Our principal executive offices are located in approximately 36,090 square feet of leased office space in Seattle, Washington. We also lease office space consisting of approximately 2,470 square feet in Anchorage, Alaska; 5,650 square feet in Chicago, Illinois; 4,640 square feet in Las Vegas, Nevada; 2,650 square feet in Honolulu, Hawaii; 3,280 square feet in Houston, Texas; 17,040 square feet in Orange, California; 6,260 square feet in Phoenix, Arizona; 3,910 square feet in Radnor, Pennsylvania; 8,830 square feet in Santa Ana, California; 400 square feet in Yucca Valley, California; and an executive suite in Benicia, California. We conduct claims and underwriting operations in our branch offices, with the exception of our Honolulu office, where we conduct only claims and loss control operations. We do not own any real property. We consider our leased facilities to be adequate for our current operations.
We derive our revenue from premiums earned, net investment income, net realized gains and losses from investments and service fee income. Our primary expense items are loss and loss adjustment expenses and underwriting, acquisition and insurance expenses.
Net premiums earned is the earned portion of our net premiums written. Premiums are earned over the terms of the related policies in proportion to the risks underwritten. Our policies typically have terms of 12 months. Thus, for example, for a policy that is written on July 1, 2011, approximately one-half of the premiums would be earned in 2011 and the other half would be earned in 2012. At the end of each accounting period, the portion of the premiums that are not yet earned is included in unearned premiums and is realized as revenue in the subsequent periods over the remaining term of the policies.
We invest our statutory surplus and the funds supporting our insurance liabilities (including unearned premiums and unpaid loss and loss adjustment expenses) in cash, cash equivalents and fixed income securities. Our investment income includes interest and dividends earned on our invested assets. Realized gains and losses on invested assets are reported separately from net investment income. We earn realized gains when invested assets are sold for an amount greater than their amortized cost in the case of fixed maturity securities and recognize realized losses when investment securities are written down as a result of an other-than-temporary impairment or sold for an amount less than their carrying value.
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, 2011, 2010, and 2009, approximately 23.6%, 26.0%, and 32.3% 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 continue to decrease over the next several years as transactions related to the Eagle Entities diminish. The next largest claims administration services customer represented approximately 25.0%, 20.9%, and 20.5% of claims service income for the years ended December 31, 2011, 2010 and 2009, respectively.
Excluding work we perform as the servicing carrier for the Washington USL&H Plan and business assumed from the NCCI residual market pools, the total number of customers we serviced decreased from approximately 1,640 at December 31, 2010 to approximately 1,510 at December 31, 2011. We experienced an increase of approximately 100 customers related to our Program Business, which was offset by a decrease of approximately 240 customers in our core business. By design, our Program Business will have a larger number of customers with a smaller average premium size than our core book of business. As of December 31, 2011, the average premium size in our Program Business was approximately $100,700 compared to approximately $262,200 in our core business, compared to approximately $100,400 for Program Business and $235,900 for core business at December 31, 2010. Total in-force payrolls, one of the factors used to determine premium charges, decreased 8.6% from $7.0 billion at December 31, 2010 to $6.4 billion at year end 2011. California continues to be our largest market, accounting for approximately $127.1 million, or 48.7% of our in-force premiums at December 31, 2011. This represents a decrease of $18.4 million, or 12.6%, from approximately $145.5 million of in-force premiums in California, or 49.9% of our in-force premiums, at December 31, 2010.
Premiums assumed from the NCCI residual markets in the twelve months ended December 31, 2011 totaled $3.7 million compared to $2.3 million for the same period in 2010, representing an increase of $1.4 million, or 60.9%. The increase was primarily attributable to adjustments in our prior policy year estimates.
Claims Service Income. Claims Service income totaled $1.3 million in 2011 and $0.9 million in 2010. Our claims service income resulted primarily from service arrangements we have with customers for claims processing services and policy administration services that we perform for them.
Other Net Realized Gains. Other net realized gains recognized in earnings totaled $1.1 million in 2011 and $15.4 million in 2010. The 2010 gains were realized in order to allow us to fully realize the approximately $15.0 million of tax capital loss carry forwards that existed at December 31, 2009.
Loss and Loss Adjustment Expenses. Loss and loss adjustment expenses totaled $218.4 million in 2011 compared to $223.1 million in 2010, representing a decrease of $4.6 million, or 2.1%. Our net loss ratio, which is calculated by dividing loss and loss adjustment expenses less claims service income by premiums earned, was 87.0% in 2011 compared to 87.4% in 2010. The net loss ratio reflects unfavorable development of prior accident year loss reserves of $31.4 million in 2011 (offset by a $0.5 million favorable commutation gain), compared to unfavorable development of prior year accident year loss reserves of $32.6 million in 2010 (offset by a $0.6 million favorable commutation gain). Our net loss ratio was also impacted by an increase in the net current accident year expected loss ratio (“ELR”) from 64.5% in 2010 to 65.0% in 2011. Our direct loss reserves are net of reinsurance and exclude reserves associated with KEIC, whom we acquired from LMC in September 2003, and the business that we involuntarily assume from the NCCI.
For accident year 2010, the ultimate loss estimates at December 31, 2011 were higher when compared to December 31, 2010 and resulted in net adverse development of our loss reserves of $9.7 million. The development was attributable to the following jurisdictions: $3.8 million for California state act, driven primarily by medical costs; $8.0 million for non-California state act, driven primarily by medical costs with additional impact due to indemnity costs; $0.2 million for our IBNR accrual for earned but unbilled premiums; offset by $2.3 million of favorable loss development for USL&H, driven primarily by favorable development in medical costs. This net adverse development was offset by net favorable development of $1.6 million related to ULAE, loss based assessments and NCCI.
For accident year 2007, the ultimate loss estimates at December 31, 2011 were higher when compared to December 31, 2010 and resulted in adverse development of our loss reserves of $6.7 million. The development was attributable to the following jurisdictions: $3.0 million for California state act, driven primarily by medical and indemnity costs; $2.3 million for non-California state act, driven primarily by indemnity costs; and $1.4 million for USL&H, driven primarily by indemnity costs. This adverse development was offset by favorable development of $0.7 million related to ULAE, loss based assessments and NCCI.
For accident years 2006 and prior, the ultimate loss estimates at December 31, 2011 were higher when compared to December 31, 2010 and resulted in net adverse development of our loss reserves of $2.6 million. The development was attributable to the following jurisdictions: $2.8 million for California state act, driven primarily by medical and indemnity costs; $0.4 million for non-California state act, driven primarily by indemnity costs; offset by favorable development of $0.6 million for USL&H, driven primarily by indemnity and medical costs. This net adverse development was offset by net favorable development of $0.7 million related to ULAE, loss based assessments and NCCI.
Underwriting, Acquisition and Insurance Expenses. Underwriting expenses totaled $75.5 million in 2011 compared to $72.1 million in 2010, representing an increase of $3.4 million, or 4.8%. Our net underwriting expense ratio, which is calculated by dividing underwriting, acquisition and insurance expenses by premiums earned, was 30.3% in 2011 compared to 28.3% in 2010. The increase in our expense ratio was primarily the result of increased underwriting expenses, driven primarily by commission costs, and decreased premiums earned as compared to the same period in 2010. We estimate that the office closures and staff reductions announced in October 2011 will reduce underwriting expense by approximately $3.2 million annually. Severance, transition services and office closure costs totaled approximately $1.0 million and were recognized in the fourth quarter of 2011.
Interest Expense. Interest expense related to the surplus notes issued by our insurance subsidiary in May 2004 totaled $0.5 million in 2011 and 2010. The surplus notes interest rate, which is calculated at the beginning of each interest payment period using the 3-month LIBOR plus 400 basis points, ranged between 4.26% and 4.51% in 2011, compared to 4.25% and 4.48% in 2010.
