As March 1, 2007, we leased approximately 240,712 square feet of total office space in the following locations:
In addition, we own a 15,120 square foot building in Carson City, Nevada, which is used as a storage facility.
We are currently in negotiations for additional space and renewing leased premises at a number of our locations. Our current leases for our Glendale and Newbury Park locations expire in September 2007. We are in active negotiations to renew our existing leases in both locations. The lease for our Reno, Nevada, offices expires in March 2008. We are currently in lease renewal negotiations for this location. The lease for our Fresno, California office expires in July 2008. We anticipate beginning lease renewal negotiations for that space in the second quarter of 2007.
At December 31, 2006, we experienced an increase of 2,056 or 7.4% in the total number of policies in force over December 31, 2005. In California, we experienced an increase of 2,040 or 10.6% in the total policies in force over December 2005. Also, for states other than California and Nevada in which we operate, we experienced an increase of 487 or 35.5% in the total policies in force over December 2005. This policy growth was insufficient to offset the decline in premium we have experienced in California principally due to declining rate levels. In Nevada, we experienced a decline of 471 or 6.7% in the number of policies in force, principally as a result of adherence to our underwriting guidelines designed to minimize underwriting of classes of business that do not meet our target risk profiles and due to competitive pressures. Companywide, we expect to see a similar declining total premium trend in 2007, where consistent policy growth will reduce but not offset the decline in premium written in California and Nevada. It is uncertain how these trends will impact profitability.
Losses and LAE. Losses and LAE represent our largest expense item and include claim payments made, estimates for future claim payments and changes in those estimates for current and prior periods and costs associated with investigating, defending and adjusting claims. The quality of our financial reporting depends in large part on accurately predicting our losses and LAE, which are inherently uncertain as they are estimates of the ultimate cost of individual claims based on actuarial estimation techniques. In states other than Nevada, we have a short operating history and must rely on a combination of industry experience and our specific experience to establish our best estimate of losses and LAE reserves. The interpretation of historical data can be impacted by external forces, principally legislative changes, economic fluctuations and legal trends. In recent years, we experienced lower losses and LAE in California than we anticipated due to factors such as regulatory reform designed to reduce loss costs in that market and inflation. The joint marketing of our workers’ compensation insurance with Wellpoint’s health insurance products also assists in reducing losses since employees make fewer workers’ compensation claims because they are insured for non-work related illnesses or injuries and thus are less likely to seek treatment for a non-work related illness or injury through their employers’ workers’ compensation insurance carrier.
Underwriting and Other Operating Expense. Underwriting and other operating expense includes the costs to acquire and maintain an insurance policy (excluding commissions) consisting of premium taxes and certain other general expenses that vary with, and are primarily related to, producing new or renewal business. These acquisition costs are deferred and amortized to underwriting and other operating expense in the statement of income as the related premiums are earned. Other underwriting expenses consist of policyholder dividends and general administrative expenses such as salaries, rent, office supplies, depreciation and all other operating expenses not otherwise classified separately, and boards, bureaus and assessments of statistical agencies for policy service and administration items such as rating manuals, rating plans and experience data. The magnitude of our underwriting and other operating expense is a reflection of our operational efficiency in producing, underwriting and administering our business. We expect that our efficiency will be enhanced by the full implementation of our cost-effective and highly automated underwriting software program that allows for electronic submission and review of insurance applications, employing our underwriting standards and guidelines. However, the cost savings realized through such efficiencies may be offset, in whole or in part, by the potentially significant costs that we may incur in connection with the reporting and internal control requirements to which we will be subject under Federal securities laws and New York Stock Exchange listing requirements as a result of becoming a public company. For 2006, other operating expenses included a charge of $10.0 million for the
costs of the conversion from a mutual holding company to a public stock company. The Company is estimating that an additional $1.0 million will be incurred in 2007.
Accounting for workers’ compensation insurance requires us to estimate the liability for the expected ultimate cost of unpaid losses and LAE, referred to as loss reserves, as of a balance sheet date. We seek to provide estimates of loss reserves that equal the difference between the expected ultimate losses and LAE of all claims that have occurred as of a balance sheet date and amounts already paid. Management establishes the loss reserve based on its own analysis of emerging claims experience and environmental conditions in our markets and review of the results of various actuarial projection methods and their underlying assumptions. Our aggregate carried reserve for unpaid losses and LAE is a point estimate, which is the sum of our reserves for each accident year in which we have exposure. This aggregate carried reserve calculated by us represents our best estimate of our outstanding unpaid losses and LAE.
Case reserves are estimates of future claim payments based upon periodic case-by-case evaluation and the judgment of our claims adjusting staff, as applied at the individual claim level. Our claims
examiners determine these case reserves for reported claims on a claim-by-claim basis, based on the examiners’ judgment and experience and on our case reserving practices. We update and monitor our case reserves frequently as appropriate to reflect current information. Our case reserving practices account for the type of occupation or business, the circumstances surrounding the claim, the nature of the accident and of the resulting injury, the current medical condition and physical capabilities of the injured worker, the expected future course and cost of medical treatment and of the injured worker’s disability, the existence of dependents of the injured worker, policy provisions, the statutory benefit provisions applicable to the claim, relevant case law in the state, and potentially other factors and considerations.
• future claim payments in excess of case reserves on recorded open claims;
Our reserve for unpaid losses and loss adjustment expenses (gross and net), as well as the above-described main components of such reserves were as follows as of December 31:
weighting of differing reserve indications that result from alternative methods and assumptions. The adequacy of our ultimate loss reserves, which are based on estimates, is inherently uncertain and represents a significant risk to our business, which we attempt to mitigate through our claims management process and by monitoring and reacting to statistics relating to the cost and duration of claims. However, no assurance can be given as to whether the ultimate liability will be more or less than our loss reserve estimates.
We have retained an independent actuarial consulting firm, the Tillinghast business of Towers, Perrin, Forster and Crosby, Inc. (which we refer to in ‘‘-Results of Operations’’ as the ‘‘consulting actuary’’), to perform a comprehensive study of our losses and LAE liability semi-annually. The role of our consulting actuary as an advisor to management is to conduct sufficient analyses to produce a range of reasonable estimates, as well as a point estimate, of our unpaid losses and LAE liability, and to present those results to management. The consulting actuary also renders an opinion, as required by statutory financial reporting requirements, as to the reasonableness of our provision for unpaid losses and LAE.
