annual increase based upon the consumer price index at the end of each preceding calendar year. In addition to the base rent, the Company is responsible for its proportionate share of expenses related to the building including, but not limited to, utilities, maintenance, real estate taxes, and insurance. The Company has a 5% interest in the limited partnership that owns the building.
(1) The net income of the segregated portfolio 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) Calculated by dividing the sum of acquisition and other underwriting expenses, other expenses, amortization of intangibles, policyholder dividend expense, and segregated portfolio dividend expense by net premiums earned.
(4) The sum of the loss and loss adjustment expense ratio and expense ratio.
The segregated portfolio cell reinsurance segment reported a combined ratio of 83.5% for the year ended December 31, 2007, compared to a combined ratio of 74.1% for the year ended December 31, 2006. The increase in the combined ratio primarily reflects the impact of purchase accounting adjustments and an increase in the loss ratio, before the effects of purchase accounting, from 2006 to 2007. Purchase accounting adjustments decreased the combined ratio by 0.9 points in 2007, compared to 3.8 points in 2006. The loss ratio, before the effects of purchase accounting, increased from 45.3% in 2006 to 50.6% in 2007. The results of operations of the segregated portfolio cell reinsurance segment are recorded to segregated portfolio cell dividend expense. As of December 31, 2007, there are 13 segregated portfolio cells, of which two are in run-off.
The group benefits insurance segment reported a combined ratio of 94.4% for the year ended December 31, 2007, compared to a combined ratio of 95.7% for the year ended December 31, 2006. The decrease in the combined ratio primarily reflects an improvement of 4.5 points in the expense ratio from 2006 to 2007, offset by an increase in the loss ratio on the dental line of business. The improvement in the expense ratio primarily reflects the impact of the Company’s efforts to integrate the workers’ compensation and group benefits operations and the increase in the group benefits insurance segment’s net premiums earned. The increase in the dental loss ratio primarily reflects the impact of new business written, which typically has a higher loss ratio than renewal business.
The specialty reinsurance segment reported a combined ratio of 122.0% for the year ended December 31, 2007, compared to a combined ratio of 135.9% for the year ended December 31, 2006. Purchase accounting adjustments increased the combined ratio by 3.6 points in 2007, compared to 23.8 points in 2006. Excluding the effect of purchase accounting, the loss ratio increased from 77.0% in 2006 to 85.0% in 2007. As noted above, the increase in the loss ratio primarily reflects the adverse development on prior year reserves for unpaid losses and LAE during 2007.
Direct and net premiums written. Direct premiums written is the sum of both direct premiums and assumed premiums before the effect of ceded reinsurance. Direct premiums written include all premiums billed during a specified policy period. Net premiums written is the difference between direct premiums written and premiums ceded or paid to reinsurers (ceded premiums written). In the segregated portfolio cell reinsurance segment, assumed premiums are derived from insurance contracts written by the Company and ceded to the segregated portfolio cells. In the specialty reinsurance segment, assumed premiums are premiums that are received from a third party under a reinsurance agreement, which are reported to the Company directly from the broker one quarter in arrears.
Other revenue. Other revenue includes claim administration, risk management, and cell rental fees earned. 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 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.
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 primarily of commissions, premium taxes and fees and other underwriting expenses incurred in acquiring, writing and administering
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, diluted earnings per share, and return on average equity.
Combined ratio. The combined ratio is the sum of the loss ratio, expense ratio and policyholder dividend expense ratio and measures the Company’s overall underwriting profit. If the combined ratio is below 100%, the Company is making an underwriting profit. If the Company’s combined ratio is at or above 100%, the Company is not profitable without investment income and may not be profitable if investment income is insufficient.
The Company’s reserves for unpaid losses and LAE in its workers’ compensation insurance segment as of December 31, 2007 and 2006 are summarized below (in thousands):
In its workers’ compensation segment, the Company records reserves for estimated losses under insurance policies and for LAE 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.
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 11-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.