The following is a summary of our top five markets based on direct premiums written (excluding premiums written under the Washington USL&H Plan):
We experienced significant reductions in our California premium rates from 2003 to 2008. Over that period, we filed, and the California Department of Insurance approved, eight rate reductions resulting in a net cumulative reduction of our California rates of approximately 54.8%. Beginning in 2008, we filed, and the California Department of Insurance approved, the following increases in our California rates: 5.0% increase effective January 1, 2009; 10.6% increase effective August 1, 2009; and 15.3% increase effective September 1, 2010. These rate increases were filed following the completion of internal studies of our California loss costs and were primarily in response to increased projected medical costs and recent decisions by the Workers’ Compensation Appeals Board. If other insurers do not adopt similar rate increases, these rate increases may have a negative effect on our ability to compete in California. Rate changes have also been adopted in other states in which we operate. For additional information regarding recent rate change activity in California and other states, see the discussion under the heading “Regulation - Federal and State Legislative and Regulatory Changes” in Part I, Item 1 of this annual report.
Claims Service Income. Claims Service income totaled $0.9 million in 2010 and $1.0 million in 2009. Our claims service income resulted primarily from service arrangements we have with customers for claims processing services and policy administration services that we perform for them.
For accident year 2009, the ultimate loss estimates at December 31, 2010 were higher when compared to December 31, 2009 and resulted in a net increase of our loss reserves of $14.0 million. The increase was attributable to the following jurisdictions: $7.1 million for California state act, driven primarily by medical costs; $3.5 million for non-California state act, driven by increased medical and indemnity costs; and $3.4 million for USL&H, driven primarily by increased indemnity costs. This adverse development was offset by favorable development of $0.2 million related to ULAE, loss based assessments and NCCI.
Our ability to adequately provide funds to pay claims comes from our disciplined underwriting and pricing standards and the purchase of reinsurance to protect us against severe claims and catastrophic events. Effective October 1, 2010, we entered into reinsurance agreements with nonaffiliated reinsurers wherein we retain the first $0.25 million of each loss occurrence and the next $0.25 million of losses per occurrence are 100% reinsured, subject to an aggregate deductible of $5.0 million. The next $0.5 million of losses per occurrence (from $0.5 million to $1.0 million per loss occurrence) are 75% reinsured. Losses in excess of $1.0 million per loss occurrence are fully reinsured through the program limit of $100.0 million per loss occurrence, subject to various deductibles and exclusions. The new reinsurance program is effective through September 30, 2011. Our reinsurance program that was effective October 1, 2009 to September 30, 2010 provided us with reinsurance protection for each loss occurrence in excess of $0.5 million, up to $85.0 million, subject to various deductibles and exclusions. Given industry and predecessor trends, we believe we are sufficiently capitalized to cover our retained losses.
Income Tax Expense (Benefit). The effective tax rate for the year ended December 31, 2010 resulted in a benefit of 75.0% compared to an expense of 18.4% for the same period in 2009. The effective tax rate for 2010 differed from the statutory tax rate of 35.0% primarily as a result of tax exempt interest income, which accounted for approximately 53.0% percentage points of the difference from the statutory rate. The increase in the effective rate was partially offset by approximately $0.6 million, or 8.8 percentage points, due to a true-up of vesting expense related to restricted stock which vested during the year. The effective rate for December 31, 2009 was lower than the statutory rate of 35.0% primarily as a result of tax exempt interest income, which accounted for approximately 20.8 percentage points of the difference from the statutory rate. This decrease in the effective rate was partially offset by approximately $0.7 million, or 4.2 percentage points, due to state income taxes and other nondeductible expenses.
Net Income (Loss). Net loss totaled $1.6 million in 2010 compared to net income of $13.5 million in 2009, representing a decrease of $15.1 million, or 111.7%. The 2010 decrease in net income resulted primarily from an increase in loss and loss adjustment expenses, offset by an increase in other realized gains recognized in earnings.
Our principal sources of funds are underwriting operations, investment income and proceeds from sales and maturities of investments. Our primary use of funds is to pay claims and operating expenses, to purchase investments and to pay declared common stock dividends.
At December 31, 2011, our investment portfolio consisted of investment-grade fixed income securities with fair values subject to fluctuations in interest rates, as well as other factors such as credit. Our investment policy allows for investment in domestic and international equities up to 6% and 1.5%, respectively, of our statutory 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.
As of December 31, 2011, we had no direct investments in any bond insurer, and the following bond insurers insured more than 10% of the municipal bond investments in our portfolio:
Our ability to adequately provide funds to pay claims comes from our disciplined underwriting and pricing standards and the purchase of reinsurance to protect us against severe claims and catastrophic events. Effective October 1, 2011, our reinsurance program provides us with reinsurance protection for each loss occurrence in excess of $0.5 million, up to $75.0 million, subject to various deductibles and exclusions. Our reinsurance program that was effective October 1, 2010 to September 30, 2011, provides us with reinsurance protection for each loss occurrence in excess of $0.25 million, up to $100.0 million, subject to various deductibles and exclusions. See the discussion under the heading “Reinsurance” in Part I, Item 1 of this annual report. Given industry and predecessor trends, we believe we are sufficiently capitalized to cover our retained losses.
The loss and loss adjustment expense payments due by period in the table above are based upon the loss and loss adjustment expense estimates as of December 31, 2011 and actuarial estimates of expected payout patterns and are not contractual liabilities as to time certain. Our contractual liability is to provide benefits under the policies we write. As a result, our calculation of loss and loss adjustment expense payments due by period is subject to the same uncertainties associated with determining the level of unpaid loss and loss adjustment expenses generally and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. For a discussion of our unpaid loss and loss adjustment expense process, see the heading “Loss Reserves” in Part I, Item 1 of this annual report and “Critical Accounting Policies, Estimates and Judgments - Unpaid Loss and Loss Adjustment Expense” in Part II, Item 7 of this annual report. Actual payments of loss and loss adjustment expenses by period will vary, perhaps materially, from the above table to the extent that current estimates of loss and loss adjustment expenses vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns. See the discussion under the heading “Risks Related to our Business - Our loss reserves are based on estimates and may be inadequate to cover our actual losses” in Part I, Item 1A of this annual report for a discussion of the uncertainties associated with estimating unpaid loss and loss adjustment expenses.
reserve for loss based assessments, also referred to as the “8F reserve” in reference to Section 8, Compensation for Disability, subsection (f), Injury increasing disability, of the United States Longshore and Harbor Workers’ Compensation Act (“USL&H”) Act.
A gross ultimate value is selected by reviewing the various ultimate estimates and applying actuarial judgment to achieve a reasonable best estimate of the ultimate liability. The gross IBNR reserve equals the selected gross ultimate loss minus the gross paid losses and gross case reserves as of the valuation date. The selected gross ultimate loss and ALAE are reviewed and updated on a quarterly basis.
For accident year 2007, there was unfavorable development in the losses for California State Act which resulted in an increase of our net ultimate loss estimates of $3.0 million. For non-California State Act, there was unfavorable development in the losses for accident year 2007 which resulted in an increase of our net ultimate loss estimates of $2.3 million. For USL&H, there was unfavorable development in the losses for accident year 2007 which resulted in an increase of our net ultimate loss estimates of $1.4 million.
For accident year 2009, there was unfavorable development in the losses for California State Act which resulted in an increase of our net ultimate loss estimates of $4.6 million. For non-California State Act, there was unfavorable development in the losses for accident year 2009 which resulted in an increase of our net ultimate loss estimates of $3.3 million. For USL&H, there was unfavorable development in the losses for accident year 2009 which resulted in an increase of our net ultimate loss estimates of $0.6 million.
For accident year 2010, there was unfavorable development in the losses for California State Act which resulted in an increase of our net ultimate loss estimates of $3.8 million. For non-California State Act, there was unfavorable development in the losses for accident year 2009 which resulted in an increase of our net ultimate loss estimates of $8.0 million. In addition, our IBNR accrual for earned but unbilled premiums resulted in an increase of our net ultimate loss estimates of $0.2 million. This was offset by favorable development in the USL&H losses for accident year 2010 which resulted in a decrease of our net ultimate loss estimates of $2.3 million.
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 $10.4 million, or 2.0%, as of December 31, 2011. 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 $25.9 million on a pre-tax basis, or 5%, as of December 31, 2011. Under these assumptions, the inadequacy of approximately $25.9 million represents approximately 7.3% of total stockholders’ equity at December 31, 2011. 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 $518.0 million as of December 31, 2011 to be 5% inadequate, we would experience a pre-tax reduction in future earnings of approximately $25.9 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 collectability of our year-end receivables and believe that all amounts are collectible based on currently available information. Therefore, as of December 31, 2011 and 2010, we had no reserve for uncollectible reinsurance recoverables. As of December 31, 2011, the top ten companies, representing 95% of our reinsurance amounts recoverable, had A.M. Best ratings of “A” or higher.
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.
No other-than-temporary declines in the fair value of our securities were recorded in 2011 or 2010. In 2009, we recognized other-than-temporary impairment charges of $0.3 million related to our investments in preferred stocks issued by Fannie Mae and Freddie Mac that were sold in 2009. Please refer to the tables in Note 3, “Investments” 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,
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of SeaBright Holdings, Inc. and subsidiaries as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles.
PointSure is a wholesale insurance broker and acts as an in-house distribution platform for SeaBright Insurance Company, and also offers insurance products from nonaffiliated insurers.
In December 2007, the Company 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, for a purchase price of $1.2 million. Following the acquisition, THM became a wholly owned subsidiary of SeaBright. In May 2011, THM was renamed Paladin Managed Care Services, Inc. (“PMCS”). PMCS offers managed care services to SBIC and non-affiliated entities.
The accompanying consolidated financial statements include the accounts of SeaBright and its wholly owned subsidiaries, SBIC, PointSure, and PMCS (collectively, the “Company”). All significant intercompany transactions among these affiliated entities have been eliminated in consolidation.
Although no impairment losses were recognized over the value of the Company’s investment portfolio in 2011, it is possible that the Company could recognize future impairment losses on some securities it owned at December 31, 2011 if future events, information or the passage of time result in a determination that a decline in value is other-than-temporary.
In the second step (if necessary), 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 third step of the impairment test is performed for purposes of measuring the impairment. In the third 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.
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, 2011, 2010 and 2009 and premiums earned for the years then ended were accruals for earned but unbilled premiums of $0.3 million, ($0.6) million, and ($0.1) million, respectively.
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. Amounts are shown net in the statements of operations and comprehensive income (loss). Premiums ceded to other companies are reported as a reduction of premiums written and earned. Reinsurance recoverables are determined based on the terms and conditions of the reinsurance contracts.
In assessing the realizability of deferred tax assets, the Company considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. This analysis requires the Company to make various estimates and assumptions, including the scheduled reversal of deferred tax liabilities, the consideration of operating versus capital items, projected future taxable income and the effect of tax planning strategies. Based on this analysis, the Company may be required to establish a valuation allowance to reduce the deferred tax assets to the amounts more likely than not to be realized. As of December 31, 2011 and 2010, the Company had no valuation allowance against its deferred tax assets.
FASB ASC Topic 740, Income Taxes, prescribes 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, 2011 and 2010, 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 and comprehensive income (loss).
The effect of including shares issuable upon the exercise of outstanding stock options and the vesting of nonvested restricted stock is antidilutive for the years ended December 31, 2011 and 2010. Therefore, such shares have been excluded from the calculation of diluted weighted average shares outstanding. The numbers of such shares excluded for the years ended December 31, 2011 and 2010 were approximately 615,000 and 577,000, respectively.
In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, to provide largely identical guidance about fair value measurement and disclosure requirements. The new standards do not extend the use of fair value but, rather, provide guidance about how fair value should be applied where it already is required or permitted under International Financial Reporting Standards (“IFRS”) or U.S. GAAP. The new guidance is effective for interim and annual reporting periods beginning after December 15, 2011. Early adoption is not permitted. The adoption of ASU 2011-04 is not expected to have a material effect on the Company’s consolidated financial condition and 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, 2011 and 2010 were as follows:
The following tables present information about investment securities with unrealized losses at December 31, 2011 and 2010.
The following table provides a breakdown of fair value by ratings on the bonds in the Company’s municipal portfolio as of December 31, 2011:
As of December 31, 2011, the Company had no direct investments in any bond insurer, and the following bond insurer insured more than 10% of the municipal bond investments in the Company’s portfolio:
The consolidated amortized cost of fixed income securities available for sale deposited with various regulatory authorities was $260.9 million and $216.7 million at December 31, 2011 and 2010, respectively.
Proceeds from the sales of fixed income and equity securities, related realized gains and losses and changes in unrealized gains (losses), excluding other-than-temporary impairments, were as follows:
Estimated fair value amounts, defined as the exit price of willing market participants, have been determined using available market information and other appropriate valuation methodologies. However, considerable judgment is required in developing the estimates of fair value. Accordingly, these estimates are not necessarily indicative of the amounts that could be realized in a current market exchange. The use of different market assumptions or estimating methodologies may have an effect on the estimated fair value amounts.
The following methods and assumptions were used by the Company in estimating the fair value disclosures for financial instruments in the accompanying consolidated financial statements and notes:
At December 31, 2011, there were no liabilities measured at fair value on a recurring basis.
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, 2011. When broker quotes are obtained, they are usually non-binding.
Premiums receivable consisted of the following at December 31, 2011 and 2010:
The activity in the allowance for doubtful accounts for the years ended December 31, 2011, 2010, and 2009 is as follows (in thousands):
Property and equipment consisted of the following at December 31, 2011 and 2010:
The following reflects the amounts of policy acquisition costs deferred and amortized for the years ended December 31, 2011, 2010, and 2009:
As part of the Acquisition, SeaBright and LMC entered into an adverse development excess of loss reinsurance agreement (the “Agreement”). The Agreement, after taking into account any recoveries from third party reinsurers, calls for LMC to reimburse SBIC 100% of the excess of the actual loss at December 31, 2011 over the initial loss reserves at September 30, 2003. The Agreement also calls for SBIC to reimburse LMC 100% of the excess of the initial loss reserves at September 30, 2003 over the actual loss results at December 31, 2011. The amount of adverse loss development under the Agreement was $3.1 and $3.0 million at December 31, 2011 and 2010, respectively. Any change in the amount receivable from LMC is netted against loss and loss adjustment expense in the accompanying consolidated statements of operations and comprehensive income (loss).
The Company recorded no write-offs of uncollectible reinsurance recoverables in the years ended December 31, 2011, 2010, and 2009.
The effects of reinsurance were as follows for the years ended December 31, 2011, 2010, and 2009:
As a result of changes in estimates of insured events in prior periods, unpaid loss and loss adjustment expenses increased by a net amount of $30.9 million in 2011. Net adverse development of prior year loss reserves totaled $36.4 million and related to the following accident years: $9.7 million in 2010, $8.5 million in 2009, $9.0 million in 2008, $6.7 million in 2007, and $2.5 million in accident years 2006 and prior. The net adverse development on loss reserves was offset by $5.0 million of net favorable development of other amounts such as ULAE, loss based assessments and losses assumed from the NCCI pools, as well as a $0.5 million favorable commutation gain.
The operations of SeaBright and its subsidiaries are included in a consolidated federal income tax return.
Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and those amounts used for income tax reporting purposes. The significant components of the deferred tax assets and liabilities at December 31, 2011 and 2010 were as follows:
As of December 31, 2011, the Company had $11.7 million of net operating loss carryovers and $0.5 million of alternative minimum tax credit carryovers, both relating to federal income tax. The $11.7 million of net operating loss carryovers expires in 2031. The $0.5 million of alternative minimum tax credit carryovers has no expiration date. The Company had no carryovers as of December 31, 2010.
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, 2011, 2010, and 2009 and statutory capital and surplus as of December 31, 2011, 2010 and 2009:
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, 2011 and 2010.
The Company maintains a defined contribution 401(k) retirement savings plan covering substantially all of its employees. In 2011, 2010 and 2009, the Company matched 100% of the first five percent of eligible compensation contributed to the plan on a pre-tax basis. Employees are 100% vested in all matching contributions when they are made. Contribution expense for the years ended December 31, 2011, 2010, and 2009 was $1.3 million, $1.1 million and $1.1 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 are recorded as additions to written or earned premium, and return retrospective premiums are recorded as reductions from written or earned premium. Approximately 6.6%, 5.9% and 7.2% of the Company’s direct premiums written for the years ended December 31, 2011, 2010 and 2009, respectively, related to retrospectively rated contracts. The Company accrued $9.2 million for retrospective premiums receivable (included in deferred premiums on the balance sheet) and $23.3 million for return retrospective premiums (included in accrued expenses and other liabilities on the balance sheet) at December 31, 2011 and $11.1 million for retrospective premiums receivable and $22.6 million for return retrospective premiums at December 31, 2010.
The Company tests for goodwill impairment in the fourth quarter of each year. At the end of each subsequent quarter, management considers the results of the previous analysis as well as any recent developments that may constitute triggering events requiring the impairment analysis to be updated. In 2011, the Company completed its impairment assessment by performing a qualitative analysis as permitted by ASU 2011-08, Intangibles - Goodwill and Other (Topic 350): Testing Goodwill for Impairment, which the Company early adopted in the fourth quarter of 2011. Among the qualitative factors considered were the following: the substantial margins by which both reporting units (PMCS and PointSure) passed the previous impairment analysis; the continued strong performance of both reporting units; the importance of both reporting units to the Company’s strategic plan; and a lack of the negative factors identified in ASU 2011-08. The Company concluded, on a more-likely-than-not basis, that no goodwill impairment existed at December 31, 2011. In June 2010, the Company recorded a $1.5 million impairment charge against the goodwill resulting from the acquisition of SBIC in September 2003.
At December 31, 2011, 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 and in May 2010, the Board of Directors further amended the 2005 Plan. The current amended and restated 2005 Plan was approved by shareholders on May 18, 2010.
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, 2011, the Company reserved 776,458 shares of common stock for issuance under the 2003 Plan, of which options to purchase 479,946 shares had been granted, and 3,505,550 shares for issuance under the 2005 Plan, of which 3,043,536 shares had been granted. In January 2006, the Compensation Committee of the Board of Directors terminated the ability to grant future stock options awards under the 2003 Plan. Therefore, the Company anticipates that all future awards will be made under the 2005 Plan.
Total stock-based compensation expense recognized in the consolidated statements of operations and comprehensive income (loss) for the years ended December 31, 2011, 2010 and 2009 is shown in the following table. No stock-based compensation cost was capitalized during years ended December 31, 2011, 2010 and 2009.
The fair values of stock options granted during the years ended December 31, 2011, 2010 and 2009 were determined on the dates of grant using the Black-Scholes-Merton option valuation model with the following weighted average assumptions:
The following table summarizes stock option activity for the years ended December 31, 2011 and 2010:
The aggregate intrinsic values in the table above are before applicable income taxes and are based on the Company’s closing stock price of $7.65 and $9.22 at December 31, 2011 and 2010, respectively. As of December 31, 2011, total unrecognized stock-based compensation cost related to nonvested stock options was approximately $1.0 million, which is expected to be recognized over a weighted average period of approximately 2.37 years. No stock options were exercised in 2011 and proceeds from the exercise of stock options totaled approximately $26,000 in 2010. The total intrinsic value of stock options exercised in 2010 was approximately $17,260.