years ended December 31, 2007, 2006, and 2005, approximately 52.6%, 66.8%, and 85.5%, respectively, of our claims service income was generated by contracts we have with LMC to provide claims handling services for the policies written by the Eagle Entities prior to the Acquisition. We expect income from these contracts to decrease substantially over the next several years as transactions related to the Eagle Entities diminish.
Loss and loss adjustment expenses represent our largest expense item and include (1) claim payments made, (2) estimates for future claim payments and changes in those estimates for current and prior periods and (3) costs associated with investigating, defending and adjusting claims. For further information regarding our loss and loss adjustment expenses, including amounts paid and unpaid, see the discussion under the heading “Critical Accounting Policies, Estimates and Judgments - Unpaid Loss and Loss Adjustment Expenses” in Part II, Item 7 of this annual report.
Gross Premiums Written. Gross premiums written totaled $282.7 million in 2007 compared to $230.3 million in 2006, representing an increase of $52.4 million, or 22.8%, even though we continued to experience rate reductions in California, our largest market, as well as in other states. The average renewal rate change for our state act, excluding California, and maritime markets for the full year of 2007 was −10.8% and −3.5%, respectively. Excluding work we perform as the servicing carrier for the Washington USL&H Plan, the number of customers we serviced at December 31, 2007 increased 45.7% to 953 from 654 at
In 2007, we continued our geographical expansion program by opening new offices in Phoenix, Arizona and Duluth, Georgia. We expect these new offices to make a significant contribution to our written premiums over the next 12-24 months. Direct premiums written in these two states in 2007 were approximately $12.8 million, or 4.7% of our total direct premiums written.
We have experienced significant reductions in our California premium rates over the past four years. In 2007, 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 was the eighth California rate reduction we have filed since October 1, 2003, resulting in a net cumulative reduction of our California rates of approximately 54.8%. Rate reductions have also been adopted in other states in which we operate. For example, effective January 1, 2008, we adopted the following rate decreases recommended by the NCCI: 10.9% in Alaska, 19.3% in Hawaii and 18.4% in Florida. Effective July 1, 2007, we adopted the Louisiana Insurance Commissioner’s recommendation of a 15.8% reduction in Louisiana, which is 2.0% more than the 13.8% rate decrease recommended by the NCCI. On February 5, 2008, the Louisiana Insurance Commissioner approved an NCCI-proposed rate reduction of 8.6%, effective May 1, 2008. On March 7, 2008, after completing a study of our Louisiana loss data, we filed with the Louisiana Insurance Commissioner our new rates reflecting an average reduction of 8.6% from prior rates for new and renewal workers’ compensation insurance policies written in Louisiana on or after May 1, 2008. We have also recently adopted rate increases in some states. For example, effective October 1, 2007, we adopted a 4.1% rate increase in Arizona and on January 1, 2008, we adopted a 4.0% rate increase in Illinois.
Net Premiums Earned. Net premiums earned totaled $228.0 million in 2007 compared to $185.6 million in 2006, representing an increase of $42.4 million, or 22.8%. We record the entire annual policy premium as unearned premium at inception and earn the premium over the life of the policy, which is generally twelve months. Consequently, the amount of premiums earned in any given year depends on when during the current or prior year the underlying policies were written. Our direct premiums earned increased $38.8 million or 19.8% to $234.5 million in 2007 from $195.7 million in 2006 due to our premium growth as described above. Net premiums earned are also affected by premiums ceded under reinsurance agreements. Ceded premiums earned in 2007 totaled $15.0 million compared to $15.6 million in 2006, representing a decrease of $0.6 million or 3.8%. A decrease in ceded premiums earned is an increase to our overall net premiums earned. Also adding to the increase in net premiums earned was an increase 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 increased $3.1 million from $5.5 million in 2006 to $8.6 million in 2007.
