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Eastern Insurance Holdings 10-Q 2008 Table of Contents
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
FORM 10-Q
for the Quarterly Period Ended June 30, 2008, or
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)
(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):
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.
Table of Contents
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Table of ContentsItem 1. Financial Statements EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Unaudited, in thousands, except share data)
See accompanying notes to unaudited consolidated financial statements.
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Table of ContentsEASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME For the Three and Six Months Ended June 30, 2008 and 2007 (Unaudited, in thousands, except per share data)
See accompanying notes to unaudited consolidated financial statements.
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Table of ContentsEASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY For the Three and Six Months Ended June 30, 2008 (Unaudited, in thousands, except share data) Three Months Ended June 30, 2008
Six Months Ended June 30, 2008
See accompanying notes to unaudited consolidated financial statements
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Table of ContentsEASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY For the Three Months Ended June 30, 2007 (Unaudited, in thousands, except share data) Three Months Ended June 30, 2007
Six Months Ended June 30, 2007
See accompanying notes to unaudited consolidated financial statements
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Table of ContentsEASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Six Months Ended June 30, 2008 and 2007 (Unaudited, in thousands)
See accompanying notes to unaudited consolidated financial statements.
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Table of ContentsEastern 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. The Company operates in five segments: workers’ compensation insurance, segregated portfolio cell reinsurance, group benefits insurance, specialty reinsurance, and corporate/other. See Note 9 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. 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 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
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Table of Contentsunrealized 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 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. 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 June 30, 2008 and December 31, 2007 and included in net premiums earned, totaled $1,500. 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.
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Table of ContentsOther 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 $3,401 and $3,474 as of June 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:
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 June 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 June 30, 2008, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity. 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.
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Table of ContentsPolicy 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 $1,919 and $1,658 for the three months ended June 30, 2008 and 2007, respectively, and $3,714 and $3,546 for the six months ended June 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 June 30, 2008 and December 31, 2007, the Company accrued dividends payable of $786 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 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 June 30, 2008 and December 31, 2007, the Company accrued $611 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.”
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Table of ContentsTreasury 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 six months ended June 30, 2008 and 2007 were as follows (unaudited, in thousands, except share data):
As of June 30, 2008 and December 31, 2007, the estimated fair value of unearned ESOP shares was $9,160 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 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.
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Table of ContentsSFAS 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. Intangible Assets The acquisition of EHC resulted in the identification of certain intangible assets, totaling $9,197. As of June 30, 2008 and December 31, 2007, intangible assets consisted of the following (unaudited, in thousands):
Amortization expense totaled $328 and $435 for the three months ended June 30, 2008 and 2007, respectively, and $656 and $869 for the six months ended June 30, 2008 and 2007, respectively. 4. 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 June 30, 2008 and 2007, stock warrants of 306,099 and restricted stock awards of 42,364 and 22,386, respectively, have been included as dilutive potential common shares outstanding. For the six months ended June 30, 2008 and 2007, stock warrants of 306,099 and restricted stock awards of 49,741 and 19,576, respectively, have been included as dilutive potential common shares outstanding. For the three months ended June 30, 2008 and 2007, there were 834,575 and 837,053 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.
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Table of ContentsFor the six months ended June 30, 2008 and 2007, there were 827,198 and 839,363 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 six months ended June 30, 2008 and 2007 were as follows (unaudited, in thousands, except share and per share data):
5. 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 252,699 and 210,970 shares, at a cost of $3,958 and $3,195, for the three months ended June 30, 2008 and 2007, respectively. The Company repurchased 991,912 and 277,383 shares, at a cost of $16,072 and $4,156 for the six months ended June 30, 2008 and 2007, respectively. The Company purchased an additional 28,079 shares, at a cost of $426, through August 6, 2008. 6. 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 June 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 June 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
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Table of Contentsother 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 June 30, 2008, excluding the segregated portfolio cell segment (unaudited, in thousands):
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 June 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):
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Table of ContentsThe activity in the Company’s limited partnership investments for the three and six months ended June 30, 2008 and 2007 was as follows (unaudited, in thousands):
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. 7. 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 June 30, 2008 and December 31, 2007 are as follows (unaudited, in thousands):
As of June 30, 2008, the Company held 69 fixed income securities with gross unrealized losses of $2,218. 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.
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Table of ContentsThe gross unrealized losses in the other structured securities primarily reflects two asset-backed securities with gross unrealized losses of $930,000 as of June 30, 2008. These securities are backed by home equity loans of prime borrowers and have been in a gross unrealized loss position for more than twelve months; however, management has evaluated the securities and determined that the losses are a result of the credit and liquidity issues in the market and are not due to the underlying credit quality of the loans. Management’s analysis included a review of the default rates of the underlying loans, available collateral, and other characteristics. In addition, the securities continue to be current on both principal and interest payments. 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 June 30, 2008, the Company held 6 equity securities with gross unrealized losses of $2,094. All of the equity securities are mutual fund instruments that have been in an unrealized loss position for less than twelve months. Management has determined that the decline in market value is due to the broad decline in the equity securities markets and that the decline is temporary. None of the equity securities have been in a gross unrealized loss position of less than 80% of cost for more than six months. 8. 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 six months ended June 30, 2008 and 2007 (unaudited, in thousands):
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Table of ContentsIncurred losses by segment were as follows for the three and six months ended June 30, 2008 and 2007 (unaudited, in thousands): Three Months Ended June 30, 2008
Three Months Ended June 30, 2007
Six Months Ended June 30, 2008
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Table of ContentsSix Months Ended June 30, 2007
The Company’s results of operations include favorable development on prior year reserves of $295 and $2,614 for the three and six months ended June 30, 2008, respectively, compared to favorable development of $1,474 and $4,209 for the same periods in 2007, respectively. The decrease in favorable development from 2007 to 2008 primarily reflects higher than expected reported losses related to prior accident years in the specialty reinsurance segment. The workers’ compensation insurance segment and the segregated portfolio cell reinsurance segment reported favorable development in 2008 and 2007, reflecting a decrease in prior accident period loss development factors as a result of claim settlements equal to, or less than, the previously established case and IBNR reserves. The favorable development in the group benefits insurance segment for the six months ended June 30, 2008 and 2007 primarily reflects better than anticipated loss experience on prior accident year reserves in the dental and short-term disability lines and prior year claim terminations in the long-term disability line during 2007. 9. 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, Maryland and Delaware. 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 $1,273 and $1,119 for the three months ended June 30, 2008 and 2007, respectively, and $3,779 and $4,053 for the six months ended June 30, 2008 and 2007, respectively.
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Table of ContentsGroup 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 six months ended June 30, 2008 and 2007 were as follows (unaudited in thousands):
Specialty Reinsurance The Company assumes business through its participation in reinsurance treaties with an unaffiliated insurance company related to an underground storage tank insurance program, referred to as “EnviroGuard,” and a non-hazardous waste transportation product, referred to as “EIA liability” (“EIA”). The EnviroGuard program provides coverage to underground 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. Net premiums earned, by program, for the three and six months ended June 30, 2008 and 2007 were as follows (unaudited in thousands):
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.
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Table of ContentsThe following table represents the segment results for the three months ended June 30, 2008 (unaudited, in thousands):
The following table represents the segment results for the three months ended June 30, 2007 (unaudited, in thousands):
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Table of ContentsThe following table represents the segment results for the six months ended June 30, 2008 (unaudited, in thousands):
The following table represents the segment results for the six months ended June 30, 2007 (unaudited, in thousands):
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Table of Contents10. 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. 11. 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. 12. 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. 13. Subsequent Event–Acquisition of Employers Security On August 6, 2008, the Company executed a definitive agreement to acquire Employers Security Holding Company and Subsidiaries (“Employers”) in a transaction valued at approximately $14.9 million, including the assumption of $2.9 million in debt. Employers’ wholly-owned subsidiary is Employers Security Insurance Company, an Indianapolis, Indiana based mono-line workers’ compensation insurance company.
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:
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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 six months ended June 30, 2008, compared to the same periods in 2007 include the following:
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.
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Table of ContentsNet 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, 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.
