Employers Holdings 10-Q 2010
WASHINGTON, DC 20549
þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE>
ACT OF 1934
For the Quarterly Period Ended June 30, 2010
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from ____ to ____
Commission file number: 001-33245
EMPLOYERS HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” “non-accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
PART I – FINANCIAL INFORMATION>
Employers Holdings, Inc. and Subsidiaries
1. Basis of Presentation
Employers Holdings, Inc. (EHI) is a holding company and through its four wholly-owned insurance subsidiaries, Employers Insurance Company of Nevada (EICN), Employers Compensation Insurance Company (ECIC), Employers Preferred Insurance Company (EPIC), and Employers Assurance Company (EAC), is engaged in the commercial property and casualty insurance industry, specializing in workers’ compensation products and services. EICN, domiciled in Nevada, ECIC, domiciled in California, and EPIC and EAC, both domiciled in Florida, provide insurance to employers against liability for workers’ compensation claims in 30 states and the District of Columbia. Unless otherwise indicated, all references to the “Company” refer to EHI, together with its subsidiaries.
The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities 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 (consisting of normal, recurring adjustments) necessary for a fair presentation of the Company’s consolidated financial position and results of operations 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 have been prepared consistent with the accounting policies described in the Company’s 2009 Annual Report on Form 10-K for the year ended December 31, 2009.
The Company considers an operating segment to be any component of its business whose operating results are regularly reviewed by the Company’s chief operating decision makers to make decisions about resources to be allocated to the segment and assess its performance based on discrete financial information. Currently, the Company has one operating segment: workers’ compensation insurance and related services.
Estimates and Assumptions
The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. As a result, actual results could differ from these estimates. The most significant areas that require management judgment are the estimate of unpaid losses and loss adjustment expenses (LAE), evaluation of reinsurance recoverables, recognition of premium revenue, deferred policy acquisition costs, deferred income taxes, and the valuation of goodwill and investments.
Certain prior period information has been reclassified to conform to the current period presentation.
2. New Accounting Standards
In January 2010, the Financial Accounting Standards Board issued Update Number 2010-06, Improving Disclosures about Fair Value Measurements to Accounting Standards Codification (ASC) Topic 820, Fair Value Measurements and Disclosures. The update changes fair value disclosures by requiring: (a) separate disclosure of the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and a description of the reasons for the transfers; and (b) separate information about purchases, sales, issuances, and settlements of Level 3 fair value measurements. The update clarifies existing disclosures by requiring: (a) fair value measurement disclosures for each class of assets and liabilities; and (b) disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements that fall in either Level 2 or Level 3. The Company adopted the standard that required disclosures for fiscal periods beginning after December 15, 2009 (Note 4). The adoption of these requirements did not have a material impact on the consolidated financial statements. As required, the Company will present the disclosures regarding the purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements for fiscal periods beginning after December 15, 2010.
The amortized cost, gross unrealized gains, gross unrealized losses, and estimated fair value of the Company’s investments were as follows:
The amortized cost and estimated fair value of fixed maturity securities at June 30, 2010, by contractual maturity, are shown below. Expected maturities differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The following is a summary of investments that have been in a continuous unrealized loss position for less than 12 months and those that have been in a continuous unrealized loss position for 12 months or greater as of June 30, 2010 and December 31, 2009.
Based on reviews of the fixed maturity securities, the Company determined that unrealized losses as of June 30, 2010 and 2009 were primarily the result of changes in prevailing interest rates and not the credit quality of the issuers. The fixed maturity securities whose fair values were less than amortized cost were not determined to be other-than-temporarily impaired given the severity and duration of the impairment, the credit quality of the issuers and the Company’s intent on not selling the securities and a determination was made that it is not more likely than not that the Company will be required to sell the securities until fair value recovers above cost, or to maturity.
