As of March 1, 2008, we leased approximately 312,193 square feet of total office space in the following locations:
We believe we benefit by targeting small businesses, a market that is characterized by fewer competitors, more attractive pricing and strong persistency when compared to the U.S. workers’ compensation insurance industry in general. As a result of our disciplined underwriting standards, we believe we are able to price our policies at levels which are competitive and profitable. Our approach to underwriting is therefore consistent with our strategy of not sacrificing profitability and stability for top-line revenue growth.
the deferred reinsurance gain, with the net effect being an increase or decrease, as the case may be, to net income. In addition, we receive a contingent commission under the LPT Agreement. Increases and decreases in the contingent commission are reflected in our commission expense, see ‘‘-Results of Operations’’.
On January 10, 2008, we announced our acquisition of AmCOMP Incorporated (AmCOMP). We believe this acquisition will provide significant opportunity to make progress in executing our strategic goals and achieving our vision of being a leader in the property and casualty insurance industry specializing in workers’ compensation.
In Nevada, our rate level increased in 2007 as a result of a decision by the Nevada Commissioner of Insurance (Nevada Commissioner) to increase loss costs effective March 1, 2007 by 3.4%, which we subsequently adopted.
On December 19, 2007, the Nevada Commissioner announced that the National Council on Compensation Insurance (NCCI) submitted a filing for an average voluntary loss cost decrease of 10.5% for new and renewal policies incepting on or after March 1, 2008. Subsequently, on February 6, 2008, the Nevada Commissioner approved the filing. According to the Nevada Commissioner, decreasing claim frequency was cited as the primary driver of the proposed decrease, which more than offset increasing indemnity and medical costs per claim, the cost of living benefit adjustments that were enacted during the 2003 Legislative session and the impact of the payroll cap. Our Nevada rates continue to be based upon our internal actuarial analysis of current and anticipated loss trends. We have adopted the approved loss costs effective for new and renewal policies incepting on or after March 1, 2008, with a revised loss cost modifier, the combination of which we expect will produce an average overall decrease of 5.0% on our book of business. We cannot determine the effect on our profitability at this time, or if there will be continued downward pricing pressure in Nevada.
The characteristics and performance of the portfolio are continually monitored and a detailed review is performed on a quarterly basis. Thus, changes in allocation will occur as we observe opportunities in the market. We anticipate that the strategy will remain focused on conservative fixed income securities.
Commission Expense. Commission expense includes commissions to our agents and brokers for the premiums that they produce for us, and is net of contingent commission income related to the LPT Agreement. Commissions paid to our agents and brokers and fronting fees paid to other insurers are deferred and amortized to commission expense in our statements of income as the premiums generating these commissions and fees are earned. We pay commissions which we believe are competitive with other workers’ compensation insurers. We generally pay between 10.0% to 12.5% commission on new and renewal business. During the last year we began paying a two percentage point increase in our commission rate on select policies.
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, changes in estimates of future write-offs of premiums receivable, 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. Our underwriting and other operating expense is a reflection of our operational efficiency in producing, underwriting and administering our business. However, the cost savings realized through such efficiencies may be offset, in whole or in part, by the potentially significant costs that we incur in connection with the reporting and internal control requirements to which we are subject under Federal securities laws and New York Stock Exchange listing requirements as a result of becoming a public company. Other operating expenses included a charge of $0.9 million and $10.0 million for the one-time costs of the conversion from a mutual holding company to a public stock company for 2007 and 2006, respectively.
We are directly liable for losses and LAE under the terms of insurance policies our insurance subsidiaries underwrite. Significant periods of time can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer and the insurer’s payment of that loss. Our loss reserves are reflected in our balance sheets under the line item caption ‘‘unpaid losses and loss adjustment expenses.’’ As of December 31, 2007, our reserve for unpaid losses and LAE, net of reinsurance, was $1.2 billion.
Maintaining the adequacy of loss reserve estimates is an inherent risk of the workers’ compensation insurance business. As described below, workers’ compensation claims may be paid over a long period of time. Therefore, estimating reserves for workers’ compensation claims may involve more uncertainty than estimating reserves for other lines of insurance with shorter or more definite periods between occurrence of the claim and final determination of the claim amount. The amount by which estimated losses in the aggregate, measured subsequently by reference to payments and additional estimates, differ from those previously estimated for a specific time period is known as ‘‘reserve development.’’ Reserve development
is unfavorable when payments for losses are made for more than the levels at which they were reserved or when subsequent estimates indicate a basis for reserve increases on open claims. In this case, the previously-estimated loss reserves are considered ‘‘deficient.’’ Reserve development is favorable when estimates of ultimate losses indicate a decrease in established reserves. In this case, the previously estimated loss reserves are considered ‘‘redundant.’’ Reserve development, whether due to an increase or decrease in the aggregate estimated losses, is reflected in operating results through an adjustment to incurred losses and LAE during the accounting period in which the development is recognized.
The three main components of our reserves for unpaid losses and LAE are case reserves, ‘‘incurred but not reported’’ or IBNR reserves, and LAE reserves.
A portion of our losses and LAE obligations are ceded to unaffiliated reinsurers. We establish our losses and LAE reserves both gross and net of ceded reinsurance. The determination of the amount of reinsurance that will be recoverable on our losses and LAE reserves includes both the reinsurance recoverable from our excess of loss reinsurance policies, as well as reinsurance recoverable under the terms of the LPT Agreement. Our reinsurance arrangements also include an intercompany pooling arrangement between EICN and ECIC, whereby each of them cedes some of its premiums, losses, and LAE to the other, but this intercompany pooling arrangement does not affect our consolidated financial statements included elsewhere in this report.
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:
Although we update and monitor our case reserves frequently as appropriate to reflect current information, it is very difficult to set precise case reserves for an individual claim due to the inherent uncertainty about the future duration of a specific injured worker’s disability, the course and cost of medical care for that injured worker, and the other factors described above. Therefore, in addition to establishing case reserves on a claim-by-claim basis, we, like other workers’ compensation insurance companies, establish IBNR reserves based on analyses and projections of aggregate claims data. Evaluating data on an aggregate basis eliminates some of the uncertainty associated with an individual claim. However, considerable uncertainty remains as many claims can be affected simultaneously by changes in environmental conditions such as medical technology, medical costs and medical cost inflation, economic conditions, the legal and regulatory climate, and other factors. The cost of a group of workers’ compensation claims is not known with certainty until every one of the claims is ultimately closed.
