We are a specialty provider of workers’ compensation insurance focused on select small businesses engaged in low to medium hazard industries. Workers’ compensation is a statutory system under which an employer is required to pay for its employees’ medical, disability and vocational rehabilitation and death benefit costs for work-related injuries or illnesses. Our business has historically targeted businesses located in several western states, primarily California and Nevada. During 2007, we were the second, ninth and twenty-third largest non-governmental writer of workers’ compensation insurance in Nevada, California and the United States, respectively, based on direct premiums written, as reported by A.M. Best.
On October 31, 2008, we acquired 100% of the outstanding common stock of AmCOMP Incorporated (AmCOMP) for $188.4 million. As a result of this acquisition, we are currently conducting business in 29 states from coast to coast, including concentrations in California, Florida and Nevada. We are also licensed to write business in seven additional states and the District of Columbia. We believe this acquisition provides significant opportunity to make progress in executing our strategic goals and achieving our vision of being the leader in the property and casualty insurance industry specializing in workers’ compensation. Our results of operations for 2008 include the acquired operations of AmCOMP for the period November 1, 2008 through December 31, 2008.
In 2008, we wrote 69.4% and 11.6% of our direct premiums written in California and Nevada, respectively. We market and sell our workers’ compensation insurance products through independent local and regional agents and brokers, and through our strategic distribution partners, including our principal strategic partners, ADP, Inc. (ADP) and Wellpoint, Inc. (Wellpoint). In 2008, we wrote $83.0 million, or 25.7%, of our gross premiums written through ADP and Wellpoint.
We commenced operations as a private domestic mutual insurance company on January 1, 2000 when our Nevada insurance subsidiary assumed the assets, liabilities and operations of the Nevada State Industrial Insurance System (the Fund). The Fund had over 80 years of workers’ compensation experience in Nevada. In July 2002, we acquired the renewal rights to a book of workers’ compensation insurance business, and certain other tangible and intangible assets, from Fremont Compensation Insurance Group and its affiliates (Fremont), primarily comprising accounts in California and, to a lesser extent, in Idaho, Montana, Utah and Colorado. Because of the Fremont transaction, we were able to establish our important relationships and distribution agreements with ADP and Wellpoint.
and this deferred gain is being amortized using the recovery method, whereby the amortization is determined by the proportion of actual reinsurance recoveries to total estimated recoveries, and the amortization is reflected in losses and LAE. We periodically reevaluate the remaining direct reserves subject to the LPT Agreement. Our reevaluation results in corresponding adjustments, if needed, to reserves, ceded reserves, reinsurance recoverables and the deferred reinsurance gain, with the net effect being an increase or decrease, as the case may be, to net income. In addition, we receive a contingent commission under the LPT Agreement. Increases and decreases in the contingent commission are reflected in our commission expense, see “-Results of Operations”.
We operate in a single reportable segment with 17 territorial offices serving the various states in which we are currently doing business.
The recommendation of the WCIRB does not reflect the cost impact of proposed changes to the Permanent Disability Rating Schedule (PDRS). If the proposed changes are adopted, the WCIRB has indicated that it will amend its recommendation to increase pure premium rates by an additional 3.7%. The WCIRB has also indicated that it will recommend that pure premium rates applicable to the unexpired portion of the 2008 policies be increased by 3.7% for the PDRS change.
In Nevada, our rate level decreased in 2008 as a result of a decision by the Nevada Commissioner of Insurance (Nevada Commissioner) to decrease loss costs effective March 1, 2008 by 10.5%, which we subsequently adopted.
We experienced a decline in the number of policies in-force in Nevada in 2008, which was the result of overall economic conditions and competitive pressures. Excluding the impacts of the acquisition of AmCOMP, our policy count growth, primarily in California, mitigated some of the decline in premiums we experienced as a result of declining rate levels and the affects of the economic recession. Companywide, we expect to see continued downward pressure on premiums in 2009, which will be partially offset by policy count growth, including growth attributable to the acquisition of AmCOMP. It is uncertain how these trends will impact profitability.
Including the acquired operations of AmCOMP, approximately 10% of our business will be generated in Florida. Florida is an “administered pricing” state and rate changes adopted by the Florida Commissioner of Insurance (Florida Commissioner) will affect the rates that we are able to charge in that state.
Net Investment Income and Realized Gains (Losses) on Investments. We invest our statutory surplus and the funds supporting our insurance liabilities (including unearned premiums and unpaid losses and loss adjustment expenses (LAE)) in fixed maturity securities and equity securities. In addition, a portion of these funds is held in cash and cash equivalents to pay current claims. Net investment income includes interest and dividends earned on our invested assets and amortization of premiums and discounts on our fixed maturity securities less bank service charges, custodial and portfolio management fees. Realized gains and losses on our investments are reported separately from our net investment income. Realized gains (losses) on investments include the gain or loss on a security at the time of sale compared to its original cost (equity securities) or amortized cost (fixed maturity investments). Net unrealized gains or losses on our securities are reported separately within accumulated other comprehensive income on our balance sheet.
Commission Expense. Commission expense includes commissions to our agents and brokers for the premiums that they produce for us, and is net of contingent commission income related to the LPT Agreement. Commissions paid to our agents and brokers are deferred and amortized to commission expense in our statements of income as the premiums generating these commissions and fees are earned. We pay commissions that we believe are competitive with other workers’ compensation insurers.
Underwriting and Other Operating Expenses. Underwriting and other operating expenses include the costs to acquire and maintain an insurance policy (excluding commissions) consisting of premium taxes and certain other general expenses that vary with, and are primarily related to, producing new or renewal business. These acquisition costs are deferred and amortized to underwriting and other operating expenses in the statement of income as the related premiums are earned. Other underwriting expenses consist of policyholder dividends, changes in estimates of future write-offs of premiums receivable, 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. Our underwriting and other operating expenses ratio (percentage of net premiums earned) is a reflection of our operational efficiency in producing, underwriting and administering our business.
loss, the reporting of the loss to the insurer and the insurer’s payment of that loss. Our loss reserves are reflected in our balance sheets under the line item caption “unpaid losses and loss adjustment expenses.” As of December 31, 2008, our reserve for unpaid losses and LAE, net of reinsurance, was $1.4 billion.
future claim payments in excess of case reserves on recorded open claims;
the cost of claims that have not yet been reported to us.
A portion of our losses and LAE obligations are ceded to unaffiliated reinsurers. We establish our losses and LAE reserves both gross and net of ceded reinsurance. The determination of the amount of reinsurance that will be recoverable on our losses and LAE reserves includes both the reinsurance recoverable from our excess of loss reinsurance policies, as well as reinsurance recoverable under the terms of the LPT Agreement. Our reinsurance arrangements also include an intercompany pooling arrangement between EICN, ECIC, EPIC and EAC, whereby each insurance subsidiary cedes some of its premiums, losses, and LAE to the other, but this intercompany pooling arrangement does not affect our consolidated financial statements included elsewhere in this report.
Our reserve for unpaid losses and loss adjustment expenses (gross and net), as well as the above-described main components of such reserves, were as follows:
Based on historical insurance industry experience countrywide, as reported by A.M. Best, approximately ten percent of workers’ compensation claim dollars are expected to be paid more than ten years after the claim occurred. While our payout pattern likely will differ from that of the industry, industry experience illustrates the general duration of workers’ compensation claims. The duration of the injured worker’s disability, the course and cost of medical treatment, as well as the lifespan of dependents, are uncertain and are difficult to determine in advance. We endeavor to minimize this risk by closing claims promptly, to the extent feasible. In addition, there are no policy limits on our liability for workers’ compensation claims as there are for other forms of insurance. We endeavor to mitigate
this risk by purchasing reinsurance that will provide us with financial protection against the impact of very large claims and catastrophes.
We retain independent consulting actuaries (consulting actuaries) to perform comprehensive studies of our losses and LAE liability on a semi-annual basis. The role of our consulting actuaries is to conduct sufficient analyses to produce a range of reasonable estimates, as well as a point estimate, of our unpaid losses and LAE liability, and to present those results to our actuarial staff and to management.
For purposes of analyzing claim payment and emergence patterns and trends over time, we compile and aggregate our claims data by grouping the claims according to the year or quarter in which the claim occurred (“accident year” or “accident quarter”), since each such group of claims is at a different stage of progression toward the ultimate resolution and payment of those claims. The claims data is aggregated and compiled separately for different types of claims and/or claimant benefits. For our Nevada business, where a substantial detailed historical database is available from the Fund (from which our Nevada insurance subsidiary, EICN, assumed assets, liabilities and operations in 2000), these
Reported Development Method. A method that uses actual historical, cumulative reported loss dollars by accident year to develop estimated ultimate losses. The overall development is based on the assumption that each accident year will develop to estimated ultimate cost in a manner that is analogous to prior years, adjusted as deemed appropriate, for the expected effects of known changes in the workers’ compensation environment, and, to the extent necessary, supplemented by analyses of the development of broader industry data. This method is used to evaluate our other than Nevada business.
Initial Expected Loss Method. This method is used directly, and also as an input to the Bornhuetter-Ferguson methods. Initial expected losses for an accident year are based on one or more of: industry-benchmark losses per dollar of payroll for the mix of employment classes insured, prior evaluation dates’ projections of ultimate losses for the accident year, and by applying to premiums a set of initial expected loss ratios selected after analyzing the development projections for each accident year, loss trends, statutory benefit changes, rate change, and historical company loss ratios.
All of the methods depend in part on the selection of an expected pattern with which the aggregate claims data will be paid or will emerge over time. We compile, to the extent available, long-term and short-term historical data for our insurance subsidiaries, organized in a manner which provides an indication of the historical patterns with which claims have emerged and have been paid. To the extent that the historical data may not provide sufficient information about future patterns, whether due to environmental changes such as legislation or due to the small volume or short history of data for some
In projections using December 31, 2008 data, the methods that use explicit medical cost inflation assumptions included medical cost inflation assumptions ranging from 3.5% to 8.5%. Corresponding medical cost inflation assumptions in prior projections were 3.5% to 8.5% at December 31, 2007 and 3.5% to 9.0% at December 31, 2006. The selection of medical cost inflation assumptions for use in the actuarial methodologies in each of these analyses has been based on observed recent and longer-term historical medical cost inflation in our claims data and in the U.S. economy more generally. The rate of medical cost inflation as reflected in our historical medical payments per claim has averaged approximately 6.5% over the past five to ten years. The rate of medical cost inflation in the general U.S. economy, as measured by the consumer price index-medical care, has averaged approximately 4.0% over the past ten years.
All of the actuarial methods described for our Nevada business are used for each of the different benefit types that are analyzed. For benefit types in which most of the loss dollars are paid out within several years of the claim occurrence (temporary total disability, permanent partial disability and vocational rehabilitation), the selection of ultimate losses for all but the most recent three to five accident years is based primarily on the results of the paid development method. This is due to the expectation that ultimate losses for the mature years will be highly correlated with the losses that have been paid to date, and the selection of estimated ultimate losses for the least mature accident years gives consideration to the results of all of the methods with the paid development method given the least consideration in the least mature (that is, most recent) accident year. For benefit types that typically involve payments extending over many years or even decades (permanent total disability, dependent benefits on fatal claims, and medical care benefits) the ultimate losses for the most recent ten or more accident years may not be highly correlated with the amounts paid to date and thus the selection of estimated ultimate losses for these recent accident years is based primarily on the frequency-severity method, the paid Bornhuetter-Ferguson method and the initial expected loss method, all of which rely in part on long-term observations regarding the average cost of claims of the particular benefit type and, in the case of medical care benefits, also allow for explicit medical cost inflation assumptions. In states other than Nevada, the paid Bornhuetter-Ferguson, reported Bornhuetter-Ferguson, paid development, and reported development methods are used for all benefit types. As our claims experience in these states is less mature, the Bornhuetter-Ferguson methods are given greater weight in the selection of estimated ultimate losses because these methods do not produce results that are as highly leveraged off our immature paid or reported claims experience.
For EICN, the analysis of unpaid loss is conducted on claims data prior to recognition of reinsurance. A separate projection is made of future reinsurance recoveries based on our reinsurance arrangements and an analysis of large claims experience, both for EICN and as reflected in industry-based benchmarks. The projections prior to recognition of reinsurance provide the basis for estimating gross-of-reinsurance unpaid losses, from which the projection of future reinsurance recoveries is subtracted to estimate net-of-reinsurance unpaid losses.
Based on the results of the analyses conducted, the stability of the historical data, and the characteristics of the various claims segments analyzed, the consulting actuaries select a range of estimated unpaid losses and LAE and a point estimate of unpaid losses and LAE, for presentation to internal actuarial staff and management. The selected range is intended to represent the range in which
view of the markets in which we are operating, including economic, business, and political conditions;
our view of trends in the future costs of managing claims; and
The aggregate carried reserve calculated by management represents our best estimate of our outstanding unpaid losses and LAE. We believe that we should be conservative in our reserving practices due to the “long-tail” nature of workers’ compensation claims payouts, the susceptibility of those future payments to unpredictable external forces such as medical cost inflation and other economic conditions, and the actual variability of loss reserve adequacy that we have observed in the workers’ compensation insurance industry.
At December 31, 2008, management’s best estimate of unpaid losses and LAE, net of reinsurance, was $1.43 billion, which was $16.5 million above the actuarial point estimate. In establishing its best estimate at December 31, 2008, management and internal actuarial staff reviewed and considered: (a) the consulting actuaries assumptions, point estimate and range; (b) the inherent uncertainty of workers’ compensation unpaid losses and LAE liabilities; and (c) the particular uncertainties associated with: (i) the potential effects on the cost and payout pattern of claims following workers’ compensation system reforms enacted by the California legislature in late 2003 and the regulatory implementation of those reforms, the effects of which will become clear over a number of years; (ii) the uncertain cost of administering claims (LAE) in the reformed California and Florida systems; (iii) the potential for legislative and/or judicial reversal of California and Florida reforms; (iv) the rapid growth in the volume of our business in California; and (v) the degree of movement observed in EICN’s prior years’ projections of losses and LAE in Nevada following premium and market share reductions. Management did not quantify a specific loss reserve increment for each of these sources of uncertainty, but rather established an overall provision for unpaid losses and LAE that, in management’s opinion, represented a best estimate of unpaid losses and LAE at December 31, 2008 in light of the historical data, the actuarial assumptions, point estimate and range, current facts and circumstances, and the sources of uncertainty identified by management. Management’s best estimate of unpaid losses and LAE at December 31, 2008 fell within the actuarial range of estimates. The decrease in management’s best
Estimates of ultimate losses and LAE may change from one balance sheet date to the next when actual claim payment or individual case reserve estimates between those dates differ from the expected claim activity underlying the prior loss reserve estimate, and when actual LAE expenditures differ from expected expenditure levels underlying the prior LAE reserve estimate. As actual losses and LAE expenditures occur during a calendar period, they replace the portion of prior estimates of unpaid losses and LAE that relate to that period. In addition, the parameters used in the various methods and the relative weight accorded to the results of the different actuarial methods, all of which require judgment, may change as a result of observing that the actual pattern of expenditures differs from prior expectations, as well as based on new industry wide data and benchmarks derived from that data, when available. The parameters and weights used in estimating ultimate losses may also change when external conditions-such as the statutory benefit structures or the manner in which it is being interpreted and administered, or inflation-differ from expectations underlying the prior estimate of ultimate losses, and when the effects of factors related to internal operations differ from expectations underlying the prior estimate of ultimate losses.
Each of the actuarial methods used in the analysis and estimation of unpaid losses and LAE depend in part on the selection of an expected pattern with which the aggregate claims data will be paid or will emerge over time, and the assumption that this expected pattern will prevail into the future. We select relevant patterns as part of the periodic review and projection of unpaid losses and LAE. In selecting these patterns, we examine, to the extent available, long-term and short-term historical data for our insurance subsidiaries, benchmarks based on industry data and forecasts made by industry rate bureaus regarding the effect of legislative benefit changes on such patterns. Actuarial judgment is required in selecting the patterns to apply to each segment of data being analyzed.
and the actual long-term and recent emergence and payment of claims. Management also considers the environmental conditions in which the insurance subsidiaries are doing business. In addition, management considers the degree of uncertainty associated with the estimates based on the degree of change that has occurred or is occurring in the environment and in operations.
Estimates of incurred losses and LAE attributable to insured events of prior years decreased due to continued favorable development in such prior accident years (actual losses and LAE paid and current projections of unpaid losses and LAE were less than we originally anticipated). The reduction in the liability for unpaid losses and LAE was $71.7 million, $60.0 million and $107.1 million for the years ended December 31, 2008, 2007 and 2006, respectively.
