request, resulting in a balance in the Trust account of approximately $2.7 million immediately following the withdrawal. If LMC is placed into receivership and the amount held in the collateralized reinsurance trust is inadequate to satisfy the obligations of LMC to us under the adverse development cover, it is unlikely that we would recover any future amounts owing by LMC to us.
We derive our revenue primarily from premiums earned, net investment income and net realized gains and losses from investments, the operations of our non-insurance subsidiaries and service income.
Gross premiums written include all premiums billed and unbilled by an insurance company during a specified policy period. Premiums are earned over the terms of the related policies. At the end of each accounting period, the portions of premiums that are not yet earned are included in unearned premiums and are realized as revenue in subsequent periods over the remaining terms of the policies. Our policies typically have terms of 12 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.
Premiums earned is the earned portion of our net premiums written. Net premiums written is the difference between gross premiums written and premiums ceded or paid to reinsurers (ceded premiums written). Our gross premiums written is the sum of both direct premiums and assumed premiums before the effect of ceded reinsurance. Assumed premiums are premiums that we have received from an authorized state-mandated pool.
We earn our direct premiums written from our maritime, alternative dispute resolution (“ADR”) and state act customers. We also earn a small portion of our direct premiums written from employers who participate in the Washington State United States Longshore and Harbor Workers Compensation Act Assigned Risk Plan (the “Washington USL&H Assigned Risk Plan”). We immediately cede 100% of those premiums, net of our expenses, and 100% of the losses in connection with that business back to the Washington USL&H Assigned Risk Plan. References to direct premiums written generally exclude premiums from the Washington USL&H Assigned Risk Plan because such business is not indicative of our core business or material to our results of operations.
We invest our statutory surplus and the funds supporting our insurance liabilities (including unearned premiums and unpaid loss and loss adjustment expense) in cash, cash equivalents, fixed income securities and, to a lesser degree, in equity securities and preferred stocks. Our investment income includes interest earned on our invested assets. Realized gains and losses on invested assets are reported separately from net investment income. We earn realized gains when invested assets are sold for an amount greater than their amortized cost in the case of fixed maturity securities and recognize 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 carrying value.
We receive claims service income in return for providing claims administration services for other companies. The claims service income we receive for providing these services approximates our costs. For the three months ended March 31, 2008 and 2007, approximately 56.8% and 49.8%, respectively, of our claims service income was generated by contracts we have with LMC to provide claims handling services for the policies written by Eagle prior to the Acquisition. We expect income from these contracts to decrease substantially over the next several years as transactions related to Eagle diminish.
Loss and loss adjustment expenses represent our largest expense item and include (1) claim payments made, (2) estimates for future claim payments and changes in those estimates for current and prior periods and (3) costs associated with investigating, defending and adjusting claims. For further information regarding our loss and loss adjustment expenses, including amounts paid and unpaid, see discussion under the heading “Critical Accounting Policies, Estimates and Judgments – Unpaid Loss and Loss Adjustment Expenses” in this Item 2 of Part I of this quarterly report.
Underwriting, Acquisition and Insurance Expenses
In our insurance subsidiary, we refer to the expenses that we incur to underwrite risks as underwriting, acquisition and insurance expenses. Such expenses consist of commission expenses, premium taxes and fees and other underwriting expenses incurred in writing and maintaining our business. We pay commission expense in our insurance subsidiary to our brokers for the premiums that they produce for us. We pay state and local taxes based on premiums; licenses and fees; assessments; and contributions to workers’ compensation security funds. Other underwriting expenses consist of general administrative expenses such as salaries and employee benefits, rent and all other operating expenses not otherwise classified separately, and boards, bureaus and assessments of statistical agencies for policy service and administration items such as rating manuals, rating plans and experience data.
Interest Expense
We incur interest expense on $12.0 million in surplus notes that our insurance subsidiary issued in May 2004. The interest expense is paid quarterly in arrears. The interest expense for each interest payment period is based on the three-month LIBOR rate two London banking days prior to the interest payment period plus 400 basis points.
Results of Operations
Three Months Ended March 31, 2008 and 2007
Gross Premiums Written. Gross premiums written for the three months ended March 31, 2008 totaled $63.6 million, an increase of $3.7 million, or 6.2%, over $59.9 million of gross premiums written in the same period of 2007 even though we continued to experience rate reductions in California, our largest market, as well as in other states. Excluding work we perform as the servicing carrier for the Washington USL&H Assigned Risk Plan, the number of customers we serviced increased 31.8% from 745 at March 31, 2007 to 982 at March 31, 2008 and in-force payrolls, one of the factors used in determining premium charges, increased 32.5% from $4.3 billion at March 31, 2007 to $5.7 billion one year later. California continues to be our largest market, accounting for approximately $109.3 million, or 40.7%, of our in-force premiums at March 31, 2008. This represents a decrease of $1.7 million, or 1.5%, from approximately $111.0 million, or 49.0%, of in-force premiums at March 31, 2007.
Illinois is our second largest market and accounted for approximately $29.4 million (11.0%) of our in-force premiums at March 31, 2008, representing an increase of $7.9 million (36.7%) from $21.5 million (9.5%) at March 31, 2007. Louisiana is our third largest market, accounting for approximately $22.2 million (8.2%) of our in-force premiums as of March 31, 2008, representing an increase of $6.2 million (38.8%) from $16.0 million (7.1%) as of March 31, 2007. The remaining states in our top five markets were Alaska and Hawaii, which accounted for approximately $18.0 million (6.7%) and $12.9 million (4.8%) of our in-force premiums at March 31, 2008, respectively, compared to $21.6 million (9.5%) and $14.2 million (6.3%), respectively, of our in-force premiums at March 31, 2007.
We have experienced significant reductions in our California premium rates over the past four years. In 2007, in response to continued reductions in California workers’ compensation claim costs, we reduced our rates by an average 14.2% for new and renewal insurance policies written in California on or after July 1, 2007. This was the eighth California rate reduction we have filed since October 1, 2003, resulting in a net cumulative reduction of our California rates of approximately 54.8%. Rate reductions have also been adopted in other states in which we operate. For example, effective January 1, 2008, we adopted the following rate decreases recommended by the NCCI: 10.9% in Alaska, 19.3% in Hawaii and 18.4% in Florida. Effective July 1, 2007, we adopted the Louisiana Insurance Commissioner’s recommendation of a 15.8% reduction in Louisiana, which is 2.0% more than the 13.8% rate decrease recommended by the NCCI. On February 5, 2008, the Louisiana Insurance Commissioner approved an NCCI-proposed rate reduction of 8.6%, effective May 1, 2008. On March 7, 2008, after completing a study of our Louisiana loss data, we filed with the Louisiana Insurance Commissioner our new rates reflecting an average reduction of 11.6% from prior rates for new and renewal workers’ compensation insurance policies written in Louisiana on or after May 1, 2008.We have also recently adopted rate increases insome states.For example, effectiveOctober 1, 2007, we adopted a 4.1% rate increase in Arizona andon January 1, 2008, we adopted a 4.0%rateincrease in Illinois.
Net Premiums Written. Net premiums written totaled $60.3 million for the three months ended March 31, 2008 compared to $56.3 million in the same period in 2007, representing an increase of $4.0 million, or 7.1%. Net premiums written are affected by premiums ceded under reinsurance agreements. Ceded written premiums for the three months ended March 31, 2008 totaled $3.2 million (5.0% of gross premiums written) compared to $3.7 million
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(6.2% of gross premiums written) in the same period of 2007. The decrease in ceded premiums as a percentage of gross premiums written resulted primarily from the renewal of our excess of loss reinsurance program on October 1, 2007 at average rates that are approximately 25.6% lower than rates under the prior reinsurance program.