For the reasons described above, estimating reserves for workers’ compensation claims may be more uncertain than estimating reserves for other lines of insurance with shorter or more definite periods between occurrence of the claim and final determination of the ultimate loss and with policy limits on liability for claim amounts. Accordingly, our reserves may prove to be inadequate to cover our actual losses and LAE.
Judgment is required in the actuarial estimation of unpaid losses and LAE. The judgments include the selection of methodologies to project the ultimate cost of claims; the selection of projection parameters based on historical company data, industry data, and other benchmarks; the identification and quantification of potential changes in parameters from historical levels to current and future levels due to changes in future claims development expectations caused by internal or external factors; and the 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.
All of the methods depend in part on the selection of an expected pattern with which the aggregate claims data will be paid or will emerge over time. We compile, to the extent available, long-term and short-term historical data for our insurance subsidiaries, organized in a manner which provides an indication of the historical patterns with which claims have emerged and have been paid. To the extent that the historical data may not provide sufficient information about future patterns-whether due to environmental changes such as legislation or due to the small volume or short history of data for some segments of our business-benchmarks based on industry data, and forecasts made by industry rate bureaus regarding the effect of legislative benefit changes on such patterns, may be used to supplement, adjust, or replace patterns based on our subsidiaries’ historical data. Actuarial judgment is required in selecting the patterns to apply to each segment of data being analyzed, and our views regarding current and future claim patterns are among the factors that enter into our establishment of the losses and LAE reserves at each balance sheet date. When short-term averages or external rate bureau analyses indicate that the claims patterns are changing from historical company or industry patterns, that new or forecasted information typically is factored into the methodologies gradually, so that the projections will not overreact to what may turn out to be a temporary or unwarranted assumption about changes in patterns. When new claims emergence or payment patterns have appeared in the actual data repeatedly over multiple evaluations, those new patterns are given greater weight in the selection process. Because some claims are paid over many years, the selection of claim emergence and payment patterns involves judgmentally estimating the manner in which recently-occurring claims will develop many years or
decades in the future, and it is likely that the actual development that will occur in the distant future could differ substantially from historical patterns or current projections. The current projections would differ if different claims development patterns were selected for each benefit type.
These benefit types account for approximately 79% of our total losses and LAE reserves. The payment patterns are reviewed each year based on the observed recent and long-term patterns in our own historical data, recent and long-term patterns in industry data, and analyses of potential changes in patterns resulting from major legislative benefit changes. The changes in the payment patterns for Nevada are the result of these regular reviews of our historical data and updating of the actuarial judgments involved in selecting expected payment patterns. For 2007 and 2006 a range is shown for medical because multiple methods were used to select medical payment patterns in Nevada. The changes in the payment patterns used in states other than Nevada were significantly influenced by analysis of the anticipated effects of the 2003 California legislation relating to workers’ compensation benefits, as well as observations of our early experience as it emerged of claims experience subsequent to the enactment of that legislation. At each reserve evaluation, as more claims experience has emerged subsequent to that legislation, the post-legislative claims experience has been given increasing judgmental weight in the actuarial selection of expected future payment patterns. The actual payout pattern for the aggregate claims associated with an accident year will not be known until decades later, when all the claims are closed.
In projections using December 31, 2007 data, the methods that use explicit medical cost inflation assumptions included medical cost inflation assumptions ranging from 3.5% to 8.5%. Corresponding medical cost inflation assumptions in prior projections were 3.5% to 9.0% at December 31, 2006 and 5.5% to 9.0% at December 31, 2005. The selection of medical cost inflation assumptions for use in the actuarial methodologies in each of these analyses has been based on observed recent and longer-term historical medical cost inflation in our claims data and in the economy more generally. The rate of medical cost inflation as reflected in our historical medical payments per claim has averaged approximately 7.0% over the past five to ten years, The rate of medical cost inflation in the general U.S. economy, as measured by the consumer price index-medical care, has averaged approximately 4.0% over the past ten years.
levels of benefit payments. Judgments about the relative proportion of claims from the most recent years that ultimately will receive benefit payments at different levels are based on historical and recent levels 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.
For EICN, the analysis of unpaid loss is conducted on claims data prior to recognition of reinsurance, and a separate projection is made of future reinsurance recoveries, based on our reinsurance arrangements, and an analysis of large claims experience both for EICN and as reflected in industry-based benchmarks. The projections prior to recognition of reinsurance provide the basis for estimating gross-of-reinsurance unpaid losses, from which the projection of future reinsurance recoveries is subtracted to estimate net-of-reinsurance unpaid losses. For ECIC, the analysis of unpaid loss is conducted on claims data net of reinsurance, and a separate projection is made of future reinsurance recoveries, which is added to the estimated net-of-reinsurance unpaid losses to estimate gross-of-reinsurance unpaid losses. Finally, reinsurance pooling arrangements between EICN and ECIC are explicitly recognized by applying factors that reflect the portion of unpaid losses that EICN cedes to ECIC and that ECIC cedes to EICN.
Based on the results of the analyses conducted, the stability of the historical data, and the characteristics of the various claims segments analyzed, the consulting actuary selects a range of estimated
unpaid losses and LAE and a point estimate of unpaid losses and LAE, for presentation to internal actuarial staff and management. The selected range is intended to represent the range in which it is most likely that the ultimate losses will fall. This range is narrower than the range of indications produced by the individual 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 actuarial 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, including a review of the assumptions and the results of the various actuarial methods used by the consulting actuary. Comprehensive studies are conducted June 30 and December 30 by both internal actuarial staff and the consulting actuary and on the other quarters the most recent of those study results are updated for quarterly claim reporting and claim payment activity and other information provided by the internal actuarial staff as indicated below. These studies use the following information:
The consulting actuary provides the following analyses which management and internal actuarial staff review also:
• workers’ compensation industry trends as reported by industry rate bureaus, in the media, and other similar sources.
The case reserve component of our loss reserves is updated on an ongoing basis, in the normal course of claims examiners managing individual claims, and this component of our loss reserves at quarter-end is the sum of the case reserve as of quarter-end on each individual open claim.
Management determines the IBNR and LAE components of our loss reserves by establishing a point in the range of the most recent actuarial analyses 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.
