Our principal executive offices are located in leased premises in Reno, Nevada. In addition to serving as our principal executive office, our Reno location also serves as our corporate headquarters providing corporate services in a variety of areas including finance, human resources, information technology, marketing and communications, legal, administration, corporate underwriting and claims. It also serves as a territorial office providing services in underwriting, marketing, loss control and claims related support. Our other territorial offices are located in Glendale, Newbury Park and San Francisco, California; Denver, Colorado; Henderson, Nevada; and Boise, Idaho. Our offices in Fresno, California; Irving, Texas; Phoenix, Arizona; Salt Lake City, Utah; Schaumburg, Illinois; and Tampa, Florida are primarily focused on marketing and underwriting services.
We recently completed lease negotiations for several of our facilities. The lease for our current corporate headquarters in Reno, Nevada expires on April 30, 2008. We have elected not to renew the lease at our current location and have entered into a lease for a new facility that will better meet our needs by consolidating our corporate headquarters into one building. We expect to complete the move to our new facility by April 30, 2008. The lease for the new corporate headquarters expires in 2018.
In addition, the lease for our Newbury Park, California office has been extended to 2012 and our Glendale, California office has been extended to 2013. We are currently in lease negotiations for our Fresno, California office which expires in July 2008.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the accompanying notes thereto included in Item 8 and Item 15 of this report. In addition to historical information, the following discussion contains forward-looking statements that are subject to risks and uncertainties and other factors described in Item 1A of this report. Our actual results in future periods may differ from those referred to herein due to a number of factors, including the risks described in the sections entitled ‘‘Risk Factors’’ and ‘‘Forward-Looking Statements’’ elsewhere in this report.
We are a specialty provider of workers’ compensation insurance focused on select small businesses engaged in low to medium hazard industries. Workers’ compensation is a statutory system under which an employer is required to pay for its employees’ medical, disability and vocational rehabilitation and death benefit costs for work-related injuries or illnesses. Our business has historically targeted businesses located in several western states, primarily California and Nevada. During 2007, based on net premiums written, we were the second, eighth and eighteenth largest non-governmental writer of workers’ compensation insurance in Nevada, California and the United States, respectively, based on net premiums written, as reported by A.M. Best.
In 2007, we wrote 71.7% and 17.4% of our direct premiums written in California and Nevada, respectively. We also write business in nine other states (Arizona, Colorado, Florida, Idaho, Illinois, Montana, Oregon, Texas and Utah) and are licensed to write business in six additional states (Georgia, Maryland, Massachusetts, New Mexico, New York, and Pennsylvania). We market and sell our workers’ compensation insurance products through independent local and regional agents and brokers, and through our strategic distribution partners, including our principal strategic distribution partners, ADP, Inc. (ADP) and Wellpoint, Inc. (Wellpoint). In 2007, we wrote $99.3 million, or 28.7%, of our gross premiums written through ADP and Wellpoint. We entered Florida and Oregon in 2007.
We experienced a decline in the number of policies in force in Nevada in 2007, which was the result of adherence to our underwriting guidelines that are designed to minimize the underwriting of classes of business that do not meet our target risk profiles, and due to competitive pressures. Our policy count growth, primarily in California, mitigated some of the decline in premiums we experienced principally due to declining rate levels. Companywide, we expect to see a similar declining total premium trend in 2008, where consistent policy growth will reduce, but not offset the decline in premium written in California and Nevada. It is uncertain how these trends will impact profitability.
Net Investment Income and Realized Gains (Losses) on Investments. We invest our statutory surplus and the funds supporting our insurance liabilities (including unearned premiums and unpaid losses and loss adjustment expenses (LAE)) in fixed maturity securities and equity securities. Net investment income includes revenue from interest and dividends on invested assets less bank service charges, custodial and portfolio management fees. Realized gains (losses) on investments include the gain or loss on a security at the time of sale compared to its original cost (equity securities) or amortized cost (fixed maturity investments). Our net investment income and realized gains and losses on investments are affected by general economic conditions. When, in the opinion of management, a decline in the fair value of an investment below its cost or amortized cost is considered to be ‘‘other-than-temporary’’ the investment’s cost or amortized cost is written-down to its fair value and the amount written-down is recorded in earnings as a realized loss on investments.
Conning Asset Management (Conning), our sole portfolio manager, follows our written investment guidelines based on strategies approved by our Board of Directors. Our investment strategy focuses on maximizing economic value through dynamic asset/liability management, subject to regulatory and rating agency constraints. The fixed maturity securities portion of our portfolio maintains a duration target of 5.00 a maximum tax-exempt capacity of not more than 60% of the total fixed maturity portfolio. The equity portion of our portfolio has an authorized allocation range of 6-20%. The decrease in the equity allocation in the fourth quarter of 2006 has had the effect of decreasing surplus volatility (because under statutory accounting principles, equity securities are carried at fair value with the unrealized gains/losses charged directly to surplus in contrast to fixed income securities which are carried at amortized cost with no impact on surplus due to changes in fair value), while increasing the duration target has helped to increase the tax-equivalent investment yield from 5.29% for the year ended December 31, 2006 to 5.37% for the year ended December 31, 2007. Our tax-exempt allocation is supported by our strong operating profitability and tax paying status.
Losses and LAE. Losses and LAE represent our largest expense item and include claim payments made, estimates for future claim payments and changes in those estimates for current and prior periods and costs associated with investigating, defending and adjusting claims. The quality of our financial reporting depends in large part on accurately predicting our losses and LAE, which are inherently uncertain as they are estimates of the ultimate cost of individual claims based on actuarial estimation techniques. In states other than Nevada, we have a short operating history and must rely on a combination of industry experience and our specific experience to establish our best estimate of losses and LAE reserves. The interpretation of historical data can be impacted by external forces, principally regulatory changes, economic fluctuations and legal trends. In recent years, we experienced lower losses and LAE in California than we anticipated due to factors such as regulatory reform designed to reduce loss costs in that market and inflation. The joint marketing of our workers’ compensation insurance with Wellpoint’s health insurance products also assists in reducing losses since employees make fewer workers’ compensation claims because they are insured for non-work related illnesses or injuries and thus are less likely to seek treatment for a non-work related illness or injury through their employers’ workers’ compensation insurance carrier.
Case reserves are estimates of future claim payments based upon periodic case-by-case evaluation and the judgment of our claims adjusting staff, as applied at the individual claim level. Our claims examiners determine these case reserves for reported claims on a claim-by-claim basis, based on the examiners’ judgment and experience and on our case reserving practices. We update and monitor our case reserves frequently as appropriate to reflect current information. Our case reserving practices account for the type of occupation or business, the circumstances surrounding the claim, the nature of the accident and of the resulting injury, the current medical condition and physical capabilities of the injured worker, the expected future course and cost of medical treatment and of the injured worker’s disability, the existence of dependents of the injured worker, policy provisions, the statutory benefit provisions applicable to the claim, relevant case law in the state, and potentially other factors and considerations.
IBNR is an actuarial estimate of future claim payments beyond those considered in the case reserve estimates, relating to claims arising from accidents that occurred during a particular time period on or prior to the balance sheet date. Thus, IBNR is the compilation of the estimated ultimate losses for each accident year less amounts that have been paid and case reserves. IBNR reserves, unlike case reserves, do not apply to a specific claim, but rather apply to the entire body of claims arising from a specific time period. IBNR primarily provides for costs due to:
Most of our IBNR reserves relate to estimated future claim payments over and above our case reserves on recorded open claims. For workers’ compensation, most claims are reported to the employer and to the insurance company relatively quickly, and relatively small amounts are paid on claims that already have been closed (which we refer to as ‘‘reopenings’’). Consequently, late reporting and reopening of claims are a less significant part of IBNR for our insurance subsidiaries.
Workers’ compensation is considered to be a ‘‘long-tail’’ line of insurance, meaning that there can be an extended elapsed period between when a claim occurs (when the worker is injured on the job) and the final payment and resolution of the claim. As discussed above, the ‘‘long tail’’ for workers’ compensation usually is not caused by a delay in the reporting of the claim. The vast majority of our workers’ compensation claims are reported very promptly. The ‘‘long tail’’ for workers’ compensation is caused by the fact that benefits are often paid over a long period of time, and many of the benefit amounts are difficult to determine in advance of their payment. Our obligations with respect to an injured worker may include medical care and disability-related payments for the duration of the injured worker’s disability, in accordance with state workers’ compensation statutes, all of which payments are considered as part of a single workers’ compensation claim and are our responsibility if we were providing coverage to the employer on the date of injury. For example, in addition to medical expenses, an injured worker may receive payments for lost income associated with total or partial disability, whether temporary or permanent (i.e., the disability is expected to continue until normal retirement age or death, whichever comes first). We may also be required to make payments, often over a period of many years, to surviving spouses and children of workers who are killed in the course and scope of their employment. The specific components of injured workers’ benefits are defined by the laws in each state.
Based on historical insurance industry experience countrywide, as reported by A.M. Best, approximately ten percent of workers’ compensation claim dollars are expected to be paid more than ten years after the claim occurred. While our payout pattern likely will differ from that of the industry, industry experience illustrates the general duration of workers’ compensation claims. The duration of the injured worker’s disability, the course and cost of medical treatment, as well as the lifespan of dependents, are uncertain and are difficult to determine in advance. We endeavor to minimize this risk by closing claims promptly, to the extent feasible. In addition, there are no policy limits on our liability for workers’ compensation claims as there are for other forms of insurance. We endeavor to mitigate this risk by purchasing reinsurance that will provide us with financial protection against the impact of very large claims and catastrophes.
Unpaid LAE is also estimated and monitored. The amount that will be spent managing claims will depend on the duration of the claims, the course of the injured worker’s disability and medical treatment, the nature and degree of any disputes relating to our obligations to the claimant, the administrative and
legal environment in which issues are addressed and resolved, and the cost of the Company personnel and other resources that are used in the management of claims. Therefore, our LAE reserves also contribute to the overall uncertainty of our aggregate reserve for unpaid losses and LAE.
We have retained an independent actuarial consulting firm (consulting actuary) to perform a comprehensive study of losses and LAE liability on a semi-annual basis. The role of our consulting actuary, as an advisor to management, is to conduct sufficient analyses to produce a range of reasonable estimates, as well as a point estimate, of our unpaid losses and LAE liability, and to present those results to our actuaries and to management.
Both the consulting actuary and the internal actuarial staff select and apply a variety of generally accepted actuarial methods to our data. The methods applied vary somewhat according to the type of claim benefit being analyzed. The primary methods utilized in recent evaluations are as follows:
Paid Bornhuetter-Ferguson Method. A method assigning partial weight to initial expected losses for each accident year and partial weight to observed paid losses. The weights assigned to the initial expected losses decrease as the accident year matures. This method is used to evaluate both our Nevada business and our other than Nevada business.
Frequency-Severity Method. This method separately projects the ultimate number of claims for an accident year, based on historical claim reporting patterns, and the average cost per claim. The average cost per claim is projected both by inflation-adjusting other accident years’ average cost per claim, and by observing and extrapolating based on historical patterns the per-claim cost observed to date for the accident year. This method is used to evaluate our Nevada business.
Initial Expected Loss Method. This method is used directly, and also as an input to the Bornhuetter-Ferguson methods. Initial expected losses for an accident year are based on one or more of: industry-benchmark losses per dollar of payroll for the mix of employment classes insured in our Nevada business, prior evaluation dates’ projections of ultimate losses for the accident year, and by applying to premiums from our other than Nevada business a set of initial expected loss ratios selected after analyzing the development projections for each accident year, loss trends, statutory benefit changes, and rate changes.
Several of the actuarial methods depend on assumptions about claim frequency trends. We examine the overall movement in the frequency, or number, of claims, as well as movements in the relative frequency of claims of different severities, as measured by the proportions of claims receiving different
All of the actuarial methods described for our Nevada business are used for each of the different benefit types that are analyzed. For benefit types in which most of the loss dollars are paid out within several years of the claim occurrence (temporary total disability, permanent partial disability and vocational rehabilitation) the selection of ultimate losses for all but the most recent three to five accident years is based primarily on the results of the paid development method due to the expectation that ultimate losses for the mature years will be highly correlated with the losses that have been paid to date, and the selection of estimated ultimate losses for the least mature accident years gives consideration to the results of all of the methods with the paid development method given the least consideration in the least mature (that is, most recent) accident year. For benefit types that typically involve payments extending over many years or even decades (permanent total disability, dependent benefits on fatal claims, and medical care benefits) the ultimate losses for the most recent ten or more accident years may not be highly correlated with the amounts paid to date and thus the selection of estimated ultimate losses for these recent accident years is based primarily on the frequency-severity method, the paid Bornhuetter-Ferguson method and the initial expected loss method, all of which rely in part on long-term observations regarding the average cost of claims of the particular benefit type and, in the case of medical care benefits, also allow for explicit medical cost inflation assumptions. In states other than Nevada, the paid Bornhuetter-Ferguson, reported Bornhuetter-Ferguson, paid development, and reported development methods are used for all benefit types. All of our claims experience in these states is immature; as a result, the results of the Bornhuetter-Ferguson methods are given greater weight in the selection of estimated ultimate losses because these methods do not produce results that are as highly leveraged off our immature paid or reported claims experience.
Both management with internal actuarial staff and the consulting actuary separately analyze LAE and estimate unpaid LAE. This analysis relies primarily on examining the relationship between the aggregate amount that has been spent on LAE historically, as compared with the dollar volume of claims activity for the corresponding historical calendar periods. Based on these historical relationships, and judgmental estimates of the extent to which claim management resources are focused more intensely on the initial handling of claims than on the ongoing management of claims, the consulting actuary selects a range of future LAE estimates that is a function of the projected future claim payment activity. The portion of unpaid LAE that will be recoverable from reinsurers is estimated based on the contractual reinsurance terms.
• case reserve component of our loss reserves. The case reserves are updated on an ongoing basis, in the normal course of claims examiners managing individual claims, and this component of our loss reserves at quarter-end is the sum of the case reserve as of quarter-end on each individual open claim.
Management determines the IBNR and LAE components of our loss reserves by establishing a point in the range of the consulting actuary’s most recent analysis of unpaid losses and LAE with the selection of the point based on management’s own view of recent and future claim emergence patterns, payment patterns, and trends information obtained from internal actuarial staff on:
• view of the markets in which we are operating, including environmental conditions and changes in those markets; and
• the characteristics of the business we have written in recent quarters; recent and pending recoveries from reinsurance; our view of trends in the future costs of managing claims; and other similar considerations as we view relevant.
At December 31, 2007, management’s best estimate of unpaid losses and LAE was $1,217.1 million, which was $88.8 million above the actuarial point estimate. In establishing its best estimate at December 31, 2007, management and internal actuarial staff reviewed and considered (i) the consulting actuary’s assumptions, point estimate and range, (ii) the inherent uncertainty of workers’ compensation unpaid loss and LAE liabilities, and (iii) the particular uncertainties associated with (a) the potential effects on the cost and payout pattern of claims following workers’ compensation system reforms enacted by the California legislature in late 2003 and the regulatory implementation of those reforms, the effects of which will become clear over a number of years, (b) the uncertain cost of administering claims (LAE) in the reformed California system, (c) the potential for legislative and/or judicial reversal of California reforms, (d) the rapid growth in the volume of our business in California, (e) the limited historical experience of ECIC to use as a base for projecting future loss development, (f) the degree of movement observed in EICN’s prior years’ projections of losses and LAE in Nevada following premium and market share reductions. Management did not quantify a specific loss reserve increment for each of these sources of uncertainty, but rather established an overall provision for unpaid losses and LAE that, in management’s opinion, represented a best estimate of unpaid losses and LAE at December 31, 2007 in light of the historical data, the actuarial assumptions, point estimate and range, current facts and circumstances, and the sources of uncertainty identified by management. Management’s best estimate of unpaid losses and LAE at December 31, 2007 fell within the actuarial range of estimates. The increase in management’s best estimate relative to the actuarial point estimate from December 31, 2006 to December 31, 2007 increased losses and LAE expense incurred by $2.5 million for the year ended December 31, 2007.