In California, in particular, where our operations began on July 1, 2002, the actuaries’ and management’s initial expectations of the ultimate level of losses and patterns of loss emergence and loss payment necessarily were based on benchmarks derived from analyses of historical insurance industry data in California. Prior to July 1, 2002, no historical data from our California insurance subsidiary existed and, although some historical data was available for the prior years for some of the market segments we entered in California, that data was limited as to the number of loss reserve evaluation points available. The industry-based benchmarks were adjusted judgmentally for the anticipated impact of significant environmental changes, specifically the enactment of major changes to the statutory workers’ compensation benefit structure and the manner in which claims are administered and adjudicated in California. The actual emergence and payment of claims by our California insurance subsidiary has been more favorable than those initial expectations, due at least in part, we believe, to the impact of enactment of the major changes in the California environment. Other insurance companies writing California workers’ compensation insurance have also experienced emergence and payment of claims more favorable than anticipated. At each evaluation date, the projected claim activity underlying the prior loss reserves has been replaced by the actual claim activity, and the expectation of future emergence and payment of California claims underlying the actuarial projections
The estimate of the future cost of handling claims, or LAE, depends primarily on examining the relationship between the aggregate amount that has been spent on LAE historically, as compared with the dollar volume of claims activity for the corresponding historical periods. For our insurance subsidiaries’ business in Nevada, as a result of operational improvements, including reductions in staff count to align with the current and anticipated volume of business in the state, our expenditures on LAE in recent years have been lower than historical levels. As these operational improvements impacted the actual emerging LAE expenditures, the estimates of future LAE have reduced. For our insurance subsidiaries’ operations in California, initial expectations of LAE when operations commenced in California were based on the assumptions used by the Company in pricing the California business, and on some limited historical data for the market segments the Company was entering. As the Company’s operations in California have matured, and as data relating to the Company’s and industry claim handling expenses reflective of the new workers’ compensation benefit environment in California have become available, the expectations of LAE underlying the projection of future LAE have been adjusted to reflect that actual costs of administering claims relative to the cost of losses themselves have been greater than initial expectations. Although our revised LAE expectations resulted in an increase in the projected future cost of administering California claims relative to losses at December 31, 2008, 2007 and 2006, given the significant decrease in the estimated projected costs of losses in California, the overall impact has been a decrease in LAE reserves.
We review our loss reserves each quarter and, as mentioned earlier, our consulting actuaries assist our review by performing a comprehensive actuarial analysis and projection of unpaid losses and LAE twice each year. We may adjust our reserves based on the results of our reviews and these adjustments could be significant. If we change our estimates, these changes are reflected in our results of operations during the period in which they are made. Our overall actual claims and LAE experience and emergence in recent years has been more favorable than anticipated in prior evaluations. Our insurance subsidiaries have been operating in a period of dramatically changing environmental conditions in our major markets, entry into new markets, and operational changes. During periods characterized by such changes, at each evaluation, the actuaries and management must make judgments as to the relative weight to accord to long- term historical and recent company data, external data, evaluations of environmental changes, and other factors in selecting the methods to use in projecting ultimate losses and LAE, the parameters to incorporate in those methods, and the relative weights to accord to the different projection indications. Since the loss reserves are providing for claim payments that will emerge over many years, if management’s projections and loss reserves were established in a manner that reacted quickly to each new emerging trend in the data or in the environment, there would be a high likelihood that future adjustments, perhaps significant in magnitude, would be required to correct for trends that turned out not to be persistent. At each balance sheet evaluation, some losses and LAE projection methods have produced indications above the loss reserve selected by management, and some losses and LAE projection methods have produced indications lower than the loss reserve selected by management. At each evaluation, management has given weight to new data, recent indications, and evaluations of environmental conditions and changes that implicitly reflect management’s expectation as to the degree to which the future will resemble the most recent information and most recent changes, as compared with long-term claim payment, claim emergence, and claim cost inflation patterns. As patterns and trends recur consistently over a period of quarters or years,
management gives greater implicit weight to these recent patterns and trends in developing our future expectations. In our view, in establishing loss reserves at each historical balance sheet date, we have used prudent judgment in balancing long-term data and recent information.
It is likely that ultimate losses and LAE will differ from the loss reserves recorded in our December 31, 2008 balance sheet. Actual losses and LAE payments could be greater or less than our projections, perhaps significantly. The following paragraphs discuss several potential sources of such deviations, and illustrate their potential magnitudes.
More than 51% of our claims payments during the three years ended December 31, 2008 related to medical care for injured workers. The utilization and cost of medical services in the future is a significant source of uncertainty in the establishment of loss reserves for workers’ compensation. We are not able to state the rate of medical cost inflation that is assumed in our loss reserves because our loss reserves are established based on reviewing the results of actuarial methods that do not contain explicit medical claim cost inflation rates, as well as methods that do. However, because medical care will be provided over many years, and in some cases decades, to the injured workers who have open claims, the pace of medical claim cost inflation has a significant impact on our ultimate claim payments. For example, if the rate of medical claim cost inflation increases by 1% above the inflation rate that is implicitly included in the loss reserves at December 31, 2008, we estimate that future medical costs over the lifetime of the current claims would increase by approximately $78.5 million on a net-of-reinsurance basis.
Our reserve estimates reflect expected increases in the costs of contested claims and assume we will not be subject to losses from significant new legal liability theories. While it is not possible to predict the impact of changes in this environment, if expanded legal theories of liability emerge, our IBNR claims may differ substantially from our IBNR reserves. Our reserve estimates assume that there will not be significant future changes in the regulatory and legislative environment. The impact of potential changes in the regulatory or legislative environment is difficult to quantify in the absence of specific,
Reinsurance recoverables represent: (a) amounts currently due from reinsurers on paid losses and LAE; (b) amounts recoverable from reinsurers on case basis estimates of reported losses; and (c) amounts recoverable from reinsurers on actuarial estimates of IBNR for losses and LAE. These recoverables, by necessity, are based upon our current estimates of the underlying losses and LAE, and are reported on our consolidated balance sheet separately as assets, as reinsurance does not relieve us
of our legal liability to policyholders. We bear credit risk with respect to the reinsurers, which can be significant considering that some of the unpaid losses and LAE remain outstanding for an extended period of time. Reinsurers might refuse or fail to pay losses that we cede to them, or they might delay payment. We are required to pay losses even if a reinsurer refuses or fails to meet its obligations under the applicable reinsurance agreement. We continually monitor the financial condition and rating agency ratings of our reinsurers. We require reinsurers that are not admitted reinsurers in California, Florida or Nevada to collateralize their share of the unearned premiums and unpaid loss reserves in order that our insurance subsidiaries receive credit for reinsurance on their statutory financial statements. Since our inception in 2000, no material amounts due from reinsurers have been written off as uncollectible and, based on this experience, we believe that amounts currently reflected in our consolidated financial statements will similarly require no material prospective adjustment.
Under the LPT Agreement, the Fund initially ceded $1.525 billion in liabilities for the incurred but unpaid losses and LAE related to claims incurred prior to July 1, 1995, for consideration of $775 million in cash. As of December 31, 2008, the estimated remaining liabilities subject to the LPT Agreement were approximately $929.6 million. Losses and LAE paid with respect to the LPT Agreement totaled approximately $447.9 million at December 31, 2008.
During 2007, we reversed $5.8 million of the liability including $0.7 million in interest as certain statutory periods expired. In 2008 the remaining balance was reversed ($10.6 million including $2.3 million in interest) and the liability was eliminated. In 2006, when the liability was initially recorded, the result was an increase in tax expense and our effective tax rate. In 2007 and 2008, as the liability was reversed, the impact was a decrease in tax expense and our effective tax rate.
Our investments in fixed maturity and equity securities are classified as available-for-sale and are reported at fair value with unrealized gains and losses excluded from earnings and reported in a separate component of equity, net of deferred taxes as a component of net accumulated other comprehensive (loss) income.
Realized gains and losses on sales of investments are recognized in operations on the specific identification basis.
Impairment of Investment Securities. Impairment of an investment security results in a reduction of the carrying value of the security and the realization of a loss when the fair value of the security declines below our cost or amortized cost, as applicable, for the security and the impairment is deemed to be other- than-temporary. We regularly review our investment portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of our investments. We consider various factors in determining if a decline in the fair value of an individual security is other-than-temporary. Some of the factors we consider include:
how long and by how much the fair value of the security has been below its cost;
our intent and ability to keep the security for a sufficient time period for it to recover its value or reach maturity;
mandated pool. We use gross premiums written, which excludes the impact of premiums ceded to reinsurers, as a measure of the underlying growth of our insurance business from period to period.
Net Premiums Earned. Net premiums earned represents that portion of net premiums written equal to the expired portion of the time for which insurance protection was provided during the financial year and is recognized as revenue. Net premiums earned are used to calculate the losses and LAE, underwriting and other operating expenses and combined ratios, as indicated below.
