incorporation language in any such filing, except to the extent that we specifically incorporate such information by reference.
Item 6.
Item 6.
Selected Financial Data.
The following table sets forth our selected historical financial information and that of our predecessor for the periods ended and as of the dates indicated. This information comes from our consolidated financial statements and those of our predecessor. You should read the following selected financial information along with the information contained in this annual report, including Part II, Item 7
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operation.
The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements and the notes to those statements included elsewhere in this annual report. The discussion and analysis below includes forward-looking statements that are subject to risks, uncertainties and other factors described in Part I, Item 1A that could cause our actual results of operations, performance and business prospects and opportunities in 2006 and beyond to differ materially from those expressed in, or implied by those forward-looking statements. See “Note on Forward-Looking Statements” in Part I, Item 1 of this annual report.
Overview
We provide workers’ compensation insurance coverage for prescribed benefits that employers are required to provide to their employees who may be injured in the course of their employment. We currently provide workers’ compensation insurance to customers in the maritime, ADR and state act markets.
On September 30, 2003, SeaBright acquired PointSure and the renewal rights and substantially all of the operating assets, systems and employees of, the Eagle Entities from LMC, their ultimate parent. We refer to Eagle Pacific, Pacific Eagle and PointSure collectively as our predecessor. In connection with the Acquisition, SeaBright also purchased KEIC, a shell company in run off that was acquired from LMC for its workers’ compensation licenses in 43 states and the District of Columbia. The Acquisition was accounted for using the purchase method of accounting. The Acquisition will prospectively affect our results of operations in certain respects. The aggregate acquisition costs, including the transaction costs of approximately $15.7 million, have been allocated to the tangible and intangible assets acquired based upon estimates of their respective fair values as of the Acquisition date.
In connection with the Acquisition, to minimize our exposure to any past business underwritten by KEIC, we entered into the adverse development cover. See the discussion under the heading “Our History” in Part I, Item 1 of this annual report. To support LMC’s obligations under the adverse development cover, LMC funded a trust account at the time of the Acquisition in the amount of $1.6 million as collateral for LMC’s potential future obligations to us under the adverse development cover. The amount on deposit in the trust account was increased to $4.8 million on December 23, 2004 and increased to $5.2 million, including accumulated interest, on December 31, 2006. In February 2007, LMC submitted a request to withdraw approximately $1.8 million of excess funds on deposit in the trust account. After due evaluation, we complied with LMC’s request, resulting in a balance in the trust account of approximately $3.4 million immediately following the withdrawal. If LMC is placed in receivership and the amount held in the collateralized reinsurance trust is inadequate to satisfy the obligations of LMC to us under the adverse development cover, it is unlikely that we would recover any future amounts owing by LMC to us.
For periods ended on or before September 30, 2003, the financial information of our predecessor discussed below represents the combined financial results of Eagle Pacific, Pacific Eagle and PointSure. For periods ended after September 30, 2003, the financial information presented below represents the consolidated financial results of SeaBright and its subsidiaries, SeaBright Insurance Company and PointSure.
Our premiums before the Acquisition are generally not comparable to our premiums after the Acquisition because we acquired renewal rights and not the underlying policies as of the date of the Acquisition. Aspects of our business that are comparable with the business of our predecessor include the loss ratio and expense ratio. We believe that our loss ratio is comparable to that of our predecessor because we are insuring accounts with the same type of risk exposure in essentially the same jurisdictions as our predecessor, and we are using the same risk selection rules, underwriting guidelines and pricing models that our predecessor used. We believe that our expense ratio is comparable to that of our predecessor because we acquired the work force and substantially all of the operating assets of our predecessor, and we are following the same business model as our predecessor, which was developed by our current management. Aspects of our business that are not comparable with the business of our predecessor include: premiums earned, investment income, service income and geographic territory. For example, our net premiums earned for the periods immediately following the Acquisition were lower than the net premiums earned for the periods immediately prior to the Acquisition
because we did not earn any premium on any of our predecessor’s policies that were in force at September 30, 2003. Our investment income is not comparable to the investment income of our predecessor because our predecessor had a significant portion of investments in cash and cash equivalents for the years presented in the selected financial information table. In contrast, our investment portfolio consists mostly of investment grade fixed income securities, which have higher yields than cash and cash equivalents. Our service income is not comparable to the service income of our predecessor because our predecessor provided only limited claims handling services for certain affiliates of LMC. In contrast, we are providing claims handling as well as policy administration and accounting services for our predecessor. Our geographic territory is not comparable to that of our predecessor because we have expanded into new territories where our predecessor did not have direct operations. For example, in 2005 we opened offices in Chicago, Illinois and Tampa, Florida to facilitate our expansion plans into the Great Lakes and the Southeast Coastal regions and in 2006 we opened an office in Radnor, Pennsylvania to facilitate our expansion into the Northeast region.
Principal Revenue and Expense Items
We derive our revenue from premiums earned, service fee income, net investment income and net realized gains and losses from investments.
Premiums Earned
Gross premiums written include all premiums billed and unbilled by an insurance company during a specified policy period. Premiums are earned over the terms of the related policies. At the end of each accounting period, the portion of the premiums that are not yet earned is included in unearned premiums and is realized as revenue in subsequent periods over the remaining terms of the policies. Our policies typically have terms of 12 months. Thus, for example, for a policy that is written on July 1, 2006, one-half of the premiums would be earned in 2006 and the other half would be earned in 2007.
Premiums earned is the earned portion of our net premiums written. Net premiums written is the difference between gross premiums written and premiums ceded or paid to reinsurers (ceded premiums written). Our gross premiums written is the sum of both direct premiums and assumed premiums before the effect of ceded reinsurance. Assumed premiums are premiums that we have received from another company under a reinsurance agreement or from an authorized state mandated pool.
We earn our direct premiums written from our maritime, ADR and state act customers. We also earn a small portion of our direct premiums written from employers who participate in the Washington USL&H Plan. We immediately cede 100% of those premiums, net of our expenses, and 100% of the losses in connection with that business to the plan. We do not include premiums from the Washington USL&H Plan in our direct premiums written because it is not indicative of our core business or material to our results of operation.
Net Investment Income and Realized Gains and Losses on Investments
We invest our statutory surplus and the funds supporting our insurance liabilities (including unearned premiums and unpaid loss and loss adjustment expenses) in cash, cash equivalents, fixed income securities and, to a lesser degree, in equity securities. Our investment income includes interest earned on our invested assets. Realized gains and losses on invested assets are reported separately from net investment income. We earn realized gains when invested assets are sold for an amount greater than their amortized cost in the case of fixed maturity securities and recognize 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 carrying value.
Claims Service Income
We receive claims service income in return for providing claims administration services for other companies. The claims service income we receive for providing these services approximates our costs. For the years ended December 31, 2006, 2005, and 2004, approximately 66.8%, 85.5%, and 92.4%, respectively, of our claims service income was generated by contracts we have with LMC to provide claims handling services
for the policies written by the Eagle Entities prior to the Acquisition. We expect income from these contracts to decrease substantially over the next several years as transactions related to the Eagle Entities diminish.
Other Service Income
Following the Acquisition, we entered into servicing arrangements with LMC to provide policy administration and accounting services for the policies written by the Eagle Entities prior to the Acquisition. The fee income we receive for providing these services approximates our costs and will substantially decrease over the next several years as transactions related to the Eagle Entities diminish.
Our expenses consist primarily of:
Loss and Loss Adjustment Expenses
Loss and loss adjustment expenses represent our largest expense item and include (1) claim payments made, (2) estimates for future claim payments and changes in those estimates for current and prior periods and (3) costs associated with investigating, defending and adjusting claims.
Underwriting, Acquisition and Insurance Expenses
In our insurance subsidiary, we refer to the expenses that we incur to underwrite risks as underwriting, acquisition and insurance expenses. Underwriting expenses consist of commission expenses, premium taxes and fees and other underwriting expenses incurred in writing and maintaining our business. We pay commission expense in our insurance subsidiary to our brokers for the premiums that they produce for us. We pay state and local taxes based on premiums; licenses and fees; assessments; and contributions to workers’ compensation security funds. Other underwriting expenses consist of general administrative expenses such as salaries and employee benefits, rent and all other operating expenses not otherwise classified separately, and boards, bureaus and assessments of statistical agencies for policy service and administration items such as rating manuals, rating plans and experience data.
Interest Expense
Included in other expense is interest expense we incur on $12.0 million in surplus notes that our insurance subsidiary issued in May 2004. The interest expense is paid quarterly in arrears. The interest expense for each interest payment period is based on the three-month LIBOR rate two London banking days prior to the interest payment period plus 400 basis points.
Results of Operations
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
Gross Premiums Written. Gross premiums written were $230.3 million in 2006 compared to $204.7 million in 2005, representing an increase of $25.6 million, or 12.5%, even though we continued to experience rate reductions in California, our largest market, as well as in other states. The average renewal rate change for our state act and maritime markets, excluding California, for the full year of 2006 was -7.3% and -10.1%, respectively. Excluding work we perform as the servicing carrier for the Washington USL&H Plan, the number of customers we serviced at December 31, 2006 increased 39.7% to 654 from 468 at December 31, 2005 and in-force payrolls, one of the factors used in determining premium charges, increased 54.6% from 2005. California continues to be our largest market, accounting for approximately $113.4 million (52.3%) of our direct premiums written in 2006. Illinois became our third largest market, accounting for $19.9 million (9.2%) or our direct premiums written in 2006. This represents an increase of $16.7 million (521.9%) from $3.2 million in direct premiums written in 2005.
On December 21, 2006, we announced the division of our Southern region into two markets, allowing us to devote greater focus and resources to further develop our key states in this region. Our new Southeast region will pursue business in selected southeastern states, including Florida. We opened an office in Atlanta, Georgia in early 2007. The Gulf region, which is based in Houston, Texas, now focuses primarily on Texas
and Louisiana. By dividing the southern states in this manner, we have substantially improved the resource level dedicated to these regions and clarified the focus on our target markets in each of the critical states. During the fourth quarter of 2006, we opened an office in Radnor, Pennsylvania, a Philadelphia suburb. This new office contributed approximately $838,000 to our direct premiums written in 2006.
Net Premiums Written. Net premiums written totaled $214.8 million in 2006 compared to $185.7 million in 2005, representing an increase of $29.1 million, or 15.7%. Net premiums written were affected by premiums ceded under reinsurance agreements. Ceded written premiums in 2006 totaled $15.5 million, or 6.7% of gross premiums written, compared to $19.1 million, or 9.3%, of gross premiums written, in 2005. The decrease in ceded premiums as a percentage of gross premiums written resulted primarily from the renewal of our excess of loss reinsurance program on October 1, 2006 at average rates that are approximately 16.8% lower than rates under the prior reinsurance program. We were able to achieve savings at the lower tiers of our program while increasing our catastrophe coverage from $50.0 million to $75.0 million.
Net Premiums Earned. Net premiums earned totaled $185.6 million in 2006 compared to $158.9 million in 2005, representing an increase of $26.7 million, or 16.8%. We record the entire annual policy premium as unearned premium when written and earn the premium over the life of the policy, which is generally twelve months. Consequently, the amount of premiums earned in any given year depends on when during the current or prior year the underlying policies were written. Our direct premiums earned increased $22.9 million or 13.3% to $195.7 million in 2006 from $172.8 million in 2005 due to our premium growth as described above. Net premiums earned are also affected by premiums ceded under reinsurance agreements. Ceded premiums earned in 2006 totaled $15.6 million compared to $22.3 million in 2005, representing a decrease of $6.7 million or 30.0%. A decrease in ceded premiums earned is an increase to our overall net premiums earned. Offsetting the increases in net premiums earned is a decrease in the amount of premiums we involuntarily assume on residual market business from the National Council for Compensation Insurance, which operates residual market programs on behalf of many states. Assumed premiums earned decreased $2.9 million from $8.4 million in 2005 to $5.5 million in 2006.