At December 31, 2006, management’s best estimate of unpaid losses and LAE net of reinsurance was $1,209.7 million, which was $86.4 million above the actuarial point estimate. In establishing its best estimate at December 31, 2007, management considered (i) the actuarial assumptions, point estimate and range, (ii) the inherent uncertainty of workers’ compensation unpaid losses and LAE liabilities, and (iii) the particular uncertainties associated with (a) the potential effects on the cost and payout pattern of claims following workers’ compensation system reforms enacted by the California legislature in late 2003 and the future regulatory implementation of those reforms, the effects of which will become clear over a number of years, but which our initial experience indicated were emerging favorably, (b) the uncertain cost of administering claims (LAE) in the reformed California system, (c) the potential for legislative and/or judicial reversal of the California reforms, (d) the rapid growth in the volume of our business in California, (e) the limited but growing historical experience of ECIC to use as a base for projecting future loss development, (f) the degree of movement observed in EICN’s prior years’ projections of losses and LAE in Nevada following continued premium and market share reductions. Management did not quantify a specific loss reserve increment for each of these sources of uncertainty, but rather established an overall provision for unpaid losses and LAE that, in management’s opinion, represented a best estimate of unpaid losses and LAE at December 31, 2006 in light of the historical data, the actuarial assumptions, point estimate and range, current facts and circumstances, and the sources of uncertainty identified by management. Management’s best estimate of unpaid losses and LAE at December 31, 2006 fell within the consulting actuary’s range of estimates. The increase in management’s best estimate relative
At December 31, 2005, management’s best estimate of unpaid losses and LAE was $1,208.5 million, which was $84.3 million above the actuarial point estimate. In establishing its best estimate at December 31, 2005, management considered (i) the actuarial assumptions, point estimate and range, (ii) the inherent uncertainty of workers’ compensation unpaid losses and LAE liabilities, and (iii) the particular uncertainties associated with (a) the potential effects on the cost and payout pattern of claims following workers’ compensation system reforms enacted by the California legislature in late 2003 and the future regulatory implementation of those reforms, the effects of which will become clear over a number of years, but which our initial experience indicated were emerging favorably, (b) the uncertain cost of administering claims (LAE) in the reformed California system, (c) the potential for legislative and/or judicial reversal of the California reforms, (d) the rapid growth in the volume of our business in California, (e) the limited but growing historical experience of ECIC to use as a base for projecting future loss development, (f) the degree of movement observed in EICN’s prior years’ projections of losses and LAE in Nevada following continued premium and market share reductions, (g) recent changes in EICN’s claim department processes, controls and management, (h) the legislative adoption of future cost-of-living increases on permanent total disability payments on injuries occurring January 1, 2004 and after in Nevada, and (i) the degree to which our reinsurance protection will absorb our unanticipated development on years subject to the LPT Agreement and on large claims in excess of our current reinsurance retention. Management did not quantify a specific loss reserve increment for each of these sources of uncertainty, but rather established an overall provision for unpaid losses and LAE that, in management’s opinion, represented a best estimate of unpaid losses and LAE at December 31, 2005 in light of the historical data, the actuarial assumptions, point estimate and range, current facts and circumstances, and the sources of uncertainty identified by management. Management’s best estimate of unpaid losses and LAE at December 31, 2005 fell within the consulting actuary’s range of estimates. The decrease in management’s best estimate relative to the consulting actuary’s point estimate from December 31, 2004 to December 31, 2005 decreased losses and LAE expense incurred by $5.4 million for the year ended December 31, 2005.
Estimates of ultimate losses and LAE may change from one balance sheet date to the next when actual claim payment or a change in individual case reserve estimates between those dates differ from the expected claim activity underlying the prior loss reserve estimate, and when actual LAE expenditures differ from expected expenditure levels underlying the prior LAE reserve estimate. As actual losses and LAE expenditures occur during a calendar period, they replace the portion of prior estimates of unpaid losses and LAE that relate to that period. In addition, the parameters used in the various methods and the relative weight accorded to the results of the different actuarial methods, all of which require judgment, may change as a result of observing that the actual pattern of expenditures differs from prior expectations, as well as based on new industry wide data and benchmarks derived from that data, when available. The parameters and weights used in estimating ultimate losses may also change when external conditions-such as the statutory benefit structures or the manner in which it is being interpreted and administered, or inflation-differ from expectations underlying the prior estimate of ultimate losses, and when the effects of factors related to internal operations differ from expectations underlying the prior estimate of ultimate losses.
The major sources of this favorable development include actual paid losses, which have been less than expected, and the impact of recalibration of selected patterns of claims emergence and claim payment used in the projection of future loss payment.
In California, in particular, where our operations began on July 1, 2002, the actuaries’ and management’s initial expectations of the ultimate level of losses and patterns of loss emergence and loss payment necessarily were based on benchmarks derived from analyses of historical insurance industry data in California, as no historical data from our California insurance subsidiary existed and, although some historical data was available for the prior years for some of the market segments we entered in California, that data was limited as to the number of loss reserve evaluation points available. The industry-based benchmarks were adjusted judgmentally for the anticipated impact of significant environmental changes, specifically the enactment of major changes to the statutory workers’ compensation benefit structure and the manner in which claims are administered and adjudicated in California. The actual emergence and payment of claims by our California insurance subsidiary has been more favorable than those initial expectations, due at least in part, we believe, to the impact of enactment of the major changes in the California environment. Other insurance companies writing California workers’ compensation insurance have also experienced emergence and payment of claims more favorable than anticipated. At each evaluation date, the projected claim activity underlying the prior loss reserves has been replaced by the actual claim activity, and the expectation of future emergence and payment of California claims underlying the actuarial projections has been reevaluated periodically based both on our insurance subsidiaries’ emerging experience and on updating the benchmarks that are derived from observing and analyzing the insurance industry data for California workers’ compensation. The change in incurred losses and LAE attributable to prior years as a result of business outside Nevada, predominantly
California, was $57.4 million, $111.0 million and $48.2 million for the years ended December 31, 2007, 2006 and 2005, respectively. In states other than California and Nevada, our insurance subsidiaries’ operations are relatively new and represent a minor portion of our loss reserves.
It is likely that ultimate losses and LAE will differ from the loss reserves recorded in our December 31, 2007 balance sheet. Actual losses and LAE payments could be greater or less than our projections, perhaps significantly. The following paragraphs discuss several potential sources of such deviations, and illustrate their potential magnitudes.
For loss adjustment expense, particularly in Nevada, our projections assume a long term cost of managing claims that is greater than the recent levels of LAE produced by our insurance subsidiaries’ current operating model, but is less than the levels of LAE expended in more distant historical past years by our insurance subsidiaries and by the Fund. Future changes in claims operations, while not currently planned or contemplated, could result in future actual LAE and future projections of LAE that may differ from current estimates. If future levels of LAE match recent levels of LAE, our current reserves for LAE could develop favorably over time; if future levels of LAE return to older historical levels, our current reserves for LAE could develop unfavorably over time.
Our reserve estimates reflect expected increases in the costs of contested claims and assume we will not be subject to losses from significant new legal liability theories. While it is not possible to predict the impact of changes in this environment, if expanded legal theories of liability emerge, our IBNR claims may differ substantially from our IBNR reserves. Our reserve estimates assume that there will not be significant future changes in the regulatory and legislative environment. The impact of potential changes in the regulatory or legislative environment is difficult to quantify in the absence of specific, significant new regulation or legislation. In the event of significant new regulation or legislation, we will attempt to quantify its impact on our business.
The range of potential variation of actual ultimate losses and LAE from our current reserve for unpaid losses and LAE is difficult to estimate because of the significant environmental changes in our markets, particularly California, and because our insurance subsidiaries do not have a lengthy operating history in our markets outside Nevada.
Furthermore, the methodologies we currently employ in evaluating our losses and LAE liability do not allow us to quantify the sensitivity of our losses and LAE reserves to reasonably likely changes in the underlying key assumptions. Management will refine its methodologies to provide for such capability in the future.
