As of February 1, 2019, we leased 225,274 square feet of office space in 7 states, including our principal executive offices located in Reno, Nevada. We believe that our existing office space is adequate for our current needs. We will continue to enter into or exit lease agreements to address future space requirements, as necessary.
Pricing on our renewals showed an overall price decrease of 11.8% for the year ended December 31, 2018, versus the rate level in effect on such business a year earlier. We believe that we can continue to write attractive business due to favorable loss costs and frequency trends and the success of our accelerated claims initiatives, despite the competitive market conditions we currently face. Given the strength of our balance sheet, the execution of our underwriting, claims, and investment strategies, we believe that we are well positioned for the current market cycle.
Adjusted stockholders' equity is a non-GAAP measure consisting of total GAAP stockholders' equity plus the Deferred Gain, less Accumulated other comprehensive (loss) income, net.
Our net income was $141.3 million, $101.2 million, and $106.7 million in 2018, 2017, and 2016, respectively, and our underwriting income was $101.7 million, $68.0 million, and $57.3 million for the same periods, respectively. The key factors that affected our financial performance during the previous two years included:
Underwriting and other operating expenses increased 13% in 2018 and 3% in 2017, each compared to the previous year;
Net realized and unrealized (losses) gains on investments of $(13.1) million, $7.4 million, and $11.2 million in 2018, 2017, and 2016, respectively; and
Income tax expense was $28.2 million ($28.6 million excluding the impact of the enactment of Tax Cuts and Jobs Act on December 22, 2017 (Enactment)), $42.8 million ($35.8 million excluding the impact of the Enactment, and $34.0 million in 2018, 2017, and 2016, respectively.
We continue to execute a number of ongoing business initiatives, including: focusing on internal and customer-facing business process excellence; offering quotes and insurance coverage directly to customers through a desktop and mobile-friendly platform; accelerating the settlement of open claims; diversifying our risk exposure across geographic markets; utilizing a multi-company pricing platform; utilizing territory-specific pricing; development and implementation of new technologies to transform the way insurance agents utilize digital capabilities; and leveraging data-driven strategies to target, price, and underwrite profitable classes of business across all of our markets.
The following items were included in our 2018 results of operations: (1) favorable prior year accident year loss development of $66.2 million, including $65.5 million of favorable development on our voluntary business and $0.7 million of favorable development on our assigned risk business, which decreased our losses and LAE by the same amount; (2) favorable development in the estimated reserves ceded under the LPT Agreement that resulted in a $2.2 million LPT Reserve Adjustment; (3) an increase in the contingent commission receivable under the LPT Agreement, which resulted in a $0.5 million cumulative adjustment to the Deferred Gain, and reduced our losses and LAE by the same amount (LPT Contingent Commission Adjustment); and (4) the inclusion of $25.6 million in net unrealized losses on equity securities during the period (unrealized gains and losses on equity securities were not included in net income during the comparable 2017 and 2016 periods). Collectively, these items increased our net income before taxes by $43.3 million. Additionally, our income tax expense was favorably impacted by the Tax Cuts and Jobs Act which reduced the statutory tax rate from 35% to 21% beginning in 2018.
The following items were included in our 2017 results of operations: (1) favorable prior year accident year loss development of $18.5 million, including $17.4 million of favorable development on our voluntary business and $1.1 million of favorable development on our assigned risk business, which decreased our losses and LAE by the same amount; (2) a write-off of $7.5 million of previously capitalized costs relating to the development of information technology capabilities that had not yet been placed in service (See -Other expenses); (3) a $7.0 million increase in our income tax expense resulting from a reduction of our net deferred tax asset resulting from Enactment, which reduced the statutory rate from 35% to 21% beginning in 2018 (See -Income tax expense); and (4) an increase in the contingent commission receivable under the LPT Agreement, which resulted in a $0.3 million cumulative adjustment to the Deferred Gain, and reduced our losses and LAE by the same amount (LPT Contingent Commission Adjustment). Collectively, these items increased our net income before taxes by $11.3 million and increased our income tax expense by $7.0 million for the year ended December 31, 2017.
We present net income before impact of the LPT Agreement because we believe that it is an important supplemental measure of our ongoing operating performance to be used by analysts, investors and other interested parties in evaluating us. The LPT Agreement was a non-
Gross premiums written were $748.9 million, $729.7 million, and $701.4 million for the years ended December 31, 2018, 2017, and 2016, respectively. The increase in 2018 was primarily due to increases in new business premiums written, partially offset by declines in renewal business premiums. The increase in new business premiums was primarily driven by higher policy counts and payroll exposure, partially offset by decreases in average rates. The increase in 2017 was primarily due to increases in new business premiums written and final audit premiums, partially offset by declines in renewal business premium, year-over-year. Final audit premiums increased $10.8 million in 2017, compared to 2016, positively impacted by California Assembly Bill 2883 (AB 2883), which limited certain officers' payroll from being excluded from the calculation of premiums effective January 1, 2017. In October 2017, California passed Senate Bill 189 (SB 189), which expanded the scope of employees that qualify for these exclusions. SB 189 went into effect on July 1, 2018 and reversed some of the benefits of AB 2883 in 2018.
Net premiums written were $742.8 million, $723.7 million, and $694.6 million for the years ended December 31, 2018, 2017, and 2016, respectively, which included $6.1 million, $6.0 million, and $6.8 million of reinsurance premiums ceded, respectively. The decrease in reinsurance premiums ceded from 2016 to 2017 reflects the increase in our retention on a per occurrence basis under our excess of loss reinsurance program compared to earlier periods.
