The Company also has regional offices in Charlotte, North Carolina and Indianapolis, Indiana and leases office space in each of these locations under multi-year operating leases expiring in January 2013 and January 2010, respectively.
The turmoil in the fixed income and equity security markets had an adverse impact on the Company’s investment portfolio. As a result of the deterioration in its investment portfolio, the Company incurred net realized investment losses of $11.1 million for the year ended December 31, 2008, including other-than-temporary impairments of $9.5 million. In addition, the Company’s other long-term investments, which consist primarily of interests in limited partnerships, experienced a decline in value of $4.0 million during 2008, including a permanent impairment of $1.4 million related to one limited partnership that was in liquidation as of December 31, 2008.
Purchase accounting adjustments of $790,000 and $480,000 favorably impacted the Company’s result of operations for the years ended December 31, 2008 and 2007, respectively.
Net premiums written to statutory surplus ratio. The net premiums written to statutory surplus ratio represents the ratio of net premiums written to statutory surplus. This ratio measures the Company’s insurance subsidiaries exposure to pricing errors in its current book of business. The higher the ratio, the greater the impact on surplus should pricing prove inadequate.
The Company establishes reserves for unpaid losses and LAE for its workers’ compensation, segregated portfolio cell reinsurance, group benefits insurance, and run-off specialty reinsurance products, which are estimates of future payments of reported and unreported claims for losses and related expenses. The adequacy of the Company’s reserves for unpaid losses and LAE are inherently uncertain because the ultimate amount that the Company may pay under many of the claims incurred as of the balance sheet date will not be known for many years. Establishing reserves is an imprecise process, requiring the use of informed estimates and judgments. The Company’s estimates and judgments may be revised as additional experience and other data becomes available and are reviewed as new or improved methodologies are developed, or as current laws change. Any such revisions could result in future changes in estimates of losses or reinsurance recoverables and would be reflected in the Company’s results of operations in the period in which the estimates are changed. Estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates and judgments using data currently available. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded as of December 31, 2008, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.
methodologies that incorporate characteristics of incurred and paid methodologies combined with a review of the Company’s exposure base. The recorded amount in each accident year is then compared to the results of these methodologies, with consideration being given to the age of the accident year. As accident years mature, the various methodologies generally produce consistent loss estimates. For more recent accident years, the methodologies produce results that are not as consistent. Accordingly, more emphasis is placed on supplementing the methodologies in more recent accident years with trends in exposure base, medical expense inflation, general inflation, severity, and claim counts, among other things.
The case incurred amount can vary over time due to changes in expectations with respect to medical treatment and outcome, length and degree of disability, employment availability and wage levels and judicial determinations. As changes occur, the case incurred amount is adjusted. The initial estimate of the case incurred amount can vary significantly from the amount ultimately paid, especially in circumstances involving severe injuries with comprehensive medical treatment. Changes in case incurred amounts, or case incurred development, is an important component of the Company’s historical claim data.
losses to produce ultimate losses. The Bornhuetter-Ferguson method is most useful as an alternative to other models for immature accident years. For these immature accident years, the amounts reported or paid may be small and unstable and therefore not predictive of future development. Therefore, future development is assumed to follow an expected pattern that is supported by more stable historical data or by emerging trends. This method is also useful when changing reporting patterns distort historical development of losses.
The Company’s reserves for unpaid losses and LAE in its segregated portfolio cell reinsurance segment as of December 31, 2008 and 2007 are summarized below (in thousands):
Loss Ratio Method. The loss ratio method involves the use of historical loss ratios to estimate the reserve for unpaid claims. Under the loss ratio method, the reserve is determined by multiplying the selected loss ratio, which is based on historical loss ratio trends, by the amount of net premiums earned or the in-force premium at the valuation date.
The dental reserves represent the Company’s estimate of future amounts due on in-process and IBNR dental claims. The Company estimates its dental reserves using a combination of the lag factor development method and the loss ratio method, which results in the development of a point estimate. The loss ratio method is generally applied to the last three months (or most recent quarter), based on recent loss ratio trends.
The long-term disability tabular reserve represents the Company’s estimate of future amounts due on reported long-term disability claims. The Company establishes a reserve at the time a long-term disability claim is reported using the 1987 Commissioners Group Disability Table. Due to the long-term nature of long-term disability claims, management discounts the liability using an interest rate that reflects the estimated investment return in the Company’s group benefits insurance segment that will be earned over the expected life of the claim. In establishing the discount rate, the Company’s management evaluates the current interest rate environment at the end of each year and, if necessary, adjusts the interest rate for the following year based on the expected rate of return on new investments. The discount rates for claims incurred in 2008, 2007 and 2006 were 3.85%, 5.25%, and 4.75%, respectively. A lower discount rate results in a higher claim reserve and an increase in losses and LAE, whereas a higher discount rate results in a lower claim reserve and a decrease in losses and LAE. The reserve established represents the present value of expected future claim payments based on the terms of the underlying long-term disability insurance contract. With the exception of the discount rate, the assumptions that impact the reserve amount, such as recovery, morbidity and mortality rates, are embedded in the table. The long-term disability IBNR reserve is estimated on a policy-by-policy basis, taking into consideration the average monthly premium, the policy elimination period, and an expected loss ratio.
