The Company also has regional offices in Charlotte, North Carolina, Indianapolis, Indiana, Brentwood, Tennessee and Wexford, Pennsylvania and leases office space in each of these locations under multi-year operating leases.
(1) Includes Employers Security Holding Company’s results of operations for the period from October 1, 2008 to December 31, 2008.
(3) The net income of the segregated portfolio cell reinsurance segment is recorded as a segregated portfolio dividend expense, which represents the dividend earned by the segregated portfolio dividend participants during the period.
(4) Total assets as of December 31, 2009, 2008, 2007 and 2006 include assets reclassified to discontinued operations totaling $115,207, $116,445, $155,319 and $151,835, respectively.
(6) Calculated by dividing losses and LAE incurred by net premiums earned.
The increase in the loss ratio primarily reflects a higher accident period loss ratio in both the workers’ compensation insurance and segregated portfolio cell reinsurance segments as a result of an increase in severity-related claims in the workers’ compensation insurance segment.
The Company returned premium to customers as a result of premium audits in 2010, reflecting the impact of the economy on customers’ payroll. Premiums returned to customers totaled $1.4 million in 2010, compared to additional premium from customers totaling $6,000 in 2009. In addition to the impact of changes in audit premium, the Company decreased its estimate of earned but unbilled premium by $750,000 in 2010. While the audit premium had a negative impact on net premiums earned, the Company wrote new business of $32.7 million in 2010 and experienced an increase in the renewal retention rate, resulting in an 11.5% increase in premium revenue from 2009 to 2010.
Direct and net premiums written. Direct premiums written is the sum of both direct premiums and assumed premiums before the effect of ceded reinsurance. Direct premiums written include all premiums billed during a specified policy period. Net premiums written is the difference between direct premiums written and premiums ceded or paid to reinsurers (ceded premiums written). In the segregated portfolio cell reinsurance segment, assumed premiums are derived from insurance contracts written by the Company and ceded to the segregated portfolio cells.
Net premiums earned. Net premiums earned represent the earned portion of the Company’s net premiums written. Premiums are earned over the term of the related policies. At the end of each accounting period, the portion of the premiums that are not yet earned are included in unearned premiums and are realized as revenue in subsequent periods over the remaining term of the policy. The Company’s workers’ compensation policies typically have a term of twelve months. Thus, for example, for a policy that is written on July 1, 2010, one-half of the premiums would be earned in 2010 and the other half would be earned in 2011. Workers’ compensation premiums are determined based upon the payroll of the insured, the applicable premium rates and, where applicable, an experience based modification factor. An audit of the policyholders’ records is conducted after policy expiration to make a final determination of applicable premiums. Included with net premiums earned is an estimate for earned but unbilled final audit premiums. The Company can estimate earned but unbilled premiums because it keeps track, by policy, of how much additional premium is billed in final audit invoices as a percentage to estimate the probable additional amount that it has earned but not yet billed as of the balance sheet date.
Net investment income and realized gains and losses on investments. The Company invests its surplus and the funds supporting its insurance liabilities (including unearned premiums and unpaid losses and LAE) in cash, cash equivalents, fixed income securities, convertible bonds and equity securities. Investment income includes interest earned on invested assets, including the impacts of premium amortization and discount accretion. Realized gains and losses on invested assets are
reported separately from net investment income. The Company recognizes realized gains when invested assets are sold for an amount greater than their cost or amortized cost (in the case of fixed income securities) and recognizes realized losses when investment securities are written down as a result of an other than temporary impairment or sold for an amount less than their cost or amortized cost. Realized gains and losses also include the change in fair value of convertible bonds.
Acquisition and other underwriting expenses. In the workers’ compensation insurance segment, expenses incurred to underwrite risks are referred to as acquisition and other underwriting expenses, which consist primarily of commissions, premium taxes, assessments and fees and other underwriting expenses incurred in acquiring, writing and administering the Company’s business. In the segregated portfolio cell reinsurance, acquisition and other underwriting expenses consist of ceding commissions earned under the respective reinsurance agreements. Ceding commissions received are netted against acquisition and other underwriting expenses.
The Company establishes reserves for unpaid losses and LAE for its workers’ compensation insurance and segregated portfolio cell reinsurance products, which are estimates of future payments of reported and unreported claims for losses and related expenses. The adequacy of the Company’s reserves for unpaid losses and LAE are inherently uncertain because the ultimate amount that the Company may pay under many of the claims incurred as of the balance sheet date will not be known for many years. Establishing reserves is an imprecise process, requiring the use of informed estimates and judgments. The Company’s estimates and judgments may be revised as additional experience and other data becomes available and are reviewed as new or improved methodologies are developed, or as current laws change. Any such revisions could result in future changes in estimates of losses or reinsurance recoverables and would be reflected in the Company’s results of operations in the period in which the estimates are changed. Estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates and judgments using data currently available. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded as of December 31, 2010, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.
