We have ceased operations of our fee-based subsidiaries - CRM CA, CRM and Eimar. Accordingly, the results of operations of CRM CA, CRM and Eimar are reported as discontinued operations for all periods presented.
a significant decrease in our net written and net earned premiums due to the A.M. Best downgrade and ongoing recession;
severance and other charges taken in 2010 due to the substantial doubt concerning our ability to continue as a going concern and resulting violation of contractual covenants.
Factors Influencing our Future Performance. Our future operating results and financial conditions will be affected by many factors including the following, all of which are discussed in “Item 1 - Business - Significant Developments:”
Our Insureds’ Payroll Levels. Our insurance premiums are ultimately determined by the policyholder’s aggregate payroll. Based on the ongoing recession in the U.S., we have seen a rise in unemployment, and as a result, we continue to experience a downward trend in the payroll levels of our insureds. Consequently, this downward trend in payrolls has resulted in a downward trend of our net earned premiums. Until unemployment declines, we may continue to experience a downward trend in our insureds’ payrolls and our net earned premiums. To the extent that payroll levels on insureds’ policies continue to decline as a result of the recession, our actual premiums earned may be less than expected.
California’s Premium Rates. In California, the state in which the largest amount of our workers’ compensation premiums are earned, the Workers’ Compensation Insurance Rating Bureau of California (WCIRB), an industry-backed private organization that provides statistical analysis, recommends claims cost benchmarks to be used by companies in determining their premium rates. The WCIRB’s recommendations are reviewed by the CA DOI, which also adopts and publishes its own claims cost benchmark. The benchmark rates cover expected loss costs, but do not contain an element to cover operating expenses or profit.
In May 2008, the Commissioner, citing forecasted marketplace stability, did not issue an interim pure premium rate advisory - the first time in six years an interim pure premium rate advisory was not issued by a California insurance commissioner.
In October 2008, the Commissioner rejected WCIRB’s recommendation of a 16% increase to the workers’ compensation benchmark rates and instead granted a 5% increase. The WCIRB’s recommended increase was based primarily on rising medical costs and loss adjustment expenses.
In July 2009, the Commissioner declined WCIRB’s application to increase the workers’ compensation benchmark rates by 23.7%. The Commissioner recommended no change, citing evidence that self-insured employers were able to reduce overall workers’ compensation costs. The WCIRB’s recommendation was based on an evaluation of the industry loss and loss adjustment expense experience as of December 31, 2008 and on expected cost increases arising from two significant Workers’ Compensation Board of Appeals decisions that affected the 2004 legislative reforms.
Effective October 1, 2009, the loss cost multiplier in New York State realized an increase of 4.5% and the New York State assessment increased from 13.4% to 14.2% of standard premium. Commencing October 1, 2010, New York State approved a 7.7% increase in the loss cost multiplier coupled with an upward adjustment of the State assessment from 14.2% to 18.1%.
A portion of our premiums are written on an adjustable basis, and premiums from those policies can be adjusted retrospectively in accordance with the actual loss experience of the policyholders’ claims arising during the policy term. These retrospective premium adjustments are periodically made to the net premiums earned to reflect the changes in the estimation of the policyholders’ ultimate losses as more information becomes available over time.
Investment Income. Our investment income is dependent upon the invested assets in our portfolio and the yield that we earn on those invested assets. Our investment yield depends on market interest rates and the credit quality and maturity period of our invested assets. In addition, we realize capital gains or losses on sales of investments and realize losses on impairment of investments as a result of (1) the inability and intent to hold investments to maturity; and (2) changing market conditions, including changes in market interest rates and changes in the credit quality of our invested assets. Investment income is recorded net of investment expenses.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses reflect our best estimate, using various actuarial analyses, of ultimate losses and loss adjustment expenses, net of any reinsurance recoverables, we expect to incur on each insurance and reinsurance contract written. Actual losses and loss adjustment expenses will depend on actual costs to settle our claims and the actual expenses incurred in settling the claims. Our loss adjustment expenses include allocated loss adjustment expenses (ALAE) or amounts that can be attributed to specific claims and unallocated loss adjustment expenses (ULAE) or claims expenses, including costs of maintaining a claims department that are not directly attributable to specific claims.
Underwriting and Acquisition Expenses. Underwriting and acquisition expenses consist of certain personnel expenses of our insurance operations, impairment of goodwill, other operational expenses and commissions, premium taxes, other policy issuance costs of our insurance subsidiaries relating to the underwriting and issuance of workers’ compensation insurance policies.
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, consequently, actual results reflected in future periods might differ from these estimates and could differ by material amounts. In addition, if factors such as those described in Item 1A. under the heading “Risk Factors” cause actual events to differ materially from management’s assumptions used in applying the relevant accounting policy, there could be a material adverse effect on our financial condition and results of operations.
Variation in Ultimate Loss Estimates. The actuarial techniques that we use to establish our loss reserves are based upon a combination of our historical experience as well as industry information. These techniques recognize, among other factors:
In addition, there are losses and loss adjustment expense risk factors that affect workers’ compensation claims that can change over time and also cause our loss reserves to fluctuate. Some examples of these risk factors include, but are not limited to, the following:
Impact of Changes in Key Assumptions on Reserve Volatility. The most significant factor currently impacting our loss reserve estimates is the reliance on our and industry historical reserving patterns and loss payments, also referred to as loss development patterns. The actuarial methods that we use depend at varying levels on loss development patterns based on past information. Development is defined as the difference, on successive valuation dates, between observed values of certain fundamental metrics that may be used in the loss reserve estimation process. For example, the data may be paid losses, case incurred losses and the change in case reserves or claim counts, including reported claims, closed claims or reopened claims. Development can be expected, meaning it is consistent with prior results; favorable (better than expected); or unfavorable (worse than expected). In all cases, we are comparing the actual development of the data in the current valuation with what was expected based on the historical patterns in the underlying data. Favorable development indicates a basis for reducing the estimated ultimate loss amounts, thereby increasing our operating results, while unfavorable development indicates a basis for increasing the estimated ultimate loss amounts, thereby decreasing our operating results. We reflect the favorable or unfavorable development in loss reserves in the results of operations in the period in which the ultimate loss estimates are changed.
Our estimated ultimate losses for accident year 2010 are based on a combination of the three primary methods described in Item 1 above under the heading “Business - Reserves for Losses and Loss Adjustment Expenses,” plus consideration of trended pure premiums. This is consistent with our reserving approach for the current accident year at prior year-end valuations. During the year ended December 31, 2010, we adjusted our current year estimated loss and ALAE ratio to 79% from 86%. We adjusted the estimated loss ratio for 2010 due to the increase in the average premium rate level in California and a reduction in our exposure in the higher loss ratio states of New York and New Jersey.
In our primary insurance policy business, our paid loss data for state act indemnity for California displayed increasing, or inflationary, trends over the most recent valuations at December 31, 2010. The increasing trends are exhibited in the paid loss development data for the 2007 and 2008 accident years. The decision to increase the estimated ultimate losses for accident years 2007 and 2008 was appropriately made, as the underlying loss data showed deterioration over the prior twelve months. We did not see similar increase in paid loss development for the 2004 through 2006 accident years. Accordingly, we have not increased the estimated ultimate losses for those accident years. We believe that our loss development factor selections are appropriate given the relative immaturity of our data. Over time, as the data for these accident years mature and uncertainty surrounding the ultimate outcome of the claim costs and associated loss adjustment expenses diminishes, the full impact of the actual loss development will be factored into our assumptions and selections.
Loss Reserve Adequacy - California Department of Insurance Examination of Majestic Insurance. We are currently undergoing an examination by the CA DOI for calendar years 2005 through 2010. As part of its examination, the CA DOI conducts a review of the adequacy of our statutory carried reserves for losses and loss adjustment expenses, net of reinsurance (statutory loss reserves). In its examination report, the statutory loss reserves estimated by the CA DOI are approximately $41.0 million higher than the statutory loss reserves carried by us at December 31, 2010.
The remainder of the difference between the estimated statutory loss reserves of the CA DOI and our carried reserves at December 31, 2010 is attributable to statutory loss reserves for business underwritten in New York and New Jersey. The methodology used by the CA DOI is based largely on the application of industry loss development factors in each state, with no weight given to our consistent nationwide case reserving philosophy.
We have evaluated the analyses of the CA DOI concerning the loss reserve adequacy of Majestic Insurance. We continue to believe that the statutory loss reserves carried by Majestic Insurance at December 31, 2010 are adequate and therefore we have not increased our carried statutory loss reserves. The decision to maintain the statutory loss reserves at their current level is based on the following factors:
An expectation of less tail development in California - this expectation is based on (1)years of historical experience (dating back to 1986) which is a good baseline for estimating the tail development for business underwritten in California; and (2) a prudent selection of loss development factors whereby we have made adjustments for extraordinarily large claims that tend to distort the average loss development factors relative to the size of the company;
The use of traditional actuarial methods to determine the loss ratios for business underwritten in California as compared to the industry factors exclusively used by the CA DOI - the traditional actuarial methods we used have historically resulted in better-than-WCIRB industry loss ratios in California; and
We adjust the cost of our invested assets for impairments in value deemed to be other-than-temporary in the period in which the determination is made. These other-than-temporary impairment (OTTI) adjustments are recorded in our results of operations as a realized loss on investments. The assessment of whether such impairment has occurred is based on management’s case-by-case evaluation of the underlying reasons for the decline in fair value.
We regularly evaluate our available-for-sale fixed-maturity investment portfolio to identify other-than-temporary impairments in the fair values of the securities we hold. When, in the opinion of management, a decline in the fair value of an available-for-sale investment below its cost or amortized cost is considered to be other-than-temporary, such investment is written-down to its fair value. We consider various factors in determining whether a decline in the fair value of an available-for-sale security is other-than-temporary, including:
Based on the accounting guidance, our assumptions are limited to business strategies which we can control. Given these limitations, we concluded that estimated future taxable income and certain tax planning strategies no longer constituted sufficient positive evidence to assert that it is more likely than not that the net deferred tax assets would be realizable in the foreseeable future. Consequently, we carried a net deferred tax valuation allowance of $28.0 million and $17.1 million at December 31, 2010 and 2009.
The termination of the proposed merger with Bayside as discussed in “Item 7 - Liquidity and Capital Resources - Capital Resources - Previously Announced and Subsequent Termination of Bayside Amalgamation Agreement.” We will not be able to benefit from the financial condition, reputation and regulatory and rating agency standing of Lancer, an affiliated insurance company of Bayside;
The conservation and rehabilitation of Majestic Insurance by the California Department of Insurance as discussed in “Item 1 - Business - Significant Developments - California Department of Insurance - Conservation and Rehabilitation of Majestic Insurance.”
The restrictions of the BMA on Twin Bridges’ ability to write new business or pay dividends/distribute surplus to its parent Majestic Capital described in “Item 1 - Business - Regulation - Minimum Solvency Margin, Enhanced Capital Requirement and Restriction on Dividends and Distributions.”
We evaluate each contingent liability separately to determine if a loss contingency should be recorded. A loss contingency is only recorded if it is both (1) probable and (2) reasonably estimable. Loss contingencies are established at our “best estimate,” or, if no one number within the range of possible losses is more probable than any other, we record an estimated reserve at the low end of the range of losses. Costs of legal defense of litigation and regulatory matters are expensed as incurred.
In October 2010, the Financial Accounting Standards Board (FASB) issued updated guidance to address the diversity in practice for the accounting for costs associated with acquiring or renewing insurance contracts. This guidance, which is now part of ASC 944, Financial Services - Insurance, modifies the definition of acquisition costs to specify that a cost must be directly related to the successful acquisition of a new or renewal insurance contract in order to be deferred. If application of this guidance would result in the capitalization of acquisition costs that had not previously been capitalized by a reporting entity, the entity may elect not to capitalize those costs. The updated guidance is effective for periods ending after December 15, 2011. The Company is currently evaluating the potential impact, if any, of the adoption of this guidance on its financial condition and results of operations.
Underwriting and acquisition expenses includes: (a) $12.6 million, $15.7 million and $20.0 million of policy acquisition costs for the years ended December 31, 2010, 2009 and 2008, respectively, and (b) $18.9 million, $20.7million and $20.1 million of general and administrative expenses for the years ended December 31, 2010, 2009 and 2008, respectively, of our insurance subsidiaries relating to the underwriting and issuance of workers’ compensation insurance policies.
The loss and loss adjustment expense ratio is calculated by dividing losses and loss adjustment expenses by net premiums earned. When the calendar year loss and loss adjustment ratio is adjusted to exclude prior period items, such as loss reserve development, it becomes the “accident year loss ratio,” a non-GAAP financial measure.
Despite a 12% annual increase in average premium rate per policy and a 23% annual increase in average premium size per policy, our direct written premiums decreased $62.0 million or 40% to $91.5 million in 2010, compared to $153.5 million in 2009. Of this decrease, $57.2 million was attributable to primary insurance policy business and $4.7 million was attributable to excess insurance policy business.
The decrease in our direct written premiums in 2010 compared to 2009 was primarily attributable to the following factors:
Lower than anticipated B++ premiums underwritten in California attributable to intense competition in the California market where we adhered to strict pricing and prudent underwriting disciplines throughout the year. This contributed to the 45% decrease in in-force premiums and the 57% decrease in in-force policy count year over year in the California market.
The ongoing recession continued to negatively impact the payroll levels of our insureds. Our current total year payroll exposure is 40% lower in 2010 compared to 2009.
Our excess insurance policy count and reported payrolls declined year-over-year based on (1) the closure of the self-insured groups we previously managed in California which resulted in the cancellation/non-renewal of the related excess insurance policies underwritten by Majestic Insurance; and (2) our decision to exit the excess insurance policy business at the end of 2010.
The decrease in our excess insurance policy business direct written premiums was primarily attributable to a decrease in the policy count and reported payrolls in both California and New York in 2009 as compared to 2008. Contributing factors to this decrease include: (1) the closure of the self-insured groups we previously managed in California and New York which resulted in the non-renewal of the related excess insurance policies underwritten by Majestic Insurance; and (2) the economic downturn negatively impacted the payroll levels of our insureds.
Factors contributing to the decrease in our primary insurance policy business include: (1) our average premium rate per policy decreased in 2009 compare to 2008; and (2) the aforementioned effects of the economic downturn which resulted in lower payroll levels of our insureds. While the effects of underwriting actions taken on primary insurance business underwritten in New York and New Jersey reduced our direct written premiums by $15.5 million, or 44%, in 2009 compared to 2008, an increase in our primary insurance business underwritten in California resulted in a $10.4 million, or 12% increase year over year.
Assumed premiums written increased $1.9 million, or $684%, to $2.2 million in 2009, from $0.3 million in 2008. This increase was attributable to premiums assumed from state mandated pools, primarily in New Jersey, in 2009 compared to 2008.
Ceded Premiums Written. Ceded premiums written decreased $28.2 million, or 39% to $44.2 million in 2010 from $72.4 million in 2009. The decrease in premiums written in 2010 as compared to 2009 is attributable to:
Ceded premiums written increased $25.4 million, or 54%, to $72.4 million in 2009 from $47.0 million in 2008. This increase was attributable to the full year effects of our ceded quota share agreements in 2009 as compared to 2008.
The cession percentages shown do not reflect the effects of amounts ceded under our excess of loss reinsurance treaty. For losses incurred between July 1, 2008 and June 30, 2009, Majestic Insurance entered into a 40% ceded quota share agreement with Max Re. For losses incurred between July 1, 2009 and June 30, 2010, Majestic Insurance entered into a 15% ceded quota share agreement with Max Re, excluding coverage for workers’ compensation business written by Majestic Insurance in New York. The cession percentage shown in the table for this agreement reflects an approximation of the exclusion of New York business.
The cession percentages shown do not reflect the effects of amounts ceded under our excess of loss reinsurance treaty. For losses incurred between July 1, 2009 and June 30, 2010, Majestic Insurance entered into a 43% ceded quota share agreement with Aspen Re and Axis. The cession percentage reflects the 80% placement with Aspen Re and Axis under the 43% quota share agreement.
Investment Income. Investment income decreased $5.7 million, or 35%, to $10.6 million in 2010 from $16.3 million in 2009. Of this decrease, aggregate charges of $3.3 million was attributable to OTTI on our total investments, $1.2 million was attributable to lower year over year net realized gains of our available-for-sale investment portfolio and $1.2 million was attributable to lower investment income earned in 2010 as compared to 2009.
As a result of (1) the uncertainty surrounding our ability to continue as a going concern; (2) the conservation of Majestic Insurance and rehabilitation plan initiated by the CA DOI; and (3) the termination of our secured policy administration operating lease, we may be required to sell certain of our available-for-sale securities to meet our future obligations. Therefore, we no longer have the intent or ability not to sell our available-for-sale securities that are in a gross unrealized loss position. In addition, if we default on our junior subordinated debt obligations (Junior Debt) due to possible future bankruptcy proceedings, we may not receive interest and principal payments on the related common securities we hold as an investment in unconsolidated subsidiary. Accordingly, we incurred aggregate OTTI charges on our invested assets of $3.3 million for the year ended December 31, 2010 as compared to immaterial OTTI charges for the year ended December 31, 2009.
(1) In 2008, we recorded an impairment charge of $0.9 million on one fixed-maturity security (Lehman Brothers Holdings Inc filed for bankruptcy in 2008). In 2010, the Lehman security matured and we recovered 100% of the impairment charge. The $0.9 million recovery is included in our 2010 net realized gains.
Loss and Loss Adjustment Expenses. Loss and loss adjustment expenses decreased $30.5 million, or 37%, to $51.2 million in 2010 from $81.7 million in 2009. Loss and loss adjustment expenses decreased $3.9 million, or 5%, to $81.7 million in 2009 compared to $85.5 million in 2008.
Our overall loss and loss adjustment expense ratio in 2009 was 101% compared to 70% in 2008. The 2009 accident year loss and loss adjustment expense ratio was adversely affected by lower net earned premiums year over year and increased to 94% in 2009 from 75% in 2008. The increase of our 2009 accident year loss and ALAE ratio to 86% from 71% was primarily attributable to (1) an increase in our claims’ severity trend in California primary insurance policy business; (2) a 7% decrease in the average premium rate level in California; and (3) greater than expected loss emergence in New York and New Jersey.
As a result of changes in estimates of insured events of prior years, we experienced favorable development of $5.6 million for the year ended December 31, 2008 of which $3.6 million was attributable to our primary insurance business and $2.0 million was attributable to our excess insurance business. Both our primary insurance and excess insurance businesses experienced favorable development as a result of favorable loss cost trends in California, predominantly in accident years 2006 and 2007.
We have established loss reserves at December 31, 2010 that are based upon our current best estimate of loss and loss adjustment expenses. Loss reserves do not represent an exact calculation of liability, but instead represent management’s best estimates, generally utilizing actuarial expertise and projection techniques, at a given accounting date. Reserves for losses and loss adjustment expenses are estimates and are inherently uncertain; they do not and cannot represent an exact measure of liability. The methods for making such estimates and for establishing the resulting reserves are continually reviewed and updated, and any adjustments are reflected in current operations. For additional information regarding our reserves for losses and loss adjustment expenses, our processes for establishing the reserves and the risks associated therewith, see “Item 1. Business - Reserves for Losses and Loss Adjustment Expenses,” “Item 1A. Risk Factors - Our loss reserves are based on estimates and may be inadequate to cover our losses,” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates - Reserve for Losses and Loss Adjustment Expenses.”
Underwriting and Acquisition Expenses. Underwriting and acquisition expenses decreased by $5.0 million, or 14%, to $31.4 million in 2010 from $36.4 million in 2009. The factors contributing to this decrease were:
No goodwill impairment charges in 2010 as compared to a $2.7 million charge in 2009;
These decreases were offset by lower ceding commission income due to the 2010 mid-year non-renewal of our ceded quota share agreements, expense increases related to the development of our integrated policy administration system, the reallocation of personnel and other resources from Majestic USA to our insurance company operations, and an increase in the expense of the regulatory review and oversight of Majestic Insurance.
Our underwriting expense ratio in 2010 was 61% compared to 45% in 2009. The increase in our expense ratio is primarily attributable to the year-over-year reduction in our net earned premiums.
Lower broker commissions, premium taxes and other policy issuance costs related to the year over year reduction in our direct premiums written; and
The effects of January 1, 2010 pay cuts for executive management and the Board of Directors as well as other reductions in general and administrative expenses resulting from cost cutting measures instituted in 2010; and
These decreases were offset by higher insurance premiums for our directors’ and officers’ insurance coverage in 2010 compared to 2009.
A $1.5 million charge related to the lease amendment and license agreement to eliminate certain office space in Poughkeepsie, New York. ;
A $0.9 million charge related to security deposits on our integrated policy administration system and our Poughkeepsie, New York office space and prepaid expenses related to our integrated policy administration system. As a result of the uncertainty surrounding our ability to continue as a going concern and the termination of the PAS lease, we determined that there is no future value to these assets at December 31, 2010; and
A $0.5 million severance charge related to the work force reductions in 2010. This reduction reflects the decrease in premium levels experienced by Majestic Insurance and is designed to better align our workforce to current premium levels and properly manage enterprise wide expenses.
Severance and other charges increased $4.7 million, or 564%, to $5.5 million in 2009 from $0.8 million in 2008. The increase was attributable to the recognition of additional severance expense for our former Co-Chief Executive Officers in 2009 compared to 2008.
Our Chief Executive Officer and Chairman of the Board resigned in March 2009. In conjunction with his resignation, we entered into a separation agreement, the terms of which include $3.3 million of cash payments, immediate vesting of restricted stock awards and payment of health and welfare benefits for up to three years. Accordingly, we recorded $3.8 million of severance expense in the first quarter of 2009.
In addition, we accelerated the recognition of the severance expense of our Former Co-Chief Executive Officer who resigned in December 2006. Historically commencing in 2007, we recognized $0.8 million of severance expense per year, which represented the total severance expense earned ratably over the term of the non-compete/non-solicitation covenants contained in his separation agreement. In 2009, we determined that there was not a significant ongoing economic benefit related to those covenants due to our decreased presence in the self-insured group market and the current economic and regulatory environment. Accordingly, we accelerated the recognition of severance expense and recorded the remaining $1.5 million of severance expense in the first quarter of 2009.
Interest Expense. Interest expense increased $0.9 million, or 24%, to $4.7 million in 2010 from $3.8 million in 2009. Interest expense increased $0.1 million, or 2%, to $3.8 million in 2009 from $3.7 million in 2008. The increases for both periods were primarily attributable to higher amounts paid to reinsurers on balances required as collateral for unpaid ceded liabilities under our reinsurance agreements year over year.
Loss from continuing operations was $41.7 million in 2009 compared to $1.0 million in 2008. The $40.6 million increase in our loss from continuing operations is attributable to lower premium volume in our insurance operations, severance expense related to our former co-chief executive officers and the impairment of goodwill in 2009 compared to 2008.
The 2008 income tax benefit included a $1.6 million income tax benefit and a $0.8 million deferred tax benefit. Our 2008 income tax benefit included the tax benefit associated with our net operating losses from continuing operations.
Our deferred tax benefit in 2010 and 2009 included tax benefits related to our net operating loss carryforwards, the deferred tax benefit for all years presented included the impact of temporary differences from net loss reserves, unearned premiums and deferred policy acquisition costs being reported differently for financial statement purposes and for federal income tax purposes.
CRM CA has ceased providing administrative services to its last self-insured group under management on December 31, 2010. Consequently, we closed down our California fee-based operations and CRM CA is reported as a discontinued operation in the consolidated statements of operations for all periods presented. Income from discontinued operations related to CRM CA was $0.0 million, $0.2 million and $0.7 million in 2010, 2009 and 2008, respectively.
As of September 8, 2008, we ceased to manage self-insured groups in New York or provide bill review and case management services for self-insured groups or third party clients. Accordingly, CRM and Eimar are reported in discontinued operations for all periods presented. Losses from discontinued operations related to CRM and Eimar were $4.7 million, $1.9 million and $3.5 million for 2010, 2009 and 2008, respectively.
The following table shows the fair market values of various categories of our available-for-sale investment portfolio, the percentage of the total market value of our invested assets represented by each category and the tax equivalent yield to maturity based on the fair market value of each category of invested assets as of the dates indicated:
our intent not to sell, or more likely than not be required to sell the security for a sufficient time period for it to recover its value;
The fair value guidance creates a common definition of fair value, establishes a hierarchy for determining fair value that emphasizes the use of observable market data whenever available and requires expanded disclosures as described in more detail in Note 7 of the Notes to our Consolidated Financial Statements under Item 8. We outsource investment accounting services for our available-for-sale investment portfolio to a third party. Through this third party, we use nationally recognized pricing services to estimate fair value measurements for our investments. These pricing services include FT Interactive Data, Hub Data, J.J. Kenny, Standard & Poors, Reuters and the Bloomberg Financial Market Services. The pricing services use market quotations for securities that have quoted prices in active markets. When quoted prices are unavailable, the pricing services use significant other observable inputs that are more subjective, such as pricing models or other financial analytical methods. To validate the techniques or models used by the pricing services, we compare the fair value estimates to our perception of the current market and will challenge any prices deemed not to be representative of fair value.
We are a holding company and our operating subsidiaries are the primary source of funds for our operations. We have two primary concerns in managing our liquidity. First, we need to ensure that there is adequate cash available in the insurance subsidiaries to pay claims. Second, we need to ensure that our holding companies, Majestic Capital, Majestic USA, and Embarcadero, which have no operating revenues, all have adequate cash to service their debt obligations and to pay other expenses, including but not limited to litigation settlement costs. The management of capital resources is primarily concerned with ensuring that there is adequate capital to operate our insurance business within the criteria imposed by regulatory requirements and by rating agencies with respect to our financial strength ratings.
Liquidity is a measure of a company’s ability to generate sufficient cash flows to meet the short- and long-term cash requirements of its business operations. Historically, the liquidity requirements of our business have been met primarily by funds generated from operations, asset maturities and income received on investments. As discussed in “Item 7 - Critical Accounting Policies and Estimates - Going Concern,” we do not believe that we have sufficient assets available to meet our obligations as they become due in the foreseeable future.
Majestic Insurance, our principal operating subsidiary, will be placed into statutory conservation by the CA DOI on April 21, 2011. In accordance with the statutory conservation, the CA DOI is structuring a rehabilitation plan as described in “Item 1 - Business - Significant Developments - California Department of Insurance - Conservation and Rehabilitation of Majestic Insurance” whereby AmTrust would not only assume the loss reserves and in-force insurance business of Majestic Insurance, but also absorb the west coast operations of Majestic Insurance. Upon completion of the AmTrust Transactions, many of the assets and liabilities of Majestic Insurance will be transferred to AmTrust, thereby relieving Majestic Insurance of many of its obligations. The remaining estate of Majestic Insurance will be liquidated by the CA DOI. The conservation order and rehabilitation plan require regulatory approval, which may take up to eight weeks. Until the conservation order and rehabilitation is approved, Majestic Insurance must continue to meet the short-term requirements of its business operations.
Sources of Liquidity - Majestic Insurance Company and Twin Bridges. Majestic Insurance Company generally creates liquidity because insurance premiums are collected prior to disbursements for claims, which may take place many years after the collection of premiums. Collected premiums may be invested until claims must be paid and investment income provides a source of additional cash. Cash flow is negative in periods in which disbursements for claims and benefits, current policy acquisition costs and current operating and other expenses exceed operating cash receipts. Such negative cash flow is offset by cash flow from investments, principally short-term investments and maturities of longer-term investments. The exact timing of the payment of claims and benefits cannot be predicted with certainty.
Majestic Insurance has a secured letter of credit facility with Comerica Bank (“Comerica Credit Facility”), under which it is able to draw secured letters of credit in an amount equal to the funds posted by Majestic Insurance. The Comerica Credit Facility has a limit of $75.0 million and may be secured by cash, investments or a combination thereof. Majestic Insurance pays a fee of 0.30% to 0.50% of the principal amount of each letter of credit issued.
$21.0 million to the CA DOI with respect to an unaffiliated reinsurer;
$1.8 million for lease obligations under its lease for San Francisco office space;
The Comerica Credit Facility has various financial covenants, one of which requires Majestic Insurance to maintain an A.M. Best rating of at least B++. The financial strength rating of Majestic Insurance was downgraded from B++ to B on March 25, 2011 and therefore, Comerica could terminate the secured credit facility due to a financial covenant violation. On March 31, 2011, Majestic Insurance notified Comerica of its default. Comerica indicated that it would not terminate the Comerica Credit Facility due to the pending AmTrust Transactions and the full collateralization of the facility by the invested assets of Majestic Insurance.
While there were no amounts drawn against the letters of credit at December 31, 2010, on March 31, 2011, $8.0 million was drawn down against the letter of credit for the benefit of our integrated policy administration software. On April 4, 2011 Majestic Insurance received written notification of the termination of its integrated policy administration system operating lease whereby the lessor indicated that an event of default had occurred. The lessor cited the A.M. Best downgrade as a material adverse change in the financial condition of Majestic Insurance. The amount of the drawdown represents the approximation of the original encumbrance capital costs paid by the lessor, including penalties as stipulated by the lease agreement.
Twin Bridges is not licensed, approved or accredited as a reinsurer anywhere in the U.S. and, therefore, under the terms of most of its contracts with U.S. ceding companies including Majestic Insurance, it is required to provide collateral to its ceding companies for unpaid ceded liabilities in a form acceptable to state insurance commissioners. Typically, this type of collateral takes the form of letters of credit issued by a bank, the establishment of a trust, or funds withheld. For obligations associated with liabilities ceded from third parties, a third party reinsurer held $0.8 million of cash as collateral at December 31, 2010.
the conservation and rehabilitation of Majestic Insurance, our principal operating subsidiary, as described above;
Net cash from financing activities increased $7.4 million in 2010 compared to 2009 and decreased by $2.0 million in 2009 compared to 2008. These changes in cash from financing activities were primarily attributable to changes in the investment mix of amounts on deposit for the benefit of various regulatory agencies.
If the amalgamation had been executed, Majestic Capital would have become a wholly-owned subsidiary of Bayside and its common shares would have been delisted from the NASDAQ Capital Market and deregistered under the Exchange Act. As a result, our capital requirements to maintain our A.M. Best rating would have been eased, and we could have alleviated the costs of operating as a small stand-alone public company where we face continuing, and sometimes conflicting pressures from our insureds, brokers, competitors, regulatory agencies, financial analysts and independent rating agencies. The failure to execute the merger leaves us with limited access to capital on favorable terms as a result of the current economic climate, the fact that the common shares of Majestic Capital continued to trade at a considerable discount to our book value and delisting procedures have been initiated by the NASDAQ Capital Market as described below.
A.M. Best Rating. Our competitive position and capital requirements are partly determined by our financial strength ratings issued by A.M. Best. In March 2011, A.M. Best downgraded Majestic Insurance’s financial strength rating from “B++” (Good) to “B” (Fair). The rating is under review with developing implications. The rating reflects AM. Best’s opinion of Majestic Insurance’s financial strength, operating performance and ability to meet its obligations. A.M. Best’s downgrade of Majestic Insurance’s rating to B places the rating in the “non-secure” category within A.M. Best’s rating scheme. The non-secured rating could cause significant negative effects to our business. In view of this threat, the litigation surrounding the Majestic Capital and its affiliates, and the adverse operating results of Majestic Insurance, the CA DOI has filed an order of voluntary conservation and rehabilitation on April 21, 2011.
NASDAQ Stock Delisting. On April 15, 2011, we received a letter from The Nasdaq Stock Market stating that we had failed to comply with the requirement of the timely filing of our Annual Report on Form 10-K with the SEC as set forth in the Listing Rule 5250(c)(1). We now have 60 calendar days to submit a plan to regain compliance with the Listing Rule and may be granted an exception until October 12, 2011 to regain compliance. Accordingly, our common shares may be delisted and will not be traded on the NASDAQ Capital Market as soon as June 14, 2011, sixty days from receipt of written notification from The Nasdaq Stock Market. For additional information and the risks associated with the Nasdaq’s notice, see “Item 1A - Risk Factors - Our common shares could be delisted from the Nasdaq Capital Market if we fail to continue to meet all applicable Nasdaq Capital Market requirements” above.
During the deferral period, we may not, except for intercompany dividends and distributions and subject to certain other exceptions, (a) declare or pay any dividends or distributions on, or redeem, purchase, acquire, or make a liquidation payment with respect to, any of our capital stock, (b) make any payments on, repay, repurchase or redeem any debt securities other than those that rank senior to the debt securities, (c) make any payment under any guarantees with respect thereto, or (d) enter into any contracts with 10% or greater shareholders.
Potential Events of Default Under Bankruptcy, Insolvency or Liquidation. Based on the termination of the Bayside Amalgamation Agreements, the conservation and rehabilitation of Majestic Insurance by the CA DOI, the restrictions placed on Twin Bridges’ ability to write new business or pay dividends/distribute capital by the BMA and our resulting inability to fund the ongoing expenses of our holding companies, we may be forced to seek relief through a filing under the U.S. Bankruptcy Code or Bermuda Companies Act. A bankruptcy filing would result in the violation of one or more legal and financial covenants of our debt and other contractual obligations. This violation would trigger an event of default or may result in the early termination of the following debt and contractual obligations:
Junior Subordinated Debt Obligation - Upon commencement of a voluntary bankruptcy, insolvency or liquidation of Majestic USA or its guarantor, Majestic Capital; or upon court appointment of a receiver to wind up or liquidate Majestic USA’s or Majestic Capital’s affairs due to the court’s decree under bankruptcy or insolvency law, principal and unpaid interest, including any deferred interest on the Junior Debt and related administrative costs become immediately due and payable. Principal and accrued interest, including deferred interest payable on the Junior Debt is approximately $40.3 million at December 31, 2010.
Senior Debt Obligation - We assumed $8.0 million of senior debentures through our acquisition of Embarcadero. The senior debentures mature May 23, 2033 and are callable on or after May 23, 2008. The interest rate of the senior debentures is three month LIBOR plus 4.2% and may not exceed 12.5%.
Integrated Policy Administration System - Hosting, License and Services Agreement - Upon adjudication of bankruptcy of Majestic Insurance, the policy administration system host, license and service provider (PAS Service Provider) may declare the hosting, license and service agreements terminated upon written notice to Majestic Insurance. At such time: (1) amounts equal to the present value of all remaining payments under the hosting agreement, which expires October 2011, are immediately due and payable; and (2) unpaid fees under the licenses and service agreement, which expires April 2013, become immediately due and payable. Furthermore, upon termination of the license agreement by the PAS Service Provider, the license and all rights in and to the license agreement shall automatically revert back to the PAS Service Provider. Future remaining aggregate payments due under the integrated policy administration system hosting, license and service agreements are approximately $0.3 million at December 31, 2010.
Information Technology Services Agreement (IT Services Agreement) - While the commencement of bankruptcy, insolvency or liquidation proceedings of Majestic USA, Majestic Insurance, CRM or CRM CA (Parties to the IT Services Agreement) would not result in an immediate termination of the IT Services Agreement, a breach of terms, including non-payment of monthly service fees could result in termination of the agreement by either the service provider or the Parties to the IT Services Agreement. Upon early termination, all unpaid amounts due under the IT Services Agreement, which terminates September 2012, become immediately due and payable. Remaining amounts due under the IT Services Agreement are approximately $1.8 million at December 31, 2010.
Miscellaneous Equipment and Service Agreements - Upon the commencement of bankruptcy, liquidation or insolvency proceedings, these agreements may automatically terminate or be voluntarily terminated by the Company. Upon termination, any unpaid amounts on miscellaneous equipment and service agreements would become immediately due and payable. Aggregate amounts due on miscellaneous equipment and service agreements are no material to our consolidated financial statements at December 31, 2010.
All of our outstanding financing obligations are included in the Consolidated Financial Statements and accompanying Notes contained in Item 8. The table below sets forth the amounts of our contractual obligations including interest payable, at December 31, 2010. Amounts presented do not include penalties or other charges in the event of a default or early termination of our contractual obligations.
In our opinion, the 2009 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Majestic Capital, Ltd. at December 31, 2009, and the consolidated results of its operations and its cash flows for the year ended December 31, 2009, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related 2009 supplemental schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
We have audited the accompanying consolidated statements of operations and comprehensive loss, shareholders’ equity, and cash flows of Majestic Capital, Ltd. (formerly CRM Holdings, Ltd.) for the year ended December 31, 2008. Our audit also included the financial statement schedules for the year ended December 31, 2008 listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to report on these financial statements and schedules based on our audit.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated results of the Company’s operations and its cash flows for the year ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedules for the year ended December 31, 2008, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
Majestic Capital, Ltd. (Majestic Capital or the Company) is a Bermuda holding company and 100% owner of Majestic USA Capital, Inc. (Majestic USA), a United States holding company, and Twin Bridges (Bermuda) Ltd. (Twin Bridges), a Bermuda insurance company. The Company’s legal domicile is Bermuda, the jurisdiction in which it is incorporated.
Majestic USA has three other subsidiaries, Compensation Risk Managers of California, LLC (CRM CA), Compensation Risk Managers, LLC (CRM), and Eimar, LLC (Eimar), none of which has active business operations. The results of CRM CA, CRM and Eimar are reported as discontinued operations as more fully described in Note 3.
The Company, through its subsidiaries, is a specialty provider of workers’ compensation insurance products and services. Workers’ compensation insurance coverage is offered to employers in California, New York, New Jersey, Arizona, Nevada and other states.
The conservation and rehabilitation of Majestic Insurance initiated by the California Department of Insurance (CA DOI) as discussed under the heading Conservation of Majestic Insurance Company in Note 24 and the related transactions contemplated under the heading AmTrust Non-Binding Letter of Intent and Term Sheet in Note 24;
The inability to fund the ongoing expenses of Majestic Capital, Majestic USA and Embarcadero (the Holding Companies) and discontinued operations for the foreseeable future. The Holding Companies and discontinued operations generate no revenue but are obligated to pay the following expenses: debt service, public company costs, other general corporate overhead and costs to defend and settle pending litigation and regulatory actions, including the proposed settlement involving the New York self-insured groups discussed under the heading Pending Litigation - Litigation Involving the New York Self-Insured Groups in Note 21. Historically, these expenses were funded by (1) the operations of our fee-based subsidiaries when they were continuing operations; (2) BMA approved dividends/return of capital from Twin Bridges.; (3) the CA DOI approved Form D filing by which certain of Majestic USA’s other general corporate overhead was allocated to/funded by Majestic Insurance; and (4) dividends from Majestic Insurance. Given the termination of our fee-based business and the regulatory aforementioned restrictions placed on Majestic Insurance and Twin Bridges, there may be limited/ no funds available to cover the ongoing expenses of the Holding Companies and discontinued operations.
Based on the above factors, the Company may be forced to seek relief through a filing under the U.S. Bankruptcy Code or Bermuda Companies Act (bankruptcy filing). A bankruptcy filing would result in the violation of one or more legal and financial covenants of the Company’s debt and other contractual obligations. This violation would trigger an event of default or may result in the early terminations of the following debt and contractual obligations:
Facilities Lease - Poughkeepsie, New York - upon an adjudication of bankruptcy of Majestic USA, the landlord may (1) terminate the lease upon five days written notice to Majestic USA; or (2) continue to enforce the terms of the lease whereby all unpaid rental amounts under the lease, including current and outstanding additional rent shall become immediately due and payable. Future remaining payments due under the Poughkeepsie, New York facilities lease, which expires December 2022, are approximately $14.8 million at December 31, 2010.
Integrated Policy Administration System - Hosting, License and Services Agreement - upon adjudication of bankruptcy of Majestic Insurance, the policy administration system host, license and service provider (PAS Service Provider) may declare the hosting, license and service agreements terminated upon written notice to Majestic Insurance. At such time: (1) amounts equal to the present value of all remaining payments under the hosting agreement, which expires October 2011, are immediately due and payable; and (2) unpaid fees under the licenses and service agreement, which expires April 2013, become immediately due and payable. Furthermore, upon termination of the license agreement by the PAS Service Provider, the license and all rights in and to the license agreement shall automatically revert back to the PAS Service Provider. Future remaining aggregate payments due under the integrated policy administration system hosting, license and service agreements are approximately $0.3 million at December 31, 2010.
Miscellaneous Equipment and Service Agreements - upon the commencement of bankruptcy, liquidation or insolvency proceedings, these agreements may automatically terminate or be voluntarily terminated by the Company. Upon termination, any unpaid amounts on miscellaneous equipment and service agreements would become immediately due and payable. Aggregate amounts due on miscellaneous equipment and service agreements are not material to our consolidated financial statements at December 31, 2010.
At the effective time of the amalgamation, each outstanding common and Class B share of Majestic Capital, other than shares owned by the Company or any subsidiary of the Company, will be canceled and converted into the right to receive payment of cash in an amount equal to $4.50 per post reverse-split share (amalgamation consideration), and each then-outstanding restricted common share that was granted under the Company’s 2005 Long Term Incentive Plan will vest and be entitled to receive the amalgamation consideration, less any applicable withholding taxes.
The amalgamation agreement contains termination rights for both the Company and Bayside. If Majestic Capital or Bayside terminates the amalgamation agreement under certain circumstances specified in the amalgamation agreement, Majestic Capital will be required to reimburse Bayside for up to $350,000 of the expenses Bayside incurred in connection with the amalgamation agreement and the transactions contemplated thereby and, in some cases, pay to Bayside a termination fee of $500,000 (less any such expenses already paid).
The accompanying consolidated financial statements have been prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP). The accompanying consolidated financial statements include the accounts of Majestic Capital and its wholly-owned subsidiaries. All significant inter-company transactions and balances have been eliminated upon consolidation.
The cost of fixed-maturity securities is adjusted for impairments in value deemed to be other-than-temporary in the period in which the determination is made. These adjustments are recorded as realized losses. The Company does not change the revised cost basis for subsequent recoveries in value. The assessment of whether such impairment has occurred is based on management's case-by-case evaluation of the underlying reasons for the decline in fair value. The Company also considers the length and severity of the temporary impairment of an investment to determine whether the impairment is other than temporary. The Company recorded impairment charges of $2.2 million, $0.0 million and $0.9 million for the years ended December 31, 2010, 2009 and 2008, respectively as described under the heading Available-For-Sale Investments in Note 6.
Cash includes currency on hand and demand deposits with financial institutions. The Company considers all highly liquid debt instruments purchased with maturities of three months or less at the date of purchase to be cash equivalents. Cash equivalents are carried at cost. At times, management maintains cash balances in excess of insured limits and believes they do not represent a significant credit risk to the Company.
Restricted cash and cash equivalent balances have been pledged as security under certain credit facilities, as more fully described in Note 13.
Premiums receivable include premiums due from policyholders and insurance carriers which cede premiums to the Company. Premiums receivable are reported net of any allowance for estimated uncollectible premiums. The allowance for doubtful accounts represents the Company’s best estimate of uncollectible premiums included in premiums receivable and amounted to $1.2 million and $1.6 million at December 31, 2010 and 2009, respectively. Premiums receivable of $1.2 million, $1.6 million and $1.3 million were written off in 2010, 2009 and 2008, respectively.
Amounts recoverable from reinsurers are estimated on an individual contract basis, in a manner consistent with the associated reserve for losses and loss adjustment expenses. Included in reinsurance recoverables are paid and unpaid losses recoverable from reinsurers. Recoverables are reported net of any allowance for estimated uncollectible reinsurance recoverables. No allowance was deemed necessary as of December 31, 2010 and 2009. No reinsurance recoverable balances were written off during 2010, 2009 and 2008. The Company evaluates and monitors the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies.
For purposes of goodwill impairment testing, if the carrying value of a reporting unit’s goodwill exceeds its estimated fair value, there is an indication of impairment and the implied fair value of the goodwill is determined in the same manner as the amount of goodwill would be determined in a business acquisition. The excess of the carrying value of goodwill over the implied fair value of goodwill is recognized as impairment and recorded as a charge against net income.
The Company recorded goodwill impairment charges of $2.7 million and $0.1 million for the years ended December 31, 2009 and 2008, respectively, as described in Note 9.
The Company’s other intangible assets have definite lives and their value is amortized on a straight-line basis over their useful lives of five years. Other intangible assets are tested for potential impairment (1) whenever events or changes in circumstances suggest that an asset’s or asset group’s carrying value may not be fully recoverable; and (2) when there is a change in the estimated useful life of other intangible assets. Changes in the useful life of the Company’s intangible assets for the year ended December 31, 2010 are described in Note 9.
Fixed assets include furniture, fixtures and equipment, computer software, and leasehold improvements and are stated at cost, net of accumulated depreciation and amortization. Fixed assets are included in other assets in the consolidated balance sheets.
The Company capitalizes costs related to computer software developed for internal use during the application development stage of software development projects. These costs generally consist of direct costs of material and services used. The Company begins amortization of these costs once the project is completed and ready for its intended use.
Direct premiums written include all direct premiums billed during a specified policy period. Assumed premiums written are premiums assumed from third parties or authorized state mandated pools. In respect to most of the direct and assumed policies written, premiums are based on the estimated payroll and loss experience of an employer and applicable premium rates. Through excess of loss, quota share, and facultative reinsurance agreements, the Company cedes a portion of the risks it has underwritten to reinsurers. Net premiums written is the difference between direct and assumed premiums written and premiums ceded or paid to third party reinsurers.
Premiums ceded also include reinstatement premiums. Reinstatement premiums represent additional premiums payable to reinsurers to maintain coverage purchased under its excess of loss reinsurance contracts. These contracts generally contain provisions requiring the Company to pay additional premiums based on a percentage of ceded losses in the event that losses of a defined magnitude are ceded under such contracts. The Company establishes reserves for potential reinstatement premiums and records such amounts once estimated actuarial loss reserves exceed the defined limits. The Company recorded no reinstatement premiums payable for the year ended December 31, 2010. Of the $3.1 million of reinstatement premiums payable recorded for the year ended December 31, 2009, $0.2 million were paid during 2010.
Net premiums earned are the elapsed portion of our net premiums written. At the end of each accounting period, (1) the portion of direct and assumed premiums that are not yet earned is included in unearned premiums and is realized in subsequent periods over the remaining terms of the policies; and (2) the portion of ceded premiums that are not earned is included in prepaid reinsurance premiums and is realized in subsequent periods over the remaining terms of the policies.
The Company evaluated whether the Trust should be consolidated under the framework established in the consolidation guidance. Since the Company does not have the power to direct the activities of the Trust and absorb any losses or receive benefit of any gains from the Trust, the Company is not the primary beneficiary of the Trust and as a result does not consolidate the Trust. Majestic Capital and Majestic USA have guaranteed the repayment of the capital securities of the Trust. This guarantee will remain in place until the full redemption of the capital securities and does not represent a variable interest as the Company is guaranteeing its own performance.
The Company is involved in the normal course of business with variable interest entities (VIEs) primarily as a passive investor in government sponsored entity mortgage-backed securities. The Company is not the primary beneficiary of these VIEs. The Company’s maximum exposure to losses with respect to these investments is limited to the investment carrying values included in the Company’s consolidated balance sheets.
Majestic USA and its subsidiaries file a consolidated U.S. federal income tax return in accordance with a tax sharing agreement, under which the income tax (benefit) provision is allocated in accordance with each entity’s proportionate share of the consolidated (benefit) provision for income taxes.
Majestic Capital and Twin Bridges are Bermuda companies, and have received undertakings from the Bermuda Minister of Finance assuring it that if any legislation is enacted in Bermuda that would impose income or capital taxes, then the imposition of any such tax will not be applicable to Majestic Capital or Twin Bridges or any of its operations, shares, debentures or other obligations until March 28, 2035. The Company believes that Majestic Capital and Twin Bridges are not involved in the active conduct of a trade or business in the U.S. for U.S. tax purposes and as such has not provided for any federal or state and local income taxes for these entities.
In June 2009, the Financial Accounting Standards Board (FASB) issued new guidance on accounting for the transfers of financial assets. The new guidance, which is now part of ASC 860, Transfers and Servicing, eliminates the concept of a qualifying special-purpose entity (QSPE), clarifies and amends the derecognition criteria for a transfer to be accounted for as a sale, amends and clarifies the unit of account eligible for sale accounting and requires that a transferor initially measure at fair value and recognize all assets obtained and liabilities incurred as a result of a transfer of an entire financial asset or group of financial assets accounted for as a sale. Additionally, on and after the effective date, existing QSPEs must be evaluated for consolidation by reporting entities in accordance with the applicable consolidation guidance. The new guidance requires enhanced disclosures about, among other things, a transferor’s continuing involvement with transfers of financial assets accounted for as sales, the risks inherent in the transferred financial assets that have been retained, and the nature and financial effect of restrictions on the transferor’s assets that continue to be reported in the statement of financial position. The Company adopted the new guidance effective January 1, 2010 and the adoption had no effect on the Company’s financial condition and results of operations.
CRM CA will have ongoing cash outflows related to the June 2008 settlement agreement for litigation commenced by Cornerstone Program Management & Insurance Services (“Cornerstone”), the former general agent for CAP, a self-insured group administered by CRM CA. Under the settlement agreement, CRM CA agreed to contribute towards CAP’s September 2006 settlement with Cornerstone, five annual payments of $0.4 million, the first of which was paid on July 1, 2009. The Company recorded the present value of the Cornerstone settlement using an interest rate of 8.65%, which approximated the fair value of the liability on the settlement date. At December 31, 2010 and 2009, $1.1 million and $1.4 million, respectively, related to the Cornerstone settlement are included in other liabilities in the consolidated balance sheets.
On September 8, 2008, the Company ceased operations of CRM and Eimar. Accordingly, the results of operations of CRM and Eimar are reported as discontinued operations in the consolidated statements of operations.
In 2008, the Company entered into an agreement to license an integrated policy administration software system (PAS) that would provide processing for workers’ compensation insurance, including billing, underwriting and policy administration functionality. Amounts capitalized under the license agreement are financed through a secured operating lease agreement whereby the Company reimburses the lessor for payments made in connection with the development of the Company’s PAS. The PAS lease agreement is secured by letter of credit facility described in Note 13 and the agreement contains various administrative, reporting, legal and financial covenants.
On April 5, 2011, the Company received notification that its PAS was terminated as described under the heading Termination of Policy Administration Operating Lease and Call on Letter of Credit in Note 24.
Included in the Company’s facilities lease amendment charges for the year ended December 31, 2010 are (1) the write-off of the $0.7 million tax credit receivable; (2) $0.6 million of the termination fee; and (3) $0.1 million of amortization of the assumed leasehold improvements. The remainder of the termination fee of $0.8 million is included in the Company’s prepaid expenses at December 31, 2010 and will be expensed ratably over the remaining term of the license agreement. The assumed leasehold improvements are included in the Company’s fixed assets and are also being amortized over the term of the license agreement.
In addition, the Company determined there is no future value to the security deposit on its Poughkeepsie, New York office space that was included in other assets in the consolidated balance sheet. Accordingly, the Company has written off the $0.1 million security deposit in the year ended December 31, 2010.
In connection with the private placement of its Junior Debt described in Note 14, the Company incurred approximately $1.2 million of issuance costs were capitalized and included in other assets in the consolidated balance sheet. These costs were being amortized using the straight-line method over the respective term of the related Junior Debt. Due to the uncertainty surrounding the Company’s ability to continue as a going concern and possible default on the Junior debt due to future bankruptcy proceedings described under the heading Going Concern in Note 1; the Company has determined there is no future value to the Company’s prepaid expense and has written off $1.1 million of unamortized debt issuance costs at December 31, 2010.
In connection with the November 4, 2010 reverse share split, the number of outstanding common shares was reduced from 16,655,928 shares to 1,666,019 shares on a fully-diluted basis and the number of outstanding Class B shares from 395,000 shares to 39,500 shares. No fractional shares were issued in connection with the reverse stock split. Instead, fractional shares were rounded up to the nearest whole share. The number of common shares granted under the Company’s outstanding restricted share grants were proportionately adjusted to reflect the reverse share split.
The following table shows the computation of the Company’s earnings per share:
Diluted earnings per share is calculated assuming conversion of dilutive convertible securities and the exercise of all dilutive stock options and warrants using the treasury stock method. For the years ended December 31, 2010, 2009 and 2008, 23 thousand, 33 thousand and 35 thousand restricted shares, respectively, were excluded from the computation of diluted earnings per share because their effects were anti-dilutive.
The amortized cost, gross unrealized gains, gross unrealized losses and fair value of the Company’s available-for-sale investments are shown in the tables below:
The Company’s investment portfolio is managed following prudent standards of diversification. Specific provisions limit the allowable holdings of a single issue and issuers. Consequently, the Company believes there are no significant concentrations of credit risk associated with its investments.
The following table sets forth the gross unrealized losses included in accumulated other comprehensive income in the consolidated balance sheets related to available-for-sale fixed-maturity securities. The table segregates investments that have been in a continuous unrealized loss position for less than 12 months from those that have been in a continuous unrealized loss position for 12 months or longer. The Company had no fixed-maturity securities that were in an unrealized loss position at December 31, 2010.
the current fair value as compared to the cost of the security;
As a result of (1) the uncertainty surrounding the Company’s ability to continue as a going concern described under the heading Going Concern in Note 1; and (2) the conservation and rehabilitation of Majestic Insurance and rehabilitation plan contemplated by the CA DOI and early termination of our policy administration lease, both of which are described under the headings Conservation of Majestic Insurance Company and Termination of Policy Administration Operating Lease and Call on Letter of Credit in Note 24, the Company may be required to either sell or transfer many of its available-for-sale fixed-maturity securities. Therefore, the Company determined that it no longer assert that it does not intend to sell its securities in a gross unrealized loss position. Accordingly, the Company recorded an impairment charge of $2.2 million for the year ended December 31, 2010.
Impairment charges for the year ended December 31, 2009 were not material to the consolidated financial statements. For the year ended December 31, 2008, the Company recorded an impairment charge of $0.9 million related to one fixed-maturity security (Lehman Brothers Holdings Inc. filed for bankruptcy in 2008) that was determined to be other-than-temporarily impaired.
In connection with the variable interest entity described under the heading Variable Interest Entity in Note 2, the Company holds 100% of the common securities and none of the capital securities of the Trust. The common securities are reflected as investment in unconsolidated subsidiary in the Company’s balance sheet, represent a 3% ownership in the Trust, and rank below the capital securities of the Trust in terms of priority of payment. Due to the uncertainty surrounding the Company’s ability to continue as a going concern and possible default on the related Junior debt due to future bankruptcy proceedings as described under the heading Going Concern in Note 1 - which would result in non-payment of principal and interest of the common securities to the Company, the Company has determined that its investment in unconsolidated subsidiary is fully impaired and has written off the related accrued interest receivable at December 31, 2010. Accordingly, aggregate charges of $1.2 million are included in investment income for the year ended December 31, 2010. There were no impairment charges on our investment in unconsolidated subsidiary for the years ended December 31, 2009 and 2008.
Majestic Insurance had available-for-sale and short-term investments with a fair value of $234.5 million and $182.5 million, at December 31, 2010 and 2009, respectively, on deposit with various regulatory agencies as required by law and assumed reinsurance partners as more fully described in Note 12. While Twin Bridges had no pledged investments at December 31, 2010, it had $0.8 million of combined available-for-sale investments and cash that were pledged as security under letter of credit facilities to secure reserves assumed under third party ceded quota share agreements at December 31, 2009.
The following table presents the level within the fair value hierarchy at which the Company’s financial assets are measured on a recurring basis at December 31, 2010:
Fair Value Information about Financial Instruments Not Measured at Fair Value
Short-term investments and cash and cash equivalents - The carrying values reported in the accompanying consolidated balance sheets for these financial instruments approximate their fair value.
Long-term debt - The carrying value of the Company’s long-term debt at December 31, 2010 was $44.1 million. Due to the substantial doubt concerning the Company’s ability to continue as a going concern and a possible bankruptcy filing discussed under the heading Going Concern in Note 1, the Company is unable to determine the fair value of its long-term debt at December 31, 2010.
As a result of the impairment of goodwill discussed below, the Company’s goodwill balance is zero at December 31, 2010 and 2009.
The following table shows the information technology other intangible asset that continues to be subject to amortization:
As a result of changes in estimates of insured events of prior years, the Company experienced unfavorable development of $5.8 million for the year ended December 31, 2009 where $7.9 million of unfavorable development it its primary insurance business was offset by $2.1 million of favorable development in its excess insurance business.
The Company’s primary insurance business experienced unfavorable development as a result of loss cost trends in California and New Jersey, predominantly in accident year 2008. The Company’s excess insurance business had favorable development where accident years 2008 and 2006 continue to develop better than industry excess of loss factors initially projected.
As a result of changes in estimates of insured events of prior years, the Company experienced favorable development of $5.6 million for the year ended December 31, 2008 of which $3.6 million was attributable to primary insurance business and $2.0 million was attributable to excess insurance business.
Both the Company’s primary insurance and excess insurance businesses experienced favorable development as a result of favorable loss cost trends in California, predominantly in accident years 2006 and 2007.
In addition, the Company performs a ground-up analysis of the excess insurance policy losses of (a) the self-insured groups that were formerly managed by CRM CA and CRM; and (b) other self-insured entities, all of which are insured by the Company in excess of their self-insured retention, most commonly $500,000 per occurrence. The expected ultimate impact of these per-occurrence excess of loss contracts is based upon actual experience of the underlying self-insured groups and industry excess of loss factors which vary by state and hazard group. In each case, gross losses were developed to ultimate and the portion of the losses expected to exceed each group’s self-insured retention was calculated.
The Company’s financial statements reflect the effects of direct insurance and assumed and ceded reinsurance activity as follows:
The Company’s assumed premiums are primarily attributable to an assumed quota share agreement that was effective April 1, 2010. The Company entered into an assumed quota share agreement with AmTrust Financial Services Inc. (AmTrust) covering underwriting, claims management and administration of workers’ compensation insurance in the western states of California, Arizona and Oregon (covered business). Under the assumed quota share agreement, the Company assumes 90% of the applicable premiums and the first $500 thousand of losses and loss adjustment expenses from any single occurrence under the covered business. The assumed quota share agreement limits the amount of covered business to $40 million in any calendar year. The assumed quota share agreement has an initial term from April 1, 2010 to December 31, 2011, with successive calendar year renewals thereafter. The Company provides security for its obligations in the form of a trust account, which may be funded with cash advances, funds withheld, letters of credit or a combination thereof. At December 31, 2010, the Company had approximately $7.8 million of pledged investments in a trust account under the assumed quota share agreement.
As of December 31, 2010 and 2009, the third party reinsurers representing the largest balances of the Company’s reinsurance recoverable were as follows:
At December 31, 2010 and 2009, the Majestic Insurance held collateral under related reinsurance agreements in the form of letters of credit totaling $21.0 million that may be drawn against amounts remaining unpaid for more than 120 days. At December 31, 2010 and 2009, no amounts were drawn under the letters of credit.
Twin Bridges is required to provide security for its third party reinsurance agreements either through funds withheld or letter of credit agreements. At December 31, 2010, a third party reinsurer held $0.8 million of cash as collateral under quota share reinsurance agreements. At December 31, 2009, a $0.8 million letter of credit was outstanding to secure reserves assumed under quota share reinsurance agreements. The letter of credit was (1) secured by cash and investments pursuant to a secured letter of credit facility; (2) terminated during 2010; and (3) subsequently replaced by the funds withheld arrangement described above.
$21.0 million to the CA DOI with respect to its unauthorized reinsurers
$15.0 million to the CA DOI with respect to unpaid losses and loss adjustment expenses;
On March 31, 2011, $8.0 million was drawn down against the letter of credit for the benefit of the integrated policy administration system as described under the headings Termination of Policy Administration Operating Lease and Call on Letter of Credit in Note 24.
Under Twin Bridges reinsurance agreements, Twin Bridges is required to provide security for any unpaid liabilities under those agreements. Twin Bridges had an informal secured letter of credit arrangement with Smith Barney Citigroup to obtain collateralized letters of credit. The secured letter of credit terminated in 2010.
Embarcadero holds an $8.0 million floating rate Senior Debt. The Senior Debt matures May 23, 2033 at which time the entire principal is due and bears interest at a floating rate of 4.2% over 3-month LIBOR per annum. The interest rate may not exceed 12.5% commencing on May 22, 2008 through the maturity of the Senior Debt. Interest is payable on a quarterly basis and the Senior Debt may be called solely at Embarcadero’s option.
The Company believes it was in compliance with its debt covenants at December 31, 2010, however, there is uncertainty surrounding the Company’s ability to continue as a going concern and possible default on its Senior and Junior debt in the future due to possible bankruptcy proceedings as described under the heading Going Concern in Note 1.
Majestic Insurance purchased annuities from life insurers under which certain claimants under Majestic Insurance insurance policies are payees. Majestic Insurance has incurred cumulative annuity premiums of $10.2 million representing the present value of future payments over the term of the various claims. The expected cost to settle these claims is $29.5 million as of December 31, 2010. Majestic Insurance has a contingent liability of $29.5 million should the issuers of these annuities fail to perform under the terms of the annuities.
The Company’s subsidiaries sponsor defined contribution plans for substantially all U.S. employees under which a portion of employee contributions are matched. The Company’s subsidiaries contributed $0.3 million, $0.8 million and $0.7 million for the years ended December 31, 2010, 2009 and 2008, respectively.
The Company has adopted the 2005 Long-Term Incentive Plan that provides for grants of incentive stock options, non-qualified stock options, restricted shares, stock appreciation rights, performance awards, restricted share units, phantom shares and other share based awards to the Company’s executives, directors and key employees. Under the Plan, 150 thousand common shares are authorized for issuance. To date, the Company has only granted restricted shares under the plan. At December 31, 2010, 59 thousand shares are available for future awards or grants. Restricted stock issued under the plan has terms set by the compensation committee, and is subject to certain restrictions relating to, among other things, vesting and forfeiture in the event of termination of employment. The restricted shares generally vest in three equal installments over a three year period from when they are granted. The fair value of the shares awarded is calculated using the market price one day prior to the date of grant.
At December 31, 2010, there was $0.2 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements, which is expected to be recognized over a weighted average period of 0.5 years. The Company recorded share-based compensation expense from continuing operations under the 2005 Long-Term Incentive Plan of $0.3 million (net of $0.1 million of income tax benefits), $0.9 million (net of $0.4 million of income tax benefits) and $1.1 million (net of $0.5 million of income tax benefits) during the years ended December 31, 2010, 2009 and 2008, respectively. Awards of restricted stock had no effect on cash flows for the years ended December 31, 2010, 2009 and 2008.
Shareholders approved the Company’s 2007 Employee Stock Purchase Plan (the “Plan”) at the Company’s Annual General Meeting of Shareholders held on May 2, 2007. Under the Plan, 20 thousand shares were authorized for issuance. The Plan is a qualified employee stock purchase plan under Section 423 of the Internal Revenue Code and provides the Company’s employees with an opportunity to purchase the Company’s common shares through accumulated payroll deductions at a discounted purchase price. The Plan provides for three month offering and purchase periods, and participants are able to purchase shares at 85% of the lower of the closing price of the Company’s common shares on the first or last day of the three month purchase period. Compensation cost is recognized for each three month period and is based on the fair value of shares at the purchase date, less the price the participant pays for the shares.
On July 1, 2009, the Company suspended the Plan. Employees of the Company purchased substantially all of the remaining shares authorized for issuance under the Plan during the quarterly offering period ended June 30, 2009. Accordingly, there were no shares purchased during the year ended December 31, 2010 and 11 thousand shares were purchased under the plan during the year ended December 31, 2009.
Proposed Settlement of Litigation Involving New York Self-Insured Groups. On September 30, 2010, the Company and the New York State Office of Attorney General and the New York State Workers’ Compensation Board (collectively referred to as the “State of New York”) entered into a memorandum of understanding outlining a proposed settlement with the State of New York described below on the following terms and conditions:
the Company will pay $4.6 million in cash to the State of New York;
the Company’s errors and omissions insurance carrier will pay $2.5 million to the State of New York;
certain of the Company’s current directors and current and formers officers will assign to the State of New York the proceeds received on the sale of an aggregate of 1.2 million common pre-reverse split shares of the Company owned by such persons;
The completion of the settlement is subject to the following conditions:
releases granted in favor of the Company and its subsidiaries and affiliates by the State of New York, the self-insured groups previously managed by CRM, all members of the self-insured groups previously managed by CRM and any party related to any of foregoing; and
The Company recorded a reserve of $4.6 million during the quarter ended September 30, 2010 for the amount to be paid by the Company to the State of New York, and except for legal fees to complete the settlement, the Company does not expect to incur further charges as a result of the proposed settlement.
There can be no assurance that the Company will ultimately enter into any definitive settlement agreement with the State of New York, or that the other conditions described above will be satisfied. In such event, the proposed settlement as contemplated by the memorandum of understanding may be terminated. The Company denies all liability with respect to the facts and claims alleged in the investigation and lawsuits. However, because it will eliminate the uncertainty and expense of further litigation, the Company has agreed to the terms of the proposed settlement described above.
If the proposed settlement is not completed, the Company intends to defend the investigation and lawsuits vigorously. If this were to occur, these matters, or other claims or lawsuits that may arise later, if decided adversely to or settled by the Company, individually or in the aggregate, could require the Company to pay significant damage amounts and could result in a material adverse effect on its business, results of operations, financial condition and cash flows. Defending such actions would divert financial and management resources and result in a general business disruption, and the Company could continue to suffer from adverse publicity and harm to its reputation, regardless of whether the allegations are valid or whether the Company is ultimately successful in its defense of the action. The Company cannot estimate what impact, if any, the litigation may have on its business reputation, results of operations, financial condition or cash flows.
New York State Workers Compensation Board v. Compensation Risk Managers, LLC et al. In December 2009, the New York State Workers’ Compensation Board (NY Workers’ Compensation Board) commenced a lawsuit on its own behalf and in its capacity as successor in interest to seven of the eight workers’ compensation self-insured groups in New York previously managed by CRM. The NY Workers’ Compensation Board’s lawsuit, brought in Supreme Court of the State of New York, Albany County, alleges that CRM, Majestic Capital, its subsidiaries and certain directors and officers breached fiduciary duties owed to the self-insured groups, breached contracts between CRM and the self-insured groups, breached duties of good faith and fair dealing owed to the self-insured groups, engaged in fraudulent activities in administering the self-insured groups, engaged in deceptive business practices and advertising, and were unjustly enriched. In March 2010, the NY Workers’ Compensation Board amended its complaint to include the Elite Contractors Trust of New York, the eighth workers’ compensation self-insured group previously administered by CRM, as a plaintiff. The amended complaint alleges that the NY Workers’ Compensation Board and the self-insured groups have suffered damages in an amount that is not currently ascertainable, but which the NY Workers’ Compensation Board believes exceeds $472 million. In April 2010, CRM submitted an application to the State of New York Litigation Coordination Panel (Panel) seeking to coordinate pretrial proceedings in the following lawsuits before a single justice of the New York State Supreme Court, Albany County: (1) FS Kids LLC, et al. v. Compensation Risk Managers, LLC; (2) Armstrong Brands, Inc., et al. v. Compensation Risk Managers, LLC; (3) Arlen Senior Contracting of Central Islip, LLC, et al. v. Compensation Risk Managers, LLC; (4) 70 Sheldon Inc., et al. v. Compensation Risk Managers, LLC; (5) Healthcare Industry Trust of New York, et al. v. Compensation Risk Managers, LLC, et al.; (6) New York State Workers Compensation Board v. Compensation Risk Managers, LLC et al.; and (7) any future lawsuits which relate to CRM’s administration of group self-insured trusts in the State of New York (Coordinated Lawsuits). In connection with CRM’s application, the Panel issued an order staying each of the Coordinated Lawsuits pending the Panel’s decision. On February 23, 2011, the Panel issued an order that any actions seeking damages alleged to have arisen from CRM’s administration of self-insured groups that provided workers’ compensation coverage to its members that were filed in the Supreme Court of the State of New York and which remain active and any such actions that are filed hereafter be coordinated unless the Panel rules otherwise. An initial conference was held on April 18, 2011. Pursuant to that conference, an order will be circulated whereby within thirty days of the order, HITNY plaintiffs will circulate its proposed third amended complaint and the parties will then either consent to the service of same or require motion practice which will be scheduled at a later date. In the interim, all discovery proceedings and pending motions are presently stayed. For information regarding the proposed settlement of this lawsuit, please see above under the heading “- Proposed Settlement of Litigation Involving New York Self-Insured Groups.”
