Our principal executive offices are located in approximately 20,100 square feet of leased office space in Seattle, Washington. We also lease office space consisting of approximately 2,650 square feet in Honolulu, Hawaii; 2,500 square feet in Anchorage, Alaska; 8,300 square feet in Orange, California; 3,400 square feet in Houston, Texas; 700 square feet in San Francisco, California; 300 square feet in Camarillo, California; 3,000 square feet in Chicago, Illinois; 3,900 square feet in Radnor, Pennsylvania; and 1,800 square feet in Tampa, Florida. We conduct claims and underwriting operations in our branch offices, with the exception of our Honolulu office, where we conduct only claims and loss control operations, and our Camarillo office, where we conduct only underwriting operations. We do not own any real property. We consider our leased facilities to be adequate for our current operations.
The following table sets forth our selected historical financial information and that of our predecessor for the periods ended and as of the dates indicated. This information comes from our consolidated financial statements and those of our predecessor. You should read the following selected financial information along with the information contained in this annual report, including Part II,
On September 30, 2003, SeaBright acquired PointSure and the renewal rights and substantially all of the operating assets, systems and employees of, the Eagle Entities from LMC, their ultimate parent. We refer to Eagle Pacific, Pacific Eagle and PointSure collectively as our predecessor. In connection with the Acquisition, SeaBright also purchased KEIC, a shell company in run off that was acquired from LMC for its workers’ compensation licenses in 43 states and the District of Columbia. The Acquisition was accounted for using the purchase method of accounting. The Acquisition will prospectively affect our results of operations in certain respects. The aggregate acquisition costs, including the transaction costs of approximately $15.7 million, have been allocated to the tangible and intangible assets acquired based upon estimates of their respective fair values as of the Acquisition date.
In connection with the Acquisition, to minimize our exposure to any past business underwritten by KEIC, we entered into the adverse development cover. See the discussion under the heading “Our History” in Part I, Item 1 of this annual report. To support LMC’s obligations under the adverse development cover, LMC funded a trust account at the time of the Acquisition in the amount of $1.6 million as collateral for LMC’s potential future obligations to us under the adverse development cover. The amount on deposit in the trust account was increased to $4.8 million on December 23, 2004 and increased to $5.2 million, including accumulated interest, on December 31, 2006. In February 2007, LMC submitted a request to withdraw approximately $1.8 million of excess funds on deposit in the trust account. After due evaluation, we complied with LMC’s request, resulting in a balance in the trust account of approximately $3.4 million immediately following the withdrawal. If LMC is placed in receivership and the amount held in the collateralized reinsurance trust is inadequate to satisfy the obligations of LMC to us under the adverse development cover, it is unlikely that we would recover any future amounts owing by LMC to us.
We invest our statutory surplus and the funds supporting our insurance liabilities (including unearned premiums and unpaid loss and loss adjustment expenses) in cash, cash equivalents, fixed income securities and, to a lesser degree, in equity securities. Our investment income includes interest earned on our invested assets. Realized gains and losses on invested assets are reported separately from net investment income. We earn realized gains when invested assets are sold for an amount greater than their amortized cost in the case of fixed maturity securities and recognize realized losses when investment securities are written down as a result of an other-than-temporary impairment or sold for an amount less than their carrying value.
for the policies written by the Eagle Entities prior to the Acquisition. We expect income from these contracts to decrease substantially over the next several years as transactions related to the Eagle Entities diminish.
Loss and loss adjustment expenses represent our largest expense item and include (1) claim payments made, (2) estimates for future claim payments and changes in those estimates for current and prior periods and (3) costs associated with investigating, defending and adjusting claims.
Gross Premiums Written. Gross premiums written were $230.3 million in 2006 compared to $204.7 million in 2005, representing an increase of $25.6 million, or 12.5%, even though we continued to experience rate reductions in California, our largest market, as well as in other states. The average renewal rate change for our state act and maritime markets, excluding California, for the full year of 2006 was -7.3% and -10.1%, respectively. Excluding work we perform as the servicing carrier for the Washington USL&H Plan, the number of customers we serviced at December 31, 2006 increased 39.7% to 654 from 468 at December 31, 2005 and in-force payrolls, one of the factors used in determining premium charges, increased 54.6% from 2005. California continues to be our largest market, accounting for approximately $113.4 million (52.3%) of our direct premiums written in 2006. Illinois became our third largest market, accounting for $19.9 million (9.2%) or our direct premiums written in 2006. This represents an increase of $16.7 million (521.9%) from $3.2 million in direct premiums written in 2005.