Net Premiums Earned. Net premiums earned totaled $56.7 million for the three months ended March 31, 2008 compared to $48.6 million for the same period in 2007, representing an increase of $8.1 million, or 16.7%. We record the entire annual policy premium as unearned premium when written and earn the premium over the life of the policy, which is generally twelve months. Consequently, the amount of premiums earned in any given year depends on when during the current or prior year the underlying policies were written. Our direct premiums earned increased $7.2 million, or 14.3%, to $57.4 million at March 31, 2008 from $50.2 million at March 31, 2007 due to our premium growth as described above. Net premiums earned are also affected by premiums ceded under reinsurance agreements. Ceded premiums earned at March 31, 2008 totaled $3.3 million compared to $3.6 million at March 31, 2007, representing a decrease of $0.3 million, or 8.3%. A decrease in ceded premiums earned is an increase to our overall net premiums earned. Also adding to the increase in net premiums earned is an increase in the amount of premiums we involuntarily assume on residual market business from the NCCI, which operates residual market programs on behalf of many states. Assumed premiums earned increased $0.6 million from $2.0 million at March 31, 2007 to $2.6 million at March 31, 2008.
Net Investment Income. Net investment income was $5.7 million for the three months ended March 31, 2008 compared to $4.8 million for the same period in 2007, representing an increase of $0.9 million, or 18.8%. Average invested assets increased $87.8 million, or 20.4%, from $429.5 million as of March 31, 2007 to $517.3 million as of March 31, 2008. The increase in net investment income is due primarily to a larger portfolio base at March 31, 2008 as a result of strong cash flow from operations of $94.6 million for the year ended December 31, 2007 and $11.5 million for the three months ended March 31, 2008. Our yield on average invested assets for the three months ended March 31, 2008 and 2007 was approximately 4.4%.
Service Income. Service income totaled $422,000 for the three months ended March 31, 2008 compared to $580,000 for the same period in 2007, representing a decrease of $158,000, or 27.2%. Our service income results primarily from service arrangements we have with LMC for claims processing and policy administration services that we perform for Eagle’s insurance policies and from claims processing services that we perform for other unrelated companies. Average monthly fees from Eagle are declining as the volume of work decreases as a result of the run off of our predecessor’s business. Service income related to our arrangements with LMC decreased $40,000, or 13.8%, to $250,000 for the three months ended March 31, 2008 from $290,000 for the same period in 2007. Service income related to claims processing services that we perform for other unrelated companies decreased approximately $130,000 and accounted for approximately 38.8% of our service income for the three months ended March 31, 2008, compared to 50.0% of service income in the same period of 2007.
Other Income. Other income totaled $1.4 million for the three months ended March 31, 2008 compared to $1.0 million for the same period in 2007, representing an increase of $0.4 million, or 40.0%. Other income is derived primarily from the operations of PointSure, our wholesale broker and third party administrator subsidiary which, due to the expansion of its portfolio of insurance products during 2007, has been able to increase the amount of income from external sources and THM, a provider of medical bill review, utilization review, nurse case management and related services that we acquired in December 2007. PointSure represents 20 insurance companies at March 31, 2008 and 2007.
Loss and Loss Adjustment Expenses. Loss and loss adjustment expenses totaled $30.4 million for the three months ended March 31, 2008 compared to $25.9 million for the same period in 2007, representing an increase of $4.5 million, or 17.4%. Our net loss ratio, which is calculated by dividing loss and loss adjustment expenses less claims service income by premiums earned, for the three months ended March 31, 2008 was 52.9% compared to 52.2% for the same period in 2007. Included in the 2008 loss ratio was a reduction of approximately $7.9 million of previously recorded direct net loss reserves to reflect a continuation of deflation trends in the paid loss data for recent accident years. In the quarter ended March 31, 2007, we reduced loss reserves by approximately $7.2 million. Our direct net loss reserves are net of reinsurance and exclude reserves associated with KEIC and the business that we involuntarily assume from the NCCI. Approximately $3.1 million of the reserve adjustment related to accident year 2007, approximately $3.6 million related to accident year 2006 and approximately $1.2 million related to accident years 2005 and prior.
There is uncertainty about whether recent lower paid loss trends, which result primarily from California legislative reforms enacted in 2003 and 2004, will be sustained, particularly in light of current efforts to change or
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repeal portions of the reforms. We will not know the full impact of these reforms with a high degree of confidence for several years. We have established loss reserves at March 31, 2008 that are based upon our current best estimate of loss costs, taking into consideration the recent lower paid loss claim data, incurred loss trends and the uncertainty regarding the permanence of recent legislative reforms. For further information regarding our loss and loss adjustment expenses, including amounts paid and unpaid, see the discussion under the heading “Critical Accounting Policies, Estimates and Judgments – Unpaid Loss and Loss Adjustment Expenses” in this Item 2 of Part I of this quarterly report.
As of March 31, 2008, we had recorded a receivable of approximately $2.5 million for adverse loss development under the adverse development cover since the date of the Acquisition. We do not expect this receivable to have any material adverse effect on our future cash flows if LMC fails to perform its obligations under the adverse development cover. At March 31, 2008, we had access to approximately $3.6 million under the collateralized reinsurance trust in the event that LMC fails to satisfy its obligations under the adverse development cover. The balance of the Trust, including interest, was $3.5 million at December 31, 2007. In April 2008, LMC submitted a request to withdraw approximately $0.8 million of excess funds on deposit in the Trust. After due evaluation, we complied with LMC’s request, resulting in a balance in the Trust account of approximately $2.7 million immediately following the withdrawal.
Underwriting Expenses. Underwriting expenses totaled $15.6 million for the three months ended March 31, 2008, compared to $12.6 million for the same period in 2007, representing an increase of $3.0 million, or 23.8%. Our net underwriting expense ratio, which is calculated by dividing underwriting, acquisition and insurance expenses less other service income by premiums earned, for the three months ended March 31, 2008 was 27.6%, compared to 25.9% for the same period in 2007. The increase in the expense ratio is primarily the result of increased staffing costs and other premium production related expenses as we invest in the geographic expansion and development of our business. The total number of employees grew from 197 at March 31, 2007 to 259 at March 31, 2008, representing an increase of 31.5%.
Commission expense as a percentage of net earned premiums averaged 9.6% for the three months ended March 31, 2008 compared to 9.2% in the same period of 2007. These increases are driven primarily by the California market, as well as other markets that have experienced rate reductions, as brokers negotiate higher commission rates during a period of declining premium rates.
Interest Expense. Interest expense related to the surplus notes issued by our insurance subsidiary in May 2004 totaled $251,000 for the three months ended March 31, 2008, compared to $281,000 for the same period in 2007, representing a decrease of $30,000, or 10.7%. The surplus notes interest rate, which is calculated at the beginning of each interest payment period using the 3-month LIBOR rate plus 400 basis points, decreased from 9.36% at March 31, 2007 to 7.09% at March 31, 2008.
Other Expenses. Other expenses totaled $2.0 million for the three months ended March 31, 2008, compared to $1.6 million for same period in 2007, representing an increase of $0.4 million, or 25.0%. Other expenses are derived primarily from the operations of PointSure, our non-insurance subsidiary which experienced direct costs associated with the expansion of insurance products they offer and, to a lesser extent, from the operations of THM.
