Eastern Insurance 10K 2009 Annual report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

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

For the fiscal year ended December 31, 2009

¨	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 001-32899

EASTERN INSURANCE HOLDINGS, INC.

Incorporated in Pennsylvania

I.R.S. Employer Identification No.

25 Race Avenue, Lancaster, Pennsylvania

17603-3179

(717) 396-7095

20-2653793

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

Title of Each Class

Name of Each Exchange on

Which Registered

Common Stock, No Par Value

NASDAQ Global Market

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

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

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

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

Indicate by check mark 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 ¨ No ¨

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

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

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

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

The aggregate market value of the common stock held by non-affiliates of the registrant, based on the closing price of the registrant on June 30, 2009, as reported by the NASDAQ National Market, was $74,488,459.

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


Title of Each Class		Number of Shares Outstanding as of March 4, 2010
Common Stock, No Par Value		9,691,257 (Outstanding Shares)

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement in connection with the 2010 Annual Meeting of Stockholders—Part III.

Table of Contents

Eastern Insurance Holdings, Inc. and Subsidiaries


Item	Description	Page
*Part I*

Item 1	Business	1

Item 1A	Risk Factors	27

Item 1B	Unresolved Staff Comments	33

Item 2	Properties	33

Item 3	Legal Proceedings	33

Item 4	Submission of Matters to a Vote of Security Holders	33

*Part II*

Item 5	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	34

Item 6	Selected Financial Data	38

Item 7	Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations	40

Item 7A	Quantitative and Qualitative Disclosures about Market Risk	72

Item 8	Financial Statements and Supplementary Data	74

Item 9	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	112

Item 9A	Controls and Procedures	112

Item 9B	Other Information	112

*Part III*

Item 10	Directors and Officers of the Registrant	113

Item 11	Executive Compensation	113

Item 12	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	113

Item 13	Certain Relationships and Related Transactions	113

Item 14	Principal Accountant Fees and Services	113

*Part IV*

Item 15	Exhibits, Financial Statement Schedules	114

PART I

Item 1—Business

Our History and Overview

Eastern Insurance Holdings, Inc. (“EIHI”) is an insurance holding company offering workers’ compensation and group benefits insurance and reinsurance products through its direct and indirect wholly-owned subsidiaries, Eastern Holding Company, Ltd. (“EHC”), Eastern Alliance Insurance Company (“Eastern Alliance”), Allied Eastern Indemnity Company (“Allied Eastern”), Eastern Advantage Assurance Company (“Eastern Advantage”), Eastern Re, Ltd., S.P.C. (“Eastern Re”), Employers Security Holding Company (“ESHC”), Employers Security Insurance Company (“ESIC”), Affinity Management Services, Inc. (“AMS”), Eastern Life and Health Insurance Company (“ELH”), Employers Alliance, Inc. (“Employers Alliance”), Global Alliance Holdings, Ltd. (“Global Alliance”), and Eastern Services Corporation (“Eastern Services”), collectively referred to as the “Company”, “we” and/or “our”.

On September 29, 2008, EIHI acquired all of the outstanding stock of ESHC and its wholly-owned subsidiaries, ESIC and AMS. ESIC is an Indiana-domiciled, mono-line workers’ compensation insurance company licensed to write business in Indiana, Illinois and Missouri.

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

•

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

•

Eastern Alliance, Allied Eastern and Eastern Advantage are stock property/casualty insurance companies domiciled in the Commonwealth of Pennsylvania and, along with ESIC, do business as Eastern Alliance Insurance Group (“EAIG”). The four insurance companies provide EAIG with increased underwriting flexibility through the use of a tiered rating structure;

•

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

•

ESHC is a holding company domiciled in the State of Indiana;

•

ESIC is a stock property/casualty insurance company domiciled in the State of Indiana;

•

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

•

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

•

AMS is an Indiana corporation offering claims administration and risk management services to self-insured property casualty customers;

•

Global Alliance is a holding company domiciled in the Commonwealth of Pennsylvania; and

•

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

Effective December 31, 2009, the Company completed a reorganization of its corporate structure. The purpose of the corporate reorganization was to reduce the number of holding companies and consolidate entities with similar operations. The reorganization included the following transactions:

•

EHC was merged into EIHI with EIHI being the surviving entity;

•

ESHC was merged into Global Alliance with Global Alliance being the surviving entity; and

•

AMS was merged into Employers Alliance with Employers Alliance being the surviving entity.

The Company currently operates in five business segments: workers’ compensation insurance, segregated portfolio cell reinsurance, group benefits insurance, specialty reinsurance and corporate/other. Effective July 1, 2008, the specialty reinsurance segment was placed into run-off.

Overview of Business Segments

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

Workers’ Compensation Insurance. The Company offers traditional workers’ compensation insurance coverage to employers, generally with 300 employees or less, primarily in the Mid-Atlantic, Southeast, and Midwest regions of the continental United States. The Company’s workers’ compensation products include guaranteed cost policies, policyholder dividend policies, retrospectively-rated policies, large deductible policies and captive programs.

Segregated Portfolio Cell Reinsurance. Workers’ compensation insurance coverage is also underwritten through the Company’s alternative markets business unit and ceded 100% to the segregated portfolio cell reinsurance segment. The Company receives a fronting fee generally based upon a percentage of direct premiums written, a segregated portfolio cell rental fee, which is also based on a percentage of direct premiums written, and fees for claims administration and risk management services. As of December 31, 2009, the segregated portfolio cells and dividend participants provided $47.2 million of irrevocable, unconditional letters of credit to secure unfunded liabilities and collateralize reserves for unpaid losses and loss adjustment expenses (“LAE”) and unearned premiums.

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

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

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

Products

Workers’ Compensation Insurance

The Company offers a complete line of workers’ compensation products including guaranteed cost policies, policyholder dividend policies, retrospectively-rated policies, large deductible policies, and alternative market products. Direct premiums written in the workers’ compensation insurance segment totaled $110.7 million for the year ended December 31, 2009.

•

Guaranteed cost policies. Guaranteed cost policies charge a fixed premium, which does not increase or decrease based upon loss experience during the policy period. For the year ended December 31, 2009, 56.7% of direct premiums written in the workers’ compensation insurance segment were derived from guaranteed cost policies.

•

Policyholder dividend policies. Policyholder dividend policies charge a fixed premium, but the customer may receive a dividend in the event of favorable loss experience during the policy period. Policyholder dividend plans are generally restricted to accounts with minimum annual premiums in excess of $20,000. For the year ended December 31, 2009, 9.9% of direct premiums written in the workers’ compensation insurance segment were derived from policyholder dividend policies.

•

Retrospectively-rated policies. Retrospectively-rated policies charge an initial premium that is subject to adjustment after the policy period expires, based upon the insured’s actual loss experience incurred during the policy period, subject to a minimum and maximum premium. These policies are typically subject to annual adjustment until all claims related to the policy year are closed. Retrospectively-rated policies are generally offered to employers with minimum annual premiums in excess of $150,000. For the year ended December 31, 2009, 2.3% of direct premiums written in the workers’ compensation insurance segment were derived from retrospectively-rated policies.

•

Large deductible policies. Large deductible policies generally result in a lower premium; however, the insured retains a greater share of the underwriting risk than under guaranteed cost or dividend paying policies, which reduces the risk to the Company and further encourages loss control practices by the insured. The customer is contractually obligated to pay its own losses up to the amount of the deductible for each occurrence. The deductibles under these policies generally range from $250,000 to $300,000. Large deductible policies are generally offered to employers with annual premiums of $500,000 or higher. For the year ended December 31, 2009, 4.7% of direct premiums written in the workers’ compensation insurance segment were derived from large deductible policies.

•

Alternative market products. Alternative market products are offered to individual companies, groups, and trade associations. As described above in “Overview of Business Segments—Segregated Portfolio Cell Reinsurance” a policy is issued to an insured and 100% of the premium written, less a ceding commission, is ceded to a segregated portfolio cell. For the year ended December 31, 2009, 26.4% of direct premiums written in the workers’ compensation insurance segment were derived from alternative market products.

Segregated Portfolio Cell Reinsurance

Segregated portfolio cells, or segregated cells or rent-a-captives, are all referred to as alternative market programs or products. The Company provides a variety of products to this marketplace, including program design, fronting, claims administration, risk management, segregated portfolio cell rental, investment and segregated portfolio management services. Direct premiums written in the segregated portfolio cell reinsurance segment totaled $28.7 million for the year ended December 31, 2009. The segregated portfolio cell reinsurance segment generated fee revenue to the Company’s workers’ compensation insurance, run-off specialty reinsurance, and corporate/other segments totaling $4.1 million for the year ended December 31, 2009.

Group Benefits Insurance

The Company’s group benefits insurance products include dental insurance, short-term disability insurance, long-term disability insurance, term life insurance, and vision insurance, which are available on an employer or employee paid (i.e., voluntary) basis, or a combination thereof.

•

Dental Insurance.Dental plans include fee for service and managed care plans. Multiple variations of these products are available which offer different degrees of coverage, affordability and flexibility. Managed care plans utilize the networks of two unaffiliated dental Preferred Provider Organizations. Direct premiums written in the dental line totaled $22.5 million for the year ended December 31, 2009.

•

Short-Term Disability Insurance. Short-term disability plans pay flat weekly benefit amounts or a percentage of an individual claimant’s weekly earnings in the event of disability. Direct premiums written in the short-term disability line totaled $6.1 million for the year ended December 31, 2009.

•

Long-Term Disability Insurance. Long-term disability plans provide preset amounts or a preset percentage of an individual claimant’s monthly earnings in the event of disability. Direct premiums written in the long-term disability line totaled $3.8 million for the year ended December 31, 2009.

•

Term Life Insurance. Term life plans pay flat amounts or a multiple of an individual’s salary. Direct premiums written in the term life line totaled $6.1 million for the year ended December 31, 2009.

•

Vision Insurance. Vision plans are offered with different degrees of coverage, affordability and flexibility. Direct premiums written in the vision line totaled $79,000 for the year ended December 31, 2009.

Run-off Specialty Reinsurance

Prior to July 1, 2008, the Company participated as a reinsurer in treaties with a large primary insurer for the EnviroGuard program and the EIA program. Assumed premiums written in the run-off specialty reinsurance segment totaled $155,000 for the year ended December 31, 2009. The Company does not anticipate any premium to be recognized subsequent to December 31, 2009.

Marketing and Distribution

Workers’ Compensation Insurance

The Company distributes its workers’ compensation products and services primarily in the Mid-Atlantic, Southeast and Midwest regions of the continental United States through a network of carefully chosen independent insurance producers. The following table provides direct premiums written, before purchase accounting adjustments, by state, for the year ended December 31, 2009 (dollars in thousands):


State	Direct Premiums Written		Percentage
Pennsylvania	$	88,306	79.8	%
Indiana		9,400	8.5	%
North Carolina		5,045	4.6	%
Maryland		2,858	2.6	%
Delaware		1,809	1.6	%
Virginia		1,560	1.4	%
Other		1,726	1.5	%

Total	$	110,704	100.0	%

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

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

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

•

The Company carefully selects producers through a process that assesses financial results, market potential, business philosophy and reputation of the producer and its staff. Senior management of the Company approves all producer appointments following extensive meetings with the producer’s principals. Following the agreement to appoint, the Company’s Senior Vice President of Marketing and other key personnel conduct a formal orientation process focusing on the Company’s workers’ compensation products and services, dedicated service team and the joint business objectives of the Company and the producer.

•

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

•

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

•

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

The Company attempts to optimize the franchise value of a workers’ compensation producer appointment by limiting the number of appointments in identified marketing territories. As a result of this producer management strategy, the average direct premiums written per agency contract was $1.1 million for the year ended December 31, 2009.

The Company’s ten largest producers in its workers’ compensation insurance segment accounted for 55.1% of its direct premiums written for the year ended December 31, 2009. The Company’s two largest producers, E.K. McConkey and The Alliance of Central PA, Inc., in its workers’ compensation insurance segment accounted for 12.9% and 11.6% of its direct premiums written, respectively, for the year ended December 31, 2009. These producers are subject to the terms and conditions of the Company’s Agency Agreement, which sets forth binding authority, premium remittance and collection and termination provisions, among other things. No other producer accounted for more than 10.0% of the Company’s direct premiums written in its workers’ compensation insurance segment for the year ended December 31, 2009.

Segregated Portfolio Cell Reinsurance

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

Group Benefits Insurance

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

The following table provides direct premiums written, by state, for the year ended December 31, 2009 (dollars in thousands):


State	Direct Premiums Written		Percentage
Pennsylvania	$	14,215	36.7	%
North Carolina		11,411	29.5	%
Maryland		2,818	7.3	%
South Carolina		2,816	7.3	%
Delaware		1,917	4.9	%
Virginia		1,798	4.6	%
Other		3,765	9.7	%

Total	$	38,740	100.0	%

The Company has established an Agency Advisory Council with its group benefits insurance producers, similar to that described above in workers’ compensation insurance. The Company has established a separate Agent Advisory Council for its Mid-Atlantic and Southeast producers, both of which meet once a year to discuss topics such as market conditions, customer service, products, competition and areas of opportunity within each geographic market.

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

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

Underwriting, Risk Management and Pricing

Workers’ Compensation Insurance

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

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

For the year ended December 31, 2009, the average annual workers’ compensation traditional premium per policy was $16,696.

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

Segregated Portfolio Cell Reinsurance

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

Group Benefits Insurance

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

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

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

Claims

Workers’ Compensation Insurance

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

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

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

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

The Company attempts to aggressively achieve final resolution of, and close, claims from prior accident years. The table below shows the number of prior years workers’ compensation claims received and closed and open claims, by accident year, as of December 31, 2009.

Traditional Business

(Exclusive of Alternative Markets)

Open Claims (1)


Accident Year	Total Claims	Open	Closed	% Closed
1994	1	0	1	100.0	%
1995	18	0	18	100.0	%
1996	342	0	342	100.0	%
1997	430	1	429	99.8	%��
1998	566	1	565	99.8	%
1999	797	2	795	99.7	%
2000	1,503	6	1,497	99.6	%
2001	1,947	5	1,942	99.7	%
2002	1,194	5	1,189	99.6	%
2003	825	7	818	99.2	%
2004	1,138	13	1,125	98.9	%
2005	1,141	21	1,120	98.2	%
2006	1,355	33	1,322	97.6	%
2007	1,424	79	1,345	94.5	%
2008	1,481	173	1,308	88.3	%
2009	1,276	536	740	58.0	%

	15,438	882	14,556	94.3	%

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

The table below shows the number of open lost time claims for accident years 2008 and prior as of December 31, 2009 and 2008:

Traditional Business

(Exclusive of Alternative Markets)

Open Claims (1)


Accident Year	12-31-09 Open	12-31-08 Open	2008 and Prior Claims Closed During 2009		% of 2008 Open Claims Closed During 2009
1997	1	1	0		0.0	%
1998	1	1	0		0.0	%
1999	2	1	(1	)	(100.0	)%
2000	6	7	1		14.3	%
2001	5	8	3		37.5	%
2002	5	10	5		50.0	%
2003	7	8	1		12.5	%
2004	13	24	11		45.8	%
2005	21	34	13		38.2	%
2006	33	61	28		45.9	%
2007	79	179	100		55.9	%
2008	173	606	433		71.5	%

	346	940	594		63.2	%

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

Segregated Portfolio Cell Reinsurance

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

Group Benefits Insurance

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

•

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

•

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

•

Long-Term Disability Claims. The Company’s long term disability claims processing is outsourced to its long-term disability partners, Disability Reinsurance Management Services, Inc. (“DRMS”) and Custom Disability Solutions (“CDS”). Management believes these outsourcing arrangements provide the Company with more experienced claim personnel and resources in a more cost-effective manner than handling claims internally.

•

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

•

Vision Claims. Vision claims are submitted by the provider to VSP, the Company’s third party vendor for its vision product. VSP processes and pays all claims and bills the Company on a monthly basis.

Run-off Specialty Reinsurance

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

Reinsurance

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

•

reduce net liability on individual risks;

•

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

•

stabilize underwriting results; and

•

decrease leverage and, accordingly, increase underwriting capacity.

Reinsurance does not legally discharge the Company from primary liability for the full amount due under the reinsured policies. However, the assuming reinsurer is obligated to reimburse the Company to the extent of the coverage ceded. As of December 31, 2009, the Company’s reinsurance recoverables, by segment and before purchase accounting adjustments, were as follows (in thousands):


Segment	Amount
Workers’ compensation insurance	$	8,815
Segregated portfolio cell reinsurance		3,501
Group benefits insurance		16,166
Run-off specialty reinsurance		—

Total	$	28,482

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

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

Workers’ Compensation Insurance

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

The following table sets forth the amounts recoverable from reinsurers for the workers’ compensation insurance segment as of December 31, 2009 (dollars in thousands):


Name	Reinsurance Recoverable		A.M. Best Rating	Percentage of Shareholders’ Equity		Percentage of Reinsurance Recoverable
Lloyd’s of London	$	4,857	A	3.2	%	17.0	%
Aspen Insurance UK, Ltd.		2,340	A	1.5	%	8.2	%
Swiss Reinsurance America Corporation		512	A(1)	0.3	%	1.8	%
Max Bermuda, Ltd.		312	A-	0.2	%	1.1	%
General Reinsurance Corporation		300	A++(2)	0.2	%	1.1	%
Catalina London, Ltd.		201	NR-3(3)	0.1	%	0.7	%
Alea Bermuda, Ltd.		122	NR-5(4)	0.1	%	0.4	%
Reliastar Life Insurance Company		108	A(5)	0.1	%	0.4	%
St. Paul Reinsurance Company Ltd.		63	NR-3(3)	0.0	%	0.2	%

	$	8,815		5.7	%	30.9	%

(1)	Swiss Reinsurance America Corporation was downgraded by A.M. Best from “A+” (Superior) to “A” (Excellent) with a stable outlook on February 27, 2009. The stable outlook was affirmed by A.M. Best on December 14, 2009.

(2)	General Reinsurance Corporation’s “A++” (Superior) rating was placed under review on November 6, 2009 with a negative outlook.

(3)	Rating assigned to companies that are not rated by A.M. Best.

(4)	Rating assigned to companies that are not formally followed by A.M. Best.

(5)	Reliastar Life Insurance Company was downgraded by A.M. Best from “A+” (Superior) to “A” (Excellent) with a negative outlook on April 24, 2009.

Segregated Portfolio Cell Reinsurance

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

•

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

•

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

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

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

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

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


Aggregate attachment point ($1,000,000 x .90)	$	900,000
Loss fund ($1,000,000 – ($1,000,000 x .40))	$	600,000
GAP	$	300,000

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

The following table sets forth the amounts recoverable from reinsurers for the segregated portfolio cell reinsurance segment as of December 31, 2009 (dollars in thousands):


Name	Reinsurance Recoverable		A.M. Best Rating		Percentage of Shareholders’ Equity		Percentage of Reinsurance Recoverable
Lloyd’s of London	$	1,938	A		1.3	%	6.8	%
Aspen Insurance UK, Ltd.		1,272	A		0.8	%	4.5	%
Catalina London, Ltd.		283	NR-3	(1)	0.2	%	1.0	%
St. Paul Reinsurance Company Ltd.		8	NR-3	(1)	0.0	%	0.0	%

	$	3,501			2.3	%	12.3	%

(1)	Rating assigned to companies that are not rated by A.M. Best.

Group Benefits Insurance

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

The Company’s long-term disability business is reinsured on a quota-share basis, under which the Company retains 20% of the first $6,000 in monthly disability benefits. Monthly benefits in excess of $6,000 are 100% reinsured. The long-term disability business is reinsured with Union Security Insurance Company and Reliance Standard Life Insurance Company.

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

The Company has a block of active disability claims that it has completely ceded to The Hartford Life and Accident Insurance Company. These claims arose out of long term disability policies that ELH formerly offered to selected professional associations. The largest of these policies terminated in April 1997 and all but two of the remaining active claims pursuant to such policies were acquired by The Hartford in 1999. The Hartford manages and pays all such claims without any involvement from the Company and provides all financial information required for the Company’s financial reporting purposes. Under the terms of the reinsurance agreement, if The Hartford’s Standard & Poor’s credit rating falls below “A”, The Hartford, at the written request of the Company, must provide the Company with collateral in the form of a letter of credit equal to 103% of the statutory reserves associated with the reinsured claims covered by the reinsurance agreement or establish a trust with assets having a market value equal to at least the statutory reserves associated with the reinsured claims.

The following table sets forth the amounts recoverables from reinsurers for the group benefits insurance segment as of December 31, 2009 (dollars in thousands):


Carrier	Reinsurance Recoverable		A.M Best Rating	Percentage of Shareholders’ Equity		Percentage of Reinsurance Recoverable
Union Security Insurance Company	$	8,091	A-	5.3	%	28.4	%
Hartford Life and Accident Insurance Company		7,769	A(1)	5.0	%	27.3	%
Swiss Re Life and Health America, Inc.		101	A(2)	0.1	%	0.4	%
Reliance Standard Life Insurance Company		95	A(3)	0.1	%	0.3	%
Reliastar Life Insurance Company		67	A(4)	0.0	%	0.2	%
United Teacher Associates Insurance Company		25	A-(5)	0.0	%	0.1	%
Combined Insurance Company of America		18	A	0.0	%	0.1	%

	$	16,166		10.5	%	56.8	%

(1)	Hartford Life and Accident Insurance Company was downgraded by A.M. Best from “A+” (Superior) to “A” (Excellent) with a negative outlook on February 27, 2009.

(2)	Swiss Re Life and Health America was downgraded by A.M. Best from “A+” (Superior) to “A” (Excellent) with a stable outlook on February 27, 2009. The stable outlook was affirmed by A.M. Best on December 14, 2009.

(3)	Reliance Standard Life Insurance Company was put on a negative outlook by A.M. Best on December 22, 2008.

(4)	Reliastar Life Insurance Company was downgraded by A.M. Best from “A+” (Superior) to “A” (Excellent) with a negative outlook on April 24, 2009.

(5)	United Teacher Associates Insurance Company was put on a negative outlook by A.M. Best on March 27, 2009.

Run-off Specialty Reinsurance

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

Loss and LAE Reserves

The Company estimates its reserves for unpaid losses and LAE as of the balance sheet date. The adequacy of the Company’s reserves is inherently uncertain and represents a significant risk to the business. The Company attempts to mitigate the uncertainty inherent in its reserves by continually reviewing loss cost trends, attempting to set premium rates that are adequate to cover anticipated future costs, and by professionally managing its claims administration function. Additionally, the Company attempts to minimize the estimation risk inherent in its reserves by employing actuarial techniques on a quarterly basis. Significant judgment is required in actuarial estimation to ascertain the relevance of historical payment and claim settlement patterns under current facts and circumstances. No assurance can be given as to whether the ultimate liability for unpaid losses and LAE will be more or less than the Company’s current estimates. While management believes that the assumptions underlying the amounts recorded for the reserves for unpaid losses and LAE as of December 31, 2009 are reasonable, the ultimate net liability may differ materially from the amount provided.

The following table provides a summary of the activity in the Company’s reserves for unpaid losses and LAE, excluding term life premium waiver reserves, for the years ended December 31, 2009, 2008 and 2007. The 2008 activity related to ESIC’s reserves for unpaid losses and LAE is for the period from October 1, 2008 to December 31, 2008 (in thousands).


	2009			2008			2007
Balance, beginning of period	$	155,314		$	125,249		$	121,396
Reinsurance recoverables on unpaid losses and LAE		25,636			23,429			24,236

Net balance, beginning of period		129,678			101,820			97,160
Net reserves acquired as a result of acquisition		—			7,004			—
Purchase accounting adjustments on acquisition date		—			537			—
Incurred related to:
Current year		90,438			85,404			80,946
Prior year		(5,447	)		15,009			(6,189	)

Total incurred before purchase accounting adjustments		84,991			100,413			74,757
Purchase accounting adjustments		(493	)		(548	)		(848	)

Total incurred		84,498			99,865			73,909
Paid related to:
Current year		43,427			40,570			37,019
Prior year		47,371			38,978			32,230

Total paid		90,798			79,548			69,249

Net balance, end of period		123,378			129,678			101,820
Reinsurance recoverables on unpaid losses and LAE		24,368			25,636			23,429

Balance, end of period	$	147,746		$	155,314		$	125,249

Total reserves for unpaid losses and LAE	$	151,512		$	159,117		$	129,788
Less: Term life premium waiver reserves		3,741			3,766			4,481
Less: Other		25			37			58

Balance, end of period	$	147,746		$	155,314		$	125,249

Incurred losses by segment were as follows for the year ended December 31, 2009 (in thousands):


	Workers’ Compensation Insurance Segment			Segregated Portfolio Cell Reinsurance Segment			Group Benefits Insurance Segment			Specialty Reinsurance Segment		Total
Incurred related to:
Current year, gross of discount	$	48,326		$	17,773		$	25,492		$	837	$	92,428
Current period discount		(1,343	)		(647	)		—			—		(1,990	)
Prior year, gross of discount		(3,749	)		(2,753	)		(611	)		—		(7,113	)
Accretion of prior period discount		1,075			591			—			—		1,666

Total incurred before purchase accounting adjustments		44,309			14,964			24,881			837		84,991
Purchase accounting adjustments		(465	)		(41	)		—			13		(493	)

Total incurred	$	43,844		$	14,923		$	24,881		$	850	$	84,498

Incurred losses by segment were as follows for the year ended December 31, 2008 (in thousands):


	Workers’ Compensation Insurance Segment			Segregated Portfolio Cell Reinsurance Segment			Group Benefits Insurance Segment			Specialty Reinsurance Segment		Total
Incurred related to:
Current year, gross of discount	$	39,880		$	15,274		$	26,114		$	5,746	$	87,014
Current period discount		(1,078	)		(532	)		—			—		(1,610	)
Prior year, gross of discount		(2,703	)		(1,960	)		(993	)		19,257		13,601
Accretion of prior period discount		928			480			—			—		1,408

Total incurred before purchase accounting adjustments		37,027			13,262			25,121			25,003		100,413
Purchase accounting adjustments		(492	)		(80	)		—			24		(548	)

Total incurred	$	36,535		$	13,182		$	25,121		$	25,027	$	99,865

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


	Workers’ Compensation Insurance Segment			Segregated Portfolio Cell Reinsurance Segment			Group Benefits Insurance Segment			Specialty Reinsurance Segment		Total
Incurred related to:
Current year, gross of discount	$	34,962		$	14,800		$	24,536		$	8,163	$	82,461
Current period discount		(979	)		(536	)		—			—		(1,515	)
Prior year, gross of discount		(8,398	)		(3,023	)		(961	)		4,844		(7,538	)
Accretion of prior period discount		787			562			—			—		1,349

Total incurred before purchase accounting adjustments		26,372			11,803			23,575			13,007		74,757
Purchase accounting adjustments		(758	)		(132	)		—			42		(848	)

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

For the years ended December 31, 2009, 2008 and 2007, the Company (decreased) increased its reserves for unpaid losses and LAE, including the accretion of prior period discount on its workers’ compensation insurance and segregated portfolio cell reinsurance reserves for unpaid losses and LAE, by the following amounts (in thousands):


	2009			2008			2007
Workers’ compensation insurance	$	(2,674	)	$	(1,775	)	$	(7,611	)
Segregated portfolio cell reinsurance		(2,162	)		(1,480	)		(2,461	)
Specialty reinsurance		—			19,257			4,844

Subtotal		(4,836	)		16,002			(5,228	)
Group benefits insurance		(611	)		(993	)		(961	)

Total	$	(5,447	)	$	15,009		$	(6,189	)

Workers’ Compensation Insurance

For the years ended December 31, 2009, 2008 and 2007, the Company (decreased) increased its workers’ compensation insurance reserves for unpaid losses and LAE by the following amounts by accident year (in thousands):


Accident Year	2009			2008			2007
2008	$	—		$	—		$	—
2007		(1,170	)		(1,203	)		—
2006		(1,504	)		(400	)		(2,048	)
2005		—			(650	)		(3,400	)
2004		(250	)		(200	)		(1,700	)
2003		(325	)		(100	)		(750	)
2002		(500	)		—			(500	)
2001		—			—			—
2000 and prior		—			(150	)		—

Total before discount accretion		(3,749	)		(2,703	)		(8,398	)
Discount accretion		1,075			928			787

Total	$	(2,674	)	$	(1,775	)	$	(7,611	)

For the year ended December 31, 2009, the Company recognized net favorable development on prior accident year workers’ compensation loss reserves of $3.7 million, representing 6.8% of the Company’s estimated workers’ compensation net loss reserves as of December 31, 2008 and 5.1% of the Company’s workers’ compensation net premiums earned for the year ended December 31, 2009. The favorable development arose mostly from accident years 2006 and 2007, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting include greater availability and use of employers’ return to work programs. Furthermore, the Company was able to settle a large amount of Pennsylvania claims via compromise and release, which is a lump sum cash payment in exchange for a full and final claim settlement. Management attributes the large amount of compromise and release claim closures to the difficult economic conditions and the claimants’ choosing a lump sum cash settlement over the continuation of a workers’ compensation annuity payment.

For the year ended December 31, 2008, the Company recognized net favorable development on prior accident year workers’ compensation loss reserves of $2.7 million, representing 6.3% of the Company’s estimated workers’ compensation net loss reserves as of December 31, 2007 and 4.1% of the Company’s workers’ compensation net premiums earned for the year ended December 31, 2008. The favorable development arose mostly from accident year 2007, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting the continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting include greater availability and use of employers’ return to work programs and an improved economy in the Company’s underwriting territories during the first nine months of 2008.

resulted from actual loss development being less than the Company had expected based on its historical loss development experience. The loss development factors used by the Company to determine its workers’ compensation loss reserves as of December 31, 2006 were based on its loss development history at that time. During 2007, the Company’s favorable loss development relative to its historical experience was driven by favorable effects from its loss mitigation efforts, which include greater availability and use of employers’ return to work programs, an improved economy relative to the historical experience of the Company, and significant claim settlements during 2007 at amounts less than reserves previously established.

Segregated Portfolio Cell Reinsurance

For the years ended December 31, 2009, 2008 and 2007, the Company (decreased) increased its segregated portfolio cell reinsurance reserves for unpaid losses and LAE by the following amounts by accident year (in thousands):


Accident Year	2009			2008			2007
2008	$	(1,506	)	$	—		$	—
2007		(247	)		(1,011	)		—
2006		(663	)		(1,023	)		(2,404	)
2005		76			402			(901	)
2004		(268	)		(232	)		135
2003		68			(47	)		(56	)
2002		(24	)		(26	)		84
2001		(45	)		(27	)		73
2000 and prior		(144	)		4			46

Total before discount accretion		(2,753	)		(1,960	)		(3,023	)
Discount accretion		591			480			562

Total	$	(2,162	)	$	(1,480	)	$	(2,461	)

The Company estimates and records reserves for its segregated portfolio cell reinsurance segment in the same manner as for its workers’ compensation insurance segment. Furthermore, the Company’s underwriting, claim administration and risk management services are consistent between its workers’ compensation insurance and segregated portfolio cell reinsurance segments. This is because the segregated portfolio cell reinsurance and workers’ compensation insurance segments derive their books of business from the same general business demographics and geography.

For the year ended December 31, 2009, the Company recognized net favorable development on prior accident year segregated portfolio cell reinsurance loss reserves of $2.8 million, representing 12.6% of the Company’s estimated segregated portfolio cell reinsurance net loss reserves as of December 31, 2008 and 11.1% of the Company’s segregated portfolio cell reinsurance net premiums earned for the year ended December 31, 2008. The favorable development arose mostly from accident years 2006 and 2008, but was generally prevalent in most prior accident years, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting include greater availability and use of employers’ return to work programs.

For the year ended December 31, 2008, the Company recognized net favorable development on prior accident year segregated portfolio cell reinsurance loss reserves of $2.0 million, representing 9.4% of the Company’s estimated segregated portfolio cell reinsurance net loss reserves as of December 31, 2007 and 8.4% of the Company’s segregated portfolio cell reinsurance net premiums earned for the year ended December 31, 2008. The favorable development arose mostly from accident years 2006 and 2007, and resulted from actual loss development being somewhat lower than the Company had expected based on its historical loss development experience, reflecting continued improvements in loss mitigation and underwriting. The improvements in loss mitigation and underwriting include greater availability and use of employers’ return to work programs and an improved economy in the Company’s underwriting territories during the first nine months of 2008.

portfolio cell reinsurance loss reserves as of December 31, 2006 were based on its loss development history at that time. During 2007, the Company’s favorable loss development relative to its historical experience was driven by favorable effects from its loss mitigation efforts, which include greater availability and use of employers’ return to work programs, an improved economy relative to the historical experience of the Company, and significant claim settlements during 2007 at amounts less than previously established.

Group Benefits Insurance

For the year ended December 31, 2009, the Company recognized net favorable development on prior accident year group benefits insurance reserves of $611,000. The favorable development primarily reflects a decrease in prior accident year dental and short-term disability reserves of $457,000 as a result of better than expected claim experience. The Company’s long-term disability reserves also decreased $328,000, primarily related to prior year claim terminations.

For the year ended December 31, 2008, the Company recognized net favorable development on prior accident year group benefits insurance reserves of $993,000. The favorable development primarily reflects a decrease in prior accident year dental and short-term disability reserves of $613,000 as a result of better than expected claim experience. The Company also decreased its term life reserves by $264,000 as a result of lower than expected reported death claims.

For the year ended December 31, 2007, the Company recognized net favorable development on prior accident year group benefits insurance reserves of $961,000. The favorable development primarily reflects a decrease in prior accident year dental and short-term disability reserves of $709,000 as a result of better than expected claim experience. The Company’s long-term disability reserves decreased $286,000, primarily related to prior year claim terminations. The Company also decreased its term life reserves by $175,000 as a result of lower than expected reported death claims.

Run-Off Specialty Reinsurance

For the years ended December 31, 2009, 2008 and 2007, the Company increased (decreased) its specialty reinsurance reserves for unpaid losses and LAE by the following amounts by accident year (in thousands):


Accident Year	2009		2008		2007
2008	$	—	$	—	$	—
2007		—		7,225		—
2006		—		4,088		423
2005		—		3,296		755
2004		—		1,357		859
2003		—		1,430		998
2002		—		783		1,891
2001		—		565		829
2000 and prior		—		513		(911	)

	$	—	$	19,257	$	4,844

For the year ended December 31, 2009, there was no development recorded on prior accident year specialty reinsurance loss reserves. While there was no reserve development recorded in 2009, there is significant uncertainty related to the estimation of the specialty reinsurance loss and LAE reserves. The Company is dependent on the ceding company to provide accurate loss information on a quarterly basis from which management estimates the specialty reinsurance loss and LAE reserves. In the event the loss information received by the Company reflected higher losses than anticipated, as occurred in 2008 and 2007, the Company may incur additional losses related to this segment. See “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations, Critical Accounting Policies and Estimates” for additional information regarding the uncertainty related to the estimation of the specialty reinsurance loss and LAE reserves.

claims audit, which was completed in January 2009. During the claims audit, management determined that the increase in losses reported by the ceding company was primarily attributable to adverse loss trends emerging in calendar year 2008 from prior accident years. Management also identified the primary factors that contributed to the increased losses reported to the Company. Those factors include 1) an improvement in the ceding company’s ability to estimate loss costs earlier in the claims process, including the receipt of damage estimates from contractors and consultants, 2) states becoming more aggressive in requiring quicker, more extensive clean-up and an increase in construction costs related to the clean-up, and 3) courts limiting the ability of insurance companies to enforce coverage limitations as the courts became more interested in an expeditious clean up due to environmental concerns. Based on the results of the claims audit, management updated its quarterly actuarial analysis as of December 31, 2008 to reflect higher loss development factors than had previously been applied to the reported loss data, which was previously based on the Company’s historical loss experience and industry loss development statistics.

For the year ended December 31, 2007, the Company recognized net unfavorable development on prior accident year specialty reinsurance loss reserves of $4.8 million, representing 24.6% of the Company’s estimated specialty reinsurance net loss reserves as of December 31, 2006. The unfavorable development arose mostly from accident years 2001, 2002, 2003, 2004 and 2005, and resulted from an increase in reported losses from the ceding company primarily related to the EIA liability product.

The analysis in the following table presents the development of the Company’s reserves for unpaid losses and LAE from December 31, 1999 to December 31, 2009. The first line in the table shows the reserves for unpaid losses and LAE, net of reinsurance, as estimated at the end of each calendar year. The first section below that line shows the cumulative actual payments of losses and LAE, net of reinsurance, that relate to each year-end liability as they were paid at the end of subsequent annual periods. The next section shows revised estimates of the original unpaid amounts, net of reinsurance, that are based on the subsequent payments and re-estimates of the remaining unpaid liabilities. The next line shows the favorable or unfavorable development of the original estimates, net of reinsurance. Loss reserve development in this table is cumulative, the estimated favorable or unfavorable development for a particular year represents the cumulative amount by which all previous liabilities are currently estimated to have been over- or under-estimated. The “cumulative redundancy/(deficiency)” is as of December 31, 2009, which represents the difference between the latest re-estimated liability and the amounts as originally estimated. A redundancy means the original estimate was higher than the current estimate; a deficiency means that the current estimate is higher than the original estimate (in thousands).


	As of December 31,
	1999 (2)			2000 (2)			2001 (2)			2002 (2)			2003 (2)			2004 (2)			2005 (2)			2006 (1)			2007 (1)			2008 (1)		2009 (1)
Reserves for unpaid losses and LAE, net of reinsurance	$	34,279		$	38,156		$	43,363		$	49,871		$	58,500		$	74,430		$	83,389		$	94,338		$	99,801		$	127,679	$	121,945
Cumulative amount of liability paid through:
One year later		18,460			21,248			23,111			23,399			23,449			24,178			27,598			31,968			38,447			47,226		—
Two years later		20,344			25,890			30,462			34,122			34,882			37,688			43,235			51,612			61,078			—		—
Three years later		21,799			29,330			35,030			39,742			41,609			47,480			53,922			64,247			—			—		—
Four years later		23,050			31,022			37,812			43,186			46,805			52,500			60,738			—			—			—		—
Five years later		23,904			32,834			39,806			46,026			50,063			56,252			—			—			—			—		—
Six years later		24,833			34,194			40,842			48,040			52,253			—			—			—			—			—		—
Seven years later		25,580			34,615			42,314			49,140			—			—			—			—			—			—		—
Eight years later		26,127			35,798			42,597			—			—			—			—			—			—			—		—
Nine years later		27,049			35,884			—			—			—			—			—			—			—			—		—
Ten years later		27,121			—			—			—			—			—			—			—			—			—		—

Liability estimated as of:
One year later		27,226			33,708			39,375			48,689			56,844			66,122			77,193			87,843			112,438			122,077		—
Two years later		28,329			36,018			42,664			50,143			57,247			66,045			75,401			96,890			107,868			—		—
Three years later		28,110			36,720			44,375			51,751			57,668			67,539			81,724			93,818			—			—		—
Four years later		28,330			37,693			45,808			52,986			59,744			70,976			80,572			—			—			—		—
Five years later		28,857			39,333			46,349			54,798			62,510			69,799			—			—			—			—		—
Six years later		29,743			39,603			46,582			56,438			61,707			—			—			—			—			—		—
Seven years later		29,812			38,925			47,661			55,822			—			—			—			—			—			—		—
Eight years later		29,171			39,440			47,643			—			—			—			—			—			—			—		—
Nine years later		29,453			39,498			—			—			—			—			—			—			—			—		—
Ten years later		29,635			—			—			—			—			—			—			—			—			—		—
Cumulative total redundancy (deficiency)	$	4,644		$	(1,342	)	$	(4,280	)	$	(5,951	)	$	(3,207	)	$	4,631		$	2,817		$	520		$	(8,067	)	$	5,602	$	121,945

Gross liability—end of year		39,042			44,141			49,327			57,955			67,549			84,555			97,755			107,027			113,068			144,280		138,544
Reinsurance recoverables		4,763			5,985			5,964			8,084			9,049			10,125			14,366			12,689			13,267			16,601		16,599

Net liability—end of year	$	34,279		$	38,156		$	43,363		$	49,871		$	58,500		$	74,430		$	83,389		$	94,338		$	99,801		$	127,679	$	121,945

Gross re-estimated liability—latest		33,996			47,770			56,947			69,234			74,051			81,951			94,941			106,169			120,370			136,663		—
Re-estimated reinsurance recoverables—latest		4,361			8,272			9,304			13,412			12,344			12,152			14,369			12,351			12,502			14,586		—

Net re-estimated liability—latest	$	29,635		$	39,498		$	47,643		$	55,822		$	61,707		$	69,799		$	80,572		$	93,818		$	107,868		$	122,077	$	—

Gross cumulative redundancy (deficiency), including run-off group medical business	$	5,046		$	(3,629	)	$	(7,620	)	$	(11,279	)	$	(6,502	)	$	2,604		$	2,814		$	858		$	(7,302	)	$	7,617	$	—
Less: Gross cumulative redundancy related to run-off group medical business (3)		(5,201	)		(4,311	)		(6,314	)		(5,508	)		(1,937	)		(332	)		(290	)		(245	)		(245	)		—		—

Gross cumulative redundancy (deficiency), excluding run-off group medical business	$	(155	)	$	(7,940	)	$	(13,934	)	$	(16,787	)	$	(8,439	)	$	2,272		$	2,524		$	613		$	(7,547	)	$	7,617	$	—

Gross liability, end of year	$	39,042		$	44,141		$	49,327		$	57,955		$	67,549		$	87,555		$	97,755		$	107,027		$	113,068		$	144,280	$	138,544
Professional group long-term disability reserves		27,443			24,285			21,843			19,082			18,921			17,152			16,330			12,453			11,132			9,997		8,664
Term life premium waiver reserves		3,868			4,474			4,458			4,305			4,661			4,783			5,333			4,815			4,482			3,766		3,742
Other		109			74			73			52			39			41			74			256			57			37		25

Total reserves for unpaid losses and LAE	$	70,462		$	72,974		$	75,701		$	81,394		$	91,170		$	106,531		$	119,492		$	124,551		$	128,739		$	158,080	$	150,975

(1)	The reserves for unpaid losses and LAE as of December 31, 2009, 2008, 2007 and 2006 are reflected before the impact of purchase accounting adjustments of $537, $1,037, $1,049 and $1,895, respectively.

(2)	The reserves for unpaid losses and LAE for December 31, 1999 through December 31, 2005 have been restated to reflect the workers’ compensation insurance, segregated portfolio cell reinsurance, and run-off specialty reinsurance operations.

(3)

For purposes of understanding the Company’s reserve estimation results for its current lines of business, the gross cumulative redundancy related to the Company’s discontinued group medical business has been deducted from the total gross cumulative redundancy (deficiency) for the years ended December 31, 1999 through December 31, 2005.

A.M. Best Rating

A.M. Best rates insurance companies based on factors of concern to policyholders. In evaluating a company’s financial and operating performance, A.M. Best reviews the company’s profitability, leverage and liquidity, its book of business, the adequacy and soundness of its reinsurance programs, the quality and estimated fair value of its investments, the adequacy of its reserves and surplus, its capital structure, the experience and competence of its management, and its marketing presence. A.M. Best ratings are intended to provide an independent opinion of an insurer’s ability to meet its obligations to its policyholders. Their evaluation is not directed at investors. As of December 31, 2009, Eastern Alliance Insurance Group had a financial strength rating of “A-” (Excellent) with a positive outlook. ELH and Eastern Re had a financial strength rating of “A-” (Excellent) with a stable outlook. An “A-” (Excellent) financial strength rating is the fourth highest out of 16 rating classifications.

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

Competition

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

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

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

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

Investments

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

The Company’s investment objectives are:

•

to meet insurance regulatory requirements;

•

to maintain adequate liquidity in its insurance subsidiaries;

•

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

•

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

The Company evaluates the performance of its investments through the use of various industry benchmarks. Benchmarks have been selected for each investment manager and/or portfolio and are reviewed on a quarterly basis by management and the Company’s Finance/Investment Committee. For the year ended December 31, 2009, the Company’s taxable equivalent total return, net of management fees, was 10.26%, compared to the composite benchmark return of 14.36%.

The Company’s investments in fixed income and equity securities are classified as “available for sale” and are reported at estimated fair value, with changes in fair value reported as a component of accumulated other comprehensive income (loss), net of applicable taxes. The Company’s convertible bonds are considered hybrid financial instruments and are reported at estimated fair value, with changes in fair value reported as a realized gain or loss in the consolidated statements of operations and comprehensive income (loss). The Company periodically evaluates its investments for other-than-temporary impairment. At the time an investment is determined to be other-than-temporarily impaired, the Company records a realized loss in the consolidated statements of operations and comprehensive income (loss). Any subsequent increase in the investment’s market value would be reported as an unrealized gain. The Company’s other long-term investments include interests in various limited partnerships.

The Company accounts for its limited partnership investments under the equity method, with changes in the Company’s interest in the limited partnerships recorded in the change in equity interest in other long-term investments.

The following table sets forth consolidated information concerning the Company’s investments as of December 31, 2009 and 2008 (in thousands).


	At December 31,
	2009				2008
	Amortized Cost or Cost		Estimated Fair Market Value		Amortized Cost or Cost		Estimated Fair Market Value
U.S. Treasuries and government agencies	$	22,795	$	23,597	$	26,463	$	28,630
State, Municipalities and political subdivisions		39,624		41,500		45,109		46,537
Corporate securities		52,850		54,937		60,480		60,617
Residential mortgage-backed securities		28,657		29,327		16,349		17,614
Commercial mortgage-backed securities		8,932		8,652		12,896		11,445
Collateralized mortgage obligations		18,045		18,079		13,477		13,109
Other structured securities		702		639		5,328		5,184

Total fixed income securities		171,605		176,731		180,102		183,136

Equity securities		17,117		21,273		22,287		17,162
Convertible bonds		14,921		16,677		13,783		12,346
Other long-term investments		10,220		10,315		10,586		9,519

Total investments	$	213,863	$	224,996	$	226,758	$	222,163

Other structured securities include other asset-backed securities collateralized by home equity loans, credit card receivables and manufactured homes.

As of December 31, 2009 and 2008, the estimated fair values of the Company’s limited partnership investments, by investment strategy, were as follows (in thousands):


	2009		2008
Multi-strategy fund of funds	$	4,908	$	4,421
Natural resources		2,361		2,130
Structured finance opportunity fund		2,410		1,958
Municipal bond arbitrage		—		466
Open-ended investment fund		573		470
Real estate		58		66

Total	$	10,310	$	9,511

The gross unrealized losses and estimated fair value of fixed income and equity securities, excluding those securities in the segregated portfolio cell reinsurance segment, classified as available-for-sale by category and length of time an individual security is in a continuous unrealized loss position as of December 31, 2009 were as follows (in thousands):


	Less Than 12 Months					12 Months or More					Total
2009	Estimated Fair Value		Gross Unrealized Losses			Estimated Fair Value		Gross Unrealized Losses			Estimated Fair Value		Gross Unrealized Losses
U.S. Treasuries and government agencies	$	6,715	$	(39	)	$	—	$	—		$	6,715	$	(39	)
States, municipalities, and political subdivisions		2,757		(56	)		—		—			2,757		(56	)
Corporate securities		4,491		(38	)		124		(2	)		4,615		(40	)
Residential mortgage-backed securities		2,947		(21	)		—		—			2,947		(21	)
Commercial mortgage-backed securities		1,991		(31	)		4,201		(308	)		6,192		(339	)
Collateralized mortgage obligations		1,327		(44	)		1,771		(223	)		3,098		(267	)
Other structured securities		—		—			564		(79	)		564		(79	)

Total fixed income securities		20,228		(229	)		6,660		(612	)		26,888		(841	)
Equity securities		—		—			—		—			—		—

Total fixed income and equity securities	$	20,228	$	(229	)	$	6,660	$	(612	)	$	26,888	$	(841	)

Note: The Company has excluded the segregated portfolio cell reinsurance segment’s gross unrealized losses from the above table because changes in the estimated fair value of the segregated portfolio cell reinsurance segment’s fixed income and equity securities inures to the segregated portfolio cell dividend participant and, accordingly, is included in the segregated portfolio cell dividend payable and the related segregated portfolio dividend expense in the Company’s consolidated balance sheet and consolidated statement of operations, respectively. Management believes the exclusion of the segregated portfolio cell reinsurance segment from this disclosure provides a more transparent understanding of gross unrealized losses in the Company’s fixed income and equity security portfolios that could impact its consolidated financial position or results of operations.

As of December 31, 2009, the Company held 49 fixed income securities with gross unrealized losses totaling $841. Management has evaluated the unrealized losses related to those fixed income securities and determined that they are primarily due to the current liquidity issues in the fixed income markets or to a fluctuation in interest rates and not to credit issues of the issuer or the underlying assets in the case of asset-backed securities. The Company does not intend to sell the fixed income securities and it is not more likely than not that the Company will be required to sell the fixed income securities before recovery of their amortized cost bases, which may be maturity; therefore, management does not consider the fixed income securities to be other–than-temporarily impaired as of December 31, 2009.

For the year ended December 31, 2009, the Company recorded other-than-temporary impairments related to its fixed income and equity securities of $189,000 and $4.3 million, respectively. One fixed income security was impaired as a result of management’s intent to sell the security. This security was sold in the second quarter of 2009. The other fixed income security was impaired as a result of management determining that a credit loss had been incurred. The Company’s equity security impairments resulted from the securities being in an unrealized loss position for more than 12 months.

As of December 31, 2009, the Company held asset-backed securities with an estimated fair value of $56.7 million. The types of underlying assets collateralizing these securities, the weighted average issuance date, average credit rating and the estimated fair values as of December 31, 2009 are as follows:


Asset Type	Weighted Average Year of Issuance	Weighted Average Credit Rating	Estimated Fair Value
Residential mortgage-backed securities (RMBS)	2008	AAA	$	29,327
Collateralized mortgage obligations (CMO)	2006	AA+		18,079
Commercial mortgage-backed securities (CMBS)	2005	AA+		8,652
Sub-prime home equity loans	2002	AA-		374
Credit card receivables	2004	AAA		198
Manufactured homes	2003	AAA		68

Total			$	56,698

The Company held 49 RMBS securities as of December 31, 2009, all of which were rated AAA. These securities were all issued by government agencies.

The Company held 39 CMO securities with credit ratings that ranged from BB to AAA as of December 31, 2009. These securities were rated AAA, except for two securities with a BB rating.

The Company held 24 CMBS securities as of December 31, 2009 with credit ratings that ranged from A- to AAA as of December 31, 2009. These securities were rated AAA, except for one security that was rated AA-, one security rated A, and one security rated A-.

The Company held three sub-prime home equity loan securities with credit ratings that ranged from BBB to AAA as of December 31, 2009. One security was rated AAA, one security was rated AA, and one security was rated BBB.

The Company held one security collateralized by credit card receivables and two securities collateralized by manufactured home loans. These securities were all rated AAA.

As of December 31, 2009, the Company held insurance enhanced securities, net of pre-refunded municipal bonds that are escrowed in U.S. government obligations, with an estimated fair value of $19.2 million, which represents approximately 8.5% of the Company’s total investments as of December 31, 2009. Municipal bonds made up 100% of the insurance enhanced securities.

The following table provides a breakdown of the ratings for these insurance enhanced securities, net of pre-refunded municipal bonds, with and without insurance (in thousands):


Ratings	Ratings With Insurance		Ratings Without Insurance
AAA	$	11,032	$	2,704
AA		6,745		12,082
A		1,380		3,497
BBB		—		387
Rating not available		—		487

Total	$	19,157	$	19,157

These securities had an average credit rating of AA+ as of December 31, 2009 (average credit rating of AA without the benefit of insurance).

The Company’s indirect exposure to third party insurers, by percent of estimated fair value as of December 31, 2009 was as follows:


Insurer	Percentage of Estimated Fair Value
Assured Guaranty Municipal Corporation	37.5	%
National Re	27.6	%
National Re FGIC	15.8	%
AMBAC Financial Group, Inc.	14.5	%
Berkshire Hathaway Assurance Group	3.0	%
Financial Guaranty Insurance Company	1.6	%

Total	100.0	%

The following table shows the ratings distribution of the Company’s fixed income securities and convertible bonds, excluding fixed income securities of the segregated portfolio cell reinsurance segment, as a percentage of the total market value of the fixed income portfolio as of December 31, 2009 (dollars in thousands).


	Total		Percentage of Total Market Value
“AAA”	$	97,671	59.9	%
“AA”		25,198	15.5	%
“A”		25,636	15.7	%
“BBB”		6,385	3.9	%
Below Investment Grade		6,778	4.2	%
Not Rated		1,280	0.8	%

Total	$	162,948	100.0	%

Note: The Company has excluded the segregated portfolio cell reinsurance segment’s investment credit ratings from the above table because management believes the exclusion of the credit ratings of the segregated portfolio cell reinsurance segment’s fixed income securities provides a more transparent understanding of the underlying risk in the Company’s fixed income portfolio.

The amortized cost and estimated fair value of fixed income securities and convertible bonds as of December 31, 2009, by contractual maturity, are shown below. Expected maturities could differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties (in thousands).


	Amortized Cost		Estimated Fair Value
Less than one year	$	20,135	$	20,351
One through five years		63,746		66,918
Five through ten years		23,578		24,692
Greater than ten years		23,433		25,389
Mortgage-backed securities		55,634		56,058

Total	$	186,526	$	193,408

Company Web Sites

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

Employees

As of December 31, 2009, the Company had 198 full time employees. The Company’s employees are not represented by a union. The Company considers its relationship with its employees to be excellent.

Regulation

General

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

•

licensing of insurers and their producers;

•

approval of policy forms and premium rates;

•

mandating certain insurance benefits;

•

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

•

classifying assets as admissible for purposes of determining statutory surplus;

•

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

•

restrictions on the nature, quality and concentration of investments;

•

assessments by guaranty and other associations;

•

restrictions on the ability of insurance companies to pay dividends;

•

restrictions on transactions between insurance companies and their affiliates;

•

restrictions on acquisitions and dispositions of insurance companies;

•

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

•

requiring deposits for the benefit of policyholders;

•

requiring certain methods of accounting;

•

periodic examinations of insurance company operations and finances;

•

reviewing claims administration practices;

•

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

•

requiring reserves for unearned premiums, losses and other purposes.

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

Examinations

Examinations of the EIHI’s insurance subsidiaries are conducted by the domiciliary insurance department every three to five years. The Pennsylvania Insurance Department’s most recent examinations of Eastern Alliance, Allied Eastern and ELH for which a report was issued were as of December 31, 2006. The Indiana Insurance Department’s most recent examination of ESIC for which a report was issued was as of December 31, 2004. The Company has been notified by the Indiana Insurance Department that ESIC will be examined in 2010. These examinations did not result in any adjustments to the financial position of the insurance companies. In addition, there were no substantive qualitative matters indicated in the examination reports that had a material adverse impact on the Company’s operations. The Pennsylvania Insurance Department conducted an organizational examination of Eastern Advantage as of October 24, 2007.

Risk-Based Capital Requirements

Pennsylvania and Indiana impose the NAIC risk-based capital requirements that require insurance companies to calculate and report information under a risk-based formula. These risk-based capital requirements attempt to measure statutory capital and surplus needs based on the risks in an insurance company’s mix of products and investment portfolio. Under the formula, a company first determines its “authorized control level” risk-based capital. This authorized control level takes into account (i) the risk with respect to the insurer’s assets; (ii) the risk of adverse insurance experience with respect to the insurer’s liabilities and obligations; (iii) the interest rate risk with respect to the insurer’s business; and (iv) all other business and other relevant risks as are set forth in the risk-based capital instructions. As of December 31, 2009, the capital levels of EIHI’s insurance subsidiaries exceeded risk-based capital requirements.

Market Conduct Regulation

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

Sarbanes-Oxley Act of 2002

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

Insurance Guaranty Funds

Almost all states have guaranty fund laws under which insurers doing business in the state can be assessed to fund policyholder liabilities of insolvent insurance companies. Pennsylvania, Indiana and the other states in which our insurance companies do business have such laws. Under these laws, an insurer is subject to assessment depending upon its market share in the state of a given line of business. The most significant assessment fund to which the Company is subject is the Pennsylvania Workers’ Compensation Security Fund (the “Security Fund”), which assesses workers’ compensation insurers

doing business in Pennsylvania for the purpose of providing funds to cover obligations to policyholders of insolvent insurance companies. The maximum assessment the Security Fund can impose is equal to 1.0% of the Company’s net workers’ compensation premiums written in Pennsylvania in the year of assessment. The Company establishes reserves relating to specific insurance company insolvencies upon notification of an assessment by the respective state guaranty association. We cannot predict the amount or timing of any future assessments under these laws.

Cayman Islands Regulation

Eastern Re is organized and licensed as a Cayman Islands unrestricted Class B insurance company and is subject to regulation by the Cayman Islands Monetary Authority. Applicable laws and regulations govern the types of policies that the Company can insure or reinsure, the amount of capital that it must maintain and the way it can be invested, and the payment of dividends without approval by the Cayman Islands Monetary Authority. Eastern Re is required to maintain minimum capital of $120,000.

As a result of the unfavorable loss reserve development recorded at Eastern Re for the year ended December 31, 2008, EIHI made a capital contribution of $23.0 million to Eastern Re on March 6, 2009 to ensure Eastern Re remained solvent and met the minimum capital requirement of $120,000. For additional information related to the capital contribution, refer to Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations, Liquidity and Capital Resources”.

Holding Company Regulation

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

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

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

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

Dividend Restrictions

EIHI’s ability to declare and pay dividends will depend in part on dividends received from its insurance subsidiaries. Our domestic insurance subsidiaries’ ability to pay dividends to the Company is limited by the insurance laws and regulations of Pennsylvania and Indiana. The maximum annual dividends that the domestic insurance entities may pay without prior approval from the Pennsylvania or Indiana Insurance Departments is limited to the greater of 10% of statutory surplus or 100% of statutory net income for the most recently filed annual statement.

Eastern Re must receive approval from the Cayman Islands Monetary Authority before it can pay any dividend to EIHI.

On March 6, 2009, the Pennsylvania Insurance Commissioner approved the payment of extraordinary dividends to EIHI from Eastern Alliance, Allied Eastern and ELH in the amount of $10.0 million, $2.0 million and $13.0 million, respectively. The $13.0 million dividend from ELH included $8.0 million previously approved by the Pennsylvania Insurance Commissioner in 2008, for which ELH had not made payment to EIHI. The proceeds from the dividends were used to fund EIHI’s capital contribution to Eastern Re of $23.0 million.

Note on Forward-Looking Statements

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

•

statements of goals, intentions and expectations;

•

statements regarding prospects and business strategy; and

•

estimates of future costs, benefits and results.

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

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

•

the ability to carry out our business plans;

•

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

•

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

•

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

•

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

•

the impact of acts of terrorism and acts of war;

•

the effects of terrorist related insurance legislation and laws;

•

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

•

the cost, availability and collectibility of reinsurance;

•

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

•

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

•

the effects of mergers, acquisitions and dispositions;

•

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

•

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

•

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

•

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

•

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

•

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

•

adverse litigation or arbitration results; and

•

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

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

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

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

Item 1A—Risk Factors

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

Risk Factors Relating to Our Business

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

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

•

trends in claim frequency and severity;

•

information regarding each claim for losses;

•

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

•

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

If we determine that our reserves for unpaid losses and LAE are inadequate, we will have to increase them. This adjustment would reduce income during the period in which the adjustment is made, which could have a material adverse impact on our financial condition and results of operations. For additional information, see “Item 1—Business, Loss and LAE Reserves” and “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations, Critical Accounting Polices and Estimates.”

Our run-off specialty reinsurance segment may experience additional losses in the event actual losses exceed our loss reserve estimates.

The estimation of the Company’s loss reserves in its run-off specialty reinsurance segment is subject to significant uncertainty and the reserves for unpaid losses and LAE as of December 31, 2009 could prove to be inadequate, which would require us to increase the reserves and incur additional losses. We are dependent on the ceding company to provide accurate paid loss information on a quarterly basis from which we estimate the run-off specialty reinsurance reserves. Furthermore, we use external and internal benchmark data to assist in the estimation of the loss and LAE reserves, both of which have limited loss development data to produce credible trends. For example, the run-off specialty reinsurance reserves were increased for the years ended December 31, 2008 and 2007 by $19.3 million and $4.8 million, respectively, as a result of an increase in reported losses from the ceding company that were much greater than we had observed in the past. For additional information related to our process for estimating the run-off specialty reinsurance reserves, see “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations, Critical Accounting Policies and Estimates.”

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

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

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

•

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

•

insufficient or unreliable data;

•

incorrect or incomplete analysis of available data;

•

uncertainties generally inherent in estimates and assumptions;

•

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

•

costs of ongoing medical treatment;

•

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

•

unanticipated court decisions, legislation or regulatory action.

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

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

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

•

identify profitable new geographic markets to enter;

•

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

•

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

•

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

•

identify, train and retain qualified employees;

•

identify, recruit and integrate new independent producers;

•

formulate and execute a merger and acquisition strategy; and

•

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

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

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

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

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

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

We are subject to credit risk with respect to the reinsurers with whom we deal because buying reinsurance does not relieve us of our liability to policyholders. The Company had net reinsurance recoverables of $28.5 million as of December 31, 2009. For example, some of our reinsurers have been adversely impacted by the current economic environment and deterioration in the investment markets and, as a result, have been downgraded by A.M. Best, which could negatively impact the reinsurers’ results of operations or financial condition. If our reinsurers are not capable of fulfilling their financial obligations to us, including the inability to secure the necessary collateral provided under the reinsurance agreements, our insurance losses would increase, which would negatively affect our financial condition and results of operations.

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

We invest the premiums we receive from policyholders until cash is needed to pay insured claims or other expenses. As of December 31, 2009, the Company had investments of $225.0 million. For the year ended December 31, 2009, the Company had $7.1 million of net investment income, representing 4.9% of its total revenues. Our investments are subject to a variety of investment risks, including risks relating to general economic conditions, market volatility, interest rate fluctuations, liquidity risk and credit risk. In particular, an unexpected increase in the volume or severity of claims may force us to liquidate securities, which may cause us to incur capital losses. If we do not structure the duration of our investments to match our insurance and reinsurance liabilities, we may be forced to liquidate investments prior to maturity at a significant loss to cover such payments. Investment losses could significantly decrease our asset base and statutory surplus, thereby affecting our ability to conduct business.

Our revenues may fluctuate with changes in interest rates.

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

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

As of December 31, 2009, MBSs, including CMOs, constituted 24.9% of the market value of the Company’s investment portfolio. MBSs and CMOs are subject to prepayment risks that vary with, among other things, interest rates. During periods of declining interest rates, MBSs generally prepay faster as the underlying mortgages are prepaid and/or refinanced by the borrowers in order to take advantage of lower interest rates. MBSs that have an amortized cost that is greater than par (i.e., purchased at a premium) may incur a reduction in yield or a loss as a result of prepayments. In addition, during such periods, we generally will be unable to reinvest the proceeds of any prepayment at comparable yields. Conversely, during periods of rising interest rates, the frequency of prepayments generally decreases, and we may receive interest payments that are below the then prevailing interest rate for longer than expected. MBSs that have an amortized cost that is less than par (i.e., purchased at a discount) may incur a decrease in yield or a loss as a result of slower prepayments.

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

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

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

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

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

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

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

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

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

The success of our business is dependent, to a large extent, on the efforts of certain key personnel, in particular, Bruce M. Eckert, our Chief Executive Officer, Michael L. Boguski, our President and Chief Operating Officer, Kevin M. Shook, our Treasurer and Chief Financial Officer, Robert A. Gilpin, our Senior Vice President of Marketing, and Suzanne M. Emmet, our Senior Vice President of Claims. We have employment agreements with each of Messrs. Eckert, Boguski,

Shook, Gilpin, and Ms. Emmet, which contain covenants not to compete. We do not maintain key man life insurance on any of these executives. The loss of key personnel could prevent us from fully implementing our business strategy and could significantly and negatively affect our financial condition and results of operations. As we continue to grow, we will need to recruit and retain additional qualified management personnel, and our ability to do so will depend upon a number of factors, such as our results of operations and prospects and the level of competition then prevailing in the market for qualified personnel. The current market for qualified insurance personnel is highly competitive.

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

Our products are marketed by independent producers. Other insurance companies compete with the Company for the services and allegiance of these producers. Because they are independent, these producers are not obligated to direct business to the Company and may choose to direct business to our competitors, or may direct less desirable risks to us. The Company’s ten largest producers in its workers’ compensation insurance segment accounted for 55.1% of its direct premiums written for the year ended December 31, 2009. The Company’s two largest producers, E.K. McConkey and The Alliance of Central PA, Inc., in its workers’ compensation insurance segment accounted for 12.9% and 11.6% of direct premiums written, respectively, for the year ended December 31, 2009. No other producer accounted for more than 10.0% of direct premiums written in the Company’s workers’ compensation insurance segment for the year ended December 31, 2009. No independent producer accounted for more than 10.0% of the Company’s group benefits insurance direct premiums written for the year ended December 31, 2009. If premium volume produced by any of the Company’s large producers were to decrease significantly, it would have a material adverse effect on us.

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

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

For the year ended December 31, 2009, 79.8% of the Company’s workers’ compensation premium was written in Pennsylvania. The Company’s workers’ compensation insurance business is affected by the economic health of Pennsylvania for two principal reasons. First, premium growth is dependent upon payroll growth, which, in turn, is affected by economic conditions. Second, losses and LAE can increase in weak economic conditions because it is more difficult to return injured workers to the job when employers are otherwise reducing payrolls. Finally, as a result of the Company’s high concentration of Pennsylvania business, the Company can be adversely affected by any material change in Pennsylvania law or regulation or any Pennsylvania court decision affecting workers’ compensation carriers generally.

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

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

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

Currently, the U.S. federal government does not directly regulate the insurance business. However, federal legislation and administrative policies in several areas can significantly and adversely affect insurance companies. These areas include financial services regulation, securities regulation, pension regulation, privacy, tort reform legislation and taxation. In addition, various forms of direct federal regulation of insurance have been proposed. These proposals include the State Modernization and Regulatory Transparency Act, which would maintain state-based regulation of insurance but would affect state regulation of certain aspects of the insurance business, including rates, producer and company licensing, and market conduct examinations, and the National Insurance Act of 2007, which would provide for optional federal charters for insurance companies. We cannot predict whether this or other proposals will be adopted, or what impact, if any, such proposals or, if enacted, such laws may have on our business, financial condition or results of operations.

Risk Factors Relating to Our Common Stock

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

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

•

Directors and management owned approximately 18.3% of the Company’s outstanding stock as of December 31, 2009.

•

The employee stock ownership plan (“ESOP”) owns 7.7%, or 747,500 shares, of the Company’s outstanding stock as of December 31, 2009. The shares held by the ESOP will be voted in the manner directed by the ESOP participants.

•

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

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

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

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

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

•

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

•

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

•

the prohibition of cumulative voting in the election of directors;

•

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

•

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

•

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

•

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

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

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

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

Our domestic insurance subsidiaries’ ability to pay dividends to the Company is limited by the insurance laws and regulations of Pennsylvania and Indiana. The maximum dividend that the domestic insurance entities may pay without prior approval from the Pennsylvania Insurance Department and the Indiana Insurance Department is limited to the greater of 10% of statutory surplus or 100% of statutory net income for the most recently filed annual statement.

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

Item 1B—Unresolved Staff Comments

Not applicable.

Item 2—Properties

The Company’s corporate headquarters are located at 25 Race Avenue in Lancaster, Pennsylvania. The Company leases its home office building under a 15-year, non-cancelable lease through February 2017. The annual base rent is subject to an annual increase based upon the consumer price index at the end of each preceding calendar year. In addition to the base rent, the Company is responsible for its proportionate share of expenses related to the building including, but not limited to, utilities, maintenance, real estate taxes, and insurance. The Company has a 5% interest in the limited partnership that owns the building.

The Company also has regional offices in Charlotte, North Carolina and Indianapolis, Indiana and leases office space in each of these locations under multi-year operating leases expiring in January 2013 and March 2017, respectively.

The home office building is used by the workers’ compensation insurance, group benefits insurance and corporate/other segments. The regional office space in North Carolina and Indiana is primarily used by the workers’ compensation insurance segment.

Item 3—Legal Proceedings

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

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

We did not submit any matters to a vote of the holders of our common stock during the fourth quarter of 2009.

PART II

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

The no par value common stock trades on the NASDAQ National Market under the symbol “EIHI”. As of March 3, 2010, there were 560 registered holders of record of our common stock.

During 2009, the Company paid four quarterly dividends of $0.07/share. Any payment of dividends in the future on the common stock is subject to determination and declaration by the Company’s Board of Directors, who will take into consideration the Company’s financial condition, results of operations and future prospects.

The table below sets forth information with respect to the amount and frequency of dividends declared on our common stock for the years ended December 31, 2009 and 2008. It is currently expected that cash dividends will continue to be paid in the future.


Date of Declaration by EIHI Board	Type of and Amount of Dividend		Record Date for Payment	Payment Date
February 19, 2009	Regular	$0.07 cash per share	March 13, 2009	March 27, 2009
May 14, 2009	Regular	$0.07 cash per share	June 12, 2009	June 26, 2009
August 13, 2009	Regular	$0.07 cash per share	September 11, 2009	September 25, 2009
November 12, 2009	Regular	$0.07 cash per share	December 11, 2009	December 24, 2009

Date of Declaration by EIHI Board	Type of and Amount of Dividend		Record Date for Payment	Payment Date
February 14, 2008	Regular	$0.07 cash per share	March 14, 2008	March 28, 2008
May 13, 2008	Regular	$0.07 cash per share	June 13, 2008	June 27, 2008
August 14, 2008	Regular	$0.07 cash per share	September 12, 2008	September 26, 2008
November 13, 2008	Regular	$0.07 cash per share	December 12, 2008	December 29, 2008

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

The table below sets forth the high and low sales prices of our common stock for each quarterly period as reported by the NASDAQ for the years ended December 31, 2009 and 2008.


	2009				2008
	Low		High		Low		High
1^st quarter	$	5.56	$	10.91	$	13.41	$	17.10
2^nd quarter	$	6.94	$	10.00	$	14.25	$	16.99
3^rd quarter	$	8.77	$	10.72	$	12.77	$	16.00
4^th quarter	$	6.75	$	9.90	$	6.25	$	14.72

Equity Compensation Plan Information

The Company adopted the Eastern Insurance Holdings, Inc. 2006 Stock Incentive Plan (the “Stock Incentive Plan”) on December 18, 2006. Under the terms of the Stock Incentive Plan, stock awards may be made in the form of incentive stock options, non-qualified stock options or restricted stock. The following table provides the total number of stock awards outstanding, including the weighted average exercise price, as of December 31, 2009:


Plan category	Number of securities to be issued upon exercise of outstanding options, warrants and rights	Weighted–average exercise price of outstanding options, warrants and rights		Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
	(a)	(b)		(c)
Equity compensation plans approved by security holders	612,523	$	14.36	383,235	(1)
Equity compensation plans not approved by security holders	—		—	—
Total	612,523	$	14.36	383,235	(1)

(1)

Beginning with calendar year 2008, the number of securities available for future issuance under the Stock Incentive Plan is automatically increased on January 1 by an amount equal to 1.0% of the total outstanding common shares on the last trading day of December of the immediately preceding calendar year. The number of securities available for future issuance can be in the form of stock options or restricted stock.

Performance Graph

Set forth below is a line graph comparing the dollar change in the cumulative total shareholder return on the Company’s common stock for the year ended December 31, 2009 compared to the cumulative total return of the NASDAQ Composite Index and the cumulative total return of the SNL Insurance Underwriter Index. The chart depicts the value on December 31, 2009 of a $100 investment made on June 19, 2006.


	*Period Ending*
*Index*	06/19/06	06/30/06	12/31/06	12/31/07	12/31/08	12/31/09
Eastern Insurance Holdings, Inc.	100.00	112.18	127.61	146.38	72.88	80.65
NASDAQ Composite	100.00	102.92	114.45	125.68	74.73	107.52
SNL Insurance Underwriter Index	100.00	101.66	116.30	116.88	60.74	70.53

Unregistered Sales of Equity Securities and Use of Proceeds

Issuer Purchases of Equity Securities

On February 15, 2007, the Company’s Board of Directors authorized the repurchase of up to 5 percent of the Company’s issued and outstanding shares of common stock for the purpose of funding the issuance of stock under the Eastern Insurance Holdings, Inc. 2006 Stock Incentive Plan. On August 2, 2007, the Company’s Board of Directors authorized the repurchase of additional shares of the Company’s outstanding common stock up to an aggregate of 1,046,500 shares, which represented the total number of shares of common stock for which awards may be granted under the Company’s Stock Incentive Plan at that time. On September 27, 2007, the Company’s Board of Directors increased the share repurchase authorization to 2,046,500 shares. On March 24, 2008, the Company received approval from the Pennsylvania Insurance Department to repurchase up to $10 million of the Company’s issued and outstanding common stock, which is in addition to the 2,046,500 shares authorized in 2007.

There were no purchases of our common stock during the year ended December 31, 2009. As of December 31, 2009, the Company has repurchased 2,091,757 shares, and has approximately $9.6 million authorized for future repurchases.

The following table presents information with respect to those purchases of our common stock made during the year ended December 31, 2008:


Period	Total number of shares purchased	Average price paid per share		Total number of shares purchases as part of publicly announced plans or programs	Maximum number (or approximate dollar value) of shares that may yet be purchased under the plans or programs
January 1-31, 2008	113,757	$	16.23	113,757	915,878
February 1-28, 2008	540,271	$	16.50	540,271	375,607
March 1-31, 2008	156,193	$	15.38	156,193	219,414
April 1-30, 2008	74,610	$	15.76	74,610	144,804
May 1-31, 2008	81,800	$	15.99	81,800	63,004
June 1-30, 2008	31,797	$	15.82	31,797	31,207	(a)
July 1-31, 2008	21,563	$	15.05	21,563	9,644	(a)
August 1-31, 2008	10,826	$	15.18	10,826	—	(a)
September 1-30, 2008	3,472	$	15.16	3,472	—	(a)
October 1-31, 2008	8,290	$	9.42	8,290	—	(a)
November 1-30, 2008	21,057	$	8.81	21,057	—	(a)
December 1-31, 2008	11,256	$	8.23	11,256	—	(a)

Total	1,074,892	$	15.86	1,074,892

(a)	The maximum number of remaining shares represents the difference between 2,046,500 authorized shares and the number of shares repurchased. The approval to repurchase an additional $10 million of the Company’s common stock is not included in this amount.

Item 6��Selected Financial Data

The following table sets forth selected historical financial information for the Company for the years ended and as of the dates indicated. This information is derived from the Company’s consolidated financial statements. You should read the following selected financial information along with the information contained in this annual report, including Part II, Item 7 of this annual report entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes and the reports of the independent registered public accounting firm included in Part II, Item 8 and elsewhere in this report. These historical results are not necessarily indicative of results to be expected from any future period (in thousands, except per share and share amounts).


	At or for the Years Ended December 31,
	2009			2008 (1)			2007			2006 (2)			2005 (3)
Income Statement Data:
Direct premiums written	$	120,187		$	111,999		$	101,761		$	65,935		$	40,994
Reinsurance premiums assumed		29,902			33,106			43,183			17,836			—
Net premiums written		138,433			134,712			131,889			67,529			38,700
Net premiums earned	$	134,986		$	135,807		$	129,495		$	74,919		$	38,702
Investment income, net of expenses		7,097			9,631			11,669			8,678			3,715
Change in equity interest in limited partnerships		1,261			(3,970	)		759			314			100
Net realized investment gains (losses)		952			(11,117	)		2,888			2,757			445
Other revenue		645			853			683			313			1,066

Total revenue	$	144,941		$	131,204		$	145,494		$	86,981		$	44,028

Expenses:
Losses and LAE incurred	$	84,552		$	99,188		$	73,588		$	47,913		$	27,090
Acquisition and other underwriting expenses		18,183			18,918			17,056			7,242			5,452
Other expenses		26,382			25,338			21,801			14,390			9,674
Amortization of intangibles		1,732			1,373			1,738			1,087			—
Policyholder dividend expense		432			551			543			239			—
Segregated portfolio dividend expense (4)		1,238			2,155			4,423			2,890			—

Total expenses	$	132,519		$	147,523		$	119,149		$	73,761		$	42,216

Income (loss) before income taxes	$	12,422		$	(16,319	)	$	26,345		$	13,220		$	1,812
Income tax expense		4,021			1,064			7,662			4,942			685

Net income (loss)	$	8,401		$	(17,383	)	$	18,683		$	8,278		$	1,127

Selected Balance Sheet Data (at period end):
Total investments and cash and cash equivalents	$	292,013		$	275,038		$	299,061		$	288,288		$	82,319
Total assets		391,524			377,311			385,518			368,206			111,225
Reserves for unpaid losses and LAE		151,512			159,117			129,788			126,467			44,137
Unearned premiums		46,099			42,365			39,826			34,600			95
Total liabilities		237,659			239,174			207,687			194,462			49,116
Total shareholders’ equity		153,865			138,137			177,831			173,744			62,109

U.S. GAAP Ratios:
Loss and LAE ratio (5)		62.6	%		73.0	%		56.8	%		64.0	%		70.0	%
Expense ratio (6)		34.3	%		33.6	%		31.4	%		30.3	%		39.1	%
Policyholder dividend expense ratio (7)		0.3	%		0.4	%		0.4	%		0.3	%		—
Combined ratio (8)		97.2	%		107.0	%		88.6	%		94.6	%		109.1	%

Per Share Data:
Basic earnings per share	$	0.92		$	(1.90	)	$	1.78		$	0.67			N/A
Diluted earnings per share	$	0.91		$	(1.90	)	$	1.72		$	0.65			N/A
Cash dividends per share	$	0.28		$	0.28		$	0.20		$	—			N/A

Weighted Average Shares:
Basic		8,984,644			8,954,098			10,264,369			10,623,182			N/A
Diluted		9,051,701			8,954,098			10,604,349			N/A			N/A

(1)	Includes ESHC’s results of operations for the period from October 1, 2008 to December 31, 2008.

(2)	Includes ELH’s results of operations for the year ended December 31, 2006 and the results of operations of EHC and its subsidiaries for the period from June 17, 2006 to December 31, 2006.

(3)	Represents the financial condition and results of operations for ELH.

(4)	The net income of the segregated portfolio cell reinsurance segment is recorded as a segregated portfolio dividend expense, which represents the dividend earned by the segregated portfolio dividend participants during the period.

(5)	Calculated by dividing losses and LAE incurred by net premiums earned.

(6)	Calculated by dividing the sum of acquisition and other underwriting expenses, other expenses and amortization of intangibles by net premiums earned.

(7)	Calculated by dividing the policyholder dividend expense by net premiums earned.

(8)	The sum of the loss and LAE ratio, expense ratio and the policyholder dividend expense ratio.

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

Overview

The Company’s results of operations for the year ended December 31, 2009 reflect the improvement in the fixed income and equity security markets during 2009, partially offset by an increase in the combined ratios in the workers’ compensation insurance, segregated portfolio cell reinsurance and group benefits insurance segments. The 2009 results also reflect the run-off of the specialty reinsurance segment.

The workers’ compensation insurance segment’s combined ratio increased from 80.2% in 2008 to 87.7% in 2009. The increased combined ratio primarily reflects the impact of the current economic environment on the Company’s workers’ compensation loss and LAE ratio and an increase in the expense ratio. The increase in the loss and LAE ratio is due primarily to an increase in the 2009 accident year loss ratio reflecting management’s view of the current economic conditions. The increase in the expense ratio primarily reflects an increase in corporate expense allocations and the impact of premium rate decreases and audits of prior year policies that resulted in return premium to customers in 2009.

The segregated portfolio cell reinsurance segment’s combined ratio increased from 88.3% in 2008 to 91.3% in 2009. The increased combined ratio primarily reflects the impact of the current economic environment on the Company’s workers’ compensation loss and LAE ratio.

The group benefits insurance segment’s combined ratio increased from 97.4% in 2008 to 101.8% in 2009. The increased combined ratio primarily reflects an increase in the dental loss ratio and a higher expense ratio. The dental loss ratio has been affected by the competitive rate environment. The increased expense ratio primarily reflects higher salary costs, consulting expenses related to an upgrade of the group benefits policy administration system and an increase in corporate expense allocations.

Principal Revenue and Expense Items

The Company derives its revenue primarily from net premiums earned, including assumed premiums earned, net investment income and net realized investment gains.

Direct and net premiums written. Direct premiums written is the sum of both direct premiums and assumed premiums before the effect of ceded reinsurance. Direct premiums written include all premiums billed during a specified policy period. Net premiums written is the difference between direct premiums written and premiums ceded or paid to reinsurers (ceded premiums written). In the segregated portfolio cell reinsurance segment, assumed premiums are derived from insurance contracts written by the Company and ceded to the segregated portfolio cells. In the run-off specialty reinsurance segment, assumed premiums represent premiums that were received under the quota-share reinsurance treaties and were reported to the Company directly from the broker one quarter in arrears.

Net premiums earned.Net premiums earned represent the earned portion of the Company’s net premiums written. Premiums are earned over the term of the related policies. At the end of each accounting period, the portion of the premiums that are not yet earned are included in unearned premiums and are realized as revenue in subsequent periods over the remaining term of the policy. The Company’s workers’ compensation policies typically have a term of twelve months. Thus, for example, for a policy that is written on July 1, 2009, one-half of the premiums would be earned in 2009 and the other half would be earned in 2010. Workers’ compensation premiums are determined based upon the payroll of the insured, the applicable premium rates and, where applicable, an experience based modification factor. An audit of the policyholders’ records is conducted after policy expiration to make a final determination of applicable premiums. Included with net premiums earned is an estimate for earned but unbilled final audit premiums. The Company can estimate earned but unbilled premiums because it keeps track, by policy, of how much additional premium is billed in final audit invoices as a percentage to estimate the probable additional amount that it has earned but not yet billed as of the balance sheet date. The majority of the Company’s group benefits insurance policies are billed on a monthly basis with premiums being earned in the month in which coverage is provided. As a result, there is minimal unearned premium related to the group benefits insurance policies as of the balance sheet date.

Net investment income and realized gains and losses on investments. The Company invests its surplus and the funds supporting its insurance liabilities (including unearned premiums and unpaid losses and LAE) in cash, cash equivalents, fixed income securities, convertible bonds and equity securities. Investment income includes interest earned on invested assets, including the impacts of premium amortization and discount accretion. Realized gains and losses on invested assets are reported separately from net investment income. The Company recognizes realized gains when invested assets are sold for an

amount greater than their cost or amortized cost (in the case of fixed income securities) and recognizes realized losses when investment securities are written down as a result of an other than temporary impairment or sold for an amount less than their cost or amortized cost. Realized gains and losses also include the change in fair value of convertible bonds.

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

The Company’s expenses consist primarily of losses and LAE, acquisition and other underwriting expenses, policyholder dividends, other expenses, and income taxes.

Losses and LAE.Losses and LAE represent the largest expense item and include: (1) claim payments made, (2) estimates for future claim payments and changes in those estimates for prior periods, and (3) costs associated with investigating, defending and adjusting claims.

Acquisition and other underwriting expenses.In the workers’ compensation and group benefits insurance segments, expenses incurred to underwrite risks are referred to as acquisition and other underwriting expenses, which consist primarily of commissions, premium taxes, assessments and fees and other underwriting expenses incurred in acquiring, writing and administering the Company’s business. In the segregated portfolio cell reinsurance and run-off specialty reinsurance segments, acquisition and other underwriting expenses consist of ceding commissions earned under the respective reinsurance agreements. Ceding commissions received are netted against acquisition and other underwriting expenses.

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

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

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

Key Financial Measures

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

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

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

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

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

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

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

Critical Accounting Policies and Estimates

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

Reserves for Unpaid Losses and LAE

The Company establishes reserves for unpaid losses and LAE for its workers’ compensation, segregated portfolio cell reinsurance, group benefits insurance, and run-off specialty reinsurance products, which are estimates of future payments of reported and unreported claims for losses and related expenses. The adequacy of the Company’s reserves for unpaid losses and LAE are inherently uncertain because the ultimate amount that the Company may pay under many of the claims incurred as of the balance sheet date will not be known for many years. Establishing reserves is an imprecise process, requiring the use of informed estimates and judgments. The Company’s estimates and judgments may be revised as additional experience and other data becomes available and are reviewed as new or improved methodologies are developed, or as current laws change. Any such revisions could result in future changes in estimates of losses or reinsurance recoverables and would be reflected in the Company’s results of operations in the period in which the estimates are changed. Estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates and judgments using data currently available. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded as of December 31, 2009, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.

Workers’ Compensation Insurance

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

produce consistent loss estimates. For more recent accident years, the methodologies produce results that are not as consistent. Accordingly, more emphasis is placed on supplementing the methodologies in more recent accident years with trends in exposure base, medical expense inflation, general inflation, severity, and claim counts, among other things.

The Company’s reserves for unpaid losses and LAE in its workers’ compensation insurance segment as of December 31, 2009 and 2008 are summarized below (in thousands):


	2009			2008
Case reserves	$	33,073		$	34,897
Case incurred development, IBNR and unallocated LAE reserves		27,451			23,320
Amount of discount		(3,097	)		(2,994	)

Net reserves before reinsurance recoverables and purchase accounting		57,427			55,223
Reinsurance recoverables on unpaid losses and LAE		4,909			4,932
Purchase accounting adjustments		514			986

Reserves for unpaid losses and LAE	$	62,850		$	61,141

In its workers’ compensation insurance segment, the Company records reserves for estimated losses under insurance policies and for LAE related to the investigation and settlement of policy claims. The Company’s reserves for unpaid losses and LAE represent the estimated cost of reported and unreported losses and LAE incurred and unpaid at a given point in time. In establishing its workers’ compensation reserves, the Company uses loss discounting, which involves recognizing the time value of money and offsetting estimates of future payments by future expected investment income.

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

•

type of loss;

•

severity of the injury or damage;

•

age and occupation of the injured employee;

•

estimated length of temporary disability;

•

anticipated permanent disability;

•

expected medical procedures, costs and duration;

•

knowledge of the circumstances surrounding the claim;

•

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

•

jurisdiction of the occurrence; and

•

other benefits defined by applicable statute.

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

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

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

In estimating case incurred development and IBNR reserves, the Company performs most of its detailed analysis on a net of reinsurance basis, and then considers expected recoveries in arriving at its recorded amounts for unpaid losses and LAE. To estimate such reserves, the Company relies primarily on the historical claim data and trends from its workers’ compensation book of business. Using standard actuarial methods, the Company estimates reserves based on historical patterns of case development, payment patterns, mix of business, premium rates charged, case reserving adequacy, operational changes, adjustment philosophy and severity and duration trends. However, the number of variables and judgments involved in establishing reserve estimates, combined with some random variation in loss development patterns, results in uncertainty regarding projected ultimate losses.

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

•

All loss and LAE data developed together;

•

Lost time claims developed independently;

•

Medical only claims developed independently;

•

The indemnity portion of lost time claims developed independently;

•

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

•

LAE developed independently.

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

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

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

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

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

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

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

As of December 31, 2009, the Company’s best estimate of its ultimate liability for losses and LAE, net of amounts recoverable from reinsurers and before purchase accounting adjustments, for its workers’ compensation insurance segment was $57.4 million.

For each of the methods described above that are used to estimate reserves for losses and LAE, the estimated paid and incurred loss development factors are key assumptions. Loss development factors are estimated based on the Company’s historical paid and incurred loss development patterns, and an estimate of the “tail factor”, or a factor to account for development beyond the maturity of the historical data. In addition, for the Bornhuetter-Ferguson methods, a key assumption is an estimate of the expected loss ratio. The expected loss ratio is determined based on estimated historical loss ratios adjusted to reflect current underwriting and rate change activity. The assumptions used in these methods by the Company over time have reflected a consistent application of the Company’s estimating processes to emerging experience. The tail factors used in the calculation of loss development factors requires considerable judgment. Selecting representative tail factors requires substantially more judgment than the historical loss development factors. While loss development factors are based on the historical claim payment and reserving patterns of the Company over a period of time, tail factors are estimated based on loss development trends in more mature accident years and industry information, and therefore are estimated in the absence of direct historical loss development history.

Management believes that changes in tail factors are reasonably likely considering the impact that changing economic conditions and medical inflation may have on the loss and LAE estimation process. There are loss and LAE risk factors that affect workers’ compensation claims that can change over time and also cause the Company’s 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;

•

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.

Although many factors influence the actual cost of claims and the corresponding reserves for unpaid losses and LAE 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. In most instances, we rely on historical

experience and tail factors to estimate values for the variables that are explicitly used in the unpaid loss and LAE analysis. For the most recent accident year, we rely on selecting an expected loss ratio to estimate the reserves for unpaid losses and LAE. In addition to the examples above that represent reasonably likely changes in our tail factor, another example of potential variability in our loss and LAE estimation process involves selecting an expected loss ratio for the most recent accident year. For example, if our expected loss ratio for the 2009 accident year were to increase by 5 percentage points, our reserves for unpaid losses and LAE as of December 31, 2009 would increase by $3.7 million, which would result in an after-tax reduction in our earnings of $2.4 million. Management believes that changes in the most recent year accident year loss ratio are reasonably likely due to variability in underwriting and rate changes. 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.

In the event that our estimates of ultimate reserves for unpaid losses and LAE 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 reserves for unpaid losses and LAE are increased. For example, if we determined our reserves for unpaid losses and LAE, net of reinsurance, of $57.4 million as of December 31, 2009 to be 5% inadequate, this would result in an after-tax reduction in our earnings of approximately $1.9 million. This reduction could be realized in one year or multiple years, depending on when the deficiency is identified. The deficiency 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 reserves for unpaid losses and LAE 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 reserves for unpaid losses and LAE prove to be redundant, our future earnings and financial position would be improved.

The Company has utilized the following tail factors for the years ended December 31, 2009, 2008, and 2007:


	2009	2008	2007
Incurred loss development	1.020	1.020	1.020
Paid loss development	1.035	1.035	1.035

Following is a sensitivity analysis of the Company’s workers’ compensation reserves to reasonably likely changes in the tail factors used to project actual current losses to ultimate losses (dollars in thousands):


Change in Tail Factor Assumption	Increase (Decrease) in Net Reserves			Impact on Net Income			Percentage of Shareholders’ Equity
2 basis point increase	$	6,223		$	(4,045	)	-2.6	%
1 basis point increase	$	3,128		$	(2,033	)	-1.3	%
1 basis point decrease	$	(3,160	)	$	2,054		1.3	%
2 basis point decrease	$	(6,354	)	$	4,130		2.7	%

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

Segregated Portfolio Cell Reinsurance

The Company’s reserves for unpaid losses and LAE in its segregated portfolio cell reinsurance segment as of December 31, 2009 and 2008 are summarized below (in thousands):


	2009			2008
Case reserves	$	10,978		$	11,808
Case incurred development, IBNR and unallocated LAE reserves		12,196			11,210
Amount of discount		(1,159	)		(1,151	)

Net reserves before reinsurance recoverables and purchase accounting		22,015			21,867
Reinsurance recoverables on unpaid losses and LAE		3,603			2,903
Purchase accounting adjustments		41			82

Reserves for unpaid losses and LAE	$	25,659		$	24,852

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

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

Group Benefits

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

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

Lag Factor Development Method. The lag factor development method is used to estimate the reserve for insurance products that are “short-tail” by nature, in which claims related to the products are settled shortly after they are reported by the insured. The method uses historical paid claims data to estimate the reserve for claims in the course of settlement (reported claims) and IBNR claims. The method involves the use of a claim model, or a loss triangle, in which paid claims data is aggregated into categories based on the dates on which the claims in question were incurred and paid. Data in the loss triangle is reviewed to evaluate historical claim payment patterns. A point estimate is then determined based on the historical claim payment patterns.

Loss Ratio Method. The loss ratio method involves the use of historical loss ratios to estimate the reserve for unpaid claims. Under the loss ratio method, the reserve is determined by multiplying the selected loss ratio, which is based on historical loss ratio trends, by the amount of net premiums earned or the in-force premium at the valuation date.

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

The Company’s reserves for unpaid losses and LAE in its group benefits insurance segment, by line business, as of December 31, 2009 and 2008, were as follows (in thousands):


	2009		2008
Case reserves	$	9,928	$	10,690
Case incurred development, IBNR and unallocated LAE reserves		4,458		3,956

Net reserves before reinsurance recoverables		14,386		14,646
Reinsurance recoverables on unpaid losses and LAE		16,033		17,939

Reserves for unpaid losses and LAE	$	30,419	$	32,585

Dental, Short-term Disability and Vision Reserves

The dental, short-term disability and vision reserves represent the Company’s estimate of future amounts due on in-process and IBNR. The Company estimates its dental, short-term disability, and vision reserves using a combination of the lag factor development method and the loss ratio method, which results in the development of a point estimate. The loss ratio method is generally applied to the last three months (or most recent quarter), based on recent loss ratio trends.

Long-Term Disability Reserves

The long-term disability tabular reserve represents the Company’s estimate of future amounts due on reported long-term disability claims. The Company establishes a reserve at the time a long-term disability claim is reported using the 1987 Commissioners Group Disability Table. Due to the long-term nature of long-term disability claims, management discounts the liability using an interest rate that reflects the estimated investment return in the Company’s group benefits insurance segment that will be earned over the expected life of the claim. In establishing the discount rate, the Company’s management evaluates the current interest rate environment at the end of each year and, if necessary, adjusts the interest rate for the following year based on the expected rate of return on new investments. The discount rates for claims incurred in 2009, 2008 and 2007 were 4.00%, 3.85%, and 5.25%, respectively. A lower discount rate results in a higher claim reserve and an increase in losses and LAE, whereas a higher discount rate results in a lower claim reserve and a decrease in losses and LAE. The reserve established represents the present value of expected future claim payments based on the terms of the underlying long-term disability insurance contract. With the exception of the discount rate, the assumptions that impact the reserve amount, such as recovery, morbidity and mortality rates, are embedded in the table. The long-term disability IBNR reserve is estimated on a policy-by-policy basis, taking into consideration the average monthly premium, the policy elimination period, and an expected loss ratio.

Term Life Reserves

Term life reserves consist of reported but unpaid and IBNR claims on the Company’s term life product, as well as a life premium waiver reserve. Reported but unpaid life claims represent those claims reported to the Company as of the balance sheet date for which payment has not yet been made. Term life IBNR claims are estimated based on historical patterns of losses incurred as a percent of in-force premium as of the balance sheet date.

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

The term life IBNR claim reserve represents the Company’s estimate of future amounts to be paid under existing term life insurance contracts for insured deaths and dismemberments that have occurred but not yet been reported. The Company estimates the term life IBNR claim reserve by applying a reserve factor to the current in-force volume of life insurance and AD & D benefits, resulting in the development of a point estimate. The reserve factor is based on past experience and is evaluated against actual results on an annual basis for reasonableness.

Life premium waiver reserves represent the present value of future life insurance benefits under those term life policies for which the premiums have been waived due to the insured’s disability and are calculated using the tabular reserve method. The Company establishes a reserve at the time the insured’s disability is reported using the 2005 Group Term Life Waiver Reserve Table for claims reported on and after October 1, 2007 and the 1970 Intercompany Group Life Disability Table for claims reported prior to October 1, 2007.

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

Run-off Specialty Reinsurance

With respect to the run-off specialty reinsurance segment, numerous internal and external factors will affect the ultimate settlements of future claims including, but not necessarily limited to, changes in the cost of environmental remediation, impacts of relevant federal or state legislation, changes in technology and the resulting impact on costs, and reliance on ceding companies to handle claims and remit proper loss information in a timely manner. Reserving for assumed reinsurance requires evaluating loss information received from the ceding company. On a quarterly basis, the Company receives a statement from the ceding company which includes premium and loss settlement activity for the period with corresponding reserves as established by the ceding company. Claims reported to the ceding company by insureds are entered into its claim system and ceded to the Company on a quarterly basis. The claim information received from the ceding company is compiled into loss development triangles. Generally accepted actuarial methodologies, supplemented by judgment where appropriate, are used to develop the appropriate IBNR reserves for the Company. Each quarter the Company compares its actual reported losses for the quarter, and cumulative reported losses since the most recently completed reserve study, to expected reported losses for the respective period, which may result in the Company increasing its losses and LAE, and its corresponding loss

reserves in that quarter. This information is used as a tool in the judgmental process by which management assesses the overall adequacy of the reserves for unpaid losses and LAE at the Company. The evaluation of the reserves for unpaid losses and LAE related to the Company’s run-off specialty reinsurance segment requires that loss development be estimated over an extended period of time. Because the primary insurer under the reinsurance program changed in 1999 and the claims management philosophy of the two primary insurers differed, historical loss data for years prior to 1999 has limited relevance. Therefore, reliance has been placed on a blend of historical loss development data, industry loss development patterns and estimated loss ratios, adjusted to reflect considerations particular to the exposure. The reliance on external benchmarks and estimated loss ratios, while necessary, creates an additional element of uncertainty.

The Company’s reserves for unpaid losses and LAE in its run-off specialty reinsurance segment as of December 31, 2009 and 2008 are summarized below (in thousands):


	2009			2008
Case reserves	$	15,761		$	15,632
Case incurred development, IBNR and unallocated LAE reserves		16,841			24,938

Net reserves before purchase accounting		32,602			40,570
Purchase accounting adjustments		(18	)		(31	)

Reserves for unpaid losses and LAE	$	32,584		$	40,539

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

The Company analyzes its ultimate losses and LAE for the run-off specialty reinsurance segment after consideration of the loss experience on each treaty for each underwriting year on a quarterly basis. The methodologies that the Company employs include, but may not be limited to, paid loss development methods and incurred loss development methods similar to those described in the workers’ compensation insurance and segregated portfolio cell reinsurance segments above.

In applying these methods, the Company evaluates loss development trends by underwriting year to determine various assumptions that are required as inputs in the actuarial methodologies it employs. These typically involve the analysis of historical loss development trends by underwriting year. In addition to the use of historical loss development data, the Company utilizes external or internal benchmark sources of information for which it has limited loss development data to calculate credible trends. External benchmarks are not precise with respect to the run-off specialty reinsurance segment’s environmental claims and historical data is subject to changes in claim payment patterns at the ceding company, which adds additional uncertainty related to the estimation of the reserves for unpaid losses and LAE. The evaluation of the reserve for unpaid losses and LAE related to the run-off specialty reinsurance segment requires that loss development be estimated over an extended period of time.

The Company relies on information provided by ceding companies regarding premiums and reported claims, and then uses that data as a key input to estimate unpaid losses and LAE. Since the Company relies on claims information reported by ceding companies, the estimation of unpaid losses and LAE for the run-off specialty reinsurance segment includes certain risks and uncertainties that do not exist with its other segments, and include, but are not necessarily limited to, the following:

•

The case reserves recorded by the ceding company may not represent a reasonable estimate of the underlying exposure, be otherwise inaccurate or necessary case reserve increases may not be recorded in a timely manner.

•

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

•

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

•

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

In order to mitigate the above risks, the Company performs quarterly reviews of the ceding companies’ detailed claim reports to assess the reasonableness of the reported claim information. Additionally, Company claim personnel perform an annual claims audit at the ceding company to evaluate internal controls surrounding the claims handling and administration.

As of December 31, 2009, the Company’s best estimate of its ultimate liability for unpaid losses and LAE, before purchase accounting adjustments, for its run-off specialty reinsurance segment was $32.6 million.

The evaluation of the reserves for unpaid losses and LAE in the run-off specialty reinsurance segment requires that loss development be estimated over an extended period of time using historical loss development data with limited relevance. As the historical loss development data has limited relevance, reliance has been placed on loss development patterns based on a blend of historical loss development data and industry loss development patterns, judgmentally adjusted to reflect considerations particular to the exposure. The reliance on external benchmarks, while necessary, creates an additional element of uncertainty. Following is a sensitivity analysis of the reserves for unpaid losses and LAE to reasonably likely changes in the blend of historical loss development data, industry loss development factors and expected loss ratios used to project current losses to ultimate losses (dollars in thousands):


Change in Actual Loss Development as a Percentage of Total and Expected Loss Ratio	Increase (Decrease) in Net Loss Reserves			Impact on Net Income			Percentage of Shareholders’ Equity
30 basis point increase	$	10,179		$	(10,179	)	-6.6	%
20 basis point increase	$	6,506		$	(6,506	)	-4.2	%
10 basis point increase	$	3,118		$	(3,118	)	-2.0	%
10 basis point decrease	$	(2,859	)	$	2,859		1.9	%
20 basis point decrease	$	(5,470	)	$	5,470		3.6	%
30 basis point decrease	$	(7,841	)	$	7,841		5.1	%

Increases or decreases in the run-off specialty reinsurance segment’s reserves for unpaid losses and LAE, as a result of changes in loss development based on actual loss results, would result in an equivalent increase or decrease in net income. There is no tax effect related to the run-off specialty reinsurance segment’s operating results as a result of the significant losses incurred in the segment for the year ended December 31, 2008.

While management believes that the assumptions underlying the amounts recorded for the reserves for unpaid losses and LAE as of December 31, 2009 are reasonable, the ultimate net liability may differ materially from the amount recorded.

“Other Than Temporary” Investment Impairments

Unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in shareholders’ equity as a component of comprehensive income (loss) and, accordingly, have no effect on net income. When, in the opinion of management, a decline in the fair value of an investment below its cost or amortized cost is considered to be “other-than-temporary,” such investment is written-down to its fair value. The amount written-down is recorded in earnings as a realized loss on investments. Generally, the determination of other-than-temporary impairment includes, in addition to other relevant factors, a presumption that if the market value is below cost by a significant amount for a period of time, a write-down is necessary. Notwithstanding this presumption, the determination of other-than-temporary impairment requires judgment about future prospects for an investment and is therefore a matter of inherent uncertainty. For the years ended December 31, 2009 and 2008, the Company recorded other-than-temporary impairments of $4.5 million and $9.5 million, respectively, including other-than-temporary impairments of $749,000 and $1.2 million, respectively in the segregated portfolio cell reinsurance segment. The Company did not record any impairments in 2007. As of December 31, 2009, the Company held fixed income securities, excluding the segregated portfolio cell reinsurance segment, with gross unrealized losses of $841,000, of which $612,000 were in an unrealized loss position for more than twelve months. Adverse investment market conditions, or poor operating results of underlying investments, could result in impairment charges in the future. The Company generally applies the following standards in determining whether the decline in fair value of an investment is other-than-temporary:

Equity securities. An equity security is considered impaired when one of the following conditions exist: 1) an equity security’s market value is less than 80% of its cost for a continuous period of 6 months, 2) an equity security’s market value is less than 50% of its cost, regardless of the amount of time the security’s market value has been below cost, and 3) an equity security’s market value has been less than cost for a continuous period of 12 months or more, regardless of the magnitude of the decline in market value. Equity securities that are in an unrealized loss position, but do not meet the above quantitative thresholds are evaluated to determine if the decline in market value is other than temporary.

For the year ended December 31, 2009, the Company recorded other-than-temporary impairments of $4.3 million related to its equity portfolio. The securities were impaired because they had been in an unrealized loss position for more than 12 months.

Fixed income securities. A fixed income security is considered to be other-than-temporarily impaired when the security’s fair value is less than its amortized cost basis and 1) the Company intends to sell the security, 2) it is more likely than not that the Company will be required to sell the security before recovery of the security’s amortized cost basis, or 3) the Company believes it will be unable to recover the entire amortized cost basis of the security (i.e., a credit loss has occurred). When the Company determines a credit loss has been incurred, but the Company does not intend to sell the security and it is not more likely than not that the Company will be required to sell the security before recovery of the security’s amortized cost basis, the portion of the other-than-temporary impairment that is credit related is recorded as a realized loss in the consolidated statements of operations and comprehensive income (loss), and the portion of the other-than-temporary impairment that is not credit related is included in other comprehensive income (loss). A fixed income security is reviewed for potential credit loss if any of the following situations occur:

•

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

•

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

•

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

For the year ended December 31, 2009, the Company recorded other-than-temporary impairments of $189,000 related to two fixed income securities. One security was impaired as a result of management’s intent to sell the security. This security was sold in the second quarter of 2009. The other security was impaired as a result of management determining that a credit loss had been incurred.

Limited partnerships.A limited partnership investment is generally written down if the Company is unable to hold or otherwise intends to sell its interest in the limited partnership at a loss, or if management has received information that suggests the Company will be unable to recover its original investment in the limited partnership. The amount written down is recorded in the change in equity interest in other long-term investments in the consolidated statement of operations.

There were no impairments related to the Company’s limited partnership investments in 2009. For the year ended December 31, 2008, the Company recorded a permanent impairment of $1.4 million related to one of its limited partnership investments.

At the time a security is determined to be other-than-temporarily impaired, the cost or amortized cost is written down to market value at the balance sheet date and the impairment is recorded as a realized loss in the consolidated statement of operations.

Goodwill

In accordance with the requirements of ASC 350, Intangibles—Goodwill and Other, goodwill is not amortized but is tested for impairment at the reporting unit level, which is at the operating segment level or one level below an operating segment. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. Goodwill is required to be tested for impairment annually and between annual tests if events or circumstances change, such as adverse changes in the business climate, that would more likely than not reduce the fair value of the reporting unit below its carrying value.

Goodwill is assigned to one or more reporting units at the date of acquisition. The Company has allocated 100% of the goodwill recorded on its consolidated balance sheet as of September 30, 2009 to its workers’ compensation insurance segment. The goodwill impairment test, performed as of September 30 of each year, is a two-step test. The first step identifies whether there is potential impairment by comparing the fair value of a reporting unit to the carrying amount, including goodwill. If the fair value of a reporting unit is less than its carrying amount, the second step of the impairment test is required to measure the amount of any impairment loss.

For the 2009 annual impairment test, the fair value of the workers’ compensation insurance segment was estimated using a discounted cash flow analysis, a form of the income approach, using management’s internal four-year forecast for the workers’ compensation insurance segment and a terminal value estimated using a long-term growth rate of 5.0%, which is reflective of the segment’s historical growth rate, and a discount rate of 13.0%, which is reflective of the risks inherent in the segment. Cash flows were adjusted as necessary to maintain adequate capital requirements.

In addition to the discounted cash flow analysis, management assessed the Company’s stock price relative to the book value of the workers’ compensation insurance segment. As of September 30, 2009, the Company’s stock price was trading below book value, primarily reflecting the impact of market conditions over the past year; therefore, management also considered an estimate of the Company’s value in a potential transaction and allocated that value to the Company’s reporting units, including the workers’ compensation insurance segment.

Both the discounted cash flow analysis and the estimate of the Company’s value in a potential transaction resulted in the workers’ compensation insurance segment’s estimated fair value exceeding its carrying value as of September 30, 2009; therefore, goodwill was considered not impaired, and the second step of impairment testing was not necessary.

In the event the operating results of the Company’s workers’ compensation insurance segment were to be adversely impacted by a significant loss of business or higher than expected losses and LAE, management’s internal forecast may need to be re-evaluated, which could result in a fair value that is less than the carrying value of the workers’ compensation insurance segment and the need to recognize a goodwill impairment.

Deferred Income Taxes

The temporary differences between the tax and book bases of assets and liabilities are recorded as deferred income taxes. Management evaluates the recoverability of the net deferred tax asset based on historical trends of generating taxable income or losses, as well as expectations of future taxable income or loss. As of December 31, 2009, the Company recorded a net deferred tax asset of $1.3 million. Management expects that the net deferred tax asset is fully recoverable. If this assumption were to change, any amount of the net deferred tax asset that the Company could not expect to recover would be provided for as an allowance and would be reflected as an increase in income tax expense in the period in which it was established.

As of December 31, 2009, the Company has not recognized a deferred tax asset related to its run-off specialty reinsurance segment of $7.3 million, which represents the excess of the tax basis over the amount for financial reporting (i.e., outside basis difference) of Eastern Re as of December 31, 2009. The outside basis difference primarily arises from losses at Eastern Re recognized for financial statement purposes, which have not yet been recognized for tax purposes. Management presently believes that the Company will not be able to recognize these tax benefits in the foreseeable future and, therefore has not recognized these tax benefits as of December 31, 2009.

As of December 31, 2009, the Company recognized a deferred tax asset of $2.0 million related to other-than-temporary investment impairments. Under United States federal income tax rules and regulations, capital losses can only be utilized to offset income generated from capital gains. Capital losses can be carried back to offset capital gains reported in the three prior tax periods and can be carried forward for five tax periods. Management has determined, based on a review of its investment portfolio and giving consideration to capital gains reported in prior tax periods, that the Company’s deferred tax asset related to other-than-temporary investment impairments and net unrealized losses on investments is recoverable; therefore, a valuation allowance has not been recorded as of December 31, 2009. Due to the significant volatility in the investment markets, management’s conclusion on the recoverability of the deferred tax asset could change in future periods. Further declines in the estimated fair value of the Company’s investments may result in the need for a valuation allowance, which could have an adverse impact of the Company’s financial condition and/or results of operations.

Reinsurance Recoverables

Amounts recoverable from Company’s reinsurers are estimated in a manner consistent with the reserves for unpaid losses and LAE associated with the reinsured policy. Amounts paid for reinsurance contracts are expensed over the contract period during which insured events are covered by the reinsurance contracts. Reinsurance balances recoverable on paid and unpaid loss and LAE are reported separately as assets, instead of being netted with the appropriate liabilities, because reinsurance does not relieve the Company of its legal liability to its policyholders. Reinsurance balances recoverable are subject to credit risk associated with the particular reinsurer. Additionally, the same uncertainties associated with estimating unpaid losses and LAE affect the estimates for the ceded portion of these liabilities. The Company continually monitors the financial condition of its reinsurers and where necessary obtains collateral. As of December 31, 2009, the Company had reinsurance recoverables of $28.5 million.

Recent Accounting Guidance

Fair Value Measurements—Investments in Certain Entities that Calculate Net Asset Value per Share

In September 2009, the Financial Accounting Standards Board (“FASB”) issued new accounting and disclosure guidance related to the determination of fair value of investments in entities (investees) that permit the investor to redeem its investments directly with the investee or receive distributions from the investee at times specified under the terms of the investee’s governing documents. Many of these investees do not have readily determinable fair values and provide their investors with a net asset value per share (or its equivalent, such as member units or an ownership interest in partners’ capital). Under the new guidance, investments in entities that calculate net asset value per share (or its equivalent) may be measured at fair value using the investee’s net asset value per share (or its equivalent) if the net asset value of the investment is calculated in a manner consistent with the measurement principles of investment companies as of the reporting entity’s measurement date, including measurement of all or substantially all of the underlying investments of the investee in accordance with the fair value measurement principles. The new guidance also requires enhanced disclosure related to the reporting entity’s investment is such investees including, but not limited to, the nature of any restrictions on the reporting entity’s ability to redeem its investments at the measurement date, any unfunded commitments, and the investment strategies of the investee. The Company’s limited partnership interests are currently reported in the consolidated balance sheets using the net asset value per share (or its equivalent) of the investee. The Company adopted the new accounting guidance effective December 31, 2009. The adoption had no impact on the estimated fair value of our limited partnership interests. The Company’s enhanced disclosures related to its limited partnership interests are included in Note 10.

FASB Accounting Standards Codification

In June 2009, the FASB established the FASB Accounting Standards Codification (“Codification”) as the single source of authoritative accounting principles in the preparation of financial statements in conformity with GAAP. The Codification explicitly recognizes rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under federal securities laws as authoritative GAAP for SEC registrants. The Codification was effective for financial statements issued for periods ending after September 15, 2009. The Company adopted the Codification effective September 30, 2009 and revised its disclosures to reflect Codification as the source of authoritative accounting principles.

Subsequent Events

In May 2009, the FASB issued new accounting and disclosure guidance related to subsequent events. The new guidance defines subsequent events as either “recognized” or “nonrecognized” and is consistent with existing guidance related to the reporting of subsequent events. Recognized subsequent events are those events that provide additional evidence about conditions that existed at the balance sheet date and must be recognized in an entity’s financial statements. Nonrecognized events are those events that provide evidence about conditions that did not exist at the balance sheet date but arose before the financial statements are issued or are available to be issued. Nonrecognized events may require disclosure in an entity’s financial statements to prevent the financial statements from being misleading. Publicly traded entities must evaluate subsequent events through the financial statement issuance date. The new guidance was effective for interim or annual financial periods ending after June 15, 2009. The Company adopted the new accounting and disclosure requirements effective June 30, 2009, which are included in Note 22.

Other-than-Temporary Investment Impairments

In April 2009, the FASB issued new accounting guidance related to the recognition and presentation of other-than-temporary investment impairments. The new guidance requires entities to separate an other-than-temporary impairment of a debt security into two components when there are credit related losses associated with the impaired debt security for which management asserts that it does not have the intent to sell the security, and it is more likely than not that it will not be required to sell the security before recovery of its cost basis. The amount of the other-than-temporary impairment related to a credit loss is recorded as a net realized investment loss in the statements of operations, and the amount of the other-than-temporary impairment related to other factors is recorded as an other comprehensive loss. The new guidance was effective for periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The Company adopted the new guidance effective April 1, 2009, which resulted in the Company recording a cumulative effect adjustment that increased retained earnings and decreased accumulated other comprehensive income (loss), net, as of April 1, 2009, by $685 and $445, respectively, resulting in an increase to shareholders’ equity of $240. The increase in shareholders’ equity reflects the reversal of a prior period deferred tax valuation allowance, of which $240 was applied to the retained earnings cumulative effect adjustment.

Fair Value Measurements

In April 2009, the FASB issued new accounting guidance related to determining fair value of an asset or liability when the volume or level of activity for the asset or liability has significantly decreased and for identifying transactions that are not orderly. Under the new guidance, if an entity determines that there has been a significant decrease in the volume and level of activity for the asset or the liability in relation to the normal market activity for the asset or liability (or similar assets or liabilities), then transactions or quoted prices may not accurately reflect fair value. In addition, if there is evidence that the transaction for the asset or liability is not orderly, the entity shall place little, if any weight on that transaction price as an indicator of fair value. The new guidance was effective for periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The Company adopted the new guidance effective June 30, 2009. The adoption of the new guidance did not have a material effect on the Company’s consolidated financial statements.

Disclosures About Fair Value of Financial Instruments

In April 2009, the FASB issued new accounting guidance related to the interim disclosures about fair value of financial instruments. The new guidance requires disclosures about fair value of financial instruments in interim and annual financial statements and was effective for periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The Company adopted the interim period disclosure requirements of effective June 30, 2009, which are included in Notes 10 and 11.

YEAR ENDED DECEMBER 31, 2009 COMPARED TO YEAR ENDED DECEMBER 31, 2008

RESULTS OF OPERATIONS

The major components of consolidated revenue were as follows for the years ended December 31, 2009 and 2008 (in thousands):


	2009		2008
Net premiums written	$	138,433	$	134,712

Net premiums earned	$	134,986	$	135,807
Net investment income		7,097		9,631
Change in equity interest in limited partnerships		1,261		(3,970	)
Net realized investment gains (losses)		952		(11,117	)
Other revenue		645		853

Consolidated revenue	$	144,941	$	131,204

The increase in consolidated revenue from 2008 to 2009 primarily reflects an improvement in the Company’s investment portfolio, partially offset by lower investment income. The Company’s limited partnership investments experienced an increase in value during 2009, compared to significant losses in 2008. Other-than-temporary impairments in the Company’s investment portfolio decreased from 2008 to 2009, which contributed to the improvement in net realized investment gains during 2009. The decrease in net investment income is reflective of a decrease in the Company’s fixed income security holdings, and lower interest rates on new fixed income security purchases and cash and short-term investment holdings. The decrease in net premiums earned reflects the July 2008 termination of the quota-share reinsurance treaties in the run-off reinsurance segment, partially offset by increased premiums in the workers’ compensation insurance segment.

The components of consolidated net income (loss), by segment, for the years ended December 31, 2009 and 2008 were as follows (in thousands):


	2009			2008
Workers’ compensation insurance	$	9,120		$	6,829
Segregated portfolio cell reinsurance		—			—
Group benefits insurance		2,808			(1,156	)
Run-off specialty reinsurance		(314	)		(18,673	)
Corporate/other		(3,213	)		(4,383	)

Consolidated net income (loss)	$	8,401		$	(17,383	)

The improvement in the Company’s net income from 2008 to 2009 primarily reflects the improvement in the run-off specialty reinsurance segment and the aforementioned improvement in the Company’s investment portfolio. The run-off specialty reinsurance segment’s 2008 financial results were adversely impacted by unfavorable loss reserve development related to prior accident years.

WORKERS’ COMPENSATION INSURANCE

The following table represents the operations of the workers’ compensation insurance segment for the years ended December 31, 2009 and 2008 (in thousands). The results of operations for the year ended December 31, 2008 include the operating results of ESIC for the period from October 1, 2008 to December 31, 2008:


	2009			2008
Revenue:
Direct premiums written	$	110,108		$	101,907
Reinsurance premiums assumed		1,086			652
Ceded premiums written		(34,241	)		(33,996	)

Net premiums written		76,953			68,563
Change in unearned premiums		(3,740	)		(2,601	)

Net premiums earned		73,213			65,962
Net investment income		3,313			4,045
Change in equity interest in limited partnerships		845			(3,051	)
Net realized investment losses		(237	)		(4,174	)
Other revenue		—			119

Total revenue	$	77,134		$	62,901

Expenses:
Losses and LAE	$	43,843		$	36,535
Acquisition and other underwriting expenses		6,207			4,920
Other expenses		13,754			10,915
Policyholder dividend expense		432			551

Total expenses	$	64,236		$	52,921

Income before income taxes		12,898			9,980
Income tax expense		3,778			3,151

Net income	$	9,120		$	6,829

Net Income

The increase in net income primarily reflects a decrease in net realized investment losses and an increase in the value of the segment’s limited partnership investments. The decrease in net realized investment losses primarily reflects a reduction in other-than-temporary impairments from 2008 to 2009. The improved investment results were partially offset by an increase in the combined ratio from 2008 to 2009. The increase in the loss and LAE ratio from 2008 to 2009 primarily reflects an increase in the 2009 accident year loss ratio reflecting management’s view of the expected impact of the current economic environment on the Company’s workers’ compensation book of business. The increase in the expense ratio primarily reflects an increase in corporate expense allocations and the impact of premium rate decreases and audits of prior year policies that resulted in return premium to customers in 2009.

The workers’ compensation insurance ratios were as follows for the years ended December 31, 2009 and 2008:


	2009		2008
Loss and LAE ratio	59.9	%	55.4	%
Expense ratio	27.2	%	24.0	%
Policyholders’ dividend expense ratio	0.6	%	0.8	%

Combined ratio	87.7	%	80.2	%

Premiums

The increase in direct premiums written from 2008 to 2009 primarily reflects new business sales of $28.0 million and direct premiums written of $6.1 million related to the acquisition of ESIC, partially offset by a reduction in the renewal retention rate from 87.6% in 2008 to 84.1% in 2009 and renewal rate decreases of 3.9%. Traditional and alternative market direct premiums written were $81.4 million and $28.7 million, respectively, for the year ended December 31, 2009, compared to $72.8 million and $29.1 million, respectively, for the same period in 2008.

Net Investment Income

The decrease in net investment income primarily reflects a decline in the average yield on the fixed income portfolio and a decline in short-term interest rates from 2008 to 2009. The average yield on the fixed income portfolio was 3.61% as of December 31, 2009, compared to 4.18% as of December 31, 2008.

Net Realized Investment Losses

The decrease in net realized investment losses from 2008 to 2009 primarily reflects a reduction in other-than-temporary impairments. Other-than-temporary impairments totaled $1.7 million in 2009, compared to $3.4 million in 2008. In addition, the convertible bond portfolio experienced an increase in fair value of $877,000 in 2009, compared to a decrease in fair value of $623,000 in 2008.

Losses and LAE

The increase in the calendar period loss and LAE ratio primarily reflects an increase in the accident period loss ratio, partially offset by an increase in favorable loss reserve development related to prior accident periods. The accident period loss ratio was 65.6% and 60.2% for the years ended December 31, 2009 and 2008, respectively. The increase in the accident period loss ratio primarily reflects management’s estimate of the impact of the current economic environment on the Company’s workers’ compensation book of business, including the impact of rising unemployment on management’s return to work controls. Favorable loss reserve development totaled $3.7 million for the year ended December 31, 2009, compared to favorable loss reserve development of $2.7 million for the same period in 2008. The favorable development primarily reflects continued improvements in loss mitigation and underwriting, including greater availability and use of employers’ return to work programs. Furthermore, the Company was able to settle a large amount of Pennsylvania claims via compromise and release, which is a lump sum cash payment in exchange for a full and final claim settlement. Management attributes the large amount of compromise and release claim closures to the difficult economic conditions and the claimants’ choosing a lump sum cash settlement over the continuation of a workers’ compensation annuity payment.

Acquisition and Other Underwriting Expenses

The increase in acquisition and other underwriting expenses primarily reflects the impact of the Indiana state tax liability related to ESIC’s operating results for the year ended December 31, 2009.

Other Expenses

The increase in other expenses as a percent of net premiums earned from 2008 to 2009 primarily reflects the impact of the lower net premiums earned and the increase in corporate expense allocations.

Policyholder Dividends

The decrease in policyholder dividend expense primarily reflects an increase in the aforementioned accident period loss ratio from 2008 to 2009. As of December 31, 2009 and 2008, approximately 10.0% of the Company’s workers’ compensation insurance policies were written on a participating basis.

Tax Expense

The effective tax rate was 29.3% and 31.6% for the years ended December 31, 2009 and 2008, respectively. The difference between the statutory tax rate of 35.0% and the effective tax rate primarily reflects tax exempt income on municipal bond securities. The decrease in the effective tax rate primarily reflects a prior year tax return adjustment that decreased income tax expense in 2009, compared to a prior year tax return adjustment that increase income tax expense in 2008.

SEGREGATED PORTFOLIO CELL REINSURANCE

The following table represents the operations of the segregated portfolio cell reinsurance segment for the years ended December 31, 2009 and 2008 (in thousands):


	2009			2008
Revenue:
Reinsurance premiums assumed	$	28,661		$	29,113
Ceded premiums written		(3,278	)		(3,023	)

Net premiums written		25,383			26,090
Change in unearned premiums		(680	)		(2,650	)

Net premiums earned		24,703			23,440
Net investment income		691			1,112
Net realized investment losses		(625	)		(1,381	)

Total revenue	$	24,769		$	23,171

Expenses:
Losses and LAE	$	14,923		$	13,182
Acquisition and other underwriting expenses		7,500			7,238
Other expenses		123			286
Segregated portfolio dividend expense (1)		2,223			2,465

Total expenses	$	24,769		$	23,171

Net income (1)	$	—		$	—

(1)

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

The segregated portfolio cell reinsurance ratios were as follows for the years ended December 31, 2009 and 2008:


	2009		2008
Loss and LAE ratio	60.4	%	56.2	%
Expense ratio	30.9	%	32.1	%

Combined ratio	91.3	%	88.3	%

Reinsurance Premiums Assumed

The decrease in reinsurance premiums assumed from 2008 to 2009 primarily reflects the impact of renewal rate decreases of 1.0% and return premium of $714,000 related to policy audits. New business sales totaled $4.1 million and the renewal retention rate increased from 87.7% in 2008 to 89.1% in 2009. In 2008, policy audits resulted in return premium of $383,000.

Net Investment Income

The decrease in net investment income primarily reflects a reduction in short-term interest rates from 2008 to 2009.

Net Realized Investment Losses

Losses and LAE

The increase in the calendar period loss and LAE ratio primarily reflects an increase in the accident period loss ratio, partially offset by an increase in favorable loss reserve development related to prior accident periods. The accident period loss ratio was 71.7% and 64.9% for the years ended December 31, 2009 and 2008, respectively. The increase in the accident period loss ratio primarily reflects management’s estimate of the impact of the current economic environment on the Company’s workers’ compensation book of business, including the impact of rising unemployment on management’s return to work controls. Favorable loss reserve development totaled $2.8 million for the year ended December 31, 2009, compared to favorable loss reserve development of $2.0 million for the same period in 2008. The favorable loss reserve development relates primarily to a decrease in the prior accident period loss development factors used to estimate losses and LAE. The decrease in prior accident period loss development factors primarily reflects prior year claim settlements during 2009 for amounts at, or less than, previously established case and IBNR reserves. This decrease had the effect of lowering loss development factors as of December 31, 2009. In the aggregate, the claims were closed at amounts lower than the provision established for IBNR claims. Management believes that the realization of the benefits of its return-to-work controls enabled it to record losses and LAE that were lower than the amount reserved for claim settlements.

Acquisition and Other Underwriting Expenses

The expense ratios are consistent with the contractual ceding commissions for the years ended December 31, 2009 and 2008.

Segregated Portfolio Dividend Expense

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

GROUP BENEFITS INSURANCE

The following table represents the operations of the group benefits insurance segment for the years ended December 31, 2009 and 2008 (in thousands):


	2009			2008
Revenue:
Direct premiums written	$	38,740		$	39,205
Ceded premiums written		(2,798	)		(2,487	)

Net premiums written		35,942			36,718
Change in unearned premiums		(5	)		5

Net premiums earned		35,937			36,723
Net investment income		1,590			2,578
Change in equity interest in limited partnerships		195			(430	)
Net realized investment gains (losses)		3,021			(5,366	)
Other revenue		2			—

Total revenues		40,745			33,505

Expenses:
Losses and LAE		24,936			24,444
Acquisition and other underwriting expenses		5,389			5,602
Other expenses		6,263			5,698

Total expenses		36,588			35,744

Income (loss) before income taxes		4,157			(2,239	)
Income tax expense (benefit)		1,349			(1,083	)

Net income (loss)	$	2,808		$	(1,156	)

Net Income (Loss)

The improvement in the segment’s operating results from 2008 to 2009 primarily reflects a reduction in other-than-temporary impairments and the increase in the fair value of the convertible bond portfolio. The improved investment results were partially offset by an increase in the combined ratio and a decrease in net investment income. The increase in the

combined ratio primarily reflects the increase in the dental loss ratio and an increase in the expense ratio. The increase in the dental loss ratio reflects the competitive rate environment. The increase in the expense ratio primarily reflects the reduction of net premiums earned from 2008 to 2009, consulting expenses related to an upgrade of the segment’s policy administration system and an increase in corporate expense allocations.

The group benefits insurance ratios were as follows for the years ended December 31, 2009 and 2008:


	2009		2008
Loss and LAE ratio	69.4	%	66.6	%
Expense ratio	32.4	%	30.8	%

Combined ratio	101.8	%	97.4	%

Premiums

Direct premiums written, by line of business, for the years ended December 31, 2009 and 2008 were as follows (in thousands):


	2009		2008
Dental	$	22,544	$	22,742
Short-term disability		6,141		6,567
Long-term disability		3,834		3,827
Term life		6,142		6,069
Vision		79		—

Total	$	38,740	$	39,205

The decrease in direct premiums written primarily reflects a decline in the renewal retention rate, partially offset by new business sales.

Net Investment Income

The decrease in net investment income primarily reflects a lower invested asset base. The average yield on the fixed income portfolio was 2.76% as of December 31, 2009, compared to 4.88% as of December 31, 2008.

Net Realized Investment Gains (Losses)

The decrease in net realized investment losses from 2008 to 2009 primarily reflects a reduction in other-than-temporary impairments. Other- than-temporary impairments totaled $120,000 in 2009, compared to $3.9 million in 2008. In addition, the convertible bond portfolio experienced an increase in fair value of $2.3 million in 2009, compared to a decrease in fair value of $2.1 million in 2008

Losses and LAE

The calendar period loss ratios, by line of business, for the years ended December 31, 2009 and 2008 were as follows:


	2009		2008
Dental	78.7	%	74.1	%
Short-term disability	59.7	%	63.8	%
Long-term disability	24.0	%	42.5	%
Term life	53.3	%	48.8	%
Vision	57.5	%	0.0	%
Total group benefits	69.4	%	66.6	%

Dental

The increase in the dental loss ratio for year ended December 31, 2009, compared to the same period in 2008, primarily reflects an increase in the accident period loss ratio from 75.6% in 2008 to 79.5% in 2009. Favorable development on prior accident year reserves reduced the loss ratio by 0.8 percentage points, or $161,000, for the year ended December 31, 2009, compared to 1.5 percentage points, or $325,000, for the same period in 2008. The increase in the accident period loss ratio primarily reflects the impact of the competitive rate environment.

Short-term Disability

The decrease in the short-term disability loss ratio for the year ended December 31, 2009, compared to the same period in 2008, primarily reflects a decrease in the accident period loss ratio from 65.6% in 2008 to 62.1% in 2009. Favorable development on prior accident year reserves further reduced the loss ratio by 2.4 percentage points, or $146,000, for the year ended December 31, 2009, compared to 1.8 percentage points, or $120,000, for the same period in 2008. The decrease in the accident period loss ratio primarily reflects lower claim frequency and severity.

Long-term Disability

The decrease in the long-term disability loss ratio primarily reflects the impact of prior year claim terminations.

Term Life

The increase in the term life loss ratio primarily reflects a reduction in premium waiver claim terminations from 2008 to 2009, partially offset by a reduction in reported death claims.

Vision

The Company introduced a vision product in 2009. The loss ratio reflects management’s estimated losses for the year ended December 31, 2009.

Acquisition and Other Underwriting Expenses

Acquisition and other underwriting expenses as a percent of direct premiums written totaled 13.9% and 14.3% for the years ended December 31, 2009 and 2008, respectively. The decrease primarily reflects lower commissions paid to general agents, primarily IBSi, the Company’s former general agent in the Southeast.

Other Expenses

The increase in other expenses from 2008 to 2009 primarily reflects the aforementioned salary costs, consulting expenses and corporate expense allocations.

Tax Expense

The effective tax rate was 32.5% and 48.4% for the years ended December 31, 2009 and 2008, respectively. The difference between the statutory tax rate of 35% and the effective tax rate primarily reflects tax exempt income on municipal bond securities. The decrease in the effective tax rate primarily reflects the impact of tax-exempt income, which increased the income tax benefit in 2008.

RUN-OFF SPECIALTY REINSURANCE

The following table represents the operations of the run-off specialty reinsurance segment for the years ended December 31, 2009 and 2008 (in thousands):


	2009			2008
Revenue:
Reinsurance premiums assumed	$	155		$	3,341
Change in unearned premiums		978			6,341

Net premiums earned	$	1,133		$	9,682
Net investment income		1,054			1,343
Change in equity interest in limited partnerships		221			(489	)
Net realized investment losses		(1,230	)		(440	)
Other revenue		457			782

Total revenue	$	1,635		$	10,878

Expenses:
Losses and LAE	$	850		$	25,027
Acquisition and other underwriting expenses		542			2,903
Other expenses		562			637

Total expenses	$	1,954		$	28,567

Loss before income taxes		(319	)		(17,689	)
Income tax (benefit) expense		(5	)		984

Net loss	$	(314	)	$	(18,673	)

Net Loss

The results of operations for the year ended December 31, 2009 reflect the run-off of the segment and the impact of other-than-temporary investment impairments of $1.8 million.

Reinsurance Premiums Assumed

Reinsurance premiums assumed, by line of business, were as follows for the years ended December 31, 2009 and 2008 (in thousands):


	2009			2008
EnviroGuard	$	196		$	1,855
EIA		(41	)		1,477
Other		—			9

Total assumed premiums	$	155		$	3,341

The decrease in reinsurance premiums assumed reflects the termination of the quota-share reinsurance treaties.

Net Investment Income

The average yield on the fixed income portfolio was 3.16% as of December 31, 2009, compared to 3.97% as of December 31, 2008.

Net Realized Investment Losses

The increase in net realized investment losses primarily reflects the aforementioned other-than-temporary investment impairments. The impairments were related to equity securities that had been in an unrealized loss position for more than twelve months.

CORPORATE/OTHER

The decrease in the net loss from 2008 to 2009 primarily reflects a reduction in audit and consulting fees related to Sarbanes Oxley outsourcing, a decrease in stock compensation expense related to the ESOP of $390,000 and an increase in the Company’s equity interest in the segregated portfolio cells of $676,000. The decrease in ESOP compensation expense reflects the decline in the Company’s stock price.

YEAR ENDED DECEMBER 31, 2008 COMPARED TO YEAR ENDED DECEMBER 31, 2007

RESULTS OF OPERATIONS

The major components of consolidated revenue were as follows for the years ended December 31, 2008 and 2007 (in thousands):


	2008			2007
Net premiums written	$	134,712		$	131,889

Net premiums earned	$	135,807		$	129,495
Net investment income		9,631			11,669
Change in equity interest in limited partnerships		(3,970	)		759
Net realized investment (losses) gains		(11,117	)		2,888
Other revenue		853			683

Consolidated revenue	$	131,204		$	145,494

The decrease in consolidated revenue reflects the impact of net realized investment losses, primarily related to other-than-temporary impairments, a decline in the fair value of limited partnership investments and a reduction in net investment income due to a decline in the Company’s invested asset base. These declines in revenue were partially offset by an increase in net premiums earned, primarily in the workers’ compensation insurance segment.

The components of consolidated net (loss) income, by segment, for the years ended December 31, 2008 and 2007 were as follows (in thousands):


	2008			2007
Workers’ compensation insurance	$	6,829		$	17,118
Segregated portfolio cell reinsurance		—			—
Group benefits insurance		(1,156	)		4,777
Run-off specialty reinsurance		(18,673	)		(286	)
Corporate/other		(4,383	)		(2,926	)

Consolidated net (loss) income	$	(17,383	)	$	18,683

The consolidated net loss for the year ended December 31, 2008 primarily reflects the unfavorable loss reserve development and the unrecognized federal income tax benefits in the run-off specialty reinsurance segment, other-than-temporary investment impairments, and a decline in the fair value of limited partnership investments.

WORKERS’ COMPENSATION INSURANCE

The following table represents the operations of the workers’ compensation insurance segment for the years ended December 31, 2008 and 2007 (in thousands). The results of operations for the year ended December 31, 2008 include the operating results of ESIC for the period from October 1, 2008 to December 31, 2008:


	2008			2007
Revenue:
Direct premiums written	$	101,907		$	91,466
Reinsurance premiums assumed		652			1,341
Ceded premiums written		(33,996	)		(34,318	)

Net premiums written		68,563			58,489
Change in unearned premiums		(2,601	)		(2,170	)

Net premiums earned		65,962			56,319
Net investment income		4,045			4,221
Change in equity interest in limited partnerships		(3,051	)		537
Net realized investment (losses) gains		(4,174	)		797
Other revenue		119			—

Total revenue	$	62,901		$	61,874

Expenses:
Losses and LAE	$	36,535		$	25,614
Acquisition and other underwriting expenses		4,920			2,495
Other expenses		10,915			8,300
Policyholder dividend expense		551			543

Total expenses	$	52,921		$	36,952

Income before income taxes		9,980			24,922
Income tax expense		3,151			7,804

Net income	$	6,829		$	17,118

Net Income

The decrease in net income primarily reflects the impact of other-than-temporary investment impairments, a decline in the fair value of limited partnership investments, and an increase in the combined ratio. Other-than-temporary impairments totaled $3.6 million for the year ended December 31, 2008. The increase in the combined ratio primarily reflects a decrease in favorable loss reserve development from 2007 to 2008 and an increase in expenses related to the Company’s Southeast expansion, state licensing initiatives and the integration expenses associated with the acquisition of ESHC.

The workers’ compensation insurance ratios were as follows for the years ended December 31, 2008 and 2007:


	2008		2007
Loss and LAE ratio	55.4	%	45.5	%
Expense ratio	24.0	%	19.1	%
Policyholders’ dividend expense ratio	0.8	%	1.0	%

Combined ratio	80.2	%	65.6	%

Premiums

The increase in direct premiums written from 2007 to 2008 primarily reflects new business sales of $23.3 million and premium of $1.9 million related to the acquisition of ESIC, partially offset by a reduction in the renewal retention rate from 88.2% in 2007 to 87.6% in 2008 and renewal rate decreases of 6.9%. Traditional and alternative market direct premiums written were $72.8 million and $29.1 million, respectively, for the year ended December 31, 2008, compared to $65.4 million and $26.1 million, respectively, for the same period in 2007.

Purchase accounting adjustments reduced direct premiums written by $513,000 in 2008, compared to a reduction of $1.2 million for the same period in 2007.

Net Investment Income

The decrease in net investment income primarily reflects a decline in the average yield on the fixed income portfolio and a decline in short-term interest rates from 2007 to 2008. The average yield on the fixed income portfolio was 4.18% as of December 31, 2008, compared to 4.44% as of December 31, 2007.

Net Realized Investment (Losses) Gains

The net realized investment losses for the year ended December 31, 2008 primarily reflect other-than-temporary impairments of $3.4 million. There were no impairments recorded in 2007. In addition, the change in the fair value of convertible bond securities increased the net realized investment losses by $623,000 in 2008, compared to a decrease in net realized investment gains of $35,000 in 2007.

Losses and LAE

The increase in the calendar period loss and LAE ratio primarily reflects a decrease in favorable loss reserve development related to prior accident periods. The accident period loss ratio was 58.8% and 60.3% for the years ended December 31, 2008 and 2007, respectively. Favorable loss reserve development totaled $2.7 million for the year ended December 31, 2008, compared to favorable loss reserve development of $8.4 million for the same period in 2007. The favorable loss reserve development primarily reflects a decrease in the prior accident period loss development factors used to estimate losses and LAE. The decrease in prior accident period loss development factors primarily reflects significant prior year claim settlements during 2008 for amounts at, or less than, previously established case and IBNR reserves. This decrease had the effect of lowering loss development factors as of December 31, 2008. For the year ended December 31, 2008, the Company closed 360, or 63.2% of the 570 open lost time claims as of December 31, 2007. In the aggregate, the claims were closed at amounts lower than the provision established for IBNR claims. Management believes that the realization of the benefits of its return-to-work controls coupled with strong economies in its underwriting territories during 2006, 2007, and the first half of 2008 enabled it to record losses and LAE that were lower than the amount reserved for claim settlements.

Acquisition and Other Underwriting Expenses

The increase in acquisition and other underwriting expenses primarily reflects growth in net premiums earned and a decrease in fee based revenue from the segregated portfolio cell reinsurance segment during 2008. In addition, the Company recorded an accrual for an expected assessment by the Security Fund on 2008 premiums as of December 31, 2008. No accrual was recorded as of December 31, 2007 due to the Company receiving communication from the Security Fund that no assessment was going to be made on 2007 premium.

Other Expenses

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

Policyholder Dividends

Policyholder dividend expense remained consistent from 2007 to 2008. As of December 31, 2008 and 2007, approximately 10.0% of the Company’s workers’ compensation insurance policies were written on a participating basis.

Tax Expense

The effective tax rate was 31.6% and 31.3% for the years ended December 31, 2008 and 2007, respectively. The difference between the statutory tax rate of 35% and the effective tax rate primarily reflects tax exempt income on municipal bond securities. The 2007 effective tax rate also includes a reduction in income tax expense related to non-recurring rehabilitation tax credits.

SEGREGATED PORTFOLIO CELL REINSURANCE

The following table represents the operations of the segregated portfolio cell reinsurance segment for the years ended December 31, 2008 and 2007 (in thousands):


	2008			2007
Revenue:
Reinsurance premiums assumed	$	29,113		$	26,143
Ceded premiums written		(3,023	)		(2,676	)

Net premiums written		26,090			23,467
Change in unearned premiums		(2,650	)		(606	)

Net premiums earned		23,440			22,861
Net investment income		1,112			1,284
Net realized investment (losses) gains		(1,381	)		320

Total revenue	$	23,171		$	24,465

Expenses:
Losses and LAE	$	13,182		$	11,671
Acquisition and other underwriting expenses		7,238			6,933
Other expenses		286			463
Segregated portfolio dividend expense (1)		2,465			5,398

Total expenses	$	23,171		$	24,465

Net income (1)	$	—		$	—

(1)

The segregated portfolio cell reinsurance ratios were as follows for the years ended December 31, 2008 and 2007:


	2008		2007
Loss and LAE ratio	56.2	%	51.1	%
Expense ratio	32.1	%	32.4	%

Combined ratio	88.3	%	83.5	%

Reinsurance Premiums Assumed

The increase in reinsurance premiums assumed from 2007 to 2008 primarily reflects new business sales of $4.7 million, partially offset by a reduction in the renewal retention rate from 88.4% in 2007 to 87.7% in 2008 and renewal rate decreases of 3.9%. Further offsetting the increase in reinsurance premiums assumed were audit premiums, which reduced premiums by $383,000 in 2008, compared to an increase in premiums of $623,000 in 2007.

Purchase accounting adjustments reduced reinsurance premiums assumed by $451,000 in 2007. There were no purchase accounting adjustments in 2008.

Net Investment Income

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

Net Realized Investment (Losses) Gains

The net realized investment losses for the year ended December 31, 2008 primarily reflect other-than-temporary impairments of $1.2 million. There were no impairments recorded in 2007.

Losses and LAE

The increase in the calendar period loss and LAE ratio primarily reflects a decrease in favorable loss reserve development related to prior accident periods. The accident period loss ratio was 62.9% and 62.4% for the years ended December 31, 2008 and 2007, respectively. Favorable loss reserve development totaled $2.0 million for the year ended December 31, 2008, compared to favorable loss reserve development of $3.0 million for the same period in 2007. The decrease in favorable loss reserve development from 2007 to 2008 primarily reflects management’s consideration of the current economic conditions and the potential impact on prior year open claims. As a result, management determined it was prudent to maintain higher reserve levels in light of the possibility that it could be more difficult to implement return to work initiatives in the current economic conditions. The favorable loss reserve development primarily reflects a decrease in the prior accident period loss development factors used to estimate losses and LAE. The decrease in prior accident period loss development factors primarily reflects significant prior year claim settlements during 2008 for amounts at, or less than, previously established case and IBNR reserves. This decrease had the effect of lowering loss development factors as of December 31, 2008.

Acquisition and Other Underwriting Expenses

The expense ratios are consistent with the contractual ceding commissions for the years ended December 31, 2008 and 2007.

Segregated Portfolio Dividend Expense

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

GROUP BENEFITS INSURANCE

The following table represents the operations of the group benefits insurance segment for the years ended December 31, 2008 and 2007 (in thousands):


	2008			2007
Revenue:
Direct premiums written	$	39,205		$	38,519
Ceded premiums written		(2,487	)		(2,655	)

Net premiums written		36,718			35,864
Change in unearned premiums		5			(1	)

Net premiums earned		36,723			35,863
Net investment income		2,578			3,277
Change in equity interest in limited partnerships		(430	)		(39	)
Net realized investment (losses) gains		(5,366	)		1,531

Total revenues		33,505			40,632

Expenses:
Losses and LAE		24,444			23,253
Acquisition and other underwriting expenses		5,602			5,556
Other expenses		5,698			5,073

Total expenses		35,744			33,882

(Loss) income before income taxes		(2,239	)		6,750
Income tax (benefit) expense		(1,083	)		1,973

Net (loss) income	$	(1,156	)	$	4,777

Net Income

The net loss in the group benefits insurance segment for the year ended December 31, 2008 primarily reflects the impact of other-than-temporary investment impairments, a decline in net investment income, and an increase in the combined ratio. Other-than-temporary investment impairments totaled $3.9 million. The decline in net investment income reflects a decrease in the invested asset base, which reflects dividends paid to EIHI during 2008. The increase in the combined ratio primarily reflects an increase in the dental loss ratio and an increase in the expense ratio. The 2007 expense ratio includes the impact of a settlement gain related to the defined benefit plan, which reduced the expense ratio by 1.1 percentage points.

The group benefits insurance ratios were as follows for the years ended December 31, 2008 and 2007:


	2008		2007
Loss and LAE ratio	66.6	%	64.8	%
Expense ratio	30.8	%	29.6	%

Combined ratio	97.4	%	94.4	%

Premiums

Direct premiums written, by line of business, for the years ended December 31, 2008 and 2007 were as follows (in thousands):


	2008		2007
Dental	$	22,742	$	21,827
Short-term disability		6,567		6,628
Long-term disability		3,827		4,049
Term life		6,069		6,015

Total	$	39,205	$	38,519

The increase in direct premiums written primarily reflects the impact of new business sales and a slight increase in renewal rates, partially offset by a decline in the renewal retention rate from 80.8% in 2007 to 78.6% in 2008.

Net Investment Income

The decrease in net investment income primarily reflects a lower invested asset base. The average yield on the fixed income portfolio was 4.88% as of December 31, 2008, compared to 5.60% as of December 31, 2007.

Net Realized Investment (Losses) Gains

The net realized investment losses for the year ended December 31, 2008 primarily reflect the aforementioned other-than-temporary impairments. There were no impairments recorded in 2007. In addition, the change in the fair value of convertible bond securities increased the net realized investment losses by $2.1 million in 2008, compared to a decrease in net realized investment gains of $422,000 in 2007.

Losses and LAE

The calendar period loss ratios, by line of business, for the years ended December 31, 2008 and 2007 were as follows:


	2008		2007
Dental	74.1	%	69.0	%
Short-term disability	63.8	%	69.3	%
Long-term disability	42.5	%	22.5	%
Term life	48.8	%	52.5	%
Total group benefits	66.6	%	64.8	%

Dental

The increase in the dental calendar period loss ratio primarily reflects a 1.4% decrease in premiums per certificate per month (“PCPM”) and a 5.9% increase in claims expense PCPM from 2007 to 2008. The decrease in the premiums PCPM primarily reflects the impact of premium discounts on new business written in 2007 and early 2008. The accident period loss ratio increased from 70.8% in 2007 to 75.6% in 2008. The increase in the accident period loss ratio primarily reflects the impact of the aforementioned premium rate discounts. In addition to the increase in the accident period loss ratio, there was a slight decrease in favorable loss reserve development from 2007 to 2008.

Short-term Disability

The decrease in the short-term disability calendar period loss ratio primarily reflects a reduction in claim frequency and severity from 2007 to 2008. The accident period loss ratio decreased from 71.5% in 2007 to 65.6% in 2008. The decrease in the accident period loss ratio was partially offset by a decline in favorable loss reserve development from $148,000, or 2.2 percentage points, in 2007, to $120,000, or 1.8 percentage points, in 2008.

Long-term Disability

The 2008 long-term disability loss ratio reflects a net reduction in open claims, which reduced claim reserves by $557,000, compared to a net reduction in claim reserves of $992,000 for the same period in 2007.

Term Life

The decrease in the term life loss ratio primarily reflects an increase in premium waiver reserve reductions from 2007 to 2008. The loss ratio related to reported death claims increased slightly from 58.2% in 2007 to 60.2% in 2008.

Acquisition and Other Underwriting Expenses

Acquisition and other underwriting expenses as a percent of direct premiums written remained consistent from 2007 to 2008.

Other Expenses

The increase in other expenses from 2007 to 2008 primarily reflects an increase in consulting costs related to actuarial services and costs associated with the acquisition of software. In addition, the 2007 expenses include a reduction of $384,000 related to the defined benefit plan settlement gain.

Tax Expense

The effective tax rate was 48.4% and 29.2% for the years ended December 31, 2008 and 2007, respectively. The difference between the statutory tax rate of 35% and the effective tax rate primarily reflects tax exempt income on municipal bond securities. The 2008 effective tax rate also includes a prior year tax return adjustment that increased the income tax benefit, and the 2007 effective tax rate includes the release of a contingency reserve related to prior tax years that decreased income tax expense.

RUN-OFF SPECIALTY REINSURANCE

The following table represents the operations of the run-off specialty reinsurance segment for the years ended December 31, 2008 and 2007 (in thousands):


	2008			2007
Revenue:
Reinsurance premiums assumed	$	3,341		$	14,069
Change in unearned premiums		6,341			383

Net premiums earned	$	9,682		$	14,452
Net investment income		1,343			1,298
Change in equity interest in limited partnerships		(489	)		261
Net realized investment (losses) gains		(440	)		7
Other revenue		782			593

Total revenue	$	10,878		$	16,611

Expenses:
Losses and LAE	$	25,027		$	13,050
Acquisition and other underwriting expenses		2,903			3,932
Other expenses		637			647

Total expenses	$	28,567		$	17,629

Loss before income taxes		(17,689	)		(1,018	)
Income tax expense (benefit)		984			(732	)

Net loss	$	(18,673	)	$	(286	)

Net Loss

The increase in the net loss reflects the unfavorable loss reserve development of $19.3 million, the reduction in net premiums earned as a result of terminating participation in the reinsurance treaties, investment losses related to other-than-temporary impairments and limited partnership interests, and an increase in income tax expense due to the inability to recognize federal income tax benefits generated by the segment’s operating losses.

The run-off specialty reinsurance ratios were as follows for the years ended December 31, 2008 and 2007:


	2008		2007
Loss and LAE ratio	258.5	%	90.3	%
Expense ratio	36.6	%	31.7	%

Combined ratio	295.1	%	122.0	%

Reinsurance Premiums Assumed

Reinsurance premiums assumed, by line of business, were as follows for the years ended December 31, 2008 and 2007 (in thousands):


	2008		2007
EnviroGuard	$	1,855	$	11,300
EIA		1,477		3,068
Other		9		550
Purchase accounting adjustments		—		(849	)

Total assumed premiums	$	3,341	$	14,069

The decrease in reinsurance premiums assumed reflects the termination of the reinsurance treaties.

Purchase accounting adjustments reduced reinsurance premiums assumed by $849,000 in 2007. There were no purchase accounting adjustments in 2008.

Net Investment Income

The average yield on the fixed income portfolio was 3.97% as of December 31, 2008, compared to 4.64% as of December 31, 2007.

Net Realized Investment (Losses) Gains

The net realized investment losses for the year ended December 31, 2008 primarily reflect other-than-temporary impairments of $732,000. There were no impairments recorded in 2007.

Losses and LAE

The increase in the calendar period loss and LAE ratio primarily reflects the aforementioned unfavorable loss reserve development. The accident period loss ratios were 59.3% and 56.5% for the years ended December 31, 2008 and 2007, respectively. The 2008 unfavorable loss reserve development of $19.3 million primarily reflects additional information acquired by the Company during the annual claims audit in January 2009. The claims audit revealed several factors which contributed to the increased case reserves reported to the Company and, therefore, resulted in management increasing the loss development factors utilized in estimating the IBNR reserves. Those factors include 1) an improvement in the ceding company’s ability to estimate loss costs earlier in the claims process, including the receipt of damage estimates from contractors and consultants, 2) jurisdictions becoming more aggressive in requiring quicker, more extensive clean-up and an increase in construction costs related to the clean-up, and 3) courts limiting the ability of insurance companies to enforce policy coverage limitations as the courts are more interested in an expeditious clean up due to environmental concerns.

Acquisition and Other Underwriting Expenses

The increase in the expense ratio is related to a decrease in net earned premium due to the termination of the reinsurance treaties. As part of its previously in-force quota share reinsurance agreement with the primary insurer, the Company paid the primary insurer a ceding commission of 30.0% based on assumed premiums.

Tax Expense

The effective tax rate was (5.6%) and 71.9% for the years ended December 31, 2008 and 2007, respectively. The 2008 effective tax rate reflects the impact of the unrecognized tax benefits of $7.2 million. The 2007 effective tax rate reflects a prior year tax return adjustment that increased income tax expense.

CORPORATE/OTHER

The increase in the net loss in the corporate/other segment primarily reflects a decline in net investment income. The decrease in net investment income reflects the decline in short-term interest rates as well as the decrease in cash related to the stock buyback program and the repayment of the junior subordinated debentures.

Financial Position

December 31, 2009 compared to December 31, 2008.Total assets were $391.5 million as of December 31, 2009, compared to $377.3 million as of December 31, 2008. Cash and investments increased $17.0 million, primarily reflecting an increase in the estimated fair value of the Company’s investment portfolio, partially offset by the sale and maturity of investments during 2009. Premiums receivable increased $2.8 million, primarily reflecting the increase in direct premiums written. Net deferred income taxes decreased $4.9 million, primarily reflecting the increase in the fair value of the Company’s investment portfolio, and federal income taxes recoverable increased $2.2 million, primarily reflecting estimated federal income tax payments and the recognition of a recoverable related to the carryback of capital losses incurred in 2008 to prior tax years.

Total liabilities were $237.6 million as of December 31, 2009, compared to $239.2 million as of December 31, 2008. Reserves for unpaid losses and LAE decreased $7.6 million primarily reflecting the run-off of the specialty reinsurance segment. Unearned premiums increased $3.7 million, primarily reflecting higher direct premiums written. The segregated portfolio cell dividend payable increased $3.5 million, reflecting positive operating results in the segregated portfolio cell reinsurance segment and an increase in the estimated fair value of the segment’s investment portfolio.

Total shareholders’ equity was $153.9 million as of December 31, 2009, compared to $138.1 million as of December 31, 2008. The increase in shareholders’ equity primarily reflects 2009 consolidated net income and the increase in the estimated fair value of the Company’s fixed income and equity security portfolios.

Liquidity and Capital Resources

Liquidity is a measure of an entity’s ability to secure sufficient cash to meet its contractual obligations and operating needs. The Company’s principal sources of funds are premiums, investment income and proceeds from sales and maturities of investments. The Company’s primary use of funds is to pay claims and operating expenses and to purchase investments. The Company’s investment portfolio is structured so that investments mature periodically over time in reasonable relation to current expectations of future claim payments. The Company’s fixed income investment portfolio as of December 31, 2009 had an effective duration of 3.22 years.

For the years ended December 31, 2009, 2008 and 2007, the Company’s cash inflows from premiums and investment activity were sufficient to support the Company’s cash outflows related to claims and operating expenses. Management expects future cash flows from operations in its workers’ compensation insurance, segregated portfolio cell reinsurance and group benefits insurance segments to be sufficient to cover claims and operating expenses. However, in the event cash flows from operations are not sufficient, the Company may have to liquidate investments to cover such costs. As of December 31, 2009, the Company’s investment portfolio included securities with gross unrealized gains totaling $10.2 million; therefore, based on current gross unrealized gains in the investment portfolio as of December 31, 2009, management does not believe it would have to sell securities at a loss in the event cash flows from operations proved insufficient to cover the Company’s operating needs.

The Company has a $2.6 million line of credit available to provide additional liquidity if needed. In addition to the line of credit, the Company has obtained letters of credit totaling $45.8 million for the purpose of securing obligations to reinsurers, if necessary. As of December 31, 2009, there was approximately $5.9 million still available under the Company’s letter of credit facilities.

The Company’s ability to manage liquidity results, in part, from the purchase of reinsurance to protect the Company against severe claims and catastrophic events. See “Item 1—Business, Reinsurance.”

Our domestic insurance subsidiaries’ ability to pay dividends to EIHI is limited by the insurance laws and regulations of Pennsylvania and Indiana. The maximum annual dividends that the domestic insurance entities may pay without prior approval from the Pennsylvania Insurance Department and the Indiana Insurance Department is limited to the greater of 10% of statutory surplus or 100% of statutory net income for the most recently filed annual statement.

Eastern Re must receive approval from the Cayman Islands Monetary Authority before it can pay any dividend to the Company.

Cash Flows

The primary sources of cash flows for the Company are net premiums written, investment income, and proceeds from the sale or maturity of investments. The major components of cash flow are as follows for the years ended December 31, 2009, 2008, and 2007 (in thousands):


	December 31,
	2009			2008			2007
Cash provided by operating activities	$	6,529		$	21,318		$	23,917
Cash provided by (used in) investing activities		10,664			13,146			(10,883	)
Cash used in financing activities		(3,051	)		(27,529	)		(17,797	)

Cash Flows for the Years Ended December 31, 2009 and 2008. The decrease incash flows from operating activities from 2008 to 2009 primarily reflects the run-off of the specialty reinsurance segment and a reduction in net investment income.

Cash flows from investing activities for the year ended December 31, 2009 primarily reflects the sale of investments to fund the Eastern Re capital contribution in March 2009.

Cash flows from financing activities for the year ended December 31, 2009 primarily reflects the payment of the quarterly shareholder dividends and the semi-annual loan payments.

Cash Flows for the Years Ended December 31, 2008 and 2007. The decrease in cash flows from operating activities from 2007 to 2008 primarily reflects a reduction in net investment income and the termination of the Company’s participation in the reinsurance treaties in the run-off specialty reinsurance segment.

The increase in cash flows from investing activities from 2007 to 2008 primarily reflects the use of proceeds from sales and maturities of securities to fund the Company’s stock repurchase program, the acquisition of ESHC and the repayment of the junior subordinated debentures.

The decrease in cash flows from financing activities for the year ended December 31, 2008 reflects an increase in share repurchases under the Company’s stock repurchase program, and increase in the quarterly shareholder dividend from $0.05/share in 2007 to $0.07/share in 2008, and the repayment of the junior subordinated debentures.

Contractual Commitments

The following table summarizes information about contractual obligations and commercial commitments before the impact of purchase accounting adjustments. The minimum payments under these agreements as of December 31, 2009 were as follows (in thousands):


	Payments Due By Period
	Total		Less than 1 year		1-3 years		4-5 years		After 5 years
Long term debt obligations:
Loan payable (1)	$	2,150	$	500	$	1,000	$	650	$	—

Total long term debt obligations	$	2,150	$	500	$	1,000	$	650	$	—
Real estate lease obligation		8,016		1,109		2,277		2,200		2,430
Loss reserves (2)		150,975		54,898		54,228		15,307		26,542

Total contractual obligations	$	161,141	$	56,507	$	57,505	$	18,157	$	28,972

(1)

The loan payable balance in the above table represents the remaining principal balance as of December 31, 2009. Interest on the loan is based on the 30-day LIBOR rate plus 165 basis points and resets on the first day of each month, based on the 30-day LIBOR rate as of the last day of the immediately preceding month. The interest rate effective on December 31, 2009 was 1.883%.

(2)	The payments related to the loss reserves are shown before purchase accounting adjustments of $537,000.

The loss reserves payments due by period in the table above are based upon the loss and LAE reserves estimates as of December 31, 2009 and actuarial estimates of expected payout patterns by line of business. As a result, our calculation of loss reserve payments due by period is subject to the same uncertainties associated with determining the level of reserves 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 reserving process, see “Item 1—Business, Loss and LAE Reserves.” Actual payments of loss and LAE by period will vary, perhaps materially, from the above table to the extent that current estimates of loss reserves vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns.

Off-Balance Sheet Arrangements

As of December 31, 2009, the Company has no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

Item 7A—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 the Company are credit risk, interest rate risk, and equity risk.

Credit Risk.Credit risk is the potential economic loss principally arising from adverse changes in the financial condition of a specific debt issuer. The Company addresses this risk by investing primarily in fixed-income securities which are rated “A” or higher by Standard & Poor’s. The Company also independently, and through the Company’s outside investment manager, monitors the financial condition of all of the issuers of fixed-income securities in the portfolio. To limit the Company’s exposure to risk, the Company employs diversification rules that limit the credit exposure to any single issuer or business sector.

Interest Rate Risk.Interest rate risk is the risk that we will incur economic loss due to adverse changes in interest rates.The Company had fixed-income investments, including convertible bonds, with a fair value of $193.4 million at December 31, 2009, that are subject to interest rate risk. The Company manages the exposure to interest rate risk through an 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 Company’s liability and capital position.

The table below summarizes the Company’s interest rate risk. It illustrates the sensitivity of the fair value of the Company’s fixed income portfolio, excluding the segregated cell reinsurance segment, to selected hypothetical changes in interest rates as of December 31, 2009. The selected scenarios are not predictions of future events, but rather illustrate the effect that such events may have on the fair value of the Company’s fixed income and convertible bond portfolio and shareholders’ equity (dollars in thousands).


Hypothetical Change in Interest Rates	Estimated Change in Fair Value			Estimated Fair Value		Hypothetical Percentage Increase (Decrease) in Shareholders’ Equity, Net of Tax
200 basis point increase	$	(9,617	)	$	136,654	(4.6	)%
100 basis point increase		(4,810	)		141,461	(2.3	)%
50 basis increase		(2,373	)		143,898	(1.1	)%
No change		—			146,271	—
50 basis point decrease		2,265			148,536	1.1	%
100 basis point decrease		4,464			150,735	2.1	%
200 basis point decrease		8,704			154,975	4.1	%

Equity Risk.Equity risk is the risk that the Company may incur economic loss due to adverse changes in equity prices. The Company’s exposure to changes in equity prices primarily results from its holdings of exchange traded funds and other equities. The Company’s portfolio of equity securities is carried on the balance sheet at fair value.

Impact of Inflation

Inflation rates may impact the Company’s financial condition and operating results in several ways. Fluctuations in rates of inflation influence interest rates, which in turn affect the market value of the investment portfolio and yields on new investments. Inflation also affects the portion of losses and loss reserves that relates to hospital and medical expenses and property claims and loss adjustment expenses, but not the portion of losses and loss reserves that relates to workers’ compensation indemnity payments for lost wages, which are fixed by statute. Adjustments for inflationary effects are included as part of the continual review of loss reserve estimates. Increased costs are considered in setting premium rates, and this is particularly important in the health care area where hospital and medical inflation rates have exceeded general inflation rates. Operating expenses, including payrolls, are affected to a certain degree by the inflation rate.

Item 8—Financial Statements and Supplementary Data

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Shareholders

of Eastern Insurance Holdings, Inc.:

In our opinion, the consolidated financial statement listed in the index appearing under Item 15 a)(1) present fairly, in all material respects, the financial position of Eastern Insurance Holdings, Inc. and its subsidiaries (the “Company”) at December 31, 2009 and December 31, 2008, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2009 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15 a)(2) present fairly, in all material respects the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established inInternal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in “Management’s Report on Internal Controls Over Financial Reporting” appearing under Item 9A—Controls and Procedures. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for the recognition and presentation of other-than-temporary impairments of debt securities as required by accounting guidance adopted on April 1, 2009.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

/s/ PricewaterhouseCoopers LLP

Philadelphia, Pennsylvania

March 5, 2010

EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)


	December 31, 2009			December 31, 2008
ASSETS

Investments:
Fixed income securities, at estimated fair value (amortized cost, $171,605; $180,102)	$	176,731		$	183,136
Convertible bonds, at estimated fair value (amortized cost, $14,921; $13,783)		16,677			12,346
Equity securities, at estimated fair value (cost, $17,117; $22,287)		21,273			17,162
Other long-term investments at estimated fair value (cost, $10,220; $10,586)		10,315			9,519

Total investments		224,996			222,163
Cash and cash equivalents		67,017			52,875
Accrued investment income		1,664			2,058
Premiums receivable (net of allowance, $632; $581)		32,457			29,615
Reinsurance recoverable on paid and unpaid losses and loss adjustment expenses		28,521			29,637
Deferred acquisition costs		6,487			5,760
Deferred income taxes, net		1,349			6,281
Federal income taxes recoverable		2,234			16
Intangible assets		7,448			9,179
Goodwill		10,752			10,752
Other assets		8,599			8,975

Total assets	$	391,524		$	377,311

LIABILITIES

Reserves for unpaid losses and loss adjustment expenses	$	151,512		$	159,117
Unearned premium reserves		46,099			42,365
Advance premium		1,720			1,594
Accounts payable and accrued expenses		13,245			13,136
Ceded reinsurance balances payable		6,102			6,886
Benefit plan liabilities		311			497
Segregated portfolio cell dividend payable		16,684			13,140
Loan payable		1,986			2,439

Total liabilities		237,659			239,174

Commitments and contingencies (Note 17)

SHAREHOLDERS’ EQUITY

Series A preferred stock, par value $0, auth. shares—5,000,000; no shares issued and outstanding		—			—
Common capital stock, par value $0, auth. shares—20,000,000; issued—11,783,014 and 11,602,723, respectively; outstanding—9,691,257 and 9,512,366, respectively		—			—
Unearned ESOP compensation		(4,859	)		(5,606	)
Additional paid in capital		113,049			111,772
Treasury stock, at cost (2,091,757 and 2,090,357 shares, respectively)		(32,666	)		(32,655	)
Retained earnings		73,038			66,492
Accumulated other comprehensive income (loss), net		5,303			(1,866	)

Total shareholders’ equity		153,865			138,137

Total liabilities and shareholders’ equity	$	391,524		$	377,311

See accompanying notes to consolidated financial statements.

EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

AND COMPREHENSIVE INCOME (LOSS)

(In thousands, except per share data)


	For the Years Ended December 31,
	2009		2008			2007
REVENUE
Net premiums earned	$	134,986	$	135,807		$	129,495
Net investment income		7,097		9,631			11,669
Change in equity interest in limited partnerships		1,261		(3,970	)		759
Net realized investment gains (losses)		952		(11,117	)		2,888
Other revenue		645		853			683

Total revenue		144,941		131,204			145,494

EXPENSES
Losses and LAE incurred		84,552		99,188			73,588
Acquisition and other underwriting expenses		18,183		18,918			17,056
Other expenses		26,382		25,338			21,801
Amortization of intangibles		1,732		1,373			1,738
Policyholder dividend expense		432		551			543
Segregated portfolio dividend expense		1,238		2,155			4,423

Total expenses		132,519		147,523			119,149

Income (loss) before income taxes		12,422		(16,319	)		26,345
Income tax expense		4,021		1,064			7,662

Net income (loss)	$	8,401	$	(17,383	)	$	18,683

Other comprehensive income (loss)
Unrealized holding gains (losses) arising during period, net of tax of $4,407, $(4,751), and $1,209		8,185		(8,823	)		1,877
Amortization of unrecognized benefit plan amounts, net of tax of $127, $(558), and $58		235		(1,037	)		108
Less: Reclassification adjustment for gains (losses) included in net income (loss), net of tax of $434, $(2,557), and $644		806		(4,749	)		1,195

Other comprehensive income (loss)		7,614		(5,111	)		790

Comprehensive income (loss)	$	16,015	$	(22,494	)	$	19,473

EARNINGS PER SHARE (SEE NOTE 5):
Net income (loss)	$	8,401	$	(17,383	)	$	18,683
Basic earnings per share	$	0.92	$	(1.90	)	$	1.78
Diluted earnings per share	$	0.91	$	(1.90	)	$	1.72

See accompanying notes to consolidated financial statements.

EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

For the Years Ended December 31, 2009, 2008 and 2007

(In thousands, except share data)


	Outstanding Shares
	Series A Preferred Stock	Common Capital Stock		Common Capital Stock		Unearned ESOP Compensation			Additional Paid-In Capital			Treasury Stock			Retained Earnings			Accumulated Other Comprehensive (Loss) Income, Net of Taxes			Total
Balance, January 1, 2007	—	11,351,048			—		(7,101	)		108,502			—			69,483			2,860			173,744
Adoption of SFAS 155	—	—			—		—			—			—			405			(405	)		—
ESOP shares released	—	—			—		747			409			—			—			—			1,156
Equity awards	—	246,675			—		—			1,255			—			—			—			1,255
Repurchase of common stock	—	(1,016,865	)		—		—			—			(15,589	)		—			—			(15,589	)
Shareholder dividend	—	—			—		—			—			—			(2,208	)		—			(2,208	)
Net income	—	—			—		—			—			—			18,683			—			18,683
Other comprehensive income, net of tax	—	—			—		—			—			—			—			790			790

Balance, December 31, 2007	—	10,580,858			—		(6,354	)		110,166			(15,589	)		86,363			3,245			177,831
ESOP shares released	—	—			—		748			297			—			—			—			1,045
Equity awards	—	5,000			—		—			1,277			—			—			—			1,277
Excess tax benefit from vested restricted stock	—	—			—		—			32			—			—			—			32
Repurchase of common stock	—	(1,073,492	)		—		—			—			(17,066	)		—			—			(17,066	)
Shareholder dividend	—	—			—		—			—			—			(2,488	)		—			(2,488	)
Net loss	—	—			—		—			—			—			(17,383	)		—			(17,383	)
Other comprehensive loss, net of tax	—	—			—		—			—			—			—			(5,111	)		(5,111	)

Balance, December 31, 2008	—	9,512,366		$	—	$	(5,606	)	$	111,772		$	(32,655	)	$	66,492		$	(1,866	)	$	138,137

Cumulative effect adjustment	—	—			—		—			—			—			685			(445	)		240
ESOP shares released	—	—			—		747			(92	)		—			—			—			655
Equity awards	—	180,291			—		—			1,369			—			—			—			1,369
Repurchase of common stock	—	(1,400	)		—		—			—			(11	)		—			—			(11	)
Shareholder dividend	—	—			—		—			—			—			(2,540	)		—			(2,540	)
Net income	—	—			—		—			—			—			8,401			—			8,401
Other comprehensive income, net of tax	—	—			—		—			—			—			—			7,614			7,614

Balance, December 31, 2009	—	9,691,257		$	—	$	(4,859	)	$	113,049		$	(32,666	)	$	73,038		$	5,303		$	153,865

See accompanying notes to consolidated financial statements.

EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Years Ended December 31, 2009, 2008 and 2007

(In thousands)


	2009			2008			2007
Cash flows from operating activities:
Net income (loss)	$	8,401		$	(17,383	)	$	18,683
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		702			561			397
Net amortization of bond premium/discount		224			452			282
Net realized investment losses (gains)		(952	)		11,117			(2,888	)
Change in equity interest in other long-term investments		(1,261	)		3,970			(759	)
Loss on disposal of property and equipment		—			5			1
Deferred tax benefit		3,062			(4,355	)		(1,795	)
Stock compensation		2,025			2,354			2,411
Intangible asset amortization		1,732			1,373			1,738
Changes in assets and liabilities:
Accrued investment income		394			396			(54	)
Premiums receivable		(2,842	)		400			(3,621	)
Reinsurance recoverable on paid and unpaid losses and loss adjustment expenses		1,116			(1,273	)		1,222
Deferred acquisition costs		(727	)		497			(1,756	)
Other assets		514			(43	)		(2,006	)
Reserves for unpaid losses and loss adjustment expenses		(7,605	)		19,741			3,321
Unearned and advance premium		3,860			(389	)		4,851
Ceded reinsurance balances payable		(784	)		124			1,139
Accounts payable and accrued expenses		157			3,328			345
Benefit plan liabilities		(191	)		(8	)		(52	)
Federal income taxes recoverable/payable		(2,218	)		479			(2,748	)
Segregated portfolio cell dividend payable		922			(28	)		5,206

Net cash provided by operating activities		6,529			21,318			23,917

Cash flows from investing activities:
Purchase of fixed income securities		(119,946	)		(43,355	)		(122,853	)
Purchase of equity securities		(6,998	)		(11,239	)		(13,280	)
Purchase of other long-term investments		—			(3,000	)		(500	)
Proceeds from sale of fixed income securities		95,518			41,058			50,309
Proceeds from maturities/calls of fixed income securities		34,276			33,575			61,947
Proceeds from the sale of equity securities		7,823			4,699			11,956
Proceeds from sale of other long-term investments		461			820			1,876
Acquisition of Employers Security Holding Company, net of cash received		—			(8,025	)		—
Principal payments received on mortgage loans		3			8			15
Purchase of equipment, net		(473	)		(1,395	)		(353	)

Net cash provided by (used in) investing activities		10,664			13,146			(10,883	)

Cash flows from financing activities:
Repurchase of common stock		(11	)		(17,066	)		(15,589	)
Shareholder dividend		(2,540	)		(2,488	)		(2,208	)
Repayment of junior subordinated debentures		—			(8,007	)		—
Repayment of long-term debt		(500	)		—			—
Excess tax benefit from vested restricted stock		—			32			—

Net cash (used in) provided by financing activities		(3,051	)		(27,529	)		(17,797	)

Net increase (decrease) in cash and cash equivalents		14,142			6,935			(4,763	)
Cash and cash equivalents, beginning of period		52,875			45,940			50,703

Cash and cash equivalents, end of period	$	67,017		$	52,875		$	45,940

Supplemental disclosure of cash flow information:
Cash paid for income taxes	$	3,175		$	4,875		$	11,800
Cash paid for interest	$	65		$	468		$	606

See accompanying notes to consolidated financial statements.

Eastern Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollars in thousands except share and per share data)

1. Background and Nature of Operations

Eastern Insurance Holdings, Inc. (“EIHI”) is an insurance holding company offering workers’ compensation and group benefits insurance products and reinsurance products through its direct and indirect wholly-owned subsidiaries. Eastern Services Corporation (“Eastern Services”), Global Alliance Holdings, Ltd. (“Global Alliance”), Eastern Alliance Insurance Company (“Eastern Alliance”), Allied Eastern Indemnity Company (“Allied Eastern”), Eastern Advantage Assurance Company (“Eastern Advantage”), Eastern Re Ltd., S.P.C. (“Eastern Re”), ELH, and Employers Alliance, Inc. (“Employers Alliance”), collectively referred to as the “Company.”

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

•

EHC was merged into EIHI with EIHI being the surviving entity;

•

ESHC was merged into Global Alliance with Global Alliance being the surviving entity; and

•

AMS was merged into Employers Alliance with Employers Alliance being the surviving entity.

The Company currently operates in five segments: workers’ compensation insurance, segregated portfolio cell reinsurance, group benefits insurance, specialty reinsurance and corporate/other. The specialty reinsurance segment was placed into run-off effective July 1, 2008. See Note 16 for a description of each segment.

2. Significant Accounting Policies

Basis of Presentation

The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”).

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

Certain amounts in the prior year consolidated financial statements have been reclassified to conform to the current year presentation.

Use of Estimates

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

Cash and Cash Equivalents

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

Investments

Fixed Income Securities

The Company’s investments in fixed income securities are classified as available-for-sale and are carried at estimated fair value, with unrealized gains and losses reported in accumulated other comprehensive income (loss), net of tax. Fixed income securities include publicly traded and private placement bonds. The estimated fair value of publicly traded bonds are based on prices obtained from an independent pricing service. Prices obtained from the independent pricing service are determined based on quoted market prices or, in the absence of quoted market prices, dealer quotes or matrix pricing, all of which are based on observable market-based inputs when available. Adverse credit market conditions have caused some markets to become relatively illiquid, thus reducing the availability of certain data used by the independent pricing services and dealers. When prices provided by the independent pricing service vary significantly from week to week, management reviews and validates such prices with other recognized market information sources or independent broker/dealers. Other criteria used by management to determine whether a market has become inactive include price quotations not based on current information, price quotations varying among brokers, significant increases in the bid-ask spread of a security and a significant decline or absence of a market for new issuances. The estimated fair value of private placement bonds is determined using valuation models, taking into consideration the securities’ coupon rate, maturity date, and other pertinent features.

Premiums or discounts are amortized using the effective interest method. Realized gains or losses are based on amortized cost and are computed using the specific identification method. The Company monitors its fixed income securities for unrealized losses that appear to be other-than-temporary. A fixed income security is considered to be other-than-temporarily impaired when the security’s fair value is less than its amortized cost basis and 1) the Company intends to sell the security, 2) it is more likely than not that the Company will be required to sell the security before recovery of the security’s amortized cost basis, or 3) the Company believes it will be unable to recover the entire amortized cost basis of the security (i.e., a credit loss has occurred). When the Company determines a credit loss has been incurred, but the Company does not intend to sell the security and it is not more likely than not that the Company will be required to sell the security before recovery of the security’s amortized cost basis, the portion of the other-than-temporary impairment that is credit related is recorded as a realized loss in the consolidated statements of operations and comprehensive income (loss), and the portion of the other-than-temporary impairment that is not credit related is included in other comprehensive income (loss). Any subsequent increase in the security’s estimated fair value would be reported as an unrealized gain.

Convertible Bond Securities

The Company’s investments in convertible bond securities are considered hybrid financial instruments and are carried at estimated fair value, with changes in estimated fair value reported as a realized gain or loss in the consolidated statement of operations and comprehensive income (loss). Prior to January 1, 2007, the Company bifurcated the fixed income and equity components of its convertible bond securities and reported the change in fair value of the fixed income component in accumulated other comprehensive income (loss). Effective January 1, 2007, the Company adopted new accounting guidance that provided for changes in fair value of the fixed income component of the convertible bond securities to be reported in the statement of operations. This change in accounting was reported as a cumulative effect adjustment to shareholders’ equity, as of January 1, 2007, and resulted in a reclassification between retained earnings and accumulated other comprehensive income of $405. The carrying value of the Company’s convertible bond securities did not change as a result of adopting the new accounting guidance.

Equity Securities

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

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

Other Long-Term Investments

Other long-term investments consist primarily of investments in limited partnerships. Investments in limited partnerships are reported in the consolidated financial statements using the equity method. The carrying value of the Company’s limited partnership investments are based on the Company’s allocable share of the limited partnerships’ net asset value. Changes in the value of the Company’s proportionate share of its limited partnership investments are included in the change in equity interest in limited partnerships in the consolidated statements of operations and comprehensive income (loss). The Company reports changes in the value of its limited partnership investments on a month lag as a result of the timing of statements being received from the limited partnership.

The Company monitors its limited partnership investments for declines in value that may be other-than-temporary. When a limited partnership interest is determined to be other-than-temporarily impaired, the Company reduces its interest in the limited partnership to its current estimated fair value at the balance sheet date. The impairment is recorded in the change in equity interest in limited partnerships in the consolidated statements of operations and comprehensive income (loss).

Premiums

Premiums generated by the Company’s workers’ compensation insurance segment, including estimates of additional premiums resulting from audits of insureds’ records, are generally recognized as written upon inception of the policy. Premiums written are primarily earned on a daily pro rata basis over the terms of the policies to which they relate. Accordingly, unearned premiums represent the portion of premiums written which is applicable to the unexpired portion of the policies in force. Workers’ compensation premiums are determined based upon the payroll of the insured, the applicable premium rates and, where applicable, an experience based modification factor. An audit of the policyholders’ records is conducted after policy expiration to make a final determination of applicable premiums. Included in net premiums earned is an estimate for earned but unbilled final audit premiums. The Company estimates earned but unbilled premiums by tracking, by policy, how much additional premium is billed in final audit invoices as a percentage of payroll exposure to estimate the probable additional amount that it has earned, but not yet billed, as of the balance sheet date. Earned but unbilled premiums accrued as of December 31, 2009 and 2008, and included in net premiums earned, totaled $1,351 and $1,800, respectively.

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

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

Other Revenue

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

Losses and Loss Adjustment Expenses

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

The Company discounts its reserves for unpaid losses and LAE for workers’ compensation claims on a non-tabular basis, using a discount rate of 3.0%, based upon regulatory guidelines. The reserves for unpaid losses and LAE have been reduced for the effects of discounting by approximately $4,256 and $4,145 as of December 31, 2009 and 2008, respectively.

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

•

The liability for reported but unpaid long-term disability claims is calculated using the 1987 Commissioners Group Disability Table. The long-term disability reserves are discounted based on the expected rate of return of ELH’s fixed income portfolio in the year that the claim was incurred. The discount rate for claims incurred in 2009, 2008 and 2007 was 4.00%, 3.85% and 5.25%, respectively. The liability for IBNR claims is estimated on a policy-by-policy basis, taking into consideration average monthly premium, policy elimination periods, and an expected loss ratio.

•

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

•

The liability for reported but unpaid term life claims represent those claims reported to the Company as of the balance sheet date for which payment has not yet been made. Term life IBNR claims are estimated based on historical patterns of claims incurred as a percent of in-force premium as of the balance sheet date.

•

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

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

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

Management believes that its reserves for unpaid losses and LAE is adequate as of December 31, 2009. However, estimating the ultimate liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates and judgments using data currently available. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded as of December 31, 2009, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.

Reinsurance

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

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

Policy Acquisition Costs

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

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

Amortization of policy acquisition costs, before the impact of purchase accounting, totaled $6,202, $6,872, and $6,033 for the years ended December 31, 2009, 2008 and 2007, respectively.

Income Taxes

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

EIHI’s insurance subsidiaries are not generally subject to state income taxes; rather, they are subject to state premium tax in the jurisdictions in which they write business. Employers Alliance and Eastern Services are subject to state income tax in the states in which they operate.

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

The Company includes income tax-related interest and penalties as a component of income tax expense. The Company did not incur any income tax-related interest or penalties during 2009, 2008 or 2007.

The Company’s federal income tax returns for tax years subsequent to December 31, 2004 are subject to examination by the Internal Revenue Service.

Policyholder Dividends

The Company issues certain workers’ compensation insurance policies with dividend payment features. These policyholders share in the operating results of their respective policies in the form of dividends. Dividends to policyholders are accrued during the period in which the related premiums are earned and are determined based on the terms of the individual policies. As of December 31, 2009 and 2008, the Company recorded accrued dividends payable of $1,157 and $1,311, respectively, which are included in accounts payable and accrued expenses on the consolidated balance sheets.

Property and Equipment

Property and equipment, including expenditures for significant improvements and purchased software, is carried at cost less accumulated depreciation and amortization. Maintenance, repairs and minor improvements are expensed as incurred. When property and equipment is retired or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is included in operations. Depreciation is computed under the straight-line method. The estimated useful lives of property and equipment range from 3-7 years. Accumulated depreciation and amortization expense totaled $7,674 and $7,246 as of December 31, 2009 and 2008, respectively. Depreciation and amortization expense totaled $702, $561, and $397 for the years ended December 31, 2009, 2008 and 2007, respectively.

Assessments

The Company is subject to state guaranty fund assessments in the states in which it is licensed, which provide for the payment of covered claims or to meet other insurance obligations from insurance company insolvencies. The Company’s assessments consist primarily of charges from the Workers’ Compensation Security Fund of Pennsylvania (“Security Fund”). The Security Fund serves as a guaranty fund to provide claim payments for those workers entitled to workers’ compensation benefits when the insurance company originally providing the benefits was placed into liquidation by a court. Security Fund assessments are established on an actuarial basis to provide an amount sufficient to pay the outstanding and anticipated claims in a timely manner, to meet the costs of the Pennsylvania Insurance Department to administer the fund and to maintain a minimum balance in the fund of $500 million. If the Security Fund determines that the balance in the Security Fund is less than $500 million based on the actuarial study, then an assessment up to one percent of direct written premium is made to all companies licensed to write workers’ compensation in Pennsylvania. Eastern Alliance, Allied Eastern and

Eastern Advantage recognize a liability and the related expense for the assessments when premiums covered under the Security Fund are written; when an assessment from the Security Fund has been imposed or it is probable that an assessment will be imposed; and the amount of the assessment is reasonably estimable. The Company accrued an assessment related to the Security Fund of $2,108 and $1,052 as of December 31, 2009 and 2008, respectively. The 2009 accrual includes an amount related to the 2008 Security Fund assessment, which was paid in January 2010.

Goodwill and Intangible Assets

Goodwill represents the excess of cost over the fair value of net assets of businesses acquired. Goodwill and other intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but are instead tested for impairment at least annually. Intangible assets with estimable useful lives are amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with Accounting Standards Codification (“ASC”) 350, Intangibles—Goodwill and Other.

Goodwill is assigned to one or more reporting units at the date of acquisition. The goodwill reported by the Company has been allocated 100% to the workers’ compensation insurance segment, which is considered a reporting unit for goodwill purposes. The annual goodwill impairment test, performed as of September 30, each year, consists of a two-step process. The first step identifies whether potential impairment exists by comparing the fair value of the reporting unit to its carrying value, including goodwill. If the fair value of a reporting unit is less than its carrying amount, the second step is required to measure the amount of any impairment loss. There have been no historical impairments of goodwill.

Management tested goodwill for impairment as of September 30, 2009 using a discounted cash flow analysis. The discounted cash flow analysis was based on management’s internal four-year forecast for the workers’ compensation insurance segment, assuming a long-term growth rate of 5.0% and a discount rate of 13.0%. Cash flows were adjusted as necessary to maintain adequate capital requirements. As of September 30, 2009, the Company’s stock price was trading below book value, primarily reflecting the impact of market conditions over the past year. Therefore, management also considered an estimate of the Company’s value in a potential transaction and allocated that value to the Company’s reporting units, including the workers’ compensation insurance segment. Both the discounted cash flow analysis and the estimate of the Company’s value in a potential transaction resulted in the workers’ compensation insurance segment’s estimated fair value exceeding its carrying value as of September 30, 2009; therefore, goodwill was considered not impaired.

Treasury Stock

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

Stock-Based Compensation

The Company adopted the Eastern Insurance Holdings, Inc. 2006 Stock Incentive Plan (the “Stock Incentive Plan”) on December 18, 2006. Under the terms of the Stock Incentive Plan, stock awards may be made in the form of incentive stock options, non-qualified stock options or restricted stock. The Company records compensation expense based on the fair value of the stock award on the grant date using the straight-line attribution method.

Employee Stock Ownership Plan

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

Concentrations of Credit Risk

Financial instruments, which potentially expose the Company to concentrations of credit risk, consist primarily of cash and cash equivalents, investments, premiums receivable, and amounts recoverable from reinsurers.

Comprehensive Income (Loss)

Comprehensive income (loss) includes all changes in shareholders’ equity during the reporting period, net of tax. The components of accumulated other comprehensive income, net of tax, as of December 31, 2009 and 2008 were as follows (in thousands):


	2009			2008
Unrealized gains (losses) on investments	$	7,367		$	(1,223	)
Unrecognized benefit plan (liabilities) assets		(416	)		(778	)
Tax effect		(1,648	)		135

Total	$	5,303		$	(1,866	)

Cash Flow Information

Purchases and sales or maturities of short-term investments are recorded net for purposes of the consolidated statements of cash flows and are included with fixed income securities.

Recent Accounting Guidance

Fair Value Measurements—Investments in Certain Entities that Calculate Net Asset Value per Share

FASB Accounting Standards Codification

Subsequent Events

Other-than-Temporary Investment Impairments

Fair Value Measurements

Disclosures About Fair Value of Financial Instruments

3. Business Combinations

Acquisition of ESHC

On September 29, 2008, EIHI acquired all of the outstanding stock of ESHC in a transaction valued at $14,820, including the assumption of $2,650 in debt. The acquisition of ESHC resulted in the recognition of certain intangible assets and goodwill totaling $4,180 and $2,760, respectively. The intangible assets included renewal rights, agency relationships, and state insurance licenses of $1,841, $1,814, and $525, respectively. ESHC reported total assets and total liabilities of $25,856 and $19,203, respectively, on the date of the transaction. ESHC’s shareholders’ equity of $6,653 on the date of the transaction was reduced by $10 as a result of purchase accounting adjustments to reflect the fair value of certain acquired assets and liabilities. The most significant purchase accounting adjustments related to the elimination of deferred acquisition costs, an increase to reserves for losses and LAE, and a decrease to unearned premiums. Direct costs related to the acquisition totaling $107 were capitalized and included in goodwill.

4. Intangible Assets

The Company’s acquisition of EHC and ESHC resulted in the identification of certain intangible assets. The renewal rights and agency relationships will be amortized over their estimated useful lives of 15 years. The state insurance licenses are considered to have an infinite life and will not be amortized.

As of December 31, 2009 and 2008, intangible assets consisted of the following (in thousands):


Intangible Assets with Finite Life	December 31, 2009				December 31, 2008
Intangible Assets with Finite Life	Gross Balance		Accumulated Amortization		Gross Balance		Accumulated Amortization
Agency relationships (15 year amortization period)	$	3,564	$	1,288	$	3,564	$	715
Renewal rights (15 year amortization period)		8,238		4,641		8,238		3,483

	$	11,802	$	5,929	$	11,802	$	4,198

Intangible Assets with Indefinite Life
State insurance licenses		1,575		—		1,575		—

Total intangible assets	$	13,377	$	5,929	$	13,377	$	4,198

Amortization expense totaled $1,732, $1,373 and $1,738 for the years ended December 31, 2009, 2008 and 2007, respectively.

The estimated aggregated amortization expense for each of the next five years is as follows (in thousands):


2010		1,284
2011		1,016
2012		806
2013		640
2014		509

Total	$	4,255

5. Earnings Per Share

Basic earnings per share are computed by dividing net (loss) income by the weighted average number of shares outstanding for the respective period. Diluted earnings per share are computed by dividing net (loss) income by the weighted average number of shares outstanding for the period, including dilutive potential common shares outstanding for the period. For the years ended December 31, 2009, 2008 and 2007, there were 797,141, 1,170,297 and 843,058 stock options and restricted stock awards, respectively, that were not included in the Company’s earnings per share calculation because to do so would have been anti-dilutive. For the years ended December 31, 2009, 2008 and 2007, dilutive potential common shares outstanding included 67,057, 0, and 339,980 restricted stock awards and stock warrants, respectively.

In June 2008, the FASB issued new accounting guidance with respect to determining whether instruments granted in share-based payment transactions are considered participating securities. The new guidance provides that unvested share-based payment awards that contain non-forfeitable rights to dividends are participating securities and shall be included in the computation of earnings per share pursuant to the two-class method described in ASC 260—Earnings Per Share. The two-class method of computing earnings per share is an earnings allocation formula that determines earnings per share for common stock and any participating securities according to dividends declared (whether paid or unpaid) and participation rights in undistributed earnings. The Company’s unvested restricted stock are considered participating securities since the share-based awards contain a non-forfeitable right to dividends irrespective of whether the awards ultimately vest. The new guidance is effective for financial statements issued for fiscal years beginning after December 15, 2008 and interim periods within those years. Upon adoption, earnings per share data must be retrospectively adjusted to conform to the new guidance. The Company adopted the new guidance effective January 1, 2009 and computed earnings per common share using the two-class method for all periods presented. The new guidance increased basic and diluted earnings per share from $(1.94) to $(1.90) for the year ended December 31, 2008 and decreased basic and diluted earnings per share by $0.04 for the year ended December 31, 2007.

Consolidated net (loss) income, basic shares outstanding, diluted shares outstanding, basic earnings per share, diluted earnings per share and cash dividends per share for the years ended December 31, 2009, 2008 and 2007 were as follows (in thousands, except share and per share data):


	2009			2008			2007
Net income (loss) for basic and diluted earnings per share	$	8,401		$	(17,383	)	$	18,683
Less: Dividends declared—common and unvested restricted share units		(2,540	)		(2,488	)		(2,208	)

Undistributed earnings		5,861			(19,871	)		16,475
Percent allocated to common shareholders		98.3	%		97.8	%		97.7	%

		5,763			(19,431	)		16,088
Add: Dividends declared—common shares		2,497			2,433			2,156

	$	8,260		$	(16,998	)	$	18,244

Denominator for basic earnings per share		8,984,644			8,954,098			10,264,369
Effect of dilutive securities		67,057			—			339,980

Denominator for diluted earnings per common share		9,051,701			8,954,098			10,604,349

Basic earnings per share	$	0.92		$	(1.90	)	$	1.78
Diluted earnings per share	$	0.91		$	(1.90	)	$	1.72
Cash dividends per share	$	0.28		$	0.28		$	0.20

6. Exercise of Outstanding Warrants

As of January 1, 2009, contingent warrants to purchase 306,099 common shares of EIHI stock at an exercise price of $1.63 were outstanding. These warrants were awarded in 1999 as compensation to a Director of the Company who acted as the insurance broker for premium production in the Company’s run-off specialty reinsurance segment. The number of warrants ultimately earned was contingent upon achievement of predetermined direct premiums written thresholds. As of January 1, 2009, 244,879 warrants were earned. The remaining 61,220 warrants will not be earned because the specialty reinsurance segment was placed into run-off on July 1, 2008 and, therefore, there is no additional premium production. On March 10, 2009, the Director notified the Company that he was exercising the 244,879 earned warrants. Furthermore, as provided in the terms of the warrant, the Director instructed the Company to retain 64,588 shares in payment of the exercise price. Accordingly, on March 31, 2009, 180,291 shares of EIHI common stock were issued to the Director in full satisfaction of the 244,879 warrants earned. This was a non-cash transaction that had no impact on cash flows from operating or financing activities.

7. Share Repurchase

On February 15, 2007, the Company’s Board of Directors authorized the repurchase of up to 5 percent, or 567,552 shares, of the Company’s issued and outstanding shares of common stock. On August 2, 2007, the Company’s Board of Directors authorized the repurchase of additional shares of the Company’s outstanding common stock up to an aggregate of 1,046,500 shares, which represents the total number of shares of common stock for which awards may be granted under the Company’s Stock Incentive Plan. On September 27, 2007, the Company’s Board of Directors increased the share repurchase authorization to 2,046,500 shares. The share repurchases will be held as treasury stock and are available for issuance in connection with the Company’s Stock Incentive Plan. For the years ended December 31, 2009 and 2008, the Company repurchased 1,400 and 1,073,492 shares at a cost of $11 and $17,066, respectively, representing a weighted average cost of $8.03 and $15.90 per share, respectively.

8. Stock-Based Compensation

Awards under the Stock Incentive Plan may be made in the form of incentive stock options, nonqualified stock options, restricted stock or any combination to employees and non-employee directors. The Stock Incentive Plan limits the number of shares that may be initially awarded as restricted stock to 299,000, and the number of shares for which incentive stock options may be granted to 500,000. The total number of shares initially authorized in the Stock Incentive Plan was 1,046,500 shares, with an annual increase equal to 1% of the shares outstanding at the end of each year. The Stock Incentive Plan provides that stock options and restricted stock awards may include vesting restrictions and performance criteria at the discretion of the Compensation Committee of the Board of Directors. The stock options and restricted stock awards vest over a five year period and are not subject to performance criteria. The term of options may not exceed ten years for incentive stock options, and ten years and one month for nonqualified stock options, and the option price may not be less than fair

market value on the date of grant. There were no stock options or restricted stock awards granted or forfeited for the year ended December 31, 2009. For the year ended December 31, 2008, grants of 15,000 incentive stock options and 5,000 restricted stock awards were made to employees. A total of 32,741 stock options were forfeited during the year ended December 31, 2008. For the year ended December 31, 2007, grants of 17,500 incentive stock options were made to employees. There were no stock options or restricted stock awards exercised in 2009 or 2008.

Total stock-based compensation expense recognized in the consolidated statement of operations and comprehensive income for the years ended December 31, 2009 and 2008 is shown in the following table (in thousands):


	2009		2008		2007
Stock compensation expense related to:
Stock options	$	575	$	565	$	547
Restricted stock		794		712		708
Total related tax benefit		388		359		356
Total unrecognized compensation expense	$	2,568	$	3,956	$	5,095

As of December 31, 2009, there were 242,009 and 109,896 vested stock options and restricted stocks awards, respectively. As of December 31, 2008, there were 119,505 and 49,335 vested stock options and restricted stock awards, respectively. The total unrecognized stock compensation expense related to non-vested stock options was $1,173 and $1,766, respectively, and the total unrecognized stock compensation expense related to non-vested restricted stock awards was $1,395 and $2,190, respectively, as of December 31, 2009 and 2008. The unrecognized stock compensation expense related to the non-vested stock options and restricted stock awards is expected to be recognized over a weighted average period of approximately 31.0 months and 34.5 months, respectively.

There were no stock options granted in 2009. The fair values of stock options granted during the years ended December 31, 2008 and 2007 were determined on the dates of grant using a lattice-based binomial option valuation model with the following assumptions:


Expected terms (years)		10.00
Expected stock price volatility		35.00	%
Risk-free interest rate		4.52	%
Expected dividend yield		3.00	%
Weighted average fair value per option	$	5.06

The expected life shown above was imputed based upon the combination of vesting provisions and the termination, retirement and early exercise assumptions input to the binomial option valuation model. As trading in the Company’s stock began in June 2006, the expected stock price volatility reflects a weighting of the average historical volatility over a 10-year period for 17 comparable companies and the average 6-month implied volatility for those comparable companies with listed options. A yield curve of risk free interest rates was developed for each valuation date based on quoted prices of US Treasury STRIPs.

The assumptions used to calculate the fair value of future options granted are evaluated and revised, as necessary, to reflect market conditions and the Company’s historical experience and future expectations. The calculated fair value is recognized as compensation expense in the Company’s consolidated statements of operations and comprehensive income over the requisite service period of the entire award. Compensation expense is recognized only for those options expected to vest, with forfeitures estimated at the date of grant and evaluated and adjusted periodically to reflect the Company’s historical experience and future expectations. Any change in the forfeiture assumption is accounted for as a change in estimate, with the cumulative effect of the change on periods previously reported being reflected in the financial statements of the period in which the change is made.

The following table summarizes stock option activity for the year ended December 31, 2009:


	Shares Subject to Options	Weighted Average Exercise Price per Share		Weighted Average Remaining Contractual Life (years)	Aggregate Intrinsic Value (in thousands)
Outstanding as of January 1, 2009	612,523	$	14.36	8.07	$	—
Granted	—
Forfeited	—
Exercised	—
Cancelled	—

Outstanding as of December 31, 2009	612,523	$	14.36	7.07	$	—

Exercisable as of December 31, 2009	242,009	$	14.37	7.05	$	—

The aggregate intrinsic value of the stock options in the above table is $0 because the Company’s closing stock price of $8.62 on December 31, 2009 was below the weighted average exercise price of the stock options.

As of December 31, 2009, there were 383,235 shares of common stock available for issuance of future share-based awards. The following table presents additional information regarding options outstanding as of December 31, 2009:


	Number Outstanding	Weighted Average Remaining Contractual Life (years)	Weighted Average Exercise Price per Share
Range of Exercise Prices
$14.35	576,099	7.01	$	14.35
$14.50	3,924	7.01	$	14.35
$14.86	7,500	7.47	$	14.86
$15.22	5,000	7.63	$	15.22
$15.47	5,000	7.67	$	15.47
$13.83	15,000	8.75	$	13.83

Outstanding as of December 31, 2009	612,523	7.07	$	14.36

The following table summarizes restricted stock activity for the year ended December 31, 2009.


	Number of Shares	Weighted Average Remaining Contractual Life (years)
Outstanding as of January 1, 2009	251,675	8.04
Granted	—
Forfeited	—
Exercised	—
Cancelled	—

Outstanding as of December 31, 2009	251,675	7.04

Exercisable as of December 31, 2009	109,896	7.02

9. Statutory Financial Information

The Company’s domestic insurance subsidiaries prepare statutory-basis financial statements in accordance with accounting practices prescribed or permitted by the insurance department in the subsidiaries’ domiciliary state. The Pennsylvania Insurance Department and the Indiana Insurance Department requires that insurance companies domiciled in their respective states prepare their statutory-basis financial statements in accordance with the National Association of Insurance Commissioners’ (“NAIC”)Accounting Practices and Proceduresmanual, subject to any deviations prescribed or permitted by domiciliary insurance commissioner (“SAP”).

Permitted statutory accounting practices encompass all accounting practices that are not prescribed; such practices differ from state to state, may differ from company to company within a state, and may change in the future. The Company’s domestic insurance subsidiaries did not have any permitted practices as of or for the year ended December 31, 2009.

The principal differences between GAAP and SAP relate to the carrying value of fixed income securities, deferred acquisition costs, deferred income taxes, dividends payable, benefit plan liabilities, the non-admissibility of certain assets for SAP purposes, and the reporting of reserves for unpaid losses and loss adjustment expenses and the related reinsurance recoverables on a gross versus net basis.

Financial Information

The statutory surplus and statutory net income (loss) of Eastern Alliance, Allied Eastern, Eastern Advantage, ESIC and ELH as of December 31, 2009 and 2008 and for the years ended December 31, 2009, 2008, and 2007 was as follows (in thousands):


	Statutory Surplus as of December 31,				Net Income (Loss) for the Year Ended December 31,
	2009		2008		2009		2008			2007
Eastern Alliance	$	41,342	$	41,665	$	4,428	$	4,643		$	14,792
Allied Eastern	$	8,534	$	10,269	$	214	$	1,013		$	2,036
Eastern Advantage	$	8,231	$	8,112	$	46	$	(583	)	$	—
ESIC	$	10,704	$	8,052	$	2,826	$	1,845		$	2,226
ELH	$	28,676	$	37,817	$	2,122	$	(710	)	$	4,581

Risk-Based Capital/Minimum Capital Requirements

Risk-based capital is designed to measure the acceptable amount of capital an insurer should have based on the inherent risks of the insurer’s business. Insurers failing to meet adequate capital levels may be subject to insurance department scrutiny and ultimately rehabilitation or liquidation. Based on established standards, Eastern Alliance, Allied Eastern, Eastern Advantage, ESIC and ELH maintained statutory-basis surplus in excess of minimum prescribed risk-based capital requirements as of December 31, 2009.

Under Cayman Islands regulations, Eastern Re is required to maintain minimum capital of $120.

Dividend Restrictions

The ability of Eastern Alliance, Allied Eastern, Eastern Advantage, ESIC and ELH to pay dividends to EIHI is limited by the laws and regulations of Pennsylvania and Indiana. The maximum annual dividends that EIHI’s insurance subsidiaries may pay without the prior approval from the Pennsylvania Insurance Department and Indiana Insurance Department is limited to the greater of 10% of statutory surplus or 100% of statutory net income for the most recently filed annual statement.

10. Fair Value Measurements

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

The following is a description of the Company’s categorization of the inputs used in the recurring fair value measurements of its financial assets included in its consolidated balance sheet as of December 31, 2009:

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

Level 2—Represents financial assets whose fair value is determined based upon: quoted market prices for similar assets in active markets; quoted market prices for identical assets in inactive markets; inputs other than quoted market prices that

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

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

The following table provides a summary of the fair value measurements of the Company’s fixed income securities, convertible bonds, and equity securities, as of December 31, 2009 and 2008, excluding the segregated portfolio cell segment (in thousands):


	12/31/09		Fair Value Measurements at Reporting Date Using
	12/31/09		Level 1		Level 2		Level 3
Fixed income securities—available for sale	$	146,271	$	11,161	$	135,110	$	—
Convertible bonds		16,677		—		16,677		—
Equity securities—available for sale		16,767		16,767		—		—

Total	$	179,715	$	27,928	$	151,787	$	—


	12/31/08		Fair Value Measurements at Reporting Date Using
	12/31/08		Level 1		Level 2		Level 3
Fixed income securities—available for sale	$	161,948	$	12,647	$	149,301	$	—
Convertible bonds		12,346		—		12,346		—
Equity securities—available for sale		14,128		14,128		—		—

Total	$	188,422	$	26,775	$	161,647	$	—

The estimated fair values of the Company’s investments in fixed income securities, convertible bonds, and equity securities are based on prices provided by an independent, nationally recognized pricing service. Approximately 99.0% of the Company’s fixed income and equity security prices are obtained from the independent pricing service. The prices provided by the independent pricing service are based on quoted market prices, when available, non-binding broker quotes, or matrix pricing. The independent pricing service provides a single price or quote per security and the Company does not adjust security prices. The Company obtains an understanding of the methods, models and inputs, used by the independent pricing service, and has controls in place to validate that amounts provided represent current exit values. The Company’s controls include, but are not limited to, initial and ongoing evaluation of the methodologies used by the independent pricing service as well as comparing the fair value estimates to the Company’s knowledge of the current market. Fixed income securities include U.S. Treasuries, agencies backed by the U.S. Government, municipal bonds, mortgage-backed securities, collateralized mortgage obligations, asset-backed securities, and corporate bonds.

The Company’s fixed income securities and convertible bonds consist primarily of publicly traded securities for which there are observable inputs and/or broker quotes. Most fixed income security prices provided by the independent pricing service are based on observable inputs and, therefore, are classified as Level 2 securities. The Company does not hold any fixed income securities, for which pricing was based on significant unobservable inputs; therefore, the Company has not classified any of its fixed income securities as Level 3 securities.

The Company’s equity securities consist primarily of mutual fund instruments for which there is an active market and quoted market prices; therefore, the Company has classified its equity securities as Level 1 securities.

