We are a Nevada holding company. Through our insurance subsidiaries, we provide workers’ compensation insurance coverage to select, small businesses in low to medium hazard industries. Workers’ compensation insurance is provided under a statutory system wherein most employers are required to provide coverage for their employees’ medical, disability, vocational rehabilitation, and/or death benefit costs for work-related injuries or illnesses. We provide workers’ compensation insurance in 37 states and the District of Columbia, with a concentration in California, where over one-half of our business is generated. Our revenues are primarily comprised of net premiums earned, net investment income, and net realized gains on investments.
Pricing on our renewals showed an overall price decrease of 3.3% for the year ended December 31, 2017, versus the rate level in effect on such business a year earlier. Despite the competitive market conditions we currently face, through our efforts in 2017, we believe that we have continued to write attractive business in new and existing states and have strengthened our relationships with our business partners. Given the strength of our balance sheet, the execution of our underwriting, claims, and investment strategies, and our active capital management, we believe that we are well positioned for the current market cycle.
Pursuant to the Purchase Agreement, all liabilities and obligations of PRNY existing as of the closing date, whether known or unknown, will be assumed by PRUS. In addition, PartnerRe Ltd., the parent company of PRUS, has provided us with a Guaranty that unconditionally, absolutely and irrevocably guarantees the full and prompt payment and performance by PRUS of all of its obligations, liabilities and indemnities under the Purchase Agreement and the transactions contemplated thereby.
Adjusted stockholders' equity is a non-GAAP measure consisting of total GAAP stockholders' equity plus the Deferred Gain, less Accumulated other comprehensive income, net.
Our net income was $101.2 million, $106.7 million, and $94.4 million in 2017, 2016, and 2015, respectively, and our underwriting income was $68.0 million, $57.3 million, and $40.4 million for the same periods, respectively. The key factors that affected our financial performance during the previous two years included:
Losses and LAE decreased slightly in 2017 and 3% in 2016, each compared to the previous year;
Underwriting and other operating expenses increased 3% in 2017 and 1% in 2016, each compared to the previous year;
We continue to execute a number of ongoing business initiatives, including: focusing on internal and customer-facing business process excellence; accelerating the settlement of open claims; diversifying our risk exposure across geographic markets; utilizing a multi-company pricing platform; utilizing territory-specific pricing; development and implementation of new technologies and capabilities; and leveraging data-driven strategies to target, price, and underwrite profitable classes of business across all of our markets.
January 1, 2000, which reduced our effective tax rate by 15.4 percentage points. Collectively, these items increased our net income before taxes by $16.2 million and decreased our income tax expense by $15.3 million for the year ended December 31, 2015.
LPT Contingent Commission Adjustments result in a cumulative adjustment to the Deferred Gain, which is recognized in losses and LAE incurred on our Consolidated Statements of Comprehensive Income, such that the Deferred Gain reflects the balance that would have existed had the revised contingent profit commission been recognized at the inception of the LPT Agreement. (See Note 2 in the Notes to our Consolidated Financial Statements.)
Gross premiums written were $729.7 million, $701.4 million, and $697.7 million for the years ended December 31, 2017, 2016, and 2015, respectively. The increase in 2017 was primarily due to increases in new business premium written and final audit premiums, partially offset by declines in renewal business premium, year-over-year. Final audit premiums increased $10.8 million, compared to 2016, positively impacted by California Assembly Bill 2883 (AB 2883), which limited certain officers' payroll from being excluded from the calculation of premiums effective January 1, 2017. In October 2017, California passed Senate Bill 189 (SB 189), which expanded the scope of employees that qualify for these exclusions. SB 189 goes into effect on July 1, 2018 and is expected to reverse some of the benefits of AB 2883 beginning in 2018. The increase in gross premiums written in 2016 was primarily due to a $9.7 million increase in final audit premiums and growth in new business premium, partially offset by lower levels of renewal premiums, year-over-year. The declines in renewal premiums in 2016, compared to 2015, were due to declines in the LA Area of California, partially offset by increases in states outside California, as well as territories outside of the LA Area of California.
Net premiums earned were $716.5 million, $694.8 million, and $690.4 million for the years ended December 31, 2017, 2016, and 2015, respectively. Net premiums earned are primarily a function of the amount and timing of net premiums previously written.
The following table shows the percentage change in our in-force premiums, policy count, average policy size, and payroll exposure upon which our premiums are based as of December 31, 2017 and 2016, respectively, overall, for California, where 56% of our premiums were generated, and for all other states, excluding California:
Our indemnity claims frequency (the number of claims expressed as a percentage of payroll) continued to decrease year-over-year in 2017 and 2016. In 2017, we saw a slight downward movement in medical and indemnity costs per claim that are reflected in our current accident year loss estimates. Total claims costs have also been reduced by cost savings associated with increased claims settlement activity that continued through 2017. We believe our current accident year loss estimate is adequate; however, ultimate losses will not be known with any certainty for many years. We assume that increasing medical and indemnity cost trends will continue to impact our long-term claims costs and current accident year loss estimate, which may be offset by rate increases. Additional information regarding our reserves for losses and LAE is set forth under “-Critical Accounting Policies-Reserves for Losses and LAE.”
risk business. The decrease from 2015 to 2016 was primarily related to $18.4 million of net favorable prior accident year loss development (versus $7.2 million of net favorable development in 2015), which included $17.0 million of favorable development on our voluntary risk business and $1.4 million of favorable development related to our assigned risk business. The favorable prior accident year loss development in each period was the result of our determination that adjustments were necessary to reflect observed favorable paid loss trends in each of these years. Paid loss trends have been impacted by cost savings associated with accelerated claims settlement activity that continued through 2017. Additionally, there were favorable LPT Reserve Adjustments of $3.1 million and $6.4 million that decreased losses and LAE by those amounts for the years ended December 31, 2016 and 2015, respectively. There were no LPT Reserve Adjustments in 2017.
Our current accident year loss ratio estimates were 62.4%, 65.2%, and 66.2% for the years ended December 31, 2017, 2016, and 2015, respectively. The decreasing trend in our current accident year loss estimates reflects the continued impact of key business initiatives, including: accelerating the settlement of open claims; diversifying our risk exposure across geographic markets; and leveraging data-driven strategies to target, underwrite, and price profitable classes of business across all of our markets. The current accident year loss estimate for the year ended December 31, 2016 included the impact of $6.5 million in large losses recognized in the second quarter of 2016, which increased the current accident year loss estimate for that year.
The table below reflects losses and LAE reserve adjustments and the impact of the LPT on net income before taxes.
Our underwriting and other operating expenses ratio was 19.5%, 19.7%, and 19.5%, and our underwriting and other operating expenses were $139.9 million, $136.1 million, and $135.2 million for the years ended December 31, 2017, 2016, and 2015, respectively. During the year ended December 31, 2017, our compensation-related expenses increased $2.6 million and professional fees increased $1.9 million, partially offset by a $0.7 million decrease in our premium taxes and assessments, each as compared to 2016. During the year ended December 31, 2016, our compensation-related expenses increased $2.3 million and premium taxes and assessments increased $1.5 million, partially offset by a $3.1 million decrease in our bad debt expense, each as compared to 2015.
Our commission expense ratio was 12.8%, 12.0%, and 12.4%, and our commission expenses were $91.4 million, $83.5 million, and $85.4 million for the years ended December 31, 2017, 2016, and 2015, respectively. The increase in the commission expense ratio in 2017 was primarily the result of increases in agency incentive commissions and an increase in the percentage of business produced by our partnerships and alliances, which are subject to a higher commission rate. The decrease in our commission expense ratio in 2016, compared to 2015, was primarily due to lower agency incentives in 2016.
During the third quarter of 2017, we wrote-off $7.5 million of previously capitalized costs relating to the development of information technology capabilities that had not yet been placed in service. This charge was the result of our continual evaluation of ongoing technology initiatives.
We purchase reinsurance to protect us against the costs of severe claims and catastrophic events. On July 1, 2017, we entered into a new reinsurance program that is effective through June 30, 2018. The reinsurance program consists of one treaty covering excess of loss and catastrophic loss events in four layers of coverage. Our reinsurance coverage is $190.0 million in excess of our $10.0 million retention on a per occurrence basis, subject to certain exclusions. We believe that our reinsurance program meets our needs and that we are sufficiently capitalized.
Net cash provided by operating activities in 2016 included net premiums received of $694.9 million, and investment income received of $87.8 million. These operating cash inflows were partially offset by net claims payments of $433.7 million, underwriting and other operating expenses paid of $125.8 million, and commissions paid of $84.2 million.
Share Repurchases. On February 16, 2016, the Board of Directors authorized a share repurchase program for up to $50.0 million of our common stock from February 22, 2016 through February 22, 2018 (the 2016 Program). The 2016 Program provided that shares of common stock may be purchased at prevailing market prices through a variety of methods, including open market or private transactions, in accordance with applicable laws and regulations and as determined by management. The timing and actual number of shares repurchased depended on a variety of factors, including the share price, corporate and regulatory requirements, and other market and economic conditions. We made no repurchases of common stock during the year ended December 31, 2017. As of December 31, 2017, we had a remaining common stock repurchase authorization of $28.9 million under the 2016 Program. See Item 5, Issuer Purchases of Equity Securities. The 2016 Program expired on February 22, 2018.
As of December 31, 2017, the capital resources available to us consisted of: (i) $20.0 million in surplus notes maturing in 2034; (ii) $947.7 million of stockholders' equity; and (iii) the $163.6 million Deferred Gain.
Both the payment of interest and repayment of the surplus notes are subject to the prior approval of the Florida Department of Financial Services.
Stockholders' Equity. The following table summarizes our beginning and ending stockholders' equity balance and the changes thereto for each of the years ended December 31, 2017, 2016, and 2015:
Contractual Obligations and Commitments. The following table identifies our long-term debt and contractual obligations as of December 31, 2017.
Notes payable includes payments of the principal and estimated interest expense on our surplus notes outstanding based on LIBOR plus a margin. The interest rates used ranged from 5.6% to 5.7%.
These investments provide a steady source of income, which may fluctuate with changes in interest rates and our current investment strategies.
As of December 31, 2017, our investment portfolio, which is classified as available-for-sale, consisted of 92.0% fixed maturity securities. We strive to limit the interest rate risk associated with fixed maturity investments by managing the duration of these securities. Our fixed maturity securities (excluding cash and cash equivalents) had a duration of 4.2 at December 31, 2017. To minimize interest rate risk, our portfolio is weighted toward short-term and intermediate-term bonds; however, our investment strategy balances consideration of duration, yield, and credit risk. Our investment guidelines require that the minimum weighted average quality of our fixed maturity securities portfolio be “AA-,” using ratings assigned by S&P. Our fixed maturity securities portfolio had a weighted average quality of “AA-” as of December 31, 2017, with 54.9% of the portfolio rated “AA” or better, based on market value.
We also have a portfolio of equity securities, which we record at fair value. We strive to limit the exposure to equity price risk associated with equity securities by diversifying our holdings across several industry sectors. Equity securities represented 7.9% of our investment portfolio at December 31, 2017.
The following table shows the percentage of total estimated fair value of our fixed maturity securities as of December 31, 2017 by credit rating category, using the lower of the ratings assigned by Moody's Investors Service or S&P.
Investments that we currently own could be subject to default by the issuer or could suffer declines in fair value that become other-than-temporary. We regularly assess individual securities as part of our ongoing portfolio management, including the identification of other-than-temporary declines in fair value. Our other-than-temporary impairment assessment includes reviewing the extent and duration of declines in fair value of investments below amortized cost, historical and projected financial performance and near-term prospects of the issuer, the outlook for industry sectors, credit rating, and macro-economic changes. We also make a
determination as to whether it is not more likely than not that we will be required to sell the security before its fair value recovers above cost, or maturity.
We believe that we have appropriately identified the declines in the fair values of our unrealized losses for the years ended December 31, 2017, 2016, and 2015. We recognized impairments on fixed maturity securities of $0.5 million (consisting of nine securities) during the year ended December 31, 2017. The other-than-temporary impairments recognized during this year were the result of our intent to sell these securities. We determined that the remaining unrealized losses on fixed maturity securities were primarily the result of prevailing interest rates and not the credit quality of the issuers. The remaining fixed maturity securities whose fair value was less than amortized cost were not determined to be other-than-temporarily impaired given the lack of severity and duration of the impairment, the credit quality of the issuers, our intent to not sell the securities, and a determination that it is not more likely than not that we will be required to sell the securities until fair value recovers to above cost, or principal value upon maturity.
We recognized impairments on equity securities of $0.9 million (consisting of seven equity securities), $5.8 million (consisting of thirty-seven equity securities), and $17.2 million (consisting of twenty-seven equity securities) during the years ended December 31, 2017, 2016, and 2015, respectively. The other-than temporary impairments recognized during these years were the result of our intent to sell and/or the severity and duration of the change in fair values of these securities. The impairments on equity securities in 2016 and 2015 were primarily due to the downturn in the energy sector that occurred during the fourth quarter of 2015 and the first quarter of 2016. Certain unrealized losses on equity securities were not considered to be other-than-temporary due to the financial condition and near-term prospects of the issuers, and our intent to hold the securities until fair value recovers to above cost.
Our loss reserves (gross and net of reinsurance), including the main components of such reserves, were as follows:
historically, compared with the volume of claims activity for the corresponding historical calendar periods. The portion of unpaid LAE that will be recoverable from reinsurers is estimated based on the contractual reinsurance terms.
The ranges of estimates of loss reserves produced by our Internal Actuary and the Consulting Actuary are intended to represent the range in which it is most likely that the ultimate losses will fall. These ranges are narrower than the range of indications produced by the individual methods applied because it is not likely that the high or low result will emerge for every claim segment and accident year. Each actuary's point estimate of loss reserves is based on a judgmental selection for each claim segment from within the range of results indicated by the different actuarial methods.
As of December 31, 2017, California and Nevada loss reserves represented approximately 77% of our total loss reserves on our Consolidated Balance Sheet.
We have actively driven a significant increase in claims settlement activity beginning in 2014 and continuing through 2017, which has primarily affected accident years 2009 and forward, that is the result of an internal initiative that emphasizes the settlement of open claims. This settlement activity has been recognized in the actuarial analysis using a methodology developed to adjust the data and loss development patterns to account for the settlements arising from this initiative.
Approximately 60% of our claims payments during the three years ended December 31, 2017 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. Our loss reserves are established based on reviewing the results of actuarial methods, most of which do not contain explicit medical claim cost inflation rates; however, because medical care may be provided to an injured worker over many years, and in some cases decades, 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, 2017, we estimate that future medical costs over the lifetime of current claims would increase by approximately $90.0 million on a net-of-reinsurance basis.
The range of estimates of loss reserves produced by our actuarial reviews of medical cost inflation data provides some indication of the potential variability of future losses and LAE payments; however, the full range of potential variation is difficult to estimate because our insurance subsidiaries do not have a lengthy operating history in many of the states in which we now operate. Our reserve estimates reflect expected increases in the costs of contested claims, but do not assume any losses resulting from significant new legal liability theories. Our reserve estimates also assume that there will not be significant future changes in the regulatory and legislative environment. In the event of significant new legal liability theories or new regulation or legislation, we will attempt to quantify its impact on our business.
Reinsurance recoverables represent: (a) amounts currently due from reinsurers on paid losses and LAE; (b) amounts recoverable from reinsurers on estimates of reported losses; and (c) amounts recoverable from reinsurers on actuarial estimates of IBNR for losses and LAE. These recoverables are based on our current estimates of the underlying loss reserves, and are reported on our Consolidated Balance Sheets separately as assets, as reinsurance does not relieve us of our legal liability to policyholders. We bear
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 as a separate component of stockholders' equity, net of deferred taxes, in accumulated other comprehensive income. Realized gains and losses resulting from sales of investments are recognized in operations on a specific-identification basis.
We use third party pricing services to assist us with our investment accounting function. The fair values of our available-for-sale fixed maturity and equity securities are based on quoted market prices, when available. These fair values are obtained primarily from third party pricing services, which generally use Level 1 or Level 2 inputs in accordance with GAAP guidance. The Company obtains a quoted price for each security from third party pricing services, which is derived through recently reported trades for identical or similar securities. For securities not actively traded, the third party pricing services may use quoted market prices of similar instruments or discounted cash flow analyses, incorporating inputs that are currently observable in the markets for similar securities. Inputs that are often used in the valuation methodologies include, but are not limited to, broker quotes, benchmark yields, credit spreads, default rates, and prepayment speeds. The Company also performs quarterly analysis on the prices received from third parties to determine whether the prices are reasonable estimates of fair value, including confirming the fair values of these securities through observable market prices using an alternative pricing source. If differences are noted in this review, the Company may obtain additional information from other pricing services to validate the quoted price (See Note 5 in the Notes to our Consolidated Financial Statements).
Impairment of Investment Securities. When, in the opinion of management, a decline in the fair value of an equity security below its cost is considered to be “other-than-temporary,” the equity security's cost is written down to its fair value at the time the other-than-temporary decline is identified. If management has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery, the investment is written down to its fair value and the entire impairment is recorded as a realized loss due to credit in the accompanying Consolidated Statements of Comprehensive Income. If management does not have the intent to sell or will not be required to sell the debt security but does not expect to recover the amortized cost basis of the debt security, the amount of the other-than-temporary impairment is bifurcated between credit loss and other loss and recorded as a component of realized gains and losses and in other comprehensive income, respectively, in the Consolidated Statements of Comprehensive Income. The amount of any write-down is determined by the difference between the cost or amortized cost of the debt security and its fair value at the time the other-than-temporary decline is identified.
15, 2019. We do not expect that this update will have a material impact to our consolidated financial condition and results of operations.
In February 2016, the FASB issued ASU Number 2016-02, Leases (Topic 842). This update provides guidance on a new lessee model that includes the recognition of assets and liabilities arising from lease transactions on the balance sheet. Additionally, the update provides clarity on the definition of a lease and the distinction between finance and operating leases. Furthermore, the update requires certain qualitative and quantitative disclosures pertaining to the amounts recorded in the financial statements. This update becomes effective for annual reporting periods, including interim periods within those annual periods, beginning after December 15, 2018 and early adoption is permitted. We have not yet estimated the full impact that the adoption will have on our consolidated financial condition and results of operations. Currently, we are analyzing the impact of the new standard on our current accounting policies, internal controls and lease contracts. Upon completion of these and other assessments, we will evaluate the impact of adopting the new standard on our consolidated financial condition and results of operations.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of Employers Holdings, Inc. and Subsidiaries as of December 31, 2017 and 2016, and the related consolidated statements of comprehensive income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2017, the related notes and financial statement schedule listed in the Index at Item 15 and our report dated March 1, 2018 expressed an unqualified opinion thereon.
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We have audited the accompanying consolidated balance sheets of Employers Holdings, Inc. and Subsidiaries (the Company) as of December 31, 2017 and 2016, the related consolidated statements of comprehensive income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2017, and the related notes and financial statement schedule listed in the Index at Item 15 (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company at December 31, 2017 and 2016, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.
Pursuant to the Purchase Agreement, all liabilities and obligations of PRNY existing as of the closing date, whether known or unknown, will be assumed by PRUS. In addition, PartnerRe Ltd., the parent company of PRUS, has provided the Company with a Guaranty that unconditionally, absolutely and irrevocably guarantees the full and prompt payment and performance by PRUS of all of its obligations, liabilities and indemnities under the Purchase Agreement and the transactions contemplated thereby.
The Company will not be acquiring any employees or ongoing business operations pursuant to the Acquisition. The Acquisition is subject to certain closing conditions, including, among other things, approval from the Department of Financial Services of the State of New York.
No reallocations of losses and LAE reserves from non-taxable periods were made in 2017 or 2016.
Restricted cash and cash equivalents represent cash and cash equivalents held in trust in order to secure certain of the Company's obligations and, accordingly, are restricted as to withdrawal or usage. As of December 31, 2017 and 2016 the Company held $24.5 million and $27.2 million, respectively, in trust for reinsurance obligations, of which $1.0 million and $3.6 million, respectively, represented restricted cash and cash equivalents.
The Company considers all liquid investments with maturities of between three and twelve months, as measured from the date of purchase, to be short-term investments.
Premiums written are recognized as revenues, net of any applicable underlying reinsurance coverage, and are earned over the term of the related policy. At the end of the policy term, payroll-based premium audits are performed on substantially all policyholder accounts to determine the actual amount of net premiums earned for that policy year. Earned but unbilled premiums include estimated future audit premiums based on the Company's historical experience. These estimates are subject to changes in policyholders' payrolls, economic conditions, and seasonality, and are continually reviewed and adjusted as experience develops or new information becomes known. Any such adjustments are included in current operations; however, they are partially offset by the resulting changes in losses and LAE, commission expenses, and premium taxes. The Company's premiums receivable on its Consolidated Balance Sheets included $64.2 million and $58.4 million of additional premiums expected to be received from policyholders for final audits at December 31, 2017 and 2016, respectively.
The Company establishes a bad debt allowance on its premiums receivable through a charge included in underwriting and other operating expenses in its Consolidated Statements of Comprehensive 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's bad debt allowance was $10.0 million and $9.8 million at December 31, 2017 and 2016, respectively. The Company had write offs, net of recoveries of amounts previously written off, of $3.2 million, $6.0 million, and $2.4 million for the years ended December 31, 2017, 2016, and 2015, respectively.
Unpaid loss and LAE reserves represent management's best estimate of the ultimate net cost of all reported and unreported losses incurred for the applicable periods, less payments made. The estimated reserves for losses and LAE include the accumulation of estimates for all claims reported prior to the balance sheet date, estimates of claims incurred but not reported, and estimates of expenses for investigating and adjusting all incurred and unadjusted claims (based on projections of relevant historical data). Amounts reported are subject to the impact of future changes in economic, regulatory and social conditions. Management believes that, subject to the inherent variability in any such estimate, the reserves are within a reasonable and acceptable range of adequacy. Estimates for claims prior to the balance sheet date are continually monitored and reviewed, and as settlements are made or reserves adjusted, the differences are reported in current operations. Salvage and subrogation recoveries are estimated based on a review of the level of historical salvage and subrogation recoveries.
In the ordinary course of business, the Company may purchase excess of loss reinsurance in order to protect it against the impact of large and/or catastrophic losses. Additionally, the Company is a party to the LPT Agreement (see Note 10). These reinsurance arrangements reduce the Company's exposure to such losses since its reinsurers are liable to the Company to the extent of the reinsurance protection provided. However, the Company remains liable for all losses it incurs to the extent that any reinsurer is unable or unwilling to make timely payments under its reinsurance agreements.
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 reinsurance recoverables on the Company’s Consolidated Balance Sheets. Reinsurance recoverables on paid losses represents amounts currently due from reinsurers. Reinsurance recoverables on unpaid losses represents amounts that will be collectible from reinsurers once the losses are paid. Reinsurance recoverables on unpaid losses and LAE amounted to $537.0 million and $580.0 million at December 31, 2017 and 2016, respectively.
The Company recognizes deferred tax assets when it determines that such assets are more likely than not to be realized in future periods. In making such a determination, the Company considers all available positive and negative evidence, including future reversals of existing taxable temporary differences, tax-planning strategies, projected future taxable income, projected future tax rates, and results of recent operations. If the Company determines that it is not more likely than not that it could realize its deferred tax assets in future periods it would establish a deferred tax asset valuation allowance that would increase the Company's provision for income taxes. If the Company determines that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, the Company would make an adjustment to the deferred tax asset valuation allowance, which would reduce the provision for income taxes.
The Company monitors the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. The Company also obtains collateral from its reinsurers in order to mitigate the risks related to insolvencies. At December 31, 2017, $3.5 million of the Company's reinsurance recoverables were collateralized by cash or letters of credit and an additional $380.8 million was in trust accounts for reinsurance recoverables specifically related to the LPT Agreement.
The fair values of the Company's financial instruments have been determined using available market information and other appropriate valuation methodologies. Judgment is required in developing fair value estimates 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 Company tests for impairment of goodwill and non-amortizable intangible assets in the fourth quarter of each year. At the end of each quarter, management considers the results of the previous analysis as well as any recent developments that may constitute triggering events requiring the impairment analysis of goodwill and other intangible assets to be updated. The Company has assessed the effects of current economic conditions on the Company's financial condition and results of operations and changes in the Company's stock price and determined that there were no impairments of these assets as of December 31, 2017 and 2016.
In February 2018, the Financial Accounting Standards Board (FASB) issued ASU Number 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220). The amendments in this update allow a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from Enactment. This update becomes effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted for reporting periods for which financial statements have not yet been issued and should be applied in the period of adoption or retrospectively to each
In February 2016, the FASB issued ASU Number 2016-02, Leases (Topic 842). This update provides guidance on a new lessee model that includes the recognition of assets and liabilities arising from lease transactions on the balance sheet. Additionally, the update provides clarity on the definition of a lease and the distinction between finance and operating leases. Furthermore, the update requires certain qualitative and quantitative disclosures pertaining to the amounts recorded in the financial statements. This update becomes effective for annual reporting periods, including interim periods within those annual periods, beginning after December 15, 2018 and early adoption is permitted. Currently, the Company is analyzing the impact of the new standard on its current accounting policies, internal controls, and lease contracts. Upon completion of these and other assessments, the Company will evaluate the impact of adopting the new standard on its consolidated financial condition and results of operations.
In May 2014, the FASB issued ASU Number 2014-09, Revenue from Contracts with Customers (Topic 606). This update clarifies the principles for recognizing revenue and develops revenue standards to improve revenue recognition guidance. This update requires an entity to recognize revenue as performance obligations are met in order to reflect the transfer of promised goods or services to customers in an amount that reflects the consideration the entity is entitled to receive for those goods or services. In applying this guidance companies are required to: (1) identify the contract(s) with a customer; (2) identify the performance obligations in the contract(s); (3) determine the transaction price; (4) allocate the transaction price to the performance obligations in the contract(s); and (5) recognize revenue when, or as, the entity satisfies a performance obligation. In August 2015, the FASB issued ASU 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date, which deferred the effective date of ASU 2014-09 to annual reporting periods beginning after December 15, 2017, and interim reporting periods within that annual reporting period. Insurance contracts are not within the scope of this updated guidance. The Company has analyzed revenue streams within the current business operation and determined the adoption of this standard will not have an impact on its consolidated financial condition and results of operations.
The carrying value and the estimated fair value of the Company's financial instruments as of December 31, were as follows:
The Company uses third party pricing services to assist with its investment accounting function. The ultimate pricing source varies depending on the investment security and pricing service used, but investment securities valued on the basis of observable inputs (Levels 1 and 2) are generally assigned values on the basis of actual transactions. Securities valued on the basis of pricing models with significant unobservable inputs or nonbinding broker quotes are classified as Level 3. The Company performs quarterly analyses on the prices it receives from third parties to determine whether the prices are reasonable estimates of fair value, including confirming the fair values of these securities through observable market prices using an alternative pricing source, as it is ultimately management’s responsibility to ensure that the fair values reflected in the Company’s consolidated financial statements are appropriate. If differences are noted in these analyses, the Company may obtain additional information from other pricing services to validate the quoted price.
For securities not actively traded, third party pricing services may use quoted market prices of similar instruments or discounted cash flow analyses, incorporating inputs that are currently observable in the markets for similar securities. Inputs that are often used in the valuation methodologies include, but are not limited to, broker quotes, benchmark yields, credit spreads, default rates, and prepayment speeds. There were no adjustments to prices obtained from third party pricing services as of December 31, 2017 and 2016 that were material to the consolidated financial statements.
The following table presents the items in the Company's Consolidated Balance Sheets that are stated at fair value and the corresponding fair value measurements.
Transferred from Level 3 to Level 2 because observable market data became available for the securities.
The Company recognized impairments on fixed maturity securities of $0.5 million (consisting of nine securities) during the year ended December 31, 2017. The other-than-temporary impairments recognized during this year were the result of the Company's intent to sell these securities. There were no other-than-temporary impairments recognized on fixed maturity securities during the years ended December 31, 2016 and 2015. The Company determined that the remaining unrealized losses on fixed maturity securities at December 31, 2017, 2016, and 2015 were primarily the result of changes in prevailing interest rates and not the credit quality of the issuers. The fixed maturity securities whose fair value was less than amortized cost were not determined to be other-than-temporarily impaired given the lack of severity and duration of the impairment, the credit quality of the issuers, the Company’s intent to not sell the securities, and a determination that it is not more likely than not that the Company will be required to sell the securities at an amount less than its amortized cost.
Depreciation expenses related to property and equipment for the years ended December 31, 2017, 2016, and 2015 were $7.9 million, $8.2 million, and $7.8 million, respectively. Internally developed software costs of $2.1 million and $1.3 million were capitalized during each of the years ended December 31, 2017 and 2016, respectively.
Additionally, during the third quarter of 2017, the Company wrote-off $7.5 million of previously capitalized costs relating to the development of information technology capabilities that had not yet been placed in service, which is recognized in Other expenses in the Company's Consolidated Statements of Comprehensive Income. The Company incurred this charge as part of a continual evaluation of its ongoing technology initiatives.
Enactment had no impact on the amount of the Company's minimum tax credit as of December 31, 2017. Despite a repeal of the corporate alternative minimum tax, the Company's minimum tax credit will be recognized (subject to annual limits) over the period from January 1, 2018 through December 31, 2021.
The Company is required to discount its loss and LAE reserves for federal income tax purposes. The Company’s income tax deduction associated with its loss and LAE reserves is discounted using interest rates prescribed by the U.S. Treasury, as well as established loss payment patterns. Enactment changes the prescribed interest rates to rates based on corporate bond yield curves and extends the time periods associated with loss payment patterns, which will result in an acceleration of future income tax payments. These changes are effective for tax years beginning after 2017 and are subject to a transition rule that spreads the additional tax payment from the amount determined by applying these changes over the eight years beginning in 2018. This item is a taxable temporary difference and has no direct impact on the Company’s total income tax expense for 2017 and future years. The Company has not yet recorded any provisional amounts to its current and deferred income taxes to reflect these changes. During 2018, the Company will obtain, prepare, and analyze the necessary information to revise and complete its accounting for loss reserve discounting.
IBNR is an actuarial estimate of future payments on claims that have occurred but have not yet been reported. In addition to this provision for late reported claims, the Company also estimates and makes a provision for the extent to which the case reserves on known claims may develop and for additional payments on closed claims, known as “reopening.” IBNR reserves apply to the entire body of claims arising from a specific time period, rather than a specific claim. Most of the Company's IBNR reserves relate to estimated future claim payments on recorded open claims.
A portion of the Company's obligations for losses and LAE are ceded to unaffiliated reinsurers. The amount of reinsurance that will be recoverable on its losses and LAE reserves includes both the reinsurance recoverable from excess of loss reinsurance contracts, as well as reinsurance recoverable under the terms of the LPT Agreement.
Losses and LAE, net of reinsurance, incurred during the period related to prior years and Total net losses and LAE incurred during the period included in the above table excludes the impact of the amortization of the Deferred Gain and LPT Reserve Adjustments (Note 10). Including these amounts, Losses and LAE, net of reinsurance, incurred during the period related to prior years was $(30.1) million, $(35.0) million, and $(27.6) million and Total net losses and LAE incurred during the period was $417.2 million, $417.9 million, and $429.4 million for the years ended December 31, 2017, 2016, and 2015, respectively.
Paid losses and LAE, net of reinsurance, related to prior years and Total net paid losses and LAE during the period included in the above table excludes the impact of the amortization of the Deferred Gain and LPT Reserve Adjustments (Note 10). Including these amounts, Paid losses and LAE, net of reinsurance, related to prior years was $332.2 million, $337.5 million, and $334.8 million and Total net paid losses and LAE during the period was $409.1 million, $416.2 million, and $410.2 million for the years ended December 31, 2017, 2016, and 2015, respectively.
The Company compiles and aggregates its claims data by grouping the claims according to the year in which the claim occurred (“accident year”) when analyzing claim payment and emergence patterns and trends over time. For the purposes of defining claims frequency, the number of reported claims includes any claim that has case reserves and/or loss and LAE payments associated with them.
Ceded losses and LAE incurred includes the amortization of the Deferred Gain, LPT Reserve Adjustments, and LPT Contingent Commission Adjustments.
The Company has consistently maintained excess of loss reinsurance coverage to protect it against the impact of large and/or catastrophic losses in its workers' compensation business. The Company currently maintains reinsurance for losses from a single occurrence or catastrophic event in excess of $10.0 million and up to $200.0 million, subject to certain exclusions. This current reinsurance program is effective July 1, 2017 through June 30, 2018. The coverage under the Company's annual reinsurance programs that ended July 1, 2017 and 2016 was $190.0 million and $193.0 million, in excess of its $10.0 million and $7.0 million retention on a per occurrence basis, respectively. The reinsurance coverage includes coverage for acts of terrorism, excluding nuclear, biological, chemical, and radiological events. Any liability outside the coverage limits of the reinsurance program is retained by the Company.
Recoverables from reinsurers on unpaid losses and LAE amounted to $537.0 million and $580.0 million at December 31, 2017 and 2016, respectively. At each of December 31, 2017 and 2016, $438.9 million and $465.5 million, respectively, of those recoverables was related to the LPT Agreement that was entered into in 1999 by the Fund and assumed by EICN. Under the LPT Agreement, substantially all of the Fund's 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 totaling $380.8 million and $355.7 million at December 31, 2017 and 2016, respectively, have been placed in trust by the three reinsurers as security for payment of the reinsured claims. Under the LPT Agreement, initially $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, 2017, the Company has paid losses and LAE claims totaling $749.3 million related to the LPT Agreement.
The Company amortized $11.3 million, $11.7 million, and $11.4 million of the Deferred Gain for the years ended December 31, 2017, 2016, and 2015, respectively. Additionally, the Deferred Gain was reduced by $3.1 million and $6.4 million for the years ended December 31, 2016 and 2015, respectively, due to favorable LPT Reserve Adjustments and by $0.3 million, $1.8 million, and $2.6 million for the years ended December 31, 2017, 2016, and 2015, respectively, due to favorable LPT Contingent Commission Adjustments (Note 2).
EPIC has a $10.0 million surplus note to Alesco Preferred Funding V, LTD issued as part of a pooled transaction. The note matures in 2034 and became callable by the Company in 2009. The terms of the note provide for quarterly interest payments at a rate 405 basis points in excess of the 90-day LIBOR. Interest paid during each of the years ended December 31, 2017, 2016, and 2015 was $0.5 million, $0.5 million, and $0.4 million, respectively. Interest accrued as of December 31, 2017 and 2016 was less than $0.1 million.
EPIC had a $12.0 million surplus note to ICONS, Inc. issued as part of a pooled transaction. This note was purchased by EHI in May 2017 for $9.9 million, resulting in a $2.1 million gain, and is no longer deemed to be outstanding on a consolidated basis. Interest paid to third parties during each of the years ended December 31, 2017, 2016, and 2015 was $0.3 million, $0.6 million and $0.6 million, respectively. Interest accrued as of December 31, 2016 was $0.1 million.
Principal payment obligations on notes payable outstanding at December 31, 2017, were as follows:
The future lease payments for the next five years on these non-cancelable operating and capital leases at December 31, 2017, were as follows:
Included in the future minimum capital lease payments are future interest charges of $0.1 million. Facilities rent expense was $4.8 million, $4.9 million, and $4.9 million for the years ended December 31, 2017, 2016, and 2015, respectively.
All of the states where the Company's insurance subsidiaries are licensed to transact business require property and casualty insurers doing business within the respective state to pay various insurance assessments. The Company accrues a liability for estimated insurance assessments as direct premiums are written, losses are recorded, or as other events occur in accordance with various states' laws and regulations, and defers these costs and recognizes them as an expense as the related premiums are earned. The Company had an accrued liability for guaranty fund assessments, second injury funds assessments, and other insurance assessments totaling $12.4 million and $18.6 million as of December 31, 2017 and 2016, respectively. These liabilities are generally expected to be paid over one to eighty year periods based on individual state's regulations. The Company also recorded an asset of $14.1 million and $21.6 million, as of December 31, 2017 and 2016, respectively, for prepaid policy charges still to be collected in the future from policyholders, or assessments that may be recovered through a reduction in future premium taxes in certain states.
These assets are expected to be realized over one to ten year periods in accordance with their type and each individual state's regulations.
On February 16, 2016, the Board of Directors authorized a share repurchase program for up to $50.0 million of the Company's common stock from February 22, 2016 through February 22, 2018 (the 2016 Program). The Company expects that its common stock may be purchased at prevailing market prices through a variety of methods, including open market or private transactions, in accordance with applicable laws and regulations and as determined by management. The timing and actual number of shares repurchased will depend on a variety of factors, including the share price, corporate and regulatory requirements, and other market and economic conditions. Repurchases under the 2016 Program may be commenced, modified, or suspended from time-to-time without prior notice, and the 2016 Program may be suspended or discontinued at any time. Through December 31, 2017, the Company has repurchased a total of 724,381 shares of common stock at an average price of $29.08 per share, including commissions, for a total of $21.1 million under the 2016 Program. The Company made no repurchases of common stock during the year ended December 31, 2017.
Since the Company's initial public offering in January 2007 through December 31, 2017, the Company has repurchased a total of 24,097,355 shares of common stock at an average cost per share of $15.92, which is reported as treasury stock, at cost, on its Consolidated Balance Sheets.
The Employers Holdings, Inc. Amended and Restated Equity and Incentive Plan (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 was 5,500,000 shares, prior to reductions for grants made. The Plan provides for the grant of stock options (both incentive stock options and nonqualified stock options), stock appreciation rights, shares of restricted stock, restricted stock units (RSUs), performance stock units (PSUs), and other stock-based awards.
Commencing in 2017, employees who were awarded RSUs and PSUs are entitled to receive dividend equivalents for eligible awards, payable in cash, when the underlying award vests and becomes payable. If the underlying award does not vest or is forfeited, dividend equivalents with respect to the underlying award will also fail to become payable and will be forfeited. These awards are not considered participating securities for the purposes of determining earnings per share.
As of December 31, 2017, the only incentive awards outstanding under the Plan were nonqualified stock options, RSUs, and PSUs.
At December 31, 2017, the Company had yet to recognize $0.5 million of unamortized expense related to stock option grants and expects to recognize these costs on a straight-line basis over the next 27 months. The fair value of stock options vested and the intrinsic value of outstanding and exercisable stock options as of December 31, were as follows:
The intrinsic value of stock options exercised was $7.6 million, $7.6 million, and $4.0 million for the years ended December 31, 2017, 2016, and 2015.
Changes in outstanding RSUs for the year ended December 31, 2017 were as follows:
At December 31, 2017, the Company had yet to recognize $4.2 million of unamortized expense related to outstanding RSUs and expects to recognize these costs on a straight-line basis over the next 39 months. The grant date fair value of RSUs vested and the intrinsic value of vested RSUs for the years ended December 31, were as follows:
The intrinsic value of outstanding RSUs was $14.5 million, $12.8 million, and $8.7 million at December 31, 2017, 2016, and 2015.
The PSUs awarded in March 2015, 2016 and 2017 were awarded to certain employees of the Company and have a performance period of two years followed by an additional one year vesting period. The PSU awards are subject to certain performance goals with payouts that range from 0% to 200% of the target awards. The values shown in the table represent the aggregate number of PSUs awarded at the target level.
Treatment of the LPT Agreement, deferred policy acquisition costs, fair value of financial instruments, and the surplus notes (see Notes 5, 10, and 11) are the primary differences in the SAP-basis capital stock and total surplus of the insurance subsidiaries of $892.4 million and $828.9 million, and the GAAP-basis equity of the Company of $947.7 million and $840.6 million as of December 31, 2017 and 2016, 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 SAP, the surplus notes are recorded as a separate component of surplus. Under SAP, changes to the estimated contingent profit commission under the LPT Agreement are reflected in commission expense in the period that the estimate is revised.
Under Florida law, without regulatory approval, EPIC and EAC may pay dividends if they do not exceed the greater of: the lesser of 10% of surplus or net income, not including realized capital gains, plus a 2-year carry forward; 10% of surplus, with dividends payable limited to unassigned funds minus 25% of unrealized capital gains; or, the lesser of 10% of surplus or net investment income plus a 3-year carry forward with dividends payable limited to unassigned funds minus 25% of unrealized capital gains. During 2017, EPIC and EAC did not pay any dividends. The maximum dividends that may be paid in 2018 by EPIC and EAC without prior regulatory approval from the Florida Office of Insurance Regulation (FOIR) is $15.9 million and $19.0 million, respectively.
Additionally, the California Insurance Holding Company System Regulatory Act limits the ability of ECIC to pay dividends to its parent. California law provides that, absent prior approval of the California Insurance Commissioner, dividends may only be declared from earned surplus. For purpose of this statute, earned surplus excludes amounts (1) derived from net appreciation in the value of assets not yet realized, or (2) derived from an exchange of assets, unless the assets received are currently realizable in cash. In addition, California law provides that the appropriate insurance regulatory authorities in the state of California must approve (or, within a 30 day notice period, not disapprove) 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 to policyholders at the preceding December 31; or (b) 100% of net income for the preceding year. During 2017, ECIC paid an ordinary dividend in the amount of $38.0 million to its parent company, EGI. ECIC can pay $10.4 million of dividends through August 8, 2018 and $48.4 million thereafter without prior regulatory approval, provided that no dividends are paid prior to August 8, 2018.
EPIC and EAC are subject to regulation by the Florida Department of Financial Services (FDFS). Florida statute Section 624.408 requires EPIC and EAC to maintain minimum capital and surplus of the greater of $4.0 million or 10% of total liabilities. Florida statute Section 624.4095 requires EPIC and EAC to maintain a ratio of written premiums, defined as 1.25 times written premiums, to surplus of no greater than 10-to-1 for gross written premiums and 4-to-1 for net written premiums. During the years ended December 31, 2017, 2016, and 2015, EPIC and EAC were in compliance with these statutes.
Basic earnings per share, which includes no dilution from outstanding stock-based awards, is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the potential dilutive impact of all outstanding stock-based awards on earnings per share. Diluted earnings per share includes common shares
The fourth quarter of 2017 was impacted by: (1) favorable prior accident year loss development of $18.0 million; (2) a reduction in our current accident year loss provision rate for that reduced Losses and LAE by $10.6 million; and (3) $7.0 million in additional income tax expense from a revaluation of the Company's net deferred tax asset resulting from Enactment.
The fourth quarter of 2016 was impacted by favorable prior accident year loss development of $16.9 million.