The medical portion of a lost time claim and medical only claims developed together; and
In estimating ULAE reserves, the Company reviews past loss 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 represents 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 LAE incurred may vary significantly from the Company’s estimates.
The Company estimates and records reserves for its segregated portfolio cell reinsurance segment in the same manner as for its workers’ compensation insurance segment.
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, underwriting expenses, policyholder dividend expenses and other expenses 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 it were a segregated portfolio cell dividend participant.
The reserves for unpaid losses and LAE includes an estimate of future amounts for reported but unpaid and IBNR claims related to the Company’s dental, long-term disability, short-term disability and term life products, as well as an estimate of the costs associated with investigating, processing and paying the related claims.
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
Tabular Reserve Method. The tabular reserve method is used to estimate the reserve for insurance products that are longer tail by nature and for which the claim payment patterns are relatively predictable. Under the tabular reserve method, the reserve for reported but unpaid claims is estimated using industry-standard valuation tables. These tables incorporate expected death and recovery rate assumptions (based on an insured’s age and length of disability) that impact the reserve for unpaid claims.
The Company’s reserves for unpaid losses and LAE in its group benefits insurance segment, by line business, as of December 31, 2007 and 2006, were as follows (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 2007, 2006 and 2005 were 5.25%, 4.75%, and 4.25%, 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 Company’s reserves for unpaid losses and LAE in its specialty reinsurance segment as of December 31, 2007 and 2006 are summarized below (in thousands):
In its specialty reinsurance segment, the Company categorizes unpaid losses and LAE into case reserves and IBNR reserves. Case reserves represent unpaid losses reported by the ceding company. The Company updates its reserve estimates on a quarterly basis using information received from its cedants.
In applying these methods, the Company evaluates loss development trends by underwriting year to determine various assumptions that are required as inputs in the actuarial methodologies it employs. These typically involve the analysis of historical loss development trends by underwriting year. In addition, the Company utilizes external or internal benchmark sources of information for which it does not have sufficient loss development data to calculate credible trends. 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.
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 LAE. Since the Company relies on claims information reported by ceding companies, the estimation of unpaid losses and LAE 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:
Claims reported to the ceding company by insureds are entered into the ceding company’s claim system and ceded to the specialty reinsurance segment on a quarterly basis. The Company mitigates the above risk by engaging an independent third party to perform periodic claims reviews of the ceding companies’ detailed claim reports to ensure reported claims information appears to be reasonably accurate and timely.
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, 2007, the Company recorded a net deferred tax asset of $1.2 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.
used, and an acquirer must be identified in all business combinations. SFAS No. 141R applies prospectively to business combinations which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. An entity is prohibited from applying SFAS No. 141R prior to that date. The Company is currently in the process of evaluating the impact of SFAS No. 141R.
The major components of consolidated revenue were as follows for the years ended December 31, 2007 and 2006 (in thousands):
The following table represents the operations of the segregated portfolio cell reinsurance segment for the years ended December 31, 2007 and 2006 (in thousands):
The following table represents the operations of the group benefits insurance segment for the years ended December 31, 2007 and 2006 (in thousands):
The increase in net income primarily reflects improved underwriting results, as the combined ratio decreased from 95.7% in 2006 to 94.4% in 2007. The improvement in the underwriting results was offset by a decrease in net investment income and net realized gains on investments.
The specialty reinsurance ratios were as follows for the years ended December 31, 2007 and 2006:
The increase in reinsurance premiums assumed relates to the acquisition of EHC on June 16, 2006. Reinsurance premiums earned, by line of business, were as follows for the years ended December 31, 2007 and 2006 (in thousands):
The increase in consolidated net income reflects the acquisition of EHC on June 16, 2006. The corporate/other segment results for the year ended December 31, 2006 include the results of operations of Employers Alliance, EIHI, Eastern Holding Company, Ltd., Eastern Services, Global Alliance, and the Company’s corporate activities for the period from June 17, 2006 to December 31, 2006, and ELH’s group medical insurance run-off operations and corporate activities for the year ended December 31, 2006. The corporate/other segment results for the year ended December 31, 2005 include the results of operations of ELH’s former general agency operations and corporate activities, and the group medical insurance run-off operations.
