Our principal executive offices are located in approximately 17,200 square feet of leased office space in Seattle, Washington. As of December 31, 2004, we also lease branch offices consisting of approximately 3,200 square feet in Honolulu, Hawaii; 1,700 square feet in Anchorage, Alaska; 5,000 square feet in Orange, California; and 3,400 square feet in Houston, Texas. We conduct claims and underwriting operations in our branch offices, with the exception of our Honolulu office where we conduct only claims 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 selected historical financial information for the Company and its predecessor for the periods ended and as of the dates indicated. The selected income statement data for the year ended December 31, 2004 and the three months ended December 31, 2003 and the balance sheet data as of December 31, 2004 and 2003 are derived from our audited consolidated financial statements included elsewhere in this annual report. The selected income statement data for the nine months ended December 31, 2003 and the years ended December 31, 2002 and 2001 and the balance sheet data as of December 31, 2002 are derived from our predecessor’s audited combined financial statements. We derived the selected income statement data for the year ended December 31, 2000 and the balance sheet data as of December 31, 2001 and 2000 from our predecessor’s unaudited financial statements which are not included in this annual report. These historical results are not necessarily indicative of future results. You should read the following selected financial information along with other information contained in this report, including Part II,
We provide workers’ compensation insurance coverage for prescribed benefits that employers are required to provide to their employees who may be injured in the course of their employment. We currently provide workers’ compensation insurance to customers in the maritime, alternative dispute resolution and state act markets.
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 and will result in increased depreciation and amortization expense.
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. 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.
Gross premiums written include all premiums billed and unbilled by an insurance company during a specified policy period. Premiums are earned over the term of the related policies. At the end of each accounting period, the portion of the premiums that are not yet earned are included in unearned premiums and are realized as revenue in subsequent periods over the remaining term of the policy. Our policies typically have a term of 12 months. Thus, for example, for a policy that is written on July 1, 2004, one-half of the premiums would be earned in 2004 and the other half would be earned in 2005.
Premiums earned are the earned portion of our net premiums written. Net premiums written is the difference between gross premiums written and premiums ceded or paid to reinsurers (ceded premiums written). Our gross premiums written is the sum of both direct premiums and assumed premiums before the effect of ceded reinsurance. Assumed premiums are premiums that we have received from another company under a reinsurance agreement or from an authorized state mandated pool.
We pay commission expense in our insurance subsidiary to our brokers for the premiums that they produce for us.
We pay state and local taxes based on premiums, licenses and fees, assessments and contributions to workers’ compensation security funds.
Year Ended December 31, 2004 Compared to Three Months Ended December 31, 2003 and Predecessor Nine Months Ended September 30, 2003
Net Premiums Earned. Net premiums earned were $78.0 million for the year ended December 31, 2004 compared to our predecessor’s $36.9 million for the nine months ended September 30, 2003 and our $3.1 million for the three months ended December 31, 2003, representing a period-over-period increase of $38.0 million, or 95.0%. As previously discussed, we believe this increase is due primarily to the additional business we were able to write as a result of our improved A.M. Best rating over that held by our predecessor and our expansion in California state act contractor business.
Net Investment Income. Net investment income was $2.5 million for the year ended December 31, 2004 compared to our predecessor’s $1.7 million for the nine months ended September 30, 2003 and our $0.3 million for the three months ended December 31, 2003, resulting in a period-over-period increase of $0.5 million, or 25.0%. Our predecessor had $6.8 million more in average invested assets for the nine months ended September 30, 2003 than we had for the year ended December 31, 2004. However, as a result of our predecessor’s realignment of its portfolio in 2003 from fixed income securities to more short term investments, our predecessor’s yield on average invested assets for the nine months ended September 30, 2003 was approximately 1.9% compared to our yield on average invested assets for the year ended December 31, 2004 of approximately 2.9%.
13.6%. Our other revenue as well as our predecessor’s other revenue results primarily from the operations of our non-insurance subsidiary.
Underwriting Expenses. Underwriting expenses totaled $17.9 million for the year ended December 31, 2004, compared to our predecessor’s $7.0 million for the nine months ended September 30, 2003 and our $1.8 million for the three months ended December 31, 2003, representing an increase of $9.1 million, or 103.4%. Our underwriting expense ratio for the year ended December 31, 2004 was 21.9%, compared to our predecessor’s underwriting expense ratio of 18.9% for the nine months ended September 30, 2003. The increase in the underwriting expense ratio resulted primarily from the fact that we have increased our staffing levels and related expenses in preparation for anticipated growth of our business. Our predecessor’s operations during the nine months ended September 30, 2003 were not expanding, as the future of the company at that time was uncertain.