Income Tax Expense. The effective tax rate for the three months ended March 31, 2008 was 31.6% compared to 30.5% for the same period in 2007. Our effective tax rate for the three months ended March 31, 2008 and 2007 was lower than the statutory tax rate of 35.0% primarily as a result of tax exempt interest income. At March 31, 2008, approximately 53.2% of our fixed-income portfolio was invested in tax-exempt securities, compared to approximately 51.1% at March 31, 2007.
Net Income. Net income was $10.9 million for the three months ended March 31, 2008, compared to $10.1 million for the same period in 2007, representing an increase of $0.8 million, or 7.9%. The increase in net income resulted primarily from increases in premiums earned and investment income and reserve releases recognized in the period, offset by increases in loss and loss adjustment expenses; underwriting, acquisition and insurance expenses; and other expenses.
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Liquidity and Capital Resources
Our principal sources of funds are underwriting operations, investment income and proceeds from sales and maturities of investments. Our primary use of funds is to pay claims and operating expenses and to purchase investments.
Our investment portfolio is structured so that investments mature periodically over time in reasonable relation to current expectations of future claim payments. Since we have a limited claims history, we have derived our expected future claim payments from industry and predecessor trends and included a provision for uncertainties. Our investment portfolio as of March 31, 2008 has an effective duration of 5.0 years with individual maturities extending out to 30 years. Currently, we make claim payments from positive cash flow from operations and invest excess cash in securities with appropriate maturity dates to balance against anticipated future claim payments. As these securities mature, we intend to invest any excess funds in investments with appropriate durations to match against expected future claim payments.
At March 31, 2008, our portfolio was made up almost entirely of investment grade fixed income securities with fair values subject to fluctuations in interest rates. The remainder of our investment portfolio consisted of investments in equity securities, which consist of investments in exchange traded funds designed to correspond to the performance of certain indexes based on domestic or international stocks, and preferred stocks. In November 2006, our investment policy was revised to allow for investment in domestic and international equities of up to 4% and 1%, respectively, of our statutory consolidated capital and surplus. All of the securities in our investment portfolio are accounted for as “available for sale” securities. While we have structured our investment portfolio to provide an appropriate matching of maturities with anticipated claim payments, if we decide or are required in the future to sell securities in a rising interest environment, we would expect to incur losses from such sales.
We had no direct sub-prime mortgage exposure in our investment portfolio as of March 31, 2008 and approximately $0.9 million of indirect exposure to sub-prime mortgages. The average credit quality of our $266.6 million fixed income municipal portfolio was AA+ (AA– based on the issuers’ underlying ratings). Insured municipal bonds totaled $205.6 million and had a weighted average credit rating of AA+ (AA– based on the issuers’ underlying ratings). The remaining $61.0 million in uninsured municipal bonds carried a weighted average credit rating of AA. Consequently, we do not expect a material impact to our investment portfolio or financial position as a result of the problems currently facing monoline bond insurers.
Our ability to adequately provide funds to pay claims comes from our disciplined underwriting and pricing standards and the purchase of reinsurance to protect us against severe claims and catastrophic events. Effective October 1, 2007, our reinsurance program provides us with reinsurance protection for each loss occurrence in excess of $1.0 million, up to $75.0 million, subject to various additional limitations and exclusions as more fully described in Note 5.a. to our unaudited condensed consolidated financial statements in Part I, Item 1 of this quarterly report and in the reinsurance agreements. Given industry and predecessor trends, we believe that we are sufficiently capitalized to cover our retained losses.
Our insurance subsidiary is required by law to maintain a certain minimum level of surplus on a statutory basis. Surplus is calculated by subtracting total liabilities from total admitted assets. The National Association of Insurance Commissioners has a risk-based capital standard designed to identify property and casualty insurers that may be inadequately capitalized based on inherent risks of each insurer’s assets and liabilities and its mix of net premiums written. Insurers falling below a calculated threshold may be subject to varying degrees of regulatory action. As of December 31, 2007, the last date that we were required to update the annual risk-based capital calculation, the statutory surplus of our insurance subsidiary was in excess of the prescribed risk-based capital requirements that correspond to any level of regulatory action.
SIH is a holding company with minimal unconsolidated revenue. Currently, there are no plans to have SBIC or other subsidiaries pay a dividend to SIH.
Our unaudited consolidated net cash provided by operating activities for the three months ended March 31, 2008 was $11.5 million, compared to our cash flow from operations of $18.7 million for the same period in 2007. The decrease resulted primarily from the decreases in unpaid loss and loss adjustment expense and deferred income tax benefit, increases in policy acquisition costs deferred and other assets and liabilities, offset by increases in the amortization of policy acquisition costs and balances related to reinsurance recoverables and unearned premium reserves, all as a result of the growth of our business and the continued favorable development of our loss reserves.
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We used net cash of $24.9 million for investing activities in the three months ended March 31, 2008, compared to $21.8 million for the same period in 2007. The difference between periods is primarily attributable to maintaining a lower overall cash balance.
For the three months ended March 31, 2008, financing activities provided cash of $101,000, compared to $56,000 in the same period in 2007.
Contractual Obligations and Commitments
The following table identifies our contractual obligations by payment due period as of March 31, 2008:
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| | Payments Due by Period | | | | |
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| | Total | | Less than
1 Year | | 1-3 Years | | 4-5 Years | | More than
5 Years | |
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Long term debt obligations: | | | | | | | | | | | | | | | | |
Surplus notes | | $ | 12,000 | | $ | — | | $ | — | | $ | — | | $ | 12,000 | |
Loss and loss adjustment expenses | | | 255,095 | | | 84,181 | | | 109,946 | | | 23,469 | | | 37,499 | |
Operating lease obligations | | | 14,484 | | | 2,627 | | | 5,968 | | | 1,672 | | | 4,217 | |
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Total | | $ | 281,579 | | $ | 86,808 | | $ | 115,914 | | $ | 25,141 | | $ | 53,716 | |
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The loss and loss adjustment expense payments due by period in the table above are based upon the loss and loss adjustment expense estimates as of March 31, 2008 and actuarial estimates of expected payout patterns and are not contractual liabilities as to time certain. Our contractual liability is to provide benefits under the policies we write. As a result, our calculation of loss and loss adjustment expense payments due by period is subject to the same uncertainties associated with determining the level of unpaid loss and loss adjustment expenses generally and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. For a discussion of our unpaid loss and loss adjustment expense process, see the heading “Critical Accounting Policies, Estimates and Judgments – Unpaid Loss and Loss Adjustment Expenses” in this Part I, Item 2 of this quarterly report. Actual payments of loss and loss adjustment expenses by period will vary, perhaps materially, from the above table to the extent that current estimates of loss and loss adjustment expenses vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns.
Off-Balance Sheet Arrangements
As of March 31, 2008, we had no off-balance sheet arrangements that have or are reasonably likely to have a material current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Critical Accounting Policies, Estimates and Judgments
It is important to understand our accounting policies in order to understand our unaudited financial statements. We consider some of these policies to be critical to the presentation of our financial results, since they require management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures at the financial reporting date and throughout the period being reported upon. Some of the estimates result from judgments that can be subjective and complex, and consequently, actual results reflected in future periods might differ from these estimates.
The most critical accounting policies involve the reporting of unpaid loss and loss adjustment expenses, including losses that have occurred but were not reported to us by the financial reporting date; the amount and recoverability of reinsurance recoverable balances; deferred policy acquisition costs; income taxes; the impairment of investment securities; earned but unbilled premiums; and retrospective premiums. The following should be read in conjunction with the notes to our financial statements.