Net Investment Income. Net investment income was $15.2 million in 2006 compared to $7.8 million in 2005, representing an increase of $7.4 million, or 94.9%. Average invested assets increased $153.2 million (79.1%) from $193.6 million in 2005 to $346.8 million in 2006. Approximately $57.6 million of the increase resulted from the net proceeds of the follow-on offering of our common stock in February 2006. During the first quarter of 2006, yields on fixed income securities were at very high levels compared to 2005 and a significant portion of the net proceeds from the follow-on offering were invested at these higher yields. Another contributing factor to the increase in net investment income is realized positive cash flow from operations of $90.3 million in 2006, which was invested in fixed income securities with higher yields in 2006 compared to 2005. Net investment income as a percentage of average invested assets rose from 4.0% in 2005 to 4.4% in 2006, reflecting the rising interest rate environment.
Service Income. Service income was $2.1 million in 2006 compared to $2.5 million in 2005, representing a decrease of $0.4 million, or 16.0%. Our service income resulted primarily from service arrangements we have with LMC for claims processing services, policy administration and administrative services we performed for the Eagle Entities’ insurance policies and from claims processing services we perform for other unrelated companies. Average monthly fees declined as the volume of work required for policy administration decreased as a result of the run off of our predecessor’s business. Service income related to our arrangements with LMC decreased $0.7 million (33.3%) to $1.4 million in 2006 from $2.1 million in 2005. Service income related to claims processing services that we perform for other unrelated companies increased approximately $0.3 million in 2006 due to the addition of one new high volume customer in early 2006.
Other Income. Other income totaled $3.4 million in 2006 compared to $3.3 million in 2005, representing an increase of $0.1 million, or 3.0%. Other income is derived primarily from the operations of PointSure, our non-insurance subsidiary, which expanded its portfolio of insurance products during 2006 to accelerate income growth from sources other than us. The number of insurance companies that PointSure represents increased by 11 to a total of 19 in 2006.
Loss and Loss Adjustment Expenses. Loss and loss adjustment expenses totaled $107.9 million in 2006 compared to $105.8 million in 2005, representing an increase of $2.1 million, or 2.0%. The higher loss and loss adjustment expenses in 2006 are attributable to the increase in premiums earned for the period, offset by a reduction of approximately $20.4 million of previously recorded direct net loss reserves to reflect a continuation of deflation trends in the paid loss data for recent accident years. Our direct net loss reserves are net of reinsurance and exclude reserves associated with KEIC and the business that we involuntarily assume from the NCCI. Approximately $14.6 million of the reserve adjustment related to accident year 2005 and approximately $5.9 million related to accident year 2004. These reductions were offset by modest adverse development of $0.1 million in the 2003 accident year. As a result of these reserve changes, our net loss ratio decreased from 65.1% in 2005 to 57.0% in 2006.
There is uncertainty about whether recent lower paid loss trends, which result primarily from California legislative reforms enacted in 2003 and 2004, will be sustained, particularly in light of current efforts to change or repeal portions of the reforms. We will not know the full impact of these reforms with a high degree of confidence for several years. We have established loss reserves at December 31, 2006 that are based upon our current best estimate of ultimate loss costs, taking into consideration the recent lower paid loss claim data, incurred loss trends and the uncertainty regarding the permanence of recent legislative reforms. See the discussion under the heading “Loss Reserves” in Part I, Item 1 of this annual report for a further discussion of our loss reserve process.
As of December 31, 2006, we had recorded a receivable of approximately $2.8 million for adverse loss development under the adverse development cover since the date of the Acquisition. We do not expect this receivable to have any material effect on our future cash flows if LMC fails to perform its obligations under the adverse development cover. At March 2, 2007, we had access to approximately $3.4 million under the collateralized reinsurance trust in the event that LMC fails to satisfy its obligations under the adverse development cover. See the discussion under the heading “Our History” in Part I, Item 1 of this annual report.
Underwriting Expenses. Underwriting expenses totaled $42.3 million in 2006 compared to $33.8 million in 2005, representing an increase of $8.5 million, or 25.1%. Our net underwriting expense ratio was 22.7% in 2006 compared to 21.2% in 2005. The increase in the expense ratio is primarily the result of increased staffing costs and other premium production related expenses as we invest in the geographic expansion of our business. In addition, we incurred increased professional consulting and audit fees related to our initial compliance with Section 404 of the Sarbanes-Oxley Act of 2002 and costs related to restricted stock and the implementation of SFAS No. 123R, Share-Based Payment.
Interest Expense. Interest expense related to the surplus notes issued by our insurance subsidiary in May 2004 totaled $1.1 million in 2006 compared to $0.9 in 2005, representing an increase of $0.2 million, or 22.2%. The surplus notes interest rate, which is calculated at the beginning of each interest payment period using the 3-month LIBOR rate plus 400 basis points, increased steadily throughout 2006 from 8.39% at the beginning of 2006 to 9.37% at the end of the year.
Other Expenses. Other expenses totaled $6.2 million in 2006 compared to $5.0 million in 2005, representing an increase of $1.2 million, or 24.0%. Other expenses are derived primarily from the operations of PointSure, our non-insurance subsidiary which experienced direct costs associated with the expansion of the insurance products they offer. In October 2006, we incurred a one time charge of $305,000 related to the settlement of a legal matter.
Income Tax Expense. Our effective tax rate in 2006 was 31.3% compared to 31.6% in 2005. Our effective tax rate for 2006 was lower than the statutory tax rate of 35.0% primarily as a result of tax exempt interest income. The effective tax rate decreased in 2006 primarily as a result of a reduction in the proportion of investment income generated from investments in tax-exempt bonds and a related true-up in the amount of taxes due with our 2005 Federal income tax return.
Net Income. Net income totaled $33.2 million in 2006 compared to $18.3 million in 2005, representing an increase of $14.9 million, or 81.4%. The 2006 increase in net income resulted primarily from the increase in premiums earned and investment income for the period, offset by related increases in loss and loss
adjustment expenses, underwriting acquisition and insurance expenses, and other expenses, including interest expense related to the surplus notes and amortization expense related to intangible assets acquired in the Acquisition.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004
Gross Premiums Written. Gross premiums written were $204.7 million in 2005 compared to $135.7 million in 2004, representing an increase of $69.0 million, or 50.8%. We began writing new insurance contracts on October 1, 2003 and began renewing some of the existing contracts of our predecessor expiring after that date. The approximately $80.8 million of net proceeds received from the initial public offering of our common stock in January 2005, of which approximately $74.8 million was contributed to SeaBright Insurance Company, allowed us to expand our business to new territories and in our niche markets. California continues to be our largest market, accounting for approximately $123.6 million (64.8%) of our direct premiums written in 2005. During 2005, we opened offices in Chicago, Illinois and Tampa, Florida.
Net Premiums Written. Net premiums written totaled $185.7 million in 2005 compared to $119.6 million in 2004, representing an increase of $66.1 million, or 55.3%. Net premiums written were affected by premiums ceded under reinsurance agreements. Ceded written premiums in 2005 totaled $19.1 million, or 9.3% of gross premiums written, compared to $16.1 million, or 11.9% of gross premiums written, in 2004 primarily due to our reinsurance program that renewed on October 1, 2005 at rates that were 50.2% lower than rates under the prior reinsurance contracts, in part because of changes in our limits and retention. Also, the October 2005 treaties provide for premiums to be ceded on an earned basis, whereas premiums were ceded on both a gross premiums written and gross premiums earned basis under the prior treaties.
Net Premiums Earned. Net premiums earned totaled $158.9 million in 2005 compared to $78.0 million in 2004, representing an increase of $80.9 million, or 103.7%. We record the entire annual policy premium as unearned premium when written and earn the premium over the life of the policy, which is generally twelve months. Because we acquired renewal rights and not policies in the Acquisition, our actual results for the year ended December 31, 2004 did not reflect premiums earned on any policies written prior to September 30, 2003, the date of the Acquisition. Consequently, the ratio of net premiums earned to net premiums written increased from 57.5% in 2004 to 77.6% in 2005.
Net Investment Income. Net investment income was $7.8 million in 2005 compared to $2.5 million in 2004, representing an increase of $5.3 million, or 212.0%. Average invested assets increased $108.2 million (126.7%) from $85.4 million in 2004 to $193.6 million in 2005. Approximately $80.8 million of the increase resulted from the net proceeds of the initial public offering of our common stock in January 2005. Net investment income as a percentage of average invested assets rose from 2.9% in 2004 to 4.0% in 2005, reflecting the rising interest rate environment.
Service Income. Service income was $2.5 million in 2005 compared to $3.7 million in 2004, representing a decrease of $1.2 million, or 32.4%. Our service income resulted primarily from service arrangements we have with LMC for claims processing services, policy administration and administrative services we performed for the Eagle Entities’ insurance policies. Average monthly fees declined as the volume of work required for policy administration decreased as a result of the run off of our predecessor’s business.
Other Income. Other income totaled $3.3 million in 2005 compared to $2.5 million in 2004, representing an increase of $0.8 million, or 32.0%. Other income derived primarily from the operations of PointSure, our non-insurance subsidiary.
Loss and Loss Adjustment Expenses. Loss and loss adjustment expenses totaled $105.8 million in 2005 compared to $53.7 million in 2004, representing an increase of $52.1 million, or 97.0%. The higher loss and loss adjustment expenses in 2005 are attributable to the increase in premiums earned for the period. Our net loss ratio in 2005 and 2004 remained flat at 65.1%. As of December 31, 2005, we had recorded a receivable of approximately $3.4 million for adverse loss development under the adverse development cover since the date of the Acquisition. We do not expect this receivable to have any material effect on our future cash flows if LMC fails to perform its obligations under the adverse development cover. At December 31, 2005, we had
access to approximately $4.9 million under the collateralized reinsurance trust in the event that LMC fails to satisfy its obligations under the adverse development cover. See the discussion under the heading “Our History” in Part I, Item 1 of this annual report.
Underwriting Expenses. Underwriting expenses totaled $33.8 million in 2005 compared to $17.9 million in 2004, representing an increase of $15.9 million, or 88.8%. Our net underwriting expense ratio was 21.2% in 2005 compared to 21.9% in 2004. Net commissions as a percentage of premiums earned increased from 6.8% in 2004 to 7.9% in 2005. Assumed commissions from state-mandated insurance pools accounted for the majority of this increase, offset by a reduction in the percentage of ceded commissions. Net direct commissions as a percentage of premiums earned equaled approximately 6.2% in 2005, down slightly from 6.3% in 2004. Other underwriting expenses as a percentage of premiums earned were 9.8% in 2005 and 11.9% in 2004.
Interest Expense. Interest expense related to the surplus notes issued by our insurance subsidiary in May 2004 totaled $0.9 million in 2005 compared to $0.4 million in 2004, representing an increase of $0.5 million, or 125.0%. Because the surplus notes were issued during 2004, our expense in 2004 was not representative of a full year.
