The Company’s results of operations for the year ended December 31, 2008 were adversely impacted by unfavorable loss reserve development in the run-off specialty reinsurance operations of $19.3 million, the current economic crisis in the United States and the continued deterioration in the fixed income and equity security markets.
Net premiums earned. Net premiums earned are the earned portion of the Company’s net premiums written. Premiums are earned over the term of the related policies. At the end of each accounting period, the portion of the premiums that are not yet earned are included in unearned premiums and are realized as revenue in subsequent periods over the remaining term of the policy. The Company’s workers’ compensation policies typically have a term of twelve months. Thus, for example, for a policy that is written on July 1, 2008, one-half of the premiums would be earned in 2008 and the other half would be earned in 2009. Workers’ compensation premiums are determined based upon the payroll of the insured, the applicable premium rates and, where applicable, an experience based modification factor. An audit of the policyholders’ records is conducted after policy expiration to make a final determination of applicable premiums. Included with net premiums earned is an estimate for earned but unbilled final audit premiums. The Company can estimate earned but unbilled premiums because it keeps track, by policy, of how much additional premium is billed in final audit invoices as a percentage to estimate the probable additional amount that it has earned but not yet billed as of the balance sheet date. The majority of the Company’s group benefits insurance policies are billed on a monthly basis with premiums being earned in the month in which coverage is provided. As a result, there is minimal unearned premium related to the group benefits insurance policies as of the balance sheet date.
statement from the ceding company which includes premium and loss settlement activity for the period with corresponding reserves as established by the ceding company. Claims reported to the ceding company by insureds are entered into its claim system and ceded to the Company on a quarterly basis. The claim information received from the ceding company is compiled into loss development triangles. Generally accepted actuarial methodologies, supplemented by judgment where appropriate, are used to develop the appropriate IBNR reserves for the Company. Each quarter the Company compares its actual reported losses for the quarter, and cumulative reported losses since the most recently completed reserve study, to expected reported losses for the respective period, which may result in the Company increasing its losses and LAE, and its corresponding loss reserves in that quarter. This information is used as a tool in the judgmental process by which management assesses the overall adequacy of the reserves for unpaid losses and LAE at the Company. The evaluation of the reserves for unpaid losses and LAE related to the Company’s run-off specialty reinsurance segment requires that loss development be estimated over an extended period of time. Because the primary insurer under the reinsurance program changed in 1999 and the claims management philosophy of the two primary insurers differed, historical loss data for years prior to 1999 has limited relevance. Therefore, reliance has been placed on a blend of historical loss development data and industry loss development patterns, adjusted to reflect considerations particular to the exposure. The reliance on external benchmarks, while necessary, creates an additional element of uncertainty.
The Company’s reserves for unpaid losses and LAE in its run-off specialty reinsurance segment as of December 31, 2008 and 2007 are summarized below (in thousands):
The net realized investment losses for the year ended December 31, 2008 primarily reflect other-than-temporary impairments of $1.2 million. There were no impairments recorded in 2007.
Purchase accounting adjustments increased the calendar period loss ratio by 0.5 percentage points for the year ended December 31, 2007, compared to an increase in the calendar period loss ratio of 4.6 points for the same period in 2006.
The increase in the dental loss ratio primarily reflects the impact of claim cost inflation, which was 5.6% from 2006 to 2007. The accident period loss ratio increased from 66.2% in 2006 to 70.8% in 2007. In addition to claim cost inflation, the accident period loss ratio was impacted by the increase in new dental business, which generally has a higher loss ratio in the first year or two after the initial sale. In addition, the impact of favorable loss reserve development on the calendar period loss ratio decreased from $533,000, or 2.7 percentage points, in 2006 to $340,000, or 1.6 percentage points, in 2007.
The Company has a $2.6 million line of credit available to provide additional liquidity if needed. In addition to the line of credit, the Company has obtained letters of credit totaling $44.9 million for the purpose of securing obligations to reinsurers, if necessary. As of December 31, 2008, there was approximately $6.6 million still available under the Company’s letter of credit facilities.
(1) The loan payable balance in the above table represents the remaining principal balance as of December 31, 2008. Interest on the loan is based on the 30-day LIBOR rate plus 165 basis points and resets on the first day of each month, based on the 30-day LIBOR rate as of the last day of the immediately preceding month. The interest rate effective on December 31, 2008 was 2.098%.
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Eastern Insurance Holdings, Inc. and its subsidiaries (the “Company”) at December 31, 2008 and December 31, 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)(2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included under Item 9A in Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
In March 2008, the FASB issued Statement No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“SFAS 161”). SFAS 161 amends and expands the disclosure requirements of SFAS 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS 161 requires qualitative disclosures about objectives and strategies
for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments and disclosures about credit-risk-related contingent features in derivative agreements. This statement is effective for financial statements issued for fiscal years beginning after November 15, 2008. The adoption of SFAS 161 will not affect the Company’s consolidated financial condition or results of operations, but may require additional disclosures if the Company enters into derivative and hedging activities.
Risk-based capital is designed to measure the acceptable amount of capital an insurer should have based on the inherent risks of the insurer’s business. Insurers failing to meet adequate capital levels may be subject to insurance department scrutiny and ultimately rehabilitation or liquidation. Based on established standards, Eastern Alliance, Allied Eastern, Eastern Advantage, ESIC and ELH maintained statutory-basis surplus in excess of minimum prescribed risk-based capital requirements as of December 31, 2008.
The Company’s results of operations include a decrease of $13.6 million related to unfavorable loss reserve development on prior accident year reserves, prior to the impact of discount accretion, for the year ended December 31, 2008, compared to an increase of $7.5 million related to favorable development for the same period in 2007. The 2008 unfavorable development primarily reflects reserve strengthening in the run-off specialty reinsurance segment, while the 2007 favorable development primarily relates to the workers’ compensation insurance segment.
As of December 31, 2008, the Company has not recognized a deferred tax asset related to its run-off specialty reinsurance segment of $7,155, which represents the excess of the tax basis over the amount for financial reporting (i.e., outside basis difference) of Eastern Re as of December 31, 2008. The outside basis difference primarily arises from losses at Eastern Re recognized for financial statement purposes, which have not yet been recognized for tax purposes. Under United States federal income tax rules and regulations, net operating losses generated by a foreign subsidiary can only be used to offset future taxable income of that subsidiary. There is no expiration date with respect to the ability to utilize the net operating losses; however, management presently believes that the Company will not be able to recognize these tax benefits in the foreseeable future and, therefore, has not recognized the future tax benefits as of December 31, 2008.
As of December 31, 2008 and 2007, the estimated fair value of unearned ESOP shares were $6,873 and $10,477, respectively.