The aggregate carried reserve calculated by management represents our best estimate of our outstanding unpaid losses and LAE. We believe that we should be conservative in our reserving practices due to the long tail nature of workers’ compensation claims payouts, the susceptibility of those future payments to unpredictable external forces such as medical cost inflation and other economic conditions, and the actual variability of loss reserve adequacy that we have observed in the workers’ compensation insurance industry.
to the consulting actuary’s point estimate from December 31, 2005 to December 31, 2006 increased losses and LAE expense incurred by $2.1 million for the year ended December 31, 2006.
The table below provides the actuarial range of estimated liabilities for unpaid losses and LAE and our carried reserves at the dates shown:
In applying actuarial techniques, judgment is required to determine the relevance of historical claim emergence and payment patterns and other historical data, external industry benchmark data, information about current economic conditions such as inflation, and recent changes in environmental conditions such as legislation as well as company operational changes in selecting parameters for those techniques under current facts and circumstances. Judgment also is required in selecting from among the loss indications
produced by the several actuarial techniques that are used. From evaluation to evaluation, it often is appropriate to adjust the various methods and parameters used in the projection of losses to reflect the expected or estimated effect of such factors. Even after such adjustments, ultimate liability may exceed or be less than the revised estimates.
Estimates of incurred losses and LAE attributable to insured events of prior years decreased due to continued favorable development in such prior accident years (actual losses and LAE paid and current projections of unpaid losses and LAE were less than we originally anticipated). The reduction in the liability for unpaid losses and LAE was $60.0 million, $107.1 million and $78.1 million for the years ended December 31, 2007, 2006 and 2005, respectively.
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 $2.6 million, ($3.9) million and $29.9 million for the years ended December 31, 2007, 2006 and 2005, respectively.
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 our insurance subsidiaries’ 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, our 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 reduced. For our insurance subsidiaries’ 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 relative to the cost of losses themselves have been greater than initial expectations. Although our revised LAE expectations resulted in an increase in the projected future cost of administering California claims relative to losses at December 31, 2007, 2006 and 2005, given the significant decrease in the estimated projected costs of losses in California, the overall impact has been a decrease in LAE reserves. 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.
We review our loss reserves each quarter and, as mentioned earlier, our consulting actuary assists our review by performing a comprehensive 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 actuaries 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 established in a manner that reacted quickly to each new emerging trend in the data or in the environment, there would be a high likelihood that future adjustments, perhaps significant in magnitude, would be required to correct for trends that turned out not to be persistent. At each balance sheet evaluation, some losses and LAE projection methods have produced indications above the loss reserve selected by management, and some losses and LAE projection methods have produced
indications lower than the loss reserve selected by management. At each evaluation, management has given weight to new data, recent indications, and evaluations of environmental conditions and changes that implicitly reflect management’s expectation as to the degree to which the future will resemble the most recent information and most recent changes, as compared with long-term claim payment, claim emergence, and claim cost inflation patterns. As patterns and trends recur consistently over a period of quarters or years, management gives greater implicit weight to these recent patterns and trends in developing our future expectations. In our view, in establishing loss reserves at each historical balance sheet date, we have used prudent judgment in balancing long-term data and recent information.
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, 2007. 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 48% of our claims payments during the three years ended December 31, 2007 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 7.0% per year. Some of our projection methods include explicit assumptions about future medical claim cost inflation. In projections using December 31, 2007 data, the methods that use explicit medical cost inflation assumptions have included medical claim cost inflation assumptions ranging from 3.5% to 8.5%. Future medical claim cost inflation, whether due to changing medical technology, utilization of medical services, or the cost of medical services, could fall outside this range. We are not able to state the rate of medical cost inflation that is assumed in our loss reserves because our loss reserves are established based on
reviewing the results of actuarial methods that do not contain explicit medical claim cost inflation rates, as well as methods that do contain explicit medical claim cost inflation rates. However, because medical care will be provided over many years, and in some cases decades, to the injured workers who have open claims, the pace of medical claim cost inflation has a significant impact on our ultimate claim payments. For example, if the rate of medical claim cost inflation increases by 1% above the inflation rate that is implicitly included in the loss reserves at December 31, 2007, we estimate that future medical costs over the lifetime of the current claims would increase by approximately $59 million for EICN and by approximately $12 million for ECIC, on a net-of-reinsurance basis.
The range of estimates of unpaid losses and LAE produced by the actuarial reviews of the impact of medical cost inflation provide some indication of the potential variability of future losses and LAE payments. If the actual unpaid losses and LAE were at the high or the low end of the actuarial range (see the table above), the impact on our financial results would be as follows:
We account for the LPT Agreement in accordance with FAS 113, Accounting and Reporting for Reinsurance of Short-Term and Long-Duration Contracts, and as retroactive reinsurance. Upon entry into the LPT Agreement, an initial deferred reinsurance gain was recorded as a liability in our consolidated balance sheet. This gain is being amortized using the recovery method, whereby the amortization is determined by the proportion of actual reinsurance recoveries to total estimated recoveries, and the amortization is reflected in losses and LAE. In addition, we are entitled to receive a contingent commission under the LPT Agreement. The contingent commission is estimated based on both actual results to date and projections of expected ultimate losses under the LPT Agreement. Increases and decreases in the estimated contingent commission are reflected in our commission expense in the year that the estimate is revised.
Our investments in fixed maturity 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.
• our intent and ability to keep the security for a sufficient time period for it to recover its value or reach maturity;
The amount of any write-downs is determined by the difference between cost or amortized cost of the investment and its fair value at the time the other-than-temporary decline was identified. Since our inception in 2000, we have recorded write-downs for investment securities considered to be other-than-temporarily impaired of an aggregate of $6.8 million.
Like many insurance companies, we analyze our losses and LAE ratios on a calendar year basis and on an accident year basis. A calendar year losses and LAE ratio is calculated by dividing the losses and LAE incurred during the calendar year, regardless of when the underlying insured event occurred, by the net premiums earned during that calendar year. The calendar year losses and LAE ratio includes changes made during the calendar year in reserves for losses and LAE established for insured events occurring in the current and prior periods. A calendar year losses and LAE ratio is calculated using premiums and losses and LAE that are net of amounts ceded to reinsurers.
(1) We define net income before impact of LPT Agreement as net income less (i) amortization of deferred reinsurance gain-LPT Agreement and (ii) adjustments to LPT Agreement ceded reserves. Deferred reinsurance gain-LPT Agreement reflects the unamortized gain from our LPT Agreement. Under GAAP, this gain is deferred and is being amortized using the recovery method, whereby the amortization is determined by the proportion of actual reinsurance recoveries to total estimated recoveries, and the amortization is reflected in losses and LAE. We periodically reevaluate the remaining direct reserves subject to the LPT Agreement. Our reevaluation results in corresponding adjustments, if needed, to reserves, ceded reserves, reinsurance recoverables and the deferred reinsurance gain, with the net effect being an increase or decrease, as the case may be, to net income. Net income before impact of LPT Agreement is not a measurement of financial performance under GAAP and should not be considered in isolation or as an alternative to net income before income taxes and net income or any other measure of performance derived in accordance with GAAP.
Net Premiums Written. Net premiums written decreased $48.6 million or 12.6%, to $338.6 million for the year ended December 31, 2007 from $387.2 million for the year ended December 31, 2006. The decrease was primarily attributable to a $51.1 million decrease in gross premiums written for the same period. Ceded premiums for the year ended December 31, 2007 totaled $12.1 million, or 3.5%, of gross premiums written as compared to $14.6 million, or 3.6%, of gross premiums written for the year ended December 31, 2006. The decrease in ceded premiums was primarily the result of the decrease in gross premiums written for the year ended December 31, 2007 as compared to the year ended December 31, 2006.
Net Investment Income. Net investment income increased $10.4 million, or 15.3%, to $78.6 million for the year ended December 31, 2007 from $68.2 million for the year ended December 31, 2006. The change was attributable to three factors: (a) an increase in fixed maturity securities resulting from the reallocation of the Company’s investment portfolio in the fourth quarter of 2006 which increased our portfolio yield; (b) an increase in the invested assets; and (c) interest income generated by higher cash balances. The pre-tax yield on invested assets increased approximately $1.9 million or approximately 15.0 basis points to 4.37% at December 31, 2007 as compared to 4.22% at December 31, 2006. The increase in our invested assets resulted in additional investment income of $6.3 million for the year ended December 31, 2007. The net proceeds from the IPO generated $1.8 million interest income prior to distribution to eligible members and higher cash balances generated $1.0 million of additional interest income.
Realized Gains (Losses) on Investments. Realized gains (losses) on investments decreased $54.1 million or 99.7%, to $0.2 million for the year ended December 31, 2007 from $54.3 million for the year ended December 31, 2006. The decrease was primarily attributable to a portfolio reallocation in the fourth quarter of 2006. The Company evaluated its equity portfolio at that time and elected to reduce the amount allocated to equity securities from 15.0% to the selected target of 6.0%. Equity sales of $169.2 million related to the portfolio reallocation generated realized gains of $49.2 million in 2006. Additional equity sales of approximately $55.0 million of fixed maturity securities were sold to fund our stock repurchase program which resulted in a realized loss of $0.5 million.
moderate in amount. This was offset by a reduction to 2007 losses and LAE over 2006 due to lower premiums in 2007 and the current accident year loss estimates and LAE rate declined approximately 1.4% points as compared to 2006.
Income Taxes. Income taxes decreased $52.1 million, or 63.0%, to $30.6 million for the year ended December 31, 2007, from $82.7 million for the year ended December 31, 2006. The decrease in income taxes was primarily due to a $103.4 million decrease in pre-tax income and other tax items discussed below. The effective tax rate for the twelve months ended December 31, 2007, was 20.3% compared to 32.5% for the same period in 2006. The decrease in the effective tax rate was primarily due to three
Net income includes amortization of deferred reinsurance gain-LPT Agreement of $18.0 million and $19.4 million for the year ended December 31, 2007 and 2006, respectively. Excluding the LPT Agreement, net income would have been $102.2 million and $152.2 million for the year ended December, 2007 and 2006, respectively.
(a) Any adjustment to the estimated direct reserves ceded under the LPT Agreement is reflected in losses and LAE for the period during which the adjustment is determined, with a corresponding increase or decrease in net income in the period. 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 8 in the Notes to our Consolidated Financial Statements which are included elsewhere in this report.)
Gross Premiums Written. Gross premiums written decreased $56.9 million, or 12.4%, to $401.8 million for the year ended December 31, 2006 from $458.7 million for the year ended December 31, 2005. The decrease in gross premiums written was primarily due to additional rate decreases in California. The average in force policy premium at December 31, 2006 decreased 21.1% to $11,528 from $14,618 at December 31, 2005. The impact of such rate reductions was partially offset by an increase of 2,056 in the number of in force policies of 29,742 for year ended December 31, 2006, as compared to 27,686 for the year ended December 31, 2005. The in force policy count increase was primarily attributable to growth in the California market of 2,040 policies or 10.6%. Of this increase, 3.4% was attributable to strategic markets in California.
Net Premiums Earned. Net premiums earned decreased $45.3 million, or 10.3%, to $393.0 million for the year ended December 31, 2006 from $438.3 million for the year ended December 31, 2005. The decrease in net premiums earned was primarily the result of the decrease in net premiums written for the year ended December 31, 2006 as compared to the year ended December 31, 2005.
Net Investment Income. Net investment income increased $13.8 million, or 25.3%, to $68.2 million for the year ended December 31, 2006 from $54.4 million for the year ended December 31, 2005. The
Additionally there was a $6.1 million realized gain on the sales of equity securities due to merger and acquisition activities related to the issuing company. These gains were offset by a realized loss of $0.6 million due to other-than-temporary impairment adjustments. The net realized capital loss for the year ended December 31, 2005 was $0.1 million. The investment activity was driven by the continued long term effort to increase after-tax income and resulted in the sale of corporate and mortgage bonds as well as equity activities.
Other Income. Other income increased $0.9 million, or 22.6%, to $4.8 million for the year ended December 31, 2006 from $3.9 million for the year ended December 31, 2005. 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 decreased $81.9 million, or 38.7%, to $129.8 million for the year ended December 31, 2006 from $211.7 million for the year ended December 31, 2005. Losses and LAE 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.
Commission Expense. Commission expense increased $1.5 million, or 3.2%, to $48.4 million for the year ended December 31, 2006 from $46.9 million for the year ended December 31, 2005. Commission expense was 12.3% and 10.7% of net premiums earned for the years ended December 31, 2006 and 2005, respectively. Commission expense increased primarily due to an increase in commission rate on selected policies from 10% to 12.5% midyear in 2006 and a $3.8 million favorable change in 2005 in the estimated LPT Agreement contingent commission. The increase in 2006 was partially offset by a decrease in commission expense due to a decrease in net earned premium of $5.0 million.
The increase in salaries and benefits of $2.4 million was due to 44 additional employees hired to support increase in force policy count, and preparation to be a publicly traded company. The technology maintenance and depreciation increased as a result of implementing EACCESS®, a new underwriting system, on July 1, 2006. The increase of professional fees was primarily due to one-time incurred expenses related to the conversion of $10.0 million. The remainder of the increase in professional fees was due to the use of 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.
Losses and LAE Ratio. The losses and LAE ratio decreased 15.3 percentage points, to 33.0%, for the year ended December 31, 2006 from 48.3% for the year ended December 31, 2005. As discussed under ‘‘-Losses and LAE’’ above, the decrease in the losses and LAE ratio was due to a decrease downward
in our current accident year loss estimates and recognition of favorable development of prior accident years. The losses and LAE ratio include amortization of deferred reinsurance gain-LPT Agreement of $19.4 million and $16.9 million for the year ended December 31, 2006 and 2005, respectively. Excluding these items, the losses and LAE ratio would have been 65.2% and 76.1% in the year ended December 31, 2006 and 2005, respectively. The losses and LAE ratio for the year ended December 31, 2006 did not include any adjustment to LPT Agreement ceded reserves whereas the year ended December 31, 2005 included a favorable reduction of $26.9 million.
Parent Company. The primary source of cash for Employers Holdings, Inc. (EHI) is dividends received from our insurance subsidiaries, EICN and ECIC, subject to regulatory restrictions. The primary uses of cash are expected to be dividend payments on our common stock, the intended acquisition of AmCOMP, repurchase of our common stock as described in ‘‘-Stock Repurchases’’, and parent holding company expenses.
The Company received approval from the Nevada Insurance Commissioner on December 18, 2007, for a $200.0 million extraordinary dividend from EICN special surplus which will be paid to EHI in 2008 and which can be used for stock repurchases, payment of dividends to stockholders, and general corporate purposes.
Operating Subsidiaries. The primary sources of cash for EICN and ECIC, our insurance operating subsidiaries, are funds generated from underwriting operations, asset maturities and income received from investments. We use trend and variance analyses to project future cash needs at both the consolidated and subsidiary levels. Cash provided from these sources has historically been used primarily for claims and claims adjustment expense payments and operating expenses. In the future, we also expect to have sufficient cash from these sources for the payment of dividends to parent holding companies to the extent permitted by law, see ‘‘-Dividend Capacity.’’
Our net cash flows are generally invested in marketable securities. We closely monitor the duration of these investments, and investment purchases and sales are executed with the objective of having
adequate funds available for the payment of claims at the subsidiary level. Because our investment strategy focuses on asset and liability durations, and not specific cash flows, we may from time to time be required to use our line of credit facility, which will be established by the end of second quarter 2008. At December 31, 2007, 93.8% of our investment portfolio consisted of fixed maturity investments and 6.2% consisted of equity securities.
Our insurance subsidiaries are 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 National Association of Insurance Commissioners (NAIC) has an RBC 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. Nevada and California have adopted laws substantially similar to the NAIC’s RBC standards. As of December 31, 2006, the last date that we were required to update the annual RBC calculation, both EICN and ECIC had total adjusted statutory surplus in excess of the prescribed RBC requirements that correspond to any level of regulatory action.
Cash Flows For the Year Ended December 31, 2007 and 2006. Our consolidated net cash provided by operating activities for the year ended December 31, 2007 was $120.2 million compared to cash flows from operations of $121.8 million for the year ended December 31, 2006. The $1.7 million decrease in net cash flow from operations for the year ended December 31, 2007, compared to the prior year, was primarily due to a decrease of $40.8 million in premiums received and an increase of $16.8 million in underwriting expenses paid. These decreases were offset by a $36.1 million decrease in income taxes paid, an increase of $14.6 million in investment income received and $7.1 million from prepaying policy surcharges in 2006 to the California Insurance Guarantee Association on behalf of policyholders that are billed and collected from policyholders in subsequent periods.
Investing activities resulted in net cash provided of $10.2 million for the year ended December 31, 2007 as compared to net cash used of $99.8 million for the year ended December 31, 2006. In 2007, we increased our cash balances in order to facilitate the repurchase of $75.0 million of our common stock according to our stock repurchase program, to pay stockholder dividends, and to support our growth.
EHI completed its IPO and conversion from a mutual insurance company to a stock company on February 5, 2007, with the sale of 30,762,500 shares of common stock at $17.00 per share. The cash proceeds from the IPO were approximately $472.7 million, after deducting approximately $34.0 million in underwriting discounts and commissions and approximately $16.3 million in other expenses related to the IPO and the conversion.
We used approximately $11.7 million of our net proceeds for required mandatory cash distributions to our eligible members, and approximately $451.3 million was distributed to eligible members electing to receive cash in the conversion. We retained approximately $9.7 million of net proceeds from the IPO, which was used for repurchases of our common stock, payments of stockholder dividends and general corporate purposes.
Our equity allocation at September 30, 2006 was above our current selected target of 6% and at the maximum exposure of 15% of our total combined investment portfolio. 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.
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 asset allocation is reevaluated by the Finance Committee of the Board of Directors at a detailed level on a quarterly basis. We employ Conning, as our independent investment manager. Conning follows our written investment guidelines based upon strategies approved by our Board of Directors. In addition to the construction and management of the portfolio, we utilize investment advisory services of Conning. These services include investment accounting and company modeling using Dynamic Financial Analysis (DFA). The DFA tool is utilized in developing a tailored set of portfolio targets and objectives, which in turn, is used in constructing an optimal portfolio.
The average credit rating for our fixed maturity securities investment portfolio, using ratings assigned by Standard & Poor’s, was ‘‘AA+’’ at December 31, 2007. The following table shows the Standard & Poor’s ratings distribution of our fixed maturity portfolio as of December 31, 2007 as a percentage of total market value:
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, 2007 and 2006, 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 $1.2 million in the fair values 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.
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, 2007 and 2006, securities having a fair market value of $516.0 million and $414.6 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, 2007 and 2006 was $4.9 million and $5.6 million, respectively.
The following table identifies our long-term debt and contractual obligations as of December 31, 2007:
(1) The losses and LAE reserves are presented gross of our reinsurance recoverables, which are as follows for each of the periods presented above:
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an Amendment of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities (SFAS No. 159). SFAS No. 159 permits an entity to choose to measure many financial instruments and certain items at fair value. The objective of this standard is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reporting earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS No. 159 permits all entities to choose to measure eligible items at fair value at specified election dates. Entities will report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option: (a) may be applied instrument by instrument, with a few exceptions, such as investments accounted for by the equity method; (b) is irrevocable (unless a new election date occurs); and (c) is applied only to entire instruments and not to portions of instruments. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007, which for the Company would be the fiscal year beginning January 1, 2008. Early adoption is permitted as of the beginning of the previous fiscal year provided that the entity makes that choice in the first 120 days of that fiscal year and also elects to apply FASB Statement No. 157, Fair Value Measurements. The Company did not make such an election. The
Company adopted SFAS No. 159 on January 1, 2008, but elected not to measure any additional financial instruments at fair value, therefore it will not have a material impact on its consolidated financial statements or results of operations.
In December 2007, the FASB issued SFAS No. 141 (Revised 2007), -Business Combinations (SFAS No. 141(R)). SFAS No. 141(R) significantly changes the accounting for business combinations and requires the acquiring entity in the transaction to recognize the acquired assets and assumed liabilities at the acquisition-date fair value with limited exceptions. SFAS No. 141(R) is effective as of the beginning of an entity’s first fiscal year that begins after December 15, 2008, which for the Company would include business combinations that are completed after January 1, 2009. Early adoption is prohibited. The adoption of SFAS No. 141(R) will have an impact on the consolidated financial statements for any business combinations completed after January 1, 2009.
Audited Financial Statements as of December 31, 2007 and 2006 and for each of the three years in the period ended December 31, 2007:
Consolidated Statements of Income for each of the three years ended December 31, 2007
Consolidated Statements of Equity for each of the three years ended December 31, 2007
We have audited the accompanying consolidated balance sheets of Employers Holdings, Inc. and Subsidiaries (the Company) as of December 31, 2007 and 2006, and the related consolidated statements of income, equity, and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
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, 2007 and 2006, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, 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.
Effective February 5, 2007, pursuant to an approved plan of reorganization, EIG converted from a mutual insurance holding company to a Nevada stock company and completed an initial public offering (IPO) of its common stock. All policyholder membership interests in EIG were extinguished on that date, and EIG’s name changed to Employers Holdings, Inc. (See Note 3).
The Company considers all highly liquid investments with an initial maturity of three months or less at the date of purchase to be cash equivalents.
The Company’s investments in fixed maturity 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.
When, in the opinion of management, a decline in the fair value of an investment below its cost or amortized cost is considered to be ‘‘other-than-temporary,’’ the investment’s cost or amortized cost is written-down to its fair value and the amount written-down is recorded in earnings as a realized loss on investments. The determination of other-than-temporary decline includes, in addition to other relevant factors, a presumption that if the market value is below cost by a significant amount for a period of time, a write-down may be necessary unless management has the ability and intent to hold a security to recovery or maturity. The amount of any write-downs is determined by the difference between cost or amortized cost of the investment and its fair value at the time the other-than-temporary decline is identified (see Note 4).
Earned premiums include an estimate for earned but unbilled premiums. The Company estimates the amount of earned but unbilled premiums by analyzing the historical final premium billed compared to the original estimated amounts billed and applying this adjustment percentage against premium earned on policies that have not yet had a final billing. Estimated earned but unbilled premiums included in premiums receivable were $20.7 million and $24.1 million at December 31, 2007 and 2006, respectively.
Net earned premium and losses and LAE incurred are stated in the accompanying consolidated statements of income after deduction of amounts ceded to reinsurers. Balances due from reinsurers on unpaid losses, including an estimate of such recoverables related to reserves for incurred but not reported losses, are reported as assets and are included in reinsurance recoverables even though amounts due on unpaid losses and LAE are not recoverable from the reinsurer until such losses are paid. Recoverables from reinsurers on unpaid losses and LAE amounted to $1.1 billion at December 31, 2007 and 2006.
Property and equipment are stated at cost less accumulated depreciation (see Note 5). 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 to seven 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.
The Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109 (FIN 48), effective January 1, 2007 (see Note 6).
Financial instruments that potentially subject the Company to concentrations of credit risk are primarily cash, cash equivalents, investments, premiums receivable and reinsurance balances.
At December 31, 2007 and 2006, the outstanding premiums receivable balance was generally diversified due to the large number of entities composing the Company’s policyholder base and their dispersion across many different industries. To reduce credit risk, the Company performs ongoing evaluations of its policyholders’ financial condition, but does not generally require collateral. The Company also has recoverables from its reinsurers. Reinsurance contracts do not relieve the Company from its obligations
The Company enters into securities lending agreements with financial institutions to improve investment income. Selected securities are loaned and are secured by collateral equal to at least 102% of the fair market value of the securities. Collateral is in the form of cash or securities issued or guaranteed by the U.S. government, and the securities lending agent has provided counterparty indemnification in the event of borrower default. The maximum amount loaned under our securities lending program in 2007 was $102 million. As of December 31, 2007 and 2006, there were no outstanding securities lending transactions.
On January 1, 2006, the Company adopted SFAS No. 123(R)-Share-based Payment (SFAS) No. 123(R). Prior to 2007, neither EHI nor its predecessor, EIG, had any outstanding shares of common stock, and therefore no stock-based payments were made. During 2007, the Company issued stock-based payments, and under SFAS No. 123(R), those payments are recognized in the consolidated statements of income based on their fair values over the employees’ service period (see Note 11).
In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 157, Fair Value Measurements (SFAS No. 157), which provides a common definition of fair value and establishes a framework to make the measurement of fair value more consistent and comparable. SFAS No. 157 also requires expanded disclosures about (1) the extent to which companies measure assets and liabilities at fair value, (2) the methods and assumptions used to measure fair value, and (3) the effect of fair value measures on earnings. The Company adopted SFAS No. 157 on January 1, 2008, and it will not have a material effect on the Company’s consolidated financial condition or results of operations.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an Amendment of FASB Statement No. 115, Accounting for Certain
In December 2007, the FASB issued SFAS No. 141 (Revised 2007), -Business Combinations (SFAS No. 141(R)). SFAS No. 141(R) significantly changes the accounting for business combinations and requires the acquiring entity in the transaction to recognize the acquired assets and assumed liabilities at the acquisition-date fair value with limited exceptions. SFAS No. 141(R) is effective as of the beginning of an entity’s first fiscal year that begins after December 15, 2008, which for the Company would include business combinations that are completed after January 1, 2009. Early adoption is prohibited. The adoption of SFAS No.141(R) will have an impact on the consolidated financial statements for any business combinations completed after January 1, 2009.
The amortized cost and estimated fair value of fixed maturity investments at December 31, 2007, by contractual maturity are shown below. Expected maturities 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 fixed maturity investments included in the tables above, the Company determined that the unrealized losses were primarily a result of the interest rate environment. Therefore, as of December 31, 2007 and 2006, none of the fixed maturity investments 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 the Company’s intent and ability to hold the securities until fair value recovers above cost, or to maturity.
Depreciation expense for the years ended December 31, 2007, 2006 and 2005, was $6.4 million, $4.2 million, and $2.2 million, respectively. During 2007, the Company retired $4.4 million of fully depreciated equipment. In 2006, there were no such retirements.
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 loss 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 year ended December 31, 2005 increased the GAAP net income, as reported in the accompanying consolidated statements of income, but did not increase taxable income for the period. 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 following is a reconciliation of the beginning and ending amounts for unrecognized tax benefits and related interest for the year ended:
During the third quarter of the year ended December 31, 2007, the Company reversed $5.1 million of liabilities for previously unrecognized tax benefits plus $0.7 million of related accrued interest, as a result of certain statutory periods expiring. The total amount of the reversal reduced the effective tax rate for the year ended December 31, 2007.
It is reasonably possible that the entire remaining balance of the unrecognized tax benefit of $10.2 million (including interest of $1.9 million), will be recognized during the second half of fiscal 2008, as statutory periods expire. The reversal of this balance will reduce the effective tax rate in the period it is recognized.
Tax years 2004 through 2006 are subject to examination by the federal taxing authority. There are no income tax examinations currently in progress.
The significant components of the deferred income taxes, net, were as follows as of December 31:
Estimates of incurred losses and LAE attributable to insured events of prior years decreased due to continued favorable development in such prior accident years (actual losses and LAE paid and current projections of unpaid losses and LAE were less than the Company originally anticipated). The reduction in the liability for unpaid losses and LAE was $60.0 million, $107.1 million and $78.1 million for the years ended December 31, 2007, 2006 and 2005, respectively.
In California, in particular, where the Company’s operations began on July 1, 2002, management’s initial expectations of both the ultimate level of its losses and patterns of loss emergence and loss payment necessarily were based on benchmarks derived from analyses of historical insurance industry data in California, as no historical data from the Company’s insurance subsidiaries existed, and although some historical data was available for the prior years of some of the market segments the Company entered in California, that data was limited as to the number of loss reserve evaluation points available. The industry-based benchmarks were adjusted judgmentally for the anticipated impact of significant environmental changes, specifically the enactment of major changes to the statutory workers’ compensation benefit structure and the manner in which claims are administered and adjudicated in California. The actual emergence and payment of California claims by the Company’s insurance subsidiaries has been more favorable than those initial expectations, due at least in part to what the Company believes are the impact of enactment of the major changes in the California workers’ compensation environment. Other insurance companies writing California workers’ compensation insurance also have experienced emergence and payment of claims more favorable than anticipated. At each evaluation date, the projected claim activity underlying the prior loss reserves has been replaced by the actual claim activity, and the expectation of future emergence and payment of California claims underlying the actuarial projections was reevaluated during 2007, 2006 and 2005 based both on the Company’s insurance subsidiaries’
In Nevada, the Company has access to an extensive history of workers’ compensation claims based on the business of the predecessor Fund, but the emergence and payment of claims in recent years has been more favorable than in the long-term history in Nevada with the predecessor Fund. The expected patterns of claim payment and emergence used in the projection of the Company’s ultimate claims payments are based on both the long-term and the short-term historical data. Also, in 2007, 2006 and 2005, the projected claim payments underlying the prior loss reserves were replaced by the actual claim payment activity that occurred during the calendar year. In Nevada, based on the observed changes in claims emergence and payment patterns in recent years, greater weight has been given to such changes in the Company’s projections. This has resulted in a decrease of $2.6 million and $29.9 million in estimated incurred loss and LAE with respect to prior years in the periods ended December 31, 2007 and December 31, 2005 compared with an increase of $3.9 million in the prior period ended December 31, 2006.
The initial deferred gain resulting from the LPT Agreement was recorded as a liability in the accompanying consolidated balance sheets and is being amortized using the recovery method, whereby the amortization is determined by the proportion of actual reinsurance recoveries to total estimated recoveries. The Company amortized $18.0 million, $19.4 million, and $16.9 million of the deferred gain for the years ended December 31, 2007, 2006 and 2005, respectively. Additionally, the deferred gain was reduced by $26.9 million in 2005, due to favorable development in the direct reserves ceded under the LPT Agreement. There were no adjustments to the direct reserves ceded under the LPT Agreement in 2007 and 2006. The amortization of the deferred gain and the adjustments due to the favorable development in the reserves are recorded in losses and LAE incurred in the accompanying consolidated statements of income. The remaining deferred gain was $425.0 million and $443.0 million as of December 31, 2007 and 2006, respectively, which is included in the accompanying consolidated balance sheets as deferred reinsurance gain-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
The Company writes workers’ compensation insurance in California in which unpaid workers’ compensation liabilities from insolvent insurers are the responsibility of the California Insurance Guarantee Association (CIGA). The Company passes through the CIGA assessment to its policyholders via a surcharge based upon the estimated annual premium at the policy’s inception and has received, and expects to continue to receive, these guarantee fund assessments, which are paid to CIGA based on premiums written by the Company. As of December 31, 2007 and 2006, the Company recorded an asset of $9.1 million and $8.1 million, respectively, for assessments paid to the CIGA that includes prepaid policy surcharges still to be collected in the future from policyholders. The Company also writes workers’ compensation insurance in other states with similar obligations as those in California. In these states, the Company is directly responsible for payment of the assessment. The Company recorded an estimate of $1.1 million and $1.3 million for its expected liability for guarantee fund assessments at December 31, 2007 and 2006, respectively. The guarantee fund assessments are expected to be paid within two years of recognition.
October 17, 2007, and resulted in 3,911,272 common shares repurchased. As of December 31, 2007, all 3,911,272 common shares repurchased in the Program were still held by the Company and are reported as Treasury stock, at cost, in the accompanying consolidated balance sheets.
On October 3, 2006, the Company’s Board of Directors approved the Employers Holdings, Inc. Equity and Incentive Plan (the Plan), effective as of the close of the Company’s IPO. The Plan is administered by the Compensation Committee of the Board of Directors, which is authorized to grant, at its discretion, awards to officers, employees, non-employee directors, consultants and independent contractors. The maximum number of common shares reserved for grants of awards under the Plan is 1,605,838 shares, or 3% of EHI’s outstanding common shares as of February 5, 2007. The Plan provides for the grant of stock options (both incentive stock options and nonqualified stock options), stock appreciation rights, restricted stock, restricted stock units, stock-based performance awards and other stock-based awards.
As of December 31, 2007, nonqualified stock options, restricted stock units, and performance share awards have been granted, but no incentive stock options, stock appreciation rights or restricted stock have been granted under the Plan.
Additionally, on August 8, 2007, the Company awarded 420,916 options to the officers of the Company. These options have a service vesting period of 3.5 years. These options vest 25% on February 8, 2008, and the subsequent three anniversaries of such date. The options are subject to accelerated vesting in certain limited circumstances, such as: termination by the Company other than for cause, termination as a result of retirement, death or disability, and in connection with a change of control. The options expire seven years from the date of grant. The per share exercise price of these options is equal to the fair market value of the stock on the grant date, or $18.79.
On August 5, 2007, the Company awarded the non-employee members of the Board of Directors, in aggregate, 23,760 restricted stock units (RSUs). These RSUs vest on the date of the first annual meeting of the shareholders after January 1, 2008, except for accelerated vesting in the case of death or disability of the Director or as a result of a change of control. Vested RSUs will be settled in Company stock six months following the awardee’s termination of service as a member of the Board of Directors. Prior to settlement, dividend equivalents are paid with respect to vested RSUs and are credited as additional
vested RSUs. The fair market value of the RSUs on the date of grant was $399.9 thousand. For the year ended December 31, 2007, the Company recognized stock-based compensation costs of $199.9 thousand as a component of other underwriting expenses. During the same period, related income tax benefits of $69.9 thousand were recognized as a component of income taxes in the consolidated statement of income. At December 31, 2007, the Company had yet to recognize $199.9 thousand in deferred compensation related to the RSUs and expects to recognize these costs over the next five months.
The capital stock, surplus and net income of the Company’s insurance subsidiaries (EICN and ECIC), prepared in accordance with the statutory accounting practices of the National Association of Insurance Commissioners (NAIC) as well as statutory accounting principles permitted by the State of California and Nevada (SAP), were as follows:
Net income for the Company’s insurance subsidiaries prepared in accordance with SAP for the years ended December 31, 2007, 2006 and 2005 was $172.2 million, $164.3 million and $96.9 million, respectively.
The treatment of the LPT Agreement is the primary difference in the SAP-basis capital stock and total surplus of the insurance subsidiaries of $697.7 million and $640.5 million, and the GAAP-basis equity of the Company of $379.5 million and $303.8 million as of December 31, 2007 and 2006, 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. The special surplus funds are also reduced by the amount of extraordinary dividends as approved by the Nevada Division of Insurance. Under GAAP accounting the gain is deferred and amortized over the period the underlying reinsured claims are paid (see Note 8).
Nevada law limits the payment of cash dividends by EICN to its parent (stockholder) by providing that payments cannot be made except from available and accumulated surplus, 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 prohibited by these restrictions may only be declared and distributed as an extraordinary dividend upon the prior approval of the Nevada Commissioner of Insurance (Nevada Commissioner). Dividends that are considered extraordinary require notice to the Nevada Commissioner who must approve or disapprove the dividends or distribution within 30 days of such notice. An extraordinary dividend or distribution is defined by statute to include any dividend or distribution of cash or property whose fair market value, together with that of other dividends or distributions made within the preceding 12 months, exceeds the greater of: (a) 10% of EICN’s statutory surplus as regards policyholders at the next preceding December 31; or (b) EICN’s statutory net income, not including realized capital gains, for the 12-month period ending at the next preceding December 31.
on October 17, 2006, which then required and resulted in approval of $38.0 million in dividends from unassigned surplus in 2007. This additional approval by the Nevada Commissioner was required because combined dividends from special and unassigned surplus for the preceding 12 months exceeded limitations on the payment of ordinary dividends. The 2007 extraordinary dividends were paid to EGI and in turn to EHI, as approved by the Nevada Division of Insurance. The $55.0 million dividend payment was conditioned on the following: the exhaustion of all proceeds retained by the Company from its IPO; EICN maintaining a risk based capital total adjusted capital above a specified level at the date of declaration and payment of any portion of such extraordinary dividend, after taking into account the effect of such dividend; and maintaining all required filings with the Department. The dividend was paid in June of 2007. In 2006, EICN paid a dividend of $1.0 million, in addition to a dividend distribution comprised of 100% of the common stock of its wholly owned subsidiaries EOH and Elite.
The Company has adopted a 401(k) defined contribution plan (the 401(k) Plan) covering all eligible Company employees. Employees age 18 or older are eligible to participate in the 401(k) Plan on the first day of the month following their date of hire. Beginning with the plan year 2007, the Company adopted a safe harbor matching contribution to the 401(k) Plan. The safe harbor matching consists of a dollar-for-dollar matching contribution on salary deferrals up to 3% of compensation and then fifty-cents on the dollar matching contribution on salary deferrals from 3% to 5% of compensation. For plan years 2006 and 2005, the Company’s match was fifty-cents for every dollar contributed by the employee, up to 6% of the employee’s annual salary. The Company’s contribution to the 401(k) Plan was $1.4 million for the year ended December 31, 2007 and $0.9 million for the years ended December 31, 2006 and 2005.
The net realized gains in the fourth quarter of 2006 were the result of the Company’s evaluation of its portfolio allocation, resulting in a decision by the Finance Committee of the Board of Directors to reduce the amount allocated to equity securities. This decision resulted in the sale of $169.2 million in equity securities, generating realized gains of $49.2 million in the fourth quarter of 2006.
During the third quarter of 2007, the Company reversed $5.8 million of liabilities for previously unrecognized tax benefits which includes $0.7 million of related accrued interest, as a result of certain statutory periods expiring (see Note 6).
The Company has received a commitment for a $50.0 million Senior Secured Revolving Credit Facility from Wells Fargo Bank, National Association (Wells Fargo). The Company expects to finalize the agreement by the end of the second quarter of 2008. The Company anticipates that the line of credit will be used for general business and corporate purposes.
On February 21, 2008, the Board of Directors declared a $0.06 dividend per share, payable March 27, 2008, to stockholders of record on March 7, 2008.