The home office building is used by the workers’ compensation insurance and corporate/other segments. The regional office space in North Carolina, Indiana, Tennessee, Western Pennyslvania and Virginia is primarily used by the workers’ compensation insurance segment to provide underwriting, marketing, claims and risk management services to insureds in the respective geographic markets.
(2) The net income of the segregated portfolio cell reinsurance segment is recorded as a segregated portfolio dividend expense, which represents the dividend earned by the segregated portfolio dividend participants during the period.
(3) Total assets as of December 31, 2009, 2008, 2007 and 2006 include assets reclassified to discontinued operations totaling $115,207, $116,445, $155,319 and $151,835, respectively.
(4) Total liabilities as of December 31, 2009, 2008, 2007 and 2006 include liabilities reclassified to discontinued operations totaling $65,054, $77,048, $72,428 and $69,013, respectively.
Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations
entities within the consolidated group. The segregated portfolio cells recognize an expense for such items (included as part of its ceding commission) and a corresponding revenue item is recognized by the affiliate providing the service. For segment reporting purposes, such revenue items primarily include claims administration, risk management, and cell rental fees. Fronting fees are included in acquisition and other underwriting expenses as an offset to the direct costs incurred. For segment reporting purposes, such fees are recognized ratably over the period in which the service is provided, which generally corresponds to the earned portion of net premiums written for the underlying policies.
Income tax expense. EIHI and certain of its subsidiaries pay federal, state and local income taxes. Income tax expense includes an amount for both current and deferred income taxes. Current income tax expense includes an amount for the Company’s current year federal income tax liability and any adjustments related to differences between the prior year federal income tax estimate and the actual income tax expense reported in the federal income tax return. Deferred tax expense represents the change in the Company’s net deferred tax asset, exclusive of the tax effect related to changes in unrealized gains and losses in the Company’s investment portfolio and changes in the unrecognized amounts related to the Company’s benefit plan liabilities.
Expense ratio. The expense ratio is the ratio (expressed as a percentage) of the sum of the acquisition and other underwriting expenses, other expenses and amortization of intangibles to net premiums earned, and measures the Company’s operational efficiency in producing, underwriting and administering its insurance business.
The Company establishes reserves for unpaid losses and LAE for its workers’ compensation insurance and segregated portfolio cell reinsurance products, which are estimates of future payments of reported and unreported claims for losses and related expenses. The adequacy of the Company’s reserves for unpaid losses and LAE are inherently uncertain because the ultimate amount that the Company may pay under many of the claims incurred as of the balance sheet date will not be known for many years. Establishing reserves is an imprecise process, requiring the use of informed estimates and judgments. The Company’s estimates and judgments may be revised as additional experience and other data becomes available and are reviewed as new or improved methodologies are developed, or as current laws change. Any such revisions could result in future changes in estimates of losses or reinsurance recoverables and would be reflected in the Company’s results of operations in the period in which the estimates are changed. Estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates and judgments using data currently available. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded as of December 31, 2011, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.
compensation insurance book of business. Using standard actuarial methods, the Company estimates reserves based on historical patterns of case development, payment patterns, mix of business, premium rates charged, case reserving adequacy, operational changes, adjustment philosophy and severity and duration trends. However, the number of variables and judgments involved in establishing reserve estimates, combined with some random variation in loss development patterns, results in uncertainty regarding projected ultimate losses.
As of December 31, 2011, the Company’s best estimate of its ultimate liability for losses and LAE, net of amounts recoverable from reinsurers, for its workers’ compensation insurance segment was $72.1 million.
Although many factors influence the actual cost of claims and the corresponding reserves for unpaid losses and LAE estimates, we do not measure and estimate values for all of these variables individually. This is due to the fact that many of the factors that are known to impact the cost of claims cannot be measured directly. In most instances, we rely on historical experience and tail factors to estimate values for the variables that are explicitly used in the unpaid loss and LAE analysis. For the most recent accident year, we rely on selecting an expected loss ratio to estimate the reserves for unpaid losses and LAE. In addition to the examples above that represent reasonably likely changes in our tail factor, another example of
potential variability in our loss and LAE estimation process involves selecting an expected loss ratio for the most recent accident year. For example, if our expected loss ratio for the 2011 accident year were to increase by 5 percentage points, our reserves for unpaid losses and LAE as of December 31, 2011 would increase by $5.2 million, which would result in an after-tax reduction in our earnings of $3.4 million. Management believes that changes in the most recent year accident year loss ratio are reasonably likely due to variability in underwriting and rate changes. It is important to note that actual claims costs will vary from our estimate of ultimate claim costs, perhaps by substantial amounts, due to the inherent variability of the business written, the potentially significant claim settlement lags and the fact that not all events affecting future claim costs can be estimated.
