We own a 130,000 square foot office facility in Woodland Hills, California which is the corporate home office of Zenith National and its subsidiaries. We also own a 120,000 square foot branch office facility in Sarasota, Florida. In the regular conduct of business, we lease offices in various cities, which also serve as branch offices and include such services as marketing, underwriting, safety and health, claims, medical management and claims adjudication, as well as premium audit. We have eight office locations in California, three in Florida, two in Illinois and offices in each of Texas, Pennsylvania, North Carolina and Alabama. We consider our owned and leased facilities to be adequate for the needs of our organization.
(1)Includes catastrophe losses before tax of $3.0 million, $19.9 million and $69.2 million in 2007, 2006 and 2005, respectively, in our reinsurance segment.
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements if accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those discussed. Forward-looking statements include those related to the plans and objectives of management for future operations, future economic performance, or projections of revenues, income, earnings per share, capital expenditures, dividends, capital structure or other financial items. Statements containing words such as expect, anticipate, believe, estimate, likely or similar words that are used in this Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations ("MD&A"), in other parts of this report or in other written or oral information conveyed by or on behalf of Zenith, are intended to identify forward-looking statements. The Company undertakes no obligation to update such forward-looking statements, which are subject to a number of risks and uncertainties that could cause actual results to differ materially from those projected. These risks and uncertainties are set forth in Item 1A. "Risk Factors."
•Workers' compensation net premiums earned declined as a result of the impacts of the recession and competition, as well as reductions in premium rates.
•The investments segment results, consisting of investment income and realized gains (losses), fluctuated as interest rates trended lower.
•Payrolls for our insureds have declined which has resulted in reduced premiums.
•Claim counts have declined, but not necessarily at the same rate as payroll declines.
•Although premium rates have trended lower, recent premium rate increases in California have been moderated to assist our customers during a weak economy.
•Selection of customers is more complex as certain businesses are facing unprecedented challenges in sustaining their operations.
Our business is comprised of the following segments: workers' compensation, reinsurance and investments. In September 2005, we exited the assumed reinsurance business; however we will be paying our assumed reinsurance claims for several years. The results of the reinsurance segment will continue to be included in the results of continuing operations. Income (loss) from the workers' compensation and reinsurance segments is determined by deducting net losses and loss adjustment expenses incurred and underwriting and other operating expenses incurred from net premiums earned (this result is also known as underwriting income or loss). Investment income and realized gains (losses) on investments are discussed under "Investments" on page 38. The losses from the parent include interest expense and the general operating expenses of Zenith National. The comparative components of net income are set forth in the following table:
As can be seen from the table above, underwriting results have declined by over $300 million in a three-year time period. Approximately one-third of this decline is attributable to the decreasing amount of favorable development on prior accident year loss reserves. Increasing loss and expense ratios comprise the balance of the decline.
The combined ratio, expressed as a percentage, is a key measurement of profitability traditionally used in the property-casualty insurance business. The combined ratio, also referred to as the "calendar year combined ratio," is the sum of the losses and loss adjustment expense ratio and the underwriting and other operating expense ratio. When the combined ratio is less than 100%, we have recorded underwriting income, and conversely, when the combined ratios is greater than 100%, we have recorded underwriting losses. The losses and loss adjustment expense ratio is the percentage of losses and loss adjustment expenses incurred to net premiums earned. The underwriting and other operating expense ratio is the percentage of underwriting and other operating expenses to net premiums earned. When the calendar year combined ratio is adjusted to exclude prior period items, such as loss reserve development and policyholders' dividends, it becomes the "accident year combined ratio," a non-GAAP financial measure.
The key operating goal for our workers' compensation segment is to achieve underwriting profitability and significantly out-perform the national workers' compensation industry ("industry"). Our risk-reward strategy emphasizes pricing and underwriting discipline to maintain profitability rather than focusing on revenue or market share. In regards to our loss ratio, it is a measure of how we manage risk over the long term. We expect to produce, and for a long period of time have produced, lower than average loss ratios compared to the industry. However, because of our service strategy as a workers' compensation specialist, our expense ratios may be higher compared to industry results. During periods of declining premiums and policy counts such as in 2009, these high expense ratios coupled with an excellent loss ratio resulted in an underwriting loss. Although we are reducing costs as our business declines, we are maintaining and improving our ability to provide services to our customers and ensuring that we will be in a position to grow our business when the economy and employment trends improve.
Workers' compensation calendar year combined ratios, along with a reconciliation to the accident year combined ratios, were as follows:
•17.4 points attributable to the increase in the loss ratio, of which 10.1 points are attributable to lower favorable development of loss reserves, and 7.3 points are attributable to the increase in the accident year loss ratio;
•5.7 points attributable to the increase in the loss adjustment expense ratio; and
•4.7 points attributable to the increase in the underwriting and other operating expense ratio. The 2007 and 2008 loss ratios were exceptionally low in comparison to our long-term experience because of the favorable impacts caused by the California and Florida legislative reforms. Although our 2009 loss ratio increased from 2008, it is consistent with our long-term history and continues to be an excellent result in comparison to historical industry trends and current industry estimates. Accident year loss ratios trended up each year primarily because of increasing average cost of claims. Expense ratios increased primarily due to the decline in premiums.