The following table represents the operations of the workers’ compensation insurance segment for the period from June 17, 2006 to December 31, 2006 (in thousands):
Net investment income was $2.2 million for the period from June 17, 2006 to December 31, 2006.
Net realized investment gains for the period from June 17, 2006 to December 31, 2006 related primarily to sales activity on equity securities.
Dividends represent payments to customers who purchased participating policies that produced favorable loss ratios. In 2006, 9.1% of all policies were written on a dividend policy basis.
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.
The following table represents the operations of the segregated portfolio cell reinsurance segment for the period from June 17, 2006 to December 31, 2006 (in thousands):
(1) The workers’ compensation insurance, specialty reinsurance and corporate/other segments provide services to the segregated portfolio cell reinsurance segment. The fees paid by the segregated portfolio cell reinsurance segment for these services are included in the revenue of the segment providing the service. The segregated portfolio cell reinsurance segment records the fees associated with these services as ceding expense, which is included in its underwriting expenses. The difference between total revenue for the segregated portfolio cell reinsurance segment for each period and the sum of losses and loss adjustment expenses, acquisition and other underwriting expenses, policyholder dividend expenses and other expenses is accrued as a segregated portfolio dividend expense. As a result, the segregated portfolio cell reinsurance segment has no net income for any period presented in this table.
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.
The calendar period loss and LAE ratio was 49.9% in 2006, including 4.6 points related to purchase accounting adjustments recorded to net premiums earned and losses and LAE.
Acquisition and other underwriting expenses were $2.7 million for the period from June 17, 2006 to December 31, 2006 and include a reduction of $1.5 million for purchase accounting adjustments. Underwriting expenses consist of the ceding commissions due under the reinsurance agreements with Eastern Alliance and/or Allied Eastern. Other expenses consist primarily of accounting, banking and legal fees. The expense ratio of 24.2% for the period from June 17, 2006 to December 31, 2006 includes a reduction of 8.4 points related to purchase accounting adjustments. The expense ratio, without regard to the aforementioned purchase accounting adjustments, is consistent with the contractual ceding commissions for this period.
The group benefits insurance ratios were as follows for the years ended December 31, 2006 and 2005:
The decrease in net premiums earned reflects the aforementioned decline in new business sales and renewal retention. New business sales totaled $3.6 million for the year ended December 31, 2006, compared to $6.2 million for the year ended December 31, 2005. Renewal retention declined 5.2 percentage points for the first six months of 2006, which adversely impacted net premiums earned for the remainder of the year.
The decrease in the calendar period dental loss ratio reflects the improvement in the accident year loss ratio and favorable development on prior year reserves. The accident year loss ratio was 66.2% and 69.8% in 2006 and 2005, respectively, which reflects renewal rate increases, lower claim frequency, and the termination of business with higher loss experience. During 2006, management began to more closely monitor the renewal rate actions, focusing on retaining more profitable business at renewal and terminating less profitable business through renewal rate actions. As a result of these efforts, the loss ratio on retained business was 61.9%, compared to a loss ratio of 79.2% on terminated business. Favorable development on prior year reserves reduced the calendar year loss ratio by 2.8 percentage points in 2006, compared to 2.5 percentage points in 2005.
The increase in other expenses primarily reflects the aforementioned gain recognized in 2005. Excluding the gain, other expenses would have decreased $869,000, which reflects management’s expense reduction efforts.
The net loss includes an after-tax charge of $647,000 related to the amortization of purchase accounting adjustments and an increase in the frequency and severity of reported claims by the ceding company, which resulted in an increase in the 2006 accident year loss and LAE ratio and after-tax unfavorable loss reserve development of $894,000.