Underwriting and Other Operating Expenses Ratio. The underwriting and other operating expenses ratio is the ratio (expressed as a percentage) of underwriting and other operating expenses to net premiums earned, and measures an insurance company’s operational efficiency in producing, underwriting and administering its insurance business.
Combined Ratio. The combined ratio is a measure used in the property and casualty insurance business to show the profitability of an insurer’s underwriting, and it represents the percentage of each premium dollar spent on claims and expenses. The combined ratio is the sum of the losses and LAE ratio, the commission expense ratio and the underwriting and other operating expenses ratio. The losses and LAE ratio, commission expense ratio and underwriting and other operating expenses ratio express the relationship between losses and LAE, commissions and underwriting and other operating expenses (including policyholder dividends), respectively, to net premiums earned. When the combined ratio is below 100%, an insurance company experiences underwriting gain, meaning that claims payments, the cost of settling claims, commissions and underwriting expenses are less than premiums collected. If the combined ratio is at or above 100%, an insurance company cannot be profitable without investment income, and may not be profitable if investment income is insufficient. Companies with lower combined ratios than their peers generally experience greater profitability.
Our net income for the year ended 2008 decreased 15.4% compared to the prior year. The primary factors that affected net income included a decline in net premiums earned, increased underwriting expenses related to the acquisition and increased realized losses due to other-than-temporary-impairment (OTTI) in our investment portfolio. The acquisition of AmCOMP resulted in a $1.1 million dollar increase to our net income in 2008. The decrease in the effective tax rate partially offset the decline in net income. Net income includes amortization of deferred reinsurance gain-LPT Agreement of $18.4 million and $18.0 million for the years ended December 31, 2008 and 2007, respectively. Excluding the impact of the LPT Agreement, net income would have been $83.4 million and $102.2 million for the years ended December 31, 2008 and 2007, respectively.
Net premiums earned for the year ended 2008 declined 5.2% compared to the prior year. Excluding the AmCOMP acquisition, net premiums earned would have declined 14.3%. The decrease in premiums earned was primarily due to the decrease in gross premium written, resulting from lower rates, competitive pressures and changes in economic and business conditions. In California, our largest market, our filed rates on new business and renewals for the year ended 2008 were 10.4% lower than the year ended 2007. In 2008, our average California policy size decreased 20.9% compared to 2007. This decrease was partially offset by an overall increase in policy count of 35.3%, including an 11.8% increase in policy count in California. The overall increase in policy count included 9,318 policies attributable to the AmCOMP acquisition. The acquisition provided an additional $31.6 million of net premium earned. The decrease in the gross written premium was also offset by a reduction in ceded premiums.
Losses and LAE decreased 4.7% compared to the prior year. Excluding the impact of the AmCOMP acquisition, losses and LAE would have decreased 17.6%. The losses and LAE were 41.5% and 41.3% of net premiums earned for years ended December 31, 2008 and 2007, respectively. This decrease was primarily due to the period over period change in net premiums earned, which reduced losses and LAE by approximately $11.4 million. Additionally, favorable prior accident year loss development increased to $71.7 million for year ended 2008 compared to $60.0 million for year ended 2007. Our current year loss rate estimate was 68.9% for the year ended 2008 compared to 63.8% for 2007.
The combined ratio increased by 5.5 percentage points for the year ended December 31, 2008, to 85.9% compared to 80.4% for the year ended December 31, 2007. Overall the increase in the combined ratio was the result of lower premium. The AmCOMP acquisition resulted in an increase in the combined ratio of 2.1 percentage points.
Net income decreased $51.3 million, or 29.9%, for the year ended December 31, 2007 when compared to the year ended December 31, 2006. Net income was primarily impacted by three items: a) a reduction in favorable losses and LAE reserve adjustments related to prior years from $107.1 million for the year ended December 31, 2006 to $61.6 million for the same period in 2007; b) realized gains of $54.1 million in 2006 primarily related to the portfolio reallocation in the fourth quarter; and c) the decrease in the effective tax rate to 20.3% in 2007 as compared to 32.5% in 2006.
Net income includes amortization of deferred reinsurance gain-LPT Agreement of $18.0 million and $19.4 million for the year ended December 31, 2007 and 2006, respectively. Excluding the impact of the LPT Agreement, net income would have been $102.2 million and $152.2 million for the year ended December, 2007 and 2006, respectively.
Net premiums earned decreased 11.7% for the year ended December 31, 2007 when compared to the year ended December 31, 2006. The decrease was primarily due to premium rate decreases in California offset by an increase in total policy count. The 13.3% overall increase in policy count included a decline in policy count of 5.8% in Nevada as a result of our adherence to our underwriting guidelines and increased competitive pressures. In California, our largest market, our filed rates on new business and renewals as of December 31, 2007 were 14.0 % lower than December 31, 2006, offset by a 17.0% increase in policy count. The average in-force policy premium at December 31, 2007 decreased 15.8% to $9,704 from $11,528 at December 31, 2006.
Net investment income increased $10.4 million for the year ended December 31, 2007. The change was attributable to three factors: (a) an increase in fixed maturity securities resulting from the reallocation of the Company’s investment portfolio in the fourth quarter of 2006 which increased our portfolio yield; (b) an increase in the invested assets; and (c) interest income generated by higher cash balances. The pre-tax yield on invested assets increased approximately $1.9 million or approximately 15 basis points to 4.37% at December 31, 2007 as compared to 4.22% at December 31, 2006. The increase in our invested assets resulted in additional investment income of $6.3 million for the year ended December 31, 2007. The net proceeds from the IPO generated $1.8 million interest income prior to distribution to eligible members and higher cash balances generated $1.0 million of additional interest income.
Losses and LAE increased $13.5 million, or 10.4%, for the year ended December 31, 2007 when compared to the year ended December 31, 2006. Losses and LAE were 41.3% and 33.0% of net premiums earned for the years ended December 31, 2007 and 2006, respectively. 2006 losses and LAE were positively impacted by a large favorable prior accident year adjustment of $107.1 million taken primarily in the third quarter of 2006 in recognition of favorable development related to California regulatory reforms. In 2007, the prior year favorable losses and LAE development adjustment was $61.6 million, a decrease of $45.5 million when compared to 2006. As the impact of the California 2003 and 2004 regulatory reforms development become more known, it is expected that any continued adjustments due to favorable development attributable to the regulatory reforms will continue to moderate in amount. Current year losses and LAE rate estimates were approximately 1.4% lower in 2007. This improved loss and LAE rate was applied to lower net earned premium in 2007, which partially offset the decrease in favorable prior years development discussed above.
Commission expense decreased $4.1 million, or 8.4%, for the year ended December 31, 2007 compared to the year ended December 31, 2006. Commission expense was 12.8% and 12.3% of net premiums earned for the years ended December 31, 2007 and 2006, respectively. Commission expense decreased approximately $5.7 million due to the decrease in net earned premium and $2.7 million related to a favorable change in the estimated LPT Agreement contingent commission. The decrease in 2007 was partially offset by a two percentage point increase in our commission rate on select policies incepting July 2006 and after, which resulted in increased commission expense of $4.3 million.
The decrease in professional fees was primarily due to the 2006 one-time incurred expenses related to the conversion of $10.0 million. The remainder of the decrease in professional fees was due to the reduction in the use of consultants for strategic planning of $1.5 million and post-implementation work
Income taxes decreased $52.1 million, or 63.0%, for the year ended December 31, 2007, compared to the year ended December 31, 2006. The decrease in income taxes was primarily due to a $103.4 million decrease in pre-tax income and other tax items discussed below. The effective tax rate for the twelve months ended December 31, 2007, was 20.3% compared to 32.5% for the same period in 2006. The decrease in the effective tax rate was primarily due to three factors: a) a decline of $54.1 million in realized gains in 2007; b) an increase in the ratio of tax exempt interest and dividends to pre-tax income resulting from the Company’s reallocation of its investment portfolio in the fourth quarter 2006; and c) the $5.8 million reversal of a liability for previously unrecognized tax benefits, including related interest, in third quarter 2007. Additionally, in 2006 there were non-deductible expenses related to the conversion.
Parent Company. We are a holding company and substantially all of our operations have historically been conducted through our insurance subsidiaries, EICN and ECIC. On October 31, 2008, we completed the acquisition of AmCOMP and, as a result, added two new insurance subsidiaries, EPIC and EAC. We require cash to pay any dividends to our stockholders, repurchase common stock, make interest and principal payments on our outstanding debt obligations and to fund our operating expenses.
Dividend Capacity. The ability of EHI to fund its operations depends upon the surplus and earnings of its subsidiaries and their ability to pay dividends to EHI. Payment of dividends by our insurance subsidiaries is restricted by state insurance laws, including laws establishing minimum solvency and liquidity thresholds, see “Item 1 - Business-Regulation-Financial, Dividend and Investment Restrictions” for a further discussion of the restrictions and requirements pertaining to the availability of additional dividends.
Based on reported capital, surplus and dividends paid within the last 12 months, the maximum dividends that may be paid by ECIC, EPIC and EAC in 2009 without prior approval by the respective state insurance regulator are $52.5 million, $17.7 million and $9.5 million, respectively. As a result of the approval of extraordinary dividends totaling $355.0 million from special surplus by the Nevada Commissioner in 2008, dividends paid by EICN in 2009 will require prior approval.
Stock Repurchases. On February 21, 2008, the EHI Board of Directors authorized a stock repurchase program of up to $100 million of the Company’s shares of common stock through June 30, 2009. On February 25, 2009, the Board of Directors extended this program through December 31, 2009. Shares may be purchased from time to time at prevailing market prices in the open market, subject to market conditions and other factors. We suspended the share repurchase program in September 2008, due to uncertainty in the capital and credit markets. There can be no assurance that we will complete any repurchases of our common stock pursuant to the program in the future. Through December 31, 2008, we repurchased 786,795 shares of common stock at the average price, including commissions, of $17.99 per share, for a total of approximately $14.2 million.
On May 10, 2007, the EHI Board of Directors authorized a stock repurchase program of up to $75.0 million of our common stock. The stock repurchase program was used to return value to our stockholders by reducing the number of shares outstanding. We began repurchasing shares on the open
market on May 31, 2007, and completed the stock repurchase program on October 17, 2007. A total of 3,911,272 shares of common stock were repurchased at an average price of $19.18 per share.
Our net cash flows are generally invested in marketable securities. Our investment portfolio is structured so that investments mature periodically over time in reasonable relation to current expectations of future claim payments. We closely monitor the duration of these investments and investment purchases and sales are executed with the objective of having adequate funds available for the payment of claims. As our investment strategy focuses on asset and liability durations, and not specific cash flows, asset sales may be required to satisfy obligations. At December 31, 2008, our investment portfolio had an effective duration of 4.74 with individual maturities extending out to 35 years.
Prior to 2008, we met our cash requirements and financed our growth principally from underwriting operations, asset maturities, and investment income. The recent acquisition of AmCOMP in 2008 was funded through a combination of available cash and proceeds from our Amended Credit Facility.
Cash Flows For the Years Ended December 31, 2007 and 2006. Cash and cash equivalents increased $50.8 million to $69.7 for the year ended December 31, 2007. The net cash changes were: $1.7 million decrease in operating activities, $110.0 million increase in investing activities and $57.5 million decrease in financing activities as compared to the year ended December 31, 2006. The decrease in net cash from operations was primarily due to a decrease of $40.8 million in premiums received offset by a $36.1 million decrease in incomes taxes paid. The net investment purchases decreased as we reinvested our cash in financing activities in order to facilitate the repurchase of our common stock, to pay stockholder dividends, and to build cash to support our growth. The majority of cash used by financing activities was used to repurchase $75.0 million of our common stock and to pay stockholder dividends of $9.3 million.
We completed our IPO and conversion from a mutual insurance company to a stock company on February 5, 2007. The cash proceeds from the IPO were approximately $472.7 million, after deducting approximately $34.0 million in underwriting discounts and commissions and approximately $16.3 million
We classify our portfolio of equity securities as available-for-sale and carry these securities on our balance sheet at fair value. Accordingly, changes in market prices of the equity securities we hold in our combined investment portfolio result in increases or decreases in our total assets. In order to minimize our exposure to equity price risk, we invest primarily in equity securities of mid-to-large capitalization issuers and seek to diversify our equity holdings across several industry sectors. Our objective has been to reduce equity exposure as a percentage of our total portfolio by increasing our fixed maturity securities. Our investment strategy allows a maximum exposure of 20% of our total combined investment portfolio in equity securities, with our current equity allocation at 2.9% of the total portfolio at December 31, 2008. Our equity position has fallen below our selected target of 6.0% due to declining market valuations and the consolidation of the AmCOMP investment portfolio into ours.
The average credit rating for our fixed maturity securities investment portfolio, using ratings assigned by Standard & Poor’s, was “AA+” at December 31, 2008. The following table shows the Standard & Poor’s ratings distribution of our fixed maturity portfolio as of December 31, 2008 as a percentage of total market value:
We regularly assess individual securities as part of our ongoing portfolio management, including the identification of declines in fair values. All securities in an unrealized loss position are reviewed to determine whether the impairment is other-than-temporary. Factors considered in determining whether a decline is other-than-temporary include the length of time and the extent to which fair value has been below cost, historical and projected company financial performance and near-term prospects of the issuer, the outlook for industry sectors, credit ratings and macro-economic changes and our ability and intent to hold the security until its expected recovery or maturity. For the year ended December 31, 2008, we recognized a total impairment of $12.7 million in the fair value of our investment portfolio. The fair value of equity securities was impaired $10.8 million as a result of the severity and duration of the decline in market value of these securities primarily due to market conditions. Our fixed maturity securities were impaired $1.9 million due to the credit downgrades and increased credit risk of issuers in the financial services sector.
We are required by various state regulations to keep securities or letters of credit on deposit with the states in which we do business in a depository account. At December 31, 2008 and 2007, securities having a fair market value of $582.1 million and $516.0 million, respectively, were on deposit. Additionally, certain reinsurance contracts require Company funds to be held in trust for the benefit of the ceding reinsurer to secure the outstanding liabilities assumed by the Company. The fair market value of securities held in trust at December 31, 2008 and 2007 was $6.7 million and $4.9 million, respectively.
The following table identifies our long-term debt and contractual obligations as of December 31, 2008:
Audited Financial Statements as of December 31, 2008 and 2007 and for each of the three years in the period ended December 31, 2008:
We have audited Employers Holdings, Inc. and Subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Company’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that: (a) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (b) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (c) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Employers Holdings, Inc. and Subsidiaries at December 31, 2008 and 2007, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Employers Holdings, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 26, 2009, expressed an unqualified opinion thereon.
On October 31, 2008 (Acquisition Date), the Company acquired 100% of the outstanding common stock of AmCOMP Incorporated (AmCOMP), including two insurance subsidiaries, AmCOMP Preferred Insurance Company and AmCOMP Assurance Corporation (see Note 4). On December 16, 2008, the Florida Commissioner approved the name changes of AmCOMP Preferred Insurance Company and AmCOMP Assurance Corporation to Employers Preferred Insurance Company (EPIC) and Employers Assurance Company (EAC), respectively.
In accordance with Statement of Financial Accounting Standards (SFAS) No. 131, Disclosures About Segments of an Enterprise and Related Information, the Company considers an operating segment to be any component of its business whose operating results are regularly reviewed by the Company’s chief operating decision makers to make decisions about resources to be allocated to the segment and assess its performance based on discrete financial information. Currently, the Company has one operating segment, workers’ compensation insurance and related services.
The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and
The Company’s investments in fixed maturity securities, equity securities and short-term investments, with remaining maturities of one year or less at the time of acquisition, are classified as available-for-sale and are reported at fair value with unrealized gains and losses excluded from earnings and reported as a separate component of equity, net of deferred taxes, in net accumulated other comprehensive income.
Investment income consists primarily of interest and dividends. Interest is recognized on an accrual basis, and dividends are recorded as earned at the ex-dividend date. Interest income on mortgage-backed and asset-backed securities is determined on the effective-yield method based on estimated principal repayments.
When, in the opinion of management, a decline in the fair value of an investment below its cost or amortized cost is considered to be “other-than-temporary,” the investment’s cost or amortized cost is written-down to its fair value and the amount written-down is recorded in earnings as a realized loss on investments. The determination of other-than-temporary decline includes, in addition to other relevant factors, a presumption that if the market value is below cost by a significant amount for a period of time, a write-down may be necessary unless management has the ability and intent to hold a security to recovery or maturity. The amount of any write-down is determined by the difference between cost or amortized cost of the investment and its fair value at the time the other-than-temporary decline is identified (see Note 6).
A premium deficiency is recognized if the sum of expected claims costs, claims adjustment expenses, expected dividends to policyholders, unamortized acquisition costs and policy maintenance costs exceed the related unearned premiums and future investment income from related in force policies. A premium deficiency would first be recognized by charging any unamortized acquisition costs to expense to the extent required to eliminate the deficiency. If the premium deficiency was greater than unamortized acquisition costs, a liability would be accrued for the excess deficiency. There was no premium deficiency at December 31, 2008 or 2007.
Electronic data processing equipment, operating software, and non-operating software are depreciated using the straight-line method over three to seven years. Leasehold improvements are carried at cost less accumulated amortization. The Company amortizes leasehold improvements using the straight-line method over the lesser of the useful life of the asset or the remaining original lease term, excluding options or renewal periods. Leasehold improvements are generally depreciated over three to five years. Other furniture and equipment and autos are depreciated using the straight-line method over three to seven years.
Financial instruments that potentially subject the Company to concentrations of credit risk are primarily cash, cash equivalents, investments, instruments held through hedging activities, premiums receivable and reinsurance recoverable balances.
At December 31, 2008 and 2007, the outstanding premiums receivable balance was generally diversified due to the large number of entities composing the Company’s policyholder base and their dispersion across many different industries. To reduce credit risk, the Company performs ongoing evaluations of its policyholders’ financial condition, but does not generally require collateral. The Company also has recoverables from its reinsurers. Reinsurance contracts do not relieve the Company from its obligations to claimants or policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. The Company obtains collateral
to mitigate the risks related to reinsurance insolvencies. At December 31, 2008, $7.8 million was collateralized by cash or letter of credit and an additional $998.4 million was in trust accounts for reinsurance related to the LPT agreement.
The Company enters into securities lending agreements with financial institutions to improve investment income. Selected securities are loaned and are secured by collateral equal to at least 102% of the fair market value of the securities. Collateral is in the form of cash or securities issued or guaranteed by the U.S. government, and the securities lending agent has provided counterparty indemnification in the event of borrower insolvency. The maximum amount loaned under our securities lending program in 2008 was $112.1 million. As of December 31, 2008 and 2007, there were no outstanding securities lending transactions.
Derivatives. The fair value of the Company’s interest rate swap is derived by using an industry standard swap valuation model, with market based inputs for swaps having similar characteristics (see Note 12).
Notes Payable. The Company’s notes payable is composed of floating rate long-term debt. Accordingly, the carrying amount is estimated to approximate fair value.
The Company accounts for goodwill and other intangible assets in accordance with SFAS No. 142, Goodwill and Other Intangible Assets (SFAS No. 142). Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired in a business combination, and is not subject to amortization. SFAS No. 142 requires that goodwill be tested for impairment on an annual basis, or more frequently if circumstances indicate that a possible impairment has occurred. The assessment of impairment involves a two step process whereby an initial assessment for potential impairment is performed, followed by a measurement of the amount of impairment, if any. The Company has determined that there was no impairment as of December 31, 2008.
There was no change to the recorded goodwill from the Acquisition Date to December 31, 2008.
On January 1, 2006, the Company adopted SFAS No. 123(R)-Share-based Payment (SFAS) No. 123(R). Prior to 2007, neither EHI nor its predecessor, EIG, had any outstanding shares of common stock, and therefore no stock-based payments were made. During 2008 and 2007 the Company issued stock-based payments, and under SFAS No. 123(R), those payments are recognized in the consolidated statements of income based on their fair values over the employees’ service period (see Note 15).
In December 2007, the FASB issued SFAS No. 141 (Revised 2007), -Business Combinations (SFAS No. 141(R)). SFAS No. 141(R) significantly changes the accounting for business combinations
and requires the acquiring entity in the transaction to recognize the acquired assets and assumed liabilities at the acquisition-date fair value with limited exceptions. SFAS No. 141(R) was adopted by the Company January 1, 2009 and its adoption will have an impact on the consolidated financial statements for any future business combinations. Early adoption was prohibited.
Effective February 5, 2007, under the terms of a plan of conversion, EIG converted from a mutual insurance holding company to a stock company. All membership interests in EIG were extinguished on that date and eligible members of EIG received, in aggregate, 22,765,407 shares of EHI’s common stock and $463.0 million of cash.
Upon completion of EHI’s IPO, the capitalized issuance costs related to the IPO of $5.4 million were netted against the IPO proceeds in additional paid-in capital in the accompanying consolidated balance sheets. The costs related to the conversion were $10.9 million, of which $0.9 million was incurred in the period from January 1, 2007 through February 5, 2007 and $10.0 million was incurred during the year ended December 31, 2006. Conversion expenses consisted primarily of printing and mailing costs and the aggregate cost of engaging independent accounting, actuarial, financial, investment banking, legal and other consultants. These costs have no tax benefit and were expensed as incurred and are included in the underwriting and other operating expenses in the accompanying consolidated statements of income.
consideration equal to the net amount of the excess, if any, of $12.15 per share over the exercise price per share of the option. The following table summarizes the purchase price of the Acquisition:
Business in-force is included in deferred policy acquisition costs on the consolidated balance sheets and is amortized over the remaining policy periods for the policies acquired. Intangible assets consist primarily of state licenses, insurance relationships and other intangibles. The state licenses relate to AmCOMP’s ability to sell workers’ compensation products in 29 states and the District of Columbia. Insurance relationships include both customer and broker relationships. The following table presents details of the purchased intangible assets acquired as part of the Acquisition:
The unaudited financial information in the table below summarizes the combined results of operations of EHI and AmCOMP, on a pro forma basis, as though the companies had been combined as of the beginning of each of the periods presented. The unaudited pro forma financial information is presented for information purposes only and is not indicative of the results that would have been achieved if the Acquisition had taken place at the beginning of the periods presented, nor is the pro forma information intended to be indicative of the Company’s future results of operations.
On January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements (SFAS No. 157), which provides a common definition of fair value and establishes a framework to make the measurement of fair value more consistent and comparable. The Company’s adoption of SFAS No. 157 did not have a material impact on its consolidated financial statements or results of operations.
Each asset class is evaluated based on relevant market information, relevant credit information, perceived market movements and sector news. The market inputs utilized in the pricing evaluation include: benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, reference data, and industry and economic events. The extent of the use of each market input depends on the asset class and the market conditions. Depending on the security, the priority of the use of inputs may change or some market inputs may not be relevant. For some securities, additional inputs may be necessary.
This method of valuation will only produce an estimate of fair value if there is objectively verifiable information to produce a valuation. If objectively verifiable information is not available, the Company would be required to produce an estimate of fair value using some of the same methodologies, but would have to make assumptions for market based inputs that are unavailable due to market conditions.
The following table provides a reconciliation of the beginning and ending balances, for the above items, that are measured using Level 3: Unobservable inputs, for the year ended December 31, 2008:
The amortized cost and estimated fair value of fixed maturity investments and short-term investments at December 31, 2008, by contractual maturity are shown below. Expected maturities differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Based on a review of the equity securities, during the years ended December 31, 2008 and 2007, the Company recognized impairments of $10.8 million and $1.2 million in the fair values of 86 and 13 securities, respectively, as a result of the severity and duration of the change in fair value of those securities. For its other equity securities, the Company determined that the unrealized losses were not considered to be other-than-temporary due to the financial condition and near term prospects of the issuers.
Depreciation expense for the years ended December 31, 2008, 2007 and 2006, was $6.5 million, $6.4 million, and $4.2 million, respectively. During 2008 and 2007, the Company retired $4.6 million and $4.4 million of fully depreciated equipment, respectively. Internally developed software costs of $1.1 million were capitalized during the year ended December 31, 2008.
The difference between the statutory federal tax rate of 35% and the Company’s effective tax rate on income before tax as reflected in the consolidated statements of income was as follows:
Prior to the Privatization, the Fund was a part of the State of Nevada and therefore was not subject to federal income tax; accordingly, it did not take an income tax deduction with respect to the establishment of its unpaid loss and LAE reserves. Due to favorable loss experience after the Privatization, it was determined that certain of the pre-Privatization unpaid loss and LAE reserves assumed by EICN as part of the Privatization were no longer necessary and the unpaid loss and LAE reserves were reduced accordingly. Such downward adjustments of pre-Privatization unpaid loss reserves increases GAAP net income but does not increase taxable income. For the year ended December 31, 2008, there were downward adjustments of pre-Privatization unpaid loss reserves that increased GAAP net income, but did not increase taxable income for the period. For the year ended December 31, 2006, there was an increase to the pre- Privatization unpaid loss reserves that decreased GAAP net income, but did not decrease taxable income for the period.
Tax years 2005 through 2007 are subject to examination by the federal taxing authority. There are no income tax examinations currently in progress.
At December 31, 2008, the Company had no net operating loss carry forward.
The above table excludes the impact of the amortization of the deferred reinsurance gain-LPT Agreement and the reduction of the ceded reserves on the LPT Agreement (Note 10), which are reflected in losses and LAE incurred in the consolidated statements of income.
Estimates of incurred losses and LAE attributable to insured events of prior years decreased due to continued favorable development in such prior accident years (actual losses and LAE paid and current projections of unpaid losses and LAE were less than the Company originally anticipated). The reduction in the liability for unpaid losses and LAE was $71.7 million, $60.0 million and $107.1 million for the years ended December 31, 2008, 2007 and 2006, respectively.
The major sources of this favorable development include actual paid losses being less than expected, and the impact of recalibration of selected patterns of claims emergence and claims payment used in the projection of future loss payments.
In California, in particular, where the Company’s operations began on July 1, 2002, management’s initial expectations of both the ultimate level of its losses and patterns of loss emergence and loss payment necessarily were based on benchmarks derived from analyses of historical insurance industry data in California, as no historical data from the Company’s insurance subsidiaries existed, and although some historical data was available for the prior years of some of the market segments the Company entered in California, that data was limited as to the number of loss reserve evaluation points available. The industry- based benchmarks were adjusted judgmentally for the anticipated impact of significant environmental changes, specifically the enactment of major changes to the statutory workers’ compensation benefit structure and the manner in which claims are administered and adjudicated in California. The actual emergence and payment of California claims by the Company’s insurance subsidiaries has been more favorable than those initial expectations, due at least in part to what the Company believes are the impact of enactment of the major changes in the California workers’ compensation environment. Other insurance companies writing California workers’ compensation insurance also have experienced emergence and payment of claims more favorable than anticipated. At each evaluation date, the projected claim activity underlying the prior loss reserves has been replaced
The initial deferred gain resulting from the LPT Agreement was recorded as a liability in the accompanying consolidated balance sheets and is being amortized using the recovery method, whereby the amortization is determined by the proportion of actual reinsurance recoveries to total estimated recoveries. The Company amortized $18.4 million, $18.0 million, and $19.4 million of the deferred gain for the years ended December 31, 2008, 2007 and 2006, respectively. There were no adjustments to the direct reserves ceded under the LPT Agreement or related adjustment to the deferred gain for the years ended December 31, 2008, 2007 and 2006. The amortization of the deferred gain and adjustments due to development in the reserves are recorded in losses and LAE incurred in the accompanying consolidated statements of income. The remaining deferred gain was $406.6 million and $425.0 million as of December 31, 2008 and 2007, respectively, which is included in the accompanying consolidated balance sheets as deferred reinsurance gain-LPT Agreement.
The LPT Agreement allows the Company to receive a contingent profit commission from the participating reinsurers based on the actual loss experience of the ceded business. Pursuant to the LPT Agreement and based on both actual results to date and projections of ultimate losses under the agreement, the Company recorded no change for the 12 months ended December 31, 2008, an increase of $2.5 million for the 12 months ended December 31, 2007 and a decrease of $0.2 million for 2006, in its estimate of the ultimate contingent profit commission. The changes in the ultimate contingent profit commission are recorded in commission expense in the accompanying consolidated statements of income. Due to payments received under the terms of the LPT Agreement, the Company had a net
The Company had no outstanding debt as of December 31, 2007. Effective September 30, 2008, EHI and Wells Fargo Bank, National Association (Wells Fargo) entered into a Second Amended and Restated Secured Revolving Credit Facility (Amended Credit Facility). The Amended Credit Facility provides the Company with a: (a) $150.0 million line of credit through December 31, 2009; (b) $100.0 million line of credit from January 1, 2010 through December 31, 2010; and (c) $50.0 million line of credit from January 1, 2011 through March 26, 2011. Amounts outstanding bear interest at a rate equal to, at the Company’s option: (a) a fluctuating rate of 1.25% above Wells Fargo’s prime rate or (b) a fixed rate that is 1.25% above the LIBOR rate then in effect. The Company paid a non-refundable commitment fee of $375.0 thousand, which is being amortized over the contractual life of the Amended Credit Facility. In addition, the Company is required to pay a quarterly commitment fee equal to a per annum rate of 0.10% on any portion of the Amended Credit Facility that is unused. The Amended Credit Facility contains customary non-financial covenants and requires EHI to maintain $7.5 million of cash and cash equivalents.
In connection with the Acquisition, the Company assumed $34.7 million in additional notes payable on October 31, 2008 (see Note 4). The acquired notes payable were comprised of three surplus notes and a loan from Regions Bank. Additionally, AmCOMP had an unused $30.0 million secured credit facility with Regions Bank. On December 22, 2008, the Company terminated the Restated Loan and Security Agreement, related to the loan, and the Loan and Security Agreement, related to the credit facility. In connection with the termination of the Restated Loan and Security Agreement, the Company repaid the outstanding principal of $2.7 million. Interest paid during the two months ended December 31, 2008 totaled less than $0.1 million.
months ended December 31, 2008 totaled $0.2 million. Interest accrued as of December 31, 2008 was $0.1 million.
EPIC has outstanding a $12.0 million surplus note, to ICONS, Inc., issued as part of a pooled transaction (ICONS Surplus Note). The note matures in 2034 and is callable by the Company in the second quarter of 2009. The terms of the note provide for quarterly interest payments at a rate 425 basis points in excess of the 90-day LIBOR. Interest paid during the two months ended December 31, 2008 totaled $0.2 million. Interest accrued as of December 31, 2008 was $0.1 million.
EPIC has outstanding a $10.0 million surplus note, to Alesco Preferred Funding V, LTD, issued as part of a pooled transaction (Alesco Surplus Note). The note matures in 2034 and is callable by the Company in the fourth quarter of 2009. The terms of the note provide for quarterly interest payments at a rate 405 basis points in excess of the 90-day LIBOR. Interest paid during the two months ending December 31, 2008 totaled $0.2 million. Interest accrued as of December 31, 2008 totaled less than $0.1 million.
Principle payment obligations on notes payable outstanding at December 31, 2008, were as follows:
On September 30, 2008, the Company, in connection with the borrowings made under the Amended Credit Facility (Note 11), executed an interest rate swap with Wells Fargo with a notional amount of $100.0 million. Execution of the interest rate swap established a fixed interest rate of 4.84%, on the notional amount, through September 30, 2010. The Company uses its interest rate swap to mitigate the risks associated with unexpected cash outflows resulting from shifts in variable interest rates. As of December 31, 2008, the interest rate swap had a liability fair value of $3.9 million and is included in other liabilities on the accompanying consolidated balance sheet. The corresponding unrealized loss of $3.9 million is included in accumulated other comprehensive income, net.
The Company writes workers’ compensation insurance in California in which unpaid workers’ compensation liabilities from insolvent insurers are the responsibility of the California Insurance Guarantee Association (CIGA). The Company passes through the CIGA assessment to its policyholders via a surcharge based upon the estimated annual premium at the policy’s inception and has received, and expects to continue to receive, these guarantee fund assessments which are paid to CIGA based on premiums written by the Company. As of December 31, 2008 and 2007, the Company recorded an asset of $7.7 million and $9.1 million, respectively, for assessments paid to the CIGA that includes prepaid policy surcharges still to be collected in the future from policyholders.
Additionally, as of December 31, 2008, guarantee fund receivable assets, excluding CIGA, of $1.4 million are included in other assets, as they can be used as a credit against future premium taxes owed. Maximum contributions required by law in any one state in which the Company offers insurance vary between 0.2% and 2.0% of direct premiums written.
Many states have laws that established second injury funds to provide compensation to injured employees for aggravation of a prior condition or injury. Funding is provided either by assessments based on paid losses or premium surcharges. The Company accrues a liability for second injury fund assessments as net premiums are written or as losses are incurred based on individual state guidelines, and for premium based assessments, the Company defers these costs and recognizes them as an expense as the related premiums are earned. For the twelve months ended December 31, 2008, the Company recognized a benefit related to Second Injury Fund of $0.1 million.
The Florida Second Disability Trust Fund (Florida SDTF) currently has significant unfunded liabilities. It is not possible to predict how the Florida SDTF will operate, if at all, in the future after further legislative review. Changes in the Florida SDTF’s operations could decrease the availability of recoveries from the Florida SDTF, increase Florida SDTF assessments payable by the Company and/or result in the discontinuation of the Florida SDTF and thus could have an adverse effect on the Company’s business, financial condition, and its operations. Under current law, future assessments are capped at 4.52% of net written premiums, and no recoveries can be made for losses or submitted on claims occurring after January 1, 1998.
On February 21, 2008, the EHI Board of Directors authorized a stock repurchase program (the 2008 Program). The 2008 Program authorizes the Company to repurchase up to $100.0 million of the Company’s common stock through June 30, 2009. On February 25, 2009, the EHI Board of Directors extended the 2008 program through December 31, 2009. As of December 31, 2008, the Company repurchased 786,795 shares at a cost of $14.2 million. EHI expects the shares may be repurchased from time to time at prevailing market prices in open market or private transactions. The Company suspended the 2008 Program in September 2008, due to the credit conditions in the financial markets.
On May 10, 2007, the EHI Board of Directors authorized a stock repurchase program (the Program). The Program authorized the Company to use up to $75.0 million in assets for the discretionary repurchase of its common stock during the remainder of 2007. The Program was completed on October 17, 2007, and resulted in the repurchase of 3,911,272 shares of common stock.
As of December 31, 2008, nonqualified stock options, restricted stock units, and performance share awards have been granted, but no incentive stock options, stock appreciation rights or restricted stock have been granted under the Plan.
Net stock-based compensation expense recognized in the accompanying consolidated statements of income is as follows:
During the year ended December 31, 2007, the Company made “founders’ grants” to employees, excluding senior officers, in the form of 186,000 nonqualified stock options and also awarded 420,916 nonqualified stock options to its officers. The founders’ grants awards vest pro rata on each of the first three anniversaries of the effective date of EHI’s IPO. The options awarded to the officers of the Company vested 25% on February 8, 2008 and the remaining 75% will vest pro rata on the subsequent three anniversaries of such date. All options granted in 2007 have an exercise price equal to the fair
had yet to recognize $1.0 million in deferred compensation related to the PSAs and expects to recognize these costs over the next year.
On May 29, 2008, the Company awarded 152,564 RSUs to the officers of the Company. The RSUs have a service vesting period of four years and vest 25% on May 29, 2009, and the subsequent three anniversaries of such date. The RSUs are subject to accelerated vesting in certain limited circumstances, such as: death or disability of the holder, or in connection with a change of control of the Company. The aggregate fair value of the RSUs on the date of grant was $2.9 million.
Under SAP, the statutory operating results of EPIC and EAC are combined with EICN and ECIC’s operating results for the entire year of 2008. Net income for the Company’s insurance subsidiaries prepared in accordance with SAP for the years ended December 31, 2008, 2007 and 2006 was $101.7 million, $172.2 million and $164.3 million, respectively.
As of December 31, 2008, EICN had positive unassigned surplus of $205.9 million. As a result of approval of extraordinary dividends totaling $355.0 million from special surplus by the Nevada Commissioner in 2008, dividends from unassigned surplus, otherwise deemed ordinary, will also require approval in 2009. The 2008 extraordinary dividends were paid to EGI, and in turn to EHI, prior to December 31, 2008 as approved by the Nevada Division of Insurance. On October 17, 2006 and December 18, 2007, EICN received approval to pay extraordinary dividends of $55.0 million and $38.0 million, respectively. Both of these dividends were paid on or before December 31, 2007.
The California Insurance Holding Company System Regulatory Act limits the ability of ECIC to pay dividends to its parent, EICN. California law provides that, absent prior approval of the California Insurance Commissioner, dividends can only be declared from earned surplus. Earned surplus for purposes of this statute excludes amounts: (a) derived from the net appreciation in the value of assets not yet realized or (b) derived from an exchange of assets, unless the assets received are currently realizable in cash. In addition, California law provides that the appropriate insurance regulatory authorities in the state of California must approve (or, within a 30-day notice period, not disapprove) any dividend that, together with all other such dividends paid during the preceding 12 months, exceeds the greater of: (a) 10% of the paying company’s statutory earned surplus as regards policyholders at the preceding December 31 or (b) 100% of the net income for the preceding year. ECIC received approval to pay an extraordinary dividend of $49.2 million in the second quarter of 2008. Due to this dividend, a maximum payout of $52.5 million, without prior approval, will be available after June 2009, subject to restrictions. ECIC declared and paid a dividend of $61.0 million on December 14, 2007.
Under Florida law, without regulatory approval, EPIC and EAC may not pay dividends or other distributions of cash or property to its stockholders within a 12-month period with a total fair market value exceeding the larger of 10% of surplus as of the preceding December 31st or 100% of its prior
EPIC and EAC are subject to comprehensive supervision and regulation by the Florida Department of Financial Services (FDFS). Florida statute Section 624.408 requires EPIC and EAC to maintain minimum capital and surplus of the greater of $4.0 million or 10% of total liabilities. Florida statute Section 624.4095 requires EPIC and EAC to maintain a ratio of written premiums times 1.25 to surplus of no greater than 10-to-1 for gross written premiums and 4-to-1 for net written premiums. During the years ended December 31, 2008, 2007 and 2006, EPIC and EAC were in compliance with these statutes.
Additionally, EICN, ECIC, EPIC and EAC are required to comply with NAIC risk-based capital (RBC) requirements. RBC is a method of measuring the amount of capital appropriate for an insurance company to support its overall business operations in light of its size and risk profile. NAIC RBC standards are used by regulators to determine appropriate regulatory actions relating to insurers that show signs of weak or deteriorating conditions. As of December 31, 2008, 2007 and 2006, EICN, ECIC, EPIC and EAC’s total adjusted capital is above all regulatory action levels.
ECIC, EPIC and EAC are subject to Florida statute 627.215 and applicable regulations related to Florida excessive profits for workers’ compensation insurance companies. Florida excessive profits are calculated based upon a complex statutory formula which is applied over rolling three year periods. Companies are required to file annual excessive profits forms, and they are required to return so-called “Florida excessive profits” to policyholders in the form of a cash refund or credit toward the future purchase of insurance. As of December 31, 2008, the Company had no amounts accrued for estimated additional Florida excessive profits based on its statutory underwriting results for the years ended 2005-2008.
The Company maintains two 401(k) defined contribution plans covering all eligible Company employees. One plan covers eligible employees of the Company and its subsidiaries that existed prior to the acquisition of AmCOMP (Note 4) (the Employers 401(k) Plan). Beginning with the plan year 2007, the Company adopted a safe harbor matching contribution to the Employers 401(k) Plan. The safe harbor matching consists of a dollar-for-dollar matching contribution on salary deferrals up to 3% of compensation and then fifty-cents on the dollar matching contribution on salary deferrals from 3% to 5% of compensation. For the 2006 plan year, the Company’s match was fifty-cents for every dollar contributed by the employee, up to 6% of the employee’s annual salary. The Company’s contribution to the Employers 401(k) Plan was $1.5 million, $1.4 million and $0.9 million for the years ended December 31, 2008, 2007 and 2006, respectively.
SFAS No. 128, Earnings per Share, provides for the calculation of “Basic” and “Diluted” earnings per share. Basic earnings per share includes no dilution and is computed by dividing income applicable to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the potential dilution of securities that could share in the earnings of equity. Diluted earnings per common share includes common shares assumed issued under the “treasury stock method,” which reflects the potential dilution that would occur if outstanding options were to be exercised.
The following table presents the net income and the weighted average shares outstanding used in the earnings per common share calculations for the stated periods:
The pro forma earnings per common share-basic and diluted-presented on the accompanying consolidated statements of income is intended to depict the impact of the conversion because neither EHI, nor its predecessor, EIG, had, prior to the conversion, any outstanding common shares. The following table presents the pro forma net income and weighted average shares outstanding used in the pro forma earnings per common share calculations for the following years:
Quarterly results for the years ended December 31, 2008 and 2007 were as follows:
The increase in net premiums earned in the fourth quarter of 2008 was a result of the acquisition of AmCOMP (see Note 4) on October 31, 2008. The acquired business resulted in an increase in fourth quarter net premiums earned of $31.6 million.
The net realized losses in the fourth quarter of 2008 resulted from the Company’s review of the severity and duration of securities that were in an unrealized loss position. This resulted in the
Earnings per common share of $0.40, for the first quarter of 2007, only includes earnings for the period after the Company’s Conversion and IPO (see Note 3) or February 5, 2007 through March 31, 2007.
The restructuring plan includes a staff reduction of approximately 14 percent of the Company’s total workforce, and consolidation of corporate activities into the Company’s Reno, Nevada headquarters. The Company expects to incur restructuring charges in the first quarter 2009, primarily associated with personnel-related termination costs.
On February 25, 2009, the Board of Directors declared a $0.06 dividend per share, payable March 25, 2009, to stockholders of record on March 11, 2009.