Our principal executive offices are 79,533 square feet located in leased premises in Reno, Nevada. As of February 1, 2012, we leased 293,641 square feet of total office space in 10 states. We believe that our existing office space is adequate for our current needs. We will continue to enter into or exit lease agreements to address future space requirements, as necessary.
We are a Nevada holding company. Through our insurance subsidiaries, we provide workers’ compensation insurance coverage to select, small businesses in low to medium hazard industries. Workers’ compensation insurance is provided under a statutory system wherein most employers are required to provide coverage for their employees’ medical, disability, vocational rehabilitation, and/or death benefit costs for work-related injuries or illnesses. We provide workers’ compensation insurance in 31 states and the District of Columbia, with a concentration in California. Our revenues are primarily comprised of net premiums earned, net investment income, and net realized gains on investments.
We target small businesses, as we believe that this market is traditionally characterized by fewer competitors, more attractive pricing, and stronger persistency when compared to the U.S. workers’ compensation insurance industry in general. We believe we are able to price our policies at levels which are competitive and profitable over the long-term. Our underwriting approach is to consistently underwrite small business accounts at an appropriate and competitive price without sacrificing long-term profitability and stability for short-term top-line revenue growth.
Net premiums earned declined 20% from 2009 to 2010 and increased 13% from 2010 to 2011;
We define net income before impact of the Deferred Gain as net income less: (a) amortization of Deferred Gain and (b) adjustments to LPT Agreement ceded reserves. Deferred Gain reflects the unamortized gain from our LPT Agreement. Under GAAP, this gain is deferred and is being amortized using the recovery method, whereby the amortization is determined by the proportion of actual reinsurance recoveries to total estimated recoveries, and the amortization is reflected in losses and LAE. We periodically reevaluate the remaining direct reserves subject to the LPT Agreement. Our reevaluation results in corresponding adjustments, if needed, to reserves, ceded reserves, reinsurance recoverables and the Deferred Gain, with the net effect being an increase or decrease, as the case may be, to net income. Net income before impact of the Deferred Gain is not a measurement of financial performance under GAAP, but rather reflects the difference in accounting treatment between statutory and GAAP, and should not be considered in isolation or as an alternative to net income before income taxes or net income or any other measure of performance derived in accordance with GAAP.
We present net income before impact of the Deferred Gain because we believe that it is an important supplemental measure of operating performance to be used by analysts, investors and other interested parties in evaluating us. The LPT Agreement was a non-recurring transaction, under which the Deferred Gain does not result in ongoing cash benefits, and, consequently, we believe this presentation is useful in providing a meaningful understanding of our operating performance. In addition, we believe this non-GAAP measure, as we have defined it, is helpful to our management in identifying trends in our performance because the excluded item has limited significance in our current and ongoing operations.
In October 2010, the Financial Accounting Standards Board (FASB) issued guidance that changes the definition of acquisition costs which may be capitalized beginning in 2012. We currently estimate that our underwriting and other operating expenses will be increased by approximately $7 million in 2012 as a result of the adoption of this new accounting guidance. Additional information regarding this change is set forth under “-New Accounting Standards.”
The following table shows the percentage change in our in-force premium, policy count, average policy size, and payroll exposure, upon which our premiums are based, and net rate.
We set our own premium rates in California based upon actuarial analyses of current and anticipated loss trends with a goal of maintaining underwriting profitability. Due to increasing loss costs, primarily medical cost inflation, we have increased our filed premium rates by a cumulative 33.3% since February 1, 2009.
increasing policy count as we continue to execute our growth strategy;
We invest our holding company assets, statutory surplus, and the funds supporting our insurance liabilities, including unearned premiums and unpaid losses and LAE. We invest in fixed maturity securities, equity securities, short-term investments, and cash equivalents. Net investment income includes interest and dividends earned on our invested assets and amortization of premiums and discounts on our fixed maturity securities, less bank service charges and custodial and portfolio management fees. We have established a high quality/short duration bias in our investment portfolio.
The combined ratio, expressed as a percentage, is a key measurement of underwriting profitability. The combined ratio is the sum of the losses and LAE ratio, the commission expense ratio, policyholder dividends ratio, and underwriting and other operating expenses ratio. When the combined ratio is below 100%, we have recorded underwriting income, and conversely, when the combined ratio is greater than 100%, we cannot be profitable without investment income. Because we only have one operating segment, holding company expenses are included in our calculation of the combined ratio.
In California, we are experiencing an increase in indemnity claims frequency (the number of indemnity claims expressed as a percentage of payroll). Our loss experience also indicates an upward trend in medical and indemnity costs that are reflected in our current accident year loss estimate. We are seeing increased medical and indemnity costs in many of our other states, partially offset by long-term favorable loss cost trends in Nevada. We believe our current accident year loss estimate is adequate; however, ultimate losses will not be known with any certainty for several years. We assume that increasing medical and indemnity cost trends will continue to impact our long-term claims costs and current accident year loss estimate. Additional information regarding our reserves for losses and LAE is set forth under “-Critical Accounting Policies-Reserves for Losses and LAE.”
Overall, losses and LAE were $264.7 million, $194.8 million, and $214.5 million for the years ended December 31, 2011, 2010, and 2009, respectively. The increase from 2010 to 2011 was primarily due to an increase in the current accident year loss estimate, an increase in net earned premiums, and the impact of favorable prior accident year loss development in 2010. Prior accident year loss development in 2011 is entirely related to our assigned risk business. The decrease in losses and LAE from 2009 to 2010 was primarily due to lower payroll exposures. Additionally, favorable prior accident year loss development decreased $34.8 million to $16.6 million for the year ended December 31, 2010, compared to the same period of 2009. Our accident year loss estimates were 77.2%, 70.6%, and 70.2% for the years ended December 31, 2011, 2010, and 2009, respectively. The accident year loss
estimate for the year ended December 31, 2010 excludes a $1.6 million expense related to the commutation of certain reinsurance treaties and a $0.9 million expense related to the write-off of certain reinsurance recoverables. The increase in the current accident year loss estimate in 2011 is primarily due to continuing increases in loss costs in California. The table below reflects losses and LAE reserve adjustments.
We accrue the estimated ultimate contingent profit commission through June 30, 2024. Increases or decreases in the estimated contingent profit commission are reflected in commission expense in the period that the estimate is revised. We increased the estimated contingent profit commission by $1.8 million and $0.8 million in 2011 and 2010, respectively, resulting in a decrease in the commission expense for those years. For the year ended December 31, 2009, we decreased commission expenses by $15.0 million as a result of an increase in contingent profit commissions and received cash payment of $10.3 million from the reinsurers. At December 31, 2011, expected amounts to be paid for losses under the LPT Agreement for the period July 1, 1999 through June 30, 2014, were $673.4 million, compared to contractually expected losses and LAE of approximately $775.0 million.
Florida statutes also require the return of the portion of policyholders' premiums that are deemed to be excessive profits under Florida law. We account for these payments as policyholder dividends.
Policyholder dividends were $3.4 million, $4.3 million, and $6.9 million for the years ended December 31, 2011, 2010, and 2009, respectively. Policyholder dividends fluctuate from time to time due to changes in premium levels on dividend policies and the eligibility of policyholders to receive dividend payments.
Income tax expense (benefit) was $(2.1) million, $3.5 million, and $9.3 million for the years ended December 31, 2011, 2010, and 2009, respectively. The effective tax rates for the years ended December 31, 2011, 2010, and 2009 were (4.6)%, 5.3%, and 10.1%, respectively. The decreased tax expense from 2009 through 2011 is primarily due to increases in tax exempt income as a percentage of pre-tax net income, which was 68.2%, 50.6%, and 36.8% for the years ended December 31, 2011, 2010, and 2009, respectively.
Based on reported capital, surplus, and dividends paid within the last 12 months, the maximum dividends that may be paid by EICN and EPIC in 2012 without prior approval by the respective state insurance regulator are $26.3 million and $13.6 million, respectively.
As of December 31, 2011, the holding company had $188.4 million of cash and cash equivalents and fixed maturity securities maturing within the next 24 months. Ten million dollars of our line of credit is payable on each of December 31, 2012 and December 31, 2013. We believe that the liquidity needs of the holding company over the next 24 months will be met with cash, maturing investments, and dividends from our insurance subsidiaries.
Our total outstanding debt was $122.0 million and $132.0 million as of December 31, 2011 and 2010, respectively. Interest and fees on debt obligations and an interest rate swap totaled $3.6 million and $5.7 million in 2011 and 2010, respectively.
Operating Cash and Cash Equivalents and Short-Term Investments. The primary sources of cash for our insurance operating subsidiaries are funds generated from underwriting operations, investment income, and maturities and sales of investments. The primary uses of cash are payments of claims and operating expenses, purchases of investments, and payments of dividends to the parent holding company, which are subject to state insurance laws and regulations.
Our insurance subsidiaries had total cash and cash equivalents and fixed maturity securities of $305.1 million maturing within the next 24 months at December 31, 2011. We believe that our subsidiaries' liquidity needs over the next 24 months will be met with cash from operations, investment income, and maturing investments.
Various state regulations require us to keep securities or letters of credit on deposit with the states in which we do business. Securities having a fair market value of $522.6 million and $558.6 million were on deposit at December 31, 2011 and 2010, respectively. These laws and regulations govern both the amount and type of fixed maturity security that is eligible for deposit. Additionally, certain reinsurance contracts require us to hold funds in trust for the benefit of the ceding reinsurer to secure the outstanding liabilities we assumed. The fair value of securities held in trust for reinsurance was $40.3 million and $52.9 million at December 31, 2011 and 2010, respectively.
Operating Activities. Major components of net cash provided by operating activities in 2011 included: net premiums received of $358.4 million; investment income received of $90.8 million; and amounts recovered from reinsurers of $46.1 million. These were partially offset by: claims payments of $316.4 million; underwriting and other operating expenses paid of $86.1 million; commissions paid of $36.3 million; premium taxes paid of $7.6 million; and policyholder dividends paid of $4.8 million.