For purposes of analyzing claim payment and emergence patterns and trends over time, we compile and aggregate our claims data by grouping the claims according to the year or quarter in which the claim occurred (‘‘accident year’’ or ‘‘accident quarter’’), since each such group of claims is at a different stage of progression toward the ultimate resolution and payment of those claims. The claims data is aggregated and compiled separately for different types of claims and/or claimant benefits. For our Nevada business, where a substantial detailed historical database is available from the Fund (from which our Nevada insurance subsidiary, EICN, assumed assets, liabilities and operations in 2000), these separate groupings of benefit types include death, permanent total disability, permanent partial disability, temporary disability, medical care and vocational rehabilitation. Third party subrogation recoveries are separately analyzed and projected. For other states such as California, where a substantial and detailed history on our book of business is not available, and where industry data is in a generally more aggregated form, the analyses are conducted separately for medical care benefits, and for all disability and death (also called ‘‘indemnity’’) benefits combined.
The consulting actuary selects and applies a variety of generally accepted actuarial methods to our data. The methods applied vary somewhat according to the type of claim benefit being analyzed. The primary methods utilized in recent evaluations are as follows:
Reported Bornhuetter-Ferguson Method. A method assigning partial weight to the initial expected losses and partial weight to observed reported loss dollars (paid losses plus case reserves). The weights assigned to the initial expected losses decrease as the accident year matures. This method is used to evaluate our other than Nevada business.
Reported Development Method. A method using historical, cumulative reported loss dollars by accident year and which develops those actual losses to estimated ultimate losses based upon the assumption that each accident year will develop to estimated ultimate cost in a manner that is analogous to prior years, adjusted as deemed appropriate for the expected effects of known changes in the workers’ compensation environment, and to the extent necessary supplemented by analyses of the development of broader industry data. This method is used to evaluate our other than Nevada business.
and movements of our claim counts and form the basis for the projection of the ultimate number of claims that will receive benefits payments for each benefit type.
The methods employed for each segment of claims data, and the relative weight accorded to each method, vary depending on the nature of the claims segment and on the age of the claims. For claim or benefit types that pay out for many years, and for the most recent accident periods in which the claims are relatively immature, more weight is given to methods that tend to produce more stable results by including initial expected losses or claim severities that are estimated in part by reliance on other accident years adjusted for inflation and other factors to the level of the accident year being analyzed.
methods applied because it is not likely, although it is possible, that the high or low result will emerge for every state, benefit type and accident year. The consulting actuary’s point estimate of unpaid losses and LAE is based on a judgmental selection for each benefit type from within the range of results indicated by the different actuarial methods.
Management formally establishes loss reserves for financial statement purposes on a quarterly basis. In doing so, we make reference to the most current analyses of our consulting actuary (which are conducted at June 30 and December 31 each year), including a review of the assumptions and the results of the various actuarial methods used by the consulting actuary; we monitor our claim reporting and claim payment activity, and consider the claim frequency and claim severity trends indicated by the claim activity as well as any emerging claims environment or operational issues that may indicate changing trends; we monitor workers’ compensation industry trends as reported by industry rate bureaus, in the media, and other similar sources; we monitor our recoveries from reinsurance and from other third party sources; we monitor the expenses of managing claims; and we monitor the characteristics of the business we have written in the current quarter and prior quarters, including characteristics such as geographical location, type of business, size of accounts, historical claims experience, and pricing levels.
Management determines the IBNR and LAE components of our loss reserves by establishing a point in the range of the consulting actuary’s most recent analysis of unpaid losses and LAE, which may be at a prior quarter-end, with the selection of the point based on management’s own view of recent and future claim emergence patterns, payment patterns, and trends, including: our view of the markets in which we are operating, including environmental conditions and changes in those markets; the characteristics of the business we have written in recent quarters; recent and pending recoveries from reinsurance; our view of trends in the future costs of managing claims; and other similar considerations as we view relevant.
best estimate relative to the consulting actuary’s point estimate from December 31, 2005 to December 31, 2006 increased losses and LAE expense incurred by $1.8 million for the year ended December 31, 2006.
The table below provides the consulting actuary’s range of estimated liabilities for unpaid losses and LAE and our carried reserves at the dates shown:
The major sources of this favorable development have been: actual paid losses have been less than expected and recalibration of selected patterns of claims emergence and claim payment used in the projection of future loss payment.
In Nevada, we have compiled a lengthy history of workers’ compensation claims payment patterns based on the business of the Fund and EICN, but the emergence and payment of claims in recent years has been more favorable than in the long-term history in Nevada with the Fund. The expected patterns of claim payment and emergence used in the projection of our ultimate claims payments are based on both the long-term and the short-term historical data. In recent evaluations, the selection of claim projection patterns has relied more heavily on the patterns observed in the short-term historical data, as recent years’ claims have continued to emerge in a manner consistent with that short-term historical data. Also, at each evaluation date, the projected claim payments underlying the prior loss reserves were replaced by the actual claim payment activity that occurred during the calendar year. The change in incurred losses and LAE attributable to prior years attributable to business in Nevada was $49.5 million, $29.9 million and $(3.9) million for the years ended December 31, 2004, 2005 and 2006, respectively.
We review our loss reserves each quarter and, as mentioned earlier, our consulting actuary assists our review by performing an actuarial analysis and projection of unpaid losses and LAE twice each year. We may adjust our reserves based on the results of our reviews and these adjustments could be significant. If we change our estimates, these changes are reflected in our results of operations during the period in which they are made. Our actual claims and LAE experience and emergence in recent years has been more favorable than anticipated in prior evaluations, although our California LAE has been higher than initially anticipated. Our insurance subsidiaries have been operating in a period of dramatically changing environmental conditions in our major markets, entry into new markets, and operational changes. During periods characterized by such changes, at each evaluation, the consulting actuary and management must make judgments as to the relative weight to accord to long-term historical and recent company data, external data, evaluations of environmental changes, and other factors in selecting the methods to use in projecting ultimate losses and LAE, the parameters to incorporate in those methods, and the relative weights to accord to the different projection indications. Since the loss reserves are providing for claim payments that will emerge over many years, if management’s projections and loss reserves were
In recent years, emerging claims costs and claim emergence and payment patterns have improved dramatically. The largest driver of this improvement has been California reform. As we observe continuing improvement in development, we have given significant weight to this emerging trend in projecting and selecting estimated ultimate losses and LAE. The amount of weight to allocate between the emerging trend and historical benchmark patterns is judgmental. We have given significant weight to the emerging trends in our selection of loss reserves as of December 31, 2006. However, recent data points from our business in California, as well as from insurance industry experience for California workers’ compensation, indicate emergence patterns more favorable than those implicitly underlying our loss reserves. If future emergence matches those more favorable patterns, our current loss reserves could develop favorably over time. If future claims emergence more closely resembles long term historical industry patterns, then our current loss reserves could develop unfavorably over time. In Nevada, we have seen a significant improvement in claims emergence and claims payment patterns in recent years, and have given these improved patterns significant weight in establishing loss reserves for our Nevada business. If future emergence in Nevada more closely resembles long term historical patterns of the predecessor Fund, then our current loss reserves could develop unfavorably over time.
