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Eastern Insurance Holdings 10-Q 2008

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.2
  6. Ex-32.2
Form 10-Q
Table of Contents

 

 

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

 

x Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

for the Quarterly Period Ended September 30, 2008,

or

 

¨ Transition report pursuant to Section 13 or 15(d) of the Exchange Act

for the Transition Period from              to             

No. 001-32899

(Commission File Number)

 

 

EASTERN INSURANCE HOLDINGS, INC.

(Exact name of Registrant as specified in its charter)

 

 

 

PENNSYLVANIA   20-2653793

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

25 Race Avenue, Lancaster, Pennsylvania   17603
(Address of principal executive offices)   (Zip Code)

(717) 396-7095

(Registrant’s telephone number, including area code)

 

(Former name, former address and former fiscal year, if changed since last report)

 

 

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 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 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 if the Registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ¨    No  x

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

 

COMMON STOCK

 

Number of Shares Outstanding as of November 4, 2008

(No par Value)   9,533,279
(Title of Class)   (Outstanding Shares)

 

 

 


Table of Contents

TABLE OF CONTENTS

 

         Page
PART I - FINANCIAL INFORMATION    3
Item 1.   Financial Statements (Unaudited)    3
Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations    24
Item 3.   Quantitative and Qualitative Disclosures About Market Risk    40
Item 4.   Controls and Procedures    41
PART II - OTHER INFORMATION    41
Item 1.   Legal Proceedings    41
Item 1A.   Risk Factors    41
Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds    42
Item 3.   Defaults Upon Senior Securities    43
Item 4.   Submission of Matters to Vote of Security Holders    43
Item 5.   Other Information    43
Item 6.   Exhibits    43

 

2


Table of Contents

PART I—FINANCIAL INFORMATION

 

Item 1. Financial Statements

EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands, except share data)

 

     September 30,
2008
    December 31,
2007
 

ASSETS

    

Investments:

    

Fixed income securities, at estimated fair value (amortized cost, $180,714; $202,039)

   $ 179,961     $ 205,785  

Convertible bonds, at estimated fair value (amortized cost, $14,292; $14,232)

     13,182       15,478  

Equity securities, at estimated fair value (cost, $27,623; $19,578)

     22,473       20,541  

Other long-term investments, at estimated fair value (cost, $10,637; $10,386)

     11,524       11,317  
                

Total investments

     227,140       253,121  

Cash and cash equivalents

     49,625       45,940  

Accrued investment income

     2,114       2,290  

Premiums receivable (net of allowance, $567; $558)

     36,813       26,846  

Reinsurance recoverable on paid and unpaid losses and loss adjustment expenses

     28,490       26,303  

Deferred acquisition costs

     6,679       6,257  

Deferred income taxes, net

     6,694       1,229  

Federal income taxes recoverable

     1,979       846  

Intangible assets

     9,568       6,372  

Goodwill

     10,908       7,992  

Other assets

     10,587       8,322  
                

Total assets

   $ 390,597     $ 385,518  
                

LIABILITIES

    

Reserves for unpaid losses and loss adjustment expenses

   $ 146,530     $ 129,788  

Unearned premium reserves

     52,356       39,826  

Advance premium

     1,348       1,380  

Accounts payable and accrued expenses

     11,823       8,422  

Ceded reinsurance balances payable

     6,303       6,762  

Benefit plan liabilities

     315       334  

Segregated portfolio cell dividend payable

     13,357       13,168  

Loan payable

     2,427       —    

Junior subordinated debentures

     —         8,007  
                

Total liabilities

   $ 234,459     $ 207,687  
                

Commitments and contingencies (Note 11)

    

SHAREHOLDERS’ EQUITY

    

Series A preferred stock, par value $0, auth. shares - 5,000,000; no shares issued and outstanding

     —         —    

Common capital stock, par value $0, auth. shares - 20,000,000; issued - 11,597,723; outstanding – 9,551,569 and 10,580,858, respectively

     —         —    

Unearned ESOP compensation

     (5,791 )     (6,354 )

Additional paid in capital

     111,431       110,166  

Treasury stock, at cost (2,051,154 and 1,016,865 shares, respectively)

     (32,308 )     (15,589 )

Retained earnings

     85,287       86,363  

Accumulated other comprehensive (loss) income, net

     (2,481 )     3,245  
                

Total shareholders’ equity

     156,138       177,831  
                

Total liabilities and shareholders’ equity

   $ 390,597     $ 385,518  
                

See accompanying notes to unaudited consolidated financial statements.

 

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Table of Contents

EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

AND COMPREHENSIVE INCOME

For the Three and Nine Months Ended September 30, 2008 and 2007

(Unaudited, in thousands, except per share data)

 

     For the Three Months
Ended September 30,
   For the Nine Months
Ended September 30,
 
     2008     2007    2008     2007  

REVENUE

         

Net premiums earned

   $ 33,118     $ 34,264    $ 99,363     $ 95,226  

Net investment income

     755       3,108      5,442       9,326  

Net realized investment (losses) gains

     (4,518 )     590      (4,213 )     2,321  

Other revenue

     167       179      522       517  
                               

Total revenue

     29,522       38,141      101,114       107,390  
                               

EXPENSES

         

Losses and loss adjustment expenses incurred

     22,517       21,459      62,930       57,968  

Acquisition and other underwriting expenses

     4,588       4,097      14,224       11,266  

Other expenses

     6,584       6,452      19,113       17,977  

Amortization of intangibles

     328       434      984       1,303  

Policyholder dividend expense

     325       95      253       349  

Segregated portfolio dividend expense

     29       780      2,602       2,172  
                               

Total expenses

     34,371       33,317      100,106       91,035  
                               

(Loss) income before income taxes

     (4,849 )     4,824      1,008       16,355  

Income tax (benefit) expense

     (1,760 )     1,263      20       5,329  
                               

Net (loss) income

   $ (3,089 )   $ 3,561    $ 988     $ 11,026  
                               

Other comprehensive (loss) income

         

Unrealized holding (losses) gains arising during period, net of tax of $(2,197), $866, $(3,667) and $568

     (4,080 )     1,608      (6,811 )     1,054  

Amortization of unrecognized benefit plan amounts, net of tax of $2, $3, $6, and $8

     4       5      12       15  

Less: Reclassification adjustment for (losses) gains included in net income, net of tax of $(893), $121, $(591), and $585

     (1,658 )     224      (1,097 )     1,086  
                               

Other comprehensive (loss) income

     (2,426 )     1,379      (5,726 )     (47 )
                               

Comprehensive (loss) income

   $ (5,515 )   $ 4,940    $ (4,738 )   $ 10,979  
                               

 

Earnings per share (See Note 4):

   Three Months Ended
September 30
   Nine Months Ended
September 30
     2008     2007    2008    2007

Net (loss) income

   $ (3,089 )   $ 3,561    $ 988    $ 11,026

Basic earnings per share

   $ (0.35 )   $ 0.35    $ 0.11    $ 1.06

Diluted earnings per share

   $ (0.35 )   $ 0.34    $ 0.11    $ 1.02

See accompanying notes to unaudited consolidated financial statements.

 

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Table of Contents

EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY

For the Three and Nine Months Ended September 30, 2008

(Unaudited, in thousands, except share data)

Three Months Ended September 30, 2008

 

    

 

Outstanding Shares

                                Accumulated
Other
Comprehensive
Income (Loss)
Net of Tax
       
     Series A
Preferred
Stock
   Common
Capital
Stock
    Common
Capital
Stock
   Unearned
ESOP
Compensation
    Additional
Paid-In
Capital
   Treasury
Stock
    Retained
Earnings
      Total  

Balance, July 1, 2008

   —      9,588,946     $ —      $ (5,978 )   $ 111,026    $ (31,661 )   $ 89,044     $ (55 )   $ 162,376  

ESOP shares released

   —      —         —        187       86      —         —         —         273  

Stock compensation expense

   —      5,000       —        —         319      —         —         —         319  

Repurchase of common stock

   —      (42,377 )     —        —         —        (647 )     —         —         (647 )

Shareholder dividend

   —      —         —        —         —        —         (668 )     —         (668 )

Net loss

   —      —         —        —         —        —         (3,089 )     —         (3,089 )

Other comprehensive loss, net of tax

   —      —         —        —         —        —         —         (2,426 )     (2,426 )
                                                                 

Balance, September 30, 2008

   —      9,551,569     $ —      $ (5,791 )   $ 111,431    $ (32,308 )   $ 85,287     $ (2,481 )   $ 156,138  
                                                                 

Nine Months Ended September 30, 2008

 

    

 

Outstanding Shares

                                Accumulated
Other
Comprehensive
Income (Loss)
Net of Tax
       
     Series A
Preferred
Stock
   Common
Capital
Stock
    Common
Capital
Stock
   Unearned
ESOP
Compensation
    Additional
Paid-In
Capital
   Treasury
Stock
    Retained
Earnings
      Total  

Balance, January 1, 2008

   —      10,580,858     $ —      $ (6,354 )   $ 110,166    $ (15,589 )   $ 86,363     $ 3,245     $ 177,831  

ESOP shares released

   —      —         —        563       284      —         —         —         847  

Stock compensation expense

   —      5,000       —        —         949      —         —         —         949  

Excess tax benefit from vested restricted stock

   —      —         —        —         32      —         —         —         32  

Repurchase of common stock

   —      (1,034,289 )     —        —         —        (16,719 )     —         —         (16,719 )

Shareholder dividend

   —      —         —        —         —        —         (2,064 )     —         (2,064 )

Net income

   —      —         —        —         —        —         988       —         988  

Other comprehensive loss, net of tax

   —      —         —        —         —        —         —         (5,726 )     (5,726 )
                                                                 

Balance, September 30, 2008

   —      9,551,569     $ —      $ (5,791 )   $ 111,431    $ (32,308 )   $ 85,287     $ (2,481 )   $ 156,138  
                                                                 

See accompanying notes to unaudited consolidated financial statements

 

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Table of Contents

EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY

For the Three and Nine Months Ended September 30, 2007

(Unaudited, in thousands, except share data)

Three Months Ended September 30, 2007

 

    

 

Outstanding Shares

                                Accumulated
Other
Comprehensive
Income Net of
Tax
      
     Series A
Preferred
Stock
   Common
Capital
Stock
    Common
Capital
Stock
   Unearned
ESOP
Compensation
    Additional
Paid-In
Capital
   Treasury
Stock
    Retained
Earnings
       Total  

Balance, July 1, 2007

   —      11,320,340     $ —      $ (6,728 )   $ 109,303    $ (4,156 )   $ 76,773     $ 1,029    $ 176,221  

ESOP shares released

   —      —         —        189       107      —         —         —        296  

Issuance of stock awards

   —      —         —        —         317      —         —         —        317  

Repurchase of common stock

   —      (591,918 )     —        —         —        (9,070 )     —         —        (9,070 )

Shareholder dividend

   —      —         —        —         —        —         (580 )     —        (580 )

Net income

   —      —         —        —         —        —         3,561       —        3,561  

Other comprehensive loss, net of tax

   —      —         —        —         —        —         —         1,379      1,379  
                                                                

Balance, September 30, 2007

   —      10,728,422     $ —      $ (6,539 )   $ 109,727    $ (13,226 )   $ 79,754     $ 2,408    $ 172,124  
                                                                

Nine Months Ended September 30, 2007

 

    

 