The table above reflects declines in premiums in-force, number of policies in-force and insured payrolls both in and outside California. The following trends affected our workers' compensation business:
•The reduction in premiums in-force reflects the impact of the decline in policies-in-force, declining payrolls, as well as net premium rate reductions;
•The reduction in policies in-force reflects the impact of competition in relation to our risk management practices; and
•The reduction in insured payrolls is caused by the reduction in policies in-force (competition), as well as the impact of increased unemployment and declining payroll levels of our insureds. To the extent that payroll levels on in-force policies continue to decline as a result of the recession or increase as the economy recovers, our actual premiums earned will be less or more than the amount implied by premiums in-force.
the workers' compensation business, particularly in California, we give weight to our own data as well as external information in determining our loss reserve estimates.
The following table shows the favorable (unfavorable) one-year loss reserve development for loss reserves for each of the periods shown, as well as the loss reserve development as a percent of loss reserves, net of reinsurance, established at the end of the preceding year. The one-year loss reserve development is the change recorded in the calendar year for the estimate of the loss reserves established at the end of the preceding year and reflects a cumulative adjustment to estimates for all accident years.
Further information about our loss reserve estimates and the favorable (unfavorable) development over the past ten years is included in Item 1. "Business" beginning on page 12.
In our workers' compensation business the large majority of claims are reported to us promptly and therefore, as of the balance sheet date, the number of IBNR claims is relatively insignificant. The greater part of the challenge in estimating our loss reserves is associated with estimating ultimate loss costs across a population of claims for each accident year. The principal uncertainty in our workers' compensation loss reserve estimates at this time is the trend of increasing claim costs, particularly medical. The cost trend is the year over year increase (or decrease) in average claim costs. Medical costs are approximately 65% of our total loss costs. In estimating loss reserves, our actuaries consider medical costs by evaluating longer term trends. During the accident years just prior to the legislative reforms (1998 - 2002), we experienced double-digit medical cost increases. During 2003 and 2004, reforms enacted in Florida and California provided both immediate medical cost reductions and more control over future medical costs. These reforms included reductions in the medical fee schedules, provision for medical networks and establishment of medical treatment guidelines. Our loss estimates for these two years reflect an average 6% per year decrease in medical costs. For the accident years following the reforms we are experiencing a return to increasing medical costs and our loss reserve estimates reflect an average 8% per year increase in medical costs for 2005 - 2009. If the average
Additional uncertainties considered in estimating ultimate loss costs include the ultimate number of expensive claims and the length of time required to settle long-term, expensive claims. Expensive claims are those involving permanent partial disability ("PPD") of an injured worker and are paid over many years. The ultimate costs of expensive claims are difficult to estimate because of such factors as the on-going and possibly increasing need for medical care, length of disability, life expectancy and changes in legal decisions and legislation. Prior to the reforms, these expensive claims were approximately 20% of all claims in California, but contributed 90% of the total costs. In the years immediately following the reforms, these claims were reduced to about 14% of all claims and 85% of total costs; however, in recent accident years we are experiencing modest annual increases in the proportion of expensive claims to total claims.
Our actuaries produce a point estimate for workers' compensation loss reserves using the results of various methods of estimation. Our actuaries prepare reserve estimates for all accident years using our own historical claims data and many of the common actuarial methodologies for estimating loss reserves, such as paid loss development methods, incurred loss development methods, Bornhuetter-Ferguson indications and claim count methods. The actuarial point estimate is based on a selection of the results of these various methods depending upon both the age of the accident year and the geographic state of the injury. For mature accident years, all of the methods produce very similar loss estimates, and our actuarial point selections are based upon incurred loss development methods because our actuaries believe this most accurately reflects the required reserves for the relatively few claims that remain open. For accident year 2009, our actuarial estimate is based upon an average of the paid and incurred methods. Our actuaries review the cost trends implied by the point estimate to determine its reasonableness.
We believe it is appropriate to provide a comparison of our California results to the California workers' compensation industry results because the amount of business we write is meaningful in relation to the California workers' compensation industry and we earn approximately 60% of our premiums from our California business. During December 2009, the Workers' Compensation Insurance Rating Bureau ("WCIRB") made available its current estimate of California workers' compensation loss experience based on data through September 2009 as follows:
•An ultimate California industry loss ratio of 70% for accident year 2008 and 57% for accident year 2007. These ratios compare to our ultimate California loss ratios of 45% and 38%, respectively. Our estimated ultimate California loss ratio for 2009 is 51% and industry data is not yet available. The comparisons demonstrate our continued focus on managing risk and are consistent with our long-term record of outperforming the industry.
3.We manage our business with a focus on risk versus reward and use actuarial data to determine adequate premium rates, except in Florida where the regulators set the rates. Our field offices have no premium or growth targets. We receive business from a limited number of agents who understand our risk management process.
We have exposure to asbestos losses in our workers' compensation segment which have not been material to results of operations or financial condition. In our history, we have paid and closed 4,340 such asbestos-related workers' compensation claims for a total of $13.4 million or 0.2% of ultimate loss estimates. At December 31, 2009, we had 304 such claims open with loss reserves of $3.4 million compared to our total workers' compensation loss reserves, net or reinsurance, of $915.0 million.
Refer to Exhibit 99.1 to this report for a listing of our available-for-sale investment portfolio as of December 31, 2009, including the securities' identification numbers assigned in accordance with the Committee on Uniform Securities Identification Procedures ("CUSIP").
Net investment income and net realized gains (losses) on investments before tax were as follows:
Net investment income was lower each year primarily because of lower yields on short-term investments and an increase in short-term investments in 2009. In addition, 2007 included a $7.3 million cash dividend on an equity security.
During 2009, we increased the portfolio liquidity and reduced the maturity length of our portfolio. At December 31, 2009 and 2008, $737.3 million and $416.8 million, respectively, of the investment portfolio was in fixed maturity securities, including short-term investments, maturing within two years. This represented 37% and 21%, respectively, of the investment portfolio. The average maturity of the fixed maturity portfolio, including short-term investments, was approximately 3.0 and 4.5 years at December 31, 2009 and 2008, respectively. The duration of the fixed maturity portfolio, including short-term investments, was approximately 2.5 years and 3.5 years at December 31, 2009 and 2008, respectively.
Our fixed maturity and short-term investment portfolio was comprised of the following:
(1)GNMA securities are mortgage-backed securities issued by the Government National Mortgage Association.
We diversify our fixed maturity portfolio across a number of industries. The table below sets forth the amortized cost and fair values of fixed maturity securities, including short-term investments, by industry as well as U.S. Government securities at December 31, 2009:
The unrealized net gains (losses) on available-for-sale investments reported as a separate component of stockholders' equity were as follows:
The fair values of our available-for-sale investments are determined using the market approach, which is based on prices and other relevant information generated by market transactions involving identical or comparable assets. We use an independent pricing service as the primary source of our fair value measures. This pricing service is a leading global provider of financial market data, analytics and related services to financial institutions, active traders and individual investors. For equity securities traded in active markets, the independent pricing service obtains closing prices from major stock markets. For the majority of our fixed income securities, the independent pricing service provides values generated by valuation models which use observable market inputs from various industry sources, including traded prices for both identical and comparable assets as reported by an over-the-counter corporate bond market real-time price dissemination service. Considerable judgment is required in making assumptions used in such models, including the selection of interest rates, default risk and recovery rates and volatility risk assumptions.
To validate that the values obtained from the independent pricing service are reasonable estimates of fair value, we perform various quantitative and qualitative procedures, including, but not limited to a review of approximately 20 valuations obtained from our pricing service each quarter. The securities selected for testing are based on values that vary significantly from the previous week's values, or where values vary significantly from actual trade information or other observable market information. When variances occur that cannot be explained internally, we challenge the prices with our independent pricing service. The pricing service responds to all challenges with either an affirmation or a change in their price. We review and validate the basis for any affirmation in values.
Based on the validation procedures noted above, we did not identify any material discrepancies between our values and those provided by the independent pricing service, and we did not adjust the prices provided by our independent pricing services as of December 31, 2009.
We use mid-market quotes from well recognized market information sources as the basis for the fair value of highly liquid U.S. Government securities (includes U.S. Government Treasury Notes and Bills). We also use market information sources and unadjusted non-binding quotes from broker-dealers to determine the fair value of a small number of our securities that are not priced by our independent pricing service. As of December 31, 2009, we had three fixed income securities with fair values based on non-binding quotes obtained from broker-dealers totaling $20.1 million. To validate that the values obtained from the broker-dealers are reasonable estimates of fair value, we confirm that the non-binding quotes are based on proprietary models that use observable market inputs and trade information for similar securities. The fair values of certain privately held or thinly traded securities are determined using internal analytical methods based on the best information available, including unobservable market data.
Investments that we currently own could be subject to default by the issuer or could suffer declines in fair value that become other-than-temporary. We continually assess the prospects for individual securities as part of our ongoing portfolio management, including the identification of other-than-temporary declines in fair values. Our other-than-temporary assessment includes reviewing the extent and duration of declines in fair values of investments below the amortized cost basis, the seniority and duration of the securities, historical and projected company financial performance, company-specific news and other developments, the outlook for industry sectors, credit ratings and macro-economic changes, including government policy initiatives. For over eighteen years, we have consistently applied the presumption that an unrealized loss of 20% or more continuously for six months or more is other-than-temporary, in addition to issuer specific events. Our adoption of the accounting guidance on "Recognition and Presentation of Other-Than-Temporary Impairments" effective January 1, 2009 amended the determination of other-than-temporary impairments for debt securities, but not for equity securities. For debt securities, the amount of an other-than-temporary impairment related to a credit loss or an impairment on a security we have the intent, at the balance sheet date, to sell before recovery of our cost is recognized in earnings and reflected as a reduction in the cost basis of the security. The amount of an other-than-temporary impairment on debt securities related to other factors is recorded consistent with changes in the fair value of all other available-for-sale securities as a component of stockholders' equity in other comprehensive income (loss) with no change to the cost basis of the security. For equity securities, an other-than-temporary impairment is recognized in earnings and reflected as a reduction in the cost basis of the security based on the extent and duration that fair value is below cost, in addition to issuer specific events.
The table below sets forth information about securities with unrealized losses at December 31, 2009 and 2008:
The scheduled maturity dates for fixed maturity securities, including short-term investments, with unrealized losses at December 31, 2009 are shown below. Actual maturities may differ from those scheduled as a result of prepayments by the issuers.
In addition to the other-than-temporary impairments included in net realized gains (losses), the following is a summary of losses realized on the sale of securities, excluding short-term investments, for the periods shown reflecting the period of time that the security had been continuously in an unrealized loss position preceding the sale:
Sales of investments at a loss result from ongoing portfolio management, and may reflect our response to changes in interest rates, changes in our view of the prospects for an issuer or its industry, or changes in our views about appropriate asset concentrations and allocation. At the time we sold these investments at a loss, the sales were not related to any liquidity needs.
The following is a summary of our net cash used in operating activities for the periods shown:
Net cash used in operations reflects primarily lower workers' compensation premiums year over year offset by income tax refunds in 2009 compared to income tax payments in 2008 and 2007.
Our insurance subsidiaries are required to have securities on deposit for the protection of injured workers in accordance with various state laws and regulations, primarily in California, our state of domicile. At December 31, 2009 and 2008, investments with a fair value of $1.0 billion and $1.3 billion, respectively, were on deposit to comply with such regulations. In addition, California laws and regulations place various restrictions on the type and amounts of investments that may be made by our insurance subsidiaries.
Zenith National requires cash to pay dividends declared to our stockholders, make interest and principal payments on our debt due 2028, fund operating expenses and, from time to time, make capital contributions to Zenith Insurance. Such cash requirements are generally funded in the long run by dividends received from Zenith Insurance and financing activities by Zenith National. Cash and short-term investments of Zenith National were $94.7 million and $82.4 million at December 31, 2009 and 2008, respectively. Zenith National's available invested assets and other sources of liquidity are currently expected to be sufficient to meet its requirements for liquidity in the short-term and long-term.
Stockholders' equity per share before stockholders dividends of $2.40 increased by 12% from December 31, 2008 to December 31, 2009 reflecting primarily the increase in the fair value of our available-for-sale investment portfolio. Annual return on average equity was 3.3% in 2009, compared to 8.9% and 22.9% in 2008 and 2007, respectively.
In our insurance subsidiaries, cash and liquid investments are required to pay claims and expenses and the amount of capital in our insurance subsidiaries can determine how much premium we can write. The principal sources of capital for the insurance subsidiaries are the earnings generated by the workers' compensation and investments segments and contributions of capital by Zenith National. The amount of capital in our insurance subsidiaries is maintained relative to standardized capital adequacy measures such as risk-based capital. Risk-based capital is used by regulators for financial surveillance purposes and by rating agencies to assign financial strength ratings to our insurance subsidiaries and ratings for the debt issued by Zenith National. Insurance regulations require insurance companies to maintain capital at a minimum of 200% of regulatory risk-based capital. At December 31, 2009, our statutory capital of $979.2 million was approximately 1,500% of regulatory risk-based capital, which was substantially above the required minimum.
In 2009, the rating agencies affirmed the financial strength of our insurance subsidiaries as follows: A.M. Best Company ("A.M. Best") at A (Excellent), Standard & Poor's Rating Services ("S&P") at A- (Strong), Moody's Investors Service ("Moody's") at A3 (Good) and Fitch Ratings ("Fitch") at A (Strong). Our competitive position is partly determined by these financial strength ratings and therefore we could be affected by a reduction in these ratings. We currently believe that the most influential of these ratings is the rating assigned by A.M. Best. In the A.M. Best rating scheme,
From time to time, we may make repurchases of our outstanding shares of common stock or outstanding debt. At December 31, 2009, we were authorized to repurchase up to 929,000 shares of our common stock at prevailing market prices pursuant to a share repurchase program authorized by our Board of Directors. Any purchases are discretionary and can be adequately funded from our existing sources of liquidity. We have not repurchased any material amounts of our common stock under this repurchase program since 2001 and do not expect to repurchase common stock during 2010.
All of our outstanding financing obligations are included in the Consolidated Financial Statements and the accompanying Notes. There are no liquidity or financing arrangements with unconsolidated entities or any off-balance sheet arrangements. Our available invested assets and other sources of liquidity are currently expected to be sufficient to meet our short-term and long-term liquidity requirements.
Our loss reserves do not have contractual maturity dates and the exact timing of the payment of claims cannot be predicted with certainty. However, based upon historical payment patterns, we have included an estimate of when we expect our loss reserves (without the benefit of any reinsurance recoveries) to be paid. We maintain a portfolio of investments with varying maturities and a substantial
amount of short-term investments to provide adequate cash for the payment of claims. We expect to pay our obligations as they become due from our liquidity, and from our assets, if needed.
Our available-for-sale investment portfolio consists of fixed maturity and equity securities and short-term investments, and is recorded at fair value. Fair values are determined using the market approach, which is based on prices and other relevant information generated by market transactions involving identical or comparable assets. We use an independent pricing service as the primary source of our fair value measures. A small number of our securities are not priced by our independent pricing services and we use non-binding quotes obtained from broker-dealers. The fair values of certain privately held or thinly traded securities are determined using internal analytical methods based in the best information available, including unobservable market data. Valuation of securities is complex and
requires considerable judgment. During periods of market volatility, the valuations on certain securities may or may not reflect the values on actual trades at any point in time.
As of December 31, 2009, there were recently issued accounting guidance that we either implemented during the year or will implement in future periods. None of this guidance had or is expected to have a material effect on our consolidated financial condition or results of operations. See Note 2 to the Consolidated Financial Statements for a more complete summary.
The Following Financial Statement Schedules are filed in Item 15. of PART IV of this report:
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") and include Zenith National Insurance Corp. ("Zenith National") and its subsidiaries. All intercompany transactions and balances have been eliminated in consolidation.
GAAP requires the use of assumptions and estimates in reporting certain assets and liabilities and related disclosures. Actual results could differ from those estimates.