Other Expenses. Other expenses totaled $5.0 million in 2005 compared to $4.5 million in 2004, representing an increase of $0.5 million, or 11.1%. The increase resulted primarily from higher expenses associated with the operations of PointSure, our non-insurance company subsidiary and increases in franchise tax and other professional services.
Federal Income Tax Expense. Our effective tax rate in 2005 was 31.6% compared to 29.5% in 2004. Our effective tax rate for 2005 was lower than the statutory tax rate of 35.0% primarily as a result of tax exempt interest income. The effective tax rate increased in 2005 primarily as a result of a reduction in the proportion of investment income generated from investments in tax-exempt bonds and a related true-up in the amount of taxes due with our 2004 Federal income tax return.
Net Income. Net income totaled $18.3 million in 2005 compared to $7.2 million in 2004. The 2005 increase in net income resulted primarily from the increase in premiums earned and investment income for the period, offset by related increases in loss and loss adjustment expenses, underwriting acquisition and insurance expenses, and other expenses, including interest expense related to the surplus notes and amortization expense related to intangible assets acquired in the Acquisition.
Liquidity and Capital Resources
Our principal sources of funds are underwriting operations, investment income and proceeds from sales and maturities of investments. Our primary use of funds is to pay claims and operating expenses and to purchase investments.
Our investment portfolio is structured so that investments mature periodically over time in reasonable relation to current expectations of future claim payments. Since we have a limited claims history, we have derived our expected future claim payments from industry and predecessor trends and included a provision for uncertainties. Our investment portfolio as of December 31, 2006 has an effective duration of 4.8 years with individual maturities extending out to 30 years. Currently, we make claim payments from positive cash flow from operations and invest excess cash in securities with appropriate maturity dates to balance against anticipated future claim payments. As these securities mature, we intend to invest any excess funds with appropriate durations to match against expected future claim payments.
Our ability to adequately provide funds to pay claims comes from our disciplined underwriting and pricing standards and the purchase of reinsurance to protect us against severe claims and catastrophic events. Effective October 1, 2006, our reinsurance program provides us with reinsurance protection for each loss occurrence in excess $1.0 million, up to $75.0 million, subject to various deductibles and exclusions. Our reinsurance program that was effective October 1, 2005 to October 1, 2006, provides us with reinsurance protection for each loss occurrence in excess $500,000, up to $50.0 million, subject to various deductibles and
exclusions. See the discussion under the heading “Reinsurance” in Part I, Item 1 of this annual report. Given industry and predecessor trends, we believe we are sufficiently capitalized to retain our retained losses.
At December 31, 2006, our portfolio was made up almost entirely of investment grade fixed income securities with fair values subject to fluctuations in interest rates. Prior to March 2005, we did not invest in common equity securities and we had no exposure to foreign currency risk. In November 2006, our investment policy was revised to allow for investment in domestic and international equities of up to 4% and 1%, respectively, of our statutory consolidated capital and surplus. While we have structured our investment portfolio to provide an appropriate matching of maturities with anticipated claim payments, if we decide or are required in the future to sell securities in a rising interest rate environment, we would expect to incur losses from such sales.
Our insurance subsidiary is required by law to maintain a certain minimum level of surplus on a statutory basis. Surplus is calculated by subtracting total liabilities from total admitted assets. The National Association of Insurance Commissioners has a risk-based capital standard designed to identify property and casualty insurers that may be inadequately capitalized based on inherent risks of each insurer’s assets and liabilities and its mix of net premiums written. Insurers falling below a calculated threshold may be subject to varying degrees of regulatory action. As of December 31, 2006, the statutory surplus of our insurance subsidiary was in excess of the prescribed risk-based capital requirements that correspond to any level of regulatory action.
SeaBright has minimal revenue and expenses. Currently there are no plans to have our insurance subsidiary or PointSure pay a dividend to SeaBright.
Net cash provided by operating activities in 2006 totaled $90.2 million, an increase of $7.5 million, or 9.1%, from $82.7 million in 2005, which increased $41.7 million from $41.0 million in 2004. These increases are mainly attributable to increases in unpaid loss and loss adjustment expense, amortization of deferred policy acquisition costs and reinsurance recoverables, offset by increases in policy acquisition costs deferred and unearned premiums net of premiums receivable, all as a result of our growth.
We used net cash of $139.6 million for investing activities in 2006 compared to $159.7 million in 2005 and $54.3 million in 2004. The difference between 2006 and 2005 is primarily attributable to a reduction in funds available for investing activities. In 2006, we invested net proceeds totaling approximately $57.6 million resulting from a follow-up public offering of 3,910,000 shares of our common stock described below. In 2005, we invested net proceeds totaling approximately $80.8 million resulting from the sale of 8,625,000 shares of common stock in our initial public offering.
Cash provided by financing activities totaled $57.6 million in 2006, a decrease of $23.2 million from $80.8 million in 2005, which increased $64.2 million from $16.6 million in 2004. As described below, the majority of cash provided by financing activities resulted from the sale of our common stock and, to a much lesser degree, from the exercise of common stock options by our employees. In 2005, we received net proceeds of approximately $80.8 million from the initial public offering of our common stock.
On February 1, 2006, we closed a follow-on public offering of 3,910,000 shares of our common stock, including the underwriters’ over-allotment option to purchase 510,000 shares of our common stock, at a price of $15.75 per share for net proceeds of approximately $57.6 million after deducting underwriters’ fees, commissions and offering costs totaling approximately $4 million. We contributed $50.0 million of the net proceeds to SBIC, which is using the capital to expand its business in core markets and to new territories. The remaining proceeds are being used for general purposes, including supporting the growth of PointSure.
Contractual Obligations and Commitments
The following table identifies our contractual obligations by payment due period as of December 31, 2006:
The loss and loss adjustment expense payments due by period in the table above are based upon the loss and loss adjustment expense estimates as of December 31, 2006 and actuarial estimates of expected payout patterns and are not contractual liabilities as to time certain. Our contractual liability is to provide benefits under the policies we write. As a result, our calculation of loss and loss adjustment expense payments due by period is subject to the same uncertainties associated with determining the level of unpaid loss and loss adjustment expenses generally 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 unpaid loss and loss adjustment expense process, see the heading “Loss Reserves” in Part I, Item 1 of this annual report. Actual payments of loss and loss adjustment expenses by period will vary, perhaps materially, from the above table to the extent that current estimates of loss and loss adjustment expenses vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns. See the discussion under the heading “Our loss reserves are based on estimates and may be inadequate to cover our actual losses” in Part I, Item 1A of this annual report for a discussion of the uncertainties associated with estimating unpaid loss and loss adjustment expenses.
Off-Balance Sheet Arrangements
As of December 31, 2006, we have no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Critical Accounting Policies, Estimates and Judgments
It is important to understand our accounting policies in order to understand our financial statements. Management considers some of these policies to be critical to the presentation of our financial results, since they require management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures at the financial reporting date and throughout the period being reported upon. Some of the estimates result from judgments that can be subjective and complex, and consequently, actual results reflected in future periods might differ from these estimates.
The most critical accounting policies involve the reporting of unpaid loss and loss adjustment expenses including losses that have occurred but were not reported to us by the financial reporting date, the amount and recoverability of reinsurance recoverable balances, accounting for our adverse development cover, deferred policy acquisition costs, deferred taxes, goodwill, intangibles, retrospective premiums, earned but unbilled premiums and the impairment of investments. The following should be read in conjunction with the notes to our financial statements.
Unpaid Loss and Loss Adjustment Expenses
Unpaid loss and loss adjustment expenses represent our estimate of the expected cost of the ultimate settlement and administration of losses, based on known facts and circumstances. Included in unpaid loss and loss adjustment expenses are amounts for case-based claims, including estimates of future developments on these claims, and claims incurred but not yet reported to us, second injury fund, allocated claim adjustment expenses and unallocated claim adjustment expenses. We use actuarial methodologies to assist us in establishing these estimates, including judgments relative to estimates of future claims severity and frequency, length of time to achieve ultimate resolution, judicial theories of liability and other third-party factors that are often beyond our control. Due to the inherent uncertainty associated with the cost of unsettled and unreported claims, the ultimate liability may differ from the original estimate. These estimates are regularly reviewed and updated and any resulting adjustments are included in the current period’s operating results. Because of the relative immaturity of our unpaid loss and loss adjustment expenses, actuarial techniques are applied that use the historical experience of our predecessor as well as industry information in the analysis of our unpaid loss and loss adjustment expenses.
Reinsurance Recoverables
Reinsurance recoverables on paid and unpaid losses represent the portion of the loss and loss adjustment expenses that is assumed by reinsurers. These recoverables are reported on our balance sheet separately as assets, as reinsurance does not relieve us of our legal liability to policyholders and ceding companies. We are required to pay losses even if a reinsurer fails to meet its obligations under the applicable reinsurance agreement. Reinsurance recoverables are determined based in part on the terms and conditions of reinsurance contracts, which could be subject to interpretations that differ from ours based on judicial theories of liability. In addition, we bear credit risk with respect to the reinsurers, which can be significant considering that some of the unpaid loss and loss adjustment expenses remain outstanding for an extended period of time.
Adverse Development Cover
The unpaid loss and loss adjustment expense subject to the adverse development cover with LMC is calculated on a quarterly basis using generally accepted actuarial methodologies. Amounts recoverable in excess of acquired reserves at September 30, 2003 are recorded gross in unpaid loss and loss adjustment expense in accordance with SFAS No. 141, Business Combinations, with a corresponding amount receivable from the seller. Amounts are shown net in the income statement.
Deferred Policy Acquisition Costs
We defer commissions, premium taxes and certain other costs that vary with and are primarily related to the acquisition of insurance contracts. These costs are capitalized and charged to expense in proportion to the recognition of premiums earned. The method followed in computing deferred policy acquisition costs limits the amount of these deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, anticipated losses and settlement expenses and certain other costs we expect to incur as the premium is earned. Judgments as to ultimate recoverability of these deferred costs are highly dependent upon estimated future costs associated with the premiums written.
Deferred Taxes
We use the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the income statement in the period that includes the enactment date.
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. If necessary, we would establish a valuation allowance to reduce the deferred tax assets to the amounts more likely than not to be realized.
Goodwill and Other Intangible Assets
Goodwill represents the excess of costs over fair value of 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 SFAS No. 144, Accounting for Impairment or Disposal of Long-Lived Assets.
Retrospective Premiums
Retrospective premiums for primary and reinsured risks are included in income as earned on a pro rata basis over the effective period of the respective policies. Earned premiums on retrospectively rated policies are based on our estimate of loss experience as of the measurement date. Unearned premiums are deferred and include that portion of premiums written that is applicable to the unexpired period of the policies in force and estimated adjustments of premiums on policies that have retrospective rating endorsements. Retrospectively rated policies accounted for approximately 25.8% of direct premiums written in 2006 and approximately 31.6% of direct premiums written in 2005.
Earned But Unbilled Premiums
We estimate the amount of premiums that have been earned but are unbilled at the end of the period by analyzing historical earned premium adjustments made and applying an adjustment percentage against premiums earned for the period.
