The Company’s corporate headquarters are located at 25 Race Avenue in Lancaster, Pennsylvania. The Company leases approximately 48,841 square feet of office space at this location under a 15-year lease entered into in February 2002. Monthly lease payments are subject to an annual increase based upon the consumer price index for the first five years and are subject to negotiation thereafter based on market conditions. The Company has a 5% interest in the limited partnership that owns the building.
Segregated Portfolio Cell Reinsurance. Workers’ compensation insurance business that is assumed by the segregated portfolio cells of Eastern Re is underwritten by EAIG through its alternative markets business unit and ceded 100% to the respective segregated portfolio cell. Market conditions and trends are substantially the same as those noted in the workers’ compensation insurance segment above.
Group Benefits Insurance. The group benefits insurance market is highly competitive. The Company has experienced significant price competition from other carriers, which can be attributed to a number of factors including, but not limited to, new carriers which enter markets with lower prices to gain market share and financially larger carriers that are able to compete on price. In addition to price, the group benefits insurance market is highly competitive with respect to new products and/or new features for existing products. The competitiveness of the marketplace has a significant impact on the Company’s ability to generate new sales as well as retain existing business. The Company continuously monitors its key markets with respect to price and products through active discussions with its independent producers. In addition, the Company enhanced its renewal process by proactively working with its independent producers to retain business which management considers to be favorable.
Net investment income and realized gains and losses on investments. The Company invests its surplus and the funds supporting its insurance liabilities (including unearned premiums and unpaid losses and loss adjustment expenses) in cash, cash equivalents, fixed income securities, equity securities, and other long-term investments. Investment income includes interest earned on invested assets. Realized gains and losses on invested assets are reported separately from net investment income. The Company recognizes realized gains when invested assets are sold for an amount greater than their cost or amortized cost (in the case of fixed income securities) and recognizes realized losses when investment securities are written down as a result of an other than temporary impairment or sold for an amount less than their cost or amortized cost.
Other revenue. Other revenue includes claim administration and risk management fees earned by Employers Alliance and cell rental fees earned by the specialty reinsurance segment. There are other revenue items that the Company recognizes on a segmental basis that are eliminated in consolidation. Such items consist primarily of fees paid by the segregated portfolio cells to other 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 fronting fees paid by the segregated portfolio cells to EAIG, claims administration and risk management fees paid by the segregated portfolio cells to Employers Alliance and cell rental fees paid by the segregated portfolio cells to Eastern Re. 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.
Acquisition and other underwriting expenses. In the workers’ compensation and group benefits insurance segments, expenses incurred to underwrite risks are referred to as acquisition and other underwriting expenses, which consist of commission expenses, premium taxes and fees and other underwriting expenses incurred in acquiring, writing and administering the Company’s business as well as required payments to the Pennsylvania Workers’ Compensation Security Fund (the “Security Fund”). The Security Fund assesses workers’ compensation insurers doing business in Pennsylvania for the purpose of providing funds to cover obligations to policyholders of insolvent insurance companies. In the specialty reinsurance and segregated portfolio cell reinsurance segments, acquisition and other underwriting expenses consist of ceding commissions earned under the respective reinsurance agreements. Ceding commissions received by EAIG are netted against other underwriting expenses.
The Company evaluates its insurance operations by monitoring certain key measures of growth and profitability. The Company measures growth by monitoring changes in direct premiums written and net premiums written. The Company measures underwriting profitability by examining loss, expense and combined ratios. On a segmental basis, the Company measures a segment’s operating results by examining net income and return on average equity.
on-going basis based on historical developments, market conditions, industry trends and other information that is believed to be reasonable under the circumstances. There can be no assurance that actual results will conform to the estimates and assumptions and that reported results of operations will not be materially adversely affected by the need to make accounting adjustments to reflect changes in these estimates and assumptions from time to time. The Company believes the following policies are the most sensitive to estimates and judgments.
The Company establishes reserves for unpaid losses and LAE for its workers’ compensation, segregated portfolio cell reinsurance, group benefits insurance, and specialty 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 continues to be a complex and 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 ultimate losses, net of reinsurance, prove to be substantially higher than the amounts recorded as of December 31, 2006, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.
The Company’s reserves for unpaid losses and LAE in its workers’ compensation insurance segment as of December 31, 2006 are summarized below (in thousands):
In its workers’ compensation segment, the Company records reserves for estimated losses under insurance policies and for loss adjustment expenses related to the investigation and settlement of policy claims. The Company’s reserves for unpaid losses and LAE represent the estimated cost of reported and unreported losses and LAE incurred and unpaid at a given point in time. In establishing its workers’ compensation
reserves, the Company uses loss discounting, which involves recognizing the time value of money and offsetting estimates of future payments by future expected investment income. For claims reported in the workers’ compensation insurance and segregated portfolio cell reinsurance segments, claims are administered by Employers Alliance.
The third component of the Company’s reserves for unpaid losses and LAE is unallocated loss adjustment expense, or ULAE. The Company’s ULAE reserve is established for the costs of future unallocated loss adjustment expenses for known and unknown claims. The Company’s ULAE reserve covers primarily the estimated cost of administering claims.
In estimating case incurred development and IBNR reserves, the Company performs most of its detailed analysis on a net of reinsurance basis, and then considers expected recoveries in arriving at its recorded amounts for unpaid losses and LAE. To estimate such reserves, the Company relies primarily on the analysis of claims in its 10-year workers’ compensation insurance history. 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 a result, the Company’s ultimate liability for losses and LAE may be more or less than its reserve estimate.
In estimating ULAE reserves, the Company reviews past adjustment expenses in relation to paid claims and estimated future costs based on expected claims activity and duration. The sum of the Company’s net loss and ALAE reserve, and ULAE reserves is its total net reserve for unpaid losses and LAE.