In the event that our estimates of ultimate reserves for unpaid losses and LAE prove to be greater or less than the ultimate liability, our future earnings and financial position could be positively or negatively impacted. Future earnings would be reduced by the amount of any deficiencies in the year(s) in which the claims are paid or the reserves for unpaid losses and LAE are increased. For example, if we determined our reserves for unpaid losses and LAE, net of reinsurance, of $72.1 million as of December 31, 2011 to be 5% inadequate, this would result in an after-tax reduction in our earnings of approximately $2.3 million. This reduction could be realized in one year or multiple years, depending on when the deficiency is identified. The deficiency would also impact our financial position because our statutory surplus would be reduced by an amount equivalent to the reduction in net income. Any deficiency is typically recognized in the reserves for unpaid losses and LAE and, accordingly, it typically does not have a material effect on our liquidity because the claims have not been paid. Since the claims will typically be paid out over a multi-year period, we have generally been able to adjust our investments to match the anticipated future claim payments. Conversely, if our estimates of ultimate reserves for unpaid losses and LAE prove to be redundant, our future earnings and financial position would be improved.
The Company has utilized the following tail factors for the years ended December 31, 2011, 2010, and 2009:
Following is a sensitivity analysis of the Company’s workers’ compensation reserves to reasonably likely changes in the tail factors used to project actual current losses to ultimate losses (dollars in thousands):
The reporting and paid loss development patterns in the segregated portfolio cell reinsurance segment are also consistent with that of the workers’ compensation insurance segment. Accordingly, the tail factors used to project actual current losses to ultimate losses for claims covered in the Company’s segregated portfolio cell reinsurance segment require considerable judgment. The difference between total revenue for the segregated portfolio cell reinsurance segment for each period and the sum of losses and LAE, acquisition and other underwriting expenses, other expenses, and policyholder dividend expense is accrued as a segregated portfolio dividend expense. Accordingly, any change in the reserve for unpaid losses and LAE is recorded to the segregated portfolio dividend payable/receivable account and would only impact the Company’s net income or shareholders’ equity if the Company were a segregated portfolio cell dividend participant.
Unrealized investment gains or losses on investments carried at estimated fair value, net of applicable income taxes, are reflected directly in shareholders’ equity as a component of accumulated other comprehensive income (loss) and, accordingly, have no effect on net income. 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 at the balance sheet date. The amount written down is recorded as a realized loss in the consolidated statements of operations and comprehensive income (loss). Generally, the determination of other-than-temporary impairment includes, in addition to other relevant factors, a presumption that if the market value is below cost by a significant amount for a period of time, a write-down is necessary. Notwithstanding this presumption, the determination of other-than-temporary impairment requires judgment about future prospects for an investment and is therefore a matter of inherent uncertainty. For the years ended December 31, 2011, 2010 and 2009, the Company recorded other-than-temporary impairments, excluding impairments in the segregated portfolio cell reinsurance segment, of $0, $6,000 and $1.9 million, respectively. Other-than-temporary impairments in the segregated portfolio cell reinsurance segment totaled $78,000, $80,000 and $749,000 for the years ended December 31, 2011, 2010 and 2009, respectively. The Company generally applies the following standards in determining whether the decline in fair value of an investment is other-than-temporary:
As of December 31, 2011, the Company held equity securities, excluding equity securities in the segregated portfolio cell reinsurance segment, with gross unrealized losses of $374,000, none of which were in an unrealized loss position for more than twelve months. The Company does not intend to sell the equity securities and it is not more likely than not that the Company will be required to sell the equity securities before recovery of their cost bases; therefore, management does not consider the equity securities to be other-than-temporarily impaired as of December 31, 2011. Adverse investment market conditions, or poor operating results of underlying investments, could result in impairment charges in the future.
During 2011, the Company wrote off its interest in the real estate limited partnership. The write off totaled $49,000 and was a result of the limited partnership being liquidated without any benefit to the Company. There were no write-offs or impairments related to the Company’s limited partnership investments in 2010 or 2009.
In accordance with the requirements of ASC 350, Intangibles - Goodwill and Other, goodwill is not amortized but is tested for impairment at the reporting unit level, which is at the operating segment level or one level below an operating segment. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. Goodwill is required to be tested for impairment annually and between annual tests if events or circumstances change, such as adverse changes in the business climate, that would more likely than not reduce the fair value of the reporting unit below its carrying value.
The temporary differences between the tax and book bases of assets and liabilities are recorded as deferred income taxes. Management evaluates the recoverability of the net deferred tax asset based on historical trends of generating taxable income or losses, as well as expectations of future taxable income or loss. As of December 31, 2011, the Company recorded a net deferred tax asset of $1.8 million. Management expects that the net deferred tax asset is fully recoverable. If this assumption were to change, any amount of the net deferred tax asset that the Company could not expect to recover would be provided for as an allowance and would be reflected as an increase in income tax expense in the period in which it was established.
Amounts recoverable from Company’s reinsurers are estimated in a manner consistent with the reserves for unpaid losses and LAE associated with the reinsured policy. Amounts paid for reinsurance contracts are expensed over the contract period during which insured events are covered by the reinsurance contracts. Reinsurance balances recoverable on paid and unpaid loss and LAE are reported separately as assets, instead of being netted with the appropriate liabilities, because reinsurance does not relieve the Company of its legal liability to its policyholders. Reinsurance balances recoverable are subject to credit risk associated with the particular reinsurer. Additionally, the same uncertainties associated with estimating unpaid losses and LAE affect the estimates for the ceded portion of these liabilities. The Company continually monitors the financial condition of its reinsurers and where necessary obtains collateral. As of December 31, 2011, the Company had reinsurance recoverables of $15.7 million.
The major components of consolidated revenue were as follows for the years ended December 31, 2011 and 2010 (in thousands):
The growth in net premiums written reflects new business of $32.8 million, renewal rate increases of 2.5%, and a renewal retention rate of 88.6% in 2011. Net premiums written were increased by additional audit premium from customers of $2.6 million in 2011, compared to audit premium returned to customers of $1.4 million which reduced net premiums written in 2010. Additionally, the EBUB estimate resulted in additional premium revenue of $950,000 in 2011, compared to a decrease in premium revenue of $750,000 in 2010.
As noted previously, the decline in the Company’s limited partnership interests reflects a reduction in operating results in each of the partnerships. The decrease in net realized investment gains primarily reflects a decline in the estimated fair value of the Company’s convertible bond portfolio, which reported a loss of $1.1 million in 2011, compared to a gain of $1.2 million for the same period in 2010.
The decrease in other revenue from 2010 to 2011 primarily reflects the loss of a large third party administration customer in the first quarter of 2011.
The increase in direct premiums written reflects new business of $32.8 million, an increase in audit premium, renewal rate increases of 2.5%, and an increase in the renewal retention rate. Traditional and alternative market direct premiums written totaled $121.7 million and $34.0 million, respectively, for the year ended December 31, 2011. Audit premium, including the EBUB estimate, increased direct premiums written by $3.5 million in 2011, compared to a decrease of $2.2 million in 2010. The traditional book of business recognized audit premium from customers of $2.3 million in 2011, compared to audit premium returned to customers of $467,000 in 2010. The renewal retention rate increased from 87.0% in 2010 to 88.6% in 2011.
Net realized investment gains for the year ended December 31, 2011 include a decrease in the estimated fair value of the Company’s convertible bond portfolio of $1.1 million, compared to an increase of $1.2 million for the same period in 2010. Net realized investment gains in 2011 also include a gain of $959,000 related to the sale of an international equity fund that the Company had impaired prior to 2011.
Severity-related claims for the years ended December 31, 2011 and 2010 were as follows:
The effective tax rate was 33.2% and 31.0% for the years ended December 31, 2011 and 2010, respectively. The primary difference between the statutory tax rate of 35.0% and the effective tax rate reflects tax exempt income on municipal bond securities.
The following table represents the operations of the segregated portfolio cell reinsurance segment for the years ended December 31, 2011 and 2010 (in thousands):
Net realized investment gains for the year ended December 31, 2011 include other-than-temporary impairments of $78,000, compared to impairments of $80,000 in 2010. The 2010 net realized investment gains reflect sale activity during the year. There were no significant gains on the sale of individual securities.
The decrease in consolidated net income primarily reflects an increase in the loss ratio from 60.0% in 2009 to 71.1% in 2010, audit premiums returned to customers, and a decrease in net investment income. These items, which contributed to the decrease in the Company’s operating results, were partially offset by a decrease in other-than-temporary investment impairments and a decrease in the expense ratio from 35.5% in 2009 to 32.7% in 2010.
Net realized investment gains for the year ended December 31, 2010 include other-than-temporary impairments of $80,000 in 2010, compared to impairments of $749,000 in 2009. The 2010 net realized investment gains reflect sale activity during the year. There were no significant gains on the sale of individual securities.
The following table represents the operations of the corporate/other segment for the years ended December 31, 2010 and 2009 (in thousands):
The increase in expenses primarily reflects a decrease in the Company’s equity interest in the segregated portfolio cells, partially offset by a decrease in intangible asset amortization.
December 31, 2011 compared to December 31, 2010. Total assets were $345.7 million as of December 31, 2011, compared to $323.3 million as of December 31, 2010. The increase in assets primarily reflects the Company’s premium growth and results of operations in 2011. The increase in premiums receivable and deferred acquisition costs is primarily attributable to the increase in written premium in 2011. The increase in cash and cash equivalents primarily reflects the Company’s positive cash flow from operations, partially offset by the use of cash to repurchase common stock. The increase in the reinsurance recoverable primarily reflects an increase in the loss reserve for a prior year claim, which is covered under the Company’s reinsurance.
The Company has a $10.0 million revolving line of credit available to provide additional liquidity if needed. The line of credit matures on May 1, 2012 and may be renewed annually for additional periods expiring on May 1 at the lender’s discretion. Outstanding balances under the line of credit bear interest at an adjustable monthly rate equal to LIBOR plus 2.0% per annum. There were no outstanding balances under the line of credit as of December 31, 2011.
Our domestic insurance subsidiaries’ ability to pay dividends to EIHI is limited by the insurance laws and regulations of Pennsylvania and Indiana. The maximum annual dividends that the domestic insurance entities may pay without prior approval from the Pennsylvania Insurance Department and the Indiana Insurance Department is limited to the greater of 10%
of statutory surplus or 100% of statutory net income for the most recently filed annual statement. The maximum dividend that may be paid in 2012 by Eastern Alliance, Allied Eastern, Eastern Advantage, or Employers Security, without prior approval from the respective domiciliary insurance departments is $8.8 million, $910,000, $997,000, and $1.3 million, respectively.
Cash flows from operating activities consist primarily of cash receipts and disbursements related to premiums, investment income, claims and related adjustment expenses, operating expenses, policyholder dividends and income taxes. Cash flows from investing activities consist primarily of purchases and sales of investments and purchases of fixed assets. Cash flows from financing activities primarily consist of cash disbursements for repurchases of the Company’s common stock and shareholder dividends.
The decrease in cash provided by operating activities from 2009 to 2010 primarily reflects an increase in claims paid and a decrease in investment income, partially offset by an increase in net premiums written and tax refunds related to the carryback of capital losses to prior tax years.
The increase in cash flows used in financing activities primarily reflects an increase in common stock repurchases in 2010 and an increase in debt payments, partially offset by a decrease in shareholder dividends. During 2010, the Company paid its only outstanding loan in full. The decrease in shareholder dividends primarily reflects the reduction in outstanding common stock due to the common stock repurchases.
The loss reserves payments due by period in the table above are based upon the loss and LAE reserves estimates as of December 31, 2011 and actuarial estimates of expected payout patterns by line of business. As a result, our calculation of loss reserve payments due by period is subject to the same uncertainties associated with determining the level of reserves and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. For a discussion of our reserving process, see “Item 1 - Business, Loss and LAE Reserves.” Actual payments of loss and LAE by period will vary, perhaps materially, from the above table to the extent that current estimates of loss reserves vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns.
As of December 31, 2011, the Company has no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Certain amounts in the prior year consolidated financial statements have been reclassified to conform to the current year presentation. Policyholder dividends payable were reclassified from accounts payable and accrued expenses and disclosed separately on the consolidated balance sheets in 2011 and 2010. In addition, the Company increased cash and cash equivalents and accounts payable and accrued expenses by $618 as of December 31, 2010 to reflect premium deposits in transit.
The Company’s investments in convertible bond securities are considered hybrid financial instruments and are carried at estimated fair value, with changes in estimated fair value reported as a realized gain or loss in the consolidated statement of operations and comprehensive income (loss).
Other long-term investments consist of investments in limited partnerships. Investments in limited partnerships are reported in the consolidated financial statements using the equity method. The carrying value of the Company’s limited
partnership investments are based on the Company’s allocable share of the limited partnerships’ net asset value. Changes in the value of the Company’s proportionate share of its limited partnership investments are included in the change in equity interest in limited partnerships in the consolidated statements of operations and comprehensive income (loss). The Company reports changes in the value of its limited partnership investments on a month lag as a result of the timing of statements being received from the limited partnership.
Premiums, including estimates of additional premiums resulting from audits of insureds’ records, are generally recognized as written upon inception of the policy. Premiums written are primarily earned on a daily pro rata basis over the terms of the policies to which they relate. Accordingly, unearned premiums represent the portion of premiums written which is applicable to the unexpired portion of the policies in force. Workers’ compensation premiums are determined based upon the payroll of the insured, the applicable premium rates and, where applicable, an experience based modification factor. An audit of the policyholders’ records is conducted after policy expiration to make a final determination of applicable premiums. Included in net premiums earned is an estimate for earned but unbilled final audit premiums. The Company estimates earned but unbilled premiums by tracking, by policy, how much additional premium is billed in final audit invoices as a percentage of payroll exposure to estimate the probable additional amount that it has earned, but not yet billed, as of the balance sheet date. As of December 31, 2011 and 2010, the Company accrued earned but unbilled premiums of $1,551 and $601, respectively. Earned but unbilled premiums increased (decreased) net premiums earned by $950, $(750), and $(450) for the years ended December 31, 2011, 2010 and 2009, respectively.
Management believes that its reserves for unpaid losses and LAE is adequate as of December 31, 2011. However, estimating the ultimate liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates and judgments using data currently available. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded as of December 31, 2011, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.
In the ordinary course of business, the Company assumes and cedes reinsurance with other insurance companies. These arrangements provide greater diversification of business and minimize the net loss potential arising from large claims. Ceded reinsurance contracts do not relieve the Company of its obligation to its insureds. Premiums and claims under the Company’s reinsurance contracts are accounted for on a basis consistent with those used in accounting for the underlying policies reinsured and the terms of the reinsurance contracts. The Company has certain reinsurance contracts that provide for return premium based on the actual loss experience of the written and reinsured business. The Company estimates the amounts to be recorded for return premium based on the terms set forth in the reinsurance agreements and the expected loss experience.
Amortization of policy acquisition costs totaled $7,501, $6,487, and $5,908 for the years ended December 31, 2011, 2010 and 2009, respectively.
Deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured using enacted tax rates and laws that are expected to be in effect when the difference is reversed. A valuation allowance is recorded against gross deferred tax assets if it is more likely than not that all or some portion of the benefits related to the deferred tax assets will not be realized.
The Company issues certain workers’ compensation insurance policies with dividend payment features. These policyholders share in the operating results of their respective policies in the form of dividends. Dividends to policyholders are accrued during the period in which the related premiums are earned and are determined based on the terms of the individual policies.
Property and equipment, including expenditures for significant improvements and purchased software, is carried at cost less accumulated depreciation and amortization. Maintenance, repairs and minor improvements are expensed as incurred. When property and equipment is retired or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is included in operations. Depreciation is computed under the straight-line method. The estimated useful lives of property and equipment range from 3-7 years. Accumulated depreciation and amortization expense totaled $3,484 and $2,754 as of December 31, 2011 and 2010, respectively. Depreciation and amortization expense totaled $741, $691, and $658 for the years ended December 31, 2011, 2010 and 2009, respectively.
The Company evaluates the remaining useful life of its intangible assets with a finite life on a quarterly basis to determine whether events or circumstances warrant a revision to the remaining period of amortization. The Company evaluates its intangible assets with an indefinite life for impairment on at least an annual basis. There were no adjustments to the remaining amortization period or impairment charges related to the Company’s intangible assets during 2011, 2010, or 2009.
The Company records the repurchase of shares of its common stock using the cost method. Under the cost method, treasury stock is recorded based on the actual cost of the shares repurchased. The Company’s primary purposes for the repurchase of its common stock is capital management and to fund the issuance of common stock under the Stock Incentive Plan.
Purchases and sales or maturities of short-term investments are recorded net for purposes of the consolidated statements of cash flows and are included with fixed income securities.
The Company paid income taxes of $2,250, $455, and $3,175 for the years ended December 31, 2011, 2010 and 2009, respectively. Taxes paid for the year ended December 31, 2010 are net of refunds related to capital loss carrybacks to prior tax years totaling $1,795.
The Company paid interest of $0, $33, and $65 for the years ended December 31, 2011, 2010 and 2009, respectively.
In October 2010, the FASB issued ASU 2010-26, “Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts” (“ASU 2010-26”). ASU 2010-26 provides specific types of costs that should be capitalized in connection with the acquisition or renewal of insurance contracts. Those costs include incremental direct costs of contract acquisition incurred in connection with independent third parties and certain costs related to activities performed by the insurer for the contract, including underwriting, policy issuance and processing, medical and inspection, and sales force contract selling. Under ASU 2010-26, costs incurred by an entity related to unsuccessful acquisition or renewal efforts must be charged to expense as incurred. ASU 2010-26 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011 and is to be applied prospectively. Retrospective application to all prior periods upon the date of adoption is permitted, but not required. Early adoption is permitted but only at the beginning of an entity’s annual reporting period. The Company currently capitalizes and defers commissions and related expenses, premium taxes and certain underwriting personnel salaries. The Company will adopt ASU 2010-26 effective January 1, 2012 and apply it prospectively. Upon adoption, the Company will reduce the amount of acquisition costs capitalized related to certain underwriting personnel salaries to give effect to unsuccessful acquisition or renewal activities. If the Company had adopted ASU 2010-26 effective January 1, 2011, underwriting salaries capitalized and deferred would have been reduced by approximately $1,340, which would have decreased the Company’s net income by approximately $870.
During the third quarter of 2011, the Company filed its 2010 corporate federal income tax return. The Company’s tax liability related to Eastern Life’s operations for the period from January 1, 2010 to June 21, 2010 and the related sale of Eastern Life was less than the estimated tax liability recorded on the Company’s balance sheet as of December 31, 2010. As a result, the Company recorded a prior year tax return adjustment of $368, which was recorded as an income tax benefit in discontinued operations for the year ended December 31, 2011.
The sale of Atlantic RE resulted in the recognition of a loss totaling $14,029, which is included in discontinued operations. The loss includes the recognition of an estimated contingent profit commission of $3,018, which is based on the adequacy of the run-off specialty reinsurance segment’s reserves for losses and LAE as of September 30, 2010, compared to a predetermined targeted reserve for losses and LAE. The recognition of the contingent profit commission is considered a non-cash investing activity and has been excluded from the consolidated statement of cash flows for the year ended December 31, 2010. Transaction expenses related to the sale of Atlantic RE totaled $510 for the year ended December 31, 2010, and have been included in discontinued operations.
The Company’s business acquisitions resulted in the identification of certain intangible assets. The renewal rights and agency relationships will be amortized over their estimated useful lives of 15 years. The state insurance licenses are considered to have an infinite life and will not be amortized.
Amortization expense totaled $1,026, $1,284 and $1,732 for the years ended December 31, 2011, 2010 and 2009, respectively.
Consolidated net income (loss), basic shares outstanding, diluted shares outstanding, basic earnings per share, diluted earnings per share and cash dividends per share for the years ended December 31, 2011, 2010 and 2009 were as follows (in thousands, except share and per share data):
As of December 31, 2011, the Company has repurchased 3,850,568 shares of its common stock and can repurchase up to an additional 1,086,567 shares, as authorized by the Company’s Board of Directors. The share repurchases will be held as treasury stock and are available for issuance in connection with the Company’s Stock Incentive Plan.
market value on the date of grant. During 2011, the Company granted 3,000 stock options and 1,500 restricted stock awards to employees. During 2010, the Company granted 208,000 stock options and 1,500 restricted stock awards to employees. There were no stock options or restricted stock awards granted in 2009. During 2011, 2010, and 2009, stock options totaling 11,046, 8,522, and 12,780, respectively, were forfeited. No stock options or restricted stock awards were exercised in 2011, 2010, or 2009.
Total stock-based compensation expense recognized in the consolidated statement of operations and comprehensive income for the years ended December 31, 2011, 2010 and 2009 is shown in the following table (in thousands):
The fair values of stock options granted in 2011 were determined on the dates of grant using a lattice-based binomial option valuation model with the following assumptions:
The following table summarizes restricted stock activity for the year ended December 31, 2011.
Risk-based capital is designed to measure the acceptable amount of capital an insurer should have based on the inherent risks of the insurer’s business. Insurers failing to meet adequate capital levels may be subject to insurance department scrutiny and ultimately rehabilitation or liquidation. Based on established standards, Eastern Alliance, Allied Eastern, Eastern Advantage, and Employers Security maintained statutory-basis surplus in excess of minimum prescribed risk-based capital requirements as of December 31, 2011.
Under Cayman Islands regulations, Eastern Re is required to maintain minimum capital of $120. Eastern Re is in compliance with the minimum capital requirements as of December 31 2011.
The Company’s equity securities consist primarily of mutual fund instruments for which there is an active market and quoted market prices; therefore, the Company has classified its mutual fund investments as Level 1 securities. As of December 31, 2010, the Company held an investment in an international equity fund that was not traded on an active
Other long-term investments include the Company’s interest in various limited partnerships, including a low volatility multi-strategy fund of funds, a natural resource limited partnership, a structured finance opportunity fund, an open-ended investment fund and a real estate limited partnership. The Company records its investment in the limited partnerships using the equity method. The carrying value of the Company’s limited partnership investments are based on the Company’s allocable share of the limited partnerships’ net asset value. Changes in the Company’s investments are based on statements received directly from the limited partnership and/or the limited partnership’s administrator. The estimated fair values of the underlying investments in the limited partnerships may be based on Level 1, Level 2, or Level 3 inputs, or a combination thereof.
Real estate partnership-The partnership was formed for the purpose of acquiring, rehabilitating, operating, leasing, and managing an apartment complex in Lancaster, Pennsylvania. The apartments are primarily marketed to low income individuals.
The following tables provide the amortized cost and estimated fair value of the Company’s fixed income and equity securities as of December 31, 2011 and 2010 (in thousands):
Corporate securities include an investment in a fixed income mutual fund, held by the segregated portfolio cell reinsurance segment, with a cost and estimated fair value of $23,991 and $23,989, respectively, as of December 31, 2011. The fixed income mutual fund’s investment objective is to provide a total return that is consistent with the preservation of capital through investing in high grade U.S. Dollar fixed income securities with a maximum maturity not exceeding five years.
Certain insurance departments in the states in which the Company is licensed to do business require a deposit to protect the Company’s policyholders should the Company become insolvent. In order to satisfy these requirements, the Company had fixed income securities with an estimated fair value of $12,023 and $11,442 on deposit with various insurance departments as of December 31, 2011 and 2010, respectively.
As of December 31, 2011, the Company held 6 equity securities with gross unrealized losses totaling $374. These securities have been in an unrealized loss position for less than twelve months. The Company does not intend to sell the equity securities and it is not more likely than not that the Company will be required to sell the equity securities before recovery of their cost bases; therefore, management does not consider the equity securities to be other-than-temporarily impaired as of December 31, 2011.
Proceeds from the sale of fixed income securities totaled $57,131, $42,218, and $36,511 for the years ended December 31, 2011, 2010 and 2009, respectively. Proceeds from the sale of equity securities totaled $12,666, $8,293, and $6,346 for the years ended December 31, 2011, 2010, and 2009, respectively. Proceeds from the sale of other long-term investments totaled $1,231, $0, and $461 for the years ended December 31, 2011, 2010, and 2009, respectively.
For the years ended December 31, 2011 and 2010, the Company did not recognize any development on prior accident period workers’ compensation insurance reserves.
For the year ended December 31, 2009, the Company recognized net favorable development on prior accident year workers’ compensation insurance reserves of $3.7 million, representing 6.7% of the Company’s estimated workers’ compensation insurance reserves as of December 31, 2008 and 5.1% of the Company’s workers’ compensation insurance net premiums earned for the year ended December 31, 2009. The favorable development arose primarily from accident years 2006 and 2007, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting included greater availability and use of employers’ return to work programs. Furthermore, the Company was able to settle a large amount of Pennsylvania claims via compromise and release, which is a lump sum cash payment in exchange for a full and final claim settlement. Management attributes the large amount of compromise and release claim closures to the difficult economic conditions and the claimants’ choosing a lump sum cash settlement over the continuation of a workers’ compensation annuity payment.
The Company estimates and records reserves for its segregated portfolio cell reinsurance segment in the same manner as for its workers’ compensation insurance segment. Furthermore, the Company’s underwriting, claim administration and risk management services are consistent between its workers’ compensation insurance and segregated portfolio cell reinsurance
For the year ended December 31, 2009, the Company recognized net favorable development on prior accident year segregated portfolio cell reinsurance reserves of $2.8 million, representing 12.5% of the Company’s estimated segregated portfolio cell reinsurance reserves as of December 31, 2008 and 11.1% of the Company’s segregated portfolio cell reinsurance net premiums earned for the year ended December 31, 2009. The favorable development arose primarily from accident years 2006 and 2008, but was generally prevalent in most prior accident years, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting include greater availability and use of employers’ return to work programs.
The following table provides a summary of the Company’s losses and loss adjustment expenses incurred on a direct, assumed, ceded and net basis for the years ended December 31, 2011, 2010, and 2009 (in thousands):
As of December 31, 2011, the net deferred tax asset of $1,768 has not been reduced by a valuation allowance because management believes that, while it is not assured, it is more likely than not that the Company will generate sufficient future taxable income to utilize these net future tax deductions. The amount of the net deferred tax asset considered realizable, however, could be materially reduced in the near term if estimates of future taxable income in the years in which the differences are expected to reverse are decreased.
As of December 31, 2011, the Company has not recognized any future tax benefit related to its foreign operations at Eastern Re. The unrecognized tax benefit, which represents the excess of the tax basis over the amount for financial reporting (i.e., outside basis difference) of Eastern Re, was $11,367 as of December 31, 2011. The outside basis difference primarily
The net periodic benefit cost incurred by the Company for the years ended December 31, 2011, 2010 and 2009 totaled $60, $17, and $68 for the pension plan and $(22), $(7), and $(5) for the postretirement plan. In July 2011, the Company purchased annuities for plan participants that were receiving benefit payments under the pension plan, which resulted in a reduction of the projected benefit obligation of $1,083 and the recognition of a settlement loss of $134.
The assumptions used in the measurement of the Company’s net periodic benefit cost for the pension plan and the postretirement plan are shown in the following table:
Benefits paid totaled $106, $117, and $39 for the pension plan and $1, $2, and $1 for the postretirement plan for the years ended December 31, 2011, 2010, and 2009, respectively. The estimated future benefits to be paid over the next ten years related to the pension plan are as follows (in thousands):
The pension plan’s assets were comprised of the following at December 31, 2011 and 2010 (in thousands):
The pension plan’s fixed income securities consist of pooled separate accounts that are valued at the net participation value of participation units held by the pension plan. The value of the participation units is determined by the trustee based on the estimated fair values of the underlying assets of the pooled separate account; therefore, the estimated fair value of the pooled separate accounts is considered a Level 2 fair value measurement. As of December 31, 2010, the pension plan’s equity securities consisted of a small-cap index mutual fund. The mutual fund’s estimated fair value was based on a quoted net asset value; therefore, the estimated fair value was considered a Level 1 fair value measurement.
As a result of the pension plan’s frozen status, the primary investment objective of the pension plan is to achieve a rate of return commensurate with the safety of principal. During 2011, the Company liquidated its investment in the small-cap index mutual fund in order to reduce market volatility in the pension plan’s investment portfolio. The pension plan’s targeted asset allocation is 100% fixed income securities and/or cash equivalents.
On September 6, 2011, the Company served a written demand (the “Arbitration Demand”) initiating arbitration proceedings against various AIG Companies under 24 reinsurance treaties pursuant to which the Company reinsured AIG Companies for certain pollution liability risks related to underground storage tanks for the policy years 1990 through 1999 (the “Treaties”). The Treaties were cancelled by the Eastern Re in 1999. In the Arbitration Demand, the Company seeks an award from the arbitration panel compelling AIG Companies to permit the Company to audit the books and records of AIG Companies relevant to the Treaties, among other reasons, to enable the Company to examine the bases for certain paid losses and loss reserves ceded by AIG Companies to Eastern Re under the Treaties. The Company believes that the Treaties permit such an audit (and the Company’s prior requests have been denied by AIG Companies).
Rent expense totaled $1,214, $918, and $1,084 for the years ended December 31, 2011, 2010 and 2009, respectively.
Management performed an evaluation of subsequent events and determined there were no recognized or unrecognized subsequent events that would require an adjustment and/or additional disclosure in the consolidated financial statements as of December 31, 2011.
20. Quarterly Financial Data (Unaudited, in thousands, except per share data)