Arlen Senior Contracting of Central Islip, LLC, et al. v. Compensation Risk Managers, LLC. On August 18, 2009, Arlen Senior Contracting of Central Islip LLC, Anchor Building Maintenance Corp., Conifer Realty, LLC, Constanza Enterprises, Inc., Court Plaza Senior Apartments, L.P., John Wesley Village II, Midland Management, LLC, Niagara River World, Inc., Plattsburgh Airbase Redevelopment Corp., and Wen Management Corp., all of which were former members of the Real Estate Management Trust of New York (the Real Estate Trust), on their own behalf and on behalf of all others similarly situated, sued CRM in New York State Supreme Court, Erie County. The lawsuit seeks class action certification and alleges that CRM: (1) breached its contract with the Real Estate Trust; (2) breached its duty of good faith and fair dealing owed to the Real Estate Trust; (3) breached its fiduciary duties owed to the Real Estate Trust; (4) was negligent in administering the Real Estate Trust; (5) engaged in deceptive business practices; (6) was unjustly enriched; and (7) should indemnify the plaintiffs for any assessments that they may incur. The plaintiffs are seeking damages (a) arising from the plaintiffs’ joint and several liability for the deficit of the Real Estate Trust, (b) from any unpaid claims of the plaintiffs’ injured employees, (c) from potentially being liable for the costs of liquidation charged or to be charged by the WCB, and (d) from fees paid by the plaintiffs and the Real Estate Trust to CRM pursuant the service agreement between CRM and the Real Estate Trust. On October 20, 2009, CRM filed a motion to dismiss the plaintiffs’ complaint. In April 2010, CRM submitted an application to the Panel seeking to coordinate pretrial proceedings and on February 23, 2011, the Panel issued an order that this action would be one of the Coordinated Lawsuits. An initial conference was held on April 18, 2011. Pursuant to that conference, an order will be circulated whereby within thirty days of the order, HITNY plaintiff will circulate its proposed third amended complaint and the parties will then either consent to the service of same or require motion practice which will be scheduled at a later date. In the interim, all discovery proceedings and pending motions are presently stayed. For information regarding the proposed settlement of this lawsuit, please see above under the heading “- Proposed Settlement of Litigation Involving New York Self-Insured Groups.”
The complaint seeks class action certification and alleges that CRM: (1) breached its contract with the Elite Contractors Trust; (2) breached its duty of good faith and fair dealing owed to the Elite Contractors Trust; (3) breached its fiduciary duties owed to Elite Contractors Trust; (4) was negligent in administering the Elite Contractors Trust; (5) engaged in deceptive business practices; (6) was unjustly enriched; and (7) should indemnify the plaintiffs for any assessments that they may incur. The plaintiffs are seeking damages (a) arising from the plaintiffs' joint and several liability for the deficit of the Elite Contractors Trust which, as of December 15, 2010, was estimated by the New York State Workers' Compensation Board to be in excess of $82 million, (b) from any unpaid claims of the plaintiffs' injured employees in an amount presently undetermined, (c) from potentially being liable for the costs of liquidation charged or to be charged by the WCB, and (d) from fees paid by the plaintiffs and the Elite Contractors Trust to CRM pursuant to the service agreement between CRM and the Elite Contractors Trust.
CRM was served on or about February 23, 2007 and an answer was interposed along with discovery demands. CRM received Binghamton Giant’s initial responses to its discovery demands on or about October 17, 2007. On or about March 17, 2008, the Binghamton Giant Defendants served a motion to amend its answer and asserted a counterclaim requesting judgment in the amount of $336,892.00, together with interest. The counterclaim is based upon Binghamton-Giant’s breach of the Joinder and Trust Agreements in that it failed to pay assessments totaling said amount. The court granted Wholesale-Retail's motion and the Binghamton Giant Defendants thereafter amended its answer to include the counterclaim. On or about March 19, 2008, Binghamton Giant served a Reply to Defendants’ Amended Complaint as well as a Demand for a Verified Bill of Particulars and Demand for Discovery and Inspection. On or about March 26, 2008, the Binghamton Giant Defendants served Binghamton Giant with their Second Set of Interrogatories seeking particulars of the affirmative defenses to the counterclaims. Plaintiff has served a reply to the counterclaims. Discovery regarding the counterclaims is still pending. The Company intends to vigorously defend this litigation, which is in a preliminary stage, and it cannot estimate what impact, if any, the litigation may have on our business reputation, results of operations, financial condition or cash flows. If, however, this matter is decided adversely to the Company, it may result in a material adverse effect on its business, results of operations, financial conditions and cash flows.
H.C.F.A. Associates Corp. v. Compensation Risk Managers, LLC. On April 9, 2007, H.C.F.A. Associates Corp. and 17 related companies, all of which were members or former members of HITNY, sued HITNY and CRM in New York State Supreme Court, Ulster County, alleging, among other things, that HITNY and CRM failed to fulfill their obligations in connection with providing workers’ compensation claims services. CRM answered the complaint, denying the plaintiffs’ material allegations. On or about December 12, 2008, HCFA served burdensome and over broad discovery demands which CRM objected to. As a result, CRM has requested a conference with the court to discuss the discovery demands. A status conference was held on October 5, 2009 and a discovery schedule for the completion of discovery was set down as follows: all paper discovery was to be completed on or before December 31, 2009, depositions of the parties were to be completed on or before March 31, 2010, and a compliance conference was to be held on May 10, 2010. The dates on the proposed discovery schedule have been adjourned and discovery remains on-going. The Company intends to vigorously defend this litigation, which is in a preliminary stage, and we cannot estimate what impact, if any, the litigation may have on our business reputation, results of operations, financial condition or cash flows. If, however, this matter is decided adversely to us, it may result in a material adverse effect on its business, results of operations, financial conditions and cash flows.
The complaint alleges that throughout the class period the defendants knew or recklessly disregarded that their public statements concerning CRM Holdings’ financial performance and prospects were materially false and misleading. Specifically, the defendants are alleged to have made false and/or misleading statements and/or failed to disclose: (1) that the defendants and their affiliates engaged in a fraudulent scheme and course of business to grow membership in eight group self-insured trusts previously administered by CRM, by charging premiums below commercial rates; (2) that the membership growth inflated gross trust revenues while reducing net paid premium income to the level that the assets of the group self-insured trusts would become insufficient to cover liabilities; (3) that, accordingly, the group self-insured trusts would fall below “fully funded” status; (4) that, as part of their fraudulent scheme and course of business to cover up the difference between assets and liabilities, the defendants and their affiliates disguised the true financial conditions of the group self-insured trusts by engaging in certain improprieties designed to result in minimal projected claims liability, including under-reserving individual claims and utilizing improper actuarial/accounting methods; (5) that the defendants and their affiliates provided the New York State Workers’ Compensation Board with materially false and/or misleading financial and actuarial reports for the group self-insured trusts which reflected artificially reduced liabilities; (6) that, as a result of the above, the Company was exposed to hundreds of millions of dollars in liabilities relating to the under-funding of the group self-insured trusts; (7) that the Company lacked adequate internal and financial controls; and (8) that, as a result of the above, the Company’s financial statements were materially false and misleading. The plaintiff seeks to recover damages on behalf of class members.
On September 10, 2010, the plaintiffs’ filed and served an amended complaint. The amended complaint’s allegations and claims are substantially the same as those in the original complaint, except that the plaintiffs have added claims against certain of the Company’s current and former executive officers and directors for insider trading violations under Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder. Those directors named in the suit have entered into a Stipulation and Tolling Agreement, dated September 10, 2010, which provides that the applicable statute of limitations will be tolled for a period of two years and that such directors shall participate in discovery as if they were named defendants. On January 7, 2011, the Company filed a motion to dismiss which is currently pending before the court.
The Company intends to vigorously defend this litigation, which is in a preliminary stage, and the Company cannot estimate what impact, if any, the litigation may have on its business reputation, results of operations, financial condition or cash flows. If, however, this matter is decided adversely to the Company, it may result in a material adverse effect on its business, results of operations, financial conditions and cash flows.
On April 20, 2010, a third party action was brought against CRM by the Classic Insurance Agency and Lifetime Insurance Brokerage, the insurance brokers for The Kids Waterfront Corp., and Andrea Meister, the individual broker (collectively, the Brokers). The Third Party Action asserts two causes of action: (1) equitable subrogation (Classic stands in the shoes of Clarendon and the Transportation Trust) and seeks recovery from CRM for any amounts paid by the Brokers to Clarendon and/or the Transportation Trust due to CRM's negligent and/or failure to adequately investigate and/or underwrite The Kids Watefront Corp. application as well as a lack of a loss control inspection; and (2) contribution such that if the plaintiffs are able to prove any causes of action against the Brokers, then CRM will be liable for the proportionate share of any damages suffered by Clarendon and/or the Transportation Trust and/or proximately caused by the acts or omissions of CRM. The Complaint was served on CRM on April 30, 2010. On May 19, 2010, CRM filed a motion to dismiss and/or sever the third-party plaintiffs’ complaint on the grounds that the plaintiffs’ failed to properly commence the third-party action and the equitable subrogation and contribution claims fail as a matter of law. On June 11, 2010, third-party plaintiffs filed an Opposition to CRM's motion to dismiss and/or sever the third-party action. CRM filed a reply on June 22, 2010. On October 26, 2010, CRM appeared for a conference which was adjourned to January 25, 2011 as CRM's motion to dismiss and/or sever the third-party plaintiffs complaint was still pending. The Court gave the plaintiff a new Note of Issue date of January 31, 2011. The Court recently rendered a decision on the motion, granting it to the extent CRM sought to dismiss the claim for equitable subrogation. On or about March 30, 2011, CRM served its answer and served discovery demands on plaintiffs and third party plaintiffs. A status conference was held on April 12, 2011 wherein a discovery order was entered into. The order requires that plaintiffs and third-party defendants produce documents within thirty days of the date of the order, depositions are to commence on June 1, 2011 and the deadline for filing the Note of Issue is now August 30, 2011. The next status conference has been scheduled for July 26, 2011. The Company intends to vigorously defend this litigation, which is in a preliminary stage, and it cannot estimate what impact, if any, the litigation may have on our business reputation, results of operations, financial condition or cash flows. If, however, this matter is decided adversely to the Company, it may result in a material adverse effect on its business, results of operations, financial conditions and cash flows.
Mark Tanner Construction, Inc., et al. v. Majestic Capital, Ltd., et al. On January 27, 2011, Mark Tanner Construction, Inc., Doe Gelso Construction, Inc., Mt. Lincoln Construction, Inc., and Sierra Paint & Chemical, Inc., all of which were former members of the Contractors Access Program of California (CAP), sued CRM, CRM CA, Majestic USA, Majestic Capital, Ltd., Twin Bridges (Bermuda) Ltd., Embarcadero Insurance Holdings, Inc., Majestic Insurance Company, Louis J. Viglotti, Chester Walczyk, James J. Scardino, and Bayside Capital Partners, LLC (“Bayside”) in California Superior Court, County of San Francisco. The plaintiffs also named three former trustees of CAP. Plaintiffs are seeking damages from the defendants’ alleged mismanagement and wrongful conduct with respect to CAP. As against CRM CA and its affiliated entities, the lawsuit alleges that CRM CA and its affiliated entities: (1) engaged in common law fraud during the administration of CAP; (2) negligently misrepresented information relative to CAP; (3) violated the Uniform Fraudulent Transfer Act California Civil Code; (4) violated Title 18 U.S.C. Section 1961, et seq., Racketeer Influenced and Corrupt Organizations Act; and (5) breached reinsurance contracts. The plaintiffs are seeking special and general damages including but not limited to (a) return of premiums and other monies paid as part of the enrollment and participation in the program; (b) punitive damages, (c) rescission of contracts between plaintiffs and defendants; (d) an order stopping the transfer to Bayside until the obligation of the defendants to plaintiffs is determined and satisfied in full; (e) an attachment or other provisional remedy against the assets of defendant sought to be or actually transferred to Bayside; (f) an injunction stopping the merger and/or transfer to Bayside or any other entity; (g) appointment of a receiver to recapture the assets transferred in violation of the Uniform Fraudulent Transfer Act; (h) an order against defendants that they divest themselves of all interest in the enterprises of the defendants; (i) an order of dissolution of all of the enterprises of all the defendants; (j) a restraining order prohibiting any action of defendants pending the outcome of this litigation; and (k) costs and attorney fees with interest at the legal rate. The Company intends to vigorously defend this litigation, which is in a preliminary stage, and the Company cannot estimate what impact, if any, the litigation may have on its business reputation, results of operations, financial condition or cash flows. If, however, this matter is decided adversely to the Company, it may result in a material adverse effect on its business, results of operations, financial conditions and cash flows.
Doria Enterprises Inc., et al. v. RMI Consulting, Inc., et al. v. Compensation Risk Managers, LLC. In November 2010, RMI Consulting, Inc. and James W. Barber sued CRM as a third-party defendant in a lawsuit commenced by Doria Enterprises, Inc. and Grace’s Marketplace, Inc. against RMI Consulting, Inc. and Mr. Barber in New York State Supreme Court, New York County. RMI Consulting, Inc. and Mr. Barber allege that CRM should be held liable for common law indemnification and contribution in the event that RMI Consulting, Inc. and Mr. Barber are held liable to plaintiffs in the underlying action, in which the plaintiffs have alleged misrepresentations, omissions, and professional negligence against RMI Consulting, Inc. and Mr. Barber while acting as plaintiffs’ brokers and allegedly wrongfully inducing the plaintiffs to become members of the Wholesale-Retail Workers’ Compensation Trust. The Company filed a motion to dismiss which is currently pending before the Court. The Company intends to vigorously defend this litigation, which is in a preliminary stage, and the Company cannot estimate what impact, if any, the litigation may have on its business reputation, results of operations, financial condition or cash flows. If, however, this matter is decided adversely to the Company, it may result in a material adverse effect on its business, results of operations, financial conditions and cash flows.
On or about January 9, 2009, Majestic Insurance Company’s underwriting department received a subpoena from the New York State Workers Compensation Board Office of the Fraud Inspector General. The subpoena requested production of various documents related to the issuance of excess workers’ compensation and employers’ liability policies by Majestic Insurance Company to the Elite Contractors Trust of New York. On May 8, 2009, CRM Holdings and Twin Bridges received a subpoena from the New York State Workers’ Compensation Board Office of Fraud Inspector General. The subpoena requested documents related to quota share agreements and a novation agreement among Twin Bridges, NY Marine and General and Majestic Insurance Company. The subpoenas were captioned In the Matter of Compensation Risk Managers, LLC and were assigned Inspector General Case No. 38839. To the Company’s knowledge, the Inspector General has not commenced any action against CRM or any of its affiliates. The Company cannot currently predict when the New York State Workers’ Compensation Board Office of Fraud Inspector General will conclude its review, what, if any, action may be taken by the Office of Fraud Inspector General, or the effect any such action may have on the Company’s business reputation, results of operations, financial condition or cash flows.
Majestic Insurance is subject to guaranty fund and other assessments by the states in which it writes business. Accordingly, Majestic Insurance has accrued a receivable for guaranty fund and other assessments of $4.1 million at December 31, 2010 and an accrued liability for guaranty fund and other assessments of $12.8 million at December 31, 2009, and has recorded a related asset for policy surcharges of $1.7 and $1.9 million at December 31, 2010 and 2009, respectively. These amounts represent management’s best estimate, based on information received from the states in which it writes business, and may change due to many factors including Majestic’s share of the ultimate cost of current insolvencies. Most assessments are paid in the year following the year in which the premiums are written or the losses are paid. Policy surcharges are generally collected in the year following the assessment.
Under the California Insurance Code, Majestic Insurance may make dividend distributions in a given year without prior approval of the Insurance Commissioner up to a maximum amount equal to the greater of its statutory net income for the preceding year or 10% of insurer’s policyholders’ surplus at the end of the preceding year, less dividends made within the preceding twelve months. In 2010 and 2009, Majestic Insurance declared and paid dividends of $0.2 million and $3.0 million, respectively, to Embarcadero. Majestic Insurance did not declare or pay any dividends for the year ended December 31, 2008. As part of its ongoing examination by the CA DOI, Majestic Insurance has agreed not to pay any dividends without the prior approval of the CA DOI.
Under the Insurance Act 1978 of Bermuda and related regulations (the “Act”), Twin Bridges is required to prepare Statutory Financial Statements and to file a Statutory Financial Return. The Act also requires Twin Bridges to meet certain minimum capital and surplus requirements. Twin Bridges is required to maintain a minimum liquidity ratio, whereby the value of its relevant assets must be not less than 75% of its relevant liabilities. Twin Bridges exceeded its minimum capital and surplus requirements and minimum liquidity ratio at December 31, 2010 and 2009.
Under the Act, Twin Bridges is prohibited from reducing its total statutory capital or declaring or paying any dividends during the current or subsequent financial year if the declaration or payment of such dividends would cause it to fail to meet its solvency margin or minimum liquidity ratio. In addition, Twin Bridges is prohibited from declaring or paying any dividends of more than 25% of its total statutory capital and surplus as set out in its previous years financial statements unless at least seven days before payment of the dividends, it files with the BMA an affidavit that it will continue to meet its solvency margins. Finally, Twin Bridges is prohibited, without prior approval from the BMA, from reducing by 15% or more its total statutory capital as set out in its previous year’s financial statements, or from paying a dividend if there are reasonable grounds for believing that it is or would be unable to pay its liabilities as they become due, or if the realizable value of its assets would be less than its liabilities and shareholder’s equity. For the years ended December 31, 2010, 2009 and 2008, Twin Bridges paid dividends and distributed capital in an aggregate amount of $9.0 million, $6.0 million, and $40.7 million, respectively.
(1) Includes $2.7 million related to goodwill impairment in the quarter ended December 31, 2009.
The Company has informed the New York State Department of Insurance and the New Jersey Division of Banking and Insurance that it intends to withdraw from the workers’ compensation insurance market in those states through a program of policy non-renewals. Commencing April 1, 2011, the Company will non-renew policies written in New York that renew on or after April 1, 2011, and commencing on June 1, 2011, the Company will non-renew policies written in New Jersey that renew on or after June 1, 2011. In addition, the Company has ceased issuing any new policies in New York or New Jersey.
As a result of this program, the Company implemented a plan to reduce its existing workforce. This reduction affects 19% of the Company’s consolidated workforce, or a total of 27 positions, all of which are located in the Company’s Poughkeepsie, New York office. The Company notified its employees on January 26, 2011, and the reduction in workforce is scheduled to occur through June 1, 2011.
On March 3, 2011, the Company successfully completed its solicitation of consent to the amendments and execution of the Supplemental Indenture and Amendment related to the Company’s Trust Preferred Securities. The successful completion of the solicitation of consent satisfied one of the conditions of the previously announced amalgamation between the Company and Bayside described in under the heading Previously Announced Acquisition of Majestic Capital in Note 1.
The Supplemental Indenture and Amendment modifies certain events of default and other covenants contained in the governing documents of the Trust Preferred Securities as follows:
defines the term “Premium Volume” as used to determine if an event of default has occurred; and
eliminates the downgrade of an A.M. Best rating below B- or the withdrawal of an A.M. Best rating as an event of default.
The CA DOI has further informed management that in conjunction with the statutory conservation, it intends to structure a comprehensive plan for the rehabilitation of Majestic Insurance that will include the transactions described below in AmTrust Non-Binding Letter of Intent and Term Sheet. The comprehensive rehabilitation plan will be subject to approval by the Conservation Court.
On March 21, 2011, Majestic Insurance entered into a non-binding letter of intent with AmTrust by which:
AmTrust would assume 100% of Majestic Insurance’s in-force business through a 100% quota share agreement (100% Quota Share) as discussed below;
Certain of Majestic Insurance’s other insurance liabilities, operating assets and other contractual obligations would be transferred to AmTrust.
Provisions of the 100% Quota Share include AmTrust’s assumption from Majestic Insurance of: (1) all liabilities under the in-force workers’ compensation policies issued by Majestic Insurance. This assumption includes, but is not limited to Majestic Insurance’s unearned premiums which are carried at $9.6 million at December 31, 2010; (2) all quota share and excess of loss reinsurance agreements of Majestic Insurance, including prepaid reinsurance, which is carried at $2.2 million at December 31, 2010; and (3) all other liabilities arising under any other insurance policy issued by Majestic Insurance, including the run-off USL&H policies issued by Majestic Insurance. The assumption of the non-workers’ compensation insurance liabilities of Majestic by AmTrust is subject to certain limitations that will be agreed upon prior to closing of the transaction.
The transactions contemplated by the letter of intent and the term sheet are subject to negotiation and execution of definitive agreements and approval by the California Department of Insurance and Conservation Court as described above in Conservation of Majestic Insurance Company. The proposed transactions between Majestic Insurance and AmTrust are not expected to yield any monetary benefits to the shareholders of the Company. Accordingly, there is substantial doubt surrounding the Company’s ability to continue as a going concern as described under the heading Going Concern in Note 1.
Prior to the regulatory approval of the transactions, Majestic Insurance will continue to participate in the fronting arrangement with AmTrust described under the heading Assumed Reinsurance in Note 12 and will continue to arrange for workers’ compensation insurance policies to be underwritten by the AmTrust group companies and reinsured by Majestic Insurance.
On March 25, 2011, A.M. Best downgraded the financial strength rating of Majestic Insurance to B (Fair) from B++ (Good). In addition, A.M. Best downgraded the debt ratings of Majestic USA and Embarcadero to “ccc+” from “b+.” The status for all ratings was revised to under review with negative implications from under review with developing implications.
The Comerica Credit Facility described in Note 13 has various financial covenants, one of which requires Majestic Insurance to maintain an A.M. Best rating of at least B++. As described above in A.M. Best Downgrade, On March 28, 2011, the financial strength rating of Majestic Insurance was downgraded from B++ to B. Therefore, Majestic Insurance is in violation of certain of its debt covenants which could result in Comerica terminating the secured credit facility.
On April 4, 2011, the Company received notification from a lessor that an event of default under its operating lease had occurred and that the lessor had terminated the PAS lease. The lessor cited the A.M. Best downgrades of the Company’s financial strength and debt ratings described above in A.M. Best Downgrade as a material adverse change in the financial condition of the Company.
In conjunction with the termination of the lease, the lessor drew down $8.0 million against the Majestic Insurance Comerica Letter of Credit on March 31, 2011. This amount represents the approximation of the original encumbrance capital costs paid by the lessor, including penalties due as stipulated by the PAS lease agreement. Accordingly, the Company recorded an $8.0 million charge in severance and other charges in the fourth quarter of 2010 as described under the heading Policy Administration System Operating Lease and Acceleration of Related Expenses in Note 4.
On April 8, 2011, the Company received notification from the BMA that in light of the termination of the Bayside amalgamation, the conservation and rehabilitation of Majestic Insurance by the CA DOI and the possibility that Majestic Capital and its non-insurance subsidiaries could seek protection under applicable United States and Bermuda bankruptcy and other similar laws, it was placing the following restrictions on Twin Bridges effective immediately:
Twin Bridges may not, without obtaining prior written approval of the BMA effect any contracts of insurance or reinsurance, and
Twin Bridges may not, without obtaining prior written approval of the BMA, declare and/or pay any dividends and/or make any capital contributions to its parent or its affiliates.