Federal Income Tax Expense. The effective tax rate for the year ended December 31, 2004 was 29.5%, compared to our predecessor’s effective tax rate of 29.4% for the nine months ended September 30, 2003. Our effective tax rate for the year ended December 31, 2004 was lower than the statutory tax rate of 34.0% primarily as a result of tax exempt interest income. Our predecessor’s effective tax rate was lower than the statutory tax rate of 34.0% primarily as a result of a decrease in the deferred tax valuation allowance.
Net Premiums Written. Our predecessor had $66.6 million in net premiums written for the nine months ended September 30, 2003, compared to $19.1 million for the year ended December 31, 2002. Our predecessor’s average monthly net premiums written of $7.4 million for the nine months ended September 30, 2003 compared to $1.6 million in average monthly net premiums written for the year ended December 31, 2002. This increase was attributable to the termination on January 1, 2003 of our predecessor’s inter-company quota share reinsurance agreements with LMC, which required our predecessor to cede to LMC 80.0% of the premiums written after external reinsurance, 80.0% of the net retained liabilities, after application of all external reinsurance, and 80.0% of underwriting expenses for all policies written by our predecessor from January 1, 1999 through December 31, 2002.
Net Investment Income. Our predecessor’s net investment income was $1.7 million for the nine months ended September 30, 2003 compared to $3.4 million for the year ended December 31, 2002. The average net yield declined from 4.2% in 2002 to 1.9% for the nine months ended September 30, 2003. This decline in yield was due primarily to the realignment of our predecessor’s portfolio in 2003 from fixed income securities to more short term investments, which carry lower interest rates than fixed income securities. Cash and short-term investments made up approximately 53.0% of our predecessor’s portfolio at September 30, 2003, compared to 34.9% at December 31, 2002.
Other Revenue. For the nine months ended September 30, 2003, our predecessor’s other revenue was $1.5 million compared to $1.2 million for the year ended December 31, 2002. The $1.5 and $1.2 million result primarily from the operations of our predecessor’s non-insurance subsidiary, which acted as a managing general underwriter for our predecessor. In 2003 our predecessor’s gross premiums were affected by the A.M. Best financial strength rating downgrade to B++ and as a result fees to its non-insurance subsidiary declined.
Underwriting, Acquisition and Insurance Expenses. For the nine months ended September 30, 2003, our predecessor’s underwriting, acquisition and insurance expenses were $7.0 million, compared to $3.7 million for the year ended December 31, 2002. The underwriting expense ratio decreased from 21.6% in 2002 to 18.9% in the 2003 period. The expenses and ratios are not comparable because of the 80% quota share reinsurance treaties with LMC, which were cancelled effective January 1, 2003 for all policies incepting after December 31, 2002. On a direct basis the expenses were $10.5 million for the nine months ended September 30, 2003 or, $1.1 million per month, compared to $17.1 million for the year ended December 31, 2002, or $1.4 million per month. The decline in average monthly expenses is due to expense control initiatives instituted in 2002 plus reduced acquisition expenses in 2003 associated with declining monthly premium volume in 2003 compared to 2002.
Other Expenses. For the nine months ended September 30, 2003, our predecessor’s other expenses were $1.8 million compared to $3.3 million for the year ended December 31, 2002. In 2003 our predecessor’s other expenses consisted primarily of operating expenses for its non-insurance company subsidiary. For the twelve months ended December 31, 2002, our predecessor’s other expenses were primarily attributable to the operating expenses of its non-insurance subsidiary and to the method of recording the amortization of the deferred gain under our predecessor’s loss portfolio transfer agreements with LMC.
Net Income Before Cumulative Effect of Change in Accounting Principle. Our predecessor’s net income before cumulative effect of change in accounting principle for the nine months ended September 30, 2003 was $4.7 million, compared to $3.3 million for the year ended December 31, 2002.
Gross Premiums Written. Gross premiums written increased $32.9 million, or 44.9%, to $106.1 million for the year ended December 31, 2002, compared to $73.2 million for the year ended December 31, 2001. This increase was due primarily to increased market penetration and price increases of 13.8%. Favorable market conditions beginning in 2001 and continuing throughout 2002 resulted in an influx of new business and enabled our predecessor to increase prices.
Net Premiums Written. Net premiums written for the twelve months ended December 31, 2002 were $19.1 million, representing an increase of $5.4 million, or 39.3%, from the $13.7 million in net premiums written for the same period in 2001. The increase resulted from price increases and market penetration, which generated greater gross premiums written.
Premiums Earned. Premiums earned were $17.1 million for the twelve months ended December 31, 2002, compared to $12.6 million for the same period in 2001. The increase in net premiums earned in 2002 was attributable to market penetration and price increases in 2002, which generated greater gross premiums written.
Net Realized Gains (Losses) on Investments. Our predecessor realized net losses of $4.5 million for the year ended December 31, 2002, compared to net losses of $484,000 for the comparable period in 2001. In 2002, our predecessor realigned its portfolio with a greater emphasis on cash and short-term investments, which resulted in approximately $0.8 million in realized losses from the sale of securities with values that had declined substantially below their cost. In addition, our predecessor adjusted the carrying value of investments in equity securities by $3.6 million for other-than-temporary impairments.
Other Revenue. For the year ended December 31, 2002, other revenue was $1.2 million compared to $3.8 million for the year ended December 31, 2001. In 2002, the $1.2 million is primarily from the operations of our predecessor’s non-insurance subsidiary, which acted as a managing general underwriter for our predecessor. Our predecessor’s other revenue for the year ended December 31, 2001 consisted primarily from the operations of our predecessor’s non-insurance subsidiary and from the amortization of the deferred gain under the loss portfolio transfer agreements. Under the loss portfolio transfer agreements, our predecessor utilized the recovery method for recording the deferred gain, which considers the amounts received in relation to the ultimate incurred loss and loss adjustment expenses under the agreements and applies that ratio to the total deferred gain. The amortized portion of the deferred gain is adjusted accordingly in the current period. In 2002, there was an accretion to the deferred gain, which was recorded in other expense. Our predecessor’s other revenue for the year ended December 31, 2001 was $3.8 million as a result of the amortization of the deferred gain under the loss portfolio transfer agreements.
gain under the recovery method for recording the deferred gain, which considers the amounts received in relation to the ultimate incurred loss and loss adjustment expenses under the agreement and applies that ratio to the total deferred gain.
Other Expenses. For the year ended December 31, 2002, our predecessor’s other expenses were $3.3 million, compared to $2.1 million in other expenses for the year ended December 31, 2001. The increase was primarily attributable to the operating expenses of our predecessor’s non-insurance company subsidiary and to the amortization of the deferred gain under our predecessor’s loss portfolio transfer agreements with LMC. The amortized portion of the deferred gain is adjusted accordingly in the current period. In 2002 there was an accretion to the deferred gain, which was recorded as other expenses.
Our investment portfolio is structured so that investments mature periodically over time in reasonable relation to current expectations of future claim payments. Since we have a limited claims history, we have derived our expected future claim payments from industry and predecessor trends and included a provision for uncertainties. Our investment portfolio as of December 31, 2004 has an effective duration of 5.89 years with individual maturities extending out to 29 years. Currently, we make claim payments from positive cash flow from operations and invest excess cash in securities with appropriate maturity dates to balance against anticipated future claim payments. As these securities mature, we intend to invest any excess funds with appropriate durations to match against expected future claim payments.
Our ability to adequately provide funds to pay claims comes from our disciplined underwriting and pricing standards and the purchase of reinsurance to protect us against severe claims and catastrophic events. Effective October 1, 2004, our reinsurance program provides us with 100% reinsurance protection
Our insurance subsidiary is required by law to maintain a certain minimum level of surplus on a statutory basis. Surplus is calculated by subtracting total liabilities from total admitted assets. The National Association of Insurance Commissioners has a risk-based capital standard designed to identify property and casualty insurers that may be inadequately capitalized based on inherent risks of each insurer’s assets and liabilities and its mix of net premiums written. Insurers falling below a calculated threshold may be subject to varying degrees of regulatory action. As of December 31, 2004, the statutory surplus of our insurance subsidiary was in excess of the prescribed risk-based capital requirements that correspond to any level of regulatory action.