Service Income. Service income was $1.9 million in 2007 compared to $2.1 million in 2006, representing a decrease of $0.2 million, or 9.5%. 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
Loss and Loss Adjustment Expenses. Loss and loss adjustment expenses totaled $128.2 million in 2007 compared to $107.9 million in 2006, representing an increase of $20.3 million, or 18.8%. The higher loss and loss adjustment expenses in 2007 are attributable to the increase in premiums earned for the period, offset by a reduction of approximately $27.7 million of previously recorded direct net loss reserves to reflect a 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 $17.3 million of the reserve adjustment related to accident year 2006 and approximately $11.6 million related to accident year 2005. These reductions were offset by adverse development of $1.2 million in the 2004 accident year. As a result of these reserve changes, our net loss ratio decreased from 57.0% in 2006 to 55.5% in 2007.
Other Expenses. Other expenses totaled $7.8 million in 2007 compared to $6.2 million in 2006, representing an increase of $1.6 million, or 25.8%. Other expenses result primarily from the operations of PointSure, our wholesale broker and third party administrator subsidiary which experienced increases in commissions and other operating expenses associated with the expansion of its business. Additionally, we incurred $0.6 million in acquisition related costs in 2007.
Net Premiums Earned. Net premiums earned totaled $185.6 million in 2006 compared to $158.9 million in 2005, representing an increase of $26.7 million, or 16.8%. We record the entire annual policy premium as unearned premium when written and earn the premium over the life of the policy, which is generally twelve
months. Consequently, the amount of premiums earned in any given year depends on when during the current or prior year the underlying policies were written. Our direct premiums earned increased $22.9 million or 13.3% to $195.7 million in 2006 from $172.8 million in 2005 due to our premium growth as described above. Net premiums earned are also affected by premiums ceded under reinsurance agreements. Ceded premiums earned in 2006 totaled $15.6 million compared to $22.3 million in 2005, representing a decrease of $6.7 million or 30.0%. A decrease in ceded premiums earned is an increase to our overall net premiums earned. Offsetting the increases in net premiums earned is 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 $2.9 million from $8.4 million in 2005 to $5.5 million in 2006.
Net Investment Income. Net investment income was $15.2 million in 2006 compared to $7.8 million in 2005, representing an increase of $7.4 million, or 94.9%. Average invested assets increased $153.2 million (79.1%) from $193.6 million in 2005 to $346.8 million in 2006. Approximately $57.6 million of the increase resulted from the net proceeds of the follow-on offering of our common stock in February 2006. During the first quarter of 2006, yields on fixed income securities were at very high levels compared to 2005 and a significant portion of the net proceeds from the follow-on offering were invested at these higher yields. Another contributing factor to the increase in net investment income is realized positive cash flow from operations of $90.3 million in 2006, which was invested in fixed income securities with higher yields in 2006 compared to 2005. Net investment income as a percentage of average invested assets rose from 4.0% in 2005 to 4.4% in 2006, reflecting the rising interest rate environment.
Loss and Loss Adjustment Expenses. Loss and loss adjustment expenses totaled $107.9 million in 2006 compared to $105.8 million in 2005, representing an increase of $2.1 million, or 2.0%. The higher loss and loss adjustment expenses in 2006 are attributable to the increase in premiums earned for the period, offset by a reduction of approximately $20.4 million of previously recorded direct net loss reserves to reflect a 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 $14.6 million of the reserve adjustment related to accident year 2005 and approximately $5.9 million related to accident year 2004. These reductions were offset by modest adverse development of $0.1 million in the 2003 accident year. As a result of these reserve changes, our net loss ratio decreased from 65.1% in 2005 to 57.0% in 2006.
There is uncertainty about whether recent lower paid loss trends, which result primarily from California legislative reforms enacted in 2003 and 2004, will be sustained, particularly in light of current efforts to change or repeal portions of the reforms. We will not know the full impact of these reforms with a high degree of confidence for several years. We have established loss reserves at December 31, 2006 that are based upon our current best estimate of ultimate loss costs, taking into consideration the recent lower paid loss claim data, incurred loss trends and the uncertainty regarding the permanence of recent legislative reforms. See the
discussion under the heading “Loss Reserves” in Part I, Item 1 of this annual report for a further discussion of our loss reserve process.
