In August 2009, the National Council on Compensation Insurance (NCCI) recommended a 6.8% average rate decrease for new and renewal policies incepting on or after January 1, 2010. According to the NCCI, this recommendation was in response to significant reductions in claims frequency, although the NCCI noted that the pace of improvement has moderated. The Florida Commissioner approved this rate decrease, making the cumulative rate decrease 63.2% since the reforms of 2003. We cannot determine the full effect on our profitability at this time or if there will be continued downward pricing pressure in Florida.
Wisconsin-Wisconsin is an administered pricing state. In July 2008, the Wisconsin Commissioner of Insurance (Wisconsin Commissioner) approved a 2.9% overall rate increase on new and renewal policies incepting on or after October 1, 2008. On May 14, 2009, the Wisconsin Compensation Rating Bureau recommended an average rate increase of 0.4% for new and renewal policies incepting on or after October 1, 2009. On July 29, 2009, the Wisconsin Commissioner approved the recommended increase.
These factors, along with the Acquisition, contributed to Nevada falling from our second to fourth largest producing state.
We estimate ultimate contingent profit commission through June 30, 2024 and record it as commission expense. Increases or decreases in the estimated contingent profit commission are reflected in commission expense in the period that the estimate is revised. For the year ended December 31, 2009, we decreased commission expenses by $15.0 million as a result of an increase in contingent profit commissions and received $10.3 million from the reinsurers. Estimated total losses and loss adjustment expenses covered by the LPT Agreement and to be paid through June 30, 2024 were reduced by approximately $40 million from the previous estimate. Pursuant to the LPT Agreement, actual amounts paid for losses under the LPT Agreement for the period July 1, 1999 through June 30, 2009, were $467.8 million as compared to contractually expected losses and loss expenses of approximately $550 million.
Each of the methods listed above requires the selection and application of parameters and assumptions. The key parameters and assumptions are: the pattern with which our aggregate claims data will be paid or will emerge over time; claims cost inflation rates; the effects of legislative benefit changes and/or judicial changes; and trends in the frequency of claims, both overall and by severity of claim. Of these, we believe the most important are the pattern with which our aggregate claims data will be paid or emerge over time and claims cost inflation rates. Each of these key items is discussed in the following paragraphs.
More than 55% of our claims payments during the three years ended December 31, 2009 related to medical care for injured workers. The utilization and cost of medical services in the future is a significant source of uncertainty in the establishment of loss reserves for workers’ compensation. We are not able to state the rate of medical cost inflation that is assumed in our loss reserves because our loss reserves are established based on reviewing the results of actuarial methods that do not contain explicit medical claim cost inflation rates, as well as methods that do. However, because medical care will be provided over many years, and in some cases decades, to the injured workers who have open claims, the pace of medical claim cost inflation has a significant impact on our ultimate claim payments. For example, if the rate of medical claim cost inflation increases by 1% above the inflation rate that is implicitly included in the loss reserves at December 31, 2009, we estimate that future medical costs over the lifetime of current claims would increase by approximately $82 million on a net-of-reinsurance basis.
All premium revenue is recognized over the period of the contract in proportion to the amount of insurance protection provided. At the end of the policy term, payroll-based premium audits are performed on substantially all policyholder accounts to determine net premiums earned for the policy year. Earned but unbilled premiums include estimated future audit premiums. Estimates of future audit premiums are based on our historical experience. These estimates are subject to changes in policyholders’ payrolls, economic conditions and seasonality. The estimates are continually reviewed and adjusted as necessary as experience develops or new information becomes known. Any such adjustments are included in current operations. Since our inception in 2000, there have been no material adjustments of our accrual for earned but unbilled premium and, based on this experience, and, although considerable variability is inherent in such estimates, we believe that amounts currently reflected in our consolidated financial statements will similarly require no material prospective adjustment.
Our net income for the year ended 2009 decreased 18.4% compared to the prior year. The change in net income was primarily driven by a $77.9 million increase in losses and LAE and a $37.5 million increase in underwriting and other operating expenses, partially offset by a $75.3 million increase in net premiums earned. Net income includes amortization of deferred reinsurance gain-LPT Agreement of $18.0 million and $18.4 million for the years ended December 31, 2009 and 2008, respectively. Excluding the impact of the deferred reinsurance gain-LPT Agreement, net income would have been $65.0 million and $83.4 million for the years ended December 31, 2009 and 2008, respectively.
For the year ended December 31, 2009, realized gains on investments were $0.8 million, compared to realized losses of $11.5 million for the same period of 2008. The realized gains are attributable to the sale of previously impaired equity securities. Realized gains for the year ended December 31, 2009 were partially offset by the other-than-temporary impairments in 2009, totaling $1.9 million. The realized losses for the year ended December 31, 2008 were the result of other-than-temporary impairments in the fair value of fixed maturity and equity securities in our investment portfolio.
Income taxes decreased 9.6% for the year ended December 31, 2009, compared to the same period of 2008. The effective tax rate for the year ended December 31, 2009 was 10.1%, as compared to 9.2% for the same period of 2008. The increase in the effective tax rate was primarily the result of transactions that decreased 2008 income taxes related to the final reversal of the liability for previously unrecognized tax benefits in the amount of $10.6 million, including interest, and the reduction of tax-exempt reserves in the amount of $5.2 million. These comparative increases were mostly offset by an $19.8 million decrease in 2009 pre-tax income, the impact of tax-exempt investment income and the LPT contingent profit commission of $15.0 million, which is not subject to tax.
Investing activities resulted in net cash used of $135.1 million for the year ended December 31, 2008, compared to net cash provided of $10.2 million in 2007. The majority of cash used by investing activities was $188.4 million for the acquisition of AmCOMP. This was partially offset by $24.5 million of cash and cash equivalents received in the Acquisition and lower net purchases of securities.
Net premiums earned and losses and LAE incurred are stated in the accompanying consolidated statements of income after deduction of amounts ceded to reinsurers. Balances due from reinsurers on unpaid losses, including an estimate of such recoverables related to reserves for incurred but not reported losses, are reported as assets and are included in reinsurance recoverables even though amounts due on unpaid losses and LAE are not recoverable from the reinsurer until such losses are paid. Recoverables from reinsurers on unpaid losses and LAE amounted to $1.1 billion at December 31, 2009 and 2008.
The Company accrues the estimated ultimate contingent profit commission to be received through June 30, 2024. Increases or decreases in the estimated contingent profit commission are reflected in commission expenses in the period that the estimate is revised.
At December 31, 2009 and 2008, the outstanding premiums receivable balance was generally diversified due to the large number of entities composing the Company’s policyholder base and their dispersion across many different industries. To reduce credit risk, the Company performs ongoing evaluations of its policyholders’ financial condition, but does not generally require collateral. The Company also has recoverables from its reinsurers. Reinsurance contracts do not relieve the Company of its obligations to claimants or policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. The Company obtains collateral to mitigate the risks related to reinsurance insolvencies. At December 31, 2009, $7.6 million was
In April 2009, the FASB issued FSP FAS 107-1, Interim Disclosures About Fair Value of Financial Instruments (FSP FAS 107-1). FSP FAS 107-1 extends the annual disclosure requirements of SFAS 107, Fair Value of Financial Instruments, to interim financial statements of publicly traded companies. FSP FAS 107-1 was effective for interim and annual periods ending after June 15, 2009. The Company has included the required disclosures in these Notes to consolidated financial statements. The guidance for FSP FAS 107-1 may now be found in the new codification as a component of FASB ASC Topic 825.
In May 2009, the FASB issued SFAS No. 165, Subsequent Events, which sets forth general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. SFAS No. 165 is effective for periods ending after June 15, 2009. SFAS No. 165 had no impact on the Company’s consolidated financial condition or results of operations. The guidance for SFAS No. 165 may now be found in the new codification as a component of FASB ASC Topic 855. The Company evaluated subsequent events through February 25, 2010.
The Company reviews its investment portfolio for securities that may have incurred an other-than-temporary impairment (OTTI) quarterly. For any investment security deemed to have an OTTI, the
The Company continues to develop its own loss experience and will rely more on its experience and less on historical industry data in projecting its reserve requirements as such data becomes
available. As the actual experience of the Company emerges, it will continue to evaluate prior estimates, which may result in additional adjustments in reserves.
On September 1, 2009, the Company changed its method of recording ECIC’s written premiums to an annual method. As a result, the method of calculating 2008 and 2007 written premiums has been conformed for this change to be comparable to 2009 written premiums. The direct, gross and net premiums written for all periods presented are calculated assuming the written premiums are 100%of the estimated annual premium. Historically, written premiums for ECIC were recorded using a billed method, where premiums were recorded at the time policy installments were billed.
As of December 31, 2009, nonqualified stock options, restricted stock units, and performance share awards have been granted, but no incentive stock options, stock appreciation rights or restricted stock have been granted under the Plan.
The decrease in net premiums earned during 2009 was primarily due to the decrease in gross premium written, resulting from lower rates, competitive pressures and changes in economic and business conditions due to the economy and its impact on small businesses.