Results and Financial Condition” that could cause our actual results of operations, performance and business prospects and opportunities in 2004 and beyond to differ materially from those expressed in, or implied by those forward-looking statements. See “Note on Forward-Looking Statements” in Part I, Item 1 of this annual report.
table. In contrast, our investment portfolio consists mostly of investment grade fixed income securities, which have higher yields than cash and cash equivalents. Our service income is not comparable to the service income of our predecessor because our predecessor provided only limited claims handling services for certain affiliates of LMC. In contrast, we are providing claims handling as well as policy administration and accounting services for our predecessor.
We derive our revenue from premiums earned, service fee income, net investment income and net realized gains (losses) from investments.
We invest our statutory surplus and the funds supporting our insurance liabilities (including unearned premiums and unpaid loss and loss adjustment expenses) in cash, cash equivalents and fixed income securities. Our investment income includes interest earned on our invested assets. Realized gains and losses on invested assets are reported separately from net investment income. We earn realized gains when invested assets are sold for an amount greater than their amortized cost in the case of fixed maturity securities and recognize 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 carrying cost.
Substantially all of our claims service income is from contracts we have with LMC to provide claims handling services for the policies written by the Eagle entities prior to the Acquisition. The claims service income we receive for providing these services approximates our costs and will substantially decrease over the next several years as transactions related to the Eagle entities diminish.
In our insurance subsidiary, we refer to the expenses that we incur to underwrite risks as underwriting, acquisition and insurance expenses. Underwriting expenses consist of commission expenses, premium taxes and fees and other underwriting expenses incurred in writing and maintaining our business.
Other underwriting expenses consist of general administrative expenses such as salaries, rent, office supplies, depreciation and all other operating expenses not otherwise classified separately, and boards, bureaus and assessments of statistical agencies for policy service and administration items such as rating manuals, rating plans and experience data.
Gross Premiums Written. Gross premiums written were $135.7 million for the year ended December 31, 2004 compared to our predecessor’s $70.7 million for the nine months ended September 30, 2003 and our $22.2 million for the three months ended December 31, 2003, representing a period-over-period increase of $42.8 million, or 46.1%. We began writing new insurance contracts on October 1, 2003 and began renewing some of the existing contracts of our predecessor expiring after that date. The increase in gross premiums written was due primarily to our “A-” (Excellent) rating from A.M. Best in 2004, in comparison to our predecessor’s rating of “B++” (Very Good) in the prior period and our expansion in California state act contractor business.
Net Premiums Written. Net premiums written totaled $119.6 million for the year ended December 31, 2004 compared to our predecessor’s $66.6 million for the nine months ended September 30, 2003 and our $19.4 million for the three months ended December 31, 2003, representing a period-over-period increase of $33.6 million, or 39.1%. Net premiums written are affected by premiums ceded under reinsurance agreements. Ceded written premiums for the year ended December 31, 2004 totaled $16.1 million, or 11.9% of gross premiums written. Our predecessors ceded written premiums for the nine months ended September 30, 2003 totaled $4.1 million, or 5.8% of gross premiums written. Our predecessor’s premiums ceded were impacted by the quota share reinsurance agreement with LMC. Our reinsurance contracts provide for the ceding of premiums on both a gross premiums written and gross premiums earned basis.
Other Revenue. Other revenue was $2.5 million for the year ended December 31, 2004 compared to our predecessor’s $1.5 million for the nine months ended September 30, 2003 and our $0.7 million for the three months ended December 31, 2003, representing a period-over-period increase of $0.3 million, or
Loss and Loss Adjustment Expenses. Loss and loss adjustment expenses totaled $53.7 million for the year ended December 31, 2004 compared to our predecessor’s $25.4 million for the nine months ended September 30, 2003 and our $3.0 million for the three months ended December 31, 2003, representing a period-over-period increase of $25.3 million, or 89.1%. The higher loss and loss adjustment expenses for the year ended December 31, 2004 are attributable to the increase in premiums earned for the period. Our loss ratio for the year ended December 31, 2004 was 65.1%, compared to our predecessor’s loss ratio of 66.9% for the nine months ended September 30, 2003 and our loss ratio of 75.3% for the three months ended December 31, 2003. Our loss ratio decreased from 75.3% in the three months ended December 31, 2003 to 65.1% in the year ended December 31, 2004. Because we acquired substantially all of the workforce of our predecessor in connection with the Acquisition but none of our predecessor’s existing premiums, the costs to operate our claims department as a percentage of net premiums earned, in our initial stages of growth, are greater than they would have been had we been in existence for a full 12 months. As of December 31, 2004, we had recorded a receivable of approximately $2.9 million for adverse loss development under the adverse development cover since the date of the Acquisition. We do not expect this receivable to have any material effect on our future cash flows if LMC fails to perform its obligations under the adverse development cover. At December 31, 2004, we have access to approximately $4.8 million under the collateralized reinsurance trust in the event that LMC fails to satisfy its obligations under the adverse development cover. See the discussion under the heading “Our History” in Part I, Item 1 of this annual report.
Other Expenses. Other expenses totaled $4.9 million for the year ended December 31, 2004, compared to our predecessor’s other expenses of $1.8 million for the nine months ended September 30, 2003 and our $0.8 million for the three months ended December 30, 2003, representing a period-over-period increase of $2.3 million, or 88.5%. The increase resulted primarily from the amortization of intangible assets acquired in connection with the Acquisition, higher expenses associated with the operations of PointSure, our non-insurance company subsidiary, and interest expense on $12.0 million of surplus notes issued by our insurance subsidiary in May 2004. Our predecessor’s other expenses consist primarily of operating expenses for PointSure.
Net Income. Net income was $7.2 million for the year ended December 31, 2004, compared to our predecessor’s $4.7 million for the nine months ended September 30, 2003 and our net loss of $0.2 million for the three months ended December 31, 2003. The 2004 increase in net income resulted primarily from the increase in premiums earned and investment income for the period, offset by related increases in loss and loss adjustment expenses; underwriting acquisition and insurance expenses; and other expenses, including interest expense related to the surplus notes and amortization expense related to intangible assets acquired in the Acquisition.
Gross Premiums Written. Our predecessor’s gross premiums written was $70.7 million for the nine months ended September 30, 2003, compared to $106.1 million in gross premiums written for the year ended December 31, 2002. Our predecessor’s average monthly gross premiums decreased 11.1% in the nine months ended September 30, 2003 compared to 2002. The decrease represents the net of the positive impact of our predecessor’s price increases averaging 16.5% for the nine months ended September 30, 2003, offset by the negative impact of our predecessor’s A.M. Best financial strength rating downgrade to “B++” in December 2002.
Predecessor Year Ended December 31, 2002 Compared to Predecessor Year Ended December 31, 2001
Net Investment Income. Our predecessor’s net investment income was $3.4 million for the years ended December 31, 2002 and 2001. The yield was 4.2% in 2002 compared to 4.7% in 2001. This decline was due primarily to the realignment of our predecessor’s portfolio in 2002 from fixed income securities to cash and short-term investments, which made up 34.9% of the portfolio in 2002 compared to 13.6% in 2001.
Claims Service Income. Our predecessor’s claims service income was $1.2 million for the year ended December 31, 2002, compared to $1.0 million for the year ended December 31, 2001 as the volume of claims serviced by our predecessor for LMC increased.
Loss and Loss Adjustment Expenses. Loss and loss adjustment expenses were $5.0 million for the year ended December 31, 2002, compared to $8.5 million for the year ended December 31, 2001. Net loss and loss adjustment expense ratios for 2002 and 2001 were 22.5% and 59.5%, respectively. In 2002, our predecessor reduced 2001 and prior accident year unpaid loss and loss adjustment expense levels by $8.3 million. In prior policy periods, Eagle Pacific Insurance Company wrote a large number of accounts with smaller average premiums than our core book of business. Due to the nature of these accounts there was an expectation that they were subject to a greater volatility of risk than our core book of business and initial unpaid loss and loss adjustment amounts were established reflecting this higher level of risk. An actuarial evaluation was performed for the 2002 and prior accident years, which concluded that the actual loss development on this business was not as great as expected. This, coupled with the more recent emphasis of writing larger, less volatile accounts using stricter underwriting standards, led management to decrease the unpaid loss and loss adjustment expenses for the prior accident years. Included in the $8.3 million reduction was $7.0 million relating to the loss portfolio transfer, which reduced our predecessor’s unpaid loss and loss adjustment expenses dollar for dollar because it was not part of the quota share reinsurance treaties. As a result of the $7.0 million reduction to the unpaid loss and loss adjustment expenses under the loss portfolio treaties, our predecessor recorded an accretion to the deferred
Federal Income Tax Expense. Our predecessor’s effective tax rate was 47.9% for the year ended December 31, 2002, compared to 42.7% for the year ended December 31, 2001. The 2002 tax rate was affected by the dividends received deduction and an increase in the valuation allowance established for deferred tax assets. The 2001 tax rate was affected by the dividends received deduction and the amortization of goodwill, which was not tax deductible.
Net Income Before Cumulative Effect of Change in Accounting Principle. Net income before the cumulative effect of a change in accounting principle was $3.3 million for the year ended December 31, 2002, compared to $3.6 million for the same period in 2001.
At December 31, 2004, our portfolio is made up almost entirely of investment grade fixed income securities with market values subject to fluctuations in interest rates. Prior to 2005, we did not invest in common equity securities and we had no exposure to foreign currency risk. In February 2005, our investment policy was revised to allow for the investment of up to 2% of our investment portfolio in foreign fixed income 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.
Our consolidated net cash provided by operating activities for the year ended December 31, 2004 was $41.0 million, compared to our cash flow from operations of $0.5 million for the three months ended December 31, 2003. The increase is mainly attributable to increases in unpaid loss and loss adjustment expense and amortization of deferred policy acquisition costs, offset by increases in policy acquisition costs deferred and balances related to reinsurance recoverables, all as a result of our growth.
The following table identifies our contractual obligations by payment due period as of December 31, 2004:
As of December 31, 2004, we have no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Unpaid loss and loss adjustment expenses represent our estimate of the expected cost of the ultimate settlement and administration of losses, based on known facts and circumstances. Included in unpaid loss and loss adjustment expenses are amounts for case-based claims, including estimates of future developments on these claims, and claims incurred but not yet reported to us, second injury fund, allocated claim adjustment expenses and unallocated claim adjustment expenses. We use actuarial methodologies to assist us in establishing these estimates, including judgments relative to estimates of future claims severity and frequency, length of time to achieve ultimate resolution, judicial theories of liability and other third-party factors that are often beyond our control. Due to the inherent uncertainty associated with the cost of unsettled and unreported claims, the ultimate liability may differ from the original estimate. These estimates are regularly reviewed and updated and any resulting adjustments are included in the current period’s operating results. Because of the relative immaturity of our unpaid loss and loss adjustment expenses, actuarial techniques are applied that use the historical experience of our predecessor as well as industry information in the analysis of our unpaid loss and loss adjustment expenses.
The unpaid loss and loss adjustment expense subject to the adverse development cover with LMC is calculated on a quarterly basis using generally accepted actuarial methodologies. Amounts recoverable in excess of acquired reserves at September 30, 2003 are recorded gross in unpaid loss and loss adjustment expense in accordance with SFAS No. 141, “Business Combinations,” with a corresponding amount receivable from the seller. Amounts are shown net in the income statement.
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. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. If necessary, we would establish a valuation allowance to reduce the deferred tax assets to the amounts more likely than not to be realized.
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. Intangible assets with estimable useful lives are amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets.”
Retrospective premiums for primary and reinsured risks are included in income as earned on a pro rata basis over the effective period of the respective policies. Earned premiums on retrospectively rated policies are based on the Company’s estimate of loss experience as of the measurement date. Unearned premiums are deferred and include that portion of premiums written that is applicable to the unexpired period of the policies in force and estimated adjustments of premiums on policies that have retrospective rating endorsements. Approximately 35.8% of premiums written in 2004 relate to retrospectively rated policies.
the approach described in Statement No. 123. However, Statement No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.
Statement No. 123(R) must be adopted no later than July 1, 2005, and we expect to adopt the Statement on that date. As permitted by Statement No. 123, the Company currently accounts for share based payments to employees using the intrinsic value method as detailed in Opinion No. 25 and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of Statement No. 123(R)’s fair value method will have an impact on our results of operations, although it will have no impact on our overall financial position. The impact of adoption of Statement No. 123(R) cannot be predicted at this time because it will depend on levels of share based payments granted in the future. However, had we adopted Statement No. 123(R) in prior periods, the impact of the standard would have approximated the impact of Statement No. 123 as described in Note 2.n. of the Notes to Consolidated Financial Statements included in Item 8 of this annual report.
SeaBright Insurance Holdings, Inc. (“SIH” or the “Company”), a Delaware corporation, was formed in June 2003. On July 14, 2003, SIH entered into a purchase agreement, effective September 30, 2003, with Kemper Employers Group, Inc. (“KEG”), Eagle Insurance Companies (“Eagle”), and Lumbermens Mutual Casualty Company (“LMC”), all ultimately owned by Kemper Insurance Companies (“KIC”) (the “Acquisition”). Under this agreement, SIH acquired Kemper Employers Insurance Company (“KEIC”), PointSure Insurance Services, Inc. (“PointSure”), and certain assets of Eagle, primarily renewal rights as further discussed in Note 17.
KEIC is licensed to write workers’ compensation insurance in 43 states and the District of Columbia. Domiciled in the State of Illinois and commercially domiciled in the State of California, it writes both state act workers’ compensation insurance and United States Longshore and Harborworkers’ Compensation insurance (“USL&H”). Prior to the Acquisition, beginning in 2000, KEIC wrote business only in California. In May 2002, KEIC ceased writing business and by December 31, 2003, all premiums related to business prior to the Acquisition were 100% earned. As further discussed in Note 17, 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 date of the Acquisition have increased or decreased from the amount existing at the date of the Acquisition.
The consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and include amounts based on the best estimates and judgment of management. Such estimates and judgments could change in the future, as more information becomes known which could impact the amounts reported and disclosed herein.
Mortgage-backed securities represent participating interests in pools of first mortgage loans originated and serviced by the issuers of securities. These securities are carried at the unpaid principal balances, adjusted for unamortized premiums and unearned discounts. Premiums and discounts are amortized using a method that approximates the level yield method over the remaining period to contractual maturity, adjusted for anticipated prepayments. To the extent that the estimated lives of such securities change as a result of changes in prepayment rates, the adjustment is also included in net investment income. Prepayment assumptions used for mortgage-backed and asset-backed securities were obtained from an external securities information service and are consistent with the current interest rate and economic environment.
For the purpose of determining realized gains and losses, which arise principally from the sale of investments, the cost of securities sold is based on specific-identification.
Cash and cash equivalents, which consist primarily of amounts deposited in banks and financial institutions, and all highly liquid investments with maturity of 90 days or less when purchased, are stated at cost.
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 date of the Acquisition have increased or decreased from the amount existing at the date of the Acquisition.
Although it is not possible to measure the degree of variability inherent in such estimates, management believes that the reserves for unpaid loss and loss adjustment expenses are adequate. The estimates are reviewed periodically and any necessary adjustments are included in the results of operations of the period in which the adjustment is determined.
The following table provides the reconciliation of weighted average common share equivalents outstanding used in calculating earnings per share for the year ended December 31, 2004:
Earnings per share is not presented for the period ended December 31, 2003 as there are not issued and outstanding shares of common stock and the Company had a net loss. Any common stock equivalents would be anti-dilutive. Outstanding options to purchase shares of our common stock are excluded above because they are not dilutive.
SFAS No. 123 (revised 2004), “Share Based Payment,” was issued in December 2004. Statement No. 123(R) is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” Statement No. 123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in Statement No. 123(R) is similar to the approach described in Statement No. 123. However, Statement No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.
Statement No. 123(R) must be adopted no later than July 1, 2005, and we expect to adopt the Statement on that date. As permitted by Statement No. 123, the Company currently accounts for share based payments to employees using the intrinsic value method as detailed in Opinion No. 25 and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of Statement No. 123(R)’s fair value method will have an impact on our results of operations, although it will have no impact on our overall financial position. The impact of adoption of Statement No. 123(R) cannot be predicted at this time because it will depend on levels of share based payments granted in the future. However, had we adopted Statement No. 123(R) in prior periods, the impact of the standard would have approximated the impact of Statement No. 123 as described in the disclosure of pro forma net income and earnings per share discussed above.
The consolidated cost or amortized cost, gross unrealized gains and losses, and estimated fair value of investment securities available-for-sale at December 31, 2004 and 2003 are as follows:
The consolidated amortized cost of investment securities available-for-sale deposited with various regulatory authorities was $26.8 million and $13.0 million at December 31, 2004 and 2003, respectively.
The consolidated proceeds and related gross realized gains and losses received from sales of investments were as follows for the year ended December 31, 2004 and the three month period ended December 31, 2003:
Cash and cash equivalents, premiums receivable, and accrued expenses and other liabilities: The carrying amounts for these financial instruments as reported in the accompanying balance sheets approximate their fair values.
Premiums receivable consist of the following at December 31, 2004 and 2003:
The activity in the allowance for doubtful accounts for the year ended December 31, 2004 and for the period from June 19, 2003 (inception) through December 31, 2003 is as follows (in thousands):
Property and equipment at December 31, 2004 and 2003 are summarized as follows:
The following reflects the amounts of policy acquisition costs deferred and amortized for the year ended December 31, 2004 and the three months ended December 31, 2003:
SBIC has in place a series of reinsurance agreements 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 agreement whereby 10% of the first $250,000 loss plus a pro-rata share of expenses are 100% reinsured with Swiss Reinsurance
Balances affected by reinsurance transactions are reported gross of reinsurance in the balance sheets. Reinsurance recoverables are comprised of the following amounts at December 31, 2004 and 2003:
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 year ended December 31, 2004 was $415,000.
The following is a reconciliation of the difference between the “expected” income tax computed by applying the federal statutory income tax rate to income before income taxes and the total federal income taxes reflected on the books for the initial year ended December 31, 2004 and the three month period ended December 31, 2003:
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. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based upon the projections of future taxable income over the periods in which the deferred taxes are deductible, management believes it is more likely than not that the Company will realize the benefits of these deductible differences.
SBIC is required to file annually with state regulatory insurance authorities financial statements prepared on an accounting basis as prescribed or permitted by such authorities (statutory basis accounting or “SAP”). Statutory net income and capital and surplus (stockholder’s equity) differ from amounts reported in accordance with GAAP, primarily because policy acquisition costs are expensed when incurred,
The Company maintains a defined contribution retirement plan covering substantially all of its employees. The amount of annual contribution is 1% of gross salaries and must be approved by the board of directors. Any additional contribution must be requested by the President and CEO and approved by the Compensation Committee. Contribution expense for the year ended December 31, 2004 and for the three month period ended December 31, 2003 was $316,000 and $60,000, respectively.
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 loss experience on business subject to such experience rating adjustment. Accrued retrospective rated premiums are determined by or allocated to individual policyholder accounts. Accrued retrospective premiums and return retrospective premiums are recorded as additions to and reductions from written premium, respectively. Approximately 35.8% of the Company’s direct premiums written for the year ended December 31, 2004 related to retrospectively rated contracts and approximately 43.8% of direct premiums written for the three month period ended December 31, 2003 related to such contracts. The Company accrued $1.1 million for retrospective premiums payable and $593,000 for return retrospective premiums at December 31, 2004. No such amounts were recorded at December 31, 2003.
On July 14, 2003, SIH entered into a purchase agreement, effective September 30, 2003, with KEG, Eagle and LMC, all ultimately owned by KIC. In the Acquisition, SIH acquired PointSure, KEIC, and the renewal rights and substantially all of the operating assets and employees of Eagle Pacific Insurance Company and Pacific Eagle Insurance Company. Eagle Pacific Insurance Company began writing specialty workers’ compensation insurance approximately 20 years ago. The Acquisition gave SIH renewal rights to an existing portfolio of business, representing a valuable asset given the renewal nature of the workers’ compensation insurance business, and a fully-operational infrastructure that would have taken many years to develop. These renewal rights gave the Company access to customer lists and the right to seek to renew
As part of the Agreement, LMC placed into trust (the “Trust”) an amount equal to 10% of the balance sheet reserves of KEIC at the date of sale. Thereafter, the Trust shall be adjusted each quarter, if warranted, to an amount equal to 102% of LMC’s obligations under the Agreement. The initial estimate of KEIC’s loss reserves was approximately $16.0 million.
In September 2003, the Company’s board of directors authorized 750,000 shares of convertible preferred stock, all of which were designated as Series A preferred stock. In September 2003, the Company sold 456,750 shares of Series A preferred stock for cash proceeds, net of issuance costs, of $45.7 million. In June 2004, the Company sold an additional 51,615.25 shares of Series A preferred stock to current preferred stockholders and certain members of Company management for an aggregate purchase price of $5.2 million. Each share of Series A preferred stock is convertible into 15.299664 shares of the Company’s common stock, after giving effect to a two-for-one split of the Company’s common stock in February 2004 and a further 7.649832-for-one split of the Company’s common stock in December 2004. All references to numbers of shares in the consolidated financial statements and accompanying notes have been adjusted to reflect the stock splits on a retroactive basis. As explained in Note 21, all outstanding shares of Series A preferred stock were converted into 7,777,808 shares of common stock in connection with the initial public offering of the Company’s common stock in January 2005.
The stockholders and board of directors approved the 2003 Stock Option Plan (the “2003 Plan”) in September 2003 and the 2005 Long-Term Equity Incentive Plan (the “2005 Plan” and, together with the 2003 Plan, the “Stock Option Plans”) in December 2004. Following completion of the Company’s initial public offering in January 2005, the Company anticipates that all future option grants will be made under the 2005 Plan, and does not intend to issue any further options under the 2003 Plan.
The board of directors has the authority to determine all matters relating to options to be granted under the Stock Option Plans, including designation as incentive or nonqualified stock options, the selection of individuals to be granted options, the number of shares subject to each grant, the exercise price, the term and vesting period, if any. Generally, options vest evenly over four years and expire ten years from the date of grant. The board of directors reserved an initial total of 1,047,755 shares of common stock under the 2005 Plan, plus an automatic annual increase, to be added on the first day of the Company’s 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.
The following table summarizes stock option information at December 31, 2004:
In January 2005, the Company amended and restated its certificate of incorporation to increase to 75.0 million the number of shares of common stock authorized to be issued.
In our opinion, the combined financial statements referred to above present fairly, in all material respects, the financial position of the Predecessor as of December 31, 2002 and the results of its operations and its cash flows for the nine months ended September 30, 2003 and for the year ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America.
As discussed in notes 2(i) and 17 to the combined financial statements, effective January 1, 2002 the Predecessor adopted the provisions of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets.
The accompanying combined financial statements include the accounts of EPIC, PEIC, and PSIS, wholly owned subsidiaries of LMC. All significant inter-company transactions among these affiliated entities have been eliminated in the combined financial statements.
The preparation of combined financial statements requires management of the Predecessor to make a number of estimates and assumptions relating to the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the combined financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates. The Predecessor has used significant estimates in determining the unpaid loss and loss adjustment expenses, earned premiums on retrospectively rated policies, and amounts related to reinsurance.
assessment includes the reasons for the impairment, the severity and duration of the impairment, changes in value subsequent to year-end, and forecasted performance of the investment.
The Predecessor accounts for derivatives and hedging activities in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Certain Hedging Activities,” as amended, which requires that all derivative instruments be recorded on the balance sheet at their respective fair values.
Cash and cash equivalents, which consist primarily of amounts deposited in banks and financial institutions and all highly liquid investments with maturity of 90 days or less when purchased, are stated at cost.
Premiums receivable are recorded at the invoiced amount. The allowance for doubtful accounts is the Predecessor’s best estimate of the amount of probable losses in the Predecessor’s existing premiums receivable. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.
Acquisition costs related to premiums written are deferred and amortized over the periods in which the premiums are earned. Such acquisition costs include commissions, premium taxes, and certain underwriting and policy issuance costs. Deferred policy acquisition costs are limited to amounts recoverable from unearned premiums and anticipated investment income. The amounts that are not considered realizable are charged as an expense through amortization of deferred policy acquisition costs.
Premiums for primary and reinsured risks are included in revenue over the period of the contract in proportion to the amount of insurance protection provided (i.e., ratably over the policy period). Premiums are shown net of reinsurance. The portion of the premium that is applicable to the unexpired period of the policies in-force is not included in revenue and is deferred and recorded as unearned premium in the liability section of the balance sheet. Deferred premiums represent the unbilled portion of annual premiums.
Earned premiums on retrospectively rated policies are based on our 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 we project 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.
Service income generated from various claims service agreements with the Predecessor’s parent and other third parties is recognized as income in the period in which services are performed.
Unpaid loss and loss adjustment expense represents estimates of the ultimate net cost of all unpaid losses incurred through the specified period. Unpaid 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, include estimates of future trends in the frequency and severity of claims and other factors that could vary as the losses are ultimately settled. Although it is not possible to measure the degree of variability inherent in such estimates, management believes that the unpaid loss and loss adjustment expenses are adequate. The estimates are continually reviewed and necessary adjustments are included in current operations.
On January 1, 1999 EPIC and PEIC entered into quota share reinsurance agreements with LMC, their ultimate parent, whereby EPIC and PEIC ceded to LMC 80% of the net retained liabilities, after application of all external reinsurance, and 80% of underwriting expenses for all policies written by EPIC and PEIC from January 1, 1999 through December 31, 2002. The unearned premiums on policies in force at December 31, 2002 were still subject, subsequent to December 31, 2002, to the terms of the quota share reinsurance treaties.
On January 1, 1999, EPIC and PEIC entered into excess stop loss reinsurance agreements with LMC, whereby LMC reinsured the excess liability which may accrue to EPIC and PEIC by reason of the net retained liability of EPIC and PEIC under the quota share reinsurance agreements. This agreement applied to all policies written by EPIC and PEIC from January 1, 1999 through December 31, 2002. The combined ratio needed to exceed 115% on a paid basis before EPIC and PEIC were entitled to any recovery under these agreements.
On January 1, 1999, EPIC and PEIC entered into retroactive Loss Portfolio Transfer Reinsurance Agreements (LPT) with LMC. Under the LPT agreements, EPIC and PEIC would cede to LMC their net retained liability for losses for the policies and losses with dates of accident on or before December 31, 1998 and LMC would assume 100% of the net retained liability relating to those losses. Subsequent to January 1, 1999, there has been adverse development of approximately $24,359,000 through December 31, 2002 on the transferred unpaid loss and loss adjustment expense. At December 31, 2002, the Predecessor has recorded a deferred gain of approximately $6,682,000. The deferred gains are amortized using the
Comprehensive income encompasses all changes in shareholder’s equity (except those arising from transactions with shareholders) and includes net income and changes in net unrealized investment gains and losses on investment securities available for sale, net of taxes.
The combined amortized cost of fixed income securities deposited with various regulatory authorities was $12,655,152 at December 31, 2002.
Investment securities: The estimated fair values for available-for-sale securities generally represent quoted market value prices for securities traded in the public marketplace. Additional data with respect to fair values of the Predecessor’s investment securities are disclosed in note 3.
The activity in the allowance for doubtful accounts for the nine months ended September 30, 2003 and the year ended December 31, 2002 are as follows:
Under reinsurance agreements, EPIC and PEIC cede various amounts of risk to nonaffiliated and affiliated insurance companies for the purpose of limiting the maximum potential loss arising from the underlying insurance risks.
Effective October 1, 1998, the Predecessor retained the first $500,000 of each loss occurrence and losses in excess of $500,000 are 100% reinsured up to $20,000,000. Effective June 1, 1999, the Predecessor entered into a reinsurance agreement wherein the Predecessor retained the first $250,000 of each loss occurrence and losses in excess of $250,000 are reinsured up to $20,000,000. Effective October 1, 2000, the Predecessor entered into a reinsurance agreement, wherein losses in excess of $1,000,000 are 100% reinsured. Effective April 1, 2001, Predecessor entered into a reinsurance agreement, wherein the Predecessor retains the first $500,000 of each loss occurrence; the next $500,000 of such loss occurrence is 60% retained by the Predecessor after meeting a $1,500,000 aggregate deductible. Losses in excess of $1,000,000 are covered under treaties previously discussed. Effective October 1, 2001, losses in excess of $1,000,000 are 100% reinsured up to $20,000,000. All of these treaties are in run-off.
Additionally, EPIC and PEIC have an excess stop loss reinsurance agreement whereby LMC reinsured the excess liability which may accrue by reason of the net retained liability of EPIC and PEIC under the quota share agreement. The combined ratio must exceed 115% on a paid basis prior to any recovery under this contract.
Balances affected by reinsurance transactions are reported gross of reinsurance in the balance sheet. Reinsurance recoverables are comprised of the following amounts as of December 31, 2002 (in thousands):
LMC has a written tax allocation agreement, approved by the Companies, that provides for federal income taxes to be paid to or recovered from LMC based on each subsidiary company’s taxable income or taxable loss as if the subsidiary were filing a separate 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 federal income taxes reflected on the books for the nine months ended September 30, 2003 and the year ended December 31, 2002:
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. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based upon the projections of future taxable income over the periods in which the deferred taxes are deductible, management believes it is more likely than not that the Predecessor will realize the benefits of these deductible differences, net of the existing valuation allowances at December 31, 2002. The amount of the deferred tax asset considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced.
The Predecessor has established a valuation allowance to offset deferred tax assets related to capital losses net of unrealized gains on investment securities. The increase (decrease) in the valuation allowance was $(198,000) for the nine months ended September 30, 2003 and $949,000 for the year ended December 31, 2002.
c. Beginning December 20, 2002, EPIC and PEIC and their parent, LMC, received lower claims-paying ability ratings by all three major rating agencies. In 2003, LMC’s ability to write new business and retain existing business was substantially impacted because of its lower rating. This condition could ultimately affect LMC’s ability to pay losses ceded from EPIC and PEIC. As of June 10, 2003, EPIC and PEIC were rated B (fair) and LMC was rated C++ (marginal) by A.M. Best Company.