The following table shows the percentage change in our in-force premiums, policy count, average policy size, and payroll exposure upon which our premiums are based as of December 31, 2018 and 2017, respectively, overall, for California, where 54% of our premiums were generated, and for all other states, excluding California:
Net Investment Income and Net Realized and Unrealized (Losses) Gains on Investments
losses on equity securities for the year ended December 31, 2018 were primarily the result of volatility in equity markets. Realized gains were primarily related to the sale of fixed maturity and equity securities, resulting from a rebalancing of our investment portfolio, partially offset by $3.3 million in other-than-temporary impairments of certain fixed maturity securities due to our intent to sell the securities. Net realized gains on investments in 2017 were primarily related to sales of municipal securities, whose proceeds were reinvested in taxable fixed maturity securities, and sales of equity securities as part of a routine rebalancing of our equity portfolio. Those gains were partially offset by $1.4 million in other-than temporary impairments of certain fixed maturity and equity securities due to our intent to sell those securities and/or the severity and duration of the change in fair value of those securities. Net realized gains on investments in 2016 were primarily the result of the sale of equity securities as part of a routine rebalancing of our equity portfolio to meet cash needs at the holding company, and to provide cash to support the internal restructuring of our insurance subsidiaries. Those gains were partially offset by $5.8 million in other-than-temporary impairments of certain equity securities due to our intent to sell those securities, and the downturn in the energy sector during that year. Additional information regarding our Investments is set forth under “-Liquidity and Capital Resources-Investments” and Note 6 in the Notes to our Consolidated Financial Statements.
Other income consists of net gains on fixed assets, non-investment interest, installment fee revenue, and other miscellaneous income. Other income was $1.2 million, $0.8 million, and $0.6 million for the years ended December 31, 2018, 2017, and 2016, respectively.
We analyze our loss and LAE ratios on both a calendar year and accident year basis.
Losses and LAE represents our largest expense item and includes claim payments made, amortization of the Deferred Gain, LPT Reserve Adjustments, LPT Contingent Commission Adjustments, estimates for future claim payments and changes in those estimates for current and prior periods, and costs associated with investigating, defending, and adjusting claims. The quality of our financial reporting depends in large part on accurately predicting our losses and LAE, which are inherently uncertain as they are estimates of the ultimate cost of individual claims based on actuarial estimation techniques.
Our indemnity claims frequency (the number of claims expressed as a percentage of payroll) continued to decrease year-over-year in 2018 and 2017; however, in 2018, we saw an upward movement in medical and indemnity costs per claim that is reflected
in our current accident year loss estimate. Total claims costs have also been reduced by cost savings associated with increased claims settlement activity that continued through 2018. We believe our current accident year loss estimate is adequate; however, ultimate losses will not be known with any certainty for many years. We assume that increasing medical and indemnity cost trends will continue to impact our long-term claims costs and current accident year loss estimate, which may be offset by rate increases. Additional information regarding our reserves for losses and LAE is set forth under “-Critical Accounting Policies-Reserves for Losses and LAE.”
Our current accident year loss ratio estimates were 62.6%, 62.4%, and 65.2% for the years ended December 31, 2018, 2017, and 2016, respectively. The slight increase in our current accident year loss estimate in 2018, compared to 2017, reflects the impact of rate decreases in many of the states in which we operate, largely offset by the continued impact of key business initiatives, including: an emphasis on the accelerated settlement of open claims; diversifying our risk exposure across geographic markets; and leveraging data-driven strategies to target, underwrite, and price profitable classes of business across all of our markets. The current accident year loss estimate for the year ended December 31, 2016 included the impact of $6.5 million in large losses recognized during that year, which increased the current accident year loss estimate for the year ended December 31, 2016.
The table below reflects prior accident year loss and LAE reserve adjustments and the impact of the LPT on net income before taxes.
new digital technologies and capabilities. During the year ended December 31, 2017, our compensation-related expenses increased $2.6 million and professional fees increased $1.9 million, partially offset by a $0.7 million decrease in our premium taxes and assessments, each as compared to 2016.
Commission expenses include direct commissions to our agents and brokers, including our partnerships and alliances, for the premiums that they produce for us, as well as incentive payments, other marketing costs, and fees.
Income tax expense was $28.2 million ($28.6 million excluding the impact of Enactment), $42.8 million ($35.8 million excluding the impact of Enactment), and $34.0 million for the years ended December 31, 2018, 2017, and 2016, respectively, representing effective tax rates of 16.6% (16.8% excluding the impact of Enactment), 29.7% (24.9% excluding the impact of Enactment), and 24.2% for the years ended December 31, 2018, 2017, and 2016, respectively.
Tax-advantaged investment income, LPT Contingent Commission Adjustments, Deferred Gain amortization and certain other adjustments reduced our income tax expense computed at a statutory rate of 21% for 2018 and 35% for 2017 and 2016 by $7.4 million, $14.6 million, and $15.3 million for the years ended December 31, 2018, 2017, and 2016, respectively. For the year ended December 31, 2017, the reductions were partially offset by a $7.0 million increase in our income tax expense due to the re-evaluation of our deferred tax assets and liabilities as of the date of Enactment. For the year ended December 31, 2017, we were required to base certain of our income tax estimates and assumptions on incomplete information and/or preliminary interpretations of the effects of Enactment. As a result, we made an adjustment of $(0.4) million to our income tax expense due to a further evaluation of our deferred tax assets and liabilities during the year ended December 31, 2018.
Our insurance subsidiaries' ability to pay dividends to their parent is based on reported capital, surplus, and dividends paid within the prior 12 months. For 2019, the maximum dividend that may be paid by EPIC without prior regulatory approval is $19.0 million. EICN can pay $2.1 million of dividends through January 25, 2019, and $19.8 million thereafter, without prior regulatory approval; ECIC can pay $8.8 million of dividends through September 5, 2019, and $57.2 million thereafter, without prior regulatory approval; and EAC can pay $0.9 million of dividends through May 18, 2019, and $19.8 million thereafter, without prior regulatory approval.