On a quarterly basis, the Company prepares actuarial analyses to assess the reasonableness of the recorded reserves for unpaid losses and LAE in its workers’ compensation insurance segment. These actuarial analyses incorporate various methodologies, including paid loss development, incurred loss development and a combination of other actuarial methodologies that incorporate characteristics of incurred and paid methodologies combined with a review of the Company’s exposure base. The recorded amount in each accident year is then compared to the results of these methodologies, with consideration being given to the age of the accident year. As accident years mature, the various methodologies generally
The Company’s reserves for unpaid losses and LAE in its workers’ compensation insurance segment as of December 31, 2010 and 2009 are summarized below (in thousands):
Although many factors influence the actual cost of claims and the corresponding reserves for unpaid losses and LAE estimates, we do not measure and estimate values for all of these variables individually. This is due to the fact that many of the factors that are known to impact the cost of claims cannot be measured directly. In most instances, we rely on historical
experience and tail factors to estimate values for the variables that are explicitly used in the unpaid loss and LAE analysis. For the most recent accident year, we rely on selecting an expected loss ratio to estimate the reserves for unpaid losses and LAE. In addition to the examples above that represent reasonably likely changes in our tail factor, another example of potential variability in our loss and LAE estimation process involves selecting an expected loss ratio for the most recent accident year. For example, if our expected loss ratio for the 2010 accident year were to increase by 5 percentage points, our reserves for unpaid losses and LAE as of December 31, 2010 would increase by $4.2 million, which would result in an after-tax reduction in our earnings of $2.7 million. Management believes that changes in the most recent year accident year loss ratio are reasonably likely due to variability in underwriting and rate changes. It is important to note that actual claims costs will vary from our estimate of ultimate claim costs, perhaps by substantial amounts, due to the inherent variability of the business written, the potentially significant claim settlement lags and the fact that not all events affecting future claim costs can be estimated.
In the event that our estimates of ultimate reserves for unpaid losses and LAE prove to be greater or less than the ultimate liability, our future earnings and financial position could be positively or negatively impacted. Future earnings would be reduced by the amount of any deficiencies in the year(s) in which the claims are paid or the reserves for unpaid losses and LAE are increased. For example, if we determined our reserves for unpaid losses and LAE, net of reinsurance, of $64.1 million as of December 31, 2010 to be 5% inadequate, this would result in an after-tax reduction in our earnings of approximately $2.1 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 our statutory surplus would be reduced by an amount equivalent to the reduction in net income. Any deficiency is typically recognized in the reserves for unpaid losses and LAE 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 reserves for unpaid losses and LAE prove to be redundant, our future earnings and financial position would be improved.
Unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in shareholders’ equity as a component of comprehensive income (loss) and, accordingly, have no effect on net income. When, in the opinion of management, a decline in the fair value of an investment below its cost or amortized cost is considered to be “other-than- temporary,” such investment is written down to its fair value. The amount written down is recorded in earnings as a realized loss on investments. Generally, the determination of other-than-temporary impairment includes, in addition to other relevant factors, a presumption that if the market value is below cost by a significant amount for a period of time, a write-down is necessary. Notwithstanding this presumption, the determination of other-than-temporary impairment requires judgment about future prospects for an investment and is therefore a matter of inherent uncertainty. For the years ended December 31, 2010, 2009 and 2008, the Company recorded other-than-temporary impairments, excluding impairments in the segregated portfolio cell reinsurance segment, of $6,000, $1.9 million and $3.6 million, respectively. Other-than-temporary impairments in the segregated portfolio cell reinsurance segment totaled $80,000, $749,000 and $1.2 million for the years ended December 31, 2010, 2009 and 2008, respectively. As of December 31, 2010, the Company held fixed income securities, excluding fixed income securities in the segregated portfolio cell reinsurance segment, with gross unrealized losses of $328,000, of which $55,000 were in an unrealized loss position for more than twelve months. There were no equity securities in an unrealized loss position as of December 31, 2010. Adverse investment market conditions, or poor operating results of underlying investments, could result in impairment charges in the future. The Company generally applies the following standards in determining whether the decline in fair value of an investment is other-than-temporary:
Equity securities. An equity security is considered impaired when one of the following conditions exist: 1) an equity security’s market value is less than 80% of its cost for a continuous period of 6 months, 2) an equity security’s market value is less than 50% of its cost, regardless of the amount of time the security’s market value has been below cost, and 3) an equity security’s market value has been less than cost for a continuous period of 12 months or more, regardless of the magnitude of the decline in market value. Equity securities that are in an unrealized loss position, but do not meet the above quantitative thresholds are evaluated to determine if the decline in market value is other than temporary.
The security has a market value below 80% of amortized cost due to deterioration in credit quality.
For the years ended December 31, 2010, 2009 and 2008, the Company recorded other-than-temporary impairments of $6,000, $189,000, and $619,000, respectively, related to its fixed income security portfolio.
Limited partnerships. A limited partnership investment is generally written down if the Company is unable to hold or otherwise intends to sell its interest in the limited partnership at a loss, or if management has received information that suggests the Company will be unable to recover its original investment in the limited partnership. The amount written down is recorded in the change in equity interest in limited partnerships in the consolidated statement of operations and comprehensive income (loss).
In accordance with the requirements of ASC 350, Intangibles-Goodwill and Other, goodwill is not amortized but is tested for impairment at the reporting unit level, which is at the operating segment level or one level below an operating segment. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. Goodwill is required to be tested for impairment annually and between annual tests if events or circumstances change, such as adverse changes in the business climate, that would more likely than not reduce the fair value of the reporting unit below its carrying value.
For the 2010 annual impairment test, the fair value of the workers’ compensation insurance segment was estimated using a discounted cash flow analysis, a form of the income approach, using management’s internal four-year forecast for the workers’ compensation insurance segment and a terminal value estimated using a long-term growth rate of 5.0%, which is reflective of the segment’s historical growth rate, and a discount rate of 13.0%, which is reflective of the risks inherent in the segment. Cash flows were adjusted as necessary to maintain adequate capital requirements.