Based on reviews of the equity securities as of June 30, 2010, the Company determined that the unrealized losses as of that date were not considered to be other-than-temporary due to the financial condition and near term prospects of the issuers. Based on reviews of the equity securities as of June 30, 2009, the Company recognized total impairments of $1.9 million in the fair values of 26 equity securities as of that date because of the severity and duration of the change in fair values of those securities.
Net realized gains (losses) and the change in unrealized gains (losses) on fixed maturity and equity securities are determined on a specific-identification basis and were as follows:
Net investment income was as follows:
The Company is required by various state laws and regulations to keep securities or letters of credit on deposit in depository accounts with the states in which we do business. As of June 30, 2010 and December 31, 2009, securities having a fair value of $565.1 million and $554.2 million, respectively, were on deposit. These laws and regulations govern not only the amount, but also the type of security that is eligible for deposit. In all states the deposits are limited to fixed maturity securities. Additionally, certain reinsurance contracts require Company funds to be held in trust for the benefit of the ceding reinsurer to secure the outstanding liabilities assumed by the Company. The fair value of securities held in trust for reinsurance at June 30, 2010 and December 31, 2009 was $6.0 million and $6.1 million, respectively.
4. Fair Value of Financial Instruments
The estimated fair values of the Company’s financial instruments as of June 30, 2010, are as follows:
As of December 31, 2009, the estimated fair value of the Company's financial instruments was equal to the carrying value.
The Company’s estimate of fair value for financial assets and liabilities is based on the inputs used in the valuation and gives the highest priority to quoted prices in active markets and requires that observable inputs be used in the valuation when available. The disclosure of fair value estimates is based on whether the significant inputs into the valuation are observable. In determining the level of the hierarchy in which the estimate is disclosed, the highest priority is given to unadjusted quoted prices in active markets and the lowest priority to unobservable inputs that reflect the Company’s significant market assumptions. The three levels of the hierarchy are as follows:
Level 1 - Unadjusted quoted market prices for identical assets or liabilities in active markets that the Company has the ability to access.
Level 2 - Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in inactive markets; or valuations based on models where the significant inputs are observable (e.g., interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.) or can be corroborated by observable market data.
Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement and involve management judgment. The fair values of certain privately held or thinly traded securities are determined using internal analytical methods based on the best information available.
Valuation of Investments. For investments that have quoted market prices in active markets, the Company uses the unadjusted quoted market prices as fair value and includes these prices in the amounts disclosed in Level 1 of the hierarchy. When quoted market prices are unavailable, the Company estimates fair value based on objectively verifiable information, if available. The fair value estimates determined by using objectively verifiable information are included in the amount disclosed in Level 2 of the hierarchy. If quoted market prices and an estimate determined by using objectively verifiable information are unavailable, the Company produces an estimate of fair value based on internally
developed valuation techniques, which, depending on the level of observable market inputs, will render the fair value estimate as Level 2 or Level 3. The Company bases all of its estimates of fair value for assets on the bid price as that represents what a third party market participant would be willing to pay in an arm’s length transaction. The valuation methods used by the Company, by type of investment, are described below.
Equity Securities. The Company utilizes market quotations for equity securities that have quoted prices in active markets.
Fixed Maturity Securities and Short-Term Investments. Estimates of fair value measurements for these securities are estimated using relevant inputs including available market information, benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing. Additionally, an Option Adjusted Spread model is used to develop prepayment and interest rate scenarios. Industry standard models are used to analyze and value securities with embedded options or prepayment sensitivities.
Derivatives. The fair value of the Company’s interest rate swap, reported as a component of other liabilities in the accompanying consolidated balance sheets, is derived by using an industry standard swap valuation model, with market-based inputs for swaps having similar characteristics.
Each asset class is valued based on relevant market information, credit information, perceived market movements, and sector news. The market inputs utilized in the valuation include: benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, reference data, and industry and economic events. The extent of the use of each market input depends on the asset class and the market conditions. Depending on the security, the priority of the use of inputs may change or some market inputs may not be relevant. For some securities, additional inputs may be necessary.