The estimates above rely on substantial judgment. There is inherent uncertainty in estimating reserves for unpaid losses and LAE. It is possible that the actual losses and loss adjustment expenses incurred may vary significantly from the Company’s estimates.
The Company utilizes a number of methodologies, explained below, to estimate its reserves for unpaid losses in its group benefits insurance segment. These methods include the lag factor development, loss ratio, and tabular reserve methods.
Lag Factor Development Method. The lag factor development method is used to estimate the reserve for insurance products that are “short-tail” by nature, in which claims related to the products are settled shortly after they are reported by the insured. The method uses historical paid claims data to estimate the reserve for claims in the course of settlement (reported claims) and IBNR claims. The method involves the use of a claim model, or a loss triangle, in which paid claims data is aggregated into categories based on the dates on which the claims in question were incurred and paid. Data in the loss triangle is reviewed to evaluate historical claim payment patterns. A point estimate is then determined based on the historical claim payment patterns.
Loss Ratio Method. The loss ratio method involves the use of historical loss ratios to estimate the reserve for unpaid claims and claims payable. Under the loss ratio method, the reserve is determined by multiplying the selected loss ratio, which is based on historical loss ratio trends, by the amount of net earned premium or the in-force premium at the valuation date.
The short-term disability reserves represent the Company’s estimate of future amounts due on in-process and IBNR short-term disability claims. The short-term disability reserve is determined using the lag factor development method, which results in the calculation of a point estimate. The inherent limitation of the lag factor development method is that the more recent incurral periods are relatively immature and the historical claim payment patterns may not be representative of the most recent claim experience. The Company takes this into consideration in its reserving process; therefore, the recorded short-term disability reserve represents the point estimate plus an amount for adverse development, equal to 10% of the point estimate. For the most recent incurral months, which usually consist of the last three months, the reserve is estimated by applying a loss ratio to the respective months’ net premiums earned. The most significant assumptions used in estimating the short-term disability reserve include the selection of claim completion factors and ultimate loss ratios. Completion factors are selected based on the average for the past twelve months and are applied to all periods prior to the most recent three months. An ultimate loss ratio is applied to the most recent three months based on recent trends. Due to the small size of the Company’s short-term disability block of business, the ultimate loss ratios on a monthly basis can be quite volatile. The Company evaluated the impact to its recorded short-term disability reserves by adjusting the loss ratios for the most recent three months by 100, 200 and 300 basis points above and below the selected loss ratios. The results of this analysis are shown in the table below (dollars in thousands):
The long-term disability tabular reserve represents the Company’s estimate of future amounts due on reported long-term disability claims. The Company establishes a reserve at the time a long-term disability claim is reported using the 1987 Commissioners Group Disability Table. Due to the long-term nature of long-term disability claims, management discounts the liability using an interest rate that reflects the estimated investment return in the Company’s group benefits insurance segment that will be earned over the expected life of the claim. In establishing the discount rate, the Company’s management evaluates the current interest rate environment at the end of each year and, if necessary, adjusts the interest rate for the following year based on the expected rate of return on new investments. The discount rates for claims incurred in 2006, 2005 and 2004 were 4.75%, 4.25%, and 3.09%, respectively. A lower discount rate results in a higher claim reserve and an increase in losses and loss adjustment expenses, whereas a higher discount rate results in a lower claim reserve and a decrease in losses and loss adjustment expenses. The reserve established represents the present value of expected future claim payments based on the terms of the underlying long-term disability insurance contract. With the exception of the discount rate, the assumptions that impact the reserve amount, such as recovery, morbidity and mortality rates, are embedded in the table. The long-term disability IBNR reserve is estimated on a policy-by-policy basis, taking into consideration the average monthly premium, the policy elimination period, and an expected loss ratio.
The impact to the long-term disability tabular reserve, net income and shareholders’ equity due to an increase or decrease in the discount rate of 10 basis points, 25 basis points, and 50 basis points is shown below (dollars in thousands):
Life premium waiver reserves represent the present value of future life insurance benefits under those term life policies for which the premiums have been waived due to the insured’s disability. The Company establishes a reserve at the time the insured’s disability is reported using the 1970 Intercompany Group Life Disability Table. Life premium waiver reserves are calculated using the tabular reserve method. Due to the long-term nature of premium waiver claims, the reserve is discounted using a rate of 3%, which is built into the standard valuation table. The assumptions that impact the reserve amount, including the discount rate, are embedded in the table.
The term life premium waiver IBNR reserve represents the Company’s estimate of unreported premium waiver claims. The Company utilizes the lag factor development method to estimate the number of unreported premium waiver claims and then applies the number of estimated outstanding claims to an average reserve amount, resulting in the development of a point estimate. The most significant assumptions used in estimating the premium waiver IBNR reserve are the completion factors and the estimated average reserve amount. As of December 31, 2006, the selected completion factors were based on a combination of the 3- and 5-year averages and the average reserve amount was based on the last three years’ reported premium waiver claims.
The following table presents the impact to the premium waiver IBNR reserve, net income, and shareholders’ equity of a change in the selected completion factor and average reserve assumptions:
The Company analyzes its ultimate losses and loss adjustment expenses for specialty reinsurance after consideration of the loss experience on each treaty for each underwriting year on a quarterly basis. The
methodologies that the Company employs include, but may not be limited to, paid loss development methods and incurred loss development methods similar to those described in the workers’ compensation insurance and segregated portfolio cell reinsurance segments above.
The Company relies on information provided by ceding companies regarding premiums and reported claims, and then uses that data as a key input to estimate unpaid losses and loss adjustment expenses. Since the Company relies on claims information reported by ceding companies, the estimation of unpaid losses and loss adjustment expenses for specialty reinsurance includes certain risks and uncertainties that do not exist with its other segments, and include, but are not necessarily limited to, the following:
As of December 31, 2006, the Company’s best estimate of its ultimate liability for unpaid losses and loss adjustment expenses, before purchase accounting adjustments, for its specialty reinsurance segment was $19.5 million. This amount was determined based on methods which were viewed to be better predictors than other methods.
While management believes that the assumptions underlying the amounts recorded for the reserves for unpaid losses and LAE as of December 31, 2006 are reasonable, the ultimate net liability may differ materially from the amount period.
Certain direct policy acquisition costs consisting of commissions, premium taxes, fronting fees and certain other direct underwriting costs are deferred and amortized as the underlying policy premiums are earned. As of December 31, 2006, deferred policy acquisition costs and the related unearned premium reserves in the Company’s workers’ compensation insurance, segregated portfolio cell reinsurance, and specialty reinsurance segments were as follows (in thousands):
In February 2006, the FASB issued SFAS 155, “Accounting for Certain Hybrid Financial Instruments, an amendment of FASB Statements No. 133 and 140”. SFAS 155 amends the accounting requirements for certain financial instruments covered by FASB Statements No. 133 and 140, including financial instruments containing embedded derivatives. SFAS 155 amends FASB Statement No. 133 by permitting fair value remeasurement of any hybrid financial instrument that contains an embedded derivative. Under current accounting guidance contained in FASB Statement No. 133, embedded derivatives must be bifurcated from their host contract and accounted for separately. SFAS 155 is effective for all financial instruments acquired, issued or subject to a remeasurement event occurring after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The fair value election for hybrid financial instruments may also be applied upon adoption of SFAS 155 to those hybrid financial instruments held by an entity and bifurcated under FASB Statement No. 133 prior to the adoption of SFAS 155. Any difference between the total carrying amount of the individual components of an existing bifurcated hybrid financial instrument and the fair value of the combined hybrid financial instrument must be recognized as a cumulative effect adjustment to beginning retained earnings. Restatement of prior periods is prohibited. The Company currently holds convertible debt securities that require bifurcation under FASB Statement No. 133. The Company expects that the adoption of SFAS 155 will not have a material effect on its consolidated financial condition or results of operations.
The increase in consolidated revenue reflects the acquisition of EHC on June 16, 2006. The increase in net investment income reflects the increase in cash and investments, which increased from $82.2 million at December 31, 2005 to $288.3 million at December 31, 2006, as a result of the initial public offering and the acquisition of EHC. Other revenue for the year ended December 31, 2006 represents fees from the Company’s third party administration operations and cell rental fees from the Company’s specialty reinsurance segment for the period from June 17, 2006 to December 31, 2006. Other revenue for the year ended December 31, 2005 represents sales and marketing fees earned by ELH’s former general agency operations segment.
The components of consolidated net income, by segment, for the year ended December 31, 2006 and 2005 were as follows (in thousands):
Net premiums written for the period from June 17, 2006 to December 31, 2006 were $22.1 million. Net premiums written include traditional production, net of external reinsurance, because alternative markets business is ceded 100% to the segregated portfolio cell reinsurance segment.
For the period from June 17, 2006 to December 31, 2006, tax expense totaled $2.6 million. The effective tax rate for the period from June 17, 2006 to December 31, 2006 was 32.5%. The primary difference between the statutory tax rate of 35.0% and the effective tax rate relates to tax exempt income recorded for the period from June 17, 2006 to December 31, 2006.
Summarized financial results of the segregated portfolio cell reinsurance segment are as follows for the period from June 17, 2006 to December 31, 2006 (in thousands):
Reinsurance premiums assumed were $6.9 million for the period from June 17, 2006 to December 31, 2006. Reinsurance premiums assumed include the impact of 2006 renewal rate decreases of 3.8%, a premium renewal retention rate of 85.0% and a reduction for purchase accounting adjustments of $2.4 million. Audit premiums of $312,000 were also included in reinsurance premiums assumed for the period from June 17, 2006 to December 31, 2006.
Net premiums written for the period from June 17, 2006 to December 31, 2006 were $6.2 million and include an increase of $1.0 million related to purchase accounting adjustments.
The Company’s segregated portfolio cell ratios were as follows for the period from June 17, 2006 to December 31, 2006:
Loss and loss adjustment expenses were $6.0 million for the period from June 17, 2006 to December 31, 2006. The calendar period loss and loss adjustment expense ratio was 49.9% in 2006, including 4.6 points related to purchase accounting adjustments recorded to net premiums earned and loss and loss adjustment expenses.
The following table represents the operations of the group benefits insurance segment for the years ended December 31, 2006 and 2005 (in thousands):
The increase in net income primarily reflects the decrease in the loss ratio and an increase in net realized investment gains, offset by the decrease in net premiums earned and an increase in other expenses. The improvement in the loss ratio primarily reflects better experience in the dental, long-term disability and term life lines of business. Net realized investment gains included proceeds of $716,000 from the sale of common stock previously written down to $0 and the change in the fair value of equity call options during 2006. The decrease in net premiums earned reflects the decline in new business sales and the decline in renewal retention during the first six months of 2006. During the fourth quarter of 2005, ELH recognized an after-tax gain of $967,000 related to its postretirement medical and life insurance benefits plan, which reduced other expenses in that period.
Net premiums earned, by line of business, for the years ended December 31, 2006 and 2005 were as follows (in thousands):
The decrease in the term life loss ratio reflects favorable development on the prior year death benefit IBNR reserve, a 54.1% decrease in premium waiver claim frequency and favorable reserve development related to the termination of prior year premium waiver claims. The favorable development on the prior year death benefit IBNR reserve reflects lower than expected reported death benefit claims. For the year ended December 31, 2006, there were only 16 reported premium waiver claims, with total reserves of $394,000, compared to 38 reported premium waiver claims, with total reserves of $852,000, for the same period in 2005. Terminated premium waiver claim reserves totaled $552,000 for the year ended December 31, 2006, compared to terminated reserves of $264,000 for the same period in 2005.
Summarized financial results of the specialty reinsurance segment are as follows for the period from June 17, 2006 to December 31, 2006 (in thousands):
The Company’s specialty reinsurance ratios were as follows for the period from June 17, 2006 to December 31, 2006:
Loss and loss adjustment expenses were $6.3 million for the period from June 17, 2006 to December 31, 2006. The calendar period loss and loss adjustment expense ratio was 114.1% in 2006, including 37.1 points related to purchase accounting adjustments recorded to net premiums earned and loss and loss adjustment expenses. The loss ratio included an increase in claims reported from the ceding company, which resulted in an increase in the 2006 accident year loss ratio and unfavorable loss reserve development on prior accident years of $894,000 or 16.2 percentage loss ratio points. The accident year loss ratio increased to 54.2% during the period from June 17, 2006 to December 31, 2006 resulting in the recording of additional loss and loss adjustment expenses of $977,000 or 17.7 percentage loss ratio points for the period from June 17, 2006 to December 31, 2006.
YEAR ENDED DECEMBER 31, 2005 COMPARED TO YEAR ENDED DECEMBER 31, 2004
The major components of consolidated revenue were as follows for the years ended December 31, 2005 and 2004 (in thousands):
The decrease in consolidated revenue primarily reflects a reduction in net premiums earned totaling $355,000 and a reduction in net realized investment gains totaling $826,000. Net premiums earned in 2004 includes the release of a reinsurance premium payable totaling $284,000 under ELH’s group medical reinsurance agreement that never materialized. The decrease in net realized investment gains primarily reflects changes in the estimated fair value of the equity call option component of ELH’s convertible bond portfolio, from a gain in 2004 totaling $217,000 to a loss in 2005 totaling $367,000. In addition, an other than temporary impairment charge totaling $104,000 was recognized in 2005. There were no impairments in 2004.
The components of consolidated net income, by segment, for the years ended December 31, 2005 and 2004 were as follows (in thousands):
The following table represents the operations of the group benefits insurance segment for the years ended December 31, 2005 and 2004 (in thousands):
The increase in net income primarily reflects a decrease in losses and loss adjustment expenses and the net after-tax reduction in the pension and postretirement liabilities, partially offset by a decrease in net realized investment gains.
The decrease in net premiums earned primarily reflects higher ceded premiums related to the Company’s long-term disability reinsurance arrangement effective July 1, 2005 and an increase in the lapse rate from 2004 to 2005. Net premiums earned in the dental line of business decreased $716,000, or 2.9%, from $24.3 million in 2004 to $23.6 million in 2005, primarily reflecting a 7.2% increase in the lapse rate, from 27.1% in 2004 to 34.3% in 2005. The decrease in dental premiums was offset by an increase in short-term disability premiums totaling $659,000, from $6.0 million in 2004 to $6.7 million in 2005, primarily reflecting a 9.1% increase in certificate months and average renewal rate increases of 9.3%.
The decrease in net investment income primarily reflects the reinvestment of proceeds from maturities of higher coupon bonds in bonds with lower yields.
The decrease in net realized investment gains primarily reflects the change in the fair value of equity call options during 2005 totaling $367,000, compared to an increase during 2004 totaling $217,000. In addition, the 2004 net realized gains included the sale of certain previously impaired securities that had recovered a portion of their fair value and were sold at a gain.
The loss ratios, by line of business, were as follows for the years ended December 31, 2005 and 2004:
The Company and its subsidiaries also have lines of credit available to provide additional liquidity if needed. The Company has a $2.6 million line of credit and Eastern Re has a $30 million letter of credit facility if needed to secure obligations to reinsurers.
On May 15, 2003, Global Alliance Statutory Trust I, a business trust subsidiary formed by Global Alliance, issued $8.0 million of fixed/floating rate trust preferred securities. These securities have a thirty-year maturity, with a provision that allows the trust, at the direction of Global Alliance, to call these securities at par after five years from the date of issuance. Cash distributions will be paid quarterly in arrears at a rate of 7.35% for a period of five years and will float thereafter at 410 basis points over the three-month London Inter-Bank Offer Rate. The Company guarantees all obligations of the trust with respect to distributions and payments of these securities. Proceeds from the sale of these securities by the trust were used to acquire $8.0 million of fixed/floating rate junior subordinated debt issued by Global Alliance. This debt has the same terms with respect to maturity, payments, and distributions as the fixed/floating rate trust preferred securities issued by the trust.
Our domestic insurance subsidiaries’ ability to pay dividends to the Company is limited by the insurance laws and regulations of Pennsylvania. The maximum annual dividends that the domestic insurance entities may pay without prior approval from the Department is limited to the greater of 10% of statutory surplus or 100% of statutory net income for the most recently filed annual statement. In addition, EIHI and its subsidiaries are prohibited from declaring or paying any dividends or other forms of distribution for the three years after June 16, 2006, the effective date of the conversion/merger transaction, without the prior approval of the Pennsylvania Insurance Commissioner. Eastern Re must receive approval from the Cayman Islands Monetary Authority before it can pay any dividend to the Company.
The primary sources of cash flows for the Company are net premiums written, investment income, and proceeds from the sale or maturity of investments. The major components of cash flow are as follows for the years ended December 31, 2006, 2005, and 2004 (in thousands):
Cash Flows for Years Ended December 31, 2006 and 2005. The increase in net cash from operating activities reflects the acquisition of EHC and the improvement in the group benefits insurance segment operating results.
The increase in net cash used in investing activities reflects the acquisition of EHC and the investment of excess cash in the group benefits segment that was held during the prior year for purposes of paying expenses related to the conversion/merger transaction.
Cash Flows for Years Ended December 31, 2005 and December 31, 2004. The decrease in net cash from operating activities primarily reflects the payment of transaction expenses totaling $2.3 million.
The following table summarizes information about contractual obligations and commercial commitments. The minimum payments under these agreements as of December 31, 2006 were as follows (in thousands):
The loss reserves payments due by period in the table above are based upon the loss and loss expense reserves estimates as of December 31, 2006, 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 Loss Adjustment Expense Reserves.” Actual payments of loss and loss adjustment expenses 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, 2006, 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.
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 consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its 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 includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Eastern Insurance Holdings, Inc. (“EIHI”) was formed by Eastern Life and Health Insurance Company (“ELH”), formerly Educators Mutual Life Insurance Company, for the purpose of converting from a mutual life and health insurance company to a stock life and health insurance company. On June 16, 2006, EIHI completed its common stock offering and ELH completed its conversion from a mutual company to a stock company and became a wholly-owned subsidiary of EIHI. In the common stock offering, EIHI sold 7,475,000 shares of its common stock at a price of $10.00 per share, raising gross proceeds of $74.8 million. Direct expenses of the offering were $5.2 million and were recorded as a direct reduction of additional paid-in capital in the accompanying consolidated balance sheet as of December 31, 2006.
Immediately after the common stock offering and conversion, EIHI purchased all of the outstanding common stock of Eastern Holding Company, Ltd. (“EHC”) for a purchase price of $78.9 million (See Note 3).
Workers’ compensation insurance is underwritten through Eastern Alliance and Allied Eastern, both Pennsylvania domiciled insurance companies, which provide workers’ compensation insurance coverage to small and medium sized businesses in rural and suburban Pennsylvania, Maryland and Delaware.
The Company provides a variety of services to self-insured workers’ compensation plans including program design, fronting, claims adjusting, investment management and cell rental services at Eastern Re. The primary insurance coverage for the segregated portfolio cell programs is underwritten by Eastern Alliance and Allied Eastern and ceded 100% to Eastern Re.
Group benefits insurance, which includes the Company’s dental, short and long-term disability, and term life insurance products are underwritten through ELH. The group benefits insurance products are primarily marketed to small and medium sized businesses. ELH is licensed to write business in 41 jurisdictions in the United States. ELH is currently actively writing business in 16 jurisdictions, primarily in the Mid-Atlantic, Southeast, and Midwest regions of the United States.
Specialty reinsurance is underwritten through Eastern Re, a Cayman domiciled reinsurer. Eastern Re assumes business through its participation in reinsurance treaties with an unaffiliated insurance company related to an underground storage tank program and a non-hazardous waste transportation product.
The corporate/other segment consists of the operating results of Employers Alliance, the Company’s third party administrator, which provides claims adjusting and risk management services to self-insured workers’ compensation and property and casualty plans. This segment also includes the operations of EIHI, EHC, Eastern Services and Global Alliance, the run-off operations of ELH’s group medical insurance operations, and certain eliminations necessary to reconcile the segment information to the consolidated statements of operations and comprehensive income (loss). Prior to January 1, 2006, the corporate/other segment included the operating results of IBSi, ELH’s former general agency operation. IBSi was sold by ELH on October 31, 2005 (See Note 14).
The preparation of the consolidated financial statements requires management to make estimates and assumptions that affect the amount of reported assets and liabilities and disclosures of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. The most significant estimates in the consolidated financial statements include reserves for unpaid losses and loss adjustment expenses, earned but unbilled premium, deferred acquisition costs, return premiums under reinsurance contracts, current and deferred income taxes, and benefit plan liabilities. Actual results could differ from these estimates.
Investments in limited partnerships are reported in the consolidated financial statements using the equity method. Changes in the value of the Company’s proportionate share of its limited partnership investments are included in net investment income in the consolidated statements of operations and comprehensive income (loss).
Premiums generated by the Company’s group benefits insurance segment are generally billed on a monthly basis with premiums being earned in the month in which the coverage is provided. Unearned premiums represent those premiums that have been received but for which the coverage period has not expired. Advance premiums represent those premiums that have been received in advance of the coverage period. Premiums receivable represent only those premiums that have been billed to policyholders for coverage periods through the balance sheet date.
Other revenue for the years ended December 31, 2005 and 2004 consists of sales and marketing fees earned by IBSi under contracts with unaffiliated insurance carriers. Prior to the sale of IBSi, sales and marketing fees were generally recognized as revenue in the period in which the insurance policy was effective. IBSi also earned bonus revenue for meeting agreed-upon production levels with certain external carriers. Bonus revenue was estimated and accrued in the period in which the agreed-upon production levels were met.
A liability is established for the estimated unpaid losses and loss adjustment expenses (“LAE”) of the Company’s workers’ compensation insurance segment under the terms of, and with respect to, its policies and agreements and includes amounts determined on the basis of claims adjusters’ evaluations and an amount based on past experience for losses incurred but not reported.
insured’s disability. The liability for life premium waiver reserves is calculated using the 1970 Intercompany Group Life Disability Table. The liability for life premium waiver reserves is discounted using a rate of 3%, which is built into the valuation table.
A liability is established for the estimated unpaid losses and LAE of the Company’s specialty reinsurance segment based on information provided by the ceding company. Premiums and reported claims data provided by the ceding company is utilized by management to estimate the ultimate losses and LAE, including an amount for incurred but not reported claims.
Amortization of policy acquisition costs totaled $1.9 million for the year ended December 31, 2006. There were no deferred acquisition costs or related amortization in 2005 or 2004.
Eastern Alliance and Allied Eastern issue 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.
Eastern Alliance and Allied Eastern are subject to state guaranty fund assessments in the Commonwealth of Pennsylvania, which provide for the payment of covered claims or to meet other insurance obligations from insurance company insolvencies. The Company’s assessments consist primarily of charges from the Workers’ Compensation Security Fund of Pennsylvania (“Security Fund”). The Security Fund serves as a guaranty fund to provide claim payments for those workers entitled to workers’ compensation benefits when the insurance company originally providing the benefits was placed into liquidation by a court. Security Fund assessments are established on an actuarial basis to provide an amount sufficient to pay the outstanding and anticipated claims in a timely manner, to meet the costs of the Pennsylvania Insurance Department to administer the fund and to maintain a minimum balance in the fund of $500 million. If the Security Fund determines that the balance in the Security Fund is less than $500 million based on the actuarial study, then an assessment equal to one percent of direct written premium is made to all companies licensed to write workers’ compensation in Pennsylvania. Eastern Alliance and Allied Eastern recognize a liability and the related expense for the assessments when premiums covered under the Security Fund are written; when an assessment from the Security Fund has been imposed or it is probable that an assessment will be imposed; and the amount of the assessment is reasonably estimable. The Company has not recorded an assessment for the year ended December 31, 2006, as an assessment is not expected in 2007 on direct premium written in 2006.
The Company’s investment policy limits the amount of securities that can be held in any one issuer or any one industry. Therefore, the Company believes there are no significant concentrations of credit risk related to its investment portfolio.
In September 2005, the American Institute of Certified Public Accountants (“AICPA”) released Statement of Position 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts” (“SOP 05-1”). SOP 05-1 requires identification of transactions that result in a substantial change in an insurance contract. Transactions subject to review include internal contract exchanges, contract modifications via amendment, rider or endorsement, and elections of benefits, features or rights contained within the contract. If determined that
On June 16, 2006, the Company acquired all of the outstanding common stock of EHC for a purchase price of $78.9 million, which consisted of the Company issuing 3,875,407 shares of its $10.00 common stock and paying cash of $40.2 million to the EHC’s shareholders. The excess of the purchase price over the net fair value of the assets and liabilities acquired was $14.3 million, consisting of identifiable intangible assets of $9.2 million and goodwill of $5.1 million. Direct expenses incurred in connection with the acquisition of EHC were $636. In connection with the acquisition of EHC, the purchase price was allocated to the estimated fair values of the acquired assets and liabilities as follows (in thousands):
discounted reserve for unpaid losses and loss adjustment expenses to reflect management’s estimate of the cost EHC would incur to reinsure the full amount of its unpaid losses and loss adjustment expenses with a third-party reinsurer. This risk margin was based upon management’s assessment of the inherent uncertainty in reserving for unpaid losses and loss adjustment expenses and their knowledge of the reinsurance marketplace. As a result of these adjustments, the reserve for unpaid losses and loss adjustment expenses was increased by $2.4 million as of June 16, 2006.
The Company issued 747,500 shares of its common stock to the ESOP for $7.5 million. The Company issued a loan to the ESOP in the amount of $7.5 million for the purchase of the common stock. The issuance of the loan to the ESOP and the related purchase of the Company’s common stock by the ESOP are considered non-cash transactions for purposes of the statement of cash flows. As such, the net proceeds received as a result of the Company’s stock offering of $69.6 million is reflected net of the proceeds from the shares purchased by the ESOP of $7.5 million, or $62.1 million, in the statement of cash flows for year ended December 31, 2006.
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, and ELH maintained statutory-basis surplus in excess of minimum prescribed risk-based capital requirements at December 31, 2006.
Certain insurance departments in the states in which the Company is licensed to do business require a deposit in the event the Company would become insolvent. In order to satisfy these requirements, the Company had fixed income securities with an estimated fair value of $5,462 and $2,951 on deposit with various insurance departments as of December 31, 2006 and 2005, respectively.
As of December 31, 2006, the Company held 51 fixed income securities with gross unrealized losses totaling $374. Management has evaluated the unrealized losses related to those fixed income securities and determined that they are primarily due to a fluctuation in interest rates and not attributable to credit risk factors. For investments in fixed income securities, losses in the estimated fair values are viewed as temporary if the security can be held to maturity and it is reasonable to assume that the issuer will be able to service the debt, both as to principal and interest. Management believes that the current carrying value of these investments will be realized and that the Company has the ability and intent to hold them until that time.
As of December 31, 2006, the Company held 16 equity securities with gross unrealized losses totaling $101. All of the equity securities have been in an unrealized loss position for less than twelve months and management has determined, based on an evaluation of these securities, that the decline in value is other-than-temporary as of December 31, 2006.
Proceeds from the sale of fixed income securities totaled $44,771, $6,166, and $9,030 for the years ended December 31, 2006, 2005, and 2004, respectively. Proceeds from the sale of equity securities totaled $4,588, $0, and $0 for the years ended December 31, 2006, 2005, and 2004, respectively.
The gross realized gains and gross realized losses recognized by the Company as a result of the sale of investments were as follows for the years ended December 31, 2006, 2005, and 2004 (in thousands):
During 2005, the Company recorded a realized loss totaling $104 related to the impairment of a fixed income security. There were no impairments of fixed income securities recorded during 2006 or 2004.
Workers’ Compensation Insurance. The Company’s results of operations include a cumulative decrease in estimated incurred losses and LAE on its workers’ compensation line of business primarily related to accident years 2005, 2004, and 2003 of $2.1 million for the year ended December 31, 2006. The favorable development on prior accident years relates primarily to significant claim settlements during 2006 for amounts at, or less than, previously established case and IBNR reserves.
Specialty Reinsurance. The Company’s results of operations included an increase in estimated incurred losses and LAE on its specialty reinsurance line of business related to prior accident years of $894 for the year ended December 31, 2006. The unfavorable prior year development was the result of changes in estimates as losses emerged at a higher rate than had been originally anticipated when the reserves were estimated with respect to accident years 2005, 2004, 2003, and 2002. The evaluation of the reserve for unpaid losses and LAE related to the specialty reinsurance segment requires that loss development be estimated over an extended period of time. Because the primary insurer under these programs changed in 1999, historical loss data is insufficiently developed. Therefore, reliance has been placed on industry loss development patterns, adjusted based on the Company’s judgment, to reflect considerations particular to the exposure. The reliance on external benchmarks, while necessary, creates an additional element of uncertainty.
The following table provides a summary of the Company’s premiums on a direct, assumed, ceded, and net basis for the years ended December 31, 2006, 2005, and 2004 (in thousands):
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, 2006, 2005, and 2004 (in thousands):
Effective October 1, 2003, ELH entered into a coinsurance agreement with London Life Reinsurance Company (LLRC), under which ELH cedes 100% of its group benefits insurance business written or renewed on or after the effective date to LLRC. Concurrent upon entering into the coinsurance agreement, LLRC retroceded the business assumed from ELH to its affiliate, London Life International Reinsurance Corporation (LLIRC). Under a stop loss reinsurance agreement with LLIRC, ELH reinsures LLIRC against any net loss on the reinsured business. As a result of the above transactions, the Company retains 100% of the insurance risk on business written and renewed by ELH, on and after the effective date. Therefore, the arrangement does not transfer insurance risk and, accordingly, is not accounted for as reinsurance. The Company recognized fees totaling $60 in each of the years ended December 31, 2006, 2005 and 2004, related to these agreements, which are included in other expenses in the consolidated statements of operations and comprehensive income (loss). In addition, ELH is required to maintain a trust deposit equal to 105% of statutory reserves at the end of each calendar quarter. As of December 31, 2006, ELH was required to maintain a trust deposit of at least $8.6 million. The actual trust deposit totaled $10.8 million as of December 31, 2006.
In addition to the income tax provision, the net deferred tax asset increased by $132, $803, and $823 in 2006, 2005, and 2004, respectively, as a result of changes in the unrealized gains and losses on the Company’s fixed income and equity securities. The tax effect of these items is recorded directly to accumulated other comprehensive income, which is a component of equity.
The provision for income taxes for the years ended December 31, 2006, 2005, and 2004 is as follows (in thousands):
The components of the net deferred tax asset as of December 31, 2006 and 2005 are as follows (in thousands):
The Company sponsors an ESOP, which was established as a result of the conversion of ELH from a mutual company to a stock company. Eligible employees generally include those employees who have reached the age of 21 and have completed one year of service. All employees that were employed by EHC or ELH on June 16, 2006 were determined to have met the eligibility requirements on that date. ESOP shares are allocated to participants based on the ratio of their individual compensation during the plan year to the total compensation of eligible employees during the plan year.
ELH sponsors a non-contributory defined benefit pension plan (the “pension plan”) covering substantially all of its employees. On May 17, 2005, ELH’s Board of Directors approved the freezing of the pension plan effective December 31, 2005. ELH also sponsors a defined benefit postretirement plan (the “postretirement plan”), which provides certain health care and life insurance benefits for retired employees. Current employees of ELH may become eligible for these benefits if they reach retirement age while working for ELH and meet certain years of service levels prior to January 1, 2015. Life insurance benefits are set at 100% of an employee’s annual salary at the time of retirement, up to a maximum of $175,000, and are reduced to $10 by age 70.
Pension costs are funded to the limits specified by the Employee Retirement Income Security Act of 1974, as amended. From time to time, the Company may contribute additional amounts to the pension plan as it deems appropriate, subject to funding limitations. Based on the funded status of the pension plan at December 31, 2006, the Company is not required to make a contribution in 2007 and does not anticipate making a contribution. The Company does anticipate making a contribution to the postretirement plan in 2007 totaling approximately $65 to cover the Company’s portion of retirees’ healthcare premiums.
The Company uses a measurement date of December 31 for its plans.
The amounts included in AOCI that are expected to be recognized in 2007 are as follows (in thousands):
As a result of freezing the pension plan at December 31, 2005, the Company recognized a decrease in its pension plan benefit obligation totaling $1,468. This decrease was offset by an increase in the benefit plan obligation and related net periodic benefit cost totaling $79 as a result of fully vesting plan participants that were involuntarily terminated by the Company during 2005. The Company also incurred additional net periodic benefit cost in 2005 totaling $215 related to the recognition of prior service cost as a result of freezing the pension plan. During 2004, the Company increased its net periodic benefit cost by $58 as a result of fully vesting plan participants that were involuntarily terminated by the Company in the 2003 plan year.
During 2005, the Company’s Board of Directors approved an amendment to the postretirement plan, which passes a portion of the healthcare premium costs to the retirees beginning with the 2006 plan year. The amendment requires retirees to contribute one-third of the healthcare premium in 2006, with the retiree contribution increasing to two-thirds in 2007 and 100% in 2008. As a result of this amendment, the Company recorded a settlement gain totaling $2,239 that reduced the postretirement obligation as of December 31, 2005. The settlement resulted in a reduction to the net periodic benefit cost in 2005 totaling $1,465.
The pension plan’s assets were comprised of the following at December 31, 2006 and 2005 (in thousands):
The following table provides the components of net periodic benefit cost for the pension plan and the postretirement plan for the years ending December 31, 2006, 2005, and 2004 (in thousands):
Eastern Alliance and ELH also sponsor defined contribution plans covering their respective eligible employees. The Company’s contributions to the defined contribution plan for the years ended December 31, 2006, 2005, and 2004 totaled $131, $108, and $120, respectively.
Workers’ compensation insurance is underwritten through Eastern Alliance and Allied Eastern, both Pennsylvania domiciled insurance companies, which provide insurance coverage to small and medium sized businesses in rural and suburban Pennsylvania, Maryland and Delaware. Eastern Alliance and Allied Eastern offer a complete line of workers’ compensation products, including guaranteed cost and loss sensitive products. Under the guaranteed cost program, the prospective workers’ compensation policy premium is determined at the beginning of the policy period based on estimated payroll. The loss sensitive products offer the opportunity of returning a portion of the policyholder’s premium in the form of a dividend based upon loss experience. Eastern Alliance and Allied Eastern distribute their products and services through a network of independent agents. Fronting fees earned by Eastern Alliance and Allied Eastern on the segregated portfolio cell reinsurance business are reported in the workers’ compensation insurance segment.
On October 31, 2005, ELH entered into a Membership Purchase Agreement (the “Agreement”) for the sale of its interest in IBSi to IBSi’s Vice President of Sales, an IBSi Regional Sales Director, and an unaffiliated third party (collectively referred to as the “purchasers”). The sale was completed through a cash purchase of $300, subject to certain purchase price adjustments. Prior to the sale, all inter-company
balances between ELH and IBSi were settled, and any remaining assets and liabilities of IBSi, excluding certain furniture and equipment, became the property of ELH. As a result of the sale, ELH recognized a net gain totaling $210. Under the terms of the Agreement, the purchasers received certain furniture and equipment owned by IBSi, totaling $5, and have the exclusive right to market ELH’s group benefits products in North and South Carolina and Virginia from October 31, 2005 through December 31, 2006. ELH may market its group benefits products directly to independent producers in the aforementioned states beginning on January 1, 2007; however, ELH is prohibited from marketing its products through IBSi’s top twenty producers in 2007, and in 2008, subject to IBSi meeting certain production goals. IBSi also has the right to market ELH’s products in other states in which IBSi operates, with the exception of Pennsylvania and Maryland. Subsequent to the sale, ELH markets and sells its group benefits products through direct relationships with its independent producers in Pennsylvania and Maryland. The net assets transferred from IBSi to ELH, as a result of the sale, totaled $4.7 million.
The Company leases its home office building under a 15-year, non-cancelable lease with a related party through February 2017. The base monthly lease payment is subject to an annual increase based upon the consumer price index. Minimum monthly lease commitments for the remainder of the lease term are as follows (in thousands):
Rent expense totaled $533, $254, and $254 for the years ended December 31, 2006, 2005 and 2004, respectively.
Prior to October 31, 2006, ELH leased its office building under a multi-year sale-leaseback agreement entered into in June 2001. The term of the lease was seven years, ending on June 30, 2008. On March 20, 2006, ELH entered into a Lease Termination Agreement with the landlord of its office building to terminate the current operating lease upon ELH vacating the building and moving to its new office space. ELH moved to its new office space on October 27, 2006. Under the terms of the Lease Termination Agreement, ELH paid the landlord $394. The impact of the termination payment on ELH’s results of operations was reduced by the recognition of the remaining deferred gain, related to the sale-leaseback agreement, on October 31, 2006, totaling $191. For the year ended December 31, 2006, ELH recognized a charge of $203 related to the lease termination. This expense is included in other expenses in the consolidated statement of operations and comprehensive income (loss) for the year ended December 31, 2006. As a result of ELH’s move, the monthly lease payments increased from $32 per month to approximately $58 per month beginning in November 2006.
Proceeds from the sale of these securities by the Trust I were used to acquire $8.0 million of Floating/Fixed Rate Junior Subordinated Deferrable Interest Rate Debentures issued by the Company. These debentures have the same terms with respect to maturity, payments, and distributions, as the fixed/floating rate trust preferred securities issued by the Trust I.
The Company adopted the Eastern Insurance Holdings, Inc. 2006 Stock Incentive Plan (the Plan) on December 18, 2006. Awards under the Plan may be made in the form of incentive stock options, nonqualified stock options, restricted stock or any combination to employees and non-employee Directors. The Plan limits to 299,000 the number of shares that may be awarded as restricted stock, and to 747,500 the number of shares for which incentive stock options may be granted. The total number of shares authorized in the plan is 1,046,500 shares, with an annual increase equal to 1% of the shares outstanding at the end of the previous year, with a corresponding proportional annual increase in the number of shares that can be issued as restricted stock. The Plan provides that stock options and restricted stock awards may include vesting restrictions and performance criteria at the discretion of the Compensation Committee of the Board of Directors. The term of options may not exceed ten years for incentive stock options, and ten years and 1 month for nonqualified stock options, and the option price may not be less than fair market value on the date of grant. On December 18, 2006, the Company authorized the grant of 616,688 stock options and 246,675 restricted stock awards on January 3, 2007. The exercise price for the stock options was $14.35 on January 3, 2007. The 2007 grants have a vesting period of 5 years on restricted stock, incentive stock options, and nonqualified stock options.