The calendar period loss and LAE ratio was 114.1% in 2006, including 37.1 points related to purchase accounting adjustments recorded to net premiums earned and losses and LAE. 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.
Acquisition and other underwriting expenses for the period from June 17, 2006 to December 31, 2006 include a reduction for purchase accounting adjustments of $1.7 million. As part of its quota share reinsurance agreement with the primary insurer, the Company pays the primary insurer a ceding commission based on assumed premiums. For the period from June 17, 2006 to December 31, 2006, the ceding commission paid to the primary insurer was 30.0%. Other expenses of $411,000 were incurred for the period from June 17, 2006 to December 31, 2006. Other expenses consist primarily of accounting, banking, management services and legal fees.
The effective tax rate for the period from June 17, 2006 to December 31, 2006 was 35.1%.
Total shareholders’ equity was $177.8 million as of December 31, 2007, compared to $173.7 million as of December 31, 2006. The increase in shareholders’ equity primarily reflects 2007 net income of $18.7 million and the change in estimated fair value of fixed income and equity securities of $624,000, offset by the Company’s stock repurchases of $15.6 million and shareholder dividends of $2.2 million.
Liquidity is a measure of an entity’s ability to secure sufficient cash to meet its contractual obligations and operating needs. The Company’s principal sources of funds are underwriting operations, investment income and proceeds from sales and maturities of investments. The Company’s primary use of funds is to pay claims and operating expenses and to purchase investments. The Company’s investment portfolio is structured so that investments mature periodically over time in reasonable relation to current expectations of future claim payments. The Company’s investment portfolio as of December 31, 2007 had an effective duration of 2.87 years. Currently, claim payments are made from positive cash flow from operations, but the Company also invests excess cash in securities with appropriate maturity dates matched against anticipated future claim payments. As these securities mature, the Company intends to invest any excess funds with appropriate durations to match expected future claim payments.
The Company has a $2.6 million line of credit available to provide additional liquidity if needed and a $44.8 million letter of credit facility if needed to secure obligations to reinsurers.
On May 15, 2003, Trust I, a business trust subsidiary formed by Global Alliance, issued $8.0 million of fixed/floating rate trust preferred securities. The securities mature on May 15, 2033, with a provision allowing the Company to call the securities at par on May 15, 2008. Cash distributions are currently being paid quarterly in arrears at a fixed rate of 7.35% through May 15, 2008. Subsequent to May 15, 2008 cash distributions will be based on a floating rate equal to the three-month LIBOR plus 410 basis points. The Company guarantees all obligations of Trust I with respect to distributions and payments of these securities. Proceeds from the sale of these securities by the Trust I were used to acquire $8.0 million of fixed/floating rate junior subordinated deferrable interest rate debentures issued by Global Alliance. These debentures have the same terms with respect to maturity, payments, and distributions, as the fixed/floating rate trust preferred securities issued by Trust I.
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, 2007, 2006, and 2005 (in thousands):
The increase in cash flows from investing activities from 2006 to 2007 primarily reflects the use of proceeds from sales and maturities of securities to fund the Company’s stock repurchase program. Also, the acquisition of EHC resulted in a cash outflow of $14.1 million during 2006.
Cash flows from financing activities for the year ended December 31, 2007 reflects the Company’s stock repurchase program and the payment of shareholder dividends. Cash flows from financing activities for the year ended December 31, 2006 primarily reflect the net proceeds from the Company’s initial public offering.
Cash Flows for the Years Ended December 31, 2006 and 2005. The increase in cash flows from operating activities from 2005 to 2006 primarily reflects the acquisition of EHC.
Cash flows from financing activities for the year ended December 31, 2006 primarily reflects the net proceeds from the Company’s initial public offering.
(1) Amounts include interest payments associated with the debt issued to related party trust using applicable interest rates as of December 31, 2007. In connection with the adoption of FIN 46R, the Company does not consolidate the trust established in connection with the issuance of its trust preferred securities. As a result, the Company reports as a component of long-term debt the junior subordinated debenture that its subsidiary, Global Alliance, pays to the trust. For a discussion of the circumstances in which the Company’s subordinated debt may be subject to acceleration, please see “Liquidity and Capital Resources.”
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, 2007, 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.
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Eastern Insurance Holdings, Inc. and its subsidiaries (the “Company”) at December 31, 2007 and December 31, 2006, and the results of their operations and their cash flows for each of the years then ended in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)(2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included under Item 9A in Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audit which was an integrated audit in 2007. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
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 $74,750. Direct expenses of the offering were $5,153 and were recorded as a direct reduction of additional paid-in capital in the accompanying consolidated balance sheet in 2006.
The consolidated statements of income and comprehensive income for the year ended December 31, 2006 represent the results of operations of the group benefits insurance segment for the year ended December 31, 2006 and the results of operations of the workers’ compensation insurance segment, segregated portfolio cell reinsurance segment and specialty reinsurance segment for the period from June 17, 2006 to December 31, 2006. The corporate/other segment for the year ended December 31, 2006 represents the results of operations of ELH’s corporate activities for the year ended December 31, 2006 and the results of operations of EIHI, EHC, Employers Alliance, Global Alliance, and Eastern Services for the period from June 17, 2006 to December 31, 2006. Basic and diluted earnings per share for the year ended December 31, 2006 is computed by dividing consolidated net income for the period from June 17, 2006 to December 31, 2006 by the weighted average number of shares outstanding for the period.
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
The Company’s investments in fixed income securities are classified as available-for-sale and are carried at estimated fair value, with unrealized gains and losses reported in accumulated other comprehensive income (loss), net of tax. Fixed income securities include publicly traded and private placement bonds. The estimated fair value of publicly traded bonds is determined based on quoted market prices received from nationally recognized pricing services or, in the absence of quoted market prices, dealer quotes or matrix pricing, all of which are based on observable market-based inputs when available. Adverse credit market conditions during the second half of 2007 caused some markets to become relatively illiquid, thus reducing the availability of certain data used by the independent pricing services and dealers. The estimated fair value of private placement bonds is determined using valuation models, taking into consideration the securities’ coupon rate, maturity date, and other pertinent features.
Premiums or discounts are amortized using the effective interest method. Realized gains or losses are based on amortized cost and are computed using the specific identification method. The Company monitors its fixed income securities for unrealized losses that appear to be other-than-temporary. The Company performs a detailed review of these securities to determine the underlying cause of the unrealized loss and whether the security is impaired. At the time a security is determined to be other-than- temporarily impaired, the Company reduces the book value of the security to the estimated fair value and records a realized loss in the consolidated statements of operations and comprehensive income (loss). Any subsequent increase in the security’s estimated fair value would be reported as an unrealized gain.
The Company discounts its reserves for unpaid losses and LAE for workers’ compensation claims on a non-tabular basis, using a discount rate of 3.0%, based upon regulatory guidelines. The reserves for unpaid losses and LAE have been reduced for the effects of discounting by approximately $3,474 and $3,308 as of December 31, 2007 and 2006, respectively.
Policy acquisition costs consist primarily of commissions and premium taxes that vary with and are primarily related to the production of premium. Policy acquisition costs are deferred and amortized over the period in which the related
premiums are earned. Deferred acquisition costs are limited to the estimated amounts recoverable after providing for losses and loss adjustment expenses that are expected to be incurred based upon historical and current experience. Anticipated investment income is considered in determining recoverability.
Amortization of policy acquisition costs, before the impact of purchase accounting, totaled $6,033 and $2,541 for the years ended December 31, 2007 and 2006, respectively. There were no deferred acquisition costs or related amortization in 2005.
Eastern Alliance, Allied Eastern and ELH are not subject to state income taxes; rather, they are subject to state premium tax in the jurisdictions in which they write business. Employers Alliance and Eastern Services are subject to Pennsylvania state income tax.
