Loss Ratio Method. The loss ratio method involves the use of historical loss ratios to estimate the reserve for unpaid claims. Under the loss ratio method, the reserve is determined by multiplying the selected loss ratio, which is based on historical loss ratio trends, by the amount of net earned premium or the in-force premium at the valuation date.
The Company analyzes its ultimate losses and LAE for specialty reinsurance after consideration of the loss experience on each treaty for each underwriting year on a quarterly basis. The methodologies that the Company employs include, but may not be limited to, paid loss development methods and incurred loss development methods similar to those described in the workers’ compensation insurance and segregated portfolio cell reinsurance segments above.
The evaluation of the reserves for unpaid losses and LAE in the specialty reinsurance segment requires that loss development be estimated over an extended period of time without the benefit of credible historical loss development patterns. As the historical loss development data lacks credibility, reliance has been placed on loss development patterns based on 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 industry loss development factors used to project current losses to ultimate losses (dollars in thousands):
Unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in shareholders’ equity as a component of comprehensive income (loss) and, accordingly, have no effect on net income. When, in the opinion of management, a decline in the fair value of an investment below its cost or amortized cost is considered to be “other-than-temporary,” such investment is written-down to its fair value. The amount written-down is recorded in earnings as a realized loss on investments. Generally, the determination of other-than-temporary impairment includes, in addition to other relevant factors, a presumption that if the market value is below cost by a significant amount for a period of time, a write-down is necessary. Notwithstanding this presumption, the determination of other-than-temporary impairment requires judgment about future prospects for an investment and is therefore a matter of inherent uncertainty. For the year ended December 31, 2007, the Company did not experience any declines in investment securities that were determined to be other-than-temporary. As of December 31, 2007, the Company held fixed income and equity securities with gross unrealized losses of $631,000, of which only $58,000 were in an unrealized loss position for more than twelve months. Adverse investment market conditions, or poor operating results of underlying investments, could result in impairment charges in the future. The Company generally applies the following standards in determining whether the decline in fair value of an investment is other-than-temporary:
Amounts recoverable from Company’s reinsurers are estimated in a manner consistent with the reserves for unpaid losses and LAE associated with the reinsured policy. Amounts paid for reinsurance contracts are expensed over the contract period during which insured events are covered by the reinsurance contracts. Reinsurance balances recoverable on paid and unpaid loss and loss adjustment expenses are reported separately as assets, instead of being netted with the appropriate liabilities, because reinsurance does not relieve the Company of its legal liability to its policyholders. Reinsurance balances recoverable are subject to credit risk associated with the particular reinsurer. Additionally, the same uncertainties associated with estimating unpaid losses and loss adjustment expenses affect the estimates for the ceded portion of these liabilities. The Company continually monitors the financial condition of its reinsurers and where necessary obtains collateral. As of December 31, 2007, the Company had reinsurance recoverables of $26.3 million. All of the Company’s reinsurers had an A.M. Best financial strength rating of “A” or better as of December 31, 2007.
The decrease in the calendar period loss and loss adjustment expense ratio reflects a decrease in the impact of purchase accounting adjustments recorded in 2007 compared to 2006 partially offset by unfavorable loss reserve development on prior accident years of $4.8 million and $894,000 for the years ended December 31, 2007 and 2006, respectively, which increased the loss ratios for the years ended December 31, 2007 and 2006 by 33.5 points and 16.2 points, respectively. The calendar year period loss ratio for the year ended December 31, 2006 includes 37.1 points related to purchase accounting adjustments recorded to premiums earned and loss and loss adjustment expenses. Purchase accounting adjustments in 2007 had a negligible impact on the 2007 calendar year loss ratio. Approximately 65.0% of the unfavorable loss reserve development in 2007 relates to the EIA liability product. A review of the EIA liability detailed claim reports indicated significant case reserve increases on prior year claims. During 2007, EIA liability claim counts with total gross (before application of the applicable quota share percentage) incurred values greater than $1 million increased from 8 claims to 11 claims. EIA liability claim counts with total gross incurred values greater than $100,000 increased from 62 claims to 80 claims during 2007, an increase of 29.0%. The 2007 accident period loss and LAE ratio for EnviroGuard and EIA liability were 44.9% and 75.9%, respectively. The unfavorable loss reserve development in 2006 relates to an increase in reported claims from the ceding company.
Losses and LAE were reduced by the amortization of purchase accounting adjustments of $484,000. The accident period loss and LAE ratio was 62.1% for the period from June 17, 2006 to December 31, 2006. The calendar period loss and LAE ratio was 62.8% for the period from June 17, 2006 to December 31, 2006, including 9.2 points related to purchase accounting adjustments. Favorable loss reserve development on prior accident years of $2.1 million was recorded for the period from June 17, 2006 to December 31, 2006. The favorable loss and LAE reserve development relates primarily to a decrease in the prior accident period loss development factors used to estimate losses and LAE. The decrease in prior accident period loss development factors relates primarily to significant prior year claim settlements during 2006 for amounts at, or less than, previously established case and IBNR reserves. This decrease had the effect of lowering loss development factors as of December 31, 2006. For the period from July 1, 2006 to December 31, 2006, the Company closed 95, or 22.5%, of the 423 open lost time claims as of December 31, 2005. In the aggregate, the claims were closed at amounts lower than the provision established for claims incurred but not reported. Management believes that the realization of the benefits of its return-to-work controls implemented in 2003 coupled with strong economies in its underwriting territories during 2006 enabled it to record loss and loss adjustment expenses that were lower than the amount reserved for claim settlements. For the period from June 17, 2006 to December 31, 2006, there were no claims that exceeded the Company’s $500,000 reinsurance retention.
December 31, 2007 compared to December 31, 2006. Total assets were $385.5 million as of December 31, 2007, compared to $368.2 million as of December 31, 2006. The increase in total assets primarily reflects an increase in cash and investments, premiums receivable, deferred acquisition costs, and other assets, partially offset by a decrease in the net deferred tax asset. The increase in cash and investments primarily reflects positive cash flows from operations, offset by stock repurchases and shareholder dividends. The increase in premiums receivable reflects higher direct premiums written in 2007, while the increase in deferred acquisition costs primarily reflects the amortization of purchase accounting adjustments of $1.5 million. The increase in other assets primarily reflects an increase in the Company’s equity interest in certain segregated portfolio cells of $974,000 and an increase in the defined benefit pension plan asset of $1.0 million. The decrease in the net deferred tax asset primarily reflects an increase in the estimated fair value of the Company’s fixed income and equity securities and the recording of a deferred tax liability related to the intangible assets acquired.
The following table summarizes information about contractual obligations and commercial commitments. The minimum payments under these agreements as of December 31, 2007 were as follows (in thousands):
In our opinion, the 2005 consolidated financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of Eastern Insurance Holdings, Inc. and subsidiaries for the year ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America.
Management believes that its reserves for unpaid losses and LAE is adequate as of December 31, 2007. However, estimating the ultimate 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, 2007, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.
As of December 31, 2007, total unrecognized stock compensation expense related to non-vested stock options and restricted stock totaled $2,263 and $2,832, respectively, which is expected to be recognized over a weighted average period of approximately 48.0 months. As of December 31, 2007, all stock options and restricted stock are unvested.
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, and ELH maintained statutory-basis surplus in excess of minimum prescribed risk-based capital requirements as of December 31, 2007.
Suspense shares, allocated shares, shares committed to be released, average price per share and stock compensation expense as of and for the years ended December 31, 2007 and 2006 were as follows (in thousands, except share data):
The primary investment objective of the pension plan is to achieve maximum rates of return commensurate with safety of principal. The pension plan asset allocation is reviewed annually to determine whether the portfolio mix is within an acceptable range of the target allocation. Target asset allocations are based on asset and liability studies with the goal to enhance the expected return of the pension plan portfolio while maintaining acceptable levels of risk. As of December 31, 2007 the target asset allocation for the portfolio is 10% equity securities and 90% fixed income securities.