These methods of valuation will only produce an estimate of fair value if there is objectively verifiable information to produce a valuation. If objectively verifiable information is not available, the Company produces an estimate of fair value using some of the same methodologies, making assumptions for market based inputs that are unavailable.
Most estimates of fair value for fixed maturities and investments are based on estimates using objectively verifiable information and are included in the amount disclosed in Level 2 of the hierarchy. The fair value estimates for determining Level 3 fair value include the Company’s assumptions about risk assessments and market participant assumptions based on the best information available, including quotes from market makers and other broker/dealers recognized as market participants, using standard or trade derived inputs, new issue data, monthly payment information, cash flow generation, prepayment speeds, spread adjustments, and/or rating updates.
The following table presents the items on the accompanying consolidated balance sheets that are stated at fair value and the fair value measurements.
5. Income Taxes
Income tax expense for interim periods is measured using an estimated effective tax rate for the annual period. During the six months ended June 30, 2010 and 2009, the Company recognized net income before taxes of $33.7 million and $43.3 million and an income tax expense of $1.1 million and $2.1 million, yielding effective tax rates of 3.3% and 4.9%, respectively. The following is a reconciliation of the federal statutory income tax rates to the Company’s effective tax rates.
6. Liability for Unpaid Losses and Loss Adjustment Expenses
The following table represents a reconciliation of changes in the liability for unpaid losses and LAE for the six months ended:
The reduction in the liability for unpaid losses and LAE attributable to insured events for prior periods was $16.6 million and $29.2 million for the six months ended June 30, 2010 and 2009, respectively. The major sources of favorable development in both periods were actual paid losses being less than expected and the impact of new information on selected claim payments and emergence patterns used in the projection of future loss payments.
7. LPT Agreement
The Company is party to a 100% quota share retroactive reinsurance agreement (LPT Agreement) under which $1.5 billion in liabilities for losses and LAE related to claims incurred by EICN prior to July 1, 1995, were reinsured for consideration of $775.0 million. The LPT Agreement provides coverage up to $2.0 billion. The initial Deferred Gain resulting from the LPT Agreement was recorded as a liability in the accompanying consolidated balance sheets and is being amortized using the recovery method, whereby the amortization is determined by the proportion of actual reinsurance recoveries to total estimated recoveries. The Company amortized $4.4 million of the Deferred Gain for both the three months ended June 30, 2010 and 2009, and amortized $8.7 million of the Deferred Gain for both the six months ended June 30, 2010 and 2009. Any adjustments to the Deferred Gain are recorded in losses and LAE incurred in the accompanying consolidated statements of income. No adjustments occurred in the current period. The remaining Deferred Gain was $379.9 million and $388.6 million as of June 30, 2010 and December 31, 2009, respectively, and is included in the accompanying consolidated balance sheets.
8. Accumulated Other Comprehensive Income
Accumulated other comprehensive income is comprised of unrealized gain on investments classified as available-for-sale and unrealized losses on interest rate swap, net of deferred tax expense. The following table summarizes the components of accumulated other comprehensive income.
The following table summarizes the changes in the components of total comprehensive income for the periods presented.
9. Stock-Based Compensation
On March 30, 2010, 406,020 stock options and 163,660 restricted stock units (RSUs) were awarded to certain officers of the Company. The fair value of the RSUs on the grant date and the per share exercise price of the stock options was $15.31. The stock options have a service vesting period of four years and vest 25% on March 30, 2011, and 25% on each of the subsequent three anniversaries of such date. The stock options are subject to accelerated vesting in circumstances of death or disability of the holder or in connection with a change of control of the Company. The stock options expire seven years from the date of grant. The aggregate fair value of the stock options and RSUs on the date of grant was $2.4 million and $2.5 million, respectively.
On May 27, 2010, 30,728 RSUs were awarded to the directors of the Company. The fair value of the RSUs on the grant date was $15.62 per share and the total fair value on the date of grant was $0.5 million.
During the first quarter of 2010, the EHI Board of Directors certified the performance period results of the performance share units (PSUs) awarded in 2007, resulting in the vesting of 196,071 shares of common stock. During the second quarter of 2010, RSUs which were awarded in prior periods to directors and executives vested into 40,536 and 78,091 shares of common stock, respectively. Of the 314,698 share awards that vested for both PSUs and RSUs, 81,327 shares of common stock were withheld to satisfy minimum employee tax withholding.
10. Earnings Per Share
Basic earnings per share includes no dilution and is computed by dividing income applicable to stockholders by the weighted average number of shares outstanding for the period. Diluted earnings per share reflects the potential dilutive impact of all convertible securities on earnings per share. Diluted earnings per share includes shares assumed issued under the “treasury stock method,” which reflects the potential dilution that would have occurred had shares been repurchased from the proceeds of potentially dilutive shares.
The following table presents the net income and the weighted average common shares outstanding used in the earnings per common share calculations for the periods presented.
11. Subsequent Event
On July 2, 2010, the Company announced that it has reorganized its operations to eliminate duplicative services and better align resources with business activity and growth opportunities. The Company has combined its four regional operating units into two units, Eastern and Western, with the Strategic Partnerships and Alliances unit remaining structurally unchanged. In connection with these efforts and with general cost control efforts, the Company has eliminated approximately 160 positions. The changes to the Company's workforce will be substantially completed in the third quarter of 2010.
The Company expects to record a restructuring charge of approximately $2.4 million related to workforce reductions in the third quarter of 2010. Additionally, the Company expects to record restructuring charges related to leases for facilities that the Company will vacate of approximately $1.3 million and $1.8 million in the third and fourth quarters of 2010, respectively.
Item 2. Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations
You should read the following discussion and analysis in conjunction with our consolidated financial statements and the related notes thereto included in Item 1 of Part I. Unless otherwise indicated, all references to “we,” “us,” “our,” “the Company” or similar terms refer to Employers Holdings, Inc. (EHI), together with its subsidiaries. The information contained in this quarterly report is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this quarterly report and in our other reports filed with the Securities and Exchange Commission (SEC), including our 2009 Annual Report on Form 10-K for the year ended December 31, 2009 (Annual Report).
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements if accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those discussed. You should not place undue reliance on these statements, which speak only as of the date of this report. Forward-looking statements include those related to our expected financial position, business, financing plans, litigation, future premiums, revenues, earnings, pricing, investments, business relationships, expected losses, loss reserves, acquisitions, competition, and rate increases with respect to our business and the insurance industry in general. Statements including words such as “expect,” “intend,” “plan,” “believe,” “estimate,” “may,” “anticipate,” “will” or similar statements of a future or forward-looking nature identify forward-looking statements.
We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. All forward-looking statements address matters that involve risks and uncertainties that could cause actual results to differ materially from historical or anticipated results, depending on a number of factors. These risks and uncertainties include, but are not limited to, those described in our Annual Report and other documents that we have filed with the SEC.
We are a Nevada holding company. Through our insurance subsidiaries, we provide workers’ compensation insurance coverage to select, small businesses in low to medium hazard industries. Workers’ compensation insurance is provided under a statutory system wherein most employers are required to provide coverage for their employees’ medical, disability, vocational rehabilitation, and/or death benefit costs for work-related injuries or illnesses. We provide workers’ compensation insurance in 30 states and the District of Columbia, with a concentration in California.
We target small businesses, as we believe this market is characterized by fewer competitors, more attractive pricing, and stronger persistency when compared to the U.S. workers’ compensation insurance industry in general. We believe we are able to price our policies at levels which are competitive and profitable. Our underwriting approach is to consistently underwrite small business accounts at an appropriate and competitive price without sacrificing long-term profitability and stability for short-term top-line revenue growth.
We market and sell our workers' compensation insurance products through independent local, regional and national agents and brokers, and through our strategic partnerships and alliances, including our principal partners ADP, Inc. and Anthem Blue Cross.
We continue to be affected by the impacts of the most recent economic recession. The pace of recovery remains uncertain and, although it appears to us that the declines in total employment and payroll may have leveled-off, we do not believe the situation will significantly improve in the near-term.
We derive our revenues primarily from two sources: Net Premiums Earned and Net Investment Income.
Net Premiums Earned. Net premiums earned decreased 27.1%, or $58.5 million, for the six months ended June 30, 2010, as compared to the same period of 2009. High unemployment and declining hours worked are reflected in our policyholders’ payroll, and have led to declining premiums in most of the states in which we operate. As of June 30, 2010, year-over-year in-force premiums declined 20.8%. Our average annual policy size decreased 17.3% to $7,903 as of June 30, 2010. Similarly, during the six and twelve months ended June 30, 2010, our in-force policy count decreased 1.9% and 4.2%, respectively. The total payroll of our insureds upon which we base our premium, declined approximately 9% and 16% for the six and twelve months ended June 30, 2010, respectively. Our net rate, defined as total premium in-force divided by total insured payroll, declined approximately 2% and 6% for the six and twelve months ended June 30, 2010, respectively. Net rate is a function of a variety of factors, including rate changes, underwriting risk profiles and pricing, and changes in business mix related to economic and competitive pressures.
Our total in-force premiums and number of policies in-force for our five largest states and all other states combined are shown in the table below.
Our strategic partnerships and alliances generated $71.6 million, or 20.9%, of our in-force premiums as of June 30, 2010, as compared to $76.7 million, or 17.7%, as of June 30, 2009. This percentage increase was primarily due to the higher retention rates for this business than for business produced by our independent agents. We believe that the bundling of services through these relationships has contributed to the higher retention rates. These relationships also allow us to access new customers that we may not have access to through our independent agent distribution channel. We continue to expand existing relationships and actively seek new partnerships and alliances.
Approximately one-half of our business is generated in California, where we have seen increased net rate on renewal business for 15 consecutive months. We continue to see a steady level of new business submittals and our policy count in California has increased 1.9% in the first half of 2010.
In April 2009, the Workers’ Compensation Insurance Rating Bureau (WCIRB), which makes rating recommendations in California, submitted a revised recommendation to increase the claims cost benchmark 23.7% effective July 1, 2009. This recommendation was based upon the WCIRB’s evaluation of March 31, 2009 loss experience and included a 16.9% rate increase due to increased medical costs and a 5.8% increase directly attributable to additional costs arising from certain Workers’ Compensation Appeals Board decisions. On July 8, 2009, the California Commissioner of Insurance (California Commissioner) rejected the recommendation of the WCIRB and left the claims cost benchmark unchanged. In August 2009, the WCIRB recommended a 22.8% increase in the claims cost benchmark effective January 1, 2010. This recommendation was based upon the WCIRB’s evaluation of March 31, 2009 loss experience and included a 16.0% rate increase due to increased medical costs and a 5.8% increase directly attributable to expected additional costs arising from Workers’ Compensation Appeals Board decisions. On November 9, 2009, the California Commissioner again rejected the WCIRB recommendation and left the claims cost benchmark unchanged. On April 16, 2010, the WCIRB submitted an analysis of premium and loss experience as of December 31, 2009, indicating a 21.1% increase in the claims cost benchmark, without making a recommendation. The California Commissioner has taken no action as a result of this analysis.
We set our own premium rates in California based upon actuarial analysis of current and anticipated loss trends with a goal of maintaining underwriting profitability. We reduced our filed premium rates in California from 2003 through 2008 as a result of favorable loss costs trends originating from the 2003 and 2004 legislative reforms. However, due to recent increases in loss costs, primarily medical cost inflation, we have increased our filed premium rates by a cumulative 25.2% since February 1, 2009.
The following table sets forth the percentage increases to our filed California rates that became effective for new and renewal policies incepting on or after the dates shown.