However, the actuarial range represents an estimated range in which it is most likely that the ultimate losses and LAE will fall, based on the actuarial review of the results of the various methodologies and parameters used by the actuaries in the projection of losses and LAE. Each different actuarial method may produce a different indication of unpaid losses and LAE because each method relies in different ways on assumptions about the future. For example, the loss development methods are based on an assumption that the selected pattern of emergence or payout of claims will recur in the future, the frequency-severity method is based on an assumption that the most recent year’s ultimate average cost per claim can be estimated by inflation-adjusting other accident years’ average cost per claim and by extrapolating based on historical patterns the per-claim cost observed to date for the accident year, the initial expected loss method assumes that the ultimate losses can be estimated based on the payroll of workers insured by us and a benchmark loss cost per payroll or as a percentage of premium, and the Bornhuetter-Ferguson methods rely on a combination of these assumptions. Actual losses are affected by a more complex combination of forces and dynamics than any one model or methodology can represent, and each
actuarial methodology is an approximation of these complex forces and dynamics, and thus each different actuarial methodology may produce different indications of unpaid losses and LAE. None of the methods is designed or intended to produce an indication that is systematically higher or lower than the other methods. Nonetheless, at any given evaluation date, some of the actuarial projection methods produce indications outside this range, and the selection of reasonable alternative methods or reasonable alternative parameters in the actuarial projection process would produce an even wider range of potential outcomes, both above and below the range shown. Accordingly, we believe that the range of potential outcomes is considerably wider than the actuarially estimated range of the most likely outcomes. The magnitude of adjustments to prior years’ reserves for unpaid losses and LAE reserves that we have made at December 31, 2007, 2006 and 2005, decreases of $60.0 million, $107.1 million, and $78.1 million respectively-also illustrate that changes in estimates of unpaid losses and LAE can be significant from year to year. We do not have a basis for anticipating that actual future payments of losses and LAE are more likely to be either greater than or less than the reserve for unpaid losses and LAE on our current balance sheet.
Reinsurance recoverables represent: (a) amounts currently due from reinsurers on paid losses and LAE; (b) amounts recoverable from reinsurers on case basis estimates of reported losses; and (c) amounts recoverable from reinsurers on actuarial estimates of IBNR for losses and LAE. These recoverables, by necessity, are based upon our current estimates of the underlying losses and LAE, and are reported on our balance sheet separately as assets, as reinsurance does not relieve us of our legal liability to policyholders. We bear credit risk with respect to the reinsurers, which can be significant considering that some of the unpaid losses and LAE remain outstanding for an extended period of time. Reinsurers might refuse or fail to pay losses that we cede to them, or they might delay payment. We are required to pay losses even if a reinsurer refuses or fails to meet its obligations under the applicable reinsurance agreement. We continually monitor the financial condition and rating agency ratings of our reinsurers. We require reinsurers that are not admitted reinsurers in Nevada and California to collateralize their share of the unearned premiums and unpaid loss reserves in order that our insurance subsidiaries receive credit for reinsurance on their statutory financial statements. Since our inception in 2000, no material amounts due from reinsurers have been written off as uncollectible and, based on this experience, we believe that amounts currently reflected in our consolidated financial statements will similarly require no material prospective adjustment.
Under the LPT Agreement, the Fund initially ceded $1.525 billion in liabilities for the incurred but unpaid losses and LAE related to claims incurred prior to July 1, 1995, for consideration of $775 million in cash. As of December 31, 2007, the estimated remaining liabilities subject to the LPT Agreement were approximately $971.7 million. Losses and LAE paid with respect to the LPT Agreement totaled approximately $405.7 million at December 31, 2007.
All premium revenue is recognized over the period of the contract in proportion to the amount of insurance protection provided. The insurance premiums we charge are billed to our policyholders either annually or under various installment plans based on the estimated annual premium under the policy terms. At the end of the policy term, payroll-based premium audits are performed on substantially all policyholder accounts to determine net premiums earned for the policy year. Earned but unbilled
premiums include estimated future audit premiums. Estimates of future audit premiums are based on our historical experience. These estimates are subject to changes in policyholders’ payrolls due to growth, economic conditions and seasonality. The estimates are continually reviewed and adjusted as necessary as experience develops or new information becomes known. Any such adjustments are included in current operations. Since our inception in 2000, there have been no material adjustments of our accrual for earned but unbilled premium and, based on this experience, and, although considerable variability is inherent in such estimates, we believe that amounts currently reflected in our consolidated financial statements will similarly require no material prospective adjustment.
We account for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes, recognizing the current and deferred tax consequences of all transactions that have been recognized in the financial statements using the provisions of the enacted tax laws. Deferred tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The effect on deferred tax assets and liabilities resulting from a tax rate change impacts our net income or loss in the reporting period that includes the enactment date of the tax rate change. Our income tax returns are subject to audit by the Internal Revenue Service and various state tax authorities. Significant disputes may arise with these tax authorities involving issues of the timing and amount of deductions and allocations of income among various tax jurisdictions because of differing interpretations of tax laws and regulations. We periodically evaluate our exposures associated with tax filing positions. Although we believe our positions comply with applicable laws, we record liabilities based upon estimates of the ultimate outcomes of these matters.
We adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109, (‘‘FIN 48’’), effective January 1, 2007. As of December 31, 2006, the Company had recorded, as a liability for tax contingencies, $14.9 million (including interest of $1.6 million). As a result, the adoption of FIN 48 did not result in any change in the amount of the unrecognized tax benefit. Further, we elected to continue to record both interest and penalties related to any unrecognized tax benefits as a component of income tax expense.
In assessing whether our deferred tax assets will be realized, management considers whether it is more likely than not that we will generate future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, tax planning strategies and projected future taxable income in making this assessment. If necessary, we establish a valuation allowance to reduce the deferred tax assets to the amounts that are more likely than not to be realized.
• the financial condition and near-term prospects of the issuer of the security, including any specific events that may affect its operations or earnings;
Gross Premiums Written. Gross premiums written is the sum of both direct premiums written and assumed premiums written before the effect of ceded reinsurance and the intercompany pooling agreement. Direct premiums written represent the premiums on all policies our insurance subsidiaries have issued during the year. Assumed premiums written represent the premiums that our insurance subsidiaries have received from an authorized state-mandated pool or under previous fronting facilities. The primary fronting facility was between ECIC and Clarendon Insurance Group (Clarendon) and that arrangement is now in run-off. We use gross premiums written, which excludes the impact of premiums ceded to reinsurers, as a measure of the underlying growth of our insurance business from period to period.
We analyze our calendar year losses and LAE ratio to measure our profitability in a particular year and to evaluate the adequacy of our premium rates charged in a particular year to cover expected losses
and LAE from all periods, including development (whether favorable or unfavorable) of reserves established in prior periods. In contrast, we analyze our accident year losses and LAE ratios to evaluate our underwriting performance and the adequacy of the premium rates we charged in a particular year in relation to ultimate losses and LAE from insured events occurring during that year.
Commission Expense Ratio. The commission expense ratio is the ratio (expressed as a percentage) of commission expense to net premiums earned and measures the effectiveness of compensating agents and brokers for the business we have underwritten.
Combined Ratio. The combined ratio is a measure used in the property and casualty insurance business to show the profitability of an insurer’s underwriting, and it represents the percentage of each premium dollar spent on claims and expenses. The combined ratio is the sum of the losses and LAE ratio, the commission expense ratio and the underwriting and other operating expense ratio. The losses and LAE ratio, commission expense ratio and underwriting and other operating expense ratio express the relationship between losses and LAE, commissions and underwriting and other operating expenses (including policyholder dividends), respectively, to net premiums earned. When the combined ratio is below 100%, an insurance company experiences underwriting gain, meaning that claims payments, the cost of settling claims, commissions and underwriting expenses are less than premiums collected. If the combined ratio is at or above 100%, an insurance company cannot be profitable without investment income, and may not be profitable if investment income is insufficient. Companies with lower combined ratios than their peers generally experience greater profitability.
Gross Premiums Written. Gross premiums written decreased $51.1 million, or 12.7%, to $350.7 million for the year ended December 31, 2007 from $401.8 million for the year ended December 31, 2006. The decrease was primarily due to premium rate decreases in California offset by a 13.3% increase in total policy count. The overall increase in policy count included a decline in policy count of 5.8% in Nevada as a result of our adherence to our underwriting guidelines and increased competitive pressures. In California, our largest market, our filed rates on new business and renewals as of December 31, 2007 were 14.0 % lower than December 31, 2006, offset by a 17.0% increase in policy count. The average in force policy premium at December 31, 2007 decreased 15.8% to $9,704 from $11,528 at December 31, 2006.
