Our principal executive offices are located in approximately 36,000 square feet of leased office space in Seattle, Washington. We also lease office space consisting of approximately 2,500 square feet in Anchorage, Alaska; 2,600 square feet in Baton Rouge, Louisiana; 5,650 square feet in Chicago, Illinois; 6,100 square feet in Concord, California; 4,000 square feet in Duluth, Georgia; 5,700 square feet in Henderson, Nevada; 2,650 square feet in Honolulu, Hawaii; 3,300 square feet in Houston, Texas; 3,400 square feet in Lake Mary, Florida; 3,700 square feet in Needham, Massachusetts; 8,300 square feet in Orange, California; 6,260 square feet in Phoenix, Arizona; 3,900 square feet in Radnor, Pennsylvania; 8,800 square feet in Santa Ana, California; and executive suites in New York, New York; New Orleans, Louisiana; and Yucca Valley, 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.
The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements and the notes to those statements included elsewhere in this annual report. The discussion and analysis below includes forward-looking statements that are subject to risks, uncertainties and other factors described in Part I, Item 1A of this annual report that could cause our actual results of operations, performance and business prospects and opportunities in 2009 and beyond to differ materially from those expressed in, or implied by those forward-looking statements. See “Note on Forward-Looking Statements” in Part I, Item 1 of this annual report.
Premiums earned is the earned portion of our net premiums written. Net premiums written is the difference between gross premiums written and premiums ceded or paid to reinsurers (ceded premiums written). Our gross premiums written is the sum of both direct premiums and assumed premiums before the effect of ceded reinsurance. Assumed premiums are premiums that we have received from another company under a reinsurance agreement or from an authorized state mandated pool.
We earn our direct premiums written from our maritime, ADR and state act customers. We also earn a small portion of our direct premiums written from employers who participate in the Washington USL&H Plan. We immediately cede 100% of those premiums, net of our expenses, and 100% of the losses in connection with that business to the plan. We do not include premiums from the Washington USL&H Plan in our direct premiums written because it is not indicative of our core business or material to our results of operation.
We invest our statutory surplus and the funds supporting our insurance liabilities (including unearned premiums and unpaid loss and loss adjustment expenses) in cash, cash equivalents, fixed income securities and, to a lesser degree, in equity securities and preferred stock. 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.
Included in other expense is interest expense we incur on $12.0 million in surplus notes that our insurance subsidiary issued in May 2004. The interest expense is paid quarterly in arrears. The interest expense for each interest payment period is based on the three-month LIBOR rate two London banking days prior to the interest payment period plus 400 basis points. The interest rates for the years ended December 31, 2008 and 2007 ranged from 6.15% to 9.03% and 9.03% to 9.50%, respectively.
Gross Premiums Written. Gross premiums written totaled $270.3 million in 2008 compared to $282.7 million in 2007, representing a decrease of $12.4 million, or 4.4%. Premiums assumed from the NCCI residual markets in the twelve months ended December 31, 2008 totaled $6.6 million compared to $9.7 million for the same period in 2007, representing a decrease of $3.1 million, or 32.0%. The decline in gross premiums written for the twelve months ended December 31, 2008 resulted primarily from the continuing soft market, competitor pricing pressure, and deteriorating economic conditions leading to lower reported payrolls year over year. We continued to experience rate reductions in California, our largest market, as well as in other states. The average renewal rates for 2008 declined by 9.6% for California State Act, 10.3% for State Act, excluding California, and 7.0% for maritime. Excluding work we perform as the servicing carrier for the Washington USL&H Plan, the number of customers we serviced at December 31, 2008 increased 17.9% to approximately 1,120 from approximately 950 at December 31, 2007. Year-end in-force payrolls, one of the factors used to determine premium charges, increased 14.9% from $5.6 billion at December 31, 2007 to $6.4 billion at year-end 2008. California in-force payrolls increased 7.7% between December 31, 2007 and December 31, 2008 and non-California in-force payrolls increased 21.4% over the same period. The following is a summary of our top five markets based on direct premiums written in 2008:
We have experienced significant reductions in our California premium rates over the past four years. In 2008, in response to continued reductions in California workers’ compensation claim costs, we reduced our rates by an average 14.2% for new and renewal insurance policies written in California on or after July 1, 2007. This action was the eighth California rate reduction we have filed since October 1, 2003, resulting in a net cumulative reduction of our California rates of approximately 54.8%. On August 15, 2008, the Workers’ Compensation Insurance Rating Bureau of California (the “WCIRB”) submitted a filing with the California Insurance Commissioner recommending a 16.0% increase in advisory pure premium rates on new and renewal policies effective on or after January 1, 2009. The filing was based on a review of loss and loss adjustment experience through March 31, 2008. In response to this recommendation, on October 24, 2008, the California Insurance Commissioner approved a 5.0% increase in advisory pure premium rates, effective January 1, 2009. With the California Department of Insurance approval, we adopted this 5.0% increase effective January 1, 2009.
Net Premiums Earned. Net premiums earned totaled $248.6 million in 2008 compared to $228.0 million in 2007, representing an increase of $20.6 million, or 9.0%. 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 the underlying policies were written. Our direct premiums earned increased $21.4 million, or 9.1%, to $255.9 million in 2008 from $234.5 million in 2007. Of the increase, approximately $13.6 million is directly related to the earn-out of basic policy premium and approximately $7.8 million is associated with retrospectively rated policies reflecting higher than expected loss ratios, resulting in lower premium adjustments. As we fully earn the premiums related to policies written in 2008, we expect the 2008 decrease in gross and net premiums written to have a similar impact on our 2009 net premiums earned.
result of thorough reviews of the investment portfolio and a determination by management that these investments met the criteria for OTTI charges primarily due to the extent and duration of the impairments and the inability to forecast a complete recovery of their book values within a reasonable period of time or, in the case of the government-sponsored entity preferred stocks, a significant decline in the underlying credit fundamentals of the securities.
Loss and Loss Adjustment Expenses. Loss and loss adjustment expenses totaled $141.9 million in 2008 compared to $128.2 million in 2007, representing an increase of $13.7 million, or 10.7%. The higher loss and loss adjustment expenses in 2008 were attributable to the increase in premiums earned for the period as well as lower favorable development of $8.0 million in 2008 compared to 2007. These increases were off set by a $2.3 million commutation gain associated with the 2005-2006 reinsurance treaty year and a $0.9 million decrease in assumed NCCI losses. The total reserve reduction of approximately $19.7 million of previously recorded direct net loss reserves in 2008, compared to approximately $27.7 million in 2007, reflects an overall continuation of deflation trends in the paid loss data for recent accident years. Our direct net loss reserves are net of reinsurance and exclude reserves associated with KEIC and the business that we involuntarily assume from the NCCI. Approximately $11.6 million of the 2008 reserve adjustments related to accident year 2007, approximately $5.1 million related to accident year 2006, and approximately $3.0 million of the reserve adjustment related to accident year 2005 and prior. As a result of these reserve changes, our net loss ratio increased from 55.5% in 2007 to 56.7% in 2008.
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, 2008 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 uncertainty regarding the permanence of recent legislative reforms. See the discussion under the headings “Loss Reserves” in Part I, Item 1 and “Critical Accounting Policies, Estimates and Judgments - Unpaid Loss and Loss Adjustment Expenses” in this Item 7 for a further discussion of our loss reserving process.
As of December 31, 2008, we had recorded a receivable of approximately $4.2 million for adverse loss development under the adverse development cover since the date of the Acquisition. We do not expect this receivable to have any material effect on our future cash flows if LMC fails to perform its obligations under the adverse development cover. At December 31, 2008, we had access to approximately $2.8 million under the collateralized reinsurance trust in the event that LMC fails to satisfy its obligations under the adverse development cover. In March 2009, we submitted a request to LMC to increase the balance in the Trust to
Other Expenses. Other expenses totaled $11.2 million, an increase of $3.4 million, or 43.6%, from $7.8 million in 2007. Other expenses result primarily from the operations of PointSure (including BWNV), which continued to experience direct costs associated with the expansion of insurance products they offer, and THM, which accounted for approximately $3.4 million of expense in the year ended December 31, 2008, due mainly to the fact that the acquisition occurred in December 2007.
