The Company also has regional offices in Charlotte, North Carolina and Indianapolis, Indiana and leases office space in each of these locations under multi-year operating leases expiring in January 2013 and March 2017, respectively.
The home office building is used by the workers’ compensation insurance, group benefits insurance and corporate/other segments. The regional office space in North Carolina and Indiana is primarily used by the workers’ compensation insurance segment.
The group benefits insurance segment’s combined ratio increased from 97.4% in 2008 to 101.8% in 2009. The increased combined ratio primarily reflects an increase in the dental loss ratio and a higher expense ratio. The dental loss ratio has been affected by the competitive rate environment. The increased expense ratio primarily reflects higher salary costs, consulting expenses related to an upgrade of the group benefits policy administration system and an increase in corporate expense allocations.
The Company derives its revenue primarily from net premiums earned, including assumed premiums earned, net investment income and net realized investment gains.
Direct and net premiums written. Direct premiums written is the sum of both direct premiums and assumed premiums before the effect of ceded reinsurance. Direct premiums written include all premiums billed during a specified policy period. Net premiums written is the difference between direct premiums written and premiums ceded or paid to reinsurers (ceded premiums written). In the segregated portfolio cell reinsurance segment, assumed premiums are derived from insurance contracts written by the Company and ceded to the segregated portfolio cells. In the run-off specialty reinsurance segment, assumed premiums represent premiums that were received under the quota-share reinsurance treaties and were reported to the Company directly from the broker one quarter in arrears.
The Company’s expenses consist primarily of losses and LAE, acquisition and other underwriting expenses, policyholder dividends, other expenses, and income taxes.
Losses and LAE. Losses and LAE represent the largest expense item and include: (1) claim payments made, (2) estimates for future claim payments and changes in those estimates for prior periods, and (3) costs associated with investigating, defending and adjusting claims.
The Company establishes reserves for unpaid losses and LAE for its workers’ compensation, segregated portfolio cell reinsurance, group benefits insurance, and run-off specialty reinsurance products, which are estimates of future payments of reported and unreported claims for losses and related expenses. The adequacy of the Company’s reserves for unpaid losses and LAE are inherently uncertain because the ultimate amount that the Company may pay under many of the claims incurred as of the balance sheet date will not be known for many years. Establishing reserves is an imprecise process, requiring the use of informed estimates and judgments. The Company’s estimates and judgments may be revised as additional experience and other data becomes available and are reviewed as new or improved methodologies are developed, or as current laws change. Any such revisions could result in future changes in estimates of losses or reinsurance recoverables and would be reflected in the Company’s results of operations in the period in which the estimates are changed. Estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates and judgments using data currently available. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded as of December 31, 2009, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.
produce consistent loss estimates. For more recent accident years, the methodologies produce results that are not as consistent. Accordingly, more emphasis is placed on supplementing the methodologies in more recent accident years with trends in exposure base, medical expense inflation, general inflation, severity, and claim counts, among other things.
In its workers’ compensation insurance segment, the Company records reserves for estimated losses under insurance policies and for LAE related to the investigation and settlement of policy claims. The Company’s reserves for unpaid losses and LAE represent the estimated cost of reported and unreported losses and LAE incurred and unpaid at a given point in time. In establishing its workers’ compensation reserves, the Company uses loss discounting, which involves recognizing the time value of money and offsetting estimates of future payments by future expected investment income.
In estimating case incurred development and IBNR reserves, the Company performs most of its detailed analysis on a net of reinsurance basis, and then considers expected recoveries in arriving at its recorded amounts for unpaid losses and LAE. To estimate such reserves, the Company relies primarily on the historical claim data and trends from its workers’ compensation book of business. Using standard actuarial methods, the Company estimates reserves based on historical patterns of case development, payment patterns, mix of business, premium rates charged, case reserving adequacy, operational changes, adjustment philosophy and severity and duration trends. However, the number of variables and judgments involved in establishing reserve estimates, combined with some random variation in loss development patterns, results in uncertainty regarding projected ultimate losses.
In the event that our estimates of ultimate reserves for unpaid losses and LAE prove to be greater or less than the ultimate liability, our future earnings and financial position could be positively or negatively impacted. Future earnings would be reduced by the amount of any deficiencies in the year(s) in which the claims are paid or the reserves for unpaid losses and LAE are increased. For example, if we determined our reserves for unpaid losses and LAE, net of reinsurance, of $57.4 million as of December 31, 2009 to be 5% inadequate, this would result in an after-tax reduction in our earnings of approximately $1.9 million. This reduction could be realized in one year or multiple years, depending on when the deficiency is identified. The deficiency would also impact our financial position because our statutory surplus would be reduced by an amount equivalent to the reduction in net income. Any deficiency is typically recognized in the reserves for unpaid losses and LAE and, accordingly, it typically does not have a material effect on our liquidity because the claims have not been paid. Since the claims will typically be paid out over a multi-year period, we have generally been able to adjust our investments to match the anticipated future claim payments. Conversely, if our estimates of ultimate reserves for unpaid losses and LAE prove to be redundant, our future earnings and financial position would be improved.
The Company has utilized the following tail factors for the years ended December 31, 2009, 2008, and 2007:
The Company’s reserves for unpaid losses and LAE in its segregated portfolio cell reinsurance segment as of December 31, 2009 and 2008 are summarized below (in thousands):
The reserves for unpaid losses and LAE in the group benefits insurance segment include an estimate of future amounts for reported but unpaid and IBNR claims related to the Company’s dental, long-term disability, short-term disability, term life and vision products, as well as an estimate of the costs associated with investigating, processing and paying the related claims.
The long-term disability tabular reserve represents the Company’s estimate of future amounts due on reported long-term disability claims. The Company establishes a reserve at the time a long-term disability claim is reported using the 1987 Commissioners Group Disability Table. Due to the long-term nature of long-term disability claims, management discounts the liability using an interest rate that reflects the estimated investment return in the Company’s group benefits insurance segment that will be earned over the expected life of the claim. In establishing the discount rate, the Company’s management evaluates the current interest rate environment at the end of each year and, if necessary, adjusts the interest rate for the following year based on the expected rate of return on new investments. The discount rates for claims incurred in 2009, 2008 and 2007 were 4.00%, 3.85%, and 5.25%, respectively. A lower discount rate results in a higher claim reserve and an increase in losses and LAE, whereas a higher discount rate results in a lower claim reserve and a decrease in losses and LAE. The reserve established represents the present value of expected future claim payments based on the terms of the underlying long-term disability insurance contract. With the exception of the discount rate, the assumptions that impact the reserve amount, such as recovery, morbidity and mortality rates, are embedded in the table. The long-term disability IBNR reserve is estimated on a policy-by-policy basis, taking into consideration the average monthly premium, the policy elimination period, and an expected loss ratio.
Term life reserves consist of reported but unpaid and IBNR claims on the Company’s term life product, as well as a life premium waiver reserve. Reported but unpaid life claims represent those claims reported to the Company as of the balance sheet date for which payment has not yet been made. Term life IBNR claims are estimated based on historical patterns of losses incurred as a percent of in-force premium as of the balance sheet date.
The term life IBNR claim reserve represents the Company’s estimate of future amounts to be paid under existing term life insurance contracts for insured deaths and dismemberments that have occurred but not yet been reported. The Company estimates the term life IBNR claim reserve by applying a reserve factor to the current in-force volume of life insurance and AD & D benefits, resulting in the development of a point estimate. The reserve factor is based on past experience and is evaluated against actual results on an annual basis for reasonableness.
Life premium waiver reserves represent the present value of future life insurance benefits under those term life policies for which the premiums have been waived due to the insured’s disability and are calculated using the tabular reserve method. The Company establishes a reserve at the time the insured’s disability is reported using the 2005 Group Term Life Waiver Reserve Table for claims reported on and after October 1, 2007 and the 1970 Intercompany Group Life Disability Table for claims reported prior to October 1, 2007.
The Company’s reserves for unpaid losses and LAE in its run-off specialty reinsurance segment as of December 31, 2009 and 2008 are summarized below (in thousands):
The Company relies on information provided by ceding companies regarding premiums and reported claims, and then uses that data as a key input to estimate unpaid losses and LAE. Since the Company relies on claims information reported by ceding companies, the estimation of unpaid losses and LAE for the run-off specialty reinsurance segment includes certain risks and uncertainties that do not exist with its other segments, and include, but are not necessarily limited to, the following:
The case reserves recorded by the ceding company may not represent a reasonable estimate of the underlying exposure, be otherwise inaccurate or necessary case reserve increases may not be recorded in a timely manner.
In order to mitigate the above risks, the Company performs quarterly reviews of the ceding companies’ detailed claim reports to assess the reasonableness of the reported claim information. Additionally, Company claim personnel perform an annual claims audit at the ceding company to evaluate internal controls surrounding the claims handling and administration.
The evaluation of the reserves for unpaid losses and LAE in the run-off specialty reinsurance segment requires that loss development be estimated over an extended period of time using historical loss development data with limited relevance. As the historical loss development data has limited relevance, reliance has been placed on loss development patterns based on a blend of historical loss development data and industry loss development patterns, judgmentally adjusted to reflect considerations particular to the exposure. The reliance on external benchmarks, while necessary, creates an additional element of uncertainty. Following is a sensitivity analysis of the reserves for unpaid losses and LAE to reasonably likely changes in the blend of historical loss development data, industry loss development factors and expected loss ratios used to project current losses to ultimate losses (dollars in thousands):
For the year ended December 31, 2009, the Company recorded other-than-temporary impairments of $4.3 million related to its equity portfolio. The securities were impaired because they had been in an unrealized loss position for more than 12 months.
A review of the financial condition and prospects of the issuer indicates that the security should be evaluated;
Limited partnerships. A limited partnership investment is generally written down if the Company is unable to hold or otherwise intends to sell its interest in the limited partnership at a loss, or if management has received information that suggests the Company will be unable to recover its original investment in the limited partnership. The amount written down is recorded in the change in equity interest in other long-term investments in the consolidated statement of operations.
There were no impairments related to the Company’s limited partnership investments in 2009. For the year ended December 31, 2008, the Company recorded a permanent impairment of $1.4 million related to one of its limited partnership investments.
At the time a security is determined to be other-than-temporarily impaired, the cost or amortized cost is written down to market value at the balance sheet date and the impairment is recorded as a realized loss in the consolidated statement of operations.
Goodwill is assigned to one or more reporting units at the date of acquisition. The Company has allocated 100% of the goodwill recorded on its consolidated balance sheet as of September 30, 2009 to its workers’ compensation insurance segment. The goodwill impairment test, performed as of September 30 of each year, is a two-step test. The first step identifies whether there is potential impairment by comparing the fair value of a reporting unit to the carrying amount, including goodwill. If the fair value of a reporting unit is less than its carrying amount, the second step of the impairment test is required to measure the amount of any impairment loss.
The temporary differences between the tax and book bases of assets and liabilities are recorded as deferred income taxes. Management evaluates the recoverability of the net deferred tax asset based on historical trends of generating taxable income or losses, as well as expectations of future taxable income or loss. As of December 31, 2009, the Company recorded a net deferred tax asset of $1.3 million. Management expects that the net deferred tax asset is fully recoverable. If this assumption were to change, any amount of the net deferred tax asset that the Company could not expect to recover would be provided for as an allowance and would be reflected as an increase in income tax expense in the period in which it was established.
In September 2009, the Financial Accounting Standards Board (“FASB”) issued new accounting and disclosure guidance related to the determination of fair value of investments in entities (investees) that permit the investor to redeem its investments directly with the investee or receive distributions from the investee at times specified under the terms of the investee’s governing documents. Many of these investees do not have readily determinable fair values and provide their investors with a net asset value per share (or its equivalent, such as member units or an ownership interest in partners’ capital). Under the new guidance, investments in entities that calculate net asset value per share (or its equivalent) may be measured at fair value using the investee’s net asset value per share (or its equivalent) if the net asset value of the investment is calculated in a manner consistent with the measurement principles of investment companies as of the reporting entity’s measurement date, including measurement of all or substantially all of the underlying investments of the investee in accordance with the fair value measurement principles. The new guidance also requires enhanced disclosure related to the reporting entity’s investment is such investees including, but not limited to, the nature of any restrictions on the reporting entity’s ability to redeem its investments at the measurement date, any unfunded commitments, and the investment strategies of the investee. The Company’s limited partnership interests are currently reported in the consolidated balance sheets using the net asset value per share (or its equivalent) of the investee. The Company adopted the new accounting guidance effective December 31, 2009. The adoption had no impact on the estimated fair value of our limited partnership interests. The Company’s enhanced disclosures related to its limited partnership interests are included in Note 10.
In April 2009, the FASB issued new accounting guidance related to determining fair value of an asset or liability when the volume or level of activity for the asset or liability has significantly decreased and for identifying transactions that are not orderly. Under the new guidance, if an entity determines that there has been a significant decrease in the volume and level of activity for the asset or the liability in relation to the normal market activity for the asset or liability (or similar assets or liabilities), then transactions or quoted prices may not accurately reflect fair value. In addition, if there is evidence that the transaction for the asset or liability is not orderly, the entity shall place little, if any weight on that transaction price as an indicator of fair value. The new guidance was effective for periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The Company adopted the new guidance effective June 30, 2009. The adoption of the new guidance did not have a material effect on the Company’s consolidated financial statements.
The increase in consolidated revenue from 2008 to 2009 primarily reflects an improvement in the Company’s investment portfolio, partially offset by lower investment income. The Company’s limited partnership investments experienced an increase in value during 2009, compared to significant losses in 2008. Other-than-temporary impairments in the Company’s investment portfolio decreased from 2008 to 2009, which contributed to the improvement in net realized investment gains during 2009. The decrease in net investment income is reflective of a decrease in the Company’s fixed income security holdings, and lower interest rates on new fixed income security purchases and cash and short-term investment holdings. The decrease in net premiums earned reflects the July 2008 termination of the quota-share reinsurance treaties in the run-off reinsurance segment, partially offset by increased premiums in the workers’ compensation insurance segment.
The decrease in net realized investment losses from 2008 to 2009 primarily reflects a reduction in other-than-temporary impairments. Other-than-temporary impairments totaled $1.7 million in 2009, compared to $3.4 million in 2008. In addition, the convertible bond portfolio experienced an increase in fair value of $877,000 in 2009, compared to a decrease in fair value of $623,000 in 2008.
The decrease in net investment income primarily reflects a reduction in short-term interest rates from 2008 to 2009.
The following table represents the operations of the group benefits insurance segment for the years ended December 31, 2009 and 2008 (in thousands):
The improvement in the segment’s operating results from 2008 to 2009 primarily reflects a reduction in other-than-temporary impairments and the increase in the fair value of the convertible bond portfolio. The improved investment results were partially offset by an increase in the combined ratio and a decrease in net investment income. The increase in the
combined ratio primarily reflects the increase in the dental loss ratio and an increase in the expense ratio. The increase in the dental loss ratio reflects the competitive rate environment. The increase in the expense ratio primarily reflects the reduction of net premiums earned from 2008 to 2009, consulting expenses related to an upgrade of the segment’s policy administration system and an increase in corporate expense allocations.
The group benefits insurance ratios were as follows for the years ended December 31, 2009 and 2008:
Direct premiums written, by line of business, for the years ended December 31, 2009 and 2008 were as follows (in thousands):
The decrease in the long-term disability loss ratio primarily reflects the impact of prior year claim terminations.
The Company introduced a vision product in 2009. The loss ratio reflects management’s estimated losses for the year ended December 31, 2009.
The increase in other expenses from 2008 to 2009 primarily reflects the aforementioned salary costs, consulting expenses and corporate expense allocations.
The decrease in the net loss from 2008 to 2009 primarily reflects a reduction in audit and consulting fees related to Sarbanes Oxley outsourcing, a decrease in stock compensation expense related to the ESOP of $390,000 and an increase in the Company’s equity interest in the segregated portfolio cells of $676,000. The decrease in ESOP compensation expense reflects the decline in the Company’s stock price.
The consolidated net loss for the year ended December 31, 2008 primarily reflects the unfavorable loss reserve development and the unrecognized federal income tax benefits in the run-off specialty reinsurance segment, other-than-temporary investment impairments, and a decline in the fair value of limited partnership investments.
Policyholder dividend expense remained consistent from 2007 to 2008. As of December 31, 2008 and 2007, approximately 10.0% of the Company’s workers’ compensation insurance policies were written on a participating basis.
Purchase accounting adjustments reduced reinsurance premiums assumed by $451,000 in 2007. There were no purchase accounting adjustments in 2008.
The decrease in net investment income primarily reflects a reduction in short-term interest rates from 2007 to 2008.
The following table represents the operations of the group benefits insurance segment for the years ended December 31, 2008 and 2007 (in thousands):
The net loss in the group benefits insurance segment for the year ended December 31, 2008 primarily reflects the impact of other-than-temporary investment impairments, a decline in net investment income, and an increase in the combined ratio. Other-than-temporary investment impairments totaled $3.9 million. The decline in net investment income reflects a decrease in the invested asset base, which reflects dividends paid to EIHI during 2008. The increase in the combined ratio primarily reflects an increase in the dental loss ratio and an increase in the expense ratio. The 2007 expense ratio includes the impact of a settlement gain related to the defined benefit plan, which reduced the expense ratio by 1.1 percentage points.
Acquisition and other underwriting expenses as a percent of direct premiums written remained consistent from 2007 to 2008.
The increase in the net loss reflects the unfavorable loss reserve development of $19.3 million, the reduction in net premiums earned as a result of terminating participation in the reinsurance treaties, investment losses related to other-than-temporary impairments and limited partnership interests, and an increase in income tax expense due to the inability to recognize federal income tax benefits generated by the segment’s operating losses.
Purchase accounting adjustments reduced reinsurance premiums assumed by $849,000 in 2007. There were no purchase accounting adjustments in 2008.
The net realized investment losses for the year ended December 31, 2008 primarily reflect other-than-temporary impairments of $732,000. There were no impairments recorded in 2007.
Liquidity is a measure of an entity’s ability to secure sufficient cash to meet its contractual obligations and operating needs. The Company’s principal sources of funds are premiums, investment income and proceeds from sales and maturities of investments. The Company’s primary use of funds is to pay claims and operating expenses and to purchase investments. The Company’s investment portfolio is structured so that investments mature periodically over time in reasonable relation to current expectations of future claim payments. The Company’s fixed income investment portfolio as of December 31, 2009 had an effective duration of 3.22 years.
Cash Flows for the Years Ended December 31, 2009 and 2008. The decrease in cash flows from operating activities from 2008 to 2009 primarily reflects the run-off of the specialty reinsurance segment and a reduction in net investment income.
Cash flows from investing activities for the year ended December 31, 2009 primarily reflects the sale of investments to fund the Eastern Re capital contribution in March 2009.
The following table summarizes information about contractual obligations and commercial commitments before the impact of purchase accounting adjustments. The minimum payments under these agreements as of December 31, 2009 were as follows (in thousands):
(1) The loan payable balance in the above table represents the remaining principal balance as of December 31, 2009. Interest on the loan is based on the 30-day LIBOR rate plus 165 basis points and resets on the first day of each month, based on the 30-day LIBOR rate as of the last day of the immediately preceding month. The interest rate effective on December 31, 2009 was 1.883%.
As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for the recognition and presentation of other-than-temporary impairments of debt securities as required by accounting guidance adopted on April 1, 2009.
Eastern Insurance Holdings, Inc. (“EIHI”) is an insurance holding company offering workers’ compensation and group benefits insurance products and reinsurance products through its direct and indirect wholly-owned subsidiaries. Eastern Services Corporation (“Eastern Services”), Global Alliance Holdings, Ltd. (“Global Alliance”), Eastern Alliance Insurance Company (“Eastern Alliance”), Allied Eastern Indemnity Company (“Allied Eastern”), Eastern Advantage Assurance Company (“Eastern Advantage”), Eastern Re Ltd., S.P.C. (“Eastern Re”), ELH, and Employers Alliance, Inc. (“Employers Alliance”), collectively referred to as the “Company.”
Effective December 31, 2009, the Company completed a reorganization of its corporate structure. The purpose of the corporate reorganization was to reduce the number of holding companies and consolidate entities with similar operations. The reorganization included the following transactions:
AMS was merged into Employers Alliance with Employers Alliance being the surviving entity.
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”).
Premiums or discounts are amortized using the effective interest method. Realized gains or losses are based on amortized cost and are computed using the specific identification method. The Company monitors its fixed income securities for unrealized losses that appear to be other-than-temporary. A fixed income security is considered to be other-than-temporarily impaired when the security’s fair value is less than its amortized cost basis and 1) the Company intends to sell the security, 2) it is more likely than not that the Company will be required to sell the security before recovery of the security’s amortized cost basis, or 3) the Company believes it will be unable to recover the entire amortized cost basis of the security (i.e., a credit loss has occurred). When the Company determines a credit loss has been incurred, but the Company does not intend to sell the security and it is not more likely than not that the Company will be required to sell the security before recovery of the security’s amortized cost basis, the portion of the other-than-temporary impairment that is credit related is recorded as a realized loss in the consolidated statements of operations and comprehensive income (loss), and the portion of the other-than-temporary impairment that is not credit related is included in other comprehensive income (loss). Any subsequent increase in the security’s estimated fair value would be reported as an unrealized gain.
The Company’s investments in convertible bond securities are considered hybrid financial instruments and are carried at estimated fair value, with changes in estimated fair value reported as a realized gain or loss in the consolidated statement of operations and comprehensive income (loss). Prior to January 1, 2007, the Company bifurcated the fixed income and equity components of its convertible bond securities and reported the change in fair value of the fixed income component in accumulated other comprehensive income (loss). Effective January 1, 2007, the Company adopted new accounting guidance that provided for changes in fair value of the fixed income component of the convertible bond securities to be reported in the statement of operations. This change in accounting was reported as a cumulative effect adjustment to shareholders’ equity, as of January 1, 2007, and resulted in a reclassification between retained earnings and accumulated other comprehensive income of $405. The carrying value of the Company’s convertible bond securities did not change as a result of adopting the new accounting guidance.
Premiums generated by the Company’s workers’ compensation insurance segment, including estimates of additional premiums resulting from audits of insureds’ records, are generally recognized as written upon inception of the policy. Premiums written are primarily earned on a daily pro rata basis over the terms of the policies to which they relate. Accordingly, unearned premiums represent the portion of premiums written which is applicable to the unexpired portion of the policies in force. Workers’ compensation premiums are determined based upon the payroll of the insured, the applicable premium rates and, where applicable, an experience based modification factor. An audit of the policyholders’ records is conducted after policy expiration to make a final determination of applicable premiums. Included in net premiums earned is an estimate for earned but unbilled final audit premiums. The Company estimates earned but unbilled premiums by tracking, by policy, how much additional premium is billed in final audit invoices as a percentage of payroll exposure to estimate the probable additional amount that it has earned, but not yet billed, as of the balance sheet date. Earned but unbilled premiums accrued as of December 31, 2009 and 2008, and included in net premiums earned, totaled $1,351 and $1,800, respectively.
Other revenue primarily consists of service revenue related to claims adjusting and risk management services. Claims adjusting and risk management service revenue is earned over the term of the related contracts in proportion to the actual services rendered.
The Company discounts its reserves for unpaid losses and LAE for workers’ compensation claims on a non-tabular basis, using a discount rate of 3.0%, based upon regulatory guidelines. The reserves for unpaid losses and LAE have been reduced for the effects of discounting by approximately $4,256 and $4,145 as of December 31, 2009 and 2008, respectively.
The liability for reported but unpaid and IBNR dental and short-term disability claims is estimated using statistical claim development models, taking into consideration historical claim severity and frequency patterns and changes in benefit structures that may impact the amount at which claims are ultimately settled. For the most recent incurral months, which usually consist of the last three months, the liability is estimated by applying an expected loss ratio to net premiums earned, less claim payments through the balance sheet date.
The Company’s group benefits insurance policies are cancelable and are not guaranteed renewable. In addition, the group benefits insurance policies provide coverage on a month-to-month basis with most policies’ coverage effective on the first of each month. As a result, most of the Company’s group benefits insurance premiums are earned as of the balance sheet date. Based on the nature of the Company’s group benefits insurance policies, costs related to the acquisition of new and renewal business are expensed as incurred.
The Company includes income tax-related interest and penalties as a component of income tax expense. The Company did not incur any income tax-related interest or penalties during 2009, 2008 or 2007.
The Company issues certain workers’ compensation insurance policies with dividend payment features. These policyholders share in the operating results of their respective policies in the form of dividends. Dividends to policyholders are accrued during the period in which the related premiums are earned and are determined based on the terms of the individual policies. As of December 31, 2009 and 2008, the Company recorded accrued dividends payable of $1,157 and $1,311, respectively, which are included in accounts payable and accrued expenses on the consolidated balance sheets.
Property and equipment, including expenditures for significant improvements and purchased software, is carried at cost less accumulated depreciation and amortization. Maintenance, repairs and minor improvements are expensed as incurred. When property and equipment is retired or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is included in operations. Depreciation is computed under the straight-line method. The estimated useful lives of property and equipment range from 3-7 years. Accumulated depreciation and amortization expense totaled $7,674 and $7,246 as of December 31, 2009 and 2008, respectively. Depreciation and amortization expense totaled $702, $561, and $397 for the years ended December 31, 2009, 2008 and 2007, respectively.
Eastern Advantage recognize a liability and the related expense for the assessments when premiums covered under the Security Fund are written; when an assessment from the Security Fund has been imposed or it is probable that an assessment will be imposed; and the amount of the assessment is reasonably estimable. The Company accrued an assessment related to the Security Fund of $2,108 and $1,052 as of December 31, 2009 and 2008, respectively. The 2009 accrual includes an amount related to the 2008 Security Fund assessment, which was paid in January 2010.
Goodwill is assigned to one or more reporting units at the date of acquisition. The goodwill reported by the Company has been allocated 100% to the workers’ compensation insurance segment, which is considered a reporting unit for goodwill purposes. The annual goodwill impairment test, performed as of September 30, each year, consists of a two-step process. The first step identifies whether potential impairment exists by comparing the fair value of the reporting unit to its carrying value, including goodwill. If the fair value of a reporting unit is less than its carrying amount, the second step is required to measure the amount of any impairment loss. There have been no historical impairments of goodwill.
Management tested goodwill for impairment as of September 30, 2009 using a discounted cash flow analysis. The discounted cash flow analysis was based on management’s internal four-year forecast for the workers’ compensation insurance segment, assuming a long-term growth rate of 5.0% and a discount rate of 13.0%. Cash flows were adjusted as necessary to maintain adequate capital requirements. As of September 30, 2009, the Company’s stock price was trading below book value, primarily reflecting the impact of market conditions over the past year. Therefore, management also considered an estimate of the Company’s value in a potential transaction and allocated that value to the Company’s reporting units, including the workers’ compensation insurance segment. Both the discounted cash flow analysis and the estimate of the Company’s value in a potential transaction resulted in the workers’ compensation insurance segment’s estimated fair value exceeding its carrying value as of September 30, 2009; therefore, goodwill was considered not impaired.
The Company recognizes compensation expense related to its employee stock ownership plan (“ESOP”) equal to the product of the number of shares earned, or committed to be released, during the period, and the average price of the Company’s common stock during the period. The estimated fair value of unearned ESOP shares is calculated based on the average price of the Company’s common stock for the period. For purposes of calculating earnings per share, the Company includes the weighted average of ESOP shares committed to be released for the period.
Comprehensive income (loss) includes all changes in shareholders’ equity during the reporting period, net of tax. The components of accumulated other comprehensive income, net of tax, as of December 31, 2009 and 2008 were as follows (in thousands):
Fair Value Measurements-Investments in Certain Entities that Calculate Net Asset Value per Share
In April 2009, the FASB issued new accounting guidance related to the interim disclosures about fair value of financial instruments. The new guidance requires disclosures about fair value of financial instruments in interim and annual financial statements and was effective for periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The Company adopted the interim period disclosure requirements of effective June 30, 2009, which are included in Notes 10 and 11.
As of December 31, 2009 and 2008, intangible assets consisted of the following (in thousands):
In June 2008, the FASB issued new accounting guidance with respect to determining whether instruments granted in share-based payment transactions are considered participating securities. The new guidance provides that unvested share-based payment awards that contain non-forfeitable rights to dividends are participating securities and shall be included in the computation of earnings per share pursuant to the two-class method described in ASC 260-Earnings Per Share. The two-class method of computing earnings per share is an earnings allocation formula that determines earnings per share for common stock and any participating securities according to dividends declared (whether paid or unpaid) and participation rights in undistributed earnings. The Company’s unvested restricted stock are considered participating securities since the share-based awards contain a non-forfeitable right to dividends irrespective of whether the awards ultimately vest. The new guidance is effective for financial statements issued for fiscal years beginning after December 15, 2008 and interim periods within those years. Upon adoption, earnings per share data must be retrospectively adjusted to conform to the new guidance. The Company adopted the new guidance effective January 1, 2009 and computed earnings per common share using the two-class method for all periods presented. The new guidance increased basic and diluted earnings per share from $(1.94) to $(1.90) for the year ended December 31, 2008 and decreased basic and diluted earnings per share by $0.04 for the year ended December 31, 2007.
On February 15, 2007, the Company’s Board of Directors authorized the repurchase of up to 5 percent, or 567,552 shares, of the Company’s issued and outstanding shares of common stock. On August 2, 2007, the Company’s Board of Directors authorized the repurchase of additional shares of the Company’s outstanding common stock up to an aggregate of 1,046,500 shares, which represents the total number of shares of common stock for which awards may be granted under the Company’s Stock Incentive Plan. On September 27, 2007, the Company’s Board of Directors increased the share repurchase authorization to 2,046,500 shares. The share repurchases will be held as treasury stock and are available for issuance in connection with the Company’s Stock Incentive Plan. For the years ended December 31, 2009 and 2008, the Company repurchased 1,400 and 1,073,492 shares at a cost of $11 and $17,066, respectively, representing a weighted average cost of $8.03 and $15.90 per share, respectively.
Awards under the Stock Incentive Plan may be made in the form of incentive stock options, nonqualified stock options, restricted stock or any combination to employees and non-employee directors. The Stock Incentive Plan limits the number of shares that may be initially awarded as restricted stock to 299,000, and the number of shares for which incentive stock options may be granted to 500,000. The total number of shares initially authorized in the Stock Incentive Plan was 1,046,500 shares, with an annual increase equal to 1% of the shares outstanding at the end of each year. The Stock Incentive Plan provides that stock options and restricted stock awards may include vesting restrictions and performance criteria at the discretion of the Compensation Committee of the Board of Directors. The stock options and restricted stock awards vest over a five year period and are not subject to performance criteria. The term of options may not exceed ten years for incentive stock options, and ten years and one month for nonqualified stock options, and the option price may not be less than fair
market value on the date of grant. There were no stock options or restricted stock awards granted or forfeited for the year ended December 31, 2009. For the year ended December 31, 2008, grants of 15,000 incentive stock options and 5,000 restricted stock awards were made to employees. A total of 32,741 stock options were forfeited during the year ended December 31, 2008. For the year ended December 31, 2007, grants of 17,500 incentive stock options were made to employees. There were no stock options or restricted stock awards exercised in 2009 or 2008.
As of December 31, 2009, there were 242,009 and 109,896 vested stock options and restricted stocks awards, respectively. As of December 31, 2008, there were 119,505 and 49,335 vested stock options and restricted stock awards, respectively. The total unrecognized stock compensation expense related to non-vested stock options was $1,173 and $1,766, respectively, and the total unrecognized stock compensation expense related to non-vested restricted stock awards was $1,395 and $2,190, respectively, as of December 31, 2009 and 2008. The unrecognized stock compensation expense related to the non-vested stock options and restricted stock awards is expected to be recognized over a weighted average period of approximately 31.0 months and 34.5 months, respectively.
The aggregate intrinsic value of the stock options in the above table is $0 because the Company’s closing stock price of $8.62 on December 31, 2009 was below the weighted average exercise price of the stock options.
As of December 31, 2009, there were 383,235 shares of common stock available for issuance of future share-based awards. The following table presents additional information regarding options outstanding as of December 31, 2009:
The following table summarizes restricted stock activity for the year ended December 31, 2009.
Risk-based capital is designed to measure the acceptable amount of capital an insurer should have based on the inherent risks of the insurer’s business. Insurers failing to meet adequate capital levels may be subject to insurance department scrutiny and ultimately rehabilitation or liquidation. Based on established standards, Eastern Alliance, Allied Eastern, Eastern Advantage, ESIC and ELH maintained statutory-basis surplus in excess of minimum prescribed risk-based capital requirements as of December 31, 2009.
Under Cayman Islands regulations, Eastern Re is required to maintain minimum capital of $120.
The following is a description of the Company’s categorization of the inputs used in the recurring fair value measurements of its financial assets included in its consolidated balance sheet as of December 31, 2009:
Level 2-Represents financial assets whose fair value is determined based upon: quoted market prices for similar assets in active markets; quoted market prices for identical assets in inactive markets; inputs other than quoted market prices that
Level 3-Represents financial assets whose fair value is determined based upon inputs that are unobservable, including the Company’s own determinations of the assumptions that a market participant would use in pricing the asset. The Company considers its limited partnership investments as Level 3 assets.
allocable share of the limited partnerships’ net asset value. Changes in the Company’s investments are based on statements received directly from the limited partnership and/or the limited partnership’s administrator. The estimated fair values of the underlying investments in the limited partnerships may be based on Level 1, Level 2, or Level 3 inputs, or a combination thereof.
As of December 31, 2009 and 2008, the estimated fair values of the Company’s limited partnership investments, by investment strategy, were as follows (in thousands):
The change in interest in the Company’s limited partnership investments is included in the change in equity interest in other long-term investments in the consolidated statements of operations and comprehensive income (loss). As a result of the
Certain insurance departments in the states in which the Company is licensed to do business require a deposit to protect the Company’s policyholders should the Company become insolvent. In order to satisfy these requirements, the Company had fixed income securities with an estimated fair value of $13,846 and $13,519 on deposit with various insurance departments as of December 31, 2009 and 2008, respectively.
As of December 31, 2009, the Company held 49 fixed income securities with gross unrealized losses totaling $841. Management has evaluated the unrealized losses related to those fixed income securities and determined that they are primarily due to the current liquidity issues in the fixed income markets or to a fluctuation in interest rates and not to credit issues of the issuer or the underlying assets in the case of asset-backed securities. The Company does not intend to sell the fixed income securities and it is not more likely than not that the Company will be required to see the fixed income securities before recovery of their amortized cost bases, which may be maturity; therefore, management does not consider the fixed income securities to be other-than-temporarily impaired as of December 31, 2009.
For the years ended December 31, 2009 and 2008, the Company recorded other-than-temporary impairments related to its fixed income and equity securities totaling $4,497 and $9,507, respectively. There were no impairments recorded in 2007.
The following table provides a rollforward of the Company’s other-than-temporary impairments related to credit losses for which a portion of the other-than-temporary impairment was recognized in other comprehensive income for the year ended December 31, 2009.
The change in the Company’s net unrealized gains and losses for the years ended December 31, 2009, 2008, and 2007 was as follows (in thousands):
Net investment income for the years ended December 31, 2009, 2008, and 2007 was as follows (in thousands):
For the year ended December 31, 2009, the Company recognized an increase of $1,261 related to its equity interest in limited partnerships. The Company’s limited partnership investments include a multi-strategy fund of funds, natural resource funds, a structured finance opportunity fund and open-ended investment fund and a real estate partnership. The Company obtains audited financial statements of its limited partnership investments on an annual basis. The total assets, total liabilities and results of operations of the limited partnerships in which the Company invests as of and for the year ended December 31, 2008, based on the limited partnerships’ audited financial statements, were as follows (in thousands):
For the years ended December 31, 2009, 2008 and 2007, the Company (decreased) increased its workers’ compensation insurance reserves for unpaid losses and LAE by the following amounts by accident year (in thousands):
For the years ended December 31, 2009, 2008 and 2007, the Company (decreased) increased its segregated portfolio cell reinsurance reserves for unpaid losses and LAE by the following amounts by accident year (in thousands):
For the year ended December 31, 2009, the Company recognized net favorable development on prior accident year segregated portfolio cell reinsurance loss reserves of $2.8 million, representing 12.6% of the Company’s estimated segregated portfolio cell reinsurance net loss reserves as of December 31, 2008 and 11.1% of the Company’s segregated portfolio cell reinsurance net premiums earned for the year ended December 31, 2008. The favorable development arose mostly from accident years 2006 and 2008, but was generally prevalent in most prior accident years, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting include greater availability and use of employers’ return to work programs.
For the year ended December 31, 2007, the Company recognized net favorable development on prior accident year segregated portfolio cell reinsurance loss reserves of $3.0 million, representing 14.3% of the Company’s estimated segregated portfolio cell reinsurance net loss reserves as of December 31, 2006 and 13.2% of the Company’s workers’ compensation net premiums earned for the year ended December 31, 2007. The favorable development arose mostly from accident years 2005 and 2006, and resulted from actual loss development being less than the Company had expected based on its historical loss development experience. The loss development factors used by the Company to determine its segregated portfolio cell reinsurance loss reserves as of December 31, 2006, were based on its loss development history at that time. During 2007, the Company’s favorable loss development relative to its historical experience was driven by favorable effects from its loss mitigation efforts, which include greater availability and use of employers’ return to work programs, an improved economy relative to the historical experience of the Company, and significant claim settlements during 2007 at amounts less than previously established.
For the year ended December 31, 2009, the Company recognized net favorable development on prior accident year group benefits insurance reserves of $611,000. The favorable development primarily reflects a decrease in prior accident year dental and short-term disability reserves of $457,000 as a result of better than expected claim experience. The Company’s long-term disability reserves also decreased $328,000, primarily related to prior year claim terminations.
For the year ended December 31, 2008, the Company recognized net unfavorable development on prior accident year specialty reinsurance loss reserves of $19.3 million, representing 77.2% of the Company’s estimated specialty reinsurance net loss reserves as of December 31, 2007. The unfavorable development arose mostly from accident years 2005, 2006 and 2007, and was the result of a significant increase in reported losses from the ceding company, primarily related to the EnviroGuard program. The Company receives quarterly loss statements from the ceding company. The statements received for the fourth quarter of 2008 indicated reported losses much greater than the Company had observed in the past. As these reported losses were incorporated into the quarterly actuarial review, management also considered input from the annual claims audit, which was completed in January 2009. During the claims audit, management determined that the increase in losses reported by the ceding company was primarily attributable to adverse loss trends emerging in calendar year 2008 from prior accident years. Management also identified the primary factors that contributed to the increased losses reported to the Company. Those factors include 1) an improvement in the ceding company’s ability to estimate loss costs earlier in the claims process, including the receipt of damage estimates from contractors and consultants, 2) states becoming more aggressive in requiring quicker, more extensive clean-up and an increase in construction costs related to the clean-up, and 3) courts limiting the ability of insurance companies to enforce coverage limitations as the courts became more interested in an expeditious clean up due to environmental concerns. Based on the results of the claims audit, management updated its
quarterly actuarial analysis as of December 31, 2008 to reflect higher loss development factors than had previously been applied to the reported loss data, which was previously based on the Company’s historical loss experience and industry loss development statistics.
The following table provides a summary of the Company’s premiums on a direct, assumed, ceded, and net basis for the years ended December 31, 2009, 2008, and 2007 (in thousands):
ELH entered into a coinsurance agreement in 1999, under which it ceded an existing block of outstanding claims related to a program that provided long-term disability coverage to certain professional associations. The Company recorded a reinsurance recoverable totaling $7,769 and $9,034 as of December 31, 2009 and 2008, related to this block of ceded claims.
The components of the income tax provision for the years ended December 31, 2009, 2008, and 2007 are as follows (in thousands):
In addition to the income tax provision, the net deferred tax asset (decreased) increased by $(2,162), $1,022, and $(696) in 2009, 2008, and 2007, respectively, as a result of changes in the unrealized gains and losses on the Company’s fixed income and equity securities. The net deferred tax asset was also (decreased) increased by $(127), $558 and $(58) in 2009, 2008 and 2007, respectively, related to unrecognized benefit plan gains. The tax effect of these items is recorded directly to accumulated other comprehensive income, which is a component of equity.
The provision for income taxes for the years ended December 31, 2009, 2008, and 2007 is as follows (in thousands):
As of December 31, 2009, the Company has not recognized a deferred tax asset related to its run-off specialty reinsurance segment of $7,261, which represents the excess of the tax basis over the amount for financial reporting (i.e., outside basis difference) of Eastern Re as of December 31, 2009. The outside basis difference primarily arises from losses at Eastern Re recognized for financial statement purposes, which have not yet been recognized for tax purposes. Management presently believes that the Company will not be able to recognize these tax benefits in the foreseeable future and, therefore, has not recognized the future tax benefits as of December 31, 2009.
As of December 31, 2009, the Company has no tax positions for which management believes a provision for uncertainty is necessary. The Company’s federal income tax returns for tax years subsequent to December 31, 2005 are subject to examination by the Internal Revenue Service.
As of December 31, 2009 and 2008, the estimated fair value of unearned ESOP shares were $4,256 and $7,838, respectively.
For the years ended December 31, 2009, 2008, and 2007 the Company made a cash contribution of $937, $858, and $1,100 to the ESOP, respectively. The ESOP used these contributions, along with dividends received on the unallocated shares of the Company’s stock held by the ESOP, to make the semi-annual principal and interest payments to the Company related to the outstanding balance of the promissory note. Dividends used by the ESOP to fund the semi-annual principal and interest payments totaled $163, $242, and $0 in 2009, 2008, and 2007, respectively. The transactions between the Company and the ESOP are considered non-cash transactions for purposes of the consolidated statements of cash flows.
The Company sponsors a contributory defined contribution plan covering eligible employees. Employees are eligible to participate in the defined contribution plan upon the attainment of 21 years of age. The Company provides a matching contribution up to 75% of the first 4% of an employee’s contributions. Employees are immediately vested in the employer matching contributions regardless of years of service. The Company’s contributions to the defined contribution plan for the years ended December 31, 2009, 2008, and 2007 totaled $309, $237, and $195, respectively.
As of December 31, 2009 and 2008, the projected benefit obligation, fair value of plan assets and funded status of the pension plan and the postretirement plan were as follows (in thousands):
The pension plan’s assets were comprised of the following at December 31, 2009 and 2008 (in thousands):
The Company’s group benefits insurance products include dental, short and long-term disability, term life, and vision insurance. The group benefits insurance products are marketed to employers, primarily in the Mid-Atlantic, Southeast, and Midwest regions of the continental United States. Net premiums earned, by product, for the years ended December 31, 2009, 2008, and 2007 were as follows (in thousands):
Rent expense totaled $1,084, $953, and $748 for the years ended December 31, 2009, 2008 and 2007, respectively.
For the years ended December 31, 2008 and 2007, the Company incurred interest expense of $468 and $606, respectively, related to the junior subordinated debentures.
As of December 31, 2009, the Company had a loan payable with an outstanding principal balance of $2,150. Semi-annual principal payments of $250 are due on or before January 1 and July 1 each year through July 1, 2013. Interest on the loan is based on the 30-day LIBOR rate plus 165 basis points and resets on the first day of each month, based on the LIBOR rate as of the last day of the immediately preceding month. The outstanding loan balance can be prepaid at any time without penalty. Under the terms of the loan, ESHC must maintain 1) a consolidated debt service coverage ratio of not less than 1.0 calculated annually on December 31, 2) consolidated net equity of $3,000 on December 31, and 3) invested assets equal to at least 125% of the outstanding principal balance of the loan. As of December 31, 2009 and for the year then ended, ESHC met the financial covenants. The Company incurred interest expense of $46 and $30 related to the loan for the years ended December 31, 2009 and 2008, respectively.
Management performed an evaluation of subsequent events and determined there were no recognized or unrecognized subsequent events that would require an adjustment and/or additional disclosure in the consolidated financial statements as of December 31, 2009.