Net Premiums Earned. Net premiums earned decreased $46.1 million, or 11.7%, to $346.9 million for the year ended December 31, 2007 from $393.0 million for the year ended December 31, 2006. The decrease in net premiums earned was primarily the result of the decrease in net premiums written for the year ended December 31, 2007 as compared to the year ended December 31, 2006.
The table below reflects the losses and LAE reserve adjustments for the periods specified:
There was no adjustment in either period to the direct reserves subject to the LPT Agreement. Losses and LAE include amortization of deferred reinsurance gain-LPT agreement of $18.0 million and $19.4 million in the year ended December 31, 2007 and 2006 respectively. Excluding the impact from the LPT agreement, losses and LAE would have been $161.3 million and $149.1 million, or 46.5% and 37.9% of net premiums earned for the year ended December 31, 2007 and 2006 respectively.
Commission Expense. Commission expense decreased $4.1 million, or 8.4%, to $44.3 million for the year ended December 31, 2007 from $48.4 million for the year ended December 31, 2006. Commission expense was 12.8% and 12.3% of net premiums earned for the years ended December 31, 2007 and 2006, respectively. Commission expense decreased approximately $5.7 million due to a decrease in net earned premium of $46.1 million and a $2.7 million favorable change in the estimated LPT Agreement contingent commission. The decrease in 2007 was partially offset by a two percentage point increase in our commission rate on select policies incepting July 2006 and after, which resulted in increased commission expense of $4.3 million.
Underwriting and Other Operating Expense. Underwriting and other operating expense increased $3.6 million, or 4.1%, to $91.4 million for the year ended December 31, 2007 from $87.8 million for the year ended December 31, 2006. The increase is composed primarily of a $9.4 million increase in salaries and benefits, with a related $3.0 million increase in general operating expenses and a $2.7 million increase in technology maintenance and depreciation. This was partially offset by a decrease of $9.4 million in professional fees and a reduction of $1.8 million in the premium related expenses of premium tax, bad debt and policyholder dividends due to lower earned premiums for the year ended December 31, 2007 as compared to the year ended December 31, 2006.
The increase in salaries and benefits and related general operating expenses were due to the increased staffing to support business needs and to meet the demands of being a public company. Employee benefit increases include higher benefit costs for medical coverage, an increased 401(k) employer match, and a new 2007 Equity and Incentive Plan. The technology maintenance and depreciation increased as a result of implementing EACCESS®, our new underwriting system, on July 1, 2006 with a full year of depreciation taken in 2007.
The decrease in professional fees was primarily due to the 2006 one-time incurred expenses related to the conversion of $10.0 million. The remainder of the decrease in professional fees was due to the reduction in the use of consultants for strategic planning of $1.5 million and post-implementation work of $1.8 million on the new underwriting system. The decreases in professional fees were partially offset by a $3.0 million increase in legal, audit and SOX compliance fees related to being a public company.
Net Income. Net income decreased $51.3 million, or 29.9%, to $120.3 million for the year ended December 31, 2007 from $171.6 million for the year ended December 31, 2006. Net income was primarily impacted by three items: a) favorable reserve adjustments related to prior years for the year ended December 31, 2006 of $107.1 million compared with $61.6 million for the same period in 2007; b) realized gains of $54.1 million in 2006 primarily related to the portfolio reallocation in the fourth quarter; and c) the decrease in the effective tax rate to 20.3% in 2007 as compared to 32.5% in 2006 as described above.
Combined Ratio. The combined ratio increased 12.7 percentage points, to 80.4%, for the year ended December 31, 2007 from 67.7% for the year ended December 31, 2006. The change in the combined ratio was primarily due to recognition of a larger favorable prior accident year adjustment in 2006 as compared to 2007, increased operating expense in 2007, and an increase to our commission rate on select policies that was partially offset by, a favorable change in the estimated LPT contingent commission.
change was attributable to two factors, the increase in the portfolio yield and in the investment portfolio. The yield on invested assets increased by $7.7 million or approximately 0.46 of a percentage point to 5.29% for year ended December 31, 2006 from 4.83% for the year ended December 31, 2005. The invested assets increased $120.0 million as a result of favorable investment yield and net cash flows from operations. The increase in invested assets generated an additional $6.1 million of investment income for the year ended December 31, 2006.
The favorable prior accident year reserve development totaled $107.1 million for the year ended December 31, 2006 compared to $105.0 million (including $26.9 million favorable development on the direct reserves subject to the LPT Agreement) for the year ended December 31, 2005. In the fourth quarter 2006, the favorable prior year accident year development was $25.4 million, offset by a year end increase to the current accident year reserves of $5.0 million. There was no adjustment in this period to the direct reserves subject to the LPT Agreement. Fourth quarter 2005 had favorable prior accident year development of $51.5 million in addition to the $26.9 million favorable losses development for LPT Agreement offset by a year end increase to the current accident year reserves of $5.5 million. Losses and LAE include amortization of deferred reinsurance gain-LPT Agreement of $19.4 million and $16.9 million in the year ended December 31, 2006 and 2005, respectively. Excluding the impact from the LPT
Agreement, losses and LAE would have been $149.1 million and $255.4 million, or 37.9% and 58.3% of net premiums earned, for the years ended December 31, 2006 and 2005, respectively. Fourth quarter losses and LAE include amortization of deferred reinsurance gain-LPT Agreement of $4.8 million and $1.4 million for the three months ended December 31, 2006 and 2005, respectively.
Underwriting and Other Operating Expense. Underwriting and other operating expense increased $17.9 million, or 25.6%, to $87.8 million for the year ended December 31, 2006 from $69.9 million for the year ended December 31, 2005. The increase is composed primarily of a $2.4 million increase in salaries and benefits, a $4.2 million increase in technology maintenance and depreciation and a $13.2 million increase in professional fees offset by a decrease of $2.6 million primarily made up of a change in bad debt expense and policyholder dividends for the year ended December 31, 2006 as compared to the year ended December 31, 2005.
Combined Ratio. The combined ratio decreased 7.3 percentage points, to 67.7%, for the year ended December 31, 2006 from 75.0% for the year ended December 31, 2005. The combined ratio decrease was primarily due to the decreased losses and LAE ratio that was partially offset by increased commission expense and underwriting and other operating expense ratios.
The availability of cash to pay claims comes from our disciplined underwriting and pricing standards and the purchase of reinsurance to protect us against severe claims and catastrophic events. On July 1, 2007, we entered into a new reinsurance program that is effective through July 1, 2008. The program consists of two master interests and liabilities agreements, one excess of loss treaty agreement and one catastrophic loss treaty agreement. The reinsurance program provides coverage up to $200.0 million per loss occurrence, subject to certain exclusions. Our loss retention for the treaty year beginning July 1, 2007, is $5.0 million. The coverage is subject to an aggregate loss in the first layer ($5.0 million in excess of our $5.0 million retention) of $20.0 million and is limited to $10.0 million for any loss to a single individual involving the second layer through six layers of our reinsurance program. The second through six layers are limited to one mandatory reinstatement for an additional premium. We believe that we are sufficiently capitalized for the above described retention.
We are currently planning to make significant capital expenditures in 2008 and 2009. It is our intention to complete the acquisition of AmCOMP for approximately $230 million including the assumption of debt of AmCOMP. We plan to finance the acquisition of AmCOMP through the issuance of debt and available cash from operations and portfolio maturities. Additionally, we expect one-time integration costs of approximately $12.0 million in 2008 and 2009 related to the acquisition of AmCOMP. These capital expenditures planned for 2008 include approximately $4.0 million of costs related to our information technology systems. These expenditures will be financed by cash from operations and maturing investments.
As of December 31, 2007, EHI had assets, excluding its investment in subsidiaries, of $23.6 million, comprised of cash and intercompany receivables. EHI’s liabilities at such date were $2.8 million, comprised of accounts payable and accrued expenses. Our ability to pay dividends on our common stock, to repurchase common stock and to pay other expenses, will be dependent, to a significant extent, upon the ability of our Nevada domiciled insurance company, EICN, to pay dividends to its immediate holding company EGI, and, in turn, the ability of EGI, to pay dividends to its parent, EHI.
that could have been made by EICN during 2008 from available unrestricted surplus without special approval, if an extraordinary dividend had not been approved in December 2007, would have been $123.0 million. However, the Company received approval on December 18, 2007 from the Nevada Commissioner for additional extraordinary dividends to be paid from EICN special surplus and which will be paid to EHI in the amount of $200 million in 2008. As a result of the extraordinary dividend approval, any additional dividends to be paid during 2008 from special or unrestricted available surplus will require approval by the Nevada Commissioner. Dividends from unrestricted available surplus may require approval if other dividends have been made from special or unrestricted surplus within the prior 12 months, or exceed certain levels. See ‘‘Item 1 - Business-Regulation-Financial, Dividend and Investment Restrictions’’ for a further discussion of the restrictions and requirements pertaining to the availability of additional dividends.
On October 17, 2006, the Nevada Commissioner granted EICN permission to pay up to an additional $55 million in one or more extraordinary dividends to us subsequent to the successful completion of the initial public offering and before December 31, 2008. The payment of these dividends was conditioned upon the expiration of any underwriters’ over-allotment option period, prior repayment of any expenses of the Company and its subsidiaries arising from the conversion and the IPO, the exhaustion of any proceeds retained by the Company from the recently completed initial public offering, maintaining the RBC total adjusted capital in EICN above a specified level on the date of declaration and payment of any particular extraordinary dividend after taking into account the effect of such dividend, and maintaining all required filings with the Nevada Commissioner. The conditions were met and the $55 million extraordinary dividend was paid in 2007. We used the dividend to pay quarterly dividends to our stockholders, to repurchase our stock, and/or for general corporate purposes, other than to increase executive compensation.
As the direct owner of ECIC, EICN will be the direct recipient of any dividends paid by ECIC. The ability of ECIC to pay dividends to EICN is limited by California law, which provides that the appropriate insurance regulatory authorities in the State of California must approve (or, within a 30-day notice period, not disapprove) any dividend that, together with all other such dividends paid during the preceding 12 months, exceeds the greater of: (a) 10% of the paying company’s statutory surplus as regards policyholders at the preceding December 31; or (b) 100% of the net income for the preceding year. The maximum pay-out that may be made by ECIC to EICN during 2008 without prior approval is $49.2 million. In California, (the domiciliary state of ECIC) the CDOI has required that in addition to applying the NAIC’s statutory accounting practices, insurance companies must record, under certain circumstances, an additional liability, called an ‘‘excess statutory reserve.’’ If the workers’ compensation losses and loss adjustment expense ratio is less than 65% in each of the three most recent accident years, the difference is recorded as an excess statutory reserve. In October 2007, the California legislature passed SB 316 which repealed the minimum reserve requirement in regards to workers’ compensation reserves, effective January 1, 2008. Based on SB 316, the Company did not record an excess statutory reserve as of December 31, 2007 in its 2007 Annual Statement, as filed with the DOI in 2008. The excess statutory reserves previously required by the DOI decreased ECIC’s statutory-basis surplus by $33.9 million and $7.5 million to $314.1 million and $277.2 million at December 31, 2006 and 2005, respectively, as filed with the DOI.
Financing activities used net cash of $60.6 million and $3.1 million for the years ended December 31, 2007 and 2006 respectively. The majority of cash used by financing activities was to repurchase $75.0 million of our common stock and to pay stockholder dividends of $9.3 million. These expenditures were offset by cash provided from our IPO and conversion as described below.
EHI has received a commitment for a $50.0 million Senior Secured Revolving Credit Facility from Wells Fargo Bank, National Association (Wells Fargo). The Company is expecting to finalize the agreement by the end of the second quarter 2008. The Company anticipates that the line of credit will be used for general business and corporate purposes.
We derive investment income from our invested assets. We invest our insurance subsidiaries’ total statutory surplus and funds to support our loss reserves and our unearned premiums. As of December 31, 2007, the amortized cost of our investment portfolio was $1.65 billion and the fair value of the portfolio was $1.73 billion.
We classify our portfolio of equity securities as available-for-sale and carry these securities on our balance sheet at fair value. Accordingly, changes in market prices of the equity securities we hold in our combined investment portfolio result in increases or decreases in our total assets. In order to minimize our exposure to equity price risk, we invest primarily in equity securities of mid-to-large capitalization issuers and seek to diversify our equity holdings across several industry sectors. Our objective during the past few years has been to reduce equity exposure as a percentage of our total portfolio by increasing our fixed maturity securities. Our investment strategy allows a maximum exposure of 20% of our total combined investment portfolio in equity securities, with our current equity allocation at 6.2% of the total portfolio at December 31, 2007.
The following table shows the market values of various categories of invested assets, the percentage of the total market value of our invested assets represented by each category and the tax equivalent yield based on the market value of each category of invested assets as of December 31, 2007:
The amortized cost and estimated fair value of fixed maturity investments at December 31, 2007 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
(2) Estimated losses and LAE reserve payment patterns have been computed based on historical information. As a result, our calculation of loss and LAE reserve payments by period is subject to the same uncertainties associated with determining the level of reserves and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. For a discussion of our reserving process, see ‘‘-Critical Accounting Policies -Reserves for Losses and Loss Adjustment Expenses.’’ Actual payments of losses and LAE by period will vary, perhaps materially, from the above table to the extent that current estimates of losses and LAE reserves vary from actual ultimate claims amounts as a result of variations between expected and actual payout patterns.
In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 157, Fair Value Measurements (SFAS No. 157), which provides a common definition of fair value and establishes a framework to make the measurement of fair value more consistent and comparable. SFAS No. 157 also requires expanded disclosures about: (a) the extent to which companies measure assets and liabilities at fair value; (b) the methods and assumptions used to measure fair value; and (c) the effect of fair value measures on earnings. The Company adopted SFAS No. 157 on January 1, 2008, and it will not have a material effect on the Company’s consolidated financial condition or results of operations.
Consolidated Statements of Cash Flows for each of the three years ended December 31, 2007
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP), and include the financial statements of EICN and its affiliated companies (ECIC, EOH and Elite) for the periods prior to the formation of EHI. This presentation is made since the reorganization described above did not have a material financial impact on the companies, as the net assets transferred to achieve the change in legal organization were accounted for at historical carrying amounts. All intercompany transactions and balances have been eliminated in consolidation.
The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure
of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. As a result, actual results could differ from these estimates. The most significant areas that require management judgment are the estimate of unpaid losses and loss adjustment expenses, evaluation of reinsurance recoverables, recognition of premium revenue, deferred policy acquisition costs, deferred income taxes and the valuation of investments.
Revenue Recognition: Premiums are billed and collected according to policy terms, predominantly in the form of installments during the policy period. Premiums are earned pro rata over the terms of the policies. Billed premiums applicable to the unexpired terms of policies in force are recorded in the accompanying consolidated balance sheets as a liability for unearned premiums.
a net recovery of amounts previously written off of $0.8 million, $0.4 million, and $0.7 million for the years ended December 31, 2007, 2006 and 2005, respectively.
Deferred policy acquisition costs were $14.9 million and $13.8 million at December 31, 2007 and 2006, respectively. Amortization for the years ended December 31, 2007, 2006 and 2005, was $46.1 million, $58.4 million, and $62.2 million, respectively.
Policyholders’ Dividends Accrued: EICN and ECIC write some workers’ compensation policies for which the policyholder may participate in favorable claims experience through a dividend. An estimated provision for workers’ compensation policyholders’ dividends is accrued as the related premiums are earned. Dividends are calculated and paid after policy expiration, usually within nine and 12 months after such expiration and must be approved by the Board of Directors. The liability is estimated based on the expected loss experience of the policies written with dividend provisions and policy terms. Policyholders’ dividends paid for the years ended December 31, 2007, 2006 and 2005, were $0.2 million, $0.8 million, and $1.4 million, respectively. Policyholder dividends are included in underwriting and other operating expense in the accompanying consolidated statements of income.
In the ordinary course of business and in accordance with general insurance industry practices, the Company purchases excess of loss reinsurance to protect the Company against the impact of large and/or catastrophic losses in its workers’ compensation business. Additionally, the Company is a party to a 100% quota share retroactive reinsurance agreement, (see Note 8). Such reinsurance reduces the financial impact of such losses on current operations and the equity of the Company. Reinsurance makes the assuming reinsurer liable to the ceding company to the extent of the reinsurance coverage provided. It does not, however, discharge the Company from its liability to its policyholders in the event the reinsurer is unable to meet its obligations under its reinsurance agreement with the Company.
The 100% quota share retroactive reinsurance agreement was entered into in 1999 by the Fund and assumed by EICN, which the Company refers to as the Loss Portfolio Transfer (LPT) Agreement (see Note 8). The Company is accounting for this transaction as retroactive reinsurance, whereby the initial deferred gain resulting from the retroactive reinsurance was recorded as a liability in the accompanying consolidated balance sheets as Deferred Reinsurance Gain-LPT Agreement and is being amortized using the recovery method, whereby the amortization is determined by the proportion of actual reinsurance recoveries to total estimated recoveries. The amortization of the deferred gain is recorded in losses and LAE incurred in the accompanying consolidated statements of income. Any adjustment to the estimated reserves ceded under the LPT agreement is recognized in earnings in the period of change with a corresponding change to reinsurance recoverables on unpaid losses and deferred reinsurance gain. A cumulative amortization adjustment is also then recognized in earnings so that the deferred reinsurance gain reflects the balance that would have existed had the revised reserves been available at the inception of the LPT Agreement.
Cash equivalents include investments in commercial paper of companies with high credit ratings, investments in money market securities and securities backed by the U.S. government. Investments are diversified throughout many industries and geographic regions. The Company limits the amount of credit exposure with any one financial institution and believes that no significant concentration of credit risk exists with respect to cash and investments.
to claimants or policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. The Company obtains collateral to mitigate the risks related to reinsurance insolvencies. At December 31, 2007, $1.2 million was collateralized by cash or letter of credit and an additional $838.3 million was in a trust account for reinsurance related to the LPT agreement.
Cash, premiums receivable, and accrued expenses and other liabilities: The carrying amounts for these financial instruments as reported in the accompanying consolidated balance sheets approximate their fair values.
Investments: The estimated fair values for available-for-sale securities generally represent quoted market value prices for securities traded in the public marketplace or estimated values for securities not traded in the public marketplace. Additional data with respect to fair values of the Company’s investment securities are disclosed in Note 4.
Investments in Debt and Equity Securities (SFAS No. 159). SFAS No. 159 permits an entity to choose to measure many financial instruments and certain items at fair value. The objective of this standard is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reporting earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS No. 159 permits all entities to choose to measure eligible items at fair value at specified election dates. Entities will report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option: (1) may be applied instrument by instrument, with a few exceptions, such as investments accounted for by the equity method; (2) is irrevocable (unless a new election date occurs); and (3) is applied only to entire instruments and not to portions of instruments. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007, which for the Company would be the fiscal year beginning January 1, 2008. Early adoption is permitted as of the beginning of the previous fiscal year provided that the entity makes that choice in the first 120 days of that fiscal year and also elects to apply FASB Statement No. 157, Fair Value Measurements. The Company did not make such an election. The Company adopted SFAS No. 159 on January 1, 2008, but elected not to measure any additional financial instruments at fair value, therefore it will not have a material impact on its consolidated financial statements or results of operations.
In addition, effective February 5, 2007, EHI completed its IPO in which it issued 30,762,500 shares of its common stock at a price of $17.00 per share. The cash proceeds of the IPO, after underwriting discounts and commission of $34.0 million and offering and conversion costs of $16.3 million, were $472.7 million, of which $9.7 million was retained by EHI and was used for working capital, payment of dividends on common stock, repurchase of shares of common stock and other general corporate purposes.
Upon completion of EHI’s IPO, the capitalized issuance costs related to the IPO of $5.4 million were netted against the IPO proceeds in additional paid-in capital in the accompanying consolidated balance sheets. The costs related to the conversion were $10.9 million, of which $0.9 million was incurred in the period from January 1, 2007 through February 5, 2007 and $10.0 million was incurred during the year ended December 31, 2006. Conversion expenses consisted primarily of printing and mailing costs and the aggregate cost of engaging independent accounting, actuarial, financial, investment banking, legal and other consultants. These costs have no tax benefit and were expensed as incurred and are included in the underwriting and other operating expense in the accompanying consolidated statements of income.
The following is a summary of investments with unrealized losses and their corresponding fair values at December 31, 2007 and 2006:
Based on a review of the investment in equities, at December 31, 2007 and 2006, the Company recognized an impairment of $1.2 million and $0.6 million in the fair values of thirteen and six securities, respectively, as a result of the severity and duration of the change in fair value of those securities. For its other equity securities, the Company determined that the unrealized losses were not considered to be other-than-temporary due to the financial condition and near term prospects of the issuers.
Net realized and unrealized investment gains (losses) on fixed maturity investments and equity securities were as follows:
The Company is required by various state laws and regulations to keep securities or letters of credit on deposit with the states in a depository account. At December 31, 2007 and 2006, securities having a fair market value of $516.0 million and $414.6 million respectively, were on deposit. Additionally, certain reinsurance contracts require Company funds to be held in trust for the benefit of the ceding reinsurer to secure the outstanding liabilities assumed by the Company. The fair market value of securities held in trust at December 31, 2007 and 2006, was $4.9 million and $5.6 million, respectively.
At December 31, 2007, the Company had no net operating loss carry forward.
The above table excludes the impact of the amortization of the deferred reinsurance gain-LPT Agreement and the reduction of the ceded reserves on the LPT Agreement (refer to Note 8), which are reflected in losses and LAE incurred in the consolidated statements of income.
The major sources of this favorable development include actual paid losses, which have been less than expected, and the impact of recalibration of selected patterns of claims emergence and claims payment used in the projection of future loss payments.
Loss reserves shown in the consolidated balance sheets are net of $10.9 million and $10.4 million for anticipated subrogation recoveries as of December 31, 2007 and 2006, respectively.
Recoverables from reinsurers on unpaid losses and LAE amounted to $1.1 billion at December 31, 2007 and 2006. At December 31, 2007 and 2006, approximately $1.0 billion of the recoverables related to the LPT Agreement entered into in 1999 by the Fund and assumed by EICN, whereby substantially all of the Fund’s losses and LAE on claims incurred prior to July 1, 1995, have been ceded to three unaffiliated reinsurers on a 100% quota share basis. Investments have been placed in trust by the three reinsurers as security for payment of the reinsured claims. Under the LPT Agreement, $1.5 billion in liabilities for the incurred but unpaid losses and LAE related to claims incurred prior to July 1, 1995, were reinsured for consideration of $775 million. The LPT Agreement provides coverage up to $2.0 billion. Through December 31, 2007, the Company has paid losses and LAE claims totaling $405.7 million related to the LPT Agreement.
Agreement and based on both actual results to date and projections of ultimate losses under the agreement, the Company recorded an increase of $2.5 million and $3.8 million for the 12 months ended December 31, 2007 and 2005, respectively, and a decrease of $0.2 million for 2006, in its estimate of the ultimate contingent profit commission. The increases (decreases) in the ultimate contingent profit commission are recorded in commission expense in the accompanying consolidated statements of income. Due to payments received under the terms of the LPT Agreement, the Company had a net payable balance of $3.8 million and $6.3 million as of December 31, 2007 and 2006, respectively, which is included in other liabilities on the accompanying consolidated balance sheets.
The Company leases facilities in nine states. At December 31, 2007, remaining lease terms ranged from one month to approximately six years and sublease terms ranged from three months to approximately five years. The minimum lease payments for the next five years and thereafter on these non-cancelable operating leases at December 31, 2007, were as follows:
On May 10, 2007, the Company’s Board of Directors authorized a stock repurchase program (the Program). The Program authorized the Company to use up to $75.0 million in assets for the discretionary repurchase of its common stock during the remainder of fiscal 2007. The Program was completed on
During the year ended December 31, 2007, EHI made ‘‘founders’ grants’’ to employees, excluding senior officers, in the form of 186,000 nonqualified stock options under the terms set forth in the Plan and the applicable grants. Full-time employees each received 300 options and part-time employees received 150 options. These options vest pro rata on each of the first three anniversaries of the effective date of EHI’s IPO. The options are subject to accelerated vesting in certain limited circumstances, such as: termination other than for cause, termination as a result of retirement, death or disability, and in connection with a change of control. The options expire seven years from the date of grant. The per share exercise price of these options is equal to the IPO price of $17.00 per common share.
The fair value of the stock options granted is estimated using a Black-Scholes option pricing model that uses the assumptions noted in the following table. Due to EHI’s limited public history, the expected stock price volatility was based on a weighted average of the Company’s historical stock price volatility since the initial public offering of its common stock and the historical volatility of peer companies’ stock for a period of time equal to the expected term of the option. EHI believes that the use of historical volatility of this peer group is currently the best estimate of expected volatility of the market price of EHI’s common stock. The expected term of the options granted is calculated using the ‘plain-vanilla’ calculation provided in the guidance of the SEC’s Staff Accounting Bulletin No. 107. The dividend yield was calculated using amounts authorized by the Board of Directors. The risk-free interest rate is the yield on the grant dates of the options of U.S. Treasury zero coupon securities with a maturity comparable to the expected term of the options.
Changes in outstanding stock options for the year ended December 31, 2007 were as follows:
The fair market value of options that vested in 2007 was $9.3 thousand and as of December 31, 2007, none of the outstanding options had any intrinsic value.
For the year ended December 31, 2007, stock-based compensation costs of $951.2 thousand were recognized as a component of other underwriting expenses. During the same period, related income tax benefits of $332.9 thousand were recognized as components of income taxes in the consolidated statement of income. At December 31, 2007, the Company had yet to recognize $2.4 million in deferred compensation related to nonqualified stock options grants and expects to recognize these costs on a straight-line basis over the next thirty-seven months. There were no stock-based compensation costs incurred during the years ended December 31, 2006 and 2005.
On August 8, 2007, officers of the Company were awarded, in aggregate, 140,311 performance share awards (PSAs) for the period ending December 31, 2009. These PSAs are subject to certain performance targets with payouts that range from 0% up to 150% of the target award. The fair market value of the PSAs on the date of grant was $2.6 million. For the year ended December 31, 2007, the Company recognized stock-based compensation costs of $568.6 thousand as a component of other underwriting expenses. During the same period, related income tax benefits of $199.0 thousand were recognized as a component of income taxes in the consolidated statement of income. At December 31, 2007, the Company had yet to recognize $2.1 million in deferred compensation related to the PSAs and expects to recognize these costs over the next two years.
As of December 31, 2007, EICN had positive unassigned surplus of $149.0 million. As a result of the approval of an extraordinary dividend of $200.0 million from special surplus by the Nevada Commissioner on December 18, 2007, dividends from unassigned surplus, otherwise deemed ordinary, will also require approval in 2008. An extraordinary dividend of $55.0 million was approved by the Nevada Commissioner
EICN has received approval from the Nevada Commissioner on December 18, 2007, to pay a $200.0 million extraordinary dividend from special surplus, subject to EICN providing the calculation of its risk based capital in support of such payments.
The California Insurance Holding Company System Regulatory Act limits the ability of ECIC to pay dividends to its parent, EICN. California law provides that, absent prior approval of the California Insurance Commissioner, dividends can only be declared from earned surplus. Earned surplus for purposes of this statute excludes amounts (1) derived from the net appreciation in the value of assets not yet realized, or (2) derived from an exchange of assets, unless the assets received are currently realizable in cash. In addition, California law provides that the appropriate insurance regulatory authorities in the state of California must approve (or, within a 30-day notice period, not disapprove) any dividend that, together with all other such dividends paid during the preceding 12 months, exceeds the greater of: (a) 10% of the paying company’s statutory earned surplus as regards policyholders at the preceding December 31; or (b) 100% of the net income for the preceding year. ECIC declared and paid a dividend to EICN of $61.0 million on December 14, 2007. Due to this dividend, a maximum pay-out of $49.2 million, without prior approval, will be available on or after December 15, 2008.
The California Department of Insurance (CDOI) (the domiciliary state of ECIC) has required that in addition to applying the NAIC’s statutory accounting practices, insurance companies must record, under certain circumstances, an additional liability, called an ‘‘excess statutory reserve.’’ If the workers’ compensation losses and loss adjustment expense ratio is less than 65% in each of the three most recent accident years, the difference is recorded as an excess statutory reserve. In October 2007, the California legislature passed SB 316 which repeals the minimum reserve requirement, in regards to workers’ compensation reserves, effective January 1, 2008. Based on SB 316, the Company did not record an excess statutory reserve as of December 31, 2007 in its 2007 Annual Statement, as filed with the CDOI in 2008. The excess statutory reserves previously required by the CDOI decreased ECIC’s statutory-basis surplus by $33.9 million to $314.1 million at December 31, 2006, as filed with the CDOI.
SFAS No. 128, Earnings per Share, provides for the calculation of ‘‘Basic’’ and ‘‘Diluted’’ earnings per share. Basic earnings per share includes no dilution and is computed by dividing income applicable to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the potential dilution of securities that could share in the earnings of equity. Diluted earnings per common share includes common shares assumed issued under the ‘‘treasury stock method,’’ which reflects the potential dilution that would occur if outstanding options were to be exercised.
The following table presents the net income and the weighted average shares outstanding used in the earnings per common share calculations for the stated period:
The earnings per common share-basic-for the period February 5, 2007 through December 31, 2007 was calculated using only the net income available to common stockholders for the period after the IPO, as shown on the consolidated statements of income, and the weighted average shares outstanding during the same period. Earnings per common share-diluted-is based on the actual weighted shares outstanding adjusted by the number of additional common shares that would have been outstanding had potentially dilutive common shares been issued and reduced by the number of common shares that could have been purchased from the proceeds of the potentially dilutive shares. The Company’s outstanding options have been excluded in computing the diluted earnings per share for the period February 5, 2007 through December 31, 2007 because their inclusion would be anti-dilutive.
The pro forma earnings per common share-basic and diluted-presented on the accompanying consolidated statements of income is intended to depict the impact of the conversion because neither EHI, nor its predecessor, EIG, had, prior to the conversion, any outstanding common shares. The following table presents the pro forma net income and weighted average shares outstanding used in the earnings per common share calculations for the following years:
The pro forma earnings per common share for the years ended December 31, 2006 and 2005 is calculated using only those shares available to eligible members in the conversion, or 50,000,002 shares, and does not include any shares issued to new investors in connection with EHI’s IPO. EIG had no common stock equivalents outstanding that would create a dilutive effect on the pro forma earnings per common share for the years ended December 31, 2006 and 2005.
Favorable prior accident year reserve development was recognized in each of the quarters of 2007 in the amount of $15.6 million, $20.4 million, $7.4 million, and $16.6 million, first quarter through fourth quarter, respectively.
The third and fourth quarters of 2006 include favorable prior accident year reserve development of $68.9 million and $25.4 million, respectively, compared to approximately $12.8 million in the first half of 2006 (see Note 7).
Earnings per common share of $0.40, for the first quarter of 2007, only includes earnings for the period after the Company’s Conversion and IPO (Note 3) or February 5, 2007 through March 31, 2007.
On January 10, 2008, the Company announced its intended acquisition of AmCOMP Incorporated. The Company believes this acquisition will provide significant opportunity to make progress in executing its strategic goals and achieving the vision of being a leader in the property and casualty insurance industry specializing in workers’ compensation. The transaction is valued at approximately $230 million, including the assumption of $37 million in debt. Under the terms of the Merger Agreement, which has been approved by the Boards of Directors of both companies, holders of AmCOMP’s approximately 15 million common shares will receive $12.50 in cash for each share of common stock. The Company expects to finance the purchase price through a combination of cash and issuance of debt. Completion of the transaction is subject to various conditions, including the receipt of required regulatory approvals and the approval by AmCOMP’s stockholders. The transaction is expected to be completed in the second quarter of 2008.
On February 21, 2008, the EHI Board of Directors authorized a stock repurchase program of up to $100 million of the Company’s shares of common stock through June 30, 2009. EHI expects the shares to be purchased from time to time at prevailing market prices in the open market. The repurchases may be commenced or suspended from time to time without prior notice. There can be no assurance that EHI will complete any repurchases of its common stock pursuant to the program. As of the date of this filing, the Company has not repurchased any shares of common stock.