Annual Reports

 
Quarterly Reports

 
8-K

 
Other

Eastern Insurance Holdings 10-K 2008
Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2007

Commission file number 001-32899

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

 

 

EASTERN INSURANCE HOLDINGS, INC.

 

 

 

Incorporated in Pennsylvania   I.R.S. Employer Identification No.

25 Race Avenue, Lancaster, Pennsylvania

17603-3179

(717) 396-7095

  20-2653793

 

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of Each Class  

Name of Each Exchange on

Which Registered

Common Stock, No Par Value   NASDAQ National Market

Securities registered pursuant to Section 12(g) of the Act: None.

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act:    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act:    Yes  ¨    No  x

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  ¨      Accelerated filer  x      Non-accelerated filer  ¨      Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act):    Yes  ¨    No  x

The aggregate market value of the common stock held by non-affiliates of the registrant, based on the closing price of the registrant on June 30, 2007, as reported by the NASDAQ National Market, was $132,307,863.

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.

 

Title of Each Class   Number of Shares Outstanding as of March 12, 2008
Common Stock, No Par Value   9,879,458 (Outstanding Shares)

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement in connection with the 2008 Annual Meeting of Stockholders—Part III.

 

 

 


Table of Contents

Table of Contents

Eastern Insurance Holdings, Inc. and Subsidiaries

 

Item

  

Description

   Page

Part I

     

Item 1

  

Business

   1

Item 1A

  

Risk Factors

   20

Item 1B

  

Unresolved Staff Comments

   26

Item 2

  

Properties

   26

Item 3

  

Legal Proceedings

   27

Item 4

  

Submission of Matters to a Vote of Security Holders

   27

Part II

     

Item 5

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   28

Item 6

  

Selected Financial Data

   30

Item 7

  

Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations

   32

Item 7A

  

Quantitative and Qualitative Disclosures about Market Risk

   61

Item 8

  

Financial Statements and Supplementary Data

   62

Item 9

  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

   94

Item 9A

  

Controls and Procedures

   94

Item 9B

  

Other Information

   94

Part III

     

Item 10

  

Directors and Officers of the Registrant

   95

Item 11

  

Executive Compensation

   95

Item 12

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   95

Item 13

  

Certain Relationships and Related Transactions

   95

Item 14

  

Principal Accountant Fees and Services

   95

Part IV

     

Item 15

  

Exhibits, Financial Statement Schedules

   96


Table of Contents

PART I

Item 1—Business

Our History and Overview

Eastern Insurance Holdings, Inc. (“EIHI”) is an insurance holding company offering workers’ compensation and group benefits insurance and reinsurance products through its direct and indirect wholly-owned subsidiaries, Eastern Holding Company, Ltd. (“EHC”), 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”), Eastern Life and Health Insurance Company (“ELH”), Employers Alliance, Inc. (“Employers Alliance”), Global Alliance Holdings, Ltd. (“Global Alliance”), Global Alliance Statutory Trust I (“Trust I”), and Eastern Services Corporation (“Eastern Services”), collectively referred to as the “Company”, “we” and/or “our”.

The following provides a brief description of EIHI’s direct and indirect wholly-owned subsidiaries:

 

   

EHC is a holding company domiciled in the Commonwealth of Pennsylvania;

 

   

Eastern Alliance, Allied Eastern and Eastern Advantage are stock property/casualty insurance companies domiciled in the Commonwealth of Pennsylvania and do business as Eastern Alliance Insurance Group (“EAIG”). The three insurance companies provide EAIG with increased underwriting flexibility through the use of a tiered rating structure. Eastern Advantage was formed in 2007 and had no operations for the year ended December 31, 2007;

 

   

Eastern Re is a segregated portfolio cell company domiciled in the Cayman Islands;

 

   

ELH is a stock life and accident and health insurance company domiciled in the Commonwealth of Pennsylvania;

 

   

Employers Alliance is a Pennsylvania corporation offering claims administration and risk management services to self-insured property/casualty customers;

 

   

Global Alliance is a holding company in the Commonwealth of Pennsylvania. Trust I is a business trust subsidiary formed by Global Alliance solely for the purpose of issuing $8.0 million of fixed/floating rate trust preferred securities; and

 

   

Eastern Services is a Pennsylvania corporation that provides management services to EAIG, ELH, and Employers Alliance.

The Company operates in five business segments: workers’ compensation insurance, segregated portfolio cell reinsurance, group benefits insurance, specialty reinsurance, and corporate/other.

Overview of Business Segments

The following discussion provides information on each of our business segments:

Workers’ Compensation Insurance. The Company offers traditional workers’ compensation insurance coverage to employers, generally with 300 employees or less, primarily in Pennsylvania, Maryland and Delaware. The Company’s workers’ compensation products include guaranteed cost policies, policyholder dividend policies, retrospectively-rated policies and large deductible policies.

Workers’ compensation insurance coverage is also underwritten through the Company’s alternative markets business unit and ceded 100% to the segregated portfolio cell reinsurance segment. The Company receives a fronting fee generally based upon a percentage of direct premiums written, a segregated portfolio cell rental fee, which is also based on a percentage of direct premiums written, and fees for claims administration and risk management services. As of December 31, 2007, the segregated portfolio cells and dividend participants have provided $44.8 million of irrevocable, unconditional letters of credit to secure unfunded liabilities and collateralize reserves for unpaid losses and loss adjustment expenses (“LAE”) and unearned premiums.

Group Benefits Insurance. The Company offers group benefits insurance products to employer groups, generally with 300 employees or less, primarily in the Mid-Atlantic, Southeast and Midwest regions of the continental United States. The Company’s group benefits insurance products consist of dental, short-term and long-term disability, and term life.

 

1


Table of Contents

Specialty Reinsurance. The Company assumes business through its participation in reinsurance treaties with an unaffiliated insurance company related to an underground storage tank insurance program, referred to as “EnviroGuard,” and a non-hazardous waste transportation product, referred to as “EIA Liability” (“EIA”). The EnviroGuard program provides coverage to underground storage tank owners for third party off-site bodily injury and property damage claims as well as clean-up coverage and first party on-site claims. The EIA program provides commercial automobile liability coverage for non-hazardous waste haulers. Effective January 1, 2008, the Company reduced its participation in the EnviroGuard and EIA programs from a 25% quota share participation to a 15% quota share participation.

Products

Workers’ Compensation Insurance

The Company offers a complete line of workers’ compensation products including guaranteed cost policies, policyholder dividend policies, retrospectively-rated policies, large deductible policies, and alternative market products. Direct premiums written in the workers’ compensation insurance segment totaled $91.5 million for the year ended December 31, 2007.

 

   

Guaranteed cost policies. Guaranteed cost policies charge a fixed premium, which does not increase or decrease based upon loss experience during the policy period. For the year ended December 31, 2007, 56.7% of direct premiums written in the workers’ compensation insurance segment was derived from guaranteed cost policies.

 

   

Policyholder dividend policies. Policyholder dividend policies charge a fixed premium, but the customer may receive a dividend in the event of favorable loss experience during the policy period. Policyholder dividend plans are generally restricted to accounts with minimum annual premiums in excess of $20,000. For the year ended December 31, 2007, 9.1% of direct premiums written in the workers’ compensation insurance segment was derived from policyholder dividend policies.

 

   

Retrospectively-rated policies. Retrospectively-rated policies charge an initial premium that is subject to adjustment after the policy period expires, based upon the insured’s actual loss experience incurred during the policy period, subject to a minimum and maximum premium. These policies are typically subject to annual adjustment until all claims related to the policy year are closed. Retrospectively-rated policies are generally offered to employers with minimum annual premiums in excess of $150,000. For the year ended December 31, 2007, 3.9% of direct premiums written in the workers’ compensation insurance segment was derived from retrospectively-rated policies.

 

   

Large deductible policies. Large deductible policies generally result in a lower premium; however, the insured retains a greater share of the underwriting risk than under guaranteed cost or dividend paying policies, which reduces the risk and further encourages loss control by the insured. The customer is contractually obligated to pay its own losses up to the amount of the deductible for each occurrence. The deductibles under these policies generally range from $250,000 to $300,000. Large deductible policies are generally offered to employers with annual premiums of $500,000 or higher. For the year ended December 31, 2007, 1.1% of direct premiums written in the workers’ compensation insurance segment was derived from large deductible policies.

 

   

Alternative market products. Alternative market products are offered to individual customers and trade associations. As described above in “Overview of Business Segments—Segregated Portfolio Cell Reinsurance,” a policy is issued to an insured and 100% of the premium written, less a ceding commission, is ceded to a segregated portfolio cell. For the year ended December 31, 2007, 29.2% of direct premiums written in the workers’ compensation insurance segment was derived from alternative market products.

Segregated Portfolio Cell Reinsurance

Segregated portfolio cells, or segregated cells or rent-a-captives, are all referred to as alternative market programs or products. The Company provides a variety of products to this marketplace, including program design, fronting, claims administration, risk management, segregated portfolio cell rental, investment and segregated portfolio management services. Direct premiums written in the segregated portfolio cell reinsurance segment totaled $26.1 million for the year ended December 31, 2007. The segregated portfolio cell reinsurance segment generated fee revenue to the Company’s workers’ compensation insurance, specialty reinsurance, and corporate/other segments totaling $3.9 million for the year ended December 31, 2007.

 

2


Table of Contents

Group Benefits Insurance

The Company’s group benefits insurance products include dental insurance, short-term disability insurance, long-term disability insurance, and term life insurance.

 

   

Dental Insurance. Dental plans include fee for service and managed care plans. Multiple variations of these products are available which offer different degrees of coverage, affordability and flexibility. Managed care plans utilize the networks of two unaffiliated dental Preferred Provider Organizations. Direct premiums written in the dental line totaled $21.8 million for the year ended December 31, 2007.

 

   

Short-Term Disability Insurance. Short-term disability plans pay flat weekly benefit amounts or a percentage of an individual claimant’s weekly earnings in the event of disability. Direct premiums written in the short-term disability line totaled $6.6 million for the year ended December 31, 2007.

 

   

Long-Term Disability Insurance. Long-term disability plans provide preset amounts or a preset percentage of an individual claimant’s monthly earnings in the event of disability. Direct premiums written in the long-term disability line totaled $4.1 million for the year ended December 31, 2007.

 

   

Term Life Insurance. Term life plans pay flat amounts or a multiple of an individual’s salary. Direct premiums written in the term life line totaled $6.0 million for the year ended December 31, 2007.

Specialty Reinsurance

The Company participates as a reinsurer in treaties with a large primary insurer for the EnviroGuard program and the EIA program. The Company’s specialty reinsurance products are primarily marketed and distributed by Americana Program Underwriters, Inc. (“AmPro”). Lawrence Bitner, a Director of the Company, is an employee of AmPro and manages a significant portion of its program business. See Item 1A—Risk Factors, “All of the specialty reinsurance business is controlled by one of our directors and is placed with one primary insurer and the loss of this business would have an adverse impact on consolidated revenue.” Assumed premiums written in the specialty reinsurance segment totaled $14.1 million for the year ended December 31, 2007.

Marketing and Distribution

Workers’ Compensation Insurance

The Company distributes its workers’ compensation products and services primarily in Pennsylvania, Maryland and Delaware through a network of carefully chosen independent insurance producers. The following table provides direct premiums written before purchase accounting adjustments, by state, for the year ended December 31, 2007 (dollars in thousands):

 

State

   Direct Premiums
Written
   Percentage  

Pennsylvania

   $ 87,894    94.8 %

Delaware

     2,744    3.0 %

Maryland

     1,964    2.1 %

Other

     66    0.1 %
             

Total

   $ 92,668    100.0 %
             

The Company has its greatest representation and largest workers’ compensation premium volume in central Pennsylvania.

During 2007, Eastern Alliance received its license to write workers’ compensation insurance in North Carolina. As a result of obtaining its license, the Company opened a regional office in Charlotte, North Carolina.

Producers are compensated through a fixed base commission plan with an opportunity for profit sharing depending on the producer’s premium volume and loss experience.

The Company proactively manages its valued relationships with producers through a detailed producer management process. The process is driven by regular interaction and strong relationships between senior management of the Company and the principals of each producer. The primary components of the producer management process are:

 

   

The Company carefully selects producers through a process that assesses financial results, market potential, business philosophy and reputation of the producer and its staff. Senior management of the Company approves all

 

3


Table of Contents
 

producer appointments following extensive meetings with the producer’s principals. Following the agreement to appoint, the Company’s Senior Vice President of Marketing and other key personnel conduct a formal orientation process focusing on the Company’s workers’ compensation products and services, dedicated service team and the joint business objectives of the Company and the producer.

 

   

The Company’s senior management team conducts annual business planning meetings with the producer’s principals to mutually agree upon the producer’s financial goals for the following year. Senior management and the underwriting staff conduct regular visits to monitor results and build relationships.

 

   

The Company has established an Agency Advisory Council to promote an active dialogue between the Company and its producer group. The Agency Advisory Council is comprised of six experienced insurance agency professionals. The Council meets twice a year to discuss such topics as market conditions, customer service, products, competition and areas of opportunity. In addition to the Agency Advisory Council, the Company has established a Select Business Focus Group with its producers. This group meets once a year to concentrate on issues that impact small workers’ compensation clients (under $20,000 in annual premium).

 

   

Producer management reports are distributed on a monthly basis, providing the producer with the data necessary to manage its relationship with the Company.

The Company attempts to optimize the franchise value of an appointment for its approximate 55 workers’ compensation producers by limiting the number of appointments in identified marketing territories. As a result of this producer management strategy, the average direct premiums written per agency contract was $1.7 million for the year ended December 31, 2007.

The Company’s ten largest producers in its workers’ compensation insurance segment accounted for 55.9% of its direct premiums written for the year ended December 31, 2007. The Company’s largest producer in its workers’ compensation insurance segment accounted for 21.2% of its direct premiums written for the year ended December 31, 2007. No other producer accounted for more than 10% of the Company’s direct premiums written in its workers’ compensation insurance segment for the year ended December 31, 2007.

Segregated Portfolio Cell Reinsurance

The distribution of policies that may be submitted for consideration for reinsurance is substantially the same as that of the workers’ compensation insurance segment. The Company’s independent producers market the products to potential customer groups within the Company’s geographic target markets.

Group Benefits Insurance

The Company markets its group benefits insurance products through direct relationships with independent producers and general agencies, primarily in the Mid-Atlantic, Southeast, and Midwest regions of the continental United States.

The Company has an agreement with IBSi Holdings, Inc. (“IBSi”), a general agent, under which IBSi markets the Company’s group benefits insurance products to independent producers. IBSi’s primary marketing territory is North Carolina, South Carolina, and Virginia, These states accounted for approximately 42.8% of the Company’s direct premiums written for the year ended December 31, 2007.

The following table provides direct premiums written, by state, for the year ended December 31, 2007 (dollars in thousands):

 

State

   Direct
Premiums
Written
   Percentage  

Pennsylvania

   $ 14,615    37.9 %

North Carolina

     12,180    31.6 %

Maryland

     3,087    8.0 %

South Carolina

     2,265    5.9 %

Virginia

     2,028    5.3 %

Other

     4,344    11.3 %
             

Total

   $ 38,519    100.0 %
             

 

4


Table of Contents

The Company provides sales, technical and educational training to its producers. Through its website, the Company provides its producers with online access to enrollment forms, product information, and online rate information for smaller groups (less than 10 people). These marketing efforts are further supported by the group benefits insurance segment’s claims and administrative philosophy, which emphasizes prompt and efficient service.

The Company provides its group benefits insurance producers with competitive compensation packages consisting of multiple commission levels, varying by product line and level of premium produced. As cost savings to the Company result when multiple product types are sold to a single group, incentive bonuses are offered to producers that reward such sales.

Specialty Reinsurance

The Company does not engage in any marketing or distribution with respect to the specialty reinsurance segment. All marketing efforts are undertaken by AmPro, which develops programs for presentation to large primary insurers. Management and the Company’s Board of Directors consider analyses of historical loss information, market potential, and rate adequacy in determining whether to participate in each program.

Underwriting, Risk Management and Pricing

Workers’ Compensation Insurance

The Company’s workers’ compensation insurance segment is committed to an individual account underwriting strategy that is focused on selecting quality accounts. The goal of the workers’ compensation underwriting professionals is to select a diverse book of business with respect to risk classification, hazard level and geographic location. The Company expects to remain a rural underwriter focusing on territories, accounts and producers that generate acceptable underwriting margins.

The workers’ compensation underwriting strategy is focused on accounts with strong return to work and safety programs and low to middle hazard levels such as clerical office, light manufacturing, auto dealers and service industries.

For the year ended December 31, 2007, the average annual workers’ compensation traditional premium per policy was $18,946.

Within the workers’ compensation underwriting operation, the Company operates a risk management unit, which delivers loss consulting services to the Company’s staff, producers and customers. The objective of the risk management operation is to protect the Company from catastrophic loss, reduce claims frequency and provide value added consulting services to insureds. The Company has expanded consulting services to include health and wellness, which supports injury prevention and mitigates claim expense. These services are provided at no additional cost to the insured and are services that differentiate the Company’s workers’ compensation products from its competitors. The risk management unit also provides risk pre-screening in support of the underwriting selection process.

Segregated Portfolio Cell Reinsurance

Underwriting and risk management services for the segregated portfolio cell reinsurance segment are substantially the same as the workers’ compensation insurance segment, although a separate alternative markets unit has been formed for the delivery of services on a group program basis. The independent producers’ knowledge of the Company’s workers’ compensation product offerings is an important component in the offering of different product proposals to customers, including the alternative market option. After successful completion of the underwriting process, if the risk is deemed to be an appropriate candidate for the alternative market, the risk is submitted for consideration of intercompany reinsurance. In general, a pool of risks such as a trade group, or for similarly situated customers of an agency, are most appropriate for submission to the alternative markets unit. If a pool of risks is accepted, reinsurance agreements and dividend participant agreements are executed, external reinsurance is bound and a segregated portfolio cell is established and presented to the Cayman Islands Monetary Authority for approval.

Group Benefits Insurance

The group benefits insurance underwriting department is responsible for managing the Company’s group benefits insurance book of business within established policies and procedures. The Company primarily underwrites small to medium size employer groups generally with 300 or less employees that fall within a low to moderate risk classification. Additionally, adequate levels of employee participation are required in order to underwrite a group.

 

5


Table of Contents

Pricing levels for the group benefits insurance products are developed based on the Company’s historical experience, as well as industry experience, and are periodically assessed for adequacy. Dental rates are evaluated on a quarterly basis, whereas short-term disability and term life rates are generally evaluated on an annual basis. Pricing for the long-term disability product is developed by the Company’s long-term disability reinsurer.

Account pricing is determined by the individual underwriter based on the level of risk, taking into consideration a group’s demographics and selected plan design.

Specialty Reinsurance

The Company does not underwrite individual risks in the specialty reinsurance segment, rather, it examines specific program analytics and determines whether to enter into the reinsurance agreement with the primary insurer. The Company conducts an annual underwriting audit of the primary insurer’s underwriting function.

Claims

Workers’ Compensation Insurance

Workers’ compensation claims management focuses on early intervention and aggressive disability management, utilizing the professional services of medical case managers to supplement the expertise of in-house claims professionals when appropriate.

The Company believes in thorough education of its clients and their employees regarding the workers’ compensation law and workplace safety. The Company utilizes frequent communication with all parties as a means to maintain control of claims and minimize the influence of factors that increase costs such as attorney involvement and “doctor shopping.” The Company provides assistance and support to its clients in the implementation of physician panels and return to work programs.

The Company utilizes strategic vendor relationships rather than in-house personnel for services such as legal representation, private investigation, vocational rehabilitation and medical case management.

Medical cost management initiatives have been implemented with strategic vendors to reduce claim costs. Medical cost management services include preferred provider networks, physical therapy networks, a prescription drug program, and subrogation recovery.

The Company attempts to aggressively achieve final resolution of, and close, claims from prior accident years. The table below shows the number of prior years workers’ compensation claims received and closed and open claims, by accident year, as of December 31, 2007.

Traditional Business

(Exclusive of Alternative Markets)

Open Claims (1)

 

Accident Year

   Total Claims    Open    Closed    % Closed  

1998

   65    0    65    100.0 %

1999

   205    1    204    99.5 %

2000

   381    0    381    100.0 %

2001

   594    0    594    100.0 %

2002

   686    5    681    99.3 %

2003

   689    8    681    98.8 %

2004

   831    21    810    97.5 %

2005

   740    46    694    93.8 %

2006

   922    133    789    85.6 %

2007

   860    356    504    58.6 %
                     
   5,973    570    5,403    90.5 %
                     

 

(1) Excludes claims for medical only expenses because such claims are opened and closed in a short period of time. Excludes reinsured claims.

 

6


Table of Contents

The table below shows the number of open lost time claims for accident years 2006 and prior as of December 31, 2007 and 2006:

Traditional Business

(Exclusive of Alternative Markets)

Open Claims (1)

 

Accident Year

   12-31-07
Open
   12-31-06
Open
   2006 and Prior
Claims Closed
During 2007
   % of 2006 Open Claims
Closed During 2007
 

1999

   1    1    0    0.0 %

2001

   0    1    1    100.0 %

2002

   5    8    3    37.5 %

2003

   8    18    10    55.6 %

2004

   21    51    30    58.8 %

2005

   46    88    42    47.7 %

2006

   133    328    195    59.5 %
                     
   214    495    281    56.8 %
                     

 

(1) Excludes claims for medical only expenses because such claims are opened and closed in a short period of time. Excludes reinsured claims.

Segregated Portfolio Cell Reinsurance

The claims administration and risk management strategy for the alternative market programs is consistent with the workers’ compensation insurance segment.

Group Benefits Insurance

The group benefits insurance claims staff is responsible for investigating, processing and paying claims. Authority levels have been established for all individuals involved in the settlement of claims.

 

   

Dental Claims. The Company’s dental claims department is comprised of experienced personnel who function within designated areas of expertise. The Company utilizes an independent dental peer review firm for claims outside of its employees’ areas of clinical expertise and to assist with benefit determination appeals. The Company’s dental claim examiners are able to review claimant x-rays and provider treatment notes online, reducing the time and expense associated with manual claims processing. In addition, the Company’s administrative software provides automated batch processing for basic claims, which allows examiners to devote greater attention to complex claims. Quality technicians are utilized to assess the accuracy of benefit determinations, with all examiners and analysts randomly audited on claims that exceed a set dollar amount. On average, dental claims are processed within two weeks of receipt by the Company.

 

   

Short-Term Disability Claims. Short-term disability claims are reviewed within 3 to 5 business days of their receipt. Lump sum benefit payments are offered for maternity claims. The short term disability claims review process may be supplemented by outside physicians who conduct independent medical examinations and provide peer review services to determine if claims are medically accurate. Following such a medical examination, the Company’s short-term disability claim examiners make the ultimate decision as to whether or not a claimant is disabled by measuring the results of the medical examination against the appropriate provisions in the disability insurance policy.

 

   

Long-Term Disability Claims. Since July 1, 2005, the Company has outsourced long term disability claims processing to Disability Reinsurance Management Services, Inc. (Disability RMS), which management believes has greater expertise and resources to administer such claims.

 

   

Term Life and Accidental Death & Dismemberment (“AD&D”) Claims. The manager of the life & disability claim department is responsible for the timely and accurate payment of term life and AD&D claims. Whenever death proceeds from an individual claimant’s policy exceed reinsurance limits, the Company’s life reinsurer participates in the benefit determination.

 

7


Table of Contents

Specialty Reinsurance

Claims management in the specialty reinsurance segment is performed by the primary insurer. When the primary insurer sustains a loss, the Company receives an invoice for its pro rata share of the loss. The Company’s claims administration is limited to verification that the claim is a covered claim under the reinsurance contract between the Company and the primary insurer. The Company engages a third party to conduct an annual audit of the primary insurer’s claim administration function.

Reinsurance

The Company’s insurance subsidiaries reinsure a portion of their loss exposure and pay to the reinsurers a portion of the premiums received on all policies reinsured. Insurance policies written by the Company’s insurance subsidiaries are reinsured with other insurance companies principally to:

 

   

reduce net liability on individual risks;

 

   

mitigate the effect of individual loss occurrences (including catastrophic losses);

 

   

stabilize underwriting results; and

 

   

decrease leverage and, accordingly, increase underwriting capacity.

Reinsurance does not legally discharge the Company from primary liability for the full amount due under the reinsured policies. However, the assuming reinsurer is obligated to reimburse the Company to the extent of the coverage ceded. As of December 31, 2007, the Company’s reinsurance recoverables, by segment, were as follows (in thousands):

 

Segment

   Amount

Workers’ compensation insurance

   $ 4,616

Segregated portfolio cell reinsurance

     2,587

Group benefits insurance

     19,100

Specialty reinsurance

     —  
      

Total

   $ 26,303
      

The Company determines the amount and scope of reinsurance coverage to purchase each year based on a number of factors, including the evaluation of the risks accepted, consultations with reinsurance representatives and a review of market conditions, including the availability and pricing of reinsurance.

The Company monitors the solvency of its reinsurers on an annual basis, at a minimum, through review of their financial statements and, if available, their A.M. Best financial strength ratings. The Company has not experienced difficulty collecting amounts due from reinsurers; however, the insolvency or inability of any reinsurer to meet its obligations could have a material adverse effect on the Company’s financial condition and results of operations.

Workers’ Compensation Insurance

The Company’s workers’ compensation traditional business is reinsured under an excess of loss arrangement with Lloyd’s of London and Aspen Insurance UK, Ltd., under which the Company retains the first $500,000 on each loss occurrence. Loss occurrences in excess of $500,000 are covered up to a maximum of $39.5 million per claim.

The following table sets forth the amounts recoverable from reinsurers for the workers’ compensation insurance segment as of December 31, 2007 (dollars in thousands):

 

Name

   Reinsurance
Recoverable
  

A.M. Best

Rating

   Percentage of
Shareholders’
Equity
    Percentage of
Reinsurance
Recoverable
 

Lloyd’s of London

   $ 3,156    A    1.8 %   12.0 %

Aspen Insurance UK, Ltd.  

     1,014    A    0.6 %   3.8 %

Alea London, Ltd.  

     202    NR-4 (1)    0.1 %   0.8 %

Alea Bermuda, Ltd.  

     147    NR-4 (1)    0.1 %   0.6 %

St. Paul Reinsurance Company Ltd.  

     82    NR-3 (2)    0.0 %   0.3 %

Fairfield Insurance Company

     15    A +    0.0 %   0.1 %
                      
   $ 4,616       2.6 %   17.6 %
                      

 

8


Table of Contents

 

(1) Rating assigned to companies that were assigned a rating by A.M. Best but requested that their ratings not be published because the companies disagree with A.M. Best’s rating conclusion.
(2) Rating assigned to companies that are not rated by A.M. Best.

Segregated Portfolio Cell Reinsurance

Intercompany Reinsurance Structure. Intercompany reinsurance agreements are the mechanisms by which premiums paid by alternative markets customers are ceded to the segregated portfolio cells. Each segregated portfolio cell has the following reinsurance agreements:

 

   

100% Quota Share Reinsurance Agreements—Under this reinsurance agreement, all premiums received from the specific customer are ceded to the respective segregated portfolio cell, net of a ceding commission. As with any reinsurance arrangement, the ultimate liability for the payment of claims resides with the primary insurance company. The ceding commission paid by the segregated portfolio cell consists of charges customary to such arrangements including fronting fees, external reinsurance, producer’s commissions, premium taxes and assessments, claims administration and risk management services and segregated portfolio cell rental fees. In addition, the ceding commission includes the risk assumed under the aggregate excess reinsurance agreement described directly below.

 

   

Aggregate Excess Reinsurance Agreements—An aggregate excess reinsurance agreement exists for each respective segregated portfolio cell whereby the Company assumes 100% of aggregate losses over an aggregate attachment point (expressed as a percentage of direct premiums written), with a maximum loss limit of $100,000. The attachment points for the aggregate excess reinsurance agreements average 89.0% of direct premiums written. For example, in the case of a segregated portfolio cell with $1.0 million in assumed premium and an 89.0% attachment point, the segregated portfolio cell pays the first $890,000 in net losses and LAE, the Company pays the next $100,000 in net losses and LAE and the external aggregate reinsurer (as described below) pays net losses and LAE beyond the initial $990,000 covered by the segregated portfolio cell and the Company.

External Reinsurance. Each segregated portfolio cell purchases external reinsurance coverage directly from Lloyd’s of London. The segregated portfolio cell purchases per occurrence coverage to cover severity of claims and aggregate reinsurance coverage to cover frequency of claims on its segregated portfolio cell business.

Per Occurrence Reinsurance Agreements. Per occurrence reinsurance agreements cover each segregated portfolio cell for a catastrophic claim resulting from one event with respect to its segregated portfolio cell business. The specific retentions for per occurrence coverage for segregated portfolio cells range from $250,000 to $350,000, with limits ranging from $39.75 million to $39.65 million. For example, in the case of a segregated portfolio cell with a $300,000 retention that has a $3.0 million claim relating to the injury and/or death of a covered employee, the segregated portfolio cell would cover the first $300,000 of the claim with the third party reinsurer paying the remaining $2.7 million in claims.

Aggregate Reinsurance Coverage. Aggregate reinsurance agreements cover the segregated portfolio cells for losses and LAE beyond the $100,000 aggregate coverage provided by the Company. The need for this coverage would arise in the event of a series of losses as opposed to a single, catastrophic event. Aggregate reinsurance coverage purchased through Lloyd’s has ultimate loss limits of $1.0 million or $2.0 million, depending on the underlying risks. This external reinsurance combined with the aggregate coverage provided by the Company provides aggregate loss limits for each segregated portfolio cell ranging from $1.1 million to $2.1 million.

In addition to the reinsurance coverage on the segregated portfolio cell business, the dividend participants of each segregated portfolio cell provide a letter of credit that is equal to the difference between the loss fund (amount of funds available to pay losses after deduction of ceding commission) and the aggregate attachment point of the reinsurance. This is sometimes called the GAP, or unfunded liability. As an example, if a program has $1.0 million of assumed premiums, a 40% ceding commission and a 90% aggregate attachment point, the letter of credit amount is $300,000 calculated as follows:

 

Aggregate attachment point ($1,000,000 x .90)

   $ 900,000

Loss fund ($1,000,000 – ($1,000,000 x .40)

   $ 600,000

GAP

   $ 300,000

The difference between the premium and the ceding commission is deposited in each respective segregated portfolio cell’s Cayman Island bank account to create the loss fund.

 

9


Table of Contents

The following table sets forth the amounts recoverable from reinsurers for the segregated portfolio cell reinsurance segment as of December 31, 2007 (dollars in thousands):

 

Name

   Reinsurance
Recoverable
   A.M. Best
Rating
    Percentage of
Shareholders’
Equity
    Percentage of
Reinsurance
Recoverable
 

Lloyd’s of London

   $ 1,462    A     0.8 %   5.6 %

Aspen Insurance UK, Ltd.  

     860    A     0.5 %   3.2 %

Alea London, Ltd.  

     258    NR-4 (1)   0.2 %   1.0 %

St. Paul Reinsurance Company Ltd.  

     7    NR-3 (2)   0.0 %   0.0 %
                     
   $ 2,587      1.5 %   9.8 %
                     

 

(1) Rating assigned to companies that were assigned a rating by A.M. Best but requested that their ratings not be published because the companies disagree with A.M. Best’s rating conclusion.
(2) Rating assigned to companies that are not rated by A.M. Best.

Group Benefits Insurance

The Company reinsures a portion of its long-term disability and term life business. There is currently no reinsurance coverage on the dental and short-term disability business.

The long-term disability business is reinsured under a quota-share arrangement with Union Security Insurance Company. Under the current quota-share arrangement, the Company retains 20% of the first $6,000 in monthly disability benefits on all new and renewal business sold on or after July 1, 2005. Monthly benefits in excess of $6,000 are 100% reinsured.

Effective August 1, 2007, the term life business is reinsured under an excess of loss arrangement with Reliastar Life Insurance Company. Prior to August 1, 2007, the term life business was reinsured by Swiss Re Life and Health America, Inc. The Company continues to retain the first $100,000 of each covered death claim and the first $50,000 of each covered accidental death or dismemberment claim.

The Company has a block of active disability claims that it has completely ceded to The Hartford Life and Accident Insurance Company. These claims arose out of long term disability policies that ELH formerly offered to selected professional associations. The largest of these policies terminated in April 1997 and all but two of the remaining active claims pursuant to such policies were acquired by The Hartford in 1999. The Hartford manages and pays all such claims without any involvement from the Company and provides any financial information required for the Company’s financial reporting purposes.

The following table sets forth the amounts recoverables from reinsurers for the group benefits insurance segment as of December 31, 2007 (dollars in thousands):

 

Carrier

   Reinsurance
Recoverable
   A.M Best
Rating
    Percentage of
Shareholders’

Equity
    Percentage of
Reinsurance
Recoverable
 

Hartford Life and Accident Insurance Company

   $ 10,163    A +   5.7 %   38.6 %

Union Security Insurance Company

     7,005    A     4.0 %   26.7 %

Transamerica Financial Life Insurance Company

     1,111    A +   0.6 %   4.2 %

Swiss Re Life and Health America, Inc.

     573    A +(1)   0.3 %   2.2 %

Reliastar Life Insurance Company

     170    A +   0.1 %   0.6 %

United Teacher Associates Insurance Company

     57    A -   0.0 %   0.2 %

Combined Insurance Company of America

     21    A     0.0 %   0.1 %
                     
   $ 19,100      10.7 %   72.6 %
                     

 

(1) Swiss Re Life and Health America, Inc. has been put on a negative outlook by A.M. Best.

Specialty Reinsurance

The Company acts as a reinsurer in the specialty reinsurance segment. None of the risks assumed in this segment are further reinsured.

 

10


Table of Contents

Loss and LAE Reserves

The Company estimates its reserves for unpaid losses and LAE as of the balance sheet date. The adequacy of the Company’s reserves is inherently uncertain and represents a significant risk to the business. The Company attempts to mitigate the uncertainty inherent in its reserves by continually reviewing loss cost trends, attempting to set premium rates that are adequate to cover anticipated future costs, and by professionally managing its claims administration function. Additionally, the Company attempts to minimize the estimation risk inherent in its reserves by employing actuarial techniques on a quarterly basis. Significant judgment is required in actuarial estimation to ascertain the relevance of historical payment and claim settlement patterns under current facts and circumstances. No assurance can be given as to whether the ultimate liability for unpaid losses and LAE will be more or less than the Company’s current estimates. While management believes that the assumptions underlying the amounts recorded for the reserves for unpaid losses and LAE as of December 31, 2007 are reasonable, the ultimate net liability may differ materially from the amount provided.

The following table provides a summary of the activity in the Company’s reserves for unpaid losses and LAE, excluding term life premium waiver reserves. The 2006 activity related to the workers’ compensation insurance, segregated portfolio cell reinsurance and specialty reinsurance segments is for the period from June 17, 2006 to December 31, 2006 (in thousands).

 

     2007     2006     2005  

Balance, beginning of period

   $ 121,396     $ 38,729     $ 38,559  

Reinsurance recoverables on unpaid losses and LAE

     24,236       23,911       23,415  
                        

Net balance, beginning of period

     97,160       14,818       15,144  

Net reserves acquired as a result of EHC acquisition

     —         73,554       —    

Purchase accounting adjustments on acquisition date

     —         2,432       —    

Incurred related to:

      

Current year

     80,946       54,104       26,962  

Prior year

     (6,189 )     (5,296 )     (269 )
                        

Total incurred before purchase accounting adjustments

     74,757       48,808       26,693  

Purchase accounting adjustments

     (848 )     (538 )     —    
                        

Total incurred

     73,909       48,270       26,693  

Paid related to:

      

Current year

     37,019       28,609       22,724  

Prior year

     32,230       13,305       4,295  
                        

Total paid

     69,249       41,914       27,019  
                        

Net balance, end of period

     101,820       97,160       14,818  

Reinsurance recoverables on unpaid losses and LAE

     23,429       24,236       23,911  
                        

Balance, end of period

   $ 125,249     $ 121,396     $ 38,729  
                        

Total reserves for unpaid losses and LAE

   $ 129,788     $ 126,467     $ 44,136  

Less: Term life premium waiver reserves

     4,481       4,815       5,333  

Less: Other

     58       256       74  
                        

Balance, end of period

   $ 125,249     $ 121,396     $ 38,729  
                        

Incurred losses by segment were as follows for the year ended December 31, 2007 (in thousands):

 

     Workers’
Compensation
Insurance
Segment
    Segregated
Portfolio Cell
Reinsurance
Segment
    Group
Benefits
Insurance
Segment
    Specialty
Reinsurance
Segment
   Total  

Incurred related to:

           

Current year, gross of discount

   $ 34,962     $ 14,800     $ 24,536     $ 8,163    $ 82,461  

Current period discount

     (979 )     (536 )     —         —        (1,515 )

Prior year, gross of discount

     (8,398 )     (3,023 )     (961 )     4,844      (7,538 )

Accretion of prior period discount

     787       562       —         —        1,349  
                                       

Total incurred before purchase accounting adjustments

     26,372       11,803       23,575       13,007      74,757  

Purchase accounting adjustments

     (758 )     (132 )     —         42      (848 )
                                       

Total incurred

   $ 25,614     $ 11,671     $ 23,575     $ 13,049    $ 73,909  
                                       

Workers’ Compensation Insurance. The Company’s results of operations include a decrease in estimated incurred losses and LAE on its workers’ compensation line of business primarily related to accident years 2006, 2005, and 2004 of $8,398

 

11


Table of Contents

for the year ended December 31, 2007. The favorable development on prior accident years relates primarily to significant claim settlements during 2007 for amounts at, or less than, previously established case and incurred but not reported (“IBNR”) reserves.

Segregated Portfolio Cell Reinsurance. The Company’s results of operations in its segregated portfolio cell reinsurance segment included a decrease in estimated incurred losses and LAE primarily related to accident years 2006, 2005 and 2004 of $3,023 for the year ended December 31, 2007. The favorable development on prior accident years relates primarily to significant claim settlements during 2007 for amounts at, or less than, previously established case and IBNR reserves. Any change in the reserves for unpaid losses and LAE in the segregated portfolio cell reinsurance segment is recorded to the segregated portfolio dividend payable/receivable account and would only impact the Company’s net income or shareholders’ equity if the Company was a segregated portfolio cell dividend participant.

Group Benefits Insurance. The Company’s results of operations for the year ended December 31, 2007 include favorable development on prior year reserves of $961 in the group benefits insurance segment. The favorable development reflects better claim experience in the dental, short-term disability and term life lines than anticipated at the time the liability was established and the termination of prior year long-term disability claims as a result of claimants returning to work, claimant death, or the termination of benefits in accordance with policy provisions.

Specialty Reinsurance. The Company’s results of operations included an increase in estimated incurred losses and LAE on its specialty reinsurance line of business related to prior accident years of $4,844 for the year ended December 31, 2007. The unfavorable prior year development was the result of changes in estimates as losses emerged at a higher rate than had been originally anticipated when the reserves were estimated with respect to accident years 2006, 2005, 2004, and 2003. The evaluation of the reserve for unpaid losses and LAE related to the specialty reinsurance segment requires that loss development be estimated over an extended period of time. Because the primary insurer under these programs changed in 1999, historical loss data is insufficiently developed. Therefore, reliance has been placed on industry loss development patterns, adjusted based on the Company’s judgment, to reflect considerations particular to the exposure. The reliance on external benchmarks, while necessary, creates an additional element of uncertainty.

 

12


Table of Contents

The analysis in the following table presents the development of the Company’s reserves for unpaid losses and LAE from December 31, 1997 to December 31, 2006. The first line in the table shows the liability for unpaid losses and LAE, net of reinsurance, as estimated at the end of each calendar year. The first section below that line shows the cumulative actual payments of loss and LAE, net of reinsurance, that relate to each year-end liability as they were paid at the end of subsequent annual periods. The next section shows revised estimates of the original unpaid amounts, net of reinsurance, that are based on the subsequent payments and re-estimates of the remaining unpaid liabilities. The next line shows the favorable or adverse development of the original estimates, net of reinsurance. Loss reserve development in this table is cumulative, the estimated favorable or adverse development for a particular year represents the cumulative amount by which all previous liabilities are currently estimated to have been over- or under-estimated. The “cumulative redundancy/(deficiency)” is as of December 31, 2007, which represents the difference between the latest reestimated liability and the amounts as originally estimated. A redundancy means the original estimate was higher than the current estimate; a deficiency means that the current estimate is higher than the original estimate (in thousands).

 

    As of December 31,
    1997
(2)
    1998
(2)
    1999
(2)
    2000
(2)
    2001 (2)     2002 (2)     2003
(2)
    2004 (2)     2005 (2)     2006 (1)

Reserve for unpaid losses and LAE, net of reinsurance

  $ 31,034     $ 31,883     $ 34,279     $ 38,156     $ 43,363     $ 49,871     $ 58,500     $ 74,430     $ 83,389     $ 94,361

Cumulative amount of liability paid through:

                   

One year later

    14,359       13,913       18,460       21,248       23,111       23,399       23,449       24,178       27,598       31,968

Two years later

    15,357       15,745       20,344       25,890       30,462       34,122       34,882       37,688       43,235       —  

Three years later

    15,997       16,555       21,799       29,330       35,030       39,742       41,609       47,480       —         —  

Four years later

    16,460       17,201       23,050       31,022       37,812       43,186       46,805       —         —         —  

Five years later

    16,906       17,860       23,904       32,834       39,806       46,026       —         —         —         —  

Six years later

    17,445       18,443       24,833       34,194       40,842       —         —         —         —         —  

Seven years later

    17,952       19,028       25,580       34,615       —         —         —         —         —         —  

Eight years later

    18,456       19,578       26,127       —         —         —         —         —         —         —  

Nine years later

    18,946       20,037       —         —         —         —         —         —         —         —  

Ten years later

    19,250       —         —         —         —         —         —         —         —         —  

Liability estimated as of:

                   

One year later

    20,819       20,676       27,881       34,382       39,782       49,166       57,373       66,374       77,420       87,983

Two years later

    20,576       21,725       29,004       36,372       43,030       50,596       57,462       66,237       75,531       —  

Three years later

    20,646       22,050       28,406       37,044       44,741       51,934       57,854       67,652       —         —  

Four years later

    20,970       22,261       28,604       38,018       45,931       53,131       59,845       —         —         —  

Five years later

    21,270       22,346       29,133       39,441       46,466       54,885       —         —         —         —  

Six years later

    21,348       22,710       29,827       38,918       46,363       —         —         —         —         —  

Seven years later

    21,697       23,325       29,894       38,987       —         —         —         —         —         —  

Eight years later

    22,195       23,121       29,221       —         —         —         —         —         —         —  

Nine years later

    21,977       22,337       —         —         —         —         —         —         —         —  

Ten years later

    21,121       —         —         —         —         —         —         —         —         —  
Cumulative total redundancy (deficiency)   $ 9,913     $ 9,546     $ 5,058     $ (831 )   $ (3,000 )   $ (5,014 )   $ (1,345 )   $ 6,778     $ 7,858     $ 6,378
                                                                             

Gross liability—end of year

    33,789       35,593       39,041       44,141       49,327       57,955       67,549       84,555       97,755       107,048

Reinsurance recoverables

    2,755       3,710       4,762       5,985       5,964       8,084       9,049       10,125       14,366       12,687
                                                                             

Net liability—end of year

  $ 31,034     $ 31,883     $ 34,279     $ 38,156     $ 43,363     $ 49,871     $ 58,500     $ 74,430     $ 83,389     $ 94,361
                                                                             

Gross re-estimated liability— latest

    23,530       24,665       33,328       46,944       55,347       66,500       71,668       80,286       89,318       102,169

Re-estimated reinsurance recoverables—latest

    2,409       2,328       4,107       7,957       8,984       11,615       11,823       12,634       13,787       14,186
                                                                             

Net reestimated liability—latest

  $ 21,121     $ 22,337     $ 29,221     $ 38,987     $ 46,363     $ 54,885     $ 59,845     $ 67,652     $ 75,531     $ 87,983
                                                                             

Gross cumulative redundancy (deficiency), including run-off group medical business

  $ 10,259     $ 10,928     $ 5,713     $ (2,803 )   $ (6,020 )   $ (8,545 )   $ (4,119 )   $ 4,269     $ 8,437     $ 4,879

Less: Gross cumulative redundancy related to run-off group medical business

    (7,885 )     (8,010 )     (5,201 )     (4,311 )     (6,314 )     (5,508 )     (1,937 )     (87 )     (45 )     —  
                                                                             

Gross cumulative redundancy (deficiency), excluding run-off group medical business

  $ 2,374     $ 2,918     $ 512     $ (7,114 )   $ (12,334 )   $ (14,053 )   $ (6,056 )   $ 4,182     $ 8,392     $ 4,879
                                                                             

Gross liability, end of year

  $ 33,789     $ 35,593     $ 39,041     $ 44,141     $ 49,327     $ 57,955     $ 67,549     $ 84,555     $ 97,755     $ 107,048

Professional group long-term disability reserves

    30,611       29,884       27,443       24,285       21,843       19,082       18,921       17,152       16,330       12,453

Term life premium waiver reserves

    2,953       3,257       3,868       4,474       4,458       4,305       4,661       4,783       5,333       4,815

Other

    299       125       109       74       73       52       39       41       74       256
                                                                             

Total reserves for unpaid losses and LAE

  $ 67,652     $ 68,859     $ 70,461     $ 72,974     $ 75,701     $ 81,394     $ 91,170     $ 106,531     $ 119,492     $ 124,572
                                                                             

 

(1) The reserves for unpaid losses and LAE as of December 31, 2006 are reflected before the impact of purchase accounting adjustments of $1,895.
(2) The reserves for unpaid losses and LAE for December 31, 1997 through December 31, 2005 have been restated to reflect the workers’ compensation insurance, segregated portfolio cell reinsurance, and specialty reinsurance segments.
(3) For purposes of understanding the Company’s reserve estimation results for its current lines of business, the gross cumulative redundancy related to the Company’s discontinued group medical business has been deducted from the total gross cumulative redundancy (deficiency) for all years presented.

 

13


Table of Contents

A.M. Best Rating

A.M. Best rates insurance companies based on factors of concern to policyholders. In evaluating a company’s financial and operating performance, A.M. Best reviews the company’s profitability, leverage and liquidity, its book of business, the adequacy and soundness of its reinsurance programs, the quality and estimated fair value of its investments, the adequacy of its reserves and surplus, its capital structure, the experience and competence of its management, and its marketing presence. A.M. Best ratings are intended to provide an independent opinion of an insurer’s ability to meet its obligations to its policyholders. Their evaluation is not directed at investors. In June 2007, A.M. Best reaffirmed the “A-” financial strength rating of Eastern Alliance, Allied Eastern, and Eastern Re, and indicated a stable rating outlook. In June 2007, A.M. Best upgraded ELH’s financial strength rating from “B++” (Very Good) to “A-”(Excellent). As a condition of receiving the upgraded rating, EIHI entered into a guaranty of ELH’s reserves for unpaid losses and LAE and certain other liabilities. An “A-” (Excellent) financial strength rating is the fourth highest out of 16 rating classifications.

The financial strength ratings assigned by A.M. Best to the Company’s insurance subsidiaries are subject to periodic review and may be upgraded or downgraded by A.M. Best as a result of changes in the views of the rating agency or positive or adverse developments in the insurance subsidiaries’ financial conditions or results of operations.

Competition

The Company’s ability to compete successfully in its principal markets is dependent upon a number of factors, many of which are outside its control. Many of the Company’s business segments are subject to significant price competition. In addition to price, competition in the Company’s lines of insurance is based on quality of the products, quality and delivery of service, financial strength, ratings, distribution systems and technical expertise.

The property and casualty insurance market is highly competitive. The Company competes with stock insurance companies, mutual companies, local cooperatives and other underwriting organizations. In its workers’ compensation insurance segment, the Company considers its principal competitors to be PMA Capital Insurance Group, Erie Insurance Group, Guard Insurance Group, Penn National Insurance Company, Selective Insurance Group, Cincinnati Insurance Company, Lackawanna Insurance Group, and the Pennsylvania State Workers’ Insurance Fund.

Group benefits insurance products are relatively inexpensive to develop and market, and as such are offered by hundreds of insurance carriers, including a number of financial services companies which are not considered members of the insurance industry. In its group benefits insurance segment, the Company’s principal competitors include Aetna, Inc., Assurant, Inc., Guardian Life Insurance Company and Metropolitan Life Insurance Company.

Certain of the Company’s competitors have higher A.M. Best financial strength ratings and substantially greater financial, technical and operating resources than the Company.

Investments

The Company’s investment portfolio consists of fixed income securities, equity securities, convertible bonds, and other long-term investments in various limited partnerships. The management and accounting for the Company’s investment function is outsourced to third parties. The Company has established an investment policy, approved by the Finance/Investment Committee of the Board of Directors, which has been communicated to the Company’s external investment managers. In addition, the Company has hired an independent investment consultant to oversee the Company’s investment managers and to assist the Company in setting and monitoring its investment policy.

The Company’s investment objectives are:

 

   

to meet insurance regulatory requirements;

 

   

to maintain adequate liquidity in its insurance subsidiaries;

 

   

to preserve capital through a well diversified, high quality investment portfolio; and

 

   

to maximize after tax income while generating competitive after tax total rates of return.

The Company’s investments in fixed income and equity securities are classified as “available for sale” and are reported at estimated fair value, with changes in fair value reported as a component of accumulated other comprehensive income (loss), net of applicable taxes. The Company’s convertible bonds are considered hybrid financial instruments and are reported at estimated fair value, with changes in fair value reported as a realized gain or loss in the consolidated statements of operations and comprehensive income (loss). The Company periodically evaluates its investments for other-than-temporary

 

14


Table of Contents

impairment. At the time an investment is determined to be other-than-temporarily impaired, the Company records a realized loss in the consolidated statements of operations and comprehensive income (loss). Any subsequent increase in the investment’s market value would be reported as an unrealized gain.

The Company’s other long-term investments include interests in various limited partnerships. These limited partnerships are viewed as a means to enhance the diversification of the Company’s portfolio. The limited partnerships include a low volatility multi-strategy fund of funds and investments in two natural resource limited partnerships. We expect that these investments will provide long-term diversification benefits to the portfolio as they tend to have very little correlation to the fixed income markets. The Company also has made a small investment in a municipal bond based limited partnership which complements its fixed income exposure. The Company accounts for its limited partnership investments under the equity method, with changes in the Company’s interest in the limited partnerships recorded in net investment income.

The Company evaluates the performance of its investments through the use of various industry benchmarks. Benchmarks have been selected for each investment manager and/or portfolio and are reviewed on a quarterly basis by management and the Company’s Finance/Investment Committee of the Board of Directors. For the year ended December 31, 2007, the Company’s taxable equivalent total return, net of management fees, was 6.42%, compared to the composite benchmark return of 6.53%.

The following table sets forth consolidated information concerning the Company’s investments as of December 31, 2007 and 2006 (in thousands).

 

     At December 31,
     2007    2006
     Amortized
Cost
   Estimated
Fair Market
Value
   Amortized
Cost
   Estimated
Fair Market
Value

U.S. Treasuries and government agencies

   $ 20,658    $ 21,561    $ 18,434    $ 18,913

State, municipalities and political subdivisions

     51,884      53,012      33,751      34,446

Foreign governments

     —        —        500      496

Corporate securities

     59,478      60,388      79,644      80,851

Mortgage-backed securities

     22,134      22,880      24,921      25,470

Other structured securities

     47,885      47,944      43,976      44,268
                           

Total fixed income securities

     202,039      205,785      201,226      204,444
                           

Equity securities

     19,578      20,541      17,027      18,219

Convertible bonds

     14,232      15,478      —        —  

Other long-term investments

     10,574      11,317      10,266      11,604

Equity call options

     —        —        2,230      3,318
                           

Total investments

   $ 246,423    $ 253,121    $ 230,749    $ 237,585
                           

As of December 31, 2007, the Company’s mortgage-backed securities included subprime and Alt-A exposures with estimated fair values of $1.1 million and $3.7 million, respectively. The subprime exposures include three AAA-rated securities and two AA-rated securities. The AA-rated securities are 2002 and 2003 vintage issues with subordination levels in excess of 28%, which management believes exceeds conservative loss assumptions for the securities. The Alt-A exposures include six securities that are AAA-rated through a combination of subordination or insurance wraps.

As of December 31, 2007, the Company’s municipal bond portfolio included prerefunded and non-prerefunded issues of 31.7% and 68.3%, respectively. The overall credit quality of the non-prerefunded portfolio was AA+ and the credit quality of the insurer was AA-.

 

15


Table of Contents

The following table shows the ratings distribution of the Company’s fixed income securities and convertible bonds, excluding fixed income securities of the segregated portfolio cell reinsurance segment, as a percentage of the total market value of the fixed income portfolio as of December 31, 2007 (dollars in thousands).

 

     Total    Percentage of
Total Market
Value
 

“AAA”

   $ 128,576    67.0 %

“AA”

     22,052    11.5 %

“A”

     18,013    9.4 %

“BBB”

     6,232    3.2 %

Below Investment Grade

     1,914    1.0 %

Not Rated

     15,257    7.9 %
             

Total

   $ 192,044    100.0 %
             

The amortized cost and estimated fair value of fixed income securities and convertible bonds as of December 31, 2007, by contractual maturity, are shown below. Expected maturities could differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties (in thousands).

 

     Amortized
Cost
   Estimated
Fair Value

Less than one year

   $ 17,649    $ 17,684

One through five years

     60,394      61,581

Five through ten years

     28,082      29,276

Greater than ten years

     35,496      37,212

Mortgage-backed securities

     74,650      75,510
             

Total

   $ 216,271    $ 221,263
             

The gross unrealized losses and estimated fair value of fixed income and equity securities, excluding those securities in the segregated portfolio cell reinsurance segment, classified as available-for-sale by category and length of time an individual security is in a continuous unrealized loss position as of December 31, 2007 were as follows (in thousands):

 

    Less Than 12 Months     12 Months or More     Total  

2007

  Estimated
Fair
Value
  Gross
Unrealized
Losses
    Estimated
Fair
Value
  Gross
Unrealized
Losses
    Estimated
Fair
Value
  Gross
Unrealized
Losses
 

U.S. Treasuries and government agencies

  $ —     $ —       $ 1,045   $ (7 )   $ 1,045   $ (7 )

Corporate securities

    4,658     (85 )     2,958     (31 )     7,616     (116 )

Mortgage-backed securities

    437     (2 )     —       —         437     (2 )

Other structured securities

    14,409     (354 )     1,758     (20 )     16,167     (374 )
                                         

Total fixed income securities

    19,504     (441 )     5,761     (58 )     25,265     (499 )

Equity securities

    5,972     (132 )     —       —         5,972     (132 )
                                         

Total fixed income and equity securities

  $ 25,476   $ (573 )   $ 5,761   $ (58 )   $ 31,237   $ (631 )
                                         

Company Web Sites

The Company operates three Web sites. The Company’s Corporate Web site (www.easterninsuranceholdings.com) provides investor relations information and news. EAIG’s Web site (www.eains.com) provides information and news regarding workers’ compensation products and services, in addition to secured content accessible to producers and insureds. The secured sections include a risk management library that allows EAIG’s risk management personnel to disseminate safety information quickly and effectively to producers and insureds. ELH’s Web site (www.elhins.com) provides information and news regarding group benefits products as well as access to an online group administration system.

Employees

As of December 31, 2007, the Company had 163 full time employees. None of the Company’s employees is represented by a union. The Company considers its relationship with its employees to be excellent.

 

16


Table of Contents

Regulation

General

Insurance companies are subject to supervision and regulation in the jurisdictions in which they do business. Insurance authorities in each jurisdiction have broad administrative powers to administer statutes and regulations with respect to all aspects of the insurance business, including:

 

   

licensing of insurers and their producers;

 

   

approval of policy forms and premium rates;

 

   

mandating certain insurance benefits;

 

   

standards of solvency, including establishing statutory and risk-based capital requirements for statutory surplus;

 

   

classifying assets as admissible for purposes of determining statutory surplus;

 

   

regulating unfair trade and claim practices, including through the imposition of restrictions on marketing and sales practices, distribution arrangements and payment of inducements;

 

   

restrictions on the nature, quality and concentration of investments;

 

   

assessments by guaranty and other associations;

 

   

restrictions on the ability of insurance companies to pay dividends;

 

   

restrictions on transactions between insurance companies and their affiliates;

 

   

restrictions on acquisitions and dispositions of insurance companies;

 

   

restrictions on the size of risks insurable under a single policy;

 

   

requiring deposits for the benefit of policyholders;

 

   

requiring certain methods of accounting;

 

   

periodic examinations of insurance company operations and finances;

 

   

reviewing claims administration practices;

 

   

prescribing the form and content of records of financial condition required to be filed; and

 

   

requiring reserves for unearned premiums, losses and other purposes.

State insurance laws and regulations require insurance companies to file financial statements with insurance departments everywhere they do business, and the operations of insurance companies are subject to examination by those departments at any time. Eastern Alliance, Allied Eastern, Eastern Advantage, and ELH prepare statutory financial statements in accordance with accounting practices and procedures prescribed or permitted by these departments.

Examinations

Examinations are conducted by the Pennsylvania Insurance Department (the “Insurance Department”) every three to five years. The Insurance Department’s most recent examinations of Eastern Alliance and ELH for which a report was issued were as of December 31, 2001. These examinations did not result in any adjustments to the financial position of Eastern Alliance or ELH. In addition, there were no substantive qualitative matters indicated in the examination reports that had a material adverse impact on the Company’s operations. The Insurance Department conducted an organizational examination of Allied Eastern and Eastern Advantage as of April 22, 2002 and October 24, 2007, respectively. As of December 31, 2007, an examination of Eastern Alliance, Allied Eastern, and ELH as of and for the five years ending December 31, 2006 by the Insurance Department was in process.

Risk-Based Capital Requirements

Pennsylvania imposes the NAIC risk-based capital requirements that require insurance companies to calculate and report information under a risk-based formula. These risk-based capital requirements attempt to measure statutory capital and surplus needs based on the risks in an insurance company’s mix of products and investment portfolio. Under the formula, a company first determines its “authorized control level” risk-based capital. This authorized control level takes into account (i) the risk with respect to the insurer’s assets; (ii) the risk of adverse insurance experience with respect to the insurer’s liabilities and obligations; (iii) the interest rate risk with respect to the insurer’s business; and (iv) all other business and other relevant risks as are set forth in the risk-based capital instructions. As of December 31, 2007, the capital levels of EIHI’s insurance subsidiaries exceeded risk-based capital requirements.

 

17


Table of Contents

Market Conduct Regulation

State insurance laws and regulations include numerous provisions governing trade practices and the marketplace activities of insurers, including provisions governing the form and content of disclosure to consumers, illustrations, advertising, sales practices and complaint handling. State regulatory authorities generally enforce these provisions through periodic market conduct examinations. To our knowledge, the Company is currently in compliance with these provisions.

Sarbanes-Oxley Act of 2002

The Company is subject to the Sarbanes-Oxley Act of 2002, which implemented legislative reforms intended to address corporate and accounting fraud. Among other reforms, the Sarbanes-Oxley Act requires chief executive officers and chief financial officers, or their equivalent, to certify to the accuracy of periodic reports filed with the SEC, subject to civil and criminal penalties if they knowingly or willfully violate this certification requirement. The Sarbanes-Oxley Act also increases the oversight of, and codifies, certain requirements relating to audit committees of public companies and how they interact with the company’s auditors. Audit committee members must be independent and are barred from accepting consulting, advisory or other compensatory fees from the company. In addition, companies must disclose whether at least one member of the committee is a “financial expert,” as such term is defined by the SEC, and if not, why not. Pursuant to the Sarbanes-Oxley Act, the SEC has adopted rules requiring inclusion of an internal control report and assessment by management in the annual report to shareholders. The Sarbanes-Oxley Act requires the auditor that issues the audit report to attest to and report on management’s assessment of the company’s internal controls.

Insurance Guaranty Funds

Almost all states have guaranty fund laws under which insurers doing business in the state can be assessed to fund policyholder liabilities of insolvent insurance companies. Pennsylvania and the other states in which our insurance companies do business have such laws. Under these laws, an insurer is subject to assessment depending upon its market share in the state of a given line of business. The Company is subject to the Pennsylvania Workers’ Compensation Security Fund (the “Security Fund”), which assesses workers’ compensation insurers doing business in Pennsylvania for the purpose of providing funds to cover obligations to policyholders of insolvent insurance companies. The Company establishes reserves relating to insurance companies that are subject to insolvency proceedings when they are notified of assessments by the guaranty associations. We cannot predict the amount and timing of any future assessments under these laws.

Cayman Islands Regulation

Eastern Re is organized and licensed as a Cayman Islands unrestricted Class B insurance company and is subject to regulation by the Cayman Islands Monetary Authority. Applicable laws and regulations govern the types of policies that the Company can insure or reinsure, the amount of capital that it must maintain and the way it can be invested, and the payment of dividends without approval by the Cayman Islands Monetary Authority.

Holding Company Regulation

EIHI is registered as an insurance holding company under the Insurance Holding Company Act amendments to the Pennsylvania Insurance Code of 1921, as amended, and is subject to regulation and supervision by the Insurance Department. EIHI is required to annually file a report of its operations with, and is subject to examination by, the Insurance Department.

Each insurance company in a holding company system is required to register with the insurance supervisory agency of its state of domicile and furnish certain information. This includes information concerning the operations of companies within the holding company system that may materially affect the operations, management or financial condition of the insurers within the system. Pursuant to these laws, the respective insurance departments may examine insurance companies and their holding companies at any time, require disclosure of material transactions by insurance companies and their holding companies and require prior notice or approval of certain transactions, such as “extraordinary dividends” distributed by insurance companies.

All transactions within the holding company system affecting insurance companies and their holding companies must be fair and equitable. Notice of certain material transactions between insurance companies and any person or entity in their holding company system will be required to be given to the applicable insurance commissioner. In some states, certain transactions cannot be completed without the prior approval of the insurance commissioner.

 

18


Table of Contents

Approval of the state insurance commissioner is required prior to any transaction affecting the control of an insurer domiciled in that state. In Pennsylvania, the acquisition of 10% or more of the outstanding capital stock of an insurer or its holding company is presumed to be a change in control. Pennsylvania law also prohibits any person from (i) making a tender offer for, or a request or invitation for tenders of, or seeking to acquire or acquiring any voting security of a Pennsylvania insurer if, after the acquisition, the person would be in control of the insurer, or (ii) effecting or attempting to effect an acquisition of control of or merger with a Pennsylvania insurer, unless the offer, request, invitation, acquisition, effectuation or attempt has received the prior approval of the Insurance Department.

Dividend Restrictions

EIHI’s ability to declare and pay dividends will depend in part on dividends received from its insurance subsidiaries. The Pennsylvania Insurance Code regulates the distribution of dividends by insurance companies and states, in part, that dividends cannot exceed the greater of 10% of an insurance company’s statutory surplus as reported on the most recent annual statement filed with the Insurance Department or an insurance company’s net income for the period covered by such annual statement.

EIHI’s insurance subsidiaries are prohibited from declaring or paying any dividends or other forms of distribution to EIHI for the three years after June 16, 2006, the effective date of the conversion/merger transaction, without the prior approval of the Pennsylvania Insurance Commissioner.

During 2007, the Pennsylvania Insurance Commissioner approved a dividend of $5.0 million each from Eastern Alliance and ELH to EIHI. The proceeds from the dividend were used primarily to fund EIHI’s stock repurchase program. In addition, the Pennsylvania Insurance Commissioner approved the four quarterly dividends of $0.05/share by EIHI to its shareholders.

Note on Forward-Looking Statements

This document contains forward-looking statements, which can be identified by the use of such words as “estimate,” “project,” “believe,” “intend,” “anticipate,” “plan,” “seek,” “expect” and similar expressions. These forward-looking statements include:

 

   

statements of goals, intentions and expectations;

 

   

statements regarding prospects and business strategy; and

 

   

estimates of future costs, benefits and results.

These forward-looking statements are subject to significant risks, assumptions and uncertainties, including, among other things, the factors discussed under the heading “Risk Factors” that could affect the actual outcome of future events.

All of these factors are difficult to predict and many are beyond our control. These important factors include those discussed under “Risk Factors” and those listed below:

 

   

the ability to carry out our business plans;

 

   

future economic conditions in the regional and national markets in which we compete that are less favorable than expected;

 

   

the effect of legislative, judicial, economic, demographic and regulatory events in the states in which we do business;

 

   

the ability to obtain licenses and enter new markets successfully and capitalize on growth opportunities either through mergers or the expansion of our producer network;

 

   

financial market conditions, including, but not limited to, changes in interest rates and the credit and equity markets causing a reduction of investment income or investment gains, an acceleration of the amortization of deferred policy acquisition costs, reduction in the value of our investment portfolio or a reduction in the demand for our products;

 

   

the impact of acts of terrorism and acts of war;

 

19


Table of Contents
   

the effects of terrorist related insurance legislation and laws;

 

   

changes in general economic conditions, including inflation, unemployment, interest rates and other factors;

 

   

the cost, availability and collectibility of reinsurance;

 

   

estimates and adequacy of loss reserves and trends in losses and LAE;

 

   

heightened competition, including specifically the intensification of price competition, increased underwriting capacity and the entry of new competitors and the development of new products by new and existing competitors;

 

   

the effects of mergers, acquisitions and dispositions;

 

   

changes in the coverage terms selected by insurance customers, including higher deductibles and lower limits;

 

   

changes in the underwriting criteria that we use resulting from competitive pressures;

 

   

our inability to obtain regulatory approval of, or to implement, premium rate increases;

 

   

the potential impact on our reported earnings that could result from the adoption of future accounting standards issued by the Financial Accounting Standards Board or other standard-setting bodies;

 

   

our inability to carry out marketing and sales plans, including, among others, development of new products or changes to existing products and acceptance of the new or revised products in the market;

 

   

unanticipated changes in industry trends and ratings assigned by nationally recognized rating organizations;

 

   

adverse litigation or arbitration results; and

 

   

adverse changes in applicable laws, regulations or rules governing insurance holding companies and insurance companies, and tax or accounting matters including limitations on premium levels, increases in minimum capital and reserves, and other financial viability requirements, and changes that affect the cost of, or demand for our products.

Because forward-looking information is subject to various risks and uncertainties, actual results may differ materially from that expressed or implied by the forward-looking information. Therefore, we caution you not to place undue reliance on this forward-looking information.

All subsequent written and oral forward-looking information attributable to the Company or any person acting on our behalf is expressly qualified in its entirety by the cautionary statements contained or referred to in this section. We do not undertake any obligation to publicly release any revisions that may be made to any forward-looking statements.

Because of these and other uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements. The Company has no obligation to update or revise any forward-looking statements to reflect any changed assumptions, any unanticipated events or any changes in the future.

Item 1A—Risk Factors

Our business is subject to numerous risks and uncertainties, the outcome of which may impact future results of operations and financial condition. These risks are as follows:

Risk Factors Relating to Our Business

Our results may be adversely affected if our actual losses exceed our loss reserves.

The Company maintains loss reserves to cover estimated amounts needed to pay for insured losses and for the LAE necessary to settle claims with respect to insured events that have occurred, including events that have not yet been reported to us. Estimating the reserves for unpaid losses and LAE is a difficult and complex process involving many variables and subjective judgments; reserves do not represent an exact measure of liability. Accordingly, our loss reserves may prove to be inadequate to cover our actual losses. We regularly review our reserving techniques and our overall amount of reserves. We review historical data and consider the impact of various factors such as:

 

   

trends in claim frequency and severity;

 

20


Table of Contents
   

information regarding each claim for losses;

 

   

legislative enactments, judicial decisions and legal developments regarding damages; and

 

   

trends in general economic conditions, including inflation and levels of employment.

If we determine that our reserves for unpaid losses and LAE are inadequate, we will have to increase them. This adjustment would reduce income during the period in which the adjustment is made, which could have a material adverse impact on our financial condition and results of operations. For additional information, see “Item 1—Business, Loss and Loss Adjustment Expense Reserves.”

If we do not accurately establish our premium rates, our results of operations may be adversely affected.

In general, the premium rates for our insurance policies are established when coverage is initiated and therefore, before all of the underlying costs are known. Like other insurance companies, we rely on estimates and assumptions in setting our premium rates. Establishing adequate rates is necessary, together with investment income, to generate sufficient revenue to offset losses, LAE and other underwriting expenses and to earn a profit. If we fail to accurately assess the risks that we assume, we may fail to charge adequate premium rates to cover our losses and expenses, which could reduce our net income and cause us to become unprofitable. As a result, our actual costs for providing insurance coverage to our policyholders may be significantly higher than our premiums.

In order to set premium rates accurately, we must collect and properly analyze a substantial volume of data; develop, test, and apply appropriate rating formulae; closely monitor and recognize changes in trends; project both severity and frequency of losses with reasonable accuracy; and estimate customer retention. Customer retention means the amount of exposure a policyholder retains on any one risk or group of risks. The term may apply to an insurance policy, where the policyholder is an individual, family or business, or a reinsurance policy, where the policyholder is an insurance company. We must also implement our pricing accurately in accordance with our assumptions. For example, as we expand the geographic market in which we offer our workers’ compensation insurance products we may not price these products accurately or adequately. Our ability to undertake these efforts successfully, and as a result set premium rates accurately, is subject to a number of risks and uncertainties, including:

 

   

inaccurate assessment of new markets in which we have little or no prior experience;

 

   

insufficient or unreliable data;

 

   

incorrect or incomplete analysis of available data;

 

   

uncertainties generally inherent in estimates and assumptions;

 

   

our inability to implement appropriate rating formulae or other pricing methodologies;

 

   

costs of ongoing medical treatment;

 

   

our inability to accurately estimate customer retention, investment yields and the duration of our liability for losses and LAE; and

 

   

unanticipated court decisions, legislation or regulatory action.

Consequently, we could set our premium rates too low, which could negatively affect our results of operations and our profitability, or we could set our premium rates too high, which could reduce our ability to obtain new or retain existing business and lead to lower net premiums earned.

If we do not effectively manage the growth of our operations we may not be able to compete or operate profitably.

Our growth strategy includes enhancing our market share in our existing markets, entering new geographic markets, introducing new insurance products and programs, further developing our agency relationships, and pursuing merger and acquisition opportunities. Our strategy is subject to various risks, including risks associated with our ability to:

 

   

identify profitable new geographic markets to enter;

 

   

obtain licenses in new states in which we wish to market and sell our products;

 

   

successfully implement our underwriting, pricing, claims management, and product strategies over a larger operating region;

 

21


Table of Contents
   

properly design and price new and existing products and programs and reinsurance facilities;

 

   

identify, train and retain qualified employees;

 

   

identify, recruit and integrate new independent producers;

 

   

formulate and execute a merger and acquisition strategy; and

 

   

augment our internal monitoring and control systems as we expand our business.

We also may encounter difficulties in the implementation of our growth strategies, including unanticipated expenditures. In addition, our growth strategies may result in us entering into markets or product lines in which we have little or no prior experience. Any such difficulties could result in diversion of senior management time and adversely affect our financial results.

All of the specialty reinsurance business of Eastern Re is controlled by one of our directors and is placed with one primary insurer.

The Company’s specialty reinsurance segment generates 100% of its premium revenue through a reinsurance contract with a large, primary insurer. This business is directly or indirectly managed by one producer, AmPro. Lawrence Bitner is a Director of the Company and the AmPro employee who produces the program business for the primary insurer and controls the placement of reinsurance contracts with the Company. If the Company lost the goodwill of Mr. Bitner, Mr. Bitner could cause this business to be placed with another reinsurer and/or could cause the insurance policies to be written by a primary insurance carrier that would not purchase reinsurance coverage in respect of the business or would not place reinsurance with the Company.

Our ability to manage our exposure to underwriting risks depends on the availability and cost of reinsurance coverage.

We use reinsurance arrangements to limit and manage the amount of risk we retain, to stabilize our underwriting results and to increase our underwriting capacity. Although we have not recently experienced difficulty in obtaining reinsurance at reasonable prices, the availability and cost of reinsurance is subject to current market conditions and may vary significantly over time. Any decrease in the amount of our reinsurance will increase our risk of loss. We may be unable to maintain our desired reinsurance coverage or to obtain other reinsurance coverage in adequate amounts and at favorable rates. If we are unable to renew our expiring coverage or obtain new coverage, it will be difficult for us to manage our underwriting risks and operate our business profitably.

It is also possible that the losses we experience on insured risks for which we have obtained reinsurance will exceed the coverage limits of the reinsurance. If the amount of our reinsurance coverage is insufficient, our insurance losses could increase substantially.

If our reinsurers do not pay our claims in a timely manner, we may incur losses.

We are subject to credit risk with respect to the reinsurers with whom we deal because buying reinsurance does not relieve us of our liability to policyholders. The Company had net reinsurance recoverables of $26.3 million as of December 31, 2007. If our reinsurers are not capable of fulfilling their financial obligations to us, our insurance losses would increase, which would negatively affect our financial condition and results of operations.

Our investment performance may suffer as a result of adverse capital market developments, which may affect our financial results and ability to conduct business.

We invest the premiums we receive from policyholders until cash is needed to pay insured claims or other expenses. As of December 31, 2007, the Company had investments of $253.1 million. For the year ended December 31, 2007, the Company had $12.4 million of net investment income, representing 8.5% of its total revenues. Our investments are subject to a variety of investment risks, including risks relating to general economic conditions, market volatility, interest rate fluctuations, liquidity risk and credit risk. In particular, an unexpected increase in the volume or severity of claims may force us to liquidate securities, which may cause us to incur capital losses. If we do not structure the duration of our investments to match our insurance and reinsurance liabilities, we may be forced to liquidate investments prior to maturity at a significant loss to cover such payments. Investment losses could significantly decrease our asset base and statutory surplus, thereby affecting our ability to conduct business.

 

22


Table of Contents

Our revenues may fluctuate with changes in interest rates.

Our investment portfolio contains a significant amount of fixed income securities, including bonds, mortgage-backed securities (“MBSs”), collateralized mortgage obligations (“CMOs”), and other asset-backed securities. The market values of all of our investments fluctuate depending on economic and political conditions and other factors beyond our control. The market values of our fixed income securities are particularly sensitive to changes in interest rates.

For example, if interest rates rise, fixed income securities generally will decrease in value. If interest rates decline, these securities generally will increase in value, except for MBSs, which may decline due to higher prepayments on the mortgages underlying the securities.

As of December 31, 2007, MBSs, including CMOs, constituted 28.0% of the market value of the Company’s investment portfolio. MBSs and CMOs are subject to prepayment risks that vary with, among other things, interest rates. During periods of declining interest rates, MBSs generally prepay faster as the underlying mortgages are prepaid and/or refinanced by the borrowers in order to take advantage of lower interest rates. MBSs that have an amortized cost that is greater than par (i.e., purchased at a premium) may incur a reduction in yield or a loss as a result of prepayments. In addition, during such periods, we generally will be unable to reinvest the proceeds of any prepayment at comparable yields. Conversely, during periods of rising interest rates, the frequency of prepayments generally decreases, and we may receive interest payments that are below the then prevailing interest rate for longer than expected. MBSs that have an amortized cost that is less than par (i.e., purchased at a discount) may incur a decrease in yield or a loss as a result of slower prepayments.

If we fail to comply with insurance industry regulations, or if those regulations become more burdensome, we may not be able to operate profitably.

Our insurance subsidiaries are regulated by government agencies in the states in which we do business, and we must comply with a number of state and federal laws and regulations. Most insurance regulations are intended to protect the interests of insureds rather than those of shareholders and other investors.

If we fail to comply with these laws and regulations, state insurance departments can exercise a range of remedies from the imposition of fines to being placed in rehabilitation or liquidation. State insurance departments also conduct periodic examinations of the affairs of insurance companies and require the filing of annual and other reports relating to financial condition, holding company issues and other matters. These regulatory requirements may adversely affect or inhibit our ability to achieve some or all of our business objectives.

Part of our strategy includes expanded licensing and product filings for the Company. Regulatory authorities, however, have broad discretion to deny or revoke licenses for various reasons, including the violation of regulations. If we do not have or obtain the requisite licenses and approvals or do not comply with applicable regulatory requirements, insurance regulatory authorities could preclude or temporarily suspend us from carrying on some or all of our activities, including our expansion objectives, or otherwise penalize us. Furthermore, changes in the level of regulation of the insurance industry or changes in laws or regulations or interpretations of such laws and regulations by regulatory authorities could adversely affect our ability to operate our business.

We are subject to various accounting and financial requirements established by the NAIC. Eastern Re is subject to the laws of the Cayman Islands and regulations promulgated by the Cayman Islands Monetary Authority. Failure to comply with these laws, regulations and requirements could result in consequences ranging from a regulatory examination to a regulatory takeover of one or more of our insurance subsidiaries. This would make our business less profitable. In addition, state regulators and the NAIC continually re-examine existing laws and regulations, with an emphasis on insurance company solvency issues and fair treatment of policyholders. Insurance laws and regulations could change or additional restrictions could be imposed that are more burdensome and make our business less profitable. Because these laws and regulations are for the protection of policyholders, any changes may not be in your best interest as a shareholder.

Compliance with applicable laws and regulations is time consuming and personnel-intensive, and changes in these laws and regulations may materially increase our direct and indirect compliance and other expenses of doing business, thus adversely affecting our financial condition and results of operations.

The group benefits insurance and workers’ compensation insurance markets in which we operate are highly competitive.

Competition in these markets is based on many factors. These factors include the perceived financial strength of the insurer, premiums charged, policy terms and conditions, services provided, reputation, financial ratings assigned by

 

23


Table of Contents

independent rating agencies and the experience of the insurer in the line of insurance to be written. The Company’s insurance subsidiaries compete with stock insurance companies, mutual companies, local cooperatives and other underwriting organizations. Our principal competitors in the group benefits market include Aetna, Inc., Assurant, Inc., Guardian Life Insurance Company, and Metropolitan Life Insurance Company. Our principal competitors in the workers’ compensation insurance market include PMA Capital Insurance Group, Erie Insurance Group, Guard Insurance Group, Penn National Insurance Company, Selective Insurance Group, Cincinnati Insurance Company, Lackawanna Insurance Group, and the Pennsylvania State Workers’ Insurance Fund. Many of these competitors have higher ratings and substantially greater financial, technical and operating resources than we have. The group benefits and workers’ compensation lines of insurance are subject to significant price competition. If competitors price their products aggressively, our ability to grow or renew our business may be adversely affected. We pay producers on a commission basis to produce business. Some competitors may offer higher commissions to independent producers or offer insurance at lower premium rates through the use of salaried personnel or other distribution methods that do not rely on independent producers. Increased competition could adversely affect our ability to attract and retain business and thereby reduce our profits from operations.

We could be adversely affected by the loss of our key personnel.

The success of our business is dependent, to a large extent, on the efforts of certain key personnel, in particular, Bruce M. Eckert, our Chief Executive Officer, Michael L. Boguski, our President and Chief Operating Officer, Kevin M. Shook, our Treasurer and Chief Financial Officer, Robert A. Gilpin, our Senior Vice President of Marketing, and Suzanne M. Emmet, our Senior Vice President of Claims. We have employment agreements with each of Messrs. Eckert, Boguski, Shook, Gilpin, and Ms. Emmet, which contain covenants not to compete. We do not maintain key man life insurance on any of these executives. The loss of key personnel could prevent us from fully implementing our business strategy and could significantly and negatively affect our financial condition and results of operations. As we continue to grow, we will need to recruit and retain additional qualified management personnel, and our ability to do so will depend upon a number of factors, such as our results of operations and prospects and the level of competition then prevailing in the market for qualified personnel. The current market for qualified insurance personnel is highly competitive.

Our results of operations may be adversely affected by any loss of business from key producers and by the creditworthiness of our producers.

Our products are marketed by independent producers. Other insurance companies compete with the Company for the services and allegiance of these producers. Because they are independent, these producers are not obligated to direct business to the Company and may choose to direct business to our competitors, or may direct less desirable risks to us. The Company’s ten largest producers in its workers’ compensation insurance segment accounted for 55.9% of its direct premiums written for the year ended December 31, 2007. The Company’s largest producer in its workers’ compensation insurance segment accounted for 21.2% of direct premiums written for the year ended December 31, 2007. No other producer accounted for more than 10.0% of direct premiums written in the Company’s workers’ compensation insurance segment for the year ended December 31, 2007. No independent producer accounted for more than 10.0% of the Company’s group benefits insurance direct premiums written for the year ended December 31, 2007. If premium volume produced by any of the Company’s large producers were to decrease significantly, it would have a material adverse effect on us.

In addition, in accordance with industry practice, our customers sometimes pay the premiums for their policies to producers for payment to us. These premiums are considered paid when received by the producer and, thereafter, the customer is no longer liable to us for those amounts, whether or not we have actually received the premiums from the producer. Consequently, we assume a degree of credit risk associated with our reliance on producers in connection with the collection of insurance premiums.

Because the Company’s workers’ compensation insurance business is concentrated in Pennsylvania, the Company is subject to local economic risks as well as to changes in the regulatory and legal climate in Pennsylvania.

Almost all of the Company’s workers’ compensation premium volume is produced in Pennsylvania. The Company’s workers’ compensation insurance business is affected by the economic health of Pennsylvania for two principal reasons. First, premium growth is dependent upon payroll growth, which, in turn, is affected by economic conditions. Second, losses and LAE can increase in weak economic conditions because it is more difficult to return injured workers to the job when employers are otherwise reducing payrolls. Finally, as predominantly a single state insurer, the Company can be adversely affected by any material change in Pennsylvania law or regulation or any Pennsylvania court decision affecting workers’ compensation carriers generally.

 

24


Table of Contents

Future changes in financial accounting standards or practices or existing tax laws may adversely affect our reported results of operations.

Financial accounting standards in the United States are constantly under review and may be changed from time to time. We would be required to apply these changes when adopted. Once implemented, these changes could materially affect our results of operations and/or the way in which such results of operations are reported. Similarly, we are subject to taxation in the United States and a number of state jurisdictions. Rates of taxation, definitions of income, exclusions from income, and other tax policies are subject to change over time. Eastern Re is domiciled in the Cayman Islands. Changes in Cayman Islands tax laws could have a material impact on our consolidated results of operations.

Proposals to federally regulate the insurance business could affect our business.

Currently, the U.S. federal government does not directly regulate the insurance business. However, federal legislation and administrative policies in several areas can significantly and adversely affect insurance companies. These areas include financial services regulation, securities regulation, pension regulation, privacy, tort reform legislation and taxation. In addition, various forms of direct federal regulation of insurance have been proposed. These proposals include the State Modernization and Regulatory Transparency Act, which would maintain state-based regulation of insurance but would affect state regulation of certain aspects of the insurance business, including rates, producer and company licensing, and market conduct examinations. We cannot predict whether this or other proposals will be adopted, or what impact, if any, such proposals or, if enacted, such laws may have on our business, financial condition or results of operations.

Risk Factors Relating to Our Common Stock

Directors and management could effectively control certain situations that may be viewed as contrary to your interests.

The extent of management’s control over the Company is related to the following factors:

 

   

Directors and management owned approximately 28.1% of the Company’s outstanding stock as of December 31, 2007. As a result of stock transactions by certain directors subsequent to December 31, 2007, the ownership percentage of the Company’s outstanding common stock by directors and management decreased to approximately 14.7% as of March 12, 2008.

 

   

The employee stock ownership plan (“ESOP”) owns 7.1%, or 747,500 shares, of the Company’s outstanding stock as of December 31, 2007. The shares held by the ESOP will be voted in the manner directed by the ESOP participants.

 

   

We have implemented a stock compensation plan pursuant to which shares of restricted stock and stock options have been issued to certain of our directors, officers and employees.

As a result of these factors, the Company’s directors and management, directly or indirectly, hold a substantial equity interest in the Company. If all members of management were to act together as a group, they could have a significant influence over the outcome of the election of directors and any other shareholder vote. Therefore, management might have the power to take actions that nonaffiliated shareholders may deem to be contrary to the shareholders’ best interests.

Provisions in our articles and bylaws and statutory provisions may serve to entrench management and also may discourage takeover attempts that you may believe are in your best interests.

We are subject to provisions of Pennsylvania corporate and insurance law that hinder a change of control. Pennsylvania law requires the Insurance Department’s prior approval of a change of control of an insurance holding company. Under Pennsylvania law, the acquisition of 10% or more of the outstanding capital stock of an insurer or its holding company is presumed to be a change in control. Approval by the Insurance Department may be withheld even if the transaction would be in the shareholders’ best interest if, among other things, the Insurance Department determines that the transaction would be detrimental to policyholders.

Our articles of incorporation and bylaws also contain provisions that may discourage a change in control. These provisions include:

 

   

the prohibition of ownership and voting of shares having in excess of 10% of the total voting power of the outstanding stock of the Company for a period of three years after the conversion/merger;

 

   

a classified Board of Directors divided into three classes serving for successive terms of three years each;

 

25


Table of Contents
   

a provision that the Board of Directors has the authority to issue shares of authorized but unissued common stock and preferred stock and to establish the terms of any one or more series of preferred stock, including voting rights, without additional shareholder approval;

 

   

the prohibition of cumulative voting in the election of directors;

 

   

the requirement that nominations for the election of directors made by shareholders and any shareholder proposals for inclusion on the agenda at any annual meeting must be made by notice (in writing) delivered or mailed to us not less than 90 days or more than 120 days prior to the meeting;

 

 

 

the provision that, for a period of three years, any merger, consolidation, sale of assets or similar transaction involving the Company requires the affirmative vote of shareholders entitled to cast at least 66 2/3% of the votes which all shareholders are entitled to cast, unless the transaction is approved in advance by 66 2/3% of the members of the Board of Directors;

 

   

the prohibition of shareholder action without a meeting and the prohibition of shareholders being able to call a special meeting;

 

   

the requirement that certain provisions of our articles of incorporation can only be amended by an affirmative vote of shareholders entitled to cast at least 80% of all votes that shareholders are entitled to cast, unless approved by an affirmative vote of at least 80% of the members of the Board of Directors; and

 

 

 

the requirement that certain provisions of our bylaws can only be amended by an affirmative vote of shareholders entitled to cast at least 66 2/3%, or in certain cases 80%, of all votes that shareholders are entitled to cast.

These provisions may serve to entrench management and may discourage a takeover attempt that you may consider to be in your best interest or in which you would receive a substantial premium over the current market price. These provisions may make it extremely difficult for any one person or group of affiliated persons to acquire voting control of the Company, with the result that it may be extremely difficult to bring about a change in the Board of Directors or management. Some of these provisions also may perpetuate present management because of the additional time required to cause a change in the control of the board. Other provisions make it difficult for shareholders owning less than a majority of the voting stock to be able to elect even a single director.

Provisions of the Pennsylvania Business Corporation Law, which we refer to as the PBCL, that are applicable to publicly traded companies provide, among other things, that we may not engage in a business combination with an “interested shareholder” during the five-year period after the interested shareholder became such, except under certain specified circumstances. Under the PBCL an interested shareholder is generally a holder of 20% or more of our voting stock. The PBCL also contains provisions providing for the ability of shareholders to object to the acquisition by a person, or group of persons acting in concert, of 20% or more of our outstanding voting securities and to demand that they be paid a cash payment for the fair value of their shares from the controlling person or group.

If our insurance subsidiaries are not sufficiently profitable, our ability to pay dividends will be limited by regulatory restrictions.

Our domestic insurance subsidiaries’ ability to pay dividends to the Company is limited by the insurance laws and regulations of Pennsylvania. The maximum dividend that the domestic insurance entities may pay without prior approval from the Insurance Department is limited to the greater of 10% of statutory surplus or 100% of statutory net income for the most recently filed annual statement. In addition, EIHI and its subsidiaries are prohibited from declaring or paying any dividends or other forms of distribution for the three years after June 16, 2006, the effective date of the conversion/merger transaction, without the prior approval of the Pennsylvania Insurance Commissioner.

Eastern Re must receive approval from the Cayman Islands Monetary Authority before it can pay any dividend. Furthermore, any dividends paid in excess of Eastern Re’s cumulative earnings and profits subsequent to June 16, 2006 would be subject to U.S. federal income tax.

Item 1B—Unresolved Staff Comments

Not applicable.

Item 2—Properties

The Company’s corporate headquarters are located at 25 Race Avenue in Lancaster, Pennsylvania. The Company leases its home office building under a 15-year, non-cancelable lease through February 2017. The annual base rent is subject to an

 

26


Table of Contents

annual increase based upon the consumer price index at the end of each preceding calendar year. In addition to the base rent, the Company is responsible for its proportionate share of expenses related to the building including, but not limited to, utilities, maintenance, real estate taxes, and insurance. The Company has a 5% interest in the limited partnership that owns the building.

Item 3—Legal Proceedings

The Company is, from time to time, involved in legal proceedings that arise in the ordinary course of business. We believe we have sufficient loss reserves and reinsurance to cover claims under insurance policies issued by us. Although there can be no assurance as to the ultimate disposition of these matters, we do not believe, based upon the information available at this time, that any current pending legal proceedings, individually or in the aggregate, will have a material adverse effect on our business, financial condition, or results of operations.

Item 4—Submission of Matters to a Vote of Security Holders

Not applicable.

 

27


Table of Contents

PART II

Item 5—Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

The no par value common stock trades on the NASDAQ National Market under the symbol “EIHI”. As of March 12, 2008, there were 601 registered holders of record of our common stock.

During 2007, the Company paid a quarterly dividend of $0.05/share. Any payment of dividends in the future on the common stock is subject to determination and declaration by the Company’s Board of Directors, who will take into consideration the Company’s financial condition, results of operations and future prospects. Additionally, the Company is prohibited from declaring or paying any dividends during the three years following the conversion/merger transaction, unless such dividends are approved by the Insurance Department.

The table below sets forth information with respect to the amount and frequency of dividends declared on our common stock. It is currently expected that cash dividends will continue to be paid in the future.

 

Date of Declaration

by EIHI Board

  

Type of and Amount of Dividend

  

Record Date for Payment

  

Payment Date

April 11, 2007    Regular    $0.05 cash per share    April 23, 2007    May 3, 2007
June 21, 2007    Regular    $0.05 cash per share    July 2, 2007    July 15, 2007
September 26, 2007    Regular    $0.05 cash per share    October 1, 2007    October 15, 2007
December 5, 2007    Regular    $0.05 cash per share    December 14, 2007    December 28, 2007

Information regarding restrictions and limitations on the payment of cash dividends can be found in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the “Financial Condition, Liquidity and Capital Resources” section.

The table below sets forth the high and low sales prices of our common stock for each quarterly period as reported by the NASDAQ for the year ended December 31, 2007 and the period from June 19, 2006 to December 31, 2006.

 

     Low    High

1st quarter 2007

   $ 14.19    $ 14.99

2nd quarter 2007

   $ 14.51    $ 16.01

3rd quarter 2007

   $ 13.78    $ 16.00

4th quarter 2007

   $ 15.15    $ 17.66
     Low    High

Period from June 19, 2006 to June 30, 2006

   $ 11.41    $ 12.80

3rd quarter 2006

   $ 12.70    $ 14.95

4th quarter 2006

   $ 14.01    $ 15.02

The Company adopted the Eastern Insurance Holdings, Inc. 2006 Stock Incentive Plan (the “Stock Incentive Plan”) on December 18, 2006. Under the terms of the Stock Incentive Plan, stock awards may be made in the form of incentive stock options, non-qualified stock options or restricted stock. The following table provides the total number of stock awards outstanding, including the weighted average exercise price, as of December 31, 2007:

Equity Compensation Plan Information

 

Plan category

   Number of securities to be
issued upon exercise of
outstanding options,
warrants and rights
   Weighted–average
exercise price of
outstanding options,
warrants and rights
   Number of securities
remaining available for
future issuance under
equity compensation plans
(excluding securities
reflected in column (a))
     (a)    (b)    (c)

Equity compensation plans approved by security holders

   630,264    $ 14.37    275,370

Equity compensation plans not approved by security holders

   —        —      —  

Total

   630,264    $ 14.37    275,370

 

28


Table of Contents

Set forth below is a line graph comparing the dollar change in the cumulative total shareholder return on the Company’s common stock for the year ended December 31, 2007 compared to the cumulative total return of the NASDAQ Composite Index and the cumulative total return of the SNL Insurance Underwriter Index. The chart depicts the value on December 31, 2007 of a $100 investment made on June 19, 2006.

LOGO

 

     Period Ending

Index

   06/19/06    12/31/06    03/31/07    06/30/07    09/30/07    12/31/07

Eastern Insurance Holdings, Inc.  

   100.00    127.61    131.29    140.17    136.82    146.38

NASDAQ Composite

   100.00    116.32    114.75    123.35    128.01    125.68

SNL Insurance Underwriter Index

   100.00    116.30    115.78    120.76    118.42    116.88

 

29


Table of Contents

Unregistered Sales of Equity Securities and Use of Proceeds

Issuer Purchases of Equity Securities

On February 15, 2007, the Company’s Board of Directors authorized the repurchase of up to 5 percent of the Company’s issued and outstanding shares of common stock for the purpose of funding the issuance of stock under the Eastern Insurance Holdings, Inc. 2006 Stock Incentive Plan. 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 following table presents information with respect to those purchases of our common stock made during the year ended December 31, 2007:

 

Period

   Total number of
shares purchased
   Average price
paid per share
   Total number of
shares purchased as
part of publicly
announced plans

or programs
   Maximum number
(or approximate
dollar value) of
shares that may yet
be purchased under
the plans or
programs

January 1-31, 2007

   —        N/A    N/A    N/A

February 1-28, 2007

   10,355    $ 14.40    10,355    557,197

March 1-31,2007

   61,868    $ 14.46    61,868    495,329

April 1-30, 2007

   1,100    $ 15.00    1,100    494,229

May 1-31, 2007

   29,319    $ 14.73    29,319    464,910

June 1-30, 2007

   262,578    $ 15.22    262,578    202,332

July 1-31, 2007

   128,088    $ 15.18    128,088    74,244

August 1-31, 2007

   243,004    $ 15.18    243,004    310,188

September 1-30, 2007

   135,689    $ 15.49    135,689    1,174,499

October 1-31, 2007

   99,700    $ 15.96    99,700    1,074,799

November 1-30, 2007

   38,933    $ 16.17    38,933    1,035,866

December 1-31, 2007

   6,231    $ 16.17    6,231    1,029,635
                   

Total

   1,016,865    $ 15.33    1,016,865   
                   

Item 6—Selected Financial Data

The following table sets forth selected historical financial information for the Company for the years ended and as of the dates indicated. This information comes from the Company’s consolidated financial statements. The information presented for the year ended December 31, 2006 includes the results of ELH for the entire year and the results of EIHI and EHC and its subsidiaries for the period from June 17, 2006 to December 31, 2006. The information presented as of December 31, 2005, 2004 and 2003 and for the years then ended represents the financial condition and results of operations of ELH for the respective periods. You should read the following selected financial information along with the information contained in this annual report, including Part II, Item 7 of this annual report entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes and the reports of the independent registered public accounting firm included in Part II, Item 8 and elsewhere in this report. These historical results are not necessarily indicative of results to be expected from any future period (in thousands, except per share and share amounts).

 

30


Table of Contents
     At or for the Years Ended December 31,  
     2007     2006     2005     2004     2003  

Income Statement Data:

          

Direct premiums written

   $ 104,263     $ 75,011     $ 40,994     $ 40,790     $ 43,911  

Reinsurance premiums assumed

     43,183       17,836       —         —         —    

Net premiums written

     131,889       67,529       38,700       39,070       41,678  

Net premiums earned

   $ 129,495     $ 74,919     $ 38,702     $ 39,057     $ 41,714  

Investment income, net of expenses

     12,428       8,992       3,815       3,724       4,361  

Net realized investment gains

     2,888       2,757       445       1,271       662  

Other revenue

     683       313       1,066       946       978  
                                        

Total revenue

   $ 145,494     $ 86,981     $ 44,028     $ 44,998     $ 47,715  
                                        

Expenses:

          

Losses and LAE incurred

   $ 73,588     $ 47,913     $ 27,090     $ 25,932     $ 25,379  

Acquisition and other underwriting expenses

     17,056       7,242       5,452       5,670       5,575  

Other expenses

     21,801       14,390       9,674       10,601       14,615  

Amortization of intangibles

     1,738       1,087       —         —         —    

Policyholder dividend expense

     543       239       —         —         —    

Segregated portfolio dividend expense (1)

     4,423       2,890       —         —         —    
                                        

Total expenses

   $ 119,149     $ 73,761     $ 42,216     $ 42,203     $ 45,569  
                                        

Income before income taxes

   $ 26,345     $ 13,220     $ 1,812     $ 2,795     $ 2,146  

Income tax expense

     7,662       4,942       685       1,012       709  
                                        

Net income

   $ 18,683     $ 8,278     $ 1,127     $ 1,783     $ 1,437  
                                        

Selected Balance Sheet Data (at period end):

          

Total investments and cash and cash equivalents

   $ 299,061     $ 288,288     $ 82,319     $ 85,168     $ 85,252  

Total assets

     385,518       368,206       111,225       111,673       113,854  

Reserves for unpaid losses and loss adjustment expenses

     129,788       126,467       44,137       43,384       46,026  

Unearned premiums

     39,826       34,600       95       98       88  

Total liabilities

     207,687       194,462       49,116       49,132       51,498  

Total shareholders’ equity

     177,831       173,744       62,109       62,541       62,355  

U.S. GAAP Ratios:

          

Loss ratio (2)

     56.8 %     64.0 %     70.0 %     66.4 %     60.8 %

Expense ratio (3)

     35.2 %     34.5 %     39.1 %     41.7 %     48.4 %

Combined ratio (4)

     92.0 %     98.5 %     109.1 %     108.1 %     109.2 %

Per-share Data:

          

Basic earnings per share

   $ 1.82     $ 0.67       N/A       N/A       N/A  

Diluted earnings per share

   $ 1.76     $ 0.65       N/A       N/A       N/A  

Cash dividends per share

   $ 0.20     $ —         N/A       N/A       N/A  

Weighted Average Shares:

          

Basic

     10,264,369       10,623,182       N/A       N/A       N/A  

Diluted

     10,604,349       10,929,281       N/A       N/A       N/A  

 

(1) The net income of the segregated portfolio reinsurance segment is recorded as a segregated portfolio dividend expense, which represents the dividend earned by the segregated portfolio dividend participants during the period.
(2) Calculated by dividing losses and loss adjustment expenses incurred by net premiums earned.
(3) Calculated by dividing the sum of acquisition and other underwriting expenses, other expenses, amortization of intangibles, policyholder dividend expense, and segregated portfolio dividend expense by net premiums earned.
(4) The sum of the loss and loss adjustment expense ratio and expense ratio.

 

31


Table of Contents

Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations

As a result of the acquisition of EHC on June 16, 2006, the Company’s financial results for the year ended December 31, 2006 include the results of operations for the workers’ compensation insurance, segregated portfolio cell reinsurance, and specialty reinsurance segments for the period from June 17, 2006 to December 31, 2006. The Company’s financial results for the year ended December 31, 2005 represent the results of operations of the group benefits insurance segment.

Overview

The Company reported net income of $18.7 million for the year ended December 31, 2007, reflecting positive operating results in the workers’ compensation insurance and group benefits insurance segments. The workers’ compensation insurance segment reported net income of $17.1 million and the group benefits insurance segment reported net income of $4.8 million for the year ended December 31, 2007. The specialty reinsurance segment reported a net loss for the year ended December 31, 2007, primarily related to adverse development on prior year reserves for losses and LAE of $4.8 million. Purchase accounting adjustments increased consolidated net income by $1.5 million for the year ended December 31, 2007, compared to a decrease of $2.0 million for the year ended December 31, 2006.

Workers’ Compensation Insurance

The workers’ compensation insurance segment reported a combined ratio of 65.6% for the year ended December 31, 2007, compared to a combined ratio of 79.1% for the year ended December 31, 2006. The decrease in the combined ratio primarily reflects the impact of purchase accounting adjustments and a decrease in the loss ratio, before the effects of purchase accounting, from 2006 to 2007. Purchase accounting decreased the combined ratio by 0.4 points in 2007, compared to increasing the combined ratio by 8.7 points in 2006. The loss ratio, before the effects of purchase accounting, decreased from 53.6% in 2006 to 45.8% in 2007, which primarily reflects favorable development on prior year reserves for unpaid losses and LAE of $8.4 million during 2007.

Segregated Portfolio Cell Reinsurance

The segregated portfolio cell reinsurance segment reported a combined ratio of 83.5% for the year ended December 31, 2007, compared to a combined ratio of 74.1% for the year ended December 31, 2006. The increase in the combined ratio primarily reflects the impact of purchase accounting adjustments and an increase in the loss ratio, before the effects of purchase accounting, from 2006 to 2007. Purchase accounting adjustments decreased the combined ratio by 0.9 points in 2007, compared to 3.8 points in 2006. The loss ratio, before the effects of purchase accounting, increased from 45.3% in 2006 to 50.6% in 2007. The results of operations of the segregated portfolio cell reinsurance segment are recorded to segregated portfolio cell dividend expense. As of December 31, 2007, there are 13 segregated portfolio cells, of which two are in run-off.

Group Benefits Insurance

The group benefits insurance segment reported a combined ratio of 94.4% for the year ended December 31, 2007, compared to a combined ratio of 95.7% for the year ended December 31, 2006. The decrease in the combined ratio primarily reflects an improvement of 4.5 points in the expense ratio from 2006 to 2007, offset by an increase in the loss ratio on the dental line of business. The improvement in the expense ratio primarily reflects the impact of the Company’s efforts to integrate the workers’ compensation and group benefits operations and the increase in the group benefits insurance segment’s net premiums earned. The increase in the dental loss ratio primarily reflects the impact of new business written, which typically has a higher loss ratio than renewal business.

Specialty Reinsurance

The specialty reinsurance segment reported a combined ratio of 122.0% for the year ended December 31, 2007, compared to a combined ratio of 135.9% for the year ended December 31, 2006. Purchase accounting adjustments increased the combined ratio by 3.6 points in 2007, compared to 23.8 points in 2006. Excluding the effect of purchase accounting, the loss ratio increased from 77.0% in 2006 to 85.0% in 2007. As noted above, the increase in the loss ratio primarily reflects the adverse development on prior year reserves for unpaid losses and LAE during 2007.

 

32


Table of Contents

Principal Revenue and Expense Items

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 specialty reinsurance segment, assumed premiums are premiums that are received from a third party under a reinsurance agreement, which are reported to the Company directly from the broker one quarter in arrears.

Net premiums earned. Net premiums earned are the earned portion of the Company’s net premiums written. Premiums are earned over the term of the related policies. At the end of each accounting period, the portion of the premiums that are not yet earned are included in unearned premiums and are realized as revenue in subsequent periods over the remaining term of the policy. The Company’s workers’ compensation policies typically have a term of twelve months. Thus, for example, for a policy that is written on July 1, 2006, one-half of the premiums would be earned in 2006 and the other half would be earned in 2007. 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 with net premiums earned is an estimate for earned but unbilled final audit premiums. The Company can estimate earned but unbilled premiums because it keeps track, by policy, of how much additional premium is billed in final audit invoices as a percentage to estimate the probable additional amount that it has earned but not yet billed as of the balance sheet date. The majority of the Company’s group benefits insurance policies are billed on a monthly basis with premiums being earned in the month in which coverage is provided. As a result, there is minimal unearned premium related to the group benefits insurance policies as of the balance sheet date.

Net investment income and realized gains and losses on investments. The Company invests its surplus and the funds supporting its insurance liabilities (including unearned premiums and unpaid losses and LAE) in cash, cash equivalents, fixed income securities, convertible bonds, equity securities, and other long-term investments. Investment income includes interest earned on invested assets and the change in equity interest of limited partnerships included in other long-term investments. Realized gains and losses on invested assets are reported separately from net investment income. The Company recognizes realized gains when invested assets are sold for an amount greater than their cost or amortized cost (in the case of fixed income securities) and recognizes realized losses when investment securities are written down as a result of an other than temporary impairment or sold for an amount less than their cost or amortized cost. Realized gains and losses also include the change in fair value of convertible bonds.

Other revenue. Other revenue includes claim administration, risk management, and cell rental fees earned. There are other revenue items that the Company recognizes on a segmental basis that are eliminated in consolidation. Such items consist primarily of fees paid by the segregated portfolio cells to other entities within the consolidated group. The segregated portfolio cells recognize an expense for such items (included as part of its ceding commission) and a corresponding revenue item is recognized by the affiliate providing the service. For segment reporting purposes, such revenue items primarily include claims administration, risk management, and cell rental fees. Fronting fees are included in acquisition and other underwriting expenses as an offset to the direct costs incurred. For segment reporting purposes, such fees are recognized ratably over the period in which the service is provided, which generally corresponds to the earned portion of net premiums written for the underlying policies.

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.

Acquisition and other underwriting expenses. In the workers’ compensation and group benefits insurance segments, expenses incurred to underwrite risks are referred to as acquisition and other underwriting expenses, which consist primarily of commissions, premium taxes and fees and other underwriting expenses incurred in acquiring, writing and administering

 

33


Table of Contents

the Company’s business as well as required payments to the Security Fund. There were no Security Fund assessments incurred by the Company in 2007 or 2006. In the segregated portfolio cell reinsurance and specialty reinsurance segments, acquisition and other underwriting expenses consist of ceding commissions earned under the respective reinsurance agreements. Ceding commissions received are netted against acquisition and other underwriting expenses.

Other expenses. Other expenses consist of general administrative expenses such as salaries, rent, office supplies, depreciation and all other operating expenses not otherwise classified separately. Other expenses also include interest expense related primarily to the Company’s junior subordinated debt.

Policyholder dividend expense. Policyholder dividends represent the amount of dividends incurred during the period that are expected to be returned to policyholders. The dividend expense is based on the loss experience of the underlying workers’ compensation insurance policy.

Income tax expense. EIHI and certain of its subsidiaries pay federal, state and local income taxes. Income tax expense includes an amount for both current and deferred income taxes. Current income tax expense includes an amount for the Company’s current year federal income tax liability and any adjustments related to differences between the prior year federal income tax estimate and the actual income tax expense reported in the federal income tax return. Deferred tax expense represents the change in the Company’s net deferred tax asset, exclusive of the tax effect related to changes in unrealized gains and losses in the Company’s investment portfolio and changes in the unrecognized amounts related to the Company’s benefit plan liabilities.

Key Financial Measures

The Company evaluates its insurance operations by monitoring certain key measures of growth and profitability. The Company measures growth by monitoring changes in direct premiums written and net premiums written. The Company measures underwriting profitability by examining loss, expense and combined ratios. On a segmental basis, the Company measures a segment’s operating results by examining net income, diluted earnings per share, and return on average equity.

Loss ratio. The loss ratio is the ratio (expressed as a percentage) of losses and LAE incurred to net premiums earned and measures the underwriting profitability of a company’s insurance business. The Company measures the loss ratio on an accident year and calendar year loss basis to measure underwriting profitability. An accident year loss ratio measures losses and LAE for insured events occurring in a particular year, regardless of when they are reported, as a percentage of net premiums earned during that year. A calendar year loss ratio measures losses and LAE for insured events occurring during a particular year and the change in loss reserves from prior accident years as a percentage of net premiums earned during that year.

Expense ratio. The expense ratio is the ratio (expressed as a percentage) of the sum of the acquisition and other underwriting expenses and other expenses to net premiums earned, and measures the Company’s operational efficiency in producing, underwriting and administering its insurance business.

Policyholder dividend expense ratio. The policyholder dividend expense ratio is the ratio (expressed as a percentage) of policyholder dividend expense to net premiums earned and measures the impact of the Company’s policyholder dividend policies on its workers’ compensation insurance segment.

Combined ratio. The combined ratio is the sum of the loss ratio, expense ratio and policyholder dividend expense ratio and measures the Company’s overall underwriting profit. If the combined ratio is below 100%, the Company is making an underwriting profit. If the Company’s combined ratio is at or above 100%, the Company is not profitable without investment income and may not be profitable if investment income is insufficient.

Net premiums written to statutory surplus ratio. The net premiums written to statutory surplus ratio represents the ratio of net premiums written to statutory surplus. This ratio measures the Company’s insurance subsidiaries exposure to pricing errors in its current book of business. The higher the ratio, the greater the impact on surplus should pricing prove inadequate.

Net income, diluted earnings per share, and return on average equity. The Company uses net income and diluted earnings per share to measure its profits and return on average equity to measure its effectiveness in utilizing shareholders’ equity to generate net income. In determining return on average equity for a given year, net income is divided by the average of the beginning and ending shareholders’ equity for that year.

 

34


Table of Contents

Critical Accounting Policies and Estimates

The preparation of financial statements in accordance with U.S. GAAP requires both the use of estimates and judgment relative to the application of appropriate accounting policies. The Company is required to make estimates and assumptions in certain circumstances that affect amounts reported in the consolidated financial statements and related footnotes. The Company evaluates these estimates and assumptions on an on-going basis based on historical developments, market conditions, industry trends and other information that is believed to be reasonable under the circumstances. There can be no assurance that actual results will conform to the estimates and assumptions and that reported results of operations will not be materially adversely affected by the need to make accounting adjustments to reflect changes in these estimates and assumptions from time to time. The Company believes the following policies are the most sensitive to estimates and judgments.

Reserves for Unpaid Losses and LAE

The Company establishes reserves for unpaid losses and LAE for its workers’ compensation, segregated portfolio cell reinsurance, group benefits insurance, and 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, 2007, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.

Workers’ Compensation Insurance

On a quarterly basis, the Company prepares actuarial analyses to assess the reasonableness of the recorded reserves for unpaid losses and LAE in its workers’ compensation insurance segment. These actuarial analyses incorporate various methodologies, including paid loss development, incurred loss development and a combination of other actuarial methodologies that incorporate characteristics of incurred and paid methodologies combined with a review of the Company’s exposure base. The recorded amount in each accident year is then compared to the results of these methodologies, with consideration being given to the age of the accident year. As accident years mature, the various methodologies generally 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.

The Company’s reserves for unpaid losses and LAE in its workers’ compensation insurance segment as of December 31, 2007 and 2006 are summarized below (in thousands):

 

     2007     2006  

Case reserves

   $ 19,915     $ 18,057  

Case incurred development, IBNR and unallocated LAE reserves

     25,295       25,910  

Amount of discount

     (2,375 )     (2,183 )
                

Net reserves before reinsurance recoverables and purchase accounting

     42,835       41,784  

Reinsurance recoverables on unpaid losses and LAE

     2,709       1,475  

Purchase accounting adjustments

     941       1,699  
                

Reserves for unpaid losses and LAE

   $ 46,485     $ 44,958  
                

In its workers’ compensation 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.

 

35


Table of Contents

When a claim is reported, the Company’s claims adjusters establish a case reserve, which consists of anticipated medical costs, indemnity costs and certain defense and cost containment expenses that the Company refers to as allocated loss adjustment expenses, or ALAE. At any point in time, the amount paid on a claim, plus the case reserve for future amounts to be paid, represents the claims adjuster’s estimate at that time of the total cost of the claim, or the case incurred amount. The case reserve for each reported claim is based upon various factors, including:

 

   

type of loss;

 

   

severity of the injury or damage;

 

   

age and occupation of the injured employee;

 

   

estimated length of temporary disability;

 

   

anticipated permanent disability;

 

   

expected medical procedures, costs and duration;

 

   

knowledge of the circumstances surrounding the claim;

 

   

insurance policy provisions, including coverage, related to the claim;

 

   

jurisdiction of the occurrence; and

 

   

other benefits defined by applicable statute.

The case incurred amount can vary over time due to changes in expectations with respect to medical treatment and outcome, length and degree of disability, employment availability and wage levels and judicial determinations. As changes occur, the case incurred amount is adjusted. The initial estimate of the case incurred amount can vary significantly from the amount ultimately paid, especially in circumstances involving severe injuries with comprehensive medical treatment. Changes in case incurred amounts, or case incurred development, is an important component of the Company’s historical claim data.

In addition to case reserves, the Company establishes loss and ALAE reserves on an aggregate basis for case incurred development and IBNR claims. Case incurred development and IBNR reserves are primarily intended to provide for aggregate changes in preexisting case incurred amounts and, secondarily, as the unpaid cost of IBNR claims for which an initial case reserve has not been established.

The third component of the Company’s reserves for unpaid losses and LAE is unallocated loss adjustment expense, or ULAE. The Company’s ULAE reserve is established for the costs of future unallocated loss adjustment expenses for known and unknown claims. The Company’s ULAE reserve covers primarily the estimated cost of administering claims.

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 analysis of claims in its 11-year workers’ compensation insurance history. 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.

To estimate reserves, the Company stratifies its data using variations of the following different categorizations of claims:

 

   

All loss and LAE data developed together;

 

   

Lost time claims developed independently;

 

   

Medical only claims developed independently;

 

   

The indemnity portion of lost time claims developed independently;

 

   

The medical portion of a lost time claim and medical only claims developed together; and

 

   

LAE developed independently.

 

36


Table of Contents

The term “developed together” refers to the summation of the claims data for a particular data stratification. For example, “All loss and LAE data developed together” represents all loss and LAE data of the Company, regardless of medical, indemnity or expense components, developed together using the historical data for this particular data stratification. The term “developed independently” refers to a specific data element. For example, “The indemnity portion of lost time claims developed independently” represents the development of the indemnity portion of a claim separately using historical data for this particular type of claim. Developing claims using different data stratifications allows the Company to identify trends for a specific group of claims that would not necessarily be readily identifiable if the data were included with other types of claim information. For example, developing the medical portion of a claim separately may allow the Company to identify a medical inflation trend that may not have been evident if it had been included with indemnity claim information. The combination of the different data stratifications and standard actuarial methods, including the following, produce different actuarial indications for the Company to evaluate:

Incurred Loss Development Method. The incurred (case incurred) loss development method relies on the assumption that, at any given state of maturity, ultimate losses can be predicted by multiplying cumulative reported losses (paid losses plus case reserves) by a cumulative development factor. The validity of the results of this method depends on the stability of claim reporting and settlement rates, as well as the consistency of case reserve levels. Case reserves do not have to be adequately stated for this method to be effective; they only need to have a fairly consistent level of adequacy at all stages of maturity. “Age-to-age” loss development factors (“LDFs”) are calculated to measure the relative development of an accident year from one maturity point to the next.

Paid Loss Development Method. The paid loss development method is mechanically identical to the incurred loss development method described above. The paid method does not rely on case reserves or claim reporting patterns in making projections. The validity of the results from using a paid loss development approach can be affected by many conditions, such as internal claim department processing changes, legal changes or variations in a company’s mix of business from one year to the next. Also, since the percentage of losses paid for immature years is often low, development factors are more volatile. A small variation in the number of claims paid can have a leveraging effect that can lead to significant changes in estimated ultimate liability for losses and LAE. Therefore, ultimate values for immature accident years are often based on alternative estimation techniques.

Bornhuetter-Ferguson Methodology. The Bornhuetter-Ferguson expected loss projection method based on reported loss data relies on the assumption that remaining unreported losses are a function of the total expected ultimate losses rather than a function of the currently reported losses. The expected ultimate losses in this analysis are based on historical results, adjusted for known pricing changes and inflationary trends. The expected ultimate losses are multiplied by the unreported percentage to produce expected unreported losses. The unreported percentage is calculated as one minus the reciprocal of the selected cumulative incurred LDFs. Finally, the unreported losses are added to the current reported losses to produce ultimate losses. The Bornhuetter-Ferguson method is most useful as an alternative to other models for immature accident years. For these immature accident years, the amounts reported or paid may be small and unstable and therefore not predictive of future development. Therefore, future development is assumed to follow an expected pattern that is supported by more stable historical data or by emerging trends. This method is also useful when changing reporting patterns distort historical development of losses.

The Bornhuetter-Ferguson method can also be applied with paid losses.

In estimating ULAE reserves, the Company reviews past loss adjustment expenses in relation to paid claims and estimated future costs based on expected claims activity and duration. The sum of the Company’s net loss and ALAE reserve, and ULAE reserves represents its total net reserve for unpaid losses and LAE.

In determining management’s best estimate, the Company considers the various accident year loss indications produced by the actuarial methods. Considering the results of the methods, the inherent strengths and weaknesses of each method as described above, as well as other statistical information such as ultimate loss ratios, ultimate loss to exposure ratios and average ultimate claim values, the Company determines and records its best estimate of unpaid losses and ALAE. Management believes its best estimate of recorded reserves for unpaid losses and LAE is representative of the inherent uncertainty surrounding reserving for a long-tail line of business such as workers’ compensation as well as the relative immature accident year historical experience of its workers’ compensation insurance segment, which completed its first full year of operations in 1998.

As of December 31, 2007, the Company’s best estimate of its ultimate liability for losses and LAE, net of amounts recoverable from reinsurers and before purchase accounting adjustments, for its workers’ compensation insurance segment was $42.8 million. This amount was determined based on methods which were viewed to be better predictors than other methods.

 

37


Table of Contents

Given the long reporting and paid development patterns, the tail factors used to project actual current losses to ultimate losses for claims covered by the Company’s workers’ compensation policies require considerable judgment. Management believes that its selected tail factors represent the most likely loss development based on historical loss payment patterns as well as the current legal and economic environment. The actual tail factor could vary from the tail factor selected. Following is a sensitivity analysis of the Company’s workers’ compensation reserves to reasonably likely changes in the tail factors used to project actual current losses to ultimate losses (dollars in thousands):

 

Change in Tail Factor Assumption

   Increase (Decrease)
in Net Reserves
    Impact on Net
Income
    Percentage of
Shareholders’
Equity
 

20 basis point increase

   $ 2,791     $ (1,814 )   -1.0 %

10 basis point increase

   $ 1,402     $ (912 )   -0.5 %

10 basis point decrease

   $ (1,417 )   $ 921     0.5 %

20 basis point decrease

   $ (2,849 )   $ 1,852     1.0 %

The estimates above rely on substantial judgment. There is inherent uncertainty in estimating reserves for unpaid losses and LAE. It is possible that the actual losses and LAE incurred may vary significantly from the Company’s estimates.

Segregated Portfolio Cell Reinsurance

The Company’s reserves for unpaid losses and LAE in its segregated portfolio cell reinsurance segment as of December 31, 2007 and 2006 are summarized below (in thousands):

 

     2007     2006  

Case reserves

   $ 8,906     $ 8,216  

Case incurred development, IBNR and unallocated LAE reserves

     13,083       13,992  

Amount of discount

     (1,099 )     (1,125 )
                

Net reserves before reinsurance recoverables and purchase accounting

     20,890       21,083  

Reinsurance recoverables on unpaid losses and LAE

     2,033       2,893  

Purchase accounting adjustments

     161       (97 )
                

Reserves for unpaid losses and loss adjustment expenses

   $ 23,084     $ 23,879  
                

The Company estimates and records reserves for its segregated portfolio cell reinsurance segment in the same manner as for its workers’ compensation insurance segment.

The reporting and paid loss development patterns in the segregated portfolio cell reinsurance segment are also consistent with that of the workers’ compensation insurance segment. Accordingly, the tail factors used to project actual current losses to ultimate losses for claims covered in the Company’s segregated portfolio cell reinsurance segment require considerable judgment. The difference between total revenue for the segregated portfolio cell reinsurance segment for each period and the sum of losses and LAE, underwriting expenses, policyholder dividend expenses and other expenses is accrued as a segregated portfolio dividend expense. Accordingly, any change in the reserve for unpaid losses and LAE is recorded to the segregated portfolio dividend payable / receivable account and would only impact the Company’s net income or shareholders’ equity if it were a segregated portfolio cell dividend participant.

Group Benefits

The reserves for unpaid losses and LAE includes an estimate of future amounts for reported but unpaid and IBNR claims related to the Company’s dental, long-term disability, short-term disability and term life products, as well as an estimate of the costs associated with investigating, processing and paying the related claims.

The Company utilizes a number of methodologies, explained below, to estimate its reserves for unpaid losses in its group benefits insurance segment. These methods include the lag factor development, loss ratio, and tabular reserve methods.

Lag Factor Development Method. The lag factor development method is used to estimate the reserve for insurance products that are “short-tail” by nature, in which claims related to the products are settled shortly after they are reported by the insured. The method uses historical paid claims data to estimate the reserve for claims in the course of settlement (reported claims) and IBNR claims. The method involves the use of a claim model, or a loss triangle, in which paid claims

 

38


Table of Contents

data is aggregated into categories based on the dates on which the claims in question were incurred and paid. Data in the loss triangle is reviewed to evaluate historical claim payment patterns. A point estimate is then determined based on the historical claim payment patterns.

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.

Tabular Reserve Method. The tabular reserve method is used to estimate the reserve for insurance products that are longer tail by nature and for which the claim payment patterns are relatively predictable. Under the tabular reserve method, the reserve for reported but unpaid claims is estimated using industry-standard valuation tables. These tables incorporate expected death and recovery rate assumptions (based on an insured’s age and length of disability) that impact the reserve for unpaid claims.

The Company’s reserves for unpaid losses and LAE in its group benefits insurance segment, by line business, as of December 31, 2007 and 2006, were as follows (in thousands):

 

     2007    2006

Dental

   $ 2,075    $ 1,634

Short-term disability

     1,005      1,141

Long-term disability

     8,165      9,210

Term life

     4,892      5,310

Other

     245      245
             

Net reserves for unpaid losses and LAE

     16,382      17,540

Reinsurance recoverable on unpaid losses and LAE

     18,900      20,289
             

Reserves for unpaid losses and LAE

   $ 35,282    $ 37,829
             

Dental Reserves

The dental reserves represent the Company’s estimate of future amounts due on in-process and IBNR dental claims. The Company estimates its dental reserves using a combination of the lag factor development method and the loss ratio method, which results in the development of a point estimate. The loss ratio method is generally applied to the last three months (or most recent quarter), based on recent loss ratio trends. Due to the small size of the Company’s dental block of business, the recorded dental reserve represents the point estimate plus an amount for adverse development equal to 10% of the point estimate.

Short-Term Disability Reserves

The short-term disability reserves represent the Company’s estimate of future amounts due on in-process and IBNR short-term disability claims. The Company’s methodology for estimating its short-term disability reserves is consistent with the methodology for estimating dental reserves.

Long-Term Disability Reserves

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 2007, 2006 and 2005 were 5.25%, 4.75%, and 4.25%, respectively. A lower discount rate results in a higher claim reserve and an increase in losses and loss adjustment expenses, whereas a higher discount rate results in a lower claim reserve and a decrease in losses and loss adjustment expenses. 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.

 

39


Table of Contents

Term Life Reserves

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 reported claim reserve represents the Company’s liability for reported but unpaid death benefits and accidental death or dismemberment (AD&D) claims. The reserve is based on the death or dismemberment benefit of the underlying term life insurance contract.

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 term life premium waiver IBNR reserve represents the Company’s estimate of unreported premium waiver claims. The Company utilizes the lag factor development method to estimate the number of unreported premium waiver claims and then applies the number of estimated outstanding claims to an average reserve amount, resulting in the development of a point estimate.

Specialty Reinsurance

With respect to the specialty reinsurance segment, numerous internal and external factors will affect the ultimate settlements of future claims including, but not necessarily limited to, changes in the cost of environmental remediation, impacts of relevant federal or state legislation, changes in technology and the resulting impact on costs, and reliance on ceding companies to handle claims and remit proper loss information in a timely manner. Reserving for assumed reinsurance requires evaluating loss information received from the ceding company. On a quarterly basis, Eastern Re receives a statement from the ceding company which includes premium and loss settlement activity for the period with corresponding reserves as established by the ceding company. Claims reported to the ceding company by insureds are entered into its claim system and ceded to Eastern Re on a quarterly basis. The claim information received from the ceding company is compiled into loss development triangles. Generally accepted actuarial methodologies, supplemented by judgment where appropriate, are used to develop the appropriate IBNR reserves for Eastern Re. Each quarter the Company compares its actual reported losses for the quarter, and cumulative reported losses since the most recently completed reserve study, to expected reported losses for the respective period, which may result in the Company increasing its losses and LAE, and its corresponding loss reserves in that quarter. This information is used as a tool in the judgmental process by which management assesses the overall adequacy of the reserves for unpaid losses and LAE at Eastern Re. The evaluation of the reserves for unpaid losses and LAE related to the Company’s specialty reinsurance programs requires that loss development be estimated over an extended period of time. Because the primary insurer under this program changed in 1999 and the claims management philosophy of the two primary insurers differed, historical loss data for years prior to 1999 is not very useful. Therefore, reliance has been placed on industry loss development patterns, adjusted to reflect considerations particular to the exposure. The reliance on external benchmarks, while necessary, creates an additional element of uncertainty.

The Company’s reserves for unpaid losses and LAE in its specialty reinsurance segment as of December 31, 2007 and 2006 are summarized below (in thousands):

 

     2007     2006

Case reserves

   $ 10,873     $ 8,985

Case incurred development, IBNR and unallocated LAE reserves

     14,117       10,523

Amount of discount

     —         —  
              

Net reserves before purchase accounting

     24,990       19,508

Purchase accounting adjustments

     (53 )     293
              

Reserves for unpaid losses and loss adjustment expenses

   $ 24,937     $ 19,801
              

 

40


Table of Contents

In its specialty reinsurance segment, the Company categorizes unpaid losses and LAE into case reserves and IBNR reserves. Case reserves represent unpaid losses reported by the ceding company. The Company updates its reserve estimates on a quarterly basis using information received from its cedants.

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.

In applying these methods, the Company evaluates loss development trends by underwriting year to determine various assumptions that are required as inputs in the actuarial methodologies it employs. These typically involve the analysis of historical loss development trends by underwriting year. In addition, the Company utilizes external or internal benchmark sources of information for which it does not have sufficient loss development data to calculate credible trends. The evaluation of the reserve for unpaid losses and LAE related to the specialty reinsurance segment requires that loss development be estimated over an extended period of time.

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 specialty reinsurance includes certain risks and uncertainties that do not exist with its other segments, and include, but are not necessarily limited to, the following:

 

   

The reported claims information could be inaccurate, and/or could be subject to significant reporting lags. Such potential inaccuracies or reporting lags would increase the risk of reserve estimation error.

 

   

A significant amount of time can lapse between the assumption of risk, occurrence of a loss event, the reporting of the event to an insurance company, often referred to as the primary company or cedant, the subsequent reporting to the reinsurance company, referred to as the reinsurer, and the ultimate payment of the claim on the loss event by the reinsurer.

 

   

Because the primary insurer under these programs changed in 1999, historical loss data is insufficiently developed. Therefore, reliance has been placed on industry loss development patterns adjusted, based on the management’s judgment, to reflect considerations particular to the exposure. The reliance on external benchmarks, while necessary, creates an additional element of uncertainty.

Claims reported to the ceding company by insureds are entered into the ceding company’s claim system and ceded to the specialty reinsurance segment on a quarterly basis. The Company mitigates the above risk by engaging an independent third party to perform periodic claims reviews of the ceding companies’ detailed claim reports to ensure reported claims information appears to be reasonably accurate and timely.

As of December 31, 2007, the Company’s best estimate of its ultimate liability for unpaid losses and LAE, before purchase accounting adjustments, for its specialty reinsurance segment was $25.0 million. This amount was determined based on methods which were viewed to be better predictors than other methods.

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):

 

Change in Industry Loss Development Factors

   Increase (Decrease)
in Net Loss Reserves
    Impact on Net
Income
    Percentage of
Shareholders’
Equity
 

100 basis point increase

   $ 3,012     $ (1,958 )   -1.1 %

75 basis point increase

   $ 2,279     $ (1,481 )   -0.8 %

50 basis point increase

   $ 1,533     $ (996 )   -0.6 %

25 basis point increase

   $ 774     $ (503 )   -0.3 %

25 basis point decrease

   $ (789 )   $ 513     0.3 %

50 basis point decrease

   $ (1,594 )   $ 1,036     0.6 %

75 basis point decrease

   $ (2,417 )   $ 1,571     0.9 %

100 basis point decrease

   $ (3,258 )   $ 2,118     1.2 %

 

41


Table of Contents

While management believes that the assumptions underlying the amounts recorded for the reserves for unpaid losses and LAE as of December 31, 2007 are reasonable, the ultimate net liability may differ materially from the amount period.

“Other Than Temporary” Investment Impairments

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:

Equity securities. If an equity security has a market value below 80% of cost and remains below 80% of cost for more than three months, a review of the financial condition and prospects of the company is performed to determine if the decline in market value is other-than-temporary. A specific determination is made for any such security. Other equity securities in an unrealized loss position not meeting these quantitative thresholds are evaluated considering the magnitude and reasons for the decline and the prospects for the fair value of the securities to recover in the near term. If the decline in market value is determined to be other-than-temporary, then the cost basis of the security is written down to realizable value and the amount of the write down is accounted for as a realized loss.

Fixed income securities. A fixed income security generally is written down if the Company is unable to hold or otherwise intends to sell a security with an unrealized loss, or if it is probable that it will be unable to collect all amounts due according to the contractual terms of the security. A fixed income security is reviewed for collectibility if any of the following situations occur:

 

   

A review of the financial condition and prospects of the issuer indicates that the security should be evaluated;

 

   

Moody’s or Standard & Poor’s rate the security below investment grade; or

 

   

The security has a market value below 80% of amortized cost due to deterioration in credit quality.

Deferred Acquisition Costs

Certain direct policy acquisition costs consisting of commissions, premium taxes, fronting fees and certain other direct underwriting costs are deferred and amortized as the underlying policy premiums are earned. As of December 31, 2007 and 2006, deferred policy acquisition costs and the related unearned premium reserves in the Company’s workers’ compensation insurance, segregated portfolio cell reinsurance, group benefits insurance, and specialty reinsurance segments were as follows (in thousands):

 

     2007    2006

Workers’ compensation insurance segment:

     

Deferred policy acquisition costs

   $ 1,924    $ 1,232

Unearned premium reserves

   $ 24,707    $ 21,336

Segregated portfolio cell reinsurance segment:

     

Deferred policy acquisition costs

   $ 2,137    $ 1,496

Unearned premium reserves

   $ 7,716    $ 6,330

Group benefits insurance segment:

     

Deferred policy acquisition costs

   $ —      $ —  

Unearned premium reserves

   $ 83    $ 80

Specialty reinsurance segment:

     

Deferred policy acquisition costs

   $ 2,196    $ 1,773

Unearned premium reserves

   $ 7,320    $ 6,854

 

42


Table of Contents

Acquisition costs of the group benefits insurance segment are not capitalized and deferred as the group benefits insurance policies are cancelable and 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 premiums are earned as of the balance sheet date and all direct expenses related to the issuance or renewal of policies are recognized when incurred.

Deferred Income Taxes

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, 2007, the Company recorded a net deferred tax asset of $1.2 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.

Reinsurance Recoverables

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.

Recent Accounting Pronouncements

SFAS 157

In September 2006, the FASB issued SFAS 157, “Fair Value Measurements”. SFAS 157 clarifies the definition of fair value for purposes of financial reporting, specifies the methods to be used to measure fair value, and requires expanded disclosures related to fair value and financial instruments measured at fair value. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. Early application is encouraged, provided an entity has not yet issued financial statements for the fiscal year, including interim financial statements. Management is currently evaluating the impact of SFAS 157 on its current fair value disclosures. The Company expects that the adoption of SFAS 157 will not have a material effect on its consolidated financial condition or results of operations.

SFAS 159

In February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” (“SFAS No. 159”) which permits all entities the option to elect, at specified election dates, to measure eligible financial instruments at fair value. An entity must report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date, and recognize upfront costs and fees related to those items in earnings as incurred and not deferred. SFAS No. 159 applies to fiscal years beginning after November 15, 2007, with early adoption permitted for an entity that has also elected to apply the provisions of SFAS No. 157. An entity is prohibited from retrospectively applying SFAS No. 159, unless it chooses early adoption. SFAS No. 159 also applies to eligible items existing as of November 15, 2007 (or early adoption date). The Company is currently in the process of evaluating the impact of SFAS No. 159; however it does not currently anticipate electing the fair value option for any of its eligible financial instruments.

SFAS 141R

In December 2007, the FASB issued Statement No. 141R, “Business Combinations” (“SFAS No. 141R”), which revises the accounting for business combination transactions previously accounted for under SFAS No. 141, “Business Combinations” (“SFAS No. 141”), and broadens the scope of transactions which should be accounted for under this standard. SFAS No. 141R retains the fundamental requirements of SFAS No. 141 in that the acquisition method of accounting is still

 

43


Table of Contents

used, and an acquirer must be identified in all business combinations. SFAS No. 141R applies prospectively to business combinations which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. An entity is prohibited from applying SFAS No. 141R prior to that date. The Company is currently in the process of evaluating the impact of SFAS No. 141R.

SFAS 160

In December 2007, the FASB issued Statement No. 160, “Noncontrolling Interests in Consolidated Financial Statements.—an amendment of ARB No. 51” (“SFAS No. 160”), which establishes accounting and reporting standards for the non-controlling interests in a subsidiary and for the deconsolidation of a subsidiary. SFAS No. 160 requires that the ownership interests and the net income of the non-controlling interest be equally identified from that of the parent on the face of the financial statements. SFAS No. 160 also provides consistent accounting principles for changes in a parent controlling ownership interest in a subsidiary, and that any retained non-controlling financial interests in a deconsolidated subsidiary be measured initially at fair value. SFAS No. 160 applies to fiscal years beginning on or after December 15, 2008, and is applied prospectively, except for presentation and disclosure requirements, which are applied retrospectively for all periods presented. The Company is currently in the process of evaluating the impact of SFAS No. 160.

YEAR ENDED DECEMBER 31, 2007 COMPARED TO YEAR ENDED DECEMBER 31, 2006

RESULTS OF OPERATIONS

The major components of consolidated revenue were as follows for the years ended December 31, 2007 and 2006 (in thousands):

 

     2007    2006

Net premiums written

   $ 131,889    $ 67,529
             

Net premiums earned

   $ 129,495    $ 74,919

Net investment income

     12,428      8,992

Net realized investment gains

     2,888      2,757

Other revenue

     683      313
             

Consolidated revenue

   $ 145,494    $ 86,981
             

The increase in consolidated revenue primarily reflects the acquisition of EHC on June 16, 2006. The increase in net premiums earned also reflects the impact of new business, improved renewal retention, and renewal rate increases in the workers’ compensation insurance and group benefits insurance segments.

The components of consolidated net income, by segment, for the years ended December 31, 2007 and 2006 were as follows (in thousands):

 

     2007     2006  

Workers’ compensation insurance

   $ 17,118     $ 5,318  

Segregated portfolio cell reinsurance

     —         —    

Group benefits insurance

     4,777       4,587  

Specialty reinsurance

     (286 )     (489 )

Corporate/other

     (2,926 )     (1,138 )
                

Consolidated net income

   $ 18,683     $ 8,278  
                

The increase in consolidated net income primarily reflects the acquisition of EHC on June 16, 2006. The increase in the net loss in the corporate/other segment primarily reflects stock compensation expense related to the Company’s stock compensation plan and ESOP of $2.4 million, and intangible asset amortization of $1.8 million for the year ended December 31, 2007, compared to stock compensation expense and intangible asset amortization of $525,000 and $1.1 million, respectively, for the year ended December 31, 2006.

 

44


Table of Contents

WORKERS’ COMPENSATION INSURANCE

The following table represents the operations of the workers’ compensation insurance segment for the years ended December 31, 2007 and 2006 (in thousands):

 

     2007     2006  

Revenue:

    

Direct premiums written

   $ 91,466     $ 34,031  

Reinsurance premiums assumed

     1,341       143  

Ceded premiums written

     (34,318 )     (12,073 )
                

Net premiums written

     58,489       22,101  

Change in unearned premiums

     (2,170 )     2,047  
                

Net premiums earned

     56,319       24,148  

Net investment income

     4,758       2,225  

Net realized investment gains

     797       586  
                

Total revenue

   $ 61,874     $ 26,959  
                

Expenses:

    

Losses and loss adjustment expenses

   $ 25,614     $ 15,162  

Acquisition and other underwriting expenses

     2,495       (40 )

Other expenses

     8,300       3,724  

Policyholder dividend expense

     543       239  
                

Total expenses

   $ 36,952     $ 19,085  
                

Income before income taxes

     24,922       7,874  

Income tax expense

     7,804       2,556  
                

Net income

   $ 17,118     $ 5,318  
                

Net Income

The increase in net income reflects the acquisition of EHC on June 16, 2006, an increase in favorable loss reserve development on prior accident years, and a reduction in the impact of purchase accounting charges in 2007. Net income for the years ended December 31, 2007 and 2006 includes after-tax favorable loss reserve development on prior accident periods of $5.5 million and $1.4 million, respectively. Net income for the year ended December 31, 2006 includes an after-tax charge of $2.4 million related to the amortization of purchase accounting adjustments compared to negligible purchase accounting charges in 2007.

The workers’ compensation insurance ratios were as follows for the years ended December 31, 2007 and 2006:

 

     2007     2006  

Loss and LAE ratio

   45.5 %   62.8 %

Expense ratio

   19.1 %   15.3 %

Policyholders’ dividend expense ratio

   1.0 %   1.0 %
            

Combined ratio

   65.6 %   79.1 %
            

Premiums

The increase in direct premiums written reflects the acquisition of EHC on June 16, 2006. Direct premiums written for traditional business and alternative markets were $65.4 million and $26.1 million, respectively, for the year ended December 31, 2007. Direct premiums written for the year ended December 31, 2007 include the impact of renewal rate decreases of 3.5%, a premium renewal retention rate of 88.2%, a reduction of $1.2 million related to the amortization of purchase accounting adjustments and audit premiums of $2.2 million.

Net Investment Income

The increase in net investment income reflects the acquisition of EHC on June 16, 2006. The average yield on the fixed income portfolio was 4.44% as of December 31, 2007, compared to an average yield of 4.48% as of December 31, 2006.

 

45


Table of Contents

Net Realized Investment Gains

Net realized investment gains primarily reflect sales activity on equity securities.

Losses and Loss Adjustment Expenses

The decrease in the calendar period loss ratio reflects an increase in favorable loss reserve development on prior accident years for the year ended December 31, 2007 compared to the same period in 2006, a decrease in the accident year loss ratio from 71.9% in 2006 to 60.3% in 2007 and a decrease in the impact of purchase accounting adjustments recorded in 2007 compared to 2006. Favorable loss reserve development on prior accident years of $8.4 million and $2.1 million was recorded for the years ended December 31, 2007 and 2006, respectively, which lowered the loss ratios for the years ended December 31, 2007 and 2006 by 14.9 points and 8.5 points, respectively. The favorable loss reserve development on prior accident years and the decrease in the accident year loss ratio relates primarily to a decrease in the current and prior accident year loss development factors used to estimate losses and LAE. The decrease in accident year loss development factors relates primarily to significant prior year claim settlements during 2007 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, 2007. For the year ended December 31, 2007, the Company closed 281, or 56.8%, of the 495 open lost time claims as of December 31, 2006. In the aggregate, the claims were closed at amounts lower than the provision established for IBNR claims. Management believes that the realization of the benefits of its return-to-work controls coupled with strong economies in its underwriting territories during 2005, 2006, and 2007 enabled it to record losses and LAE that were lower than the amount reserved for claim settlements. The calendar period loss ratio for the year ended December 31, 2006 includes 9.2 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. For the year ended December 31, 2007, there was one claim that exceeded the Company’s $500,000 reinsurance retention. There were no claims that exceeded the Company’s $500,000 reinsurance retention for the year ended December 31, 2006.

Acquisition and Other Underwriting Expenses

The increase in the expense ratio primarily reflects a reduction in fee based revenue from the segregated portfolio cell reinsurance segment from 2006 to 2007, and purchase accounting adjustments in 2006, which lowered the expense ratio by 4.0 points compared to negligible purchase accounting adjustments in 2007.

Policyholder Dividends

The increase in policyholder dividend expense reflects the acquisition of EHC on June 16, 2006. Policyholder dividends represent payments to customers who purchased participating policies that produced favorable loss ratios. For the years ended December 31, 2007 and 2006, 10.0% and 9.1%, respectively, of all workers’ compensation policies were written on a dividend policy basis.

Tax Expense

The effective tax rate was 31.3% and 32.5% for the years ended December 31, 2007 and 2006, respectively. The decrease in the effective tax rate primarily reflects non-recurring rehabilitation tax credits recognized in 2007. The primary difference between the statutory tax rate of 35% and the effective tax rate relates to tax exempt income on municipal securities in 2007 and 2006, and the non-recurring rehabilitation tax credits in 2007.

 

46


Table of Contents

SEGREGATED PORTFOLIO CELL REINSURANCE

The following table represents the operations of the segregated portfolio cell reinsurance segment for the years ended December 31, 2007 and 2006 (in thousands):

 

     2007     2006  

Revenue:

    

Reinsurance premiums assumed

   $ 26,143     $ 6,896  

Ceded premiums written

     (2,676 )     (671 )
                

Net premiums written

     23,467       6,225  

Change in unearned premiums

     (606 )     5,581  
                

Net premiums earned

     22,861       11,806  

Net investment income

     1,284       588  

Net realized investment gains

     320       365  
                

Total revenue

   $ 24,465     $ 12,759  
                

Expenses:

    

Losses and loss adjustment expenses

   $ 11,671     $ 5,892  

Acquisition and other underwriting expenses

     6,933       2,746  

Other expenses

     463       106  

Segregated portfolio dividend expense (1)

     5,398       4,015  
                

Total expenses

   $ 24,465     $ 12,759  
                

Net income (1)

   $ —       $ —    
                

 

 

(1) The workers’ compensation insurance, specialty reinsurance and corporate/other segments provide services to the segregated portfolio cell reinsurance segment. The fees paid by the segregated portfolio cell reinsurance segment for these services are included in the revenue of the segment providing the service. The segregated portfolio cell reinsurance segment records the fees associated with these services as ceding expense, which is included in its underwriting expenses. The difference between total revenue for the segregated portfolio cell reinsurance segment for each period and the sum of losses and loss adjustment expenses, underwriting expenses, policyholder dividend expenses and other expenses is accrued as a segregated portfolio dividend expense. As a result, the segregated portfolio cell reinsurance segment has no net income for the period presented in this table.

The segregated portfolio cell reinsurance ratios were as follows for the years ended December 31, 2007 and 2006:

 

     2007     2006  

Loss and LAE ratio

   51.1 %   49.9 %

Expense ratio

   32.4 %   24.2 %
            

Combined ratio

   83.5 %   74.1 %
            

Reinsurance Premiums Assumed

The increase in reinsurance premiums assumed reflects the acquisition of EHC on June 16, 2006. Reinsurance premiums assumed for the year ended December 31, 2007 include the impact of renewal rate decreases of 1.5%, a premium renewal retention rate of 88.4%, a reduction of $781,000 related to the amortization of purchase accounting adjustments, and audit premiums of $623,000.

Net premiums written for the year ended December 31, 2007 include an increase of $330,000 related to the amortization of purchase accounting adjustments.

Net Investment Income

The increase in net investment income reflects the acquisition of EHC on June 16, 2006. The average yield on the fixed income portfolio was 5.11% as of December 31, 2007, compared to an average yield of 5.33% as of December 31, 2006.

 

47


Table of Contents

Losses and Loss Adjustment Expenses

The increase in the calendar year loss ratio from 2006 to 2007 relates to favorable loss reserve development recorded on prior accident years of $3.0 million for the year ended December 31, 2007 compared to $2.0 million for the year ended December 31, 2006, which lowered loss ratios for the years ended December 31, 2007 and 2006 by 13.2 points and 17.7 points, respectively, partially offset by purchase accounting adjustments recorded in 2006 that increased the calendar period loss ratio by 4.6 points compared to negligible purchase accounting adjustments in 2007. The favorable loss reserve development on prior accident years relates primarily to a decrease in the prior year loss development factors used to estimate losses and loss adjustment expenses. The decrease in accident year loss development factors relates primarily to significant prior year claim settlements during 2007 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, 2007.

Acquisition and Other Underwriting Expenses

The increase in the expense ratio from 2006 to 2007 relates primarily to purchase accounting adjustments recorded for the year ended December 31, 2006 that reduced the expense ratio by 8.4 points compared to negligible purchase accounting adjustments in 2007. The expense ratios, without regard to the aforementioned purchase accounting adjustments in 2006, are consistent with the contractual ceding commissions for the years ended December 31, 2007 and 2006.

Segregated Portfolio Dividend Expense

The segregated portfolio dividend expense represents the amount of net income or loss in a specific period that may be payable to the segregated portfolio dividend participants.

GROUP BENEFITS INSURANCE

The following table represents the operations of the group benefits insurance segment for the years ended December 31, 2007 and 2006 (in thousands):

 

     2007     2006  

Revenue:

    

Direct premiums written

   $ 38,519     $ 35,913  

Ceded premiums written

     (2,655 )     (2,485 )
                

Net premiums written

     35,864       33,428  

Change in unearned premiums

     (1 )     23  
                

Net premiums earned

     35,863       33,451  

Net investment income

     3,238       3,669  

Net realized investment gains

     1,531       1,972  
                

Total revenues

     40,632       39,092  
                

Expenses:

    

Losses and loss adjustment expenses

     23,253       20,600  

Acquisition and other underwriting expenses

     5,556       5,072  

Other expenses

     5,073       6,336  
                

Total expenses

     33,882       32,008  
                

Income before income taxes

     6,750       7,084  

Income tax expense

     1,973       2,497  
                

Net income

   $ 4,777     $ 4,587  
                

Net Income

The increase in net income primarily reflects improved underwriting results, as the combined ratio decreased from 95.7% in 2006 to 94.4% in 2007. The improvement in the underwriting results was offset by a decrease in net investment income and net realized gains on investments.

The group benefits insurance ratios were as follows for the years ended December 31, 2007 and 2006:

 

     2007      2006  

Loss and LAE ratio

   64.8 %    61.6 %

Expense ratio

   29.6 %    34.1 %
             

Combined ratio

   94.4 %    95.7 %
             

 

48


Table of Contents

Short-term Disability

The decrease in the short-term disability loss ratio primarily reflects a reduction in claim severity, which decreased 2.4% from 2006 to 2007. The accident period loss ratio decreased from 80.3% in 2006 to 71.5% in 2007. The decrease in the accident period loss ratio was partially offset by a decline in favorable loss reserve development from $337,000, or 5.2 percentage points, in 2006 to $148,000, or 2.2 percentage points, in 2007.

Long-term Disability

The long-term disability loss ratio was relatively consistent from 2006 to 2007. The loss ratio reflects the continued impact of prior year claim terminations that were covered under the 50/50 coinsurance arrangement.

Term Life

The term life loss ratio was relatively consistent from 2006 to 2007. The loss ratio related to death benefits decreased from 61.7% in 2006 to 58.2% in 2007, primarily reflecting a decrease in reported life claims. The death benefit loss ratio was offset by a reduction in outstanding premium waiver claims during 2007 and 2006. The reduction in premium waiver reserves reduced the term life loss ratio by 5.7 points and 9.7 points in 2007 and 2006, respectively.

Acquisition and Other Underwriting Expenses

The increase in acquisition and other underwriting expenses primarily reflects the increase in net premiums earned.

Other Expenses

The decrease in other expenses primarily reflects the impact of expense savings realized as a result integration efforts in the last six months of 2006 and first six months of 2007. In addition, the group benefits insurance segment recognized a gain of $384,000 during the fourth quarter of 2007 related to its defined benefit pension plan. The gain resulted from the purchase of an annuity to fund the current retiree portion of the pension plan liability.

Tax Expense

The decrease in income tax expense primarily reflects a reduction in the effective tax rate, from 35.2% in 2006 to 29.2% in 2007. The reduction in the effective tax rate primarily reflects the impact of tax-exempt interest income and the release of a contingency reserve in 2007 related to prior tax years.

SPECIALTY REINSURANCE

The following table represents the operations of the specialty reinsurance segment for the years ended December 31, 2007 and 2006 (in thousands):

 

     2007     2006  

Revenue:

    

Reinsurance premiums assumed

   $ 14,069     $ 5,775  

Change in unearned premiums

     383       (261 )
                

Net premiums earned

   $ 14,452     $ 5,514  

Net investment income

     1,559       1,032  

Net realized investment gains

     7       15  

Other revenue

     593       177  
                

Total revenue

   $ 16,611     $ 6,738  
                

Expenses:

    

Losses and loss adjustment expenses

   $ 13,050     $ 6,292  

Acquisition and other underwriting expenses

     3,932       789  

Other expenses

     647       411  
                

Total expenses

   $ 17,629     $ 7,492  
                

Loss before income taxes

     (1,018 )     (754 )

Income tax benefit

     (732 )     (265 )
                

Net loss

   $ (286 )   $ (489 )
                

 

49


Table of Contents

Net Loss

The decrease in the net loss reflects a decrease in the calendar year loss ratio in 2007 compared to 2006 and a reduction of the impact of purchase accounting charges in 2007 compared to 2006. Net income for the year ended December 31, 2006 includes an after-tax charge of $647,000 related to the amortization of purchase accounting adjustments compared to negligible purchase charges in 2007.

The specialty reinsurance ratios were as follows for the years ended December 31, 2007 and 2006:

 

     2007     2006  

Loss and LAE ratio

   90.3 %   114.1 %

Expense ratio

   31.7 %   21.8 %
            

Combined ratio

   122.0 %   135.9 %
            

Reinsurance Premiums Assumed

The increase in reinsurance premiums assumed relates to the acquisition of EHC on June 16, 2006. Reinsurance premiums earned, by line of business, were as follows for the years ended December 31, 2007 and 2006 (in thousands):

 

     2007     2006  

EnviroGuard

   $ 11,241     $ 5,815  

EIA

     3,510       2,320  

Other

     550       —    

Purchase accounting adjustments

     (849 )     (2,621 )
                

Total assumed premiums earned

   $ 14,452     $ 5,514  
                

Net Investment Income

The increase in net investment income is related to the acquisition of EHC on June 16, 2006. The average yield on the fixed income portfolio was 4.64% as of December 31, 2007 compared to an average yield of 4.52% as of December 31, 2006.

Losses and Loss Adjustment Expenses

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.

Acquisition and Other Underwriting Expenses

The increase in the expense ratio is related to a reduction in the impact of purchase accounting adjustments in 2007 compared to 2006. Purchase accounting adjustments reduced acquisition and other underwriting expenses by $1.7 million in 2006 compared to negligible purchase accounting adjustments in 2007. As part of its quota share reinsurance agreement with the primary insurer, the Company pays the primary insurer a ceding commission based on assumed premiums. For the years ended December 31, 2007 and 2006, the ceding commission paid to the primary insurer was 30.0%.

 

50


Table of Contents

Tax Expense

The effective tax rate for the year ended December 31, 2007 was 71.9% compared to 35.1% in 2006. The difference between the statutory rate of 35.0% and the effective rate relates to a prior year tax return adjustment recorded during 2007.

CORPORATE/OTHER

The corporate/other segment results for the year ended December 31, 2007 include the impact of stock compensation expense related to the Company’s stock incentive plans and ESOP, amortization of intangible assets and costs related to the implementation of Sarbanes-Oxley. Stock compensation expense and intangible asset amortization totaled $2.4 million and $1.7 million for the year ended December 31, 2007, respectively. Costs related to the implementation of Sarbanes-Oxley totaled $658,000 for the year ended December 31, 2007. The corporate/other segment results for the year ended December 31, 2006 include the impact of transaction expenses incurred by ELH totaling $303,000, stock compensation expense of $525,000, and intangible asset amortization of $1.1 million.

YEAR ENDED DECEMBER 31, 2006 COMPARED TO YEAR ENDED DECEMBER 31, 2005

RESULTS OF OPERATIONS

The components of consolidated revenue were as follows for the year ended December 31, 2006 and 2005 (in thousands):

 

     2006    2005

Net premiums written

   $ 67,529    $ 38,700
             

Net premiums earned

   $ 74,919    $ 38,702

Net investment income

     8,992      3,815

Net realized investment gains

     2,757      445

Other revenue

     313      1,066
             

Consolidated revenue

   $ 86,981    $ 44,028
             

The increase in consolidated revenue reflects the acquisition of EHC on June 16, 2006. The increase in net investment income reflects the increase in cash and investments, which increased from $82.2 million at December 31, 2005 to $288.3 million at December 31, 2006, as a result of the initial public offering and the acquisition of EHC. Other revenue for the year ended December 31, 2006 represents fees from the Company’s third party administration operations and cell rental fees from the Company’s specialty reinsurance segment for the period from June 17, 2006 to December 31, 2006. Other revenue for the year ended December 31, 2005 represents sales and marketing fees earned by ELH’s former general agency operations segment.

The components of consolidated net income, by segment, for the year ended December 31, 2006 and 2005 were as follows (in thousands):

 

     2006     2005  

Workers’ compensation insurance

   $ 5,318     $ —    

Segregated portfolio cell reinsurance

     —         —    

Group benefits insurance

     4,587       1,987  

Specialty reinsurance

     (489 )     —    

Corporate/other

     (1,138 )     (860 )
                

Consolidated net income

   $ 8,278     $ 1,127  
                

The increase in consolidated net income reflects the acquisition of EHC on June 16, 2006. The corporate/other segment results for the year ended December 31, 2006 include the results of operations of Employers Alliance, EIHI, Eastern Holding Company, Ltd., Eastern Services, Global Alliance, and the Company’s corporate activities for the period from June 17, 2006 to December 31, 2006, and ELH’s group medical insurance run-off operations and corporate activities for the year ended December 31, 2006. The corporate/other segment results for the year ended December 31, 2005 include the results of operations of ELH’s former general agency operations and corporate activities, and the group medical insurance run-off operations.

 

51


Table of Contents

Consolidated net income for the year ended December 31, 2006 includes the impact of purchase accounting adjustments that reduced net income by $2.2 million, including reductions in the workers’ compensation insurance and specialty reinsurance segments of $2.4 million and $647,000, respectively, and a decrease in the net loss in the corporate/other segment of $801,000.

WORKERS’ COMPENSATION INSURANCE

The following table represents the operations of the workers’ compensation insurance segment for the period from June 17, 2006 to December 31, 2006 (in thousands):

 

     2006  

Revenue:

  

Direct premiums written

   $ 34,031  

Reinsurance premiums assumed

     143  

Ceded premiums written

     (12,073 )
        

Net premiums written

     22,101  

Change in unearned premiums

     2,047  
        

Net premiums earned

     24,148  

Net investment income

     2,225  

Net realized investment gains

     586  
        

Total revenue

   $ 26,959  
        

Expenses:

  

Losses and loss adjustment expenses

   $ 15,162  

Acquisition and other underwriting expenses

     (40 )

Other expenses

     3,724  

Policyholder dividend expense

     239  
        

Total expenses

   $ 19,085  
        

Income before income taxes

     7,874  

Income tax expense

     2,556  
        

Net income

   $ 5,318  
        

Net Income

Net income reflects an after-tax charge of $2.4 million related to the amortization of purchase accounting adjustments, favorable loss reserve development on prior accident years of $1.4 million and a $567,000 reduction in the accrual for the Security Fund assessment.

The workers’ compensation ratios were as follows for the period from June 17, 2006 to December 31, 2006:

 

     2006  

Loss and LAE ratio

   62.8 %

Expense ratio

   15.3 %

Policyholders’ dividend expense ratio

   1.0 %
      

Combined ratio

   79.1 %
      

Premiums

Direct premiums written for traditional business and alternative markets were $27.1 million and $6.9 million for the period from June 17, 2006 to December 31, 2006, respectively. Direct written premiums include the impact of 2006 renewal rate decreases of 6.1%, a premium renewal retention rate of 85.4% and a reduction for purchase accounting adjustments of $5.1 million. Audit premiums of $1.6 million were also included in direct premiums written for the period from June 17, 2006 to December 31, 2006.

Net premiums written include traditional production, net of external reinsurance, because alternative markets business is ceded 100% to the segregated portfolio cell reinsurance segment.

 

52


Table of Contents

Net Investment Income

Net investment income was $2.2 million for the period from June 17, 2006 to December 31, 2006.

Net Realized Investment Gains

Net realized investment gains for the period from June 17, 2006 to December 31, 2006 related primarily to sales activity on equity securities.

Losses and Loss Adjustment Expenses

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.

Acquisition and Other Underwriting Expenses

Acquisition and other underwriting expenses for the period from June 17, 2006 to December 31, 2006 include a reduction for purchase accounting adjustments of $968,000 and a decrease of $872,000 related to management’s estimate that the Security Fund will not be making an assessment in 2007 based on 2006 direct written premium. Other expenses were $3.7 million for the period from June 17, 2006 to December 31, 2006. The expense ratio was 15.3% for the period from June 17, 2006 to December 31, 2006.

Policyholder Dividends

Dividends represent payments to customers who purchased participating policies that produced favorable loss ratios. In 2006, 9.1% of all policies were written on a dividend policy basis.

Tax Expense

The effective tax rate for the period from June 17, 2006 to December 31, 2006 was 32.5%. The primary difference between the statutory tax rate of 35.0% and the effective tax rate relates to tax exempt income recorded for the period from June 17, 2006 to December 31, 2006.

 

53


Table of Contents

SEGREGATED PORTFOLIO CELL REINSURANCE

The following table represents the operations of the segregated portfolio cell reinsurance segment for the period from June 17, 2006 to December 31, 2006 (in thousands):

 

     2006  

Revenue:

  

Reinsurance premiums assumed

   $ 6,896  

Ceded premiums written

     (671 )
        

Net premiums written

     6,225  

Change in unearned premiums

     5,581  
        

Net premiums earned

     11,806  

Net investment income

     588  

Net realized investment gains

     365  
        

Total revenue

   $ 12,759  
        

Expenses:

  

Losses and loss adjustment expenses

   $ 5,892  

Acquisition and other underwriting expenses

     2,746  

Other expenses

     106  

Segregated portfolio dividend expense (1)

     4,015  
        

Total expenses

   $ 12,759  
        

Net income (1)

   $ 0  
        

 

(1) The workers’ compensation insurance, specialty reinsurance and corporate/other segments provide services to the segregated portfolio cell reinsurance segment. The fees paid by the segregated portfolio cell reinsurance segment for these services are included in the revenue of the segment providing the service. The segregated portfolio cell reinsurance segment records the fees associated with these services as ceding expense, which is included in its underwriting expenses. The difference between total revenue for the segregated portfolio cell reinsurance segment for each period and the sum of losses and loss adjustment expenses, acquisition and other underwriting expenses, policyholder dividend expenses and other expenses is accrued as a segregated portfolio dividend expense. As a result, the segregated portfolio cell reinsurance segment has no net income for any period presented in this table.

The Company’s segregated portfolio cell ratios were as follows for the period from June 17, 2006 to December 31, 2006:

 

     2006  

Loss and LAE ratio

   49.9 %

Expense ratio

   24.2 %
      

Combined ratio

   74.1 %
      

Premiums

Reinsurance premiums assumed include the impact of 2006 renewal rate decreases of 3.8%, a premium renewal retention rate of 85.0% and a reduction for purchase accounting adjustments of $2.4 million. Audit premiums of $312,000 were also included in reinsurance premiums assumed for the period from June 17, 2006 to December 31, 2006.

Net premiums written for the period from June 17, 2006 to December 31, 2006 include an increase of $1.0 million related to purchase accounting adjustments.

Losses and Loss Adjustment Expenses

The calendar period loss and LAE ratio was 49.9% in 2006, including 4.6 points related to purchase accounting adjustments recorded to net premiums earned and losses and LAE.

 

54


Table of Contents

Acquisition and Other Underwriting Expenses

Acquisition and other underwriting expenses were $2.7 million for the period from June 17, 2006 to December 31, 2006 and include a reduction of $1.5 million for purchase accounting adjustments. Underwriting expenses consist of the ceding commissions due under the reinsurance agreements with Eastern Alliance and/or Allied Eastern. Other expenses consist primarily of accounting, banking and legal fees. The expense ratio of 24.2% for the period from June 17, 2006 to December 31, 2006 includes a reduction of 8.4 points related to purchase accounting adjustments. The expense ratio, without regard to the aforementioned purchase accounting adjustments, is consistent with the contractual ceding commissions for this period.

Segregated Portfolio Dividend Expense

Segregated portfolio dividend expense was $4.0 million for the period from June 17, 2006 to December 31, 2006. The segregated portfolio dividend expense represents the amount of net income or loss in a specific period that may be payable to the segregated portfolio dividend participants.

GROUP BENEFITS INSURANCE

The following table represents the operations of the group benefits insurance segment for the years ended December 31, 2006 and 2005 (in thousands):