Both the consulting actuaries and the internal actuarial staff select and apply a variety of generally accepted actuarial methods to our data. The methods applied vary somewhat according to the type of claim benefit being analyzed. The primary methods utilized in recent evaluations are as follows:
For EICN and ECIC, management along with internal actuarial staff and the consulting actuary separately analyze LAE and estimate unpaid LAE. This analysis relies primarily on examining the relationship between the aggregate amount that has been spent on LAE historically and the dollar volume of claims activity for the corresponding historical calendar periods. Based on these historical relationships, and judgmental estimates of the extent to which claim management resources are focused more intensely on the initial handling of claims than on the ongoing management of claims, the consulting actuary selects a range of future LAE estimates that is a function of the projected future claim payment activity. The portion of unpaid LAE that will be recoverable from reinsurers is estimated based on the contractual reinsurance terms. For EPIC and EAC, the defense and cost containment portion of LAE is analyzed in combination with the evaluation of losses utilizing the methodologies described above (i.e. Bornuetter-Ferguson, paid development, etc.).
The table below provides the actuarial range of estimated liabilities for net unpaid losses and LAE and our carried reserves at the dates shown:
The table below shows the reconciliation of net income to net income before impact of LPT Agreement for the periods presented:
Our equity allocation at September 30, 2006, was above our selected target of 6%, at 15% of our total combined investment portfolio. We evaluated our portfolio equity allocation during the fourth quarter of 2006 and elected to reduce the amount allocated to equity securities to the target level during that period. This portfolio reallocation also increased the fixed maturity securities to 94% of the total portfolio and reduced our exposure to market volatility. The additional fixed maturity securities generated additional investment income in 2007 and 2008, as compared to 2006.
In December 2007, the FASB issued SFAS No. 141 (Revised 2007), -Business Combinations (SFAS No. 141(R)). SFAS No. 141(R) significantly changes the accounting for business combinations and requires the acquiring entity in the transaction to recognize the acquired assets and assumed liabilities at the acquisition-date fair value with limited exceptions. We adopted SFAS No. 141(R) on January 1, 2009 and it will have an impact on the consolidated financial statements for any future business combinations. Early adoption was prohibited.
bad debt allowance and makes adjustments as necessary. Future additions to the bad debt allowance may be necessary based on changes in the general economic conditions and the policyholders’ financial conditions. The Company had write-offs, net of recoveries of amounts previously written off, of $1.0 million, $0.8 million, and $0.4 million for the years ended December 31, 2008, 2007 and 2006, respectively.
The 100% quota share retroactive reinsurance agreement was entered into in 1999 by the Fund and assumed by EICN, which the Company refers to as the Loss Portfolio Transfer (LPT) Agreement (see Note 10). The Company is accounting for this transaction as retroactive reinsurance, whereby the initial deferred gain resulting from the retroactive reinsurance was recorded as a liability in the accompanying consolidated balance sheets as deferred reinsurance gain-LPT Agreement and is being amortized using the recovery method, whereby the amortization is determined by the proportion of actual reinsurance recoveries to total estimated recoveries. The amortization of the deferred gain is recorded in losses and LAE incurred in the accompanying consolidated statements of income. Any adjustment to the estimated reserves ceded under the LPT agreement is recognized in earnings in the period of change with a corresponding change to reinsurance recoverables on unpaid losses and deferred reinsurance gain. A cumulative amortization adjustment is also then recognized in earnings so that the deferred reinsurance gain reflects the balance that would have existed had the revised reserves been available at the inception of the LPT Agreement.
The Company’s estimates of fair value for financial assets and financial liabilities are based on the framework established in SFAS No. 157. The framework is based on the inputs used in valuation and gives the highest priority to quoted prices in active markets and requires that observable inputs be used in the valuations when available. The disclosure of fair value estimates in the SFAS No. 157 hierarchy is based on whether the significant inputs into the valuation are observable. In determining the level of the hierarchy in which the estimate is disclosed, the highest priority is given to unadjusted quoted prices in active markets and the lowest priority to unobservable inputs that reflect the Company’s significant market assumptions. The three levels of the hierarchy are as follows:
The estimate of the future cost of handling claims, or LAE, depends primarily on examining the relationship between the aggregate amount that has been spent on LAE historically, as compared with the dollar volume of claims activity for the corresponding historical periods. For the Company’s business in Nevada, as a result of operational improvements and reductions in staff count to align with the current and anticipated volume of business in the state, the Company’s expenditures on LAE in recent years have been lower than historical levels. As these operational improvements and staffing levels have been reflected in the actual emerging LAE expenditures and in the projection of future LAE, the estimates of future LAE have been reduced in recent years. For the Company’s operations in California, initial expectations of LAE when operations commenced in California were based on the assumptions used by the Company in pricing the California business, and on some limited historical data for the market segments the Company was entering. As the Company’s operations in California have matured, and as data relating to the Company’s and industry claim handling expenses reflective of the new workers’ compensation benefit environment in California have become available, the expectations of LAE underlying the projection of future LAE have been adjusted to reflect that actual costs of administering claims relative to the cost of losses themselves have been greater than initial expectations. Although the Company’s revised LAE expectations resulted in an increase in the projected future cost of administering California claims relative to losses at December 31, 2008, 2007 and 2006, given the significant decrease in the estimated projected costs of losses in California, the overall impact has been a decrease in LAE reserves.
The Company leases facilities in 14 states. At December 31, 2008, remaining lease terms ranged from one month to approximately ten years. The minimum lease payments for the next five years and thereafter on these non-cancelable operating leases at December 31, 2008, were as follows:
The fair value of the stock options granted is estimated using a Black-Scholes option pricing model that uses the assumptions noted in the following table. Due to EHI’s limited public history, the 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 and the historical volatility of peer companies’ stock for a period of time equal to the expected term of the option. EHI believes that the use of historical volatility of this peer group, along with its own historical stock price volatility, is currently the best estimate of expected volatility of the market price of EHI’s common stock. The expected term of the options granted is calculated using the ‘plain-vanilla’ calculation provided in the guidance of the SEC’s Staff Accounting Bulletin No. 107. The dividend yield was calculated using amounts authorized by the Board of Directors. The risk-free interest rate is the yield on the grant dates of the options of U.S. Treasury zero coupon securities with a maturity comparable to the expected term of the options.
The treatment of the LPT Agreement and the surplus notes (see Note 11) are the primary differences in the SAP-basis capital stock and total surplus of the insurance subsidiaries of $577.8 million and $697.7 million, and the GAAP-basis equity of the Company of $444.7 million and $379.5 million as of December 31, 2008 and 2007, respectively. Under SAP accounting, the retroactive reinsurance gain resulting from the LPT Agreement is recorded as a special component of surplus (special surplus funds) in the initial year of the contract, and not reported as unassigned surplus until the Company has recovered amounts in excess of the original consideration paid. The special surplus funds are also reduced by the amount of extraordinary dividends as approved by the Nevada Division of Insurance. Under GAAP accounting the gain is deferred and amortized over the period the underlying reinsured claims are paid (see Note 10). Under SAP, the surplus notes are recorded as a separate component of surplus. Under GAAP the surplus notes are considered debt.
The increase in fourth quarter 2008 underwriting and other operating expenses was primarily the result of the acquisition of AmCOMP (see Note 4) on October 31, 2008 in the amount of $11.6 million. Subsequent to year end, the Company announced a strategic restructuring plan to achieve corporate and operational objectives related to the acquisition and integration of AmCOMP (see Note 21).