On December 21, 2006, we announced the division of our Southern region into two markets, allowing us to devote greater focus and resources to further develop our key states in this region. Our new Southeast region will pursue business in selected southeastern states, including Florida. We opened an office in Atlanta, Georgia in early 2007. The Gulf region, which is based in Houston, Texas, now focuses primarily on Texas
and Louisiana. By dividing the southern states in this manner, we have substantially improved the resource level dedicated to these regions and clarified the focus on our target markets in each of the critical states. During the fourth quarter of 2006, we opened an office in Radnor, Pennsylvania, a Philadelphia suburb. This new office contributed approximately $838,000 to our direct premiums written in 2006.
Service Income. Service income was $2.1 million in 2006 compared to $2.5 million in 2005, representing a decrease of $0.4 million, or 16.0%. Our service income resulted primarily from service arrangements we have with LMC for claims processing services, policy administration and administrative services we performed for the Eagle Entities’ insurance policies and from claims processing services we perform for other unrelated companies. Average monthly fees declined as the volume of work required for policy administration decreased as a result of the run off of our predecessor’s business. Service income related to our arrangements with LMC decreased $0.7 million (33.3%) to $1.4 million in 2006 from $2.1 million in 2005. Service income related to claims processing services that we perform for other unrelated companies increased approximately $0.3 million in 2006 due to the addition of one new high volume customer in early 2006.
Other Income. Other income totaled $3.4 million in 2006 compared to $3.3 million in 2005, representing an increase of $0.1 million, or 3.0%. Other income is derived primarily from the operations of PointSure, our non-insurance subsidiary, which expanded its portfolio of insurance products during 2006 to accelerate income growth from sources other than us. The number of insurance companies that PointSure represents increased by 11 to a total of 19 in 2006.
There is uncertainty about whether recent lower paid loss trends, which result primarily from California legislative reforms enacted in 2003 and 2004, will be sustained, particularly in light of current efforts to change or repeal portions of the reforms. We will not know the full impact of these reforms with a high degree of confidence for several years. We have established loss reserves at December 31, 2006 that are based upon our current best estimate of ultimate loss costs, taking into consideration the recent lower paid loss claim data, incurred loss trends and the uncertainty regarding the permanence of recent legislative reforms. See the discussion under the heading “Loss Reserves” in Part I, Item 1 of this annual report for a further discussion of our loss reserve process.
Net Income. Net income totaled $33.2 million in 2006 compared to $18.3 million in 2005, representing an increase of $14.9 million, or 81.4%. The 2006 increase in net income resulted primarily from the increase in premiums earned and investment income for the period, offset by related increases in loss and loss
Gross Premiums Written. Gross premiums written were $204.7 million in 2005 compared to $135.7 million in 2004, representing an increase of $69.0 million, or 50.8%. We began writing new insurance contracts on October 1, 2003 and began renewing some of the existing contracts of our predecessor expiring after that date. The approximately $80.8 million of net proceeds received from the initial public offering of our common stock in January 2005, of which approximately $74.8 million was contributed to SeaBright Insurance Company, allowed us to expand our business to new territories and in our niche markets. California continues to be our largest market, accounting for approximately $123.6 million (64.8%) of our direct premiums written in 2005. During 2005, we opened offices in Chicago, Illinois and Tampa, Florida.
Net Investment Income. Net investment income was $7.8 million in 2005 compared to $2.5 million in 2004, representing an increase of $5.3 million, or 212.0%. Average invested assets increased $108.2 million (126.7%) from $85.4 million in 2004 to $193.6 million in 2005. Approximately $80.8 million of the increase resulted from the net proceeds of the initial public offering of our common stock in January 2005. Net investment income as a percentage of average invested assets rose from 2.9% in 2004 to 4.0% in 2005, reflecting the rising interest rate environment.
Service Income. Service income was $2.5 million in 2005 compared to $3.7 million in 2004, representing a decrease of $1.2 million, or 32.4%. Our service income resulted primarily from service arrangements we have with LMC for claims processing services, policy administration and administrative services we performed for the Eagle Entities’ insurance policies. Average monthly fees declined as the volume of work required for policy administration decreased as a result of the run off of our predecessor’s business.
Other Income. Other income totaled $3.3 million in 2005 compared to $2.5 million in 2004, representing an increase of $0.8 million, or 32.0%. Other income derived primarily from the operations of PointSure, our non-insurance subsidiary.
access to approximately $4.9 million under the collateralized reinsurance trust in the event that LMC fails to satisfy its obligations under the adverse development cover. See the discussion under the heading “Our History” in Part I, Item 1 of this annual report.
Underwriting Expenses. Underwriting expenses totaled $33.8 million in 2005 compared to $17.9 million in 2004, representing an increase of $15.9 million, or 88.8%. Our net underwriting expense ratio was 21.2% in 2005 compared to 21.9% in 2004. Net commissions as a percentage of premiums earned increased from 6.8% in 2004 to 7.9% in 2005. Assumed commissions from state-mandated insurance pools accounted for the majority of this increase, offset by a reduction in the percentage of ceded commissions. Net direct commissions as a percentage of premiums earned equaled approximately 6.2% in 2005, down slightly from 6.3% in 2004. Other underwriting expenses as a percentage of premiums earned were 9.8% in 2005 and 11.9% in 2004.
Federal Income Tax Expense. Our effective tax rate in 2005 was 31.6% compared to 29.5% in 2004. Our effective tax rate for 2005 was lower than the statutory tax rate of 35.0% primarily as a result of tax exempt interest income. The effective tax rate increased in 2005 primarily as a result of a reduction in the proportion of investment income generated from investments in tax-exempt bonds and a related true-up in the amount of taxes due with our 2004 Federal income tax return.
exclusions. See the discussion under the heading “Reinsurance” in Part I, Item 1 of this annual report. Given industry and predecessor trends, we believe we are sufficiently capitalized to retain our retained losses.
Net cash provided by operating activities in 2006 totaled $90.2 million, an increase of $7.5 million, or 9.1%, from $82.7 million in 2005, which increased $41.7 million from $41.0 million in 2004. These increases are mainly attributable to increases in unpaid loss and loss adjustment expense, amortization of deferred policy acquisition costs and reinsurance recoverables, offset by increases in policy acquisition costs deferred and unearned premiums net of premiums receivable, all as a result of our growth.
We used net cash of $139.6 million for investing activities in 2006 compared to $159.7 million in 2005 and $54.3 million in 2004. The difference between 2006 and 2005 is primarily attributable to a reduction in funds available for investing activities. In 2006, we invested net proceeds totaling approximately $57.6 million resulting from a follow-up public offering of 3,910,000 shares of our common stock described below. In 2005, we invested net proceeds totaling approximately $80.8 million resulting from the sale of 8,625,000 shares of common stock in our initial public offering.
Cash provided by financing activities totaled $57.6 million in 2006, a decrease of $23.2 million from $80.8 million in 2005, which increased $64.2 million from $16.6 million in 2004. As described below, the majority of cash provided by financing activities resulted from the sale of our common stock and, to a much lesser degree, from the exercise of common stock options by our employees. In 2005, we received net proceeds of approximately $80.8 million from the initial public offering of our common stock.
On February 1, 2006, we closed a follow-on public offering of 3,910,000 shares of our common stock, including the underwriters’ over-allotment option to purchase 510,000 shares of our common stock, at a price of $15.75 per share for net proceeds of approximately $57.6 million after deducting underwriters’ fees, commissions and offering costs totaling approximately $4 million. We contributed $50.0 million of the net proceeds to SBIC, which is using the capital to expand its business in core markets and to new territories. The remaining proceeds are being used for general purposes, including supporting the growth of PointSure.
As of December 31, 2006, we have no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
The unpaid loss and loss adjustment expense subject to the adverse development cover with LMC is calculated on a quarterly basis using generally accepted actuarial methodologies. Amounts recoverable in excess of acquired reserves at September 30, 2003 are recorded gross in unpaid loss and loss adjustment expense in accordance with SFAS No. 141, Business Combinations, with a corresponding amount receivable from the seller. Amounts are shown net in the income statement.
We defer commissions, premium taxes and certain other costs that vary with and are primarily related to the acquisition of insurance contracts. These costs are capitalized and charged to expense in proportion to the recognition of premiums earned. The method followed in computing deferred policy acquisition costs limits the amount of these deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, anticipated losses and settlement expenses and certain other costs we expect to incur as the premium is earned. Judgments as to ultimate recoverability of these deferred costs are highly dependent upon estimated future costs associated with the premiums written.
In May 2005, Financial Accounting Standards Board (the “FASB”) issued SFAS No. 154, Accounting Changes and Error Corrections, which supersedes APB No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS No. 154 provides guidance on the
accounting for and reporting of accounting changes and error corrections. It establishes, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to the newly adopted accounting principle. SFAS No. 154 also provides guidance for determining whether retrospective application is impracticable. The correction of an error in previously issued financial statements is not an accounting change. However, the reporting of an error correction involves adjustments to previously issued financial statements similar to those generally applicable to reporting an accounting change retrospectively. Therefore, the reporting of a correction of an error by restating previously issued financial statements is addressed by the Statement. We adopted the provisions of SFAS No. 154 as of January 1, 2006, which did not have a material effect on the consolidated financial condition or results of operations.
In November 2005, the FASB issued FASB Staff Position (“FSP”) SFAS No. 115-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments, which addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. SFAS No. 115-1 also includes accounting considerations subsequent to the recognition of other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance amends SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. We adopted the provisions of SFAS No. 115-1 as of January 1, 2006, which did not have a material effect on the consolidated financial condition or results of operations
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109 (“FIN 48”), which provides for the recognition, measurement, presentation and disclosure of uncertain tax positions. A tax benefit from an uncertain position may be recognized only if it is more likely than not that the position is sustainable based on its technical merits. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. We expect that FIN 48 will not have a material effect on our consolidated financial condition or results of operations.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of prior-year uncorrected misstatements should be considered when quantifying misstatements in the current year financial statements. SAB 108 requires registrants to quantify misstatements using both an income statement (“rollover”) and balance sheet (“iron curtain”) approach and evaluate whether either approach results in a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. If prior year errors that had been previously considered immaterial now are considered material based on either approach, no restatement is required so long as management properly applied its previous approach and all relevant facts and circumstances were
considered. If prior years are not restated, the cumulative effect adjustment is recorded in opening accumulated earnings as of the beginning of the fiscal year of adoption. SAB 108 is effective for fiscal years ending on or after November 15, 2006, with earlier adoption encouraged. We adopted the provisions of SAB 108 as of December 31, 2006 which did not have a material effect on the consolidated financial condition or results of operations.
SeaBright Insurance Holdings, Inc. (“SIH” or the “Company”), a Delaware corporation, was formed in June 2003. On July 14, 2003, SIH entered into a purchase agreement, effective September 30, 2003, with Kemper Employers Group, Inc. (“KEG”), Eagle Insurance Companies (“Eagle”), and Lumbermens Mutual Casualty Company (“LMC”), the ultimate owner of KEG and Eagle (the “Acquisition”). Under this agreement, SIH acquired Kemper Employers Insurance Company (“KEIC”), PointSure Insurance Services, Inc. (“PointSure”), and certain assets of Eagle, primarily renewal rights.
PointSure is engaged primarily in administrative and brokerage activities. Eagle consists of Eagle Pacific Insurance Company, Inc. and Pacific Eagle Insurance Company, Inc., both writers of state act workers’ compensation insurance and USL&H that are in run-off as of December 31, 2006.
Investment securities are classified as available-for-sale and carried at fair value, adjusted for other-than-temporary declines in fair value, with changes in unrealized gains and losses recorded in other comprehensive loss, net of applicable income taxes. The estimated fair value of investments in available-for-sale securities is generally based on quoted market prices for securities traded in the public marketplace.
Cash and cash equivalents, which consist primarily of amounts deposited in banks and financial institutions, and all highly liquid investments with maturities of 90 days or less when purchased, are stated at cost. Cash in excess of daily requirements is invested in money market funds and repurchase agreements with maturities of 90 days or less. Such investments are deemed to be cash equivalents for purposes of the consolidated balance sheets and statements of cash flows. The Company had $19.2 million and $11.0 million of cash equivalents at December 31, 2006 and 2005, respectively.
Premiums receivable are recorded at the invoiced amount as they are earned over the life of the contract in proportion to the amount of insurance protection provided. The allowance for doubtful accounts is the Company’s best estimate of the amount of uncollectible premium in the Company’s existing premiums receivable balance. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.