Major components of net cash provided by operating activities in 2009 were net premiums received of $398.0 million and investment income received of $96.0 million, partially offset by claims payments of $284.6 million (net of reinsurance recoverables), underwriting and other operating expenses paid of $177.3 million, and federal income taxes paid of $8.7 million.
Financing Activities. The majority of cash used in financing activities in 2011 and 2010 was to repurchase $92.0 million and $63.6 million of our common stock, respectively, and to pay dividends to stockholders. Additionally, cash was used to pay down $10 million on the line of credit provided by the Amended Credit Facility in 2011. In 2009, the majority of cash used in financing activities was to repurchase $74.2 million of our common stock and to pay down $50 million of the line of credit provided by the Amended Credit Facility.
Given the economic uncertainty and continued market volatility, we believe that our asset allocation best meets our strategy to preserve capital for policyholders, to provide sufficient income to support insurance operations, and to effectively grow book value over a long-term investment horizon.
The following table shows the estimated fair value, the percentage of the fair value to total invested assets, and the average tax equivalent yield based on the fair value of each category of invested assets as of December 31, 2011.
The following table shows the percentage of total estimated fair value of our fixed maturity securities as of December 31, 2011 by credit rating category, using the lower of ratings assigned by Moody's Investor Service and/or S&P.
whether it is not more likely than not that we will be required to sell the security before its fair value recovers above cost, or to maturity.
Based on our review of fixed maturity and equity securities, we believe that we appropriately identified the declines in the fair values of our unrealized losses at December 31, 2011 and 2010. We determined that the unrealized losses on fixed maturity securities were primarily the result of prevailing interest rates and not the credit quality of the issuers. The fixed maturity securities whose fair value was less than amortized cost were not determined to be other-than-temporarily impaired given the severity and duration of the impairment, the credit quality of the issuers, the Company’s intent on not selling the securities, and a determination that it is not more likely than not that the Company will be required to sell the securities until fair value recovers to above cost, or to maturity.
Accounting for workers' compensation insurance requires us to estimate the liability for the expected ultimate cost of unpaid losses and LAE (loss reserves) as of a balance sheet date. Loss reserve estimates are inherently uncertain because the ultimate amount we pay for many of the claims we have incurred as of the balance sheet date will not be known for many years. Our estimate of loss reserves is intended to equal the difference between the expected ultimate losses and LAE of all claims that have occurred as of a balance sheet date and amounts already paid. We establish loss reserves based on our own analysis of emerging claims experience and environmental conditions in our markets and review of the results of various actuarial projections. Our aggregate carried reserve for unpaid losses and LAE is the sum of our reserves for each accident year (point estimate) and represents our best estimate of outstanding loss reserves.
Judgment is required in the actuarial estimation of loss reserves, including the selection of various actuarial methodologies to project the following: the ultimate cost of claims; the selection of projection parameters based on historical company data, industry data, and other benchmarks; the identification and quantification of potential changes in parameters from historical levels to current and future levels due to changes in future claims development expectations; and the weighting of differing reserve indications resulting from alternative methods and assumptions. The adequacy of our ultimate loss reserves is inherently uncertain and represents a significant risk to our business. We attempt to mitigate this risk through our claims management process and by monitoring and reacting to statistics relating to the cost and duration of claims.
We retain an independent actuarial consulting firm (Consulting Actuary) to perform comprehensive studies of our liability for losses and LAE on a semi-annual basis. The role of the Consulting Actuary is to conduct sufficient analyses to produce a range of reasonable estimates, as well as a point estimate, of our liability for unpaid losses and LAE, and to present those results to our actuarial staff and to management.
In Nevada, one method involves adjusting historical data for inflation. The inflation rates used in the analysis are judgmentally selected based on historical year-to-year movements in the cost of claims observed in our insurance subsidiaries' data and industry-wide data, as well as on broader inflation indices. The results of this method would differ if different inflation rates were selected.
The aggregate carried reserve calculated by management represents our best estimate of our outstanding unpaid losses and LAE. We believe that we should be conservative in our reserving practices due to the “long-tail” nature of workers' compensation claims payouts, the susceptibility of those future payments to unpredictable external forces such as medical cost inflation and other economic conditions, and the actual variability of loss reserve adequacy that we have observed in the workers' compensation insurance industry.
The increase in the estimate of incurred losses and LAE attributable to insured events of prior years in 2011 was related to the Company's assigned risk business, while the decreases in 2010 and 2009 were due to favorable development in those prior accident years. The sources of favorable development include actual paid losses that were less than expected and the impact of new information on selected patterns of claims emergence and payment used in the projection of future loss payments. New information includes our own data regarding patterns of claims emergence, development and payment that have been observed in the most recent periods, and external information regarding the workers' compensation environments in the states in which we operate.
As of December 31, 2011, California and Nevada represented approximately 78% of our reserves for unpaid losses and LAE on our consolidated balance sheet.
Our insurance subsidiaries have been operating in a period characterized by changing environmental conditions in our major markets, entry into new markets, and operational changes. During periods characterized by such changes, at each evaluation, the actuaries and management must make judgments as to the relative weight to accord to long-term historical and recent company data, external data, evaluations of environmental and operational changes, and other factors in selecting the methods to use in projecting ultimate losses and LAE, the parameters to incorporate in those methods, and the relative weights to accord to the different projection indications. At each evaluation, management has given weight to new data, recent indications, and evaluations of environmental conditions and changes that implicitly reflect management's expectation as to the degree to which the future will resemble the most recent information and most recent changes, compared with long-term claim payment, claims emergence, and
More than 59% of our claims payments during the three years ended December 31, 2011 related to medical care for injured workers. The utilization and cost of medical services in the future is a significant source of uncertainty in the establishment of loss reserves for workers' compensation. Our loss reserves are established based on reviewing the results of actuarial methods, some of which do not contain explicit medical claim cost inflation rates, however, because medical care may be provided to an injured worker over many years, and in some cases decades, the pace of medical claim cost inflation has a significant impact on our ultimate claim payments. For example, if the rate of medical claim cost inflation increases by 1% above the inflation rate that is implicitly included in the loss reserves at December 31, 2011, we estimate that future medical costs over the lifetime of current claims would increase by approximately $81 million on a net-of-reinsurance basis.
Actual losses are affected by a more complex combination of forces and dynamics than any one model or actuarial methodology can represent, and each methodology is an approximation of these complex forces and dynamics. None of the methods are designed or intended to produce an indication that is systematically higher or lower than the other methods. At any given evaluation date, some of the actuarial projection methods produce indications outside the Consulting Actuary's selected range. Accordingly, we believe that the range of potential outcomes is considerably wider than the actuarially estimated range of the most likely outcomes. We increased our prior years' reserves for unpaid losses and LAE by $1.1 million as of December 31, 2011, while we decreased our prior years' reserves for unpaid losses and LAE by $14.1 million and $51.4 million as of December 31, 2010 and 2009, respectively, illustrating that changes in estimates of loss reserves can be significant from year-to-year. We have no basis for anticipating whether actual future payments of losses and LAE may be either greater than or less than the reserve for unpaid losses and LAE currently on our balance sheet.
Under the LPT Agreement, the Fund initially ceded $1.5 billion in liabilities for the incurred but unpaid losses and LAE related to claims incurred prior to July 1, 1995 for consideration of $775.0 million in cash. The estimated remaining liabilities subject to the LPT Agreement were $807.5 million as of December 31, 2011. Losses and LAE paid with respect to the LPT Agreement totaled $569.9 million at December 31, 2011. We account for the LPT Agreement as retroactive reinsurance. Entry into the LPT Agreement resulted in a deferred reinsurance gain that was recorded on our consolidated balance sheet as a liability. This deferred
Our investments in fixed maturity and equity securities are classified as available-for-sale and are reported at fair value with unrealized gains and losses excluded from earnings and reported as a separate component of equity, net of deferred taxes, in accumulated other comprehensive income, net. Realized gains and losses on sales of investments are recognized in operations on a specific-identification basis.
Fair values of our available-for-sale fixed maturity and equity securities are based on quoted market prices, where available. These fair values are obtained primarily from third party pricing services, which generally use Level 1 or Level 2 inputs in accordance with FASB guidance. The Company obtains a quoted price for each security from third party pricing services, which are derived through recently reported trades for identical or similar securities. For securities not actively traded, the third party pricing services may use quoted market prices of similar instruments or discounted cash flow analyses, incorporating inputs that are currently observable in the markets for similar securities. Inputs that are often used in the valuation methodologies include, but are not limited to, broker quotes, benchmark yields, credit spreads, default rates, and prepayment speeds. The Company also performs quarterly analysis on the prices received from third parties to determine whether the prices are reasonable estimates of fair value, including confirming the fair values of these securities through observable market prices using an alternative pricing source. If unusual fluctuations are noted in this review, the Company may obtain additional information from other pricing services to validate the quoted price.
Prior to December 31, 2011, additional accounting guidance had been issued that we either implemented during 2011 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 3 in the Notes to our Consolidated Financial Statements.
Consolidated Statements of Stockholders' Equity for each of the three years ended December 31, 2011
Consolidated Statements of Cash Flows for each of the three years ended December 31, 2011
Management conducted an assessment of the effectiveness of the Company's internal control over financial reporting as of December 31, 2011 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO Framework).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Employers Holdings, Inc. and Subsidiaries' internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 1, 2012 expressed an unqualified opinion thereon.
Premium revenue is recognized over the period of the contract in proportion to the amount of time insurance protection is provided. At the end of the policy term, payroll-based premium audits are performed on substantially all policyholder accounts to determine net premiums earned for the policy year. Earned but unbilled premiums include estimated future audit premiums based on the Company's historical experience. These estimates are subject to changes in policyholders' payrolls, economic conditions, and seasonality, and are continually reviewed and adjusted as experience develops or new information becomes known. Any such adjustments are included in current operations; however, they are partially offset by the resulting changes in losses and LAE, commission expenses, and premium taxes. At December 31, 2011, premiums receivable on the consolidated balance sheet included $6.9 million of additional premiums expected to be received from policyholders for final audits. At December 31, 2010, premiums receivable are net of $4.0 million to be returned to policyholders for final audits.
The Company establishes a bad debt allowance on its premiums receivable through a charge included in underwriting and other operating expenses in the accompanying consolidated statements of comprehensive income. This bad debt allowance is determined based on estimates and assumptions to project future experience. After all collection efforts have been exhausted, the Company reduces the bad debt allowance for write-offs of premiums receivable that have been deemed uncollectible. The Company had write-offs, net of recoveries of amounts previously written off, of $0.2 million, $0.8 million, and $1.2 million for the years ended December 31, 2011, 2010, and 2009, respectively.
Policy acquisition costs, consisting of commissions, premium taxes, and certain other underwriting costs that vary with, and are primarily related to, the production of new or renewal business are deferred and amortized as the related premiums are earned. Amortization of deferred policy acquisition costs for the years ended December 31, 2011, 2010, and 2009, was $74.5 million, $72.1 million, and $87.6 million, respectively.
A premium deficiency would exist if expected future losses and LAE, expected policyholder dividends, deferred policy acquisition costs, and expected policy maintenance costs, offset by anticipated investment income, exceed the related unearned premiums. A premium deficiency would reduce the value of deferred policy acquisition costs. If the deficiency exceeded the deferred policy acquisition costs, a separate liability would be accrued for the excess deficiency. There was no premium deficiency at December 31, 2011 or 2010.
Commission expense includes direct commissions to agents and brokers for the premiums that they produce for the Company, as well as incentive payments, other marketing costs, and fees. Additionally, the Company is entitled to receive a contingent profit commission under the Loss Portfolio Transfer (LPT) Agreement (See "-Reinsurance").
In the ordinary course of business and in accordance with general insurance industry practices, the Company purchases excess of loss reinsurance to protect the Company against the impact of large and/or catastrophic losses in its workers' compensation business. Additionally, the Company is a party to a 100% quota share retroactive reinsurance agreement, (see Note 9). This reinsurance reduces the financial impact of such losses on current operations and the equity of the Company. Reinsurance makes the assuming reinsurer liable to the ceding company to the extent of the reinsurance coverage provided. It does not, however, discharge the Company from its liability to its policyholders in the event the reinsurer is unable or unwilling to meet its obligations under its reinsurance agreement with the Company.
The Company accounts for its restructuring plans by recording a loss when it is probable that a liability has been incurred. The amount of the loss is estimated and recorded at fair value using the Company's incremental interest rate.
Certain policyholders may qualify for policyholder dividends. Dividends are accrued on such policies based on specific dividend provisions and the policies' earned premiums and loss ratios. Additionally, dividend plans also allow the Company to reduce the amount to be paid at the Company's discretion. Should management choose to reduce the ultimate dividends to be paid, once the amount of the total dividend that will be paid for a policy year is determined, the dividend accrued would be reduced to the level determined by the Company. The reduced dividend amount would be allocated ratably to the participating policies, based on the dividend amount calculated prior to the reduction. Approximately 4.3%, 5.2% and 9.6% of direct written premiums were subject to dividend participation during the years ended December 31, 2011, 2010, and 2009, respectively. Policyholder dividends are ultimately paid at the sole discretion of the Board of Directors and must be approved by the Board prior to payment. Board-approved dividends accrued for 2011, 2010, and 2009 policies reflect the full potential amount allowed under the respective policies.
At December 31, 2011 and 2010, the outstanding premiums receivable balance was generally diversified due to the large number of entities composing the Company's policyholder base and their dispersion across many different industries. The Company also has recoverables from its reinsurers. Reinsurance contracts do not relieve the Company of its obligations to claimants or policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. The Company obtains collateral to mitigate the risks related to reinsurance insolvencies. At December 31, 2011, $11.6 million was collateralized by cash or letter of credit and an additional $896.1 million was in trust accounts for reinsurance related to the LPT Agreement.
to fair values of the Company's investment securities is disclosed in Note 4. The fair values reported in the accompanying consolidated balance sheets equal the carrying amounts for these investments.
Intangible assets related to state licenses are not subject to amortization. Intangibles related to insurance relationships will be amortized over the next seven years.
In October 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) Number 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. This update changes the definition of acquisition costs which may be capitalized to specify costs which relate directly to the successful acquisition of new or renewal insurance contracts; adds to the definition the concept of incremental costs; further restricts costs to be capitalized by identifying only those costs which may be capitalized; and requires additional granularity in the disclosures related to type of acquisition costs capitalized during the period. This guidance became effective for interim and annual reporting periods beginning after December 15, 2011. The Company expects to adopt this standard on a prospective basis and currently estimates that adoption will increase its underwriting and other operating expenses by approximately $7 million in 2012 and decrease total assets on the consolidated balance sheet by the same amount.
In May 2011, the FASB issued ASU Number 2011-04, Fair Value Measurement. This update is a result of efforts by the FASB and the International Accounting Standards Board (IASB) to develop common requirements for measuring fair value and for disclosing information about fair value measurements in GAAP and International Financial Reporting Standards (IFRS). This update changes the wording used to describe many of the requirements in GAAP for measuring fair value and for disclosing information about fair value measurements. The intent was to clarify existing fair value measurement and disclosure requirements
Level 3 - Inputs that are unobservable that reflect management's best estimate of what market participants would use in pricing the assets or liabilities at the measurement date.
The following methods and assumptions were used to determine the fair value of each class of assets and liabilities recorded at fair value in the consolidated balance sheets:
Based on reviews of the fixed maturity securities, the Company determined that unrealized losses as of December 31, 2011 and 2010 were primarily the result of changes in prevailing interest rates and not the credit quality of the issuers. The fixed maturity securities whose fair value was less than amortized cost were not determined to be other-than-temporarily impaired given the severity and duration of the impairment, the credit quality of the issuers, the Company’s intent on not selling the securities, and a determination that it is not more likely than not that the Company will be required to sell the securities until fair value recovers to above cost, or to maturity.
Based on reviews of the equity securities as of December 31, 2011, the Company recognized total impairments of $0.1 million in the fair values of four equity securities as a result of the severity and duration of the change in fair values of those securities. The Company also determined that the unrealized losses on equity securities as of December 31, 2010 were not considered to be other-than-temporary due to the financial condition and near-term prospects of the issuers.
The Company is required by various state laws and regulations to keep securities or letters of credit in depository accounts with the states in which it does business. As of December 31, 2011 and 2010, securities having a fair value of $522.6 million and $558.6 million, respectively, were on deposit. These laws and regulations govern not only the amount, but also the type of security that is eligible for deposit. The deposits are limited to fixed maturity securities in all states. Additionally, certain reinsurance contracts require Company funds to be held in trust for the benefit of the ceding reinsurer to secure the outstanding liabilities assumed by the Company. The fair value of securities held in trust for reinsurance at December 31, 2011 and 2010 was $40.3 million and $52.9 million, respectively. The Company's debt was secured by fixed maturity securities and restricted cash and cash equivalents that had a fair value of $126.7 million and $131.0 million at December 31, 2011 and 2010, respectively.
Depreciation and amortization expenses related to property and equipment for the years ended December 31, 2011, 2010 and 2009, were $4.8 million, $4.8 million, and $6.9 million, respectively. Internally developed software costs of $0.2 million and $0.1 million were capitalized during the years ended December 31, 2011 and 2010, respectively.
On January 1, 2000, EICN assumed the assets, liabilities, and operations of the Fund pursuant to legislation passed in the 1999 Nevada Legislature (the Privatization). Prior to the Privatization, the Fund was a part of the State of Nevada and therefore was not subject to federal income tax; accordingly, it did not take an income tax deduction with respect to the establishment of its unpaid loss and LAE reserves. Due to favorable loss experience after the Privatization, it was determined that certain of the pre-Privatization unpaid loss and LAE reserves assumed by EICN as part of the Privatization were no longer necessary and the unpaid loss and LAE reserves were reduced accordingly. Such downward adjustments of pre-Privatization unpaid loss reserves increases GAAP net income, but does not increase taxable income. For the years ended December 31, 2011, 2010, and 2009 there were downward adjustments of pre-Privatization unpaid loss reserves of $4.6 million, $3.9 million, and $1.6 million, respectively.
For the years ended December 31, 2011 and 2010, the Company increased the estimated ultimate contingent profit commission related to the LPT Agreement by $1.8 million and $0.8 million, respectively. Such increases to the estimated ultimate contingent profit commission increases GAAP net income but does not increase taxable income. There was no change to the estimate during the year ended December 31, 2009.
Tax years 2007 through 2011 are subject to full examination by the federal taxing authority. Tax year 2006 is open to examination by the federal taxing authority only to the extent of benefits from the carry-back of certain capital losses from tax years 2008 and 2009. Currently, tax years 2006 through 2010 are under review.
The Company continues to develop its own loss experience and will rely more on its experience and less on historical industry data in projecting its reserve requirements as such data becomes available. As the actual experience of the Company emerges, it will continue to evaluate prior estimates, which may result in additional adjustments in reserves.
A $1.6 million expense related to the commutation of certain reinsurance treaties, and a $0.9 million expense related to the write-off of certain reinsurance recoverables that had previously been accounted for as an allowance for bad debt, increased losses and LAE incurred in prior periods for the year ended December 31, 2010, which are included in the $(14.1) million prior period development.
The Company is also entitled to receive a contingent profit commission under the LPT Agreement. The Company accrues the estimated ultimate contingent profit commission to be received through June 30, 2024. The estimate was revised to increase the ultimate contingent profit commission by $1.8 million and $0.8 million, for the years ended December 31, 2011 and 2010, respectively, as a result of actual paid losses and LAE being lower than expected paid losses and LAE under the LPT Agreement. The Company recorded no change to the estimate for the year ended December 31, 2009. As of December 31, 2011 and 2010, the Company had a receivable of $3.6 million and $1.7 million related to the contingent profit commission, respectively.
In the fourth quarter of 2010, the Company re-negotiated the terms of a reinsurance agreement with Clarendon, which resulted in the release and return of funds held by Clarendon in the amount of $74.6 million. The Company placed $47.1 million in trust, of which $35.0 million was placed in an investment trust and $12.1 million was classified as restricted cash and cash equivalents, for the benefit of Clarendon to support the liabilities under the reinsurance agreement and invested the remaining $27.5 million.
In the second quarter of 2011, the Company released $12.1 million of the restricted cash from the trust, based on Clarendon and the Company's determination the trust was over-collateralized. The Company still has $35.2 million in the trust, which includes an original amount of $35.0 million plus $0.2 million of interest. Of that amount, $1.7 million is classified as restricted cash and cash equivalents.
EPIC has a $10.0 million surplus note to Alesco Preferred Funding V, LTD issued as part of a pooled transaction. The note matures in 2034 and became callable by the Company in the fourth quarter of 2009. The terms of the note provide for quarterly interest payments at a rate 405 basis points in excess of the 90-day LIBOR. Interest paid during the years ended December 31, 2011, 2010, and 2009 was $0.4 million, $0.4 million, and $0.5 million, respectively. Interest accrued as of December 31, 2011 and 2010 was $0.1 million.
Principal payment obligations on notes payable outstanding at December 31, 2011, were as follows:
made and when the assessment becomes due. These assets are expected to be realized over two to ten year periods in accordance with their type and individual states' regulations.
On November 3, 2010, the Board of Directors authorized a share repurchase program of up to $100.0 million of the Company's common stock from November 8, 2010 through June 30, 2012 (the 2011 Program). In November 2011, the Board of Directors authorized a $100.0 million expansion of the 2011 Program, to $200.0 million, and extended the repurchase authority pursuant to the 2011 Program through June 30, 2013. The Company expects that shares may be purchased at prevailing market prices through a variety of methods, including open market or private transactions, in accordance with applicable laws and regulations. The timing and actual number of shares repurchased will depend on a variety of factors, including the share price, corporate and regulatory requirements, and other market and economic conditions. Repurchases under the 2011 Program may be commenced or suspended from time-to-time without prior notice, and the 2011 Program may be suspended or discontinued at any time. From inception of the 2011 Program through December 31, 2011, the Company repurchased a total of 7,004,790 shares of common stock at an average price of $15.28 per share, including commissions, for a total of $107.0 million.
Changes in outstanding stock options for the year ended December 31, 2011 were as follows:
Net income for the Company's insurance subsidiaries prepared in accordance with SAP for the years ended December 31, 2011, 2010 and 2009 was $13.8 million, $59.1 million and $89.5 million, respectively.
Treatment of the LPT Agreement and the surplus notes (see Notes 9 and 10) are the primary differences in the SAP-basis capital stock and total surplus of the insurance subsidiaries of $387.9 million and $454.3 million, and the GAAP-basis equity of the Company of $474.2 million and $490.1 million as of December 31, 2011 and 2010, respectively. Under SAP accounting, the retroactive reinsurance gain resulting from the LPT Agreement is recorded as a special component of surplus (special surplus funds) in the initial year of the contract, and not reported as unassigned surplus until the Company has recovered amounts in excess of the original consideration paid. The special surplus funds are also reduced by the amount of extraordinary dividends as approved by the Nevada Division of Insurance. Under GAAP accounting, the gain is deferred and amortized over the period the underlying reinsured claims are paid (see Note 9). Under SAP, the surplus notes are recorded as a separate component of surplus. Under
EPIC and EAC are subject to regulation by the Florida Department of Financial Services (FDFS). Florida statute Section 624.408 requires EPIC and EAC to maintain minimum capital and surplus of the greater of $4.0 million or 10% of total liabilities. Florida statute Section 624.4095 requires EPIC and EAC to maintain a ratio of written premiums times 1.25 to surplus of no greater than 10-to-1 for gross written premiums and 4-to-1 for net written premiums. During the years ended December 31, 2011, 2010, and 2009, EPIC and EAC were in compliance with these statutes.
Additionally, EICN, ECIC, EPIC, and EAC are required to comply with NAIC RBC requirements. RBC is a method of measuring the amount of capital appropriate for an insurance company to support its overall business operations in light of its size and risk profile. NAIC RBC standards are used by regulators to determine appropriate regulatory actions relating to insurers that show signs of weak or deteriorating conditions. As of December 31, 2011, 2010, and 2009, EICN, ECIC, EPIC, and EAC each had total adjusted capital above all regulatory action levels.