Outstanding Shares

                                Accumulated
Other
Comprehensive
Income Net of
Tax
       
     Series A
Preferred
Stock
   Common
Capital
Stock
    Common
Capital
Stock
   Unearned
ESOP
Compensation
    Additional
Paid-In
Capital
   Treasury
Stock
    Retained
Earnings
      Total  

Balance, January 1, 2007

   —      11,351,048     $ —      $ (7,101 )   $ 108,502    $ —       $ 69,483     $ 2,860     $ 173,744  

Adoption of SFAS 155

   —      —         —        —         —        —         405       (405 )     —    

ESOP shares released

   —      —         —        562       298      —         —         —         860  

Issuance of stock awards

   —      246,675       —        —         927      —         —         —         927  

Repurchase of common stock

   —      (869,301 )     —        —         —        (13,226 )     —         —         (13,226 )

Shareholder dividend

   —      —         —        —         —        —         (1,160 )     —         (1,160 )

Net income

   —      —         —        —         —        —         11,026       —         11,026  

Other comprehensive loss, net of tax

   —      —         —        —         —        —         —         (47 )     (47 )
                                                                 

Balance, September 30, 2007

   —      10,728,422     $ —      $ (6,539 )   $ 109,727    $ (13,226 )   $ 79,754     $ 2,408     $ 172,124  
                                                                 

See accompanying notes to unaudited consolidated financial statements

 

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Table of Contents

EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Nine Months Ended September 30, 2008 and 2007

(Unaudited, in thousands)

 

     2008     2007  

Cash flows from operating activities:

    

Net income

   $ 988     $ 11,026  

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation and amortization

     390       280  

Net amortization of bond premium/discount

     326       736  

Net realized investment losses (gains)

     4,212       (2,321 )

Equity in loss (income) of limited partnerships

     1,965       (413 )

Deferred tax benefit

     (3,437 )     (1,323 )

Stock compensation

     1,828       1,786  

Intangible asset amortization

     984       1,303  

Changes in assets and liabilities:

    

Accrued investment income

     340       (63 )

Premiums receivable

     (6,797 )     (11,727 )

Reinsurance recoverable on paid and unpaid losses and loss adjustment expenses

     (125 )     130  

Deferred acquisition costs

     (421 )     (2,956 )

Other assets

     (259 )     (1,805 )

Reserves for unpaid losses and loss adjustment expenses

     7,153       7,443  

Unearned and advance premium

     9,356       14,999  

Ceded reinsurance balances payable

     (459 )     1,403  

Accounts payable and accrued expenses

     2,489       1,615  

Segregated portfolio cell dividend payable

     189       2,731  

Benefit plan liabilities

     (36 )     (57 )

Federal income taxes recoverable/payable

     (1,483 )     (3,050 )
                

Net cash provided by operating activities

     17,203       19,737  
                

Cash flows from investing activities:

    

Purchase of fixed income securities

     (34,171 )     (96,167 )

Purchase of equity securities

     (11,070 )     (11,299 )

Purchase of other long-term investments

     (3,000 )     (500 )

Proceeds from sale of fixed income securities

     39,907       30,990  

Proceeds from maturities/calls of fixed income securities

     25,701       49,417  

Proceeds from equity securities

     4,263       10,907  

Proceeds from other long-term investments

     820       1,876  

Change in unsettled investment purchases and sales

     —         230  

Acquisition of Employers Security Holding Company, net of cash received

     (8,025 )     —    

Principal payments received on mortgage loans

     7       10  

Purchase of equipment, net

     (1,192 )     (222 )
                

Net cash provided by (used in) investing activities

     13,377       (14,758 )
                

Cash flows from financing activities:

    

Repurchase of common stock

     (16,719 )     (13,226 )

Repayment of junior subordinated debentures

     (8,007 )     —    

Shareholder dividend

     (2,064 )     (1,160 )

Excess tax benefit from vested restricted stock

     32       —    
                

Net cash used in financing activities

     (26,758 )     (14,386 )
                

Net increase (decrease) in cash and cash equivalents

     3,685       (9,407 )

Cash and cash equivalents, beginning of period

     45,940       50,703  
                

Cash and cash equivalents, end of period

   $ 49,625     $ 41,296  
                

Supplemental disclosure of cash flow information:

    

Cash paid for income taxes

   $ 4,875     $ 9,300  

Cash paid for interest

   $ 468     $ 455  

See accompanying notes to unaudited consolidated financial statements.

 

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Table of Contents

Eastern Insurance Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited, dollars in thousands except share and per share data)

1. Background and Nature of Operations

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

On September 29, 2008, EIHI acquired all of the outstanding stock of Employers Security Holding Company (“ESHC”) and its wholly-owned subsidiaries, Employers Security Insurance Company and Affinity Management Services (Note 3). Employers Security Insurance Company (“ESIC”) is an Indiana-domiciled, mono-line workers’ compensation insurance company licensed to write business in Indiana, Illinois and Missouri.

The Company operates in five segments: workers’ compensation insurance, segregated portfolio cell reinsurance, group benefits insurance, specialty reinsurance, and corporate/other. See Note 10 for a description of each segment.

2. Significant Accounting Policies

Basis of Presentation

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities and Exchange Act of 1934, as amended. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments, being normal, recurring adjustments, necessary for a fair statement of the financial position and results of operations of the Company for the periods presented have been included. The results of operations for an interim period are not necessarily indicative of the results for an entire year. These financial statements should be read in conjunction with the Company’s audited financial statements and notes thereto as of and for the year ended December 31, 2007 included in the Company’s Annual Report on Form 10-K, which was filed with the U.S. Securities and Exchange Commission on March 14, 2008.

All inter-company transactions and related account balances have been eliminated in consolidation.

Certain amounts in the prior year consolidated financial statements have been reclassified to conform to the current year presentation. Net investment income and segregated portfolio dividend expense for the three and nine months ended September 30, 2007 were reduced by $774 to reflect the elimination of an inter-company transaction between the corporate/other and segregated portfolio cell reinsurance segments.

Use of Estimates

The preparation of the unaudited interim consolidated financial statements requires management to make estimates and assumptions that affect the amount of reported assets and liabilities and disclosures of contingent assets and liabilities as of the date of the unaudited interim consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. The most significant estimates in the unaudited interim consolidated financial statements include reserves for unpaid losses and loss adjustment expenses (“LAE”), earned but unbilled premium, deferred acquisition costs, return premiums under reinsurance contracts, and current and deferred income taxes. Actual results could differ from these estimates.

Cash and Cash Equivalents

The Company considers all investments with original maturity dates of three months or less to be cash equivalents for purposes of the consolidated statements of cash flows. The carrying amount of cash equivalents approximates their fair value.

Investments

Fixed Income Securities

The Company’s investments in fixed income securities are classified as available-for-sale and are carried at estimated fair value, with unrealized gains and losses reported in accumulated other comprehensive income (loss), net of tax. Fixed income securities include publicly traded and private placement bonds. The estimated fair value of publicly traded bonds is determined based on quoted market

 

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prices or, in the absence of quoted market prices, dealer quotes or matrix pricing, all of which are based on observable market-based inputs when available. Adverse credit market conditions have caused some markets to become relatively illiquid, thus reducing the availability of certain data used by the independent pricing services and dealers. The estimated fair value of private placement bonds is determined using valuation models, taking into consideration the securities’ coupon rate, maturity date, and other pertinent features.

Premiums or discounts are amortized using the effective interest method. Realized gains or losses are based on amortized cost and are computed using the specific identification method. The Company monitors its fixed income securities for unrealized losses that appear to be other-than-temporary. The Company performs a detailed review of these securities to determine the underlying cause of the unrealized loss and whether the security is impaired. When a security is determined to be other-than-temporarily impaired, the Company reduces the book value of the security to the current estimated fair value at the balance sheet date and records a realized loss in the consolidated statements of operations and comprehensive income (loss). Any subsequent increase in the security’s estimated fair value would be reported as an unrealized gain.

Convertible Bond Securities

The Company adopted Statement of Financial Accounting Standards No. 155 (“SFAS 155”), “Accounting for Certain Hybrid Financial Instruments, an amendment of FASB Statements No. 133 and 140”, on January 1, 2007. Under SFAS 155, the change in fair value of the Company’s convertible bond securities, which meet the definition of a hybrid financial instrument under SFAS 155, is reported as a realized gain or loss in the consolidated statements of operations and comprehensive income (loss). The adoption of SFAS 155 was reported as a cumulative effect adjustment to shareholders’ equity, as of January 1, 2007, and resulted in a reclassification between retained earnings and accumulated other comprehensive income of $405. The carrying value of the Company’s convertible bond securities did not change as a result of adopting SFAS 155.

Equity Securities

The Company’s investments in equity securities, which consist primarily of index and exchange-traded mutual funds, are classified as available-for-sale and are carried at estimated fair value, with unrealized gains and losses reported in accumulated other comprehensive income (loss), net of tax. The estimated fair value of equity securities is determined based on quoted market prices or independent broker quotes.

Realized gains or losses are based on cost and are computed using the specific identification method. The Company monitors its equity securities for unrealized losses that appear to be other-than-temporary. The Company performs a detailed review of these securities to determine the underlying cause of the unrealized loss and whether the security is impaired. When a security is determined to be other-than-temporarily impaired, the Company reduces the cost of the security to the current estimated fair value at the balance sheet date and records a realized loss in the consolidated statements of operations and comprehensive income (loss). Any subsequent increase in the security’s estimated fair value would be reported as an unrealized gain.

Other Long-Term Investments

Other long-term investments consist primarily of investments in limited partnerships. Investments in limited partnerships are reported in the consolidated financial statements using the equity method. Changes in the value of the Company’s proportionate share of its limited partnership investments are included in net investment income in the consolidated statements of operations and comprehensive income (loss). The Company reports changes in the value of its limited partnership investments on a month lag (quarter lag for one investment) as a result of the timing of statements being received from the limited partnership. The Company monitors its limited partnership investments for declines in value that may be other-than-temporary. When a limited partnership interest is determined to be other-than-temporarily impaired, the Company reduces its interest in the limited partnership to its current estimated fair value at the balance sheet date. The impairment is recorded as a reduction to net investment income in the consolidated statements of operations and comprehensive income (loss).

Premiums

Premiums generated by the Company’s workers’ compensation insurance segment, including estimates of additional premiums resulting from audits of insureds’ records, are generally recognized as written upon inception of the policy. Premiums written are primarily earned on a daily pro rata basis over the terms of the policies to which they relate. Accordingly, unearned premiums represent the portion of premiums written which is applicable to the unexpired portion of the policies in force. Workers’ compensation premiums are determined based upon the payroll of the insured, the applicable premium rates and, where applicable, an experience based modification factor. An audit of the policyholders’ records is conducted after policy expiration to make a final determination of applicable premiums. Included in net premiums earned is an estimate for earned but unbilled final audit premiums. The Company estimates earned but unbilled premiums by tracking, by policy, how much additional premium is billed in final audit invoices as a percentage of payroll exposure to estimate the probable additional amount that it has earned, but not yet billed, as of the balance sheet date. Earned but unbilled premiums accrued as of September 30, 2008 and December 31, 2007 and included in net premiums earned, totaled $1,200 and $1,500, respectively.

 

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Premiums generated by the Company’s group benefits insurance segment are generally billed on a monthly basis with premiums being earned in the month in which the coverage is provided. Unearned premiums represent those premiums that have been received but for which the coverage period has not expired. Advance premiums represent those premiums that have been received in advance of the coverage period. Premiums receivable represent only those premiums that have been billed to policyholders for coverage periods through the balance sheet date.

Reinsurance premiums assumed by the Company’s specialty reinsurance segment are estimated based on information provided by the ceding company. The information used in establishing these estimates is reviewed and subsequent adjustments are recorded in the period in which they are reported. These premiums are earned over the terms of the related reinsurance contracts.

Other Revenue

Other revenue primarily consists of service revenue related to claims adjusting and risk management services. Claims adjusting and risk management service revenue is earned over the term of the related contracts in proportion to the actual services rendered.

Losses and Loss Adjustment Expenses

A liability is established for the estimated unpaid losses and LAE of the Company’s workers’ compensation insurance segment under the terms of, and with respect to, its policies and agreements and includes amounts determined on the basis of claims adjusters’ evaluations and an amount based on past experience for losses incurred but not reported (“IBNR”).

The Company discounts its reserves for unpaid losses and LAE for worker’s compensation claims on a non-tabular basis, using a discount rate of 3%, based upon regulatory guidelines. The reserves for unpaid losses and LAE have been reduced for the effects of discounting by approximately $4,044 and $3,474 as of September 30, 2008 and December 31, 2007, respectively.

A liability is established for the estimated unpaid losses and LAE of the Company’s group benefits insurance segment as follows:

 

   

The liability for reported but unpaid long-term disability claims is calculated using the 1987 Commissioners Group Disability Table. The long-term disability reserves are discounted based on the expected rate of return of ELH’s fixed income portfolio in the year that the claim was incurred. The discount rate for claims incurred in 2008 and 2007 is 3.85% and 5.25%, respectively. The liability for IBNR claims is estimated on a policy-by-policy basis, taking into consideration average monthly premium, policy elimination periods, and an expected loss ratio.

 

   

The liability for reported but unpaid and IBNR dental and short-term disability claims is estimated using statistical claim development models, taking into consideration historical claim severity and frequency patterns and changes in benefit structures that may impact the amount at which claims are ultimately settled. For the most recent incurral months, which usually consist of the last three months, the liability is estimated by applying an expected loss ratio to net premiums earned, less claim payments through the balance sheet date.

 

   

The liability for reported but unpaid term 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 claims incurred as a percent of in-force premium as of the balance sheet date.

 

   

The liability for life premium waiver reserves represents the present value of future life insurance benefits under those term life insurance policies for which premium has been waived due to the insured’s disability. The liability for life premium waiver reserves is calculated using the 2005 Group Term Life Waiver Reserve Table for claims reported on or after October 1, 2007 and the 1970 Intercompany Group Life Disability Table for claims reported prior to October 1, 2007.

A liability is established for the estimated unpaid losses and LAE of the Company’s specialty reinsurance segment based on information provided by the ceding company. Premium and reported claim data provided by the ceding company is utilized by management to estimate the ultimate losses and LAE, including an amount for IBNR claims. As a result of a lag in receiving quarterly premium and reported claim data from the ceding company, the estimated unpaid losses and LAE are based on claim data one quarter in arrears.

The methods used to estimate the reserves for unpaid losses and LAE are reviewed periodically and any adjustments resulting therefrom are reflected in current operations.

Management believes that its reserves for unpaid losses and LAE are adequate as of September 30, 2008. However, estimating the ultimate liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates and judgments using data currently available. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded as of September 30, 2008, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.

 

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Reinsurance

In the ordinary course of business, the Company assumes and cedes reinsurance with other insurance companies. These arrangements provide greater diversification of business and minimize the net loss potential arising from large claims. Ceded reinsurance contracts do not relieve the Company of its obligation to its insureds. Premiums and claims under the Company’s reinsurance contracts are accounted for on a basis consistent with those used in accounting for the underlying policies reinsured and the terms of the reinsurance contracts. The Company has certain reinsurance contracts that provide for return premium based on the actual loss experience of the written and reinsured business. The Company estimates the amounts to be recorded for return premium based on the terms set forth in the reinsurance agreements and the expected loss experience.

The reinsurance recoverable for unpaid losses and LAE includes the balances due from reinsurance companies for unpaid losses and LAE that are expected to be recovered from reinsurers, based on contracts in force.

Policy Acquisition Costs

Policy acquisition costs consist primarily of commissions and premium taxes that vary with and are primarily related to the production of premium. Acquisition costs are deferred and amortized over the period in which the related premiums are earned. Deferred acquisition costs are limited to the estimated amounts recoverable after providing for losses and LAE that are expected to be incurred based upon historical and current experience. Anticipated investment income is considered in determining recoverability.

The Company’s group benefits insurance policies are cancelable and are not guaranteed renewable. In addition, the group benefits insurance policies provide coverage on a month-to-month basis with most policies’ coverage effective on the first of each month. As a result, most of the Company’s group benefits insurance premiums are earned as of the balance sheet date. Based on the nature of the Company’s group benefits insurance policies, costs related to the acquisition of new and renewal business are expensed as incurred.

Amortization of policy acquisition costs, before the impact of purchase accounting, totaled $1,380 and $(136) for the three months ended September 30, 2008 and 2007, respectively, and $5,093 and $3,410 for the nine months ended September 30, 2008 and 2007, respectively.

Income Taxes

Deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured using enacted tax rates and laws that are expected to be in effect when the difference is reversed. A valuation allowance is recorded against gross deferred tax assets if it is more likely than not that all or some portion of the benefits related to the deferred tax assets will not be realized.

Eastern Alliance, Allied Eastern, Eastern Advantage and ELH are generally not subject to state income taxes; rather, they are subject to state premium tax in the jurisdictions in which they write business. Employers Alliance and Eastern Services are subject to Pennsylvania state income tax.

Eastern Re is an exempt entity under the Companies Law of the Cayman Islands; however, Eastern Re’s earnings and profits are subject to federal income tax subsequent to June 16, 2006.

The Company includes income tax-related interest and penalties as a component of income tax expense. The Company did not incur any income tax-related interest or penalties during 2008 or 2007.

The Company’s federal income tax returns for tax years subsequent to December 31, 2003 are subject to examination by the Internal Revenue Service.

Policyholder Dividends

The Company issues certain workers’ compensation insurance policies with dividend payment features. These policyholders share in the operating results of their respective policies in the form of dividends. Dividends to policyholders are accrued during the period in which the related premiums are earned and are determined based on the terms of the individual policies. As of September 30, 2008 and December 31, 2007, the Company accrued dividends payable of $1,052 and $989, respectively, which are included in accounts payable and accrued expenses on the consolidated balance sheets.

Assessments

The Company is subject to state guaranty fund assessments in the Commonwealth of Pennsylvania, which provide for the payment of covered claims or to meet other insurance obligations from insurance company insolvencies. The Company’s assessments consist primarily of charges from the Workers’ Compensation Security Fund of Pennsylvania (“Security Fund”). The Security Fund serves as a guaranty fund to provide claim payments for those workers entitled to workers’ compensation benefits when the insurance company originally providing the benefits was placed into liquidation by a court. Security Fund assessments are established on an actuarial basis

 

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to provide an amount sufficient to pay the outstanding and anticipated claims in a timely manner, to meet the costs of the Pennsylvania Insurance Department (the “Insurance Department”) to administer the fund and to maintain a minimum balance in the fund of $500 million. If the Security Fund determines that the balance in the Security Fund is less than $500 million based on the actuarial study, then an assessment equal to one percent of direct premiums written is made to all companies licensed to write workers’ compensation in Pennsylvania. The Company recognizes a liability and the related expense for the assessments when premiums covered under the Security Fund are written; when an assessment from the Security Fund has been imposed or it is probable that an assessment will be imposed; and the amount of the assessment is reasonably estimable. As of September 30, 2008 and December 31, 2007, the Company accrued $881 and $0 related to the Security Fund assessment.

Goodwill and Intangible Assets

Goodwill represents the excess of cost over the fair value of net assets of businesses acquired. Goodwill and other intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but are instead tested for impairment at least annually. Intangible assets with estimable useful lives are amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets.”

Treasury Stock

The Company records the repurchase of shares of its common stock using the cost method. Under the cost method, treasury stock is recorded based on the actual cost of the shares repurchased.

Stock-Based Compensation

The Company adopted the Eastern Insurance Holdings, Inc. 2006 Stock Incentive Plan on December 18, 2006. Under the terms of the Plan, stock awards may be made in the form of incentive stock options, non-qualified stock options or restricted stock. The Company accounts for stock-based compensation in accordance with SFAS 123R, “Share-Based Payment”. In accordance with SFAS 123R, the Company records compensation expense based on the fair value of the stock award on the grant date using the straight-line attribution method.

Employee Stock Ownership Plan

The Company recognizes compensation expense related to its employee stock ownership plan (“ESOP”) equal to the product of the number of shares earned, or committed to be released, during the period, and the average price of the Company’s common stock during the period. The estimated fair value of unearned ESOP shares is calculated based on the average price of the Company’s common stock for the period. For purposes of calculating earnings per share, the Company includes the weighted average of ESOP shares committed to be released for the period.

Suspense shares, allocated shares, shares committed to be released, average price per share and stock compensation expense as of and for the three and nine months ended September 30, 2008 and 2007 were as follows (unaudited, in thousands, except share data):

 

     As of and for the Three Months
Ended September 30,
   As of and for the Nine Months
Ended September 30,
     2008    2007    2008    2007

Suspense shares

     635,375      710,125      635,375      710,125

Allocated shares

     112,125      37,375      112,125      37,375

Shares committed to be released

     18,841      18,841      56,318      56,216

Average price per share

   $ 14.49    $ 15.68    $ 15.04    $ 15.30

Stock compensation expense

   $ 273    $ 296    $ 847    $ 860

As of September 30, 2008 and December 31, 2007, the estimated fair value of unearned ESOP shares was $8,709 and $10,477, respectively.

Recent Accounting Pronouncements

SFAS 159

In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 159 (“SFAS 159”), “The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of FASB Statement No. 115.” SFAS 159 permits entities to elect to measure certain financial instruments at fair value with changes in fair value being reported in earnings. SFAS 159 can be applied on an instrument-by-instrument basis and is effective for all eligible financial instruments as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Retrospective application to prior years’ financial statements is not permitted. For eligible financial instruments existing at the effective date, and for which an

 

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entity elects the fair value option, the first remeasurement to fair value must be recorded as a cumulative effect adjustment to beginning retained earnings. The Company adopted SFAS 159 effective January 1, 2008; however, no election was made to measure the Company’s financial instruments at fair value. The adoption of SFAS 159 had no effect on the Company’s consolidated financial condition and results of operations.

SFAS 141R

In December 2007, the FASB issued Statement No. 141R, “Business Combinations” (“SFAS 141R”), which revises the accounting for business combination transactions previously accounted for under SFAS No. 141, “Business Combinations” (“SFAS 141”), and broadens the scope of transactions which should be accounted for under this standard. SFAS 141R retains the fundamental requirements of SFAS 141 in that the acquisition method of accounting is still used, and an acquirer must be identified in all business combinations. SFAS 141R applies prospectively to business combinations for 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 141R prior to that date. The Company is currently in the process of evaluating the impact of SFAS 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 160”), which establishes accounting and reporting standards for the non-controlling interests in a subsidiary and for the deconsolidation of a subsidiary. SFAS 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 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 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 160.

SFAS 161

In March 2008, the FASB issued Statement No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“SFAS 161”). SFAS 161 amends and expands the disclosure requirements of SFAS 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments and disclosures about credit-risk-related contingent features in derivative agreements. This statement is effective for financial statements issued for fiscal years beginning after November 15, 2008. The adoption of SFAS 161 will not affect the Company’s consolidated financial condition or results of operations, but may require additional disclosures if the Company enters into derivative and hedging activities.

SFAS 163

In May 2008, the FASB issued Statement No. 163, “Accounting for Financial Guarantee Insurance Contracts, an interpretation of FASB Statement No. 60” (“SFAS 163”). SFAS 163 clarifies how FASB Statement No. 60 applies to the recognition and measurement of premium revenue and claim liabilities under financial guarantee insurance contracts and requires expanded disclosures about financial guarantee insurance contracts. SFAS 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years, except for certain disclosures about an entity’s risk management activities. The Company does not currently write financial guarantee insurance contracts; therefore, the adoption of SFAS 163 will not affect the Company’s consolidated financial condition or results of operations.

3. Acquisition of ESHC

On September 29, 2008, EIHI acquired all of the outstanding stock of ESHC in a transaction valued at $14,820, including the assumption of $2,650 in debt. The acquisition of ESHC resulted in the recognition of certain intangible assets totaling $4,180 (Note 4) and goodwill totaling $2,917. ESHC reported total assets and total liabilities of $25,856 and $19,203, respectively, on the date of the transaction. ESHC’s shareholders’ equity of $6,653 on the date of the transaction was reduced by $10 as a result of purchase accounting adjustments to reflect the fair value of certain acquired assets and liabilities. The most significant purchase accounting adjustments related to the elimination of deferred acquisition costs, an increase to reserves for losses and LAE, and a decrease to unearned premiums. Direct costs related to the acquisition totaling $107 were capitalized and included in goodwill.

 

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4. Intangible Assets

The Company’s intangible assets consisted of the following as of September 30, 2008 and December 31, 2007(unaudited, in thousands):

 

     September 30, 2008    December 31, 2007

Intangible Assets with Finite Life

   Gross
Balance
   Accumulated
Amortization
   Gross
Balance
   Accumulated
Amortization

Agency relationships (15 year amortization period)

   $ 3,564    $ 625    $ 1,750    $ 447

Renewal rights (15 year amortization period)

     8,238      3,184      6,397      2,378
                           
   $ 11,802    $ 3,809    $ 8,147    $ 2,825
                           

Intangible Assets with Indefinite Life

                   

State insurance licenses

     1,575      —        1,050      —  
                           

Total intangible assets

   $ 13,377    $ 3,809    $ 9,197    $ 2,825
                           

The acquisition of ESHC resulted in the recognition of certain intangible assets, including renewal rights of $1,841, agency relationships of $1,814, and state insurance licenses of $525. The renewal rights and agency relationships will be amortized over their estimated useful lives of 15 years. The state insurance licenses are considered to have an infinite life and will not be amortized.

Amortization expense totaled $328 and $434 for the three months ended September 30, 2008 and 2007, respectively, and $984 and $1,303 for the nine months ended September 30, 2008 and 2007, respectively.

5. Earnings Per Share

Basic earnings per share are computed by dividing net income for the period by the weighted average number of shares outstanding for the respective period. Diluted earnings per share are computed by dividing net income for the period by the weighted average number of shares outstanding for the period, including dilutive potential common shares outstanding for the period. For the three months ended September 30, 2007, stock warrants of 306,099 and restricted stock awards of 30,187 have been included as dilutive potential common shares outstanding. For the nine months ended September 30, 2008 and 2007, stock warrants of 306,099 and restricted stock awards of 47,944 and 23,528, respectively, have been included as dilutive potential common shares outstanding. For the three months ended September 30, 2008 and 2007, there were 1,203,038 and 846,752 stock options and restricted stock awards, respectively, that were not included in the Company’s earnings per share calculation because to do so would have been anti-dilutive. For the nine months ended September 30, 2008 and 2007, there were 848,995 and 853,411 stock options and restricted stock awards, respectively, that were not included in the Company’s earnings per share calculation because to do so would have been anti-dilutive. Consolidated net income, basic shares outstanding, diluted shares outstanding, basic earnings per share, diluted earnings per share and cash dividends per share for the three and nine months ended September 30, 2008 and 2007 were as follows (unaudited, in thousands, except share and per share data):

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
     2008     2007    2008    2007

Consolidated net income

   $ (3,089 )   $ 3,561    $ 988    $ 11,026

Basic shares outstanding

     8,776,743       10,105,204      9,017,853      10,435,468

Diluted shares outstanding

     8,776,743       10,441,490      9,371,896      10,765,095

Basic earnings per share

   $ (0.35 )   $ 0.35    $ 0.11    $ 1.06

Diluted earnings per share

   $ (0.35 )   $ 0.34    $ 0.11    $ 1.02

Cash dividends per share

   $ 0.07     $ 0.05    $ 0.21    $ 0.10

6. Share Repurchase

During 2007, the Company’s Board of Directors authorized the repurchase of up to 2,046,500 shares of the Company’s issued and outstanding shares of common stock. The share repurchases are held as treasury stock and are available for issuance in connection with the Company’s 2006 Stock Incentive Plan. On March 24, 2008, the Company received approval from the Insurance Department to repurchase up to $10,000 of the Company’s issued and outstanding common stock, which is in addition to the 2,046,500 shares authorized in 2007. The Company repurchased 42,377 and 591,918 shares, at a cost of $647 and $9,070, for the three months ended September 30, 2008 and 2007, respectively. The Company repurchased 1,034,289 and 869,301 shares, at a cost of $16,719 and $13,226 for the nine months ended September 30, 2008 and 2007, respectively. The Company purchased an additional 18,290 shares, at a cost of $179, through November 4, 2008.

 

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7. Fair Value Measurements

The Company adopted Statement No. 157, “Fair Value Measurements” (“SFAS 157”) effective January 1, 2008. 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. The adoption of SFAS 157 had no impact on the Company’s consolidated financial condition or results of operation.

On February 12, 2008, SFAS 157 was amended by FASB Staff Position No. FAS 157-2 (“FSP FAS 157-2”). FSP FAS 157-2 delayed the effective date of SFAS 157 for non-financial assets and non-financial liabilities which are measured at fair value on a nonrecurring basis. Non-financial assets and non-financial liabilities which are measured at fair value on a recurring basis (i.e. at least annually) are not subject to this deferral. This deferral is effective until fiscal years beginning after November 15, 2008 and interim periods within those fiscal years. At that time, provisions of SFAS 157 will apply to non-financial assets and non-financial liabilities which are measured at fair value on a non-recurring basis.

As of September 30, 2008, the Company has no non-financial assets or non-financial liabilities that are measured at fair value on a recurring basis. The Company is currently evaluating the impact of measuring non-financial assets and non-financial liabilities on a non-recurring basis.

SFAS 157 requires assets and liabilities measured at fair value on a recurring basis to be segregated between those assets and liabilities that are valued based on quoted prices (unadjusted) in active markets for identical assets or liabilities, which the reporting entity can access at the measurement date (Level 1), direct or indirect observable inputs other than Level 1 quoted prices (Level 2), or unobservable inputs to the extent that observable inputs are not available (Level 3).

The following is a description of the Company’s categorization of the inputs used in the recurring fair value measurements of its financial assets included in its consolidated balance sheet as of September 30, 2008:

Level 1 – Represents financial assets whose fair value is determined based upon observable unadjusted quoted market prices for identical financial assets in active markets that the Company has the ability to access. An example of a Level 1 input utilized to measure fair value includes the closing price of one share of common stock on an active exchange market. The Company considers U.S. Treasuries and equity securities as Level 1 assets.

Level 2 – Represents financial assets whose fair value is determined based upon: quoted market prices for similar assets in active markets; quoted market prices for identical assets in inactive markets; inputs other than quoted market prices that are observable for the asset such as interest rates or yield curves; or other inputs derived principally from or corroborated from other observable market information. An example of a Level 2 input utilized to measure fair value, specifically for the Company’s fixed income portfolio, is “matrix pricing.” “Matrix pricing” relies on observable inputs from active markets other than quoted market prices including, but not limited to, benchmark securities and yields, latest reported trades, quotes from brokers or dealers, issuer spreads, bids, offers, and other relevant reference data to determine fair value. “Matrix pricing” is used to measure the fair value of fixed income securities where obtaining individual quoted market prices is impractical. The Company considers U.S. Government agencies, municipal bonds, mortgage-backed securities, collateralized mortgage obligations, asset-backed securities, corporate bonds, and convertible bonds as Level 2 assets.

Level 3 – Represents financial assets whose fail value is determined based upon inputs that are unobservable, including the Company’s own determinations of the assumptions that a market participant would use in pricing the asset. The Company considers its limited partnership investments as Level 3 assets.

The following table provides a summary of the fair value measurements of the Company’s fixed income securities, convertible bonds, and equity securities, as of September 30, 2008, excluding the segregated portfolio cell segment (unaudited, in thousands):

 

          Fair Value Measurements at Reporting
Date Using
     9/30/08    Level 1    Level 2    Level 3

Fixed income securities - available for sale

   $ 155,543    $ 10,635    $ 144,908    $ —  

Convertible bonds

     13,182      —        13,182      —  

Equity securities - available for sale

     18,385      18,385      —        —  
                           

Total

   $ 187,110    $ 29,020    $ 158,090    $ —  
                           

 

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The Company’s investments in fixed income securities, convertible bonds, and equity securities are valued through the use of a nationally recognized pricing service. The Company believes the scope of work performed when using data from outside parties is sufficient to validate the prices such that it does not rely upon these independent pricing services as experts, nor would it seek indemnification from them in the event the prices provided were deemed inappropriate. Where independent pricing services provide fair values, the Company has obtained an understanding of the methods, models and inputs used in pricing, and has controls in place to validate that amounts provided represent current exit values. The Company’s controls include, but are not limited to, initial and ongoing evaluation of methodologies used by outside parties as well as other techniques and assumptions to calculate fair value and comparing the fair value estimates to the Company’s knowledge of the current market. Fixed income securities include U.S. Treasuries, agencies backed by the U.S. Government, municipal bonds, mortgage-backed securities, collateralized mortgage obligations, asset-backed securities, and corporate bonds.

Other long-term investments include the Company’s interest in various limited partnerships, including a low volatility multi-strategy fund of funds, two natural resource limited partnerships, a municipal bond based limited partnership, an open-ended investment fund and a real estate limited partnership. The Company records its investment in the limited partnerships using the equity method. Changes in the Company’s investments are based on statements received directly from the limited partnership and/or the limited partnership’s administrator. The estimated fair values of the underlying investments in the limited partnerships may be based on Level 1, Level 2, or Level 3 inputs, or a combination thereof.

As of September 30, 2008 and December 31, 2007, the estimated fair values of the Company’s limited partnership investments, by investment strategy, were as follows (unaudited, in thousands):

 

     9/30/08    12/31/07

Multi-strategy fund of funds

   $ 5,617    $ 5,809

Natural resources

     2,855      3,312

Structured finance opportunity fund

     1,991      —  

Municipal bond arbitrage

     466      1,484

Open-ended investment fund

     520      622

Real estate

     67      73
             

Total

   $ 11,516    $ 11,300
             

The activity in the Company’s limited partnership investments for the three and nine months ended September 30, 2008 and 2007 was as follows (unaudited, in thousands):

 

     Three Months Ended September 30,    Nine Months Ended September 30,  
     2008     2007    2008     2007  

Balance, beginning of period

   $ 11,999     $ 10,394    $ 11,300     $ 11,572  

Contributions

     2,000       500      3,000       500  

Withdrawals

     (820 )     —        (820 )     (1,876 )

Unrealized change in interest

     (1,663 )     60      (1,964 )     758  
                               

Balance, end of period

   $ 11,516     $ 10,954    $ 11,516     $ 10,954  
                               

The change in interest in the Company’s limited partnership investments is included in net investment income in the consolidated statements of operations and comprehensive income (loss). As a result of the current credit market conditions, the municipal bond arbitrage fund experienced a permanent decline in value during the third quarter of 2008 and will be dissolved. The estimated fair value of the Company’s interest in the limited partnership as of September 30, 2008 reflects management’s best estimate of the proceeds the Company is expected to receive upon dissolution of the fund. As a result of these events, the Company recorded an impairment write-down of $1,397 as of and for the three and nine months ended September 30, 2008.

 

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8. Investments

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 has been in a continuous unrealized position as of September 30, 2008 and December 31, 2007 are as follows (unaudited, in thousands):

 

     Less Than 12 Months     12 Months or More     Total  

September 30, 2008

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

U.S. Treasuries and government agencies

   $ 8,195    $ (77 )   $ 501    $ (7 )   $ 8,696    $ (84 )

States, municipalities, and political subdivisions

     20,476      (545 )     235      (26 )     20,711      (571 )

Corporate securities

     9,585      (1,021 )     1,908      (136 )     11,493      (1,157 )

Mortgage-backed securities

     383      (1 )     —        —         383      (1 )

Other structured securities

     17,633      (726 )     4,400      (603 )     22,033      (1,329 )
                                             

Total fixed income securities

     56,272      (2,370 )     7,044      (772 )     63,316      (3,142 )

Equity securities

     17,276      (4,428 )     18      (5 )     17,294      (4,443 )
                                             

Total fixed income and equity securities

   $ 73,548    $ (6,798 )   $ 7,062    $ (777 )   $ 80,610    $ (7,575 )
                                             
     Less Than 12 Months     12 Months or More     Total  

December 31, 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 )
                                             

As of September 30, 2008, the Company held 148 fixed income securities with gross unrealized losses of $3,142. Management has evaluated the gross unrealized losses related to the fixed income securities and determined that the decline in the market value primarily reflects the current credit and liquidity issues in the fixed income markets and not the underlying credit quality of the issuer of the securities. Management has concluded that the carrying value of its fixed income securities in a gross unrealized loss position will be realized and that the Company has the ability and intent to hold them until that time.

As of September 30, 2008, the Company held 41 equity securities with gross unrealized losses of $4,443. The equity securities consist primarily of mutual fund instruments. Management has determined that the decline in market value is due to the broad decline in the equity securities markets.

As a result of the current adverse conditions in the credit markets, as well as the bankruptcy of Lehman Brothers Holdings, Inc. (“Lehman Brothers”), the Company recorded other-than-temporary investment impairments totaling $2,768 related to 8 fixed income securities as of and for the three and nine months ended September 30, 2008. The Company held 4 Lehman Brothers fixed income securities, which comprises $1,126 of the total impairment write-downs. The other impairment write-downs related primarily to collateralized mortgage obligations that had experienced a significant and prolonged decline in value as a result of the illiquidity in the credit markets. These securities continue to remain current on principal and interest payments; however, due to the significant and prolonged decline in value and the continued uncertainty surrounding the credit markets, management has determined that an impairment write-down is appropriate.

 

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9. Reserves for Unpaid Losses and Loss Adjustment Expenses

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, for the three and nine months ended September 30, 2008 and 2007 (unaudited, in thousands):

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2008     2007     2008     2007  

Balance, beginning of period

   $ 129,599     $ 125,650     $ 125,249     $ 121,397  

Reinsurance recoverables on unpaid losses and LAE

     24,260       24,663       23,429       24,236  
                                

Net balance, beginning of period

     105,339       100,987       101,820       97,161  

Net reserves acquired as a result of ESHC acquisition

     9,591       —         —         —    

Incurred related to:

        

Current year

     20,405       20,791       62,868       60,834  

Prior year

     2,362       862       867       (2,167 )
                                

Total incurred before purchase accounting adjustments

     22,767       21,653       63,735       58,667  

Purchase accounting adjustments

     (81 )     (155 )     (391 )     (692 )
                                

Total incurred

     22,686       21,498       63,344       57,975  

Paid related to:

        

Current year

     9,911       10,180       24,851       24,519  

Prior year

     9,229       7,540       31,428       25,852  
                                

Total paid

     19,140       17,720       56,279       50,371  
                                

Net balance, end of period

     118,476       104,765       118,476       104,765  

Reinsurance recoverables on unpaid losses and LAE

     24,032       24,261       24,032       24,261  
                                

Balance, end of period

   $ 142,508     $ 129,026     $ 142,508     $ 129,026  
                                

Total reserves for unpaid for losses and loss adjustment expenses

   $ 146,530     $ 133,910     $ 146,530     $ 133,910  

Less: Term life premium waiver reserves

     3,980       4,807       3,980       4,807  

Less: Other

     42       77       42       77  
                                

Balance, end of period

   $ 142,508     $ 129,026     $ 142,508     $ 129,026  
                                

Incurred losses by segment were as follows for the three and nine months ended September 30, 2008 and 2007 (unaudited, in thousands):

Three Months Ended September 30, 2008

 

     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

   $ 9,642     $ 3,803     $ 6,159     $ 1,189    $ 20,793  

Current period discount

     (285 )     (103 )     —         —        (388 )

Prior year, gross of discount

     —         (77 )     (54 )     2,271      2,140  

Accretion of prior period discount

     148       74       —         —        222  
                                       

Total incurred before purchase accounting adjustments

     9,505       3,697       6,105       3,460      22,767  

Purchase accounting adjustments

     (71 )     (14 )     —         4      (81 )
                                       

Total incurred

   $ 9,434     $ 3,683     $ 6,105     $ 3,464    $ 22,686  
                                       

 

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Three Months Ended September 30, 2007

 

     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

   $ 8,641     $ 4,535     $ 6,000    $ 1,725    $ 20,901  

Current period discount

     (60 )     (50 )     —        —        (110 )

Prior year, gross of discount

     (2,252 )     (1,133 )     206      4,056      877  

Accretion of prior period discount

     (23 )     8       —        —        (15 )
                                      

Total incurred before purchase accounting adjustments

     6,306       3,360       6,206      5,781      21,653  

Purchase accounting adjustments

     (137 )     (26 )     —        8      (155 )
                                      

Total incurred

   $ 6,169     $ 3,334     $ 6,206    $ 5,789    $ 21,498  
                                      

Nine Months Ended September 30, 2008

 

     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

   $ 27,651     $ 11,842     $ 19,769     $ 5,042    $ 64,304  

Current period discount

     (981 )     (455 )     —         —        (1,436 )

Prior year, gross of discount

     (2,500 )     (2,698 )     (670 )     5,394      (474 )

Accretion of prior period discount

     907       434       —         —        1,341  
                                       

Total incurred before purchase accounting adjustments

     25,077       9,123       19,099       10,436      63,735  

Purchase accounting adjustments

     (345 )     (66 )     —         20      (391 )
                                       

Total incurred

   $ 24,732     $ 9,057     $ 19,099     $ 10,456    $ 63,344  
                                       

Nine Months Ended September 30, 2007

 

     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

   $ 25,449     $ 12,204     $ 18,785     $ 5,844    $ 62,282  

Current period discount

     (979 )     (469 )     —         —        (1,448 )

Prior year, gross of discount

     (4,500 )     (2,158 )     (1,091 )     4,418      (3,331 )

Accretion of prior period discount

     787       377       —         —        1,164  
                                       

Total incurred before purchase accounting adjustments

     20,757       9,954       17,694       10,262      58,667  

Purchase accounting adjustments

     (621 )     (106 )     —         35      (692 )
                                       

Total incurred

   $ 20,136     $ 9,848     $ 17,694     $ 10,297    $ 57,975  
                                       

The Company’s results of operations include (unfavorable) favorable development on prior year reserves of $(2,140) and $474 for the three and nine months ended September 30, 2008, respectively, compared to (unfavorable) favorable development of $(877) and $3,331 for the same periods in 2007, respectively. The unfavorable development for the three months ended September 30, 2008 and 2007 primarily reflects an increase in reported claims from the ceding company related to prior accident years in the specialty reinsurance segment.

 

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10. Segment Information

The Company’s current operations are organized into the five following business segments.

Workers’ Compensation Insurance

The Company offers workers’ compensation insurance coverage to employers, primarily in Pennsylvania, Indiana, Maryland, Delaware and North Carolina. The Company offers a complete line of workers’ compensation products, including guaranteed cost and loss sensitive products.

Segregated Portfolio Cell Reinsurance

The Company offers alternative market workers’ compensation solutions to individual companies, groups and associations (referred to as “segregated portfolio cell dividend participants”) through the creation of segregated portfolio cells. The segregated portfolio cells are segregated pools of assets that function as insurance companies within an insurance company. The pool of assets and associated liabilities of each segregated portfolio cell are solely for the benefit of the segregated portfolio cell dividend participants, and the pool of assets of one segregated portfolio cell are statutorily protected from the creditors of the others. This permits the Company to provide customers with a turn-key alternative markets solution that includes program design, fronting, claims administration, risk management, segregated portfolio cell rental, investment and segregated portfolio management services. The segregated portfolio cell structure provides dividend participants the opportunity to share in both underwriting profit and investment income derived from their respective segregated portfolio cell’s financial results. The segregated portfolio cell reinsurance segment generated fee revenue to the Company’s workers’ compensation, specialty reinsurance, and corporate/other segments totaling approximately $910 and $864 for the three months ended September 30, 2008 and 2007, respectively, and $3,437 for the nine months ended September 30, 2008 and 2007.

Group Benefits Insurance

The Company’s group benefits insurance products include dental, short and long-term disability, and term life insurance. The group benefits insurance products are marketed to employers, primarily in the Mid-Atlantic, Southeast, and Midwest regions of the United States. Net premiums earned, by product, for the three and nine months ended September 30, 2008 and 2007 were as follows (unaudited in thousands):

 

     Three months ended September 30,    Nine months ended September 30,
     2008    2007    2008    2007

Dental

   $ 5,669    $ 5,564    $ 17,002    $ 16,097

Short-term disability

     1,625      1,657      4,932      4,962

Long-term disability

     385      413      1,205      1,263

Term life

     1,452      1,430      4,366      4,256
                           

Total

   $ 9,131    $ 9,064    $ 27,505    $ 26,578
                           

Specialty Reinsurance

Prior to July 1, 2008, the Company assumed business through 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 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 July 1, 2008, the reinsurance treaties that comprise the specialty reinsurance segment were terminated on a run-off basis. Net premiums earned, by program, for the three and nine months ended September 30, 2008 and 2007 were as follows (unaudited in thousands):

 

     Three months ended September 30,    Nine months ended September 30,  
     2008    2007    2008    2007  

EnviroGuard

   $ 1,723    $ 3,582    $ 6,588    $ 8,772  

EIA

     391      148      2,156      2,456  

Other

     —        175      6      383  

Purchase accounting

     —        —        —        (849 )
                             

Total

   $ 2,114    $ 3,905    $ 8,750    $ 10,762  
                             

 

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Corporate/Other

The corporate/other segment includes the holding company and third party administration activities of the Company, as well as certain eliminations necessary to reconcile the segment information to the consolidated statements of operations and comprehensive income (loss). The corporate/other segment also includes the Company’s 10% interest in a segregated portfolio cell with an unaffiliated primary carrier that writes insurance coverage for sprinkler contractors.

The following table represents the segment results for the three months ended September 30, 2008 (unaudited, in thousands):

 

     Workers’
Compensation
Insurance
    Segregated
Portfolio Cell
Reinsurance
    Group
Benefits
Insurance
    Specialty
Reinsurance
    Corporate/
Other
    Total  

Revenue:

            

Net premiums earned

   $ 15,822     $ 6,051     $ 9,131     $ 2,114     $ —       $ 33,118  

Net investment income

     (299 )     291       535       195       33       755  

Net realized investment (losses) gains

     (731 )     (706 )     (2,883 )     (263 )     65       (4,518 )

Other revenue

     —         —         —         361       (194 )     167  
                                                

Total revenue

     14,792       5,636       6,783       2,407       (96 )     29,522  
                                                

Expenses:

            

Losses and LAE incurred

     9,435       3,686       5,932       3,464       —         22,517  

Acquisition and other underwriting expenses

     1,322       1,872       1,383       635       (624 )     4,588  

Other expenses

     2,952       183       1,420       297       1,732       6,584  

Amortization of intangibles

     —         —         —         —         328       328  

Policyholder dividend expense

     325       —         —         —         —         325  

Segregated portfolio dividend expense

     —         (105 )     —         —         134       29  
                                                

Total expenses

     14,034       5,636       8,735       4,396       1,570       34,371  
                                                

Income (loss) before income taxes

     758       —         (1,952 )     (1,989 )     (1,666 )     (4,849 )

Income tax expense (benefit)

     231       —         (814 )     (696 )     (481 )     (1,760 )
                                                

Net income (loss)

   $ 527     $ —       $ (1,138 )   $ (1,293 )   $ (1,185 )   $ (3,089 )
                                                

Total assets

   $ 233,551     $ 54,171     $ 82,484     $ 46,428     $ (26,037 )   $ 390,597  
                                                

 

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The following table represents the segment results for the three months ended September 30, 2007 (unaudited, in thousands):

 

     Workers’
Compensation
Insurance
   Segregated
Portfolio Cell
Reinsurance
   Group
Benefits
Insurance
   Specialty
Reinsurance
    Corporate/
Other
    Total

Revenue:

               

Net premiums earned

   $ 15,217    $ 6,078    $ 9,064    $ 3,905     $ —       $ 34,264

Net investment income

     1,100      334      795      379       500       3,108

Net realized investment gains

     133      22      422      —         13       590

Other revenue

     —        —        —        121       58       179
                                           

Total revenue

     16,450      6,434      10,281      4,405       571       38,141
                                           

Expenses:

               

Losses and LAE incurred

     6,160      3,336      6,174      5,789       —         21,459

Acquisition and other underwriting expenses

     1,107      1,924      1,389      1,132       (1,455 )     4,097

Other expenses

     2,271      187      1,197      181       2,616       6,452

Amortization of intangibles

     —        —        —        —         434       434

Policyholder dividend expense

     95      —        —        —         —         95

Segregated portfolio dividend expense

     —        987      —        —         (207 )     780
                                           

Total expenses

     9,633      6,434      8,760      7,102       1,388       33,317
                                           

Income (loss) before income taxes

     6,817      —        1,521      (2,697 )     (817 )     4,824

Income tax expense (benefit)

     1,938      —        291      (1,207 )     241       1,263
                                           

Net income (loss)

   $ 4,879    $ —      $ 1,230    $ (1,490 )   $ (1,058 )   $ 3,561
                                           

Total assets

   $ 204,981    $ 50,400    $ 111,000    $ 50,038     $ (23,257 )   $ 393,162
                                           

The following table represents the segment results for the nine months ended September 30, 2008 (unaudited, in thousands):

 

     Workers’
Compensation
Insurance
    Segregated
Portfolio Cell
Reinsurance
    Group
Benefits
Insurance
    Specialty
Reinsurance
    Corporate/
Other
    Total  

Revenue:

            

Net premiums earned

   $ 45,961     $ 17,147     $ 27,505     $ 8,750     $ —       $ 99,363  

Net investment income

     1,077       855       2,161       881       468       5,442  

Net realized investment (losses) gains

     (836 )     (445 )     (3,212 )     33       247       (4,213 )

Other revenue

     —         —         —         776       (254 )     522  
                                                

Total revenue

     46,202       17,557       26,454       10,440       461       101,114  
                                                

Expenses:

            

Losses and LAE incurred

     24,733       9,057       18,684       10,456       —         62,930  

Acquisition and other underwriting expenses

     3,546       5,306       4,242       2,624       (1,494 )     14,224  

Other expenses

     8,137       234       4,179       623       5,940       19,113  

Amortization of intangibles

     —         —         —         —         984       984  

Policyholder dividend expense

     253       —         —         —         —         253  

Segregated portfolio dividend expense

     —         2,960       —         —         (358 )     2,602  
                                                

Total expenses

     36,669       17,557       27,105       13,703       5,072       100,106  
                                                

Income (loss) before income taxes

     9,533       —         (651 )     (3,263 )     (4,611 )     1,008  

Income tax expense (benefit)

     3,060       —         (501 )     (1,142 )     (1,397 )     20  
                                                

Net income (loss)

   $ 6,473     $ —       $ (150 )   $ (2,121 )   $ (3,214 )   $ 988  
                                                

Total assets

   $ 233,551     $ 54,171     $ 82,484     $ 46,428     $ (26,037 )   $ 390,597  
                                                

 

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The following table represents the segment results for the nine months ended September, 2007 (unaudited, in thousands):

 

     Workers’
Compensation
Insurance
   Segregated
Portfolio Cell
Reinsurance
   Group
Benefits
Insurance
   Specialty
Reinsurance
    Corporate/
Other
    Total

Revenue:

               

Net premiums earned

   $ 40,876    $ 17,010    $ 26,578    $ 10,762     $ —       $ 95,226

Net investment income

     3,475      967      2,365      1,154       1,365       9,326

Net realized investment gains (losses)

     744      181      1,347      (5 )     54       2,321

Other revenue

     —        —        —        525       (8 )     517
                                           

Total revenue

     45,095      18,158      30,290      12,436       1,411       107,390
                                           

Expenses:

               

Losses and LAE incurred

     20,125      9,850      17,696      10,297       —         57,968

Acquisition and other underwriting expenses

     2,683      5,093      4,159      2,861       (3,530 )     11,266

Other expenses

     5,867      395      3,969      539       7,207       17,977

Amortization of intangibles

     —        —        —        —         1,303       1,303

Policyholder dividend expense

     349      —        —        —         —         349

Segregated portfolio dividend expense

     —        2,820      —        —         (648 )     2,172
                                           

Total expenses

     29,024      18,158      25,824      13,697       4,332       91,035
                                           

Income (loss) before income taxes

     16,071      —        4,466      (1,261 )     (2,921 )     16,355

Income tax expense (benefit)

     4,836      —        1,309      (704 )     (112 )     5,329
                                           

Net income (loss)

   $ 11,235    $ —      $ 3,157    $ (557 )   $ (2,809 )   $ 11,026
                                           

Total assets

   $ 204,981    $ 50,400    $ 111,000    $ 50,038     $ (23,257 )   $ 393,162
                                           

11. Commitments and Contingencies

Legal Proceedings

The Company is subject to legal proceedings and claims that arise in the ordinary course of its business and have not been finally adjudicated. Although there can be no assurance as to the ultimate disposition of these matters, it is the opinion of the Company’s management, based upon the information available at this time, that the expected outcome of these matters, individually or in the aggregate, will not have a material adverse effect on the Company’s results of operations or financial condition.

12. Junior Subordinated Debentures

On May 15, 2008, the Company called its junior subordinated debentures at par. The Company paid $8,400 to satisfy its outstanding obligation related to the debentures, including accrued interest of $253.

13. Agency Stock Purchase Plan

On June 17, 2008, the Company announced its 2008 Agency Stock Purchase Plan (the “Stock Purchase Plan”). The purpose of the Stock Purchase Plan is to provide eligible insurance agencies of the Company with the opportunity to purchase the Company’s common stock at a discount from fair market value and is designed to foster the common interests of the Company and agencies in achieving long-term profitable growth for the Company. The Company has reserved 125,000 shares of its common stock for purchase under the Stock Purchase Plan for the five-year period ending June 30, 2013. Common stock issued under the Stock Purchase Plan will be issued from treasury stock.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of financial condition and results of operations should be read in conjunction with the unaudited interim consolidated financial statements of Eastern Insurance Holdings, Inc. (the “Company”) and the related notes thereto included in Item 1 of this Part 1. The information contained in this quarterly report is not a complete description of the Company’s business or the risks associated with an investment in the Company’s common stock. You should carefully review and consider the various disclosures made by the Company in this quarterly report and in the Company’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 14, 2008.

Forward-looking Statements

The Company may from time to time make written or oral “forward-looking statements,” including statements contained in the Company’s filings with the U.S. Securities and Exchange Commission (including this Quarterly Report on Form 10-Q and the exhibits hereto), in its reports to shareholders and in other communications by the Company, which are made in good faith by the Company pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995.

These forward-looking statements include statements with respect to the Company’s beliefs, plans, objectives, goals, expectations, anticipations, estimates and intentions, that are subject to significant risks and uncertainties, and are subject to change based on various factors (some of which are beyond the Company’s control). The words “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan” and similar expressions are intended to identify forward-looking statements. The following factors, among others, could cause the Company’s financial performance to differ materially from the plans, objectives, expectations, estimates and intentions expressed in such forward-looking statements:

 

   

the ability to carry out business plans;

 

   

future economic conditions in the regional and national markets in which we compete that are less favorable than expected, specifically in Pennsylvania, North Carolina, and Indiana;

 

   

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;

 

   

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 FASB 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.

 

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The Company cautions that the foregoing list of important factors is not exclusive. Readers are also cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date of this report. The Company does not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of the Company.

Overview

The Company’s results of operations for the three and nine months ended September 30, 2008, compared to the same periods in 2007 include the following:

 

   

A decrease in net premiums earned for the three months ended September 30, 2008, compared to the same period in 2007, primarily reflecting the impact of the termination of the quota share reinsurance treaty in the specialty reinsurance segment effective July 1, 2008;

 

   

Other-than-temporary impairments totaling $4.2 million for the three and nine months ended September 30, 2008, compared to no impairments for the same periods in 2007. The impairments include the write-down of an interest in a limited partnership totaling $1.4 million, which was reported as a reduction to net investment income in the workers’ compensation insurance segment;

 

   

Net realized investment losses related to the change in fair value of the Company’s convertible bond portfolio totaling $1.3 million and $2.4 million for the three and nine months ended September 30, 2008, compared to an increase of $208,000 and $28,000 for the same periods in 2007;

 

   

An increase in the loss ratio from 2007 to 2008, primarily reflecting unfavorable loss reserve development in the specialty reinsurance segment and a reduction in favorable loss reserve development from 2007 to 2008 in the workers’ compensation insurance segment;

 

   

An increase in the expense ratio from 2007 to 2008, primarily reflecting costs associated with the opening of a regional office in North Carolina, state licensing initiatives in the workers’ compensation segment, and integration activities related to the acquisition of ESHC. In addition, the specialty reinsurance segment’s expense ratio increased as a result of the reduction in and subsequent termination of the quota share reinsurance treaty; and

 

   

Purchase accounting adjustments that increased net income by $163,000 and $732,000 for three and nine months ended September 30, 2008, respectively, compared to adjustments that increased net income by $208,000 and $146,000 for the same periods in 2007, respectively.

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 specific 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, 2007, one-half of the premiums would be earned in 2007 and the other half would be earned in 2008. Workers’ compensation premiums are determined based upon the payroll of the insured, the applicable premium rates and, where applicable, an experience based modification factor. An audit of the policyholders’ records is conducted after policy expiration, to make a final determination of applicable premiums. Included in net premiums earned is an estimate for earned but unbilled final audit premiums. The Company 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 of payroll exposure 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,

 

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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 loss adjustment expenses. 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 of commissions, premium taxes and fees and other underwriting expenses incurred in acquiring, writing and administering the Company’s business as well as required payments to the Security Fund. 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 consolidated 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.

 

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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 segment.

Combined ratio. The combined ratio is the sum of the loss ratio and the 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.

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 insurance, 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 continues to be a complex and 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 ultimate losses, net of reinsurance, prove to be substantially higher than the amounts recorded as of September 30, 2008, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.

The Company discounts its workers’ compensation reserves, using a discount rate of 3%, which is based on regulatory guidelines. As of September 30, 2008 and December 31, 2007, the Company’s reserves for unpaid losses and LAE were reduced by $4.0 million and $3.5 million, respectively, related to the effects of discounting.

 

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The Company’s reserves for unpaid losses and LAE in its workers’ compensation insurance, segregated portfolio cell reinsurance, group benefits insurance, and specialty reinsurance segments as of September 30, 2008 (unaudited) and December 31, 2007 are summarized below (in thousands):

 

September 30, 2008

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

Case/tabular reserves

   $ 35,522     $ 11,208     $ 10,848    $ 15,002     $ 72,580  

Case incurred development, IBNR, and unallocated LAE reserves

     21,270       11,191       4,582      13,568       50,611  

Amount of discount

     (2,924 )     (1,120 )     —        —         (4,044 )
                                       

Net reserves

     53,868       21,279       15,430      28,570       119,147  

Reinsurance recoverables on unpaid losses and LAE

     5,362       2,832       17,995      —         26,189  

Purchase accounting adjustments

     1,134       95       —        (35 )     1,194  
                                       

Reserves for unpaid losses and LAE

   $ 60,364     $ 24,206     $ 33,425    $ 28,535     $ 146,530  
                                       

 

December 31, 2007

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

Case/tabular reserves

   $ 19,915     $ 8,906     $ 12,131    $ 10,873     $ 51,825  

Case incurred development, IBNR, and unallocated LAE reserves

     25,295       13,083       4,251      14,117       56,746  

Amount of discount

     (2,375 )     (1,099 )     —        —         (3,474 )
                                       

Net reserves

     42,835       20,890       16,382      24,990       105,097  

Reinsurance recoverables on unpaid losses and LAE

     2,709       2,033       18,900      —         23,642  

Purchase accounting adjustments

     941       161       —        (53 )     1,049  
                                       

Reserves for unpaid losses and LAE

   $ 46,485     $ 23,084     $ 35,282    $ 24,937     $ 129,788  
                                       

As a result of the economic uncertainty in the Company’s primary geographic markets and the potential impact on its insureds, management increased the absolute value of its workers’ compensation base case reserves during the third quarter of 2008. The increase in case reserves resulted in a reduction to the workers’ compensation IBNR reserves. The workers’ compensation case and IBNR reserves also reflect the acquisition of ESHC, which reported case and IBNR reserves of $5,991 and $1,524, respectively, as of September 30, 2008.

“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. For fixed income and equity securities, the amount written down is recorded in earnings as a realized loss on investments. For limited partnership investments, the amount written down is included as a reduction to net investment income. 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 three and nine months ended September 30, 2008, the Company recorded other-than-temporary investment impairments totaling $4.2 million. For the three and nine months ended September 30, 2007, the Company did not experience any declines in investment securities that were determined to be other-than-temporary. As of September 30, 2008, the Company held securities with gross unrealized losses of $7.6 million, of which $777,000 were in an unrealized loss position for more than 12 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:

Equities. 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. Equity securities in an unrealized loss position not meeting these quantitative thresholds are evaluated considering, among other things, 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 judged to be other-than-temporary, then the

 

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cost basis of the security is written down to realizable value. Equity securities whose market value has been below 80% of cost for more than six months are deemed other-than-temporarily impaired and are written down to net realizable value. Realizable value is defined as the quoted market price of the security.

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 contracted terms of a debt security not impaired at acquisition. A fixed income security review for collectibility is done 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.

Limited partnerships. A limited partnership investment is generally written down if the Company is unable to hold or otherwise intends to sell its interest in the limited partnership at a loss, or it management has received information that suggests the Company will be unable to recover its original investment in the limited partnership.

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 September 30, 2008 (unaudited) and December 31, 2007, deferred policy acquisition costs and the related unearned premium reserves were as follows (in thousands):

 

     September 30,
2008
   December 31,
2007

Workers’ compensation insurance segment:

     

Deferred policy acquisition costs

   $ 2,607    $ 1,924

Unearned premium reserves

   $ 37,583    $ 24,707

Segregated portfolio cell reinsurance segment:

     

Deferred policy acquisition costs

   $ 3,333    $ 2,137

Unearned premium reserves

   $ 12,233    $ 7,716

Group benefits insurance segment:

     

Deferred policy acquisition costs

   $ —      $ —  

Unearned premium reserves

   $ 78    $ 83

Specialty reinsurance segment:

     

Deferred policy acquisition costs

   $ 739    $ 2,196

Unearned premium reserves

   $ 2,462    $ 7,320

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. The profits and losses of the Company’s specialty reinsurance segment and investment income related to the Company’s ownership interests in certain segregated portfolio cells are subject to U.S. federal income tax under Subpart F of the Internal Revenue Code. However, a Subpart F taxable loss cannot be used to offset taxable income related to the Company’s domestic operations. As of September 30, 2008, the Company’s federal income tax estimate includes a net taxable loss related to Subpart F. As of September 30, 2008, management expects the net deferred tax asset, including the net operating loss related to Subpart F, to be 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 the Company’s reinsurers are estimated in a manner consistent with the claim liability 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 losses and LAE 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 LAE affect the estimates for the ceded portion of these liabilities. The Company continually monitors the financial condition of its reinsurers.

 

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Recent Accounting Pronouncements

SFAS 159

In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 159 (“SFAS 159”), “The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of FASB Statement No. 115.” SFAS 159 permits entities to elect to measure certain financial instruments at fair value with changes in fair value being reported in earnings. SFAS 159 can be applied on an instrument-by-instrument basis and is effective for all eligible financial instruments as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Retrospective application to prior years’ financial statements is not permitted. For eligible financial instruments existing at the effective date, and for which an entity elects the fair value option, the first remeasurement to fair value must be recorded as a cumulative effect adjustment to beginning retained earnings. The Company adopted SFAS 159 effective January 1, 2008; however, no election was made to measure the Company’s financial instruments at fair value. The adoption of SFAS 159 had no effect on the Company’s consolidated financial condition and results of operations.

SFAS 141R

In December 2007, the FASB issued Statement No. 141R, “Business Combinations” (“SFAS 141R”), which revises the accounting for business combination transactions previously accounted for under SFAS No. 141, “Business Combinations” (“SFAS 141”), and broadens the scope of transactions which should be accounted for under this standard. SFAS 141R retains the fundamental requirements of SFAS 141 in that the acquisition method of accounting is still used, and an acquirer must be identified in all business combinations. SFAS 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 141R prior to that date. The Company is currently in the process of evaluating the impact of SFAS 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 160”), which establishes accounting and reporting standards for the non-controlling interests in a subsidiary and for the deconsolidation of a subsidiary. SFAS 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 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 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 160.

SFAS 161

In March 2008, the FASB issued Statement No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“SFAS 161”). SFAS 161 amends and expands the disclosure requirements of SFAS 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments and disclosures about credit-risk-related contingent features in derivative agreements. This statement is effective for financial statements issued for fiscal years beginning after November 15, 2008. The adoption of SFAS 161 will not affect the Company’s consolidated financial condition or results of operations, but may require additional disclosures if the Company enters into derivative and hedging activities.

SFAS 163

In May 2008, the FASB issued Statement No. 163, “Accounting for Financial Guarantee Insurance Contracts, an interpretation of FASB Statement No. 60” (“SFAS 163”). SFAS 163 clarifies how FASB Statement No. 60 applies to the recognition and measurement of premium revenue and claim liabilities under financial guarantee insurance contracts and requires expanded disclosures about financial guarantee insurance contracts. SFAS 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years, except for certain disclosures about an entity’s risk management activities. The Company does not currently write financial guarantee insurance contracts; therefore, the adoption of SFAS 163 will not affect the Company’s consolidated financial condition or results of operations.

 

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RESULTS OF OPERATIONS

The major components of consolidated revenue were as follows for the three and nine months ended September 30, 2008 and 2007 (unaudited, in thousands):

 

     Three Months Ended September 30,    Nine Months Ended September 30,
     2008     2007    2008     2007

Net premiums written

   $ 33,314     $ 35,655    $ 108,752     $ 107,836
                             

Net premiums earned

   $ 33,118     $ 34,264    $ 99,363     $ 95,226

Net investment income

     755       3,108      5,442       9,326

Net realized investment (losses) gains

     (4,518 )     590      (4,213 )     2,321

Other revenue

     167       179      522       517
                             

Consolidated revenue

   $ 29,522     $ 38,141    $ 101,114     $ 107,390
                             

The decrease in consolidated revenue primarily reflects the aforementioned other-than-temporary investment impairments and the termination of the quota share reinsurance treaty.

The components of consolidated net (loss) income, by segment, for the three and nine months ended September 30, 2008 and 2007 were as follows (unaudited, in thousands):

 

     Three Months Ended September 30,     Nine Months Ended September 30,  
     2008     2007     2008     2007  

Workers’ compensation insurance

   $ 527     $ 4,879     $ 6,473     $ 11,235  

Segregated portfolio cell reinsurance

     —         —         —         —    

Group benefits insurance

     (1,138 )     1,230       (150 )     3,157  

Specialty reinsurance

     (1,293 )     (1,490 )     (2,121 )     (557 )

Corporate/other

     (1,185 )     (1,058 )     (3,214 )     (2,809 )
                                

Consolidated net (loss) income

   $ (3,089 )   $ 3,561     $ 988     $ 11,026  
                                

The decrease in consolidated net income primarily reflects the impact of the aforementioned other-than-temporary investment impairments and the increase in the loss and expense ratios as described earlier. The other-than-temporary impairments reduced net income in the workers’ compensation insurance, group benefits insurance, and specialty reinsurance segments by $1.9 million, $2.0 million, and $260,000, respectively, for the three and nine months ended September 30, 2008.

 

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WORKERS’ COMPENSATION INSURANCE

The following table represents the operations of the workers’ compensation insurance segment for the three and nine months ended September 30, 2008 and 2007 (unaudited, in thousands):

 

     Three Months Ended September 30,     Nine Months Ended September 30,  
     2008     2007     2008     2007  

Revenue:

        

Direct premiums written

   $ 26,416     $ 25,510     $ 83,067     $ 78,391  

Reinsurance premiums assumed

     128       293       535       1,078  

Ceded premiums written

     (7,287 )     (7,410 )     (27,908 )     (29,393 )
                                

Net premiums written

     19,257       18,393       55,694       50,076  

Change in unearned premiums

     (3,435 )     (3,176 )     (9,733 )     (9,199 )
                                

Net premiums earned

     15,822       15,271       45,961       40,876  

Net investment income

     (299 )     1,100       1,077       3,475  

Net realized investment (losses) gains

     (731 )     133       (836 )     744  
                                

Total revenue

   $ 14,792     $ 16,450     $ 46,202     $ 45,095  
                                

Expenses:

        

Losses and LAE incurred

   $ 9,435     $ 6,160     $ 24,733     $ 20,125  

Acquisition and other underwriting expenses

     1,322       1,107       3,546       2,683  

Other expenses

     2,952       2,271       8,137       5,867  

Policyholder dividend expense

     325       95       253       349  
                                

Total expenses

   $ 14,034     $ 9,633     $ 36,669     $ 29,024  
                                

Income before income taxes

     758       6,817       9,533       16,071  

Income tax expense

     231       1,938       3,060       4,836  
                                

Net income

   $ 527     $ 4,879     $ 6,473     $ 11,235  
                                

Net Income

The decrease in net income primarily reflects an increase in the loss and expense ratios and the impact of other-than-temporary investment impairments. The decrease in net income for the nine months ended September 30, 2008 was partially offset by the impact of purchase accounting adjustments, which increased net income by $224,000 in 2008, compared to a decrease in net income of $228,000 for the same period in 2007.

The workers’ compensation insurance ratios were as follows for the three and nine months ended September 30, 2008 and 2007:

 

     Three Months Ended September 30,     Nine Months Ended September 30,  
     2008     2007     2008     2007  

Loss and LAE ratio

   59.6 %   40.5 %   53.8 %   49.2 %

Expense ratio

   27.0 %   22.2 %   25.4 %   20.9 %

Policyholders’ dividend ratio

   2.1 %   0.6 %   0.6 %   0.9 %
                        

Combined ratio

   88.7 %   63.3 %   79.8 %   71.0 %
                        

Premiums

The increase in direct premiums written primarily reflects an increase in new business production and a decrease in the impact of purchase accounting adjustments from 2007 to 2008, partially offset by a decrease in the premium renewal retention rate and continued renewal rate decreases. Direct premiums written for traditional business and alternative markets were $20.4 million and $6.0 million, respectively, for the three months ended September 30, 2008 and $59.2 million and $23.9 million for the nine months ended September 30, 2008, respectively. Direct premiums written in 2008 and 2007 include the impact of renewal rate decreases of 7.6%. Premium renewal retention rates were 87.9% and 90.0%, respectively, in 2008 and 2007. New business production was $5.8 million and $17.5 million for the three and nine months ended September 30, 2008, respectively, compared to $3.7 million and $13.3 million for the same periods in 2007, respectively. Direct premiums written for the nine months ended September 30, 2007 includes a reduction of $1.2 million related to the amortization of purchase accounting adjustments. There were no purchase accounting adjustments in 2008 or for the three months ended September 30, 2007.

 

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Net Investment Income

The decrease in net investment income primarily reflects a decline in value of a limited partnership interest and a slight decrease in the portfolio yield. The decline in value of the limited partnership interest totaled $1.4 million and $1.9 million for the three and nine months ended September 30, 2008, including an impairment write-down of $1.4 million. The average yield on the fixed income portfolio was 4.34% as of September 30, 2008, compared to 4.49% as of September 30, 2007.

Net Realized Gains

Net realized investment losses for the three and nine months ended September 30, 2008 primarily reflect the decline in fair value of the convertible bond portfolio from 2007 to 2008 and other-than-temporary investment impairments totaling $504,000 recognized in the third quarter of 2008. The fair value of the convertible bond portfolio declined $206,000 and $474,000 for the three and nine months ended September 30, 2008, respectively, compared to an increase of $16,000 and $101,000 for the same periods in 2007, respectively. Net realized gains for the nine months ended September 30, 2007 also include gains recognized on the sale of an equity portfolio. There were no impairments recognized in 2007.

Losses and Loss Adjustment Expenses

The increase in the calendar period loss and LAE ratios primarily reflects a decrease in favorable loss reserve development on prior accident periods. The accident period loss and LAE ratio was 60.0% for the three months ended September 30, 2008 and the nine months ended September 30, 2008 and 2007. The accident period loss ratio was decreased from 62.0% to 60.0% during the third quarter of 2007, which further decreased the calendar period loss ratio for the three months ended September 30, 2007. Favorable loss reserve development on prior accident periods of $2.5 million was recorded for the nine months ended September 30, 2008, compared to $2.3 million and $4.5 million for the three and nine months ended September 30, 2007, respectively, which lowered loss ratios by 14.8 points for the three months ended September 30, 2007 and lowered loss ratios for the nine months ended September 30, 2008 and 2007 by 5.4 points and 10.7 points, respectively. There was no loss reserve development on prior accident periods recorded for the three months ended September 30, 2008. The favorable 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 2008 for amounts at, or less than, previously established case and IBNR reserves. This decrease had the effect of lowering loss development factors as of September 30, 2008. For the nine months ended September 30, 2008, the Company closed 315, or 44.7% of the 570 open lost time claims as of December 31, 2007. 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 2006, 2007, and the first half of 2008 enabled it to record losses and LAE that were lower than the amount reserved for claim settlements. For the three and nine months ended September 30, 2008, there was one claim that exceeded the Company’s $500,000 reinsurance retention, compared to no reinsured claims for the same period in 2007.

Acquisition and Other Underwriting Expenses

The increase in acquisition and other underwriting expenses primarily reflects growth in net premiums earned and a decrease in fee based revenue from the segregated portfolio reinsurance segment during 2008, which is netted against acquisition and other underwriting expenses.

Other Expenses

The increase in other expenses primarily reflects start-up costs incurred in conjunction with the Company’s expansion into the Southeast, due diligence and integration expenses associated with the acquisition of ESHC and other state licensing initiatives.

Policyholder Dividends

The increase in the policyholders’ dividend expense ratio is due to a decrease in the loss ratio of participating policies. Policyholder dividends represent payments to customers who purchased participating policies that produced favorable loss ratios. In 2008 and 2007, 10.9% and 10.1%, respectively, of all policies were written on a dividend policy basis.

Tax Expense

The effective tax rate for the three and nine months ended September 30, 2008 was 30.5% and 32.1%, respectively, and 28.4% and 30.1% for the three and nine months ended September 30 2007, respectively. The increase in the effective tax rate from 2007 to 2008 primarily reflects rehabilitation tax credits recognized in 2007.

 

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SEGREGATED PORTFOLIO CELL REINSURANCE

The following table represents the operations of the segregated portfolio cell reinsurance segment for the three and nine months ended September 30, 2008 and 2007 (unaudited, in thousands):

 

     Three Months Ended September 30,     Nine Months Ended September 30,  
     2008     2007     2008     2007  

Revenue:

        

Reinsurance premiums assumed

   $ 6,008     $ 5,718     $ 23,873     $ 22,958  

Ceded premiums written

     (792 )     (786 )     (2,209 )     (1,912 )
                                

Net premiums written

     5,216       4,933       21,664       21,047  

Change in unearned premiums

     835       1,145       (4,517 )     (4,037 )
                                

Net premiums earned

     6,051       6,078       17,147       17,010  

Net investment income

     291       334       855       967  

Net realized investment (losses) gains

     (706 )     22       (445 )     181  
                                

Total revenue

   $ 5,636     $ 6,434     $ 17,557     $ 18,158  
                                

Expenses:

        

Losses and LAE incurred

   $ 3,686     $ 3,336     $ 9,057     $ 9,850  

Acquisition and other underwriting expenses

     1,872       1,924       5,306       5,093  

Other expenses

     183       187       234       395  

Segregated portfolio dividend expense (1)

     (105 )     987       2,960       2,820  
                                

Total expenses

   $ 5,636     $ 6,434     $ 17,557     $ 18,158  
                                

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 three and nine months ended September 30, 2008 and 2007:

 

     Three Months Ended September 30,     Nine Months Ended September 30,  
     2008     2007     2008     2007  

Loss and LAE ratio

   60.9 %   54.9 %   52.8 %   57.9 %

Expense ratio

   34.0 %   34.7 %   32.3 %   32.3 %
                        

Combined ratio

   94.9 %   89.6 %   85.1 %   90.2 %
                        

Reinsurance Premiums Assumed

The increase in reinsurance premiums assumed primarily reflects an increase in new business production and a decrease in the impact of purchase accounting adjustments, partially offset by a decrease in audit premiums, a decrease in premium renewal retention rates and continued renewal rate decreases. New business sales totaled $690,000 and $2.7 million for the three and nine months ended September 30, 2008, respectively, compared to $625,000 and $1.7 million for the same periods in 2007, respectively. Reinsurance premiums assumed in 2008 and 2007 include the impact of renewal rate decreases of 4.0%. Premium renewal retention rates were 87.7% and 89.9%, respectively, in 2008 and 2007. The decrease in audit premiums reflects additional premium to the Company of $122,000 for the three months ended September 30, 2008 and return premium to customers of $344,000 for the nine months ended September 30, 2008, compared to additional premium to the Company of $413,000 and $572,000 for the three and nine months ended September 30, 2007, respectively. Reinsurance premiums assumed for the nine months ended September 30, 2007 includes a reduction of $849,000 related to the amortization of purchase accounting adjustments. There were no purchase accounting adjustments in 2008 or for the three months ended September 30, 2007.

 

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Net Investment Income

The decrease in net investment income primarily reflects a reduction in short-term interest rates from 2007 to 2008.

Net Realized Investment (Losses) Gains

Net realized investment losses for the three and nine months ended September 30, 2008 include other-than-temporary impairments of $478,000. There were no impairments recorded in 2007.

Losses and Loss Adjustment Expenses

The increase in the calendar period loss and LAE ratios from 2007 to 2008 reflects a decrease in favorable loss reserve development recorded on prior accident periods of $77,000 and $2.7 million for the three and nine months ended September 30, 2008, respectively, compared to $1.1 million and $2.2 million for the same periods in 2007, respectively, which lowered loss ratios for the three months ended September 30, 2008 and 2007 by 1.3 points and 18.6 points, respectively, and lowered loss ratios for the nine months ended September 30, 2008 and 2007 by 15.7 points and 12.4 points, respectively. The favorable loss reserve development on prior accident periods relates primarily to a decrease in the prior year loss development factors used to estimate losses and LAE. The decrease in accident period loss development factors relates primarily to significant prior year claim settlements during 2008 for amounts at, or less than, previously established case and IBNR reserves. This decrease had the effect of lowering loss development factors as of September 30, 2008. The accident period loss ratios were 62.4% and 68.9% for the three and nine months ended September 30, 2008, respectively, compared to 73.9% and 71.2% for the same periods in 2007, respectively.

Acquisition and Other Underwriting Expenses

The expense ratios are consistent with the contractual ceding commissions for the three and nine months ended September 30, 2008 and 2007.

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 three and nine months ended September 30, 2008 and 2007 (unaudited, in thousands):

 

     Three Months Ended September 30,     Nine Months Ended September 30,  
     2008     2007     2008     2007  

Revenue:

        

Direct premiums written

   $ 9,774     $ 9,737     $ 29,339     $ 28,607  

Ceded premiums written

     (643 )     (672 )     (1,838 )     (2,027 )
                                

Net premiums written

     9,131       9,065