The following table sets forth our selected historical financial information for the periods ended and as of the dates indicated. This information comes from our consolidated financial statements. Certain reclassifications have been made to prior year financials statements to conform to classifications used in the current year. For further information, see Part II, Item 8, Note 2, “Summary of Significant Accounting Policies”. You should read the following selected financial information along with the information contained in this annual report, including Part II,
Net premiums earned is the earned portion of our net premiums written. Premiums are earned over the terms of the related policies in proportion to the risks underwritten. Our policies typically have terms of 12 months. Thus, for example, for a policy that is written on July 1, 2010, approximately one-half of the premiums would be earned in 2010 and the other half would be earned in 2011. At the end of each accounting period, the portion of the premiums that are not yet earned is included in unearned premiums and is realized as revenue in the subsequent periods over the remaining term of the policies.
Net Premiums Earned. Net premiums earned totaled $254.3 million in 2010 compared to $244.4 million in 2009, representing an increase of $9.9 million, or 4.0%. We record the entire annual policy premium as unearned premium at inception and earn the premium over the life of the policy, which is generally twelve months, in proportion to the underlying exposure. Consequently, the amount of premiums earned in any given year depends on when the underlying policies were written and how the underlying payroll exposure is reported. Our direct premiums earned increased $13.5 million, or 5.1%, to $277.0 million in 2010 from $263.5 million in 2009. Net premiums earned in 2010 were reduced by net adjustments of approximately $1.8 million on retrospectively rated policies due to favorable loss results on those policies. Net premiums earned are also affected by premiums ceded under reinsurance treaties. Ceded earned premiums in 2010 totaled $27.0 million compared to $22.7 million in 2009, representing an increase of $4.3 million, or 18.9%.
Net Investment Income. Net investment income was $23.5 million in 2010 compared to $23.1 million in 2009, representing an increase of $0.3 million, or 1.4%. Average invested assets increased $67.2 million, or 11.3%, from $597.0 million in 2009 to $664.2 million in 2010. This increase in our investment portfolio is due primarily to cash flow from operations of $56.7 million for the year ended December 31, 2010, which was invested primarily in fixed income securities. Net investment income as a percentage of average invested assets decreased slightly to 3.5% in 2010 from 3.9% in 2009 primarily due to reduced reinvestment interest rates.
Loss and Loss Adjustment Expenses. Loss and loss adjustment expenses totaled $223.1 million in 2010 compared to $174.3 million in 2009, representing an increase of $48.7 million, or 28.0%. Our net loss ratio, which is calculated by dividing loss and loss adjustment expenses less claims service income by premiums earned, was 87.4% in 2010 compared to 70.9% in 2009. The increase in our net loss ratio was primarily attributable to unfavorable development of prior accident year loss reserves of $32.6 million in 2010 (offset by a $0.6 million favorable commutation gain), compared to unfavorable development of prior year accident year loss reserves of $0.4 million in 2009 (offset by a $0.6 million favorable commutation gain). The increase in our net loss ratio was also impacted by an increase in the current accident year loss ratio from 60.0% at December 31, 2009 to 64.5% at December 31, 2010 and an increase of approximately $8.9 million in the earned premium against which the current accident year expected loss ratio (“ELR”) is applied. Our direct loss reserves are net of reinsurance and exclude reserves associated with KEIC, whom we acquired from LMC in September 2003, and the business that we involuntarily assume from the NCCI.
For accident year 2010, an expected loss ratio was established for each jurisdiction and type of loss (indemnity, medical and allocated loss and loss adjustment expenses (“ALAE”)). The expected loss ratio was multiplied by the booked accident year earned premium to produce the ultimate loss to date. The expected loss ratio selections are reviewed quarterly with each internal IBNR study. Given the short experience period for the current accident year, the expected loss ratios are usually maintained at least through the first 12 months of the accident year and revised as the underlying data matures. However, we increased the expected loss ratio for 2010 from 61.5% to 64.5% in the second quarter of 2010 after reviewing results for the 2010 accident year and considering the adverse development of accident years 2008 and 2009.
For accident year 2007, the ultimate loss estimates at December 31, 2010 were higher when compared to December 31, 2009 and resulted in a net increase of our loss reserves of $5.6 million. The increase was attributable to the following jurisdictions: $3.7 million for California state act, driven primarily by medical costs; $0.6 million for non-California state act, driven primarily by indemnity and ALAE costs; and $1.3 million for USL&H, driven primarily by increased indemnity and ALAE costs. This adverse development was offset by favorable development of $0.1 million related to ULAE, loss based assessments and NCCI, as well as $0.1 million related to favorable commutation.
We have recently observed an increase in severity estimates for accident years 2007 through 2009 in California following several years of decreasing trends. We have established loss reserves at December 31, 2010 that are based upon our current best estimate of ultimate loss costs, taking into consideration the recent paid loss claim data, incurred loss trends and uncertainty regarding the permanence of recent legislative reforms. We continue to monitor the impact of reforms and potential challenges to reforms in our loss data. See the discussion under the headings “Loss Reserves” in Part I, Item 1 and “Critical Accounting Policies, Estimates and Judgments - Unpaid Loss and Loss Adjustment Expense” in this Item 7 for a further discussion of our loss reserving process.
Underwriting, Acquisition and Insurance Expenses. Underwriting expenses totaled $72.2 million in 2010 compared to $73.0 million in 2009, representing a decrease of $0.8 million, or 1.1%. Our net underwriting expense ratio, which is calculated by dividing underwriting, acquisition and insurance expenses less other service income by premiums earned, was 28.3% in 2010 compared to 29.8% in 2009. The decline in our expense ratio resulted from decreases in our underwriting expenses and increases in our net premiums earned from the same period of 2009.
Interest Expense. Interest expense related to the surplus notes issued by our insurance subsidiary in May 2004 totaled $0.5 million in 2010 and $0.6 million in 2009. The surplus notes interest rate, which is calculated at the beginning of each interest payment period using the 3-month LIBOR plus 400 basis points, ranged between 4.25% and 4.48% in 2010 down from 4.26% and 6.15% in 2009.
Income Tax Expense (benefit). The effective tax rate for the year ended December 31, 2010 resulted in a benefit of 75.0% compared to an expense of 18.4% for the same period in 2009. The effective tax rate for 2010 differed from the statutory tax rate of 35.0% primarily as a result of tax exempt interest income, which accounted for approximately 53.0% percentage points of the increase to the statutory rate. The increase in the benefit was partially offset by approximately $0.6 million, or 8.8 percentage points, due to a true-up of vesting expense related to restricted stock which vested during the year. The effective rate for December 31, 2009 was lower than the statutory rate of 35.0% primarily as a result of tax exempt interest income, which accounted for approximately 20.8 percentage points of the reduction from the statutory rate. This decrease in the statutory rate was partially offset by approximately $0.7 million, or 4.2 percentage points, due to state income taxes and other nondeductible expenses.
Net Income (loss). Net loss totaled $1.6 million in 2010 compared to net income of $13.5 million in 2009, representing a decrease of $15.1 million, or 111.7%. The 2010 decrease in net income resulted primarily from an increase in loss and loss adjustment expenses, offset by an increase in other realized gains recognized in earnings.
Gross premiums written totaled $290.0 million in 2009 compared to $270.3 million in 2008, representing an increase of $19.7 million, or 7.3%. Much of the increase in gross premiums written resulted from premium growth primarily related to new business growth in our Program Business. Program Business, which includes alternative markets and small maritime programs, increased $32.2 million in 2009 compared to 2008. The increase in Program Business was offset by a $10.0 million decrease in our “core” product lines, which includes energy, maritime and construction business. The decrease was primarily driven by our construction business as a result of the continuing impact of the current economic downturn. Excluding work we perform as the servicing carrier for the Washington USL&H Plan and excluding business assumed from the NCCI residual market pool, the total number of customers we serviced increased from more than 1,120 at December 31, 2008 to approximately 1,530 at December 31, 2009. Approximately 14.1% of the 410 customer increase related to our core book of business and 85.9% of the increase related to our Program Business. By design, our Program Business will have a larger number of customers with a smaller average premium size than our core book of business. Total in-force payrolls, one of the factors used to determine premium charges, increased 12.5% from $6.4 billion at December 31, 2008 to $7.2 billion at year-end 2009. California continues to be our largest market, accounting for approximately $132.5 million, or 43.1% of our in-force premiums at December 31, 2009. This represents an increase of $22.0 million, or 19.9%, from approximately $110.5 million, or 39.6%, of in-force premiums in California at December 31, 2008.
The following is a summary of our top five markets based on direct premiums written (excluding premiums written under the Washington USL&H Plan and NCCI):
Net Premiums Written. Net premiums written totaled $262.8 million in 2009 compared to $255.8 million in 2008, representing an increase of $7.0 million, or 2.7%. The increase was primarily attributable to the increase in gross written premiums, offset in part by a $12.7 million increase in premiums ceded related to the increased ceding rate of the 2008 reinsurance contracts due primarily to an increase in limits at the lower and upper ends of the program, as well as the addition of a new reinsurance treaty related to the residual market business. Included in gross premiums written in 2009 is a decrease in the amount of premiums we involuntarily assume on residual market business from the NCCI, which operates residual market programs on behalf of many states.
Other-Than-Temporary Impairment Losses. OTTI losses totaled $0.3 million for the year ended December 31, 2009, compared to $13.4 million, in 2008. In 2008, we recorded $13.4 million of OTTI charges in connection with investments in government-sponsored agency and corporate preferred stock ($10.2 million charge) and equity indexed securities exchange-traded funds ($3.2 million charge). The $0.3 million OTTI charge in 2009 also related to our investment in government-sponsored agency preferred stock. The OTTI charges were the result of thorough reviews of the investment portfolio and a determination by management that these investments met the criteria for OTTI charges primarily due to the extent and duration of the impairments and the inability to forecast a complete recovery of their book values within a reasonable period of time or, in the case of the government-sponsored entity preferred stocks, a significant decline in the underlying credit fundamentals of the securities.
There is uncertainty about whether the positive effects of California legislative reforms enacted in 2003 and 2004 will be sustained, particularly in light of current efforts to change or repeal portions of the reforms. We will not know the full impact of these reforms with a high degree of confidence for several years. We observed an increase in severity estimates for accident years 2007 and 2008 in California following several years of decreasing trends. We have established loss reserves at December 31, 2009 that are based upon our current best estimate of ultimate loss costs, taking into consideration the recent paid loss claim data, incurred loss trends and uncertainty regarding the permanence of recent legislative reforms. We continue to monitor the impact of reforms and potential challenges to reforms in our loss data. See the discussion under the headings “Loss Reserves” in Part I, Item 1 and “Critical Accounting Policies, Estimates and Judgments - Unpaid Loss and Loss Adjustment Expense” in this Item 7 for a further discussion of our loss reserving process.
As of December 31, 2009, we had recorded a receivable of approximately $3.0 million for adverse loss development under the adverse development cover since the date of the Acquisition. We do not expect this receivable to have any material effect on our future cash flows if LMC fails to perform its obligations under the adverse development cover. At December 31, 2009, we had access to approximately $3.8 million under the collateralized reinsurance trust in the event that LMC fails to satisfy its obligations under the adverse development cover. See the discussion under the heading “Loss Reserves - KEIC Loss Reserves” in Part I, Item 1 of this annual report.
Net Income. Net income totaled $13.5 million in 2009 compared to $29.3 million in 2008, representing a decrease of $15.7 million, or 53.8%. The 2009 decrease in net income resulted primarily from a reduction in earned premiums, primarily resulting from the effects of the current economic downturn, and increases in loss and loss adjustment expense, underwriting, acquisition, and insurance expenses, and other expenses, offset by $13.4 million of OTTI losses in 2008.
Net cash used in financing activities totaled $3.9 million in 2010, an increase of $3.4 million from $0.4 million in 2009, which decreased $1.6 million from $1.2 million of net cash provided in 2008. The increase in net cash used in financing activities in 2010 was primarily the result of quarterly cash dividends paid in 2010.
The following table identifies our contractual obligations by payment due period as of December 31, 2010:
The loss and loss adjustment expense payments due by period in the table above are based upon the loss and loss adjustment expense estimates as of December 31, 2010 and actuarial estimates of expected payout patterns and are not contractual liabilities as to time certain. Our contractual liability is to provide benefits under the policies we write. As a result, our calculation of loss and loss adjustment expense payments due by period is subject to the same uncertainties associated with determining the level of unpaid loss and loss adjustment expenses generally and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. For a discussion of our unpaid loss and loss adjustment expense process, see the heading “Loss Reserves” in Part I, Item 1 of this annual report and “Critical Accounting Policies, Estimates and Judgments - Unpaid Loss and Loss Adjustment Expense” in Part II, Item 7 of this annual report. Actual payments of loss and loss adjustment expenses by period will vary, perhaps materially, from the above table to the extent that current estimates of loss and loss adjustment expenses vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns. See the discussion under the heading “Risks Related to our Business - Our loss reserves are based on estimates and may be inadequate to cover our actual losses” in Part I, Item 1A of this annual report for a discussion of the uncertainties associated with estimating unpaid loss and loss adjustment expenses.
As of December 31, 2010, we had no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
For the current accident year, we establish the initial reserve for claims incurred-but-not-reported (“IBNR”) using an expected loss ratio (“ELR”) method. The ELR method is based on an analysis of historical loss ratios adjusted for current pricing levels, exposure growth, anticipated trends in claim frequency and severity, the impact of reform activity and any other factors that may have an impact on the loss ratio. The actual paid and incurred loss data for the accident year is reviewed each quarter and changes to the ELR may be made based on the emerging data, although changes are typically not made until the end of the accident year when the loss data can be analyzed as a complete accident year. However, due to results experienced for the 2010 accident year and the adverse development of accident years 2008 and 2009, we increased our 2010 ELR from 61.5% to 64.5% at June 30, 2010. The ELR is multiplied by the year-to-date earned premium to determine the ultimate losses for the current accident year. The actual paid and case outstanding losses are subtracted from the ultimate losses to determine the IBNR for the accident year. As the accident year matures, we incorporate a standard actuarial reserving methodology referred to as the Bornhuetter-Ferguson method. This method blends the loss development and expected loss ratio methods by assigning partial weight to the initial expected losses, calculated from the expected loss ratio method, with the remaining weight applied to the actual losses, either paid or incurred. The weights assigned to the initial expected losses decrease as the accident year matures. A reserve estimate implies a pattern of expected loss emergence. If this emergence does not occur as expected, it may cause us to revisit our previous assumptions. We may adjust loss development patterns, the various method weights or the expected loss ratios used in our analysis. Management employs judgment in each reserve valuation as to how to make these adjustments to reflect current information.
In the last three years there have been ongoing challenges to the PDRS, one of the most significant reforms to emerge from the 2004-2005 legislation. The PDRS was revised effective January 1, 2005. The revised schedule has resulted in significantly reduced permanent disability awards, leading to concerns that injured workers may not be adequately compensated for their work related permanent injuries.
In February of 2009, the California Workers’ Compensation Appeals Board ( the “Appeals Board”) rendered an en banc decision on a series of cases, commonly referred to as Almarez, Guzman and Ogilvie. Allowing a rebuttal of the AMA Guides, the decision has a material impact on the value of permanent disability awards. The en banc decision led to considerable comment and debate in the Workers’ Compensation community. In September of 2009, the Appeals Board reaffirmed most aspects of its prior work, with some clarifications to its February decisions. Its decision is considered final with details to be determined by case law and through appeal. In November of 2010, the California Supreme Court declined to review the Guzman case. An appeal of the Almarez case to the Fifth Circuit Court of Appeals is pending.
Our analysis is done separately for the indemnity, medical and DCC components of the total loss reserves within each accident year. In addition, the analysis is completed separately for the following five categories: State Act, California (California); State Act, Alaska and Hawaii (Alaska & Hawaii); State Act, Illinois (Illinois); State Act, all other states (All Other); and USL&H claims. The business is divided into these categories for the determination of ultimate losses due to differences in the laws that cover each of these categories.
Workers’ compensation insurance is statutorily provided for in all of the states in which we do business. State laws and regulations provide for the form and content of policy coverage and the rights and benefits that are available to injured workers, their representatives and medical providers. Because the benefits are established by state statute, there can be significant variation in these benefits by state. We refer to this coverage as State Act.
For accident years 2006 and prior, there was unfavorable development in the losses for California State Act which resulted in an increase of our net ultimate loss estimates of $1.9 million. For non-California State Act, there was unfavorable development in the losses for accident years 2006 and prior which resulted in an increase of our net ultimate loss estimates of $0.9 million. For USL&H, there was unfavorable development in the losses for accident years 2006 and prior which resulted in an increase of our net ultimate loss estimates of $0.7 million.
For accident year 2009, there was unfavorable development in the losses for California State Act which resulted in an increase of our net ultimate loss estimates of $7.1 million. For non-California State Act, there was unfavorable development in the losses for accident year 2009 which resulted in an increase of our net ultimate loss estimates of $3.5 million. For USL&H, there was unfavorable development in the losses for accident year 2009 which resulted in an increase of our net ultimate loss estimates of $3.4 million.
For accident year 2010, the ultimate losses were set by multiplying the selected ELR to the booking earned premium. Given the results from the 2010 accident year and the adverse development of prior accident years, we increased the ELR for 2010 from 61.5% to 64.5% in the second quarter of 2010. For more information on the ELR method and selection see the related discussion under the heading “Actuarial Loss Reserve Estimation Methods” in this Item 7.
As discussed in the previous section, there are a number of variables that can impact, individually or in combination, the adequacy of our loss and loss adjustment expense liabilities. While the actuarial methods employed factor in amounts for these circumstances, the loss reserves may prove to be inadequate despite the actuarial methods used. Several examples are provided below to highlight the potential variability present in our loss reserves. Each of these examples represents scenarios that are reasonably likely to occur over time. For example, there may be a number of claims where the unpaid loss and loss adjustment expense associated with future medical treatment proves to be inadequate because the injured workers do not respond to medical treatment as expected by the claims examiner. If we assume this affects 10% of the open claims and, on average, the unpaid loss and loss adjustment expenses on these claims are 20% inadequate, this would result in our unpaid loss and loss adjustment expense liability being inadequate by approximately $8.8 million, or 2.0%, as of December 31, 2010. Another example is claim inflation. Claim inflation can result from medical cost inflation or wage inflation. As discussed above, the actuarial methods employed include an amount for claim inflation based on historical experience. We assume that the historical effect of this factor, which is embedded in our experience and industry experience, is representative of future effects for claim inflation. To the extent that the historical factors, and the actuarial methods utilized, are inadequate to recognize future inflationary trends, our unpaid loss and loss adjustment expense liabilities may be inadequate. If our estimate of future medical trend is two percentage points inadequate (e.g., if we estimate a 9% annual trend and the actual trend is 11%), our unpaid loss and loss adjustment expense liability could be inadequate. The amount of the inadequacy would depend on the mix of medical and indemnity payments and the length of time until the claims are paid. For example, if we assume that 50% of the unpaid loss and loss adjustment expense is associated with medical payments and an average payout period of 5 years, our unpaid loss and loss adjustment expense liabilities would be inadequate by approximately $22.0 million on a pre-tax basis, or 5%, as of December 31, 2010. Under these assumptions, the inadequacy of approximately $22.0 million represents approximately 6.3% of total stockholders’ equity at December 31, 2010. The impact of any reserve deficiencies, or redundancies, on our reported results and future earnings is discussed below.
Reinsurance recoverables on paid and unpaid losses represent the portion of the loss and loss adjustment expenses that is assumed by reinsurers. These recoverables are reported on our balance sheet separately as assets, as reinsurance does not relieve us of our legal liability to policyholders and ceding companies. We are required to pay losses even if a reinsurer fails to meet its obligations under the applicable reinsurance agreement. Reinsurance recoverables are determined based in part on the terms and conditions of reinsurance contracts, which could be subject to interpretations that differ from ours based on judicial theories of liability. We calculate amounts recoverable from reinsurers based on our estimates of the underlying loss and loss adjustment expenses, which themselves are subject to significant judgments and uncertainties described above under the heading “Unpaid Loss and Loss Adjustment Expense.” Changes in the estimates and assumptions underlying the calculation of our loss reserves may have an impact on the balance of our reinsurance recoverables. In general, one would expect an increase in our underlying loss reserves on claims subject to reinsurance to have an upward impact on our reinsurance recoverables. The amount of the impact on reinsurance recoverables would depend on a number of considerations including, but not limited to, the terms and attachment points of our reinsurance contracts and the incurred amount on various claims subject to reinsurance. We also bear credit risk with respect to our reinsurers, which can be significant considering that some claims may remain open for an extended period of time.
We periodically evaluate our reinsurance recoverables, including the financial ratings of our reinsurers, and revise our estimates of such amounts as conditions and circumstances change. Changes in reinsurance recoverables are recorded in the period in which the estimate is revised. We assessed the collectability of our year-end receivables and believe that all amounts are collectible based on currently available information. Therefore, as of December 31, 2010 and 2009, we had no reserve for uncollectible reinsurance recoverables. As of December 31, 2010, the top ten companies, representing 92.3% of our reinsurance amounts recoverable, had A.M. Best ratings of “A” or higher.
We defer commissions, premium taxes and certain other costs that vary with and are primarily related to the acquisition of insurance contracts. These costs are capitalized and charged to expense in proportion to the recognition of premiums earned. The method followed in computing deferred policy acquisition costs limits the amount of these deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related estimated investment income, anticipated losses and settlement expenses and certain other costs we expect to incur as the premium is earned. Judgments regarding the ultimate recoverability of these deferred costs are highly dependent upon the estimated future costs associated with our unearned premiums. If our expected claims and expenses, after considering investment income, exceed our unearned premiums, we would be required to write-off all or a portion of deferred policy acquisition costs. Since inception, we have not needed to write-off any portion of our deferred acquisition costs. If our estimate of anticipated losses and related costs was 10% inadequate, our deferred acquisition costs as of December 31, 2010 would still be fully recoverable and no write-off would be necessary. We will continue to monitor the balance of deferred acquisition costs for recoverability.
FASB ASC Topic 740, Income Taxes, prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and also provides guidance on the derecognition of previously recorded benefits and their classification, as well as the proper recording of interest and penalties, accounting in interim periods, disclosures and transition. As of December 31, 2010 and December 31, 2009, we had no unrecognized tax benefits. We do not anticipate that the amount of unrecognized tax benefits will significantly increase in the next 12 months. Our policy is to recognize interest and penalties on unrecognized tax benefits as an element of income tax expense (benefit) in our consolidated statements of operations. We file consolidated U.S. federal and state income tax returns. The tax years which remain subject to examination by the taxing authorities are the years ended December 31, 2007, 2008, 2009 and 2010.
For debt securities that are considered OTTI and that we do not intend to sell and more likely than not would not be required to sell prior to recovery of the amortized cost basis, we recognize OTTI losses in accordance with the provisions of the ASC. The amount of the OTTI loss is separated into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss component is recognized in earnings and is the difference between a security’s amortized cost basis and the present value of expected future cash flows discounted at the security’s effective interest rate. The amount due to all other factors is recognized in other comprehensive income.
We regularly review our investment portfolio for declines in value. In general, we review all securities that are impaired by 5% or more at the end of the period. We focus our review of securities with no stated maturity date on securities that were impaired by 20% or more at the end of the period or have been impaired 10% or more continuously for six months or longer as of the end of the period. We also analyze the entire portfolio for other factors that might indicate a risk of impairment, including credit ratings and interest rates. It is possible that we could recognize future impairment losses on some securities we owned at December 31, 2010 if future events, information and the passage of time result in a determination that a decline in value is other-than-temporary.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of SeaBright Holdings, Inc. and subsidiaries as of December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), SeaBright Holdings, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 14, 2011 expressed an unqualified opinion on the effectiveness of SeaBright Holdings, Inc and subsidiaries’ internal control over financial reporting.
SeaBright Insurance Holdings, Inc. (“SeaBright”), a Delaware corporation, was formed in June 2003. In May 2010, SeaBright announced that it had changed its corporate name to SeaBright Holdings, Inc. On July 14, 2003, SeaBright entered into a purchase agreement, effective September 30, 2003, with Kemper Employers Group, Inc. (“KEG”), Eagle Pacific Insurance Company and Pacific Eagle Insurance Company (“Eagle”), and Lumbermens Mutual Casualty Company (“LMC”), the ultimate owner of KEG and Eagle (the “Acquisition”). Under this agreement, SeaBright acquired Kemper Employers Insurance Company (“KEIC”), PointSure Insurance Services, Inc. (“PointSure”), and certain assets of Eagle, primarily renewal rights. KEG, LMC and Eagle are no longer writing new business and, as of December 31, 2010, were operating under a voluntary run-off plan which has been approved by the Illinois Department of Insurance.
PointSure is a wholesale insurance broker and third party claims administrator, and acts primarily as an in-house distribution platform for SeaBright Insurance Company.
In July 2008, PointSure acquired 100% of the outstanding common stock of Black/White and Associates, Inc., Black/White and Associates of Nevada and Black/White Rockridge Insurance Services, Inc. (referred to collectively as “BWNV”), a privately held managing general agent and wholesale insurance broker. Also included in the transaction were a covenant not to compete from key principals of BWNV and other intangible assets. The preliminary purchase price paid at closing was $1.7 million, of which $0.5 million was allocated to the purchase of BWNV capital stock. The stock purchase agreement provided for a contingent purchase price to be paid by (or refunded to) the Company approximately 13 months following the closing date, depending on whether BWNV revenue in the 12 months following closing exceeded (or was less than) the base revenue assumed at the time of the closing. The Company paid approximately $159,000 as additional purchase consideration upon resolution of the contingency period in 2009. The Company has recorded goodwill of approximately $0.5 million in connection with this acquisition as of December 31, 2009. In November 2010, PointSure reorganized its corporate structure and directly assumed the business and operations of BWNV. The BWNV legal entities were subsequently dissolved.
In accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 280, Segment Reporting, the Company considers an operating segment to be any component of its business whose operating results are regularly reviewed by the Company’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance. Currently, the Company has one operating segment, workers’ compensation insurance and related services.
Furniture and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful lives, which range from three to five years. Leasehold improvements are depreciated on a straight-line basis over periods ranging from approximately two to seven years, which is the shorter of their estimated useful lives or the remaining term of the respective lease. Depreciation expense totaled $1.7 million, $1.9 million and $1.4 million for the years ended December 31, 2010, 2009, and 2008, respectively.
In light of the Company’s short operating history, and uncertainties concerning the effects of legislative reform specifically as it relates to the Company’s California workers compensation class of business, actuarial techniques are applied that use the historical experience of the Company and the Company’s predecessor as well as industry information in the analysis of unpaid loss and loss adjustment expense. These techniques consider, among other factors:
The following table provides the reconciliation of weighted average common share equivalents outstanding used in calculating earnings per share for the years ended December 31, 2010, 2009, and 2008:
In January 2010, the FASB issued Accounting Standards Update (“ASU) 2010-06, Improving Disclosures about Fair Value Measurements, to require additional disclosures for transfers in and out of Levels 1 and 2 and certain information regarding activity in Level 3 of the fair value hierarchy. The new guidance is effective for interim and annual reporting periods beginning after December 15, 2009, except for the Level 3 disclosure, which is effective for interim and annual reporting periods beginning after December 15, 2010. The Company adopted all provisions of this standard effective January 1, 2010, which did not have a material effect on its consolidated financial position or results of operations.
In October 2010, the FASB issued ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. This ASU allows insurance entities to defer costs related to the acquisition of new or renewal insurance contracts that are (1) incremental direct costs of the contract transaction (i.e., would not have occurred without the contract transaction), (2) a portion of the employee's compensation and fringe benefits related to certain activities for successful contract acquisitions, or (3) direct-response advertising costs as defined in ASC Subtopic 340-20, Other Assets and Deferred Costs - Capitalized Advertising Costs. All other costs related to the acquisition of new or renewal insurance contracts are required to be expensed as incurred. This ASU is effective for interim and annual periods beginning after December 15, 2011 with either prospective or retrospective application permitted. The Company has not determined the impact that adoption of this new standard will have on its consolidated financial condition or results of operations. However, since the new standard represents a significant departure from current practice, its adoption may result in a significant reduction in the amount of acquisition costs eligible for deferral.
The consolidated cost or amortized cost, gross unrealized gains and losses, estimated fair value and carrying value of investment securities available for sale at December 31, 2010 and 2009 are as follows:
The $172,000 of securities with unrealized losses of 12 months or longer at December 31, 2010 in the above table consist of one security, whose amortized cost at December 31, 2010 was approximately $199,000. No security had an unrealized loss that exceeded 20% of the related security’s book value at December 31, 2010. As of December 31, 2010, all payments were current on these debt securities and the Company expects to fully recover its investment in these securities no later than their scheduled maturities. The Company has no current intent to sell these securities nor is it more likely than not that the Company would be required to sell these securities. Therefore, based on management’s review of the financial strength of these debt securities and the Company’s expectation regarding future receipt of principal and interest, management concluded these debt securities were temporarily impaired as of December 31, 2010. The Company recognized no OTTI losses in 2010 and approximately $0.3 million of OTTI losses in 2009, which were related to its investment in preferred stock issued by Fannie Mae and Freddie Mac. In 2008, the Company recognized OTTI losses of approximately $10.2 million on its investments in preferred stocks (nearly all of which were government-sponsored agency fixed and variable preferred stocks) and approximately $3.2 million on its investment in equity indexed securities exchange-traded funds.
Significant changes in the factors considered when evaluating investments for impairment losses could result in a significant change in impairment losses reported in the financial statements. At December 31, 2010 and 2009, the Company evaluated investment securities with fair values less than amortized cost and determined that the declines in value were temporary and were related primarily to the change in market rates since purchase or to other market anomalies that are expected to correct themselves. Furthermore, the Company has the ability and intent to hold the impaired investments to maturity or for a period of time sufficient for recovery of their carrying amount.
Consists of $310.7 million of tax-exempt municipal bonds and $21.6 million of taxable municipal bonds.
Represents insured ratings on insured bonds and ratings on uninsured bonds.
The 2010 gains were realized in order to allow the Company to fully realize the approximately $15.0 million of tax capital loss carry forwards that existed at December 31, 2009.
Investment securities: The Company measures and reports its financial assets and liabilities, including investment securities, in accordance with ASC Topic 820, “Fair Value Measurements and Disclosures.” The estimated fair values for available-for-sale securities are generally based on quoted market value prices for securities traded in the public marketplace. The Company also considers the impact of a significant decrease in volume and level of activity for an asset or liability when compared with normal activity. Additional information with respect to fair values of the Company’s investment securities is disclosed in Note 3, “Investments”.
Level 3 - Valuations for assets and liabilities that are derived from other valuation methodologies, including discounted cash flow models and similar techniques, and not based on market exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities. As of December 31, 2010, the Company had no Level 3 financial assets or liabilities.
Active markets are those in which transactions occur with sufficient frequency and volume to provide reliable pricing information on an ongoing basis. Inactive markets are those in which there are few transactions for the asset, prices are not current, or price quotations vary substantially either over time or among market makers, or in which little information is released publicly. When the market for an investment is judged to be inactive, appropriate adjustments must be made to observable inputs to account for such inactivity. As of December 31, 2010, the Company’s investment portfolio consisted of securities that it considered to be traded in active markets. Therefore, no adjustment for market inactivity or illiquidity was necessary. There were no transfers between levels during the year ended December 31, 2010.
The Company also seeks input from independent portfolio managers and financial advisors engaged by the Company to assist in the management and oversight of its investment portfolio. The Company and an independent portfolio manager engaged by the Company review such amounts for reasonableness in relation to the following considerations, among others: recent trades of a particular security; the Company’s independent observations of recent developments affecting the economy in general and certain issuers in particular; and fair values from other sources, such as statements from the Company’s custodial banks. When other evidence indicates a fair value that is significantly different from that provided by an independent pricing service, the Company may challenge the fair value and request further validation and support from the independent pricing service, which may result in a revised fair value from the independent pricing service. If the Company has independent evidence indicating that a security’s fair value is significantly different from the final value provided by an independent pricing service, it may adjust the fair value accordingly. The Company did not adjust any of the values it obtained from independent pricing services and used those values in developing the fair value measurements in the Company’s consolidated financial statements as of December 31, 2010 and 2009.
The Company holds a limited amount ($10.8 million at December 31, 2010) of privately placed corporate bonds and estimates the fair value of these bonds using an internal matrix that is based in part on market information regarding interest rates, credit spreads and liquidity. The pricing matrix begins with current U.S. Treasury rates and uses credit spreads received from third-party sources to estimate fair value. The Company includes the fair value estimates of these corporate bonds in Level 2, since all significant inputs are market observable. As some of these securities are issued by public companies, the Company compares the estimates of fair value to the fair values of these companies’ publicly traded debt to test the validity of the internal pricing matrix.
Property and equipment consisted of the following at December 31, 2010 and 2009:
The following reflects the amounts of policy acquisition costs deferred and amortized for the years ended December 31, 2010, 2009, and 2008:
As part of the Acquisition, SeaBright and LMC entered into an adverse development excess of loss reinsurance agreement (the “Agreement”). The Agreement, after taking into account any recoveries from third party reinsurers, calls for LMC to reimburse SBIC 100% of the excess of the actual loss at December 31, 2011 over the initial loss reserves at September 30, 2003. The Agreement also calls for SBIC to reimburse LMC 100% of the excess of the initial loss reserves at September 30, 2003 over the actual loss results at December 31, 2011. The amount of adverse loss development under the Agreement was $3.0 million at December 31, 2010 and 2009. Any change in the amount receivable from LMC is netted against loss and loss adjustment expense in the accompanying consolidated statements of operations.
The following table summarizes the activity in unpaid loss and loss adjustment expense for the years ended December 31, 2010, 2009 and 2008:
As a result of changes in estimates of insured events in prior periods, unpaid loss and loss adjustment expenses decreased by a net amount of $0.2 million in 2009. Net adverse development of prior year loss reserves totaled $14.4 million and related to the following accident years: $8.8 million in 2008, $5.0 million in 2007, and $0.9 million in 2006. This adverse development was offset by $0.3 million of net favorable development of loss reserves related to accident years 2005 and prior. The net adverse development on loss reserves was offset by $14.0 million of net favorable development of other amounts such as ULAE, loss based assessments and losses assumed from the NCCI pools, as well as a $0.6 million favorable commutation gain. The $14.0 million related to the following accident years: $4.4 million in 2008, $3.7 million in 2007, $3.3 million in 2006, and $2.6 million in 2005 and prior.
In 2008, unpaid loss and loss adjustment expense related to prior years decreased by a net amount of $26.6 million. Favorable development of prior year loss reserves totaled $19.7 million and related to the following accident years: $11.6 million in 2007, $5.1 million in 2006, $2.4 million in 2005, and $0.6 million in 2005 and prior. Additionally, there was $6.9 million of net favorable development of other amounts such as ULAE, loss based assessments and losses assumed from the NCCI pools. The $6.9 million related to the following accident years: $3.5 million in 2007, $2.3 million in 2006 and $1.1 million in 2005 and prior.
The notes are redeemable prior to 2034 by the Company, in whole or in part, on any interest payment date.
Issuance costs of $591,000 incurred in connection with the Surplus Notes are being amortized over the life of the notes using the effective interest method. Amortization expense for the years ended December 31, 2010, 2009, and 2008 was $26,000, $29,000 and $43,000, respectively.
The following is a reconciliation of the difference between the “expected” income tax computed by applying the federal statutory income tax rate of 35% to income before income taxes and the total income taxes reflected on the books for the years ended December 31, 2010, 2009, and 2008:
Deferred federal income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and those amounts used for federal income tax reporting purposes. The significant components of the deferred tax assets and liabilities at December 31, 2010 and 2009 are as follows:
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the taxes paid in prior years, the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based upon the level of historic taxable income and projections of future taxable income over the periods in which the deferred tax assets are deductible, management expects to realize the benefits of these deductible differences.
During 2010, the Company realized net gains of approximately $15.4 million on the sale of investment securities and was thus able to fully realize in 2010 the approximately $15.0 million of capital loss carry forwards that existed at December 31, 2009.
As of December 31, 2010 and 2009, the Company had no unrecognized tax benefits. Management does not anticipate that the amount of unrecognized tax benefits will significantly increase in the next 12 months. The Company’s policy is to recognize interest and penalties on unrecognized tax benefits as an element of income tax expense (benefit) in the consolidated statements of operations. The Company files consolidated U.S. federal and state income tax returns. The tax years that remain subject to examination by the taxing authorities are the years ended December 31, 2007, 2008, 2009 and 2010.
SBIC is required to file annually with state regulatory insurance authorities financial statements prepared on an accounting basis as prescribed or permitted by such authorities (statutory basis accounting or “SAP”). Statutory net income and capital and surplus (stockholders’ equity) differ from amounts reported in accordance with GAAP, primarily because of the following accounting treatments prescribed by SAP: policy acquisition costs are expensed when incurred; certain assets designated as “nonadmitted” for statutory purposes are charged to surplus; fixed-income securities are reported primarily at amortized cost or fair value based on their rating by the National Association of Insurance Commissioners (“NAIC”); policyholders’ dividends are expensed as declared rather than accrued as incurred; deferred income taxes are charged or credited directly to unassigned surplus; and any change in the admitted net deferred tax asset is offset to equity. Following is a summary of SBIC’s statutory net gain for the years ended December 31, 2010, 2009, and 2008 and statutory capital and surplus as of December 31, 2010, 2009 and 2008:
The maximum amount of dividends that can be paid to stockholders by insurance companies domiciled in the State of Illinois without prior approval of regulatory authorities is restricted if such dividend, together with other distributions during the 12 preceding months, would exceed the greater of 10% of the insurer’s statutory surplus as of the preceding December 31 or the statutorily adjusted net income for the preceding calendar year. If the limitation is exceeded, then such proposed dividend must be reported to the Illinois Department of Insurance at least 30 days prior to the proposed payment date and may be paid only if not disapproved. The Illinois insurance laws also permit payment of dividends only out of earned surplus, exclusive of most unrealized gains. At December 31, 2010, SBIC had statutory earned surplus of $109.4 million. Consequently, SBIC would be able to pay up to $30.1 million of stockholder dividends in 2011 without the prior approval of regulators.
The State of Illinois imposes minimum risk-based capital requirements that were developed by the NAIC. The formulas for determining the amount of risk-based capital specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of the enterprise’s regulatory total adjusted capital to certain minimum capital amounts as defined by the NAIC. Enterprises below specified trigger points or ratios are classified within certain levels, each of which requires specified corrective action. SBIC exceeded the minimum risk-based capital requirements at December 31, 2010 and 2009.
The Company maintains a defined contribution 401(k) retirement savings plan covering substantially all of its employees. In 2010, 2009 and 2008, the Company matched 100% of the first five percent of eligible compensation contributed to the plan on a pre-tax basis. Employees are 100% vested in all matching contributions when they are made. Contribution expense for the years ended December 31, 2010, 2009, and 2008 was $1.1 million, $1.1 million and $1.2 million, respectively.
a. SBIC is subject to guaranty fund and other assessments by the states in which it writes business. Guaranty fund assessments are accrued at the time premiums are written. Other assessments are accrued either at the time of assessment or in the case of premium-based assessments, at the time the premiums are written, or in the case of loss-based assessments, at the time the losses are incurred. SBIC has accrued a liability for guaranty fund and other assessments of $6.2 million at December 31, 2010 and has recorded a related asset for premium tax offset and policy surcharges of $4.2 million at that date. These amounts represent management’s best estimate based on information received from the states in which it writes business and may change due to many factors including the Company’s share of the ultimate cost of current insolvencies. Most assessments are paid out in the year following the year in which the premium is written or the losses are paid. Guaranty fund receivables and other surcharge items are generally realized by a charge to new and renewing policyholders in the year following the year in which the related assessments were paid.
If current difficult market conditions persist during 2011 or if the Company’s actions to limit risk associated with its products or investments causes a significant change in any one reporting unit’s fair value, subsequent reviews of goodwill could result in an impairment of goodwill during 2011 or later.
At December 31, 2010, the Company had outstanding stock options and nonvested stock granted according to the terms of two equity incentive plans. The stockholders and Board of Directors approved the 2003 Stock Option Plan (the “2003 Plan”) in September 2003, and amended and restated the 2003 Plan in February 2004, and approved the 2005 Long-Term Equity Incentive Plan (the “2005 Plan” and, together with the 2003 Plan, the “Stock Option Plans”) in December 2004. In April 2007, the Board of Directors further amended the 2003 Plan and amended the 2005 Plan and in May 2010, the Board of Directors further amended the 2005 Plan. The current amended and restated 2005 Plan was approved by shareholders on May 18, 2010.
The following table summarizes restricted stock activity for the years ended December 31, 2010 and 2009:
The following table summarizes selected unaudited quarterly financial data for each quarter of the years ended December 31, 2010, 2009 and 2008.