Impairment of Investment Securities
Impairment of investment securities results in a charge to operations when the fair value of a security declines to below our cost and is deemed to be other-than-temporary. We regularly review our fixed maturity portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. A number of criteria are considered during this process, including but not limited to the following: the current fair value as compared to amortized cost or cost, as appropriate, of the security; the length of time the security’s fair value has been below amortized cost; our intent and ability to retain the investment for a period of time sufficient to allow for an anticipated recovery in value; and specific credit issues related to the issuer and current economic conditions, including interest rates. In general, we focus on those securities whose fair value was less than 80% of their amortized cost or cost, as appropriate, for six or more consecutive months. We also analyze the entire portfolio for other factors that might indicate a risk of impairment. Other-than-temporary impairment losses result in a permanent reduction of the carrying amount of the underlying investment. Significant changes in the factors considered when evaluating investments for impairment losses could result in a significant change in impairment losses reported in the financial statements.
Recent Accounting Pronouncements
In May 2005, Financial Accounting Standards Board (the “FASB”) issued SFAS No. 154, Accounting Changes and Error Corrections, which supersedes APB No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS No. 154 provides guidance on the
accounting for and reporting of accounting changes and error corrections. It establishes, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to the newly adopted accounting principle. SFAS No. 154 also provides guidance for determining whether retrospective application is impracticable. The correction of an error in previously issued financial statements is not an accounting change. However, the reporting of an error correction involves adjustments to previously issued financial statements similar to those generally applicable to reporting an accounting change retrospectively. Therefore, the reporting of a correction of an error by restating previously issued financial statements is addressed by the Statement. We adopted the provisions of SFAS No. 154 as of January 1, 2006, which did not have a material effect on the consolidated financial condition or results of operations.
In September 2005, the American Institute of Certified Public Accountants (“AICPA”) released Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (“SOP 05-1”). SOP 05-1 requires identification of transactions that result in a substantial change in an insurance contract. If it is determined that a substantial change to an insurance contract has occurred, the related unamortized deferred policy acquisition costs, unearned premiums and other related balances must be written off. SOP 05-1 is effective for fiscal years beginning after December 15, 2006. We expect that SOP 05-1 will not have a material effect on our consolidated financial condition or result of operations.
In November 2005, the FASB issued FASB Staff Position (“FSP”) SFAS No. 115-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments, which addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. SFAS No. 115-1 also includes accounting considerations subsequent to the recognition of other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance amends SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. We adopted the provisions of SFAS No. 115-1 as of January 1, 2006, which did not have a material effect on the consolidated financial condition or results of operations
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109 (“FIN 48”), which provides for the recognition, measurement, presentation and disclosure of uncertain tax positions. A tax benefit from an uncertain position may be recognized only if it is more likely than not that the position is sustainable based on its technical merits. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. We expect that FIN 48 will not have a material effect on our consolidated financial condition or results of operations.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which defines fair value and establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. The provisions for SFAS No. 157 are effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Early adoption is permitted. We must adopt these new requirements no later than its first fiscal quarter of 2008. We expect that SFAS No. 157 will not have a material effect on our consolidated financial condition or result of operations.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of prior-year uncorrected misstatements should be considered when quantifying misstatements in the current year financial statements. SAB 108 requires registrants to quantify misstatements using both an income statement (“rollover”) and balance sheet (“iron curtain”) approach and evaluate whether either approach results in a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. If prior year errors that had been previously considered immaterial now are considered material based on either approach, no restatement is required so long as management properly applied its previous approach and all relevant facts and circumstances were
considered. If prior years are not restated, the cumulative effect adjustment is recorded in opening accumulated earnings as of the beginning of the fiscal year of adoption. SAB 108 is effective for fiscal years ending on or after November 15, 2006, with earlier adoption encouraged. We adopted the provisions of SAB 108 as of December 31, 2006 which did not have a material effect on the consolidated financial condition or results of operations.
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 us are credit risk and interest rate risk.
Credit Risk
Credit Risk is the potential economic loss principally arising from adverse changes in the financial condition of a specific debt issuer. We address this risk by investing generally in fixed-income securities which are rated “A” or higher by Standard & Poor’s. We also independently, and through our outside investment managers, monitor the financial condition of all of the issuers of fixed-income securities in the portfolio. To limit our exposure to risk we employ stringent diversification rules that limit the credit exposure to any single issuer or business sector.
Interest Rate Risk
We had fixed-income investments with a fair value of $399.1 million at December 31, 2006 that are subject to interest rate risk compared with $258.0 million at December 31, 2005. We manage the exposure to interest rate risk through a disciplined 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 liability and capital position.
The table below summarizes our interest rate risk as of December 31, 2006 and December 31, 2005. It illustrates the sensitivity of the fair value of fixed-income investments to selected hypothetical changes in interest rates as of December 31, 2006 and December 31, 2005. The selected scenarios are not predictions of future events, but rather illustrate the effect that such events may have on the fair value of our fixed-income portfolio and stockholders’ equity.
Interest Rate Risk as of December 31, 2006:
Interest Rate Risk as of December 31, 2005:
Item 8.
Item 8. Financial Statements and Supplementary Data.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
SeaBright Insurance Holdings, Inc.:
We have audited the accompanying consolidated balance sheets of SeaBright Insurance Holdings, Inc. and subsidiaries (the Company) as of December 31, 2006 and 2005, and the related consolidated statements of operations, changes in stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our 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 audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of SeaBright Insurance Holdings, Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 2 of the consolidated financial statements, effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123(R), Share-Based Payment.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of SeaBright Insurance Holdings, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 16, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
/s/ KPMG LLP
Seattle, Washington
March 16, 2007
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements.
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes to consolidated financial statements.
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
AND COMPREHENSIVE INCOME
See accompanying notes to consolidated financial statements.
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.
Organization
SeaBright Insurance Holdings, Inc. (“SIH” or the “Company”), a Delaware corporation, was formed in June 2003. On July 14, 2003, SIH entered into a purchase agreement, effective September 30, 2003, with Kemper Employers Group, Inc. (“KEG”), Eagle Insurance Companies (“Eagle”), and Lumbermens Mutual Casualty Company (“LMC”), the ultimate owner of KEG and Eagle (the “Acquisition”). Under this agreement, SIH acquired Kemper Employers Insurance Company (“KEIC”), PointSure Insurance Services, Inc. (“PointSure”), and certain assets of Eagle, primarily renewal rights.
At the time of the Acquisition, KEIC was licensed to write workers’ compensation insurance in 45 states and the District of Columbia. Domiciled in the State of Illinois and commercially domiciled in the State of California, it wrote both state act workers’ compensation insurance and United States Longshore and Harborworkers’ Compensation insurance (“USL&H”). Prior to the Acquisition, beginning in 2000, KEIC wrote business only in California. In May 2002, KEIC ceased writing business and by December 31, 2003, all premiums related to business prior to the Acquisition were 100% earned. As further discussed in Note 8.a., in connection with the Acquisition, KEIC and LMC entered into an agreement whereby LMC agreed to indemnify KEIC in the event of adverse development of the reserves stated on KEIC’s balance sheet at the Acquisition date, for a period of approximately eight years. In addition, KEIC agreed to share with LMC any positive development of those reserves. December 31, 2011 is the date to which the parties will look to determine whether the loss and loss adjustment expenses with respect to KEIC’s insurance policies in effect at the date of the Acquisition have increased or decreased from the amount existing at the date of the Acquisition.
KEIC resumed writing business effective October 1, 2003, primarily targeting policy renewals for former Eagle business in the States of California, Hawaii and Alaska. In November 2003, permission was granted by the Illinois Department of Financial and Professional Regulation, Division of Insurance (the “Illinois Division of Insurance”) for KEIC to change its name to SeaBright Insurance Company (“SBIC”).
PointSure is engaged primarily in administrative and brokerage activities. Eagle consists of Eagle Pacific Insurance Company, Inc. and Pacific Eagle Insurance Company, Inc., both writers of state act workers’ compensation insurance and USL&H that are in run-off as of December 31, 2006.
2.
Summary of Significant Accounting Policies
a. Basis of Presentation
The accompanying consolidated financial statements include the accounts of SIH and its wholly owned subsidiaries, PointSure and SBIC, (collectively, the “Company”). All significant intercompany transactions among these affiliated entities have been eliminated in consolidation.
The consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and include amounts based on the best estimates and judgments of management. Such estimates and judgments could change in the future, as more information becomes known which could impact the amounts reported and disclosed herein.
In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 131, Disclosures About Segments of an Enterprise and Related Information, the Company considers an operating segment to be any component of its business whose operating results are regularly reviewed by the Company’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance. Currently, the Company has one operating segment, workers’ compensation insurance and related services.
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
b. Investment Securities
Investment securities are classified as available-for-sale and carried at fair value, adjusted for other-than-temporary declines in fair value, with changes in unrealized gains and losses recorded in other comprehensive loss, net of applicable income taxes. The estimated fair value of investments in available-for-sale securities is generally based on quoted market prices for securities traded in the public marketplace.
The Company regularly reviews its fixed maturity portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. In general, the Company focuses on those securities whose fair values were less than 80% of their amortized cost or cost, as appropriate, for six or more consecutive months. The Company also analyzes the entire portfolio for other factors that might indicate a risk of impairment, including credit ratings and interest rates. A decline in the fair value of any available-for-sale security below cost that is deemed to be other-than-temporary results in a reduction in the carrying amount of the security to fair value. The impairment is charged to earnings and a new cost basis for the security is established.
Mortgage-backed securities represent participating interests in pools of first mortgage loans originated and serviced by the issuers of securities. These securities are carried at fair value. Premiums and discounts are amortized using a method that approximates the level yield method over the remaining period to contractual maturity, adjusted for anticipated prepayments. To the extent that the estimated lives of such securities change as a result of changes in prepayment rates, the adjustment is also included in net investment income. Prepayment assumptions used for mortgage-backed and asset-backed securities were obtained from an external securities information service and are consistent with the current interest rate and economic environment.
Investment income is recorded when earned. For the purpose of determining realized gains and losses, which arise principally from the sale of investments, the cost of securities sold is based on specific-identification as of the trade date.
c. Cash and Cash Equivalents
Cash and cash equivalents, which consist primarily of amounts deposited in banks and financial institutions, and all highly liquid investments with maturities of 90 days or less when purchased, are stated at cost. Cash in excess of daily requirements is invested in money market funds and repurchase agreements with maturities of 90 days or less. Such investments are deemed to be cash equivalents for purposes of the consolidated balance sheets and statements of cash flows. The Company had $19.2 million and $11.0 million of cash equivalents at December 31, 2006 and 2005, respectively.
d. Use of Estimates
The preparation of the consolidated financial statements in conformity with GAAP requires management of the Company to make a number of estimates and assumptions relating to the reported amount of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates. The Company has used significant estimates in determining fair value and impairment of investment securities, unpaid loss and loss adjustment expenses, goodwill and other intangibles, earned premiums on retrospectively rated policies, earned but unbilled premiums, deferred acquisition costs, federal income taxes and certain amounts related to reinsurance.
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e. Premiums Receivable
Premiums receivable are recorded at the invoiced amount as they are earned over the life of the contract in proportion to the amount of insurance protection provided. The allowance for doubtful accounts is the Company’s best estimate of the amount of uncollectible premium in the Company’s existing premiums receivable balance. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.
f. Deferred Policy Acquisition Costs
Acquisition costs related to premiums written are deferred and amortized over the periods in which the premiums are earned. Such acquisition costs vary with and are primarily related to the acquisition of insurance contracts and include commissions, premium taxes, and certain underwriting and policy issuance costs. Deferred policy acquisition costs are limited to amounts recoverable from unearned premiums and anticipated investment income.
g. Property and Equipment
Furniture and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful lives, which range from three to five years. Leasehold improvements are depreciated on a straight-line basis over ranging from approximately two to seven years, which is the shorter of their estimated useful lives or the remaining term of the respective lease. Depreciation expense totaled $435,000, $310,000 and $166,000 for the years ended December 31, 2006, 2005, and 2004, respectively.
h. Goodwill and Other Intangible Assets
Goodwill represents the excess of costs over fair value of 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 SFAS No. 144, Accounting for Impairment or Disposal of Long-Lived Assets.
i. Revenue Recognition
Premiums for primary and reinsured risks are included in revenue over the life of the contract in proportion to the amount of insurance protection provided (i.e., ratably over the policy period). The portion of the premium that is applicable to the unexpired period of a policy in-force is not included in revenue but is deferred and recorded as unearned premium in the liability section of the balance sheet. Deferred premiums represent the unbilled portion of annual premiums.