As of December 31, 2006, we had recorded a receivable of approximately $2.8 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 March 2, 2007, we had access to approximately $3.4 million under the collateralized reinsurance trust in the event that LMC fails to satisfy its obligations under the adverse development cover. See the discussion under the heading “Loss Reserves - KEIC Loss Reserves” in Part I, Item 1 of this annual report.
Underwriting Expenses. Underwriting expenses totaled $42.3 million in 2006 compared to $33.8 million in 2005, representing an increase of $8.5 million, or 25.1%. Our net underwriting expense ratio was 22.7% in 2006 compared to 21.2% in 2005. The increase in the expense ratio is primarily the result of increased staffing costs and other premium production related expenses as we invest in the geographic expansion of our business. In addition, we incurred increased professional consulting and audit fees related to our initial compliance with Section 404 of the Sarbanes-Oxley Act of 2002 and costs related to restricted stock and the implementation of SFAS No. 123R, Share-Based Payment.
Interest Expense. Interest expense related to the surplus notes issued by our insurance subsidiary in May 2004 totaled $1.1 million in 2006 compared to $0.9 in 2005, representing an increase of $0.2 million, or 22.2%. The surplus notes interest rate, which is calculated at the beginning of each interest payment period using the 3-month LIBOR rate plus 400 basis points, increased steadily throughout 2006 from 8.39% at the beginning of 2006 to 9.37% at the end of the year.
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.
At December 31, 2007, approximately 96.0% of our investment portfolio consisted of primarily investment-grade fixed income securities with fair values subject to fluctuations in interest rates. The remainder of our investment portfolio consisted of investments in equity securities, which consist of investments in exchange traded funds designed to correspond to the performance of certain indexes based on domestic or international stocks, and preferred stocks. In November 2006, our investment policy was revised to allow for investment in domestic and international equities of up to 4% and 1%, respectively, of our statutory consolidated capital and surplus. All of the securities in our investment portfolio are accounted for as “available for sale” securities. While we have structured our investment portfolio to provide an appropriate matching of maturities with anticipated claim payments, if we decide or are required in the future to sell securities in a rising interest rate environment, we would expect to incur losses from such sales.
We had no direct sub-prime mortgage exposure in our investment portfolio as of December 31, 2007 and less than $800,000 of indirect exposure to sub-prime mortgages. The average credit quality of our $250.9 million fixed income municipal portfolio was AA+ (AA− based on the issuers’ underlying ratings). Insured municipal bonds totaled $192.8 million and had a weighted average credit rating of AAA (AA− based on the issuers’ underlying ratings). The remaining $58.1 million in uninsured municipal bonds carried a weighted average credit rating of AA. Consequently, we do not expect a material impact to our investment portfolio or financial position as a result of the problems currently facing monoline bond insurers.
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 NAIC 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, 2007, 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.
Net cash provided by operating activities in 2007 totaled $94.6 million, an increase of $4.3 million, or 4.8%, from $90.3 million in 2006, which increased $7.6 million, or 9.2%, from $82.7 million in 2005. These increases are mainly attributable to increases in unpaid loss and loss adjustment expense, amortization of deferred policy acquisition costs and taxes payable, offset by increases in policy acquisition costs deferred and deferred taxes, all as a result of our growth.
majority of cash provided by financing activities in 2006 and 2005 resulted from the sale of our common stock and, to a much lesser degree, from the exercise of common stock options by our employees. In 2006, we received net proceeds of approximately $57.6 million from a follow-on public offering of 3,910,000 shares of our common stock and in 2005, we received net proceeds of approximately $80.8 million from the initial public offering of our common stock.
The following table identifies our contractual obligations by payment due period as of December 31, 2007:
As of December 31, 2007, 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.
The most critical accounting policies involve the reporting of 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, deferred policy acquisition costs, income taxes, the impairment of investments, earned but unbilled premiums and retrospective premiums. The following should be read in conjunction with the notes to our consolidated financial statements.
SB 228 established a prescription medication fee schedule set at 100% of Medi-Cal Schedule amounts.
SB 899 provided that after January 1, 2005, an employer or insurer may establish medical provider networks meeting certain conditions and, with limited exceptions, medical treatment can be provided within those networks.
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, 2007, accident year 2004 is 48 months developed, accident year 2005 is 36 months developed, accident year 2006 is 24 months developed and accident year 2007 is 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.
IBNR reserves for defense and cost containment expenses (“DCC”, also referred to as allocated loss adjustment expenses (“ALAE”)), net of subrogation recoveries and deductibles;
Our analysis is done separately for the indemnity, medical and DCC components of the total loss reserves within each accident year. In addition, the analysis is completed separately for the following three categories: State Act California; State Act excluding California; and USL&H. The business is divided into these three categories for the determination of ultimate losses due to differences in the laws that cover each of these categories.
The State Act category is further split into California and excluding non-California groupings. This is due to the extensive reform activity that has taken place in California as discussed above. Since the California data is subject to additional variation due to the reform activity, separating the data in this fashion allows us to review the non-California State Act data with no impact from the California reform activity.
In light of our short operating history and uncertainties concerning the effects of recent legislative reforms, specifically as they relate to our California workers’ compensation experience, the actuarial techniques discussed above use the historical experience of our predecessor as well as industry information in the analysis of loss reserves. We are able to effectively draw on the historical experience of our predecessor because most of the current members of our management and adjusting staff also served as the management and adjusting staff of our predecessor. Over time, we expect to place more reliance on our own developed loss experience and less on our predecessor’s and industry experience.
as the difference, on successive valuation dates, between observed values of certain fundamental quantities that may be used in the loss reserve estimation process. For example, the data may be paid losses, case incurred losses and the change in case reserves or claim counts, including reported claims, closed claims or reopened claims. Development can be expected, meaning it is consistent with prior results; favorable (better than expected); or unfavorable (worse than expected). In all cases, we are comparing the actual development of the data in the current valuation with what was expected based on the historical patterns in the underlying data. Favorable development indicates a basis for reducing the estimated ultimate loss amounts while unfavorable development indicates a basis for increasing the estimated ultimate loss amounts. We reflect the favorable or unfavorable development in loss reserves in the results of operations in the period in which the ultimate loss estimates are changed.
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 four complete accident years that were developed 48 months, 36 months, 24 months and 12 months (2004, 2005, 2006 and 2007, respectively) at December 31, 2007. Our oldest complete accident year was 48 months old as of December 31, 2007. The estimated ultimate losses for accident year 2007 are based on the ELR method described earlier. This is consistent with our reserving approach for the current accident year at prior year-end valuations. For accident years 2003 through 2006, we are using a Bornhuetter-Ferguson approach, which blends the loss development and expected loss ratio methods. Due to the favorable development exhibited by the data for accident years 2004 and 2005 at 17 to 18 months of development, management began to place more weight on the results of the Bornhuetter-Ferguson method in its ultimate loss estimates for accident years 2005 and 2006. As new data emerges and continues to demonstrate favorable development, this adds credibility to the existing data which enables management to reflect it more fully in its estimation process. For all accident years, we have not completely relied on the most recent data points in our loss development selections. Because of recent favorable development trends, we believe this has the effect of increasing our estimated reserves as compared to reserves calculated with complete reliance on these data points. 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. Our paid loss data for state act indemnity, both California and excluding California, displayed decreasing, or deflationary, trends over the most recent three valuations at December 31, 2007. The decreasing trends are exhibited in the paid loss development data for the 11 months to 48 months development period. The decisions to decrease the estimated ultimate losses for accident years 2004 and 2005 at December 31, 2006 and for accident years 2005 and 2006 at December 31, 2007 were appropriately made, as the underlying loss data showed sustained and continued improvement over the prior twelve months, which we determined was an appropriate amount of time to be considered reliable for our estimate. We believe that our loss development factor selections are appropriate given the relative immaturity of our data. Over time, as the data for these accident years mature and uncertainty surrounding the ultimate outcome of the claim costs diminishes, the full impact of the actual loss development will be factored into our assumptions and selections.
As discussed in the previous section, there are a number of variables that can impact, individually or in combination, the adequacy of our loss and loss adjustment expense liabilities. While the actuarial methods employed factor in amounts for these circumstances, the loss reserves may prove to be inadequate despite the actuarial methods used. Several examples are provided below to highlight the potential variability present in our loss reserves. Each of these examples represents scenarios that are reasonably likely to occur over time. For example, there may be a number of claims where the unpaid loss and loss adjustment expense associated with future medical treatment proves to be inadequate because the injured workers do not respond to medical treatment as expected by the claims examiner. If we assume this affects 10% of the open claims and, on average, the unpaid loss and loss adjustment expenses on these claims are 20% inadequate, this would result in our unpaid loss and loss adjustment expense liability being inadequate by approximately $5.0 million, or 2%, as of December 31, 2007. Another example is claim inflation. Claim inflation can result from medical cost inflation or wage inflation. As discussed above, the actuarial methods employed include an amount for claim inflation based on historical experience. We assume that the historical effect of this factor, which is embedded in our experience and industry experience, is representative of future effects for claim inflation. To the extent that the historical factors, and the actuarial methods utilized, are inadequate to recognize future inflationary trends, our unpaid loss and loss adjustment expense liabilities may be inadequate. If our estimate of future medical trend is two percentage points inadequate (e.g., if we estimate a 9% annual trend and the actual trend is 11%), our unpaid loss and loss adjustment expense liability could be inadequate. The amount of the inadequacy would depend on the mix of medical and indemnity payments and the length of time until the claims are paid. For example, if we assume that 50% of the unpaid loss and loss adjustment expense is associated with medical payments and an average payout period of 5 years, our unpaid loss and loss adjustment expense liabilities would be inadequate by approximately $12.5 million on a pre-tax basis, or 5%, as of December 31, 2007. Under these assumptions, the inadequacy of approximately $12.5 million represents approximately 4.2% of total stockholders’ equity at December 31, 2007. The impact of any reserve deficiencies, or redundancies, on our reported results and future earnings is discussed below.
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 $250.1 million as of December 31, 2007 to be 5% inadequate, we would experience a pre-tax reduction in future earnings of approximately $12.5 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 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 periodically evaluate our reinsurance recoverables, including the financial ratings of our reinsurers, and revise our estimates of such amounts as conditions and circumstances change. Changes in reinsurance recoverables are recorded in the period in which the estimate is revised. We assessed the collectibility of our year-end receivables and believe that all amounts are collectible based on currently available information. Therefore, as of December 31, 2007 and 2006, we had no reserve for uncollectible reinsurance recoverables.
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 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, 2007 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.
In general, we focus on those securities whose fair value was less than 80% of their amortized cost or cost, as appropriate, for six or more consecutive months. We also analyze the entire portfolio for other factors that might indicate a risk of impairment. Other-than-temporary impairment losses result in a permanent reduction of the carrying value of the underlying investment. To date, we have not needed to record any other-than-temporary impairments of our investment securities. Please refer to the tables in Note 3 of the consolidated financial statements in Part II, Item 8 of this annual report for additional information on unrealized losses on our investment securities. Please refer to Part II,
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, 2007, 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 17, 2008 expressed an unqualified opinion on the effectiveness of SeaBright Insurance Holdings, Inc and subsidiaries’ internal control over financial reporting.
SeaBright Insurance Holdings, Inc. (“SIH”), a Delaware corporation, was formed in June 2003. On July 14, 2003, SIH entered into a purchase agreement, effective September 30, 2003, with Kemper Employers Group, Inc. (“KEG”), Eagle Insurance Companies (“Eagle”), and Lumbermens Mutual Casualty Company (“LMC”), the ultimate owner of KEG and Eagle (the “Acquisition”). Under this agreement, SIH acquired Kemper Employers Insurance Company (“KEIC”), PointSure Insurance Services, Inc. (“PointSure”), and certain assets of Eagle, primarily renewal rights.
The accompanying consolidated financial statements include the accounts of SIH and its wholly owned subsidiaries, SBIC, PointSure and THM (collectively, the “Company”). All significant intercompany transactions among these affiliated entities have been eliminated in consolidation.
The Company regularly reviews its investment portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. In general, the Company focuses on those securities whose fair values were less than 80% of their amortized cost or cost, as appropriate, for six or more consecutive months. The Company also analyzes the entire portfolio for other factors that might indicate a risk of impairment, including credit ratings and interest rates. A decline in the fair 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.
Mortgage-backed securities represent participating interests in pools of first mortgage loans originated and serviced by the issuers of securities. These securities are carried at fair value. Premiums and discounts are amortized using a method that approximates the level yield method over the remaining period to contractual maturity, adjusted for anticipated prepayments. To the extent that the estimated lives of such securities change as a result of changes in prepayment rates, the adjustment is also included in net investment income. Prepayment assumptions used for mortgage-backed and asset-backed securities were obtained from an external securities information service and are consistent with the current interest rate and economic environment.
Investment income is recorded when earned. For the purpose of determining realized gains and losses, which arise principally from the sale of investments, the cost of securities sold is based on specific-identification as of the trade date.
Cash and cash equivalents, which consist primarily of amounts deposited in banks and financial institutions, and all highly liquid investments with maturities of 90 days or less when purchased, are stated at cost. Cash in excess of daily requirements is invested in money market funds and repurchase agreements with maturities of 90 days or less. Such investments are deemed to be cash equivalents for purposes of the consolidated balance sheets and statements of cash flows. The Company had $20.6 million and $19.2 million of cash equivalents at December 31, 2007 and 2006, respectively.
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 fair value and impairment of investment securities, unpaid loss and loss adjustment expenses, goodwill and other intangibles, earned premiums on retrospectively rated policies, earned but unbilled premiums, deferred acquisition costs, federal income taxes and certain amounts related to reinsurance.
Goodwill represents the excess of costs over fair value of assets of businesses acquired. Goodwill and other intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but are instead tested for impairment at least annually. No impairments were identified as of December 31, 2007 and 2006. Intangible assets with estimable useful lives are amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 144, Accounting for Impairment or Disposal of Long-Lived Assets.
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 protects itself from excessive losses by reinsuring certain levels of risk in various areas of exposure with nonaffiliated reinsurers. Regardless of type, reinsurance does not legally discharge the ceding insurer from primary liability for the full amount due under the reinsured policies. Reinsurance premiums, commissions, expense reimbursements and reserves related to ceded business are accounted for on a basis consistent with the accounting for the original policies issued and the terms of reinsurance contracts. The unpaid loss and loss adjustment expense subject to the adverse development cover with LMC is calculated on
The Company adopted SFAS No. 123R, Share-Based Payment, on January 1, 2006, using the modified-prospective transition method. Prior to adoption, the Company measured 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, and adopted the disclosure-only provisions of SFAS No. 123, Accounting for Stock-based Compensation. None of the Company’s stock options granted prior to adoption had an intrinsic value at grant date and, accordingly, no compensation cost was recognized for its stock option plan activity prior to adoption.
In September 2005, the American Institute of Certified Public Accountants (“AICPA”) released Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (“SOP 05-1”). SOP 05-1 requires identification of transactions that result in a substantial change in an insurance contract. If it is determined that a substantial
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109 (“FIN 48”), which provides for the recognition, measurement, presentation and disclosure of uncertain tax positions. A tax benefit from an uncertain position may be recognized only if it is more likely than not that the position is sustainable based on its technical merits. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. The Company adopted the provisions of FIN 48 as of January 1, 2007, which did not have a material effect on the consolidated financial condition or results of operations.
Equity securities at December 31, 2007 and 2006 consist of investments in exchange traded funds designed to correspond to the performance of certain indexes based on domestic or international stocks. The
Of the $45.5 million of securities with unrealized losses of 12 months or longer at December 31, 2007 in the above table, only two securities with a combined fair value of $585,000 had fair values that were less than 90% of the securities’ amortized cost. The combined unrealized loss on those securities is $181,000.
allow for an anticipated recovery in value; specific credit issues related to the issuer; and current economic conditions.
Major categories of consolidated net investment income are summarized as follows for the years ended December 31, 2007, 2006, and 2005:
The activity in the allowance for doubtful accounts for the years ended December 31, 2007, 2006, and 2005 is as follows (in thousands):
Property and equipment consisted of the following at December 31, 2007 and 2006:
Fully reinsured, subject to an aggregate annual limit of $12.0 million
Fully reinsured, subject to an aggregate annual limit of $15.0 million
Effective from October 1, 2004 through October 1, 2005, 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.
All of the reinsurance policies described in this Note 8 are subject to various additional limitations and exclusions as more fully described in the reinsurance agreements.
The Company involuntarily assumes residual market business either directly from various states that operate their own residual market programs or indirectly from the National Council for Compensation Insurance, which operates residual market programs on behalf of some states. The states in which the Company assumed residual market business in 2007 and 2006 include the following: Alabama, Alaska, Arizona, Arkansas, Connecticut, Delaware, the District of Columbia, Georgia, Idaho, Illinois, Iowa, Kansas, Massachusetts, Michigan, Nevada, New Jersey, New Mexico, Oregon, South Carolina, and Virginia.
Balances affected by reinsurance transactions are reported gross of reinsurance in the balance sheets. Reinsurance recoverables comprise the following amounts at December 31, 2007 and 2006:
The following table summarizes the Company’s top ten reinsurers, based on net amount recoverable, as of December 31, 2007:
The Company recorded no write-offs of uncollectible reinsurance recoverables in the years ended December 31, 2007, 2006, and 2005.
The effects of reinsurance are as follows for the years ended December 31, 2007, 2006, and 2005:
The Company did not commute any reinsurance agreements in the years ended December 31, 2007, 2006 and 2005.
At December 31, 2007 and 2006, the Company reduced unpaid loss and loss adjustment expense by $4.3 million and $3.3 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 transaction was underwritten by Morgan Stanley & Company and Cochran & Caronia Securities, LLC. 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 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 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, 2007 was 9.03%. Interest and principal may be paid only 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 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, 2007, 2006, and 2005 was $1.1 million, $1.1 million, and $888,000, respectively.
The following is a reconciliation of the difference between the “expected” income tax computed by applying the federal statutory income tax rate to income before income taxes and the total income taxes reflected on the books for the years ended December 31, 2007, 2006, and 2005:
tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based upon the projections of future taxable income over the periods in which the deferred taxes are deductible, management believes it is more likely than not that the Company will realize the benefits of these deductible differences.
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, 2007, SBIC had statutory earned surplus of $42.0 million. Consequently, SBIC would be able to pay up to $33.7 million of stockholder dividends in 2008 without the prior approval of the regulators.
The Company maintains a defined contribution 401(k) retirement savings plan covering substantially all of its employees. In 2007 and 2006, the Company matched 100% of the first five percent of eligible compensation contributed to the plan on a pre-tax basis. In 2005, the Company matched 100% of the first three percent and 50% of the next two percent of such compensation. For the years ended December 31, 2007, 2006, and 2005, the Company made additional contributions equal to one percent of compensation for all persons who were employed at the end of the year. Additionally, the Company made discretionary year-end contributions of one percent for 2005 to the accounts of all persons who were employed at the end of year. Employees are 100% vested in all matching contributions when they are made. Contribution expense for the years ended December 31, 2007, 2006, and 2005 was $824,000, $640,000 and $571,000, respectively.
a. SBIC is subject to guaranty fund and other assessments by the states in which it writes business. Guaranty fund assessments are accrued at the time premiums are written. Other assessments are accrued either at the time of assessment or in the case of premium-based assessments, at the time the premiums are written, or in the case of loss-based assessments, at the time the losses are incurred. SBIC has accrued a liability for guaranty fund and other assessments of $3.5 million at December 31, 2007 and has recorded a related asset for premium tax offset and policy surcharges of $3.8 million at that date. This amount represents management’s best estimate based on information received from the states in which it writes business and may change due to many factors including the Company’s share of the ultimate cost of current insolvencies. Most assessments are paid out in the year following the year in which the premium is written or the losses are paid. Policy surcharges are generally collected in the year following assessment and premium tax offsets are generally recognized over a period of up to five years following the year of assessment.
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.
Intangible assets, other than goodwill, consist of the following at December 31, 2007 and 2006 (dollar amounts in thousands):
The weighted average amortization period for all intangible assets subject to amortization is 2.6 years. Aggregate amortization expense was $10,000, $246,000 and $629,000 for the years ended December 31, 2007, 2006, and 2005, respectively. Estimated remaining amortization expense is $7,500 in 2008.
On February 1, 2006, the Company closed a follow-on public offering of 3,910,000 shares of common stock, including the underwriters’ over-allotment option to purchase 510,000 shares of common stock, at a price of $15.75 per share for net proceeds of approximately $57.6 million, after deducting underwriters’ fees, commissions and offering costs totaling approximately $4.0 million. The Company contributed $50.0 million of the net proceeds to SBIC, which is using the capital to expand its business in its core markets and to new territories. The remaining proceeds are being used for general corporate purposes, including supporting the growth of PointSure. The use of proceeds from the offering does not represent a material change from the use of proceeds described in the prospectus that was included in the related Registration Statement on Form S-1. Except for the contribution of proceeds to SBIC, no proceeds or expenses were paid to the Company’s directors, officers, ten percent shareholders or affiliates.
The Board of Directors reserved an initial total of 776,458 shares of common stock under the 2003 Plan and 1,047,755 shares of common stock under the 2005 Plan, plus an automatic annual increase on the first day of each fiscal year beginning in 2006 and ending in 2015 equal to the lesser of: (i) 2% of the shares of common stock outstanding on the last day of the immediately preceding fiscal year or (ii) such lesser number of shares as determined by the Board of Directors. At December 31, 2007, the Company reserved 776,458 shares of common stock for issuance under the 2003 Plan, of which options to purchase 481,946 shares had been granted, and 1,787,046 shares for issuance under the 2005 Plan, of which 1,051,669 shares had been
The Company issues new shares of common stock upon exercise of stock options or award of nonvested shares.
The fair values of stock options granted during the years ended December 31, 2007, 2006 and 2005 were determined on the dates of grant using the Black-Scholes-Merton option valuation model with the following weighted average assumptions:
For 2006 and 2007, the expected term of options was determined using the “simplified method,” which averages an award’s weighted average vesting period and its contractual term and expected stock price volatility was based on a weighted average of the Company’s historical stock price volatility since the initial public offering of its common stock in January 2005 and the historical volatility of a peer company’s stock for a period of time equal to the expected term of the option. Prior to the adoption of SFAS No. 123R, expected term was based on the Company’s historical experience and future expectations and price volatility was estimated using the Company’s historical volatility. The risk-free interest rate is based on the yield of U.S. Treasury securities with an equivalent remaining term. The Company has not paid stockholder dividends in the past and has no current plan to pay any stockholder dividends in the future.
for as a change in estimate, with the cumulative effect of the change on periods previously reported being reflected in the financial statements of the period in which the change is made.
The aggregate intrinsic values in the table above are before applicable income taxes and are based on the Company’s closing stock price of $15.08 and $18.01 at December 31, 2007 and 2006, respectively. As of December 31, 2007, 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 30.4 months. Proceeds from the exercise of stock options totaled approximately $310,000 in 2007 and approximately $32,400 in 2006. The total intrinsic value of stock options exercised was approximately $373,500 in 2007 and approximately $42,300 in 2006.
As of December 31, 2007, there were 735,377 shares of common stock available for issuance of future share-based awards. The following table presents additional information regarding options outstanding as of December 31, 2007:
The following table summarizes nonvested stock activity for the years ended December 31, 2007 and 2006:
The following table summarizes selected unaudited quarterly financial data for each quarter of the years ended December 31, 2007, 2006 and 2005.