Other long-term investments include the Company’s interest in various limited partnerships, including a low volatility multi-strategy fund of funds, two natural resource limited partnerships, a structured finance opportunity fund, an open-ended investment fund and a real estate limited partnership. The Company records its investment in the limited partnerships using the equity method. The carrying value of the Company’s limited partnership investments are based on the Company’s

allocable share of the limited partnerships’ net asset value. Changes in the Company’s investments are based on statements received directly from the limited partnership and/or the limited partnership’s administrator. The estimated fair values of the underlying investments in the limited partnerships may be based on Level 1, Level 2, or Level 3 inputs, or a combination thereof.

As of December 31, 2009 and 2008, the estimated fair values of the Company’s limited partnership investments, by investment strategy, were as follows (in thousands):


	2009		2008
Multi-strategy fund of funds	$	4,908	$	4,421
Natural resources		2,361		2,130
Structured finance opportunity fund		2,410		1,958
Municipal bond arbitrage		—		466
Open-ended investment fund		573		470
Real estate		58		66

Total	$	10,310	$	9,511

Following is a summary of the investment objectives of each of the Company’s limited partnership investments, by investment strategy:

Multi-strategy fund of funds—The fund seeks to build and manage low volatility, multi-manager portfolios that have little or no correlation to the broader fixed income and equity security markets.

Natural resources—The Company invests in two separate natural resource funds. The investment objective of one of the funds is to achieve long-term capital appreciation primarily through investments in hard asset securities and hard asset commodities. The investment objective of the other fund is to provide an enhancement to an investor’s portfolio of investments and to provide a partial inflation hedge with an attractive risk/return profile as compared to other products using a commodity index or pool of commodities.

Structured finance opportunity fund—The fund seeks superior risk-adjusted absolute returns by acquiring and actively managing a diversified portfolio of debt securities, including bonds, loans, and other asset-backed instruments.

Open-ended investment fund—The fund seeks above-average capital growth through investment in domestic equity securities and equity related securities that are publicly traded in the United States.

Real estate partnership—The partnership was formed for the purpose of acquiring, rehabilitating, operating, leasing, and managing an apartment complex in Lancaster, Pennsylvania. The apartments are primarily marketed to low income individuals.

As of December 31, 2009, the only restrictions on the Company’s ability to redeem its interest in its limited partnership investments relate to the timing of redemption (i.e., monthly, quarterly). There are no restrictions related to the amount the Company can redeem, in the event it chooses to redeem all or a portion of its interest in its limited partnership investments. The Company has no unfunded commitments related to these investments as of December 31, 2009.

The activity in the Company’s limited partnership investments for the years ended December 31, 2009, 2008 and 2007 was as follows (in thousands):


	Years Ended December 31,
	2009			2008			2007
Balance, beginning of period	$	9,511		$	11,300		$	11,572
Contributions		—			3,000			500
Withdrawals		(462	)		(820	)		(1,876	)
Unrealized change in interest		1,261			(3,969	)		1,104

Balance, end of period	$	10,310		$	9,511		$	11,300

The change in interest in the Company’s limited partnership investments is included in the change in equity interest in other long-term investments in the consolidated statements of operations and comprehensive income (loss). As a result of the

current credit market conditions, the municipal bond arbitrage fund experienced a permanent decline in value during 2008 and will be dissolved. The estimated fair value of the Company’s interest in the limited partnership as of December 31, 2008 reflects management’s best estimate of the proceeds the Company is expected to receive upon dissolution of the fund. As a result of these events, the Company recorded an impairment write-down of $1,397 for the year ended December 31, 2008. There were no impairments in 2007 or 2006.

11. Investments

The following tables provide the amortized cost and estimated fair value of the Company’s fixed income and equity securities as of December 31, 2009 and 2008 (in thousands):


2009	Cost or Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
U.S. Treasuries and government agencies	$	22,795	$	841	$	(39	)	$	23,597
States, municipalities, and political subdivisions		39,624		1,932		(56	)		41,500
Corporate securities		52,850		2,152		(65	)		54,937
Residential mortgage-backed securities		28,657		691		(21	)		29,327
Commercial mortgage-backed securities		8,932		60		(340	)		8,652
Collateralized mortgage obligations		18,045		301		(267	)		18,079
Other structured securities		702		16		(79	)		639

Total fixed income securities		171,605		5,993		(867	)		176,731
Equity securities		17,117		4,169		(13	)		21,273

Total fixed income and equity securities	$	188,722	$	10,162	$	(880	)	$	198,004


2008	Cost or Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
U.S. Treasuries and government agencies	$	26,463	$	2,170	$	(3	)	$	28,630
States, municipalities, and political subdivisions		45,109		1,611		(183	)		46,537
Corporate securities		60,480		991		(854	)		60,617
Residential mortgage-backed securities		16,349		1,265		—			17,614
Commercial mortgage-backed securities		12,896		12		(1,463	)		11,445
Collateralized mortgage obligations		13,477		324		(692	)		13,109
Other structured securities		5,328		7		(151	)		5,184

Total fixed income securities		180,102		6,380		(3,346	)		183,136
Equity securities		22,287		50		(5,175	)		17,162

Total fixed income and equity securities	$	202,389	$	6,430	$	(8,521	)	$	200,298

Other structured securities include other asset-backed securities collateralized by home equity loans, credit card receivables and manufactured homes.

Certain insurance departments in the states in which the Company is licensed to do business require a deposit to protect the Company’s policyholders should the Company become insolvent. In order to satisfy these requirements, the Company had fixed income securities with an estimated fair value of $13,846 and $13,519 on deposit with various insurance departments as of December 31, 2009 and 2008, respectively.

The amortized cost and estimated fair value of fixed income securities and convertible bonds as of December 31, 2009, by contractual maturity, are shown below (in thousands). Expected maturities could differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties.


	Amortized Cost		Estimated Fair Value
Less than one year	$	20,135	$	20,351
One through five years		63,746		66,918
Five through ten years		23,578		24,692
Greater than ten years		23,433		25,389
Mortgage-backed securities		55,634		56,058

Total	$	186,526	$	193,408

The gross unrealized losses and estimated fair value of fixed income and equity securities, excluding those securities in the segregated portfolio cell reinsurance segment, classified as available-for-sale by category and length of time an individual security has been in a continuous unrealized position as of December 31, 2009 and 2008 are as follows (in thousands):


2009	Less Than 12 Months					12 Months or More					Total
2009	Estimated Fair Value		Gross Unrealized Losses			Estimated Fair Value		Gross Unrealized Losses			Estimated Fair Value		Gross Unrealized Losses
U.S. Treasuries and government agencies	$	6,715	$	(39	)	$	—	$	—		$	6,715	$	(39	)
States, municipalities, and political subdivisions		2,757		(56	)		—		—			2,757		(56	)
Corporate securities		4,491		(38	)		124		(2	)		4,615		(40	)
Residential mortgage-backed securities		2,947		(21	)		—		—			2,947		(21	)
Commercial mortgage-backed securities		1,991		(31	)		4,201		(308	)		6,192		(339	)
Collateralized mortgage obligations		1,327		(44	)		1,771		(223	)		3,098		(267	)
Other structured securities		—		—			564		(79	)		564		(79	)

Total fixed income securities		20,228		(229	)		6,660		(612	)		26,888		(841	)
Equity securities		—		—			—		—			—		—

Total fixed income and equity securities	$	20,228	$	(229	)	$	6,660	$	(612	)	$	26,888	$	(841	)


2008	Less Than 12 Months					12 Months or More					Total
2008	Estimated Fair Value		Gross Unrealized Losses			Estimated Fair Value		Gross Unrealized Losses			Estimated Fair Value		Gross Unrealized Losses
U.S. Treasuries and government agencies	$	200	$	(3	)	$	—	$	—		$	200	$	(3	)
States, municipalities, and political subdivisions		6,631		(169	)		246		(14	)		6,877		(183	)
Corporate securities		15,506		(552	)		1,398		(67	)		16,904		(619	)
Commercial mortgage-backed securities		6,834		(284	)		4,229		(1,179	)		11,063		(1,463	)
Collateralized mortgage obligations		3,435		(644	)		160		(48	)		3,595		(692	)
Other structured securities		3,401		(60	)		637		(91	)		4,038		(151	)

Total fixed income securities		36,007		(1,712	)		6,670		(1,399	)		42,677		(3,111	)
Equity securities		9,047		(4,184	)		—		—			9,047		(4,184	)

Total fixed income and equity securities	$	45,054	$	(5,896	)	$	6,670	$	(1,399	)	$	51,724	$	(7,295	)

As of December 31, 2009, the Company held 49 fixed income securities with gross unrealized losses totaling $841. Management has evaluated the unrealized losses related to those fixed income securities and determined that they are primarily due to the current liquidity issues in the fixed income markets or to a fluctuation in interest rates and not to credit issues of the issuer or the underlying assets in the case of asset-backed securities. The Company does not intend to sell the fixed income securities and it is not more likely than not that the Company will be required to see the fixed income securities before recovery of their amortized cost bases, which may be maturity; therefore, management does not consider the fixed income securities to be other-than-temporarily impaired as of December 31, 2009.

Proceeds from the sale of fixed income securities totaled $95,518, $41,058, and $50,309 for the years ended December 31, 2009, 2008 and 2007, respectively. Proceeds from the sale of equity securities totaled $7,823, $4,699, and $11,956 for the years ended December 31, 2009, 2008, and 2007, respectively. Proceeds from the sale of other long-term investments totaled $461, $820, and $1,876 for the years ended December 31, 2009, 2008, and 2007, respectively.

The gross realized gains and gross realized losses recognized by the Company as a result of the sale of investments were as follows for the years ended December 31, 2009, 2008, and 2007 (in thousands):


2009	Fixed Income Securities			Equity Securities			Other Invested Assets		Total
Gross realized gains	$	3,349		$	852		$	—	$	4,201
Gross realized losses		(1,252	)		(695	)		—		(1,947	)

Net realized gains	$	2,097		$	157		$	—	$	2,254


2008	Fixed Income Securities			Equity Securities			Other Invested Assets		Total
Gross realized gains	$	1,414		$	380		$	—	$	1,794
Gross realized losses		(576	)		(145	)		—		(721	)

Net realized gains	$	838		$	235		$	—	$	1,073



2007	Fixed Income Securities			Equity Securities			Other Invested Assets		Total
Gross realized gains	$	2,284		$	1,116		$	344	$	3,744
Gross realized losses		(136	)		(263	)		—		(399	)

Net realized gains	$	2,148		$	853		$	344	$	3,345

For the years ended December 31, 2009 and 2008, the Company recorded other-than-temporary impairments related to its fixed income and equity securities totaling $4,497 and $9,507, respectively. There were no impairments recorded in 2007.

The following table provides a rollforward of the Company’s other-than-temporary impairments related to credit losses for which a portion of the other-than-temporary impairment was recognized in other comprehensive income for the year ended December 31, 2009.


Balance, January 1, 2009	$	—
Credit loss remaining in retained earnings related to adoption of new accounting guidance on April 1, 2009		1,737
Credit loss impairment recognized in current period on securities not previously impaired		29
Credit loss impairments previously recognized on securities which matured, paid down, or were sold during the period		(1,737	)

Balance, December 31, 2009	$	29

For the years ended December 31, 2009, 2008 and 2007, the change in the estimated fair value of convertible bonds included in net realized investment (losses) gains in the consolidated statement of operations and comprehensive income totaled $3,195, $(2,674) and $(457), respectively.

The change in the Company’s net unrealized gains and losses for the years ended December 31, 2009, 2008, and 2007 was as follows (in thousands):


2009	Fixed Income Securities			Equity Securities			Total
Change in unrealized gains and losses, gross of tax	$	1,246		$	7,508		$	8,754
Tax effect		(373	)		(1,681	)		(2,054	)

Change in net unrealized gains and losses	$	873		$	5,827		$	6,700


2008	Fixed Income Securities			Equity Securities			Total
Change in unrealized gains and losses, gross of tax	$	(647	)	$	(4,751	)	$	(5,398	)
Tax effect		159			1,165			1,324

Change in net unrealized gains and losses	$	(488	)	$	(3,586	)	$	(4,074	)


2007	Fixed Income Securities			Equity Securities			Total
Change in unrealized gains and losses, gross of tax	$	995		$	56		$	1,051
Tax effect		(349	)		(20	)		(369	)

Change in net unrealized gains and losses	$	646		$	36		$	682

Net investment income for the years ended December 31, 2009, 2008, and 2007 was as follows (in thousands):


	2009			2008			2007
Fixed income and convertible bond securities	$	7,570		$	9,276		$	10,345
Equity securities		387			346			290
Cash and cash equivalents		143			896			2,277
Other		90			123			60

Gross investment income		8,190			10,641			12,972
Investment expenses		(1,093	)		(1,010	)		(1,303	)

Net investment income	$	7,097		$	9,631		$	11,669

For the year ended December 31, 2009, the Company recognized an increase of $1,261 related to its equity interest in limited partnerships. The Company’s limited partnership investments include a multi-strategy fund of funds, natural resource funds, a structured finance opportunity fund and open-ended investment fund and a real estate partnership. The Company obtains audited financial statements of its limited partnership investments on an annual basis. The total assets, total liabilities and results of operations of the limited partnerships in which the Company invests as of and for the year ended December 31, 2008, based on the limited partnerships’ audited financial statements, were as follows (in thousands):


	Total Assets		Total Liabilities		Results of Operations
Multi-strategy fund of funds	$	627,658	$	56,084	$	(222,389	)
Natural resource funds	$	222,351	$	18,957	$	(135,691	)
Structured finance opportunity fund	$	78,181	$	50	$	(1,595	)
Open-ended investment fund	$	91,176	$	1,657	$	(29,904	)
Real estate partnership	$	4,098	$	2,802	$	(157	)

12. Reserves for Unpaid Losses and LAE


	2009			2008			2007
Balance, beginning of period	$	155,314		$	125,249		$	121,396
Reinsurance recoverables on unpaid losses and LAE		25,636			23,429			24,236

Net balance, beginning of period		129,678			101,820			97,160
Net reserves acquired as a result of acquisition		—			7,004			—
Purchase accounting adjustments on acquisition date		—			537			—
Incurred related to:
Current year		90,438			85,404			80,946
Prior year		(5,447	)		15,009			(6,189	)

Total incurred before purchase accounting adjustments		84,991			100,413			74,757
Purchase accounting adjustments		(493	)		(548	)		(848	)

Total incurred		84,498			99,865			73,909
Paid related to:
Current year		43,427			40,570			37,019
Prior year		47,371			38,978			32,230

Total paid		90,798			79,548			69,249

Net balance, end of period		123,378			129,678			101,820
Reinsurance recoverables on unpaid losses and LAE		24,368			25,636			23,429

Balance, end of period	$	147,746		$	155,314		$	125,249

Total reserves for unpaid for losses and LAE	$	151,512		$	159,117		$	129,788
Less: Term life premium waiver reserves		3,741			3,766			4,481
Less: Other		25			37			58

Balance, end of period	$	147,746		$	155,314		$	125,249

Incurred losses by segment were as follows for the year ended December 31, 2009 (in thousands):


	Workers’ Compensation Insurance Segment			Segregated Portfolio Cell Reinsurance Segment			Group Benefits Insurance Segment			Specialty Reinsurance Segment		Total
Incurred related to:
Current year, gross of discount	$	48,326		$	17,773		$	25,492		$	837	$	92,428
Current period discount		(1,343	)		(647	)		—			—		(1,990	)
Prior year, gross of discount		(3,749	)		(2,753	)		(611	)		—		(7,113	)
Accretion of prior period discount		1,075			591			—			—		1,666

Total incurred before purchase accounting adjustments		44,309			14,964			24,881			837		84,991
Purchase accounting adjustments		(465	)		(41	)		—			13		(493	)

Total incurred	$	43,844		$	14,923		$	24,881		$	850	$	84,498

Incurred losses by segment were as follows for the year ended December 31, 2008 (in thousands):


	Workers’ Compensation Insurance Segment			Segregated Portfolio Cell Reinsurance Segment			Group Benefits Insurance Segment			Specialty Reinsurance Segment		Total
Incurred related to:
Current year, gross of discount	$	39,880		$	15,274		$	26,114		$	5,746	$	87,014
Current period discount		(1,078	)		(532	)		—			—		(1,610	)
Prior year, gross of discount		(2,703	)		(1,960	)		(993	)		19,257		13,601
Accretion of prior period discount		928			480			—			—		1,408

Total incurred before purchase accounting adjustments		37,027			13,262			25,121			25,003		100,413
Purchase accounting adjustments		(492	)		(80	)		—			24		(548	)

Total incurred	$	36,535		$	13,182		$	25,121		$	25,027	$	99,865

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


	Workers’ Compensation Insurance Segment			Segregated Portfolio Cell Reinsurance Segment			Group Benefits Insurance Segment			Specialty Reinsurance Segment		Total
Incurred related to:
Current year, gross of discount	$	34,962		$	14,800		$	24,536		$	8,163	$	82,461
Current period discount		(979	)		(536	)		—			—		(1,515	)
Prior year, gross of discount		(8,398	)		(3,023	)		(961	)		4,844		(7,538	)
Accretion of prior period discount		787			562			—			—		1,349

Total incurred before purchase accounting adjustments		26,372			11,803			23,575			13,007		74,757
Purchase accounting adjustments		(758	)		(132	)		—			42		(848	)

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


	2009			2008			2007
Workers’ compensation insurance	$	(2,674	)	$	(1,775	)	$	(7,611	)
Segregated portfolio cell reinsurance		(2,162	)		(1,480	)		(2,461	)
Specialty reinsurance		—			19,257			4,844

Subtotal		(4,836	)		16,002			(5,228	)
Group benefits insurance		(611	)		(993	)		(961	)

Total	$	(5,447	)	$	15,009		$	(6,189	)

Workers’ Compensation Insurance


Accident Year	2009			2008			2007
2008	$	—		$	—		$	—
2007		(1,170	)		(1,203	)		—
2006		(1,504	)		(400	)		(2,048	)
2005		—			(650	)		(3,400	)
2004		(250	)		(200	)		(1,700	)
2003		(325	)		(100	)		(750	)
2002		(500	)		—			(500	)
2001		—			—			—
2000 and prior		—			(150	)		—

Total before discount accretion		(3,749	)		(2,703	)		(8,398	)
Discount accretion		1,075			928			787

Total	$	(2,674	)	$	(1,775	)	$	(7,611	)

For the year ended December 31, 2007, the Company recognized net favorable development on prior accident year workers’ compensation loss reserves of $8.4 million, representing 20.1% of the Company’s estimated workers’ compensation net loss reserves as of December 31, 2006 and 14.9% of the Company’s workers’ compensation net premiums earned for the year ended December 31, 2007. The favorable development arose mostly from accident years 2004, 2005 and 2006, and resulted from actual loss development being less than the Company had expected based on its historical loss development experience. The loss development factors used by the Company to determine its workers’ compensation loss reserves as of December 31, 2006, were based on its loss development history at that time. During 2007, the Company’s favorable loss development relative to its historical experience was driven by favorable effects from its loss mitigation efforts, which include greater availability and use of employers’ return to work programs, an improved economy relative to the historical experience of the Company, and significant claim settlements during 2007 at amounts less than reserves previously established.

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Segregated Portfolio Cell Reinsurance


Accident Year	2009			2008			2007
2008	$	(1,506	)	$	—		$	—
2007		(247	)		(1,011	)		—
2006		(663	)		(1,023	)		(2,404	)
2005		76			402			(901	)
2004		(268	)		(232	)		135
2003		68			(47	)		(56	)
2002		(24	)		(26	)		84
2001		(45	)		(27	)		73
2000 and prior		(144	)		4			46

Total before discount accretion		(2,753	)		(1,960	)		(3,023	)
Discount accretion		591			480			562

Total	$	(2,162	)	$	(1,480	)	$	(2,461	)

The Company estimates and records reserves for its segregated portfolio cell reinsurance segment in the same manner as for its workers’ compensation insurance segment. Furthermore, the Company’s underwriting, claim administration and risk management services are consistent between its workers’ compensation insurance and segregated portfolio cell reinsurance segments. This is because the segregated portfolio cell and workers’ compensation segments derive their books of business from the same general business demographics and geography.

For the year ended December 31, 2007, the Company recognized net favorable development on prior accident year segregated portfolio cell reinsurance loss reserves of $3.0 million, representing 14.3% of the Company’s estimated segregated portfolio cell reinsurance net loss reserves as of December 31, 2006 and 13.2% of the Company’s workers’ compensation net premiums earned for the year ended December 31, 2007. The favorable development arose mostly from accident years 2005 and 2006, and resulted from actual loss development being less than the Company had expected based on its historical loss development experience. The loss development factors used by the Company to determine its segregated portfolio cell reinsurance loss reserves as of December 31, 2006, were based on its loss development history at that time. During 2007, the Company’s favorable loss development relative to its historical experience was driven by favorable effects from its loss mitigation efforts, which include greater availability and use of employers’ return to work programs, an improved economy relative to the historical experience of the Company, and significant claim settlements during 2007 at amounts less than previously established.

101

Group Benefits Insurance

Run-Off Specialty Reinsurance


Accident Year	2009		2008		2007
2008	$	—	$	—	$	—
2007		—		7,225		—
2006		—		4,088		423
2005		—		3,296		755
2004		—		1,357		859
2003		—		1,430		998
2002		—		783		1,891
2001		—		565		829
2000 and prior		—		513		(911	)

	$	—	$	19,257	$	4,844

For the year ended December 31, 2008, the Company recognized net unfavorable development on prior accident year specialty reinsurance loss reserves of $19.3 million, representing 77.2% of the Company’s estimated specialty reinsurance net loss reserves as of December 31, 2007. The unfavorable development arose mostly from accident years 2005, 2006 and 2007, and was the result of a significant increase in reported losses from the ceding company, primarily related to the EnviroGuard program. The Company receives quarterly loss statements from the ceding company. The statements received for the fourth quarter of 2008 indicated reported losses much greater than the Company had observed in the past. As these reported losses were incorporated into the quarterly actuarial review, management also considered input from the annual claims audit, which was completed in January 2009. During the claims audit, management determined that the increase in losses reported by the ceding company was primarily attributable to adverse loss trends emerging in calendar year 2008 from prior accident years. Management also identified the primary factors that contributed to the increased losses reported to the Company. Those factors include 1) an improvement in the ceding company’s ability to estimate loss costs earlier in the claims process, including the receipt of damage estimates from contractors and consultants, 2) states becoming more aggressive in requiring quicker, more extensive clean-up and an increase in construction costs related to the clean-up, and 3) courts limiting the ability of insurance companies to enforce coverage limitations as the courts became more interested in an expeditious clean up due to environmental concerns. Based on the results of the claims audit, management updated its

102

quarterly actuarial analysis as of December 31, 2008 to reflect higher loss development factors than had previously been applied to the reported loss data, which was previously based on the Company’s historical loss experience and industry loss development statistics.

13. Reinsurance

The Company purchases reinsurance to manage its loss exposure. Although reinsurance agreements contractually obligate the Company’s reinsurers to reimburse the Company for the agreed upon portion of its gross paid losses, they do not discharge the primary liability of the Company.

The following table provides a summary of the Company’s premiums on a direct, assumed, ceded, and net basis for the years ended December 31, 2009, 2008, and 2007 (in thousands):


	2009						2008						2007
	Written			Earned			Written			Earned			Written			Earned
Direct premiums	$	120,783		$	116,667		$	112,512		$	109,518		$	104,263		$	102,260
Assumed premiums		29,902			30,142			33,106			36,915			43,183			42,890
Ceded premiums		(11,656	)		(11,227	)		(10,393	)		(10,113	)		(13,055	)		(13,153	)

Net premiums before purchase accounting		139,029			135,582			135,225			136,320			134,391			131,997
Purchase accounting adjustment		(596	)		(596	)		(513	)		(513	)		(2,502	)		(2,502	)

Net premiums	$	138,433		$	134,986		$	134,712		$	135,807		$	131,889		$	129,495

The following table provides a summary of the Company’s losses and loss adjustment expenses incurred on a direct, assumed, ceded and net basis for the years ended December 31, 2009, 2008, and 2007 (in thousands):


	2009			2008			2007
Direct losses and LAE incurred	$	71,532		$	62,829		$	52,023
Assumed losses and LAE incurred		16,839			39,325			25,791
Ceded losses and LAE incurred		(3,326	)		(2,418	)		(3,378	)

Net losses and LAE incurred before purchase accounting		85,045			99,736			74,436
Purchase accounting adjustment		(493	)		(548	)		(848	)

Net losses and LAE	$	84,552		$	99,188		$	73,588

As a result of A.M. Best upgrading ELH’s financial strength rating from “B++” (Very Good) to “A-” (Excellent) in June 2007, the Company terminated its coinsurance agreement with London Life Reinsurance Company (LLRC) and the related stop loss reinsurance agreement with London Life International Reinsurance Corporation effective June 30, 2007. The termination of these agreements had no effect on the consolidated financial statements.

ELH entered into a coinsurance agreement in 1999, under which it ceded an existing block of outstanding claims related to a program that provided long-term disability coverage to certain professional associations. The Company recorded a reinsurance recoverable totaling $7,769 and $9,034 as of December 31, 2009 and 2008, related to this block of ceded claims.

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14. Income Taxes

The components of the income tax provision for the years ended December 31, 2009, 2008, and 2007 are as follows (in thousands):


	2009		2008			2007
Current tax expense	$	958	$	5,418		$	9,458
Deferred tax (benefit) expense		2,795		(4,681	)		(1,066	)

Income tax expense before purchase accounting	$	3,753	$	737		$	8,392
Purchase accounting adjustment		268		327			(730	)

Income tax expense	$	4,021	$	1,064		$	7,662

In addition to the income tax provision, the net deferred tax asset (decreased) increased by $(2,162), $1,022, and $(696) in 2009, 2008, and 2007, respectively, as a result of changes in the unrealized gains and losses on the Company’s fixed income and equity securities. The net deferred tax asset was also (decreased) increased by $(127), $558 and $(58) in 2009, 2008 and 2007, respectively, related to unrecognized benefit plan gains. The tax effect of these items is recorded directly to accumulated other comprehensive income, which is a component of equity.

The provision for income taxes for the years ended December 31, 2009, 2008, and 2007 is as follows (in thousands):


	2009			2008			2007
Income tax (benefit) expense at statutory rate	$	4,078		$	(6,099	)	$	8,963
Outside basis difference related to Eastern Re		107			7,155			—
Non-deductible intangible asset amortization		—			—			608
Adoption of FAS 115-2		240			—			—
Tax-exempt interest		(655	)		(554	)		(608	)
Other		(17	)		235			(571	)

Income tax expense before purchase accounting adjustment		3,753			737			8,392
Purchase accounting adjustment		268			327			(730	)

Income tax expense	$	4,021		$	1,064		$	7,662

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The components of the net deferred tax asset as of December 31, 2009 and 2008 are as follows (in thousands):


	2009		2008
Deferred tax assets:
Reserve discounting	$	2,397	$	2,256
Unearned/advance premiums		2,532		2,257
Other-than-temporary investment impairments		1,958		2,687
Unrealized loss on investments		—		715
Basis difference in limited partnerships		—		1,210
Policyholder dividends		372		389
Stock compensation expense		799		646
Other		361		398

Total deferred tax assets		8,419		10,558


Deferred tax liabilities:
Intangible assets		2,239		2,845
Unrealized gain on investments		2,568		—
Deferred acquisition costs		1,035		898
Basis difference in limited partnerships		230		—
Basis difference in foreign operations		664		470
Other		449		267

Total deferred tax liabilities		7,185		4,480

Net deferred tax asset before purchase accounting		1,234		6,078
Purchase accounting adjustment		115		203

Net deferred tax asset	$	1,349	$	6,281

As of December 31, 2009, the net deferred tax asset of $1,349 has not been reduced by a valuation allowance because management believes that, while it is not assured, it is more likely than not that the Company will generate sufficient future taxable income to utilize these net future tax deductions. The amount of the net deferred tax asset considered realizable, however, could be materially reduced in the near term if estimates of future taxable income in the years in which the differences are expected to reverse are decreased.

As of December 31, 2009, the Company has not recognized a deferred tax asset related to its run-off specialty reinsurance segment of $7,261, which represents the excess of the tax basis over the amount for financial reporting (i.e., outside basis difference) of Eastern Re as of December 31, 2009. The outside basis difference primarily arises from losses at Eastern Re recognized for financial statement purposes, which have not yet been recognized for tax purposes. Management presently believes that the Company will not be able to recognize these tax benefits in the foreseeable future and, therefore, has not recognized the future tax benefits as of December 31, 2009.

As of December 31, 2009, the Company has no tax positions for which management believes a provision for uncertainty is necessary. The Company’s federal income tax returns for tax years subsequent to December 31, 2005 are subject to examination by the Internal Revenue Service.

15. Employee Benefit Plans

ESOP

The Company sponsors an ESOP. Eligible employees generally include those employees who have reached the age of 21 and have completed one year of service. All employees that were employed by EHC or ELH on June 16, 2006 were determined to have met the eligibility requirements on that date. ESOP shares are allocated to participants based on the ratio of their individual compensation during the plan year to the total compensation of eligible employees during the plan year.

105

The Company issued 747,500 shares of its common stock to the ESOP on June 16, 2006, and the ESOP signed a promissory note in the amount of $7,475 for the purchase of the shares, which is due in ten equal installments, with interest accruing annually at 4%. Shares purchased are held in a suspense account for allocation among participating employees as the loan is repaid.

Suspense shares, allocated shares, shares committed to be released, average price per share and stock compensation expense as of and for the years ended December 31, 2009 and 2008 were as follows (in thousands, except share data):


	As of and for the Years Ended December 31,
	2009			2008
Suspense shares		560,625	��		635,375
Allocated shares		186,875			112,125
Shares committed to be released		74,750			74,750
Average price per share	$	8.76		$	13.98
Stock compensation expense	$	655		$	1,045

Suspense shares represent shares held by the ESOP that have not been allocated to participant accounts. Allocated shares have been earned and allocated to participant accounts, while shares committed to be released have been earned, but have not yet been allocated to participant accounts.

As of December 31, 2009 and 2008, the estimated fair value of unearned ESOP shares were $4,256 and $7,838, respectively.

For the years ended December 31, 2009, 2008, and 2007 the Company made a cash contribution of $937, $858, and $1,100 to the ESOP, respectively. The ESOP used these contributions, along with dividends received on the unallocated shares of the Company’s stock held by the ESOP, to make the semi-annual principal and interest payments to the Company related to the outstanding balance of the promissory note. Dividends used by the ESOP to fund the semi-annual principal and interest payments totaled $163, $242, and $0 in 2009, 2008, and 2007, respectively. The transactions between the Company and the ESOP are considered non-cash transactions for purposes of the consolidated statements of cash flows.

Defined Contribution Plan

The Company sponsors a contributory defined contribution plan covering eligible employees. Employees are eligible to participate in the defined contribution plan upon the attainment of 21 years of age. The Company provides a matching contribution up to 75% of the first 4% of an employee’s contributions. Employees are immediately vested in the employer matching contributions regardless of years of service. The Company’s contributions to the defined contribution plan for the years ended December 31, 2009, 2008, and 2007 totaled $309, $237, and $195, respectively.

Employees may invest the contributions to their account in a variety of mutual funds. The estimated fair values of the mutual fund investments are based on quoted net asset values; therefore, the estimated fair values are considered Level 1 fair value measurements.

Other Benefit Plans

ELH sponsors a non-contributory defined benefit pension plan (the “pension plan”) and a defined benefit postretirement plan (the “postretirement plan”), both of which are frozen as to the earning of additional benefits.

As of December 31, 2009 and 2008, the projected benefit obligation, fair value of plan assets and funded status of the pension plan and the postretirement plan were as follows (in thousands):


	Pension Plan					Postretirement Plan
	2009			2008		2009		2008
Projected benefit obligation at end of year	$	6,020		$	5,673	$	311	$	312
Fair value of plan assets at end of year		6,135			5,489		—		—
Funded status		(115	)		184		311		312

Based on the funded status of the pension plan as of December 31, 2009, the Company does not anticipate making a contribution in 2010.

106

The assumptions used in the measurement of the Company’s benefit obligation are shown in the following table:


	Pension Plan				Postretirement Plan
	2009		2008		2009		2008
Weighted average discount rate	6.00	%	6.00	%	5.30	%	6.18	%
Rate of increase in compensation levels	N/A		N/A		3.50	%	3.50	%

The net periodic benefit cost incurred by the Company for the years ended December 31, 2009, 2008 and 2007 totaled $68, $(59), and $(533) for the pension plan and $(5), $(3), and $(12) for the postretirement plan.

The assumptions used in the measurement of the Company’s net periodic benefit cost for the pension plan and the postretirement plan are shown in the following table:


	Pension Plan						Postretirement Plan
	2009		2008		2007		2009		2008		2007
Weighted average discount rate	6.00	%	6.50	%	5.60	%	6.18	%	6.10	%	5.60	%
Expected long-term rate of return on plan assets	6.00	%	6.00	%	6.75	%	N/A		N/A		N/A
Rate of increase in compensation levels	N/A		N/A		N/A		3.50	%	3.50	%	3.50	%

Benefits paid totaled $39, $234, and $424 for the pension plan and $1, $21, and $134 for the postretirement plan for the years ended December 31, 2009, 2008, and 2007, respectively. The estimated future benefits to be paid over the next ten years are as follows (in thousands):


	Pension Plan		Postretirement Plan
2010		110		34
2011		100		34
2012		240		33
2013		200		25
2014		210		26
2015-2019		1,700		123

Total	$	2,560	$	273

The pension plan’s assets were comprised of the following at December 31, 2009 and 2008 (in thousands):


	2009		2008
Equity securities	$	601	$	441
Fixed income securities		5,534		5,048

Total	$	6,135	$	5,489

The pension plan’s equity securities consist of a small-cap index mutual fund. The mutual fund’s estimated fair value is based on a quoted net asset value; therefore, the estimated fair value is considered a Level 1 fair value measurement. The pension plan’s fixed income securities consist of pooled separate accounts that are valued at the net participation value of participation units held by the pension plan. The value of the participation units is determined by the trustee based on the estimated fair values of the underlying assets of the pooled separate account; therefore, the estimated fair value of the pooled separate accounts is considered a Level 2 fair value measurement.