Earned premiums on retrospectively rated policies are based on the Company’s estimate of loss experience as of the measurement date. Loss experience includes known losses specifically identifiable to a retrospective policy as well as provisions for future development on known losses and for losses incurred but not yet reported using actuarial loss development factors and is consistent with how the Company projects losses in general. For retrospectively rated policies, the governing contractual minimum and maximum rates are established at policy inception and are made a part of the insurance contract. While the typical retrospectively rated policy has five annual adjustment or measurement periods, premium adjustments continue until mutual agreement to cease future adjustments is reached with the policyholder. For the years ended December 31, 2006 and 2005, approximately 25.8% and 31.6%, respectively, of direct premiums written related to retrospectively rated policies.
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The Company estimates the amount of premiums that have been earned but are unbilled at the end of the period by analyzing historical earned premium adjustments made and applying an adjustment percentage against premiums earned for the period. Included in deferred premiums at December 31, 2006 and 2005 and premiums earned for the years then ended are accruals for earned but unbilled premiums of $1.5 million and $2.2 million, respectively.
Service income generated from various underwriting and claims service agreements with third parties is recognized as income in the period in which services are performed.
j. Unpaid Loss and Loss Adjustment Expense
Unpaid loss and loss adjustment expense represents an estimate of the ultimate net cost of all unpaid losses incurred through the specified period. Loss adjustment expenses are estimates of unpaid expenses to be incurred in settlement of the claims included in the liability for unpaid losses. These liabilities, which anticipate salvage and subrogation recoveries and are presented gross of amounts recoverable from reinsurers, include estimates of future trends in claim severity and frequency and other factors that could vary as the losses are ultimately settled. Liabilities for unpaid loss and loss adjustment expenses are not discounted to account for the time value of money.
We use consulting actuaries to assist in the evaluation of the reasonableness of our liability for unpaid loss and loss adjustment expense. In light of the Company’s short operating history, and uncertainties concerning the effects of legislative reform specifically as it relates to the Company’s California workers compensation class of business, actuarial techniques are applied that use the historical experience of the Company’s predecessor as well as industry information in the analysis of unpaid loss and loss adjustment expense. These techniques recognize, among other factors:
•
the Company’s claims experience and that of its predecessor;
•
the industry’s claims experience;
•
historical trends in reserving patterns and loss payments;
•
the impact of claim inflation;
•
the pending level of unpaid claims;
•
the cost of claim settlements;
•
legislative reforms affecting workers’ compensation; and
•
the environment in which insurance companies operate.
Although it is not possible to measure the degree of variability inherent in such estimates, management believes that the liability for unpaid loss and loss adjustment expense is reasonable. The estimates are reviewed periodically and any necessary adjustments are included in the results of operations of the period in which the adjustment is determined.
k. Reinsurance
The Company protects itself from excessive losses by reinsuring certain levels of risk in various areas of exposure with nonaffiliated reinsurers. Reinsurance premiums, commissions, expense reimbursements and reserves related to ceded business are accounted for on a basis consistent with the accounting for the original policies issued and the terms of reinsurance contracts. The unpaid loss and loss adjustment expense subject to the adverse development cover with LMC is calculated on a quarterly basis using generally accepted actuarial methodologies for estimating unpaid loss and loss adjustment expense liabilities, including incurred loss and
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paid loss development methods. Amounts recoverable in excess of acquired reserves at September 30, 2003 are recorded gross in unpaid loss and loss adjustment expense in accordance with SFAS No. 141, Business Combinations, with a corresponding amount receivable from the seller. Amounts are shown net in the statement of operations. Premiums ceded to other companies are reported as a reduction of premiums written and earned. Reinsurance recoverables are determined based on the terms and conditions of the reinsurance contracts.
Balances due from reinsurers on unpaid loss and loss adjustment expenses, including an estimate of such recoverables related to reserves for IBNR losses, are reported as assets and are included in reinsurance recoverables even though amounts due on unpaid loss and loss adjustment expenses are not recoverable from the reinsurer until such losses are paid. The Company monitors the financial condition of its reinsurers and does not believe that it is currently exposed to any material credit risk through our reinsurance agreements because most of its reinsurance is recoverable from large, well-capitalized reinsurance companies. Historically, no amounts from reinsurers have been written-off as uncollectible.
l. Income Taxes
The asset and liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that are estimated to be in effect when the differences are expected to reverse, net of any applicable valuation allowances. We evaluate the necessity of a deferred tax asset valuation allowance by determining, based on the weight of available evidence, whether it is more likely than not that some portion or all of the deferred tax asset will not be realized. When necessary, a valuation allowance is recorded to reduce the deferred tax asset to the amount that is more likely than not to be realized.
m. Earnings Per Share
The following table provides the reconciliation of weighted average common share equivalents outstanding used in calculating earnings per share for the years ended December 31, 2006, 2005, and 2004:
Outstanding options to purchase shares of our common stock are excluded for the year ended December 31, 2004 because they are anti-dilutive.
n. Stock Based Compensation
The Company adopted SFAS No. 123R, Share-Based Payment, on January 1, 2006, using the modified-prospective transition method. Prior to adoption, the Company measured its employee stock-based compensation arrangements using the provisions outlined in Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, which is an intrinsic value-based method of recognizing
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compensation costs, and adopted the disclosure-only provisions of SFAS No. 123, Accounting for Stock-based Compensation. None of the Company’s stock options granted prior to adoption had an intrinsic value at grant date and, accordingly, no compensation cost was recognized for its stock option plan activity prior to adoption.
Under the modified-prospective transition method, stock-based compensation cost is recognized in the consolidated financial statements for granted, modified, or settled share-based payments. Compensation cost recognized includes the estimated cost for stock options granted on or after January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R, and the estimated expense for the portion of awards granted prior to January 1, 2006 vesting in the current period, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123. Results for prior periods have not been restated, as provided for under the modified-prospective method.
Total stock-based compensation expense recognized in the consolidated statement of operations for the year ended December 31, 2006 is shown in the following table. No compensation cost was capitalized during year ended December 31, 2006.
The following table shows the effect on net income and earnings per share for the years ended December 31, 2005 and 2004 as if compensation cost had been recognized based upon the estimated grant date fair value of stock options in accordance with SFAS No. 123, as amended by SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, and as if such cost had been determined in accordance with SFAS No. 123R:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Disclosures for the year ended December 31, 2006 are not presented because the amounts are recognized in the consolidated financial statements. The compensation cost included in pro forma net income is not likely to be representative of the effect on reported net income for future years because options vest over several years and additional awards may be made each year.
The following table presents the impact of our adoption of SFAS No. 123R on selected line items from our consolidated financial statements for the year ended December 31, 2006:
o. Recent Accounting Statements
In May 2005, Financial Accounting Standards Board (the “FASB”) issued SFAS No. 154, Accounting Changes and Error Corrections, which supersedes APB No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS No. 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to the newly adopted accounting principle. SFAS No. 154 also provides guidance for determining whether retrospective application is impracticable. The correction of an error in previously issued financial statements is not an accounting change. However, the reporting of an error
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
correction involves adjustments to previously issued financial statements similar to those generally applicable to reporting an accounting change retrospectively. Therefore, the reporting of a correction of an error by restating previously issued financial statements is addressed by the Statement. The Company adopted the provisions of SFAS No. 154 as of January 1, 2006, which did not have a material effect on the consolidated financial condition or results of operations.
In September 2005, the American Institute of Certified Public Accountants (“AICPA”) released Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (“SOP 05-1”). SOP 05-1 requires identification of transactions that result in a substantial change in an insurance contract. If it is determined that a substantial change to an insurance contract has occurred, the related unamortized deferred policy acquisition costs, unearned premiums and other related balances must be written off. SOP 05-1 is effective for fiscal years beginning after December 15, 2006. The Company expects that SOP 05-1 will not have a material effect on its consolidated financial condition or result of operations.
In November 2005, the FASB issued FASB Staff Position (“FSP”) SFAS No. 115-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments, which addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. SFAS No. 115-1 also includes accounting considerations subsequent to the recognition of other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance amends SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. The Company adopted the provisions of SFAS No. 115-1 as of January 1, 2006, which did not have a material effect on the consolidated financial condition or results of operations
In July 2006, the Financial Accounting Standards Board (the “FASB”) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109 (“FIN 48”), which provides for the recognition, measurement, presentation and disclosure of uncertain tax positions. A tax benefit from an uncertain position may be recognized only if it is more likely than not that the position is sustainable based on its technical merits. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. The Company expects that FIN 48 will not have a material effect on its consolidated financial condition or results of operations.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. The provisions for SFAS No. 157 are effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Early adoption is permitted. The Company must adopt these new requirements no later than its first fiscal quarter of 2008. The Company expects that SFAS No. 157 will not have a material effect on its consolidated financial condition or result of operations.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of prior-year uncorrected misstatements should be considered when quantifying misstatements in the current year financial statements. SAB 108 requires registrants to quantify misstatements using both an income statement (“rollover”) and balance sheet (“iron curtain”) approach and evaluate whether either approach results in a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. If prior year errors that had been previously considered immaterial now are considered material based on either approach, no restatement is required so long as management properly applied its previous approach and all relevant facts and circumstances were considered. If prior years are not restated, the cumulative effect adjustment is recorded in opening accumulated
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
earnings as of the beginning of the fiscal year of adoption. SAB 108 is effective for fiscal years ending on or after November 15, 2006, with earlier adoption encouraged. The Company adopted the provisions of SAB 108 as of December 31, 2006 which did not have a material impact on the consolidated financial condition or result of operations.
p. Reclassifications
Certain reclassifications have been made to the prior years’ financial statements to conform to classifications used in the current year.
3.