More than 46% of our claims payments during the three years ended December 31, 2006 has related to medical care for injured workers. The utilization and cost of medical services in the future is a significant source of uncertainty in the establishment of loss reserves for workers’ compensation. In recent years, our medical costs per claim have been rising at an average rate of approximately 6.5% per year. Some of our projection methods include explicit assumptions about future medical claim cost inflation. In
Reinsurance recoverables represent: (1) amounts currently due from reinsurers on paid losses and LAE, (2) amounts recoverable from reinsurers on case basis estimates of reported losses and (3) amounts recoverable from reinsurers on actuarial estimates of IBNR for losses and LAE. These recoverables, by necessity, are based upon our current estimates of the underlying losses and LAE, and are reported on our balance sheet separately as assets, as reinsurance does not relieve us of our legal liability to policyholders. We bear credit risk with respect to the reinsurers, which can be significant considering that some of the unpaid losses and LAE remain outstanding for an extended period of time. Reinsurers might refuse or fail to pay losses that we cede to them, or they might delay payment. We are required to pay losses even if a reinsurer refuses or fails to meet its obligations under the applicable reinsurance agreement. We continually monitor the financial condition and rating agency ratings of our reinsurers. We require reinsurers that are not admitted reinsurers in Nevada and California (where EICN and ECIC, respectively, are domiciled) to collateralize their share of the unearned premiums and unpaid loss reserves in order that our insurance subsidiaries receive credit for reinsurance on their statutory financial statements. Since our inception in 2000, no material amounts due from reinsurers have been written-off as uncollectible and, based on this experience, we believe that amounts currently reflected in our consolidated financial statements will similarly require no material prospective adjustment.
Under the LPT Agreement, the Fund initially ceded $1.525 billion in liabilities for the incurred but unpaid losses and LAE related to claims incurred prior to July 1, 1995, for consideration of $775 million in cash. As of December 31, 2006, the estimated remaining liabilities subject to the LPT Agreement were approximately $1.0 billion. Losses and LAE paid with respect to the LPT Agreement totaled approximately $364.5 million at December 31, 2006.
We use the liability method of accounting for income taxes. Under this method, deferred income tax assets and liabilities are recognized for the future tax consequences attributed to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities resulting from a tax rate change impacts our net income or loss in the reporting period that includes the enactment date of the tax rate change. Our income tax returns are subject to audit by the Internal Revenue Service and various state tax authorities. Significant disputes may arise with these tax authorities involving issues of the timing and amount of deductions and allocations of income among various tax jurisdictions because of differing interpretations of tax laws and regulations. We periodically evaluate our exposures associated with tax filing positions. Although we believe our positions comply with applicable laws, we record liabilities based upon estimates of the ultimate outcomes of these matters.
Our investments in fixed maturity investments and equity securities are classified as available-for-sale and are reported at fair value with unrealized gains and losses excluded from earnings and reported in a separate component of equity, net of deferred taxes as a component of accumulated other comprehensive income.
• how long and by how much the fair value of the security has been below its cost;
• any downgrades of the security by a rating agency; and
Gross Premiums Written. Gross premiums written is the sum of both direct premiums written and assumed premiums written before the effect of ceded reinsurance and the intercompany pooling agreement. Direct premiums written represent the premiums on all policies our insurance subsidiaries have issued during the year. Assumed premiums written represent the premiums that our insurance subsidiaries have received from an authorized state-mandated pool or under previous fronting facilities. The primary fronting facility was between ECIC and Clarendon and that arrangement is now in run-off. We use gross premiums written, which excludes the impact of premiums ceded to reinsurers, as a measure of the underlying growth of our insurance business from period to period.
Net Premiums Earned. Net premiums earned represents that portion of net premiums written equal to the expired portion of the time for which insurance protection was provided during the financial year and is recognized as revenue. Net premiums earned are used to calculate the losses and LAE, underwriting and other operating expense and combined ratios, as indicated below.
Underwriting and Other Operating Expense Ratio. The underwriting and other operating expense ratio is the ratio (expressed as a percentage) of underwriting and other operating expense to net premiums earned, and measures an insurance company’s operational efficiency in producing, underwriting and administering its insurance business.
Net Premiums Written. Net premiums written decreased $52.5 million or 11.9%, to $387.2 million for the year ended December 31, 2006 from $439.7 million for the year ended December 31, 2005. The decrease was primarily attributable to a $56.9 million decrease in gross premiums written. This decrease was partially offset by a reduction in ceded premiums. Ceded premiums for the year ended December 31, 2006 totaled $14.6 million, or 3.6%, of gross premiums written as compared to $19.0 million, or 4.1%, of gross premiums written for the year ended December 31, 2005. The decrease in ceded premiums was due to favorable market trends in reinsurance rates and an increase in the amount of risk we retained under the excess of loss reinsurance treaty, which is reset on June 30 of each year.
were 33.0% and 48.3% of net premiums earned for the years ended December 31, 2006 and 2005, respectively. The majority of the decrease was due to a 10.9 percentage point downward adjustment in our current accident year loss estimate from 76.1% for the year ended December 31, 2005 to 65.2% for the year ended December 31, 2006. This adjustment was made after observation of several successive quarters of reduced loss development in California due to the impact of regulatory reforms designed to control loss costs.
The table below reflects the losses and LAE reserve adjustments for the years and quarters ended December 31, 2006 and 2005:
The favorable prior accident year reserve development totaled $107.1 million for the year ended December 31, 2006 compared to $105.0 million (including $26.9 million favorable development on the direct reserves subject to the LPT Agreement) for the year ended December 31, 2005. In the fourth quarter 2006, the favorable prior year accident year development was $25.4 million, offset by a year end increase to the current accident year reserves of $5.0 million. There was no adjustment in this period to the direct reserves subject to the LPT Agreement. Fourth quarter 2005 had favorable prior accident year development of $51.5 million in addition to the $26.9 million favorable losses development for LPT Agreement offset by a year end increase to the current accident year reserves of $5.5 million. Losses and LAE include amortization of deferred reinsurance gain-LPT Agreement of $19.4 million and $16.9 million in the year ended December 31, 2006 and 2005, respectively. Excluding the impact from the LPT Agreement, losses and LAE would have been $149.1 million and $255.4 million, or 37.9% and 58.3% of net premiums earned, for the years ended December 31, 2006 and 2005, respectively. Fourth quarter losses and LAE include amortization of deferred reinsurance gain-LPT Agreement of $4.8 million and $1.4 million for the three months ended December 31, 2006 and 2005, respectively.
consultants for strategy planning for $1.5 million and the use of consultants for post-implementation work of $1.3 million on the new underwriting system.
Income Taxes. Income taxes increased $52.3 million, or 172.2%, to $82.7 million for the year ended December 31, 2006 from $30.4 million for the year ended December 31, 2005. The increase in income taxes was due to an $86.3 million increase in pre-tax income (including a realized gain of $49.2 million from the investment portfolio reallocation) for the year ended December 31, 2006 resulting in an additional $30.2 million income tax expense. The expense was also impacted by the tax treatment of the non-deductible conversion cost of $10.0 million and non-taxable pre-Privatization and LPT Agreement reserve adjustments. The year ended December 31, 2005 included an increase to income of approximately $48.5 million; related to favorable reserve adjustments (non-taxable pre-Privatization and LPT Agreement reserve adjustments) that did not increase taxable income for the period. The effective tax rate for the year ended December 31, 2006 was 32.5% compared to 18.1% for the same period in 2005. The effective tax rate was impacted by the items noted above in addition to the impact of tax exempt interest and dividends received deductions.
Commission Expense Ratio. The commission expense ratio increased 1.6 percentage points, to 12.3%, for the year ended December 31, 2006 from 10.7% for the year ended December 31, 2005. The commission expense ratio increase was primarily due to a decrease in the contingent commission income from the LPT Agreement, in combination with the impact of premium rate declines in California, the result of regulatory reforms and a commission rate increase as discussed under ‘‘-Commission Expense’’ above.
There is a corresponding change to the reinsurance recoverables on unpaid losses as well as the deferred reinsurance gain. A cumulative adjustment to the amortization of the deferred gain is also then recognized in earnings so that the deferred reinsurance gain reflects the balance that would have existed had the revised reserves been recognized at the inception of the LPT Agreement. See Note 2 in the Notes to our Consolidated Financial Statements which are included elsewhere in this report.
Gross Premiums Written. Gross premiums written increased $21.0 million, or 4.8%, in 2005 to $458.7 million from $437.7 million in 2004. The increase in gross premiums written in 2005 was primarily due to an increase of 1,681 in the number of in force policies of 27,686 for the year ended December 31, 2005 as compared to 26,005 for the year ended December 31, 2004. The increase of our in force policy count can be attributed largely to growth in the number of policies written through our strategic distribution partnerships, which accounted for 62.0% of the in force policy count increase. The average in force policy premium decreased slightly to $14,618 in 2005 from $15,773 in 2004.
Other Income. Other income increased $0.9 million, or 32.7%, to $3.9 million in 2005 compared to $3.0 million in 2004. The increase in other income was primarily attributable to interest income earned on assets held in trust related to our fronting facility with Clarendon.
Losses and LAE. Losses and LAE decreased $17.5 million, or 7.6%, to $211.7 million in 2005 from $229.2 million in 2004. Losses and LAE were 48.3% and 55.9% of net premiums earned in 2005 and 2004, respectively. The decrease was primarily the net result of favorable development on prior accident year reserves, totaling $78.1 million. Losses and LAE include amortization of deferred reinsurance gain-LPT Agreement of $16.9 million and $20.3 million in 2005 and 2004, respectively, and change in LPT Agreement ceded reserves of $26.9 million and $2.4 million in 2005 and 2004, respectively. The increase in the reduction in the ceded reserves related to the LPT Agreement was due to continued favorable loss development. Excluding these items, losses and LAE would have been $255.4 million and $252.0 million, or 58.3% and 61.4% of net premiums earned, in 2005 and 2004, respectively.
Commission Expense. Commission expense decreased $8.5 million, or 15.3%, to $46.9 million in 2005 from $55.4 million in 2004. Commission expense was 10.7% and 13.5% of net premiums earned in 2005 and 2004, respectively. The commission expense decrease was primarily due to reduced fronting facility fee expenses of $3.6 million. We entered into a fronting facility in July 2002 in connection with the Fremont acquisition. The entry into the inter-company reinsurance pooling agreement allowed us to exit the fronting arrangement with Clarendon and thereby reduced fronting fees in 2003 and eliminate or pay
Net Income. Net income increased $42.0 million, or 44.0%, to $137.6 million in 2005 from $95.6 million in 2004. Net income was significantly impacted by our losses and LAE relative to the net premiums earned as indicated by losses and LAE ratios of 48.3% and 55.9% in 2005 and 2004, respectively. Net income includes amortization of deferred reinsurance gain-LPT Agreement of $16.9 million and $20.3 million in 2005 and 2004, respectively, and change in LPT Agreement ceded reserves of $26.9 million and $2.4 million in 2005 and 2004, respectively. Excluding these items, net income would have been $93.8 million and $72.8 million in 2005 and 2004, respectively.
We present net income before impact of LPT Agreement because we believe that it is an important supplemental measure of operating performance to be used by analysts, investors and other interested parties in evaluating us. The LPT Agreement was a non-recurring transaction which does not result in ongoing cash benefits and consequently we believe this presentation is useful in providing a meaningful understanding of our operating performance. In addition, we believe this non-GAAP measure, as we have defined it, is helpful to our management in identifying trends in our performance because the excluded item has limited significance in our current and ongoing operations.
Gross Premiums Written. Gross premiums written increased $100.6 million, or 29.8%, to $437.7 million in 2004 from $337.1 million in 2003. In force policy count increased by approximately 1,000 between December 31, 2004 and December 31, 2003. This increase was principally attributable to an increase in the number of in force policies associated with our strategic distribution partnerships, which increased by 16% in 2004 compared to 2003, partially offset by a 17.8% decrease in force policy counts in Nevada in 2004 as compared to 2003. In addition, in 2004, the average premium per in force policies increased $1,436 to $15,773 from $14,337 in 2003, primarily due to the elimination of smaller accounts in Nevada.
Other Income. Other income increased $1.4 million, or 84.1%, to $3.0 million in 2004 from $1.6 million in 2003. The increase in other income was primarily attributable to interest income derived from the funds withheld related to our fronting facility with Clarendon.
Losses and LAE. Losses and LAE increased $111.1 million, or 94.1%, to $229.2 million in 2004 from $118.1 million in 2003. Losses and LAE were 55.9% and 39.6% of net premiums earned in 2004 and 2003, respectively. The increase in losses and LAE was primarily due to favorable reserve development on prior accident years recorded in 2003 of $69.2 million. Losses and LAE include amortization of deferred reinsurance gain-LPT Agreement of $20.3 million and $19.0 million in 2004 and 2003, respectively, and change in LPT Agreement ceded reserves of $2.4 million and $31.1 million in 2004 and 2003, respectively. Excluding these items, losses and LAE would have been $252.0 million and $168.2 million, or 61.4% and 56.4% of net premiums earned, in 2004 and 2003, respectively.
Commission Expense. Commission expense decreased $0.9 million, or 1.7%, to $55.4 million in 2004 from $56.3 million in 2003. Commission expense was 13.5% and 18.9% of net premiums earned in 2004 and 2003, respectively. The change in commission expense was nominal from 2004 to 2003.
Commission Expense Ratio. The commission expense ratio decreased by 5.4 percentage points, to 13.5%, in 2004 from 18.9% in 2003. The decrease was primarily due to the nominal change of $0.9 million in overall commission expenses in 2004 over 2003 and the increase in net premiums earned of $112.1 million.
Parent Company. The primary source of cash for Employers Holdings is dividends received from our insurance subsidiaries. The primary uses of cash are expected to be dividend payments on our common stock, repurchases of our common stock as described in ‘‘-Stock Repurchases’’ and parent holding company expenses. Our board of directors has authorized the payment of a dividend of $0.06 per share of our common stock per quarter to our stockholders of record beginning in the second quarter of 2007. Any determination to pay dividends will be at the discretion of our board of directors and will be dependent upon our subsidiaries’ payment of dividends and/or other statutorily permissible payments to us, our results of operations and cash flows, our financial position and capital requirements, general business conditions, any legal, tax, regulatory and contractual restrictions on the payment of dividends (including those described under ‘‘Regulation-Financial, Dividend and Investment Restrictions’’), and any other factors our board of directors deems relevant. There can be no assurance that we will declare
and pay any dividends. Management also intends to recommend to our board of directors that the board authorize a stock repurchase program. See ‘‘-Stock Repurchases.’’ There can be no assurance that we will undertake any repurchases of our common stock pursuant to the program.
Both internal and external forces influence our financial condition, results of operations and cash flows. Claims settlements, premium rate levels and investment returns may be impacted by changing rates of inflation and other economic conditions. In many cases, significant periods of time, ranging up to several years or more, may lapse between the occurrence of an insured loss, the reporting of the loss to us and the settlement of the liability for that loss. The exact timing of the payment of claims and benefits cannot be predicted with certainty. In addition, catastrophe claims, the timing and amount of which are inherently unpredictable, may create increased liquidity requirements.
We believe that our liquidity needs through 2008, including remaining expenses with respect to our information technology systems of approximately $6 million, arising in the ordinary course of business at both the parent holding company and insurance subsidiary levels will be met from all of the above sources. We are not currently planning to make significant capital expenditures in 2007 or 2008, and we believe we do not need additional surplus to support our near-term growth strategy.
Nevada law limits the payment of cash dividends by EICN to its immediate holding company by providing that payments cannot be made except from available and accumulated surplus money otherwise unrestricted (unassigned) and derived from realized net operating profits and realized and unrealized capital gains. A stock dividend may be paid out of any available surplus. A cash or stock dividend otherwise prohibited by these restrictions may be declared and distributed upon the prior approval of the Nevada Commissioner of Insurance, except that prior notice of extraordinary distributions by EICN to its intermediate holding company must be given to the Nevada Commissioner of Insurance who must approve or disapprove the distribution within 30 days of such notice.
at the preceding December 31; or (b) 100% of the net income for the preceding year. The maximum pay-out that may be made by ECIC to EICN during 2007 without prior approval is $61.0 million. California regulations require that in addition to applying the NAIC’s statutory accounting practices, insurance companies must record, under certain circumstances, an additional liability, called an ‘‘excess statutory reserve.’’ If the workers’ compensation losses and LAE ratio is less than 65% in each of the three most recent accident years, the difference is recorded as an excess statutory reserve. The excess statutory reserves required by such regulations reduced ECIC’s statutory-basis surplus by $33.9 million to $314.1 million at December 31, 2006, as filed with and reported to the regulators. The excess statutory reserves required by such regulations reduced ECIC’s statutory-basis surplus by $7.5 million to $277.2 million at December 31, 2005, as filed with and reported to the regulators. There were no excess statutory reserves for December 31, 2004.
On October 17, 2006, the Nevada Division of Insurance granted EICN permission to pay us up to an additional $55 million in one or more extraordinary dividends subsequent to the successful completion of the initial public offering and before December 31, 2008. The payment of such dividends is conditioned upon the expiration of the underwriters’ over-allotment option period, prior repayment of any expenses of the Company and its subsidiaries arising from the conversion and the initial public offering, the exhaustion of any proceeds retained by Employers Holdings, Inc. from the recently completed initial public offering, maintaining such RBC total adjusted capital in EICN of above a specified level on the date of declaration and payment of any particular extraordinary dividend after taking into account the effect of such dividend, and maintaining all required filings with the Nevada Division of Insurance. The dividend may be used to pay dividends to stockholders, to repurchase stock and/or general corporate purposes, other than to increase executive compensation.
We monitor cash flows at both the consolidated and subsidiary levels. We use trend and variance analyses to project future cash needs making adjustments to the forecasts when needed.
Cash Flows For the Year Ended December 31, 2006 and 2005. The key changes of the net cash inflow of $18.9 million for the year ended December 31, 2006 were the net cash provided by operations of $121.8 million, net investment purchases of $99.8 million and $3.1 million in cash used for financing activities compared to net cash from operations of $258.1 million and net investment purchases of $257.4 million for the year ended December 31, 2005. The decrease in net cash from operations for the year ended December 31, 2006 was due to a decrease in premiums received of $393.3 million, as compared to premiums received of $447.4 million for the year ended December 31, 2005. There was also an increase in the income taxes paid from $72.3 million for the year ended December 31, 2006 compared to income taxes paid in year ended 2005 of $14.9 million. The net investment purchases decreased as a result of the change in operating cash flows. The Company also had $3.1 million in cash used for financing activities related to the direct costs of the initial public offering.
Cash Flows For the Year Ended December 31, 2005 and 2004. The key changes of the net cash inflow of $0.7 million for the year ended December 31, 2005 were due to the increase of premiums received of $447.4 million, as compared to premiums received of $415.7 million for the year ended December 31, 2004.
Management intends to recommend to our board of directors that the board authorize a stock repurchase program of up to an aggregate amount of $75 million of our shares of common stock in 2007 and up to an aggregate amount of $50 million of our shares of common stock in 2008. If the program is authorized, we may make purchases of our common stock under the program up to such amounts from time to time, in the open market or in privately negotiated transactions, at such prices and on such terms as may be determined by our board of directors (or an authorized committee of our board of directors) out of funds legally available therefore and subject to applicable law.
The actual amount of stock repurchased, if any, will be subject to the discretion of our board of directors and will be dependent on various factors, including market conditions, legal, tax, regulatory and contractual restrictions on repurchases (including legal restrictions affecting the amount and timing of repurchase activity), our capital position, the performance of our investment portfolio, our results of operations and cash flows, our financial position and capital requirements, general business conditions, alternative potential investment opportunities available to us and any other factors our board of directors deems relevant. There can be no assurance that we will undertake any repurchases of our common stock pursuant to the program.
We employ an investment strategy that emphasizes asset quality and the matching of maturities of our fixed maturity securities against anticipated claim payments and expenditures or other liabilities. The amounts and types of our investments are governed by statutes and regulations in the states in which our
We classify our portfolio of equity securities as available-for-sale and carry these securities on our balance sheet at fair value. Accordingly, changes in market prices of the equity securities we hold in our combined investment portfolio result in increases or decreases in our total assets. In order to minimize our exposure to equity price risk, we invest primarily in equity securities of mid-to-large capitalization issuers and seek to diversify our equity holdings across several industry sectors. Our objective during the past few years has been to reduce equity exposure as a percentage of our total portfolio by increasing our fixed maturity securities. We target a maximum exposure of 15% of our total combined investment portfolio in equity securities.
Our investment strategy focuses on maximizing economic value through dynamic asset and liability management, subject to regulatory and rating agency constraints, at the consolidated and individual company level. The fixed maturity securities portion of our portfolio maintains a duration target of five years and a tax-exempt securities capacity of not more than 60% of the total fixed maturity securities portfolio. The equity allocation target is 6% of the total portfolio. Our equity allocation at September 30, 2006 was above our target of 6% and at the maximum exposure of 15% of our total combined investment portfolio, per our current investment policy. We evaluated our portfolio equity allocation during the fourth quarter of 2006 and elected to reduce the amount allocated to equity securities to the target level during that period. Reducing our equity allocation has the effect of decreasing expected surplus volatility (because under statutory accounting principles, equity securities are carried at fair value with the unrealized gains/losses charged directly to surplus, in contrast to fixed income securities which are carried at amortized cost with no impact on surplus due to changes in fair value) and increasing portfolio income in the fourth quarter of 2006. Equity sales of $169.2 million related to the portfolio reallocation generated taxable gains of $49.2 million. Previous to the sales, these equity securities were recorded on the balance sheet at fair value, with unrealized gains recognized as a component of accumulated other comprehensive income in the consolidated statements of equity. These sales did not materially increase assets or equity.
Based on a review of the fixed maturity securities included in the tables set forth below, we determined that the unrealized losses were a result of the interest rate environment and not the credit quality of the issuers. Therefore, as of December 31, 2006 and 2005, none of the fixed maturity securities whose fair value was less than amortized cost were considered to be other-than-temporarily impaired given the severity and duration of the impairment, the credit quality of the issuers and our intent and ability to hold the securities until fair value recovers above costs.
Based on a review of the investment in equity securities included in the tables set forth below, except for the $0.6 million in the fair values of six of the equity holdings, we determined that the unrealized losses were not considered to be other-than-temporary due to the financial condition and the near term prospects of the issuers.
Our current analysis of impaired investments complies with the provisions of Financial Accounting Standards Board (FASB) Staff Position (FSP) FAS No. 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, effective for reporting periods beginning subsequent to December 15, 2005. Therefore, the adoption of FSP 115-1 did not have a significant impact on our consolidated financial position and results of operation.
The cost or amortized cost, gross unrealized gains, gross unrealized losses and estimated fair value of our investments were as follows:
The amortized cost and estimated fair value of fixed maturity investments at December 31, 2006 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The following is a summary of investments with unrealized losses and their corresponding fair values at December 31, 2005 and 2006:
We are required by various state regulations to keep securities or letters of credit on deposit with the states in which we do business in a depository account. At December 31, 2006 and 2005, securities having a fair market value of $414.6 million and $195.9 million, respectively, were on deposit. Additionally, certain reinsurance contracts require Company funds to be held in trust for the benefit of the ceding reinsurer to secure the outstanding liabilities assumed by the Company. The fair market value of securities held in trust at December 31, 2006 and 2005 was $5.6 million and $55.9 million, respectively.
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, (FIN 48). Among other things, FIN 48 creates a model to address uncertainty in tax positions and clarifies the accounting for income taxes by prescribing a minimum recognition threshold which all income tax positions must achieve before being recognized in the financial statements. In addition, FIN 48 requires expanded annual disclosures, including a tabular rollforward of the beginning and ending aggregate unrecognized tax benefits as well as specific detail related to tax uncertainties for which it is reasonably possible the amount of unrecognized tax benefit will significantly increase or decrease within
12 months. FIN 48 is effective for us as of January 1, 2007. Any differences between the amounts recognized in the statements of financial position prior to the adoption of FIN 48 and the amounts reported after adoption are generally accounted for as a cumulative-effect adjustment recorded to the beginning balance of retained earnings. We expect that the adoption of FIN 48 will not have a material impact on our consolidated financial position and results of operations.
Audited Financial Statements as of December 31, 2006 and 2005 and for each of the three years in the period ended December 31, 2006:
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Employers Holdings, Inc. and Subsidiaries at December 31, 2006 and 2005, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
Employers Holdings, Inc. (EHI), formerly EIG Mutual Holding Company (EMHC), a Nevada mutual holding company, was formed effective April 1, 2005, as part of a reorganization of Employers Insurance Company of Nevada (EICN), formerly Employers Insurance Company of Nevada, a Mutual Company (the reorganization plan). As part of the approved reorganization plan, EICN changed its legal structure from a Nevada mutual insurance company to a Nevada stock insurance company. The mutual members’ rights were exchanged for members’ rights in the newly formed EMHC. EMHC was issued 100% of the stock in the newly formed Employers Group, Inc. (EGI), formally Employers Insurance Group, Inc., a Nevada stock holding company, which in turn owns 100% of the newly issued stock of EICN. Prior to January 1, 2000, EICN was an independent public agency of the state of Nevada and a fund of the Nevada State Insurance Fund (the Fund). As of January 1, 2000, all of the assets were transferred from the Fund to EICN and EICN assumed all the liabilities related to the transferred assets (the Privatization).
The accompanying consolidated financial statements have been prepared in accordance with U. S. generally accepted accounting principles (GAAP), and include the financial statements of EICN and its affiliated companies (ECIC, Elite and EOHI) for the periods prior to the formation of EMHC. This presentation is used because the reorganization described above did not have a material financial impact on the companies, as the net assets transferred to achieve the change in legal organization were accounted for at historical carrying amounts. All intercompany transactions and balances have been eliminated in consolidation.
The Company’s investments in fixed maturity investments and equity securities are classified as available-for-sale and are reported at fair value with unrealized gains and losses excluded from earnings and reported in a separate component of equity, net of deferred taxes as a component of accumulated other comprehensive income.
Short-term investments include investments with remaining maturities of one year or less at the time of acquisition and are principally stated at cost or amortized cost, which approximates fair value.
The Company writes a relatively small number of workers’ compensation policies that are retrospectively rated. Under this type of policy, subsequent to policy expiration, the policyholder may be entitled to a refund or may owe additional premium based on the amount of losses sustained under the policy. These retrospective premium adjustments are limited in the amount by which they increase or decrease the standard amount of premium applicable to the policy.
The Company estimates accrued retrospective premium adjustments through the review of each individual retrospectively rated risk, comparing case basis loss development with that anticipated in the
The Company establishes an allowance for bad debts (bad debt allowance) on its premiums receivable through a charge to allowance for bad debt, included in underwriting and other operating expense in the accompanying consolidated statements of income. This bad debt allowance is determined based on estimates and assumptions to project future experience. After all collection efforts have been exhausted, the Company reduces the bad debt allowance for write-offs of premiums receivable that have been deemed uncollectible. The Company periodically reviews the adequacy of the bad debt allowance and makes adjustments as necessary. Future additions to the bad debt allowance may be necessary based on changes in the general economic conditions and the policyholders’ financial conditions. The Company had a net recovery of amounts previously written off of $0.4 million, $0.7 million and $2.2 million for the years ended December 31, 2006, 2005 and 2004, respectively.
A premium deficiency is recognized if the sum of expected claims costs, claims adjustment expenses, expected dividends to policyholders, unamortized acquisition costs and policy maintenance costs exceed the related unearned premiums. A premium deficiency would first be recognized by charging any unamortized acquisition costs to expense to the extent required to eliminate the deficiency. If the premium deficiency was greater than unamortized acquisition costs, a liability would be accrued for the excess deficiency. There was no premium deficiency at December 31, 2006 or 2005.
Policyholders’ Dividends Accrued: EICN writes workers’ compensation policies for which the policyholder may participate in favorable claims experience through a dividend. An estimated provision for workers’ compensation policyholders’ dividends is accrued as the related premiums are earned. Dividends are calculated and paid after policy expiration, usually within nine and twelve months after such expiration and must be approved by the Board of Directors of EICN. The liability is estimated based on the expected loss experience of the policies written with dividend provisions and policy terms. Policyholders’ dividends paid for the years ended December 31, 2006, 2005 and 2004, were $0.8 million, $1.4 million and $2.8 million, respectively. Policyholder dividends are included in underwriting and other operating expense in the accompanying consolidated statements of income.
In the ordinary course of business and in accordance with general insurance industry practices, the Company purchases excess of loss reinsurance to protect the Company against the impact of large, catastrophic losses in its workers’ compensation business. Additionally, the Company is a party to a 100% quota share retroactive reinsurance agreement (see Note 7). Such reinsurance reduces the magnitude of
Ceded premiums, losses and LAE are accounted for on a basis consistent with those used in accounting for the original policies issued and the terms of the relevant reinsurance agreement.
The 100% quota share retroactive reinsurance agreement was entered into in 1999 by the Nevada State Industrial Insurance System (the Fund) and assumed by EICN, which the Company refers to as the Loss Portfolio Transfer (LPT) Agreement (see Note 7). The Company is accounting for this transaction as retroactive reinsurance, whereby the initial deferred gain resulting from the retroactive reinsurance was recorded as a liability in the accompanying consolidated balance sheets as Deferred Reinsurance Gain - LPT Agreement and is being amortized using the recovery method, whereby the amortization is determined by the proportion of the actual reinsurance recoveries to total estimated recoveries. The amortization of the deferred gain is recorded in losses and LAE incurred in the accompanying consolidated statements of income. Any adjustment to the estimated reserves ceded under the LPT Agreement is recognized in earnings in the period of change with a corresponding change to reinsurance recoverables on the unpaid losses and deferred reinsurance gain. A cumulative amortization adjustment is also then recognized in earnings so that the deferred reinsurance gain reflects the balance that would have existed had the revised reserves been available at the inception of the LPT Agreement.
Property and equipment are stated at cost less accumulated depreciation. Expenditures for maintenance and repairs are charged against operations as incurred.
Electronic data processing equipment, operating software and non-operating software are depreciated using the straight-line method over three years. Leasehold improvements are carried at cost less accumulated amortization. The Company amortizes leasehold improvements using the straight-line method over the lesser of the useful life of the asset or the remaining original lease term, excluding options or renewal periods. Leasehold improvements are generally depreciated over three to five years. Other furniture and equipment is depreciated using the straight-line method over three to seven years.
Estimated fair value amounts, defined as the quoted market price of a financial instrument, have been determined using available market information and other appropriate valuation methodologies. However, considerable judgments are required in developing the estimates of fair value where quoted market prices are not available. 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 in these notes:
Investments: The estimated fair values for available-for-sale securities generally represent quoted market value prices for securities traded in the public marketplace or estimated values for securities not traded in the public marketplace. Additional data with respect to fair values of the Company’s investment securities are disclosed in Note 3.
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48). Among other things, FIN 48 creates a model to address uncertainty in tax positions and clarifies the accounting for income taxes by prescribing a minimum recognition threshold which all income tax
The cost or amortized cost, gross unrealized gains, gross unrealized losses and estimated fair value of the Company’s investments were as follows:
The amortized cost and estimated fair value of fixed maturity investments at December 31, 2006, by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Based on a review of the investment in equities as of December 31, 2006, the Company recognized an impairment of $0.6 million in the fair values of six securities, as a result of the severity and duration of the market decline in those securities. For its other equity securities, the Company determined that the unrealized losses were not considered to be other-than-temporary due to the financial condition and near term prospects of the issuers. As of December 31, 2005, the Company determined that the unrealized losses were not other-than-temporary due to the financial condition and near term prospects of the issuers.
Prior to the Privatization, the Fund was a part of the State of Nevada and therefore was not subject to federal income tax; accordingly, it did not take an income tax deduction with respect to the establishment of its unpaid losses and LAE reserves. Due to favorable loss experience after the Privatization, it was determined that certain of the pre-Privatization unpaid loss and LAE reserves assumed by EICN as part of the Privatization were no longer necessary and the unpaid loss and LAE reserves were reduced accordingly. This downward adjustment of such pre-Privatization unpaid loss reserves in the years ended December 31, 2005 and 2004 increased the GAAP net income, as reported in the accompanying consolidated statements of income, but did not increase taxable income for those periods. For the year ended December 31, 2006, there was an increase to the Pre-privatization unpaid loss reserves that decreased GAAP net income, but did not decrease taxable income for the period.
The significant components of the deferred income taxes, net were as follows as of December 31:
The estimate of the future cost of handling claims, or LAE, depends primarily on examining the relationship between the aggregate amount that has been spent on LAE historically, as compared with the dollar volume of claims activity for the corresponding historical periods. For the Company’s business in Nevada, as a result of operational improvements and reductions in staff count to align with the current and anticipated volume of business in the state, the Company’s expenditures on LAE in recent years have been lower than historical levels. As these operational improvements and staffing levels have been reflected in the actual emerging LAE expenditures and in the projection of future LAE, the estimates of future LAE have been reduced at December 31, 2006, 2005 and 2004. For the Company’s operations in California, initial expectations of LAE when operations commenced in California were based on the assumptions used by the Company in pricing the California business, and on some limited historical data for the market segments the Company was entering. As the Company’s operations in California have matured, and as data relating to the Company’s and industry claim handling expenses reflective of the new workers’ compensation benefit environment in California have become available, the expectations of LAE underlying the projection of future LAE have been adjusted to reflect that actual costs of administering claims have been greater than the initial expectations. This has resulted in an increase in the projected future cost of administering California claims at December 31, 2006, 2005 and 2004. The changes in the Company’s estimates of the cost of future LAE in California and Nevada are included in the California and Nevada development results cited in the preceding two paragraphs.
The Company maintains reinsurance for losses from a single occurrence or event in excess of $4.0 million up to $175.0 million. The reinsurance coverage includes coverage for acts of terrorism, excluding nuclear, biological, chemical and radiological events.
Recoverables from reinsurers on unpaid losses and LAE amounted to $1.1 billion at December 31, 2006 and 2005. At December 31, 2006 and 2005, approximately $1.0 billion and $1.1 billion, respectively, of the recoverables related to the LPT Agreement entered into in 1999 by the Fund and assumed by EICN, whereby substantially all of the Fund losses and LAE on claims incurred prior to July 1, 1995, have been ceded to three unaffiliated reinsurers on a 100% quota share basis. Investments have been placed in trust by the three reinsurers as security for payment of the reinsured claims. Under the LPT Agreement, $1.5 billion in liabilities for the incurred but unpaid losses and LAE related to claims incurred prior to July 1, 1995, were reinsured for consideration of $775.0 million. The LPT Agreement provides coverage up to $2.0 billion. Through December 31, 2006, the Company has paid losses and LAE claims totaling $364.5 million related to the LPT Agreement.
The LPT Agreement allows the Company to receive a contingent profit commission from the participating reinsurers based on the actual loss experience of the ceded business. Pursuant to the LPT Agreement and based on both actual results to date and projections of ultimate losses under the agreement, the Company recorded a decrease of $0.2 million for the twelve months ended
December 31, 2006, an increase of $3.8 million for 2005 and a decrease of $1.5 million for 2004, in its estimate of the ultimate contingent profit commission. The increases (decreases) in the ultimate contingent profit commission are recorded in commission expense in accompanying consolidated statements of income. Due to payments received under the terms of the LPT Agreement the Company had a net payable balance of $6.3 million and $6.1 million as of December 31, 2006 and 2005, respectively, which is included in other liabilities on the accompanying consolidated balance sheets.
The Company has 14 leased facilities, which include several subleased spaces, located in Nevada, California, Arizona, Colorado, Florida, Idaho, Illinois and Utah. At December 31, 2006, remaining lease terms ranged from one month to approximately six years and sublease terms ranged from three months to approximately five years. The minimum lease payments for the next five years and thereafter on these noncancelable operating leases at December 31, 2006, were as follows:
On October 10, 2006, a complaint was filed in the second judicial district court of the State of Nevada. The complaint alleges, among other things, that in 1999 the Nevada Legislature unconstitutionally transferred the assets, liabilities and operations of the State Industrial Insurance System (the Fund) to the Company effective January 1, 2000. The complaint contends that, although the Nevada Constitution requires that the assets that were transferred to the Company by the Fund, the Company has falsely and knowingly claimed that (i) it had and has legal title to these assets, and (ii) it was not and is not a trustee with respect to such assets. Although the complaint does not specify the amount of money damages that it seeks, the complaint does seek money damages for the State of Nevada in an amount equal to three times the amount of all funds transferred to the Company as well as three times the amount of all rents, profits and income from the funds so transferred. The complaint also seeks declaratory relief and an accounting. The Company believes that the allegations in the complaint are without merit and that a material adverse judgment is remote.
The treatment of the LPT Agreement is the primary difference in the SAP-basis capital stock and total surplus of the insurance subsidiaries of $640.5 million and $530.6 million, and the GAAP-basis equity of the Company of $303.8 million and $144.6 million as of December 31, 2006 and 2005, respectively. Under SAP accounting the retroactive reinsurance gain resulting from the LPT Agreement is recorded as a special component of surplus (special surplus funds) in the initial year of the contract, and not reported as unassigned surplus until the Company has recovered amounts in excess of the original consideration paid. Under GAAP accounting the gain is deferred and amortized over the period the underlying reinsured claims are paid (see Note 7).
The California Insurance Holding Company System Regulatory Act limits the ability of ECIC to pay dividends to its parent by providing that the appropriate insurance regulatory authorities in the State of California must approve any dividend that, together with all other such dividends paid during the preceding 12 months, exceeds the greater of: (a) 10% of the paying company’s statutory surplus as regards policyholders at the preceding December 31; or (b) 100% of the net income for the preceding year. In addition, any such dividend must be paid from policyholders’ surplus attributable to accumulated earnings. The maximum pay-out that may be made during 2007 without prior approval is $61.0 million. No dividends were paid or declared in 2006, 2005 or 2004.
The California Department of Insurance (CDI) (the domiciliary state of ECIC) requires that in addition to applying the NAIC’s statutory accounting practices, insurance companies must record, under certain circumstances, an additional liability, called an ‘‘excess statutory reserve.’’ If the workers’ compensation losses and loss adjustment expense ratio is less than 65% in each of the three most recent accident years, the difference is recorded as an excess statutory reserve. The excess statutory reserves required by the CDI decreased ECIC’s statutory-basis surplus by $33.9 million to $314.1 million at December 31, 2006 and by $7.5 million to $277.2 million at December 31, 2005, as filed and reported to the regulators. Excess statutory reserves do not impact statutory net income and it is not expected they will have any material impact on the operation of the Company.
The following table summarizes the changes in the components of other comprehensive income, other than net income:
Quarterly results for the years ended December 31, 2006 and 2005 were as follows:
The third and fourth quarters of 2006 include favorable prior accident year reserve development of $68.9 million and $25.4 million, respectively, compared to approximately $12.8 million in the first half of 2006 (see Note 6).
The third and fourth quarters of 2005 include favorable accident year reserve development of $23.3 million and $51.5 million, respectively, compared to approximately $3.3 million in the first half of 2005 (see Note 6). Additionally, the fourth quarter of 2005 includes a reduction to the LPT Agreement deferred gain of $26.9 million due to favorable development in the direct reserves ceded under the LPT Agreement (see Note 7).
- basic and diluted - was computed using only the shares of the Company’s common stock issued to eligible members in the conversion (50,000,002), and does not include any shares issued to new investors in connection with the Company’s IPO or the impact of the cash election made by eligible members. The Company had no common stock equivalents outstanding for the periods presented that would create a dilutive effect on pro forma earnings per common share.