In determining whether a credit loss existed on debt securities with other-than-temporary impairments as of each balance sheet date, we estimated the present value of cash flows expected to be collected from the fixed maturity securities. Considerable judgment is required in determining estimated cash flows for any individual security and we use market observable data as well as management judgment. The cash flow estimates incorporate our assumption regarding the probability of default, and the timing and amount of recoveries associated with a default. We develop our estimates using information based on market observable data such as industry analysts' reports and forecasts, analysis of investment yield spreads to comparable peer company securities where there are no indications of credit related impairments, analysis of credit default swap spreads and other data relevant to the collectability of a security.
The consideration paid for an insurance policy is generally known as a "premium." Premiums billed to and paid by our policyholders are the revenues attributable to our workers' compensation segment. Premiums are billed and collected according to policy terms, predominantly in the form of installments during the policy period. Premiums are earned pro-rata over the terms of the policies. Billed premiums applicable to the unexpired terms of policies in-force are recorded in the accompanying consolidated balance sheets as a liability for unearned premiums. Premiums exclude policyholder surcharges primarily attributable to California business, which generally represent state insolvency fund assessments. These insolvency fund assessments are generally paid in advance to the various state agencies and subsequently collected from policyholders in the form of a surcharge, and do not affect our results of operations.
Workers' compensation premiums are determined based upon the payroll of the insured, the applicable premium rates and, where applicable, an experience-based modification factor and a debit or credit applied by our underwriters based upon individual risk characteristics. An audit of the policyholders' records is conducted after policy expiration to make a final determination of applicable premiums. Included with premiums earned is an estimate for the impact of final audit premiums. We can estimate this adjustment because we keep track, by policy, of how much additional premium is billed or refunded in final audit invoices as a percentage of the original estimated amount that was billed. We use the historical percentage and current trends to estimate the probable amount to be billed or refunded as of the balance sheet date. At times, such as 2009 during a recessionary period where payrolls are declining during policy periods, we may have billed more premium than is actually owed and we establish a liability for the estimated amount to be refunded to our policyholders. Included in other liabilities was $4.2 million at December 31, 2009 for estimated amounts to be refunded to our policyholders. Included in premiums receivable was $2.2 million at December 31, 2008 for estimated additional amounts to be billed to our policyholders.
We have written a relatively small number of workers' compensation policies that are retrospectively rated. Under this type of policy, subsequent to policy expiration, the policyholder may be entitled to a refund or may owe additional premium based on the amount of losses sustained under the policy. These retrospective premium adjustments are limited in the amount by which they increase or decrease the standard amount of premium applicable to the policy. We can estimate these retrospective premium adjustments because we know the underlying loss experience of the policies involved. The estimated liability for return of premiums under retrospectively rated workers' compensation policies included in unearned premiums was $1.5 million and $4.1 million at December 31, 2009 and 2008, respectively.
Reinsurance contracts covering catastrophe losses were customarily written to provide reinsurance for losses associated with one catastrophic event with a provision to reinstate the contract for the unexpired term of the original contract. An additional premium, called a reinstatement premium, is due in consideration of the reinstatement which gets adjusted and earned as losses develop over time.
Losses and loss adjustment expenses incurred in the accompanying consolidated statements of operations include provisions for the amount we expect to ultimately pay for all reported and unreported claims for the applicable periods. Loss adjustment expenses are the expenses applicable to the process of administering, settling and investigating claims, including legal expenses.
Estimates of losses from environmental and asbestos related claims are included in overall loss reserves and to date have not been material.
The liabilities for unpaid losses and loss adjustment expenses ("loss reserves") in the accompanying consolidated balance sheets are estimates of the unpaid amounts that we expect to pay for the ultimate cost of reported and unreported claims as of the balance sheet date. Loss reserves are estimates and are inherently uncertain; they do not and cannot represent an exact measure of ultimate liability. We perform a comprehensive review of our loss reserves at the end of every quarter. Estimating loss reserves is a complex process that involves a combination of actuarial techniques and methods and management judgment to establish the most reasonable estimate of loss reserves. Any resulting adjustments to loss reserves are reflected in our Consolidated Statements of Operations in the period in which the change is made.
When losses are reported to us, we establish individual estimates of the ultimate cost of the claims, known as "case reserves." These case reserves are continually monitored and revised in response to new information and for amounts paid. Our actuaries use this information about reported claims in some of their estimation techniques. In estimating our total loss reserves, we make provision for two types of loss development. At the end of any calendar period, there are a number of claims that have not yet been reported but will arise out of accidents that have already occurred. These are referred to in the insurance industry as incurred but not reported ("IBNR") claims and our loss reserves contain an estimate for IBNR claims. In addition to this provision for late reported claims, we also have to estimate, and make provision for, the extent to which the case reserves on known claims may also develop. These types of reserves are referred to in the insurance industry as "bulk" reserves. Our loss reserves make provision for both IBNR and bulk reserves in total, but not separately.
The principal uncertainty in our workers' compensation loss reserve estimates at this time is the trend of increasing claim costs, particularly medical. In estimating loss reserves, our actuaries consider medical costs by evaluating longer term trends. The additional uncertainties considered in estimating ultimate loss costs include the ultimate number of expensive cases and the length of time required to settle long-term expensive cases. Expensive claims are those involving permanent disability of an injured worker and are paid over many years. The ultimate costs of expensive claims are difficult to estimate because of such factors as the on-going and possibly increasing need for medical care, length of disability, life expectancy and benefits for dependents.
