The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements and the notes to those statements included elsewhere in this annual report. The discussion and analysis below includes forward-looking statements that are subject to risks, uncertainties and other factors described in Part I, Item 1A of this annual report that could cause our actual results of operations, performance and business prospects and opportunities in 2012 and beyond to differ materially from those expressed in, or implied by, those forward-looking statements. See “Note on Forward-Looking Statements” in Part I, Item 1 of this annual report.
In our insurance subsidiary, we refer to the expenses that we incur to underwrite risks as underwriting, acquisition and insurance expenses. Underwriting expenses consist of commission expenses, premium taxes and fees and other underwriting expenses incurred in writing and maintaining our business. We pay commission expense in our insurance subsidiary to our brokers for the premiums that they produce for us. We pay state and local taxes based on premiums; licenses and fees; assessments; and contributions to workers’ compensation security funds. Other underwriting expenses consist of general administrative expenses such as salaries and employee benefits, rent and all other operating expenses not otherwise classified separately, and boards, bureaus and assessments of statistical agencies for policy service and administration items such as rating manuals, rating plans and experience data. Certain of these costs that vary with and are primarily related to the acquisition of insurance contracts (“deferred acquisition costs”) are initially deferred and amortized over the typical policy term of 12 months. Therefore, with respect to deferred acquisition costs, there are timing differences between when the costs are incurred or paid and when the related expense is recognized in our statements of operations and comprehensive income (loss).
Net Investment Income. Net investment income was $21.0 million in 2011 compared to $23.5 million in 2010, representing a decrease of $2.4 million, or 10.3%. Average invested assets increased $44.7 million, or 6.7%, from $664.2 million in 2010 to $708.9 million in 2011. This increase in our investment portfolio is due primarily to cash flow from operations of $27.6 million for the year ended December 31, 2011, which was invested primarily in fixed income securities. Net investment income as a percentage of average invested assets decreased slightly to 3.0% in 2011 from 3.5% in 2010 primarily due to reduced reinvestment interest rates.
As of December 31, 2011, we had recorded a receivable of approximately $3.1 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, 2011, we had access to approximately $3.1 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.
Other Income. Other income totaled $4.3 million for the year ended December 31, 2010 compared to $5.3 million for the same period in 2009, representing a decrease of $1.0 million, or 19.5%. Other income is derived primarily from the operations of PointSure, our wholesale broker, and PMCS, our provider of medical bill review, utilization review, nurse care management and related services.
Our investment portfolio is structured so that investments mature periodically over time in reasonable relation to current expectations of future claim payments. Since we have limited claims history, we have derived our expected future claim payments from industry and predecessor trends and included a provision for uncertainties. Our investment portfolio as of December 31, 2011 had an effective duration of 4.5 years with individual maturities extending to 29 years. Currently, we make claim payments from positive cash flows from operations and invest excess cash in securities with appropriate maturity dates to balance against anticipated future claim payments. As these securities mature, we intend to invest any excess funds with appropriate durations to match against expected future claim payments.
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 net ELR from 61.5% to 64.5% at June 30, 2010. In 2011, given the trend of the early actuarial indicated ultimate loss ratios for the 2011 accident year and considering the adverse development in recent accident years, we increased our 2011 net ELR from 62.5% to 65.0% in the fourth quarter of the year.
Variation can also occur in the loss reserves due to factors that affect our book of business in general. Some examples of these risk factors include, but are not limited to, the following:
Estimating loss reserves is an uncertain and complex process which involves actuarial techniques and management judgment. Actuarial analysis generally assumes that past patterns demonstrated in the data will repeat themselves and that the data provides a basis for estimating future loss reserves. However, since conditions and trends that have affected losses in the past may not occur in the future in the same manner, if at all, future results may not be reliably predicted by the prior data. Due to the relative immaturity of our book of business, the challenge has been to give the appropriate weight in the ultimate loss estimation process to the new data as it becomes available. As discussed above, management believes that it generally takes workers’ compensation losses approximately 48 to 60 months after the start of an accident year until the data is viewed as fully credible for paid and incurred reserve evaluation methods. Due to our limited operating history, we have eight complete accident years that were developed 96 months, 84 months, 72 months, 60 months, 48 months, 36 months, 24 months and 12 months (2004, 2005, 2006, 2007, 2008, 2009, 2010 and 2011, respectively) at December 31, 2011. At December 31, 2011, the analysis for accident years 2003 through 2010 utilizes a Bornhuetter-Ferguson approach, which blends the loss development and expected loss ratio methods, in addition to the paid and incurred loss development methods. See “Results of Operations - Year Ended December 31, 2011 Compared to Year Ended December 31, 2010 - Loss and Loss Adjustment Expenses” in this Item 7 for a discussion of the net unfavorable development in accident years 2006 through 2010 as well as the ELR for accident year 2011. 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.
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, 2011 and 2010, 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 and comprehensive income (loss). 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, 2008, 2009, 2010 and 2011.
We review our goodwill for potential impairment at least annually, and more frequently if a triggering event or other conditions indicate the possibility of impairment. Our analysis begins with a consideration of various qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of the reporting unit in question is less than its carrying amount. If such a determination is not reached, then performance of further impairment testing is not necessary. If the results of our qualitative analysis indicate a potential for impairment, then further impairment testing (consisting of discounted cash flow analysis and similar methodologies) is performed as required by ASC Topic 350, Intangibles - Goodwill and Other.
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, 2011 if future events, information and the passage of time result in a determination that a decline in value is other-than-temporary.
Direct premiums written totaled $257.7 million, $262.0 million, and $286.0 million for the years ended December 31, 2011, 2010 and 2009, respectively.
b. The Company is involved in various claims and lawsuits arising in the ordinary course of business. Management believes the outcome of these matters will not have a material adverse effect on the Company’s financial position or results of operations.
The weighted average amortization period for all intangible assets subject to amortization is 6.1 years. Aggregate amortization expense was $11,000, $141,000 and $184,000 for the years ended December 31, 2011, 2010, and 2009, respectively.