The primary sources of cash for our operating subsidiaries, which include our insurance and other operating subsidiaries, are premium collections, investment income, sales and maturities of investments and reinsurance recoveries. The primary uses of cash for our operating subsidiaries are payments of losses and LAE, commission expenses, underwriting and other operating expenses, ceded reinsurance, investment purchases and dividends paid to their parent.
Total cash and investments held by our operating subsidiaries was $2,700.1 million at December 31, 2018, consisting of $60.7 million of cash, cash equivalents, and restricted cash, $2,471.8 million of fixed maturity securities, and $167.6 million of equity securities. Sources of immediate and unencumbered liquidity at our operating subsidiaries as of December 31, 2018 consisted of $59.5 million of cash and cash equivalents, $161.2 million of publicly-traded equity securities whose proceeds are available within three business days, and $1,405.4 million of highly liquid fixed maturity securities whose proceeds are available within three business days. We believe that our subsidiaries' liquidity needs over the next 24 months will be met with cash from operations, investment income, and maturing investments.
Each of our insurance subsidiaries is a member of the Federal Home Loan Bank of San Francisco (FHLB). Membership allows our subsidiaries access to collateralized advances, which may be used to support and enhance liquidity management. The amount of advances that may be taken is dependent on statutory admitted assets on a per company basis. Currently, none of our subsidiaries has advances outstanding under the FHLB facility.
FHLB membership also allows our insurance subsidiaries access to Letter of Credit Agreements and on March 9, 2018, ECIC, EPIC, and EAC entered into Letter of Credit Agreements with the FHLB. The Letter of Credit Agreements are between the FHLB and each of EAC, in the amount of $40.0 million, ECIC, in the amount of $50.0 million, and EPIC, in the amount of $50.0 million. The Letter of Credit Agreements became effective March 9, 2018 and expire March 31, 2019. The Letter of Credit Agreements may only be used to satisfy, in whole or in part, insurance deposit requirements with the State of California and are fully secured with eligible collateral at all times (See Note 11).
Net cash provided by operating activities in 2018 included net premiums received of $745.9 million and investment income received of $91.1 million. These operating cash inflows were partially offset by net claims payments of $416.4 million, underwriting and other operating expenses paid of $142.1 million, and commissions paid of $92.6 million.
Net cash provided by operating activities in 2016 included net premiums received of $694.9 million and investment income received of $87.8 million. These operating cash inflows were partially offset by net claims payments of $433.7 million, underwriting and other operating expenses paid of $125.8 million, and commissions paid of $84.2 million.
Net cash used in financing activities in 2017 included stockholder dividend payments and the purchase of a note payable.
Net cash used in financing activities in 2016 was primarily related to common stock repurchases and payments of stockholder dividends, partially offset by net proceeds from stock-based compensation, mainly proceeds from exercises of stock options.
Dividends. Dividends paid to stockholders were $26.7 million, $19.7 million, and $11.5 million in 2018, 2017, and 2016, respectively. The declaration and payment of future dividends to common stockholders will be at the discretion of our Board of Directors and will depend upon many factors, including our financial position, capital requirements of our operating subsidiaries, legal and regulatory requirements, and any other factors our Board of Directors deems relevant. On February 20, 2019, the Board of Directors declared a $0.22 dividend per share, payable March 20, 2019, to stockholders of record on March 6, 2019.
As of December 31, 2018, the capital resources available to us consisted of: (i) $20.0 million in surplus notes maturing in 2034; (ii) $1,018.2 million of stockholders' equity; and (iii) the $149.6 million Deferred Gain.
In 2017, EHI purchased one of EPIC's outstanding notes payable in the amount of $12.0 million for $9.9 million, resulting in a $2.1 million gain. As a result of EHI's purchase of the note, it was no longer considered outstanding on a consolidated basis as of December 31, 2017. The note was formally redeemed and retired by EPIC in May 2018.
Contractual Obligations and Commitments. The following table identifies our long-term debt and contractual obligations as of December 31, 2018.
As of December 31, 2018, our investment portfolio consisted of 92% fixed maturity securities. We strive to limit the interest rate risk associated with fixed maturity investments by managing the duration of these securities. Our fixed maturity securities (excluding cash and cash equivalents) had a duration of 4.1 at December 31, 2018. To minimize interest rate risk, our portfolio is weighted toward short-term and intermediate-term bonds; however, our investment strategy balances consideration of duration, yield, and credit risk. Our investment guidelines require that the minimum weighted average quality of our fixed maturity securities portfolio be “A+,” using ratings assigned by S&P. Our fixed maturity securities portfolio had a weighted average quality of “AA-” as of December 31, 2018, with 50.5% of the portfolio rated “AA” or better, based on market value. Other securities within fixed maturity securities consist of bank loans, which are classified as AFS and are reported at fair value.
The following table shows the percentage of total estimated fair value of our fixed maturity securities as of December 31, 2018 by credit rating category, using the lower of the ratings assigned by Moody's Investors Service or S&P.
We currently have operating leases that constitute off-balance sheet arrangements. Our operating lease obligations are provided under "-Liquidity and Capital Resources-Capital Resources-Contractual Obligations and Commitments."
Accounting for workers' compensation insurance requires us to estimate the liability for the expected ultimate cost of unpaid losses and LAE (loss reserves) as of a balance sheet date. Loss reserve estimates are inherently uncertain because the ultimate amount
we pay for many of the claims we have incurred as of the balance sheet date will not be known for many years. Our estimate of loss reserves is intended to equal the difference between the expected ultimate losses and LAE of all claims that have occurred as of a balance sheet date and amounts already paid. We establish loss reserves based on our own analysis of emerging claims experience and environmental conditions in our markets and review of the results of various actuarial projections. Our aggregate carried loss reserves is the sum of our reserves for each accident year and represents our best estimate of outstanding loss reserves.
