The Company’s other regional offices are located in Charlotte, North Carolina (Southeast Region), Indianapolis, Indiana (Midwest Region), and Madison, Mississippi (Gulf South Region). The Company has satellite offices located in Wexford, Pennsylvania (Mid-Atlantic Region), Franklin, Tennessee (Southeast Region) and Richmond, Virginia (Southeast Region).
The home office building and the Camp Hill office are used by the workers’ compensation insurance and corporate/other segments. The office space in Western Pennsylvania, North Carolina, Indiana, Tennessee and Virginia is primarily used by the workers’ compensation insurance segment to provide underwriting, marketing, claims and risk management services to insureds in the respective geographic markets.
(4) Total liabilities as of December 31, 2009 and 2008 include liabilities reclassified to discontinued operations totaling $65,054 and $77,048, respectively.
(5) Calculated by dividing losses and LAE incurred by net premiums earned.
(6) Calculated by dividing the sum of acquisition and other underwriting expenses, other expenses and amortization of intangibles by net premiums earned.
(8) The sum of the loss and LAE ratio, expense ratio and the policyholder dividend expense ratio.
The Company’s consolidated expense ratio decreased from 30.0% in 2011 to 28.8% in 2012. The decrease in the expense ratio primarily reflects the increase in net premiums earned, including the impact of audit premium, partially offset by an increase in the expense ratio of 1.5 percentage points related to the Company’s adoption of ASU 2010-6, which reduced the amount of underwriting salaries capitalized and deferred over the life of the underlying workers’ compensation insurance policies.
The consolidated effective tax rate increased from 24.9% in 2011 to 28.3% in 2012, which primarily reflects the improvement in the Company’s pre-tax operating results.
Direct and net premiums written. Direct premiums written is the sum of both direct premiums and assumed premiums before the effect of ceded reinsurance. Direct premiums written include all premiums billed during a specified policy period. Net premiums written is the difference between direct premiums written and premiums ceded or paid to reinsurers (ceded premiums written). In the segregated portfolio cell reinsurance segment, assumed premiums are derived from insurance contracts written by EAIG and ceded to the segregated portfolio cells.
Net investment income and realized gains and losses on investments. The Company invests its surplus and the funds supporting its insurance liabilities (including unearned premiums and unpaid losses and LAE) in cash, cash equivalents, fixed income securities, convertible bonds, equity securities, and limited partnership investments. Investment income includes
interest earned on invested assets, including the impacts of premium amortization and discount accretion. Realized gains and losses on invested assets are reported separately from net investment income. The Company recognizes realized gains when invested assets are sold for an amount greater than their cost or amortized cost (in the case of fixed income securities) and recognizes realized losses when investment securities are written down as a result of an other than temporary impairment or sold for an amount less than their cost or amortized cost. Realized gains and losses also include the change in the estimated fair value of convertible bonds.
Loss ratio. The loss ratio is the ratio (expressed as a percentage) of losses and LAE incurred to net premiums earned and measures the underwriting profitability of a company’s insurance business. The Company measures the loss ratio on an accident year and calendar year loss basis to measure underwriting profitability. An accident year loss ratio measures losses and LAE for insured events occurring in a particular policy year, regardless of when they are reported, as a percentage of net
Net income, diluted earnings per share, and return on average equity. The Company uses net income and diluted earnings per share to measure its profits and return on average equity to measure its effectiveness in utilizing shareholders’ equity to generate net income. In determining return on average equity for a given year, net income is divided by the average of the beginning and ending shareholders’ equity for that year.
The Company establishes reserves for unpaid losses and LAE for its workers’ compensation insurance and segregated portfolio cell reinsurance products, which are estimates of future payments of reported and unreported claims for losses and related expenses. The adequacy of the Company’s reserves for unpaid losses and LAE are inherently uncertain because the ultimate amount that the Company may pay under many of the claims incurred as of the balance sheet date will not be known for many years. Establishing reserves is an imprecise process, requiring the use of informed estimates and judgments. The Company’s estimates and judgments may be revised as additional experience and other data becomes available and are reviewed as new or improved methodologies are developed, or as current laws change. Any such revisions could result in future changes in estimates of losses or reinsurance recoverables and would be reflected in the Company’s results of operations in the period in which the estimates are changed. Estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates and judgments using data currently available. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded as of December 31, 2012, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.
The Company’s reserves for unpaid losses and LAE in its workers’ compensation insurance segment as of December 31, 2012 and 2011 are summarized below (in thousands):
For each of the methods described above that are used to estimate reserves for losses and LAE, the estimated paid and incurred loss development factors are key assumptions. Loss development factors are estimated based on the Company’s historical paid and incurred loss development patterns, and an estimate of the “tail factor”, or a factor to account for development beyond the maturity of the historical data. In addition, for the Bornhuetter-Ferguson methods, a key assumption is an estimate of the expected loss ratio. The expected loss ratio is determined based on estimated historical loss ratios adjusted to reflect current underwriting and rate change activity. The assumptions used in these methods by the Company over time have reflected a consistent application of the Company’s estimating processes to emerging experience. The tail factors used in the calculation of loss development factors requires considerable judgment. Selecting representative tail factors requires substantially more judgment than the historical loss development factors. While loss development factors are based on the historical claim payment and reserving patterns of the Company over a period of time, tail factors are estimated based on loss development trends in more mature accident years and industry information, and therefore are estimated in the absence of direct historical loss development history.
Although many factors influence the actual cost of claims and the corresponding reserves for unpaid losses and LAE estimates, we do not measure and estimate values for all of these variables individually. This is due to the fact that many of the factors that are known to impact the cost of claims cannot be measured directly. In most instances, we rely on historical experience and tail factors to estimate values for the variables that are explicitly used in the unpaid loss and LAE analysis. For the most recent accident year, we rely on selecting an expected loss ratio to estimate the reserves for unpaid losses and LAE. In addition to the examples above that represent reasonably likely changes in our tail factor, another example of potential variability in our loss and LAE estimation process involves selecting an expected loss ratio for the most recent accident year. For example, if our expected loss ratio for the 2012 accident year were to increase by 5 percentage points, our reserves for unpaid losses and LAE as of December 31, 2012 would increase by $6.3 million, which would result in an after-tax reduction in our earnings of $4.1 million. Management believes that changes in the most recent year accident year loss ratio are reasonably likely due to variability in underwriting and rate changes. It is important to note that actual claims costs will vary from our estimate of ultimate claim costs, perhaps by substantial amounts, due to the inherent variability of the business written, the potentially significant claim settlement lags and the fact that not all events affecting future claim costs can be estimated.
In the event that our estimates of ultimate reserves for unpaid losses and LAE prove to be greater or less than the ultimate liability, our future earnings and financial position could be positively or negatively impacted. Future earnings would be reduced by the amount of any deficiencies in the year(s) in which the claims are paid or the reserves for unpaid losses and LAE are increased. For example, if we determined our reserves for unpaid losses and LAE, net of reinsurance, of $79.1 million as of December 31, 2012 to be 5% inadequate, this would result in an after-tax reduction in our earnings of approximately $2.6 million. This reduction could be realized in one year or multiple years, depending on when the deficiency is identified. The deficiency would also impact our financial position because our statutory surplus would be reduced by an amount equivalent to the reduction in net income. Any deficiency is typically recognized in the reserves for unpaid losses and LAE and, accordingly, it typically does not have a material effect on our liquidity because the claims have not been paid. Since the claims will typically be paid out over a multi-year period, we have generally been able to adjust our investments to match the anticipated future claim payments. Conversely, if our estimates of ultimate reserves for unpaid losses and LAE prove to be redundant, our future earnings and financial position would be improved.
Fixed income securities. A fixed income security is considered to be other-than-temporarily impaired when the security’s estimated fair value is less than its amortized cost basis and 1) the Company intends to sell the security, 2) it is more likely than not that the Company will be required to sell the security before recovery of the security’s amortized cost basis, or 3) the Company believes it will be unable to recover the entire amortized cost basis of the security (i.e., a credit loss has occurred). When the Company determines a credit loss has been incurred, but the Company does not intend to sell the security and it is not more likely than not that the Company will be required to sell the security before recovery of the security’s amortized cost basis, the portion of the other-than-temporary impairment that is credit related is recorded as a realized loss in the consolidated statements of operations and comprehensive income (loss), and the portion of the other-than-temporary impairment that is not credit related is included in other comprehensive income (loss). A fixed income security is reviewed for potential credit loss if any of the following situations occur:
As of December 31, 2012, the Company held fixed income securities, excluding fixed income securities in the segregated portfolio cell reinsurance segment, with gross unrealized losses of $125,000, of which $3,000 were in an unrealized loss position for more than twelve months. Management has evaluated the unrealized losses related to those fixed income securities and determined that they are primarily due to a fluctuation in interest rates and not to credit issues of the issuer or the underlying assets in the case of asset-backed securities. The Company does not intend to sell the fixed income securities and it is not more likely than not that the Company will be required to sell the fixed income securities before recovery of their amortized cost bases, which may be maturity; therefore, management does not consider the fixed income securities to be other-than-temporarily impaired as of December 31, 2012. Adverse investment market conditions, or poor operating results of underlying investments, could result in impairment charges in the future.
In July 2012, the FASB issued ASU 2012-02, “Testing Indefinite-Lived Intangible Assets for Impairment (the revised standard)”. ASU 2012-02 does not change the existing guidance on when to test indefinite-lived intangible assets for impairment, which must be performed annually and between annual tests if events or circumstances indicate that it is more likely than not that the asset is impaired. ASU 2012-02 provides entities with an option to first perform a qualitative assessment to determine whether further impairment testing is necessary. The qualitative assessment is not required to be performed and an entity may proceed directly to the quantitative impairment test. Additionally, the qualitative assessment may be performed on all, some or none of an entity’s indefinite-lived intangible assets. If an entity performs the qualitative assessment and determines that it is not more likely than not that the asset is impaired, no further action is required. If an entity determines that it is more likely than not (that is, a likelihood of more than 50 percent) that the asset is impaired, the quantitative assessment must be performed to calculate the asset’s fair value and determine if the asset is impaired. ASU 2012-02 is effective for annual and interim indefinite-lived intangible asset impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted for calendar year-end public entities whose annual impairment test is performed in the third or fourth quarter. The Company adopted ASU 2012-02 effective September 30, 2012.
In May 2011, the FASB issued ASU 2011-04, “Fair Value Measurements and Disclosures-Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.” ASU 2011-04 clarifies the application of existing fair value measurement and disclosure requirements, changes certain principles related to measuring fair value, and requires additional disclosures about fair value measurements. ASU 2011-04 was effective for periods beginning after December 15, 2011. The Company adopted ASU 2011-04 effective January 1, 2012. The adoption of ASU 2011-04 did not affect the Company’s financial condition or results of operations.
The major components of consolidated revenue were as follows for the years ended December 31, 2012 and 2011 (in thousands):
The increase in consolidated revenue from 2011 to 2012 primarily reflects the following:
An increase in net premiums earned of 20.8%, reflecting new business growth, renewal rate increases and an increase in audit premium from customers;
An increase in net realized investment gains, primarily reflecting an increase in the estimated fair value of the convertible bond portfolio.
The increase in consolidated net income from 2011 to 2012 primarily reflects an increase in net premiums earned, equity interest in limited partnerships and net realized investment gains in the workers’ compensation insurance segment, partially offset by an increase in the workers’ compensation insurance combined ratio. The increase in the combined ratio primarily reflects the impact of adopting the new accounting policy for deferred acquisition costs, which increased the expense ratio by 1.9 percentage points in 2012.
The following table represents the operations of the workers’ compensation insurance segment for the years ended December 31, 2012 and 2011 (in thousands).
The increase in the calendar period loss and LAE ratio from 2011 to 2012 primarily reflects an increase in the accident period loss ratio, partially offset by the impact of audit premium. Audit premium, including the EBUB estimate, reduced the 2012 loss ratio by 3.3 percentage points, compared to a reduction in the 2011 loss ratio of 2.1 percentage points. The Company did not record any prior year reserve development in 2012 or 2011.
The acquisition and other underwriting expense ratio was 8.4% in 2012, compared to 6.8% in 2011. The increase in the ratio primarily reflects the 1.9 percentage point increase related to the change in accounting for deferred policy acquisition costs, partially offset by the increase in net premiums earned.
The decrease in the policyholder dividend expense primarily reflects an increase in the loss experience of underlying policies related to policies with a 2010 policy effective date, partially offset by dividends earned on policies with a 2012 policy effective date. As of December 31, 2012, approximately 11.6% of the Company’s policies were written on a participating basis.
The increase in reinsurance premiums assumed primarily reflects new business of $5.0 million and renewal rate increases of 3.8%. Audit premium results and the renewal retention rate were consistent from 2011 to 2012. Audit premium from customers totaled $271,000 in 2012, compared to $280,000 in 2011. The renewal retention rate decreased from 91.3% in 2011 to 91.1% in 2012.
The increase in net realized investment gains from 2011 to 2012 primarily reflects the sale of individual equity securities in the first quarter of 2012. The proceeds from the sale of the equity securities were used to purchase equity mutual funds.
The increase in the calendar period loss and LAE ratio primarily reflects an increase in the accident period loss ratio and a decrease in favorable loss reserve development on prior accident periods. The accident period loss ratio was 71.4% in 2012, compared to 65.9% in 2011. The increase in the accident period loss ratio primarily reflects the emergence of increased claim activity in two of the segregated portfolio cells. Favorable loss reserve development totaled $2.1 million in 2012, compared to $2.9 million in 2011.
The decrease in revenue from 2011 to 2012 primarily reflects a realized loss on the commutation of the SprinklerPro contract totaling $641,000 and a decrease in third-party administration (“TPA”) revenue, partially offset by an increase in net investment income and the equity interest in limited partnerships. The decrease in TPA revenue reflects the loss of three customer accounts in 2012. The Company is not actively pursuing new TPA customers. Net investment income in 2011 reflects a decrease in the equity interest in SprinklerPro of $450,000. The increase in net investment income from 2011 to 2012 reflects the 2011 decrease in the equity interest in SprinklerPro, partially offset by a decrease in invested assets at EIHI. The increase in equity interest in limited partnerships primarily reflects an increase in the multi-strategy fund of funds partnership interest held by Eastern Re.
The decrease in expenses primarily reflects a change in the Company’s internal organizational structure and a decrease in stock compensation expense. Effective January 1, 2012, expenses related to the Company’s executive officers are included in the workers’ compensation insurance segment. Executive expenses included in the corporate/other segment for the year
ended December 31, 2011 totaled $1.7 million. Stock compensation expense totaled $1.9 million for the year ended December 31, 2012, compared to $2.5 million for the same period in 2011. The decrease in stock compensation expense primarily reflects the full vesting of options and restricted stock issued in January 2007, partially offset by the recognition of stock compensation expense related to options and restricted stock issued in 2012.
The effective tax rate was 34.5% in 2012, compared to 47.9% in 2011. The decrease in the income tax benefit from 2011 to 2012 primarily reflects the Company’s outside basis difference in its foreign operations.
A decrease in other revenue primarily reflecting the loss of a large third party administration customer in the first quarter of 2011.
The components of consolidated net income, by segment, for the years ended December 31, 2011 and 2010 were as follows (in thousands):
The increase in net investment income primarily reflects an increase in invested assets, partially offset by a decline in the average yield on the fixed income portfolio and a decline in short-term interest rates from 2010 to 2011. The average yield on the fixed income portfolio was 3.04% as of December 31, 2011, compared to 3.52% as of December 31, 2010.
(1) The workers’ compensation insurance and corporate/other segments provide services to the segregated portfolio cell reinsurance segment. The segregated portfolio cell reinsurance segment records the fees associated with these services as ceding expense, which is included in acquisition and other underwriting expenses. Fees incurred for the years ended December 31, 2011 and 2010 totaled $5.5 million and $4.5 million, respectively. The difference between total revenue for the segregated portfolio cell reinsurance segment for each period and the sum of losses and loss adjustment expenses, underwriting expenses, policyholder dividend expenses and other expenses is accrued as a segregated portfolio dividend expense. As a result, the segregated portfolio cell reinsurance segment has no net income for the period presented in this table.
The following table represents the operations of the corporate/other segment for the years ended December 31, 2011 and 2010 (in thousands):
Total assets were $380.8 million as of December 31, 2012, compared to $345.7 million as of December 31, 2011. The increase in the Company’s assets is primarily reflects the following items:
An increase in invested assets, which primarily reflects net purchases of $19.1 million in 2012 and an increase in the estimated fair value of the Company’s fixed income, convertible bond and equity securities;
An increase in premiums receivable, which reflects the growth in the Company’s direct premiums written from 2011 to 2012;
An increase in the reinsurance recoverable, which primarily reflects a few large losses incurred in the segregated portfolio cell reinsurance segment in 2012;
An increase in other assets, which primarily reflects an increase in deductible receivables and the EIHI’s equity interest in certain segregated portfolio cells.
An increase in accounts payable and accrued expenses, which primarily reflects deposits in transit of $2.2 million, an increase in commissions payable and the Pennsylvania employee assessment payable as a result of the increase in direct premiums written, and an increase in accrued benefit plan liabilities as a result of a decrease in the discount rate used to estimate the liability as of December 31, 2012;
Net income of $10.4 million for the year ended December 31, 2012;
A decrease in accumulated other comprehensive income, net of tax, which primarily reflects an increase in the Company’s benefit plan liabilities, partially offset by an increase in the estimated fair value of the Company’s investment portfolio.
The Company has a $10.0 million revolving line of credit available to provide additional liquidity if needed. The line of credit matures on May 1, 2013 and may be renewed annually for additional periods expiring on May 1 at the lender’s discretion. Outstanding balances under the line of credit bear interest at an adjustable monthly rate equal to LIBOR plus 2.0% per annum. There were no outstanding balances under the line of credit as of December 31, 2012.
The major components of cash flow from continuing operations are as follows for the years ended December 31, 2012, 2011, and 2010 (in thousands):
The decrease in cash provided by operating activities primarily reflects the increase in claims paid from 2011 to 2012. The Company settled a significant amount of claims in 2012 through compromise and release agreements with injured workers.
The increase in cash used in investing activities from 2011 to 2012 primarily reflects a reduction in investment sales in 2012. During 2011, the Company sold investments to fund common stock repurchases at EIHI. In addition, fixed income securities were sold in the segregated portfolio cell reinsurance segment in 2011 and reinvested in fixed income mutual funds and the Company liquidated certain mutual fund holdings in 2011 to generate gains in the portfolio.
The increase in cash provided by operating activities from 2010 to 2011 primarily reflects the increase in net premiums written, partially offset by an increase in claims paid and federal income taxes paid.
The decrease in cash used in investing activities from 2010 to 2011 primarily reflects the liquidation of investments at EIHI to fund the Company’s repurchase of its common stock. The decrease in cash used for the purchase of fixed income securities from 2010 to 2011 primarily reflects purchases of securities by EIHI in 2010 from the proceeds of the sale of Eastern Life.
The loss reserves payments due by period in the table above are based upon the loss and LAE reserves estimates as of December 31, 2012 and actuarial estimates of expected payout patterns by line of business. As a result, our calculation of loss reserve payments due by period is subject to the same uncertainties associated with determining the level of reserves and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. For a discussion of our reserving process, see “Item 1 - Business, Loss and LAE Reserves.” Actual payments of loss and LAE by period will vary, perhaps materially, from the above table to the extent that current estimates of loss reserves vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns.
In our opinion, the consolidated financial statements listed in the index appearing under Item 15 (a) (1) present fairly, in all material respects, the financial position of Eastern Insurance Holdings, Inc. and its subsidiaries (collectively, the “Company”) at December 31, 2012 and 2011, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2012 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15 (a) (2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in “Management’s Report on Internal Control Over Financial Reporting” appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
As discussed in Note 2 to the consolidated financial statements, the Company adopted Accounting Standard Update 2010-26, “Accounting for costs associated with acquiring or renewing insurance contracts” effective January 1, 2012.
On December 9, 2010, EIHI completed the sale of Eastern Atlantic RE (“Atlantic RE”). Atlantic RE was a Cayman Islands reinsurance company formed for the purpose of transferring certain assets and liabilities related to EIHI’s run-off specialty reinsurance segment as part of the sale. As a result of the sale, the results of operations for the portion of the run-off specialty reinsurance segment that was transferred to Atlantic RE have been reflected as discontinued operations in the accompanying consolidated financial statements. The portion of the run-off specialty reinsurance segment that was not sold has been reclassified to the corporate/other segment. See Note 3 for additional information related to the sale.
On June 21, 2010, EIHI completed the sale of Eastern Life and Health Insurance Company (“Eastern Life”). As a result of the sale, Eastern Life’s operations have been reflected as discontinued operations in the accompanying consolidated financial statements. See Note 3 for additional information related to the sale.
Premiums or discounts are amortized using the effective interest method. Realized gains or losses are based on amortized cost and are computed using the specific identification method. The Company monitors its fixed income securities for unrealized losses that appear to be other-than-temporary. A fixed income security is considered to be other-than-temporarily impaired when the security’s fair value is less than its amortized cost basis and 1) the Company intends to sell the security, 2) it is more likely than not that the Company will be required to sell the security before recovery of the security’s amortized cost basis, or 3) the Company believes it will be unable to recover the entire amortized cost basis of the security (i.e., a credit loss has occurred). When the Company determines a credit loss has been incurred, but the Company does not intend to sell the security and it is not more likely than not that the Company will be required to sell the security before recovery of the security’s amortized cost basis, the portion of the other-than-temporary impairment that is credit related is recorded as a realized loss in the consolidated statements of operations and comprehensive income (loss), and the portion of the other-than-temporary impairment that is not credit related is included in other comprehensive income (loss). Any subsequent increase in the fixed income security’s estimated fair value would be reported as an unrealized gain. Fixed income securities that are in an unrealized loss position, but do not meet the above quantitative thresholds are evaluated to determine if the decline in market value is other than temporary.
The Company’s investments in equity securities, which consist primarily of index and exchange-traded mutual funds, are classified as available-for-sale and are carried at estimated fair value, with unrealized gains and losses reported in accumulated other comprehensive income (loss), net of tax. The estimated fair value of equity securities is determined based on quoted market prices obtained from an independent pricing service.
Realized gains or losses are based on cost and are computed using the specific identification method. The Company monitors its equity securities for unrealized losses that appear to be other-than-temporary. An equity security is considered impaired when one of the following conditions exist: 1) an equity security’s market value is less than 80% of its cost for a continuous period of 6 months, 2) an equity security’s market value is less than 50% of its cost, regardless of the amount of time the security’s market value has been below cost, and 3) an equity security’s market value has been less than cost for a continuous period of 12 months or more, regardless of the magnitude of the decline in market value. Any subsequent increase in the equity security’s estimated fair value would be reported as an unrealized gain. Equity securities that are in an unrealized loss position, but do not meet the above quantitative thresholds are evaluated to determine if the decline in market value is other than temporary.
Other long-term investments consist of investments in limited partnerships. Investments in limited partnerships are reported in the consolidated financial statements using the equity method. The carrying value of the Company’s limited partnership investments are based on the Company’s allocable share of the limited partnerships’ net asset value. Changes in the value of the Company’s proportionate share of its limited partnership investments are included in the change in equity interest in limited partnerships in the consolidated statements of operations and comprehensive income (loss). The Company reports changes in the value of its limited partnership investments on a month lag as a result of the timing of statements being received from the limited partnership.
The Company monitors its limited partnership investments for declines in value that may be other-than-temporary. When a limited partnership interest is determined to be other-than-temporarily impaired, the Company reduces its interest in the limited partnership to its current estimated fair value at the balance sheet date. The impairment is recorded in the change in equity interest in limited partnerships in the consolidated statements of operations and comprehensive income (loss).
Premiums, including estimates of additional premiums resulting from audits of insureds’ records, are generally recognized as written upon inception of the policy. Premiums written are primarily earned on a daily pro rata basis over the terms of the policies to which they relate. Accordingly, unearned premiums represent the portion of premiums written which is applicable to the unexpired portion of the policies in force. Workers’ compensation premiums are determined based upon the payroll of the insured, the applicable premium rates and, where applicable, an experience based modification factor. An audit of the policyholders’ records is conducted after policy expiration to make a final determination of applicable premiums. Audit premium due from or due to a policyholder as a result of an audit is reflected in net premiums earned when billed. In addition, the Company estimates earned but unbilled (“EBUB”) premiums by tracking, by policy, how much additional premium is billed in final audit invoices as a percentage of payroll exposure to estimate the probable additional amount that it has earned, but not yet billed, as of the balance sheet date. The EBUB premium estimate is included in net premiums earned.
As of December 31, 2012 and 2011, the Company accrued earned but unbilled premiums and increased (decreased) net premiums earned for the years ended December 31, 2012, 2011 and 2010, as follows (in thousands):
A liability is established for the estimated unpaid losses and LAE under the terms of, and with respect to, its policies and agreements and includes amounts determined on the basis of claims adjusters’ evaluations and an amount based on past experience for losses incurred but not reported (“IBNR”).
The Company discounts its reserves for unpaid losses and LAE for workers’ compensation claims on a non-tabular basis, using a discount rate of 3.0%, based upon regulatory guidelines. The reserves for unpaid losses and LAE have been reduced for the effects of discounting by approximately $6,503 and $5,723 as of December 31, 2012 and 2011, respectively.
Management believes that its reserves for unpaid losses and LAE is adequate as of December 31, 2012. However, estimating the ultimate liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates and judgments using data currently available. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded as of December 31, 2012, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.
The Company includes income tax-related interest and penalties as a component of income tax expense. The Company did not incur any income tax-related interest or penalties during 2012, 2011 or 2010.
The statute of limitations has expired for the Company’s federal taxable years through December 31, 2008.
The Company writes deductible policies under which the insured is contractually obligated to pay its own losses up to the amount of the deductible for each occurrence, up to an aggregate retention. The Company pays claims under the policies and then bills the insured for the amount due. In order to reduce its credit risk, the Company requires the insured to provide collateral in the form of a letter of credit or cash to secure amounts due the Company under the deductible policy. As of December 31, 2012 and 2011, amounts due and unpaid for claims billed to policyholders totaled $2,185 and $909, respectively. The Company recorded an allowance for doubtful accounts totaling $259 and $0 as of December 31, 2012 and 2011, respectively.
The Company is subject to state guaranty fund assessments in the states in which it is licensed, which provide for the payment of covered claims or to meet other insurance obligations from insurance company insolvencies. The Company’s assessments consist primarily of charges from the Workers’ Compensation Security Fund of Pennsylvania (“Security Fund”). The Security Fund serves as a guaranty fund to provide claim payments for those workers entitled to workers’ compensation benefits when the insurance company originally providing the benefits was placed into liquidation by a court. Security Fund assessments are established on an actuarial basis to provide an amount sufficient to pay the outstanding and anticipated claims in a timely manner, to meet the costs of the Pennsylvania Insurance Department to administer the fund and to maintain a minimum balance in the fund of $500 million. If the Security Fund determines that the balance in the Security Fund is less than $500 million based on the actuarial study, then an assessment up to one percent of direct written premium is made to all companies licensed to write workers’ compensation in Pennsylvania. Eastern Alliance, Allied Eastern and Eastern Advantage recognize a liability and the related expense for the assessments when premiums covered under the Security Fund are written; when an assessment from the Security Fund has been imposed or it is probable that an assessment will be imposed; and the amount of the assessment is reasonably estimable. The Company did not record a liability related to the Security Fund as of December 31, 2012 or 2011 because the Company received notification that an assessment would not be imposed.
Goodwill is assigned to one or more reporting units at the date of acquisition. The Company has allocated 100% of the goodwill recorded on its consolidated balance sheet as of December 31, 2012 to its workers’ compensation insurance segment.
Income taxes and interest paid for the years ended December 31, 2012, 2011 and 2010 were as follows (in thousands):
Taxes paid for the year ended December 31, 2010 are net of refunds related to capital loss carrybacks to prior tax years totaling $1,795.
In October 2010, the FASB issued ASU 2010-26, “Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts” (“ASU 2010-26”). ASU 2010-26 provides specific types of costs that should be capitalized in connection with the acquisition or renewal of insurance contracts. Those costs include incremental direct costs of contract acquisition incurred in connection with independent third parties and certain costs related to activities performed by the insurer for the contract, including underwriting, policy issuance and processing, medical and inspection, and sales force contract selling. Under ASU 2010-26, costs incurred by an entity related to unsuccessful acquisition or renewal efforts must be charged to expense as incurred. ASU 2010-26 was effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011 and is to be applied prospectively. Retrospective application to all prior periods upon the date of adoption was permitted, but not required. The Company adopted ASU 2010-26 effective January 1, 2012 and applied it prospectively. As a result of adoption, the Company expensed certain underwriting salaries totaling approximately $2.4 million ($1.5 million, net of tax) for the year ended December 31, 2012 that would have been capitalized under the previous accounting guidance to give effect to unsuccessful acquisition or renewal activities. If the new accounting guidance had been adopted effective January 1, 2011, the Company would have recognized additional expense related to underwriting salaries totaling $2.9 million ($1.9 million, net of tax) for the year ended December 31, 2011.
On December 9, 2010, EIHI completed the sale of Eastern Atlantic RE (“Atlantic RE”) to an investor group advised by Dowling Advisors, Inc. (“Dowling”). Atlantic RE is a Cayman Islands reinsurance company and was part of EIHI’s run-off specialty reinsurance segment. Under the terms of the sale, Dowling purchased 100% of the outstanding stock of Atlantic RE for $2,300 of cash.
The estimated contingent profit commission is included in other assets and any decrease in the estimated amount would be recorded as a loss from discontinued operations. As of December 31, 2012, management believes that the estimated contingent profit commission is realizable; however, due to the inherent uncertainty in the run-off specialty reinsurance segment’s reserves for losses and LAE, the estimated realizable amount could decrease in the future.
Basic earnings per share are computed by dividing net income (loss) by the weighted average number of shares outstanding for the respective period. Diluted earnings per share are computed by dividing net income (loss) by the weighted average number of shares outstanding for the period, including dilutive potential common shares outstanding for the period.
Awards under the Stock Incentive Plan may be made in the form of incentive stock options, nonqualified stock options, restricted stock or any combination to employees and non-employee directors. The Stock Incentive Plan limits the number of shares that may be initially awarded as restricted stock to 299,000, and the number of shares for which incentive stock options may be granted to 500,000. The total number of shares initially authorized in the Stock Incentive Plan was 1,046,500 shares, with an annual increase equal to 1% of the shares outstanding at the end of each year. The Stock Incentive Plan provides that stock options and restricted stock awards may include vesting restrictions and performance criteria at the discretion of the Compensation Committee of the Board of Directors. The stock options and restricted stock awards vest over a five year period and are not subject to performance criteria. The term of options may not exceed ten years for incentive stock options, and ten years and one month for nonqualified stock options, and the option price may not be less than fair market value on the date of grant. Upon exercise of stock options, the Company expects to issue shares to the option holder from treasury shares.
Total stock-based compensation expense recognized in the consolidated statement of operations and comprehensive income for the years ended December 31, 2012, 2011 and 2010 is shown in the following table (in thousands):
The fair values of stock options granted in 2012 were determined on the dates of grant using a lattice-based binomial option valuation model with the following assumptions:
The assumptions used to calculate the fair value of future options granted are evaluated and revised, as necessary, to reflect market conditions and the Company’s historical experience and future expectations. The calculated fair value is recognized as compensation expense in the Company’s consolidated statements of operations and comprehensive income (loss) over the requisite service period of the entire award. Compensation expense is recognized only for those options expected to vest, with forfeitures estimated at the date of grant and evaluated and adjusted periodically to reflect the Company’s historical experience and future expectations. Any change in the forfeiture assumption is accounted for as a change in estimate, with the cumulative effect of the change on periods previously reported being reflected in the financial statements of the period in which the change is made.
The following table summarizes stock option activity for the year ended December 31, 2012:
The ability of Eastern Alliance, Allied Eastern, Eastern Advantage, and Employers Security to pay dividends to EIHI is limited by the laws and regulations of Pennsylvania and Indiana. The maximum annual dividends that EIHI’s insurance subsidiaries may pay without the prior approval from the Pennsylvania Insurance Department and Indiana Insurance Department is limited to the greater of 10% of statutory surplus or 100% of statutory net income for the most recently filed annual statement. The maximum dividend that may be paid by Eastern Alliance, Allied Eastern and Eastern Advantage in 2013, without prior approval from the Pennsylvania Insurance Department, is $5,681, $2,024 and $1,047, respectively. The maximum dividend that may be paid by Employers Security in 2013, without prior approval from the Indiana Insurance Department, is $1,301.
There were no transfers between Level 1 and Level 2 securities for the year ended December 31, 2012.
Other long-term investments include the Company’s interest in various limited partnerships, including a low volatility multi-strategy fund of funds, a natural resource limited partnership, a structured finance opportunity fund, an open-ended investment fund and a real estate limited partnership. The Company records its investment in the limited partnerships using the equity method. The carrying value of the Company’s limited partnership investments are based on the Company’s
As of December 31, 2012 and 2011, the estimated fair values of the Company’s other long-term investments, by investment strategy, were as follows (in thousands):
Following is a summary of the investment objectives of each of the Company’s limited partnership investments held as of December 31, 2012, by investment strategy:
The activity in the Company’s limited partnership investments for the years ended December 31, 2012, 2011 and 2010 was as follows (in thousands):
During 2012, the Company liquidated its interest in the natural resource fund. The change in interest in the Company’s limited partnership investments is included in the change in equity interest in limited partnerships in the consolidated statements of operations and comprehensive income (loss).
The following tables provide the amortized cost and estimated fair value of the Company’s fixed income and equity securities as of December 31, 2012 and 2011 (in thousands):
Other structured securities include two asset-backed securities collateralized by auto loan receivables and one security in an equipment trust made up of fixed retail installment contracts and retail installment loans.
Certain insurance departments in the states in which the Company is licensed to do business require a deposit to protect the Company’s policyholders should the Company become insolvent. In order to satisfy these requirements, the Company had fixed income securities with an estimated fair value of $12,772 and $12,023 on deposit with various insurance departments as of December 31, 2012 and 2011, respectively.
Note: The Company has excluded the segregated portfolio cell reinsurance segment’s gross unrealized losses from the above table because changes in the estimated fair value of the segregated portfolio cell reinsurance segment’s fixed income and equity securities inures to the segregated portfolio cell dividend participant and, accordingly, is included in the segregated portfolio cell dividend payable and the related segregated portfolio dividend expense in the Company’s consolidated balance sheet and consolidated statement of operations, respectively. Management believes the exclusion of the segregated portfolio cell reinsurance segment from this disclosure provides a more transparent understanding of gross unrealized losses in the Company’s fixed income and equity security portfolios that could impact its consolidated financial position or results of operations.
Proceeds from the sale of investments for the years ended December 31, 2012, 2011 and 2010 were as follows (in thousands):
The change in the Company’s net unrealized gains and losses for the years ended December 31, 2012, 2011, and 2010 was as follows (in thousands):
The following table provides a summary of the activity in the Company’s reserves for unpaid losses and LAE for the years ended December 31, 2012, 2011, and 2010 (in thousands):
For the years ended December 31, 2012, 2011 and 2010, the Company increased (decreased) its workers’ compensation insurance reserves for unpaid losses and LAE by the following amounts by accident year (in thousands):
For the years ended December 31, 2012, 2011 and 2010, the Company (decreased) increased its segregated portfolio cell reinsurance reserves for unpaid losses and LAE by the following amounts by accident year (in thousands):
For the year ended December 31, 2010, the Company recognized net favorable development on prior accident year segregated portfolio cell reinsurance reserves of $1.4 million, representing 6.5% of the Company’s estimated segregated portfolio cell reinsurance reserves as of December 31, 2009 and 5.8% of the Company’s segregated portfolio cell reinsurance net premiums earned for the year ended December 31, 2010. The favorable development arose primarily from accident years 2008 and 2009, but was generally prevalent in most prior accident years, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting include greater availability and use of employers’ return to work programs.
The following table provides a summary of the Company’s premiums on a direct, assumed, ceded, and net basis for the years ended December 31, 2012, 2011, and 2010 (in thousands):
The components of the consolidated income tax provision from continuing operations for the years ended December 31, 2012, 2011, and 2010 are as follows (in thousands):
The reconciliation of taxes computed at the statutory tax rate of 35.0% for the years ended December 31, 2012, 2011, and 2010 to the consolidated income tax expense from continuing operations is as follows (in thousands):
A reconciliation of the beginning and ending amount of unrecognized tax benefits for the year ended December 31, 2012 is as follows:
The Company issued 747,500 shares of its common stock to the ESOP on June 16, 2006, and the ESOP signed a promissory note in the amount of $7,475 for the purchase of the shares, which is due in twenty equal semi-annual installments, with interest accruing annually at 8.00%. Shares purchased are held in a suspense account for allocation among participating employees as the loan is repaid.
For the years ended December 31, 2012, 2011, and 2010 the Company made a cash contribution of $1,000, $979, and $958 to the ESOP, respectively. The ESOP used these contributions, along with dividends received on the unallocated shares of the Company’s stock held by the ESOP, to make the semi-annual principal and interest payments to the Company related to the outstanding balance of the promissory note. Dividends used by the ESOP to fund the semi-annual principal and interest payments totaled $100, $121, and $142 in 2012, 2011, and 2010, respectively. The transactions between the Company and the ESOP are considered non-cash transactions for purposes of the consolidated statements of cash flows.
Benefits paid totaled $210, $106, and $117 for the pension plan and $1, $1, and $2 for the postretirement plan for the years ended December 31, 2012, 2011, and 2010, respectively. The estimated future benefits to be paid over the next ten years related to the pension plan are as follows (in thousands):
The pension plan’s assets were comprised of the following at December 31, 2012 and 2011 (in thousands):
The Company currently operates in three business segments. Prior to the sale of Atlantic RE and Eastern Life, the Company’s operations included a run-off specialty reinsurance segment and a group benefits insurance segment. The components of the run-off specialty reinsurance segment that were not transferred to Atlantic RE have been included in the corporate/other segment for the years ended December 31, 2012, 2011 and 2010.
The Company offers traditional workers’ compensation insurance coverage to employers, primarily in the Mid-Atlantic, Southeast and Midwest regions of the continental United States. The Company’s workers’ compensation products include guaranteed cost policies, alternative market products, policyholder dividend policies, deductible policies and retrospectively-rated policies.
The Company is a preferred shareholder in certain of the segregated portfolio cells. For those segregated portfolio cells in which the Company participates, the Company shares in the operating and investment results of those cells and recognizes its share of the segregated portfolio dividend in the consolidated statements of operations and comprehensive income (loss).
The following table represents the segment results for the year ended December 31, 2012 (in thousands):
On October 3, 2011, AIG Companies responded to the Arbitration Demand by advising that they will seek an award from the arbitration panel of approximately $1.9 million plus future amounts that may become due under the Treaties before the final hearing in the arbitration. Both the Company and AIG Companies seek attorney’s fees and costs in the arbitration.
The arbitration proceedings initiated by the Company against AIG Companies are on-going and there has been no further action in 2012 related to the arbitration process.
It is reasonably possible that the final outcome of the arbitration could go against the Company, which could result in a material, adverse effect on the Company’s results of operations and financial condition.
Rent expense totaled $1,539, $1,214, and $918 for the years ended December 31, 2012, 2011 and 2010, respectively.
The Company has an agreement with Alliance Impairment Management, Inc. (“AIM”), which provides case management services to certain of the Company’s insurance subsidiaries. For the years ended December 31, 2012, 2011, and 2010, the Company paid fees to AIM totaling approximately $2,700, $3,700 and $3,200, respectively. Bruce Eckert, the Company’s Vice Chairman was an investor in AIM through September 30, 2012. The fees paid to AIM for the year ended December 31, 2012 represent fees paid through September 30, 2012.
On March 1, 2013, the Company announced that its Board of Directors approved an increase in its quarterly cash dividend on its issued and outstanding shares of common stock, from $0.07 per share to $0.09 per share. The first quarter 2013 dividend will be payable on March 29, 2013 to shareholders of record at the close of business on March 15, 2013.