Unpaid Loss and Loss Adjustment Expenses
Unpaid loss and loss adjustment expenses represent our estimate of the expected cost of the ultimate settlement and administration of losses, based on known facts and circumstances. Included in unpaid loss and loss adjustment expenses are amounts for case-based insurance liabilities, including estimates of future developments on these claims; claims incurred but not yet reported to us; second injury fund expenses; allocated claim adjustment expenses; and unallocated claim adjustment expenses. We use actuarial methodologies to assist us in establishing these estimates, including judgments relative to estimates of future claims severity and frequency, length of time to
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achieve ultimate resolution, judicial theories of liability and other third-party factors that are often beyond our control. Due to the inherent uncertainty associated with the cost of unsettled and unreported claims, the ultimate liability may differ from the original estimates. These estimates are regularly reviewed and updated and any resulting adjustments are included in the current period’s operating results.
Following is a summary of the gross loss and loss adjustment expense reserves by line of business as of March 31, 2008 and December 31, 2007. The workers’ compensation line of business comprises over 99% of our total loss reserves as of both dates.
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| | As of March 31, 2008 | | As of December 31, 2007 | |
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Line of Business | | Case | | IBNR | | Total | | Case | | IBNR | | Total | |
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| | (in thousands) | |
Workers’ Compensation | | $ | 99,679 | | $ | 153,685 | | $ | 253,364 | | $ | 93,457 | | $ | 155,042 | | $ | 248,499 | |
Ocean Marine | | | 319 | | | 1,412 | | | 1,731 | | | 564 | | | 1,022 | | | 1,586 | |
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Total | | $ | 99,998 | | $ | 155,097 | | $ | 255,095 | | $ | 94,021 | | $ | 156,064 | | $ | 250,085 | |
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Actuarial Loss Reserve Estimation Methods
We use a variety of actuarial methodologies to assist us in establishing the reserve for unpaid loss and loss adjustment expense. We also make judgments relative to estimates of future claims severity and frequency, length of time to achieve ultimate resolution, judicial theories of liability and other third-party factors that are often beyond our control.
For the current accident year, we establish the initial reserve for claims incurred-but-not-reported (“IBNR”) using an expected loss ratio (“ELR”) method. The ELR method is based on an analysis of historical loss ratios adjusted for current pricing levels, exposure growth, anticipated trends in claim frequency and severity, the impact of reform activity and any other factors that may have an impact on the loss ratio. The actual paid and incurred loss data for the accident year is reviewed each quarter and changes to the ELR may be made based on the emerging data, although changes are typically not made until the end of the accident year when the loss data can be analyzed as a complete accident year. The ELR is multiplied by the year-to-date earned premium to determine the ultimate losses for the current accident year. The actual paid and case outstanding losses are subtracted from the ultimate losses to determine the IBNR for the accident year. As the accident year matures, we incorporate a standard actuarial reserving methodology referred to as the Bornhuetter-Ferguson method. This method blends the loss development and expected loss ratio methods by assigning partial weight to the initial expected losses, calculated from the expected loss ratio method, with the remaining weight applied to the actual losses, either paid or incurred. The weights assigned to the initial expected losses decrease as the accident year matures. A reserve estimate implies a pattern of expected loss emergence. If this emergence does not occur as expected, it may cause us to revisit our previous assumptions. We may adjust loss development patterns, the various method weights or the expected loss ratios used in our analysis. Management employs judgment in each reserve valuation as to how to make these adjustments to reflect current information.
For all other accident years, the estimated ultimate losses are developed using a variety of actuarial techniques as described below. In reviewing this information, we consider the following factors to be especially important at this time because they increase the variability risk factors in our loss reserve estimates:
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| • | We wrote our first policy on October 1, 2003 and, as a result, our total reserve portfolio is relatively immature when compared to other industry data. |
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| • | We have been growing consistently since we began operations and have entered into several new states that are not included in our predecessor’s historical data. |
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| • | At March 31, 2008, approximately $156.3 million, or 49.5%, of our direct loss reserves were related to business written in California. Over the last several years, three significant comprehensive legislative reforms were enacted in California: AB 749 was enacted in February 2002; AB 227 and SB 228 were enacted in September 2003; and SB 899 was enacted in April 2004. This reform activity has resulted in uncertainty regarding the impact of the reforms on loss payments, loss development and, ultimately, loss reserves, making historical data less reliable as an indicator of future loss. All four bills enacted structural changes to the benefit delivery system in California, in addition to changes in the indemnity and medical benefits afforded injured workers. In response to the reform legislation and a continuing drop in the frequency of workers’ compensation claims, the pure premium rates approved by the California Insurance |
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| Commissioner effective January 1, 2008 were 65.1% lower than the pure premium rates in effect as of July 1, 2003. |
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| Key elements of the reforms as they relate to indemnity and medical benefits were as follows: |
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| Indemnity Benefits |
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| AB 749 significantly increased most classes of workers’ compensation indemnity benefits over a four-year period beginning in 2003. |
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| AB 227 and SB 228 repealed the mandatory vocational rehabilitation benefits and replaced them with a system of non-transferable education vouchers. |
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| SB 899 required the Division of Workers’ Compensation (“DWC”) Administrative Director to adopt, on or before January 1, 2005, a new permanent disability rating schedule (“PDRS”) based in part on American Medical Association guidelines. Also, temporary disability was limited to a duration of two years. |
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| SB 899 provided that, effective April 19, 2004, apportionment of disability for purposes of permanent disability determination must be based on causation. |
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| Medical Benefits |
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| AB 749 repealed the presumption given to the primary treating physician (except when the worker has pre-designated a personal physician), effective for injuries occurring on or after January 1, 2003. (SB 228 and SB 899 later extended this to all future medical treatment on earlier injuries.) |
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| SB 228 required the DWC Administrative Director to establish, by December 1, 2004, an Official Medical Treatment Utilization Schedule meeting specific criteria. SB 228 also provided that beginning three months after the publication date of the updated American College of Occupational and Environmental Medical (“ACOEM”) Practice Guidelines and continuing until such time as the DWC Administrative Director establishes an Official Medical Treatment Utilization Schedule, the ACOEM standards will be presumed to be correct regarding the extent and scope of all medical treatment. The DWC Administrative Director has subsequently adopted the ACOEM Guidelines as the Official Medical Treatment Utilization Schedule. |
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| SB 228 limited the number of chiropractic visits and the number of physical therapy visits to 24 each per claim. |
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| SB 228 established a prescription medication fee schedule set at 100% of Medi-Cal Schedule amounts. |
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| SB 228 provided that the maximum facility fee for services performed in an ambulatory surgical center may not exceed 120% of the Medicare fees for the same service performed in a hospital outpatient facility. |
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| SB 899 provided that after January 1, 2005, an employer or insurer may establish medical provider networks meeting certain conditions and, with limited exceptions, medical treatment can be provided within those networks. |
These reforms are a source of variability in the reserve estimates as legislative changes affecting benefit levels not only impact the cost of benefits but also the rate at which accident year benefits or losses develop over time. In addition, the PDRS, one of the most significant reforms, faces ongoing challenges. The PDRS was revised effective January 1, 2005. The revised schedule has resulted in significantly reduced permanent disability awards, leading to concerns that injured workers may not be adequately compensated for their work related permanent injuries. The PDRS is currently being challenged on three fronts – legislative, administrative and legal. Legislation has been proposed in the 2008 legislative session that would modify the formula used to determine the amount of permanent disability benefits. It is too early to determine what impact the legislation may have on permanent disability benefits, or if it will be enacted into law. A prior legislative effort to modify the PDRS was vetoed by the Governor of California in 2007. On the administrative front, the California Division of Workers’ Compensation has undertaken a review of the PDRS. The nature and extent of proposed changes, if any, are not yet known. The Division of Workers’ Compensation has not published a schedule to communicate their
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recommendations. Finally, recent court decisions continue to lend uncertainty to the interpretation and application of the PDRS. All of these factors contribute to the uncertainty of California workers’ compensation claim costs.
