Our principal executive offices are located in approximately 36,000 square feet of leased office space in Seattle, Washington. We also lease office space consisting of approximately 2,500 square feet in Anchorage, Alaska; 2,600 square feet in Baton Rouge, Louisiana; 5,650 square feet in Chicago, Illinois; 6,100 square feet in Concord, California; 5,700 square feet in Henderson, Nevada; 2,650 square feet in Honolulu, Hawaii; 3,300 square feet in Houston, Texas; 3,400 square feet in Lake Mary, Florida; 3,700 square feet in Needham, Massachusetts; 8,300 square feet in Orange, California; 6,260 square feet in Phoenix, Arizona; 3,900 square feet in Radnor, Pennsylvania; 8,800 square feet in Santa Ana, California; and executive suites in New Orleans, Louisiana; and Yucca Valley, California. We conduct claims and underwriting operations in our branch offices, with the exception of our Honolulu office, where we conduct only claims and loss control operations. We do not own any real property. We consider our leased facilities to be adequate for our current operations.
The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements and the notes to those statements included elsewhere in this annual report. The discussion and analysis below includes forward-looking statements that are subject to risks, uncertainties and other factors described in Part I, Item 1A of this annual report that could cause our actual results of operations, performance and business prospects and opportunities in 2011 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.
We receive claims service income in return for providing claims administration services for other companies. The claims service income we receive for providing these services approximates our costs. For the years ended December 31, 2010, 2009, and 2008 approximately 26.0%, 32.3%, and 46.3% respectively, of our claims service income was generated by contracts we have with LMC to provide claims handling services for the policies written by the Eagle Entities prior to the Acquisition. We expect income from these contracts to continue to decrease substantially over the next several years as transactions related to the Eagle Entities diminish. The next largest claims administration services customer represented approximately 20.9%, 20.5%, and 17.9% of claims service income for the years ended December 31, 2010, 2009 and 2008, respectively.
Excluding work we perform as the servicing carrier for the Washington USL&H Plan and business assumed from the NCCI residual market pools, the total number of customers we serviced increased from approximately 1,530 at December 31, 2009 to approximately 1,640 at December 31, 2010. We experienced an increase of approximately 300 customers related to our Program Business, which was offset by a decrease of approximately 200 customers in our core business. By design, our Program Business will have a larger number of customers with a smaller average premium size than our core book of business. As of December 31, 2010, the average premium size in our Program Business was approximately $100,400 compared to approximately $235,900 in our core business. These numbers were virtually unchanged from average premium sizes at December 31, 2009. Total in-force payrolls, one of the factors used to determine premium charges, decreased 2.8% from $7.2 billion at December 31, 2009 to $7.0 billion at year end 2010. California continues to be our largest market, accounting for approximately $145.5 million, or 49.9% of our in-force premiums at December 31, 2010. This represents an increase of $13.0 million, or 9.8%, from approximately $132.5 million, or 43.1%, of in-force premiums in California at December 31, 2009.
Premiums assumed from the NCCI residual markets in the twelve months ended December 31, 2010 totaled $2.3 million compared to $4.0 million for the same period in 2009, representing a decrease of $1.7 million, or 42.5%. The decrease was primarily attributable to a reduction in our 2009 policy year estimates recorded in 2010.
Claims and Other Service Income. Claims and Other Service income totaled $1.1 million in 2010 and $1.2 million in 2009. Our service income resulted primarily from service arrangements we have with customers for claims processing services and policy administration services that we perform for them.
Other Income. Other income totaled $4.3 million for the year ended December 31, 2010 compared to $5.3 million for the same period in 2009, representing a decrease of $1.0 million, or 19.5%. Other income is derived primarily from the operations of PointSure, our wholesale broker and third party administrator, and PMCS, our provider of medical bill review, utilization review, nurse care management and related services.
For accident year 2008, the ultimate loss estimates at December 31, 2010 were higher when compared to December 31, 2009 and resulted in a net increase of our loss reserves of $10.3 million. The increase was attributable to the following jurisdictions: $6.9 million for California state act, driven primarily by medical costs; $2.4 million for non-California state act, driven primarily by medical costs; and $1.0 million for USL&H, driven primarily by increased indemnity and ALAE costs. This adverse development was offset by favorable development of $0.5 million related to ULAE, loss based assessments and NCCI, as well as $0.5 million related to favorable commutation.
Other Expenses. Other expenses totaled $7.5 million in 2010, a decrease of $1.6 million, or 17.3%, from $9.1 million in 2009. Other expenses result primarily from the operations of PointSure and PMCS. The decrease in other expenses was largely attributable to reduced personnel costs and direct costs.
We experienced significant reductions in our California premium rates from 2003 to 2008. On August 15, 2008, the Workers’ Compensation Insurance Rating Bureau of California (the “WCIRB”) submitted a filing with the California Insurance Commissioner recommending a 16.0% increase in advisory pure premium rates on new and renewal policies effective on or after January 1, 2009. The filing was based on a review of loss and loss adjustment experience through March 31, 2008. In response to this recommendation, on October 24, 2008, the California Insurance Commissioner approved a 5.0% increase in advisory pure premium rates, effective January 1, 2009. With the California Department of Insurance approval, we adopted this 5.0% increase effective January 1, 2009.
Net premiums earned are also affected by premiums ceded under reinsurance treaties. Ceded earned premiums in 2009 totaled $22.7 million compared to $14.5 million in 2008, representing an increase of $8.2 million, or 56.6%. An increase in ceded earned premiums is a decrease to our overall net premiums earned. Effective January 2009, we ceded 100% of NCCI assumed business for policy year 2009, which totaled $3.6 million for the year ended December 31, 2009.
Net Investment Income. Net investment income was $23.1 million in 2009 compared to $22.6 million in 2008, representing an increase of $0.5 million, or 2.3%. Average invested assets increased $62.4 million, or 11.7%, from $534.6 million in 2008 to $597.0 million in 2009. This increase in our investment portfolio is due primarily to cash flow from operations of $68.3 million for the year ended December 31, 2009, which was invested primarily in fixed income securities. Net investment income as a percentage of average invested assets decreased slightly to 3.9% in 2009 from 4.2% in 2008 due to the effects of the global financial crisis discussed previously.
Claims and Other Service Income. Claims and Other Service income totaled $1.2 million in 2009 and 2008. Our service income resulted primarily from service arrangements we have with customers for claims processing services, policy administration and administrative services that we perform for them.
Other Income. Other income totaled $5.3 million for the twelve months ended December 31, 2009 compared to $5.2 million for the same period in 2008, representing a decrease of $0.1 million, or 1.5%. Other income is derived primarily from the operations of PointSure, our wholesale broker and third party administrator, and PMCS, our provider of medical bill review, utilization review, nurse care management and related services.
Loss and Loss Adjustment Expenses. Loss and loss adjustment expenses totaled $174.3 million in 2009 compared to $141.9 million in 2008, representing an increase of $32.4 million, or 22.8%. Our net loss ratio, which is calculated by dividing loss and loss adjustment expenses less claims service income by premiums earned, was 70.9% in 2009 compared to 56.7% in 2008. The higher loss ratio in 2009 was attributable primarily to net unfavorable development of prior accident year loss reserves of $0.4 million in 2009 (offset by a favorable commutation gain of $0.6 million), compared to favorable development of $24.4 million and a favorable commutation gain of $2.2 million in 2008; an increase in the current accident year loss ratio from 57.5% at December 31, 2008 to 60.0% at December 31, 2009; and an increase of approximately $6.4 million in the earned premium against which the current accident year ELR is applied. Our direct net loss reserves are net of reinsurance and exclude reserves associated with KEIC and the business we involuntarily assume from the NCCI.
For accident year 2009, an expected loss ratio was established for each jurisdiction and type of loss (indemnity, medical, allocated loss adjustment expense ALAE). The expected loss ratio was multiplied by the booked accident year earned premium to produce the ultimate loss to date. The expected loss ratio selections are reviewed quarterly with each internal IBNR study. Given the short experience period for the current accident year, the expected loss ratios are usually maintained at least through the first 12 months of the accident year and revised as the underlying data matures. However, after reviewing the year-to-date results for the 2009 accident year, we increased the expected loss ratio for this year from 56.7% to 60.0% in the fourth quarter, resulting in $8.3 million of additional loss and allocated loss adjustment expenses in the quarter.
For accident year 2008, the ultimate loss estimates at December 31, 2009 were higher when compared to December 31, 2008 and resulted in a net increase of our loss reserves of $8.8 million. The increase was primarily due to an increase in ultimate loss estimates due to higher severity development in our indemnity and medical reserves. This adverse development was offset by favorable development of $3.1 million related to ULAE and $1.3 million related to loss based assessments and NCCI.
For accident year 2007, the ultimate loss estimates at December 31, 2009 were higher when compared to December 31, 2008 and resulted in a net increase of our loss reserves of $5.0 million. The adverse development was offset by favorable development of $2.1 million related to ULAE, $1.6 million for loss based assessments and NCCI, and a favorable commutation gain of $0.5 million.
Underwriting, Acquisition and Insurance Expenses. Underwriting expenses totaled $73.0 million in 2009 compared to $71.2 million in 2008, representing an increase of $1.9 million, or 2.6%. Our net underwriting expense ratio, which is calculated by dividing underwriting, acquisition and insurance expenses less other service income by premiums earned, was 29.8% in 2009 compared to 28.5% in 2008. The increase in the expense ratio was driven primarily by increased staffing costs and other premium production related expenses as we invest in the geographic expansion and development of our business; higher broker commissions; Florida policyholder dividend expense; and lower-than-expected earned premiums when compared to the increase in gross premiums written, primarily as a result of the impact of the continuing economic recession on covered payrolls, and adjustments related to retrospectively rated policies.
Interest Expense. Interest expense related to the surplus notes issued by our insurance subsidiary in May 2004 totaled $0.6 million in 2009 and $0.9 million in 2008. The surplus notes interest rate, which is calculated at the beginning of each interest payment period using the 3-month LIBOR plus 400 basis points, ranged between 4.26% and 6.15% in 2009 down from 6.15% to 9.03% in 2008.
Income Tax Expense. The effective tax rate for the year ended December 31, 2009 was 18.4% compared to 30.5% for the same period in 2008. The effective tax rate for 2009 was lower than the statutory tax rate of 35.0% primarily as a result of tax exempt interest income, which accounted for approximately 20.8 percentage points of the reduction from the statutory rate. This decrease was partially offset by approximately $0.7 million, or 4.2 percentage points, due to state income taxes and other nondeductible expenses. The effective rate for December 31, 2008 was lower than the statutory rate of 35.0% primarily as a result of tax exempt interest income, which accounted for approximately 7.5 points of the reduction from the statutory rate. This decrease in the statutory rate was partially offset by approximately $1.0 million, or 2.3 points, due to a valuation allowance established against our deferred tax assets as of December 31, 2008.
Our principal sources of funds are underwriting operations, investment income and proceeds from sales and maturities of investments. Our primary use of funds is to pay claims and operating expenses and to purchase investments.
Our investment portfolio is structured so that investments mature periodically over time in reasonable relation to current expectations of future claim payments. Since we have limited claims history, we have derived our expected future claim payments from industry and predecessor trends and included a provision for uncertainties. Our investment portfolio as of December 31, 2010 has an effective duration of 5.0 years with individual maturities extending to 30 years. Currently, we make claim payments from positive cash flows from operations and invest excess cash in securities with appropriate maturity dates to balance against anticipated future claim payments. As these securities mature, we intend to invest any excess funds with appropriate durations to match against expected future claim payments.
At December 31, 2010, of our investment portfolio consisted of investment-grade fixed income securities with fair values subject to fluctuations in interest rates, as well as other factors such as credit. Our investment policy allows for investment in domestic and international equities up to 6% and 1.5%, respectively, of our statutory capital and surplus. All of the securities in our investment portfolio are accounted for as “available for sale” securities. While we have structured our investment portfolio to provide an appropriate matching of maturities with anticipated claim payments, if we decide or are required in the future to sell securities in a rising interest rate environment, we would expect to incur losses from such sales.
We had no direct sub-prime mortgage exposure in our investment portfolio as of December 31, 2010 and $9.1 million of indirect exposure to sub-prime mortgages. As of December 31, 2010, our portfolio included $113.2 million of insured municipal bonds and $219.2 million of uninsured municipal bonds.
Our ability to adequately provide funds to pay claims comes from our disciplined underwriting and pricing standards and the purchase of reinsurance to protect us against severe claims and catastrophic events. Effective October 1, 2010, our reinsurance program provides us with reinsurance protection for each loss occurrence in excess of $0.25 million, up to $100.0 million, subject to various deductibles and exclusions. Our reinsurance program that was effective October 1, 2009 to September 30, 2010, provides us with reinsurance protection for each loss occurrence in excess of $0.75 million, up to $85.0 million, subject to various deductibles and exclusions. See the discussion under the heading “Reinsurance” in Part I, Item 1 of this annual report. Given industry and predecessor trends, we believe we are sufficiently capitalized to cover our retained losses.
Our insurance subsidiary is required by law to maintain a certain minimum level of surplus on a statutory basis. Surplus is calculated by subtracting total liabilities from total admitted assets. The NAIC has a risk-based capital standard designed to identify property and casualty insurers that may be inadequately capitalized based on inherent risks of each insurer’s assets and liabilities and its mix of net premiums written. Insurers falling below a calculated threshold may be subject to varying degrees of regulatory action. As of December 31, 2010, the statutory surplus of our insurance subsidiary was in excess of the prescribed risk-based capital requirements that correspond to any level of regulatory action.
SeaBright is a holding company with minimal unconsolidated revenue and expenses. As SeaBright pays dividends and has other capital needs in the future, we anticipate that it will be necessary for our insurance subsidiary to pay dividends to SeaBright. In August 2010, SBIC declared and paid its first such dividend to SeaBright in the amount of $5.8 million. The payment of such dividends will be regulated as previously described.
Net cash provided by operating activities in 2010 totaled $56.7 million, a decrease of $11.6 million, or 16.9%, from $68.3 million in 2009, which increased $1.3 million, or 2.0%, from $66.9 million in 2008. The decrease in 2010 was primarily attributable to an increase in loss and loss adjustment expenses paid (net of reinsurance collected) of approximately $28.7 million, partially offset by decreases in income taxes and underwriting expenses paid of approximately $9.1 million and $4.0 million, respectively. The increase in 2009 was primarily attributable to an increase in premiums collected of approximately $5.5 million and a decrease in federal income taxes paid of approximately $14.8 million, offset by an increase in loss and loss adjustment expenses paid (net of reinsurance collected) of approximately $16.9 million. We expect to experience a reduction in operating cash flows as a result of increased claim payments and higher premiums under the excess of loss reinsurance treaty program renewed on October 1, 2010, among other factors.
We used net cash of $49.8 million for investing activities in 2010 compared to $77.8 million in 2009 and $65.6 million in 2008. The decrease in 2010 from 2009 was driven by lower net investment purchase activity (purchases, net of sales and maturities). The increase in 2009 from 2008 was driven by higher net investment purchase activity (purchases, net of sales and maturities) partially offset by a reduction in purchases of property and equipment.
The most critical accounting policies involve the reporting of unpaid loss and loss adjustment expenses including losses that have occurred but were not reported to us by the financial reporting date, the amount and recoverability of reinsurance recoverable balances, deferred policy acquisition costs, income taxes, the impairment of investment securities, earned but unbilled premiums and retrospective premiums. The following should be read in conjunction with the notes to our consolidated financial statements.
At December 31, 2010, approximately $184.6 million, or 47.9%, of our direct loss reserves were related to business written in California. Over the last several years, four significant comprehensive legislative reforms were enacted in California: AB 749 was enacted in February 2002; AB 227 and SB 228 were enacted in September 2003; and SB 899 was enacted in April 2004. This reform activity has resulted in uncertainty regarding the impact of the reforms on loss payments, loss development and, ultimately, loss reserves, making historical data less reliable as an indicator of future loss. All four bills enacted structural changes to the benefit delivery system in California, in addition to changes in the indemnity and medical benefits afforded injured workers. In response to the reform legislation and a continuing drop in the frequency of workers’ compensation claims, the pure premium rates approved by the California Insurance Commissioner effective January 1, 2010 were 63.4% lower than the pure premium rates in effect as of July 1, 2003. More recent data has indicated the need for an increase in rates in California. With the California Department of Insurance’s approval, we adopted a 5.0% increase in advisory pure premium rates effective January 1, 2009. In June 2009, we filed for a 10.6% rate increase to be effective August 1, 2009, which was approved by the California Insurance Department. In July 2010, we filed for a 15.3% average rate increase with the California Department of Insurance, which was approved in August 2010 and became effective on September 1, 2010.
SB 228 provided that the maximum facility fee for services performed in an ambulatory surgical center may not exceed 120% of the Medicare fees for the same service performed in a hospital outpatient facility.
Workers’ compensation is considered a long-tail line of business, as it takes a relatively long period of time to finalize claims from a given accident year. Management believes that it generally takes workers’ compensation losses approximately 48 to 60 months after the start of an accident year until the data is viewed as fully credible for paid and incurred reserve evaluation methods. Workers’ compensation losses can continue to develop beyond 60 months and in some cases claims can remain open more than 20 years. As indicated above, we wrote our first policy on October 1, 2003 so our first complete accident year is 2004. As of December 31, 2010, accident year 2004 was 84 months developed, accident year 2005 was 72 months developed, accident year 2006 was 60 months developed, accident year 2007 was 48 months developed, accident year 2008 was 36 months developed, accident year 2009 was 24 months developed, and accident year 2010 was 12 months developed. Our loss reserve estimates are subject to considerable variation due to the relative immaturity of the accident years from a development standpoint.
A gross ultimate value is selected by reviewing the various ultimate estimates and applying actuarial judgment to achieve a reasonable point estimate of the ultimate liability. The gross IBNR reserve equals the selected gross ultimate loss minus the gross paid losses and gross case reserves as of the valuation date. The selected gross ultimate loss and ALAE are reviewed and updated on a quarterly basis.
In addition, there are loss and loss adjustment expense risk factors that affect workers’ compensation claims that can change over time and also cause our loss reserves to fluctuate. Some examples of these risk factors include, but are not limited to, the following:
Estimating loss reserves is an uncertain and complex process which involves actuarial techniques and management judgment. Actuarial analysis generally assumes that past patterns demonstrated in the data will repeat themselves and that the data provides a basis for estimating future loss reserves. However, since conditions and trends that have affected losses in the past may not occur in the future in the same manner, if at all, future results may not be reliably predicted by the prior data. Due to the relative immaturity of our book of business, the challenge has been to give the appropriate weight in the ultimate loss estimation process to the new data as it becomes available. As discussed above, management believes that it generally takes workers’ compensation losses approximately 48 to 60 months after the start of an accident year until the data is viewed as fully credible for paid and incurred reserve evaluation methods. Due to our limited operating history, we have seven complete accident years that were developed 84 month, 72 months, 60 months, 48 months, 36 months, 24 months and 12 months (2004, 2005, 2006, 2007, 2008, 2009 and 2010, respectively) at December 31, 2010. At December 31, 2010, the analysis for accident years 2003 through 2009 utilizes a Bornhuetter-Ferguson approach, which blends the loss development and expected loss ratio methods, in addition to the paid and incurred loss development methods. For accident years 2003 through 2009, the actuarial analysis showed varying degrees of net unfavorable movement when compared to the prior actuarial estimates at December 31, 2009.
For accident year 2008, there was unfavorable development in the losses for California State Act which resulted in an increase of our net ultimate loss estimates of $6.9 million. For non-California State Act, there was unfavorable development in the losses for accident year 2008 which resulted in an increase of our net ultimate loss estimates of $2.4 million. For USL&H, there was unfavorable development in the losses for accident year 2008 which resulted in an increase of our net ultimate loss estimates of $1.0 million.
Although many factors influence the actual cost of claims and the corresponding unpaid loss and loss adjustment expense 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. This is the case for the impact of economic inflation on claim costs, coverage interpretations and jury determinations. In most instances, we rely on historical experience or industry information to estimate values for the variables that are explicitly used in the unpaid loss and loss adjustment expense analysis. We assume that the historical effect of these unmeasured factors, which is embedded in our experience or industry experience, is representative of future effects of these factors. 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 assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. This analysis requires management to make various estimates and assumptions, including the scheduled reversal of deferred tax liabilities, the consideration of operating versus capital items, projected future taxable income and the effect of tax planning strategies. If actual results differ from management’s estimates and assumptions, we may be required to establish a valuation allowance to reduce the deferred tax assets to the amounts more likely than not to be realized. The establishment of a valuation allowance could have a significant impact on our financial position and results of operations in the period in which it is deemed necessary. As of December 31, 2010, no valuation allowance was recorded. We established a valuation allowance of approximately $2.0 million at December 31, 2008 (of which $976,000 was recorded in tax expense and $1.0 million was recorded in accumulated other comprehensive income) and reversed the $2.0 million allowance through accumulated other comprehensive income in 2009.
In December 2007, the Company completed the acquisition of Total HealthCare Management, Inc. (“THM”), a privately held California provider of medical bill review, utilization review, nurse case management and related services. The total purchase price was $1.5 million, of which $1.2 million was paid at closing. The remaining $0.3 million was scheduled to be paid in three equal installments on the first three anniversaries of the closing date, provided that THM achieved certain revenue objectives in 2008, 2009 and 2010. Based on THM’s performance in 2008, 2009 and 2010, these installments were not paid. Goodwill recognized in connection with this acquisition totaled approximately $1.4 million. Following the acquisition, THM became a wholly owned subsidiary of SeaBright. In September 2010, THM was rebranded and changed its name to Paladin Managed Care Services (“PMCS”) as a “doing business as” designation.
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 judgments 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.
Certain reclassifications have been made to prior year financial statements to conform to classifications used in the current year. The consolidated statements of operations for the years ended December 31, 2009, 2008, 2007 and 2006 have been revised to correct an immaterial error in the elimination of intercompany revenue and expense. Additionally, the consolidated statement of operations for the year ended December 31, 2009 has been revised to reflect a change in 2010 in where the Company eliminates the intercompany expense related to medical bill review and related services that PMCS provides SBIC. The elimination had previously been recorded in loss and loss adjustment expense. However, management concluded in 2010 that the elimination would more properly be recorded in other expense (where the majority of PMCS’s expenses are recorded in the consolidated statement of operations) so that loss and loss adjustment expense will reflect the total cost of administering the Company’s claims. The reclassifications above had no impact on income before taxes or net income. The following table summarizes the impact of the reclassifications:
The following table summarizes the impact of the change in the elimination of intercompany charges for medical bill review and related services for the quarters ended March 31, June 30 and September 30 and December 31:
The Company regularly reviews its investment portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of its investments. A number of criteria are considered during this process including, but not limited to: whether the Company intends to sell the security; the current fair value as compared to amortized cost or cost, as appropriate, of the security; the length of time the security’s fair value has been below amortized cost or cost; the likelihood that the Company will be required to sell the security before recovery of its cost basis; objective information supporting recovery in a reasonable period of time; specific credit issues related to the issuer; and current economic conditions.
Although no impairment losses were recognized over the value of the Company’s investment portfolio in 2010, it is possible that the Company could recognize future impairment losses on some securities it owned at December 31, 2010 if future events, information and the passage of time result in a determination that a decline in value is other-than-temporary.
Cash and cash equivalents, which consist primarily of amounts deposited in banks and financial institutions, and all highly liquid investments with maturities of 90 days or less when purchased, are stated at cost. Cash in excess of daily requirements is invested in money market funds and repurchase agreements with maturities of 90 days or less. Such investments are deemed to be cash equivalents for purposes of the consolidated balance sheets and statements of cash flows.
Earned premiums on retrospectively rated policies are based on the Company’s estimate of loss experience as of the measurement date. Loss experience includes known losses specifically identifiable to a retrospective policy as well as provisions for future development of known losses and for losses incurred but not yet reported. Future loss development is projected using actuarial loss development factors, assumptions and methodologies that are consistent with how the Company projects losses in general. For retrospectively rated policies, the governing contractual minimum and maximum premiums 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.
The Company protects itself from excessive losses by reinsuring certain levels of risk in various areas of exposure with nonaffiliated reinsurers. Regardless of type, reinsurance does not legally discharge the ceding insurer from primary liability for the full amount due under the reinsured policies. Reinsurance premiums, commissions, expense reimbursements and reserves related to ceded business are accounted for on a basis consistent with the accounting for the original policies issued and the terms of reinsurance contracts. The unpaid loss and loss adjustment expense subject to the adverse development cover with LMC is calculated on a quarterly basis using generally accepted actuarial methodologies for estimating unpaid loss and loss adjustment expense liabilities, including incurred loss and paid loss development methods. The minimum amount that must be maintained in the trust account is equal to the greater of (a) $1.6 million or (b) 102% of the then existing quarterly estimate of LMC’s total obligations under the adverse development cover. Amounts recoverable in excess of acquired reserves at September 30, 2003 are recorded gross in unpaid loss and loss adjustment expense in accordance with ASC Topic 805, Business Combinations, with a corresponding amount receivable from the seller. Amounts are shown net in the statements of operations. Premiums ceded to other companies are reported as a reduction of premiums written and earned. Reinsurance recoverables are determined based on the terms and conditions of the reinsurance contracts.
The Company uses the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the income statement in the period that includes the enactment date.
As of December 31, 2010 and 2009, the Company had no unrecognized tax benefits. The Company’s policy is to recognize interest and penalties on unrecognized tax benefits as an element of income tax expense (benefit) in the consolidated statements of operations. The Company files consolidated U.S. federal and state income tax returns. The tax years which remain subject to examination by the taxing authorities are the years ended December 31, 2007, 2008, 2009 and 2010.
The effect of including shares issuable upon the exercise of outstanding stock options and the vesting of nonvested restricted stock is antidilutive for the year ended December 31, 2010. Therefore, such shares have been excluded from the calculation of diluted weighted average shares outstanding. The number of such shares excluded for the year ended December 31, 2010 was approximately 577,000.
In February 2010, the FASB issued ASU 2010-09, Amendments to Certain Recognition and Disclosure Requirements, to address potential practice issues associated with ASC Topic 855, Subsequent Events. The provisions of ASU 2010-09 are effective for reporting periods ending after June 15, 2010. The adoption of ASU 2010-09 did not have a material effect on the Company’s consolidated financial condition and results of operations.
In July 2010, the FASB issued ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, to expand existing disclosures about the credit quality of financing receivables and the allowance for credit losses as are defined in ASC Topic 310, Receivables. The provisions of ASU 2010-20 are effective for annual or interim reporting periods beginning after December 15, 2010. The adoption of ASU 2010-20 is not expected to have a material effect on the Company’s consolidated financial condition and results of operations.
The following tables present information about investment securities with unrealized losses at December 31, 2010 and 2009.
The Company had no direct sub-prime mortgage exposure in its investment portfolio as of December 31, 2010 and $9.1 million of indirect exposure to sub-prime mortgages. The following table provides a breakdown of fair value by ratings on the bonds in the Company’s municipal portfolio as of December 31, 2010:
As of December 31, 2010, the Company had no direct investments in any bond insurer, and the following bond insurer insured more than 10% of the municipal bond investments in the Company’s portfolio:
The Company does not expect a material impact to its investment portfolio or financial position as a result of the problems currently facing monoline bond insurers.
The amortized cost and estimated fair value of fixed income securities available for sale at December 31, 2010, by contractual maturity, are set forth below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
The consolidated amortized cost of fixed income securities available for sale deposited with various regulatory authorities was $216.7 million and $205.8 million at December 31, 2010 and 2009, respectively.
At December 31, 2010, there were no liabilities measured at fair value on a recurring basis.
The Company may be required, from time to time, to measure certain other financial assets, such as goodwill, fixed assets and other long-lived assets, at fair value on a non-recurring basis in accordance with GAAP. These adjustments to fair value usually result from write-downs of individual assets. In 2010, the Company adjusted to fair value the goodwill resulting from the Acquisition of SBIC in September 2003. For further discussion of the considerations and methodology relating to the goodwill adjustment, see the related discussion at Note 17, “Intangible Assets and Goodwill”.
Premiums receivable consisted of the following at December 31, 2010 and 2009:
The activity in the allowance for doubtful accounts for the years ended December 31, 2010, 2009, and 2008 is as follows (in thousands):
On October 1, 2010, the Company entered into new reinsurance treaties with nonaffiliated reinsurers wherein it retains the first $0.25 million of each loss occurrence. The next $0.25 million of losses per occurrence (excess of the first $0.25 million of losses per occurrence retained by the Company) are 100% reinsured, subject to an annual aggregate deductible. The new reinsurance program, which is effective through September 30, 2011, provides coverage up to $100.0 million per loss occurrence. The following table summarizes the new program as well as the prior reinsurance that was in place from October 1, 2009 through September 30, 2010:
As of December 31, 2010, the Company’s current excess of loss reinsurance treaties were placed with the following reinsurers:
Effective January 1, 2011, the Company renewed its quota-share reinsurance agreement with a nonaffiliated reinsurer wherein it cedes 100% of its residual market business assumed from the National Council on Compensation Insurance (the “NCCI”) for policy years 2009, 2010 and 2011.
As part of the Agreement, LMC placed into trust (the “Trust”) $1.6 million, equal to 10% of the balance sheet reserves of SBIC at the date of the Acquisition. Thereafter, the Trust is adjusted each quarter, if warranted, to an amount equal to the greater of (a) $1.6 million or (b) 102% of LMC’s obligations under the Agreement. The balance of the Trust, including accumulated interest, was $3.8 million at December 31, 2010 and 2009.
The Company involuntarily assumes residual market business either directly from various states that operate their own residual market programs or indirectly from the National Council for Compensation Insurance, which operates residual market programs on behalf of some states. The states in which the Company assumed residual market business in 2010 and 2009 include the following: Alabama, Alaska, Arizona, Arkansas, Connecticut, Delaware, the District of Columbia, Georgia, Idaho, Illinois, Iowa, Kansas, Massachusetts, Michigan, Nevada, New Hampshire, New Jersey, New Mexico, North Carolina, Oregon, South Carolina, South Dakota, Vermont, Virginia and West Virginia.
Balances affected by reinsurance transactions are reported gross of reinsurance in the balance sheets. Reinsurance recoverables are comprised of the following amounts at December 31, 2010 and 2009:
The following table summarizes the Company’s top ten reinsurers, based on net amount recoverable, as of December 31, 2010:
The Company recorded no write-offs of uncollectible reinsurance recoverables in the years ended December 31, 2010, 2009, and 2008.
The effects of reinsurance are as follows for the years ended December 31, 2010, 2009, and 2008:
Provisions in the lower layer treaties of the Company’s excess of loss reinsurance programs since 2005 allow the Company the ability, at its sole discretion, to commute the contracts within 24 months of expiration in return for a contingent profit commission calculated in accordance with terms specified in the contracts. In accordance with those provisions, the Company commuted the following layers in its reinsurance programs:
The contingent profit commissions were recorded as reductions of loss and loss adjustment expenses. As of December 31, 2010, there were no ceded losses associated with the commuted layers and it is not expected that developed losses that would otherwise be covered by reinsurance will exceed the contingent profit commission.
At December 31, 2010 and 2009, the Company reduced unpaid loss and loss adjustment expense by $10.2 million and $8.9 million, respectively, for anticipated salvage and subrogation recoveries.
On October 1, 2003, the Company began selling workers’ compensation insurance policies for which the premiums vary based on loss experience. Accrued retrospective premiums are determined based upon the loss experience of business subject to such experience rating adjustment. Accrued retrospectively rated premiums are determined by and allocated to individual policyholder accounts. Accrued retrospective premiums and return retrospective premiums are recorded as additions to and reductions from written premium, respectively. Approximately 5.9%, 7.2% and 10.7% of the Company’s direct premiums written for the years ended December 31, 2010, 2009 and 2008, respectively, related to retrospectively rated contracts. The Company accrued $11.1 million for retrospective premiums receivable (included in deferred premiums on the balance sheet) and $22.6 million for return retrospective premiums (included in accrued expenses and other liabilities on the balance sheet) at December 31, 2010 and $11.8 million for retrospective premiums receivable and $21.5 million for return retrospective premiums at December 31, 2009.
The unamortized balances of intangible assets, other than goodwill, consist of the following at December 31, 2010 and 2009:
The weighted average amortization period for all intangible assets subject to amortization is 2.7 years. Aggregate amortization expense was $141,000, $184,000 and $7,500 for the years ended December 31, 2010, 2009, and 2008, respectively.
The Company tests for goodwill impairment in the fourth quarter of each year. At the end of each subsequent quarter, management considers the results of the previous analysis as well as any recent developments that may constitute triggering events requiring the impairment analysis to be updated. The Company assessed the impact of the $30.5 million strengthening of the Company’s loss reserves in the second quarter of 2010, the continuing negative effect of the economic slowdown on the Company’s gross premiums written, and the observed decline in the Company’s stock price and determined that a triggering event occurred for SBIC. The fair value of the reporting unit was estimated using a discounted cash flow analysis, resulting in the Company recording a $1.5 million impairment charge against the goodwill resulting from the acquisition of SBIC in September 2003. The Company did not identify any triggering events that required the reevaluation of goodwill resulting from the acquisitions of PMCS and BWNV, nor did the Company identify any triggering events subsequent to the second quarter that required the reevaluation of goodwill from these acquisitions.
As previously discussed, the Company completed the dissolution of BWNV that was acquired by PointSure in July 2008. Concurrent with the dissolution, the BWNV operations were transferred to PointSure and BWNV’s offices became an operating location of PointSure. Because the goodwill that PointSure carries relates to the BWNV acquisition, the Company evaluated the effect of the dissolution on the carrying value of the goodwill and concluded that the dissolution has no detrimental impact on the carried goodwill. PointSure still enjoys the benefit of the systems, processes, employees, and other assets acquired in the acquisition, and BWNV is now a direct part of PointSure rather than being a wholly owned subsidiary.
The Board of Directors reserved an initial total of 776,458 shares of common stock under the 2003 Plan and 1,047,755 shares of common stock under the 2005 Plan, plus an automatic annual increase on the first day of each fiscal year beginning in 2006 and ending in 2015 equal to the lesser of: (i) 2% of the shares of common stock outstanding on the last day of the immediately preceding fiscal year or (ii) such lesser number of shares as determined by the Board of Directors. At December 31, 2010, the Company reserved 776,458 shares of common stock for issuance under the 2003 Plan, of which options to purchase 481,946 shares had been granted, and 3,065,041 shares for issuance under the 2005 Plan, of which 2,587,138 shares had been granted. In January 2006, the Compensation Committee of the Board of Directors terminated the ability to grant future stock options awards under the 2003 Plan. Therefore, the Company anticipates that all future awards will be made under the 2005 Plan.
The 2005 Plan provides for the grant of incentive or non-qualified stock options, restricted stock, restricted stock units, deferred stock units, performance awards, or any combination of the foregoing. The Board of Directors has the authority to determine all matters relating to awards 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 the vesting period, if any. Options to purchase the Company’s common stock are granted at prices at or above the fair value of the common stock on the date of grant, generally vest 25% per year on each of the first four anniversaries of the vesting start date, and expire 10 years from the date of grant. Options granted to non-employee directors generally vest 25% on the first anniversary of the grant date and the remaining 75% in equal monthly installments over the following 36 months. Nonvested stock issued to employees and directors generally vests on the third anniversary of the grant date, assuming the holder is still employed by or providing service to the Company and satisfies all other conditions of the grant. Generally, stock options granted to employees are incentive stock options, while options granted to non-employee directors are non-qualified stock options.
The following table summarizes stock option activity for the years ended December 31, 2010 and 2009:
The aggregate intrinsic values in the table above are before applicable income taxes and are based on the Company’s closing stock price of $9.22 and $11.49 at December 31, 2010 and 2009, respectively. As of December 31, 2010, total unrecognized stock-based compensation cost related to nonvested stock options was approximately $1.2 million, which is expected to be recognized over a weighted average period of approximately 2.39 years. Proceeds from the exercise of stock options totaled approximately $26,000 in 2010 and approximately $47,000 in 2009. The total intrinsic value of stock options exercised was approximately $17,260 in 2010 and approximately $27,580 in 2009.
As of December 31, 2010, there was $5.2 million of total unrecognized compensation cost related to restricted stock granted under the 2005 Plan. That cost is expected to be recognized over a weighted-average period of 1.81 years.