Acquisition costs related to premiums written are deferred and amortized over the periods in which the premiums are earned. Such acquisition costs vary with and are primarily related to the acquisition of insurance contracts and include commissions, premium taxes, and certain underwriting and policy issuance costs. Deferred policy acquisition costs are limited to amounts recoverable from unearned premiums and anticipated investment income.
Goodwill represents the excess of costs over fair value of 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 SFAS No. 144, Accounting for Impairment or Disposal of Long-Lived Assets.
The asset and liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that are estimated to be in effect when the differences are expected to reverse, net of any applicable valuation allowances. We evaluate the necessity of a deferred tax asset valuation allowance by determining, based on the weight of available evidence, whether it is more likely than not that some portion or all of the deferred tax asset will not be realized. When necessary, a valuation allowance is recorded to reduce the deferred tax asset to the amount that is more likely than not to be realized.
Outstanding options to purchase shares of our common stock are excluded for the year ended December 31, 2004 because they are anti-dilutive.
Under the modified-prospective transition method, stock-based compensation cost is recognized in the consolidated financial statements for granted, modified, or settled share-based payments. Compensation cost recognized includes the estimated cost for stock options granted on or after January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R, and the estimated expense for the portion of awards granted prior to January 1, 2006 vesting in the current period, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123. Results for prior periods have not been restated, as provided for under the modified-prospective method.
The following table shows the effect on net income and earnings per share for the years ended December 31, 2005 and 2004 as if compensation cost had been recognized based upon the estimated grant date fair value of stock options in accordance with SFAS No. 123, as amended by SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, and as if such cost had been determined in accordance with SFAS No. 123R:
In July 2006, the Financial Accounting Standards Board (the “FASB”) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109 (“FIN 48”), which provides for the recognition, measurement, presentation and disclosure of uncertain tax positions. A tax benefit from an uncertain position may be recognized only if it is more likely than not that the position is sustainable based on its technical merits. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. The Company expects that FIN 48 will not have a material effect on its consolidated financial condition or results of operations.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. The provisions for SFAS No. 157 are effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Early adoption is permitted. The Company must adopt these new requirements no later than its first fiscal quarter of 2008. The Company expects that SFAS No. 157 will not have a material effect on its consolidated financial condition or result of operations.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of prior-year uncorrected misstatements should be considered when quantifying misstatements in the current year financial statements. SAB 108 requires registrants to quantify misstatements using both an income statement (“rollover”) and balance sheet (“iron curtain”) approach and evaluate whether either approach results in a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. If prior year errors that had been previously considered immaterial now are considered material based on either approach, no restatement is required so long as management properly applied its previous approach and all relevant facts and circumstances were considered. If prior years are not restated, the cumulative effect adjustment is recorded in opening accumulated
The consolidated cost or amortized cost, gross unrealized gains and losses, and estimated fair value of investment securities available-for-sale at December 31, 2006 and 2005 are as follows:
no direct investments in equity securities at December 31, 2006 or 2005. At December 31, 2006 and 2005, the unrealized loss on temporarily impaired investments totaled $2.4 million and $2.5 million, respectively, for investment securities available-for-sale with a fair value of $209.4 million and $188.0 million, respectively. Approximately $1.9 million at December 31, 2006 and $0.5 million at December 31, 2005 of total unrealized losses were from securities that had been impaired for more than one year. At December 31, 2006 and 2005, no unrealized loss exceeded 20% of the related security’s book value at that date. The following table presents information about fixed maturity securities with unrealized losses December 31, 2006 and 2005:
Estimated fair value amounts, defined as the quoted market price of a financial instrument, have been determined using available market information and other appropriate valuation methodologies. However, considerable judgment is required in developing the estimates of fair value. Accordingly, these estimates are not necessarily indicative of the amounts that could be realized in a current market exchange. The use of
Cash and cash equivalents, premiums receivable, accrued expenses, other liabilities and surplus notes: The carrying amounts for these financial instruments as reported in the accompanying consolidated balance sheets approximate their fair values.
Premiums receivable consist of the following at December 31, 2006 and 2005:
Property and equipment consisted of the following at December 31, 2006 and 2005:
On October 1, 2006, the Company entered into new reinsurance agreements with nonaffiliated reinsurers wherein it retains the first $1.0 million of each loss occurrence. The new reinsurance program, which is effective through October 1, 2007, provides coverage up to $75.0 million per loss occurrence as follows:
Fully reinsured, subject to an aggregate annual limit of $8.0 million
Fully reinsured, subject to a limit of $7.5 million maximum any one loss and an aggregate limit of $20.0 million
Fully reinsured in two sub-layers. The first sub-layer affords coverage of up to $30.0 million for each loss occurrence in excess of $20.0 million, subject to an aggregate annual limit of $60.0 million, and the second sub-layer affords coverage up to $25.0 million for each loss occurrence in excess of $50.0 million, subject to an annual aggregate limit of $50.0 million. Both sub-layers are subject to a limit of $5.0 million maximum any one loss.
Effective from October 1, 2005 through October 1, 2006, the Company entered into reinsurance agreements wherein it retains the first $500,000 of each loss occurrence. Losses in excess of $500,000 up to $50.0 million are reinsured with nonaffiliated reinsurers as follows:
Fully reinsured, subject to an annual aggregate deductible of $2.0 million and an aggregate limit of $16.0 million
Fully reinsured in two sub-layers. The first sub-layer affords coverage of up to $10.0 million for each loss occurrence in excess of $10.0 million, subject to an aggregate limit of $20.0 million. The second sub-layer affords coverage up to $30.0 million for each loss occurrence in excess of $20.0 million, subject to an aggregate limit of $60.0 million.
As part of the purchase of SBIC, SIH, and LMC entered into an adverse development excess of loss reinsurance agreement (the “Agreement”). The Agreement, after taking into account any recoveries from third party reinsurers, calls for LMC to reimburse SBIC 100% of the excess of the actual loss at December 31, 2011 over the initial loss reserves at September 30, 2003. The Agreement also calls for SBIC to reimburse LMC 100% of the excess of the initial loss reserves at September 30, 2003 over the actual loss results at December 31, 2011. The amount of adverse loss development under the Agreement was $2.8 million at December 31, 2006 and $3.4 million at December 31, 2005. The decrease in the amount receivable from LMC is netted against loss and loss adjustment expense in the accompanying consolidated statements of operations.
The Company recorded no write-offs of uncollectible reinsurance recoverables in the years ended December 31, 2006, 2005, and 2004.
At December 31, 2006 and 2005, the Company reduced unpaid loss and loss adjustment expense by $3.3 million and $2.1 million, respectively, for anticipated salvage and subrogation recoveries.
The following is a reconciliation of the difference between the “expected” income tax computed by applying the federal statutory income tax rate to income before income taxes and the total income taxes reflected on the books for the years ended December 31, 2006, 2005, and 2004:
As of December 31, 2006, the Company has capital loss carryforwards of approximately $577,000. Approximately $146,000 expires in 2010 and $431,000 expires in 2011.
SBIC is required to file annually with state regulatory insurance authorities financial statements prepared on an accounting basis as prescribed or permitted by such authorities (statutory basis accounting or “SAP”). Statutory net income and capital and surplus (stockholders’ equity) differ from amounts reported in accordance with GAAP, primarily because of the following accounting treatments prescribed by SAP: policy acquisition costs are expensed when incurred; certain assets designated as “nonadmitted” for statutory purposes are charged to surplus; fixed-income securities are reported primarily at amortized cost or fair value based on their rating by the National Association of Insurance Commissioners (“NAIC”); policyholders’ dividends are expensed as declared rather than accrued as incurred; deferred income taxes are charged or credited directly to unassigned surplus; and any change in the admitted net deferred tax asset is offset to equity. Following is a summary of SBIC’s statutory net gain (loss) for the years ended December 31, 2006, 2005, and 2004 and statutory capital and surplus as of December 31, 2006, 2005 and 2004:
KEIC was last examined by the Illinois Division of Insurance as of December 31, 2000. In September 2006, SBIC was notified by the Illinois Division of Insurance that a routine comprehensive examination of its 2005 statutory annual statement had been scheduled. Field work began in October 2006 and was still in process at December 31, 2006.
within certain levels, each of which requires specified corrective action. SBIC exceeded the minimum risk-based capital requirements at December 31, 2006 and 2005.
On October 1, 2003, the Company began selling workers’ compensation insurance policies for which the premiums vary based on loss experience. Accrued retrospective premiums are determined based upon the loss experience of business subject to such experience rating adjustment. Accrued retrospectively rated premiums are determined by and allocated to individual policyholder accounts. Accrued retrospective premiums and return retrospective premiums are recorded as additions to and reductions from written premium, respectively. Approximately 25.8%, 31.6% and 35.8% of the Company’s direct premiums written for the years ended December 31, 2006, 2005 and 2004, respectively, related to retrospectively rated contracts. The Company accrued $9.6 million for retrospective premiums receivable and $12.7 million for return retrospective premiums at December 31, 2006 and $4.2 million for retrospective premiums receivable and $6.3 million for return retrospective premiums at December 31, 2005.
On July 14, 2003, SIH entered into a purchase agreement, effective September 30, 2003, with KEG, Eagle and LMC, all ultimately owned by KIC. In the Acquisition, SIH acquired PointSure, KEIC, and the renewal rights and substantially all of the operating assets and employees of Eagle Pacific Insurance Company and Pacific Eagle Insurance Company. Eagle Pacific Insurance Company began writing specialty workers’ compensation insurance approximately 20 years ago. The Acquisition gave SIH renewal rights to an existing portfolio of business, representing a valuable asset given the renewal nature of the workers’ compensation insurance business, and a fully-operational infrastructure that would have taken many years to develop. These renewal rights gave the Company access to customer lists and the right to seek to renew its continuing in-force insurance contracts. In addition, KEIC provided the requisite insurance licenses needed to write business.
Intangible assets, other than goodwill, consist of the following at December 31, 2006 and 2005 (dollar amounts in thousands):
The weighted average amortization period for all intangible assets subject to amortization is 2.6 years. Aggregate amortization expense was $246,000, $629,000 and $731,000 for the years ended December 31, 2006, 2005, and 2004, respectively. Estimated remaining amortization expense is $10,000 in 2007 and $7,500 in 2008.
In September 2003, the Company’s Board of Directors authorized 750,000 shares of common stock with a par value $0.01 per share. The number of authorized shares of common stock was increased to 1.1 million in March 2004, 1.2 million in August 2004, 10.0 million in December 2004 and 75.0 million in January 2005. The Board of Directors declared a two-for-one common stock split in February 2004 and a further 7.649832-for-one common stock split in December 2004. The Company completed the initial public offering of its common stock in January 2005, issuing 8,625,000 shares of common stock at a price of $10.50 per share for net proceeds of approximately $80.8 million.
On February 1, 2006, the Company closed a follow-on public offering of 3,910,000 shares of common stock, including the underwriters’ over-allotment option to purchase 510,000 shares of common stock, at a
price of $15.75 per share for net proceeds of approximately $57.6 million, after deducting underwriters’ fees, commissions and offering costs totaling approximately $4.0 million. The Company contributed $50.0 million of the net proceeds to SBIC, which is using the capital to expand its business in its core markets and to new territories. The remaining proceeds are being used for general corporate purposes, including supporting the growth of PointSure. The use of proceeds from the offering does not represent a material change from the use of proceeds described in the prospectus that was included in the related Registration Statement on Form S-1. Except for the contribution of proceeds to SBIC, no proceeds or expenses were paid to the Company’s directors, officers, ten percent shareholders or affiliates.
For 2006, the expected term of options was determined using the “simplified method,” which averages an award’s weighted average vesting period and its contractual term. For 2006, expected stock price volatility was based on a weighted average of the Company’s historical stock price volatility since the initial public offering of its common stock in January 2005 and the historical volatility of a peer company’s stock for a period of time equal to the expected term of the option. Prior to the adoption of SFAS No. 123R, expected term was based on the Company’s historical experience and future expectations and price volatility was estimated using the Company’s historical volatility. The risk-free interest rate is based on the yield of U.S. Treasury securities with an equivalent remaining term. The Company has not paid stockholder dividends in the past and has no current plan to pay any stockholder dividends in the near future.
expected to be recognized over a weighted average period of approximately 29.4 months. Proceeds from the exercise of stock options totaled approximately $32,400 in 2006 and approximately $15,300 in 2005. The total intrinsic value of stock options exercised was approximately $42,300 in 2006 and approximately $17,100 in 2005.
The following table summarizes nonvested stock activity for the year ended December 31, 2006: