The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements and the notes to those statements included elsewhere in this annual report. The discussion and analysis below includes forward-looking statements that are subject to risks, uncertainties and other factors described in Part I, Item 1A of this annual report that could cause our actual results of operations, performance and business prospects and opportunities in 2010 and beyond to differ materially from those expressed in, or implied by those forward-looking statements. See “Note on Forward-Looking Statements” in Part I, Item 1 of this annual report.
We receive claims service income in return for providing claims administration services for other companies. The claims service income we receive for providing these services approximates our costs. For the years ended December 31, 2009, 2008, and 2007, approximately 32.3%, 46.3%, and 52.6%, respectively, of our claims service income was generated by contracts we have with LMC to provide claims handling services
Also included in other service income are amounts received from LMC. Following the Acquisition, we entered into servicing arrangements with LMC to provide policy administration and accounting services for the policies written by the Eagle Entities prior to the Acquisition. The fee income we receive for providing these services approximates our costs and will decrease substantially over the next several years as transactions related to the Eagle Entities diminish.
In our insurance subsidiary, we refer to the expenses that we incur to underwrite risks as underwriting, acquisition and insurance expenses. Underwriting expenses consist of commission expenses, premium taxes and fees and other underwriting expenses incurred in writing and maintaining our business. 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. Other underwriting expenses consist of general administrative expenses such as salaries and employee benefits, rent and all other operating expenses not otherwise classified separately, and boards, bureaus and assessments of statistical agencies for policy service and administration items such as rating manuals, rating plans and experience data. Certain of these costs that vary with and are primarily related to the acquisition of insurance contracts (“deferred acquisition costs”) are initially deferred and amortized over the typical policy term of 12 months. Therefore, with respect to deferred acquisition costs, there are timing differences between when the costs are incurred or paid and when the related expense is recognized in our statements of operations.
Other-Than-Temporary Impairment Losses. Other-than-temporary impairment losses totaled $0.3 million for the year ended December 31, 2009, compared to $13.4 million, in 2008. In 2008, we recorded $13.4 million of other-than-temporary-impairment (“OTTI”) charges in connection with investments in government-sponsored agency and corporate preferred stock ($10.2 million charge) and equity indexed securities exchange-traded funds ($3.2 million charge). The $0.3 million OTTI charge in 2009 also related to our investment in government-sponsored agency preferred stock. The OTTI charges were the result of thorough reviews of the investment portfolio and a determination by management that these investments met the criteria for OTTI charges primarily due to the extent and duration of the impairments and the inability to forecast a complete recovery of their book values within a reasonable period of time or, in the case of the government-sponsored entity preferred stocks, a significant decline in the underlying credit fundamentals of the securities.
Other Income. Other income totaled $8.1 million for the twelve months ended December 31, 2009 compared to $8.7 million for the same period in 2008, representing a decrease of $0.6 million, or 6.4%. Other income is derived primarily from the operations of PointSure (including BWNV), our wholesale broker and third party administrator, and THM, our provider of medical bill review, utilization review, nurse care management and related services.
For accident year 2009, an expected loss ratio was established for each jurisdiction and type of loss (indemnity, medical, allocated loss adjustment expense (“ALAE”)). The expected loss ratio was multiplied by the booked accident year earned premium to produce the ultimate loss to date. The expected loss ratio selections are reviewed quarterly with each internal IBNR study. Given the short experience period for the current accident year, the expected loss ratios are usually maintained at least through the first 12 months of the accident year and revised as the underlying data matures. However, after reviewing the year-to-date results for the 2009 accident year, we increased the expected loss ratio for this year from 56.7% to 60.0% in the fourth quarter, resulting in $8.3 million of additional loss and allocated loss adjustment expenses in the quarter.
and medical reserves. This adverse development was offset by favorable development of $3.1 million related to ULAE and $1.3 million related to loss based assessments and NCCI.
For accident year 2007, the ultimate loss estimates at December 31, 2009 were higher when compared to December 31, 2008 and resulted in a net increase of our loss reserves of $5.0 million. The development in the ultimate loss selections can be attributed to indemnity and medical loss development results in certain states, both in our State Act and Longshore & Maritime business. With each quarterly IBNR study, we monitor actual versus expected loss development closely, along with claim severity and frequency changes. The combination of these results warranted increases totaling $2.1 million to our indemnity and medical ultimate loss estimates in the fourth quarter. This adverse development was offset by favorable development of $2.1 million related to ULAE and $1.6 million related to loss based assessments and NCCI.
Gross Premiums Written. Gross premiums written totaled $270.3 million in 2008 compared to $282.7 million in 2007, representing a decrease of $12.4 million, or 4.4%. Premiums assumed from the NCCI residual markets in the twelve months ended December 31, 2008 totaled $6.6 million compared to $9.7 million for the same period in 2007, representing a decrease of $3.1 million, or 32.0%. The decline in gross premiums written for the twelve months ended December 31, 2008 resulted primarily from the continuing soft market, competitor pricing pressure, and deteriorating economic conditions leading to lower reported payrolls year over year. We continued to experience rate reductions in California, our largest market, as well as in other states. The average renewal rates for 2008 declined by 9.6% for California State Act, 10.3% for State Act, excluding California, and 7.0% for maritime. Excluding work we perform as the servicing carrier for the Washington USL&H Plan, the number of customers we serviced at December 31, 2008 increased 17.9% to approximately 1,120 from approximately 950 at December 31, 2007. Year-end in-force payrolls, one of the factors used to determine premium charges, increased 14.9% from $5.6 billion at December 31, 2007 to $6.4 billion at year-end 2008. California in-force payrolls increased 7.7% between December 31, 2007 and
We have experienced significant reductions in our California premium rates from 2003 to 2008. In 2008, in response to continued reductions in California workers’ compensation claim costs, we reduced our rates by an average 14.2% for new and renewal insurance policies written in California on or after July 1, 2007. This action was the eighth California rate reduction we had filed since October 1, 2003, resulting in a net cumulative reduction of our California rates of approximately 54.8%. On August 15, 2008, the WCIRB submitted a filing with the California Insurance Commissioner recommending a 16.0% increase in advisory pure premium rates on new and renewal policies effective on or after January 1, 2009. The filing was based on a review of loss and loss adjustment experience through March 31, 2008. In response to this recommendation, on October 24, 2008, the California Insurance Commissioner approved a 5.0% increase in advisory pure premium rates, effective January 1, 2009. With the California Department of Insurance approval, we adopted this 5.0% increase effective January 1, 2009.
Net Premiums Written. Net premiums written totaled $255.8 million in 2008 compared to $267.4 million in 2007, representing a decrease of $11.6 million, or 4.3%. As discussed above, the decline in net premiums written for the twelve months ended December 31, 2008 was primarily attributable to the soft market and deteriorating general economic conditions leading to lower reported payrolls. Contributing to the decrease in net premiums written for the year ended December 31, 2008 was a $3.1 million decrease in premiums assumed from the NCCI residual markets.
Net premiums earned are also affected by premiums ceded under reinsurance treaties. Ceded premiums earned in 2008 totaled $14.5 million compared to $15.0 million in 2007, representing a decrease of $0.5 million, or 3.3%. A decrease in ceded premiums earned is an increase to our overall net premiums earned. Offsetting the increase in net premiums earned was a decrease in the amount of premiums we involuntarily assume on residual market business from the NCCI, which operates residual market programs on behalf of many states. Assumed premiums earned decreased $1.4 million from $8.6 million in 2007 to $7.2 million in 2008.
Service Income. Service income totaled $1.2 million in 2008 compared to $1.9 million in 2007, representing a decrease of $0.7 million, or 36.8%. 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. During 2008, we discovered that claim data used to determine billing amounts for claims administration services provided by us had, since August 2006, been incorrectly reported to us by a customer, resulting in an overstatement of claims service income in 2007 and 2006 by approximately $0.3 million. As a result, the financial position and results of operations for the year ended December 31, 2008 reflect a $0.3 million reduction in service income receivable and claims service income, and a related decrease of $0.1 million in federal income tax payable and income tax expense, to reflect the correction of this error. Average monthly fees received from LMC 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 $0.6 million, or 66.7%, from $0.9 million in 2007 to $0.3 million in 2008.
Other-Than-Temporary Impairment Losses. Other-than-temporary-impairments (“OTTI”) charges in 2008 were recorded in connection with investments in government-sponsored agency and corporate preferred stock ($10.2 million charge) and equity indexed securities exchange-traded funds ($3.2 million charge). Approximately $1.9 million of the total charge was recorded in the second quarter with the remaining $11.5 million recorded in the third quarter. The OTTI charges were the result of thorough reviews of the investment portfolio and a determination by management that these investments met the criteria for OTTI charges primarily due to the extent and duration of the impairments and the inability to forecast a complete recovery of their book values within a reasonable period of time or, in the case of the government-sponsored entity preferred stocks, a significant decline in the underlying credit fundamentals of the securities.
continuation of deflation trends in the paid loss data for recent accident years. Our direct net loss reserves are net of reinsurance and exclude reserves associated with KEIC and the business that we involuntarily assume from the NCCI. Approximately $11.6 million of the 2008 reserve adjustments related to accident year 2007, approximately $5.1 million related to accident year 2006, and approximately $3.0 million of the reserve adjustment related to accident year 2005 and prior. As a result of these reserve changes, our net loss ratio increased from 55.5% in 2007 to 56.7% in 2008.
As discussed under the heading “Critical Accounting Policies, Estimates and Judgments - Unpaid Loss and Loss Adjustment Expenses - Actuarial Loss Reserve Estimation Methods” in Part II, Item 7 of this annual report, we use an expected loss ratio (“ELR”) method to establish the loss reserves for the current accident year. Once the accident year is complete and begins to age, the ELR method is blended with the actual paid and incurred losses to determine the revised estimated ultimate losses for the accident year. For accident year 2007, this resulted in lower ultimate loss estimates at December 31, 2008 when compared to December 31, 2007. The positive development in accident year 2007 can be attributed to the actual indemnity and medical losses being lower than the losses produced by the ELR used to book the initial ultimate losses for the accident year. These lower-than-expected actual losses were a function of both claim frequency and claim severity trending below the amounts considered in the ELR. The positive development for indemnity and medical was offset by negative development for allocated loss adjustment expense (“ALAE”) as the actual ALAE costs were greater than the expected ALAE produced by the ELR method, resulting in an increase in the reserve. For accident year 2006, the positive development can be attributed to better-than-expected loss severity for indemnity and medical, resulting in a reserve reduction. While the estimated ultimate losses for accident year 2006 were reduced below the ELR level at December 31, 2007 (age 24 months), the actual loss development during 2008 warranted further reduction in the estimated ultimate losses for indemnity and medical as of December 31, 2008 (age 36 months). For accident year 2006, there was minimal change in the estimated ultimate ALAE amount at December 31, 2008 when compared to December 31, 2007. As discussed under the heading “Critical Accounting Policies, Estimates and Judgments - Unpaid Loss and Loss Adjustment Expenses - Variation in Ultimate Loss Estimates” in Part II, Item 7 of this annual report, there are a number of factors that could lead to the actual losses trending below the expected amounts. We closely watch the medical and indemnity trends, loss development and claim settlement patterns in our data and believe our reserving methodology is consistent with our analysis.
As of December 31, 2008, we had recorded a receivable of approximately $4.2 million for adverse loss development under the adverse development cover since the date of the Acquisition. We do not expect this receivable to have any material effect on our future cash flows if LMC fails to perform its obligations under the adverse development cover. At December 31, 2008, we had access to approximately $2.8 million under the collateralized reinsurance trust in the event that LMC fails to satisfy its obligations under the adverse development cover. In March 2009, we submitted a request to LMC to increase the balance in the trust to 102% of its obligations under the adverse development cover. LMC subsequently increased the balance in the trust to the required level. See the discussion under the heading “Loss Reserves - KEIC Loss Reserves” in Part I, Item 1 of this annual report.
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 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, 2009 has an effective duration of 4.98 years with individual maturities extending to 30 years. Currently, we make claim payments from positive cash flows 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.
As of December 31, 2009, we had no direct investments in any bond insurer, and the following three bond insurers insured more than 10% of the municipal bond investments in our portfolio:
As of December 31, 2009, we had 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.
For the current accident year, we establish the initial reserve for claims incurred-but-not-reported (“IBNR”) using an expected loss ratio (“ELR”) method. The ELR method is based on an analysis of historical loss ratios adjusted for current pricing levels, exposure growth, anticipated trends in claim frequency and severity, the impact of reform activity and any other factors that may have an impact on the loss ratio. The actual paid and incurred loss data for the accident year is reviewed each quarter and changes to the ELR may be made based on the emerging data, although changes are typically not made until the end of the accident year when the loss data can be analyzed as a complete accident year. In the December 31, 2009 internal IBNR analysis, the ELR for accident year 2009 was increased from 56.7% on a net and gross basis to 60.0% on a net and gross basis. This was the first time the ELR was changed prior to the accident year being complete. The change was made to recognize the emerging loss experience primarily in the Illinois state act segment. The ELR is multiplied by the year-to-date earned premium to determine the ultimate losses for the current accident year. The actual paid and case outstanding losses are subtracted from the ultimate losses to determine the IBNR for the accident year. As the accident year matures, we incorporate a standard actuarial reserving methodology referred to as the Bornhuetter-Ferguson method. This method blends the loss development and expected loss ratio methods by assigning partial weight to the initial expected losses, calculated from the expected loss ratio method, with the remaining weight applied to the actual losses, either paid or incurred. The weights assigned to the initial expected losses decrease as the accident year matures. A reserve estimate implies a pattern of expected loss emergence. If this emergence does not occur as expected, it may cause us to revisit our previous assumptions. We may adjust loss development patterns, the various method weights or the expected loss ratios used in our analysis. Management employs judgment in each reserve valuation as to how to make these adjustments to reflect current information.
At December 31, 2009, approximately $135.8 million, or 44.9%, of our direct loss reserves were related to business written in California. Over the last several years, four significant comprehensive legislative reforms were enacted in California: AB 749 was enacted in February 2002; AB 227 and SB 228 were enacted in September 2003; and SB 899 was enacted in April 2004. This reform activity has resulted in uncertainty regarding the impact of the reforms on loss payments, loss development and, ultimately, loss reserves, making historical data less reliable as an indicator of future loss. All four bills enacted structural changes to the benefit delivery system in California, in addition to changes in the indemnity and medical benefits afforded injured workers. In response to the reform legislation and a continuing drop in the frequency of workers’ compensation claims, the pure premium rates approved by the California Insurance Commissioner effective January 1, 2009 were 63.4% lower than the pure premium rates in effect as of July 1, 2003. More recent data has indicated the need for an increase in rates in California. On June 23, 2009, we filed for a 10.6% rate increase to be effective August 1, 2009, which was approved by the California Insurance Department. With the California Department of Insurance’s approval, we adopted a 5.0% increase in advisory pure premium rates effective January 1, 2009.
SB 228 limited the number of chiropractic visits and the number of physical therapy visits to 24 each per claim.
Workers’ compensation is considered a long-tail line of business, as it takes a relatively long period of time to finalize claims from a given accident year. Management believes that it generally takes workers’ compensation losses approximately 48 to 60 months after the start of an accident year until the data is viewed as fully credible for paid and incurred reserve evaluation methods. Workers’ compensation losses can continue to develop beyond 60 months and in some cases claims can remain open more than 20 years. As indicated above, we wrote our first policy on October 1, 2003 so our first complete accident year is 2004. As of December 31, 2009, accident year 2004 was 72 months developed, accident year 2005 was 60 months developed, accident year 2006 was 48 months developed, accident year 2007 was 36 months developed, accident year 2008 was 24 months developed and accident year 2009 was 12 months developed. Our loss reserve estimates are subject to considerable variation due to the relative immaturity of the accident years from a development standpoint.
Development factors, expected loss rates and expected loss ratios are derived from the combined experience of us and our predecessor.
Estimating loss reserves is an uncertain and complex process which involves actuarial techniques and management judgment. Actuarial analysis generally assumes that past patterns demonstrated in the data will repeat themselves and that the data provides a basis for estimating future loss reserves. However, since conditions and trends that have affected losses in the past may not occur in the future in the same manner, if at all, future results may not be reliably predicted by the prior data. Due to the relative immaturity of our book of business, the challenge has been to give the right weight in the ultimate loss estimation process to the new data as it becomes available. As discussed above, management believes that it generally takes workers’ compensation losses approximately 48 to 60 months after the start of an accident year until the data is viewed as fully credible for paid and incurred reserve evaluation methods. Due to our limited operating history, we have five complete accident years that were developed 72 months, 60 months, 48 months, 36 months, 24 months and 12 months (2004, 2005, 2006, 2007, 2008 and 2009, respectively) at December 31, 2009. At December 31, 2009, the analysis for accident years 2003 through 2008 utilizes a Bornhuetter-Ferguson approach, which blends the loss development and expected loss ratio methods, in addition to the paid and incurred loss development methods. For accident years 2003 through 2008, the actuarial analysis did show some movement, both upward and downward, when compared to the prior actuarial estimates at December 31, 2008. For accident years 2003 through 2006, the movement was minimal and resulted in a net increase of our net ultimate loss estimates of $0.6 million for the year ended December 31, 2009.
For accident year 2007, there was unfavorable development in the gross losses for California State Act which resulted in an increase of our net ultimate loss estimates of $3.3 million. For non-California State Act, there was unfavorable development in the gross losses for accident year 2007 which resulted in an increase of our net ultimate loss estimates of $0.9 million. For USL&H, there was unfavorable development in the gross losses for accident year 2007 which resulted in an increase of our ultimate loss estimates of $0.7 million. For California State Act and USL&H, we placed more reliance on the most recent data points in our loss development selections than in the prior year. As with the prior year, we did not completely rely on the most recent data points in our loss development selections. We believe that our loss development factor selections are appropriate given the maturity level of our data. Over time, as the data for these accident years mature and uncertainty surrounding the ultimate outcome of the claim costs diminish, the full impact of the actual loss development will be factored into our assumptions and selections.
Although many factors influence the actual cost of claims and the corresponding unpaid loss and loss adjustment expense estimates, we do not measure and estimate values for all of these variables individually. This is due to the fact that many of the factors that are known to impact the cost of claims cannot be measured directly. This is the case for the impact of economic inflation on claim costs, coverage interpretations and jury determinations. In most instances, we rely on historical experience or industry information to estimate values
for the variables that are explicitly used in the unpaid loss and loss adjustment expense analysis. We assume that the historical effect of these unmeasured factors, which is embedded in our experience or industry experience, is representative of future effects of these factors. It is important to note that actual claims costs will vary from our estimate of ultimate claim costs, perhaps by substantial amounts, due to the inherent variability of the business written, the potentially significant claim settlement lags and the fact that not all events affecting future claim costs can be estimated.
In the event that our estimates of ultimate unpaid loss and loss adjustment expense liabilities prove to be greater or less than the ultimate liability, our future earnings and financial position could be positively or negatively impacted. Future earnings would be reduced by the amount of any deficiencies in the year(s) in which the claims are paid or the unpaid loss and loss adjustment expense liabilities are increased. For example, if we determined our unpaid loss and loss adjustment expense liability of $351.5 million as of December 31, 2009 to be 5% inadequate, we would experience a pre-tax reduction in future earnings of approximately $17.6 million. This reduction could be realized in one year or multiple years, depending on when the deficiency is identified. The deficiency would also impact our financial position because most of our statutory surplus would be reduced by an amount equivalent to the reduction in net income. Any deficiency is typically recognized in the unpaid loss and loss adjustment expense liability and, accordingly, it typically does not have a material effect on our liquidity because the claims have not been paid. Since the claims will typically be paid out over a multi-year period, we have generally been able to adjust our investments to match the anticipated future claim payments. Conversely, if our estimates of ultimate unpaid loss and loss adjustment expense liabilities prove to be redundant, our future earnings and financial position would be improved.
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 estimated investment income, anticipated losses and settlement expenses and certain other costs we expect to incur as the premium is earned. Judgments regarding the ultimate recoverability of these deferred costs are highly dependent upon the estimated future costs associated with our unearned premiums. If our expected claims and expenses, after considering investment income, exceed our unearned premiums, we would be required to write-off all or a portion of deferred policy acquisition costs. To date, we have not needed to write-off any portion of our deferred acquisition costs. If our estimate of anticipated losses and related costs was 10% inadequate, our deferred acquisition costs as of December 31, 2009 would still be fully recoverable and no write-off would be necessary. We will continue to monitor the balance of deferred acquisition costs for recoverability.
valuation allowance could have a significant impact on our financial position and results of operations in the period in which it is deemed necessary. As of December 31, 2009, no valuation allowance was recorded. We established a valuation allowance of approximately $2.0 million at December 31, 2008 (of which $976,000 was recorded in tax expense and $1.0 million was recorded in accumulated other comprehensive income) and reversed the $2.0 million allowance through accumulated other comprehensive income in 2009.
We apply a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and also provides guidance on the derecognition of previously recorded benefits and their classification, as well as the proper recording of interest and penalties, accounting in interim periods, disclosures and transition. As of December 31, 2009 and December 31, 2008, we had no unrecognized tax benefits. We do not anticipate that the amount of unrecognized tax benefits will significantly increase in the next 12 months. Our policy is to recognize interest and penalties on unrecognized tax benefits as an element of income tax expense (benefit) in our consolidated statements of operations. We file consolidated U.S. federal and state income tax returns. The tax years which remain subject to examination by the taxing authorities are the years ended December 31, 2006, 2007, 2008 and 2009.
We regularly review our investment portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. A number of criteria are considered during this process, including but not limited to the following: whether we intend to sell the security; the current fair value as compared to amortized cost or cost, as appropriate, of the security; the length of time the security’s fair value has been below amortized cost; objective information supporting recovery in a reasonable period of time; the likelihood that we will be required to sell the security before recovery of its cost basis; specific credit issues related to the issuer; and current economic conditions, including interest rates.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of SeaBright Insurance Holdings, Inc. and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), SeaBright Insurance Holdings, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 16, 2010 expressed an unqualified opinion on the effectiveness of SeaBright Insurance Holdings, Inc and subsidiaries’ internal control over financial reporting.
SeaBright Insurance Holdings, Inc. (“SeaBright”), a Delaware corporation, was formed in June 2003. On July 14, 2003, SeaBright 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, SeaBright acquired Kemper Employers Insurance Company (“KEIC”), PointSure Insurance Services, Inc. (“PointSure”), and certain assets of Eagle, primarily renewal rights.
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 Insurance for KEIC to change its name to SeaBright Insurance Company (“SBIC”).
On December 17, 2007, we completed the acquisition of Total HealthCare Management, Inc. (“THM”), a privately held California provider of medical bill review, utilization review, nurse case management and related services. The total purchase price was $1.5 million, of which $1.2 million was paid at closing. The remaining $0.3 million was scheduled to be paid in three equal installments on the first three anniversaries of the closing date, provided that THM achieves certain revenue objectives in 2008, 2009 and 2010. Based on THM’s performance in 2008 and 2009, the first two installments have not been paid at this time. However, such amount may be paid later if warranted by THM’s future performance. Goodwill recognized in connection with this acquisition totaled approximately $1.4 million. Following the acquisition, THM became a wholly owned subsidiary of SeaBright.
The consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and include amounts based on the best estimates and judgments of management. Such estimates and judgments could change in the future, as more information becomes known which could impact the amounts reported and disclosed herein.
In accordance with ASC Topic 280, Segment Reporting (formerly known as FAS 131, “Disclosures about Segments of an Enterprise and Related Information”), the Company considers an operating segment to be any component of its business whose operating results are regularly reviewed by the Company’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance. Currently, the Company has one operating segment, workers’ compensation insurance and related services.
Certain reclassifications have been made to the prior year financial statements to conform to classifications used in the current year.
For debt securities that are considered OTTI and that the Company does not intend to sell and more likely than not would not be required to sell prior to recovery of the amortized cost basis, the Company recognizes OTTI losses in accordance with the provisions of the Codification. The amount of the OTTI loss is separated into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss component is recognized in earnings and is the difference between a security’s amortized cost basis and the present value of expected future cash flows discounted at the security’s effective interest rate. The amount due to all other factors is recognized in other comprehensive income. For the year ended December 31, 2009, the Company recognized no OTTI losses related to debt securities.
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 unpaid loss and loss adjustment expenses, including losses that have occurred but were not reported to us by the financial reporting date; the amount and recoverability of reinsurance recoverable balances; goodwill and other intangibles; retrospective premiums; earned but unbilled premiums; deferred policy acquisition costs; income taxes; and the valuation and other-than-temporary impairments of investment securities.
The goodwill impairment test follows a two step process. In the first step, the fair value of a reporting unit is compared to its carrying value. If the carrying value of a reporting unit exceeds its fair value, the second step of the impairment test is performed for purposes of measuring the impairment. In the second step, the fair value of the reporting unit is allocated to all of the assets and liabilities of the reporting unit to determine an implied goodwill value. If the carrying amount of the reporting unit goodwill exceeds the implied goodwill value, an impairment loss would be recognized in an amount equal to that excess, and the charge could have a material adverse effect on the Company’s results of operations and financial position.
Management’s determination of the fair value of each reporting unit incorporates multiple inputs including discounted cash flow calculations, the level of the Company’s own share price and assumptions that market participants would make in valuing the reporting unit. Other assumptions include levels of economic capital, future business growth, earnings projections, assets under management for reporting units and the discount rate utilized.
December 31, 2009, 2008 and 2007, approximately 7.2%, 10.7% and 11.9%, respectively, of direct premiums written related 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 at final audit and applying an adjustment percentage against premiums earned for the period. Final audit adjustments may result in increasing or decreasing the estimated premium earned and billed to date. Included in deferred premiums at December 31, 2009, 2008 and 2007 and premiums earned for the years then ended were accruals for earned but unbilled premiums of ($132,000), ($611,000) and $44,000, respectively.
Unpaid loss and loss adjustment expense represents an estimate 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. Liabilities for unpaid loss and loss adjustment expenses are not discounted to account for the time value of money.
Balances due from reinsurers on unpaid loss and loss adjustment expenses, including an estimate of such recoverables related to reserves for IBNR losses, are reported as assets and are included in reinsurance recoverables even though amounts due on unpaid loss and loss adjustment expenses are not recoverable from the reinsurer until such losses are paid. The Company monitors the financial condition of its reinsurers and does not believe that it is currently exposed to any material credit risk through its reinsurance treaties because most of its reinsurance is recoverable from large, well-capitalized reinsurance companies. Historically, no amounts from reinsurers have been written-off as uncollectible.
As of December 31, 2009 and 2008, the Company had no unrecognized tax benefits. The Company’s policy is to recognize interest and penalties on unrecognized tax benefits as an element of income tax expense (benefit) in the consolidated statements of operations. The Company files consolidated U.S. federal and state income tax returns. The tax years which remain subject to examination by the taxing authorities are the years ended December 31, 2006, 2007, 2008 and 2009.
The following table provides the reconciliation of weighted average common share equivalents outstanding used in calculating earnings per share for the years ended December 31, 2009, 2008, and 2007:
In January 2009, the FASB issued FSP EITF 99-20-1, Amendments to the Impairment Guidance of EITF Issue No. 99-20, (“FSP EITF 99-20-1”) which amends FASB Emerging Issues Task Force (“EITF”) No. 99-20, Recognition of Interest Income and Impairment on Purchased Beneficial Interest and Beneficial Interests That Continue to Be Held by a Transferor or in Securitized Financial Assets, (“EITF 99-20”) to align the impairment guidance in EITF 99-20 with the impairment guidance and related implementation guidance in SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. The provisions of FSP EITF 99-20-1 are effective for reporting periods ending after December 15, 2008. The adoption of FSP EITF 99-20-1 did not have a material impact on our results of operations or financial position.
In April 2009, the FASB issued FSP FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments” (“FSP FAS 115-2/124-2”). FSP FAS 115-2/124-2 requires entities to separate an other-than-temporary impairment of a debt security into two components when there are credit related losses associated with the impaired debt security for which management asserts that it does not have the intent to sell the security, and it is more likely than not that it will not be required to sell the security before recovery of its cost basis. The amount of the other-than-temporary impairment related to a credit loss is recognized in earnings, and the amount of the other-than-temporary impairment related to other factors is recorded in other comprehensive loss. FSP FAS 115-2/124-2 is effective for periods ending after June 15, 2009. The Company adopted the provisions of FSP FAS 115-2/124-2 in the quarter ended June 30, 2009. There were no impairments previously recognized on debt securities we owned at December 31, 2008 and therefore, there was no cumulative effect adjustment to retained earnings and other comprehensive income (loss) as a result of adopting this standard. There were no impairments recognized on debt securities in the year ended December 31, 2009 and therefore, the adoption of FSP FAS 115-2/124-2 had no effect on the Company’s consolidated financial condition or results of operations.
In April 2009, the FASB issued FSP FAS 157-4, “Determining Fair Value When Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions that are Not Orderly” (“FSP FAS 157-4”). Under FSP FAS 157-4, if an entity determines that there has been a significant decrease in the volume and level of activity for an asset or liability in relation to the normal market activity for the asset or liability (or similar assets or liabilities), then transactions or quoted prices may not accurately reflect fair value. In addition, if there is evidence that the transaction for the asset or liability is not orderly, the entity shall place little, if any, weight on that transaction price as an indicator of fair value. FSP FAS 157-4 is effective for periods ending after June 15, 2009. The Company adopted FSP FAS 157-4 in the quarter ended June 30, 2009, which did not have a material effect on the Company’s consolidated financial condition and results of operations.
about the fair value of financial instruments in interim and annual financial statements. FSP FAS 107-1 and APB 28-1 is effective for periods ending after June 15, 2009. The Company adopted FSP FAS 107-1 and APB 28-1 in the quarter ended June 30, 2009. Because FSP FAS 107-1 and APB 28-1 amends only the disclosure requirements related to the fair value of financial instruments, adoption of FSP 107-1 and APB 28-1 did not affect the Company’s consolidated financial condition and results of operations.
In June 2009, the Financial Accounting Standards Board (“FASB”) issued FASB Statement of Financial Accounting Standards (“SFAS”) No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles (“SFAS 168”). SFAS 168 identifies the sources of accounting principles and the framework for selecting the principles used in preparing the financial statements of nongovernmental entities that are presented in conformity with U.S. GAAP. SFAS 168 further identifies the FASB Accounting Standards Codification (the “Codification”) as the source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities. The Codification does not change existing U.S. GAAP authoritative literature in place as of July 1, 2009. SFAS 168 is effective for financial statements issued for interim and annual periods ending after September 15, 2009. The Company adopted SFAS 168 as of September 30, 2009, which did not have a material effect on the Company’s consolidated financial condition or results of operations.
The consolidated cost or amortized cost, gross unrealized gains and losses, estimated fair value and carrying value of investment securities available-for-sale at December 31, 2009 and 2008 are as follows:
Equity securities at December 31, 2008 consisted of investments in exchange traded funds designed to correspond to the performance of certain indexes based on domestic or international stocks. The following tables present information about investment securities with unrealized losses at December 31, 2009 and 2008.
Of the $13.9 million of securities with unrealized losses of 12 months or longer at December 31, 2009 in the above table, two securities with a combined fair value of $1.5 million had fair values that were less than 90% of the securities’ amortized cost. The combined unrealized loss on those securities is $0.3 million.
The amortized cost and estimated fair value of fixed income securities available-for-sale at December 31, 2009, 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 consolidated amortized cost of fixed income securities available-for-sale deposited with various regulatory authorities was $205.8 million and $203.6 million at December 31, 2009 and 2008, respectively.
Level 2 - Valuations for assets and liabilities traded in less active dealer or broker markets. Level 2 valuations are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market. Level 2 includes government sponsored agency securities, corporate fixed-income securities, municipal bonds, mortgage pass-through securities, collateralized mortgage obligations and asset-backed securities.
Level 3 - Valuations for assets and liabilities that are derived from other valuation methodologies, including discounted cash flow models and similar techniques, and not based on market exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities. As of December 31, 2009, the Company had no Level 3 financial assets or liabilities.
The table below presents the December 31, 2009 balances of assets and liabilities measured at fair value on a recurring basis.
Active markets are those in which transactions occur with sufficient frequency and volume to provide reliable pricing information on an ongoing basis. Inactive markets are those in which there are few transactions for the asset, prices are not current, or price quotations vary substantially either over time or among market makers, or in which little information is released publicly. When the market for an investment is judged to be inactive, appropriate adjustments must be made to observable inputs to account for such inactivity. As of December 31, 2009, the Company’s investment portfolio consisted of securities that it considered to be traded in active markets. Therefore, no adjustment for market inactivity or illiquidity was necessary.
The Company obtains fair value inputs for securities in its investment portfolio from independent, nationally recognized pricing services. The Company obtains one price per instrument from these pricing services. The pricing services utilize multidimensional pricing models that vary by asset class and incorporate relevant inputs such as available trade, bid and quote market data for identical or similar instruments, model-based valuation techniques for which significant assumptions were observable and other market information to arrive at a fair value price for each security. This process takes into consideration the relevance of observable inputs based on factors such as the level of trading activity and the volume and currency of available prices and includes appropriate adjustments for nonperformance and liquidity risks. The Company did not obtain any broker quotes as part of the portfolio valuation process at December 31, 2009. When broker quotes are obtained, they are usually non-binding.
The Company also seeks input from independent portfolio managers and financial advisors engaged by the Company to assist in the management and oversight of its investment portfolio. The Company and an independent portfolio manager engaged by the Company review such amounts for reasonableness in relation to the following considerations, among others: recent trades of a particular security; the Company’s independent observations of recent developments affecting the economy in general and certain issuers in particular; and fair values from other sources, such as statements from the Company’s custodial banks. When other evidence indicates a fair value that is significantly different from that provided by an independent pricing service, the Company may challenge the fair value and request further validation and support from the independent pricing service, which may result in a revised fair value from the independent pricing service. If the Company has independent evidence indicating that a security’s fair value is significantly different from the final value provided by an independent pricing service, it may adjust the fair value accordingly. The Company did not adjust any of the December 31, 2009 values it obtained from independent pricing services and used those values in developing the fair value measurements in the Company’s consolidated financial statements as of December 31, 2009.
The Company may be required, from time to time, to measure certain other financial assets, such as goodwill, fixed assets and other long-lived assets, at fair value on a non-recurring basis in accordance with
Direct premiums written totaled $286.0 million, $263.8 million, and $273.0 million for the years ended December 31, 2009, 2008 and 2007, respectively.
The activity in the allowance for doubtful accounts for the years ended December 31, 2009, 2008, and 2007 is as follows (in thousands):
Property and equipment consisted of the following at December 31, 2009 and 2008:
On October 1, 2009, the Company renewed its reinsurance treaties with nonaffiliated reinsurers wherein it retains the first $500,000 of each loss occurrence. The next $500,000 of losses per occurrence (excess of the first $500,000 of losses per occurrence retained by the Company) are 50% reinsured. The new reinsurance program, which is effective through September 30, 2010 and similar to the program that expired September 30, 2009, provides coverage up to $85.0 million per loss occurrence as follows:
Fully reinsured, subject to an aggregate annual limit of $10.0 million. Includes general liability coverage.
Effective January 1, 2010, the Company renewed its quota-share reinsurance agreement with a nonaffiliated reinsurer wherein it cedes 100% of its residual market business assumed from the National Council on Compensation Insurance (the “NCCI”) for policy years 2009 and 2010.
Fully reinsured, subject to an aggregate annual limit of $8.0 million.
As part of the Agreement, LMC placed into trust (the “Trust”) $1.6 million, equal to 10% of the balance sheet reserves of SBIC at the date of the Acquisition. Thereafter, the Trust shall be adjusted each quarter, if warranted, to an amount equal to the greater of (a) $1.6 million or (b) 102% of LMC’s obligations under the Agreement. The balance of the Trust, including accumulated interest, was $3.8 million at December 31, 2009 and $2.8 million at December 31, 2008.
The Company recorded no write-offs of uncollectible reinsurance recoverables in the years ended December 31, 2009, 2008, and 2007.
The following table summarizes the activity in unpaid loss and loss adjustment expense for the years ended December 31, 2009, 2008 and 2007:
In 2007, unpaid loss and loss adjustment expense related to prior years decreased by a net amount of $34.1 million. Net favorable development of prior year loss reserves totaled $27.7 million and related to the following accident years: $17.3 million in 2006 and $11.7 million in 2005, offset by $1.3 million of adverse development in 2004 and prior. Additionally, there was $6.4 million of net favorable development of other
At December 31, 2009 and 2008, the Company reduced unpaid loss and loss adjustment expense by $8.9 million and $5.6 million, respectively, for anticipated salvage and subrogation recoveries.
On May 26, 2004, SBIC issued in a private placement $12.0 million in subordinated floating rate Surplus Notes due in 2034. The note holder 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 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 rate or amount of interest required to be paid in any quarter is also subject to limitations imposed by the Illinois Insurance Code. Interest amounts not paid as a result of these limitations become “Excess Interest,” which the Company may be required to pay in the future, subject to the same limitations and all other provisions of the Surplus Notes Indenture. To date, there has been no Excess Interest. The interest rate at December 31, 2009 was 4.3%. Interest and principal may be paid only upon the prior approval of the Illinois Department of Insurance. In the event of default, as defined, or failure to pay interest due to lack of Illinois Department 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 or principal on any debt issued by the Company which ranks equal with or junior to the Surplus Notes. If an event of default occurs and is continuing, the principal and accrued interest can become immediately due and payable. Interest expense for the years ended December 31, 2009, 2008, and 2007 was $0.6 million, $0.9 million, and $1.1 million, respectively.
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 for the years ended December 31, 2009, 2008, and 2007 and statutory capital and surplus as of December 31, 2009, 2008 and 2007:
The maximum amount of dividends that can be paid to stockholders by insurance companies domiciled in the State of Illinois 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 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, 2009, SBIC had statutory earned surplus of $112.7 million. Consequently, SBIC would be able to pay up to $30.7 million of stockholder dividends in 2010 without the prior approval of the regulators.
In June 2007, the Illinois Department of Insurance completed a comprehensive financial examination of SBIC’s 2005 statutory annual statement. The examination report contained three findings, none of which resulted in any fines, penalties or adjustments to SBIC’s financial statements. Prior to this examination, KEIC was last examined by the Illinois Department 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. SBIC exceeded the minimum risk-based capital requirements at December 31, 2009 and 2008.
The Company maintains a defined contribution 401(k) retirement savings plan covering substantially all of its employees. In 2009, 2008 and 2007, the Company matched 100% of the first five percent of eligible compensation contributed to the plan on a pre-tax basis. For the year ended December 31, 2007, the Company made additional contributions equal to one percent of compensation for all persons who were employed at the end of the year. Employees are 100% vested in all matching contributions when they are made. Contribution expense for the years ended December 31, 2009, 2008, and 2007 was $1.1 million, $1.2 million and $0.8 million, respectively.
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 7.2%, 10.7% and 11.9% of the Company’s direct premiums written for the years ended December 31, 2009, 2008 and 2007, respectively, related to retrospectively rated contracts. The Company accrued $11.8 million for retrospective premiums receivable and $21.5 million for return retrospective
Intangible assets, other than goodwill, consist of the following at December 31, 2009 and 2008:
The Company completed its annual goodwill assessment for the individual reporting units as of December 31, 2009. The conclusion reached as a result of the annual goodwill impairment testing was that the fair value of each reporting unit to which goodwill had been allocated was in excess of the respective reporting unit’s carrying value; therefore, no impairment was necessary.
The changes in the carrying amount of goodwill for the year ended December 31, 2009, were as follows:
At December 31, 2009, the Company had outstanding stock options and nonvested stock granted according to the terms of two equity incentive plans. The stockholders and Board of Directors approved the 2003 Stock Option Plan (the “2003 Plan”) in September 2003, and amended and restated the 2003 Plan in February 2004, and approved the 2005 Long-Term Equity Incentive Plan (the “2005 Plan” and, together with the 2003 Plan, the “Stock Option Plans”) in December 2004. In April 2007, the Board of Directors further amended the 2003 Plan and amended the 2005 Plan.
The Company has only issued new shares of common stock upon exercise of stock options or award of nonvested shares.
The expected term of options was determined using the “simplified method,” which averages an award’s weighted average vesting period. For 2007, the 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. In 2008 and 2009, expected stock price volatility was based on the Company’s historical stock price volatility since the public offering of its common stock in January 2005. The change in determining volatility was made in 2008 because the Company had developed credible historical data based solely on the Company’s stock volatility. The risk-free interest rate is based on the yield of U.S. Treasury securities with an equivalent remaining term. The Company did not pay stockholder dividends in 2009 or in prior years.
The aggregate intrinsic values in the table above are before applicable income taxes and are based on the Company’s closing stock price of $11.49 and $11.74 at December 31, 2009 and 2008, respectively. As of December 31, 2009, total unrecognized stock-based compensation cost related to nonvested stock options was approximately $1.4 million, which is expected to be recognized over a weighted average period of approximately 29.1 months. Proceeds from the exercise of stock options totaled approximately $47,000 in 2009 and approximately $1.1 million in 2008. The total intrinsic value of stock options exercised was approximately $27,580 in 2009 and approximately $758,700 in 2008.
As of December 31, 2009, there were 524,833 shares of common stock available for issuance of future share-based awards. In accordance with the provisions of the 2005 Plan, the number of shares authorized for issuance under the 2005 Plan was automatically increased by 433,516 shares on January 1, 2010, resulting in 958,349 shares available for issuance as of that date. The following table presents additional information regarding options outstanding as of December 31, 2009:
As of December 31, 2009, there was $5.2 million of total unrecognized compensation cost related to restricted stock granted under the 2005 Plan. That cost is expected to be recognized over a weighted-average period of 20.7 months.