The term life reported claim reserve represents the Company’s liability for reported but unpaid death benefits and accidental death or dismemberment (AD&D) claims. The reserve is based on the death or dismemberment benefit of the underlying term life insurance contract.
In its run-off specialty reinsurance segment, the Company categorizes unpaid losses and LAE into case reserves and IBNR reserves. Case reserves represent unpaid losses reported by the ceding company. The Company updates its reserve estimates on a quarterly basis using information received from the ceding companies.
In applying these methods, the Company evaluates loss development trends by underwriting year to determine various assumptions that are required as inputs in the actuarial methodologies it employs. These typically involve the analysis of historical loss development trends by underwriting year. In addition to the use of historical loss development data, the Company utilizes external or internal benchmark sources of information for which it has limited loss development data to calculate credible trends. The evaluation of the reserve for unpaid losses and LAE related to the run-off specialty reinsurance segment requires that loss development be estimated over an extended period of time.
Because the primary insurer under these programs changed in 1999, historical loss data has limited relevance. Therefore, reliance has been placed on a blend of historical loss development data and industry loss development patterns adjusted, based on the management’s judgment, to reflect considerations particular to the exposure. The reliance on external benchmarks, while necessary, creates an additional element of uncertainty.
Claims reported to the ceding company by insureds are entered into the ceding company’s claim system and ceded to Eastern Re on a quarterly basis. In order to mitigate the above risk, Company claim personnel perform annual reviews of the ceding companies’ detailed claim reports to ensure reported claims information appears to be reasonably accurate and timely.
As of December 31, 2008, the Company’s best estimate of its ultimate liability for unpaid losses and LAE, before purchase accounting adjustments, for its run-off specialty reinsurance segment was $40.6 million.
Unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in shareholders’ equity as a component of comprehensive income (loss) and, accordingly, have no effect on net income. When, in the opinion of management, a decline in the fair value of an investment below its cost or amortized cost is considered to be “other-than-temporary,” such investment is written-down to its fair value. The amount written-down is recorded in earnings as a realized loss on investments. Generally, the determination of other-than-temporary impairment includes, in addition to other relevant factors, a presumption that if the market value is below cost by a significant amount for a period of time, a write-down is necessary. Notwithstanding this presumption, the determination of other-than-temporary impairment requires judgment about future prospects for an investment and is therefore a matter of inherent uncertainty. For the year ended December 31, 2008, the Company recorded other-than-temporary impairments of $9.5 million related to its fixed income and equity securities. The Company did not record any impairments in 2007 or 2006. As of December 31, 2008, the Company held fixed income and equity securities, excluding the segregated portfolio cell reinsurance segment, with gross unrealized losses of $7.3 million, of which $1.4 million were in an unrealized loss position for more than twelve months. Adverse investment market conditions, or poor operating results of underlying investments, could result in impairment charges in the future. The Company generally applies the following standards in determining whether the decline in fair value of an investment is other-than-temporary:
For the year ended December 31, 2008, the Company recorded other-than-temporary impairments of $5.0 million related to its equity portfolio. The securities impaired included an international equity mutual fund that experienced a decline in value of more than 50% of cost as of December 31, 2008 and two international equity mutual funds that experienced a decline in value of more than 40% of cost as of December 31, 2008.
For the year ended December 31, 2008, the Company recorded a permanent impairment of $1.4 million related to one of its limited partnership investments. As a result of the current credit market conditions, the limited partnership experienced a permanent decline in value during 2008 and will be dissolved. The estimated fair value of the Company’s interest in the limited partnership as of December 31, 2008 reflects management’s best estimate of the proceeds the Company is expected to receive upon dissolution of the fund.
Goodwill is assigned to one or more reporting units at the date of acquisition. The Company has allocated 100% of the goodwill recorded on its consolidated balance sheet as of December 31, 2008 to its workers’ compensation insurance segment. The goodwill impairment test, performed as of December 31 of each year, is a two-step test. The first step identifies whether there is potential impairment by comparing the fair value of a reporting unit to the carrying amount, including goodwill. If the fair value of a reporting unit is less than its carrying amount, the second step of the impairment test is required to measure the amount of any impairment loss.
For the 2008 annual impairment test, the fair value of the workers’ compensation insurance segment was calculated using a discounted cash flow analysis, a form of the income approach, using management’s internal four-year forecast for the workers’ compensation insurance segment and a terminal value calculated using a growth rate of 5%, which is reflective of the historical growth rate of the segment and a discount rate of 13%, which is reflective of risks inherent in the segment. Cash flows were adjusted as necessary in order to maintain adequate capital requirements.
In addition to the discounted cash flow analysis, management assessed its stock price relative to the book value of the workers’ compensation insurance segment. Due to market conditions, the Company’s stock price experienced a significant decline in value in 2008 and was trading below book value as of December 31, 2008. Management considered an estimate of the Company’s value in a potential transaction and allocated that value to its reporting units, including the workers’ compensation insurance segment.
Acquisition costs of the group benefits insurance segment are not capitalized and deferred as the group benefits insurance policies are cancelable and not guaranteed renewable. In addition, the group benefits insurance policies provide coverage on a month-to-month basis with most policies’ coverage effective on the first of each month. As a result, most of the premiums are earned as of the balance sheet date and all direct expenses related to the issuance or renewal of policies are recognized when incurred.
The temporary differences between the tax and book bases of assets and liabilities are recorded as deferred income taxes. Management evaluates the recoverability of the net deferred tax asset based on historical trends of generating taxable income or losses, as well as expectations of future taxable income or loss. As of December 31, 2008, the Company recorded a net deferred tax asset of $6.3 million. Management expects that the net deferred tax asset is fully recoverable. If this assumption were to change, any amount of the net deferred tax asset that the Company could not expect to recover would be provided for as an allowance and would be reflected as an increase in income tax expense in the period in which it was established.
As of December 31, 2008, the Company recognized a deferred tax asset of $2.7 million and $715,000 related to other-than-temporary investment impairments and net unrealized losses on investments, respectively. Under United States federal income tax rules and regulations, capital losses can only be utilized to offset income generated from capital gains. Capital losses can be carried back to offset capital gains reported in the three prior tax periods and can be carried forward for five tax
periods. Management has determined, based on a review of its investment portfolio and giving consideration to capital gains reported in prior tax periods, that the Company’s deferred tax asset related to other-than-temporary investment impairments and net unrealized losses on investments is recoverable; therefore, a valuation allowance has not been recorded as of December 31, 2008. Due to the significant volatility in the investment markets, management’s conclusion on the recoverability of the deferred tax asset could change in future periods. Further declines in the estimated fair value of the Company’s investments may result in the need for a valuation allowance, which could have an adverse impact of the Company’s financial condition and/or results of operations.
Amounts recoverable from Company’s reinsurers are estimated in a manner consistent with the reserves for unpaid losses and LAE associated with the reinsured policy. Amounts paid for reinsurance contracts are expensed over the contract period during which insured events are covered by the reinsurance contracts. Reinsurance balances recoverable on paid and unpaid loss and LAE are reported separately as assets, instead of being netted with the appropriate liabilities, because reinsurance does not relieve the Company of its legal liability to its policyholders. Reinsurance balances recoverable are subject to credit risk associated with the particular reinsurer. Additionally, the same uncertainties associated with estimating unpaid losses and LAE affect the estimates for the ceded portion of these liabilities. The Company continually monitors the financial condition of its reinsurers and where necessary obtains collateral. As of December 31, 2008, the Company had reinsurance recoverables of $29.6 million.
In May 2008, the FASB issued Statement No. 163, “Accounting for Financial Guarantee Insurance Contracts, an interpretation of FASB Statement No. 60” (“SFAS 163”). SFAS 163 clarifies how FASB Statement No. 60 applies to the recognition and measurement of premium revenue and claim liabilities under financial guarantee insurance contracts and requires expanded disclosures about financial guarantee insurance contracts. SFAS 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years, except for certain disclosures about an entity’s risk management activities. The Company does not currently write financial guarantee insurance contracts; therefore, the adoption of SFAS 163 will not affect the Company’s consolidated financial condition or results of operations.
The decrease in consolidated revenue reflects the impact of net realized investment losses, primarily related to other-than-temporary impairments, a decline in the fair value of limited partnership investments and a reduction in net investment income due to a decline in the Company’s invested asset base. These declines in revenue were partially offset by an increase in net premiums earned, primarily in the workers’ compensation insurance segment.
The increase in direct premiums written from 2007 to 2008 primarily reflects new business sales of $23.3 million and premium of $1.9 million related to the acquisition of ESIC, partially offset by a reduction in the renewal retention rate from 88.2% in 2007 to 87.6% in 2008 and renewal rate decreases of 6.9%. Traditional and alternative market direct premiums written were $72.8 million and $29.1 million, respectively, for the year ended December 31, 2008, compared to $65.4 million and $26.1 million, respectively, for the same period in 2007.
The increase in reinsurance premiums assumed from 2007 to 2008 primarily reflects new business sales of $4.7 million, partially offset by a reduction in the renewal retention rate from 88.4% in 2007 to 87.7% in 2008 and renewal rate decreases of 3.9%. Further offsetting the increase in reinsurance premiums assumed were audit premiums, which reduced premiums by $383,000 in 2008, compared to an increase in premiums of $623,000 in 2007.
The net loss in the group benefits insurance segment for the year ended December 31, 2008 primarily reflects the impact of other-than-temporary investment impairments, a decline in net investment income, and an increase in the combined ratio. Other-than-temporary investment impairments totaled $3.9 million. The decline in net investment income reflects a decrease in the invested asset base, which reflects dividends paid to EIHI during 2008. The increase in the combined ratio
primarily reflects an increase in the dental loss ratio and an increase in the expense ratio. The 2007 expense ratio includes the impact of a settlement gain related to the defined benefit plan, which reduced the expense ratio by 1.1 percentage points.
The group benefits insurance ratios were as follows for the years ended December 31, 2008 and 2007:
Direct premiums written, by line of business, for the years ended December 31, 2008 and 2007 were as follows (in thousands):
The decrease in the term life loss ratio primarily reflects an increase in premium waiver reserve reductions from 2007 to 2008. The loss ratio related to reported death claims increased slightly from 58.2% in 2007 to 60.2% in 2008.
Reinsurance premiums assumed, by line of business, were as follows for the years ended December 31, 2008 and 2007 (in thousands):
The decrease in reinsurance premiums assumed reflects the termination of the reinsurance treaties.
The net realized investment losses for the year ended December 31, 2008 primarily reflect other-than-temporary impairments of $732,000. There were no impairments recorded in 2007
The effective tax rate was (5.6%) and 71.9% for the years ended December 31, 2008 and 2007, respectively. The 2008 effective tax rate reflects the impact of the unrecognized tax benefits of $7.2 million. The 2007 effective tax rate reflects a prior year tax return adjustment that increased income tax expense.
YEAR ENDED DECEMBER 31, 2007 COMPARED TO YEAR ENDED DECEMBER 31, 2006
As a result of the acquisition of EHC on June 16, 2006, the Company’s financial results for the year ended December 31, 2006 include the results of operations for the workers’ compensation insurance, segregated portfolio cell reinsurance, and run-off specialty reinsurance segment for the period from June 17, 2006 to December 31, 2006.
The increase in consolidated revenue primarily reflects the acquisition of EHC on June 16, 2006. The increase in net premiums earned also reflects the impact of new business, improved renewal retention, and renewal rate increases in the workers’ compensation insurance and group benefits insurance segments.
The components of consolidated net income, by segment, for the years ended December 31, 2007 and 2006 were as follows (in thousands):
The increase in direct premiums written reflects the acquisition of EHC on June 16, 2006. Direct premiums written for traditional business and alternative markets were $65.4 million and $26.1 million, respectively, for the year ended December 31, 2007. Direct premiums written for the year ended December 31, 2007 include the impact of renewal rate decreases of 3.5%, a premium renewal retention rate of 88.2%, a reduction of $1.2 million related to the amortization of purchase accounting adjustments and audit premiums of $2.2 million.
Net realized investment gains primarily reflect sales activity on equity securities.
Purchase accounting adjustments decreased the calendar period loss ratio by 0.3 percentage points for the year ended December 31, 2007, compared to an increase in the calendar period loss ratio of 9.2 percentage points for same period in 2006.
The increase in reinsurance premiums assumed reflects the acquisition of EHC on June 16, 2006. Reinsurance premiums assumed for the year ended December 31, 2007 include the impact of renewal rate decreases of 1.5%, a premium renewal retention rate of 88.4%, a reduction of $781,000 related to the amortization of purchase accounting adjustments, and audit premiums of $623,000.
The increase in the calendar year loss ratio primarily reflects favorable loss reserve development related to prior accident periods, partially offset by a decrease in the impact of purchase accounting adjustments from 2006 to 2007.
Favorable loss reserve development totaled $3.0 million for the year ended December 31, 2007 compared to favorable loss reserve development of $2.0 million for the same period in 2006, which lowered loss ratios by 13.2 percentage points and 17.7 percentage points, respectively. The favorable loss reserve development primarily reflects a decrease in the prior year loss development factors used to estimate losses and LAE. The decrease in prior accident period loss development factors primarily reflects significant prior year claim settlements during 2007 for amounts at, or less than, previously established case and IBNR reserves. This decrease had the effect of lowering loss development factors as of December 31, 2007.
The increase in the expense ratio from 2006 to 2007 relates primarily to purchase accounting adjustments recorded for the year ended December 31, 2006 that reduced the expense ratio by 8.4 points compared to negligible purchase accounting adjustments in 2007. The expense ratios, without regard to the aforementioned purchase accounting adjustments in 2006, are consistent with the contractual ceding commissions for the years ended December 31, 2007 and 2006.
The group benefits insurance ratios were as follows for the years ended December 31, 2007 and 2006:
The increase in net premiums earned reflects an increase in new business sales and a higher renewal retention rate. New business sales totaled $9.1 million in 2007, compared to $3.6 million in 2006. The renewal retention rate increased from 74.4% in 2006 to 80.8% in 2007. The improvement in the retention rate primarily reflects the increased focus on customer retention by the underwriting department.
The term life loss ratio was relatively consistent from 2006 to 2007. The loss ratio related to death benefits decreased from 61.7% in 2006 to 58.2% in 2007, primarily reflecting a decrease in reported life claims. The death benefit loss ratio was offset by a reduction in outstanding premium waiver claims during 2007 and 2006. The reduction in premium waiver reserves reduced the term life loss ratio by 5.7 points and 9.7 points in 2007 and 2006, respectively.
The decrease in other expenses primarily reflects the impact of expense savings realized as a result integration efforts in the last six months of 2006 and first six months of 2007. In addition, the group benefits insurance segment recognized a gain of $384,000 during the fourth quarter of 2007 related to its defined benefit pension plan. The gain resulted from the purchase of an annuity to fund the current retiree portion of the pension plan liability.
The following table represents the operations of the run-off specialty reinsurance segment for the years ended December 31, 2007 and 2006 (in thousands):
The decrease in the net loss reflects a decrease in the calendar year loss ratio in 2007 compared to 2006 and a reduction of the impact of purchase accounting charges in 2007 compared to 2006. Net income for the year ended December 31, 2006 includes an after-tax charge of $647,000 related to the amortization of purchase accounting adjustments compared to negligible purchase charges in 2007.
The run-off specialty reinsurance ratios were as follows for the years ended December 31, 2007 and 2006:
The increase in reinsurance premiums assumed relates to the acquisition of EHC on June 16, 2006. Reinsurance premiums assumed, by line of business, were as follows for the years ended December 31, 2007 and 2006 (in thousands):
The effective tax rate for the year ended December 31, 2007 was 71.9% compared to 35.1% in 2006. The difference between the statutory rate of 35.0% and the effective rate relates to a prior year tax return adjustment recorded during 2007.
The corporate/other segment results for the year ended December 31, 2007 include the impact of stock compensation expense related to the Company’s stock incentive plans and ESOP, amortization of intangible assets and costs related to the implementation of Sarbanes-Oxley. Stock compensation expense and intangible asset amortization totaled $2.4 million and $1.7 million for the year ended December 31, 2007, respectively. Costs related to the implementation of Sarbanes-Oxley totaled $658,000 for the year ended December 31, 2007. The corporate/other segment results for the year ended December 31, 2006 include the impact of transaction expenses incurred by ELH totaling $303,000, stock compensation expense of $525,000, and intangible asset amortization of $1.1 million.
December 31, 2008 compared to December 31, 2007. Total assets were $377.3 million as of December 31, 2008, compared to $385.5 million as of December 31, 2007. The acquisition of ESHC resulted in an increase to consolidated assets of $26.0 million, including the recognition of goodwill and intangible assets of $2.8 million and $4.2 million, respectively. The increase in consolidated assets related to the acquisition of ESHC was partially offset by a decrease in investments, which reflects the sale of investments to fund the acquisition of ESHC, share repurchases, and the repayment of the junior subordinated debentures, as well as the decrease in the fair value of the Company’s investment portfolio. The increase in deferred income taxes primarily reflects the decrease in the fair value of the Company’s investment portfolio, including the recognition of other-than-temporary impairments.
Liquidity is a measure of an entity’s ability to secure sufficient cash to meet its contractual obligations and operating needs. The Company’s principal sources of funds are premiums, investment income and proceeds from sales and maturities of investments. The Company’s primary use of funds is to pay claims and operating expenses and to purchase investments. The Company’s investment portfolio is structured so that investments mature periodically over time in reasonable relation to current expectations of future claim payments. The Company’s investment portfolio as of December 31, 2008 had an effective duration of 2.66 years.
The capital contribution from EIHI to Eastern Re was funded by dividends paid to EIHI from Eastern Alliance, Allied Eastern and ELH in the amount of $10.0 million, $2.0 million and $13.0 million, respectively, on March 6, 2009, of which $2.0 million was retained by EIHI. The dividends were approved by the Pennsylvania Insurance Department and were considered extraordinary in nature.
Cash Flows for the Years Ended December 31, 2007 and 2006. The increase in cash flows from operating activities from 2006 to 2007 primarily reflects the positive operating results in the workers’ compensation insurance and group benefits insurance segments during 2007.
The following table summarizes information about contractual obligations and commercial commitments before the impact of purchase accounting adjustments. The minimum payments under these agreements as of December 31, 2008 were as follows (in thousands):
As of December 31, 2008, the Company has no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
As discussed in Note 2 to the consolidated financial statements, the Company changed the manner in which it accounts for convertible bond securities in 2007.
As described in Management’s Report on Internal Control over Financial Reporting, management has excluded Employers Security Holding Company from its assessment of internal control over financial reporting as of December 31, 2008 because it was acquired by the Company in a purchase business combination during 2008. We have also excluded Employers Security Holding Company from our audit of internal control over financial reporting. Employers Security Holding Company is a wholly-owned subsidiary of the Company whose total assets and total revenues represent 6.8% and 1.5%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2008.
EIHI is an insurance holding company offering workers’ compensation and group benefits insurance products and reinsurance products through its direct and indirect wholly-owned subsidiaries. Eastern Services Corporation (“Eastern Services”), Global Alliance Holdings, Ltd. (“Global Alliance”), Eastern Alliance Insurance Company (“Eastern Alliance”), Allied Eastern Indemnity Company (“Allied Eastern”), Eastern Advantage Assurance Company (“Eastern Advantage”), Eastern Re Ltd., S.P.C. (“Eastern Re”), ELH, and Employers Alliance, Inc. (“Employers Alliance”), collectively referred to as the “Company.”
The liability for reported but unpaid long-term disability claims is calculated using the 1987 Commissioners Group Disability Table. The long-term disability reserves are discounted based on the expected rate of return of ELH’s fixed income portfolio in the year that the claim was incurred. The discount rate for claims incurred in 2008, 2007
Amortization of policy acquisition costs, before the impact of purchase accounting, totaled $6,872, $6,033, and $2,541 for the years ended December 31, 2008, 2007 and 2006, respectively.
Eastern Re is an exempt entity under the Companies Law of the Cayman Islands; however, Eastern Re’s earnings and profits are subject to federal income tax for earnings subsequent to June 16, 2006, as a result of the redomestication of EHC.
The Company is subject to state guaranty fund assessments in the states in which it is licensed, which provide for the payment of covered claims or to meet other insurance obligations from insurance company insolvencies. The Company’s assessments consist primarily of charges from the Workers’ Compensation Security Fund of Pennsylvania (“Security Fund”). The Security Fund serves as a guaranty fund to provide claim payments for those workers entitled to workers’ compensation benefits when the insurance company originally providing the benefits was placed into liquidation by a court. Security Fund assessments are established on an actuarial basis to provide an amount sufficient to pay the outstanding and anticipated claims in a timely manner, to meet the costs of the Pennsylvania Insurance Department to administer the fund and to maintain a minimum balance in the fund of $500 million. If the Security Fund determines that the balance in the Security Fund is less than $500 million based on the actuarial study, then an assessment up to one percent of direct written premium is made to all companies licensed to write workers’ compensation in Pennsylvania. Eastern Alliance, Allied Eastern and Eastern Advantage recognize a
Goodwill represents the excess of cost over the fair value of net assets of businesses acquired. Goodwill and other intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but are instead tested for impairment at least annually. Intangible assets with estimable useful lives are amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 144 (“SFAS 144”), “Accounting for Impairment or Disposal of Long-Lived Assets.”
Goodwill is assigned to one or more reporting units at the date of acquisition. The goodwill recorded by the Company has been allocated 100% to the workers’ compensation insurance segment, which is considered a reporting unit for goodwill purposes. The annual goodwill impairment test, performed as of December 31, each year, consists of a two-step process. The first step identifies whether potential impairment exists by comparing the fair value of the reporting unit to its carrying value, including goodwill. If the fair value of a reporting unit is less than its carrying amount, the second step is required to measure the amount of any impairment loss.
Comprehensive income (loss) includes all changes in shareholders’ equity during the reporting period, net of tax. The components of accumulated other comprehensive income, net of tax, as of December 31, 2008 and 2007 were as follows (in thousands):
In December 2007, the FASB issued Statement No. 141R, “Business Combinations” (“SFAS 141R”), which revises the accounting for business combination transactions previously accounted for under SFAS No. 141, “Business Combinations” (“SFAS 141”), and broadens the scope of transactions which should be accounted for under this standard. SFAS 141R retains the fundamental requirements of SFAS 141 in that the acquisition method of accounting is still used, and an acquirer must be identified in all business combinations. SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. An entity is prohibited from applying SFAS 141R prior to that date.
In connection with the acquisition of EHC, the assets and liabilities acquired by EIHI were adjusted to fair value. The increase (decrease) to EHC’s assets and liabilities were as follows (in thousands):
For the year ended December 31, 2006, the net proceeds received as a result of the Company’s stock offering of $69,622 is reflected net of the proceeds from the shares purchased by the ESOP of $7,500 in the statement of cash flows for year ended December 31, 2006.
As of December 31, 2008 and 2007, intangible assets consisted of the following (in thousands):
On February 15, 2007, the Company’s Board of Directors authorized the repurchase of up to 5 percent, or 567,552 shares, of the Company’s issued and outstanding shares of common stock. On August 2, 2007, the Company’s Board of Directors authorized the repurchase of additional shares of the Company’s outstanding common stock up to an aggregate of 1,046,500 shares, which represents the total number of shares of common stock for which awards may be granted under the Company’s Stock Incentive Plan. On September 27, 2007, the Company’s Board of Directors increased the share repurchase authorization to 2,046,500 shares. The share repurchases will be held as treasury stock and are available for issuance in connection with the Company’s Stock Incentive Plan. For the years ended December 31, 2008 and 2007, the Company repurchased 1,073,492 and 1,016,865 shares at a cost of $17,066 and $15,589, respectively, representing a weighted average cost of $15.90 and $15.33 per share, respectively. The Company repurchased an additional 1,400 shares at a cost of $11 through March 4, 2009.
The fair values of stock options granted during the years ended December 31, 2008 and 2007 were determined on the dates of grant using a lattice-based binomial option valuation model with the following assumptions:
The expected life shown above was imputed based upon the combination of vesting provisions and the termination, retirement and early exercise assumptions input to the binomial option valuation model. As trading in the Company’s stock began in June 2006, the expected stock price volatility reflects a weighting of the average historical volatility over a 10-year period for 17 comparable companies and the average 6-month implied volatility for those comparable companies with listed options. A yield curve of risk free interest rates was developed for each valuation date based on quoted prices of US Treasury STRIPs.
The aggregate intrinsic value of the stock options in the above table is $0 because the Company’s closing stock price of $8.03 on December 31, 2008 was below the weighted average exercise price of the stock options.
As of December 31, 2008, there were 288,111 shares of common stock available for issuance of future share-based awards. The following table presents additional information regarding options outstanding as of December 31, 2008:
The following table summarizes restricted stock activity for the year ended December 31, 2008.
Permitted statutory accounting practices encompass all accounting practices that are not prescribed; such practices differ from state to state, may differ from company to company within a state, and may change in the future. Prior to January 1, 2008, the reserves for unpaid losses and loss adjustment expenses of Eastern Alliance and Allied Eastern were discounted on both a tabular and non-tabular basis. The discounting of workers’ compensation indemnity reserves on a tabular basis is a prescribed practice by the NAIC. The discounting of other workers’ compensation reserves on a non-tabular basis is a permitted practice by the Pennsylvania Insurance Department. The non-tabular discounting of other workers’ compensation reserves increased Eastern Alliance’s and Allied Eastern’s statutory surplus by $1,346 and $198, respectively, as of December 31, 2007. The non-tabular discounting of other workers’ compensation reserves increased Eastern Alliance’s statutory net income by $107, and $176 and increased Allied Eastern’s statutory net income by $18, and $34 for the years ended December 31, 2007, and 2006, respectively. Eastern Alliance, Allied Eastern, Eastern Advantage, ESIC and ELH did not have any permitted practices for the year ended December 31, 2008. ELH did not have any permitted practices for the years ended December 31, 2007 or 2006.
The Company adopted Statement No. 157, “Fair Value Measurements” (“SFAS 157”) effective January 1, 2008. SFAS 157 clarifies the definition of fair value for purposes of financial reporting, specifies the methods to be used to measure fair value, and requires expanded disclosures related to fair value and financial instruments measured at fair value. The adoption of SFAS 157 had no impact on the Company’s consolidated financial condition or results of operation.
On February 12, 2008, SFAS 157 was amended by FASB Staff Position No. FAS 157-2 (“FSP FAS 157-2”). FSP FAS 157-2 delayed the effective date of SFAS 157 for non-financial assets and non-financial liabilities which are measured at fair value on a nonrecurring basis. Non-financial assets and non-financial liabilities which are measured at fair value on a recurring basis (i.e. at least annually) are not subject to this deferral. This deferral is effective until fiscal years beginning after November 15, 2008 and interim periods within those fiscal years. At that time, provisions of SFAS 157 will apply to non-financial assets and non-financial liabilities which are measured at fair value on a non-recurring basis.
As of December 31, 2008, the Company has no non-financial assets or non-financial liabilities that are measured at fair value on a recurring basis. The Company is currently evaluating the impact of measuring non-financial assets and non-financial liabilities on a non-recurring basis.
Level 3-Represents financial assets whose fair value is determined based upon a significant level of unobservable inputs, including the Company’s own determinations of the assumptions that a market participant would use in pricing the asset. The Company considers its limited partnership investments as Level 3 assets.
The following table provides a summary of the fair value measurements of the Company’s fixed income securities, convertible bonds, and equity securities, as of December 31, 2008, excluding the segregated portfolio cell segment (in thousands):
Other long-term investments include the Company’s interest in various limited partnerships, including a low volatility multi-strategy fund of funds, two natural resource limited partnerships, a municipal bond based limited partnership, an open-ended investment fund and a real estate limited partnership. The Company records its investment in the limited partnerships using the equity method. Changes in the Company’s investments are based on statements received directly from the limited partnership and/or the limited partnership’s administrator. The estimated fair values of the underlying investments in the limited partnerships may be based on Level 1, Level 2, or Level 3 inputs, or a combination thereof.
The change in interest in the Company’s limited partnership investments is included in the change in equity interest in other long-term investments in the consolidated statements of operations and comprehensive income (loss). As a result of the current credit market conditions, the municipal bond arbitrage fund experienced a permanent decline in value during 2008 and will be dissolved. The estimated fair value of the Company’s interest in the limited partnership as of December 31, 2008 reflects management’s best estimate of the proceeds the Company is expected to receive upon dissolution of the fund. As a result of these events, the Company recorded an impairment write-down of $1,397 for the year ended December 31, 2008. There were no impairments in 2007 or 2006.
Other structured securities primarily include collateralized mortgage obligations and other asset-backed securities.
As of December 31, 2008, the Company held 105 fixed income securities with gross unrealized losses totaling $3,111. Management has evaluated the unrealized losses related to those fixed income securities and determined that they are primarily due to the current liquidity issues in the fixed income markets or to a fluctuation in interest rates and not to credit issues of the issuer or the underlying assets in the case of mortgage-backed and other structured securities. For investments in fixed income securities, losses in the estimated fair values are viewed as temporary if the Company has the intent and ability to hold the security to recovery, which may be maturity, and management expects that the issuer will be able to service the debt, both as to principal and interest, in accordance with contractual terms. Management believes that the current carrying value of these investments will be realized and that the Company has the ability and intent to hold them until that time.
As of December 31, 2008, the Company held 33 equity securities with gross unrealized losses totaling $4,184. All of the equity securities have been in an unrealized loss position for less than twelve months and management has determined, based on an evaluation of these securities, that the decline in value is temporary as of December 31, 2008.
Incurred losses by segment were as follows for the year ended December 31, 2008 (in thousands):
Incurred losses by segment were as follows for the year ended December 31, 2007 (in thousands):
Incurred losses by segment were as follows for the year ended December 31, 2006 (in thousands):
The following provides a summary, by segment, of the impact of prior year reserve development on the Company’s loss and loss adjustment expenses:
Workers’ Compensation Insurance. The favorable loss reserve development in the workers’ compensation insurance segment for the year ended December 31, 2008 primarily reflects the impact of claim settlements in 2008 for amounts at, or less than, previously established case and IBNR reserves. For the year ended December 31, 2008, the Company closed 360, or 63.2%, of the 570 open lost time claims as of December 31, 2007. In the aggregate, the claims were closed at amounts lower than the provision established for IBNR claims. The favorable loss reserve development in the workers’ compensation insurance segment for the year ended December 31, 2007 primarily reflects the impact of claim settlements in 2007 for amounts at, or less than, previously established case and IBNR reserves. For the year ended December 31, 2007, the Company closed 281, or 56.8%, of the 490 open lost time claims as of December 31, 2006. In the aggregate, the claims were closed at amounts lower than the provision established for IBNR claims.
Run-off Specialty Reinsurance. The unfavorable loss reserve development in the run-off specialty reinsurance segment for the year ended December 31, 2008 primarily reflects the impact of reserve strengthening related to the EnviroGuard program. Of the $19.3 million in unfavorable development, $13.9 million was recorded in the fourth quarter of 2008 and reflects additional information acquired by the Company during the annual claim audit conducted in January 2009. The claim
The Company purchases reinsurance to manage its loss exposure. Although reinsurance agreements contractually obligate the Company’s reinsurers to reimburse the Company for the agreed upon portion of its gross paid losses, they do not discharge the primary liability of the Company.
The components of the income tax provision for the years ended December 31, 2008, 2007, and 2006 are as follows (in thousands):
As of December 31, 2008, the net deferred tax asset of $6,281 has not been reduced by a valuation allowance because management believes that, while it is not assured, it is more likely than not that the Company will generate sufficient future taxable income to utilize these net future tax deductions. The amount of the net deferred tax asset considered realizable, however, could be materially reduced in the near term if estimates of future taxable income in the years in which the differences are expected to reverse are decreased.
ELH sponsors a non-contributory defined benefit pension plan (the “pension plan”) covering substantially all of its employees. On May 17, 2005, ELH’s Board of Directors approved the freezing of the pension plan effective December 31, 2005. ELH also sponsors a defined benefit postretirement plan (the “postretirement plan”), which provides certain health care
and life insurance benefits for retired employees. Current employees of ELH may become eligible for these benefits if they reach retirement age while working for ELH and meet certain years of service levels prior to January 1, 2015. Life insurance benefits are set at 100% of an employee’s annual salary at the time of retirement, up to a maximum of $175, and are reduced to $10 by age 70.
Pension costs are funded to the limits specified by the Employee Retirement Income Security Act of 1974, as amended. From time to time, the Company may contribute additional amounts to the pension plan as it deems appropriate, subject to funding limitations. Based on the funded status of the pension plan as of December 31, 2008, the Company does not anticipate making a contribution in 2009. The Company anticipates making a contribution to the postretirement plan in 2009 of approximately $43.
During 2007, the Company purchased an annuity to satisfy future obligations of the pension plan related to participants receiving benefits as of December 31, 2007. As a result of this transaction, the benefit obligation and plan assets were reduced by $3,780, which reflects the cost of the annuity.
The amounts included in AOCI that are expected to be recognized in 2009 are as follows (in thousands):
The primary investment objective of the pension plan is to achieve maximum rates of return commensurate with safety of principal. The pension plan asset allocation is reviewed annually to determine whether the portfolio mix is within an acceptable range of the target allocation. Target asset allocations are based on asset and liability studies with the goal to enhance the expected return of the pension plan portfolio while maintaining acceptable levels of risk. As of December 31, 2008 the target asset allocation for the portfolio is 10% equity securities and 90% fixed income securities.
The following table provides the components of net periodic benefit cost for the pension plan and the postretirement plan for the years ending December 31, 2008, 2007, and 2006 (in thousands):
The Company also sponsors a defined contribution plan covering eligible employees. The Company’s contributions to the defined contribution plan for the years ended December 31, 2008, 2007, and 2006 totaled $237, $195, and $131, respectively.
The Company’s current operates in four business segments. The specialty reinsurance segment was placed into run-off effective July 1, 2008.
The Company offers workers’ compensation insurance coverage to employers, primarily in Pennsylvania, Delaware, North Carolina, Maryland and Indiana. The Company offers a complete line of workers’ compensation products, including guaranteed cost and loss sensitive products.
The Company offers alternative market workers’ compensation solutions to individual companies, groups and associations (referred to as “segregated portfolio cell dividend participants”) through the creation of segregated portfolio cells. The segregated portfolio cells are segregated pools of assets that function as insurance companies within an insurance company. The pool of assets and associated liabilities of each segregated portfolio cell are solely for the benefit of the segregated portfolio cell dividend participants, and the pool of assets of one segregated portfolio cell are statutorily protected from the creditors of the others. This permits the Company to provide customers with a turn-key alternative markets solution that includes program design, fronting, claims administration, risk management, segregated portfolio cell rental, investment and segregated portfolio management services. The segregated portfolio cell structure provides dividend participants the opportunity to share in both underwriting profit and investment income derived from their respective segregated portfolio cell’s financial results. The segregated portfolio cell reinsurance segment generated fee revenue to the Company’s workers’ compensation, run-off specialty reinsurance, and corporate/other segments totaling approximately $4,188 and $3,900 for the years ended December 31, 2008 and 2007, respectively.
The Company’s group benefits insurance products include dental, short and long-term disability, and term life insurance. The group benefits insurance products are marketed to employers, primarily in the Mid-Atlantic, Southeast, and Midwest regions of the United States. Net premiums earned, by product, for the years ended December 31, 2008, 2007, and 2006 were as follows (in thousands):
The following table represents the segment results for the year ended December 31, 2007 (in thousands):
The following table represents the segment results for the year ended December 31, 2006 (in thousands):
The Company maintains regional offices in North Carolina and Indiana and leases office space under multi-year operating leases through January 2013 and January 2010, respectively.
Rent expense totaled $953, $748, and $533 for the years ended December 31, 2008, 2007 and 2006, respectively.