The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our audited financial statements and related notes included in Item 8 of this Annual Report on Form 10-K. We caution you that our results of operations for prior periods are not indicative of the actual results that may be achieved in future periods. In addition, some of the information contained in this discussion and analysis includes forward-looking statements that involve risks and uncertainties. Many factors may cause our actual results to differ materially from those anticipated or implied by these forward-looking statements including, but not limited to, those discussed in “Risk Factors.” You should read the information under “Risk Factors” as presented in Item 1A. for information about material risks and uncertainties that affect us, our business and our common shares and the cautionary note regarding “Forward-Looking Statements” which precedes Item 1 in this Annual Report on Form 10-K.
We report our business in the following four segments: (1) primary insurance; (2) reinsurance; (3) fee-based management services; and (4) corporate and other. On September 8, 2008, we ceased operations of our subsidiaries, CRM and Eimar. Accordingly, the results of operations of CRM and Eimar, which historically were reported in the fee-based management services segment, are reported as discontinued operations for all periods presented.
the establishment of a valuation allowance on our deferred tax asset;
Net Earned Premiums. We had a significant decrease in our net earned premiums during 2009. This primarily resulted from two items - increased reinsurance and difficult market conditions. In April 2008, A.M. Best placed Majestic’s financial strength rating under review based on a concern of limited capital being available to support our anticipated growth and capitalization levels falling somewhat short of A.M. Best’s requirements. In response, we purchased quota share reinsurance coverage with third party reinsurers, which resulted in our net earned premiums being reduced year-over-year. We currently do not expect to renew our quota share reinsurance, which is set to expire on June 30, 2010; however, we are still evaluating our current capital needs, and if available on terms acceptable to us, we may elect to purchase further quota share coverage. Our net earned premiums were also lower during 2009 as a result of difficult workers’ compensation insurance market conditions. Ongoing weakness in business and economic conditions in the U.S. and competitive market and pricing conditions in California, our largest market, adversely affected our year-over-year net earned premiums.
Losses and Loss Adjustment Expenses. We experienced an increase in our losses and loss adjustment expense ratio during 2009. Majestic’s losses and loss adjustment expense ratio was 105% in 2009 as compared to 73% in 2008. The higher loss ratio was primarily based on two factors - an increased current year accident loss ratio and a change from favorable development to unfavorable development with respect to prior accident years. We sought growth in 2008 and reduced prices to achieve that growth, amidst a softening market and deteriorating economic conditions. We began 2009 with our pricing indexed to the reduced rates established in 2008. As claims developed and paid losses emerged, we realized the need for an upward adjustment to our current year accident loss ratio. This resulted in a corresponding increase in our loss reserves. In addition, our loss reserves were increased in 2009 as a result of net unfavorable development with respect to prior accident years. This was primarily related to accident year 2008 in California and New Jersey.
Other Items. Based on our net losses and other factors, we recorded a full deferred tax valuation allowance and wrote off our goodwill during 2009. In addition, we recorded severance expense related to the former co-chief executive officers during 2009.
Factors Influencing Our Future Performance. Our 2010 operating results and financial conditions could be adversely affected by many factors including:
Our premium growth also may lag as a result of our downgraded A.M. Best rating and as we seek to increase premium rates and take corrective underwriting actions in certain areas of our business.
The California insurance marketplace could remain competitive, which could cause carriers to pursue strategies that they believe could lead to economies of scale, market share gains or the potential for an improved competitive posture.
We are currently exploring ways to enhance our future operating performance. For example, we are exploring a potential strategic partnership to help us retain and compete for rating sensitive business. We may partner with other insurance carriers with which we can align to provide our customers an A.M. Best “A-” or better rating. In addition, we are exploring ways to enhance our capital position, which, among other things, could help support premium growth and restore our A.M. Best rating to “A-”. However, our explorations of these matters are at a very preliminary stage, and we cannot determine whether or when we may enter into a strategic partnership or if additional capital will be available to us or what the amount, form or cost of the capital will be. Furthermore, we believe that our ability to raise additional capital will be adversely affected until there is greater clarity with respect to the pending regulatory matters and lawsuits.
Our business segments are affected by the trends of the workers’ compensation insurance market. The workers’ compensation insurance market has historically fluctuated with periods of low premium rates and excess underwriting capacity resulting from increased competition, followed by periods of high premium rates and shortages of underwriting capacity resulting from decreased competition. Our revenues have historically been generated primarily in California and New York.
Our Insureds’ Payroll Levels. Our primary insurance premiums are ultimately determined by the policyholder’s aggregate payroll. Based on the recession in the U.S. during the end of 2008 and during 2009, we have seen a rise in unemployment, and as a result, we are experiencing a downward trend in the payroll levels of our insureds. Consequently, this downward trend in payrolls has resulted in a downward trend of our net earned premiums. Until unemployment declines, we may continue to experience a downward trend in our insureds’ payrolls and our net earned premiums. To the extent that payroll levels on insureds’ policies continue to decline as a result of the recession, our actual premiums earned may be less than expected.
California’s Premium Rates. In California, the state in which the largest amount of our workers’ compensation premiums are earned, the Workers’ Compensation Insurance Rating Bureau of California (WCIRB), an industry-backed private organization that provides statistical analysis, recommends claims cost benchmarks to be used by companies in determining their premium rates. The WCIRB’s recommendations are reviewed by the California Department of Insurance, which also adopts and publishes its own claims cost benchmark. The benchmark rates cover expected loss costs, but do not contain an element to cover operating expenses or profit.
In November 2009, the Commissioner declined WCIRB’s recommendation of a 22.8% increase to the workers’ compensation benchmark rates. The Commissioner recommended no change, citing evidence that insurers were not realizing efficiencies to bring down the costs in the system, including failing to achieve a balance between cost and benefit with medical provider networks and utilization review, and are not communicating effectively with medical providers. The WCIRB’s recommendation was based on an analysis of insurer experience as of June 30, 2009, and an analysis of anticipated cost increases stemming from two significant Workers’ Compensation Board of Appeals decisions affecting the 2004 legislation.
Net Premiums Earned. Gross premiums written include all direct premiums billed during a specified policy period and assumed premiums written. Assumed premiums written are premiums from affiliate or third party companies or authorized state mandated pools. Net premiums written is the difference between gross premiums written and premiums ceded or paid to affiliate or third party reinsurers.
Fee-Based Management Services. Our fee-based management service revenues include management fees received from self-insured groups for management services. Our fees are based on a percentage of premiums paid by members to the self-insured groups.
We record reserves for estimated losses under insurance policies that we write and for loss adjustment expenses related to the investigation and settlement of policy claims. Our reserves for losses and loss adjustment expenses represent the estimated cost of all reported and unreported losses and loss adjustment expenses incurred and unpaid at any given point in time based on known facts and circumstances. In establishing our reserves, we do not use loss discounting, which would involve recognizing the time value of money and offsetting estimates of future payments by future expected investment income. Our reserves for loss and loss adjustment expenses are estimated using case-by-case valuations and various actuarial analyses. Additional information regarding our reserves for losses and loss adjustment expenses and our processes for establishing the reserves can be found in Item 1 under the headings “Business - Primary Insurance Segment - Reserves for Losses and Loss Adjustment Expenses” and “Business - Reinsurance Segment - Reserves for Losses and Loss Adjustment Expenses.”
Our loss reserves can also vary due to factors that affect our book of primary insurance and reinsurance business. Some examples of these risk factors include, but are not limited to, the following:
Amounts recoverable from reinsurers are estimated on an individual contract basis, in a manner consistent with the associated reserve for losses and loss adjustment expenses. Included in reinsurance recoverables are paid losses recoverable from reinsurers and prepaid reinsurance premiums to reinsurers. Such recoverables are reported net of any allowance for estimated uncollectible reinsurance recoverables. We evaluate and monitor the financial condition of our reinsurers to minimize our exposure to significant losses from reinsurer insolvencies. We calculate amounts recoverable from reinsurers based on our estimates of the underlying loss and loss adjustment expenses, which themselves are subject to significant judgments and uncertainties described above under the heading “Reserve for Losses and Loss Adjustment Expenses.” Changes in the estimates and assumptions underlying the calculation of our loss reserves may have an impact on the balance of our reinsurance recoverables. In general, an increase in our underlying loss reserves on claims subject to reinsurance should increase our reinsurance recoverables. The amount of the increase would depend on a number of considerations including, but not limited to, the terms and attachment points of our reinsurance contracts and the incurred amount on various claims subject to reinsurance. Changes in reinsurance recoverables are recorded in the period in which the estimate is revised. We assessed the collectability of our year-end receivables and believe all amounts are collectible based on currently available information. Therefore, as of December 31, 2009, 2008 and 2007, we had no reserve for uncollectible reinsurance recoverables.