Amounts recoverable from Company’s reinsurers are estimated in a manner consistent with the reserves for unpaid losses and LAE associated with the reinsured policy. Amounts paid for reinsurance contracts are expensed over the contract period during which insured events are covered by the reinsurance contracts. Reinsurance balances recoverable on paid and unpaid loss and LAE are reported separately as assets, instead of being netted with the appropriate liabilities, because reinsurance does not relieve the Company of its legal liability to its policyholders. Reinsurance balances recoverable are subject to credit risk associated with the particular reinsurer. Additionally, the same uncertainties associated with estimating unpaid losses and LAE affect the estimates for the ceded portion of these liabilities. The Company continually monitors the financial condition of its reinsurers and where necessary obtains collateral. As of December 31, 2010, the Company had reinsurance recoverables of $12.3 million.
In October 2010, the Financial Accounting Standards Board (“FASB”) issued new accounting guidance related to the accounting for costs related to the acquisition or renewal of insurance contracts. The new guidance provides specific types of costs that should be capitalized in connection with the acquisition or renewal of insurance contracts. Those costs include incremental direct costs of contract acquisition incurred in connection with independent third parties and certain costs related to activities performed by the insurer for the contract, including underwriting, policy issuance and processing, medical and inspection, and sales force contract selling. Under the new guidance, costs incurred by an entity related to unsuccessful acquisition or renewal efforts must be charged to expense as incurred. The new guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011 and is to be applied prospectively. Retrospective application to all prior periods upon the date of adoption is permitted, but not required. Early adoption is permitted but only at the beginning of an entity’s annual reporting period. The Company currently capitalizes and defers commissions and related expenses, premium taxes and certain underwriting personnel salaries. The Company expects to adopt this new guidance effective January 1, 2012 and apply it retrospectively to prior periods for purposes of consistency across all periods presented. Upon adoption, the Company expects to reduce the amount of acquisition costs capitalized related to certain underwriting personnel salaries to give effect to unsuccessful acquisition or renewal activities. Management does not expect the adoption of the new guidance to have a material effect of the Company’s financial condition or results of operations.
In January 2010, the FASB issued new accounting guidance related to disclosures about fair value measurements. The new guidance requires the following new or enhanced disclosures: 1) details of significant transfers in and out of Level 1 and Level 2 measurements and the reasons for the transfers, 2) a gross presentation of activity within the Level 3 rollforward, presenting separately information about purchases, sales, issuances, and settlements, and 3) fair value disclosures must be presented by class of assets and liabilities rather than by major category. The new guidance was effective for the first interim or annual reporting period beginning after December 15, 2009, except for the gross presentation of the Level 3 rollforward information, which is required for annual reporting periods beginning after December 15, 2010 and for interim periods within those years. The Company adopted the new accounting guidance effective January 1, 2010. The adoption of the new guidance resulted in enhanced disclosures related to the Company’s fair value measurements of its investments.
The major components of consolidated revenue were as follows for the years ended December 31, 2010 and 2009 (in thousands):
The decrease in net income primarily reflects an increase in the severity-related claims, the impact of return premium to customers and a decrease in net investment income related to the current interest rate environment, partially offset by new business growth, particularly in the Company’s Southeast region, an increase in realized gains related to the sale of investments, and a reduction in other-than-temporary investment impairments.
The workers’ compensation insurance ratios were as follows for the years ended December 31, 2010 and 2009:
Net realized investment gains for the year ended December 31, 2010 include an increase in the fair value of the Company’s convertible bond portfolio of $1.2 million, compared to an increase of $877,000 for the same period in 2009. The Company recognized other-than-temporary impairments of $6,000 in 2010, compared to $1.7 million in 2009.
The increase in the policyholder dividend expense primarily reflects the loss experience of underlying policies related to policies with a 2010 policy effective date. As of December 31, 2010, approximately 12.3% of the Company’s policies were written on a participating basis, compared to approximately 10.0% as of December 31, 2009.
The segregated portfolio cell reinsurance ratios were as follows for the years ended December 31, 2010 and 2009:
The increase in reinsurance premiums assumed primarily reflects new business of $5.2 million, partially offset by a decrease in the renewal retention rate, the impact of audit premium returned and renewal rate decreases of 0.3%. The renewal retention rate decreased from 89.1% in 2009 to 87.1% in 2010. The Company returned $974,000 in premium to customers as a result of premium audits in 2010, compared to $714,000 for the same period in 2009. The decrease in audit premium reflects the impact of lower payrolls in economically sensitive segregated portfolio cells.
The decrease in net investment income primarily reflects a reduction in short-term interest rates from 2009 to 2010.
Net realized investment gains for the year ended December 31, 2010 include other-than-temporary impairments of $80,000 in 2010, compared to impairments of $749,000 in 2009.
The increase in the calendar period loss and LAE ratio reflects an increase in the accident period loss ratio and a decrease in favorable loss reserve development related to prior accident period reserves. The accident period loss ratio was 79.9% and 71.7% for the years ended December 31, 2010 and 2009, respectively. The increase in the accident period loss ratio primarily reflects management’s estimate of the impact of the current economic environment on the Company’s workers’ compensation book of business, including the impact of rising unemployment on management’s return to work controls and an increase in severity-related claims in 2010. Favorable loss reserve development totaled $1.4 million for the year ended December 31, 2010, compared to favorable loss reserve development of $2.8 million for the same period in 2009. The favorable loss reserve development relates primarily to a decrease in the prior accident period loss development factors used to estimate losses and LAE. The decrease in prior accident period loss development factors primarily reflects prior year claim settlements during 2010 for amounts at, or less than, previously established case and IBNR reserves. This decrease had the effect of lowering loss development factors as of December 31, 2010. In the aggregate, the claims were closed at amounts lower than the provision established for IBNR claims. Management believes that the realization of the benefits of its return-to-work controls enabled it to record losses and LAE that were lower than the amount reserved for claim settlements.
The following table represents the operations of the workers’ compensation insurance segment for the years ended December 31, 2009 and 2008 (in thousands). The results of operations for the year ended December 31, 2008 include the operating results of Employers Security for the period from October 1, 2008 to December 31, 2008:
(1) Ceded premiums written include premiums ceded to the segregated portfolio cell reinsurance segment of $28,661 and $29,113 for the years ended December 31, 2009 and 2008, respectively.
The increase in net income primarily reflects a decrease in net realized investment losses and an increase in the value of the segment’s limited partnership investments. The decrease in net realized investment losses primarily reflects a reduction in other-than-temporary impairments from 2008 to 2009. The improved investment results were partially offset by an increase in the combined ratio from 2008 to 2009. The increase in the loss and LAE ratio from 2008 to 2009 primarily reflects an increase in the 2009 accident year loss ratio reflecting management’s view of the expected impact of the then current economic environment on the Company’s workers’ compensation book of business. The increase in the expense ratio primarily reflects an increase in corporate expense allocations and the impact of premium rate decreases and audits of prior year policies that resulted in return premium to customers in 2009.
The workers’ compensation insurance ratios were as follows for the years ended December 31, 2009 and 2008:
The increase in direct premiums written from 2008 to 2009 primarily reflects new business sales of $28.0 million and direct premiums written of $6.1 million related to the acquisition of Employers Security, partially offset by a reduction in the renewal retention rate from 87.6% in 2008 to 84.1% in 2009 and renewal rate decreases of 3.9%. Traditional and alternative market direct premiums written were $81.4 million and $28.7 million, respectively, for the year ended December 31, 2009, compared to $72.8 million and $29.1 million, respectively, for the same period in 2008.
The increase in acquisition and other underwriting expenses primarily reflects the impact of the Indiana state tax liability related to Employers Security’s operating results for the year ended December 31, 2009.
The decrease in reinsurance premiums assumed from 2008 to 2009 primarily reflects the impact of renewal rate decreases of 1.0% and return premium of $714,000 related to policy audits. New business sales totaled $4.1 million and the renewal retention rate increased from 87.7% in 2008 to 89.1% in 2009. In 2008, policy audits resulted in return premium of $383,000.
The decrease in net realized investment losses from 2008 to 2009 primarily reflects a reduction in other-than-temporary impairments. Other-than-temporary impairments totaled $749,000 in 2009, compared to $1.2 million in 2008.
The increase in the calendar period loss and LAE ratio primarily reflects an increase in the accident period loss ratio, partially offset by an increase in favorable loss reserve development related to prior accident periods. The accident period loss ratio was 71.7% and 64.9% for the years ended December 31, 2009 and 2008, respectively. The increase in the accident period loss ratio primarily reflects management’s estimate of the impact of the then current economic environment on the Company’s workers’ compensation book of business, including the impact of rising unemployment on management’s return to work controls. Favorable loss reserve development totaled $2.8 million for the year ended December 31, 2009, compared to favorable loss reserve development of $2.0 million for the same period in 2008. The favorable loss reserve development relates primarily to a decrease in the prior accident period loss development factors used to estimate losses and LAE. The decrease in prior accident period loss development factors primarily reflects prior year claim settlements during 2009 for amounts at, or less than, previously established case and IBNR reserves. This decrease had the effect of lowering loss development factors as of December 31, 2009. In the aggregate, the claims were closed at amounts lower than the provision established for IBNR claims. Management believes that the realization of the benefits of its return-to-work controls enabled it to record losses and LAE that were lower than the amount reserved for claim settlements.
The expense ratios are consistent with the contractual ceding commissions for the years ended December 31, 2009 and 2008.
The corporate/other segment reported a net loss of $3.2 million for the year ended December 31, 2009, compared to a net loss of $4.8 million for the same period in 2008. The decrease in the net loss from 2008 to 2009 primarily reflects an increase in the equity interest in limited partnerships at Eastern Re, a reduction in audit and consulting fees related to Sarbanes Oxley outsourcing, a decrease in stock compensation expense related to the ESOP of $390,000 and an increase in the Company’s equity interest in the segregated portfolio cells of $676,000. The decrease in ESOP compensation expense reflects the decline in the Company’s stock price.
Liquidity is a measure of an entity’s ability to secure sufficient cash to meet its contractual obligations and operating needs. The Company’s principal sources of funds are premiums, investment income and proceeds from sales and maturities of investments. The Company’s primary use of funds is to pay claims and operating expenses and to purchase investments. The Company’s investment portfolio is structured so that investments mature periodically over time in reasonable relation to current expectations of future claim payments. The Company’s fixed income investment portfolio as of December 31, 2010 had an effective duration of 3.81 years.
For the years ended December 31, 2010, 2009 and 2008, the Company’s cash inflows from premiums and investment activity were sufficient to support the Company’s cash outflows related to claims and operating expenses. Management expects future cash flows from operations in its workers’ compensation insurance and segregated portfolio cell reinsurance segments to be sufficient to cover claims and operating expenses. However, in the event cash flows from operations are not sufficient, the Company may have to liquidate investments to cover such costs. As of December 31, 2010, the Company’s investment portfolio included securities with gross unrealized gains totaling $8.2 million, excluding gross unrealized gains on investments in the segregated portfolio cell reinsurance segment of $1.1 million; therefore, based on current gross unrealized gains in the investment portfolio as of December 31, 2010, management does not believe it would have to sell securities at a loss in the event cash flows from operations proved insufficient to cover the Company’s operating needs.
The primary sources of cash flows for the Company are net premiums written, investment income, and proceeds from the sale or maturity of investments. The major components of cash flow from continuing operations are as follows for the years ended December 31, 2010, 2009, and 2008 (in thousands):
Cash Flows From Continuing Operations for the Years Ended December 31, 2010 and 2009. Cash flows from operating activities for the year ended December 31, 2010 primarily reflects the increase in direct premiums written and tax refunds related to the carryback of capital losses to prior tax years, partially offset by claim payments and a decrease in net investment income.
The following table summarizes information about contractual obligations and commercial commitments before the impact of purchase accounting adjustments. The minimum payments under these agreements as of December 31, 2010 were as follows (in thousands):
The loss reserves payments due by period in the table above are based upon the loss and LAE reserves estimates as of December 31, 2010 and actuarial estimates of expected payout patterns by line of business. As a result, our calculation of loss reserve payments due by period is subject to the same uncertainties associated with determining the level of reserves and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. For a discussion of our reserving process, see “Item 1 - Business, Loss and LAE Reserves.” Actual payments of loss and LAE by period will vary, perhaps materially, from the above table to the extent that current estimates of loss reserves vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns.
As of December 31, 2010, the Company has no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
In our opinion, the consolidated financial statement listed in the index appearing under Item 15 a)(1) present fairly, in all material respects, the financial position of Eastern Insurance Holdings, Inc. and its subsidiaries (the “Company”) at December 31, 2010 and December 31, 2009, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2010 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15 a)(2) present fairly, in all material respects the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective 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 (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in “Management’s Report on Internal Control Over Financial Reporting” appearing under Item 9A - Controls and Procedures. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
On December 9, 2010, EIHI completed the sale of Eastern Atlantic RE (“Atlantic RE”). Atlantic RE was a Cayman Islands reinsurance company formed for the purpose of transferring certain assets and liabilities related to EIHI’s run-off specialty reinsurance segment as part of the sale. As a result of the sale, the results of operations for the portion of the run-off specialty reinsurance segment that was transferred to Atlantic RE have been reflected as discontinued operations in the accompanying consolidated financial statements. The portion of the run-off specialty reinsurance segment that was not sold has been reclassified to the corporate/other segment. See Note 4 for additional information related to the sale.
On June 21, 2010, EIHI completed the sale of Eastern Life and Health Insurance Company (“Eastern Life”). As a result of the sale, Eastern Life’s operations have been reflected as discontinued operations in the accompanying consolidated financial statements. See Note 4 for additional information related to the sale.
On September 29, 2008, EIHI acquired all of the outstanding stock of Employers Security Holding Company (“ESHC”) and its wholly-owned subsidiaries, Employers Security and Affinity Management Services (“AMS”) (See Note 3). Employers Security is an Indiana-domiciled, mono-line workers’ compensation insurance company licensed to write business in Indiana, Illinois and Missouri.
As a result of adopting new accounting guidance related to the recognition and presentation of other-than-temporary investment impairments in 2009, the Company recorded a cumulative effect adjustment that increased retained earnings by $685 and decreased accumulated other comprehensive income (loss), net by $445, resulting in an increase to shareholders’ equity of $240. The increase in shareholders’ equity reflects the reversal of a prior period deferred tax valuation allowance, of which $240 was applied to the retained earnings cumulative effect adjustment.
Realized gains or losses are based on cost and are computed using the specific identification method. The Company monitors its equity securities for unrealized losses that appear to be other-than-temporary. The Company performs a detailed review of these securities to determine the underlying cause of the unrealized loss and whether the security is impaired. At the time a security is determined to be other-than-temporarily impaired, the Company reduces the cost of the security to the current estimated fair value as of the balance sheet date and records a realized loss in the consolidated statements of operations and comprehensive income (loss). Any subsequent increase in the security’s estimated fair value would be reported as an unrealized gain.
The Company discounts its reserves for unpaid losses and LAE for workers’ compensation claims on a non-tabular basis, using a discount rate of 3.0%, based upon regulatory guidelines. The reserves for unpaid losses and LAE have been reduced for the effects of discounting by approximately $4,633 and $4,256 as of December 31, 2010 and 2009, respectively.
Management believes that its reserves for unpaid losses and LAE is adequate as of December 31, 2010. However, estimating the ultimate liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates and judgments using data currently available. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded as of December 31, 2010, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.
The reinsurance recoverable for unpaid losses and LAE includes the balances due from reinsurance companies for unpaid losses and LAE that are expected to be recovered from reinsurers, based on contracts in force.
Eastern Re is an exempt entity under the Companies Law of the Cayman Islands; however, Eastern Re’s earnings and profits are subject to federal income tax for earnings subsequent to June 16, 2006.
Management tested goodwill for impairment as of September 30, 2010 using a discounted cash flow analysis. The discounted cash flow analysis was based on management’s internal four-year forecast for the workers’ compensation insurance segment, assuming a long-term growth rate of 5.0% and a discount rate of 13.0%. Cash flows were adjusted, as necessary, to maintain adequate capital requirements. The discounted cash flow analysis resulted in the workers’ compensation insurance segment’s estimated fair value exceeding its carrying value as of September 30, 2010; therefore, goodwill was considered not impaired.
The following table provides the assets and liabilities of the group benefits insurance segment and run-off specialty reinsurance segment that are included in discontinued operations on the Company’s consolidated balance sheet as of December 31, 2009:
The sale of Eastern Life resulted in the recognition of a gain totaling $564, which is included in discontinued operations. Transaction expenses related to the sale of Eastern Life totaled $873 ($567, net of tax) for the year ended December 31, 2010, and have been included in discontinued operations. Certain corporate expenses previously reported in the group benefits insurance segment were reclassified to continuing operations. The reclassification of these corporate expenses totaled $500 for each of the years ended December 31, 2010, 2009, and 2008.
For the years ended December 31, 2010, 2009, and 2008, the group benefits insurance segment reported net premiums earned of $18,262, $35,937, and $36,723, respectively, and total revenue of $20,563, $40,745, and $33,505, respectively. Income (loss) before income taxes in the group benefits insurance segment totaled $952, $4,157, and $(2,239) for the years ended December 31, 2010, 2009, and 2008, respectively.
Basic earnings per share are computed by dividing net (loss) income by the weighted average number of shares outstanding for the respective period. Diluted earnings per share are computed by dividing net (loss) income by the weighted average number of shares outstanding for the period, including dilutive potential common shares outstanding for the period. For the years ended December 31, 2010, 2009 and 2008, there were 978,430, 784,361 and 834,757 stock options and restricted stock awards, respectively, that were not included in the Company’s earnings per share from continuing operations calculation because to do so would have been anti-dilutive.
Consolidated net (loss) income, basic shares outstanding, diluted shares outstanding, basic earnings per share, diluted earnings per share and cash dividends per share for the years ended December 31, 2010, 2009 and 2008 were as follows (in thousands, except share and per share data):
As of December 31, 2010, the Company’s Board of Directors has authorized repurchases of the Company’s issued and outstanding shares of common stock equal to 2,046,500 shares plus additional shares not to exceed $10.0 million. The share repurchases will be held as treasury stock and are available for issuance in connection with the Company’s Stock Incentive Plan.
On January 12, 2011, the Company’s Board of Directors authorized the repurchase of an additional 1,000,000 shares after the $10.0 million in share repurchases has been completed.
Awards under the Stock Incentive Plan may be made in the form of incentive stock options, nonqualified stock options, restricted stock or any combination to employees and non-employee directors. The Stock Incentive Plan limits the number of shares that may be initially awarded as restricted stock to 299,000, and the number of shares for which incentive stock
Total stock-based compensation expense recognized in the consolidated statement of operations and comprehensive income for the years ended December 31, 2010 and 2009 is shown in the following table (in thousands):
As of December 31, 2010, there were 361,959 and 160,231 vested stock options and restricted stocks awards, respectively. As of December 31, 2009, there were 236,897 and 109,896 vested stock options and restricted stock awards, respectively. The total unrecognized stock compensation expense related to non-vested stock options was $1,593 and $1,173, respectively, and the total unrecognized stock compensation expense related to non-vested restricted stock awards was $689 and $1,395, respectively, as of December 31, 2010 and 2009. The unrecognized stock compensation expense related to the non-vested stock options and restricted stock awards is expected to be recognized over a weighted average period of approximately 28.1 months and 22.5 months, respectively.
The fair values of stock options granted in 2010 were determined on the dates of grant using a lattice-based binomial option valuation model with the following assumptions:
Permitted statutory accounting practices encompass all accounting practices that are not prescribed; such practices differ from state to state, may differ from company to company within a state, and may change in the future. The Company’s domestic insurance subsidiaries did not have any permitted practices as of or for the year ended December 31, 2010.
The statutory surplus and statutory net income (loss) of Eastern Alliance, Allied Eastern, Eastern Advantage and Employers Security as of December 31, 2010 and 2009 and for the years ended December 31, 2010, 2009, and 2008 was as follows (in thousands):
The ability of Eastern Alliance, Allied Eastern, Eastern Advantage, and Employers Security to pay dividends to EIHI is limited by the laws and regulations of Pennsylvania and Indiana. The maximum annual dividends that EIHI’s insurance subsidiaries may pay without the prior approval from the Pennsylvania Insurance Department and Indiana Insurance Department is limited to the greater of 10% of statutory surplus or 100% of statutory net income for the most recently filed annual statement. The maximum dividend that may be paid by Eastern Alliance, Allied Eastern and Eastern Advantage in 2011, without prior approval from the Pennsylvania Insurance Department, is $4,747, $840 and $855, respectively. The maximum dividend that may be paid by Employers Security in 2011, without prior approval from the Indiana Insurance Department, is $1,056.
The following is a description of the Company’s categorization of the inputs used in the recurring fair value measurements of its financial assets included in its consolidated balance sheet as of December 31, 2010:
Level 2-Represents financial assets whose fair value is determined based upon: quoted market prices for similar assets in active markets; quoted market prices for identical assets in inactive markets; inputs other than quoted market prices that are observable for the asset such as interest rates or yield curves; or other inputs derived principally from or corroborated from other observable market information. An example of a Level 2 input utilized to measure fair value, specifically for the Company’s fixed income portfolio, is “matrix pricing.” “Matrix pricing” relies on observable inputs from active markets other than quoted market prices including, but not limited to, benchmark securities and yields, latest reported trades, quotes from brokers or dealers, issuer spreads, bids, offers, and other relevant reference data to determine fair value. “Matrix pricing” is used to measure the fair value of fixed income securities where obtaining individual quoted market prices is impractical. The Company considers U.S. Government agencies, municipal bonds, mortgage-backed securities, collateralized mortgage obligations, asset-backed securities, corporate bonds, and convertible bonds as Level 2 assets.
Level 3-Represents financial assets whose fair value is determined based upon inputs that are unobservable, including the Company’s own determinations of the assumptions that a market participant would use in pricing the asset.
The following table provides a summary of the fair value measurements of the Company’s fixed income securities, convertible bonds, and equity securities, as of December 31, 2010 and 2009, excluding the segregated portfolio cell segment (in thousands):
There were no transfers between Level 1 and Level 2 securities for the year ended December 31, 2010.
include, but are not limited to, initial and ongoing evaluation of the methodologies used by the independent pricing service as well as comparing the fair value estimates to the Company’s knowledge of the current market. Fixed income securities include U.S. Treasuries, agencies backed by the U.S. Government, municipal bonds, mortgage-backed securities, collateralized mortgage obligations, asset-backed securities, and corporate bonds.
Other long-term investments include the Company’s interest in various limited partnerships, including a low volatility multi-strategy fund of funds, two natural resource limited partnerships, a structured finance opportunity fund, an open-ended investment fund and a real estate limited partnership. The Company records its investment in the limited partnerships using the equity method. The carrying value of the Company’s limited partnership investments are based on the Company’s allocable share of the limited partnerships’ net asset value. Changes in the Company’s investments are based on statements received directly from the limited partnership and/or the limited partnership’s administrator. The estimated fair values of the underlying investments in the limited partnerships may be based on Level 1, Level 2, or Level 3 inputs, or a combination thereof.
As of December 31, 2010 and 2009, the estimated fair values of the Company’s other long-term investments, by investment strategy, were as follows (in thousands):
Following is a summary of the investment objectives of each of the Company’s limited partnership investments, by investment strategy:
Multi-strategy fund of funds-The fund seeks to build and manage low volatility, multi-manager portfolios that have little or no correlation to the broader fixed income and equity security markets.
Open-ended investment fund-The fund seeks above-average capital growth through investment in domestic equity securities and equity related securities that are publicly traded in the United States.
The activity in the Company’s limited partnership investments for the years ended December 31, 2010, 2009 and 2008 was as follows (in thousands):
Other structured securities include other asset-backed securities collateralized by home equity loans, auto loan receivables and manufactured homes.
Certain insurance departments in the states in which the Company is licensed to do business require a deposit to protect the Company’s policyholders should the Company become insolvent. In order to satisfy these requirements, the Company had fixed income securities with an estimated fair value of $11,442 and $10,699 on deposit with various insurance departments as of December 31, 2010 and 2009, respectively.
The amortized cost and estimated fair value of fixed income securities and convertible bonds as of December 31, 2010, by contractual maturity, are shown below (in thousands). Expected maturities could differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties.
The gross unrealized losses and estimated fair value of fixed income securities, excluding those securities in the segregated portfolio cell reinsurance segment, classified as available-for-sale by category and length of time an individual security has been in a continuous unrealized position as of December 31, 2010 and 2009 are as follows (in thousands):
As of December 31, 2010, the Company held 51 fixed income securities with gross unrealized losses totaling $328. Management has evaluated the unrealized losses related to those fixed income securities and determined that they are primarily due to a fluctuation in interest rates and not to credit issues of the issuer or the underlying assets in the case of asset-backed securities. The Company does not intend to sell the fixed income securities and it is not more likely than not that the Company will be required to see the fixed income securities before recovery of their amortized cost bases, which may be maturity; therefore, management does not consider the fixed income securities to be other-than-temporarily impaired as of December 31, 2010.
$2,858 for the years ended December 31, 2010, 2009, and 2008, respectively. Proceeds from the sale of other long-term investments totaled $0, $461, and $370 for the years ended December 31, 2010, 2009, and 2008, respectively.
For the years ended December 31, 2010, 2009 and 2008, the Company recorded other-than-temporary impairments, excluding the segregated portfolio cell reinsurance segment, related to its fixed income and equity securities totaling $6, $1,852 and $3,644, respectively. Other-than-temporary impairments in the segregated portfolio cell reinsurance segment totaled $80, $749, and $1,211 for the years ended December 31, 2010, 2009 and 2008, respectively.
For the years ended December 31, 2010, 2009 and 2008, the change in the estimated fair value of convertible bonds included in net realized investment (losses) gains in the consolidated statement of operations and comprehensive income totaled $1,166, $877 and $(623), respectively.
The change in the Company’s net unrealized gains and losses for the years ended December 31, 2010, 2009, and 2008 was as follows (in thousands):
Net investment income for the years ended December 31, 2010, 2009, and 2008 was as follows (in thousands):
The following table provides a summary of the activity in the Company’s reserves for unpaid losses and LAE for the years ended December 31, 2010, 2009, and 2008 (in thousands):
Incurred losses by segment were as follows for the year ended December 31, 2010 (in thousands):
Incurred losses by segment were as follows for the year ended December 31, 2009 (in thousands):
For the years ended December 31, 2010, 2009 and 2008, the Company increased (decreased) its workers’ compensation insurance reserves for unpaid losses and LAE by the following amounts by accident year (in thousands):
For the year ended December 31, 2009, the Company recognized net favorable development on prior accident year workers’ compensation reserves of $3.7 million, representing 6.8% of the Company’s estimated workers’ compensation reserves as of December 31, 2008 and 5.1% of the Company’s workers’ compensation net premiums earned for the year ended December 31, 2009. The favorable development arose primarily from accident years 2006 and 2007, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting include greater availability and use of employers’ return to work programs. Furthermore, the Company was able to settle a large amount of Pennsylvania claims via compromise and release, which is a lump sum cash payment in exchange for a full and final claim settlement. Management attributes the large amount of compromise and release claim closures to the difficult economic conditions and the claimants’ choosing a lump sum cash settlement over the continuation of a workers’ compensation annuity payment.
For the year ended December 31, 2008, the Company recognized net favorable development on prior accident year workers’ compensation reserves of $2.7 million, representing 6.3% of the Company’s estimated workers’ compensation reserves as of December 31, 2007 and 4.1% of the Company’s workers’ compensation net premiums earned for the year ended December 31, 2008. The favorable development arose primarily from accident year 2007, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting the continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting include greater availability and use of employers’ return to work programs and an improved economy in the Company’s underwriting territories during the first nine months of 2008.
For the years ended December 31, 2010, 2009 and 2008, the Company (decreased) increased its segregated portfolio cell reinsurance reserves for unpaid losses and LAE by the following amounts by accident year (in thousands):
For the year ended December 31, 2008, the Company recognized net favorable development on prior accident year segregated portfolio cell reinsurance reserves of $2.0 million, representing 9.4% of the Company’s estimated segregated portfolio cell reinsurance reserves as of December 31, 2007 and 8.4% of the Company’s segregated portfolio cell reinsurance net premiums earned for the year ended December 31, 2008. The favorable development arose primarily from accident years 2006 and 2007, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting include greater availability and use of employers’ return to work programs and an improved economy in the Company’s underwriting territories during the first nine months of 2008.
The components of the income tax provision from continuing operations for the years ended December 31, 2010, 2009, and 2008 are as follows (in thousands):
The provision for income taxes from continuing operations for the years ended December 31, 2010, 2009, and 2008 is as follows (in thousands):
As of December 31, 2010, the net deferred tax asset of $721 has not been reduced by a valuation allowance because management believes that, while it is not assured, it is more likely than not that the Company will generate sufficient future taxable income to utilize these net future tax deductions. The amount of the net deferred tax asset considered realizable, however, could be materially reduced in the near term if estimates of future taxable income in the years in which the differences are expected to reverse are decreased.
The Company issued 747,500 shares of its common stock to the ESOP on June 16, 2006, and the ESOP signed a promissory note in the amount of $7,475 for the purchase of the shares, which is due in ten equal installments, with interest accruing annually at 4%. Shares purchased are held in a suspense account for allocation among participating employees as the loan is repaid.
Suspense shares, allocated shares, shares committed to be released, average price per share and stock compensation expense as of and for the years ended December 31, 2010 and 2009 were as follows (in thousands, except share data):
As of December 31, 2010 and 2009, the estimated fair value of unearned ESOP shares were $4,259 and $4,256, respectively.
The Company sponsors a contributory defined contribution plan covering eligible employees. Employees are eligible to participate in the defined contribution plan upon the attainment of 21 years of age. The Company provides a matching
contribution up to 75% of the first 4% of an employee’s contributions. Employees are immediately vested in the employer matching contributions regardless of years of service. The Company’s contributions to the defined contribution plan for the years ended December 31, 2010, 2009, and 2008 totaled $297, $309, and $237, respectively.
The Company also sponsors a non-contributory defined benefit pension plan (the “pension plan”) and a defined benefit postretirement plan (the “postretirement plan”), both of which are frozen as to the earning of additional benefits.
The assumptions used in the measurement of the Company’s benefit obligation are shown in the following table:
The net periodic benefit cost incurred by the Company for the years ended December 31, 2010, 2009 and 2008 totaled $17, $68, and $(59) for the pension plan and $(7), $(5), and $(3) for the postretirement plan.
The estimated future benefits to be paid over the next ten years related to the postretirement plan are expected to be minimal. The only benefits currently being paid by the Company under the postretirement plan relate to life insurance premiums for certain retirees.
The pension plan’s equity securities consist of a small-cap index mutual fund. The mutual fund’s estimated fair value is based on a quoted net asset value; therefore, the estimated fair value is considered a Level 1 fair value measurement. The pension plan’s fixed income securities consist of pooled separate accounts that are valued at the net participation value of participation units held by the pension plan. The value of the participation units is determined by the trustee based on the estimated fair values of the underlying assets of the pooled separate account; therefore, the estimated fair value of the pooled separate accounts is considered a Level 2 fair value measurement.
Historical and future expected returns of multiple asset classes were analyzed to develop a risk-free real rate of return and risk premiums for each asset class. The overall rate for each asset class was developed by combining a long-term inflation component, the risk-free real rate of return, and the associated risk premium. A weighted average rate was developed based on those overall rates and the target asset allocation of the pension plan.
The corporate/other segment primarily includes the expenses of the holding company, the third party administration activities of the Company, and the non-segregated portfolio cell reinsurance results of operations of Eastern Re, as well as certain eliminations necessary to reconcile the segment information to the consolidated statements of operations and comprehensive income (loss). The corporate/other segment also includes the Company’s 10% interest in a segregated
The following table represents the segment results for the year ended December 31, 2010 (in thousands):
The following table represents the segment results for the year ended December 31, 2009 (in thousands):
On May 15, 2008, the Company called its junior subordinated debentures at par. The Company paid cash of $8,400 to satisfy its outstanding obligation related to the debentures, including accrued interest of $253.
Management performed an evaluation of subsequent events and determined there were no recognized or unrecognized subsequent events that would require an adjustment and/or additional disclosure in the consolidated financial statements as of December 31, 2010.
23. Quarterly Financial Data (Unaudited, in thousands, except per share data)