For the year ended December 31, 2004, financing activities provided cash of $5.2 million from the sale of additional convertible preferred stock in June 2004. Additionally, in May 2004, our insurance subsidiary issued an aggregate principal amount of $12.0 million in floating rate surplus notes due 2034 to ICONS, LTD in a transaction in which Morgan Stanley & Co. Incorporated and Cochran Caronia Securities LLC acted as placement agents. Quarterly interest payments at the rate of LIBOR plus 4% are expected to be made from cash flow from operations.
On January 26, 2005, we closed the initial public offering of 8,625,000 shares of our common stock, including the underwriters’ over-allotment option, at a price of $10.50 per share for net proceeds of approximately $80.8 million, after deducting underwriters’ fees, commissions and offering costs totaling approximately $9.7 million. On January 26, 2005, we contributed approximately $74.8 million of the net proceeds to SeaBright Insurance Company. We intend to use the remaining net proceeds for general corporate purposes, including supporting the growth of PointSure. In connection with the initial public offering, all 508,365.25 outstanding shares of our Series A preferred stock were converted into 7,777,808 shares of common stock.
We estimate the amount of premiums that have been earned but are unbilled at the end of the period by analyzing historical earned premium adjustments made and applying an adjustment percentage against premiums earned for the period.
SFAS No. 123 (revised 2004), “Share Based Payment,” was issued in December 2004. Statement No. 123(R) is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” Statement No. 123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in Statement No. 123(R) is similar to
We have audited the accompanying consolidated balance sheets of SeaBright Insurance Holdings, Inc. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, changes in stockholders’ equity and comprehensive income (loss), and cash flows for the year ended December 31, 2004 and for the period from June 19, 2003 (inception) through December 31, 2003. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
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, 2004.
KEIC resumed writing business effective October 1, 2003, primarily targeting policy renewals for former Eagle business in the States of California, Hawaii, and Alaska. In November 2003, permission was granted by the Illinois Department of Financial and Professional Regulation, Division of Insurance (the “Illinois Division of Insurance”) for KEIC to change its name to SeaBright Insurance Company (“SBIC”).
The accompanying consolidated financial statements include the accounts of SIH and its wholly owned subsidiaries, PointSure and SBIC, (collectively, the “Company”). All significant intercompany transactions among these affiliated entities have been eliminated in consolidation.
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 directly in other comprehensive income, net of applicable income taxes. The estimated fair value of investments in available-for-sale securities is generally based on quoted market value prices for securities traded in the public marketplace. A decline in the market value of any available-for-sale security below cost that is deemed to be other-than-temporary results in a reduction in the carrying amount of the security to fair value. The impairment is charged to earnings and a new cost basis for the security is established.
The preparation of the consolidated financial statements in conformity with GAAP requires management of the Company to make a number of estimates and assumptions relating to the reported amount of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates. The Company has used significant estimates in determining the unpaid loss and loss adjustment expenses, goodwill and other intangibles, earned premiums on retrospectively rated policies, earned but unbilled premiums, federal income taxes and amounts related to reinsurance.
Premiums receivable are recorded at the invoiced amount. The allowance for doubtful accounts is the Company’s best estimate of the amount of uncollected 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 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.
Furniture and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful lives, which range from three to five years. Depreciation expense for the year ended December 31, 2004 and period from inception through December 31, 2003 was approximately $166,000 and $20,000, respectively.
Premiums for primary and reinsured risks are included in revenue over the life of the contract in proportion to the amount of insurance protection provided (i.e., ratably over the policy period). The portion of the premium that is applicable to the unexpired period of the policies in-force is not included in revenue and is deferred and recorded as unearned premium in the liability section of the balance sheet. Deferred premiums represent the unbilled portion of annual premiums.
Earned premiums on retrospectively rated policies are based on the Company’s estimate of loss experience as of the measurement date. Loss experience includes known losses specifically identifiable to a retrospective policy as well as provisions for future development on known losses and for losses incurred but not yet reported using actuarial loss development factors and is consistent with how the Company projects losses in general. For retrospectively rated policies, the governing contractual minimum and maximum rates are established at policy inception and are made a part of the insurance contract. While the typical retrospectively rated policy has five annual adjustment or measurement periods, premium adjustments continue until mutual agreement to cease future adjustments is reached with the policyholder. As of December 31, 2004 and 2003, approximately 35.8% and 43.8%, respectively, of premiums written relates to retrospectively rated policies.
The Company estimates the amount of premiums that have been earned but are unbilled at the end of the period by analyzing historical earned premium adjustments made and applying an adjustment percentage against premiums earned for the period. Included in deferred premiums at December 31, 2004 and 2003 and premiums earned for the periods then ended are accruals for earned but unbilled premiums of $1.7 million and $0, respectively.
Unpaid loss and loss adjustment expenses represent estimates of the ultimate net cost of all unpaid losses incurred through the specified period. Loss adjustment expenses are estimates of unpaid expenses to be incurred in settlement of the claims included in the liability for unpaid losses. These liabilities, which anticipate salvage and subrogation recoveries and are presented gross of amounts recoverable from reinsurers, include estimates of future trends in claim severity and frequency and other factors that could vary as the losses are ultimately settled. In connection with the Acquisition, KEIC and LMC entered into an adverse development cover agreement to indemnify each other with respect to developments in KEIC’s
We use independent actuaries to assist in the evaluation of the adequacy of our reserve for unpaid loss and loss adjustment expense. In light of the Company’s short operating history, and uncertainties concerning the effects of legislative reform specifically as it relates to the Company’s California workers compensation class of business, actuarial techniques are applied that use the historical experience of the Company’s predecessor as well as industry information in the analysis of unpaid loss and loss adjustment expense. These techniques recognize, among other factors:
The Company measures its employee stock-based compensation arrangements using the provisions outlined in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” which is an intrinsic value-based method of recognizing compensation costs. The Company has adopted the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-based Compensation.” None of the Company’s stock options has an intrinsic value at grant date and, accordingly, no compensation cost has been recognized for its stock option plan activity.
The following table illustrates the effect on net income (loss) for the year ended December 31, 2004 and for the three month period ended December 31, 2003 as if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock based compensation:
The per-share weighted average grant date fair value of options granted was $1.09 in 2004 and $1.06 in 2003. The fair value of stock options granted was estimated on the date of grant using the Black-Scholes option pricing model. The following weighted average assumptions were used to perform the calculations:
At December 31, 2004 and 2003, the unrealized loss on temporarily impaired investments totaled $224,000 and $122,000, respectively, for investment securities available-for-sale with a fair value of $29.8 million and $17.6 million, respectively. All were impaired for less than one year. The majority of the impairment on investment securities available-for-sale was in U.S. treasury notes and government sponsored agency obligations, which accounted for 50% of the total impairment. Temporarily impaired securities are a result of market value changes and are expected to regain the lost value with market shifts. Other-than-temporarily impaired securities are a result of contractual failure by the issuer, are not expected to rebound and, therefore, are considered not collectable.
The Company evaluated investment securities with December 31, 2004 fair values less than amortized cost and has determined that the decline in value is temporary and is related to the change in market interest rates since purchase. The Company anticipates full recovery of amortized costs with respect to these securities at maturity or sooner in the event of a more favorable market interest rate environment.
The amortized cost and estimated fair value of investment securities available-for-sale at December 31, 2004, by contractual maturity, are set forth below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
The following methods and assumptions were used by the Company in estimating the fair value disclosures for financial instruments in the accompanying financial statements and notes:
Investment securities: The estimated fair values for available-for-sale securities generally represent quoted market value prices for securities traded in the public marketplace or analytically determined values for securities not traded in the public marketplace. Additional data with respect to fair values of the Company’s investment securities are disclosed in Note 3.
Direct premiums written totaled $134.5 million for the year ended December 31, 2004 and $22.2 million for the three month period ended December 31, 2003.
Effective October 1, 2004, 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 $100.0 million are 100% reinsured with nonaffiliated reinsurers.
Company. Effective January 1, 2002 through May 31, 2002, 100% of all losses are 100% quota-shared to Argonaut Insurance Company.
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 $2.9 million at December 31, 2004 and $2.5 million at December 31, 2003. The increase in the amount receivable from LMC is netted against loss and loss adjustment expense in the accompanying consolidated statements of operations.
As part of the Agreement, LMC placed into trust (the “Trust”) an amount equal to 10% of the balance sheet reserves of SBIC at the date of sale. Thereafter, the Trust shall be adjusted each quarter, if warranted, to an amount equal to 102% of LMC’s obligations under the Agreement. Initial loss reserves were $16.0 million. The balance of the Trust was $4.8 million at December 31, 2004 and $1.6 million at December 31, 2003.
The Company assumes business from the National Council for Compensation Insurance in the states of Alaska, Nevada and Oregon as part of the Residual Market Pool program.
The Company recorded no write-offs of uncollectible reinsurance recoverables in the year ended December 31, 2004 or the three month period ended December 31, 2003.
The Company did not commute any reinsurance agreements in the year ended December 31, 2004 or the three month period ended December 31, 2003.
The following table summarizes the activity in unpaid loss and loss adjustment expense for the year ended December 31, 2004 and the three month period ended December 31, 2003:
On May 26, 2004, SBIC issued in a private placement $12.0 million in subordinated floating rate Surplus Notes due in 2034. The transaction was underwritten by Morgan Stanley & Company and Cochran & Caronia Securities, LLC. The noteholder is ICONS, Ltd. and Wilmington Trust Company acts as Trustee. Interest, paid quarterly in arrears, is calculated at the beginning of the interest payment period using the 3-month LIBOR rate plus 400 basis points. The quarterly interest rate cannot exceed the initial interest rate by more than 10% per year, cannot exceed the corporate base (prime) rate by more than 2% and cannot exceed the highest rate permitted by New York law. The interest rate at December 31, 2004 was 6.36%. Interest and principal may only be paid upon the prior approval of the Illinois Division of Insurance. In the event of default, as defined, or failure to pay interest due to lack of Illinois Division of Insurance approval, the Company cannot pay dividends on its capital stock, is limited in its ability to redeem, purchase or acquire any of its capital stock and cannot make payments of interest
Issuance costs of $591,000 incurred in connection with the Surplus Notes are being amortized over the life of the notes using the effective interest method. Amortization expense for the year ended December 31, 2004 was $20,000.
Deferred federal income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and those amounts used for federal income tax reporting purposes. The significant components of the deferred tax assets and liabilities at December 31, 2004 and 2003 are as follows:
At December 31, 2003, the Company had a net operating loss carryforward of $343,000, which management fully utilized as an offset against the Company’s federal taxable income for its first full year of operations in calendar year 2004. Consequently, the Company has no net operating loss carry forward at December 31, 2004.
The maximum amount of dividends which can be paid by insurance companies domiciled in the State of Illinois to shareholders without prior approval of regulatory authorities is restricted, if such dividend together with other distributions during the 12 preceding months would exceed the greater of 10% of the insurer’s statutory surplus as regards policyholders as of the preceding December 31, or the statutorily adjusted net income for the preceding calendar year. If the limitation is exceeded, then such proposed dividend must be reported to the Director of Insurance at least 30 days prior to the proposed payment date and may be paid only if not disapproved. The Illinois insurance laws also permit payment of dividends only out of earned surplus, exclusive of most unrealized gains. At December 31, 2004, the Company had negative statutory earned surplus of $2.5 million. Consequently, SBIC will not be able to pay any shareholder dividends in 2005 without the prior approval of the regulators. KEIC was last examined by the Illinois Division of Insurance as of December 31, 2000. The State of Illinois imposes minimum risk-based capital requirements that were developed by the NAIC. The formulas for determining the amount of risk-based capital specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of the enterprise’s regulatory total adjusted capital to certain minimum capital amounts as defined by the NAIC. Enterprises below specified trigger points or ratios are classified within certain levels, each of which requires specified corrective action. At December 31, 2004 and 2003, the Company exceeded the minimum risk-based capital requirements.
The Company leases certain office space for its headquarters and regional offices under agreements that are accounted for as operating leases. Lease expense for the year ended December 31, 2004 and the three month period ended December 31, 2003 totaled $571,000 and $158,000, respectively. Future minimum payments required under the agreements are as follows:
its continuing in-force insurance contracts. In addition, KEIC provided the requisite insurance licenses needed to write business.
The initial aggregate purchase price, including acquisition costs of $1.3 million, was $16.0 million. The acquired assets and liabilities were recorded on the Company’s books at their respective fair values as of the date of Acquisition. Goodwill, the excess of the purchase price over the net fair value of the assets and liabilities acquired, was $2.1 million. The consolidated statements of operations for the year ended December 31, 2004 and for the three month period ended December 31, 2003 include the operations of KEIC and PointSure since October 1, 2003.
The Company and LMC negotiated a final purchase price adjustment settlement on September 28, 2004. Included in the original purchase price allocation was an estimated purchase price settlement amount of $1.1 million. The final purchase price adjustment settlement of $771,000 reduced the October 1, 2003 balance of reinsurance recoverables by $155,000 and increased the reserve for unpaid loss and loss adjustment expenses by $226,000. The Company was required to pay interest expense of $30,000 related to the settlement period. In addition, the Company recorded an entry to increase other assets and reduce goodwill by $241,000.
As part of the purchase of KEIC, 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 result 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 result at September 30, 2003 over the actual loss reserves at December 31, 2011.
In addition to the final purchase price adjustment settlement, the Company and LMC agreed to hire an outside actuary to determine the unpaid loss and loss adjustment expenses at September 30, 2004 related to the adverse development cover agreement with LMC, agreeing that, if necessary, LMC would place additional funds into the Trust account to increase the amount to 102% of any determined obligation. In accordance with the terms of adverse development cover agreement and the agreement governing the Trust account, on December 23, 2004, LMC deposited into the Trust account an additional $3.2 million. At December 31, 2004, the Company was waiting to receive a final report from the outside actuary as to the final amount required to be held in the trust account as of September 30, 2004 (see Note 21). The balance of the Trust was $4.8 million at December 31, 2004 and $1.6 million at December 31, 2003.
Intangible assets, other than goodwill, consist of the following at December 31, 2004 and 2003 (dollar amounts in thousands):
Aggregate amortization expense was $731,000 for the year ended December 31, 2004 and $183,000 for the three month period ended December 31, 2003. Estimated remaining amortization expense is $629,500 in 2005, $246,000 in 2006, $10,000 in 2007 and $7,500 in 2008.
The valuation of renewal rights was developed using the income approach, which focuses on the income-producing capability of the renewal rights asset by measuring the present value of the after tax cash flows over the life of the renewal rights.
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. As explained in Note 21, 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 total gross proceeds of $90.6 million and converting all outstanding shares of its Series A preferred stock into 7,777,808 shares of common stock.
At December 31, 2004, the Company reserved 776,458 shares of common stock for issuance under the 2003 Plan, of which options to purchase 491,508 shares had been granted, and 1,047,755 shares for issuance under the 2005 Plan. No options had been granted under the 2005 Plan as of December 31, 2004. The following table summarizes stock option activity:
The following table summarizes selected unaudited quarterly financial data for each quarter of the year ended December 31, 2004 and for the quarter ended December 31, 2003, the only quarter in 2003 in which the Company was operational.
Eagle Pacific Insurance Company (“EPIC”), Pacific Eagle Insurance Company (“PEIC”), and PointSure Insurance Services, Inc. (“PSIS”), which are collectively referred to as “Predecessor,” were purchased by Lumbermens Mutual Casualty Company (“LMC”) on July 31, 1998 from Services Group of America, Inc. in a transaction accounted for as a purchase business combination.
On September 30, 2003, LMC sold PSIS and the renewal rights and substantially all of the operating assets, systems and employees of EPIC and PEIC to SeaBright Insurance Holdings, Inc. (“SIH”). Since SIH acquired renewal rights and not the in-force insurance contracts, the in-force insurance contracts will remain with EPIC and PEIC until policy expiration or the date of cancellation. Premium and loss obligations for the policies remain with EPIC and PEIC. SIH has entered into services agreements with LMC to handle claims and policy administration for these policies.
As further described in note 17, the Predecessor adopted the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets,” as of January 1, 2002. Under SFAS No. 142, 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 in accordance with the provisions for SFAS No. 142. SFAS No. 142 also requires that intangible assets with definite lives be 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.”
In accordance with SFAS No. 144, long-lived assets, such as property and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposed group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet.
As of December 31, 2002, 42% of the Predecessor’s direct business was from retrospectively rated policies.
At December 31, 2002, the unrealized loss on temporarily impaired investments totaled $554,239 for equity securities with a fair value of $7,964,000. All equity securities were impaired for less than one year. Temporarily impaired equity securities are a result of market value changes and are expected to regain the lost value with market shifts.
The Predecessor evaluated equity securities with market values less than cost and has determined that the decline in value is temporary. The Predecessor anticipates full recovery with respect to these securities.
The combined cost or amortized cost and estimated fair value of fixed income securities at December 31, 2002, by contractual maturity, are set forth below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
The following methods and assumptions were used by the Predecessor in estimating the fair value disclosures for financial instruments in the accompanying financial statements and notes:
The following reflects the amounts of policy acquisition costs deferred and amortized:
During the periods presented, the Predecessor is included in the consolidated federal income tax return of LMC as the common parent corporation.