The cost of fixed-maturity securities is adjusted for impairments in value deemed to be other-than-temporary in the period in which the determination is made. These adjustments are recorded as investment losses. The assessment of whether such impairment has occurred is based on management’s case-by-case evaluation of the underlying reasons for the decline in fair value. We regularly evaluate our investment portfolio to identify other-than-temporary impairments in the fair values of the securities held in our investment portfolio. When, in the opinion of management, a decline in the fair value of an investment below its cost or amortized cost is considered to be other-than-temporary, such investment is written-down to its fair value. The amount written-down is recorded in earnings as a realized loss on investments. We consider various factors in determining whether a decline in the fair value of a security is other-than-temporary, including:
Impairment testing is performed using the fair value approach, which requires the use of estimates and judgment, at the “reporting unit” level. A reporting unit is the operating segment or a business one level below the operating segment, if discrete financial information is prepared and regularly reviewed by management at that level.
The valuation methodologies utilized are subject to key judgments and assumptions that are sensitive to change. Estimates of fair value are inherently uncertain and represent only management’s reasonable expectation regarding future developments. These estimates and the judgments and assumptions upon which the estimates are based will, in all likelihood, differ from actual future results and the difference could be material.
As a result of our 2009 annual impairment testing, we determined that the goodwill recorded in the primary insurance segment was fully impaired. Consequently, we recorded goodwill impairment charges of $2.7 million in the year ended December 31, 2009. Factors that occurred in the fourth quarter of 2009 that resulted in the full impairment of our goodwill include: (1) the downgrade of Majestic’s AM Best rating from “A-“ to “B++” with negative implications, (2) a reduction in Majestic’s projected premiums written due to the AM Best downgrade, (3) an increase in Majestic’s losses and loss adjustment expenses, and (4) the unexpected net operating loss in the fourth quarter of 2009 - which resulted from adverse development of Majestic’s current and prior year losses and loss adjustment expenses.
The realization of deferred tax assets depends upon the existence of sufficient taxable income within the carryback or carryforward periods. A valuation allowance is established when management determines, based on available information, that it is more likely than not that deferred income tax assets will not be realized. Significant judgment is required in determining whether valuation allowances should be established as well as the amount of such allowances. When making such determination, consideration is given to future taxable income, future reversals of existing taxable temporary differences, taxable income in prior carryback years and tax planning strategies.
We evaluated our net deferred tax asset for recoverability and considered the relative impact of negative and positive evidence, including historical profitability and projections of future taxable income within the foreseeable future. In evaluating the need for a valuation allowance, we estimated future taxable income based on business plans and ongoing tax planning strategies. This process involved significant management judgment about assumptions that are subject to change from period to period based on changes in tax laws or about assumptions relating to our projected operating performance, actual results and other factors.
The accompanying financial statements have been prepared assuming that we will continue as a going concern which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. These consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded assets nor relating to the amounts and classification of liabilities that may be necessary should we be unable to continue as a going concern.
Management will continue its past approved practice under its Form D filing with the California Department of Insurance of allocating expenses from the domestic Holding Companies to the insurance entity, Majestic.
It is possible, however, that the actual results of one or more of management’s plans could be materially worse than anticipated, or that one or more of management’s significant judgments or estimates concerning the risks and uncertainties affecting us could prove to be materially incorrect. As a result of any of the foregoing, there could be substantial doubt about our ability to continue as a going concern, unless we are able to obtain sufficient financing, as to which there can be no assurances.
In January 2010, the Financial Accounting Standards Board (“FASB”), issued new guidance for fair value measurements and disclosures. The new guidance, which is now part of ASC 820, Fair Value Measurements and Disclosure, clarifies existing disclosure requirements regarding the level of disaggregation and inputs and valuation techniques and provides new disclosure requirements regarding disclosures about, among other things, transfers in and out of levels 1 and 2 of the fair value hierarchy and details of the activity in level 3 of the fair value hierarchy. The new guidance is effective for fiscal years beginning after December 15, 2009 for the levels 1 and 2 disclosures and for fiscal years beginning after December 15, 2010 for level 3 disclosures. The new disclosure requirements will be applied prospectively to our fair value disclosure subsequent to the effective date.
In June 2009, the FASB issued new guidance on accounting for the transfers of financial assets. The new guidance, which is now part of ASC 860, Transfers and Servicing, eliminates the concept of a qualifying special-purpose entity (“QSPE”), clarifies and amends the derecognition criteria for a transfer to be accounted for as a sale, amends and clarifies the unit of account eligible for sale accounting and requires that a transferor initially measure at fair value and recognize all assets obtained and liabilities incurred as a result of a transfer of an entire financial asset or group of financial assets accounted for as a sale. Additionally, on and after the effective date, existing QSPEs must be evaluated for consolidation by reporting entities in accordance with the applicable consolidation guidance. The new guidance requires enhanced disclosures about, among other things, a transferor’s continuing involvement with transfers of financial assets accounted for as sales, the risks inherent in the transferred financial assets that have been retained, and the nature and financial effect of restrictions on the transferor’s assets that continue to be reported in the statement of financial position. The new guidance, effective for fiscal years beginning after November 15, 2009, affects financial asset transfers occurring on or after the effective date. Early adoption is prohibited. We are currently evaluating the potential impact, if any, of the adoption of the new guidance on our financial condition and results of operations.
Total Revenues. Consolidated total revenues decreased $41.7 million, or 29%, to $101.5 million in 2009, from $143.2 million in 2008. The decrease was primarily attributable to:
a decrease of $22.9 million in our primary insurance segment net premiums earned primarily a result of more premiums ceded under reinsurance agreements in 2009 as compared to 2008 and a reduction in 2009 gross premiums earned resulting from lower payrolls and underwriting actions taken in New York;
a decrease of $18.5 million in our reinsurance segment net earned premiums resulting from less business assumed from Majestic, and
a decrease of $2.7 million in management fee income in our fee-based management services segment resulting from less premiums under management of self-insured groups.
These decreases were offset by a $2.4 million increase in net investment income, primarily attributable to an increase in net realized gains in our primary insurance segment.
Total Expenses. Consolidated total expenses decreased by $0.8 million, or 1%, to $142.3 million in 2009, from $143.1 million in 2008. Our consolidated total expenses decreased as a result of:
a decrease of $3.9 million in our consolidated losses and loss adjustment expenses where lower losses and loss adjustment expenses assumed by our reinsurance segment were offset by higher 2008 and 2009 accident year loss and loss adjustment expenses in 2009 as compared to 2008,
a decrease of $3.9 million in our consolidated policy acquisition costs, a direct result of lower consolidated net earned premiums, and
a decrease of $2.0 million in fee paid to general agents and brokers in our fee-based management services segment.
an $8.9 million increase in selling, general and administrative expenses, of which $5.3 million consists of severance expense in our corporate and other segment related to our former co-chief executive officers,
a $2.7 million impairment charge of goodwill in our primary insurance segment, and
Discontinued Operations. We recorded net losses of $1.8 million and $3.5 million on discontinued operations for the years ended December 31, 2009 and 2008, respectively. As of September 8, 2008, we stopped providing fee-based management services in New York and ceased to manage any self-insured groups in New York or provide bill review and case management services for self-insured groups or third party clients. Accordingly, the results of CRM and Eimar, which were historically reported in the fee-based management services segment, were reclassified to discontinued operations. In 2009, we recorded $1.6 million of professional fees, primarily for legal defense costs related to the regulatory proceedings and pending litigation relating to our discontinued operations and described in “Item 8. Financial Statements - Note 20. Contingencies.”
Total Revenues. Consolidated total revenues increased $6.2 million, or 5%, to $143.2 million in 2008, from $137.0 million in 2007. The increase in total revenues was primarily due to
an increase of $1.8 million in our primary insurance segment net premiums earned where growth in business underwritten in New York and New Jersey was offset by an increase in premiums ceded under reinsurance agreements ,
an increase of $3.3 million in our reinsurance segment net earned premiums resulting from the full year effect of primary policy premiums assumed from Majestic in 2008 as compared to 2007, and
an $0.8 million net increase in our consolidated policy acquisition costs resulting from increases in business underwritten,
a $1.5 million increase to fees paid to general agents and brokers in our fee-based management services segment, and
Income from Continuing Operations before Income Taxes. Income from continuing operations before taxes was $0.1 million for 2008, as compared to $19.0 million for 2007, a decrease of $18.9 million. Decreases in the operating results of our primary insurance, reinsurance and fee-based management services segment were somewhat offset by decreased operating losses in our corporate and other segment.
The income tax provision for 2007 included a current tax provision of $3.0 million and a deferred tax benefit of $2.0 million. The deferred tax benefit of $2.0 million was primarily due to temporary reporting differences of net loss reserves, unearned premium reserves and deferred policy acquisition costs for financial statement purposes and for federal income tax purposes.
Net losses recorded in 2008 were primarily due to (a) the continuation of claims management and other administrative services provided to the New York self-insured groups without the benefit of management fees earned for providing those services, (b) reserving for uncollectible receivables, and (c) the write off of impaired fixed assets, goodwill and other intangible assets of CRM and Eimar. In addition, general corporate overhead previously included in CRM and Eimar was reclassified to continuing operations in our corporate and other segment which is discussed under the heading “Corporate and Other Segment - Selling, General and Administrative Expenses” below.
Net (Loss) Income. Consolidated net loss for 2008 was $1.5 million compared to net income of $20.1 million for 2007. Decreases in the net income of our reinsurance, primary insurance and fee-based management services segments and the effects of discontinued operations were somewhat offset by decreased net losses of our corporate and other segment.
Net Premiums Earned. Net premiums earned decreased $22.9 million, or 25%, to $70.4 million in 2009 compared to $93.3 million in 2008. Of this decrease, $22.1 million was attributable to primary insurance policies and $0.8 million was attributable to excess insurance policies.
Of the $22.1 million decrease in net earned premiums on primary policies, $18.9 million was attributable to more premiums ceded to reinsurers under quota share agreements in 2009 as compared to 2008. Majestic ceded premiums to external and affiliate reinsurers under quota share agreements in the following proportions in 2009 as compared to 2008:
For losses incurred between July 1, 2008 and June 30, 2009, Majestic entered into a 40% ceded quota share agreement with Max Re. For losses incurred between July 1, 2009 and June 30, 2010, Majestic entered into a 15% ceded quota share agreement with Max Re, excluding coverage for workers’ compensation business written by Majestic in New York. The cession percentage shown in the table for this agreement reflects an approximation of the exclusion of New York business.
Net earned premiums were also lower due to a $2.6 million decrease in our gross earned premiums on primary policies. This decrease was attributable to reduced payroll levels of our insureds in California and underwriting actions taken on our New York primary insurance business. The principal factors contributing to lower net earned premiums on excess policies were a reduction in both the number of issued policies and reported payrolls.
Finally, net earned premiums were also reduced by $3.1 million of estimated reinstatement premiums on Majestic’s excess of loss treaty that expired June 30, 2009. The current reinstatement premium accrual is based on the actuary’s estimated ultimate losses, while the exact amount of reinstatement premiums will depend on ultimate paid losses above $500,000 that occurred during the applicable treaty year.
Majestic’s current year accident loss ratio for 2009 was 96%, as compared to 77% for 2008. The increase was primarily attributable to the fourth quarter increase in our claims’ severity trend in California on primary insurance policies. In addition, the current year losses and loss adjustment expense ratio was higher in 2009 as a result of the effects of lower net earned premiums. Majestic’s net earned premiums were reduced by: (1) lower average prices for premiums earned in 2009 as compared to 2008; (2) reinstatement premiums that reduced net earned premiums as described in “Primary Insurance Segment Results of Operations 2009 Compared to 2008 - Net Premiums Earned;” and (3) the completion of premium audits which resulted in return of premiums to policyholders.
In 2008, Majestic experienced favorable loss reserve development as a result of favorable loss cost trends in the California market. The favorable development was predominantly related to accident years 2007 and 2006, for which reported indemnity claims have developed better than expected.
Selling, General and Administrative Expenses. Selling, general and administrative expenses increased $0.7 million, or 4%, to $19.8 million in 2009 compared to $19.1 million in 2008. The increase was primarily attributable to goodwill impairment charge of $2.7 million, an increase of $1.0 million in our reserves for uncollectible receivables, and a $0.6 million increase in expenses related to our integrated policy administration system. These increases were offset by $3.8 decrease in general corporate overhead expenses allocated from our corporate and other segment.
Primary net earned premiums in 2007 included the one time effect of the Novation Agreement, which is more fully described in “Item 8. Financial Statements - Note 11. Insurance Activity.” The Novation Agreement resulted in $10.7 million of additional premiums in 2007.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses increased $10.9 million, or 19%, to $68.3 million in 2008, from $57.4 million in 2007. The loss and loss adjustment expense ratio for our primary insurance segment in 2008 was 73% compared to 63% in 2007. Excluding prior year development, Majestic’s losses and loss adjustment expense ratio was 77% in 2008 and 68% in 2007. The current accident year loss and loss adjustment expense ratio was higher in 2008 compared to 2007 as a result of rate reductions in California, as discussed above in “Workers Compensation Insurance Market Conditions - California Premium Rates,” and higher than expected losses associated with certain business underwritten in New York.
Majestic experienced $3.6 million of net favorable development on prior accident years in 2008 as compared to $5.0 million of net favorable development on prior accident years in 2007. The favorable development was the result of favorable loss cost trends in the California market, predominantly related to accident years 2007 and 2006, where reported indemnity claims developed better than expected.
During 2007, Majestic recorded $5.0 million of favorable development on its estimated cost of settling claims. The favorable development was predominantly from California accident year 2006.
The underwriting expense ratio is calculated by dividing the total of policy acquisition costs and selling, general and administrative expenses by net premiums earned.
Net Premiums Earned. Net premiums earned decreased $18.5 million, or 65%, to $10.1 million in 2009, from $28.6 million in 2008.
Twin Bridges assumed 40% of primary insurance policy premiums for the three months ended March 31, 2008 and assumed 5% of primary insurance policy premiums from Majestic thereafter.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses decreased $9.3 million, or 54%, to $7.9 million in 2009, from $17.2 million in 2008. Twin Bridges; losses and loss adjustment expense ratio was 78% in 2009 as compared to 60% in 2008. Similar to our primary insurance segment, Twin Bridges’ losses and loss adjustment expenses did not decrease in the same proportion as the decrease in its net earned premiums.
Excluding prior year development, Twin Bridges’ losses and loss adjustment expense ratio was 79% in 2009 and 67% in 2008. The higher loss ratio in 2009 for Twin Bridges resulted from an increased current year accident loss ratio and a reduction in the amount of favorable development recognized on prior accident years.
Twin Bridges experienced $0.1 million of net favorable development on prior accident years in 2009, as compared to $2.0 million of net favorable development on prior accident years in 2008. In 2009, Twin Bridges experienced $1.6 million of favorable loss reserve development on excess policy business assumed from Majestic. The favorable loss reserve development resulted from excess insurance policies underwritten for self-insured groups in California for the 2008 accident year. Losses on these policies have emerged lower than expected. This favorable development was offset by $1.5 million of prior year unfavorable development on primary policy business assumed from Majestic as discussed above in “Primary Segment Results of Operations 2009 Compared to 2008 - Losses and Loss Adjustment Expenses”.
Income from Continuing Operations before Income Taxes. Income from continuing operations before income taxes attributable to the reinsurance segment decreased $5.1 million, or 100%, to break even in 2009. Decreases in net earned premiums and investment income were offset by decreases in losses and loss adjustment expenses and policy acquisition costs.
Of the reduction in net premiums under the excess quota share agreement, $10.8 million was attributable to the closure of the New York self-insured groups formerly managed by CRM and $4.1 million was attributable to reduced premiums under management of the self-insured groups managed by CRM CA. These decreases were partially offset by a $0.9 million increase in premiums under management in Florida.
Net Investment Income. Net investment income decreased $0.9 million, or 30%, to $2.1 million in 2008, from $3.0 million in 2007. Twin Bridges paid dividends of $35.5 million to CRM Holdings in 2008 which resulted in lower investment holdings and investment income at Twin Bridges in 2008 as compared to 2007.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses increased $10.5 million, or 157%, to $17.2 million in 2008, from $6.7 million in 2007. The loss and loss adjustment expense ratio for Twin Bridges in 2008 was 60% as compared to 27% in 2007.
Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased $0.8 million, or 20%, to $3.1 million, in 2009, from $3.9 million in 2008. We incurred lower administrative expenses based on fewer groups under management, and the decrease in selling, general and administrative expenses was primarily attributable to decreased payroll and related expenses, advertising and marketing expenses and travel and entertainment expenses.
Income from Continuing Operations before Income Taxes. Income from continuing operations before taxes for the fee-based management services segment decreased $0.3 million, or 75%, to $0.1 million in 2009 from $0.4 million in 2008. This decrease was primarily due to lower management fees.
Revenues from Fee-Based Management Services. Revenues from fee-based management services decreased $2.1 million, or 21%, to $8.2 million in 2008, from $10.3 million in 2007. The decrease in revenues was principally attributable to lower premiums under management of the self-insured groups which resulted from lower contribution rates being charged to the existing members of the self-insured groups. The reduced contribution rates took into account the decreased benchmark premium rates described above in “Workers Compensation Insurance Market Conditions - California Premium Rates.” Approximately 70%, 13% and 13% of the decrease was due to lower revenues from our self-insured groups covering the contracting, healthcare and auto dealer industries, respectively.
Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased $2.2 million, or 37%, to $3.9 million in 2008, from $6.1 million in 2007. The reduction in the self-insured groups’ premiums under management resulted in lower administrative expenses and the decrease in selling, general and administrative expenses was primarily attributable to decreased payroll and related expenses, travel and entertainment expenses and a reduction in general corporate overhead.
Income from Continuing Operations before Income Taxes. Income from continuing operations before taxes for the fee-based management services segment decreased $1.4 million to $0.4 million in 2008, from $1.8 million in 2007, a decrease of 80%. The decrease was primarily attributable to reduced premiums under management and the settlement of the Cornerstone litigation.
Corporate and Other Segment Results of Operations 2009 Compared to 2008
Interest Expense. Interest expense decreased $0.2 million, or 5%, to $3.5 million in 2009 from $3.7 million in 2008. The decrease was primarily due to a decrease in the floating interest rate of Embarcadero’s senior debt obligation as described in “Item 8. Financial Statements - Note 13. Long-Term Debt.
Selling, General and Administrative Expense. Selling, general and administrative expenses increased $9.1 million to $15.8 million in 2009 from $6.8 million in 2008. The increase was due to
The acceleration of the recognition of severance expense of $1.5 million related to the resignation of Mr. Rakoff, our former co-chief executive officer. We had previously recognized severance expense for Mr. Rakoff, who resigned in December 2006, over the term of his non-compete/non-solicitation covenant, which expires in December 2010. However, due to our decreased presence in the self-insured group management market and the current economic and regulatory environment, we determined that there was not a significant ongoing economic benefit to Mr. Rakoff’s non-compete/non-solicitation covenants; and
Interest Expense. Interest expense decreased $0.2 million, or 32%, to $3.7 million in 2008, from $3.9 million in 2007. This decrease was primarily due to a decrease in the floating interest rate of Embarcadero’s senior debt obligation.
Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased $4.9 million, or 42%, to $6.8 million in 2008, from $11.6 million in 2007. The decrease was attributable to:
reduced allocation of general corporate overhead expenses from discontinued operations into our corporate and other segment in 2008 as compared to 2007.
We invest the funds made available by our insurance and reinsurance subsidiaries’ capital and the net cash flows from operations, with the objective to earn income and realize gains on investments. As of December 31, 2009, our consolidated investment portfolio, including cash and cash equivalents, totaled $332.6 million, a decrease of 4% from December 31, 2008. The following table shows the fair market values of various categories of our consolidated investment portfolio, the percentage of the total market value of our invested assets represented by each category and the tax equivalent yield to maturity based on the fair market value of each category of invested assets as of the dates indicated:
The following table shows the ratings distribution of our fixed-income portfolio by Standard and Poor’s rating as a percentage of total market value as of the dates indicated:
In order to maximize after tax yields of our investment portfolio, we began liquidating our tax exempt municipal bond portfolio in the second quarter of 2009. We recorded net realized gains of $3.8 million for the year ended December 31, 2009. We reinvested the proceeds from the liquidation in taxable fixed-maturity securities.
Liquidity is a measure of a company’s ability to generate sufficient cash flows to meet the short- and long-term cash requirements of its business operations. The liquidity requirements of our business have been met primarily by funds generated from operations, asset maturities and income received on investments. As discussed in “Item 7 - Critical Accounting Policies and Estimates - Going Concern,” we believe that we will be able to meet our obligations as they become due in the foreseeable future.
Majestic has a secured letter of credit facility with Comerica Bank (“Comerica Credit Facility”), under which Majestic is able to draw secured letters of credit in an amount equal to the funds posted by Majestic. The Comerica Credit Facility has a limit of $50.0 million and may be secured by cash, investments or a combination thereof. Majestic pays a fee of 0.30% to 0.50% of the principal amount of each letter of credit issued.
$6.0 million for lease obligations related to its integrated policy administration software, and
The letters of credit for the benefit of the United States Department of Labor, the San Francisco office space, the integrated policy administration system and excess workers’ compensation insurance policy are secured by a combination of cash and the investments that are on deposit with Comerica. The letter of credit for the benefit of the California Department of Insurance is secured by a third party letter of credit of $21.0 million with an unaffiliated reinsurer. There were no amounts drawn against the letters of credit at December 31, 2009.
Twin Bridges is not licensed, approved or accredited as a reinsurer anywhere in the U.S. and, therefore, under the terms of most of its contracts with U.S. ceding companies, it is required to provide collateral to its ceding companies for unpaid ceded liabilities in a form acceptable to state insurance commissioners. Typically, this type of collateral takes the form of letters of credit issued by a bank, the establishment of a trust, or funds withheld.
Consolidated Cash Flows. The following table summarized our consolidated cash flows from operating, investing and financing activities in the last three years:
Net cash flows from operating activities declined by $52.5 million in 2009, as compared to 2008 and $26.8 million in 2008, as compared to 2007. These decreases were primarily attributable to adverse operating results, specifically in our primary insurance and reinsurance segments.
Net cash provided by investing activities increased by $76.8 million in 2009 as compared to 2008. The increase in cash was primarily due to proceeds received from maturities and sales of available-for-sale investments. In order to maximize the after tax yield of our investment portfolio, we sold many of tax-exempt municipal securities and reinvested the proceeds in taxable fixed-maturity securities. The remaining proceeds were not reinvested at December 31, 2009 and were therefore retained in cash and cash equivalents.
Net cash used in investing activities decreased $16.1 million in 2008 as compared to 2007. The decrease was primarily attributable to due to increases in proceeds from sales and maturities of our available-for-sale portfolio, proceeds from net sales and maturities of short-term investments, some of which were used to purchase available-for-sale investments.
Net cash used in financing activities was $1.9 million in 2008 as compared to net cash provided by financing activities of $5.8 million in 2007. The decrease in cash used was primarily attributable to a decrease in restricted cash and cash equivalents on deposit with respect to third party ceded quota share agreements.
Our insurance and reinsurance subsidiaries, Majestic and Twin Bridges, require cash and liquid investments to pay claims and expenses, but the amount of capital in our insurance and reinsurance subsidiaries influences how much premium we can write.
Majestic currently maintains a financial strength rating of “B++” (Good), which is the fifth highest of 15 rating categories used by A.M. Best. Twin Bridges currently maintains a financial strength rating of “B+” (Good), which is the sixth highest. Both ratings are under review and have a negative outlook. See Item 1 above under the heading “Ratings” for a further discussion of our A.M. Best insurer financial strength ratings. Our competitive position is partly determined by these financial strength ratings and therefore we could be affected by a reduction in these ratings. These ratings reflect AM. Best’s opinion of our financial strength, operating performance and ability to meet obligations. If an independent rating agency downgrades or withdraws either of our ratings, we could be severely limited or prevented from writing any new insurance or reinsurance contracts, which would significantly and negatively affect our business. Insurer financial strength ratings are based upon factors relevant to policyholders and are not directed toward the protection of investors.
We have elected to defer our regularly scheduled quarterly interest payments with respect to the $36.1 million in junior subordinated debentures, beginning December 15, 2009. Although we have the financial means to pay the interest on the debt securities, we elected to defer payments of interest to conserve cash. The total estimated annual interest that would be payable on the Debt Securities, if not deferred, is approximately $3.1 million. The terms of the debt securities allow us to defer payment of interest at any time or from time to time for up to 20 consecutive quarters provided no event of default (as defined in the debt securities) has occurred and is continuing. We are not in default with respect to the debt securities, and the deferral of interest does not constitute an event of default under the debt securities. While we defer the payment of interest, we will continue to accrue expense for interest owed at a compounded rate. Upon the expiration of the deferral, all accrued and unpaid interest is due and payable.
We assumed $8.0 million of senior debentures through our acquisition of Embarcadero. The senior debentures mature May 23, 2033 and are callable on or after May 23, 2008. The interest rate of the senior debentures is three month LIBOR plus 4.2% and may not exceed 12.5%.
Retrospective premiums are an estimate of the amounts that would be paid to policyholders if losses incurred under these policies perform as currently anticipated.
Our gross loss reserves exclude $3.8 million of GAAP fair value purchase accounting adjustments and do not have contractual maturity dates and the exact timing of the payment of claims cannot be predicted with certainty. However, based upon historical payment patterns, we have included an estimate of when we expect our loss reserves (without the benefit of any reinsurance recoveries) to be paid. As more fully discussed in Item 1 above under the headings “Business - Primary Insurance Segment - Reserves for Losses and Loss Adjustment Expenses” and “Business - Reinsurance Segment - Reserves for Losses and Loss Adjustment Expenses,” the estimation of losses reserves is based on various complex and subjective judgments. Actual losses paid may differ, perhaps significantly, from the reserve estimates reflected in our financial statements. Similarly, the timing of payment of our estimated losses and benefits is not fixed and there may be significant changes in the timing of actual payment. The assumptions used in estimating the likely payments due by period are based on our historical claims payment experience and industry payment patterns, but due to the inherent uncertainty in the process of estimating the timing of such payments, there is a risk that the amounts paid in any such period can be significantly different than the amounts estimated above for any particular period. Retrospective premiums are an estimate of the amounts that would be paid to policyholders if losses incurred under their policies perform as currently anticipated.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), CRM Holdings, Ltd.’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 19, 2010 expressed an unqualified opinion thereon.
We conducted our audit 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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion
We have audited the accompanying consolidated balance sheet of CRM Holdings, Ltd. (the Company) as of December 31, 2008, and the related consolidated statements of operations and comprehensive loss, shareholders’ equity, and cash flows for the years ended December 31, 2008 and 2007. Our audits also included the financial statement schedules for the years ended December 31, 2008 and 2007 listed in the Index at Item 15. These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and schedules based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of CRM Holdings, Ltd. at December 31, 2008 and the consolidated results of its operations and its cash flows for the years ended December 31, 2008 and 2007, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedules for the years ended December 31, 2008 and 2007, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
CRM Holdings, Ltd. is a Bermuda holding company and 100% owner of CRM USA Holdings Inc., a United States holding company, and Twin Bridges, a Bermuda company. The Company’s legal domicile is Bermuda, the jurisdiction in which it is incorporated.
CRM USA Holdings has two principal subsidiaries, CRM CA, and Embarcadero. Embarcadero has one principal operating subsidiary, Majestic.
The accompanying consolidated financial statements have been prepared in accordance with GAAP. The accompanying consolidated financial statements include the accounts of CRM Holdings and its wholly-owned subsidiaries. All significant inter-company transactions and balances have been eliminated upon consolidation.
Short-term investments include investments with remaining maturities of one year or less, but greater than three months, at the time of acquisition and are stated at amortized cost.
Amounts recoverable from reinsurers are estimated on an individual contract basis, in a manner consistent with the associated reserve for losses and loss adjustment expenses. Included in reinsurance recoverables are paid and unpaid losses recoverable from reinsurers. Recoverables are reported net of any allowance for estimated uncollectible reinsurance recoverables. No allowance was deemed necessary as of December 31, 2009 and 2008. No reinsurance recoverable balances were written off during 2009, 2008 and 2007. The Company evaluates and monitors the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies.
Goodwill represents the excess of the cost of acquiring a business enterprise over the fair value of the net assets acquired. Goodwill is not amortized but is tested for impairment at least annually, or more frequently if events or circumstances, such as adverse changes in the business climate, indicate that there may be justification for conducting an interim test. The Company performs its annual goodwill impairment testing in the fourth quarter of each year.
The valuation methodologies utilized are subject to key judgments and assumptions that are sensitive to change. Estimates of fair value are inherently uncertain and represent only management’s reasonable expectation regarding future developments. These estimates and the judgments and assumptions upon which the estimates are based will, in all likelihood, differ in some respects from actual future results.
The Company’s other intangible assets have definite lives and their value is amortized on a straight-line basis over their useful lives of five years. Other intangible assets are tested for potential impairment whenever events or changes in circumstances suggest that an asset’s or asset group’s carrying value may not be fully recoverable. The restrictive covenant related to the acquisition of Medical Expense Management was deemed to be impaired and written off on September 8, 2008 as the operations of Eimar were discontinued as more fully described in Note 8.
Fixed assets include furniture, fixtures and equipment, computer software, automobiles, and leasehold improvements and are stated at cost, net of accumulated depreciation and amortization. Fixed assets are included in other assets in the consolidated balance sheets.
Depreciation and amortization is computed using the straight-line method over the estimated useful lives of fixed assets as follows:
Fixed assets are tested for potential impairment whenever events or changes in circumstances suggest that an asset’s or asset group’s carrying value may not be fully recoverable. Fixed assets related to discontinued operations were deemed to be impaired and written off on September 8, 2008 as more fully described in Notes 2 and 9.
Reserve for losses and loss adjustment expenses represents the ultimate cost of all reported and unreported losses and loss adjustment expenses associated with reported claims and claims incurred but not reported which are unpaid at the balance sheet date. Anticipated recoveries on subrogation are deducted from liabilities for unpaid losses and loss adjustment expenses. Liabilities for reserves are determined by many variables, including case evaluation for reported losses, actuarial studies, statistical analysis, industry data and other factors. Management believes that the aggregate liability for losses and loss adjustment expenses at year-end represents its best estimate, based on available data, of the amounts necessary to settle the ultimate cost of expected loss and loss adjustment expenses.
Premiums ceded also include reinstatement premiums. Reinstatement premiums represent additional premiums payable to reinsurers to maintain coverage purchased under its excess of loss reinsurance contracts. These contracts generally contain provisions requiring the Company to pay additional premiums based on a percentage of ceded losses in the event that losses of a defined magnitude are ceded under such contracts. The Company establishes reserves for potential reinstatement premiums and records such amounts once estimated actuarial loss reserves exceed the defined limits. The Company recorded $3.1 million of reinstatement premiums payable for the year ended December 31, 2009 and no reinstatement premiums payable for the years ended December 31, 2008 and 2007.
Revenues from fee-based management services include management fees received from self-insured groups, which are based on a percentage of the premiums of the self-insured groups. The portion of such management fees that are payable to general agents and brokers is recorded as (a) revenue when payable by the group, and (b) expense included in fees paid to general agents and brokers when payable by CRM CA to the general agents and brokers. The balance of such fees is earned ratably over the period to which they apply. The portion of management fees that relates to future periods at the balance sheet date is recorded as unearned management fees and included in other liabilities in the consolidated balance sheets.
The Company also receives commissions for excess insurance coverage it places for these groups, as more fully described in Note 11. Such commission income is earned ratably over the terms of the underlying insurance coverage. The portion of commission income that relates to the remaining term of the underlying insurance coverage at the balance sheet date is recorded as unearned commission income and included in other liabilities in the consolidated balance sheets.
The common securities are held by CRM USA Holdings and represent 100% of the issued and outstanding common securities of the Trust. They are reflected as investment in unconsolidated subsidiary in the Company’s consolidated balance sheets. CRM USA Holdings’ common stock investment does not represent a significant variable interest in the Trust, as it does not receive any distributions or absorb any losses from the Trust.
Due to the Company’s decreased presence in the self-insured group market and the current economic and regulatory environment, the Company determined that there is not a significant ongoing economic benefit related to Mr. Hickey’s and Martin D. Rakoff’s non-compete/non-solicitation covenants. Mr. Rakoff was the Company’s former Co-Chief Executive Officer and Deputy Chairman of the Board who resigned December 19, 2006. Previously, the Company recognized severance expense for Mr. Rakoff over the term of his non-complete/non-solicitation covenant, which expires December 2010. The Company accelerated the recognition of Mr. Rakoff’s severance expense and recorded the $1.5 million of remaining severance payments in the first quarter of 2009.
The Company evaluates each contingent matter separately to determine if a loss contingency should be recorded. A loss contingency is only recorded if it is both (1) probable and (2) reasonably estimable. Loss contingencies are established at the Company’s “best estimate,” or, if no one number within the range of possible losses is more probable than any other, the Company records an estimated reserve at the low end of the range of losses. Costs of legal defense of litigation and regulatory matters are expensed as incurred.
The realization of deferred tax assets depends upon the existence of sufficient taxable income within the carryback or carryforward periods. A valuation allowance is established when the Company determines, based on available information, that it is more likely than not that deferred income tax assets will not be realized. Significant judgment is required in determining whether valuation allowances should be established as well as the amount of such allowances. When making such determination, consideration is given to future taxable income, future reversals of existing taxable temporary differences, taxable income in prior carryback years and tax planning strategies.
The Company determines whether it is more-likely-than-not that a tax position will be sustained upon examination by the appropriate taxing authorities before any part of the benefit can be recorded in the consolidated financial statements. The Company recognizes interest and penalties related to unrecognized tax benefits as a component of the provision (benefit) for income taxes.
In April 2009, the FASB issued new guidance for the accounting for other-than-temporary impairments. Under the new guidance, which is now part of ASC 320, Investments - Debt and Equity Securities, the Company is required to separate an other-than-temporary impairment of a debt security into two components when there are credit losses associated with the impaired debt security for which management asserts that it does not have the intent to sell the security, and it is more likely than not that it will not be required to sell the security before recovery of its cost basis. The amount of the other-than-temporary impairment related to other factors is recorded in other comprehensive loss.
In April 2008, the FASB issued revised guidance on determining the useful life of intangible assets. The revised guidance, which is now part of ASC 350, Intangibles - Goodwill and Other, amends the factors that an entity should consider in determining the useful life of a recognized intangible asset to include the entity’s historical experience in renewing or extending similar arrangements, whether or not the arrangements have explicit renewal or extension provisions. The amendment may result in the useful life of an entity’s intangible asset differing from the period of expected cash flows that was used to measure the fair value of the underlying asset using the market participant’s perceived value. The adoption of the new guidance did not have a material effect on the Company’s consolidated financial condition and results of operations.
In June 2009, the FASB issued new guidance on accounting for the transfers of financial assets. The new guidance, which is now part of ASC 860, Transfers and Servicing, eliminates the concept of a qualifying special-purpose entity (“QSPE”), clarifies and amends the derecognition criteria for a transfer to be accounted for as a sale, amends and clarifies the unit of account eligible for sale accounting and requires that a transferor initially measure at fair value and recognize all assets obtained and liabilities incurred as a result of a transfer of an entire financial asset or group of financial assets accounted for as a sale. Additionally, on and after the effective date, existing QSPEs must be evaluated for consolidation by reporting entities in accordance with the applicable consolidation guidance. The new guidance requires enhanced disclosures about, among other things, a transferor’s continuing involvement with transfers of financial assets accounted for as sales, the risks inherent in the transferred financial assets that have been retained, and the nature and financial effect of restrictions on the transferor’s assets that continue to be reported in the statement of financial position. The new guidance, effective for fiscal years beginning after November 15, 2009, affects financial asset transfers occurring on or after the effective date. Early adoption is prohibited. The Company is currently evaluating the potential impact, if any, of the adoption of the new guidance on its financial condition and results of operations.
In June 2009, the FASB issued revised guidance on the accounting for variable interest entities. The revised guidance, which is now part of ASC 810, Consolidations, amends the consolidation rules applicable to a variable interest entity (“VIE”). In addition, the revised guidance amends the rules governing the determination of whether an enterprise is the primary beneficiary of a VIE, and is therefore required to consolidate an entity, by requiring a qualitative analysis rather than a quantitative analysis. The qualitative analysis will include, among other things, consideration of who has the power to direct the activities of the entity that most significantly impact the entity’s economic performance and who has the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE and requires continuous reassessments of whether an enterprise is the primary beneficiary of a VIE. Previous guidance required reconsideration of whether an enterprise was the primary beneficiary of a VIE only when specific events had occurred. Finally, the revised guidance requires enhanced disclosures about an enterprise’s involvement with a VIE and is effective for fiscal years beginning after November 15, 2009, and for interim periods within those fiscal years. Early adoption is prohibited. The Company is currently evaluating the potential impact, if any, of the adoption of the revised guidance on its financial condition and results of operations.
On September 8, 2008, the Company ceased operations of CRM and Eimar. Accordingly, the results of operations of CRM and Eimar are reported as discontinued operations in the consolidated statements of operations and are excluded from the Company’s Fee-based Management Services segment.
In conjunction with the voluntary termination of the New York self-insured groups, the Company has ceased the operations of Eimar, a provider of medical bill review and case management services, because the majority of Eimar’s business was derived from these New York self-insured groups.
Medical bill review services for Majestic and certain self-insured groups managed by CRM CA were performed by the Company until the medical bill review function was transitioned to a third party medical bill review provider. This transition was completed in the third quarter of 2009.
The Company’s investment portfolio is managed following prudent standards of diversification. Specific provisions limit the allowable holdings of a single issue and issuers. Consequently, the Company believes there are no significant concentrations of credit risk associated with its investment.
For the year ended December 31, 2008, the Company recorded an impairment charge of $0.9 million related to one fixed-maturity security that was determined to be other-than-temporarily impaired. In September 2008, the Company recorded impairment charges on its fixed-maturity investment in Lehman Brothers Holdings Inc. as a result of its bankruptcy filing. Impairment charges for the year ended December 31, 2009 is not material to the consolidated financial statements.
Based upon changes in the investment environment and in order to protect its capital adequacy, the Company liquidated its equity securities portfolio during the second quarter of 2008. As a result, the Company recorded gross realized gains of $3.2 million and gross realized losses of $2.2 million, including losses on equity securities that historically were determined to be other-than-temporarily impaired.
Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement. The unobservable inputs reflect the Company’s own assumptions about assumptions that market participants might use. The Company has no Level 3 financial assets.
Short-term investments, investment in unconsolidated subsidiary and cash and cash equivalents - The carrying values reported in the accompanying consolidated balance sheets for these financial instruments approximate their fair value.
The 2006 acquisition of Embarcadero resulted in the establishment of goodwill of $2.7 million. The Company performed its annual impairment testing of goodwill in the fourth quarter of 2009 and determined that goodwill recorded in the primary insurance segment was impaired. Consequently, the Company recorded goodwill impairment charges of $2.7 million in the year ended December 31, 2009. Factors that occurred in the fourth quarter of 2009 that resulted in the full impairment of goodwill include: (1) the downgrade of Majestic’s AM Best rating from A- to B++ with negative implications, (2) a reduction in Majestic’s projected premiums written due to the AM Best downgrade, (3) an increase in Majestic’s losses and loss adjustment expenses, and (4) the unexpected net operating loss in the fourth quarter of 2009, which resulted from adverse development of Majestic’s current and prior year losses and loss adjustment expenses
In 2007, the Company recorded goodwill of $0.1 million and an other intangible asset of $0.2 million related to the acquisition of Medical Expense Management. The other intangible asset was a covenant not to compete for one Medical Expense Management executive. Upon acquisition, the operations of Medical Expense Management were merged into the operations of Eimar and reported in the Fee-Based Management segment.
Depreciation and amortization expense for the years ended December 31, 2009, 2008 and 2007 was $0.5 million, $0.6 million and $0.5 million, respectively, of which $0.2 million, $0.3 million and $0.1 million, respectively, was attributable to amortization of capitalized computer software. Unamortized computer software was $0.1 million and $0.3 million at December 31, 2009 and 2008, respectively.
Effective September 8, 2008, the results of CRM and Eimar were classified as discontinued operations. Consequently, furniture, fixtures and computer equipment and computer software with an aggregate book value of $0.5 million were deemed to be impaired and included in loss from discontinued operations for the year ended December 31, 2008.
Activity in the reserve for losses and loss adjustment expenses is as follows:
The estimate of Twin Bridges losses and loss adjustment expenses assumed from Majestic are based on the direct analyses of Majestic’s business taking into account Twin Bridges share of the losses based on the terms of applicable reinsurance agreements.
The loss reserve estimates are reviewed regularly and are adjusted as experience develops or new information becomes known. Such adjustments are included in the period in which they become known.
As a result of changes in estimate of insured events in prior years, loss reserves for the year ended December 31, 2009 increased by $5.8 million, primarily as a result of development in the primary insurance policy business. Majestic experienced unfavorable loss reserve development as a result of loss cost trends in its primary business in California and New Jersey, predominantly in accident year 2008. As a result, Twin Bridges also experienced unfavorable loss reserve development on primary policy business assumed from Majestic. Twin Bridges’ unfavorable loss reserve development on primary policies was offset by favorable loss reserve development under excess policy business assumed from Majestic where accident years 2008 and 2006 continue to develop better than industry excess of loss factors initially projected.
As a result of changes in estimate of insured events in prior years, loss reserves for the year ended December 31, 2007 decreased by $7.7 million, of which $5.0 million was attributable to the primary insurance segment and $2.7 million was attributable to the reinsurance segment. Majestic experienced favorable loss development as a result of favorable loss cost trends in its primary business in California, predominantly in accident year 2006. Twin Bridges also experienced favorable loss reserve development on its assumed excess policy business, primarily from accident years 2005 and 2006 in which actual results were better than industry excess of loss factors initially projected.
A summary of direct insurance and ceded and assumed reinsurance transactions in the affected segment is as follows:
At December 31, 2009 and 2008, the Majestic held collateral under related reinsurance agreements in the form of letters of credit totaling $21.0 million that may be drawn against amounts remaining unpaid for more than 120 days. At December 31, 2009 and 2008, no amounts were drawn under the letters of credit.
Twin Bridges assumed earned premiums consist of the expired portion of annual premiums accepted from Majestic for quota share reinsurance policies and excess of loss reinsurance policies. Assumed quota share reinsurance policies comprised over 90% of Twin Bridges assumed earned premiums for the years ended December 31, 2009, 2008 and 2007.
Twin Bridges issued two direct excess policies to self-insured individual enterprises. Twin Bridges purchased facultative reinsurance to reduce its maximum potential loss on these individual risks and to protect against possible catastrophes.
In connection with the private placement of Junior Debt, CRM USA Holdings incurred approximately $1.2 million of issuance costs which have been capitalized and included in other assets. These costs are being amortized using the straight-line method over the respective term of the related Junior Debt.
Embarcadero holds an $8.0 million floating rate senior debt obligation (“Senior Debt”). The Senior Debt matures May 23, 2033 at which time the entire principal is due and bears interest at a floating rate of 4.2% over 3-month LIBOR per annum. The interest rate may not exceed 12.5% commencing on May 22, 2008 through the maturity of the Senior Debt. Interest is payable on a quarterly basis and the Senior Debt may be called solely at Embarcadero’s option.
The components of (loss) income from continuing operations before income taxes were as follows:
The significant components of the consolidated provision (benefit) for income taxes were as follows:
The income tax provision (benefit) from continuing operations differs from the amount computed by applying the U.S. Federal income tax rate of 35% to income before taxes as a result of the following:
The Company evaluated its net deferred tax asset for recoverability and considered the relative impact of negative and positive evidence, including historical profitability and projections of future taxable income within the foreseeable future. In evaluating the need for a valuation allowance, the Company estimated future taxable income based on business plans and ongoing tax planning strategies. This process involved significant management judgment about assumptions that are subject to change from period to period as a result of changes in tax laws or in the Company’s projected operating performance, compared to actual results, and other factors.
The Company’s ability to pay dividends on its common shares is subject to restrictions contained in the Bermuda Companies Act. Under the Bermuda Companies Act, dividends may be declared or paid out of the Company’s retained earnings or contributed surplus only if the Company has reasonable grounds for believing that the Company is, after the payment of such dividends, able to pay its liabilities as they become due and that the realizable value of its assets would not be less than the aggregate of its liabilities and issued share capital and share premium accounts. The Company has never paid cash dividends on its common shares.
During the first quarter of 2007, 395 thousand Class B shares were converted into common shares in connection with the registration and sale of Mr. Rakoff’s shares as prescribed by his 2006 separation agreement.
The Company leases office space, office equipment and its integrated policy administration software system under various operating lease agreements. Some of the office space leases contain rent adjustment provisions to compensate the lessor for increases in operating costs. Leasehold improvements related to these operating leases are amortized over the shorter of their estimated useful lives or the noncancellable lease term. Rent expense from continuing operations under these operating leases was approximately $3.7 million, $3.3 million and $1.5 million for the years ended December 31, 2009, 2008 and 2007, respectively.
Certain of the Company’s lease agreements contain various administrative, reporting, legal and financial covenants. Non-compliance with these covenants, one of which is for no material adverse changes to the Company’s financial condition, may cause the remaining payments under the lease agreements to become immediately due. The Company notified the lessor of its operating loss for the year ended December 31, 2009, received assurance that the remaining lease payments were not immediately due and therefore believes it was in compliance with all lease agreement covenants at December 31, 2009.
Total minimum future payments under the operating leases and the litigation settlement described above and the separation agreements between the Company and its former Co-Chief Executive Officers are as follows:
The Company’s subsidiaries sponsor defined contribution plans for substantially all U.S. employees under which a portion of employee contributions are matched. The Company’s subsidiaries contributed $0.8 million, $0.8 million and $0.4 million for the years ended December 31, 2009, 2008 and 2007, respectively.
Following is a summary of non-vested shares as of December 31, 2009 and changes during the year:
Shareholders approved the Company’s 2007 Employee Stock Purchase Plan (the “Plan”) at the Company’s Annual General Meeting of Shareholders held on May 2, 2007. Under the Plan, 200 thousand shares are authorized for issuance. The Plan is a qualified employee stock purchase plan under Section 423 of the Internal Revenue Code and provides the Company’s employees with an opportunity to purchase the Company’s common shares through accumulated payroll deductions at a discounted purchase price. The Plan provides for three month offering and purchase periods, and participants are able to purchase shares at 85% of the lower of the closing price of the Company’s common shares on the first or last day of the three month purchase period.
The Company conducts business with Hickey Finn and Company, Inc. (Hickey-Finn), an insurance broker whose owners include Daniel G. Hickey, Sr., one of our directors, an existing shareholder and the father of Daniel G. Hickey, Jr., who served as our chief executive officer and chairman of the Board until March 13, 2009. David M. Birsner, another of our directors and an existing shareholder, is also an employee of Hickey-Finn.
Currently, the Company pays Hickey-Finn broker fees for primary insurance business placed with Majestic. In addition, the Company leased office space during 2007 and purchases certain bonds and liability coverage from Hickey-Finn. Amounts related to these transactions are not material to the consolidated financial statements.
The Company has cooperated fully with the NY Attorney General’s investigation. To our knowledge, the NY Attorney General has not commenced a lawsuit against the Company, our subsidiaries or any of our current or former directors or officers. The Company cannot currently predict when the NY Attorney General will conclude its investigation, commence a lawsuit, what, if any, action may be taken by the NY Attorney General, or the effect any such action may have on our business reputation, results of operations, financial condition or cash flows.
In June 2008, Majestic received a “Call for Special Report and Documents Pursuant to Section 308 of the Insurance Law” from the New York State Insurance Department. Among other items, the New York State Insurance Department requested information related to Majestic’s loss reserving practices and Majestic’s providing insurance to former members of the self-insured groups previously managed by CRM as insureds of Majestic. In September 2009, Majestic received a further request from the New York State Insurance Department requesting information related to CRM’s acquisition of Majestic and additional information related to Majestic’s issuance of workers’ compensation policies in New York, including policies issued to previous members of the self-insured groups managed by CRM. Majestic is cooperating fully with the New York State Insurance Department. To the Company’s knowledge, the New York State Insurance Department has not initiated any proceedings against Majestic. The Company cannot currently predict when the New York State Insurance Department will conclude its review, what, if any, actions may be taken by the New York State Insurance Department, or the effect any such action may have on the Company’s results of operations, reputation, financial condition, or cash flows.
On or about January 9, 2009, Majestic’s underwriting department received a subpoena from the New York State Workers Compensation Board Office of the Fraud Inspector General. The subpoena requested production of various documents related to the issuance of excess workers’ compensation and general liability policies by Majestic to the Elite Contractors Trust of New York. On May 8, 2009, CRM Holdings and Twin Bridges received a subpoena from the New York State Workers’ Compensation Board Office of Fraud Inspector General. The subpoena requested documents related to quota share agreements and a novation agreement among Twin Bridges, NY Marine and General and Majestic. The subpoenas were captioned In the Matter of Compensation Risk Managers, LLC and were assigned Inspector General Case No. 38839. To our knowledge, the Inspector General has not commenced any action against CRM or any of its affiliates. The Company cannot currently predict when the New York State Workers’ Compensation Board Office of Fraud Inspector General will conclude its review, what, if any, action may be taken by the Office of Fraud Inspector General, or the effect any such action may have on the Company’s business reputation, results of operations, financial condition or cash flows.
In November 2008, RBG Management Corp., Red & White Markets, Inc., Doria Enterprises Inc. and Grace’s Marketplace Inc., all of which were former members of the Wholesale Retail Workers’ Compensation Trust of New York (“WRWCTNY”), sued CRM, WRWCTNY, certain current and former officers and directors of CRM, the Board of Trustees of WRWCTNY, and S.A.F.E., LLC, which is the successor third-party administrator for WRWCTNY, in the Supreme Court of the State of New York, New York County. The lawsuit sought a declaratory judgment relieving the plaintiffs from any liabilities owed in relation to their previous membership in WRWCTNY and damages arising from allegations that the defendants breached their fiduciary duties to the plaintiffs by failing to maintain adequate reserves and failing to properly determine an adequate level of reserves necessary to maintain the solvency of WRWCTNY.
FS Kids LLC, et al. v. Compensation Risk Managers, LLC. On November 24, 2008, FS Kids, LLC, Mask Foods, Inc., Valu Home Centers, Inc., KBLM Foods, Inc., KDJB Foods, Inc., Gaige & Son Grocery, Inc., TJ’s Market, Inc., BB&T Supermarkets Inc., BNR-Larson, LLC, and Gift Express of New York, Inc., all of which were former members of WRWCTNY, on their own behalf and on behalf of all others similarly situated, sued CRM in New York Supreme Court, Erie County. On August 26, 2009, the plaintiffs filed an amended complaint seeking class action certification and alleging that CRM: (1) breached its contract with WRWCTNY; (2) breached its duty of good faith and fair dealing owed to WRWCTNY; (3) breached its fiduciary duties owed to WRWCTNY; (4) was negligent in administering WRWCTNY; (5) engaged in deceptive business practices; (6) was unjustly enriched; and (7) should indemnify the plaintiffs for any assessments that they may incur. The plaintiffs are seeking damages arising from the plaintiffs’ joint and several liability for the deficit of WRWCTNY which, as of September 30, 2007, was estimated at $19 million, and from any unpaid claims of the plaintiffs’ injured employees in an amount presently undetermined. On September 14, 2009, CRM filed a motion to dismiss the plaintiffs’ amended complaint. CRM’s motion to dismiss was denied by the court on March 11, 2010. CRM’s answer to the plaintiffs’ complaint will be due following entry of the court’s decision and the matter will proceed to discovery. CRM may also seek to renew and/or reargue its motion to dismiss on the grounds that the record before the Court did not contain the lawsuit filed by the New York State Workers’ Compensation Board on December 8, 2009 in New York State Supreme Court, Albany County.
Arlen Senior Contracting of Central Islip, LLC, et al. v. Compensation Risk Managers, LLC. On August 18, 2009, Arlen Senior Contracting of Central Islip LLC, Anchor Building Maintenance Corp., Conifer Realty, LLC, Constanza Enterprises, Inc., Court Plaza Senior Apartments, L.P., John Wesley Village II, Midland Management, LLC, Niagara River World, Inc., Plattsburgh Airbase Redevelopment Corp., and Wen Management Corp., all of which were former members of the Real Estate Management Trust of New York (the “Real Estate Trust”), on their own behalf and on behalf of all others similarly situated, sued CRM in New York State Supreme Court, Erie County. The lawsuit seeks class action certification and alleges that CRM: (1) breached its contract with the Real Estate Trust; (2) breached its duty of good faith and fair dealing owed to the Real Estate Trust; (3) breached its fiduciary duties owed to the Real Estate Trust; (4) was negligent in administering the Real Estate Trust; (5) engaged in deceptive business practices; (6) was unjustly enriched; and (7) should indemnify the plaintiffs for any assessments that they may incur. The plaintiffs are seeking damages (a) arising from the plaintiffs’ joint and several liability for the deficit of the Real Estate Trust which, as of December 31, 2006, was estimated at $1.6 million, (b) from any unpaid claims of the plaintiffs’ injured employees in an amount presently undetermined, (c) from potentially being liable for the costs of liquidation charged or to be charged by the WCB, and (d) from fees paid by the plaintiffs and the Real Estate Trust to CRM pursuant the service agreement between CRM and the Real Estate Trust. On October 20, 2009, CRM filed a motion to dismiss the plaintiffs’ complaint. CRM has granted plaintiffs an extension of time to respond to CRM’s motion to dismiss until 20 days after entry of the court’s decision on CRM’s motion to dismiss in the FS Kids LLC, et al. v. Compensation Risk Managers, LLC lawsuit.
Healthcare Industry Trust of New York, et al. v. Compensation Risk Managers, LLC, et al.
Plaintiffs are seeking damages from the defendants’ alleged failure to carry out their respective contractual, common law and statutory obligations to the plaintiffs to provide third-party administration and insurance services to HITNY. As against CRM, its affiliated entities and directors and officers, the lawsuit alleges that: (1) CRM breached its contract with HITNY; (2) CRM breached its duty of good faith and fair dealing owed to HITNY; (3) CRM breached its fiduciary duties owed to HITNY; (4) CRM engaged in common law fraud during its administration of HITNY; (5) CRM, its affiliated entities and directors and officers converted the assets of HITNY’s members for personal use; (6) CRM, its affiliated entities and directors and officers were unjustly enriched; (7) CRM negligently misrepresented information relative to HITNY; (8) CRM committed fraud in the inducement with respect to plaintiffs’ decision to join HITNY; (9) CRM and its directors and officers engaged in deceptive business practices; (10) CRM, its affiliated entities and directors and officers are alter egos of each other and should be liable for the debts, judgments and liabilities of each other; and (11) CRM, certain of its affiliated entities, a current director and a former officer committed a civil conspiracy in violation of the Racketeer Influenced and Corrupt Organizations Act, 18 U.S.C. §1962(c) (“RICO”).
The plaintiffs are seeking damages (a) arising from the plaintiffs’ joint and several liability for the deficit of HITNY which the plaintiffs estimate at $91 million, (b) from any unpaid claims of the plaintiffs’ injured employees in an amount presently undetermined, (c) from potentially being liable for other costs to be charged by the WCB, and (d) from fees paid by HITNY to CRM and its affiliated entities. In addition, the plaintiffs are seeking treble damages for the allegedly deceptive business practices and RICO claims.
In July 2009, the Company was contacted by an attorney representing the Elite Contractors Trust of New York (ECTNY) in connection with the service agreement between CRM and ECTNY. ECTNY believes that CRM has breached its service agreement with ECTNY by failing to provide claims administration services through the closure of all claims and consequently owes damages to ECTNY. CRM disagrees with ECTNY’s assertions and intends to vigorously contest ECTNY’s claim and any subsequent litigation that may arise.
New York State Workers Compensation Board v. Compensation Risk Managers, LLC et al.
In February 2010, CRM CA was contacted by an attorney representing CAP regarding the Cornerstone settlement and the Service Agreement amendment between CRM CA and CAP. CAP’s attorney asserted that it appears that CRM CA has a current outstanding obligation to CAP of approximately $4.0 million, [which was the sum paid by CAP to Cornerstone allegedly at the direction of CRM CA solely to serve the interests of CRM CA]. The attorney alleged that the repayment and amendment to the Service Agreement were not properly negotiated and that all payments or credits have not been made. Consequently, CAP demanded that, under the circumstances surrounding the litigation with Cornerstone and the terms of the repayment plan, CRM CA should immediately deposit $4.0 million with CAP, and if CRM CA fails to do so, a lawsuit may be commenced. CRM CA disagrees with CAP’s assertions and intends to vigorously contest CAP’s claim for $4.0 million and any subsequent litigation that may arise.
Majestic is subject to guaranty fund and other assessments by the states in which it writes business. Accordingly, Majestic has accrued a liability for guaranty fund and other assessments of $12.8 million and $11.6 million at December 31, 2009 and 2008, respectively, and has recorded a related asset for policy surcharges of $1.9 and $2.2 million at December 31, 2009 and 2008, respectively. These amounts represent management’s best estimate, based on information received from the states in which it writes business, and may change due to many factors including Majestic’s share of the ultimate cost of current insolvencies. Most assessments are paid in the year following the year in which the premiums are written or the losses are paid. Policy surcharges are generally collected in the year following the assessment.
Each U.S. domestic insurance company’s state of domicile imposes minimum risk-based capital requirements that were developed by the National Association of Insurance Commissioners (“NAIC”). The formula for determining the amount of risk-based capital specifies various weighting factors that are applied to financial balances or levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of total adjusted capital and surplus to authorized risk-based capital, as defined by the NAIC. Specific corrective action can result for companies below specific trigger points or with ratios that are classified within certain levels. The NAIC provides authoritative guidance on current statutory accounting practices by promulgating a codified set of statutory accounting practices which the California Department of Insurance requires Majestic to follow. Majestic exceeded the minimum risk-based capital requirements as of December 31, 2009 and 2008.
The following is a summary of Majestic’s statutory net income for the years ended December 31, 2009, 2008 and 2007 and the statutory capital and surplus as of December 31:
Under the Act, Twin Bridges is prohibited from reducing its total statutory capital or declaring or paying any dividends during the current or subsequent financial year if the declaration or payment of such dividends would cause it to fail to meet its solvency margin or minimum liquidity ratio. In addition, Twin Bridges is prohibited from declaring or paying any dividends of more than 25% of its total statutory capital and surplus as set out in its previous years financial statements unless at least seven days before payment of the dividends, it files with the Bermuda Monetary Authority an affidavit that it will continue to meet its solvency margins. Finally, Twin Bridges is prohibited, without prior approval from the Bermuda Monetary Authority, from reducing by 15% or more its total statutory capital as set out in its previous year’s financial statements, or from paying a dividend if there are reasonable grounds for believing that it is or would be unable to pay its liabilities as they become due, or if the realizable value of its assets would be less than its liabilities and shareholders’ equity. For the years ended December 31, 2009, 2008 and 2007, Twin Bridges paid dividends and distributed capital in an aggregate amount of $6.0 million, $35.5 million and $2.0 million, respectively.
The Company operates as four reportable segments, primary insurance, reinsurance, fee-based management services and corporate and other.
Premiums earned by the primary insurance segment for the years ended December 31, 2009, 2008 and 2007 includes $10.0 million, $28.4 million and $25.1 million, respectively, of earned premiums ceded to the reinsurance segment. Such ceded premiums reduce premiums earned in the primary insurance segment and increase premiums earned in the reinsurance segment. Ceding commission income reported in underwriting expenses of the primary insurance segment for the years ended December 31, 2009, 2008 and 2007 includes $2.5 million, $6.7 million and $2.9 million, respectively, of ceding commissions from the reinsurance segment. Such amounts are reflected in underwriting expenses of the reinsurance segment.
Income of the fee-based management services segment and underwriting expenses of the Primary Insurance segment for the years ended December 31, 2009, 2008 and 2007 included $0.5 million, $0.9 million and $1.5 million, respectively, of commissions paid by Majestic to CRM CA for excess policies placed with Majestic on behalf of the self-insured groups managed by CRM CA.
(1) Includes $5.3 million related to severance expense in the quarter ended March 31, 2009 and $2.7 million related to goodwill impairment in the quarter ended December 31, 2009.