The three main components of our loss reserves are case reserves, incurred but not reported (IBNR) loss reserves, and LAE reserves.
LAE reserves are our estimate of the future expenses of investigating, administering, and settling claims that will be paid to manage claims that have occurred, including legal expenses. LAE reserves are established in the aggregate, rather than on a claim-by-claim basis. LAE reserves are categorized between defense and cost containment, and adjusting and other.
Management, along with our Internal Actuary and the Consulting Actuary, separately analyze LAE and estimate unpaid LAE. These analyses rely primarily on examining the relationship between the aggregate amounts that have been spent on LAE historically, compared with the volume of claims activity for the corresponding historical calendar periods. The portion of unpaid LAE that will be recoverable from reinsurers is estimated based on the contractual reinsurance terms.
Management formally establishes loss reserves for financial statement purposes on a quarterly basis. In doing so, we make reference to the most current analyses of our Internal Actuary and of the Consulting Actuary, including a review of the assumptions and the results of the various actuarial methods used. Comprehensive studies are conducted in the second and fourth quarters by both our Internal Actuary and the Consulting Actuary. On the alternate quarters, the results of the preceding quarter's studies are updated for actual claim payment and case reserve activity by our Internal Actuary.
As of December 31, 2018, California and Nevada loss reserves represented approximately 76% of our total loss reserves on our Consolidated Balance Sheet.
In California, our recent loss experience from 2012 through 2018, indicates a slight downward trend in medical severity and a slight upward trend in indemnity severity. The reduction in medical severity can be attributed to a number of factors including California Senate Bill 863 (SB 863), which was enacted in 2012 and largely became effective in 2013/2014. Among the more significant changes, SB 863 introduced independent medical review (IMR) into the dispute resolution process and also introduced filing fees for medical liens. On the indemnity side, various provisions of SB 863 resulted in an overall increase in certain benefits. Our indemnity claims frequency (the number of claims expressed as a percentage of payroll) has decreased year-over-year for the
past three years. Aside from the impact of recent regulatory changes, we believe our increased emphasis on claims settlements, as well as our various underwriting initiatives, have contributed to more favorable trends in our California results.
We have actively driven a significant increase in claims settlement activity beginning in 2014 and continuing through 2018, which has primarily affected accident years 2009 and forward, that is the result of an internal initiative that emphasizes the settlement of open claims. This settlement activity has been recognized in the actuarial analysis using a methodology developed to adjust the data and loss development patterns to account for the settlements arising from this initiative.
Additionally, we are entitled to receive a contingent profit commission under the LPT Agreement. The contingent profit commission is an amount based on the favorable difference between actual paid losses and LAE and expected paid losses and LAE as established in the LPT Agreement. The calculation of actual amounts paid versus expected amounts is determined every five years beginning June 30, 2004 for the first twenty-five years of the agreement. We are paid 30% of the favorable difference between the actual and expected losses and LAE paid at each calculation point. Each quarter, management records its best estimate of the estimated ultimate contingent profit commission through June 30, 2024, which is impacted by estimates for ceded losses and LAE. The related Deferred Gain is amortized using the recovery method, whereby the amortization is determined by the proportion of actual reinsurance recoveries to total estimated recoveries over the life of the contingent profit commission, or through June 30, 2024, and is recorded in losses and LAE incurred in the accompanying Consolidated Statements of Comprehensive Income. Changes in estimates of the reserves ceded under the LPT Agreement may significantly impact the Contingent commission receivable-LPT Agreement and the Deferred Gain on our Consolidated Balance Sheets and losses and LAE on our Consolidated Statements of Comprehensive Income.
We use third party pricing services to assist us with our investment accounting function. The fair values of our AFS fixed maturity and equity securities are based on quoted market prices, when available. These fair values are obtained primarily from third party pricing services, which generally use Level 1 or Level 2 inputs in accordance with GAAP guidance. The Company obtains a quoted price for each security from third party pricing services, which is derived through recently reported trades for identical or similar securities. For securities not actively traded, the third party pricing services may use quoted market prices of similar instruments or discounted cash flow analyses, incorporating inputs that are currently observable in the markets for similar securities. Inputs that are often used in the valuation methodologies include, but are not limited to, broker quotes, benchmark yields, credit spreads, default rates, and prepayment speeds. The Company also performs quarterly analysis on the prices received from third parties to determine whether the prices are reasonable estimates of fair value, including confirming the fair values of these securities through observable market prices using an alternative pricing source. If differences are noted in this review, the Company may obtain additional information from other pricing services to validate the quoted price (See Note 5 in the Notes to our Consolidated Financial Statements).
In August 2018, the Financial Accounting Standards Board (FASB) issued ASU Number 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement. This update removes the disclosure requirements for the amounts of and the reasons for transfers between Level 1 and Level 2 and disclosure of the policy for timing of transfers between levels. This update also removes disclosure requirements for the valuation processes for Level 3 fair value measurements. Additionally, this update adds disclosure requirements for the changes in unrealized gains and losses for recurring Level 3 fair value measurements and quantitative information for certain unobservable inputs in Level 3 fair value measurements. This update becomes effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The Company has determined that the impact of this new standard will not be material to the Company's financial statements.
In July 2018, the FASB issued ASU Number 2018-09, Codification Improvements. This update provides clarification, corrects errors in and makes minor improvements to the Codification within various ASC topics. Many of the amendments in this update have transition guidance with effective dates for annual periods beginning after December 15, 2018 and some amendments in this update do not require transition guidance and are effective upon issuance of this update. We will adopt amendments as they become applicable and have determined that the impact of these improvements will not be material to our consolidated financial condition and results of operations.
In January 2017, the FASB issued ASU Number 2017-04, Intangibles-Goodwill and Other (Topic 350). This update simplifies the measurement of goodwill by eliminating the performance of Step 2 in the goodwill impairment testing. This update allows the testing to be performed by comparing the fair value of a reporting unit with its carrying amount and recognizing an impairment charge when the carrying amount exceeds fair value. Additionally, this update eliminates the requirements of any reporting unit with a zero or negative carrying value to perform Step 2, but requires disclosure of the amount of goodwill allocated to a reporting unit with zero or negative carrying amount of net assets. This update becomes effective for fiscal years beginning after December 15, 2019. We do not expect that this update will have a material impact to our consolidated financial condition and results of operations.
update provides clarity on the definition of a lease and the distinction between finance and operating leases. Furthermore, the update requires certain qualitative and quantitative disclosures pertaining to the amounts recorded in the financial statements. This update becomes effective for annual reporting periods, including interim periods within those annual periods, beginning after December 15, 2018 and early adoption is permitted. We have determined that the impact of this new standard will be equal to the present value of our lease obligations under various non-cancellable operating lease contracts, which amounted to approximately $18.4 million at December 31, 2018, and will be recognized as lease assets and liabilities on our Consolidated Balance Sheets upon adoption.
In August 2018, the FASB issued ASU Number 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40) Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract. This update clarifies certain aspects of ASU 2015-05 and aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software and hosting arrangements that include an internal-use software license. This update becomes effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years and early adoption is permitted. We elected to adopt this standard as of July 1, 2018 using the retrospective method of adoption. Prior to adoption, our accounting policy for capitalization of implementation costs followed the existing guidance for internal use software and therefore this update had no impact on the amounts previously capitalized. In accordance with ASU Number 2018-15, $4.8 million of capitalized costs included on our June 30, 2018 Consolidated Balance Sheets were reclassified from Property and equipment to Cloud computing arrangements on the date of adoption. Amortization under the new guidance will commence once the module or component is ready for its intended use, regardless of whether the hosting arrangement has been placed into service and will be recognized over the remaining life of the service contract.
In February 2018, the FASB issued ASU Number 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220). The amendments in this update allow a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from Enactment. This update becomes effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted for reporting periods for which financial statements have not yet been issued and should be applied in the period of adoption or retrospectively to each period (or periods) in which the effect of the change in the U.S. federal corporate income tax rate in the Tax Cuts and Jobs Act is recognized. We elected to early adopt this update and, accordingly, reclassified $17.8 million of net tax effects resulting from Enactment from Accumulated other comprehensive (loss) income, net of tax, to Retained earnings at December 31, 2017.
prior to January 1, 2018, our investment in FHLB stock is presented within Equity securities at fair value on our Consolidated Balance Sheets.
This update became effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. We adopted this update effective January 1, 2018. Adoption of this accounting standard resulted in a $74.0 million reclassification adjustment, net of tax, from accumulated other comprehensive income to retained earnings.
Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting
Consolidated Statements of Stockholders' Equity for each of the years ended December 31, 2018, 2017 and 2016
The Company's independent registered public accounting firm, Ernst & Young LLP, has independently assessed the effectiveness of the Company's internal control over financial reporting. A copy of their report is included in Item 8 of this report.
We have audited Employers Holdings, Inc. and Subsidiaries' internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, Employers Holdings, Inc. and Subsidiaries' (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2018 and 2017, the related consolidated statements of comprehensive income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2018, and the related notes and financial statement schedule listed in the Index at Item 15 and our report dated February 28, 2019 expressed an unqualified opinion thereon.
is subject to certain closing conditions, including, among other things, approval from the Department of Financial Services of the State of New York.
The Company reduced its estimated loss and LAE reserves ceded under the LPT Agreement (LPT Reserve Adjustments) in each of the years 2018 and 2016 as a result of the determination that adjustments were necessary to reflect observed favorable paid loss trends in each of these years. There were no LPT Reserve Adjustments in 2017. The following table shows the financial statement impact related to the LPT Reserve Adjustments.
Restricted cash and cash equivalents represent cash and cash equivalents held in trust in order to secure certain of the Company's obligations and, accordingly, are restricted as to withdrawal or usage. As of December 31, 2018 and 2017 the Company held $23.2 million and $24.5 million, respectively, in cash and investments in trust for reinsurance obligations, of which $0.6 million and $1.0 million, respectively, represented restricted cash and cash equivalents.
and unrealized (losses) gains on investments on the Company's Consolidated Statements of Comprehensive Income. Effective January 1, 2018, the Company's investment in FHLB stock is presented within Equity securities at cost on the Company's Consolidated Balance Sheets. As of December 31, 2017, the Company's investment in FHLB stock was presented within Equity securities at fair value on the Company's Consolidated Balance Sheet.
The adoption of ASU 2016-01 also removed the impairment assessment for equity securities at fair value beginning in 2018 and changes in fair value are included in Net realized and unrealized (losses) gains on investments on the Company's Consolidated Statements of Comprehensive Income. Prior to adoption of this standard, when, in the opinion of management, a decline in the fair value of an equity security below its cost was considered to be “other-than-temporary,” the equity security's cost was written down to its fair value at the time the other-than-temporary decline is identified.
In the ordinary course of business, the Company purchases excess of loss reinsurance in order to protect it against the impact of large and/or catastrophic losses. Additionally, the Company is a party to the LPT Agreement (see Note 10). These reinsurance arrangements reduce the Company's exposure to such losses since its reinsurers are liable to the Company to the extent of the reinsurance protection provided. However, the Company remains liable for all losses it incurs to the extent that any reinsurer is unable or unwilling to make timely payments under its reinsurance agreements.
amortizes leasehold improvements using the straight-line method over the lesser of the useful life of the asset or the remaining original lease term, excluding options or renewal periods. Leasehold improvements are generally amortized over three to eight years.
The Company capitalizes software license fees and implementation costs associated with hosting arrangements that are service contracts. These amounts are included in Cloud computing arrangements on the Company's Consolidated Balance Sheets. Amortization of the software license fees is calculated using the straight-line method over the term of the service contract or based on the expected utilization of the asset. Amortization of the implementation costs are calculated using the straight-line method based on the term of the service contract and commence once the module or component is ready for its intended use, regardless of whether the hosted software has been placed into service, and will be recognized over the remaining life of the service contract.
The Company tests for impairment of goodwill and non-amortizable intangible assets in the fourth quarter of each year. At the end of each quarter, management considers the results of the previous analysis as well as any recent developments that may constitute triggering events requiring the impairment analysis of goodwill and other intangible assets to be updated. The Company has assessed the effects of current economic conditions on the Company's financial condition and results of operations and changes in the Company's stock price and determined that there were no impairments of these assets as of December 31, 2018 and 2017.
Intangible assets related to state licenses are not subject to amortization. Intangibles related to insurance relationships were amortized in proportion to the expected period of benefit and were fully amortized as of December 31, 2018.
have transition guidance with effective dates for annual periods beginning after December 15, 2018 and some amendments in this update do not require transition guidance and are effective upon issuance of this update. The Company will adopt amendments as they become applicable and has determined that the impact of these improvements will not be material to its consolidated financial condition and results of operations.
In July 2018, the FASB issued ASU Number 2018-11, Leases (Topic 842): Targeted Improvements. This update provides entities with an additional and optional transition method to adopt ASU Number 2016-02 with a cumulative-effect adjustment in the period of adoption. This update also provides guidance for a practical expedient that permits lessors to not separate non-lease components from the associated lease components. Additionally, in July 2018, the FASB issued ASU Number 2018-10, Codification Improvements to Topic 842, Leases. This update provides additional guidance on the new lease model with improvements in numerous aspects of the guidance in ASC 842 including, but not limited to, implicit rates, reassessment of lease classification, terms and purchase options, investment tax credits, and various other transition guidance. In December 2018, the FASB issued ASU 2018-20, Leases (Topic 842): Narrow-Scope Improvements for Lessors. This update provides amendments to various lease topics including sales taxes collected from lessees, certain lessor costs paid to third parties, and variable payments for contracts with lease and non-lease components. These updates will be adopted concurrently with ASU Number 2016-02. The Company has determined that the impact of these new standards will not be material to the Company's financial statements.
In August 2018, the FASB issued ASU Number 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40) Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract. This update clarifies certain aspects of ASU 2015-05 and aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software and hosting arrangements that include an internal-use software license. This update becomes effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years and early adoption is permitted. The Company elected to adopt this standard as of July 1, 2018 using the retrospective method of adoption. Prior to adoption, the Company's accounting policy for capitalization of implementation costs followed the existing guidance for internal use software and therefore this update had no impact on the amounts previously capitalized. In accordance with ASU Number 2018-15, $4.8 million of capitalized costs included on the Company's June 30, 2018 Consolidated Balance Sheets were reclassified from Property and equipment to Cloud computing arrangements on the date of adoption. Amortization under the new guidance
In March 2018, the FASB issued ASU Number 2018-05, Income Taxes (Topic 740). This update provides guidance regarding the application of ASC Topic 740 for the income tax effects of the Tax Cuts and Jobs Act. This update allowed companies to report provisional amounts of the effects of the Tax Cuts and Jobs Act in their financial statements in the first reporting period they are able to determine a reasonable estimate and any adjustments to provisional amounts should be included in income from continuing operations as an adjustment to tax expense or benefit in the reporting period the amounts are determined. The Company adopted this update in the fourth quarter of 2017 and included an estimate of the income tax effects on its financial statements for the year ended December 31, 2017. In accounting for certain tax effects of Enactment in accordance with SAB 118, the Company made a final adjustment in 2018 of $(0.4) million.
In March 2017, the FASB issued ASU Number 2017-08, Receivables - Nonrefundable Fees and Other Costs (Subtopic 310-20). This update shortens the amortization period on callable debt securities held at a premium to the earliest call date, which now closely aligns the amortization period of premiums and discounts to expectations incorporated in the market pricing on callable debt securities. This update becomes effective for fiscal years beginning after December 15, 2018 and interim periods within those fiscal years, and early adoption is permitted. The Company's current accounting practices align with this standard and the adoption had no impact on its consolidated financial condition or results of operations.
This update did not apply to the Company’s investment in Federal Home Loan Bank (FHLB) stock. Rather, it specified that FHLB stock shall be carried at cost and evaluated periodically for impairment; furthermore, it specified that, beginning January 1, 2018, FHLB stock shall not be shown with securities accounted for under ASC 321, which provides detailed guidance on, among other things, accounting and reporting of investments in equity securities that have readily determinable fair values. As a result, the Company’s investment in FHLB stock is presented within Equity securities at cost on the Company's Consolidated Balance Sheet at March 31, 2018. In all periods prior to January 1, 2018, the Company's investment in FHLB stock is presented within Equity securities at fair value on the Company's Consolidated Balance Sheets.
Assets and liabilities recorded at fair value on the Company's Consolidated Balance Sheets are categorized based upon the levels of judgment associated with the inputs used to measure their fair value. Level inputs are defined as follows:
For securities not actively traded, third party pricing services may use quoted market prices of similar instruments or discounted cash flow analyses, incorporating inputs that are currently observable in the markets for similar securities. Inputs that are often used in the valuation methodologies include, but are not limited to, broker quotes, benchmark yields, credit spreads, default rates, and prepayment speeds. There were no material adjustments to prices obtained from third party pricing services as of December 31, 2018 and 2017.
The following table provides a reconciliation of the beginning and ending balances that are measured using Level 3 inputs for the years ended December 31, 2018 and 2017.
The cost and estimated fair value of the Company's equity securities recorded at fair value at December 31, 2018 were as follows:
At December 31, 2017, the Company also had $0.6 million of gross unrealized losses on twenty-four equity securities that were in a continuous loss position for less than 12 months.
The adoption of ASU 2016-01 removed the impairment assessment for equity securities at fair value, and, beginning in 2018, changes in fair value are included in net realized and unrealized gains and losses on investments on the Company's Consolidated Statements of Comprehensive Income. Prior to adoption of this standard, the Company recognized impairments on equity securities of $0.9 million (consisting of seven securities) and $5.8 million (consisting of thirty-seven securities) during the years ended December 31, 2017 and 2016, respectively. The other-than-temporary impairments recognized during these years were the result of the Company's intent to sell the securities and/or the severity and duration of the change in fair values of these securities. The impairments on equity securities in 2016 were primarily due to the downturn in the energy sector that occurred during the first quarter of 2016. Certain unrealized losses on equity securities during the years ended December 31, 2017 and 2016 were not
Realized gains and losses on investments include the gain or loss on a security at the time of sale compared to its original or adjusted cost (equity securities) or amortized cost (fixed maturity securities). Realized losses on fixed maturity securities are also recognized when securities are written down as a result of an other-than-temporary impairment.
Certain reinsurance contracts require the Company's funds to be held in trust for the benefit of the ceding reinsurer to secure the outstanding liabilities assumed by the Company. The fair value of fixed maturity securities and restricted cash and cash equivalents held in trust for the benefit of ceding reinsurers at December 31, 2018 and 2017 was $23.2 million and $24.5 million, respectively.
The Company capitalized $26.0 million of service contract fees and implementation costs associated with hosting arrangements on the Company's Consolidated Balance Sheets as of December 31, 2018. The Company had no capitalized assets associated with hosting arrangements as of December 31, 2017. Total amortization for hosting arrangements for the year ended December 31, 2018 was $0.8 million.
Deferred tax assets are required to be reduced by a valuation allowance if it is more likely than not that all or some portion of the deferred tax asset will not be realized. Realization of the deferred income tax asset is dependent on the Company generating sufficient taxable income in future years as the deferred income tax charges become deductible for tax reporting purposes. Although realization is not assured, management believes that it is more likely than not that the net deferred income tax asset will be realized.
temporary difference and had no direct impact on the Company’s total income tax expense for 2017 or future years. The Company has followed the guidance of Revenue Procedure 2019-06 to complete its accounting for loss reserve discounting.
The amount by which estimated losses in the aggregate differ from those previously estimated for a specific time period is known as reserve “development.” Reserve development is unfavorable when losses ultimately settle for more than the amount reserved or subsequent estimates indicate a basis for reserve increases on open claims, causing the previously estimated loss reserves to be ''deficient.'' Reserve development is favorable when estimates of ultimate losses indicate a decrease in established reserves, causing the previously estimated loss reserves to be ''redundant.'' Development is reflected in the Company's operating results through an adjustment to incurred losses and LAE during the period in which it is recognized.
Each actuarial methodology requires the selection and application of various parameters and assumptions. The key parameters and assumptions include: the pattern with which our aggregate claims will be paid or emerge over time; the magnitude and changes in claim settlement activity, claims cost inflation rates; the effects of legislative benefit changes and/or judicial changes; and trends in the frequency of claims, both overall and by severity of claim. The Company believes the pattern with which our aggregate
In California, where the Company's operations began in 2002, the actuaries' and management's initial expectations of ultimate losses and patterns of loss emergence and payment were based on benchmarks derived from analyses of historical insurance industry data in California. No historical data from the Company's California insurance subsidiary existed prior to July 1, 2002; however, some historical data was available for the prior years for some of the market segments the Company entered in California, but was limited as to the number of loss reserve evaluation points available. The industry-based benchmarks were judgmentally adjusted for the anticipated impact of significant environmental changes, specifically the enactment of major changes to the statutory workers' compensation benefit structure and the manner in which claims are administered and adjudicated in California. The actual emergence and payment of claims by the Company's California insurance subsidiary have been more favorable than those initial expectations through 2008, due in part to the enactment of the major changes in the California workers' compensation environment. The Company's recent loss experience, from 2010 through 2016, indicates an upward trend in medical and indemnity costs that are reflected in its loss reserves. Loss experience in 2017 indicated a slight downward movement in medical and indemnity costs per claim. The Company's indemnity claims frequency (the number of claims expressed as a percentage of payroll) continued to decrease year-over-year for the past three years; however, in 2018, the Company saw an upward movement in medical and indemnity costs per claim that is reflected in the Company's current accident year loss estimate. The Company's reserve estimates assume that increasing medical cost trends will continue and will impact the Company's long-term claims costs and loss reserves.
Loss reserves shown in the Company's Consolidated Balance Sheets are net of $34.4 million and $35.0 million for anticipated subrogation recoveries as of December 31, 2018 and 2017, respectively.
The effects of reinsurance on the Company's written and earned premiums and on its losses and LAE incurred were as follows:
EPIC has a $10.0 million surplus note to Dekania CDO II, Ltd. issued as part of a pooled transaction. The note matures in 2034 and became callable by the Company in 2009. The terms of the note provide for quarterly interest payments at a rate 425 basis points in excess of the 90-day LIBOR. Both the payment of interest and repayment of the principal under this note and the surplus notes described in the succeeding two paragraphs are subject to the prior approval of the Florida Department of Financial Services. Interest paid during each of the years ended December 31, 2018, 2017, and 2016 was $0.7 million, $0.6 million, and $0.5 million. Interest accrued as of December 31, 2018 and 2017 was $0.1 million.
EPIC has a $10.0 million surplus note to Alesco Preferred Funding V, LTD issued as part of a pooled transaction. The note matures in 2034 and became callable by the Company in 2009. The terms of the note provide for quarterly interest payments at a rate 405 basis points in excess of the 90-day LIBOR. Interest paid during each of the years ended December 31, 2018, 2017, and 2016 was $0.6 million, $0.5 million, and $0.5 million, respectively. Interest accrued as of December 31, 2018 and 2017 was less than $0.1 million.
EPIC had a $12.0 million surplus note to ICONS, Inc. issued as part of a pooled transaction. This note was purchased by EHI in 2017 for $9.9 million, resulting in a $2.1 million gain. As a result of EHI's purchase of the note, it was no longer considered outstanding on a consolidated basis at December 31, 2017. The note was formally redeemed and retired by EPIC in May 2018. Interest paid to third parties during each of the years ended December 31, 2017 and 2016 was $0.3 million and $0.6 million, respectively.
Principal payment obligations on notes payable outstanding at December 31, 2018, were as follows:
The Company leases office facilities and certain equipment under operating and capital leases. Most leases have renewal options, typically with increased rental rates during the option period. Certain of these leases contain options to purchase the property at amounts that approximate fair market value; other leases contain options to purchase at a bargain purchase price. At December 31, 2018, the remaining lease terms expire over the next nine years.
The future lease payments for the next five years on these non-cancellable operating and capital leases at December 31, 2018, were as follows:
As of December 31, 2018, the only incentive awards outstanding under the Plan were nonqualified stock options, RSUs, and PSUs.
The fair value of the stock options granted during the year ended December 31, 2016 was calculated using the following weighted average assumptions:
Changes in outstanding stock options for the year ended December 31, 2018 were as follows:
At December 31, 2018, the Company had yet to recognize $0.2 million of unamortized expense related to stock option grants and expects to recognize these costs on a straight-line basis over the next 15 months. The fair value of stock options vested and the intrinsic value of outstanding and exercisable stock options as of December 31, were as follows:
The intrinsic value of stock options exercised was $1.4 million, $7.6 million, and $7.6 million for the years ended December 31, 2018, 2017, and 2016.
Changes in outstanding RSUs for the year ended December 31, 2018 were as follows:
The PSUs awarded in March 2016, 2017, and 2018 were awarded to certain employees of the Company and have a performance period of two years followed by an additional one year vesting period. The PSU awards are subject to certain performance goals with payouts that range from 0% to 200% of the target awards. The values shown in the table represent the aggregate number of PSUs awarded at the target level.
Net income for the Company's insurance subsidiaries prepared in accordance with SAP for the years ended December 31, 2018, 2017 and 2016 was $159.3 million, $116.8 million, and $101.4 million, respectively.
Treatment of the LPT Agreement, deferred policy acquisition costs, fair value of financial instruments, and the surplus notes (see Notes 5, 10, and 11) are the primary differences in the SAP-basis capital stock and total surplus of the insurance subsidiaries of $927.9 million and $892.4 million, and the GAAP-basis equity of the Company of $1,018.2 million and $947.7 million as of December 31, 2018 and 2017, 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 SAP, the surplus notes are recorded as a separate component of surplus. Under SAP, changes to the estimated contingent profit commission under the LPT Agreement are reflected in commission expense in the period that the estimate is revised.
EPIC and EAC are subject to regulation by the Florida Department of Financial Services (FDFS). Florida statute Section 624.408 requires EPIC and EAC to maintain minimum capital and surplus of the greater of $4.0 million or 10% of total liabilities. Florida statute Section 624.4095 requires EPIC and EAC to maintain a ratio of written premiums, defined as 1.25 times written premiums, to surplus of no greater than 10-to-1 for gross written premiums and 4-to-1 for net written premiums. During the years ended December 31, 2018, 2017, and 2016, EPIC and EAC were in compliance with these statutes.
Diluted earnings per share excludes those outstanding stock options and any other common stock equivalents in periods where the inclusion of such stock options and common stock equivalents would be anti-dilutive. The following table presents the number of stock options, PSUs and RSUs that were excluded from the Company's calculation of diluted earnings per share.
Quarterly results for the years ended December 31, 2018 and 2017 were as follows:
Changes in Net unrealized (losses) gains on investments in 2018 were due to volatility in equity markets. Beginning in 2018, equity securities at fair value are no longer classified as AFS and changes in fair value are included in Net realized and unrealized (losses) gains on investments on the Company's Consolidated Statements of Comprehensive Income. Additionally, Income tax expense was impacted by the volatility in Net unrealized (losses) gains on investments, affecting net income for each quarter of 2018.
The second quarter of 2018 was impacted by: (1) favorable prior accident year loss development of $16.5 million, which decreased losses and LAE by the same amount; (2) favorable development in the estimated reserves ceded under the LPT Agreement that resulted in a $2.2 million LPT Reserve Adjustment and a $0.5 million LPT Contingent Commission Adjustment, which decreased losses and LAE by the same amount; and (3) the inclusion of $3.5 million in net unrealized gains on equity securities.