We earn our direct premiums written from our maritime, ADR and state act customers. We also earn a small portion of our direct premiums written from employers who participate in the Washington USL&H Plan. We immediately cede 100% of those premiums, net of our expenses, and 100% of the losses in connection with that business to the plan.
Loss and loss adjustment expenses represent our largest expense item and include (1) claim payments made, (2) estimates for future claim payments and changes in those estimates for current and prior periods and (3) costs associated with investigating, defending and adjusting claims. For further information regarding our loss and loss adjustment expenses, including amounts paid and unpaid, see the discussion under the heading “Critical Accounting Policies, Estimates and Judgments - Unpaid Loss and Loss Adjustment Expense” in Part II, Item 7 of this annual report.
Gross premiums written totaled $261.4 million in 2011 compared to $264.3 million in 2010, representing a decrease of $2.9 million, or 1.1%. The change from 2010 resulted from premium declines primarily related to our “core” business, offset by business growth in our “Program Business.” Program Business, which includes alternative markets and small maritime programs, increased $13.8 million in 2011 compared to 2010. This increase was offset by a $15.4 million decrease in our core product lines, which include everything other than our Program Business (primarily energy, maritime and construction business). The decrease was primarily driven by declines in our construction business as a result of the continuing impact of the economic downturn. We have also experienced a reduction in our renewal retention rates as a result of rate increases and other underwriting actions we’ve taken in response to recent upward trends in medical and indemnity claims costs. Our overall renewal retention rate was 65% for the fourth quarter of 2011, compared to 74% for third quarter 2011 and 70% for fourth quarter 2010.
We expect our California concentration to decline significantly in 2012 as a result of previously announced changes in our underwriting standards for California construction business. Effective October 1, 2011, we offer California construction coverage only to contractors with estimated annual premiums greater than $500,000 and only on a loss sensitive basis. We no longer offer guaranteed cost plans to California contractors. Although these changes will reduce our premiums in the short term, we believe they will produce a stronger, more balanced book of business in the long term. We expect the reduction in California construction premiums will be partially offset by growth in California in other industries, such as healthcare and manufacturing, as well as growth in other states where we currently do business. We also expect to reduce the proportion of writings in California to 25 to 30% of our overall book, down from historical levels which have typically been approximately 50% or higher.
We experienced significant reductions in our California premium rates from 2003 to 2008. Over that period, we filed, and the California Department of Insurance approved, eight rate reductions resulting in a net cumulative reduction of our California rates of approximately 54.8%. Beginning in 2008, we filed, and the California Department of Insurance approved, the following increases in our California rates: 5.0% increase effective January 1, 2009; 10.6% increase effective August 1, 2009; 15.3% increase effective September 1, 2010; and 10.9% increase effective January 1, 2012. These rate increases were filed following the completion of internal studies of our California loss costs and were primarily in response to increased projected medical costs and recent decisions by the Workers’ Compensation Appeals Board. If other insurers do not adopt similar rate increases, these rate increases may have a negative effect on our ability to compete in California. Rate changes have also been adopted in other states in which we operate. For additional information regarding recent rate change activity in California and other states, see the discussion under the heading “Regulation - Federal and State Legislative and Regulatory Changes” in Part I, Item 1 of this annual report.
Net Premiums Written. Net premiums written totaled $225.6 million in 2011 compared to $240.2 million in 2010, representing a decrease of $14.6 million, or 6.1%. The decrease was primarily attributable to an increase in ceded premiums resulting from higher ceding rates in our excess of loss reinsurance program effective October 1, 2010 through September 30, 2011. Our ceding rate under that program increased by approximately 141% as a result of lowering the attachment point from $0.5 million to $0.25 million and increasing maximum coverage from $85.0 million to $100.0 million. When we renewed our reinsurance program on October 1, 2011, we increased the attachment point to $0.5 million and reduced our maximum coverage to $75.0 million, which reduced our ceding rate to more historical levels.
Net Premiums Earned. Net premiums earned totaled $249.6 million in 2011 compared to $254.3 million in 2010, representing a decrease of $4.8 million, or 1.9%. We record the entire annual policy premium as unearned premium at inception and earn the premium over the life of the policy, which is generally twelve months, in proportion to the underlying exposure. Consequently, the amount of premiums earned in any given year depends on when the underlying policies were written and how the underlying payroll exposure is reported. Our direct premiums earned increased $4.5 million, or 1.6%, to $281.5 million in 2011 from $277.0 million in 2010. Net premiums earned in 2011 were reduced by net adjustments of approximately $2.7 million on retrospectively rated policies due to favorable loss results on those policies. Net premiums earned were also affected by premiums ceded under reinsurance treaties. Ceded earned premiums in 2011 totaled $36.3 million compared to $27.0 million in 2010, representing an increase of $9.3 million, or 34.6%.
Other Income. Other income totaled $4.3 million for the years ended December 31, 2011 and 2010. Other income is derived primarily from the operations of PointSure, our wholesale broker, and PMCS, our provider of medical bill review, utilization review, nurse case management and related services.
For accident year 2011, an ELR of 62.5% was established initially, which took into consideration the higher ceding rates under our 2010-2011 reinsurance program and adverse reserve development experienced in recent accident years. The ELR was multiplied by the booked accident year earned premium to produce the ultimate loss to date. The ELR selections are reviewed quarterly with each internal IBNR study. Given the short experience period for the current accident year, the ELRs are usually maintained at least through the first 12 months of the accident year and revised as the underlying data matures. However, we increased the ELR for 2011 from 62.5% to 65.0% in the fourth quarter of 2011 after reviewing results for the 2011 accident year and considering the adverse development in recent accident years.
For accident year 2009, the ultimate loss estimates at December 31, 2011 were higher when compared to December 31, 2010 and resulted in adverse development of our loss reserves of $8.5 million. The development was attributable to the following jurisdictions: $4.6 million for California state act, driven primarily by medical and indemnity costs; $3.3 million for non-California state act, driven primarily by indemnity costs; and $0.6 million for USL&H, driven primarily by indemnity costs. This adverse development was offset by favorable development of $1.4 million related to ULAE, loss based assessments and NCCI, as well as a $0.4 million favorable commutation gain.
For accident year 2008, the ultimate loss estimates at December 31, 2011 were higher when compared to December 31, 2010 and resulted in adverse development of our loss reserves of $9.0 million. The development was attributable to the following jurisdictions: $3.2 million for California state act, driven primarily by medical and indemnity costs; $5.3 million for non-California state act, driven primarily by indemnity costs; and $0.5 million for USL&H, driven primarily by indemnity costs. This adverse development was offset by net favorable development of $0.7 million related to ULAE, loss based assessments and NCCI, as well as a $0.1 million favorable commutation gain.
We have observed an increase in severity estimates for accident years 2006 through 2010 in California following several years of decreasing trends. We have established loss reserves at December 31, 2011 that are based upon our current best estimate of ultimate loss costs, taking into consideration the recent paid loss claim data, incurred loss trends and uncertainty regarding the permanence of recent legislative reforms. We continue to monitor the impact of reforms and potential challenges to reforms in our loss data. See the discussion under the headings “Loss Reserves” in Part I, Item 1 and “Critical Accounting Policies, Estimates and Judgments - Unpaid Loss and Loss Adjustment Expense” in this Item 7 for a further discussion of our loss reserving process.
Other Expenses. Other expenses totaled $8.0 million in 2011, an increase of $0.5 million, or 6.9%, from $7.5 million in 2010. Other expenses result primarily from the operations of PointSure and PMCS. The increase in other expenses was largely attributable to the growth of these companies’ operations.
Income Tax Expense (Benefit). The effective tax rate for the year ended December 31, 2011 resulted in a benefit of 42.6% compared to a benefit of 75.0% for the same period in 2010. The effective tax rate for 2011 differed from the statutory tax rate of 35.0% primarily as a result of tax exempt interest income, which accounted for approximately 11.1 percentage points of the difference from the statutory rate. The increase in the effective rate was partially offset by $0.5 million, or 1.9 percentage points, due to the true-up of tax deductions relating to stock option and restricted stock awards that vested during the year. The effective rate for December 31, 2010 differed from the statutory rate of 35.0% primarily as a result of tax exempt interest income, which accounted for approximately 53.0 percentage points of the difference from the statutory rate. This increase in the effective rate was partially offset by $0.6 million, or 8.8 percentage points, due to the true-up of tax deductions relating to stock options and restricted stock awards that vested during the year.
Net Income (Loss). Net loss totaled $12.8 million in 2011 compared to a net loss of $1.6 million in 2010, representing an increase of $11.2 million, or 708.1%. The increase in net loss resulted primarily from a decrease in other net realized gains recognized in earnings in 2011 as compared to 2010.
Gross premiums written totaled $264.3 million in 2010 compared to $290.0 million in 2009, representing a decrease of $25.7 million, or 8.9%. Much of the decrease in gross premiums written resulted from premium declines primarily related to our “core” business, offset by business growth in our “Program Business”. Program Business, which includes alternative markets and small maritime programs, increased $27.8 million in 2010 compared to 2009. This increase was offset by a $52.0 million decrease in our core product lines, which include everything other than our Program Business (primarily energy, maritime and construction business). The decrease was primarily driven by our construction business as a result of the continuing impact of the economic downturn. We have also experienced a reduction in our renewal retention rates as a result of rate increases and other underwriting actions we’ve taken in response to recent upward trends in medical and indemnity claims costs. Our overall renewal retention rate was 70% for the fourth quarter of 2010, compared to 73% for third quarter 2010 and 84% for fourth quarter 2009.
Net Premiums Written. Net premiums written totaled $240.2 million in 2010 compared to $262.8 million in 2009, representing a decrease of $22.6 million, or 8.6%. The decrease was primarily attributable to the decrease in gross written premiums, offset in part by a $3.1 million decrease in premiums ceded primarily resulting from residual market business. Premiums ceded were also impacted by our new excess of loss reinsurance program that became effective on October 1, 2010. Gross premiums written assumed from the NCCI residual market pools in 2010 decreased approximately $1.7 million (41.7%) from the prior year amount, resulting in a similar reduction in ceded premiums since the business assumed from the NCCI for policy years 2009 and 2010 is ceded to independent reinsurers. This reduction in ceded premiums was offset by a higher ceding rate in our excess of loss reinsurance program that renewed in October 2010. Our ceding rate increased by approximately 141% as a result of lowering the attachment point from $0.5 million to $0.25 million and increasing maximum coverage from $85.0 million to $100.0 million.
Other-Than-Temporary Impairment Losses. We had no other-than-temporary impairment (“OTTI”) losses for the year ended December 31, 2010, compared to $0.3 million in 2009, which related to our investment in government-sponsored agency preferred stock. The 2009 charge followed a $10.2 million OTTI charge related to the same securities in 2008 and was recorded at the time management made the decision to liquidate the impaired securities.
Loss and Loss Adjustment Expenses. Loss and loss adjustment expenses totaled $223.1 million in 2010 compared to $174.3 million in 2009, representing an increase of $48.7 million, or 28.0%. Our net loss ratio, which is calculated by dividing loss and loss adjustment expenses less claims service income by premiums earned, was 87.4% in 2010 compared to 70.9% in 2009. The increase in our net loss ratio was primarily attributable to unfavorable development of prior accident year loss reserves of $32.6 million in 2010 (offset by a $0.6 million favorable commutation gain), compared to unfavorable development of prior year accident year loss reserves of $0.4 million in 2009 (offset by a $0.6 million favorable commutation gain). Our net loss ratio was also impacted by an increase in the current accident year loss ratio from 60.0% in 2009 to 64.5% in 2010. Our direct loss reserves are net of reinsurance and exclude reserves associated with KEIC, whom we acquired from LMC in September 2003, and the business that we involuntarily assume from the NCCI.
For accident years 2006 and prior, the ultimate loss estimates at December 31, 2010 were higher when compared to December 31, 2009 and resulted in a net increase of our loss reserves of $3.5 million.
As of December 31, 2010, we had recorded a receivable of approximately $3.0 million for adverse loss development under the adverse development cover since the date of the Acquisition. We do not expect this receivable to have any material effect on our future cash flows if LMC fails to perform its obligations under the adverse development cover. At December 31, 2010, we had access to approximately $ 3.8 million under the collateralized reinsurance trust in the event that LMC fails to satisfy its obligations under the adverse development cover. See the discussion under the heading “Loss Reserves - KEIC Loss Reserves” in Part I, Item 1 of this annual report.
Underwriting, Acquisition and Insurance Expenses. Underwriting expenses totaled $72.1 million in 2010 compared to $72.8 million in 2009, representing a decrease of $0.7 million, or 1.0%. Our net underwriting expense ratio, which is calculated by dividing underwriting, acquisition and insurance expenses less other service income by premiums earned, was 28.3% in 2010 compared to 29.8% in 2009. The decline in our expense ratio resulted from decreases in our underwriting expenses and increases in our net premiums earned from the same period of 2009.
We had no direct sub-prime mortgage exposure in our investment portfolio and $10.0 million of indirect exposure to sub-prime mortgages as of December 31, 2011. As of December 31, 2011, our portfolio included $92.2 million of insured municipal bonds and $258.8 million of uninsured municipal bonds. See “Investments” in Part I, Item 1 of this annual report for a discussion of the limited exposure in our investment portfolio at December 31, 2011 to the European sovereign debt crisis.
The following table provides a breakdown of ratings on the bonds in our municipal portfolio as of December 31, 2011:
Our insurance subsidiary is required by law to maintain a certain minimum level of surplus on a statutory basis. Surplus is calculated by subtracting total liabilities from total admitted assets. The NAIC has a risk-based capital standard designed to identify property and casualty insurers that may be inadequately capitalized based on inherent risks of each insurer’s assets and liabilities and its mix of net premiums written. Insurers falling below a calculated threshold may be subject to varying degrees of regulatory action. As of December 31, 2011, the statutory surplus of our insurance subsidiary was in excess of the prescribed risk-based capital requirements that correspond to any level of regulatory action.
Net cash provided by operating activities in 2011 totaled $27.6 million, a decrease of $29.1 million, or 51.4%, from $56.7 million in 2010, which decreased $11.6 million, or 16.9%, from $68.3 million in 2009. The decrease in 2011 was primarily attributable to a decrease in premiums collected of approximately $10.6 million and an increase in loss and loss adjustment expenses paid (net of reinsurance collected) of approximately $22.8 million. The decrease in 2010 was primarily attributable to an increase in loss and loss adjustment expenses paid (net of reinsurance collected) of approximately $28.7 million, partially offset by decreases in income taxes and underwriting expenses paid of approximately $9.1 million and $4.0 million, respectively.
We used net cash of $9.7 million for investing activities in 2011 compared to $49.8 million in 2010 and $77.8 million in 2009. The decrease in 2011 from 2010 and in 2010 from 2009 was driven by lower net investment purchase activity (purchases, net of sales and maturities).
Net cash used in financing activities totaled $5.3 million in 2011, an increase of $1.4 million from $3.9 million in 2010, which increased $3.4 million from $0.4 million in 2009. The increase in net cash used in financing activities in 2011 over 2010 and in 2010 over 2009 was primarily the result of quarterly cash dividends paid.
The most critical accounting policies involve the reporting of unpaid loss and loss adjustment expenses including losses that have occurred but were not reported to us by the financial reporting date, the amount and recoverability of reinsurance recoverable balances, deferred policy acquisition costs, income taxes, the valuation of goodwill, the impairment of investment securities, earned but unbilled premiums and retrospective premiums. The following should be read in conjunction with the notes to our consolidated financial statements.
Unpaid loss and loss adjustment expense represents our estimate of the expected cost of the ultimate settlement and administration of losses, based on known facts and circumstances. Our policy is to record the liability for unpaid claims and claim adjustment expense equal to the best estimate we determine. Included in unpaid loss and loss adjustment expense are amounts for case-based reserves, including estimates of future developments on those claims, and claims incurred but not yet reported to us, second injury fund expenses, and allocated and unallocated claim adjustment expenses. Due to the inherent uncertainty associated with the cost of unsettled and unreported claims, the ultimate liability may differ, perhaps materially, from the original estimate. These estimates are regularly reviewed and updated and any resulting adjustments are included in the current period’s operating results.
Following is a summary of the gross loss and loss adjustment expense reserves by line of business as of December 31, 2011 and 2010. The workers’ compensation line of business comprises over 98% of our total loss reserves as of both dates.
The ELR is multiplied by the year-to-date earned premium to determine the ultimate losses for the current accident year. The actual paid and case outstanding losses are subtracted from the ultimate losses to determine the IBNR for the accident year. As the accident year matures, we incorporate standard actuarial reserving methodologies, including the Bornhuetter-Ferguson method and the Berquist-Sherman Adjusted Incurred Loss Development method. These methods blend the loss development and expected loss ratio methods by assigning partial weight to the initial expected losses, calculated from the expected loss ratio method, with the remaining weight applied to the actual losses, either paid or incurred. The weights assigned to the initial expected losses decrease as the accident year matures. A reserve estimate implies a pattern of expected loss emergence. If this emergence does not occur as expected, it may cause us to revisit our previous assumptions. We may adjust loss development patterns, the various method weights or the expected loss ratios used in our analysis. Management employs judgment in each reserve valuation as to how to make these adjustments to reflect current information.
At December 31, 2011, approximately $221.1 million, or 48.0%, of our direct loss reserves were related to business written in California. Over the last several years, four significant comprehensive legislative reforms were enacted in California: AB 749 was enacted in February 2002; AB 227 and SB 228 were enacted in September 2003; and SB 899 was enacted in April 2004. This reform activity has resulted in uncertainty regarding the impact of the reforms on loss payments, loss development and, ultimately, loss reserves, making historical data less reliable as an indicator of future loss. All four bills enacted structural changes to the benefit delivery system in California, in addition to changes in the indemnity and medical benefits afforded injured workers. In response to the reform legislation and a drop in the frequency of workers’ compensation claims, the pure premium rates approved by the California Insurance Commissioner effective January 1, 2012 were 49.3% lower than the pure premium rates in effect as of July 1, 2003. More recent data has indicated the need for an increase in rates in California. With the California Department of Insurance’s approval, we adopted a 5.0% increase in advisory pure premium rates effective January 1, 2009. In June 2009, we filed for a 10.6% rate increase effective August 1, 2009, which was also approved. In July 2010, we filed for a 15.3% average rate increase effective September 1, 2010, which was also approved. In November 2011, we filed for a 10.9% average rate increase, which was approved in December 2011 and became effective on January 1, 2012. The California Department of Insurance has more recently recognized pure premium deterioration for the market as a whole, approving in full the January 1, 2012 pure premium rate filing submitted by the WCIRB. Consequently, the bureau-approved pure premium rates are now 49.3% lower than the pure premium rates in effect as of July 1, 2003.
AB 749 repealed the presumption given to the primary treating physician (except when the worker has pre-designated a personal physician), effective for injuries occurring on or after January 1, 2003. (SB 228 and SB 899 later extended this to all future medical treatment on earlier injuries.)
These reforms are a source of variability in the reserve estimates as legislative changes affecting benefit levels not only impact the cost of benefits but also the rate at which accident year benefits or losses develop over time. Ongoing efforts by some system stakeholders to challenge the reforms, either through legislative, administrative or judicial means, further adds to the variability.
Workers’ compensation is considered a long-tail line of business, as it takes a relatively long period of time to finalize claims from a given accident year. Management believes that it generally takes workers’ compensation losses approximately 48 to 60 months after the start of an accident year until the data is viewed as fully credible for paid and incurred reserve evaluation methods. Workers’ compensation losses can continue to develop beyond 60 months and in some cases claims can remain open more than 20 years. As indicated above, we wrote our first policy on October 1, 2003 so our first complete accident year is 2004. As of December 31, 2011, accident year 2004 was 96 months developed, accident year 2005 was 84 months developed, accident year 2006 was 72 months developed, accident year 2007 was 60 months developed, accident year 2008 was 48 months developed, accident year 2009 was 36 months developed, accident year 2010 was 24 months developed and accident year 2011 was 12 months developed. Our loss reserve estimates are subject to considerable variation due to the relative immaturity of the accident years from a development standpoint.
The reserves for losses and DCC are also reviewed gross and net of reinsurance (referred to as “net”). For gross losses, the claims for the Washington USL&H Plan, the KEIC claims assumed in the Acquisition and claims assumed from the NCCI residual market pools are excluded from this discussion.
For accident years 2006 and prior, there was unfavorable development in the losses for California State Act which resulted in an increase of our net ultimate loss estimates of $2.8 million. For non-California State Act, there was unfavorable development in the losses for accident years 2006 and prior which resulted in an increase of our net ultimate loss estimates of $0.4 million. This was offset by favorable development in the USL&H losses for accident years 2006 and prior which resulted in a decrease of our net ultimate loss estimates of $0.6 million.
For accident year 2008, there was unfavorable development in the losses for California State Act which resulted in an increase of our net ultimate loss estimates of $3.2 million. For non-California State Act, there was unfavorable development in the losses for accident year 2008 which resulted in an increase of our net ultimate loss estimates of $5.3 million. For USL&H, there was unfavorable development in the losses for accident year 2008 which resulted in an increase of our net ultimate loss estimates of $0.5 million.
For accident year 2011, the ultimate losses were set by multiplying the selected ELR to the booking earned premium. We initially established a net ELR for accident year 2011 of 62.5%. However, after reviewing the 2011 results and considering the adverse development in recent accident years and the impact of lower ceding rates in our 2011-2012 reinsurance treaty, we increased the 2011 net ELR to 65.0% in the fourth quarter of the year. For more information on the ELR method and selection see the related discussion under the heading “Actuarial Loss Reserve Estimation Methods” in this Item 7.
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. This analysis requires management to make various estimates and assumptions, including the scheduled reversal of deferred tax liabilities, the consideration of operating versus capital items, projected future taxable income and the effect of tax planning strategies. If actual results differ from management’s estimates and assumptions, we may be required to establish a valuation allowance to reduce the deferred tax assets to the amounts more likely than not to be realized. The establishment of a valuation allowance could have a significant impact on our financial position and results of operations in the period in which it is deemed necessary. We reached a conclusion that, as of December 31, 2011, it is more likely than not that the deferred tax assets will be realized, and therefore no valuation allowance was recorded.
As previously reported, in the second quarter of 2010, we determined that a triggering event related to our insurance subsidiary had occurred, necessitating an update of the prior year’s impairment analysis. The fair value of the reporting unit was estimated using a discounted cash flow analysis, resulting in our recording a $1.5 million impairment charge against the goodwill resulting from the acquisition of SBIC in September 2003.
We performed our 2011 impairment analysis of the remaining goodwill related to the acquisitions of PMCS and BWNV in the fourth quarter of 2011 and concluded, on a more-likely-than-not basis, that no goodwill impairment existed. Among the qualitative factors considered in our analysis were the following: the substantial margins by which both reporting units passed our previous impairment analysis; the continued strong performance of both companies; the importance of both companies to our strategic plan; and a lack of the negative factors identified in ASU 2011-08, Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment.
We have audited the accompanying consolidated balance sheets of SeaBright Holdings, Inc. and subsidiaries as of December 31, 2011 and 2010, and the related consolidated statements of operations and comprehensive income (loss), changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2011. These consolidated financial statements are the responsibility of SeaBright Holdings, Inc.’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), SeaBright Holdings, Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 5, 2012 expressed an unqualified opinion on the effectiveness of SeaBright Holdings, Inc. and subsidiaries’ internal control over financial reporting.
SeaBright Insurance Holdings, Inc. (“SeaBright”), a Delaware corporation, was formed in June 2003. In May 2010, SeaBright changed its corporate name to SeaBright Holdings, Inc. On July 14, 2003, SeaBright entered into a purchase agreement, effective September 30, 2003, with Kemper Employers Group, Inc. (“KEG”), Eagle Pacific Insurance Company and Pacific Eagle Insurance Company (“Eagle”), and Lumbermens Mutual Casualty Company (“LMC”), the ultimate owner of KEG and Eagle (the “Acquisition”). Under this agreement, SeaBright acquired Kemper Employers Insurance Company (“KEIC”), PointSure Insurance Services, Inc. (“PointSure”), and certain assets of Eagle, primarily renewal rights. KEG, LMC and Eagle are no longer writing new business and, as of December 31, 2011, were operating under a voluntary run-off plan which has been approved by the Illinois Department of Insurance.
At the time of the Acquisition, KEIC was licensed to write workers’ compensation insurance in 43 states and the District of Columbia. Domiciled in the State of Illinois and commercially domiciled in the State of California, it wrote both state act workers’ compensation insurance and United States Longshore and Harbor Workers’ Compensation Act (“USL&H”) insurance. Prior to the Acquisition, beginning in 2000, KEIC wrote business only in California. In May 2002, KEIC ceased writing business and by December 31, 2003, all premiums related to business prior to the Acquisition were 100% earned. As further discussed in Note 8.a., “Reinsurance Ceded”, in connection with the Acquisition, KEIC and LMC entered into an agreement whereby LMC agreed to indemnify KEIC in the event of adverse development of the reserves stated on KEIC’s balance sheet at the Acquisition date, for a period of approximately eight years. In addition, KEIC agreed to share with LMC any positive development of those reserves. December 31, 2011 is the date to which the parties will look to determine whether the loss and loss adjustment expenses with respect to KEIC’s insurance policies in effect at the date of the Acquisition have increased or decreased from the amount existing at the date of the Acquisition.
In July 2008, PointSure acquired 100% of the outstanding common stock of Black/White and Associates, Inc., Black/White and Associates of Nevada and Black/White Rockridge Insurance Services, Inc. (referred to collectively as “BWNV”), a privately held managing general agent and wholesale insurance broker. Also included in the transaction were a covenant not to compete from key principals of BWNV and other intangible assets. The preliminary purchase price paid at closing was $1.7 million, of which $0.5 million was allocated to the purchase of BWNV capital stock. PointSure paid approximately $159,000 as additional purchase consideration upon resolution of a contingency period in 2009. Following the acquisition, BWNV became a wholly owned subsidiary of PointSure. In November 2010, PointSure reorganized its corporate structure and directly assumed the business and operations of BWNV. The BWNV legal entities were subsequently dissolved.
Certain reclassifications have been made to prior year financial statements to conform to classifications used in the current year.
Investment securities are classified as available-for-sale and are carried at fair value. The estimated fair value of investments in available-for-sale securities is generally based on quoted market prices for securities traded in the public marketplace. If a quoted market price is not available, fair value is generally estimated using quoted market prices for similar securities.
Cash and cash equivalents, which consist primarily of amounts deposited in banks and financial institutions, and all highly liquid investments with maturities of 90 days or less when purchased, are stated at cost. Cash in excess of daily requirements is invested in short-term, highly liquid bank funds and are deemed to be cash equivalents for purposes of the consolidated balance sheets and statements of cash flows.
The preparation of the consolidated financial statements in conformity with GAAP requires management of the Company to make a number of estimates and assumptions relating to the reported amount of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates. The Company has used significant estimates in determining unpaid loss and loss adjustment expense, including losses that have occurred but were not reported to us by the financial reporting date; the amount and recoverability of reinsurance recoverable balances; goodwill and other intangibles; retrospective premiums; earned but unbilled premiums; deferred policy acquisition costs; income taxes; and the valuation and other-than-temporary impairments of investment securities.
Furniture and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful lives, which range from three to five years. Leasehold improvements are depreciated on a straight-line basis over periods ranging from approximately two to seven years, which is the shorter of their estimated useful lives or the remaining term of the respective lease. Depreciation expense totaled $1.5 million, $1.7 million and $1.9 million for the years ended December 31, 2011, 2010, and 2009, respectively.
The goodwill impairment test follows a three step process. The first step consists of consideration of various qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of the reporting unit in question is less than its carrying amount. If such a determination is not reached, then performance of further impairment testing is not necessary.
Management’s determination of the fair value of each reporting unit incorporates multiple inputs including various qualitative considerations, discounted cash flow calculations and, as appropriate, the level of the Company’s own share price and assumptions that market participants would make in valuing the reporting unit. Other assumptions include levels of economic capital, future business growth, earnings projections, assets under management and the discount rate utilized.
Premiums for primary and reinsured risks are included in revenue over the life of the contract in proportion to the amount of insurance protection provided (i.e., ratably over the policy period). The portion of the premium that is applicable to the unexpired period of a policy in-force is not included in revenue but is deferred and recorded as unearned premium in the liability section of the balance sheet. Deferred premiums represent the unbilled portion of annual premiums.
The unpaid loss and loss adjustment expense subject to the adverse development cover with LMC is calculated on a quarterly basis using generally accepted actuarial methodologies for estimating unpaid loss and loss adjustment expense liabilities, including incurred loss and paid loss development methods. The minimum amount that must be maintained in the trust account is equal to the greater of (a) $1.6 million or (b) 102% of the then existing quarterly estimate of LMC’s total obligations under the adverse development cover. Amounts recoverable in excess of acquired reserves at September 30, 2003 are recorded gross in unpaid loss and loss adjustment expense in accordance with ASC Topic 805, Business Combinations, with a corresponding amount receivable from the seller.
The following table provides the reconciliation of weighted average common share equivalents outstanding used in calculating earnings (loss) per share for the years ended December 31, 2011, 2010, and 2009:
In October 2010, the FASB issued Accounting Standards Update (“ASU”) 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. This ASU allows insurance entities to defer costs related to the acquisition of new or renewal insurance contracts that are (1) incremental direct costs of the contract transaction (i.e., would not have occurred without the contract transaction), (2) a portion of an employee's compensation and fringe benefits related to certain activities for successful contract acquisitions, or (3) direct-response advertising costs as defined in ASC Subtopic 340-20, Other Assets and Deferred Costs - Capitalized Advertising Costs. All other costs related to the acquisition of new or renewal insurance contracts are required to be expensed as incurred. This ASU is effective for interim and annual periods beginning after December 15, 2011 with either prospective or retrospective application permitted. The Company will adopt this guidance retrospectively effective January 1, 2012. The Company currently estimates that adoption will reduce its December 31, 2011 retained earnings (the period immediately prior to adoption) by approximately $4.5 million, net of taxes.
In June 2011, the FASB issued ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, to increase the prominence of other comprehensive income in the financial statements. An entity will have the option to present the components of net income and comprehensive income in either one or two consecutive financial statements. The new guidance is effective for interim and annual reporting periods beginning after December 15, 2011, with earlier adoption permitted. The Company adopted this guidance retrospectively effective September 30, 2011. The adoption of ASU 2011-05 did not have a material effect on the Company’s consolidated financial condition or results of operations.
In September 2011, the FASB issued ASU 2011-08, Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment, to simplify the current two-step goodwill impairment test required under Topic 350. Under this update, an entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If such a determination is not reached, then performance of further impairment testing is not necessary. The new guidance is effective for annual and interim goodwill tests performed for fiscal years beginning after December 15, 2011. However, early adoption is permitted. The Company adopted ASU 2011-08 in the fourth quarter of 2011, which did not have a material effect on the Company’s consolidated financial condition or results of operations.
The $2.9 million of securities with unrealized losses of 12 months or longer at December 31, 2011 in the above table consist of two securities whose amortized cost at December 31, 2011 was approximately $2.9 million. One of these securities had an unrealized loss that exceeded 20% of the related security’s book value at December 31, 2011. As of December 31, 2011, all payments were current on these debt securities and the Company expects to fully recover its investment in these securities no later than their scheduled maturities. The Company has no current intent to sell these securities nor is it more likely than not that the Company would be required to sell these securities. Therefore, based on management’s review of the financial strength of these debt securities and the Company’s expectation regarding future receipt of principal and interest, management concluded these debt securities were temporarily impaired as of December 31, 2011. The Company recognized no OTTI losses in 2011 or 2010. In 2009, the Company recognized OTTI losses of approximately $0.3 million, which were related to its investment in preferred stock issued by Fannie Mae and Freddie Mac.
Significant changes in the factors considered when evaluating investments for impairment losses could result in a significant change in impairment losses reported in the financial statements. At December 31, 2011 and 2010, the Company evaluated investment securities with fair values less than amortized cost and determined that the declines in value were temporary and were related primarily to the change in market rates since purchase or to other market anomalies that are expected to correct themselves. Furthermore, the Company has the ability and intent to hold the impaired investments to maturity or for a period of time sufficient for recovery of their carrying amount.
The Company had no direct sub-prime mortgage exposure in its investment portfolio and $10.0 million of indirect exposure to sub-prime mortgages as of December 31, 2011. As of December 31, 2011, the Company’s portfolio included $92.2 million of insured municipal bonds and $258.8 million of uninsured municipal bonds.
The Company had no direct exposure in our investment portfolio to the European sovereign debt crisis as of December 31, 2011. The Company did own, as of that date, approximately $13.1 million of securities issued by domestic and foreign banks that have indirect European sovereign debt exposure through their global financial dealings. The Company believes the risks of these exposures are well contained and managed. Each of the banks whose securities the Company holds has been deemed Globally Systemically Important Financial Institutions (“G-SIFI”) by the Financial Stability Board. The list of G-SIFIs is updated annually and included 29 large financial institutions as of December 31, 2011. At December 31, 2011, The Company also owned a $1.5 million debt security issued by a domestic broker dealer that has acknowledged some exposure to European sovereign debt.
Consists of $326.9 million of tax-exempt municipal bonds and $24.2 million of taxable municipal bonds.
The amortized cost and estimated fair value of fixed income securities available for sale at December 31, 2011, by contractual maturity, are set forth below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
Major categories of consolidated net investment income are summarized as follows for the years ended December 31, 2011, 2010, and 2009:
Investment securities: The Company measures and reports its financial assets and liabilities, including investment securities, in accordance with ASC Topic 820, Fair Value Measurements and Disclosures. The estimated fair values for available-for-sale securities are generally based on quoted market value prices for securities traded in the public marketplace. The Company also considers the impact of a significant decrease in volume and level of activity for an asset or liability when compared with normal activity. Additional information with respect to fair values of the Company’s investment securities is disclosed in Note 3, “Investments”.
Level 3 - Valuations for assets and liabilities that are derived from other valuation methodologies, including discounted cash flow models and similar techniques, and not based on market exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities. As of December 31, 2011, the Company had no Level 3 financial assets or liabilities.
The tables below present balances of assets measured at fair value on a recurring basis.
Active markets are those in which transactions occur with sufficient frequency and volume to provide reliable pricing information on an ongoing basis. Inactive markets are those in which there are few transactions for the asset, prices are not current, or price quotations vary substantially either over time or among market makers, or in which little information is released publicly. When the market for an investment is judged to be inactive, appropriate adjustments must be made to observable inputs to account for such inactivity. As of December 31, 2011, the Company’s investment portfolio consisted of securities that it considered to be traded in active markets. Therefore, no adjustment for market inactivity or illiquidity was necessary. There were no transfers between levels during the year ended December 31, 2011.
The Company holds a limited amount ($20.1 million at December 31, 2011) of privately placed corporate bonds and estimates the fair value of these bonds using an internal matrix that is based in part on market information regarding interest rates, credit spreads and liquidity. The pricing matrix begins with current U.S. Treasury rates and uses credit spreads received from third-party sources to estimate fair value. The Company includes the fair value estimates of these corporate bonds in Level 2, since all significant inputs are market observable. As some of these securities are issued by public companies, the Company compares the estimates of fair value to the fair values of these companies’ publicly traded debt to test the validity of the internal pricing matrix.
On October 1, 2011, the Company entered into new reinsurance treaties with nonaffiliated reinsurers wherein it retains the first $0.5 million of each loss occurrence. The next $0.5 million of losses per occurrence (excess of the first $0.5 million of losses per occurrence retained by the Company) are 50% reinsured. The new reinsurance program, which is effective through September 30, 2012, provides coverage up to $75.0 million per loss occurrence. The following table summarizes the new program as well as the prior reinsurance that was in place from October 1, 2010 through September 30, 2011:
As of December 31, 2011, the Company’s current excess of loss reinsurance treaties were placed with the following reinsurers:
Effective January 1, 2012, the Company renewed its quota-share reinsurance agreement with a nonaffiliated reinsurer wherein it cedes 100% of its residual market business assumed from the National Council on Compensation Insurance (the “NCCI”) for policy years 2009, 2010, 2011 and 2012.
As part of the Agreement, LMC placed into trust (the “Trust”) $1.6 million, equal to 10% of the balance sheet reserves of SBIC at the date of the Acquisition. Thereafter, the Trust is adjusted each quarter, if warranted, to an amount equal to the greater of (a) $1.6 million or (b) 102% of LMC’s obligations under the Agreement. The balance of the Trust, including accumulated interest, was $3.1 and $3.8 million at December 31, 2011 and 2010, respectively.
The Company involuntarily assumes residual market business either directly from various states that operate their own residual market programs or indirectly from the National Council for Compensation Insurance, which operates residual market programs on behalf of some states. The states in which the Company assumed residual market business in 2011 and 2010 include the following: Alabama, Alaska, Arizona, Arkansas, Connecticut, Delaware, the District of Columbia, Georgia, Idaho, Illinois, Iowa, Kansas, Massachusetts, Michigan, Nevada, New Hampshire, New Jersey, New Mexico, North Carolina, Oregon, South Carolina, South Dakota, Vermont, Virginia and West Virginia.
Balances affected by reinsurance transactions are reported gross of reinsurance in the balance sheets. Reinsurance recoverables are comprised of the following amounts at December 31, 2011 and 2010:
The following table summarizes the Company’s top ten reinsurers, based on net amount recoverable, as of December 31, 2011:
The contingent profit commissions were recorded as reductions of loss and loss adjustment expenses. As of December 31, 2011, there were no ceded losses associated with the commuted layers and it is not expected that developed losses that would otherwise be covered by reinsurance will exceed the contingent profit commission.
The following table summarizes the activity in unpaid loss and loss adjustment expense for the years ended December 31, 2011, 2010 and 2009:
As a result of changes in estimates of insured events in prior periods, unpaid loss and loss adjustment expenses increased by a net amount of $32.0 million in 2010. Net adverse development of prior year loss reserves totaled $33.4 million and related to the following accident years: $14.0 million in 2009, $10.3 million in 2008, $5.6 million in 2007, $2.1 million in 2006, and $1.4 million in accident years 2005 and prior. The net adverse development on loss reserves was offset by $0.8 million of net favorable development of other amounts such as ULAE, loss based assessments and losses assumed from the NCCI pools, as well as a $0.6 million favorable commutation gain.
As a result of changes in estimates of insured events in prior periods, unpaid loss and loss adjustment expenses decreased by a net amount of $0.2 million in 2009. Adverse development of prior year loss reserves totaled $14.7 million and related to the following accident years: $8.8 million in 2008, $5.0 million in 2007, and $0.9 million in 2006. This adverse development was offset by $0.3 million of net favorable development of loss reserves related to accident years 2005 and prior. The net adverse development on loss reserves was offset by $14.0 million of net favorable development of other amounts such as ULAE, loss based assessments and losses assumed from the NCCI pools, as well as a $0.6 million favorable commutation gain. The $14.0 million related to the following accident years: $4.4 million in 2008, $3.7 million in 2007, $3.3 million in 2006, and $2.6 million in 2005 and prior.
At December 31, 2011 and 2010, the Company reduced unpaid loss and loss adjustment expense by $10.3 million and $10.2 million, respectively, for anticipated salvage and subrogation recoveries.
On May 26, 2004, SBIC issued in a private placement $12.0 million in subordinated floating rate Surplus Notes due in 2034. The note holder is ICONS, Ltd. and Wilmington Trust Company acts as Trustee. Interest, paid quarterly in arrears, is calculated at the beginning of the interest payment period using the 3-month LIBOR plus 400 basis points. The quarterly interest rate cannot exceed the initial interest rate by more than 10% per year, cannot exceed the corporate base (prime) rate by more than 2% and cannot exceed the highest rate permitted by New York law. The rate or amount of interest required to be paid in any quarter is also subject to limitations imposed by the Illinois Insurance Code. Interest amounts not paid as a result of these limitations become “Excess Interest,” which the Company may be required to pay in the future, subject to the same limitations and all other provisions of the Surplus Notes Indenture. To date, there has been no Excess Interest. The interest rates at December 31, 2011 and 2010 were 4.5% and 4.3%, respectively. Interest and principal may be paid only upon the prior approval of the Illinois Department of Insurance. In the event of default, as defined, or failure to pay interest due to lack of Illinois Department of Insurance approval, the Company cannot pay dividends on its capital stock, is limited in its ability to redeem, purchase or acquire any of its capital stock and cannot make payments of interest or principal on any debt issued by the Company which ranks equal with or junior to the Surplus Notes. If an event of default occurs and is continuing, the principal and accrued interest can become immediately due and payable. Interest expense for the years ended December 31, 2011, 2010, and 2009 was $0.5 million, $0.5 million, and $0.6 million, respectively.
Issuance costs of $591,000 incurred in connection with the Surplus Notes and included within other assets on the consolidated balance sheets are being amortized over the life of the notes using the effective interest method. Amortization expense for the years ended December 31, 2011, 2010, and 2009 was $26,000, $26,000 and $29,000, respectively.
The following is a reconciliation of the difference between the “expected” federal income tax computed by applying the statutory income tax rate of 35% to income (loss) before taxes and the actual total income taxes reflected on the books for the years ended December 31, 2011, 2010, and 2009:
As of December 31, 2011 and 2010, the Company had no unrecognized tax benefits, and the Company does not expect to have any unrecognized tax benefits in the next 12 months. The Company files consolidated U.S. federal and state income tax returns, as well as separate company state income tax returns. The tax years that remain subject to examination by the Internal Revenue Service are the years ended December 31, 2008, 2009, 2010 and 2011.
The maximum amount of dividends that can be paid to stockholders by insurance companies domiciled in the State of Illinois without prior approval of regulatory authorities is restricted if such dividend, together with other distributions during the 12 preceding months, would exceed the greater of 10% of the insurer’s statutory surplus as of the preceding December 31 or the statutorily adjusted net income for the preceding calendar year. If the limitation is exceeded, then such proposed dividend must be reported to the Illinois Department of Insurance at least 30 days prior to the proposed payment date and may be paid only if not disapproved. The Illinois insurance laws also permit payment of dividends only out of statutory earned surplus. At December 31, 2011, SBIC had statutory earned surplus of $96.5 million (unaudited). Consequently, SBIC would be able to pay up to $29.2 million of stockholder dividends in 2012 without the prior approval of regulators.
The Company leases certain office space for its headquarters and regional offices under agreements that are accounted for as operating leases. Lease expense totaled $3.5 million, $3.5 million and $3.4 million for the years ended December 31, 2011, 2010, and 2009, respectively. Total rent, including the effect of rent increases and concessions, is expensed on a straight-line basis over the respective lease terms.
As of December 31, 2011, future minimum payments required under the agreements were as follows:
a. SBIC is subject to guaranty fund and other assessments by the states in which it writes business. Guaranty fund assessments are accrued at the time premiums are written. Other assessments are accrued either at the time of assessment or in the case of premium-based assessments, at the time the premiums are written, or in the case of loss-based assessments, at the time the losses are incurred. As of December 31, 2011 and 2010, SBIC had accrued liabilities for guaranty fund and other assessments of $6.5 million and $6.2 million, respectively, and had recorded related assets for premium tax offset and policy surcharges of $5.1 million and $4.2 million as of those dates, 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 the Company’s share of the ultimate cost of current insolvencies. Most assessments are paid out in the year following the year in which the premium is written or the losses are paid. Guaranty fund receivables and other surcharge items are generally realized by a charge to new and renewing policyholders in the year following the year in which the related assessments were paid.
The unamortized balances of intangible assets, other than goodwill, consist of the following at December 31, 2011 and 2010:
If current difficult market conditions persist during 2012 or if the Company’s actions to limit risk associated with its products or investments causes a significant change in any one reporting unit’s fair value, subsequent reviews of goodwill could result in an impairment of goodwill during 2012 or later.
The assumptions used to calculate the fair value of options granted are evaluated and revised, as necessary, to reflect market conditions and the Company’s historical experience and future expectations. The calculated fair value is recognized as compensation cost in the Company’s financial statements over the requisite service period of the entire award. Compensation cost is recognized only for those options expected to vest, with forfeitures estimated at the date of grant and evaluated and adjusted over the requisite service period to reflect the Company’s historical experience and future expectations. Any change in the forfeiture assumption is accounted for as a change in estimate, with the cumulative effect of the change on periods previously reported being reflected in the financial statements of the period in which the change is made.
As of December 31, 2011, there were 462,014 shares of common stock available for issuance of future share-based awards. In accordance with the provisions of the 2005 Plan, the number of shares authorized for issuance under the 2005 Plan was automatically increased by 446,555 shares on January 1, 2012, resulting in 908,569 shares available for issuance as of that date. The following table presents additional information regarding options outstanding as of December 31, 2011:
The following table summarizes restricted stock activity for the years ended December 31, 2011 and 2010:
As of December 31, 2011, there was $5.3 million of total unrecognized compensation cost related to restricted stock granted under the 2005 Plan. That cost is expected to be recognized over a weighted-average period of 1.89 years.
The following table summarizes selected unaudited quarterly financial data for each quarter of the years ended December 31, 2011, 2010 and 2009.
Includes adjustment to reflect adverse development of prior years’ loss reserves. See Note 9, “Unpaid Loss and Loss Adjustment Expense”.