Workers’ compensation is considered a long-tail line of business, as it takes a relatively long period of time to finalize claims from a given accident year. Management believes that it generally takes workers’ compensation losses approximately 48 to 60 months after the start of an accident year until the data is viewed as fully credible for paid and incurred reserve evaluation methods. Workers’ compensation losses can continue to develop beyond 60 months and in some cases claims can remain open more than 20 years. As indicated above, we wrote our first policy on October 1, 2003 so our first complete accident year is 2004. As of March 31, 2008, accident year 2004 is 51 months developed, accident year 2005 is 39 months developed and accident year 2006 is 27 months developed. Our loss reserve estimates are subject to considerable variation due to the relative immaturity of the accident years from a development standpoint.
We review the following significant components of loss reserves on a quarterly basis:
| | |
| • | IBNR reserves for losses – This includes amounts for the medical and indemnity components of the workers’ compensation claim payments, net of subrogation recoveries and deductibles; |
| | |
| • | IBNR reserves for defense and cost containment expenses (“DCC”, also referred to as allocated loss adjustment expenses (“ALAE”)), net of subrogation recoveries and deductibles; |
| | |
| • | reserve for adjusting and other expenses, also known as unallocated loss adjustment expenses (“ULAE”); and |
| | |
| • | reserve for loss based assessments, also referred to as the “8F reserve” in reference to Section 8, Compensation for Disability, subsection (f), Injury increasing disability, of the United States Longshore and Harbor Workers’ Compensation Act (“USL&H”) Act. |
The reserves for losses and DCC are also reviewed gross and net of reinsurance (referred to as “net”). For gross losses, the claims for the Washington USL&H Plan, the KEIC claims assumed in the Acquisition and claims assumed from the NCCI residual market pools are excluded from this discussion.
IBNR reserves include a provision for future development on known claims, a reopened claims reserve, a provision for claims incurred but not reported and a provision for claims in transit (incurred and reported but not recorded).
�� Our analysis is done separately for the indemnity, medical and DCC components of the total loss reserves within each accident year. In addition, the analysis is completed separately for the following three categories: State Act California; State Act excluding California; and USL&H. The business is divided into these three categories for the determination of ultimate losses due to differences in the laws that cover each of these categories.
Workers’ compensation insurance is statutorily provided for in all of the states in which we do business. State laws and regulations provide for the form and content of policy coverage and the rights and benefits that are available to injured workers, their representatives and medical providers. Because the benefits are established by state statute there can be significant variation in these benefits by state. We refer to this coverage as State Act.
Our business is also affected by federal laws including the USL&H Act, which is administered by the Department of Labor, and the Merchant Marine Act of 1920, or Jones Act. The USL&H Act contains various provisions affecting our business, including the nature of the liability of employers of longshoremen, the rate of compensation to an injured longshoreman, the selection of physicians, compensation for disability and death and the filing of claims. We refer to the business covered under the USL&H Act and the Jones Act as USL&H.
Because there are different laws and benefit levels that affect the State Act versus USL&H business, there is a strong likelihood that these categories will exhibit different loss development characteristics which will influence the ultimate loss calculations. Separating the data into the State Act and USL&H categories allows us to use actuarial methods that contemplate these differences.
The State Act category is further split into California and excluding non-California groupings. This is due to the extensive reform activity that has taken place in California as discussed above. Since the California data is subject to
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additional variation due to the reform activity, separating the data in this fashion allows us to review the non-California State Act data with no impact from the California reform activity.
Development factors, expected loss rates and expected loss ratios are derived from the combined experience of us and our predecessor.
Gross ultimate loss (indemnity, medical and ALAE separately) for each category is estimated using the following actuarial methods:
| | |
| • | paid loss (or ALAE) development; |
| | |
| • | incurred loss (or ALAE) development; |
| | |
| • | Bornhuetter-Ferguson using ultimate premiums and paid loss (or ALAE); and |
| | |
| • | Bornhuetter-Ferguson using ultimate premiums and incurred loss (or ALAE). |
A gross ultimate value is selected by reviewing the various ultimate estimates and applying actuarial judgment to achieve a reasonable point estimate of the ultimate liability. The gross IBNR reserve equals the selected gross ultimate loss minus the gross paid losses and gross case reserves as of the valuation date. The selected gross ultimate loss and ALAE are reviewed and updated on a quarterly basis.
Variation in Ultimate Loss Estimates
In light of our short operating history and uncertainties concerning the effects of recent legislative reforms, specifically as they relate to our California workers’ compensation experience, the actuarial techniques discussed above use the historical experience of our predecessor as well as industry information in the analysis of loss reserves. We are able to effectively draw on the historical experience of our predecessor because most of the current members of our management and adjusting staff also served as the management and adjusting staff of our predecessor. Over time, we expect to place more reliance on our own developed loss experience and less on our predecessor’s and industry experience.
These techniques recognize, among other factors:
| | |
| • | our claims experience and that of our predecessor; |
| | |
| • | the industry’s claim experience; |
| | |
| • | historical trends in reserving patterns and loss payments; |
| | |
| • | the impact of claim inflation and/or deflation; |
| | |
| • | the pending level of unpaid claims; |
| | |
| • | the cost of claim settlements; |
| | |
| • | legislative reforms affecting workers’ compensation; |
| | |
| • | the overall environment in which insurance companies operate; and |
| | |
| • | trends in claim frequency and severity. |
In addition, there are loss and loss adjustment expense risk factors that affect workers’ compensation claims that can change over time and also cause our loss reserves to fluctuate. Some examples of these risk factors include, but are not limited to, the following:
| | |
| • | recovery time from the injury; |
| | |
| • | degree of patient responsiveness to treatment; |
| | |
| • | use of pharmaceutical drugs; |
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| | |
| • | type and effectiveness of medical treatments; |
| | |
| • | frequency of visits to healthcare providers; |
| | |
| • | changes in costs of medical treatments; |
| | |
| • | availability of new medical treatments and equipment; |
| | |
| • | types of healthcare providers used; |
| | |
| • | availability of light duty for early return to work; |
| | |
| • | attorney involvement; |
| | |
| • | wage inflation in states that index benefits; and |
| | |
| • | changes in administrative policies of second injury funds. |
Variation can also occur in the loss reserves due to factors that affect our book of business in general. Some examples of these risk factors include, but are not limited to, the following:
| | |
| • | injury type mix; |
| | |
| • | change in mix of business by state; |
| | |
| • | change in mix of business by employer type; |
| | |
| • | small volume of internal data; and |
| | |
| • | significant exposure growth over recent data periods. |
Impact of Changes in Key Assumptions on Reserve Volatility
The most significant factor currently impacting our loss reserve estimates is the reliance on historical reserving patterns and loss payments from our predecessor and the industry, also referred to as loss development. This is due to our limited operating history as discussed above. The actuarial methods that we use depend at varying levels on loss development patterns based on past information. Development is defined as the difference, on successive valuation dates, between observed values of certain fundamental quantities that may be used in the loss reserve estimation process. For example, the data may be paid losses, case incurred losses and the change in case reserves or claim counts, including reported claims, closed claims or reopened claims. Development can be expected, meaning it is consistent with prior results; favorable (better than expected); or unfavorable (worse than expected). In all cases, we are comparing the actual development of the data in the current valuation with what was expected based on the historical patterns in the underlying data. Favorable development indicates a basis for reducing the estimated ultimate loss amounts while unfavorable development indicates a basis for increasing the estimated ultimate loss amounts. We reflect the favorable or unfavorable development in loss reserves in the results of operations in the period in which the ultimate loss estimates are changed.
Due to the relative immaturity of our book of business, the challenge has been to give the right weight in the ultimate loss estimation process to the new data as it becomes available. As discussed above, management believes that it generally takes workers’ compensation losses approximately 48 to 60 months after the start of an accident year until the data is viewed as fully credible for paid and incurred reserve evaluation methods. Due to our limited operating history, we have four complete accident years that were developed 51 months, 39 months, 27 months and 15 months (2004, 2005, 2006 and 2007, respectively) at March 31, 2008. Our oldest complete accident year was 51 months old as of March 31, 2008. For accident years 2003 through 2007, we are using a Bornhuetter-Ferguson approach, which blends the loss development and expected loss ratio methods. Due to the favorable development exhibited by the data for accident years 2004 and 2005 at 17 to 18 months of development, management began to place more weight on the results of the Bornhuetter-Ferguson method in its ultimate loss estimates for accident years 2005, 2006 and 2007. As new data emerges and continues to demonstrate favorable development, this adds credibility to the existing data which enables management to reflect it more fully in its estimation process. For all accident years, we have not completely relied on the most recent data points in our loss development selections.
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Because of recent favorable development trends, we believe this has the effect of increasing our estimated reserves as compared to reserves calculated with complete reliance on these data points. Estimating loss reserves is an uncertain and complex process which involves actuarial techniques and management judgment. Actuarial analysis generally assumes that past patterns demonstrated in the data will repeat themselves and that the data provides a basis for estimating future loss reserves. However, since conditions and trends that have affected losses in the past may not occur in the future in the same manner, if at all, future results may not be reliably predicted by the prior data.
Our paid loss data for state act indemnity, both California and excluding California, displayed decreasing, or deflationary, trends over recent valuations. The decreasing trends are exhibited in the paid loss development data for the 15 months to 51 months development period. The decisions to decrease the estimated ultimate losses for accident years 2005, 2006 and 2007 at March 31, 2008 were made, as the underlying loss data showed sustained and continued improvement over the prior twelve months, which we determined was an appropriate amount of time to be considered reliable for our estimate. We believe that our loss development factor selections are appropriate given the relative immaturity of our data. Over time, as the data for these accident years mature and uncertainty surrounding the ultimate outcome of the claim costs diminishes, the full impact of the actual loss development will be factored into our assumptions and selections.
In the first quarter of 2008, we experienced development in all three categories. For State Act California, there was favorable development for accident years 2005, 2006 and 2007 that resulted in a reduction of our gross ultimate loss estimates of $1.5 million, $2.7 million and $1.0 million, respectively. For accident year 2004 there was unfavorable development for ALAE which resulted in an increase in our gross ultimate ALAE estimate of $0.4 million. For non-California State Act, there was favorable development for accident year 2006 and 2007 that resulted in a reduction of our gross ultimate loss estimate of 0.6 million and $1.5 million, respectively. For USL&H, there was favorable development for accident years 2006 and 2007 that resulted in a reduction of our gross ultimate loss estimates by $0.3 million and $0.7 million, respectively. For accident years 2005 and 2004, there was unfavorable development which resulted in an increase in our gross ultimate loss estimates of $0.2 million and $0.1 million, respectively. For all other accident years, the development was at expected levels which did not warrant a change to our gross ultimate loss estimates.
Reserve Sensitivities
Although many factors influence the actual cost of claims and the corresponding unpaid loss and loss adjustment expense estimates, we do not measure and estimate values for all of these variables individually. This is due to the fact that many of the factors that are known to impact the cost of claims cannot be measured directly. This is the case for the impact of economic inflation on claim costs, coverage interpretations and jury determinations. In most instances, we rely on historical experience or industry information to estimate values for the variables that are explicitly used in the unpaid loss and loss adjustment expense analysis. We assume that the historical effect of these unmeasured factors, which is embedded in our experience or industry experience, is representative of future effects of these factors. It is important to note that actual claims costs will vary from our estimate of ultimate claim costs, perhaps by substantial amounts, due to the inherent variability of the business written, the potentially significant claim settlement lags and the fact that not all events affecting future claim costs can be estimated.
As discussed in the previous section, there are a number of variables that can impact, individually or in combination, the adequacy of our loss and loss adjustment expense liabilities. While the actuarial methods employed factor in amounts for these circumstances, the loss reserves may prove to be inadequate despite the actuarial methods used. Several examples are provided below to highlight the potential variability present in our loss reserves. Each of these examples represents scenarios that are reasonably likely to occur over time. For example, there may be a number of claims where the unpaid loss and loss adjustment expense associated with future medical treatment proves to be inadequate because the injured workers do not respond to medical treatment as expected by the claims examiner. If we assume this affects 10% of the open claims and, on average, the unpaid loss and loss adjustment expenses on these claims are 20% inadequate, this would result in our unpaid loss and loss adjustment expense liability being inadequate by approximately $5.1 million, or 2%, as of March 31, 2008. Another example is claim inflation. Claim inflation can result from medical cost inflation or wage inflation. As discussed above, the actuarial methods employed include an amount for claim inflation based on historical experience. We assume that the historical effect of this factor, which is embedded in our experience and industry experience, is representative of future effects for claim inflation. To the extent that the historical factors, and the actuarial methods utilized, are inadequate to recognize future inflationary trends, our unpaid loss and loss adjustment expense liabilities may be inadequate. If our estimate of future medical trend is two percentage points inadequate (e.g., if we estimate a 9% annual trend and the actual trend is 11%), our unpaid loss and loss adjustment expense liability could be inadequate.
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The amount of the inadequacy would depend on the mix of medical and indemnity payments and the length of time until the claims are paid. For example, if we assume that 50% of the unpaid loss and loss adjustment expense is associated with medical payments and an average payout period of 5 years, our unpaid loss and loss adjustment expense liabilities would be inadequate by approximately $12.8 million on a pre-tax basis, or 5%, as of March 31, 2008. Under these assumptions, the inadequacy of approximately $12.8 million represents approximately 4.2% of total stockholders’ equity at March 31, 2008. The impact of any reserve deficiencies, or redundancies, on our reported results and future earnings is discussed below.
In the event that our estimates of ultimate unpaid loss and loss adjustment expense liabilities prove to be greater or less than the ultimate liability, our future earnings and financial position could be positively or negatively impacted. Future earnings would be reduced by the amount of any deficiencies in the year(s) in which the claims are paid or the unpaid loss and loss adjustment expense liabilities are increased. For example, if we determined our unpaid loss and loss adjustment expense liability of $255.1 million as of March 31, 2008 to be 5% inadequate, we would experience a pre-tax reduction in future earnings of approximately $12.8 million. This reduction could be realized in one year or multiple years, depending on when the deficiency is identified. The deficiency, after tax effects, would also impact our financial position because our statutory surplus would be reduced by an amount equivalent to the reduction in net income. Any deficiency is typically recognized in the unpaid loss and loss adjustment expense liability and, accordingly, it typically does not have a material effect on our liquidity because the claims have not been paid. Since the claims will typically be paid out over a multi-year period, we have generally been able to adjust our investments to match the anticipated future claim payments. Conversely, if our estimates of ultimate unpaid loss and loss adjustment expense liabilities prove to be redundant, our future earnings and financial position would be improved.
Reinsurance Recoverables
Reinsurance recoverables on paid and unpaid losses represent the portion of the loss and loss adjustment expenses that is assumed by reinsurers. These recoverables are reported on our balance sheet separately as assets, as reinsurance does not relieve us of our legal liability to policyholders and ceding companies. We are required to pay losses even if a reinsurer fails to meet its obligations under the applicable reinsurance agreement. Reinsurance recoverables are determined based in part on the terms and conditions of reinsurance contracts, which could be subject to interpretations that differ from ours based on judicial theories of liability. We calculate amounts recoverable from reinsurers based on our estimates of the underlying loss and loss adjustment expenses, which themselves are subject to significant judgments and uncertainties described above under the heading “Unpaid Loss and Loss Adjustment Expenses.” Changes in the estimates and assumptions underlying the calculation of our loss reserves may have an impact on the balance of our reinsurance recoverables. In general, one would expect an increase in our underlying loss reserves on claims subject to reinsurance to have an upward impact on our reinsurance recoverables. The amount of the impact on reinsurance recoverables would depend on a number of considerations including, but not limited to, the terms and attachment points of our reinsurance contracts and the incurred amount on various claims subject to reinsurance. We also bear credit risk with respect to our reinsurers, which can be significant considering that some claims may remain open for an extended period of time.
We periodically evaluate our reinsurance recoverables, including the financial ratings of our reinsurers, and revise our estimates of such amounts as conditions and circumstances change. Changes in reinsurance recoverables are recorded in the period in which the estimate is revised. As of March 31, 2008 and December 31, 2007, we had no reserve for uncollectible reinsurance recoverables. We assessed the collectibility of our period-end receivables and believe that all amounts are collectible based on currently available information.
Deferred Policy Acquisition Costs
We defer commissions, premium taxes and certain other costs that vary with and are primarily related to the acquisition of insurance contracts. These costs are capitalized and charged to expense in proportion to the recognition of premiums earned. The method followed in computing deferred policy acquisition costs limits the amount of these deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related estimated investment income, anticipated losses and settlement expenses and certain other costs we expect to incur as the premium is earned. Judgments regarding the ultimate recoverability of these deferred costs are highly dependent upon the estimated future costs associated with our unearned premiums. If our expected claims and expenses, after considering investment income, exceed our unearned premiums, we would be required to write-off a portion of deferred policy acquisition costs. To date, we have not needed to write-off any portion of our deferred acquisition costs. If our estimate of anticipated losses and related costs was 10% inadequate, our deferred acquisition
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costs as of March 31, 2008 would still be fully recoverable and no write-off would be necessary. We will continue to monitor the balance of deferred acquisition costs for recoverability.
Income Taxes
We use the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the statement of operations in the period that includes the enactment date.
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. This analysis requires management to make various estimates and assumptions, including the scheduled reversal of deferred tax liabilities, projected future taxable income and the effect of tax planning strategies. If actual results differ from management’s estimates and assumptions, we may be required to establish a valuation allowance to reduce the deferred tax assets to the amounts more likely than not to be realized. The establishment of a valuation allowance could have a significant impact on our financial position and results of operations in the period in which it is deemed necessary. To date, we have not needed to record a valuation allowance against our deferred tax assets. We anticipate that our deferred tax assets will increase as our business continues to grow. We will continue to monitor the balance of our deferred tax assets for realizability.
Effective January 1, 2007, we adopted FASB Interpretation No. 48,Accounting for Uncertainties in Income Taxes, an Interpretation of FASB Statement No. 109 (“FIN 48”), and it did not have a significant impact on our financial position or results of operations. FIN 48 prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and also provides guidance on the derecognition of previously recorded benefits and their classification, as well as the proper recording of interest and penalties, accounting in interim periods, disclosures and transition. As of March 31, 2008 and December 31, 2007, we had no unrecognized tax benefits. We do not anticipate that the amount of unrecognized tax benefits will significantly increase in the next 12 months. Our policy is to recognize interest and penalties on unrecognized tax benefits as an element of income tax expense (benefit) in our consolidated statements of operations. We file consolidated U.S. federal and state income tax returns. The tax years which remain subject to examination by the taxing authorities are the years ending December 31, 2004, 2005, 2006 and 2007.
Impairment of Investment Securities
Impairment of investment securities results in a charge to operations when the fair value of a security declines below our cost and is deemed to be other-than-temporary. We regularly review our investment portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. A number of criteria are considered during this process, including but not limited to the following: the current fair value as compared to amortized cost or cost, as appropriate, of the security; the length of time the security’s fair value has been below amortized cost; our intent and ability to retain the investment for a period of time sufficient to allow for an anticipated recovery in value; specific credit issues related to the issuer; and current economic conditions, including interest rates.
In general, we focus on those securities whose fair value was less than 80% of their amortized cost or cost, as appropriate, for six or more consecutive months. We also analyze the entire portfolio for other factors that might indicate a risk of impairment. Other-than-temporary impairment losses result in a permanent reduction of the carrying value of the underlying investment. To date, we have not needed to record any other-than-temporary impairments of our investment securities. Please refer to the tables in Note 3 of the unaudited condensed consolidated financial statements in Part I, Item 1 of this quarterly report for additional information on unrealized losses on our investment securities. Please refer to Part I, Item 3 of this quarterly report for tables showing the sensitivity of the fair value of our fixed-income investments to selected hypothetical changes in interest rates.
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Earned But Unbilled Premiums
Shortly following the expiration of an insurance policy, we perform a final payroll audit of our insureds to determine the final premium to be billed and earned. These final audits generally result in an audit adjustment, either increasing or decreasing the estimated premium earned and billed to date. We estimate the amount of premiums that have been earned but are unbilled at the end of a reporting period by analyzing historical earned premium adjustments made at final audit for the preceding 12 months and applying the average adjustment percentage against our in-force earned premium for the period. These estimates are subject to changes in policyholders’ payrolls due to growth, economic conditions, seasonality and other factors and to fluctuations in our in-force premium. For example, the amount of our accrual for premiums earned but unbilled fluctuated between $0 and $1.2 million in 2007 and between $1.2 million and $1.8 million in 2006. The balance of our accrual for premiums earned but unbilled was a $0 and $44,000 at March 31, 2008 and December 31, 2007, respectively. Although considerable variability is inherent in such estimates, management believes that the accrual for earned but unbilled premiums is reasonable. The estimates are reviewed quarterly and adjusted as necessary as experience develops or new information becomes known. Any such adjustments are included in current operations.
Retrospective Premiums
The premiums for our retrospectively rated loss sensitive plans are reflective of the customer’s loss experience because, beginning six months after the expiration of the relevant insurance policy, and annually thereafter, we recalculate the premium payable during the policy term based on the current value of the known losses that occurred during the policy term. While the typical retrospectively rated policy has around five annual adjustment or measurement periods, premium adjustments continue until mutual agreement to cease future adjustments is reached with the policyholder. Retrospective premiums for primary and reinsured risks are included in income as earned on a pro rata basis over the effective period of the respective policies. Earned premiums on retrospectively rated policies are based on our estimate of loss experience as of the measurement date. Unearned premiums are deferred and include that portion of premiums written that is applicable to the unexpired period of the policies in force and estimated adjustments of premiums on policies that have retrospective rating endorsements.
We bear credit risk with respect to retrospectively rated policies. Because of the long duration of our loss sensitive plans, there is a risk that the customer will fail to pay the additional premium. Accordingly, we obtain collateral in the form of letters of credit or deposits to mitigate credit risk associated with our loss sensitive plans. If we are unable to collect future retrospective premium adjustments from an insured, we would be required to write-off the related amounts, which could impact our financial position and results of operations. To date, there have been no such write-offs. Retrospectively rated policies accounted for approximately 9.3% of direct premiums written in the three months ended March 31, 2008 and approximately 11.9% of direct premiums written in the year ended December 31, 2007.
Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157,Fair Value Measurements, which defines fair value and establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. The provisions for SFAS No. 157 are effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We adopted the provisions of SFAS No. 157 as of January 1, 2008, which did not have a material effect on our consolidated financial condition or results of operations.
In February 2007, the FASB issued SFAS No. 159,The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115, which permits entities to choose to measure many financial instruments and certain other items at fair value in order to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently and without having to apply complex hedge accounting provisions. The provisions for SFAS No. 159 are effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We adopted the provisions of SFAS No. 159 as of January 1, 2008, which did not have a material effect on our consolidated financial condition or results of operations.
| |
Item 3. | Quantitative and Qualitative Disclosures About Market Risk |
Market risk is the potential economic loss principally arising from adverse changes in the fair value of financial instruments. The major components of market risk affecting us are credit risk and interest rate risk.
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Credit Risk
Credit risk is the potential economic loss principally arising from adverse changes in the financial condition of a specific debt issuer. We address this risk by investing primarily in fixed-income securities which are rated “A” or higher by Standard & Poor’s. We also independently, and through our outside investment managers, monitor the financial condition of all of the issuers of fixed-income securities in the portfolio. To limit our exposure to risk, we employ stringent diversification rules that limit the credit exposure to any single issuer or business sector.
Interest Rate Risk
We had fixed-income investments with a fair value of $493.0 million at March 31, 2008 that are subject to interest rate risk, compared with $474.8 million at December 31, 2007. We manage the exposure to interest rate risk through a disciplined asset/liability matching and capital management process. In the management of this risk, the characteristics of duration, credit and variability of cash flows are critical elements. These risks are assessed regularly and balanced within the context of the liability and capital position.
The table below summarizes our interest rate risk as of March 31, 2008 and December 31, 2007. It illustrates the sensitivity of the fair value of fixed-income investments to selected hypothetical changes in interest rates as of March 31, 2008 and December 31, 2007. The selected scenarios are not predictions of future events, but rather illustrate the effect that such events may have on the fair value of our fixed-income portfolio and shareholders’ equity.
Interest Rate Risk as of March 31, 2008
| | | | | | | | | | | | |
Hypothetical Change in Interest Rates | | Estimated
Change in
Fair Value | | Fair Value | | Hypothetical
Percentage
Increase
(Decrease) in
Portfolio
Value | |
| |
| |
| |
| |
| | ($ in thousands) | |
200 basis point increase | | $ | (44,347 | ) | $ | 448,630 | | | | (9.0 | )% | |
100 basis point increase | | | (21,672 | ) | | 471,305 | | | | (4.4 | )% | |
No change | | | — | | | 492,977 | | | | — | | |
100 basis point decrease | | | 20,651 | | | 513,628 | | | | 4.2 | % | |
200 basis point decrease | | | 40,299 | | | 533,276 | | | | 8.2 | % | |
Interest Rate Risk as of December 31, 2007
| | | | | | | | | | | | |
Hypothetical Change in Interest Rates | | Estimated
Change in
Fair Value | | Fair Value | | Hypothetical
Percentage
Increase
(Decrease) in
Portfolio
Value | |
| |
| |
| |
| |
| | | | | ($ in thousands) | | | | | | |
200 basis point increase | | $ | (40,927 | ) | $ | 433,829 | | | | (8.6 | )% | |
100 basis point increase | | | (20,041 | ) | | 454,715 | | | | (4.2 | )% | |
No change | | | — | | | 474,756 | | | | — | | |
100 basis point decrease | | | 19,195 | | | 493,951 | | | | 4.0 | % | |
200 basis point decrease | | | 37,545 | | | 512,301 | | | | 7.9 | % | |
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Item 4. | Controls and Procedures |
Disclosure Controls and Procedures
Under the supervision and with the participation of management, including our Chief Executive Officer and our former Chief Financial Officer, we have carried out an evaluation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Based on that evaluation, our Chief Executive Officer and our former Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report to ensure that information we are required to disclose in reports that are filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms specified by the SEC and is accumulated and communicated to our management, including our Chief Executive Officer and our former Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
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Changes in Internal Control over Financial Reporting
There have not been any changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during our first fiscal quarter of 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II – OTHER INFORMATION
You should carefully consider the risks described below and in our Annual Report on Form 10-K filed with the SEC on March 17, 2008, together with all of the other information included in this quarterly report. Such risks and uncertainties are not the only ones facing us. If any such risks actually occur, our business, financial condition or operating results could be harmed. Any such risks could result in a significant or material adverse effect on our financial condition or results of operations, and a corresponding decline in the market price of our common stock. You could lose all or part of your investment. Such risks also include forward-looking statements and our actual results may differ substantially from those discussed in those forward-looking statements. Please refer to the discussion under the heading “Cautionary Statement” in Part I, Item 2 of this quarterly report.
Under the heading “Item 1A. Risk Factors – Risk Related to Our Business – We could be adversely affected by the loss of one or more principal employees or by an inability to attract or retain staff” in our Annual Report on Form 10-K filed with the SEC on March 17, 2008, we included a discussion about the potential adverse impact to our business of losing a member of our senior management team, including our chief financial officer. Joseph S. De Vita, our senior vice president and chief financial officer, passed away unexpectedly on Sunday, April 20, 2008. We have begun the process of selecting a new chief financial officer but are unable to predict how long the selection process, which could be challenging, will take and when we will name a new chief financial officer. In the meantime, the duties of the chief financial officer are being handled by other senior officers on whom we will be more dependent during this transition period.
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Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds |
We did not purchase any of our equity securities during the three months ended March 31, 2008.
The list of exhibits in the Exhibit Index to this quarterly report is incorporated herein by reference.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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| SEABRIGHT INSURANCE HOLDINGS, INC. |
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Date: May 12, 2008 | | | |
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| By: | /s/ John G. Pasqualetto | |
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| | John G. Pasqualetto | |
| | Chairman, President and Chief Executive Officer | |
| | (Principal Executive Officer) | |
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| By: | /s/ M. Philip Romney | |
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| | M. Philip Romney | |
| | Vice President – Finance, Principal Accounting | |
| | Officer and Assistant Secretary | |
| | (Chief Accounting Officer) | |
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EXHIBIT INDEX
The list of exhibits in the Exhibit Index to this quarterly report on Form 10-Q is incorporated herein by reference. Exhibits 31.1 and 31.2 are being filed as part of this quarterly report on Form 10-Q. Exhibits 32.1 and 32.2 are being furnished with this quarterly report on Form 10-Q.