Investments
The consolidated cost or amortized cost, gross unrealized gains and losses, and estimated fair value of investment securities available-for-sale at December 31, 2006 and 2005 are as follows:
Equity securities at December 31, 2006 consist of investments in exchange traded funds designed to correspond to the performance of certain indexes based on domestic or international stocks. Equity securities at December 31, 2005 consist of investments in a high-yield municipal bond mutual fund. The Company had
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
no direct investments in equity securities at December 31, 2006 or 2005. At December 31, 2006 and 2005, the unrealized loss on temporarily impaired investments totaled $2.4 million and $2.5 million, respectively, for investment securities available-for-sale with a fair value of $209.4 million and $188.0 million, respectively. Approximately $1.9 million at December 31, 2006 and $0.5 million at December 31, 2005 of total unrealized losses were from securities that had been impaired for more than one year. At December 31, 2006 and 2005, no unrealized loss exceeded 20% of the related security’s book value at that date. The following table presents information about fixed maturity securities with unrealized losses December 31, 2006 and 2005:
The Company regularly reviews its fixed maturity portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. A number of criteria are considered during this process including, but not limited to, the following: the current fair value as compared to amortized cost or cost, as appropriate, of the security; the length of time the security’s fair value has been below amortized cost; the Company’s intent and ability to retain the investment for a period of time sufficient to allow for an anticipated recovery in value; specific credit issues related to the issuer; and current economic conditions. In general, the Company focuses on those securities whose fair values were less than 80% of their amortized cost or cost, as appropriate, for six or more consecutive months. Other-than-temporary impairment losses result in a permanent reduction of the carrying amount of the underlying investment. Significant changes in the factors considered when evaluating investments for impairment losses could result in a significant change in impairment losses reported in the financial statements. At December 31, 2006 and 2005, the Company evaluated investment securities with fair values less than amortized cost and has determined that the decline in value is temporary and is related primarily to the change in market interest rates since purchase. Furthermore, the Company has the ability to hold the impaired investments to maturity or for a period of time sufficient for recovery of their carrying amount. Therefore, no other-than-temporary impairment losses were recorded in the years ended December 31, 2006, 2005 and 2004.
The amortized cost and estimated fair value of fixed income securities available-for-sale at December 31, 2006, by contractual maturity, are set forth below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The consolidated amortized cost of fixed income securities available-for-sale deposited with various regulatory authorities was $118.8 million and $53.4 million at December 31, 2006 and 2005, respectively.
Major categories of consolidated net investment income are summarized as follows for the years ended December 31, 2006, 2005, and 2004:
Proceeds from the sales of fixed income and equity securities, related realized gains and losses and changes in unrealized gains (losses) were as follows:
4.
Fair Value of Financial Instruments
Estimated fair value amounts, defined as the quoted market price of a financial instrument, have been determined using available market information and other appropriate valuation methodologies. However, considerable judgment is required in developing the estimates of fair value. Accordingly, these estimates are not necessarily indicative of the amounts that could be realized in a current market exchange. The use of
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
different market assumptions or estimating methodologies may have an effect on the estimated fair value amounts.
The following methods and assumptions were used by the Company in estimating the fair value disclosures for financial instruments in the accompanying consolidated financial statements and notes:
•
Cash and cash equivalents, premiums receivable, accrued expenses, other liabilities and surplus notes: The carrying amounts for these financial instruments as reported in the accompanying consolidated balance sheets approximate their fair values.
•
Investment securities: The estimated fair values for available-for-sale securities generally represent quoted market value prices for securities traded in the public marketplace. Additional information with respect to fair values of the Company’s investment securities is disclosed in Note 3.
Other financial instruments qualify as insurance-related products and are specifically exempted from fair value disclosure requirements.
5.
Premiums
Direct premiums written totaled $221.8 million, $195.5 million, and $134.0 million for the years ended December 31, 2006, 2005 and 2004, respectively.
Premiums receivable consist of the following at December 31, 2006 and 2005:
The activity in the allowance for doubtful accounts for the years ended December 31, 2006, 2005, and 2004 is as follows (in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
6.
Property and Equipment
Property and equipment consisted of the following at December 31, 2006 and 2005:
7.
Deferred Policy Acquisition costs
The following reflects the amounts of policy acquisition costs deferred and amortized for the years ended December 31, 2006, 2005, and 2004:
8.
Reinsurance
a. Reinsurance Ceded
Under reinsurance agreements, the Company cedes various amounts of risk to nonaffiliated insurance companies for the purpose of limiting the maximum potential loss arising from the underlying insurance risks.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
On October 1, 2006, the Company entered into new reinsurance agreements with nonaffiliated reinsurers wherein it retains the first $1.0 million of each loss occurrence. The new reinsurance program, which is effective through October 1, 2007, provides coverage up to $75.0 million per loss occurrence as follows:
All of the reinsurance policies described in this Note 8 are subject to various additional limitations and exclusions as more fully described in the reinsurance agreements.
Effective from October 1, 2005 through October 1, 2006, the Company entered into reinsurance agreements wherein it retains the first $500,000 of each loss occurrence. Losses in excess of $500,000 up to $50.0 million are reinsured with nonaffiliated reinsurers as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Effective from October 1, 2004 through October 1, 2005, the Company entered into reinsurance agreements wherein it retains the first $500,000 of each loss occurrence. Losses in excess of $500,000 up to $100.0 million are 100% reinsured with nonaffiliated reinsurers.
Effective from October 1, 2003 through October 1, 2004, the Company entered into reinsurance agreements wherein it retains the first $500,000 of each loss occurrence. The next $500,000 of such loss occurrence is 50% retained by SBIC after meeting a $1.5 million aggregate deductible. Losses in excess of $1.0 million up to $100.0 million are 100% reinsured with nonaffiliated reinsurers.
SBIC has in place a series of reinsurance agreements that were entered into prior to its acquisition by SIH which are as follows: Effective from January 1, 1999 through January 1, 2001, SBIC retains the first $250,000 of each loss occurrence; the next $750,000 of such loss occurrence is 100% reinsured with nonaffiliated reinsurers. Losses in excess of $1.0 million up to $4.0 million for this time period are 100% reinsured with nonaffiliated reinsurers. Effective July 1, 2000 through July 1, 2002, SBIC retains the first $500,000 of each loss occurrence; the next $500,000 of such loss occurrence is 100% reinsured with nonaffiliated reinsurers. Effective January 1, 2001 through January 1, 2002, SBIC retains the first $1.0 million of each loss occurrence; losses up to $5.0 million are 100% reinsured with nonaffiliated reinsurers. Effective October 1, 2000 through October 1, 2001 SBIC has a quota-share agreement whereby 10% of the first $250,000 loss plus a pro-rata share of expenses are 100% reinsured with Swiss Reinsurance Company. Effective January 1, 2002 through May 31, 2002, 100% of all losses are 100% quota-shared to Argonaut Insurance Company.
As part of the purchase of SBIC, SIH, and LMC entered into an adverse development excess of loss reinsurance agreement (the “Agreement”). The Agreement, after taking into account any recoveries from third party reinsurers, calls for LMC to reimburse SBIC 100% of the excess of the actual loss at December 31, 2011 over the initial loss reserves at September 30, 2003. The Agreement also calls for SBIC to reimburse LMC 100% of the excess of the initial loss reserves at September 30, 2003 over the actual loss results at December 31, 2011. The amount of adverse loss development under the Agreement was $2.8 million at December 31, 2006 and $3.4 million at December 31, 2005. The decrease in the amount receivable from LMC is netted against loss and loss adjustment expense in the accompanying consolidated statements of operations.
As part of the Agreement, LMC placed into trust (the “Trust”) $1.6 million, equal to 10% of the balance sheet reserves of SBIC at the date of sale. Thereafter, the Trust shall be adjusted each quarter, if warranted, to an amount equal to the greater of (a) $1.6 million or (b) 102% of LMC’s obligations under the Agreement. The balance of the Trust, including accumulated interest, was $5.2 million at December 31, 2006 and $4.9 million at December 31, 2005. In February 2007, LMC submitted a request to withdraw approximately $1.8 million of excess funds on deposit in the trust account. The balance of the Trust totaled approximately $3.4 million immediately following the withdrawal.
b. Reinsurance Assumed
The Company involuntarily assumes residual market business either directly from various states that operate their own residual market programs or indirectly from the National Council for Compensation Insurance, which operates residual market programs on behalf of some states. The states in which we assumed residual market business in 2006 and 2005 include the following: Alabama, Alaska, Arizona, Arkansas, Georgia, Illinois, Nevada, New Jersey, New Mexico, Oregon, South Carolina and Virginia.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
c. Reinsurance Recoverables and Income Statement Effects
Balances affected by reinsurance transactions are reported gross of reinsurance in the balance sheets. Reinsurance recoverables comprise the following amounts at December 31, 2006 and 2005:
The Company evaluates the financial condition of its reinsurers and monitors concentrations of credit risk arising from activities or economic characteristics of the reinsurers to minimize its exposure to losses from reinsurer insolvencies. In the event a reinsurer is unable to meet its obligations, the Company would be liable for the losses under the agreement.
The Company recorded no write-offs of uncollectible reinsurance recoverables in the years ended December 31, 2006, 2005, and 2004.
The effects of reinsurance are as follows for the years ended December 31, 2006, 2005, and 2004:
The Company did not commute any reinsurance agreements in the years ended December 31, 2006, 2005 and 2004.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
9.
Unpaid Loss and Loss Adjustment Expenses
The following table summarizes the activity in unpaid loss and loss adjustment expense for the years ended December 31, 2006, 2005 and 2004:
As a result of changes in estimates of insured events in prior periods, the unpaid loss and loss adjustment expenses decreased by approximately $16.0 million in 2006 due to positive development on previously reported claims in accident year 2005 and $6.3 million due to positive development on previously reported claims in accident year 2004. For accident years 2003 and prior, unpaid loss and loss adjustment expenses decreased $486,000 due to positive development on previously reported claims. According to the terms of the adverse development cover, the Company is obligated to reimburse LMC for $571,000 of the prior period positive development. In connection with the Acquisition, KEIC and LMC entered into an agreement to indemnify each other with respect to developments in KEIC’s unpaid loss and loss adjustment expenses over a period of approximately eight years. December 31, 2011 is the date to which the parties will look to determine whether the loss and loss adjustment expenses with respect to KEIC’s insurance policies in effect at the Acquisition have increased or decreased from the amount existing at the date of the Acquisition.
Approximately $3.6 million of the $2.1 million reduction in 2005 related to positive development on previously reported claims in accident year 2004. This adjustment was offset by an increase of approximately $1.5 million in reserves for reported claims in accident year 2003 and prior. Of that amount, the Company was entitled to recover from LMC, according to the terms of the adverse development cover, approximately $499,000 of adverse development of KEIC losses. Approximately $385,000 of the $451,000 adverse development in 2004 related to KEIC claims, which the Company was entitled to recover from LMC according to the terms of the adverse development cover. The remaining amount of $66,000 related to adverse development of the Company’s reserves for reported claims in accident year 2003.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
At December 31, 2006 and 2005, the Company reduced unpaid loss and loss adjustment expense by $3.3 million and $2.1 million, respectively, for anticipated salvage and subrogation recoveries.
10.
Surplus Notes
On May 26, 2004, SBIC issued in a private placement $12.0 million in subordinated floating rate Surplus Notes due in 2034. The transaction was underwritten by Morgan Stanley & Company and Cochran & Caronia Securities, LLC. The note holder is ICONS, Ltd. and Wilmington Trust Company acts as Trustee. Interest, paid quarterly in arrears, is calculated at the beginning of the interest payment period using the 3-month LIBOR rate plus 400 basis points. The quarterly interest rate cannot exceed the initial interest rate by more than 10% per year, cannot exceed the corporate base (prime) rate by more than 2% and cannot exceed the highest rate permitted by New York law. The rate or amount of interest required to be paid in any quarter is also subject to limitations imposed by the Illinois Insurance Code. Interest amounts not paid as a result of these limitations become “Excess Interest,” which the Company may be required to pay in the future, subject to the same limitations and all other provisions of the Surplus Notes Indenture. To date, there has been no Excess Interest. The interest rate at December 31, 2006 was 9.37%. Interest and principal may only be paid upon the prior approval of the Illinois Division of Insurance. In the event of default, as defined, or failure to pay interest due to lack of Illinois Division of Insurance approval, the Company cannot pay dividends on its capital stock, is limited in its ability to redeem, purchase or acquire any of its capital stock and cannot make payments of interest or principal on any debt issued by the Company which ranks equal with or junior to the Surplus Notes. If an event of default occurs and is continuing, the principal and accrued interest can become immediately due and payable. Interest expense for the years ended December 31, 2006, 2005, and 2004 was $1.1 million, $888,000, and $415,000, respectively.