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 December 31, 2006 and year-end in-force payrolls, one of the factors used in determining premium charges, increased 44.6% from 2006 to 2007. California continues to be our largest market, accounting for approximately $108.0 million (40.2%) of our direct premiums written in 2007, compared to $113.4 million (52.3%) of our direct premiums written in 2006. The reduction in our California premium resulted from rate reductions, the effects of competition and the growth of our business in other geographies. Illinois and Louisiana were our second and third largest markets in 2007, together accounting for approximately $48.7 million (18.1%) of our total direct premiums written, up from $33.5 million (15.5%) in 2006.
In 2007, we continued our geographical expansion program by opening new offices in Phoenix, Arizona and Duluth, Georgia. When fully established, we expect these new offices to make a significant contribution to
our written premiums. Direct premiums written in these two states in 2007 were approximately $12.8 million, or 4.7% of our total direct premiums written.
Net Premiums Written. Net premiums written totaled $267.4 million in 2007 compared to $214.8 million in 2006, representing an increase of $52.6 million, or 24.5%. Net premiums written were affected by premiums ceded under reinsurance agreements. Ceded written premiums in 2007 totaled $15.3 million, or 5.4% of gross premiums written, compared to $15.5 million, or 6.7%, of gross premiums written, in 2006. The decrease in ceded premiums as a percentage of gross premiums written resulted primarily from the renewal of our excess of loss reinsurance program on October 1, 2006 at average rates that were approximately 16.8% lower than rates under the prior reinsurance program. Effective October 1, 2007, we renewed our reinsurance program at average rates that are approximately 25.6% lower than the expiring rates.
invested primarily in fixed income securities. Net investment income as a percentage of average invested assets decreased slightly from 4.4% in 2006 to 4.3% in 2007.
Other Income. Other income totaled $4.4 million in 2007 compared to $3.4 million in 2006, representing an increase of $1.0 million, or 29.4%. Other income results primarily from the operations of PointSure, our wholesale broker and third party administrator subsidiary whose total revenues for the year ended December 31, 2007 increased approximately 21.4% over the same period in 2006, and THM, a provider of medical bill review, utilization review, nurse case management and related services that we acquired in December 2007.
As of December 31, 2007, we had recorded a receivable of approximately $2.5 million for adverse loss development under the adverse development cover since the date of the Acquisition. We do not expect this receivable to have any material effect on our future cash flows if LMC fails to perform its obligations under the adverse development cover. At December 31, 2007, we had access to approximately $3.5 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.
Interest Expense. Interest expense related to the surplus notes issued by our insurance subsidiary in May 2004 totaled $1.1 million in 2007 and 2006. 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, ranged between 9.03% and 9.50% 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.
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, 2008, our reinsurance program provides us with reinsurance protection for each loss occurrence in excess $0.75 million, up to $85.0 million, subject to various deductibles and exclusions. Our reinsurance program that was effective October 1, 2007 to October 1, 2008, provides us with reinsurance protection for each loss occurrence in excess of $1.0 million, up to $75.0 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.
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, 2008, 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.
We used net cash of $65.6 million for investing activities in 2008 compared to $95.1 million in 2007 and $139.6 million in 2006. The reduction in 2008 from 2007 and 2006 is primarily attributable to a reduction in funds generated by operations and made available for investing. In 2006, we invested net proceeds totaling approximately $57.6 million resulting from a follow-on public offering of 3,910,000 shares of our common stock described below.
The following table identifies our contractual obligations by payment due period as of December 31, 2008:
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.
Following is a summary of the gross loss and loss adjustment expense reserves by line of business as of December 31, 2008 and 2007. The workers’ compensation line of business comprises over 98% of our total loss reserves as of December 31, 2008.
We use a variety of actuarial methodologies to assist us in establishing the reserve for unpaid loss and loss adjustment expense. We also make judgments relative to estimates of future claims severity and frequency, length of time to achieve ultimate resolution, judicial theories of liability and other third-party factors that are often beyond our control.
AB 227 and SB 228 repealed the mandatory vocational rehabilitation benefits and replaced them with a system of non-transferable education vouchers.
SB 899 required the Division of Workers’ Compensation (“DWC”) Administrative Director to adopt, on or before January 1, 2005, a new permanent disability rating schedule (“PDRS”) based in part on American Medical Association guidelines. Also, temporary disability was limited to a duration of two years.
These reforms are a source of variability in the reserve estimates as legislative changes affecting benefit levels not only impact the cost of benefits but also the rate at which accident year benefits or losses develop over time. In addition, the PDRS, one of the most significant reforms, faces ongoing challenges. The PDRS was revised effective January 1, 2005. The revised schedule has resulted in significantly reduced permanent disability awards, leading to concerns that injured workers may not be adequately compensated for their work related permanent injuries. The PDRS is currently being challenged on three fronts - legislative, administrative and legal. Legislation has been proposed in the 2008 legislative session that would modify the formula used to determine the amount of permanent disability benefits. It is too early to determine what impact the legislation may have on permanent disability benefits, or if it will be enacted into law. A prior legislative effort to modify the PDRS was vetoed by Governor Schwarzenegger in 2007.
On the administrative front, the California Division of Workers’ Compensation has undertaken a review of the PDRS. The nature and extent of proposed changes, if any, are not yet known. The Division of Workers’ Compensation has not published a schedule to communicate their recommendations. Finally, recent court decisions continue to lend uncertainty to the interpretation and application of the PDRS. All of these factors add uncertainty to this key driver of California workers’ compensation claim costs.
2008 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 losses - This includes amounts for the medical and indemnity components of the workers’ compensation claim payments, net of subrogation recoveries and deductibles;
The most significant factor currently impacting our loss reserve estimates is the reliance on historical reserving patterns and loss payments from our predecessor and the industry, also referred to as loss development. This is due to our limited operating history as discussed above. The actuarial methods that we use depend at varying levels on loss development patterns based on past information. Development is defined 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.
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. The decisions to decrease the estimated ultimate losses for accident years 2004 through 2007 during calendar year 2008 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.
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,
In 2008, we recognized other-than-temporary impairment charges of approximately $10.2 million on our investments in preferred stocks (nearly all of which were government-sponsored agency fixed and variable preferred stocks) and approximately $3.2 million on our investment in equity indexed securities exchange-traded funds. No other-than-temporary declines in the fair value of our securities were recorded in 2007 or
2006. 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,
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of SeaBright Insurance Holdings, Inc. and subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles.
In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 131, Disclosures About Segments of an Enterprise and Related Information, the Company considers an operating segment to be any component of its business whose operating results are regularly reviewed by the Company’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance. Currently, the Company has one operating segment, workers’ compensation insurance and related services.
In general, the Company reviews all securities that are impaired by 5% or more at the end of the period. The Company focuses its review of securities with no stated maturity date on securities that were impaired by 20% or more at the end of the period or have been impaired 10% or more continuously for six months or longer as of the end of the period. 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.
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 $23.7 million and $20.6 million of cash equivalents at December 31, 2008 and 2007, respectively.
Premiums receivable are recorded at the invoiced amount as they are earned over the life of the contract in proportion to the amount of insurance protection provided. The allowance for doubtful accounts, which represents the Company’s best estimate of the amount of uncollectible premium in the Company’s existing premiums receivable balance, is based on historical account write-offs and takes into consideration the current economic environment. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.
Furniture and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful lives, which range from three to five years. Leasehold improvements are depreciated on a straight-line basis over periods ranging from approximately two to seven years, which is the shorter of their estimated useful lives or the remaining term of the respective lease. Depreciation expense totaled $1.4 million, $1.0 million and $0.4 million for the years ended December 31, 2008, 2007, and 2006, respectively.
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, 2008 and 2007 and premiums earned for the years then ended were accruals for earned but unbilled premiums of ($611,000) and $44,000, respectively.
include estimates of future trends in claim severity and frequency and other factors that could vary as the losses are ultimately settled. Liabilities for unpaid loss and loss adjustment expenses are not discounted to account for the time value of money.
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 a quarterly basis using generally accepted actuarial methodologies for estimating unpaid loss and loss adjustment expense liabilities, including incurred loss and paid loss development methods. Amounts recoverable in excess of acquired reserves at September 30, 2003 are recorded gross in unpaid loss and loss adjustment expense in accordance with SFAS No. 141, Business Combinations, with a corresponding amount receivable from the seller. Amounts are shown net in the statements of operations. 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.
Balances due from reinsurers on unpaid loss and loss adjustment expenses, including an estimate of such recoverables related to reserves for IBNR losses, are reported as assets and are included in reinsurance recoverables even though amounts due on unpaid loss and loss adjustment expenses are not recoverable from the reinsurer until such losses are paid. The Company monitors the financial condition of its reinsurers and does not believe that it is currently exposed to any material credit risk through its reinsurance agreements because most of its reinsurance is recoverable from large, well-capitalized reinsurance companies. Historically, no amounts from reinsurers have been written-off as uncollectible.
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.
Total stock-based compensation expense recognized in the consolidated statements of operations for the years ended December 31, 2008, 2007 and 2006 are shown in the following table. No compensation cost was capitalized during years ended December 31, 2008, 2007 and 2006.
Government sponsored agency securities are not backed by the full faith and credit of the U.S. Government.
Other-than-temporary impairment losses result in a permanent reduction of the carrying amount of the underlying investment. 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. A number of
Significant changes in the factors considered when evaluating investments for impairment losses could result in a significant change in impairment losses reported in the financial statements. At December 31, 2008 and 2007, the Company evaluated investment securities with fair values less than amortized cost and determined that the declines in value were temporary and were related primarily to the change in market rates since purchase or to other market anomalies that are expected to correct themselves. Furthermore, the Company has the ability and intent to hold the impaired investments to maturity or for a period of time sufficient for recovery of their carrying amount. For equity securities, the company evaluates whether the expected recovery is in a reasonable period of time.
The Company had no direct sub-prime mortgage exposure in its investment portfolio as of December 31, 2008 and less than $1.0 million of indirect exposure to sub-prime mortgages. The average credit quality of the Company’s $293.8 million fixed income municipal portfolio was AA/AA− (AA/AA− based on the issuers’ underlying ratings). Insured municipal bonds totaled $208.6 million and had a weighted average credit rating of AA/AA− (AA− based on the issuers’ underlying ratings). The remaining $85.2 million in uninsured municipal bonds carried a weighted average credit rating of AA/AA−. As of December 31, 2008, the Company’s municipal portfolio had no single lot size exceeding 1.1% of the total. Consequently, the Company does not expect a material impact to its investment portfolio or financial position as a result of the problems currently facing monoline bond insurers.
The amortized cost and estimated fair value of fixed income securities and preferred stock available-for-sale at December 31, 2008, by contractual maturity, are set forth below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
The consolidated amortized cost of fixed income securities available-for-sale deposited with various regulatory authorities was $203.6 million and $179.7 million at December 31, 2008 and 2007, respectively.
Other financial instruments qualify as insurance-related products and are specifically exempted from fair value disclosure requirements.
Level 1 - Valuations for assets and liabilities traded in active exchange markets, such as the New York Stock Exchange. Level 1 includes U.S. Treasury securities and equity securities that are traded by dealers or brokers in active markets. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.
Level 2 - Valuations for assets and liabilities traded in less active dealer or broker markets. Level 2 valuations are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market. Level 2 includes government sponsored agency securities, corporate fixed-income securities, municipal bonds, mortgage pass-through securities, collateralized mortgage obligations, asset-backed securities and preferred stocks.
The Company may be required, from time to time, to measure certain other financial assets, such as goodwill, fixed assets and other long-lived assets, at fair value on a non-recurring basis in accordance with GAAP. These adjustments to fair value usually result from write-downs of individual assets. None of these assets were measured to fair value during the year ended December 31, 2008.
Direct premiums written totaled $263.8 million, $273.0 million, and $221.8 million for the years ended December 31, 2008, 2007 and 2006, respectively.
The activity in the allowance for doubtful accounts for the years ended December 31, 2008, 2007, and 2006 is as follows (in thousands):
Under reinsurance treaties, the Company cedes various amounts of risk to nonaffiliated insurance companies for the purpose of limiting the maximum potential loss arising from the underlying insurance risks. These reinsurance treaties do not relieve the Company from its obligations to policyholders.
Fully reinsured, subject to an aggregate annual limit of $10.0 million. Includes general liability coverage limited to 77% recovery of each general liability loss occurrence. The remaining 23% of each general liability loss occurrence in this layer is retained by the Company.
$3.0 million for each loss occurrence in excess of $2.0 million for each loss occurrence
Fully reinsured, subject to an aggregate annual limit of $12.0 million. Includes general liability coverage.
$5.0 million for each loss occurrence in excess of $5.0 million for each loss occurrence
Fully reinsured, subject to an aggregate annual limit of $15.0 million. Includes general liability coverage.
$10.0 million for each loss occurrence in excess of $10.0 million for each loss occurrence
Fully reinsured, subject to an annual aggregate limit of $60.0 million and a limit of $7.5 million maximum for any one life.
As of December 31, 2008, the Company’s current excess of loss reinsurance treaties were placed with the following reinsurers:
Fully reinsured, subject to a limit of $7.5 million maximum for any one life and an aggregate limit of $20.0 million.
Effective from October 1, 2005 through October 1, 2006, the Company entered into reinsurance treaties wherein it retains the first $500,000 of each loss occurrence. Losses in excess of $500,000 up to $50.0 million are reinsured with nonaffiliated reinsurers as follows:
Effective from October 1, 2004 through October 1, 2005, the Company entered into reinsurance treaties 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.
The following table summarizes the Company’s top ten reinsurers, based on net amount recoverable, as of December 31, 2008:
The following table summarizes the activity in unpaid loss and loss adjustment expense for the years ended December 31, 2008, 2007 and 2006:
agreement to indemnify each other with respect to developments in KEIC’s unpaid loss and loss adjustment expenses over a period of approximately eight years. December 31, 2011 is the date to which the parties will look to determine whether the loss and loss adjustment expenses with respect to KEIC’s insurance policies in effect at the Acquisition have increased or decreased from the amount existing at the date of the Acquisition.
Issuance costs of $591,000 incurred in connection with the Surplus Notes are being amortized over the life of the notes using the effective interest method. Amortization expense for the years ended December 31, 2008, 2007, and 2006 was $43,000, $56,000 and $54,000, respectively.
Deferred federal income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and those amounts used for federal income tax reporting purposes. The significant components of the deferred tax assets and liabilities at December 31, 2008 and 2007 are as follows:
In assessing the realizability of deferred tax assets, management 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. Management considers the taxes paid in prior years, the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment.
As of December 31, 2008, management established a $2.0 million valuation allowance against deferred taxes generated by the realized and unrealized losses in the Company’s preferred stock and equity portfolios. Of this amount, $1.0 million is reflected in accumulated other comprehensive income and is directly associated with unrealized losses on the Company’s equity and preferred stock portfolio. The remaining $1.0 million of the valuation allowance has been recorded as an increase in deferred tax expenses and is related to the $13.4 million other-than-temporary-impairment charge. Management established this reserve after determining that these capital loss carry forwards were more likely than not to expire unused since there was an inadequate amount of capital gains available in the fixed income portfolio to offset the anticipated net capital loss. No such valuation allowances were established for the years ended December 31, 2007 or 2006.
As of December 31, 2008, the Company has capital loss carry forwards of approximately $1.2 million. Approximately $146,000 expires in 2010, $431,000 expires in 2011, $106,000 expires in 2012 and $475,000 expires in 2013.
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, 2008, 2007, and 2006 and statutory capital and surplus as of December 31, 2008, 2007 and 2006:
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, 2008, SBIC had statutory earned surplus of $92.6 million. Consequently, SBIC would be able to pay up to $24.4 million of stockholder dividends in 2009 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 2008, 2007 and 2006, the Company matched 100% of the first five percent of eligible compensation contributed to the plan on a pre-tax basis. For the years ended December 31, 2008, 2007, and 2006, the Company made additional contributions equal to one percent of compensation for all persons who were employed at the end of the year. Employees are 100% vested in all matching contributions when they are made. Contribution expense for the years ended December 31, 2008, 2007, and 2006 was $1.2 million, $0.8 million and $0.6 million respectively.
The Company completed its annual goodwill assessment for the individual reporting units as of December 31, 2008. The conclusion reached as a result of the annual goodwill impairment testing was that the fair value of each reporting unit, for which goodwill had been allocated, was in excess of the respective reporting unit’s carrying value, and therefore determined not to be impaired.
If current market conditions persist during 2009, in particular if the Company’s share price remains below book value per share, or if the Company’s actions to limit risk associated with its products or investments
The weighted average amortization period for all intangible assets subject to amortization is 2.6 years. Aggregate amortization expense was $7,500, $10,000 and $246,000 for the years ended December 31, 2008, 2007, and 2006, respectively.
The changes in the carrying amount of goodwill for the year ended December 31, 2008, were as follows:
The 2005 Plan provides for the grant of incentive or non-qualified stock options, restricted stock, restricted stock units, deferred stock units, performance awards, or any combination of the foregoing. The Board of Directors has the authority to determine all matters relating to awards granted under the Stock Option Plans, including designation as incentive or nonqualified stock options, the selection of individuals to be
granted options, the number of shares subject to each grant, the exercise price, the term and the vesting period, if any. Options to purchase the Company’s common stock are granted at prices at or above the fair value of the common stock on the date of grant, generally vest 25% per year on each of the first four anniversaries of the vesting start date, and expire 10 years from the date of grant. Options granted to non-employee directors generally vest one-third on the first anniversary of the grant date and the remaining two-thirds in equal monthly installments over the following 24 months. Nonvested stock issued to employees and directors generally vests on the third anniversary of the grant date, assuming the holder is still employed by or providing service to the Company and satisfies all other conditions of the grant. Generally, stock options granted to employees are incentive stock options, while options granted to non-employee directors are non-qualified stock options.
The aggregate intrinsic values in the table above are before applicable income taxes and are based on the Company’s closing stock price of $11.74 and $15.08 at December 31, 2008 and 2007, respectively. As of December 31, 2008, 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 33.2 months. Proceeds from the exercise of stock options totaled approximately $1.1 million in 2008 and approximately $310,000 in 2007. The total intrinsic value of stock options exercised was approximately $758,700 in 2008 and approximately $373,500 in 2007.
As of December 31, 2008, there were 551,691 shares of common stock available for issuance of future share-based awards. In accordance with the provisions of the 2005 Plan, the number of shares authorized for issuance under the 2005 Plan was automatically increased by 427,857 shares on January 1, 2009, resulting in 979,548 shares available for issuance as of that date. The following table presents additional information regarding options outstanding as of December 31, 2008:
The following table summarizes nonvested stock activity for the years ended December 31, 2008 and 2007:
The following table summarizes selected unaudited quarterly financial data for each quarter of the years ended December 31, 2008, 2007 and 2006.