Most of our workers' compensation policies are non-participating; however, we issue certain policies in which the policyholder may participate in favorable claims experience through a dividend. An estimated provision for workers' compensation policyholders' dividends is accrued as the related premiums are earned. Such dividends do not become a fixed liability unless and until declared by the respective Boards of Directors of our insurance subsidiaries. The dividend to which a policyholder may be entitled is set forth in the policy and is related to the amount of losses sustained under the policy. Dividends are calculated after policy expiration (usually at 6 months and 18 months after expiration). We are able to estimate any liability we may have because we know the underlying loss experience of the policies we have written with dividend provisions and can estimate future dividend payments from the policy terms.
In addition, Florida statutes require payment of additional dividends to policyholders pursuant to a formula based on underwriting results. At December 31, 2008, we accrued approximately $20 million for Florida dividends payable for prior accident years. During 2009, we reduced our estimated Florida policyholders' dividends for prior accident years by $11.1 million based on our actual filing with the Florida Department of Insurance and paid the remaining amount to our policyholders.
State guarantee funds ("Guarantee Funds") exist to ensure that policyholders (holders of direct insurance policies but not of reinsurance policies) receive payment of their claims if insurance companies become insolvent. The Guarantee Funds are funded primarily by statutorily prescribed assessments they bill to insurance companies doing business in their states. Various mechanisms exist in some of these states for assessed insurance companies to recover these assessments. Upon the insolvency of an insurance company, the Guarantee Funds become primarily liable for the payment of the insolvent company's liabilities to policyholders. The declaration of an insolvency establishes the presumption that assessments by the Guarantee Funds are probable. We write workers' compensation insurance in many states in which unpaid workers' compensation liabilities are the responsibility of the Guarantee Funds and have received, and expect to continue to receive, Guarantee Fund assessments, some of which may be based on a certain amount of the premiums we have already earned as of December 31, 2009.
We recorded an estimate of $6.4 million and $6.6 million for our expected liability at December 31, 2009 and 2008, respectively, for Guarantee Fund assessments. We did not incur material amounts of estimated expense for Guarantee Fund assessments in 2009, 2008 and 2007. We expect that we will continue to receive and accrue Guarantee Fund assessments; and the ultimate impact of such assessments will depend upon the amount and timing of the assessments and of any recoveries to which we are entitled.
In the ordinary course of business and in accordance with general insurance industry practices, we purchase excess of loss reinsurance to protect us against the impact of large, irregularly occurring losses in the workers' compensation segment. Such reinsurance reduces the magnitude of such losses on net income and the capital of Zenith Insurance. Reinsurance makes the assuming reinsurer liable to the ceding company to the extent of the reinsurance. It does not, however, discharge the ceding company from its primary liability to its policyholders in the event the reinsurer is unable to meet its obligations under such reinsurance agreement. We monitor the financial condition of our reinsurers and do not believe that we are currently exposed to any material credit risk through our ceded reinsurance arrangements because most of our reinsurance is recoverable from large, well-capitalized reinsurance companies.
In 1998, Zenith Insurance acquired substantially all of the assets and certain liabilities of RISCORP, Inc. and certain of its subsidiaries (collectively, "RISCORP") related to its workers' compensation business. Also, in 1998, we entered into an aggregate excess of loss reinsurance agreement which provides ceded reinsurance for unpaid losses assumed by Zenith Insurance from RISCORP up to $50.0 million in excess of $182.0 million. Receivable from reinsurers on unpaid losses and loss adjustment expenses at December 31, 2009 and 2008 includes recoverable under such insurance of $10.6 million and $13.0 million, respectively, which is fully secured by an investment grade security held in a trust account. The deferred benefit associated with such reinsurance was $4.2 million and $4.5 million at December 31, 2009 and 2008, respectively.
At December 31, 2009 and 2008, goodwill from acquisitions was $21.0 million, of which $19.0 million is included in assets of the workers' compensation segment with the remaining $2.0 million included in parent assets. Other than goodwill, we had no intangible assets at December 31, 2009 or 2008. We test goodwill for impairment annually as of December 31 and more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. A reporting unit is an operating segment or a unit one level below the operating segment. The impairment tests include a comparison of the carrying amount of goodwill to the present value of future cash flows of both our workers' compensation segment and our Florida workers' compensation business operation, a reporting unit. The fair value, estimated based on Zenith National's common stock price and present value techniques, of the reporting unit exceeded its carrying amount as of December 31, 2009, therefore, goodwill of the reporting unit is not considered impaired.
In April 2009, the Financial Accounting Standards Board ("FASB") issued guidance that requires entities to separate an other-than-temporary impairment of a debt security into two components when there are credit related losses associated with the impaired debt security for which management asserts that it does not have the intent to sell the security and it is more likely than not that it will not be required to sell the security before recovery of its cost basis. The amount of the other-than-temporary impairment related to a credit loss is recognized in earnings and the amount of the other-than-temporary impairment related to other factors is recorded in other comprehensive income (loss). This guidance was effective for periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. We adopted this guidance effective January 1, 2009 (see Note 3). There were no impairments previously recognized on debt securities we owned at December 31, 2008; therefore, there was no cumulative effect adjustment to retained earnings or other comprehensive loss as a result of adopting this guidance (see Note 3).
In April 2009, the FASB issued guidance on "Determining Fair Value When Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions that are Not Orderly." Under this guidance, if an entity determines that there has been a significant decrease in the volume and level of activity for the asset or the liability in relation to the normal market activity for the asset or liability (or similar assets or liabilities), then transactions or quoted prices may not accurately reflect fair value. In addition, if there is evidence that the transaction for the asset or liability is not orderly, the entity shall place little, if any, weight on that transaction price as an indicator of fair value. This guidance was effective for periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. We adopted this guidance effective January 1, 2009.
In September 2009, the FASB issued updated guidance for the fair value measurement of alternative investments such as hedge funds, private equity funds, and venture capital funds. This guidance allows companies to determine the fair value of such investments using net asset value ("NAV") as a practical expedient if the fair value of the investment is not readily determinable and the investee entity issues financial statements in accordance with measurement principles for investment companies. Use of this practical expedient is prohibited if it is probable the investment will be sold at something other than NAV. This guidance also requires new disclosures for each major category of alternative investments and was effective for financial statements issued in the period ending after December 15, 2009.
The following accounting guidance will be adopted in 2010, and is not expected to have a material impact, if any, on our consolidated financial position or results of operations.
In June 2009, the FASB issued guidance which 1) replaces the quantitative-based risks and rewards calculation for determining whether an enterprise is the primary beneficiary in a variable interest entity with an approach that is primarily qualitative; 2) requires ongoing assessments of whether an enterprise is the primary beneficiary of a variable interest entity; and 3) requires additional disclosures about an enterprise's involvement in variable interest entities. This guidance is effective for financial statements issued for fiscal years beginning after November 15, 2009.
The cost or amortized cost, fair value and carrying value of available-for-sale investments at December 31, 2009 and held-to-maturity and available-for-sale investments at December 31, 2008 were as follows:
At December 31, 2009, all of the investments in fixed maturity securities and short-term investments were classified as available-for-sale securities compared to 89% at December 31, 2008. We reclassified our entire held-to-maturity investment portfolio to available-for-sale during the first quarter 2009 because we determined that we no longer had the positive intent to hold these securities to maturity as a result of the unprecedented events in the financial markets which caused market and economic risks that were not present at the time we elected to hold these securities to maturity. In March 2009, we sold all of our GNMA securities, most of which were originally classified as held-to-maturity, resulting in a realized gain of $8.8 million before tax.
Fixed maturity securities, including short-term investments, by contractual maturity were as follows at December 31, 2009:
Mortgage-backed securities are shown as being due at their average expected maturity dates. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Included in the $19.1 million other-than-temporary impairments recognized in 2009, were credit related impairments of $9.7 million for two corporate debt securities based on estimated cash flows as of March 31, 2009. We determined the estimated cash flows at 60% of par value for one of the debt securities and 90% of par value for the other debt security, and discounted the cash flows using the effective interest rate of 6.60% and 5.49% implicit in the two debt securities at the date of acquisition.
The following table presents the change in other-than-temporary credit related impairments before tax recognized in earnings:
The unprecedented events in the capital and credit markets resulted in extreme volatility and disruption to the financial markets over the past two years. The fair value of our available-for-sale investment portfolio improved from a net unrealized loss before tax of $77.3 million at December 31, 2008 to a net unrealized gain before tax of $56.1 million at December 31, 2009, an increase of $133.4 million. This change in fair value of investments classified as available-for-sale resulted in an increase in stockholders' equity of $86.7 million after tax for the year ended December 31, 2009 compared to a decrease of $62.3 million after tax for the comparable period in 2008. Our internal investments department manages our investment portfolio and for the most part we do not rely on external portfolio managers. We review the appropriateness and consistency of the fair values, which are affected primarily by changes in interest rates, as well as changes in the credit quality and liquidity of the companies in which we have invested or changes in general economic and market conditions.
We believe that our unrealized losses on individual fixed maturity and equity securities at December 31, 2009 are not material and are not indicative of impaired values. We base this conclusion on our current understanding of the issuers of these securities. As of December 31, 2009, we have not made a decision to sell any of these securities and we have adequate liquidity and will not be required to sell before recovery of their cost basis. It is possible that we could recognize future impairments on some securities we owned at December 31, 2009 if future events, information and the passage of time cause us to determine that a decline in value is other-than-temporary.
The gross realized gains and the gross realized losses on sales of fixed maturity and equity securities were as follows:
Net investment income from equity securities in the years ended December 31, 2008 and 2007 include a $1.1 million and $7.3 million, respectively, cash dividend from an equity security investment.
Our available-for-sale investment portfolio consists of fixed maturity and equity securities and short-term investments and is recorded at fair value in the accompanying Consolidated Balance Sheets.
Fair value measurements are determined under a three-level hierarchy that prioritizes the inputs to valuation techniques used to measure fair value, distinguishing between market participant assumptions developed based on market data obtained from sources independent of the reporting entity ("observable inputs") and the reporting entity's own assumptions about market participant assumptions developed based on the best information available in the circumstances ("unobservable inputs"). The hierarchy level assigned to each security in our available-for-sale portfolio is based on our assessment of the transparency and reliability of the inputs used in the valuation of each instrument at the measurement date. The highest priority is given to unadjusted quoted prices in active markets for identical assets (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). Securities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The three hierarchy levels are defined as follows:
Level 2 - Valuations based on observable inputs (other than Level 1 prices), such as quoted prices for similar assets at the measurement date; quoted prices in markets that are not active; or other inputs that are observable, either directly or indirectly. The fair value of fixed maturity securities and short-term investments included in the Level 2 category were based on market values obtained from independent pricing services that were evaluated using pricing models that vary by asset class and incorporate available trade, bid and other market information and price quotes from well-established independent broker-dealers. The independent pricing services monitor market indicators, industry and economic events, and for broker-quoted only securities, obtain quotes from market makers or broker-dealers that they recognize to be market participants. Our Level 2 category includes corporate bonds, foreign government bonds, municipal bonds, short-term commercial paper (at December 31, 2008), redeemable preferred stocks and certain publicly traded common stocks with no trades on the measurement date.
Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement and involve management judgment. The fair values of certain privately held or thinly traded securities are determined using internal analytical methods based on the best information available. The estimated fair values of Level 3 equity securities consist primarily of the following: 1) An equity security of a company based in the United Kingdom with a fair value approximating its net asset value because a significant portion of the net asset value, excluding cash balances, is comprised of real estate holdings supported by appraisals. The estimated fair value for this investment also includes foreign currency fluctuations and considers the value of an unrecognized tax loss carry forward. 2) A fixed maturity security representing our participation in a commercial senior secured term loan. The
fair value of this fixed maturity security was determined internally based on a non-binding broker quote and other unobservable inputs.
We file a consolidated federal income tax return. The insurance subsidiaries pay premium taxes on gross premiums written in lieu of most state income or franchise taxes.
The components of the provision for tax on income were as follows:
The net favorable development of $9.1 million in 2009 is principally for the 2005 and 2006 accident years due to the reduction in the workers' compensation paid and incurred trends.
The net favorable development on prior accident years of $109.8 million in 2007 is principally related to a reduction in estimated workers' compensation losses for the 2003 through 2006 accident years.
The issue costs and discount on the Subordinated Debentures of $1.7 million are being amortized over the term of the Subordinated Debentures. During each of the years ended December 31, 2009, 2008, and 2007, $5.0 million of interest, issue costs and discount were expensed.
We maintain excess of loss and catastrophe reinsurance which provides protection up to $150 million for workers' compensation losses including catastrophe losses arising out of California earthquakes. We retain the first $5 million of each loss. In the layer of $5 million in excess of $5 million we retain any losses that exceed our annual aggregate limit of $15 million. In the layer of $10 million excess of $10 million we retain 50%.
We maintain excess of loss and catastrophe reinsurance which provides protection up to $20 million for acts of terrorism including nuclear, biological and chemical attacks. We retain the first $5 million of each loss. We retain any losses in the $5 million excess $5 million layer which exceed our annual aggregate of $5 million. We also retain 50% of any loss other than nuclear, biological or chemical in the $10 million excess $10 million layer. We retain none of the loss in the $10 million excess $10 million layer in events of nuclear, biological or chemical attacks.
Reinsurance transactions reflected in the accompanying Consolidated Statements of Operations were as follows:
In 2007, we reviewed our workers' compensation losses in excess of our reinsurance retention (ceded losses), a small population of high-value claims which remain open for several years. We determined it was prudent to incorporate industry-wide loss development factors in addition to using our own historical claims data to estimate our ceded loss reserves. As of December 31, 2007, our estimate of ceded losses included in unpaid losses and loss adjustment expenses was increased by approximately $97.3 million, offset in full by the resulting increase in receivable from reinsurers.
The following table provides information regarding the shares under the Restricted Stock Plan:
Changes in restricted stock for each of the three years ended December 31, 2009 were as follows:
We have office space, equipment and automobile leases expiring through 2015. The minimum lease payments for the next five years on these non-cancelable operating leases at December 31, 2009 were as follows:
We are involved in various litigation proceedings that arise in the ordinary course of our business. Disputes adjudicated in the workers' compensation administrative systems may be appealed to review boards or civil courts, depending on the issues and local jurisdictions involved. From time to time plaintiffs also sue us on theories falling outside of the exclusive jurisdiction and remedies of the workers' compensation claims adjudication systems. Certain of these legal proceedings seek injunctive relief or substantial monetary damages, including claims for punitive damages, which may not be covered by our third party reinsurance agreements. Historically, the Company has not experienced any material exposure or damages from any of these legal proceedings. In addition, in the opinion of management, after consultation with legal counsel, all of our currently outstanding litigation is either without merit or the ultimate liability, if any, is not expected to have a material adverse effect on our consolidated financial condition, results of operations or cash flows.
paid-in capital and retained earnings. There was no impact on our consolidated stockholders' equity as a result of the cancellation and retirement.
Through December 31, 2007, California statutes (the domiciliary state of our insurance subsidiaries) required that in addition to applying the NAIC's statutory accounting practices, insurance companies must record, under certain circumstances, an additional liability, called an "excess statutory reserve." The excess statutory reserve formula established a 65% losses and loss adjustment expense ratio for the current and prior two years. Excess statutory reserves reduced statutory surplus but did not impact statutory net income. As of December 31, 2008, the excess statutory reserves were no longer required under California law. At December 31, 2007, we reported statutory surplus of $451.1 million, which reflects a reduction of $582.1 million for the excess statutory reserves as determined under the formula.
The following table sets forth the computation of basic and diluted net income per common share and cash dividends declared per common share:
The following table summarizes the components of accumulated other comprehensive income (loss):
The combined ratio, expressed as a percentage, is a key measurement of profitability traditionally used in the property-casualty insurance business. The combined ratio, also referred to as the "calendar year combined ratio," is the sum of the losses and loss adjustment expense ratio and the underwriting
and other operating expense ratio. The losses and loss adjustment expense ratio is the percentage of net losses and loss adjustment expenses incurred to net premiums earned. The underwriting and other operating expense ratio is the percentage of underwriting and other operating expenses to net premiums earned.