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Table of ContentsKey Financial Measures The Company evaluates its insurance operations by monitoring certain key measures of growth and profitability. The Company measures growth by monitoring changes in direct premiums written and net premiums written. The Company measures underwriting profitability by examining loss, expense and combined ratios. On a segmental basis, the Company measures a segment’s operating results by examining net income, diluted earnings per share, and return on average equity. Loss ratio. The loss ratio is the ratio (expressed as a percentage) of losses and LAE incurred to net premiums earned and measures the underwriting profitability of a company’s insurance business. The Company measures the loss ratio on an accident year and calendar year loss basis to measure underwriting profitability. An accident year loss ratio measures losses and LAE for insured events occurring in a particular year, regardless of when they are reported, as a percentage of net premiums earned during that year. A calendar year loss ratio measures losses and LAE for insured events occurring during a particular year and the change in loss reserves from prior accident years as a percentage of net premiums earned during that year. Expense ratio. The expense ratio is the ratio (expressed as a percentage) of the sum of the acquisition and other underwriting expenses and other expenses to net premiums earned and measures the Company’s operational efficiency in producing, underwriting and administering its insurance business. Policyholder dividend expense ratio. The policyholder dividend expense ratio is the ratio (expressed as a percentage) of policyholder dividend expense to net premiums earned and measures the impact of the Company’s policyholder dividend policies on its workers’ compensation 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 June 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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Table of ContentsThe Company discounts its workers’ compensation reserves, using a discount rate of 3%, which is based on regulatory guidelines. As of June 30, 2008 and December 31, 2007, the Company’s reserves for unpaid losses and LAE were reduced by $3,401 and $3,474, respectively, related to the effects of discounting. 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 June 30, 2008 (unaudited) and December 31, 2007 are summarized below (in thousands):
“Other Than Temporary” Investment Impairments Unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in shareholders’ equity as a component of comprehensive income (loss) and, accordingly, have no effect on net income. When, in the opinion of management, a decline in the fair value of an investment below its cost or amortized cost is considered to be “other-than-temporary,” such investment is written down to its fair value. The amount written down is recorded in earnings as a realized loss on investments. Generally, the determination of other-than-temporary impairment includes, in addition to other relevant factors, a presumption that if the market value is below cost by a significant amount for a period of time, a write-down is necessary. Notwithstanding this presumption, the determination of other-than-temporary impairment requires judgment about future prospects for an investment and is therefore a matter of inherent uncertainty. For the three and six months ended June 30, 2008 and 2007, the Company did not experience any declines in investment securities that were determined to be other-than-temporary. As of June 30, 2008, the Company held securities with gross unrealized losses of $4,312, of which $1,799 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 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.
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Table of ContentsFixed 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:
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 June 30, 2008 (unaudited) and December 31, 2007, deferred policy acquisition costs and the related unearned premium reserves were as follows (in thousands):
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. Management expects that the net deferred tax asset is fully recoverable. If this assumption were to change, any amount of the net deferred tax asset that the Company could not expect to recover would be provided for as an allowance and would be reflected as an increase in income tax expense in the period in which it was established. Reinsurance Recoverables Amounts recoverable from 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. 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.
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Table of ContentsSFAS 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. RESULTS OF OPERATIONS The major components of consolidated revenue were as follows for the three and six months ended June 30, 2008 and 2007 (unaudited, in thousands):
The decrease in consolidated revenue for the three months ended June 30, 2008, compared to the same period in 2007, primarily reflects the impact of the fixed income and equity securities markets. The decrease in net investment income primarily reflects a decline in a limited partnership interest totaling $571,000, lower fixed income securities as a result of the Company’s stock buyback program and the repayment of the junior subordinated debentures, and lower short-term interest rates. The decrease in net realized investment gains primarily reflects a decline in the fair value of the Company’s convertible bond portfolio.
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Table of ContentsThe components of consolidated net income (loss), by segment, for the three and six months ended June 30, 2008 and 2007 were as follows (unaudited, in thousands):
The decrease in consolidated net income primarily reflects the decreases in net investment income and net realized investment gains, unfavorable prior year reserve development in the specialty reinsurance segment and an increase in the group benefits loss ratio. WORKERS’ COMPENSATION INSURANCE The following table represents the operations of the workers’ compensation insurance segment for the three and six months ended June 30, 2008 and 2007 (unaudited, in thousands):
Net Income The decrease in net income primarily reflects an increase in the expense ratio and a decrease in net investment income, partially offset by a decrease in the calendar period loss and LAE ratio and impact of purchase accounting adjustments. Purchase accounting adjustments increased net income by $89,000 and $178,000 for the three and six months ended June 30, 2008, respectively, compared to an increase of $45,000 and a decrease of $317,000 for the same periods in 2007, respectively.
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Table of ContentsThe workers’ compensation insurance ratios were as follows for the three and six months ended June 30, 2008 and 2007:
Premiums The increase in direct premiums written primarily reflects an improved premium renewal retention rate and a decrease in the impact of purchase accounting adjustments, partially offset by renewal rate decreases of 7.2% in 2008, compared to rate decreases of 3.8% in 2007. Direct premiums written for traditional business and alternative markets were $16.5 million and $6.0 million, respectively, for the three months ended June 30, 2008 and $38.8 million and $17.9 million for the six months ended June 30, 2008, respectively. Direct premiums written include the impact of premium renewal retention rates of 88.8% and 88.5%, respectively, for 2008 and 2007. Direct premiums written for the three and six months ended June 30, 2007 includes a reduction of $214,000 and $1.2 million, respectively, related to the amortization of purchase accounting adjustments, compared to no purchase accounting amortization in 2008. Net Investment Income The decrease in net investment income primarily reflects a decline in value on a limited partnership interest and a slight decrease in the portfolio yield. The average yield on the fixed income portfolio was 4.42% as of June 30, 2008, compared to 4.51% as of June 30, 2007. Net Realized Gains The decrease in net realized investment gains primarily reflects the decline in the fair value of the convertible bond portfolio from 2007 to 2008. The fair value of the convertible bond portfolio declined $121,000 and $269,000 for the three and six months ended June 30, 2008, respectively, compared to an increase of $27,000 and $84,000 for the same periods in 2007, respectively. Net realized gains for the six months ended June 30, 2007 also include gains recognized on the sale of an equity portfolio. Losses and Loss Adjustment Expenses The decrease in the calendar period loss and LAE ratios primarily reflects a decrease in the current accident period loss ratio. The accident period loss and LAE ratio was 60.0% for the three and six months ended June 30, 2008, compared to 62.0% for the three and six months ended June 30, 2007. Favorable loss reserve development on prior accident periods of $1.0 million and $2.5 million was recorded for the three and six months ended June 30, 2008, respectively, compared to $1.2 million and $2.2 million for the same periods in 2007, respectively. 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 June 30, 2008. For the three and six months ended June 30, 2008, the Company closed 94, or 16.5%, and 193 or 33.9%, respectively, 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 to a lesser extent in 2008 enabled it to record losses and LAE that were lower than the amount reserved for claim settlements. For the three and six months ended June 30, 2008 and 2007, there were no claims that exceeded the Company’s $500,000 reinsurance retention. 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 and other state licensing initiatives.
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Table of ContentsPolicyholder Dividends The decrease in the policyholders’ dividend ratio is due to an increase 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, 12.5% and 11.1%, respectively, of all policies were written on a dividend policy basis. Tax Expense The effective tax rate for the three and six months ended June 30, 2008 was 33.5% and 32.2%, respectively, and 30.0% and 31.3% for the three and six months ended June 30 2007, respectively. The increase in the effective tax rate from 2007 to 2008 primarily reflects rehabilitation tax credits recognized in 2007. SEGREGATED PORTFOLIO CELL REINSURANCE The following table represents the operations of the segregated portfolio cell reinsurance segment for the three and six months ended June 30, 2008 and 2007 (unaudited, in thousands):
The segregated portfolio cell reinsurance ratios were as follows for the three and six months ended June 30, 2008 and 2007:
Reinsurance Premiums Assumed The increase in reinsurance premiums assumed primarily reflects an improved premium renewal retention rate, increased new business production, and a decrease in the impact of purchase accounting adjustments, partially offset by a decrease in audit premiums
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Table of Contentsand continued renewal rate decreases. New business sales totaled $1.2 million and $2.0 million for the three and six months ended June 30, 2008, respectively, compared to $324,000 and $1.1 million for the same period in 2007, respectively. Reinsurance premiums assumed in 2008 and 2007 include the impact of renewal rate decreases of 2.6% and 3.4%, respectively, and premium renewal retention rates of 89.8% and 89.5%, respectively. The decrease in audit premiums reflects return premium to customers of $110,000 and $466,000 for the three and six months ended June 30, 2008, respectively, compared to additional premium to the Company of $44,000 and $159,000 for the three and six months ended June 30, 2007, respectively. Reinsurance premiums assumed for the three and six months ended June 30, 2007 includes a reduction of $198,000 and $849,000, respectively, related to the amortization of purchase accounting adjustments, compared to no purchase accounting amortization in 2008. Losses and Loss Adjustment Expenses The decrease in the calendar period loss and LAE ratios from 2007 to 2008 reflects favorable loss reserve development recorded on prior accident periods of $2.0 million and $2.6 million for the three and six months ended June 30, 2008, respectively, compared to $544,000 and $1,026,000 for the same periods in 2007, respectively, which lowered loss ratios for the three months ended June 30, 2008 and 2007 by 35.9 points and 9.8 points, respectively, and lowered loss ratios for the six months ended June 30, 2008 and 2007 by 23.6 points and 9.4 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 June 30, 2008. Purchase accounting adjustments recorded in 2007 increased the calendar period loss ratio by 1.0 points and 1.7 points for the three and six months ended June 30, 2007, respectively, compared to negligible purchase accounting adjustments in 2008. Acquisition and Other Underwriting Expenses The expense ratios are consistent with the contractual ceding commissions for the three and six months ended June 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 six months ended June 30, 2008 and 2007 (unaudited, in thousands):
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Table of ContentsNet Income The decrease in net income from 2007 to 2008 primarily reflects an increase in the calendar period loss ratio and a reduction in net realized investment gains. The increase in the loss ratio primarily reflects increased utilization in the dental line and the negative loss ratio in the long-term disability line in 2007. Net realized investment gains (losses) in 2008 reflect the decline in the fair market value of the convertible bond portfolio, which is related to the current conditions in the equity securities markets. The group benefits insurance ratios were as follows for the three and six months ended June 30, 2008 and 2007:
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