EPIC and PEIC are required to file annual statements with state regulatory insurance authorities prepared on an accounting basis as prescribed or permitted by such authorities (statutory basis). Statutory net income and capital and surplus (stockholder’s equity) differ from amounts reported in accordance with Standards of the Public Company Accounting Oversight Board (United States), primarily because policy acquisition costs are expensed when incurred, certain assets designated as nonadmitted for statutory purposes are charged to surplus, fixed-income securities are reported at amortized cost or fair value based on their rating by the National Association of Insurance Commissioners, policyholders’ dividends are expensed as declared rather than accrued as incurred, income tax expense reflects only taxes paid or
All stockholder dividends must be submitted for review to the Insurance Commissioner’s office prior to distribution. Dividends which exceed the greater of prior year net income or 10% of surplus or amounts in excess of earned surplus are considered to be extraordinary and require an extended period of review and approval by the Department of Insurance. During 2003 EPIC and PEIC could not pay more than $3.7 million and $1.6 million, respectively, in shareholder dividends without the prior approval of the regulators. Each insurance company’s state of domicile imposes minimum risk-based capital requirements that were developed by the NAIC. The formulas for determining the amount of risk-based capital specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of the enterprise’s regulatory total adjusted capital to certain minimum capital amounts as defined by the NAIC. Enterprises below specified trigger points or ratios are classified within certain levels, each of which requires specified corrective action. As of December 31, 2002, EPIC and PEIC exceeded the minimum risk-based capital requirements.
The Predecessor writes workers’ compensation for which the premiums vary based on loss experience. The percentage of premiums written on retrospectively rated contracts for the nine months ending September 30, 2003, and for the years ended December 31, 2002 and 2001 were 48.4%, 42.0%, and 45.8%, respectively. Accrued retrospective premiums are determined based upon loss experience on business
subject to such experience rating adjustment. Accrued retrospective rated premiums are determined by or allocated to individual policyholder accounts. Accrued retrospective premiums and return retrospective premiums are recorded as additions to and reductions from written premium, respectively. The Predecessor had $5,667,060 accrued for retrospective premiums and $2,715,913 for return retrospective premiums at December 31, 2002.
In June 2001, the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142 supersedes Accounting Principles Board Opinion No. 17, “Intangible Assets”, and requires goodwill and other intangible assets that have indefinite lives to no longer be amortized; however, these assets must be tested at least annually for impairment. SFAS No. 142 also requires an evaluation of existing acquired goodwill and other intangible assets for proper classification under the new requirements.
In addition, intangible assets (other than goodwill) that have finite useful lives will continue to be amortized over their useful lives; however, the amortization period of such intangible assets will no longer be limited to 40 years.
The Predecessor adopted SFAS No. 142 effective January 1, 2002 and, accordingly ceased amortizing amounts related to goodwill starting January 1, 2002. The balance of goodwill relates to the acquisition of the Predecessor by its ultimate parent. In accordance with SFAS No. 142, management was required to perform an assessment of whether there was an indication that goodwill was impaired as of the date of the adoption. To accomplish this, management was required to identify its reporting units and determine the carrying value of its reporting units by assigning assets and liabilities, including the existing goodwill and other intangible assets, to each reporting unit as of January 1, 2002. Management then determined the fair value of the Predecessor’s reporting units and compared it to the carrying amounts of the reporting units. To the extent the carrying amounts exceeded the fair value, management was required to perform the second step of the transitional impairment test, to determine the implied fair value of the reporting unit’s goodwill, as this would be an indication that the reporting unit’s goodwill may be impaired. As a result of this process, an impairment loss of $4,731,000 related to goodwill associated with the EPIC and PEIC reporting units was recognized upon adoption of SFAS No. 142. The state licenses and trademark were purchased on July 31, 1998 and were being amortized on a straight-line basis over 40 years and 5 years, respectively. Upon initial application of SFAS No. 142, the management reassessed the useful lives of these intangible assets and determined that the state licenses with a net book value at January 1, 2002 of $914,583 has an indefinite useful life because it is expected to generate cash flows indefinitely. Management ceased amortizing the trademark on January 1, 2002. The trademark is deemed to approximate the original useful life of 5 years and the remaining balance of $5,833 will be amortized during 2003.
The following is a reconciliation of reported net income adjusted for adoption of SFAS No. 142: