Provisions in the three lower layer treaties (covering losses from $1.0 million to $10.0 million) in our 2007-2008 reinsurance program allow us the ability, at our sole discretion, to commute the contracts within 24 months of expiration in return for a contingent profit commission calculated in accordance with terms specified in the contracts. In accordance with these provisions, we commuted the $5.0 million excess $5.0 million layer of this treaty in 2010 in return for a contingent profit commission of approximately $0.6 million. The two lower layers (from $1.0 million to $5.0 million) were not commuted. As of December 31, 2010, there were no ceded losses associated with the $5.0 million excess $5.0 million layer and it is not expected that developed losses that would otherwise be covered by reinsurance will exceed the contingent profit commission. The contingent profit commission was recorded as a reduction of loss and loss adjustment expenses.
For accident years 2006 and prior, the ultimate loss estimates at December 31, 2009 were slightly higher when compared to December 31, 2008 and resulted in a net increase of our loss reserves of $0.6 million. This small movement resulted from the recognition of the results from the standard actuarial methodologies in our December 31, 2009 IBNR study. This adverse development was offset by favorable development of $2.4 million related to ULAE, $3.5 million related to loss based assessments and NCCI and a favorable commutation gain of $0.1 million. Due to the longer tail nature of workers’ compensation, small movement in an accident year’s ultimate loss estimate can be reasonably expected.
The following table provides a breakdown of ratings on the bonds in our municipal portfolio as of December 31, 2010:
Following is a summary of the gross loss and loss adjustment expense reserves by line of business as of December 31, 2010 and 2009. The workers’ compensation line of business comprises over 98% of our total loss reserves as of both dates.
For accident year 2007, there was unfavorable development in the losses for California State Act which resulted in an increase of our net ultimate loss estimates of $3.7 million. For non-California State Act, there was unfavorable development in the losses for accident year 2007 which resulted in an increase of our net ultimate loss estimates of $0.6 million. For USL&H, there was unfavorable development in the losses for accident year 2007 which resulted in an increase of our net ultimate loss estimates of $1.3 million. For California State Act and USL&H, we placed more reliance on the most recent data points in our loss development selections than in the prior year. We believe that our loss development factor selections are appropriate given the maturity level of our data. Over time, as the data for these accident years mature and uncertainty surrounding the ultimate outcome of the claim costs diminish, the full impact of the actual loss development will be factored into our assumptions and selections.
In the event that our estimates of ultimate unpaid loss and loss adjustment expense liabilities prove to be greater or less than the ultimate liability, our future earnings and financial position could be positively or negatively impacted. Future earnings would be reduced by the amount of any deficiencies in the year(s) in which the claims are paid or the unpaid loss and loss adjustment expense liabilities are increased. For example, if we determined our unpaid loss and loss adjustment expense liability of $440.9 million as of December 31, 2010 to be 5% inadequate, we would experience a pre-tax reduction in future earnings of approximately $22.0 million. This reduction could be realized in one year or multiple years, depending on when the deficiency is identified. The deficiency would also impact our financial position because our statutory surplus would be reduced by an amount equivalent to the reduction in net income. Any deficiency is typically recognized in the unpaid loss and loss adjustment expense liability and, accordingly, it typically does not have a material effect on our liquidity because the claims have not been paid. Since the claims will typically be paid out over a multi-year period, we have generally been able to adjust our investments to match the anticipated future claim payments. Conversely, if our estimates of ultimate unpaid loss and loss adjustment expense liabilities prove to be redundant, our future earnings and financial position would be improved.
In 2010, no other-than-temporary declines in the fair value of our securities were recorded. In 2009, we recognized other-than-temporary impairment charges of $0.3 million related to our investments in preferred stocks issued by Fannie Mae and Freddie Mac that were sold in 2009. In 2008, we recognized other-than-temporary impairment charges of approximately $10.2 million on our investments in preferred stocks (nearly all of which were government-sponsored agency fixed and variable preferred stocks) and approximately $3.2 million on our investment in equity indexed securities exchange-traded funds. Please refer to the tables in Note 3, “Investments” of the consolidated financial statements in Part II, Item 8 of this annual report for additional information on unrealized losses on our, investment securities. Please refer to Part II,
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 at final audit and applying an adjustment percentage against premiums earned for the period. Final audit adjustments may result in increasing or decreasing the estimated premium earned and billed to date. Included in deferred premiums at December 31, 2010, 2009 and 2008 and premiums earned for the years then ended were accruals for earned but unbilled premiums of ($625,000), ($132,000)and ($611,000), respectively.
The Company obtains fair value inputs for securities in its investment portfolio from independent, nationally recognized pricing services. The Company obtains one price per instrument from these pricing services. The pricing services utilize multidimensional pricing models that vary by asset class and incorporate relevant inputs such as available trade, bid and quote market data for identical or similar instruments, model-based valuation techniques for which significant assumptions were observable and other market information to arrive at a fair value price for each security. This process takes into consideration the relevance of observable inputs based on factors such as the level of trading activity and the volume and currency of available prices and includes appropriate adjustments for nonperformance and liquidity risks. The Company did not obtain any broker quotes as part of the portfolio valuation process at December 31, 2010. When broker quotes are obtained, they are usually non-binding.
Total stock-based compensation expense recognized in the consolidated statements of operations for the years ended December 31, 2010, 2009 and 2008 is shown in the following table. No stock-based compensation cost was capitalized during years ended December 31, 2010, 2009 and 2008.
The fair values of stock options granted during the years ended December 31, 2010, 2009 and 2008 were determined on the dates of grant using the Black-Scholes-Merton option valuation model with the following weighted average assumptions:
The expected term of options was determined using the “simplified method,” which averages an award’s weighted average vesting period. The expected stock price volatility in the above years was based on the Company’s historical stock price volatility since the public offering of its common stock in January 2005. The risk-free interest rate is based on the yield of U.S. Treasury securities with an equivalent remaining term.
As of December 31, 2010, there were 477,903 shares of common stock available for issuance of future share-based awards. In accordance with the provisions of the 2005 Plan, the number of shares authorized for issuance under the 2005 Plan was automatically increased by 440,509 shares on January 1, 2011, resulting in 918,412 shares available for issuance as of that date. The following table presents additional information regarding options outstanding as of December 31, 2010: