We market and sell our workers' compensation insurance products through independent local, regional and national agents and brokers, and through our strategic partnerships and alliances, including our principal partners ADP, Inc. and Anthem Blue Cross (Anthem).
On October 31, 2008, we acquired 100% of the outstanding common stock of AmCOMP Incorporated (AmCOMP) for $188.4 million (the Acquisition). Our results of operations for 2008 include the acquired operations of AmCOMP for the period November 1, 2008 through December 31, 2008.
Our goal is to maintain focus on disciplined underwriting and to continue to pursue profitable growth opportunities across market cycles; however, we continue to be affected by the impacts of the most recent economic recession. The pace of recovery remains uncertain and, although it appears to us that the declines in total employment and payroll may have leveled-off, we do not believe the situation will significantly improve in the near-term. In 2010, we reduced our expenses while maintaining and improving our ability to provide services to our customers. We believe that we will be positioned to grow our business when the economy and employment trends improve.
We measure our performance by our ability to increase stockholders’ equity, including the impact of the deferred reinsurance gain-LPT Agreement (Deferred Gain), over the long-term. Our stockholders’ equity, including the Deferred Gain, was $860.5 million, $887.0 million, and $851.3 million at December 31, 2010, 2009, and 2008, respectively. Stockholders’ equity, including the Deferred Gain, is a non-GAAP measure that is defined as total stockholders’ equity plus the deferred reinsurance gain-LPT Agreement, which we believe is an important supplemental measure of our capital position. Stockholders’ equity on a GAAP basis was $490.1 million, $498.4 million, and $444.7 million at December 31, 2010, 2009, and 2008, respectively.
Underwriting (loss) income is determined by deducting losses and LAE, commission expenses, dividends to policyholders, and underwriting and other operating expenses from net premiums earned. Our underwriting (loss) income was $(21.8) million, $8.0 million, and $46.4 million for the years ended December 31, 2010, 2009, and 2008, respectively. Investment income and realized gains (losses) on investments, along with our interest expense and income tax expense, further contribute to our net income.
The comparative components of net income are set forth in the following table for the years ended December 31:
The table below shows the reconciliation of net income to net income before impact of the deferred reinsurance gain-LPT Agreement for the years ended:
Net rate, defined as total premium in-force divided by total insured payroll exposure, is a function of a variety of factors, including rate changes, underwriting risk profiles and pricing, and changes in business mix related to economic and competitive pressures.
Approximately one-half of our business is generated in California, where we saw increased net rate on renewal business for 17 consecutive months, through August 2010. We continue to see a steady level of new business submittals and our policy count in California has increased 5.1% during the year ended December 31, 2010.
We set our own premium rates in California based upon actuarial analysis of current and anticipated loss trends with a goal of maintaining underwriting profitability. We reduced our filed premium rates in California from 2003 through 2008 due to favorable loss costs trends originating from the 2003 and 2004 legislative reforms. Due to increasing loss costs, primarily medical cost inflation, we have increased our filed premium rates by a cumulative 28.3% since February 1, 2009.
As we continue to execute our growth strategy, we have increased our network of independent insurance agencies by approximately 14% in 2010 and continue to deploy our technology to make it easier for agents to do business with us. While the effects of the recession have resulted in lower total in-force payroll exposure and average policy size, we increased our in-force policy count by 0.9% in 2010, including a 2.4% increase during the fourth quarter.
We invest our holding company assets, statutory surplus, and the funds supporting our insurance liabilities, including unearned premiums and unpaid losses and LAE. We invest in fixed maturity securities, equity securities, short-term investments, and cash equivalents. Net investment income includes interest and dividends earned on our invested assets and amortization of premiums and discounts on our fixed maturity securities, less bank service charges and custodial and portfolio management fees.
Net investment income decreased $7.5 million for the year ended December 31, 2010, compared to the same period of 2009, but increased $12.4 million in 2009, compared to 2008. The decrease in 2010 was primarily related to a 1.4% decrease in average invested assets for the year. This decrease in our average invested assets was primarily due to repayment of debt and the return of capital to stockholders through share repurchases and stockholder dividends. The increase in net investment income for the year ended 2009, compared to the same period of 2008, was related to a 17.0% increase in average invested assets year-over-year. The average pre-tax book yield on invested assets was 4.2%, 4.5%, and 4.2% at December 31, 2010, 2009, and 2008, respectively. The tax-equivalent yield on invested assets was 5.3%, 5.6%, and 5.5% at December 31, 2010, 2009, and 2008, respectively.
Realized gains and losses on our investments are reported separately from our net investment income. Realized gains and losses on investments include the gain or loss on a security at the time of sale compared to its original cost (equity securities) or amortized cost (fixed maturity securities). Realized losses are recognized when securities are written down as a result of an other-than-temporary impairment.
Realized gains on investments increased $9.3 million, for the year ended December 31, 2010, compared to the same period of 2009. We evaluated our portfolio allocation during the fourth quarter of 2010 and elected to shift $20.0 million of our equity securities into a high dividend yield portfolio, which resulted in a $9.2 million gain. In 2008, we had realized losses on investments of $11.5 million. The realized losses for 2008 were the result of other-than-temporary impairments on equity securities and sales of impaired fixed maturity securities in our investment portfolio.
The combined ratio, expressed as a percentage, is a key measurement of underwriting profitability. The combined ratio is the sum of the losses and LAE ratio, the commission expense ratio, dividends to policyholders’ ratio, and underwriting and other operating expenses ratio. When the combined ratio is below 100%, we have recorded underwriting income, and conversely, when the combined ratio is greater than 100%, we cannot be profitable without investment income. Because we only have one operating segment, holding company expenses are included in our calculation of the combined ratio.
We analyze our losses and LAE ratios on both a calendar year and accident year basis. A calendar year losses and LAE ratio is calculated by dividing the losses and LAE incurred during the calendar year, regardless of when the underlying insured event occurred, by the net premiums earned during that calendar year. The calendar year losses and LAE ratio includes changes made during the calendar year in reserves for losses and LAE established for insured events occurring in the current and prior years. A calendar year losses and LAE ratio is calculated using premiums and losses and LAE that are net of amounts ceded to reinsurers.
The accident year losses and LAE ratio, or losses and LAE for insured events that occurred during a particular year divided by the premiums earned for the year, is calculated by dividing the losses and LAE, regardless of when such losses and LAE are incurred, for insured events that occurred during a particular year by the net premiums earned for that year. The accident year losses and LAE ratio is calculated using premiums and losses and LAE that are net of amounts ceded to reinsurers. The accident year losses and LAE ratio for a particular year can decrease or increase when recalculated in subsequent periods as the reserves established for insured events occurring during that year develop favorably or unfavorably; and is an operating ratio based on our statutory financial statements and is not derived from our GAAP financial information. The calendar year losses and LAE ratio for a particular year will not change in future periods.
Losses and LAE expense represents our largest expense item and includes claim payments made, amortization of the LPT deferred gain, estimates for future claim payments, and changes in those estimates for current and prior periods, and costs associated with investigating, defending and adjusting claims. The quality of our financial reporting depends in large part on accurately predicting our losses and LAE, which are inherently uncertain as they are estimates of the ultimate cost of individual claims based on actuarial estimation techniques.
The $77.9 million increase in losses and LAE for the year ended December 31, 2009, compared to the same period of 2008, was primarily attributable to the Acquisition, partially offset by a change in overall payroll exposures, which reduced losses and LAE by approximately $51.9 million. Our current accident year loss estimates were 70.9%, 70.2%, and 68.9% for the years ended December 31, 2010, 2009, and 2008, respectively.
Prior accident year favorable development, net, excludes a $1.6 million expense related to the commutation of certain reinsurance treaties and a $0.9 million expense related to the write-off of certain reinsurance recoverables, which are included in losses and LAE for the year ended December 31, 2010.
Excluding the impact from the LPT Agreement, losses and LAE would have been $213.0 million, $232.5 million, and $154.9 million, or 66.2%, 57.5%, and 47.1%, of net premiums earned for the year ended December 31, 2010, 2009, and 2008, respectively.
Underwriting and other operating expenses are those costs that we incur to underwrite and maintain the insurance policies we issue, excluding commission. These expenses include premium taxes and certain other general expenses that vary with, and are primarily related to, producing new or renewal business. Other underwriting expenses include changes in estimates of future write-offs of premiums receivable, general administrative expenses such as salaries and benefits, rent, office supplies, depreciation, and all other operating expenses not otherwise classified separately. Policy acquisition costs are variable based on premiums earned; however, other operating costs are more fixed in nature and become a larger percentage of net premiums earned as premiums decline.
In July 2010, we announced the reorganization of our operations to eliminate duplicative services and better align resources with business activity and growth opportunities. We combined our four regional operating units into two units, Eastern and Western, with the Strategic Partnerships and Alliances unit remaining structurally unchanged. In connection with these efforts and with general cost control efforts, we eliminated approximately 160 positions. These changes to our workforce were substantially completed in the third quarter of 2010. Facility closures associated with this reorganization were completed in the second half of 2010. In conjunction with this reorganization, we recorded restructuring charges of $5.2 million in 2010, including $3.0 million related to workforce reductions and $2.2 million related to leases for facilities that were vacated during the year.
Underwriting and other operating expenses decreased 23.6% for the year ended December 31, 2010, compared to the same period of 2009, including restructuring items for both years. We incurred charges of $6.1 million in the year ended December 31, 2010, including $3.9 million related to workforce reductions and $2.2 million related to leases for facilities that were vacated. This compared to integration and restructuring charges of $5.7 million for the same period of 2009 related to the Acquisition. Excluding these restructuring charges, underwriting and other operating expenses decreased $33.1 million, or 24.9%, for the year ended December 31, 2010, compared to the same period of 2009. The decrease reflects efforts to manage our expenses during a period of declining premiums. During the year ended December 31, 2010 information technology expenses declined $3.5 million and compensation expenses declined $16.5 million, compared to the same period of 2009. Additionally, there was a $5.8 million decrease in premium taxes and a $3.6 million decrease in bad debt expense.
Commission expense includes direct commissions to our agents and brokers for the premiums that they produce for us, as well as incentive payments, other marketing costs, and fees. Additionally, we are entitled to receive a contingent profit commission under the LPT Agreement. The contingent profit is an amount based on the favorable difference between actual paid losses and LAE and expected paid losses and LAE under the LPT Agreement. Loss expenses are deemed to be 7% of total losses paid and are paid to us as compensation for management of the LPT claims. The calculation of actual amounts paid versus expected amounts is determined every five years beginning June 30, 2004 for the first twenty-five years of the agreement. The reinsurers pay us 30% of any favorable difference between the actual and expected amounts paid at each calculation point. Conversely, we could be required to return any previously paid contingent profit commission, plus interest, in the event of unfavorable differences.
estimate of certain administrative fees due Anthem under our joint marketing agreements, which decreased the commission expense in the fourth quarter of 2010. The decrease in 2009, compared to 2008, of $7.5 million, or 17.1%, was primarily attributable to a $15.0 million increase in the LPT contingent profit commission, partially offset by increased commission expense from our acquired subsidiaries. Excluding the impact of the LPT contingent profit commission, the re-negotiated reinsurance agreement, and the change in accrual for fees due Anthem, commission expense would have been 12.6%, 12.7%, and 13.3% of net premiums earned for the years ended December 31, 2010, 2009, and 2008, respectively.
Dividends to Policyholders Ratio. The dividends to policyholders ratio is the ratio (expressed as a percentage) of dividends to policyholders expense to net premiums earned and measures the cost of returning premium to policyholders in the form of dividends.
In administered pricing states such as Florida and Wisconsin, insurance rates are set by state insurance regulators. Rate competition generally is not permitted and policyholder dividend programs are an important competitive factor in these states. We offer dividend programs to eligible policyholders, under which a portion of the policyholders’ premium may be returned in the form of a dividend.
Florida statutes also require the return of the portion of policyholders’ premiums that are deemed to be excessive profits under Florida law. We account for these payments as dividends to policyholders.
Income tax expense decreased $5.8 million for the year ended December 31, 2010, compared to the same period of 2009. Similarly, income taxes decreased $1.0 million for the year ended December 31, 2009, compared to the same period of 2008. The effective tax rates for the years ended December 31, 2010, 2009, and 2008 were 5.3%, 10.1%, and 9.2%, respectively. Tax exempt income as a percentage of pre-tax income was 50.6%, 36.8%, and 27.7% for the years ended December 31, 2010, 2009, and 2008, respectively. The increase in tax exempt income in 2010, as a percentage of pre-tax income, was primarily due to a $28.9 million decrease in pre-tax income, partially offset by the $15.0 million LPT contingent profit commission in 2009, which was not subject to tax.
The increase in the effective tax rate in 2009, compared to 2008, was primarily the result of transactions that decreased 2008 income taxes related to the final reversal of the liability for previously unrecognized tax benefits in the amount of $10.6 million, including interest, and the reduction of tax-exempt reserves in the amount of $5.2 million. These comparative increases were largely offset by a $19.8 million decrease in 2009 pre-tax income, the impact of tax-exempt investment income and the LPT contingent profit commission of $15.0 million, which is not subject to tax.
Operating Cash and Short-Term Investments. We are a holding company and our ability to fund our operations is contingent upon our insurance subsidiaries’ and their ability to pay dividends to the holding company. Payment of dividends by our insurance subsidiaries is restricted by state insurance laws, including laws establishing minimum solvency and liquidity thresholds. We require cash to pay stockholder dividends, repurchase common stock, make interest and principal payments on our outstanding debt obligations, fund our operating expenses, and support our growth strategy.
During 2010, EICN and EPIC paid dividends of $100.3 million and $14.9 million, respectively, to Employers Group, Inc. (EGI), their immediate holding company, and subsequently from EGI to EHI. These amounts represented the maximum dividends that could be paid without prior approval by the respective state insurance regulator.
Outstanding Debt. We entered into the Second Amended and Restated Secured Credit Facility with Wells Fargo (Existing Credit Facility), in September 2008, under which we borrowed $150.0 million. The Existing Credit Facility provided us with: (a) $150.0 million line of credit through December 31, 2009; (b) $100.0 million line of credit from January 1, 2010 through December 31, 2010; and (c) $50.0 million line of credit from January 1, 2011 through March 26, 2011. Amounts outstanding bore interest at a rate equal to, at our option: (a) a fluctuating rate of 1.25% above prime rate or (b) a fixed rate that is 1.25% above the LIBOR rate then in effect.
In accordance with the terms of the contract, we repaid $50.0 million of the line of credit provided by the Amended Credit Facility on December 30, 2009. In connection with the borrowing, we had entered into an interest rate swap agreement for an interest rate of 4.84% on the notional amount of $100.0 million, which expired on September 30, 2010.
On December 28, 2010, we entered into the Third Amended and Restated Credit Agreement with Wells Fargo (Amended Credit Facility) under which we are provided with: (a) $100.0 million line of credit through December 31, 2011; (b) $90.0 million line of credit from January 1, 2012 through December 31, 2012; (c) $80.0 million line of credit from January 1, 2013 through December 31, 2013; (d) $70 million line of credit from January 1, 2014 through December 31, 2014; and (e) $60 million line of credit from January 1, 2015 through December 31, 2015. Amounts outstanding bear interest at a rate equal to, at our option: (a) a fluctuating rate of 1.75% above prime rate or (b) a fixed rate that is 1.75% above the LIBOR rate then in effect. The Amended Credit Facility is secured by fixed maturity securities and cash and cash equivalents that had a fair value of $129.0 million and $2.0 million of restricted cash and cash equivalents at December 31, 2010. The Amended Credit Facility contains customary non-financial covenants and requires us to maintain $5.0 million of cash and cash equivalents at all times at the holding company. We are currently in compliance with all applicable covenants.
Our total outstanding debt was $132.0 million as of December 31, 2010 and 2009. Interest and fees on debt obligations totaled $5.7 million in 2010, down $1.7 million from 2009.
Our capital structure is comprised of outstanding debt and stockholders’ equity. As of December 31, 2010, our capital structure consisted of $100.0 million principal balance on our Amended Credit Facility, $32.0 million in surplus notes maturing in 2034, and $860.5 million of stockholders’ equity, including the deferred reinsurance gain-LPT Agreement. Outstanding debt was 13.3% of total capitalization, including the deferred reinsurance gain-LPT Agreement, as of December 31, 2010.
Operating Cash and Short-Term Investments. The primary sources of cash for our insurance operating subsidiaries are funds generated from underwriting operations, investment income, and maturities of investments. The primary uses of cash are payments of claims and operating expenses, purchases of investments, and payments of dividends to the parent holding company, which are subject to state insurance laws and regulations.
We purchase reinsurance to protect us against the costs of severe claims and catastrophic events. On July 1, 2010, we entered into a new reinsurance program that is effective through June 30, 2011. The reinsurance program consists of one treaty covering excess of loss and catastrophic loss events in five layers of coverage. Our reinsurance coverage is $195.0 million in excess of our $5.0 million retention on a per occurrence basis, subject to a $2.0 million annual aggregate deductible and certain exclusions. We believe that our reinsurance program meets our needs and that we are sufficiently capitalized for the above described retention.
Various state regulations require us to keep securities or letters of credit on deposit with the states in which we do business in depository accounts. Securities having a fair market value of $558.6 million and $554.2 million were on deposit at December 31, 2010 and 2009, respectively. These laws and regulations govern both the amount and type of fixed maturity security that is eligible for deposit. Additionally, certain reinsurance contracts require Company funds to be held in trust for the benefit of the ceding reinsurer to secure the outstanding liabilities we assumed. The fair value of securities held in trust for reinsurance at December 31, 2010 and 2009 was $52.9 million and $6.1 million, respectively.
In the fourth quarter of 2010, we re-negotiated the terms of a reinsurance agreement with Clarendon National Insurance Company (Clarendon), resulting in the release and return of funds held by Clarendon to us in the amount of $74.6 million. We placed $47.1 million in trust for the benefit of Clarendon to support liabilities under the reinsurance agreement and invested the remaining $27.5 million.
Net cash provided by operating activities increased $16.2 million for the year ended December 31, 2010, compared to the same period of 2009.
decreased funds held of $72.8 million, including the release of funds held by Clarendon;
Net cash used in investing activities was $56.3 million in 2010, compared to cash provided of $86.0 million in 2009. In 2008, we had $135.2 million of net cash used by investing activities. The difference in 2010, compared to 2009, was primarily due to the reinvestment of funds from maturities and redemptions in 2010. The difference in 2009, compared to 2008, was primarily due to the purchase of AmCOMP for $188.4 million in 2008. We also used proceeds from maturities and redemptions of investments primarily for the repurchase of our common stock in 2009 and 2008.
The amortized cost of our investment portfolio was $1.95 billion and the fair value was $2.08 billion as of December 31, 2010.
As of December 31, 2010, our investment portfolio, which is classified as available-for-sale, consisted of 96.1% fixed maturity securities whose fair values may fluctuate. We strive to limit interest rate risk by managing the duration of our fixed maturity securities. Our fixed maturity securities (excluding cash and cash equivalents) had a duration of 4.91 at December 31, 2010. To minimize interest rate risk, our portfolio is weighted toward short-term and intermediate-term bonds; however, our investment strategy balances consideration of duration, yield and credit risk. Our investment guidelines require that the minimum weighted average quality of our fixed maturity securities portfolio shall be “AA”. As of December 31, 2010, our fixed maturity securities portfolio had an average quality of “AA” using ratings assigned by Standard & Poor’s with approximately 73.3% of the market value rated “AA” or better.
Given the economic uncertainty and continued market volatility, we believe our asset allocation best meets our strategy to preserve capital for policyholders, to provide sufficient income to support insurance operations, and to effectively grow book value over a long-term investment horizon.
The following table shows the fair value, the percentage of the fair value to total invested assets and the tax equivalent yield based on the fair value of each category of invested assets as of December 31, 2010:
For the year ended December 31, 2009, we recognized an impairment of $1.9 million in the fair value of equity securities in our investment portfolio. The impairment was recognized as a result of the severity and duration of the decline in the market values of these securities primarily due to market conditions. We determined that the remaining unrealized losses on equity securities were not considered to be other-than-temporary due to the financial condition and the near term prospects of the issuers. None of our fixed maturity securities were impaired in 2009. Based on our review of fixed maturity and equity securities, we believe that we have appropriately identified the declines in the fair values of our unrealized losses at December 31, 2010 and 2009.
The amortized cost, gross unrealized gains, gross unrealized losses, and estimated fair value of our investments were as follows:
Net investment income was as follows for the years ended December 31:
The following table identifies our long-term debt and contractual obligations as of December 31, 2010.
Estimated losses and LAE reserve payment patterns have been computed based on historical information. Our calculation of loss and LAE reserve payments 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 ‘‘-Critical Accounting Policies-Reserves for Losses and Loss Adjustment Expenses.’’ Actual payments of losses and LAE by period will vary, perhaps materially, from the above table to the extent that current estimates of losses and LAE reserves vary from actual ultimate claims amounts due to variations between expected and actual payout patterns.
The amount by which estimated losses in the aggregate, measured subsequently by reference to payments and additional estimates, differ from those previously estimated for a specific time period is known as reserve “development.” Reserve
When losses are reported to us, we establish, individually, estimates of the ultimate cost of the claims (case reserves). These case reserves are continually monitored and revised in response to new information and for amounts paid.
IBNR is an actuarial estimate of future payments on claims that have occurred but have not yet been reported to us. In addition to this provision for late reported claims, we also estimate, and make a provision for, the extent to which the case reserves on known claims may develop and for additional payments on closed claims, known as “reopening.” IBNR reserves apply to the entire body of claims arising from a specific time period, rather than a specific claim.
Our reserve for unpaid losses and LAE (gross and net of reinsurance), including the main components of such reserves, were as follows as of December 31:
Prior to this change, the Consulting Actuary based its point estimate for EICN strictly on the basis of paid loss development methods. Beginning in 2009, our new Consulting Actuary determined its point estimate for EICN based on a combination of methodologies, similar to those utilized for our other insurance subsidiaries, as described below. While such a determination, based on a combination of methodologies is valid, this change in methodologies prevents any direct year over year comparison of the Consulting Actuaries’ point estimates. The new Consulting Actuary has provided us with a separate calculation for EICN that is based strictly on the historically utilized paid loss methods for 2010 and 2009. This calculation in combination with the new Consulting Actuary’s point estimate for our other insurance subsidiaries allows for comparability of our overall carried reserves, relative to the previous Consulting Actuary’s calculations. Management believes that using strictly paid loss methods for Nevada losses is the preferred approach given our depth of knowledge of Nevada losses and the consistency of paid data over time resulting from and related to the statutory prohibition of entering into full and final settlements of Nevada claims.
Each actuarial methodology requires the selection and application of various parameters and assumptions. The key parameters and assumptions include: the pattern with which our aggregate claims data will be paid or will emerge over time; claims cost inflation rates; the effects of legislative benefit changes and/or judicial changes; and trends in the frequency of claims, both overall and by severity of claim. We believe the pattern with which our aggregate claims data will be paid or emerge over time and claims cost inflation rates are the most important parimeters and assumptions.
In Nevada, one method involves adjusting historical data for inflation. The inflation rates used in the analysis are judgmentally selected based on historical year-to-year movements in the cost of claims observed in our insurance subsidiaries’ data and industry-wide data, as well as on broader inflation indices. The results of this method would differ if different inflation rates were selected.
In projections using December 31, 2010 data, the method that uses explicit medical cost inflation assumptions included medical cost inflation assumptions ranging from 5.5% to 7.5%. The selection of medical cost inflation assumptions used has been based on observed recent and longer-term historical medical cost inflation in our claims data and in the U.S. economy more generally. The rate of medical cost inflation, as reflected in our historical medical payments per claim, has averaged approximately 5.5% over the past ten years. The rate of medical cost inflation in the general U.S. economy, as measured by the consumer price index-medical care, has averaged approximately 4.1% over the past ten years.
The range of estimates of loss reserves produced by the Consulting Actuary is intended to represent the range in which it is most likely that the ultimate losses will fall. This range is narrower than the range of indications produced by the individual methods applied because it is not likely that the high or low result will emerge for every claim segment and accident year. The Consulting Actuary’s point estimate of loss reserves is based on a judgmental selection for each claim segment from within the range of results indicated by the different actuarial methods.
Management formally establishes loss reserves for financial statement purposes on a quarterly basis. In doing so, we make reference to the most current analyses of our Consulting Actuary, including a review of the assumptions and the results of the various actuarial methods used. Comprehensive studies are conducted as of June 30 and December 31 by both internal actuarial staff and the Consulting Actuary. On the alternate quarters, the preceding study results are updated for actual claim payment activity during the quarter.
The table below provides the actuarial range of estimated liabilities for net unpaid losses and LAE and our carried reserves as of December 31:
Each of the actuarial methods used in the analysis and estimation of loss reserves depend in part on the selection of an expected pattern with which the aggregate claims data will be paid or will emerge over time, and the assumption that this expected pattern will prevail into the future. We select relevant patterns as part of the periodic review and projection of unpaid losses and LAE. In selecting these patterns, we examine long and short-term historical data for our insurance subsidiaries, benchmarks based on industry data, and forecasts made by industry rating bureaus regarding the effect of legislative benefit changes on these patterns.
The following table reconciles the beginning and ending loss reserves as of December 31:
As of December 31, 2010, California and Nevada represented approximately 78% of our reserves for unpaid losses and LAE on our consolidated balance sheet.
More than 57% of our claims payments during the three years ended December 31, 2010 related to medical care for injured workers. The utilization and cost of medical services in the future is a significant source of uncertainty in the establishment of loss reserves for workers' compensation. Our loss reserves are established based on reviewing the results of actuarial methods, some of which do not contain explicit medical claim cost inflation rates, however, because medical care may be provided to an injured worker over many years, and in some cases decades, the pace of medical claim cost inflation has a significant impact on our ultimate claim payments. For example, if the rate of medical claim cost inflation increases by 1% above the inflation rate that is implicitly included in the loss reserves at December 31, 2010, we estimate that future medical costs over the lifetime of current claims would increase by approximately $79 million on a net-of-reinsurance basis.
Actual losses are affected by a more complex combination of forces and dynamics than any one model or actuarial methodology can represent; and each methodology is an approximation of these complex forces and dynamics. None of the methods are designed or intended to produce an indication that is systematically higher or lower than the other methods. At any given evaluation date, some of the actuarial projection methods produce indications outside the Consulting Actuary’s selected range. Accordingly, we believe that the range of potential outcomes is considerably wider than the actuarially estimated range of the most likely outcomes. We have decreased our prior years' reserves for unpaid losses and LAE $14.1 million, $51.4 million, and $71.7 million as of December 31, 2010, 2009, and 2008, respectively,
Reinsurance recoverables represent: (a) amounts currently due from reinsurers on paid losses and LAE; (b) amounts recoverable from reinsurers on case basis estimates of reported losses; and (c) amounts recoverable from reinsurers on actuarial estimates of IBNR for losses and LAE. These recoverables are based on our current estimates of the underlying losses and LAE, and are reported on our consolidated balance sheets separately as assets, as reinsurance does not relieve us of our legal liability to policyholders. We bear credit risk with respect to the reinsurers, which can be significant considering that some of the unpaid losses and LAE remain outstanding for an extended period of time. Reinsurers may refuse or fail to pay losses that we cede to them, or they might delay payment. We are required to pay losses even if a reinsurer refuses or fails to meet its obligations under the applicable reinsurance agreement. We continually monitor the financial condition and rating agency ratings of our reinsurers. No material amounts due from reinsurers have been written-off as uncollectible since our inception in 2000; and we believe that amounts currently reflected in our consolidated financial statements will similarly not require any material prospective adjustment.
Under the LPT Agreement, the Fund initially ceded $1.525 billion in liabilities for the incurred but unpaid losses and LAE related to claims incurred prior to July 1, 1995, for consideration of $775 million in cash. The estimated remaining liabilities subject to the LPT Agreement were $846.7 million as of December 31, 2010. Losses and LAE paid with respect to the LPT Agreement totaled $530.7 million at December 31, 2010. We account for the LPT Agreement as retroactive reinsurance. Entry into the LPT Agreement resulted in a deferred reinsurance gain that was recorded on our consolidated balance sheet as a liability. This deferred gain is being amortized using the recovery method, whereby the amortization is determined by the proportion of actual reinsurance recoveries to total estimated recoveries, and the amortization is reflected in losses and LAE. In addition, we are entitled to receive a contingent commission under the LPT Agreement. Changes in the estimated contingent commission are reflected in our commission expense in the period that the estimate is revised.
Premium revenue is recognized over the period of the contract in proportion to the amount of insurance protection provided. At the end of the policy term, payroll-based premium audits are performed on substantially all policyholder accounts to determine net premiums earned for the policy year. Earned but unbilled premiums include estimated future audit premiums based on our historical experience. These estimates are subject to changes in policyholders' payrolls, economic conditions, and seasonality; and are continually reviewed and adjusted as experience develops or new information becomes known. Any such adjustments are included in current operations. No material adjustments have been made to our accrual for earned but unbilled premium since our inception in 2000. Although considerable variability is inherent in such estimates, we believe that amounts currently reflected in our consolidated financial statements will similarly not require any material prospective adjustment.
Our accounting for income taxes considers the current and deferred tax consequences of all transactions that have been recognized in the financial statements using the provisions of enacted tax laws. Deferred tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The effect on deferred tax assets and liabilities resulting from a tax rate change affects our net income or loss in the period that includes the enactment date of the tax rate change. Our income tax returns are subject to audit by the Internal Revenue Service and various state tax authorities. Significant disputes may arise with these tax authorities involving issues of the timing and amount of deductions and allocations of income among various tax jurisdictions because of differing interpretations of tax laws and regulations. We periodically evaluate our exposures associated with tax filing positions. Although we believe our positions comply with applicable laws, we record liabilities based upon estimates of the ultimate outcomes of these matters.
that it is not more likely than not that we will not be required to sell the securities until its fair value recovers above cost, or to maturity;
Audited Financial Statements as of December 31, 2010 and 2009 and for each of the three years in the period ended December 31, 2010:
Consolidated Statements of Income for each of the three years ended December 31, 2010
Consolidated Statements of Cash Flows for each of the three years ended December 31, 2010
The Company’s internal control over financial reporting includes policies and procedures that: (a) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the Company’s assets; (b) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that receipts and expenditures of the Company are being made only in accordance with authorizations of its management and Board of Directors; and (c) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.
Based on this assessment, management did not identify any material weaknesses in the internal control over financial reporting and management has concluded that the Company’s internal control over financial reporting was effective as of December 31, 2010.
We have audited Employers Holdings, Inc. and Subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Company’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.
We have audited the accompanying consolidated balance sheets of Employers Holdings, Inc. and Subsidiaries (the Company) as of December 31, 2010 and 2009, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2010. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Employers Holdings, Inc. and Subsidiaries at December 31, 2010 and 2009, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
Investments with remaining maturities of one year or less at the time of acquisition are classified as short-term investments. The Company’s investments in fixed maturity securities, equity securities, and short-term investments are classified as available-for-sale and are reported at fair value with unrealized gains and losses excluded from earnings and reported as a separate component of equity, net of deferred taxes, in accumulated other comprehensive income, net.
A premium deficiency is recognized if the sum of expected claims costs, claims adjustment expenses, expected dividends to policyholders, unamortized acquisition costs, and policy maintenance costs exceed the related unearned premiums and future investment income from related in-force policies. A premium deficiency would first be recognized by charging any unamortized acquisition costs to expense to the extent required to eliminate the deficiency. If the premium deficiency was greater than unamortized acquisition costs, a liability would be accrued for the excess deficiency. There was no premium deficiency at December 31, 2010 or 2009.
Loss and LAE reserves represent management’s best estimate of the ultimate net cost of all reported and unreported losses incurred for the applicable periods. The estimated reserves for losses and LAE include the accumulation of estimates for all claims reported prior to the balance sheet date, estimates (based on projections of relevant historical data) of claims incurred but not reported, and estimates of expenses for investigating and adjusting all incurred and unadjusted claims. Amounts reported are necessarily subject to the impact of future changes in economic, regulatory and social conditions. Management believes that, subject to the inherent variability in any such estimate, the reserves are within a reasonable and acceptable range of adequacy. Estimates for claims reported prior to the balance sheet date are continually monitored and reviewed, and as settlements are made or reserves adjusted, the differences are reported in current operations. Salvage and subrogation recoveries are estimated based on a review of the level of historical salvage and subrogation recoveries.
Net premiums earned and losses and LAE incurred are stated in the accompanying consolidated statements of income after deduction of amounts ceded to reinsurers. Balances due from reinsurers on unpaid losses, including an estimate of such recoverables related to reserves for incurred but not reported losses, are reported as assets and are included in reinsurance recoverables even though amounts due on unpaid losses and LAE are not recoverable from the reinsurer until such losses are paid. Recoverables from reinsurers on unpaid losses and LAE amounted to $1.0 billion and $1.1 billion at December 31, 2010 and 2009, respectively.
In addition, the Company is entitled to receive a contingent profit commission under the LPT Agreement. The contingent profit is an amount based on the favorable difference between actual paid losses and LAE and expected paid losses and LAE as established in the LPT Agreement. The calculation of actual amounts paid versus expected amounts is determined every five years beginning June 30, 2004 for the first twenty-five years of the agreement. The Company is paid 30% of the favorable difference between the actual and expected losses and LAE paid at each calculation point.
The Company accrues the estimated ultimate contingent profit commission through June 30, 2024. Increases or decreases in the estimated contingent profit commission are reflected in commission expense in the period that the estimate is revised.
Certain policyholders have entered into agreements that provide the opportunity for dividends. Dividends are accrued on such policies based on specific dividend contract provisions and the policies’ earned premiums and loss ratios. Additionally, dividend agreements also allow the Company to reduce the amount to be paid at the Company’s discretion, based on the overall profitability. Should management choose to reduce the ultimate dividends to be paid, once the amount of the total dividend that will be paid for a policy year is determined, the dividend accrued would be reduced to the level determined by the Company. The reduced dividend amount would be allocated ratably to the participating policies, based on the dividend amount calculated prior to the reduction. Approximately 5.2%, 9.6%, and 2.6% of direct written premiums were subject to dividend participation during the years ended December 31, 2010, 2009, and 2008,
Derivatives. The fair value of the Company’s interest rate swap was derived by using an industry standard swap valuation model, with market based inputs for swaps having similar characteristics (see Note 12). The fair value, reported as a component of other liabilities in the accompanying consolidated balance sheets, equals the carrying amount.
The Company acquired intangible assets in the acquisition of AmCOMP (see Note 4) comprised of state licenses, insurance relationships and other intangible assets. The intangible assets related to state licenses are not subject to amortization, and the remaining intangibles are being amortized over an eight year period.
The Company issues stock-based payments, which are recognized in the consolidated statements of income based on their fair values over the employees’ service period (see Note 15).
Net income for the years ended December 31, 2010 and 2009, presented in the accompanying consolidated statements of income, includes the results of AmCOMP for the full year. The unaudited financial information in the table below summarizes the combined results of operations of EHI and AmCOMP, on a pro forma basis, as though the companies had been combined as of the beginning of the period presented. The unaudited pro forma financial information is presented for informational purposes only and is not indicative of the results that would have been achieved if the Acquisition had taken place at the beginning of the period presented, nor is the pro forma information intended to be indicative of the Company’s future results of operations.
Level 1 - Valuations based on unadjusted quoted market prices for identical assets or liabilities in active markets. The Company uses the quoted market prices as fair value and includes these prices in the amounts disclosed in Level 1 of the hierarchy.
Level 2 - Valuations based on observable inputs (other than Level 1 prices), such as quoted prices for similar assets or liabilities at the measurement date; quoted prices in inactive markets; or other inputs that are observable, either directly or indirectly. When quoted market prices are unavailable, the Company estimates fair value based on objectively verifiable information, if available, and these estimates are included in the amount disclosed in Level 2 of the hierarchy.
Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement and involve management judgment. The fair value of certain privately held or thinly traded securities is determined using internal analytical methods based on the best information available.
Derivatives. The fair value of the Company’s interest rate swap, reported as a component of other liabilities in the accompanying 2009 consolidated balance sheet, was derived by using an industry standard swap valuation model, with market-based inputs for swaps having similar characteristics (see Note 12).
Most estimates of fair value for fixed maturities are based on estimates using objectively verifiable information and are included in the amount disclosed in Level 2 of the hierarchy. The fair value estimates for determining Level 3 fair value include the Company’s assumptions about risk assessments and market participant assumptions based on the best information available, including quotes from market makers and other broker/dealers recognized as market participants, using standard or trade derived inputs, new issue data, monthly payment information, cash flow generation, prepayment speeds, spread adjustments, or rating updates.
The amortized cost and estimated fair value of fixed maturity securities at December 31, 2010, by contractual maturity, are shown below. Expected maturities differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The following is a summary of investments that have been in a continuous unrealized loss position for less than 12 months and those that have been in a continuous unrealized loss position for 12 months or greater, in each case as of December 31, 2010 and December 31, 2009:
Based on reviews of the equity securities as of December 31, 2010, the Company determined that the unrealized losses as of that date were not considered to be other-than-temporary due to the financial condition and near term prospects of the issuers. Based on reviews of the equity securities as of December 31, 2009, the Company recognized total impairments of $1.9 million in the fair values of 26 equity securities as of that date because of the severity and duration of the change in fair values of those securities.
Depreciation and amortization expenses related to property and equipment for the years ended December 31, 2010, 2009 and 2008, were $4.8 million, $6.9 million, and $6.5 million, respectively. Internally developed software costs of $0.1 million and $0.7 million were capitalized during the years ended December 31, 2010 and 2009, respectively.
The difference between the statutory federal tax rate of 35% and the Company’s effective tax rate on net income before income taxes as reflected in the consolidated statements of income was as follows:
For the years ended December 31, 2010 and 2009, the Company increased the estimated ultimate contingent profit commission related to the LPT Agreement by $0.8 million and $15.0 million, respectively. Such increases to the estimated ultimate contingent profit commission increases GAAP net income but does not increase taxable income. There was no change to the estimate during the year ended December 31, 2008.
The following table represents a reconciliation of changes in the liability for unpaid losses and LAE for the years ended:
Estimates of incurred losses and LAE attributable to insured events of prior years have decreased due to continued favorable development in such prior accident years.
In California, where the Company’s operations began on July 1, 2002, the actuaries’ and management’s initial expectations of the ultimate level of its losses and patterns of loss emergence and payment were based on benchmarks derived from analyses of historical insurance industry data in California. No historical data from the Company’s California insurance subsidiary existed prior to July 1, 2002; however, some historical data was available for the prior years for some of the market segments the Company entered in California, but was limited as to the number of loss reserve evaluation points available. The industry-based benchmarks were judgmentally adjusted for the anticipated impact of significant environmental changes, specifically the enactment of major changes to the statutory workers’ compensation benefit structure and the manner in which claims are administered and adjudicated in California. The actual emergence and payment of claims by the Company’s California insurance subsidiary has been more favorable than those initial expectations, due at least in part to the enactment of the major changes in the California workers’ compensation environment. Other insurance companies writing workers’ compensation insurance in California also have experienced claims emergence and payment patterns more favorable than anticipated following the enactment of legislative changes.
In Nevada, the Company has compiled a lengthy history of workers’ compensation claims payment patterns based on the business of the Fund and EICN, but the emergence and payment of claims in recent years has been more favorable than in the long-term history in Nevada with the Fund. The expected patterns of claim payments and emergence used in the projection of the Company’s ultimate claim payments are based on both the long and short-term historical paid data. In recent evaluations, claim patterns have continued to emerge in a manner consistent with short-term historical data. Consequently, the Company’s selection of claim projection patterns has relied more heavily on patterns observed in recent years.
A $1.6 million expense related to the commutation of certain reinsurance treaties, and a $0.9 million expense related to the write-off of certain reinsurance recoverables that had previously been accounted for as an allowance for bad debt, increased losses and LAE incurred in prior periods for the year ended December 31, 2010, which are included in the $14.1 million prior period development.
Reinsurance transactions reflected in the accompanying consolidated statements of income were as follows for the years ended December 31:
gain for the years ended December 31, 2010, 2009, and 2008. The amortization of the deferred gain and adjustments due to development in the reserves are recorded in losses and LAE incurred in the accompanying consolidated statements of income. The remaining deferred gain was $370.3 million and $388.6 million as of December 31, 2010 and 2009, respectively, which is included in the accompanying consolidated balance sheets as deferred reinsurance gain - LPT Agreement.
In the fourth quarter of 2010, the Company re-negotiated the terms of a reinsurance agreement with Clarendon, which resulted in the release and return of funds held by Clarendon in the amount of $74.6 million, The Company placed $47.1 million in trust, of which $35.0 million was placed in an investment trust and $12.1 million is classified as restricted cash and cash equivalents, for the benefit of Clarendon to support the liabilities under the reinsurance agreement and invested the remaining $27.5 million.
On September 30, 2008, EHI borrowed $150.0 million through the Second Amended Restated Credit Facility with Wells Fargo (Existing Credit Facility. The proceeds borrowed under the Existing Credit Facility were used to finance the acquisition of AmCOMP (see Note 4) and for general working capital purposes. Interest paid during the years ended December 31, 2010, 2009, and 2008, including the interest rate swap (see Note 12), totaled $4.4 million, $5.8 million, and $1.2 million, respectively. In accordance with the terms of the contract, a repayment of $50.0 million was made toward the Amended Credit Facility on December 30, 2009.
EPIC has a $10.0 million surplus note to Dekania CDO II, Ltd., issued as part of a pooled transaction. The note matures in 2034 and became callable by the Company in the second quarter of 2009. The terms of the note provide for quarterly interest payments at a rate 425 basis points in excess of the 90-day LIBOR. Both the payment of interest and repayment of the principal under this note and the surplus notes described in the succeeding two paragraphs are subject to the prior
approval of the Florida Department of Financial Services. Interest paid during the year ended December 31, 2010 and 2009 was $0.5 million and $0.6 million, respectively, and during the two months ended December 31, 2008 was $0.2 million. Interest accrued as of December 31, 2010 and 2009 was $0.1 million.
EPIC has a $12.0 million surplus note, to ICONS, Inc., issued as part of a pooled transaction. The note matures in 2034 and became callable by the Company in the second quarter of 2009. The terms of the note provide for quarterly interest payments at a rate 425 basis points in excess of the 90-day LIBOR. Interest paid during the years ended December 31, 2010 and 2009, was $0.6 million and $0.7 million, respectively, and during the two months ended December 31, 2008, was $0.2 million. Interest accrued as of December 31, 2010 and 2009 was $0.1 million.
EPIC has a $10.0 million surplus note, to Alesco Preferred Funding V, LTD, issued as part of a pooled transaction. The note matures in 2034 and became callable by the Company in the fourth quarter of 2009. The terms of the note provide for quarterly interest payments at a rate 405 basis points in excess of the 90-day LIBOR. Interest paid during the years ended December 31, 2010 and 2009, was $0.4 million and $0.5 million, respectively, and during the two months ended December 31, 2008, was $0.2 million. Interest accrued as of December 31, 2010 and 2009 was $0.1 million and less than $0.1 million, respectively.
Principal payment obligations on notes payable outstanding at December 31, 2010, were as follows:
On September 30, 2008, the Company, in connection with the borrowings made under the Existing Credit Facility (Note 11), executed an interest rate swap with Wells Fargo with a notional amount of $100.0 million. Execution of the interest rate swap established a fixed interest rate of 4.84%, on the notional amount, which expired September 30, 2010. The Company used its interest rate swap to mitigate the risks associated with unexpected cash outflows resulting from shifts in variable interest rates. As of December 31, 2009, the interest rate swap had a negative fair value of $2.2 million, and is included in other liabilities on the accompanying consolidated balance sheets. The corresponding unrealized losses of $2.2 million for the year ended December 31, 2009 is included in accumulated other comprehensive income, net.
Included in the future minimum capital lease payments are future interest charges of $0.2 million. Facilities rent expense was $8.9 million, $7.4 million, and $5.9 million for the years ended December 31, 2010, 2009, and 2008, respectively.
Additionally, as of December 31, 2010 and 2009 guarantee fund receivable assets, excluding CIGA, of $0.6 million and $1.1 million, respectively, are included in other assets, as they can be used as a credit against future premium taxes owed. Maximum contributions required by law in any one state in which the Company offers insurance vary between 0.2% and 2.0% of direct premiums written.
On February 21, 2008, the EHI Board of Directors (Board of Directors) authorized a stock repurchase program (the 2008 Program). The 2008 Program authorized the Company to repurchase up to $100.0 million of the Company’s common stock through June 30, 2009. On February 25, 2009, the Board of Directors extended the 2008 Program through December 31, 2009. From inception of the 2008 Program through the end of the 2008 Program on December 31, 2009, the Company repurchased 6,743,862 shares at a cost of $88.7 million, or $13.16 per share, including commissions.
On November 3, 2010, the Board of Directors authorized a share repurchase program for up to $100.0 million of the Company’s common stock from November 8, 2010 through June 30, 2012 (the 2011 Program). The Company expects that shares may be purchased at prevailing market prices through a variety of methods, including open market or private transactions, in accordance with applicable laws and regulations. The timing and actual number of shares repurchased
will depend on a variety of factors, including the share price, corporate and regulatory requirements, and other market and economic conditions. Repurchases under the 2011 Program may be commenced or suspended from time to time without prior notice, and the program may be suspended or discontinued at any time. Through December 31, 2010, the Company repurchased 867,149 shares of common stock under the 2011 Program at an average price per share of $16.59, including commissions, for a total of $14.4 million.
The Employers Holdings, Inc. Amended and Restated Equity and Incentive Plan (the Plan) is administered by the Compensation Committee of the Board of Directors, which is authorized to grant, at its discretion, awards to officers, employees, non-employee directors, consultants, and independent contractors. The maximum number of common shares reserved for grants of awards under the Plan is 7,105,838 shares. The Plan provides for the grant of stock options (both incentive stock options and nonqualified stock options), stock appreciation rights, restricted stock, restricted stock units, stock-based performance awards, and other stock-based awards.
As of December 31, 2010, nonqualified stock options, restricted stock units, and performance share awards have been granted, but no incentive stock options, stock appreciation rights, or restricted stock have been granted under the Plan.
On May 29, 2008, the Company awarded 475,167 options to the officers of the Company. These options have a service vesting period of four years and vested 25% on May 29, 2009 and 2010, and will vest 25% on the subsequent two anniversaries of such date. The options are subject to accelerated vesting in certain limited circumstances, such as: death or disability, or in connection with a change of control of the Company. The options expire seven years from the date of grant.
On March 30, 2010, the Company awarded 406,020 options to certain officers of the Company. These options have a service vesting period of four years and vest 25% on March 30, 2011, and 25% on each of the subsequent three anniversaries of such date. The options are subject to accelerated vesting in the following circumstances: death or disability of the holder, or in connection with a change of control of the Company. The options expire seven years from the date of grant.
The fair market value of the stock options granted during the years ended December 31, 2010, 2009, and 2008 were calculated using the following weighted average assumptions:
On May 29, 2009, 24,984 RSUs, awarded to the non-employee members of the Board of Directors during 2008, vested in connection with the annual stockholders meeting. 9,369 of the vested RSUs, at the awardees’ election, were settled in common stock and the remaining 15,615 RSUs were deferred until six months following the awardees’ termination of service from the Board of Directors. In the event of a deferral election, dividend equivalents are paid with respect to vested RSUs and are credited as additional vested RSUs. During the years ended December 31, 2009 and 2008, in connection with the Company’s dividends to its stockholders, an aggregate of 632 and 240 RSUs were credited to vested RSU holders, respectively.
On May 29, 2008, the Company awarded 152,564 RSUs to certain officers of the Company. The RSUs have a service vesting period of four years and vested 25% on May 29, 2009, and the subsequent three anniversaries of such date. On May 29, 2009, 35,874 RSUs, vested with an intrinsic value of $0.4 million. Of the 35,874 RSUs vested, 10,151 shares of
common stock were withheld to satisfy minimum employee tax withholding. The RSUs are subject to accelerated vesting in certain limited circumstances, such as: death or disability of the holder, or in connection with a change of control of the Company.
On May 28, 2009, the Company awarded 176,871 RSUs to certain officers of the Company. The RSUs have a service vesting period of four years and vest 25% on May 28, 2010 and 25% on each of the subsequent three anniversaries of such date. The RSUs are subject to accelerated vesting in certain limited circumstances, such as: death or disability of the holder, or in connection with a change of control of the Company.
As of December 31, 2010 outstanding RSUs have an intrinsic value of $7.5 million.
Net income for the Company’s insurance subsidiaries prepared in accordance with SAP for the years ended December 31, 2010, 2009 and 2008 was $59.1 million, $89.5 million and $101.7 million, respectively. Under SAP, the statutory operating results of EPIC and EAC are combined with the operating results of EICN and ECIC for the entire year of 2008, the year of the Acquisition.
Company has recovered amounts in excess of the original consideration paid. The special surplus funds are also reduced by the amount of extraordinary dividends as approved by the Nevada Division of Insurance. Under GAAP accounting, the gain is deferred and amortized over the period the underlying reinsured claims are paid (see Note 10). Under SAP, the surplus notes are recorded as a separate component of surplus. Under GAAP, the surplus notes are considered debt.
Nevada law limits the payment of cash dividends by EICN to its parent by providing that payments cannot be made except from available and accumulated surplus, otherwise unrestricted (unassigned), and derived from realized net operating profits and realized and unrealized capital gains. A stock dividend may be paid out of any available surplus. A cash or stock dividend prohibited by these restrictions may only be declared and distributed as an extraordinary dividend upon the prior approval of the Nevada Commissioner of Insurance (Nevada Commissioner). EICN may not pay such an extraordinary dividend or make an extraordinary distribution until the Nevada Commissioner either approves or does not disapprove the payment within 30 days after receiving notice of its declaration. An extraordinary dividend or distribution is defined by statute to include any dividend or distribution of cash or property whose fair market value, together with that of other dividends or distributions made within the preceding 12 months, exceeds the greater of: (a) 10% of EICN’s statutory surplus as regards to policyholders at the next preceding December 31; or (b) EICN’s statutory net income, not including realized capital gains, for the 12-month period ending at the next preceding December 31.
Under Florida law, without regulatory approval, EPIC may pay dividends if they do not exceed the greater of: the lesser of 10% of surplus or net income, not including realized capital gains, plus a 2-year carryforward; 10% of surplus, with dividends payable limited to unassigned funds minus 25% of unrealized capital gains; or, the lesser of 10% of surplus or net investment income plus a 3-year carryforward with dividends payable limited to unassigned funds minus 25% of unrealized capital gains. During 2010, EPIC declared and paid a dividend of $14.9 million to EGI, and in turn to EHI. The maximum dividends that may be paid in 2011 by EPIC without prior approval, is $15.5 million.
Quarterly results for the years ended December 31, 2010 and 2009 were as follows:
The decrease in net premiums earned in 2009 and the first six months of 2010 was primarily due to the decrease in gross premium written, resulting from lower rates, competitive pressures, and changes in business conditions due to the economy and its impact on small businesses. In the third and fourth quarters of 2010 the net premiums earned increased primarily as a result of favorable adjustments in the final audit accrual.
Favorable prior accident year reserve development was recognized in each of the quarters of 2009 in the amount of $13.5 million, $15.7 million, $10.4 million, and $11.8 million, for the first quarter through fourth quarters, respectively.
During the fourth quarter of 2010 the Company reduced its estimate of certain administrative fees due under its joint marketing agreements by $3.0 million, which decreased the commission expense in the fourth quarter of 2010. The Company also re-negotiated the terms of certain reinsurance agreements, which increased commission expense by $1.8 million in the fourth quarter of 2010.
During the first quarter of 2009, the Company announced a strategic restructuring plan (Note 20) and recognized an additional expense of $3.0 million for personnel-related termination costs. The increase in underwriting and other operating expenses in the fourth quarter 2009 was primarily attributable to an accrual of $2.3 million for management bonuses.
The third and fourth quarters of 2009 were impacted by the favorable adjustments to the LPT contingent profit commission which is tax-exempt. The remaining quarterly variances are due to changes in the relative level of tax-exempt investment income to net income for the quarters.
On January 19, 2011, the Company and Martin J. Welch, the President and Chief Operating Officer of, among others, the insurance subsidiaries of the Company, mutually agreed to the separation of Mr. Welch’s employment with the Company. Effective February 1, 2011, Mr. Welch (i) ceased his employment with the Company and its subsidiaries, and (ii) resigned as a member of the Company’s Board of Directors and the Boards of Directors of all subsidiaries of the Company on which he served. Mr. Welch’s resignation was not the result of any disagreement with the Company on any matter relating to the Company’s operations, policies or practices.
The Company has negotiated a separation agreement with Mr. Welch that provided for severance pursuant to the terms of Mr. Welch’s existing employment agreement. Mr. Welch’s employment agreement is filed as Exhibit 10.4 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on December 23, 2008.