The primary investment objective of the pension plan is to achieve maximum rates of return commensurate with safety of principal. The pension plan asset allocation is reviewed annually to determine whether the portfolio mix is within an acceptable range of the target allocation. Target asset allocations are based on asset and liability studies with the goal to enhance the expected return of the pension plan portfolio while maintaining acceptable levels of risk. As of December 31, 2009 the target asset allocation for the portfolio is 10% equity securities and 90% fixed income securities.

Historical and future expected returns of multiple asset classes were analyzed to develop a risk-free real rate of return and risk premiums for each asset class. The overall rate for each asset class was developed by combining a long-term inflation component, the risk-free real rate of return, and the associated risk premium. A weighted average rate was developed based on those overall rates and the target asset allocation of the pension plan.

107

16. Segment Information

The Company’s current operates in five business segments. The specialty reinsurance segment was placed into run-off effective July 1, 2008.

Workers’ Compensation Insurance

The Company offers traditional workers’ compensation insurance coverage to employers, primarily in the Mid-Atlantic, Southeast and Midwest regions of the continental United States. The Company’s workers’ compensation products include guaranteed cost policies, policyholder dividend policies, retrospectively-rated policies and large deductible policies.

Segregated Portfolio Cell Reinsurance

The Company offers alternative market workers’ compensation solutions to individual companies, groups and associations (referred to as “segregated portfolio cell dividend participants”) through the creation of segregated portfolio cells. The segregated portfolio cells are segregated pools of assets that function as insurance companies within an insurance company. The pool of assets and associated liabilities of each segregated portfolio cell are solely for the benefit of the segregated portfolio cell dividend participants, and the pool of assets of one segregated portfolio cell are statutorily protected from the creditors of the others. This permits the Company to provide customers with a turn-key alternative markets solution that includes program design, fronting, claims administration, risk management, segregated portfolio cell rental, investment and segregated portfolio management services. The segregated portfolio cell structure provides dividend participants the opportunity to share in both underwriting profit and investment income derived from their respective segregated portfolio cell’s financial results. The segregated portfolio cell reinsurance segment generated fee revenue to the Company’s workers’ compensation, run-off specialty reinsurance, and corporate/other segments totaling approximately $4,054,$4,188 and $3,900 for the years ended December 31, 2009, 2008 and 2007, respectively.

Group Benefits Insurance

The Company’s group benefits insurance products include dental, short and long-term disability, term life, and vision insurance. The group benefits insurance products are marketed to employers, primarily in the Mid-Atlantic, Southeast, and Midwest regions of the continental United States. Net premiums earned, by product, for the years ended December 31, 2009, 2008, and 2007 were as follows (in thousands):


	2009		2008		2007
Dental	$	22,536	$	22,737	$	21,819
Short-term disability		6,139		6,571		6,627
Long-term disability		1,554		1,591		1,691
Term life		5,629		5,824		5,726
Vision		79		—		—

Total	$	35,937	$	36,723	$	35,863

Run-off Specialty Reinsurance

Prior to July 1, 2008, the Company assumed business through its participation in reinsurance treaties with an unaffiliated insurance company related to an underground storage tank insurance program, referred to as “EnviroGuard,” and a non-hazardous waste transportation product, referred to as “EIA liability” (“EIA”). The EnviroGuard program provided coverage to underground tank owners for third party off-site bodily injury and property damage claims as well as clean-up coverage and first party on-site claims. The EIA program provided commercial automobile liability coverage for non-hazardous waste haulers. Prior to terminating its participation in the reinsurance treaties effective July 1, 2008, the Company had reduced its participation in the EnviroGuard and EIA programs from a 25% quota share participation to a 15% quota share participation effective January 1, 2008. Net premiums earned, by program and before purchase accounting adjustments, for the years ended December 31, 2009, 2008 and 2007 were as follows (in thousands):


	2009		2008		2007
EnviroGuard	$	860	$	6,697	$	11,241
EIA		273		2,976		3,510
Other		—		9		550

Total	$	1,133	$	9,682	$	15,301

108

Corporate/Other

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

The following table represents the segment results for the year ended December 31, 2009 (in thousands):


	Workers’ Compensation Insurance			Segregated Portfolio Cell Reinsurance			Group Benefits Insurance		Run-Off Specialty Reinsurance			Corporate/ Other			Total
Revenue:
Net premiums earned	$	73,213		$	24,703		$	35,937	$	1,133		$	—		$	134,986
Net investment income		3,313			691			1,590		1,054			449			7,097
Change in equity interest in limited partnerships		845			—			195		221			—			1,261
Net realized investment (losses) gains		(237	)		(625	)		3,021		(1,230	)		23			952
Other revenue		—			—			2		457			186			645

Total revenue		77,134			24,769			40,745		1,635			658			144,941

Expenses:
Losses and LAE incurred		43,843			14,923			24,936		850			—			84,552
Acquisition and other underwriting expenses		6,207			7,500			5,389		542			(1,455	)		18,183
Other expenses		13,754			123			6,263		562			5,680			26,382
Amortization of intangibles		—			—			—		—			1,732			1,732
Policyholder dividend expense		432			—			—		—			—			432
Segregated portfolio dividend expense		—			2,223			—		—			(985	)		1,238

Total expenses		64,236			24,769			36,588		1,954			4,972			132,519

Income (loss) before income taxes		12,898			—			4,157		(319	)		(4,314	)		12,422
Income tax expense (benefit)		3,778			—			1,349		(5	)		(1,101	)		4,021

Net income (loss)	$	9,120		$	—		$	2,808	$	(314	)	$	(3,213	)	$	8,401

Total assets	$	237,509		$	57,382		$	66,935	$	56,415		$	(26,717	)	$	391,524

The following table represents the segment results for the year ended December 31, 2008 (in thousands):


	Workers’ Compensation Insurance			Segregated Portfolio Cell Reinsurance			Group Benefits Insurance			Run-Off Specialty Reinsurance			Corporate/ Other			Total
Revenue:
Net premiums earned	$	65,962		$	23,440		$	36,723		$	9,682		$	—		$	135,807
Net investment income		4,045			1,112			2,578			1,343			553			9,631
Change in equity interest in limited partnerships		(3,051	)		—			(430	)		(489	)		—			(3,970	)
Net realized investment (losses) gains		(4,174	)		(1,381	)		(5,366	)		(440	)		244			(11,117	)
Other revenue		119			—			—			782			(48	)		853

Total revenue		62,901			23,171			33,505			10,878			749			131,204

Expenses:
Losses and LAE incurred		36,535			13,182			24,444			25,027			—			99,188
Acquisition and other underwriting expenses		4,920			7,238			5,602			2,903			(1,745	)		18,918
Other expenses		10,915			286			5,698			637			7,802			25,338
Amortization of intangibles		—			—			—			—			1,373			1,373
Policyholder dividend expense		551			—			—			—			—			551
Segregated portfolio dividend expense		—			2,465			—			—			(310	)		2,155

Total expenses		52,921			23,171			35,744			28,567			7,120			147,523

Income (loss) before income taxes		9,980			—			(2,239	)		(17,689	)		(6,371	)		(16,319	)
Income tax expense (benefit)		3,151			—			(1,083	)		984			(1,988	)		1,064

Net income (loss)	$	6,829		$	—		$	(1,156	)	$	(18,673	)	$	(4,383	)	$	(17,383	)

Total assets	$	230,307		$	51,975		$	78,875		$	39,706		$	(23,552	)	$	377,311

109

The following table represents the segment results for the year ended December 31, 2007 (in thousands):


	Workers’ Compensation Insurance		Segregated Portfolio Cell Reinsurance		Group Benefits Insurance			Run-Off Specialty Reinsurance			Corporate/ Other			Total
Revenue:
Net premiums earned	$	56,319	$	22,861	$	35,863		$	14,452		$	—		$	129,495
Net investment income		4,221		1,284		3,277			1,298			1,589			11,669
Change in equity interest in limited partnerships		537		—		(39	)		261			—			759
Net realized investment gains		797		320		1,531			7			233			2,888
Other revenue		—		—		—			593			90			683

Total revenue		61,874		24,465		40,632			16,611			1,912			145,494

Expenses:
Losses and LAE incurred		25,614		11,671		23,253			13,050			—			73,588
Acquisition and other underwriting expenses		2,495		6,933		5,556			3,932			(1,860	)		17,056
Other expenses		8,300		463		5,073			647			7,318			21,801
Amortization of intangibles		—		—		—			—			1,738			1,738
Policyholder dividend expense		543		—		—			—			—			543
Segregated portfolio dividend expense		—		5,398		—			—			(975	)		4,423

Total expenses		36,952		24,465		33,882			17,629			6,221			119,149

Income (loss) before income taxes		24,922		—		6,750			(1,018	)		(4,309	)		26,345
Income tax expense (benefit)		7,804		—		1,973			(732	)		(1,383	)		7,662

Net income (loss)	$	17,118	$	—	$	4,777		$	(286	)	$	(2,926	)	$	18,683

Total assets	$	189,028	$	47,118	$	107,470		$	51,228		$	(9,326	)	$	385,518

17. Commitments and Contingencies

Lease Commitments

The Company maintains regional offices in North Carolina and Indiana and leases office space under multi-year operating leases through January 2013 and March 2017, respectively.

Minimum monthly lease commitments for the remainder of the office lease terms are as follows (in thousands):


2009	$	1,109
2010		1,118
2011		1,159
2012		1,100
2013		1,100
2014 thereafter		2,430

Total	$	8,016

Rent expense totaled $1,084, $953, and $748 for the years ended December 31, 2009, 2008 and 2007, respectively.

110

18. Junior Subordinated Debentures

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

For the years ended December 31, 2008 and 2007, the Company incurred interest expense of $468 and $606, respectively, related to the junior subordinated debentures.

19. Loan Payable

As of December 31, 2009, the Company had a loan payable with an outstanding principal balance of $2,150. Semi-annual principal payments of $250 are due on or before January 1 and July 1 each year through July 1, 2013. Interest on the loan is based on the 30-day LIBOR rate plus 165 basis points and resets on the first day of each month, based on the LIBOR rate as of the last day of the immediately preceding month. The outstanding loan balance can be prepaid at any time without penalty. Under the terms of the loan, ESHC must maintain 1) a consolidated debt service coverage ratio of not less than 1.0 calculated annually on December 31, 2) consolidated net equity of $3,000 on December 31, and 3) invested assets equal to at least 125% of the outstanding principal balance of the loan. As of December 31, 2009 and for the year then ended, ESHC met the financial covenants. The Company incurred interest expense of $46 and $30 related to the loan for the years ended December 31, 2009 and 2008, respectively.

20. Agency Stock Purchase Plan

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

21. Eastern Re Capital Contribution

As a result of Eastern Re’s net loss for the year ended December 31, 2008, EIHI made a capital contribution of $23.0 million to Eastern Re on March 6, 2009 to improve Eastern Re’s capital position and to maintain Eastern Re’s current A.M. Best financial strength rating of “A-” (Excellent). The capital contribution was funded by dividends paid to EIHI from Eastern Alliance, Allied Eastern and ELH in the amount of $10.0 million, $2.0 million and $13.0 million, respectively, on March 6, 2009, of which $2.0 million was retained by EIHI. The dividends were approved by the Pennsylvania Insurance Department.

22. Subsequent Events

Management performed an evaluation of subsequent events and determined there were no recognized or unrecognized subsequent events that would require an adjustment and/or additional disclosure in the consolidated financial statements as of December 31, 2009.

23. Quarterly Financial Data (Unaudited, in thousands, except per share data)


2009	March 31			June 30		September 30		December 31
Total revenue	$	34,156		$	36,173	$	37,885	$	36,727
Income from operations	$	578		$	3,698	$	4,626	$	3,520
Net (loss) income	$	(555	)	$	2,977	$	3,291	$	2,688
Basic earnings per share	$	(0.06	)	$	0.33	$	0.36	$	0.30
Diluted earnings per share	$	(0.06	)	$	0.33	$	0.36	$	0.30



2008	March 31		June 30		September 30			December 31
Total revenue	$	35,540	$	36,052	$	29,522		$	30,090
Income (loss) from operations	$	3,643	$	2,214	$	(4,849	)	$	(17,327	)
Net income (loss)	$	2,574	$	1,503	$	(3,089	)	$	(18,371	)
Basic earnings per share	$	0.27	$	0.17	$	(0.35	)	$	(2.10	)
Diluted earnings per share	$	0.26	$	0.16	$	(0.35	)	$	(2.10	)

111

Item 9—Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None

Item 9A—Controls and Procedures

Evaluation of Disclosure Controls and Procedures.

Our disclosure controls and procedures, as that term is defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are designed with the objective of providing reasonable assurance that information required to be disclosed in our reports filed or submitted under the Exchange Act, such as this report, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission (the “SEC”). In designing and evaluating our disclosure controls and procedures, our management recognizes that any disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable, rather than absolute, assurance of achieving the desired control objectives.

An evaluation was performed by our management, with the participation of our chief executive officer (“CEO”) and chief financial officer (“CFO”), of the effectiveness of the design and operation of the our disclosure controls and procedures as of the end of the period covered by this report. Based on this evaluation, our CEO and CFO have concluded that, as of the end of such period, our disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms and made known to our management, including our CEO and CFO, as appropriate, to allow timely decisions regarding required disclosures.

Changes in Internal Controls.

There have been no changes in EIHI’s internal control over financial reporting identified in connection with the evaluation described in the above paragraph that have materially affected, or are reasonably likely to materially affect, EIHI’s internal control over financial reporting.

(c)

Management’s Report on Internal Control Over Financial Reporting.

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) under the Securities Exchange Act of 1934. Under the supervision and with the participation of our management, including the principal executive officer and principal financial officer, we have conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation under the framework in Internal Control-Integrated Framework, we have concluded that the internal control over financial reporting was effective as of December 31, 2009.

Because of its inherent limitations, internal control over the financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

(d)

The Report of Independent Registered Public Accounting Firm on internal control over financial reporting is included in this Annual Report on Form 10-K immediately before the consolidated financial statements.

Item 9B—Other Information

None

112

PART III

Item 10—Directors and Officers of the Registrant

Incorporated by reference from the Company’s 2010 Proxy Statement.

Item 11—Executive Compensation

Incorporated by reference from the Company’s 2010 Proxy Statement.

Item 12—Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

Incorporated by reference from the Company’s 2010 Proxy Statement.

Item 13—Certain Relationships and Related Transactions

Incorporated by reference from the Company’s 2010 Proxy Statement.

Item 14—Principal Accountant Fees and Services

Incorporated by reference from the Company’s 2010 Proxy Statement.

113

Part IV

Item 15—Exhibits, Financial Statement Schedules

(1) Financial Statements.

The following consolidated financial statements are filed as part of this report in Item 8:

Consolidated Financial Statements

Consolidated Balance Sheets as of December 31, 2009 and 2008

Consolidated Statements of Operations and Comprehensive Income (Loss) for Years Ended December 31, 2009, 2008 and 2007

Consolidated Statements of Changes in Shareholders’ Equity for Years Ended December 31, 2009, 2008 and 2007

Consolidated Statements of Cash Flows for Years Ended December 31, 2009, 2008 and 2007

Notes to Consolidated Financial Statements

(2)Financial Statement Schedules.

The following financial statement schedules for the years 2009, 2008 and 2007 are submitted herewith:

Schedule I—Summary of Investments

Schedule II—Condensed Financial Information of Parent Company

Schedule III—Supplementary Schedule Information

Schedule IV—Reinsurance

Schedule VI—Supplemental Information

The information required by Schedule V—Allowance for Uncollectible Premiums and Other Receivables has been included within the consolidated financial statements or notes thereto.

(3) Exhibits.

114

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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.


EASTERN INSURANCE HOLDINGS, INC.

By:		/s/ KEVIN M. SHOOK
		Kevin M. Shook, Chief Financial Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities indicated on the date indicated:


Signature

/S/ BRUCE M. ECKERT Bruce M. Eckert	Chief Executive Officer (Principal Executive Officer) and Director	March 5, 2010


/S/ KEVIN M. SHOOK Kevin M. Shook	Treasurer and Chief Financial Officer (Principal Financial and Accounting Officer)	March 5, 2010


/S/ ROBERT M. MCALAINE Robert M. McAlaine	Chairman and Director	March 5, 2010


/S/ LAWRENCE W. BITNER Lawrence W. Bitner	Director	March 5, 2010


/S/ PAUL R. BURKE Paul R. Burke	Director	March 5, 2010


/S/ RONALD L. KING Ronald L. King	Director	March 5, 2010


/S/ SCOTT C. PENWELL Scott C. Penwell	Director	March 5, 2010


/S/ JOHN O. SHIRK John O. Shirk	Director	March 5, 2010


/S/ W. LLOYD SNYDER III W. Lloyd Snyder III	Director	March 5, 2010


/S/ CHARLES H. VETTERLEIN, JR. Charles H. Vetterlein, Jr.	Director	March 5, 2010

115

EXHIBIT INDEX


Exhibit Number		Description
2.1		Plan of Conversion from Mutual to Stock Organization of Educators Mutual Life Insurance Company adopted March 17, 2005, as amended June 9, 2005. (Incorporated by reference from Exhibit 2.1 to the Eastern Insurance Holdings, Inc. Registration Statement No. 333-128913 on Form S-1)

2.2		Agreement and Plan of Reorganization dated March 17, 2005, between and among Educators Mutual Life Insurance Company, Eastern Insurance Holdings, Inc., and Eastern Holding Company, Ltd. (Incorporated by reference from Exhibit 2.2 to the Eastern Insurance Holdings, Inc. Registration Statement No. 333-131215 on Form S-4)

2.3		Agreement and Plan of Merger by and among Eastern Insurance Holdings, Inc., Eastern Acquisition Corp. and Employers Security Holding Company, dated as of August 6, 2008. (Incorporated by reference from Exhibit 2.1 to the Eastern Insurance Holdings, Inc. Current Report on Form 8-K filed on August 7, 2008)

3.1		Articles of Incorporation of Eastern Insurance Holdings, Inc. (Incorporated by reference from Exhibit 3.1 to the Eastern Insurance Holdings, Inc. Registration Statement No. 333-128913 on Form S-1)

3.2		Bylaws of Eastern Insurance Holdings, Inc. (Incorporated by reference from Exhibit 3.2 to the Eastern Insurance Holdings, Inc. Registration Statement No. 333-128913 on Form S-1)

4.1		Form of Stock Certificate of Eastern Insurance Holdings, Inc. (Incorporated by reference from Exhibit 4.1 to the Eastern Insurance Holdings, Inc. Registration Statement No. 333-128913 on Form S-1)

10.1		Transition Agreement, dated March 4, 2005, between Educators Insurance Company and Alex T. Schneebacher (Incorporated by reference from Exhibit 10.1 to the Eastern Insurance Holdings, Inc. Registration Statement No. 333-128913 on Form S-1)

10.2		Employee Stock Ownership Plan of Eastern Insurance Holdings, Inc. (Incorporated by reference from Exhibit 10.2 to the Eastern Insurance Holdings, Inc. Registration Statement No. 333-128913 on Form S-1)

10.3		Stock Compensation Plan of Eastern Insurance Holdings, Inc. (Incorporated by reference from Exhibit 10.3 to the Eastern Insurance Holdings, Inc. Registration Statement No. 333-128913 on Form S-1)

10.4		Employment Agreement, dated March 17, 2005, between Eastern Holding Company, Ltd. and Bruce M. Eckert (Incorporated by reference from Exhibit 10.4 to the Eastern Insurance Holdings, Inc. Registration Statement No. 333-128913 on Form S-1)

10.5		Employment Agreement, dated March 17, 2005, between Eastern Holding Company, Ltd. and Michael L. Boguski (Incorporated by reference from Exhibit 10.5 to the Eastern Insurance Holdings, Inc. Registration Statement No. 333-128913 on Form S-1)

10.6		Employment Agreement, dated March 17, 2005, between Eastern Holding Company, Ltd. and Kevin M. Shook (Incorporated by reference from Exhibit 10.6 to the Eastern Insurance Holdings, Inc. Registration Statement No. 333-128913 on Form S-1)

10.7		Employment Agreement, dated March 17, 2005, between Eastern Holding Company, Ltd. and Robert A. Gilpin (Incorporated by reference from Exhibit 10.7 to the Eastern Insurance Holdings, Inc. Registration Statement No. 333-128913 on Form S-1)

10.8		Employment Agreement, dated March 17, 2005, between Eastern Holding Company, Ltd. and Suzanne M. Emmet (Incorporated by reference from Exhibit 10.8 to the Eastern Insurance Holdings, Inc. Registration Statement No. 333-128913 on Form S-1)

10.9		Coinsurance Agreement, effective October 1, 2003, between Educators Mutual Life Insurance Company and London Life Reinsurance Company (Incorporated by reference from Exhibit 10.10 to the Eastern Insurance Holdings, Inc. Registration Statement No. 333-128913 on Form S-1)

10.10		Agreement of Sale for IBSi (Incorporated by reference from Exhibit 10.26 to the Eastern Insurance Holdings, Inc. Registration Statement No. 333-128913 on Form S-1)

10.11		Officer Retention Agreement dated March 4, 2005, between M. Christine Gimber and Educators Mutual Life Insurance Company (Incorporated by reference from Exhibit 10.27 to the Eastern Insurance Holdings, Inc. Registration Statement No. 333-128913 on Form S-1)

116


Exhibit Number		Description
10.12		Eastern Insurance Holdings, Inc. 2006 Stock Incentive Plan (Incorporated by reference from Exhibit 4.1 to EIHI’s Registration Statement on Form S-8 filed on April 2, 2007)

10.13		Loan Agreement, effective December 17, 2007, between Eastern Insurance Holdings, Inc. and Fulton Bank (Incorporated by reference to Exhibit 10.13 to EIHI’s Form 10-K filed on March 14, 2008)

10.14		Eastern Insurance Holdings, Inc. 2008 Agency Stock Purchase Plan, effective July 1, 2008 (Incorporated by reference to Exhibit 99.1 to EIHI’s Registration Statement No. 333-151706 on Form S-3 filed on June 17, 2008)

14.1		Eastern Insurance Holdings, Inc. Code of Conduct and Ethics (Incorporated by reference from Exhibit 14 to EIHI’s Current Report on Form 8-K filed on February 14, 2008.

21.1		Subsidiaries of Eastern Insurance Holdings, Inc. (filed herewith as Exhibit 21.1)

23.1		Consent of PricewaterhouseCoopers LLP, dated March 12, 2009 (filed herewith as Exhibit 23.1)

31.1		Certification of Chief Executive Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith)

31.2		Certification of Chief Financial Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith)

32.1		Certification of Chief Executive Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith)

32.2		Certification of Chief Financial Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith)

99.1		Eastern Insurance Holdings, Inc. Audit Committee Charter and Policy (filed herewith as Exhibit 99.1)

117

Eastern Insurance Holdings, Inc. and Subsidiaries

Schedule I—Summary of Investments—Other than

Investments in Related Parties as of December 31, 2009


Column A	Column B		Column C		Column D
Type of Investment	Cost		Market Value		Balance Sheet
	(Dollars in thousands)
Fixed maturities:
Bonds:
United States Government and government agencies and authorities	$	22,795	$	23,597	$	23,597
States, municipalities and political subdivisions		39,624		41,500		41,500
Convertibles and bonds with warrants attached		14,921		16,677		16,677
All other corporate bonds		109,186		111,634		111,634

Total fixed maturities		186,526		193,408		193,408

Equity securities:
Common stocks:
Industrial, miscellaneous and all other		17,117		21,273		21,273

Total equity securities		17,117		21,273		21,273

Other long-term investments		10,220		10,315		10,315

Total investments	$	213,863	$	224,996	$	224,996

118

Eastern Insurance Holdings, Inc.

Schedule II—Condensed Financial Information of Parent Company

Condensed Balance Sheets

December 31, 2009 and 2008

(In thousands, except share data)


	2009			2008
ASSETS
Investment in common stock of subsidiaries (equity method)	$	135,787		$	118,731
Cash and cash equivalents		782			1,569
Intangible assets		7,448			9,179
Goodwill		10,752			10,752
Federal income taxes recoverable		944			238
Other assets		191			222

Total assets	$	155,904		$	140,691

LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Accounts payable and accrued expenses	$	136		$	202
Deferred tax liability, net		1,423			2,182
Due to subsidiaries, net		480			170

Total liabilities		2,039			2,554

Equity:
Series A preferred stock, par value $0; authorized shares—5,000,000; no shares issued and outstanding		—			—
Common stock, par value $0, authorized shares—20,000,000; issued—11,783,014 and 11,602,723, respectively; outstanding—9,691,257 and 9,512,366, respectively		—			—
Unearned ESOP compensation		(4,859	)		(5,606	)
Additional paid-in capital		113,049			111,772
Treasury stock, at cost (2,091,757 and 2,090,357 shares, respectively)		(32,666	)		(32,655	)
Accumulated other comprehensive income:
Unrealized gains in investments, net of taxes		5,573			(1,361	)
Unrecognized benefit plan gains, net of taxes		(270	)		(505	)
Retained Earnings		73,038			66,492

Total stockholders’ equity		153,865			138,137

Total liabilities and stockholders’ equity	$	155,904		$	140,691

See accompanying notes to consolidated financial statements.

119

Eastern Insurance Holdings, Inc.

Schedule II—Condensed Financial Information of Parent Company

Condensed Statement of Earnings

For the Years Ended December 31, 2009, 2008 and 2007

(In thousands)


	2009			2008			2007
Revenue
Investment income, net of expenses	$	424		$	594		$	1,320
Net realized investment gains		105			276			233

Total revenue		529			870			1,553

Expenses:
Other expenses		3,512			4,767			4,898
Amortization of intangibles		1,732			1,373			1,738

Total expenses		5,244			6,140			6,636

Loss before income tax expense		(4,715	)		(5,270	)		(5,083	)
Income tax benefit		(1,276	)		(1,532	)		(2,016	)

Loss before equity in income of subsidiaries		(3,439	)		(3,738	)		(3,067	)
Equity in income (loss) of subsidiaries		11,840			(13,645	)		21,750

Net income (loss)	$	8,401		$	(17,383	)	$	18,683

See accompanying notes to consolidated financial statements.

120

Eastern Insurance Holdings, Inc.

Schedule II—Condensed Financial Information of Parent Company

Condensed Statements of Cash Flows

For the Years ended December 31, 2009, 2008 and 2007

(In thousands)


	2009			2008			2007
Cash flows from operating activities:
Net (loss) income	$	8,401		$	(17,383	)	$	18,683
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Equity in undistributed income of subsidiaries		(11,840	)		13,645			(21,750	)
Dividends from subsidiaries		25,750			28,500			10,000
Stock compensation		2,025			2,353			2,410
Intangible asset amortization		1,732			1,373			1,738
Deferred income tax provision		(338	)		(376	)		(1,076	)
Other		(951	)		(435	)		(1,748	)

Net cash provided by operating activities		24,779			27,677			8,257

Cash flows from investing activities:
Acquisition of ESHC		—			(12,277	)		—
Capital contributions to subsidiaries		(23,015	)		(4,326	)		—

Net cash used in investing activities		(23,015	)		(16,603	)		—

Cash flows from financing activities:
Repurchase of common stock		(11	)		(17,066	)		(17,066	)
Shareholder dividends		(2,540	)		(2,488	)		(2,488	)

Net cash used in financing activities		(2,551	)		(19,554	)		(19,554	)

Net decrease in cash and cash equivalents		(787	)		(8,480	)		(8,480	)
Cash and cash equivalents at beginning of period		1,569			10,049			10,049

Cash and cash equivalents at end of period	$	782		$	1,569		$	1,569

Cash received during the year for:
Income taxes	$	(232	)	$	(1,889	)	$	(129	)

See accompanying notes to consolidated financial statements.

121

Eastern Insurance Holdings, Inc. and Subsidiaries

Schedule III—Supplementary Schedule Information

(In thousands)


Column A	Column B		Column C		Column D		Column E		Column F
	Deferred Policy Acquisition Costs		Future Policy Benefits, Losses, Claims, and Loss Expenses		Unearned Premiums		Other Policy Claims and Benefits Payable		Premium Revenue
December 31, 2009
Workers’ compensation insurance	$	3,468	$	62,546	$	34,969	$	—	$	73,213
Group benefits insurance		—		30,419		83		—		35,937
Run-off specialty reinsurance		—		32,584		—		—		1,133
Segregated portfolio cell reinsurance		3,019		25,659		11,047		—		24,703
Corporate and other		—		—		—		—		—

Total	$	6,487	$	151,208	$	46,099	$	—	$	134,986

December 31, 2008
Workers’ compensation insurance	$	2,617	$	61,141	$	30,941	$	—	$	65,962
Group benefits insurance		—		32,585		79		—		36,723
Run-off specialty reinsurance		294		40,539		978		—		9,682
Segregated portfolio cell reinsurance		2,849		24,852		10,367		—		23,440
Corporate and other		—		—		—		—		—

Total	$	5,760	$	159,117	$	42,365	$	—	$	135,807

December 31, 2007
Workers’ compensation insurance	$	1,924	$	46,485	$	24,707	$	—	$	56,319
Group benefits insurance		—		35,282		83		—		35,863
Run-off specialty reinsurance		2,196		24,937		7,320		—		14,452
Segregated portfolio cell reinsurance		2,137		23,084		7,716		—		22,861
Corporate and other		—		—		—		—		—

Total	$	6,257	$	129,788	$	39,826	$	—	$	129,495


	Column G		Column H		Column I		Column J		Column K
	Net Investment Income		Benefits, Claims, Losses and Settlement Expenses		Amortization of DPAC		Other Operating Expenses		Premiums Written
December 31, 2009
Workers’ compensation insurance	$	3,313	$	43,843	$	3,059	$	17,334	$	76,953
Group benefits insurance		1,590		24,936		—		11,652		35,942
Run-off specialty reinsurance		1,054		850		294		810		155
Segregated portfolio cell reinsurance		691		14,923		2,849		4,774		25,383
Corporate and other		449		—		—		5,957		—

Total	$	7,097	$	84,552	$	6,202	$	40,527	$	138,433

December 31, 2008
Workers’ compensation insurance	$	4,045	$	36,535	$	2,159	$	14,227	$	68,563
Group benefits insurance		2,578		24,444		—		11,300		36,718
Run-off specialty reinsurance		1,343		25,027		2,196		1,344		3,341
Segregated portfolio cell reinsurance		1,112		13,182		2,137		5,387		26,090
Corporate and other		553		—		—		7,430		—

Total	$	9,631	$	99,188	$	6,492	$	39,688	$	134,712

December 31, 2007
Workers’ compensation insurance	$	4,221	$	25,614	$	1,524	$	9,814	$	58,489
Group benefits insurance		3,277		23,253		—		10,629		35,864
Run-off specialty reinsurance		1,298		13,050		1,773		2,806		14,069
Segregated portfolio cell reinsurance		1,284		11,671		1,497		5,899		23,467
Corporate and other		1,589		—		—		7,196		—

Total	$	11,669	$	73,588	$	4,794	$	36,344	$	131,889

122

Eastern Insurance Holdings, Inc. and Subsidiaries

Schedule IV—Reinsurance

For the years ended December 31, 2009, 2008 and 2007

(In thousands)


Column A	Column B		Column C		Column D		Column E		Column F
	Gross Amount		Ceded to Other Companies		Assumed from Other Companies		Net Amount		Percentage of Amount Assumed to Net
Premiums Earned
For the year ended December 31, 2009
Life insurance in force	$	1,742,954	$	178,359	$	—	$	1,564,595	0.0	%

Premiums:
Life insurance	$	6,140	$	510	$	—	$	5,630	0.0	%
Accident and health insurance	$	32,596	$	2,289	$	—	$	30,307	0.0	%
Property and liability insurance	$	77,335	$	8,428	$	30,142	$	99,049	30.4	%
For the year ended December 31, 2008
Life insurance in force	$	1,758,863	$	91,095	$	—	$	1,667,768	0.0	%

Premiums:
Life insurance	$	6,068	$	244	$	—	$	5,824	0.0	%
Accident and health insurance	$	33,142	$	2,243	$	—	$	30,899	0.0	%
Property and liability insurance	$	69,795	$	7,626	$	36,915	$	99,084	37.3	%
For the year ended December 31, 2007
Life insurance in force	$	1,782,647	$	87,476	$	—	$	1,695,171	0.0	%

Premiums:
Life insurance	$	6,014	$	289	$	—	$	5,725	0.0	%
Accident and health insurance	$	32,502	$	2,364	$	—	$	30,138	0.0	%
Property and liability insurance	$	61,242	$	10,500	$	42,890	$	93,632	45.8	%

123

Eastern Insurance Holdings, Inc.

Schedule VI—Supplemental Information

For the year ended December 31, 2009


Column A	Column B		Column C		Column D		Column E		Column F		Column G
Affiliation with Registrant	Deferred Policy Acquisition Costs		Reserve for Losses and Loss Adj. Expenses		Discount if any Deducted in Column C		Unearned Premiums		Net Earned Premiums		Net Investment Income
	(Dollars in thousands)
Consolidated property-casualty entities:
Year ended December 31, 2009	$	6,487	$	120,789	$	3,097	$	46,016	$	99,049	$	5,058
Year ended December 31, 2008	$	5,760	$	126,532	$	4,145	$	42,286	$	99,084	$	6,500
Year ended December 31, 2007	$	6,257	$	94,506	$	3,474	$	39,743	$	93,632	$	6,803


	Column H Losses and LAE Incurred					Column I		Column J		Column K
	Current Period		Prior Year			Amortization of DPAC		Paid Losses and Adjustment Expenses		Net Written Premiums
	(Dollars in thousands)
Consolidated property-casualty entities:
Year ended December 31, 2009	$	64,453	$	(4,836	)	$	6,202	$	65,733	$	102,491
Year ended December 31, 2008	$	58,742	$	16,002		$	6,492	$	53,352	$	97,994
Year ended December 31, 2007	$	55,562	$	(5,228	)	$	4,794	$	44,840	$	96,025

124

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Eastern Insurance (EIHI) Inactive 10-K2009 FY Annual report

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