ECIC, EPIC, and EAC are subject to Florida statute and applicable regulations related to Florida excessive profits for workers' compensation insurance companies. Florida excessive profits are calculated based upon a complex statutory formula which is applied over a rolling three year period. Companies are required to file annual excessive profits forms, and they are required to return so-called “Florida excessive profits” to policyholders in the form of a cash refund or credit toward the future purchase of
insurance. As of December 31, 2011 and 2010, the Company had no amounts accrued for estimated additional Florida excessive profits based on its statutory underwriting results for the years ended 2008-2010.
Accumulated other comprehensive income, net, is comprised of unrealized gains on investments classified as available-for-sale and unrealized losses on an interest rate swap, net of deferred tax expense. The following table summarizes the components of accumulated other comprehensive income, net:
The Company maintained two 401(k) defined contribution plans covering all eligible Company employees until April 2011. One plan covered eligible employees of the Company that existed prior to the acquisition of AmCOMP Incorporated (AmCOMP) in 2008 (the Employers 401(k) Plan). The second plan covered all eligible employees of the Company acquired in the AmCOMP acquisition (the AmCOMP 401(k) Plan). Effective April 1, 2011, the two plans merged and participants of the AmCOMP 401(k) Plan transferred to the Employers 401(k) Plan. Under the Employers 401(k) Plan, the Company's safe harbor matching consists of 100% matching contribution on salary deferrals up to 3% of compensation and then 50% matching contribution on salary deferrals from 3% to 5% of compensation. The Company's contribution to the Employers 401(k) Plan was $1.5 million, $1.4 million, and $1.6 million for the years ended December 31, 2011, 2010, and 2009, respectively. Expenses relating to the AmCOMP 401(k) Plan were $0.5 million and $0.7 million for the years ended December 31, 2010 and 2009, respectively.
Diluted earnings per share exclude outstanding options and other common stock equivalents in periods where the inclusion of such potential common stock instruments would be anti-dilutive. For the years ended December 31, 2011, 2010, and 2009, 1.1 million, 0.9 million, and 1.0 million stock options, respectively, were excluded from diluted earnings per share, as the exercise price of the options was greater than the average market price of the common stock during the period. During the same periods, 0.5 million, 0.4 million, and 0.7 million outstanding RSU's and stock options, respectively, were excluded from diluted earnings per share under the treasury method, as the potential proceeds on settlement or exercise was greater than the value of shares acquired.
On January 23, 2009, the Company announced a strategic restructuring plan to achieve the corporate and operational objectives set forth as part of its acquisition and integration of AmCOMP, and in response to then current economic conditions. The restructuring plan included a staff reduction of 14% of the Company's total workforce and consolidation of corporate activities into the Company's Reno, Nevada headquarters. During the year ended December 31, 2009, the Company incurred integration and restructuring charges of $5.7 million, including $2.8 million in personnel-related termination costs. These charges are included in underwriting and other operating expenses in the consolidated statements of comprehensive income. Cash payments relating to the 2009 restructuring were $0.6 million and $5.1 million during the years ending December 31, 2010 and 2009, respectively. As of December 31, 2010 and 2009, the Company had zero and $0.6 million accrued, respectively, for the remaining 2009 restructuring costs that are included in accounts payable and accrued expenses in the accompanying consolidated balance sheets.
The fourth quarter of 2011 was impacted by two adjustments which consisted of (1) a pretax $849 thousand decrease in underwriting and other operating expenses (after tax of $552 thousand) resulting from an over-accrual of sales incentives throughout 2011, and (2) a $993 thousand increase in income tax expense primarily related to the write off a deferred tax asset related to the prior year. These adjustments were not material to any individual prior period or the current period and, accordingly, the prior period results have not been adjusted.
The increase in realized gains on investments, net in the fourth quarter of 2011 resulted from a strategic rebalancing of our investment portfolio in an effort to increase portfolio allocations to taxable fixed income sectors, shorten portfolio duration following the decline in interest rates in the second half of 2011, and increase the allocation in high dividend equity securities.
Commission expense increased in the first, second and fourth quarters of 2011, primarily due to higher net earned premiums. Additionally, in the fourth quarter of 2011 there was a change in the accrual for agency incentive commissions of $1.2 million, which increased the commission expense in the quarter.
During the fourth quarter of 2010, the Company reduced its estimate of certain administrative fees due under its joint marketing agreements by $3.0 million, which decreased the commission expense in the fourth quarter of 2010. The Company also re-negotiated the terms of certain reinsurance agreements, which increased commission expense by $1.8 million in the fourth quarter of 2010.
Underwriting and other operating expenses declined in the first, second, and fourth quarters of 2010 as the Company managed its expenses, primarily through workforce reductions. The first quarter included charges of a $0.9 million expense related to workforce reductions. In the third quarter of 2010, the Company recorded a $4.3 million expense related to workforce reductions and leases for facilities that were vacated during the quarter. The fourth quarter included a $0.9 million expense related to leases for facilities that were vacated during that quarter.
Income tax expense (benefit) for interim periods is measured using an estimated effective tax rate for the annual period based on projected net income and tax adjustments. On an interim basis, actual results to date replace the projections and the annual effective tax rate is updated. A cumulative change is recorded in the quarter the effective tax rate changes.