The losses generated by the run-off specialty reinsurance operations and the Company’s investment portfolio offset profitable results in the Company’s core insurance operations. The workers’ compensation insurance segment and the group benefits insurance segment generated combined ratios of 80.2% and 97.4%, respectively, for the year ended December 31, 2008.
In addition to the unfavorable loss reserve development in the run-off specialty reinsurance segment, the Company has not recognized future tax benefits of $7.2 million, which represents the outside basis difference between financial statement and tax purposes of Eastern Re as of December 31, 2008. The outside basis difference primarily arises from losses at Eastern Re recognized for financial statement purposes, which are not recognized for tax purposes. Management presently believes that the Company will not be able to recognize these benefits in the foreseeable future and, therefore, has not recognized these tax benefits as of December 31, 2008.
Direct and net premiums written. Direct premiums written is the sum of both direct premiums and assumed premiums before the effect of ceded reinsurance. Direct premiums written include all premiums billed during a specified policy period. Net premiums written is the difference between direct premiums written and premiums ceded or paid to reinsurers (ceded premiums written). In the segregated portfolio cell reinsurance segment, assumed premiums are derived from insurance contracts written by the Company and ceded to the segregated portfolio cells. In the run-off specialty reinsurance operations, assumed premiums represent premiums that were received under the quota-share reinsurance treaties and were reported to the Company directly from the broker one quarter in arrears.
Net investment income and realized gains and losses on investments. The Company invests its surplus and the funds supporting its insurance liabilities (including unearned premiums and unpaid losses and LAE) in cash, cash equivalents, fixed income securities, convertible bonds and equity securities. Investment income includes interest earned on invested assets,
including the impacts of premium amortization and discount accretion. Realized gains and losses on invested assets are reported separately from net investment income. The Company recognizes realized gains when invested assets are sold for an amount greater than their cost or amortized cost (in the case of fixed income securities) and recognizes realized losses when investment securities are written down as a result of an other than temporary impairment or sold for an amount less than their cost or amortized cost. Realized gains and losses also include the change in fair value of convertible bonds.
Acquisition and other underwriting expenses. In the workers’ compensation and group benefits insurance segments, expenses incurred to underwrite risks are referred to as acquisition and other underwriting expenses, which consist primarily of commissions, premium taxes, assessments and fees and other underwriting expenses incurred in acquiring, writing and administering the Company’s business. In the segregated portfolio cell reinsurance and run-off specialty reinsurance segments, acquisition and other underwriting expenses consist of ceding commissions earned under the respective reinsurance agreements. Ceding commissions received are netted against acquisition and other underwriting expenses.
Loss ratio. The loss ratio is the ratio (expressed as a percentage) of losses and LAE incurred to net premiums earned and measures the underwriting profitability of a company’s insurance business. The Company measures the loss ratio on an accident year and calendar year loss basis to measure underwriting profitability. An accident year loss ratio measures losses and LAE for insured events occurring in a particular year, regardless of when they are reported, as a percentage of net
premiums earned during that year. A calendar year loss ratio measures losses and LAE for insured events occurring during a particular year and the change in loss reserves from prior accident years as a percentage of net premiums earned during that year.
The Company’s reserves for unpaid losses and LAE in its workers’ compensation insurance segment as of December 31, 2008 and 2007 are summarized below (in thousands):
Paid Loss Development Method. The paid loss development method is mechanically identical to the incurred loss development method described above. The paid method does not rely on case reserves or claim reporting patterns in making projections. The validity of the results from using a paid loss development approach can be affected by many conditions, such as internal claim department processing changes, legal changes or variations in a company’s mix of business from one year to the next. Also, since the percentage of losses paid for immature years is often low, development factors are more volatile. A small variation in the number of claims paid can have a leveraging effect that can lead to significant changes in estimated ultimate liability for losses and LAE. Therefore, ultimate values for immature accident years are often based on alternative estimation techniques.
Bornhuetter-Ferguson Methodology. The Bornhuetter-Ferguson expected loss projection method based on reported loss data relies on the assumption that remaining unreported losses are a function of the total expected ultimate losses rather than a function of the currently reported losses. The expected ultimate losses in this analysis are based on historical results, adjusted for known pricing changes and inflationary trends. The expected ultimate losses are multiplied by the unreported percentage to produce expected unreported losses. The unreported percentage is calculated as one minus the reciprocal of the selected cumulative incurred LDFs. Finally, the unreported losses are added to the current reported
As of December 31, 2008, the Company’s best estimate of its ultimate liability for losses and LAE, net of amounts recoverable from reinsurers and before purchase accounting adjustments, for its workers’ compensation insurance segment was $55.2 million.
Given the long reporting and paid development patterns, the tail factors used to project actual current losses to ultimate losses for claims covered by the Company’s workers’ compensation policies require considerable judgment. Management believes that its selected tail factors represent the most likely loss development based on historical loss payment patterns as well as the current legal and economic environment. The actual tail factor could vary from the tail factor selected. Following is a sensitivity analysis of the Company’s workers’ compensation reserves to reasonably likely changes in the tail factors used to project actual current losses to ultimate losses (dollars in thousands):
The reporting and paid loss development patterns in the segregated portfolio cell reinsurance segment are also consistent with that of the workers’ compensation insurance segment. Accordingly, the tail factors used to project actual current losses to ultimate losses for claims covered in the Company’s segregated portfolio cell reinsurance segment require considerable judgment. The difference between total revenue for the segregated portfolio cell reinsurance segment for each period and the sum of losses and LAE, acquisition and other underwriting expenses, policyholder dividend expense and other expenses is accrued as a segregated portfolio dividend expense. Accordingly, any change in the reserve for unpaid losses and LAE is recorded to the segregated portfolio dividend payable/receivable account and would only impact the Company’s net income or shareholders’ equity if it were a segregated portfolio cell dividend participant.
The reserves for unpaid losses and LAE in the group benefits insurance segment include an estimate of future amounts for reported but unpaid and IBNR claims related to the Company’s dental, long-term disability, short-term disability and term life products, as well as an estimate of the costs associated with investigating, processing and paying the related claims.
The Company’s reserves for unpaid losses and LAE in its group benefits insurance segment, by line business, as of December 31, 2008 and 2007, were as follows (in thousands):
With respect to the run-off specialty reinsurance segment, numerous internal and external factors will affect the ultimate settlements of future claims including, but not necessarily limited to, changes in the cost of environmental remediation, impacts of relevant federal or state legislation, changes in technology and the resulting impact on costs, and reliance on ceding companies to handle claims and remit proper loss information in a timely manner. Reserving for assumed reinsurance requires evaluating loss information received from the ceding company. On a quarterly basis, the Company receives a
The reported claims information could be inaccurate, and/or could be subject to significant reporting lags. Such potential inaccuracies or reporting lags would increase the risk of reserve estimation error.
The evaluation of the reserves for unpaid losses and LAE in the run-off specialty reinsurance segment requires that loss development be estimated over an extended period of time using historical loss development data with limited relevance. As the historical loss development data has limited relevance, reliance has been placed on loss development patterns based on a blend of historical loss development data and industry loss development patterns, judgmentally adjusted to reflect considerations particular to the exposure. The reliance on external benchmarks, while necessary, creates an additional element of uncertainty. Following is a sensitivity analysis of the reserves for unpaid losses and LAE to reasonably likely changes in the blend of historical loss development data and industry loss development factors used to project current losses to ultimate losses (dollars in thousands):
For the year ended December 31, 2008, the Company recorded other-than-temporary impairments of $4.5 million related to its fixed income portfolio. The securities impaired included $1.2 million related to Lehman Brothers securities and certain other mortgage-backed securities for which management determined an impairment existed as a result of a significant and prolonged decline in value due to illiquidity in the credit markets. The mortgage-backed securities continue to remain current on principal and interest payments; however, due to the significant and prolonged decline in value and the continued uncertainty surrounding the credit markets, management determined that an impairment write-down was appropriate.
Limited partnerships. A limited partnership investment is generally written down if the Company is unable to hold or otherwise intends to sell its interest in the limited partnership at a loss, or it management has received information that suggests the Company will be unable to recover its original investment in the limited partnership. The amount written down is recorded in the change in equity interest in other long-term investments in the consolidated statement of operations.
In accordance with the requirements of SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”), goodwill is not amortized but is tested for impairment at the reporting unit level, which is at the operating segment level or one level below an operating segment. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. Goodwill is required to be tested for impairment annually and between annual tests if events or circumstances change, such as adverse changes in the business climate, that would more likely than not reduce the fair value of the reporting unit below its carrying value.
Based on the comparison of fair value to carrying amount, as calculated using the methodologies summarized above, fair value exceeded carrying amount as of December 31, 2008; therefore, goodwill was considered not impaired, and the second step of impairment testing was unnecessary.
Certain direct policy acquisition costs consisting of commissions, premium taxes, fronting fees and certain other direct underwriting costs are deferred and amortized as the underlying policy premiums are earned. As of December 31, 2008 and 2007, deferred policy acquisition costs and the related unearned premium reserves in the Company’s workers’ compensation insurance, segregated portfolio cell reinsurance, group benefits insurance, and run-off specialty reinsurance segment were as follows (in thousands):
As of December 31, 2008, the Company has not recognized a deferred tax asset related to its run-off specialty reinsurance segment of $7.2 million, which represents the excess of the tax basis over the amount for financial reporting (i.e., outside basis difference) of Eastern Re as of December 31, 2008. The outside basis difference primarily arises from losses at Eastern Re recognized for financial statement purposes, which have not yet been recognized for tax purposes. Management presently believes that the Company will not be able to recognize these tax benefits in the foreseeable future and, therefore has not recognized these tax benefits as of December 31, 2008. Under United States federal income tax rules and regulations, tax losses generated by operations outside the United States are generally unable to be utilized to offset taxable income generated by operations within the United States. Therefore, the Company’s ability to utilize these future tax benefits is contingent upon the generation of future taxable income in its operations outside the United States.
In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 159 (“SFAS 159”), “The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of FASB Statement No. 115.” SFAS 159 permits entities to elect to measure certain financial instruments at fair value with changes in fair value being reported in earnings. SFAS 159 can be applied on an instrument-by-instrument basis and is effective for all eligible financial instruments as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Retrospective application to prior years’ financial statements is not permitted. For eligible financial instruments existing at the effective date, and for which an entity elects the fair value option, the first remeasurement to fair value must be recorded as a cumulative effect adjustment to beginning retained earnings. The Company adopted SFAS 159 effective January 1, 2008; however, no election was made to measure the Company’s financial instruments at fair value. The adoption of SFAS 159 had no effect on the Company’s consolidated financial condition and results of operations.
In December 2007, the FASB issued Statement No. 160, “Noncontrolling Interests in Consolidated Financial Statements - an amendment of ARB No. 51” (“SFAS 160”), which establishes accounting and reporting standards for the non-controlling interests in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 requires that the ownership interests and the net income of the non-controlling interest be equally identified from that of the parent on the face of the financial statements. SFAS 160 also provides consistent accounting principles for changes in a parent controlling ownership interest in a subsidiary, and that any retained non-controlling financial interests in a deconsolidated subsidiary be measured initially at fair value. SFAS 160 applies to fiscal years beginning on or after December 15, 2008, and is applied prospectively, except for presentation and disclosure requirements, which are applied retrospectively for all periods presented. The Company is currently in the process of evaluating the impact of SFAS 160.
In March 2008, the FASB issued Statement No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“SFAS 161”). SFAS 161 amends and expands the disclosure requirements of SFAS 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments and disclosures about credit-risk-related contingent features in derivative agreements. This statement is effective for financial statements issued for fiscal years beginning after November 15, 2008. The adoption of SFAS 161 will not affect the Company’s consolidated financial condition or results of operations, but may require additional disclosures if the Company enters into derivative and hedging activities.
The following table represents the operations of the workers’ compensation insurance segment for the years ended December 31, 2008 and 2007 (in thousands). The results of operations for the year ended December 31, 2008 include the operating results of ESIC for the period from October 1, 2008 to December 31, 2008:
The workers’ compensation insurance ratios were as follows for the years ended December 31, 2008 and 2007:
Purchase accounting adjustments reduced direct premiums written by $513,000 in 2008, compared to a reduction of $1.2 million for the same period in 2007.
The decrease in net investment income primarily reflects a decline in the average yield on the fixed income portfolio and a decline in short-term interest rates from 2007 to 2008. The average yield on the fixed income portfolio was 4.18% as of December 31, 2008, compared to 4.44% as of December 31, 2007.
The increase in the calendar period loss and LAE ratio primarily reflects a decrease in favorable loss reserve development related to prior accident periods. The accident period loss ratio was 58.8% and 60.3% for the years ended December 31, 2008 and 2007, respectively. Favorable loss reserve development totaled $2.7 million for the year ended December 31, 2008, compared to favorable loss reserve development of $8.4 million for the same period in 2007. The favorable loss reserve development primarily reflects a decrease in the prior accident period loss development factors used to estimate losses and LAE. The decrease in prior accident period loss development factors primarily reflects significant prior year claim settlements during 2008 for amounts at, or less than, previously established case and IBNR reserves. This decrease had the effect of lowering loss development factors as of December 31, 2008. For the year ended December 31, 2008, the Company closed 360, or 63.2% of the 570 open lost time claims as of December 31, 2007. In the aggregate, the claims were closed at amounts lower than the provision established for IBNR claims. Management believes that the realization of the benefits of its return-to-work controls coupled with strong economies in its underwriting territories during 2006, 2007, and the first half of 2008 enabled it to record losses and LAE that were lower than the amount reserved for claim settlements.
The increase in acquisition and other underwriting expenses primarily reflects growth in net premiums earned and a decrease in fee based revenue from the segregated portfolio cell reinsurance segment during 2008. In addition, the Company recorded an accrual for an expected assessment by the Security Fund on 2008 premiums as of December 31, 2008. No accrual was recorded as of December 31, 2007 due to the Company receiving communication from the Security Fund that no assessment was going to be made on 2007 premium.
The increase in other expenses primarily reflects start-up costs incurred in conjunction with the Company’s expansion into the Southeast, due diligence and integration expenses associated with the acquisition of ESHC and other state licensing initiatives.
The effective tax rate was 31.6% and 31.3% for the years ended December 31, 2008 and 2007, respectively. The difference between the statutory tax rate of 35% and the effective tax rate primarily reflects tax exempt income on municipal bond securities. The 2007 effective tax rate also includes a reduction in income tax expense related to non-recurring rehabilitation tax credits.
The following table represents the operations of the segregated portfolio cell reinsurance segment for the years ended December 31, 2008 and 2007 (in thousands):
The increase in the calendar period loss and LAE ratio primarily reflects a decrease in favorable loss reserve development related to prior accident periods. The accident period loss ratio was 62.9% and 62.4% for the years ended December 31, 2008 and 2007, respectively. Favorable loss reserve development totaled $2.0 million for the year ended December 31, 2008, compared to favorable loss reserve development of $3.0 million for the same period in 2007. The decrease in favorable loss reserve development from 2007 to 2008 primarily reflects management’s consideration of the current economic conditions and the potential impact on prior year open claims. As a result, management determined it was prudent to maintain higher reserve levels in light of the possibility that it could be more difficult to implement return to work initiatives in the current economic conditions. The favorable loss reserve development primarily reflects a decrease in the prior accident period loss development factors used to estimate losses and LAE. The decrease in prior accident period loss development factors primarily reflects significant prior year claim settlements during 2008 for amounts at, or less than, previously established case and IBNR reserves. This decrease had the effect of lowering loss development factors as of December 31, 2008.
The decrease in net investment income primarily reflects a lower invested asset base. The average yield on the fixed income portfolio was 4.88% as of December 31, 2008, compared to 5.60% as of December 31, 2007.
The calendar period loss ratios, by line of business, for the years ended December 31, 2008 and 2007 were as follows:
The effective tax rate was 48.4% and 29.2% for the years ended December 31, 2008 and 2007, respectively. The difference between the statutory tax rate of 35% and the effective tax rate primarily reflects tax exempt income on municipal bond securities. The 2008 effective tax rate also includes a prior year tax return adjustment that increased the income tax benefit, and the 2007 effective tax rate includes the release of a contingency reserve related to prior tax years that decreased income tax expense.
The run-off specialty reinsurance ratios were as follows for the years ended December 31, 2008 and 2007:
The increase in net income reflects the acquisition of EHC on June 16, 2006, an increase in favorable loss reserve development on prior accident years, and a reduction in the impact of purchase accounting charges in 2007. Net income for the years ended December 31, 2007 and 2006 includes after-tax favorable loss reserve development on prior accident periods of $5.5 million and $1.4 million, respectively. Net income for the year ended December 31, 2006 includes an after-tax charge of $2.4 million related to the amortization of purchase accounting adjustments compared to negligible purchase accounting charges in 2007.
The workers’ compensation insurance ratios were as follows for the years ended December 31, 2007 and 2006:
The increase in net investment income reflects the acquisition of EHC on June 16, 2006. The average yield on the fixed income portfolio was 4.44% as of December 31, 2007, compared to an average yield of 4.48% as of December 31, 2006.
The decrease in the calendar period loss ratio primarily reflects an increase in favorable loss reserve development related to prior accident periods, a decrease in the accident year loss ratio from 71.9% in 2006 to 60.3% in 2007 and a decrease in the impact of purchase accounting adjustments from 2006 to 2007. Favorable loss reserve development totaled $8.4 million for the year ended December 31, 2007, compared to favorable loss reserve development of $2.1 million for the same period in 2006, which lowered the calendar period loss ratios by 14.9 percentage points and 8.5 percentage points, respectively. The favorable loss reserve development and the decrease in the accident period loss ratio primarily reflects a decrease in the current and prior accident period loss development factors used to estimate losses and LAE. The decrease in accident year loss development factors primarily reflects significant prior year claim settlements during 2007 for amounts at, or less than, previously established case and IBNR reserves. This decrease had the effect of lowering loss development factors as of December 31, 2007. For the year ended December 31, 2007, the Company closed 281, or 56.8%, of the 495 open lost time claims as of December 31, 2006. In the aggregate, the claims were closed at amounts lower than the provision established for IBNR claims. Management believes that the realization of the benefits of its return-to-work controls coupled with strong economies in its underwriting territories during 2005, 2006, and 2007 enabled it to record losses and LAE that were lower than the amount reserved for claim settlements.
The effective tax rate was 31.3% and 32.5% for the years ended December 31, 2007 and 2006, respectively. The decrease in the effective tax rate primarily reflects non-recurring rehabilitation tax credits recognized in 2007. The primary difference between the statutory tax rate of 35% and the effective tax rate relates to tax exempt income on municipal securities in 2007 and 2006, and the non-recurring rehabilitation tax credits in 2007.
The segregated portfolio cell reinsurance ratios were as follows for the years ended December 31, 2007 and 2006:
The increase in net investment income reflects the acquisition of EHC on June 16, 2006. The average yield on the fixed income portfolio was 5.11% as of December 31, 2007, compared to an average yield of 5.33% as of December 31, 2006.
Direct premiums written, by line of business, for the years ended December 31, 2007 and 2006 were as follows (in thousands):
The decrease in net investment income primarily reflects an increase in investment management expenses. Investment management expenses increased $239,000 from 2006 to 2007 primarily reflecting fees paid related to the performance of the group benefits insurance segment’s convertible bond portfolio.
The average yield on the fixed income portfolio was 5.60% as of December 31, 2007, compared to 5.61% as of December 31, 2006.
Net realized investment gains in 2007 includes a gain on the sale of the aforementioned limited partnership interest totaling $344,000, while net realized investment gains in 2006 includes a gain on the sale of an equity security of $716,000.
The increase in losses and loss adjustment expenses primarily reflects the increase in net premiums earned and an increase in the loss ratio from 61.6% in 2006 to 64.8% in 2007. The calendar period loss ratios, by line of business, for the years ended December 31, 2007 and 2006 were as follows:
The long-term disability loss ratio was relatively consistent from 2006 to 2007. The loss ratio reflects the continued impact of prior year claim terminations that were covered under the 50/50 coinsurance arrangement.
The increase in acquisition and other underwriting expenses primarily reflects the increase in net premiums earned.
The decrease in income tax expense primarily reflects a reduction in the effective tax rate, from 35.2% in 2006 to 29.2% in 2007. The reduction in the effective tax rate primarily reflects the impact of tax-exempt interest income and the release of a contingency reserve in 2007 related to prior tax years.
The increase in the expense ratio is related to a reduction in the impact of purchase accounting adjustments in 2007 compared to 2006. Purchase accounting adjustments reduced acquisition and other underwriting expenses by $1.7 million in 2006 compared to negligible purchase accounting adjustments in 2007. As part of its quota share reinsurance agreement with the primary insurer, the Company pays the primary insurer a ceding commission based on assumed premiums. For the years ended December 31, 2007 and 2006, the ceding commission paid to the primary insurer was 30.0%.
Total shareholders’ equity was $138.1 million as of December 31, 2008, compared to $177.8 million as of December 31, 2007. The decrease primarily reflects the net loss of $17.4 million, stock repurchases of $17.1 million, shareholder dividends of $2.5 million, and a decline in the market value of the Company’s investments of $4.1 million.
For the years ended December 31, 2008, 2007 and 2006, the Company’s cash inflows from premiums and investment activity were sufficient to support the Company’s cash outflows related to claims and operating expenses. Management expects future cash flows from operations in its workers’ compensation insurance, segregated portfolio cell reinsurance and group benefits insurance segments to be sufficient to cover claims and operating expenses. However, in the event cash flows from operations are not sufficient, the Company may have to liquidate investments to cover such costs. As of December 31, 2008, the Company’s investment portfolio included securities with gross unrealized gains totaling $6.4 million; therefore, based on current gross unrealized gains in the investment portfolio as of December 31, 2008, management does not believe it would have to sell securities at a loss in the event cash flows from operations proved insufficient to cover the Company’s operating needs.
Our domestic insurance subsidiaries’ ability to pay dividends to EIHI is limited by the insurance laws and regulations of Pennsylvania and Indiana. The maximum annual dividends that the domestic insurance entities may pay without prior approval from the Pennsylvania Insurance Department and the Indiana Insurance Department is limited to the greater of 10% of statutory surplus or 100% of statutory net income for the most recently filed annual statement. In addition, EIHI and its Pennsylvania-domiciled subsidiaries are prohibited from declaring or paying any dividends or other forms of distribution for the three years after June 16, 2006, the effective date of the conversion/merger transaction, without the prior approval of the Pennsylvania Insurance Commissioner. Eastern Re must receive approval from the Cayman Islands Monetary Authority before it can pay any dividend to the Company.
The primary sources of cash flows for the Company are net premiums written, investment income, and proceeds from the sale or maturity of investments. The major components of cash flow are as follows for the years ended December 31, 2008, 2007, and 2006 (in thousands):
Cash Flows for the Years Ended December 31, 2008 and 2007. The decrease in cash flows from operating activities from 2007 to 2008 primarily reflects a reduction in net investment income and the termination of the Company’s participation in the reinsurance treaties in the run-off specialty reinsurance segment.
The increase in cash flows from investing activities from 2007 to 2008 primarily reflects the use of proceeds from sales and maturities of securities to fund the Company’s stock repurchase program, the acquisition of ESHC and the repayment of the junior subordinated debentures.
The loss reserves payments due by period in the table above are based upon the loss and LAE reserves estimates as of December 31, 2008, and actuarial estimates of expected payout patterns by line of business. As a result, our calculation of loss reserve payments due by period is subject to the same uncertainties associated with determining the level of reserves and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. For a discussion of our reserving process, see “Item 1 - Business, Loss and LAE Reserves.” Actual payments of loss and LAE by period will vary, perhaps materially, from the above table to the extent that current estimates of loss reserves vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns.
On September 29, 2008, EIHI acquired all of the outstanding stock of Employers Security Holding Company (“ESHC”) and its wholly-owned subsidiaries, Employers Security Insurance Company and Affinity Management Services (See Note 3). Employers Security Insurance Company (“ESIC”) is an Indiana-domiciled, mono-line workers’ compensation insurance company licensed to write business in Indiana, Illinois and Missouri.
The Company currently operates in four segments: workers’ compensation insurance, segregated portfolio cell reinsurance, group benefits insurance, and corporate/other. The specialty reinsurance segment was placed into run-off effective July 1, 2008. See Note 16 for a description of each segment.
The consolidated statements of income and comprehensive income for the year ended December 31, 2006 represent the results of operations of the group benefits insurance segment for the year ended December 31, 2006 and the results of operations of the workers’ compensation insurance segment, segregated portfolio cell reinsurance segment and run-off specialty reinsurance operations for the period from June 17, 2006 to December 31, 2006. The corporate/other segment for the year ended December 31, 2006 represents the results of operations of ELH’s corporate activities for the year ended December 31, 2006 and the results of operations of EIHI, EHC, Employers Alliance, Global Alliance, and Eastern Services for the period from June 17, 2006 to December 31, 2006. Basic and diluted earnings per share for the year ended December 31, 2006 is computed by dividing consolidated net income for the period from June 17, 2006 to December 31, 2006 by the weighted average number of shares outstanding for the period.
Certain amounts in the prior year consolidated financial statements have been reclassified to conform to the current year presentation. The Company reclassified the change in equity interest in its limited partnership investments from net investment income to the change in equity interest in other long-term investments in the consolidated statements of operations. This reclassification did not have any impact on prior year revenues, expenses, or net income.
The preparation of the consolidated financial statements requires management to make estimates and assumptions that affect the amount of reported assets and liabilities and disclosures of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. The most significant estimates in the consolidated financial statements include reserves for unpaid losses and loss adjustment expenses (“LAE”), earned but unbilled premium, deferred acquisition costs, return premiums under reinsurance contracts, and current and deferred income taxes. Actual results could differ from these estimates.
The Company’s investments in fixed income securities are classified as available-for-sale and are carried at estimated fair value, with unrealized gains and losses reported in accumulated other comprehensive income (loss), net of tax. Fixed income securities include publicly traded and private placement bonds. The estimated fair value of publicly traded bonds is determined based on quoted market prices or, in the absence of quoted market prices, dealer quotes or matrix pricing, all of which are based on observable market-based inputs when available. Adverse credit market conditions have caused some markets to become relatively illiquid, thus reducing the availability of certain data used by the independent pricing services and dealers. The estimated fair value of private placement bonds is determined using valuation models, taking into consideration the securities’ coupon rate, maturity date, and other pertinent features.
Premiums or discounts are amortized using the effective interest method. Realized gains or losses are based on amortized cost and are computed using the specific identification method. The Company monitors its fixed income securities for unrealized losses that appear to be other-than-temporary. The Company performs a detailed review of these securities to determine the underlying cause of the unrealized loss and whether the security is impaired. At the time a security is determined to be other-than- temporarily impaired, the Company reduces the book value of the security to the current estimated fair value at the balance sheet date and records a realized loss in the consolidated statements of operations and comprehensive income (loss). Any subsequent increase in the security’s estimated fair value would be reported as an unrealized gain.
The Company adopted Statement of Financial Accounting Standards No. 155 (SFAS 155), “Accounting for Certain Hybrid Financial Instruments, an amendment of FASB Statements No. 133 and 140”, on January 1, 2007. Under SFAS 155, the change in fair value of the Company’s convertible bond securities, which meet the definition of a hybrid financial instrument under SFAS 155, is reported as a realized gain or loss in the consolidated statement of operations and comprehensive income (loss). The adoption of SFAS 155 was reported as a cumulative effect adjustment to shareholders’ equity, as of January 1, 2007, and resulted in a reclassification between retained earnings and accumulated other comprehensive income of $405. The carrying value of the Company’s convertible bond securities did not change as a result of adopting SFAS 155.
Realized gains or losses are based on cost and are computed using the specific identification method. The Company monitors its equity securities for unrealized losses that appear to be other-than-temporary. The Company performs a detailed review of these securities to determine the underlying cause of the unrealized loss and whether the security is impaired. At the time a security is determined to be other-than-temporarily impaired, the Company reduces the cost of the security to the current estimated fair value at the balance sheet date and records a realized loss in the consolidated statements of operations and comprehensive income (loss). Any subsequent increase in the security’s estimated fair value would be reported as an unrealized gain.
Other long-term investments consist primarily of investments in limited partnerships. Investments in limited partnerships are reported in the consolidated financial statements using the equity method. Changes in the value of the Company’s proportionate share of its limited partnership investments are included in the change in equity interest in other long-term investments in the consolidated statements of operations and comprehensive income (loss). The Company reports changes in the value of its limited partnership investments on a month lag (quarter lag for one investment) as a result of the timing of statements being received from the limited partnership. The Company monitors its limited partnership investments for declines in value that may be other-than-temporary. When a limited partnership interest is determined to be other-than-temporarily impaired, the Company reduces its interest in the limited partnership to its current estimated fair value at the balance sheet date. The impairment is recorded in the change in equity interest in other long-term investments in the consolidated statements of operations and comprehensive income (loss).
Premiums generated by the Company’s workers’ compensation insurance segment, including estimates of additional premiums resulting from audits of insureds’ records, are generally recognized as written upon inception of the policy. Premiums written are primarily earned on a daily pro rata basis over the terms of the policies to which they relate. Accordingly, unearned premiums represent the portion of premiums written which is applicable to the unexpired portion of the policies in force. Workers’ compensation premiums are determined based upon the payroll of the insured, the applicable premium rates and, where applicable, an experience based modification factor. An audit of the policyholders’ records is conducted after policy expiration to make a final determination of applicable premiums. Included in net premiums earned is an estimate for earned but unbilled final audit premiums. The Company estimates earned but unbilled premiums by tracking, by policy, how much additional premium is billed in final audit invoices as a percentage of payroll exposure to estimate the probable additional amount that it has earned, but not yet billed, as of the balance sheet date. Earned but unbilled premiums accrued as of December 31, 2008 and 2007, and included in net premiums earned, totaled $1,800 and $1,500, respectively.
Premiums generated by the Company’s group benefits insurance segment are generally billed on a monthly basis with premiums being earned in the month in which the coverage is provided. Unearned premiums represent premiums that have been received but for which the coverage period has not expired. Advance premiums represent premiums that have been received in advance of the coverage period. Premiums receivable represent only those premiums that have been billed to policyholders for coverage periods through the balance sheet date.
A liability is established for the estimated unpaid losses and LAE of the Company’s workers’ compensation insurance segment under the terms of, and with respect to, its policies and agreements and includes amounts determined on the basis of claims adjusters’ evaluations and an amount based on past experience for losses incurred but not reported (“IBNR”).
and 2006 was 3.85%, 5.25% and 4.75%, respectively. The liability for IBNR claims is estimated on a policy-by-policy basis, taking into consideration average monthly premium, policy elimination periods, and an expected loss ratio.
The liability for reported but unpaid term life claims represent those claims reported to the Company as of the balance sheet date for which payment has not yet been made. Term life IBNR claims are estimated based on historical patterns of claims incurred as a percent of in-force premium as of the balance sheet date.
A liability is established for the estimated unpaid losses and LAE of the Company’s run-off specialty reinsurance operations based on information provided by the ceding company. Premiums and reported claims data provided by the ceding company is utilized by management to estimate the ultimate losses and LAE, including an amount for IBNR claims. As a result of a lag in receiving quarterly premium and reported claim data from the ceding company, the estimated unpaid losses and LAE are based on claim data one quarter in arrears.
The methods used to estimate the reserves for unpaid losses and LAE are reviewed periodically and any adjustments resulting therefrom are reflected in current operations.
Management believes that its reserves for unpaid losses and LAE is adequate as of December 31, 2008. However, estimating the ultimate liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates and judgments using data currently available. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded as of December 31, 2008, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.
EIHI’s insurance subsidiaries are not generally subject to state income taxes; rather, they are subject to state premium tax in the jurisdictions in which they write business. Employers Alliance, Eastern Services and AMS are subject to state income tax in the states in which they operate.
The Company includes income tax-related interest and penalties as a component of income tax expense. The Company did not incur any income tax-related interest or penalties during 2008, 2007 or 2006.
The Company issues certain workers’ compensation insurance policies with dividend payment features. These policyholders share in the operating results of their respective policies in the form of dividends. Dividends to policyholders are accrued during the period in which the related premiums are earned and are determined based on the terms of the individual policies. As of December 31, 2008 and 2007, the Company recorded accrued dividends payable of $1,311 and $989, respectively, which are included in accounts payable and accrued expenses on the consolidated balance sheets.
Property and equipment, including expenditures for significant improvements and purchased software, is carried at cost less accumulated depreciation and amortization. Maintenance, repairs and minor improvements are expensed as incurred. When property and equipment is retired or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is included in operations. Depreciation is computed under the straight-line method. The estimated useful lives of property and equipment range from 3-7 years. Accumulated depreciation and amortization expense totaled $7,246 and $6,534 as of December 31, 2008 and 2007, respectively. Depreciation and amortization expense totaled $561, $397, and $263 for the years ended December 31, 2008, 2007 and 2006, respectively.
Property, equipment and software are reviewed for impairment whenever changes in circumstances indicate that the carrying value of such assets may not be recoverable. Impairment losses are recognized to the extent the carrying amount of the asset exceeds the undiscounted cash flows expected to result from the use of the asset and its eventual disposal. There were no impairments recorded in 2008, 2007 or 2006.
liability and the related expense for the assessments when premiums covered under the Security Fund are written; when an assessment from the Security Fund has been imposed or it is probable that an assessment will be imposed; and the amount of the assessment is reasonably estimable. The Company recorded an assessment related to the Security Fund of $1,052 as of December 31, 2008. No assessment was recorded for the Security Fund as of December 31, 2007.
The Company tested goodwill for impairment as of December 31, 2008 using a discounted cash flow analysis and by comparing the Company’s common stock price relative to book value of the workers’ compensation insurance segment. Management performed the discounted cash flow analysis using its internal four-year forecast for the workers’ compensation insurance segment, assuming an annual growth rate of 5.0% and a discount rate of 13.0%. Cash flows were adjusted as necessary to maintain adequate capital requirements. Due to market conditions, the Company’s stock price experienced a significant decline in value during 2008 and was trading below book value as of December 31, 2008; therefore, management considered an estimate of the Company’s value in a potential transaction and allocated that value to the Company’s reporting units, including the workers’ compensation insurance segment. Based on the results of the above tests, the fair value of the workers’ compensation insurance segment exceeded its carrying value as of December 31, 2008; therefore, goodwill was considered not impaired.
The Company records the repurchase of shares of its common stock using the cost method. Under the cost method, treasury stock is recorded based on the actual cost of the shares repurchased.
The Company adopted the Eastern Insurance Holdings, Inc. 2006 Stock Incentive Plan (the “Stock Incentive Plan”) on December 18, 2006. Under the terms of the Stock Incentive Plan, stock awards may be made in the form of incentive stock options, non-qualified stock options or restricted stock. The Company accounts for stock-based compensation in accordance with SFAS 123R, “Share-Based Payment”. In accordance with SFAS 123R, the Company records compensation expense based on the fair value of the stock award on the grant date using the straight-line attribution method.
On September 29, 2008, EIHI acquired all of the outstanding stock of ESHC in a transaction valued at $14,820, including the assumption of $2,650 in debt. The acquisition of ESHC resulted in the recognition of certain intangible assets totaling $4,180 (Note 4) and goodwill totaling $2,760. ESHC reported total assets and total liabilities of $25,856 and $19,203, respectively, on the date of the transaction. ESHC’s shareholders’ equity of $6,653 on the date of the transaction was reduced by $10 as a result of purchase accounting adjustments to reflect the fair value of certain acquired assets and liabilities. The most significant purchase accounting adjustments related to the elimination of deferred acquisition costs, an increase to reserves for losses and LAE, and a decrease to unearned premiums. Direct costs related to the acquisition totaling $107 were capitalized and included in goodwill.
On June 16, 2006, EIHI acquired all of the outstanding common stock of EHC for a purchase price of $78,929, which consisted of the Company issuing 3,876,048 shares of its $10.00 common stock and paying cash of $40,175 to EHC’s shareholders. The excess of the purchase price over the net fair value of the assets and liabilities acquired was $14,337, consisting of identifiable intangible assets of $9,197 and goodwill of $5,140. Direct expenses incurred in connection with the acquisition of EHC were $636. In connection with the acquisition of EHC, the purchase price was allocated to the estimated fair values of the acquired assets and liabilities as follows (in thousands):
For the years ended December 31, 2008 and 2007, the Company contributed $1,100 to the ESOP, which the ESOP used to make principal and interest payments to the Company related to the outstanding loan balance. The Company’s contributions and the related principal and interest payments are considered non-cash transactions for purposes of the consolidated statements of cash flows.
The acquisition of EHC resulted in the identification of certain intangible assets. The allocation of the purchase price in excess of the fair value of the Company’s net assets acquired to intangible assets totaled $9,197. The acquisition of ESHC resulted in the recognition of certain intangible assets, including renewal rights of $1,841, agency relationships of $1,814, and state insurance licenses of $525. The renewal rights and agency relationships will be amortized over their estimated useful lives of 15 years. The state insurance licenses are considered to have an infinite life and will not be amortized.
Amortization expense totaled $1,373, $1,738 and $1,087 for the years ended December 31, 2008, 2007 and 2006, respectively.
Basic earnings per share are computed by dividing net (loss) income by the weighted average number of shares outstanding for the respective period. Diluted earnings per share are computed by dividing net (loss) income by the weighted average number of shares outstanding for the period, including dilutive potential common shares outstanding for the period. For the year ended December 31, 2008, there were 1,170,297 stock options, restricted stock awards and stock warrants that were not included in the Company’s earnings per share calculation because to do so would have been anti-dilutive. For the year ended December 31, 2007, dilutive potential common shares outstanding included 33,881 restricted stock awards and 306,099 stock warrants, and there were 843,058 stock options and restricted stock awards that were not included in the Company’s earnings per share calculation because to do so would have been anti-dilutive. Of the shares excluded from the diluted earnings per share calculation, 335,541 shares were considered anti-dilutive because of the Company’s net loss for the year ended December 31, 2008. There were no stock options or restricted stock awards outstanding as of December 31, 2006. Consolidated net (loss) income, basic shares outstanding, diluted shares outstanding, basic earnings per share and diluted earnings per share for the years ended December 31, 2008, 2007 and 2006 were as follows (in thousands, except share and per share data):
Awards under the Stock Incentive Plan may be made in the form of incentive stock options, nonqualified stock options, restricted stock or any combination to employees and non-employee directors. The Stock Incentive Plan limits the number of shares that may be awarded as restricted stock to 299,000, and the number of shares for which incentive stock options may be granted to 500,000. The total number of shares initially authorized in the Stock Incentive Plan was 1,046,500 shares, with an annual increase equal to 1% of the shares outstanding at the end of each year. The Stock Incentive Plan provides that stock options and restricted stock awards may include vesting restrictions and performance criteria at the discretion of the Compensation Committee of the Board of Directors. The term of options may not exceed ten years for incentive stock options, and ten years and one month for nonqualified stock options, and the option price may not be less than fair market value on the date of grant. During 2008, grants of 15,000 incentive stock options and 5,000 restricted stock awards were made to employees. During 2007, grants of 17,500 incentive stock options were made to employees. A total of 32,741 and 3,924 stock options were forfeited during the years ended December 31, 2008 and 2007, respectively. The stock options and restricted stock awards vest over a five year period and are not subject to performance criteria. As of December 31, 2008, 119,505 stock options and 49,335 restricted stock awards have vested and there were no stock options or restricted stock awards exercised during 2008.
Total stock-based compensation expense recognized in the consolidated statement of operations and comprehensive income for the years ended December 31, 2008 and 2007 is shown in the following table (in thousands):
There was no stock-based compensation expense for the year ended December 31, 2006.
As of December 31, 2008, there were 119,505 and 49,335 vested stock options and restricted stock awards, respectively. There were no vested stock options or restricted stock awards as of December 31, 2007. The total unrecognized stock compensation expense related to non-vested stock options was $1,766 and $2,263, respectively, and the total unrecognized stock compensation expense related to non-vested restricted stock awards was $2,190 and $2,832, respectively, as of December 31, 2008 and 2007. The unrecognized stock compensation expense related to the non-vested stock options and restricted stock awards is expected to be recognized over a weighted average period of approximately 43.0 months and 46.5 months, respectively.
The Company’s domestic insurance subsidiaries, Eastern Alliance, Allied Eastern, Eastern Advantage, ESIC and ELH, prepare statutory-basis financial statements in accordance with accounting practices prescribed or permitted by the insurance department in the subsidiaries’ domiciliary state. The Pennsylvania Insurance Department and the Indiana Insurance Department requires that insurance companies domiciled in their respective states prepare their statutory-basis financial statements in accordance with the National Association of Insurance Commissioners’ (“NAIC”) Accounting Practices and Procedures manual, subject to any deviations prescribed or permitted by domiciliary insurance commissioner (“SAP”).
The statutory surplus and statutory net income (loss) of Eastern Alliance, Allied Eastern, Eastern Advantage, ESIC and ELH as of December 31, 2008 and 2007 and for the years ended December 31, 2008, 2007, and 2006 was as follows (in thousands):
On March 6, 2009, Eastern Alliance, Allied Eastern and ELH received approval from the Pennsylvania Insurance Department to pay dividends in the amount of $10,000, $2,000 and $13,000, respectively, to EIHI (See Note 21). Subsequent to these dividend payments, the statutory capital and surplus levels of Eastern Alliance, Allied Eastern and ELH continued to exceed statutory risk-based capital requirements.
The ability of Eastern Alliance, Allied Eastern, Eastern Advantage, ESIC and ELH to pay dividends to EIHI is limited by the laws and regulations of Pennsylvania and Indiana. The maximum annual dividends that EIHI’s insurance subsidiaries may pay without the prior approval from the Pennsylvania Insurance Department and Indiana Insurance Department is limited to the greater of 10% of statutory surplus or 100% of statutory net income for the most recently filed annual statement. For the three years subsequent to June 16, 2006, the effective date of the common stock offering, conversion of ELH, and acquisition of EHC, Eastern Alliance, Allied Eastern, Eastern Advantage and ELH are prohibited from declaring or paying any dividends or other forms of distribution without the prior approval of the Pennsylvania Insurance Commissioner.
SFAS 157 requires assets and liabilities measured at fair value on a recurring basis to be segregated between those assets and liabilities that are valued based on quoted prices (unadjusted) in active markets for identical assets or liabilities, which the reporting entity can access at the measurement date (Level 1), direct or indirect observable inputs other than Level 1 quoted prices (Level 2), or unobservable inputs to the extent that observable inputs are not available (Level 3).
Level 2-Represents financial assets whose fair value is determined based upon: quoted market prices for similar assets in active markets; quoted market prices for identical assets in inactive markets; inputs other than quoted market prices that are observable for the asset such as interest rates or yield curves; or other inputs derived principally from or corroborated from other observable market information. An example of a Level 2 input utilized to measure fair value, specifically for the Company’s fixed income portfolio, is “matrix pricing.” “Matrix pricing” relies on observable inputs from active markets other than quoted market prices including, but not limited to, benchmark securities and yields, latest reported trades, quotes
from brokers or dealers, issuer spreads, bids, offers, and other relevant reference data to determine fair value. “Matrix pricing” is used to measure the fair value of fixed income securities where obtaining individual quoted market prices is impractical. The Company considers U.S. Government agencies, municipal bonds, mortgage-backed securities, collateralized mortgage obligations, asset-backed securities, corporate bonds, and convertible bonds as Level 2 assets.
The Company’s investments in fixed income securities, convertible bonds, and equity securities are valued through the use of a nationally recognized pricing service. The Company believes the scope of work performed when using data from outside parties is sufficient to validate the prices such that it does not rely upon these independent pricing services as experts, nor would it seek indemnification from them in the event the prices provided were deemed inappropriate. Where independent pricing services provide fair values, the Company has obtained an understanding of the methods, models and inputs used in pricing, and has controls in place to validate that amounts provided represent current exit values. The Company’s controls include, but are not limited to, initial and ongoing evaluation of methodologies used by outside parties as well as other techniques and assumptions to calculate fair value and comparing the fair value estimates to the Company’s knowledge of the current market. Fixed income securities include U.S. Treasuries, agencies backed by the U.S. Government, municipal bonds, mortgage-backed securities, collateralized mortgage obligations, asset-backed securities, and corporate bonds.
As of December 31, 2008 and 2007, the estimated fair values of the Company’s limited partnership investments, by investment strategy, were as follows (in thousands):
The following tables provide the amortized cost and estimated fair value of the Company’s fixed income and equity securities as of December 31, 2008 and 2007 (in thousands):
Certain insurance departments in the states in which the Company is licensed to do business require a deposit to protect the Company’s policyholders should the Company become insolvent. In order to satisfy these requirements, the Company had fixed income securities with an estimated fair value of $13,519 and $5,869 on deposit with various insurance departments as of December 31, 2008 and 2007, respectively.
The amortized cost and estimated fair value of fixed income securities and convertible bonds as of December 31, 2008, by contractual maturity, are shown below (in thousands). Expected maturities could differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties.
The gross unrealized losses and estimated fair value of fixed income and equity securities, excluding those securities in the segregated portfolio cell reinsurance segment, classified as available-for-sale by category and length of time an individual security has been in a continuous unrealized position as of December 31, 2008 and 2007 are as follows (in thousands):
Proceeds from the sale of fixed income securities totaled $41,058, $50,309, and $42,443 for the years ended December 31, 2008, 2007, and 2006, respectively. Proceeds from the sale of equity securities totaled $4,699, $11,956, and $6,855 for the years ended December 31, 2008, 2007, and 2006, respectively. Proceeds from the sale of other long-term investments totaled $820, $1,876, and $550 for the years ended December 31, 2008, 2007, and 2006, respectively.
The gross realized gains and gross realized losses recognized by the Company as a result of the sale of investments were as follows for the years ended December 31, 2008, 2007, and 2006 (in thousands):
For the year ended December 31, 2008, the Company recorded other-than-temporary impairments related to fixed income and equity securities totaling $4,532 and $4,975, respectively. There were no impairments recorded in 2007 or 2006.
For the years ended December 31, 2008, 2007 and 2006, the change in the estimated fair value of convertible bonds included in net realized investment (losses) gains in the consolidated statement of operations and comprehensive income totaled $(2,674), $(457) and $837, respectively.
The change in the Company’s net unrealized gains and losses for the years ended December 31, 2008, 2007, and 2006 was as follows (in thousands):
Net investment income for the years ended December 31, 2008, 2007, and 2006 was as follows (in thousands):
The following table provides a summary of the activity in the Company’s reserves for unpaid losses and LAE, excluding term life premium waiver reserves, for the years ended December 31, 2008, 2007, and 2006 (in thousands):
Segregated Portfolio Cell Reinsurance. The favorable loss reserve development in the workers’ compensation insurance segment for the years ended December 31, 2008 and 2007 primarily reflects the impact of claim settlements in each respective year for amounts at, or less than, previously established case and IBNR reserves.
Group Benefits Insurance. The favorable loss reserve development in the group benefits insurance segment primarily reflects better than expected claim results in the dental, short-term disability and term life lines.
audit revealed several factors which contributed to the increased case reserves reported to the Company by the primary insurer and, therefore, resulted in management increasing the loss development factors utilized in estimating the IBNR reserves. Those factors include 1) an improvement in the ceding company’s ability to estimate loss costs earlier in the claims process, including the receipt of damage estimates from contractors and consultants, 2) jurisdictions becoming more aggressive in requiring quicker, more extensive clean-up and an increase in construction costs related to the clean-up, and 3) courts limiting the ability of insurance companies to enforce policy coverage limitations as the courts are more interested in an expeditious clean up due to environmental concerns. The unfavorable loss reserve development for the year ended December 31, 2007 primarily reflects the result of changes in estimates as losses emerged at a higher rate than had been originally anticipated when the reserves were estimated with respect to accident periods 2006, 2005, 2004 and 2003.
The following table provides a summary of the Company’s premiums on a direct, assumed, ceded, and net basis for the years ended December 31, 2008, 2007, and 2006 (in thousands):
ELH entered into a coinsurance agreement in 1999, under which it ceded an existing block of outstanding claims related to a program that provided long-term disability coverage to certain professional associations. The Company recorded a reinsurance recoverable totaling $9,034 and $10,163 as of December 31, 2008 and 2007, related to this block of ceded claims.
In addition to the income tax provision, the net deferred tax asset increased (decreased) by $1,022, $(696), and $132 in 2008, 2007, and 2006, respectively, as a result of changes in the unrealized gains and losses on the Company’s fixed income and equity securities. The net deferred tax asset was also increased (decreased) by $558 and $(58) in 2008 and 2007, respectively, related to unrecognized benefit plan gains. The tax effect of these items is recorded directly to accumulated other comprehensive income, which is a component of equity.
The provision for income taxes for the years ended December 31, 2008, 2007, and 2006 is as follows (in thousands):
The components of the net deferred tax asset as of December 31, 2008 and 2007 are as follows (in thousands):
The Company adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”) effective January 1, 2007. The adoption of FIN 48 had no effect on the Company’s consolidated financial statements. As of December 31, 2008, the Company has no tax positions for which management believes a provision for uncertainty is necessary. The Company’s federal income tax returns for tax years subsequent to December 31, 2004 are subject to examination by the Internal Revenue Service.
The Company sponsors an ESOP. Eligible employees generally include those employees who have reached the age of 21 and have completed one year of service. All employees that were employed by EHC or ELH on June 16, 2006 were determined to have met the eligibility requirements on that date. ESOP shares are allocated to participants based on the ratio of their individual compensation during the plan year to the total compensation of eligible employees during the plan year.
Suspense shares, allocated shares, shares committed to be released, average price per share and stock compensation expense as of and for the years ended December 31, 2008 and 2007 were as follows (in thousands, except share data):
A reconciliation of changes in the benefit obligation, fair value of plan assets and funded status of the pension plan and the postretirement plan as of December 31, 2008 and 2007 is as follows (in thousands):
As of December 31, 2008 and 2007, the following amounts related to the pension plan and postretirement plan have been included in accumulated other comprehensive income (“AOCI”) (in thousands):
Benefits paid totaled $234, $424, and $522 for the pension plan and $21, $134, and $152 for the postretirement plan for the years ended December 31, 2008, 2007, and 2006, respectively. The estimated future benefits to be paid over the next ten years are as follows (in thousands):
The pension plan’s assets were comprised of the following at December 31, 2008 and 2007 (in thousands):
During 2007, the Company recognized a settlement gain of $384 related to the purchase of the annuity to satisfy the future obligations of the pension plan related to participants receiving benefits as of December 31, 2007.
As of December 31, 2008, the assumed healthcare cost trend rate used in the estimate of the postretirement benefit plan obligation was 6.00%, with the rate decreasing to 4.00% in 2011 and thereafter. An increase or decrease in the assumed healthcare cost trend of one percentage point does not have a material impact on the Company’s benefit obligation or net periodic benefit cost as of December 31, 2008.
Prior to July 1, 2008, the Company assumed business through its participation in reinsurance treaties with an unaffiliated insurance company related to an underground storage tank insurance program, referred to as “EnviroGuard,” and a non-hazardous waste transportation product, referred to as “EIA liability” (“EIA”). The EnviroGuard program provided coverage to underground tank owners for third party off-site bodily injury and property damage claims as well as clean-up coverage and first party on-site claims. The EIA program provided commercial automobile liability coverage for non-hazardous waste haulers. Prior to terminating its participation in the reinsurance treaties effective July 1, 2008, the Company had reduced its participation in the EnviroGuard and EIA programs from a 25% quota share participation to a 15% quota share participation effective January 1, 2008. Net premiums earned, by program and before purchase accounting adjustments, for the years ended December 31, 2008 and 2007 were as follows (in thousands):
The following table represents the segment results for the year ended December 31, 2008 (in thousands):
Prior to October 31, 2006, ELH leased its office space under a multi-year sale-leaseback agreement. On March 20, 2006, ELH entered into a Lease Termination Agreement with the landlord to terminate the lease prior to the end of the initial term of the lease. Under the terms of the Lease Termination Agreement, ELH paid the landlord $394. The impact of the termination payment on the Company’s results of operations was reduced by the recognition of the remaining deferred gain related to the sale-leaseback agreement as of October 31, 2006, totaling $191. For the year ended December 31, 2006, the Company recognized a charge of $203 related to the lease termination, which is included in other expenses in the consolidated statement of operations and comprehensive income (loss).
For the years ended December 31, 2008 and 2007, the Company incurred interest expense of $468 and $606 related to the junior subordinated debentures.
As of December 31, 2008, the Company had a loan payable with an outstanding principal balance of $2,650. Semi-annual principal payments of $250 are due on or before January 1 and July 1 each year through July 1, 2013. Interest on the loan is based on the 30-day LIBOR rate plus 165 basis points and resets on the first day of each month, based on the LIBOR rate as of the last day of the immediately preceding month. The outstanding loan balance can be prepaid at any time without penalty. Under the terms of the loan, ESHC must maintain 1) a consolidated debt service coverage ratio of not less than 1.0 calculated annually on December 31, 2) consolidated net equity of $3,000 on December 31, and 3) invested assets equal to at least 125% of the outstanding principal balance of the loan. As of December 31, 2008 and for the year then ended, ESHC met the financial covenants. The Company incurred interest expense of $30 related to the loan for the year ended December 31, 2008.
On June 17, 2008, the Company announced its 2008 Agency Stock Purchase Plan (the “Stock Purchase Plan”). The purpose of the Stock Purchase Plan is to provide eligible insurance agencies of the Company with the opportunity to purchase the Company’s common stock at a discount from fair market value and is designed to foster the common interests
of the Company and agencies in achieving long-term profitable growth for the Company. The Company has reserved 125,000 shares of its common stock for purchase under the Stock Purchase Plan for the five-year period ending June 30, 2013. Common stock issued under the Stock Purchase Plan may be issued from treasury stock.
As a result of Eastern Re’s net loss for the year ended December 31, 2008, EIHI made a capital contribution of $23.0 million to Eastern Re on March 6, 2009 to improve Eastern Re’s capital position and to maintain Eastern Re’s current A.M. Best financial strength rating of “A-” (Excellent). The capital contribution was funded by dividends paid to EIHI from Eastern Alliance, Allied Eastern and ELH in the amount of $10.0 million, $2.0 million and $13.0 million, respectively, on March 6, 2009, of which $2.0 million was retained by EIHI. The dividends were approved by the Pennsylvania Insurance Department.
On March 12, 2009, the Company announced that its Board of Directors authorized a $0.07 per share quarterly cash dividend on its issued and outstanding shares of common stock, payable March 27, 2009 to shareholders of record at the close of business on March 13, 2009.
22. Quarterly Financial Data (Unaudited, in thousands, except per share data)
The net loss for the quarter ended December 31, 2008 primarily reflects the after-tax impact of other-than-temporary impairments of $4,354, unfavorable loss reserve development of $13,863 related to the run-off specialty reinsurance segment, and income tax expense of $2,126 related to the non-recognition of future tax benefits related to the run-off specialty reinsurance segment as of December 31, 2008.