The notes are redeemable prior to 2034 by the Company, in whole or in part, from time to time, on or after May 24, 2009 on an interest payment date or at any time prior to May 24, 2009, in whole but not in part, upon the occurrence and continuation of a tax event as defined in the agreement. The Company may not exercise its option to redeem with respect to a tax event unless it pays a premium in addition to the redemption price.
Issuance costs of $591,000 incurred in connection with the Surplus Notes are being amortized over the life of the notes using the effective interest method. Amortization expense for the years ended December 31, 2006, 2005, and 2004 was $54,000, $44,000 and $20,000, respectively.
11.
Income Taxes
The operations of SIH and its subsidiaries are included in a consolidated federal income tax return.
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following is a reconciliation of the difference between the “expected” income tax computed by applying the federal statutory income tax rate to income before income taxes and the total income taxes reflected on the books for the years ended December 31, 2006, 2005, and 2004:
Deferred federal income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and those amounts used for federal income tax reporting purposes. The significant components of the deferred tax assets and liabilities at December 31, 2006 and 2005 are as follows:
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based upon the projections of future taxable income over the periods in which the deferred taxes are deductible, management believes it is more likely than not that the Company will realize the benefits of these deductible differences.
As of December 31, 2006, the Company has capital loss carryforwards of approximately $577,000. Approximately $146,000 expires in 2010 and $431,000 expires in 2011.
12.
Statutory Net Income and Stockholders’ Equity
SBIC is required to file annually with state regulatory insurance authorities financial statements prepared on an accounting basis as prescribed or permitted by such authorities (statutory basis accounting or “SAP”). Statutory net income and capital and surplus (stockholders’ equity) differ from amounts reported in accordance with GAAP, primarily because of the following accounting treatments prescribed by SAP: policy acquisition costs are expensed when incurred; certain assets designated as “nonadmitted” for statutory purposes are charged to surplus; fixed-income securities are reported primarily at amortized cost or fair value based on their rating by the National Association of Insurance Commissioners (“NAIC”); policyholders’ dividends are expensed as declared rather than accrued as incurred; deferred income taxes are charged or credited directly to unassigned surplus; and any change in the admitted net deferred tax asset is offset to equity. Following is a summary of SBIC’s statutory net gain (loss) for the years ended December 31, 2006, 2005, and 2004 and statutory capital and surplus as of December 31, 2006, 2005 and 2004:
The maximum amount of dividends that can be paid to stockholders by insurance companies domiciled in the State of Illinois without prior approval of regulatory authorities is restricted if such dividend, together with other distributions during the 12 preceding months, would exceed the greater of 10% of the insurer’s statutory surplus as of the preceding December 31 or the statutorily adjusted net income for the preceding calendar year. If the limitation is exceeded, then such proposed dividend must be reported to the Director of Insurance at least 30 days prior to the proposed payment date and may be paid only if not disapproved. The Illinois insurance laws also permit payment of dividends only out of earned surplus, exclusive of most unrealized gains. At December 31, 2006, SBIC had statutory earned surplus of $40.5 million. Consequently, SBIC would be able to pay up to $14.5 million of stockholder dividends in 2007 without the prior approval of the regulators.
KEIC was last examined by the Illinois Division of Insurance as of December 31, 2000. In September 2006, SBIC was notified by the Illinois Division of Insurance that a routine comprehensive examination of its 2005 statutory annual statement had been scheduled. Field work began in October 2006 and was still in process at December 31, 2006.
The State of Illinois imposes minimum risk-based capital requirements that were developed by the NAIC. The formulas for determining the amount of risk-based capital specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of the enterprise’s regulatory total adjusted capital to certain minimum capital amounts as defined by the NAIC. Enterprises below specified trigger points or ratios are classified
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
within certain levels, each of which requires specified corrective action. SBIC exceeded the minimum risk-based capital requirements at December 31, 2006 and 2005.
13.
Commitments
The Company leases certain office space for its headquarters and regional offices under agreements that are accounted for as operating leases. Lease expense totaled $950,000, $1.1 million and $571,000 for the years ended December 31, 2006, 2005, and 2004, respectively. Total rent, including the effect of rent increases and concessions, is expensed on a straight-line basis over the respective lease terms.
Future minimum payments required under the agreements are as follows:
14.
Retirement Plan
The Company maintains a defined contribution 401(k) retirement savings plan covering substantially all of its employees. In 2006, the Company matched 100% of the first five percent of eligible compensation contributed to the plan on a pre-tax basis. In 2005 and 2004, the Company matched 100% of the first three percent and 50% of the next two percent of such compensation. For the years ended December 31, 2006, 2005, and 2004, the Company made additional contributions equal to one percent of compensation for all persons who were employed at the end of the year. Additionally, the Company made discretionary year-end contributions of one percent for 2005 and 2 percent for 2004 to the accounts of all persons who were employed at the end of year. Employees are 100% vested in all matching contributions when they are made. Contribution expense for the years ended December 31, 2006, 2005, and 2004 was $640,000, $571,000 and $316,000, respectively.
15.
Contingencies
a. SBIC is subject to guaranty fund and other assessments by the states in which it writes business. Guaranty fund assessments are accrued at the time premiums are written. Other assessments are accrued either at the time of assessment or in the case of premium-based assessments, at the time the premiums are written, or in the case of loss-based assessments, at the time the losses are incurred. SBIC has accrued a liability for guaranty fund and other assessments of $3.2 million at December 31, 2006 and has recorded a related asset for premium tax offset and policy surcharges of $3.5 million at that date. This amount represents management’s best estimate based on information received from the states in which it writes business and may change due to many factors including the Company’s share of the ultimate cost of current insolvencies. Most assessments are paid out in the year following the year in which the premium is written or the losses are paid. Policy surcharges are generally collected in the year following assessment and premium tax offsets are generally recognized over a period of up to five years following the year of assessment.
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
b. As previously reported, in June 2004, the Company was notified of a claim for damages brought by an individual against PointSure. In April 2005, a complaint against PointSure in connection with this matter was filed in the Superior Court of Washington for King County. The complaint alleged breach and unjust enrichment related to the termination of an alleged contract between PointSure and the plaintiff and sought a judgment awarding damages to the plaintiff in an amount to be proven at trial, plus attorneys’ fees and costs. In July 2006, the court granted plaintiff’s motion to file an amended complaint adding SIH and SBIC to the complaint. In October 2006, the parties agreed to settle the case. A one-time pre-tax charge of $305,000 related to the settlement of this case was included in operations for the year ended December 31, 2006.
c. The Company is involved in various claims and lawsuits arising in the ordinary course of business. Management believes the outcome of these matters will not have a material adverse effect on the Company’s financial position.
16.
Retrospectively Rated Contracts
On October 1, 2003, the Company began selling workers’ compensation insurance policies for which the premiums vary based on loss experience. Accrued retrospective premiums are determined based upon the loss experience of business subject to such experience rating adjustment. Accrued retrospectively rated premiums are determined by and allocated to individual policyholder accounts. Accrued retrospective premiums and return retrospective premiums are recorded as additions to and reductions from written premium, respectively. Approximately 25.8%, 31.6% and 35.8% of the Company’s direct premiums written for the years ended December 31, 2006, 2005 and 2004, respectively, related to retrospectively rated contracts. The Company accrued $9.6 million for retrospective premiums receivable and $12.7 million for return retrospective premiums at December 31, 2006 and $4.2 million for retrospective premiums receivable and $6.3 million for return retrospective premiums at December 31, 2005.
17.
Acquisition
On July 14, 2003, SIH entered into a purchase agreement, effective September 30, 2003, with KEG, Eagle and LMC, all ultimately owned by KIC. In the Acquisition, SIH acquired PointSure, KEIC, and the renewal rights and substantially all of the operating assets and employees of Eagle Pacific Insurance Company and Pacific Eagle Insurance Company. Eagle Pacific Insurance Company began writing specialty workers’ compensation insurance approximately 20 years ago. The Acquisition gave SIH renewal rights to an existing portfolio of business, representing a valuable asset given the renewal nature of the workers’ compensation insurance business, and a fully-operational infrastructure that would have taken many years to develop. These renewal rights gave the Company access to customer lists and the right to seek to renew its continuing in-force insurance contracts. In addition, KEIC provided the requisite insurance licenses needed to write business.
The initial aggregate purchase price, including acquisition costs of $1.3 million, was $16.0 million. The acquired assets and liabilities were recorded on the Company’s books at their respective fair values as of the date of Acquisition. Goodwill, the excess of the purchase price over the net fair value of the assets and liabilities acquired, was $2.1 million.
The Company and LMC negotiated a final purchase price adjustment settlement on September 28, 2004. Included in the original purchase price allocation was an estimated purchase price settlement amount of $1.1 million. The final purchase price adjustment settlement of $771,000 reduced the October 1, 2003 balance of reinsurance recoverables by $155,000 and increased the liability for unpaid loss and loss adjustment expenses by $226,000. The Company was required to pay interest expense of $30,000 related to the settlement period. In addition, the Company recorded an entry to increase other assets and reduce goodwill by $535,000.
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
18.
Intangible Assets
Intangible assets, other than goodwill, consist of the following at December 31, 2006 and 2005 (dollar amounts in thousands):
The weighted average amortization period for all intangible assets subject to amortization is 2.6 years. Aggregate amortization expense was $246,000, $629,000 and $731,000 for the years ended December 31, 2006, 2005, and 2004, respectively. Estimated remaining amortization expense is $10,000 in 2007 and $7,500 in 2008.
19.
Stockholders’ Equity
a. Convertible Preferred Stock
In September 2003, the Company’s Board of Directors authorized 750,000 shares of convertible preferred stock, all of which were designated as Series A preferred stock. In September 2003, the Company sold 456,750 shares of Series A preferred stock for cash proceeds, net of issuance costs, of $45.7 million. In June 2004, the Company sold an additional 51,615.25 shares of Series A preferred stock to current preferred stockholders and certain members of Company management for an aggregate purchase price of $5.2 million. Each share of Series A preferred stock was convertible into 15.299664 shares of the Company’s common stock, after giving effect to a two-for-one split of the Company’s common stock in February 2004 and a further 7.649832-for-one split of the Company’s common stock in December 2004. All references to numbers of shares in the consolidated financial statements and accompanying notes have been adjusted to reflect the stock splits on a retroactive basis. All outstanding shares of Series A preferred stock were converted into 7,777,808 shares of common stock in connection with the initial public offering of the Company’s common stock in January 2005.
b. Common Stock
In September 2003, the Company’s Board of Directors authorized 750,000 shares of common stock with a par value $0.01 per share. The number of authorized shares of common stock was increased to 1.1 million in March 2004, 1.2 million in August 2004, 10.0 million in December 2004 and 75.0 million in January 2005. The Board of Directors declared a two-for-one common stock split in February 2004 and a further 7.649832-for-one common stock split in December 2004. The Company completed the initial public offering of its common stock in January 2005, issuing 8,625,000 shares of common stock at a price of $10.50 per share for net proceeds of approximately $80.8 million.
On February 1, 2006, the Company closed a follow-on public offering of 3,910,000 shares of common stock, including the underwriters’ over-allotment option to purchase 510,000 shares of common stock, at a
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
price of $15.75 per share for net proceeds of approximately $57.6 million, after deducting underwriters’ fees, commissions and offering costs totaling approximately $4.0 million. The Company contributed $50.0 million of the net proceeds to SBIC, which is using the capital to expand its business in its core markets and to new territories. The remaining proceeds are being used for general corporate purposes, including supporting the growth of PointSure. The use of proceeds from the offering does not represent a material change from the use of proceeds described in the prospectus that was included in the related Registration Statement on Form S-1. Except for the contribution of proceeds to SBIC, no proceeds or expenses were paid to the Company’s directors, officers, ten percent shareholders or affiliates.
20.
Share-Based Payment Arrangements
At December 31, 2006, the Company had outstanding stock options and nonvested stock granted according to the terms of two equity incentive plans. The stockholders and Board of Directors approved the 2003 Stock Option Plan (the “2003 Plan”) in September 2003, and amended and restated the 2003 Plan in February 2004, and approved the 2005 Long-Term Equity Incentive Plan (the “2005 Plan” and, together with the 2003 Plan, the “Stock Option Plans”) in December 2004.
The Board of Directors reserved an initial total of 776,458 shares of common stock under the 2003 Plan and 1,047,755 shares of common stock under the 2005 Plan, plus an automatic annual increase on the first day of each fiscal year beginning in 2006 and ending in 2015 equal to the lesser of: (i) 2% of the shares of common stock outstanding on the last day of the immediately preceding fiscal year or (ii) such lesser number of shares as determined by the Board of Directors. At December 31, 2006, the Company reserved 776,458 shares of common stock for issuance under the 2003 Plan, of which options to purchase 487,683 shares had been granted, and 1,375,978 shares for issuance under the 2005 Plan, of which 671,063 shares had been granted. In January 2006, the Compensation Committee of the Board of Directors terminated the ability to grant future stock options awards under the 2003 Plan. Therefore, the Company anticipates that all future awards will be made under the 2005 Plan.
The 2005 Plan provides for the grant of incentive or non-qualified stock options, restricted stock, restricted stock units, deferred stock units, performance awards, or any combination of the foregoing. The Board of Directors has the authority to determine all matters relating to awards granted under the Stock Option Plans, including designation as incentive or nonqualified stock options, the selection of individuals to be granted options, the number of shares subject to each grant, the exercise price, the term and the vesting period, if any. Options to purchase the Company’s common stock are granted at prices at or above the fair value of the common stock on the date of grant, generally vest 25% per year on each of the first four anniversaries of the vesting start date, and expire 10 years from the date of grant. Options granted to non-employee directors generally vest one-third on the first anniversary of the grant date and the remaining two-thirds in equal monthly installments over the following 24 months. Nonvested stock issued to employees and directors generally vests on the third anniversary of the grant date, assuming the holder is still employed by or providing service to the Company and satisfies all other conditions of the grant. Generally, stock options granted to employees are incentive stock options, while options granted to non-employee directors are non-qualified stock options.
The Company issues new shares of common stock upon exercise of stock options or award of nonvested shares.
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
a. Stock Options
The fair values of stock options granted during the years ended December 31, 2006, 2005 and 2004 were determined on the dates of grant using the Black-Scholes-Merton option valuation model with the following weighted average assumptions:
For 2006, the expected term of options was determined using the “simplified method,” which averages an award’s weighted average vesting period and its contractual term. For 2006, expected stock price volatility was based on a weighted average of the Company’s historical stock price volatility since the initial public offering of its common stock in January 2005 and the historical volatility of a peer company’s stock for a period of time equal to the expected term of the option. Prior to the adoption of SFAS No. 123R, expected term was based on the Company’s historical experience and future expectations and price volatility was estimated using the Company’s historical volatility. The risk-free interest rate is based on the yield of U.S. Treasury securities with an equivalent remaining term. The Company has not paid stockholder dividends in the past and has no current plan to pay any stockholder dividends in the near future.
The assumptions used to calculate the fair value of 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 cost in the Company’s financial statements over the requisite service period of the entire award. Compensation cost 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, 2006:
The aggregate intrinsic values in the table above are before applicable income taxes and are based on the Company’s closing stock price of $18.01 on December 31, 2006. As of December 31, 2006, total unrecognized stock-based compensation cost related to nonvested stock options was approximately $1.1 million, which is
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
expected to be recognized over a weighted average period of approximately 29.4 months. Proceeds from the exercise of stock options totaled approximately $32,400 in 2006 and approximately $15,300 in 2005. The total intrinsic value of stock options exercised was approximately $42,300 in 2006 and approximately $17,100 in 2005.
As of December 31, 2006, there were 704,915 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, 2006:
b. Nonvested Stock
The following table summarizes nonvested stock activity for the year ended December 31, 2006:
As of December 31, 2006, there was $3.0 million of total unrecognized compensation cost related to nonvested stock granted under the 2005 Plan. That cost is expected to be recognized over a weighted-average period of 26.6 months. No shares vested during the year ended December 31, 2006.
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
21.
Quarterly Financial Information (unaudited)
The following table summarizes selected unaudited quarterly financial data for each quarter of the years ended December 31, 2006, 2005 and 2004.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A.
Controls and Procedures.
Disclosure Controls and Procedures
Under the supervision and with the participation of management, including our Chief Executive Officer and our Chief Financial Officer, we have carried out an evaluation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Based on that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report to ensure that information we are required to disclose in reports that are filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms specified by the SEC and is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Management’s Report on Internal Control Over Financial Reporting
The management of SeaBright Insurance Holdings, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting as required by the Sarbanes-Oxley Act of 2002 and as defined in Exchange Act Rule 13a-15(f). Our system of internal control over financial reporting is designed to provide reasonable assurance to our management and Board of Directors regarding the preparation and fair presentation of published financial statements. A system of internal control can provide only reasonable, not absolute assurance, that the objectives of the control system are met. Our management, including our Chief Executive Officer and Chief Financial Officer, conducted an assessment of the design and operating 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 assessment, our management has concluded that, as of December 31, 2006, our internal control over financial reporting was effective.
KPMG LLP, an independent registered public accounting firm, has issued an attestation report on management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006, which is included at Part II, Item 8 of this annual report.
Changes in Internal Controls
There have not been any changes in our internal controls over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during our fourth fiscal quarter of 2006 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
SeaBright Insurance Holdings, Inc.:
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting that SeaBright Insurance Holdings, Inc. and subsidiaries (the Company) maintained effective internal control over financial reporting as of December 31, 2006, 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 maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
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 (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) 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 (3) 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.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of SeaBright Insurance Holdings, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2006, and our report dated March 16, 2007 expressed an unqualified opinion on those consolidated financial statements.
/s/
KPMG LLP
Seattle, Washington
March 16, 2007
Item 9B.
Item 9B.
Other Information.
We had no information that was required to be disclosed in a report on Form 8-K during the fourth quarter of 2006, but that was not disclosed.
PART III
Item 10.
Item 10.
Directors, Executive Officers and Corporate Governance.
The information required by this item is incorporated by reference from the sections captioned “Board of Directors and Corporate Governance” and “Common Stock Ownership” contained in our proxy statement for the 2007 annual meeting of stockholders, to be filed with the Commission pursuant to Regulation 14A not later than 120 days after December 31, 2006.
Item 11.
Item 11.
Executive Compensation.
The information required by this item is incorporated by reference from the sections captioned “Executive Compensation” and “Director Compensation” contained in our proxy statement for the 2007 annual meeting of stockholders, to be filed with the Commission pursuant to Regulation 14A not later than 120 days after December 31, 2006.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The information required by this item is incorporated by reference from the sections captioned “Common Stock Ownership” and “Executive Compensation” contained in our proxy statement for the 2007 annual meeting of stockholders, to be filed with the Commission pursuant to Regulation 14A not later than 120 days after December 31, 2006.
Item 13.
Item 13.
Certain Relationships and Related Transactions, and Director Independence.
The information required by this item is incorporated by reference from the section captioned “Certain Relationships and Related Transactions” contained in our proxy statement for the 2007 annual meeting of stockholders, to be filed with the Commission pursuant to Regulation 14A not later than 120 days after December 31, 2006.
Item 14.
Item 14.
Principal Accounting Fees and Services.
The information required by this item is incorporated by reference from the sections captioned “Principal Accounting Fees and Services” contained in our proxy statement for the 2007 annual meeting of stockholders, to be filed with the Commission pursuant to Regulation 14A not later than 120 days after December 31, 2006.
PART IV
Item 15.
Item 15.
Exhibits, Financial Statement Schedules.
The following documents are being filed as part of this annual report.
(a) (1) Financial Statements. The following financial statements and notes are filed under Item 8 of this report.
(2) Financial Statement Schedules.
SeaBright Insurance Holdings, Inc.
Schedule II - Condensed Financial Information of Registrant
Schedule IV - Reinsurance
Schedule VI - Supplemental Information Concerning Insurance Operations
All other schedules for which provision is made in the applicable accounting requirements of the Securities and Exchange Commission are not required or the required information has been included within the financial statements or the notes thereto.
(3) Exhibits. The list of exhibits in the Exhibit Index to this annual report is incorporated herein by reference.
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.
SEABRIGHT INSURANCE HOLDINGS, INC.
By:
/s/ John G. Pasqualetto
John G. Pasqualetto,
Chairman, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities indicated below on March 16, 2007.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
SeaBright Insurance Holdings, Inc.:
Under date of March 16, 2007, we reported on the consolidated balance sheets of SeaBright Insurance Holdings, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, changes in stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2006, which report is included in this annual report on Form 10-K. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedules in this annual report on Form 10-K. These financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statement schedules based on our audits.
As noted on Schedule II (condensed statements of cash flows), equity in earnings of subsidiaries for 2005 and 2004 has been corrected.
In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
As discussed in Note 2 of the consolidated financial statements, effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123(R), Share-Based Payment.
/s/ KPMG LLP
Seattle, Washington
March 16, 2007
S-1
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
SEABRIGHT INSURANCE HOLDINGS, INC.
CONDENSED BALANCE SHEETS
See report of independent registered public accounting firm.
S-2
SEABRIGHT INSURANCE HOLDINGS, INC.
CONDENSED STATEMENTS OF OPERATIONS
See report of independent registered public accounting firm.
S-3
SEABRIGHT INSURANCE HOLDINGS, INC.
CONDENSED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
See report of independent registered public accounting firm.
S-4
SEABRIGHT INSURANCE HOLDINGS, INC.
CONDENSED STATEMENTS OF CASH FLOWS
Note: Equity in earnings of subsidiaries for 2005 and 2004 has been corrected as follows:
See report of independent registered public accounting firm.
S-5
SCHEDULE IV - REINSURANCE
SEABRIGHT INSURANCE HOLDINGS, INC.
See report of independent registered public accounting firm.
S-6
SCHEDULE VI - SUPPLEMENTAL INFORMATION CONCERNING INSURANCE OPERATIONS
SEABRIGHT INSURANCE HOLDINGS, INC.
(1)
Net unearned premium represents unearned premiums minus prepaid reinsurance.
See report of independent registered public accounting firm.
S-7
EXHIBIT INDEX
The list of exhibits in the Exhibit Index to this annual report is incorporated herein by reference.
*
Filed herewith.

Indicates a management contract, compensatory plan, contract or arrangement required to be filed pursuant to Item 601 of Regulation S-K.