The following table sets forth our selected historical financial information for the periods ended and as of the dates indicated. This information comes from our consolidated financial statements. You should read the following selected financial information along with the information contained in this annual report, including Part II,
Claim Service and Other Service Income. Claims service and other service income totaled $1.2 million in 2008 compared to $1.9 million in 2007, representing a decrease of $0.7 million, or 36.8%. Our service income resulted primarily from service arrangements we have with LMC for claims processing services, policy administration and administrative services we performed for the Eagle Entities’ insurance policies and from claims processing services we perform for other unrelated companies. During 2008, we discovered that claim data used to determine billing amounts for claims administration services provided by us had, since August 2006, been incorrectly reported to us by a customer, resulting in an overstatement of claims service income in 2007 and 2006 by approximately $0.3 million. As a result, the financial position and results of operations for the year ended December 31, 2008 reflect a $0.3 million reduction in service income receivable and claims service income, and a related decrease of $0.1 million in federal income tax payable and income tax expense, to reflect the correction of this error. Average monthly fees received from LMC declined as the volume of work required for policy administration decreased as a result of the run-off of our predecessor’s business. Service income related to our arrangements with LMC decreased $0.6 million, or 66.7%, from $0.9 million in 2007 to $0.3 million in 2008.
Net Realized Losses. Net realized losses for the year ended December 31, 2008 totaled $13.9 million, compared to $0.1 million, in 2007. The increase in realized losses were primarily the result of $13.4 million of other-than-temporary-impairments (“OTTI”) charges recorded in connection with investments in government-sponsored agency and corporate preferred stock ($10.2 million charge) and equity indexed securities exchange-traded funds ($3.2 million charge). Approximately $1.9 million of the total charge was recorded in the second quarter with the remaining $11.5 million recorded in the third quarter. The OTTI charges were the
102% of 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.
Interest Expense. Interest expense related to the surplus notes issued by our insurance subsidiary in May 2004 totaled $0.9 million in 2008 and $1.1 million in 2007. The surplus notes interest rate, which is calculated at the beginning of each interest payment period using the 3-month LIBOR rate plus 400 basis points, ranged between 6.15% and 9.03% in 2008.
Income Tax Expense. The effective tax rate for the year ended December 31, 2008 was 30.5% compared to 31.7% for the same period in 2007. The effective rate for December 31, 2008 was lower than the statutory rate of 35.0% primarily as a result of tax exempt interest income, which accounted for approximately 7.5 points of the reduction from the statutory rate. This decrease in the statutory rate was partially offset by a $1.0 million, or 2.3 points of the reduction from the statutory rate, valuation allowance established against our deferred tax assets as of December 31, 2008. The valuation allowance was necessary primarily as a result of the OTTI charges we incurred in the second and third quarters of 2008 and, to a lesser degree, our capital loss carry forwards.
Service Income. Service income was $1.9 million in 2007 compared to $2.1 million in 2006, representing a decrease of $0.2 million, or 9.5%. Our service income resulted primarily from service arrangements we have with LMC for claims processing services, policy administration and administrative services we performed for the Eagle Entities’ insurance policies and from claims processing services we perform for other unrelated companies. Average monthly fees declined as the volume of work required for policy administration decreased as a result of the run-off of our predecessor’s business. Service income related to our arrangements with LMC decreased $100,000, or 10.0%, from $1.0 million in 2006 to $0.9 million in 2007. Service income related to claims processing services that we perform for other unrelated companies decreased approximately $215,000 in 2007.
Net Investment Income. Net investment income was $20.3 million in 2007 compared to $15.2 million in 2006, representing an increase of $5.1 million, or 33.6%. Average invested assets increased $120.7 million, or 34.8%, from $346.8 million in 2006 to $467.5 million in 2007. This increase in our investment portfolio is due primarily to cash flow from operations of $94.6 million for the year ended December 31, 2007, which was
Income Tax Expense. Our effective tax rate in 2007 was 31.7% compared to 31.3% in 2006. Our effective tax rate for 2007 was lower than the statutory tax rate of 35.0% primarily as a result of tax exempt interest income of 4.4% in 2007 and 6.6% in 2006.
Our investment portfolio is structured so that investments mature periodically over time in reasonable relation to current expectations of future claim payments. Since we have a limited claims history, we have derived our expected future claim payments from industry and predecessor trends and included a provision for uncertainties. Our investment portfolio as of December 31, 2008 has an effective duration of 4.31 years with individual maturities extending out to 30 years. Currently, we make claim payments from positive cash flow from operations and invest excess cash in securities with appropriate maturity dates to balance against anticipated future claim payments. As these securities mature, we intend to invest any excess funds with appropriate durations to match against expected future claim payments.
At December 31, 2008, approximately 98.2% of our investment portfolio consisted of primarily investment-grade fixed income securities with fair values subject to fluctuations in interest rates and other factors such as credit. The remainder of our investment portfolio consisted of investments in equity securities, which consist of investments in exchange traded funds designed to correspond to the performance of certain indexes based on domestic or international stocks, and preferred stocks. In November 2006, our investment policy was revised to allow for investment in domestic and international equities of up to 4% and 1%, respectively, of our statutory consolidated capital and surplus. All of the securities in our investment portfolio are accounted for as “available for sale” securities. While we have structured our investment portfolio to provide an appropriate matching of maturities with anticipated claim payments, if we decide or are required in the future to sell securities in a rising interest rate environment, we would expect to incur losses from such sales.
We had no direct sub-prime mortgage exposure in our investment portfolio as of December 31, 2008 and less than $1.0 million of indirect exposure to sub-prime mortgages. The average credit quality of our $293.8 million fixed income municipal portfolio was AA/AA− (AA/AA− based on the issuers’ underlying ratings). Insured municipal bonds totaled $208.6 million and had a weighted average credit rating of AA/AA− (AA− based on the issuers’ underlying ratings). The remaining $85.2 million in uninsured municipal bonds carried a weighted average credit rating of AA/AA−. Consequently, we do not expect a material impact to our investment portfolio or financial position as a result of the problems currently facing monoline bond insurers.
Cash provided by financing activities totaled $1.2 million in 2008, an increase of $0.8 million from $0.4 million in 2007, which decreased $57.2 million from $57.6 million in 2006. As described above, the majority of cash provided by financing activities in 2006 resulted from the sale of our common stock and, to a much lesser degree, from the exercise of common stock options by our employees. In 2006, we received net proceeds of approximately $57.6 million from a follow-on public offering of 3,910,000 shares of our common stock.
For the current accident year, we establish the initial reserve for claims incurred-but-not-reported (“IBNR”) using an expected loss ratio (“ELR”) method. The ELR method is based on an analysis of historical loss ratios adjusted for current pricing levels, exposure growth, anticipated trends in claim frequency and severity, the impact of reform activity and any other factors that may have an impact on the loss ratio. The actual paid and incurred loss data for the accident year is reviewed each quarter and changes to the ELR may be made based on the emerging data, although changes are typically not made until the end of the accident year when the loss data can be analyzed as a complete accident year. 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 a standard actuarial reserving methodology referred to as the Bornhuetter-Ferguson method. This method blends 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.
We wrote our first policy on October 1, 2003 and, as a result, our total reserve portfolio is relatively immature when compared to other industry data.
At December 31, 2008, approximately $108.2 million, or 45.6%, 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 continuing drop in the frequency of workers’ compensation claims, the pure premium rates approved by the California Insurance Commissioner effective January 1, 2009 were 63.4% lower than the pure premium rates in effect as of July 1, 2003.
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, 2008, accident year 2004 is 60 months developed, accident year 2005 is 48 months developed, accident year 2006 is 36 months developed, accident year 2007 is 24 months developed and accident year
IBNR reserves include a provision for future development on known claims, a reopened claims reserve, a provision for claims incurred but not reported and a provision for claims in transit (incurred and reported but not recorded).
Due to the relative immaturity of our book of business, the challenge has been to give the right weight in the ultimate loss estimation process to the new data as it becomes available. As discussed above, 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. Due to our limited operating history, we have five complete accident years that were developed 60 months, 48 months, 36 months, 24 months and 12 months (2004, 2005, 2006, 2007, and 2008, respectively) at December 31, 2008. Our oldest complete accident year was 60 months old as of December 31, 2008. The estimated ultimate losses for accident year 2008 are based on the ELR method described earlier. This is consistent with our reserving approach for the current accident year at prior year-end valuations. For accident years 2003 through 2007, we are using a Bornhuetter-Ferguson approach, which blends the loss development and expected loss ratio methods. Due to the favorable development exhibited by the data for accident years 2004 and 2005 at 17 to 18 months of development, management began to place more weight on the results of the Bornhuetter-Ferguson method in its ultimate loss estimates for accident years 2005, 2006 and 2007. As new data emerges and continues to demonstrate favorable development, this adds credibility to the existing data which enables management to reflect it more fully in its estimation process. For all accident years, we have not completely relied on the most recent data points in our loss development selections. Because of recent favorable development trends, we believe this has the effect of increasing our estimated reserves as compared to reserves calculated with complete reliance on these data points. Estimating loss reserves is an uncertain and complex process which involves actuarial techniques and management judgment. Actuarial analysis generally assumes that past patterns demonstrated in the data will repeat themselves and that the data
As discussed in the previous section, there are a number of variables that can impact, individually or in combination, the adequacy of our loss and loss adjustment expense liabilities. While the actuarial methods employed factor in amounts for these circumstances, the loss reserves may prove to be inadequate despite the actuarial methods used. Several examples are provided below to highlight the potential variability present in our loss reserves. Each of these examples represents scenarios that are reasonably likely to occur over time. For example, there may be a number of claims where the unpaid loss and loss adjustment expense associated with future medical treatment proves to be inadequate because the injured workers do not respond to medical treatment as expected by the claims examiner. If we assume this affects 10% of the open claims and, on average, the unpaid loss and loss adjustment expenses on these claims are 20% inadequate, this would result in our unpaid loss and loss adjustment expense liability being inadequate by approximately $5.8 million, or 2%, as of December 31, 2008. Another example is claim inflation. Claim inflation can result from medical cost inflation or wage inflation. As discussed above, the actuarial methods employed include an amount for claim inflation based on historical experience. We assume that the historical effect of this factor, which is embedded in our experience and industry experience, is representative of future effects for claim inflation. To the extent that the historical factors, and the actuarial methods utilized, are inadequate to recognize future inflationary trends, our unpaid loss and loss adjustment expense liabilities may be inadequate. If our estimate of future medical trend is two percentage points inadequate (e.g., if we estimate a 9% annual trend and the actual trend is 11%), our unpaid loss and loss adjustment expense liability could be inadequate. The amount of the inadequacy would depend on the mix of medical and indemnity payments and the length of time until the claims are paid. For example, if we assume that 50% of the unpaid loss and loss adjustment expense is associated with medical payments and an average payout period of 5 years, our unpaid loss and loss adjustment expense liabilities would be inadequate by approximately $14.6 million on a pre-tax basis, or 5%, as of December 31, 2008. Under these assumptions, the inadequacy of approximately $14.6 million represents approximately 4.5% of total stockholders’ equity at December 31, 2008. The impact of any reserve deficiencies, or redundancies, on our reported results and future earnings is discussed below.
if we determined our unpaid loss and loss adjustment expense liability of $292.0 million as of December 31, 2008 to be 5% inadequate, we would experience a pre-tax reduction in future earnings of approximately $14.6 million. This reduction could be realized in one year or multiple years, depending on when the deficiency is identified. The deficiency would also impact our financial position because most of our statutory surplus would be reduced by an amount equivalent to the reduction in net income. Any deficiency is typically recognized in the unpaid loss and loss adjustment expense liability and, accordingly, it typically does not have a material effect on our liquidity because the claims have not been paid. Since the claims will typically be paid out over a multi-year period, we have generally been able to adjust our investments to match the anticipated future claim payments. Conversely, if our estimates of ultimate unpaid loss and loss adjustment expense liabilities prove to be redundant, our future earnings and financial position would be improved.
Reinsurance recoverables on paid and unpaid losses represent the portion of the loss and loss adjustment expenses that is assumed by reinsurers. These recoverables are reported on our balance sheet separately as assets, as reinsurance does not relieve us of our legal liability to policyholders and ceding companies. We are required to pay losses even if a reinsurer fails to meet its obligations under the applicable reinsurance agreement. Reinsurance recoverables are determined based in part on the terms and conditions of reinsurance contracts, which could be subject to interpretations that differ from ours based on judicial theories of liability. We calculate amounts recoverable from reinsurers based on our estimates of the underlying loss and loss adjustment expenses, which themselves are subject to significant judgments and uncertainties described above under the heading “Unpaid Loss and Loss Adjustment Expenses.” Changes in the estimates and assumptions underlying the calculation of our loss reserves may have an impact on the balance of our reinsurance recoverables. In general, one would expect an increase in our underlying loss reserves on claims subject to reinsurance to have an upward impact on our reinsurance recoverables. The amount of the impact on reinsurance recoverables would depend on a number of considerations including, but not limited to, the terms and attachment points of our reinsurance contracts and the incurred amount on various claims subject to reinsurance. We also bear credit risk with respect to our reinsurers, which can be significant considering that some claims may remain open for an extended period of time.
We periodically evaluate our reinsurance recoverables, including the financial ratings of our reinsurers, and revise our estimates of such amounts as conditions and circumstances change. Changes in reinsurance recoverables are recorded in the period in which the estimate is revised. We assessed the collectibility of our year-end receivables and believe that all amounts are collectible based on currently available information. Therefore, as of December 31, 2008 and 2007, we had no reserve for uncollectible reinsurance recoverables. As of December 31, 2008, nine of the ten companies from which we had reinsurance amounts recoverable had A.M. Best ratings of “A−” or higher. The tenth company is not rated by A.M. Best.
We defer commissions, premium taxes and certain other costs that vary with and are primarily related to the acquisition of insurance contracts. These costs are capitalized and charged to expense in proportion to the recognition of premiums earned. The method followed in computing deferred policy acquisition costs limits the amount of these deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related estimated investment income, anticipated losses and settlement expenses and certain other costs we expect to incur as the premium is earned. Judgments regarding the ultimate recoverability of these deferred costs are highly dependent upon the estimated future costs associated with our unearned premiums. If our expected claims and expenses, after considering investment income, exceed our unearned premiums, we would be required to write-off all or a portion of deferred policy acquisition costs. To date, we have not needed to write-off any portion of our deferred acquisition costs. If our estimate of anticipated losses and related costs was 10% inadequate, our deferred acquisition costs as of December 31, 2008 would still be fully recoverable and no write-off would be necessary. We will continue to monitor the balance of deferred acquisition costs for recoverability.
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. As more fully described in Note 11 to our consolidated financial statements, we established a valuation allowance of approximately $2.0 million at December 31, 2008.
Effective January 1, 2007, we adopted the Financial Accounting Standards Board (“FASB”) Interpretation No. 48, Accounting for Uncertainties in Income Taxes, an Interpretation of FASB Statement No. 109 (“FIN 48”), and it did not have a significant impact on our financial position or results of operations. FIN 48 prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and also provides guidance on the derecognition of previously recorded benefits and their classification, as well as the proper recording of interest and penalties, accounting in interim periods, disclosures and transition. As of the January 1, 2007 date of adoption of FIN 48 and as of December 31, 2008, we had no unrecognized tax benefits. We do not anticipate that the amount of unrecognized tax benefits will significantly increase in the next 12 months. Our policy is to recognize interest and penalties on unrecognized tax benefits as an element of income tax expense (benefit) in our consolidated statements of operations. We file consolidated U.S. federal and state income tax returns. The tax years which remain subject to examination by the taxing authorities are the years ended December 31, 2005, 2006, 2007 and 2008.
We have audited the accompanying consolidated balance sheets of SeaBright Insurance Holdings, Inc. and subsidiaries (the Company) as of December 31, 2008 and 2007, and the related consolidated statements of operations, changes in stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2008. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
As discussed in Note 2 of the consolidated financial statements, effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123(R), Share-Based Payment.
PointSure is engaged primarily in administrative and brokerage activities. Eagle consists of Eagle Pacific Insurance Company, Inc. and Pacific Eagle Insurance Company, Inc., both writers of state act workers’ compensation insurance and USL&H that are in run-off as of December 31, 2008.
In December 2007, SIH acquired 100% of the outstanding common stock of Total HealthCare Management, Inc. (“THM”), a privately held California based provider of medical bill review, utilization review, nurse case management and other related services. The total purchase price was $1.5 million, of which $1.2 million was paid at closing. The remaining $0.3 million is scheduled to be paid in three equal installments on the first three anniversaries of the closing date, provided that THM achieves certain revenue objectives in 2008, 2009 and 2010. Based on THM’s performance in 2008, the initial installment is not payable at this time. The Company recorded goodwill of $1.4 million in connection with this acquisition.
The accompanying consolidated financial statements include the accounts of SIH and its wholly owned subsidiaries, SBIC, PointSure, THM and BWNV (collectively, the “Company”). All significant intercompany transactions among these affiliated entities have been eliminated in consolidation.
Investment securities are classified as available-for-sale and carried at fair value, adjusted for other-than-temporary declines in fair value, with changes in unrealized gains and losses recorded in other comprehensive income (loss), net of applicable income taxes. 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 estimated using quoted market prices for similar securities.
The Company regularly reviews its investment portfolio for declines in value. A number of criteria are considered during this process, including but limited to the following: (1) the Company’s ability and intent to retain the investment for a period of time sufficient to allow for an anticipated recovery in value; (2) the expected recoverability of principal and interest; (3) the length of time and extent to which the fair value has been less than amortized cost for fixed income securities, or cost for equity securities; (4) the financial condition, near-term and long-term prospects of the issue or issuer, including relevant industry conditions and trends, and implications of rating agency actions and offering prices; and (5) the specific reasons that a security is in a significant unrealized loss position, including market conditions which could affect liquidity.
Goodwill represents the excess of costs over fair value of assets of businesses acquired. Goodwill and other intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but are instead tested for impairment at least annually or earlier, if factors warrant a review. No impairments were identified as of December 31, 2008 and 2007. Intangible assets with estimable useful lives are amortized over their respective estimated useful lives to their estimated residual values, and reviewed annually for impairment in accordance with SFAS No. 144, Accounting for Impairment or Disposal of Long-Lived Assets.
Earned premiums on retrospectively rated policies are based on the Company’s estimate of loss experience as of the measurement date. Loss experience includes known losses specifically identifiable to a retrospective policy as well as provisions for future development on known losses and for losses incurred but not yet reported using actuarial loss development factors and is consistent with how the Company projects losses in general. For retrospectively rated policies, the governing contractual minimum and maximum rates are established at policy inception and are made a part of the insurance contract. While the typical retrospectively rated policy has five annual adjustment or measurement periods, premium adjustments continue until mutual agreement to cease future adjustments is reached with the policyholder. For the years ended December 31, 2008, 2007 and 2006, approximately 11.0%, 11.9% and 17.0%, respectively, of direct premiums written related to retrospectively rated policies.
Unpaid loss and loss adjustment expense represents an estimate of the ultimate net cost of all unpaid losses incurred through the specified period. Loss adjustment expenses are estimates of unpaid expenses to be incurred in settlement of the claims included in the liability for unpaid losses. These liabilities, which anticipate salvage and subrogation recoveries and are presented gross of amounts recoverable from reinsurers,
The following table provides the reconciliation of weighted average common share equivalents outstanding used in calculating earnings per share for the years ended December 31, 2008, 2007, and 2006:
The Company adopted SFAS No. 123R, Share-Based Payment, on January 1, 2006, using the modified-prospective transition method. Prior to adoption, the Company measured its employee stock-based compensation arrangements using the provisions outlined in Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, which is an intrinsic value-based method of recognizing compensation costs, and adopted the disclosure-only provisions of SFAS No. 123, Accounting for Stock-based
Compensation. None of the Company’s stock options granted prior to adoption had an intrinsic value at grant date and, accordingly, no compensation cost was recognized for its stock option plan activity prior to adoption.
Under the modified-prospective transition method, stock-based compensation cost is recognized in the consolidated financial statements for granted, modified, or settled share-based payments. Compensation cost recognized includes the estimated cost for stock options granted on or after January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R, and the estimated expense for the portion of awards granted prior to January 1, 2006 vesting in the current period, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which defines fair value and establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. The provisions for SFAS No. 157 are effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company adopted the provisions of SFAS No. 157 as of January 1, 2008, which did not have a material effect on its consolidated financial condition or results of operations.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115, which permits entities to choose to measure many financial instruments and certain other items at fair value in order to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently and without having to apply complex hedge accounting provisions. The provisions for SFAS No. 159 are effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company adopted the provisions of SFAS No. 159 as of January 1, 2008 and elected not to present any additional assets or liabilities at fair value. Consequently, the adoption of SFAS No. 159 did not have a material effect on the Company’s consolidated financial condition or results of operations.
On October 10, 2008, the FASB issued FASB Staff Position No. 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active, which clarifies the application of FAS 157, Fair Value Measurements, in an inactive market and illustrates how an entity would determine fair value when the market for a financial asset is not active. FSP 157-3 states that an entity should not automatically conclude that a particular transaction price is determinative of fair value. In a dislocated market, judgment is required to evaluate whether individual transactions are forced liquidations or distressed sales. When relevant observable market information is not available, a valuation approach that incorporates management’s judgments about the assumptions that market participants would use in pricing the asset in a current sale transaction would be acceptable. The FSP also indicates that quotes from brokers or pricing services may be relevant inputs when
measuring fair value, but are not necessarily determinative in the absence of an active market for the asset. In weighing a broker quote as an input to a fair value measurement, an entity should place less reliance on quotes that do not reflect the result of market transactions. Further, the nature of the quote (for example, whether the quote is an indicative price or a binding offer) should be considered when weighing the available evidence. FSP 157-3 is effective immediately and applies to prior periods for which financial statements have not been issued, including interim or annual periods ending on or before September 30, 2008. Accordingly, the Company adopted FSP 157-3 prospectively, beginning July 1, 2008. The adoption of FSP 157-3 did not have a material impact on the Company’s financial results or fair value determinations.
In January 2009, the FASB issued FSP EITF 99-20-1, Amendments to the Impairment Guidance of EITF Issue No. 99-20, (“FSP EITF 99-20-1”) which amends FASB Emerging Issues Task Force (“EITF”) No. 99-20, Recognition of Interest Income and Impairment on Purchased Beneficial Interest and Beneficial Interests That Continue to Be Held by a Transferor or in Securitized Financial Assets, (“EITF 99-20”) to align the impairment guidance in EITF 99-20 with the impairment guidance and related implementation guidance in SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. The provisions of FSP EITF 99-20-1 are effective for reporting periods ending after December 15, 2008. The adoption of FSP EITF 99-20-1 did not have a material impact on the Company’s results of operations or financial position.
The consolidated cost or amortized cost, gross unrealized gains and losses, and estimated fair value of investment securities available-for-sale at December 31, 2008 and 2007 are as follows:
Equity securities at December 31, 2008 and 2007 consist of investments in exchange traded funds designed to correspond to the performance of certain indexes based on domestic or international stocks. The Company had no direct investments in equity securities at December 31, 2008 or 2007. The following table presents information about investment securities with unrealized losses at December 31, 2008 and 2007.
Of the $66.6 million of securities with unrealized losses of 12 months or longer at December 31, 2008 in the above table, 23 securities with a combined fair value of $26.6 million had fair values that were less than 90% of the securities’ amortized cost. The combined unrealized loss on those securities is $5.2 million.
criteria are considered during this process including, but not limited to, the following: the current fair value as compared to amortized cost or cost, as appropriate, of the security; the length of time the security’s fair value has been below amortized cost; the Company’s intent and ability to retain the investment for a period of time sufficient to allow for an anticipated recovery in value within a reasonable time period; specific credit issues related to the issuer; and current economic conditions.
In general, the Company reviews all securities that are impaired by 5% or more at the end of the period. The Company focuses its review of securities with no stated maturity date on securities that were impaired by 20% or more at the end of the period or have been impaired 10% or more continuously for six months or longer as of the end of the period. The Company also analyzes the entire portfolio for other factors that might indicate a risk of impairment, including credit ratings and interest rates.
In 2008, the Company recognized an other-than-temporary impairment charge of approximately $10.2 million on its investments in preferred stocks (nearly all of which were government-sponsored agency fixed and variable preferred stocks) and approximately $3.2 million on its investment in equity indexed securities exchange-traded funds. No other-than-temporary declines in the fair value of the Company’s securities were recorded in 2007 or 2006.
Major categories of consolidated net investment income are summarized as follows for the years ended December 31, 2008, 2007, and 2006:
In accordance with SFAS 157, the Company groups its financial assets and financial liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:
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.
The table below presents the December 31, 2008 balances of assets and liabilities measured at fair value on a recurring basis.
Premiums receivable consisted of the following at December 31, 2008 and 2007:
Property and equipment consisted of the following at December 31, 2008 and 2007:
The following reflects the amounts of policy acquisition costs deferred and amortized for the years ended December 31, 2008, 2007, and 2006:
On October 1, 2008, the Company entered into new reinsurance treaties with nonaffiliated reinsurers wherein it retains the first $500,000 of each loss occurrence. The next $500,000 of losses per occurrence (excess of the first $500,000 of losses per occurrence retained by the Company) are 50% reinsured. The new reinsurance program, which is effective through September 30, 2009, provides coverage up to $85.0 million per loss occurrence as follows:
$30.0 million for each loss occurrence in excess of $20.0 million for each loss occurrence
$35.0 million for each loss occurrence in excess of $50.0 million for each loss occurrence
Fully reinsured, subject to an annual aggregate limit of $70.0 million and a limit of $7.5 million maximum for any one life.
Fully reinsured, subject to an aggregate annual limit of $60.0 million and a limit of $5.0 million maximum for any one life.
Fully reinsured, subject to an annual aggregate limit of $50.0 million and a limit of $5.0 million maximum for any one life.
Effective from October 1, 2003 through October 1, 2004, the Company entered into reinsurance treaties wherein it retains the first $500,000 of each loss occurrence. The next $500,000 of such loss occurrence is 50% retained by SBIC after meeting a $1.5 million aggregate deductible. Losses in excess of $1.0 million up to $100.0 million are 100% reinsured with nonaffiliated reinsurers.
All of the reinsurance treaties described in this Note are subject to various additional limitations and exclusions as more fully described in the treaties.
SBIC has in place a series of reinsurance treaties that were entered into prior to its acquisition by SIH which are as follows: Effective from January 1, 1999 through January 1, 2001, SBIC retains the first $250,000 of each loss occurrence; the next $750,000 of such loss occurrence is 100% reinsured with nonaffiliated reinsurers. Losses in excess of $1.0 million up to $4.0 million for this time period are 100% reinsured with nonaffiliated reinsurers. Effective July 1, 2000 through July 1, 2002, SBIC retains the first $500,000 of each loss occurrence; the next $500,000 of such loss occurrence is 100% reinsured with nonaffiliated reinsurers. Effective January 1, 2001 through January 1, 2002, SBIC retains the first $1.0 million of each loss occurrence; losses up to $5.0 million are 100% reinsured with nonaffiliated reinsurers. Effective October 1, 2000 through October 1, 2001, SBIC has a quota-share treaty whereby 10% of the first $250,000 loss plus a pro-rata share of expenses are 100% reinsured with Swiss Reinsurance Company. Effective January 1, 2002 through May 31, 2002, 100% of all losses are 100% quota-shared to Argonaut Insurance Company.
As part of the Acquisition, SIH and LMC entered into an adverse development excess of loss reinsurance agreement (the “Agreement”). The Agreement, after taking into account any recoveries from third party reinsurers, calls for LMC to reimburse SBIC 100% of the excess of the actual loss at December 31, 2011 over the initial loss reserves at September 30, 2003. The Agreement also calls for SBIC to reimburse LMC 100% of the excess of the initial loss reserves at September 30, 2003 over the actual loss results at December 31, 2011. The amount of adverse loss development under the Agreement was $4.2 million at December 31, 2008 and $2.5 million at December 31, 2007. The increase in the amount receivable from LMC is netted against loss and loss adjustment expense in the accompanying consolidated statements of operations.
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 shall be 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 $2.8 million at December 31, 2008 and $3.5 million at December 31, 2007. In March 2009, the Company submitted a request to LMC to increase the balance in the Trust to 102% of its obligations under the adverse development cover.
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 2008 and 2007 include the following: Alabama, Alaska, Arizona, Arkansas, Connecticut, Delaware, the District of Columbia, Georgia, Idaho, Illinois, Iowa, Kansas, Massachusetts, Michigan, Nevada, New Jersey, New Mexico, Oregon, South Carolina, and Virginia.
Balances affected by reinsurance transactions are reported gross of reinsurance in the balance sheets. Reinsurance recoverables comprise the following amounts at December 31, 2008 and 2007:
The effects of reinsurance are as follows for the years ended December 31, 2008, 2007, and 2006:
As a result of changes in estimates of insured events in prior periods, the unpaid loss and loss adjustment expenses decreased by approximately $15.1 million in 2008 due to positive development on previously reported claims in accident year 2007, $7.4 million due to positive development on previously reported claims in accident year 2006 and approximately $2.4 million due to positive development on previously reported claims in accident years 2005. For accident years 2004 and prior, unpaid loss and loss adjustment expenses increased by approximately $1.1 million as a result of unfavorable development on previously reported claims due to the small base of claims and losses assumed from the NCCI pools. In connection with the Acquisition, KEIC and LMC entered into an agreement to indemnify each other with respect to developments in KEIC’s unpaid loss and loss adjustment expenses over a period of approximately eight years. 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 Acquisition have increased or decreased from the amount existing at the date of the Acquisition.
As a result of changes in estimates of insured events in prior periods, the unpaid loss and loss adjustment expenses decreased by approximately $16.0 million in 2006 due to positive development on previously reported claims in accident year 2005 and $6.3 million due to positive development on previously reported claims in accident year 2004. For accident years 2003 and prior, unpaid loss and loss adjustment expenses decreased $486,000 due to positive development on previously reported claims. According to the terms of the adverse development cover, the Company is obligated to reimburse LMC for $571,000 of the prior period positive development.
At December 31, 2008 and 2007, the Company reduced unpaid loss and loss adjustment expense by $5.6 million and $4.3 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 rate 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 rate at December 31, 2008 was 6.2%. Interest and principal may be paid only upon the prior approval of the Illinois Division of Insurance. In the event of default, as defined, or failure to pay interest due to lack of Illinois Division 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, 2008, 2007, and 2006 was $0.9 million, $1.1 million, and $1.1 million, respectively.
The operations of SIH and its subsidiaries are included in a consolidated federal income tax return.
The following is a reconciliation of the difference between the “expected” income tax computed by applying the federal statutory income tax rate of 35% to income before income taxes and the total income taxes reflected on the books for the years ended December 31, 2008, 2007, and 2006:
The State of Illinois imposes minimum risk-based capital requirements that were developed by the NAIC. The formulas for determining the amount of risk-based capital specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of the enterprise’s regulatory total adjusted capital to certain minimum capital amounts as defined by the NAIC. Enterprises below specified trigger points or ratios are classified within certain levels, each of which requires specified corrective action. SBIC exceeded the minimum risk-based capital requirements at December 31, 2008 and 2007.
The Company leases certain office space for its headquarters and regional offices under agreements that are accounted for as operating leases. Lease expense totaled $2.9 million, $1.3 million and $1.0 million for the years ended December 31, 2008, 2007, and 2006, respectively. Total rent, including the effect of rent increases and concessions, is expensed on a straight-line basis over the respective lease terms.
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. Policy surcharges are generally collected in the year following assessment and premium tax offsets are generally recognized over a period of up to five years following the year of assessment.
On October 1, 2003, the Company began selling workers’ compensation insurance policies for which the premiums vary based on loss experience. Accrued retrospective premiums are determined based upon the loss experience of business subject to such experience rating adjustment. Accrued retrospectively rated premiums are determined by and allocated to individual policyholder accounts. Accrued retrospective premiums and return retrospective premiums are recorded as additions to and reductions from written premium, respectively. Approximately 11.0%, 11.9% and 17.0% of the Company’s direct premiums written for the years ended December 31, 2008, 2007 and 2006, respectively, related to retrospectively rated contracts. The Company accrued $12.3 million for retrospective premiums receivable and $18.5 million for return retrospective premiums at December 31, 2008 and $9.3 million for retrospective premiums receivable and $17.8 million for return retrospective premiums at December 31, 2007.
On December 17, 2007, the Company completed the acquisition of Total Health Care Management, Inc. (“THM”), a provider of medical bill review, utilization review, nurse case management and other related services. The total purchase price was $1.5 million, of which $1.2 million was paid at closing. The remaining $0.3 million is scheduled to be paid in three equal installments on the first three anniversaries of the closing date, provided that THM achieves certain revenue objectives in 2008, 2009 and 2010. Based on THM’s performance in 2008, the initial installment has not been paid at this time. However, such amount may be paid later if warranted by THM’s future performance. As a result of this acquisition, the Company recorded additional goodwill of $1.4 million.
Financial Accounting Standards Board SFAS No. 142, Goodwill and Other Intangible Assets, requires that goodwill balances be reviewed for impairment at least annually or more frequently if events occur or circumstances change that would indicate that a triggering event, as defined in SFAS No. 142, has occurred. A reporting unit is defined as an operating segment or one level below an operating segment.
The goodwill impairment test follows a two step process as defined in SFAS No. 142. In the first step, the fair value of a reporting unit is compared to its carrying value. If the carrying value of a reporting unit exceeds its fair value, the second step of the impairment test is performed for purposes of measuring the impairment. In the second step, the fair value of the reporting unit is allocated to all of the assets and liabilities of the reporting unit to determine an implied goodwill value. If the carrying amount of the reporting unit goodwill exceeds the implied goodwill value, an impairment loss would be recognized in an amount equal to that excess, and the charge could have a material adverse effect on the Company’s results of operations and financial position.
As part of the Company’s goodwill analysis, the Company compared the fair value of the aggregated reporting units to the market capitalization of the Company using the December 31, 2008 common stock price. The difference between the aggregated fair value of the reporting units and the market capitalization of the Company was attributed to transaction premium. The amount of the transaction premium was determined to be reasonable based on recent insurance transactions and specific facts and circumstances related to the Company.
causes a significant change in any one reporting unit’s fair value, the Company may need to reassess goodwill impairment at the end of each quarter as part of an interim impairment test. Subsequent reviews of goodwill could result in an impairment of goodwill during 2009.
At December 31, 2008, the Company had outstanding stock options and nonvested stock granted according to the terms of two equity incentive plans. The stockholders and Board of Directors approved the 2003 Stock Option Plan (the “2003 Plan”) in September 2003, and amended and restated the 2003 Plan in February 2004, and approved the 2005 Long-Term Equity Incentive Plan (the “2005 Plan” and, together with the 2003 Plan, the “Stock Option Plans”) in December 2004. In April 2007, the Board of Directors further amended the 2003 Plan and amended the 2005 Plan.
The Board of Directors reserved an initial total of 776,458 shares of common stock under the 2003 Plan and 1,047,755 shares of common stock under the 2005 Plan, plus an automatic annual increase on the first day of each fiscal year beginning in 2006 and ending in 2015 equal to the lesser of: (i) 2% of the shares of common stock outstanding on the last day of the immediately preceding fiscal year or (ii) such lesser number of shares as determined by the Board of Directors. At December 31, 2008, the Company reserved 776,458 shares of common stock for issuance under the 2003 Plan, of which options to purchase 481,946 shares had been granted, and 2,203,668 shares for issuance under the 2005 Plan, of which 1,651,977 shares had been granted. In January 2006, the Compensation Committee of the Board of Directors terminated the ability to grant future stock options awards under the 2003 Plan. Therefore, the Company anticipates that all future awards will be made under the 2005 Plan.
The fair values of stock options granted during the years ended December 31, 2008, 2007 and 2006 were determined on the dates of grant using the Black-Scholes-Merton option valuation model with the following weighted average assumptions:
For 2006 and 2007, the expected term of options was determined using the “simplified method,” which averages an award’s weighted average vesting period and its contractual term and expected stock price volatility was based on a weighted average of the Company’s historical stock price volatility since the initial public offering of its common stock in January 2005 and the historical volatility of a peer company’s stock for a period of time equal to the expected term of the option. In 2008, expected stock price volatility was based on the Company’s historical stock price volatility since the public offering of its common stock in January 2005. The change in determining volatility was made in 2008 because the Company had developed credible historical data based solely on the Company’s stock volatility. The risk-free interest rate is based on the yield of U.S. Treasury securities with an equivalent remaining term. The Company has not paid stockholder dividends in the past and has no current plan to pay any stockholder dividends in the future.