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 $6,534 and $6,038 as of December 31, 2007 and 2006, respectively. Depreciation and amortization expense totaled $397, $263, and $222 for the years ended December 31, 2007, 2006 and 2005, respectively.
Property, equipment and software are reviewed for impairment whenever changes in circumstances indicate that the carrying value of such assets may not be recoverable. Impairment losses are recognized to the extent the carrying amount of the asset exceeds the undiscounted cash flows expected to result from the use of the asset and its eventual disposal. There were no impairments recorded in 2007, 2006 or 2005.
Goodwill represents the excess of cost over the fair value of net assets of businesses acquired. Goodwill and other intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but are instead tested for impairment at least annually. Intangible assets with estimable useful lives are amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 144 (“SFAS 144”), “Accounting for Impairment or Disposal of Long-Lived Assets.” No impairments were recorded in 2007 or 2006.
shareholders. The excess of the purchase price over the net fair value of the assets and liabilities acquired was $14,337, consisting of identifiable intangible assets of $9,197 and goodwill of $5,140. 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):
During 2007, the Company increased the goodwill related to the acquisition of EHC from $5,140 to $7,992, as a result of recognizing a deferred tax liability against the intangible assets acquired.
Amortization expense totaled $1,738 and $1,087 for the year ended December 31, 2007 and 2006, respectively. The estimated aggregated amortization expense for each of the next five years is as follows (in thousands):
Awards under the Stock Incentive Plan may be made in the form of incentive stock options, nonqualified stock options, restricted stock or any combination to employees and non-employee directors. The Stock Incentive Plan limits the number of shares that may be awarded as restricted stock to 299,000, and the number of shares for which incentive stock options may be granted to 500,000. The total number of shares initially authorized in the Stock Incentive Plan was 1,046,500 shares, with an annual increase equal to 1% of the shares outstanding at the end of each year. The Stock Incentive Plan provides that stock options and restricted stock awards may include vesting restrictions and performance criteria at the discretion of the Compensation Committee of the Board of Directors. The term of options may not exceed ten years for incentive stock options, and ten years and one month for nonqualified stock options, and the option price may not be less than fair market value on the date of grant. During 2007, grants of 355,672 non-qualified stock options, 278,516 incentive stock options and 246,675 restricted stock awards were made to employees and non-employee directors. A total of 3,924 stock options were forfeited during the year ended December 31, 2007. The stock options and restricted stock awards vest over a five year period and are not subject to performance criteria. No stock options have vested as of December 31, 2007 and, accordingly, no stock options granted under the Stock Incentive Plan have been exercised.
Total stock-based compensation expense recognized in the consolidated statement of operations and comprehensive income for the year ended December 31, 2007 is shown in the following table (in thousands):
The fair values of stock options granted during the year ended December 31, 2007 were determined on the dates of grant using a lattice-based binomial option valuation model with the following assumptions:
The aggregate intrinsic value in the table above is before applicable income taxes, and is based on the Company’s closing stock price of $16.49 on December 31, 2007.
As of December 31, 2007, there were 275,370 shares of common stock available for issuance of future share-based awards. The following table presents additional information regarding options outstanding as of December 31, 2007:
The following table summarizes restricted stock activity for the year ended December 31, 2007:
The statutory net loss of ELH for the year ended December 31, 2005 included the recognition of a realized loss on the sale of IBSi, totaling $10,335. Under SAP, the equity in income or loss of affiliates is recorded directly to statutory surplus as an unrealized gain or loss. As a result of the sale of IBSi, the cumulative unrealized loss was reclassified to a realized loss. There was no impact to statutory surplus as a result of this transaction.
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 $5,869 and $5,462 on deposit with various insurance departments as of December 31, 2007 and 2006, respectively.
As of December 31, 2007, the Company held 49 fixed income securities with gross unrealized losses totaling $499. 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, 2007, the Company held 3 equity securities with gross unrealized losses totaling $132. 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 temporary as of December 31, 2007.
Proceeds from the sale of fixed income securities totaled $50,309, $42,443, and $6,166 for the years ended December 31, 2007, 2006, and 2005, respectively. Proceeds from the sale of equity securities totaled $11,956, $6,855, and $0 for the years ended December 31, 2007, 2006, and 2005, respectively. Proceeds from the sale of other long-term investments totaled $1,876, $550, and $0 for the years ended December 31, 2007, 2006, and 2005, respectively.
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 2007 or 2006.
The following table provides a summary of the activity in the Company’s reserves for unpaid losses and LAE, excluding term life premium waiver reserves, for the years ended December 31, 2007, 2006, and 2005 (in thousands):
Segregated Portfolio Cell Reinsurance. The Company’s results of operations in its segregated portfolio cell reinsurance segment included a decrease in estimated incurred losses and LAE primarily related to accident years 2006, 2005 and 2004 of $3,023 for the year ended December 31, 2007. The favorable development on prior accident years relates primarily to significant claim settlements during 2007 for amounts at, or less than, previously established case and IBNR reserves. Any change in the reserves for unpaid losses and LAE in the segregated portfolio cell reinsurance segment 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 was a segregated portfolio cell dividend participant.
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, 2007, 2006, and 2005 (in thousands):
As a result of A.M. Best upgrading ELH’s financial strength rating from “B++” (Very Good) to “A-” (Excellent) in June 2007, the Company terminated its coinsurance agreement with London Life Reinsurance Company (LLRC) and the related stop loss reinsurance agreement with London Life International Reinsurance Corporation effective June 30, 2007. The termination of these agreements had no effect on the consolidated financial statements.
ELH entered into a coinsurance agreement in 1999, under which it ceded an existing block of outstanding claims related to a program that provided long-term disability coverage to certain professional associations. The Company recorded a reinsurance recoverable totaling $10,163 and $11,549 as of December 31, 2007 and 2006, related to this block of ceded claims.
As of December 31, 2007, the net deferred tax asset 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.
Suspense shares represent shares held by the ESOP that have not been allocated to participant accounts. Allocated shares have been earned and allocated to participant accounts, while shares committed to be released have been earned, but have not yet been allocated to participant accounts.
As of December 31, 2007 and 2006, the estimated fair value of unearned ESOP shares were $10,477 and $10,339, respectively.
Benefits paid totaled $424, $522, and $561 for the pension plan and $134, $152, and $194 for the postretirement plan for the years ended December 31, 2007, 2006, and 2005, respectively. The estimated future benefits to be paid over the next ten years are as follows (in thousands):
The Company also sponsors a defined contribution plan covering eligible employees. The Company’s contributions to the defined contribution plan for the years ended December 31, 2007, 2006, and 2005 totaled $195, $131, and $108, respectively.
The Company’s current operations are organized into the five following business segments.
The Company’s group benefits insurance products include dental, short and long-term disability, and term life insurance. The group benefits insurance products are marketed to employers, primarily in the Mid-Atlantic, Southeast, and Midwest regions of the United States. Net premiums earned, by product, for the years ended December 31, 2007, 2006, and 2005 were as follows (in thousands):
The Company assumes business through its participation in reinsurance treaties with an unaffiliated insurance company related to an underground storage tank insurance program, referred to as “EnviroGuard,” and a non-hazardous waste transportation product, referred to as “EIA liability” (“EIA”). The EnviroGuard program provides coverage to underground tank owners for third party off-site bodily injury and property damage claims as well as clean-up coverage and first party on-site claims. The EIA program provides commercial automobile liability coverage for non-hazardous waste haulers. Net premiums earned, by program and before purchase accounting adjustments, for the years ended December 31, 2007 and 2006 were as follows (in thousands):
Rent expense totaled $748, $533, and $254 for the years ended December 31, 2007, 2006 and 2005, respectively.
For the years ended December 31, 2007 and 2006, the Company incurred interest expense of $606 and $324 related to the junior subordinated debentures.