Eastern Insurance (EIHI) 10-Q 2012 Q3 Quarterly report

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.20549

FORM 10-Q

Quarterly Report pursuant to Section 13 or 15(d) of

the Securities Exchange Act of 1934

for the Quarterly Period Ended September 30, 2012,

or

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 No. 001-32899

EASTERN INSURANCE HOLDINGS, INC.

Incorporated in Pennsylvania	I.R.S. Employer Identification No. 20-2653793
25 Race Avenue, Lancaster, Pennsylvania 17603-3179 (717) 396-7095

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

Indicate by check mark whether the registrant 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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

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

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

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

Title of Each Class	Number of Shares Outstanding as of October 31, 2012
Common Stock, No Par Value	7,910,609 (Outstanding Shares)

TABLE OF CONTENTS

		Page
PART I – FINANCIAL INFORMATION			3
Item 1.	Financial Statements (Unaudited)		3
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		23
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		36
Item 4.	Controls and Procedures		36
PART II – OTHER INFORMATION			37
Item 1.	Legal Proceedings		37
Item 1A.	Risk Factors		37
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		37
Item 3.	Defaults Upon Senior Securities		38
Item 4.	Mine Safety Disclosures		38
Item 5.	Other Information		38
Item 6.	Exhibits		38

2

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands, except share data)

	September 30 2012			December 31 2011
ASSETS
Investments:
Fixed income securities, at estimated fair value (amortized cost, $138,451; $128,619)	$	144,217		$	133,422
Convertible bonds, at estimated fair value (amortized cost, $17,346; $16,856)		18,866			17,574
Equity securities, at estimated fair value (cost, $18,549; $16,566)		21,319			17,629
Other long-term investments, at estimated fair value (cost, $7,000; $8,100)		9,704			10,209
Total investments		194,106			178,834
Cash and cash equivalents		49,368			52,448
Accrued investment income		1,059			972
Premiums receivable (net of allowance, $356; $225)		72,252			56,443
Reinsurance recoverable on paid and unpaid losses and loss adjustment expenses		18,470			15,720
Deferred acquisition costs		10,003			9,206
Deferred income taxes, net		2,564			1,768
Federal income taxes recoverable		896			731
Intangible assets		4,532			5,137
Goodwill		10,752			10,752
Other assets		14,941			13,668
Total assets	$	378,943		$	345,679
LIABILITIES
Reserves for unpaid losses and loss adjustment expenses	$	115,685		$	106,077
Unearned premium reserves		80,211			63,432
Advance premium		164			747
Accounts payable and accrued expenses		19,150			18,892
Ceded reinsurance balances payable		9,629			10,265
Segregated portfolio cell dividend payable		17,263			15,774
Policyholder dividends payable		2,496			2,233
Total liabilities	$	244,598		$	217,420
Commitments and contingencies (Note 11)
SHAREHOLDERS’ EQUITY
Series A preferred stock, par value $0, auth. shares – 5,000,000; no shares issued and outstanding		—			—
Common capital stock, par value $0, auth. shares – 20,000,000; issued – 11,927,714 and 11,786,014; respectively; outstanding – 7,910,609 and 7,935,446, respectively		—			—
Unearned ESOP compensation		(2,803	)		(3,364	)
Additional paid in capital		117,111			116,272
Treasury stock, at cost (4,017,105 and 3,850,568 shares, respectively)		(56,532	)		(54,109	)
Retained earnings		72,346			66,910
Accumulated other comprehensive income, net		4,223			2,550
Total shareholders’ equity		134,345			128,259
Total liabilities and shareholders’ equity	$	378,943		$	345,679

See accompanying notes to unaudited consolidated financial statements.

3

EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

AND COMPREHENSIVE INCOME (LOSS)

For the Three and Nine Months Ended September 30, 2012 and 2011

(Unaudited, in thousands, except per share data)

	For the Three Months Ended September 30,					For the Nine Months Ended September 30,
	2012		2011			2012		2011
REVENUE
Net premiums earned	$	41,397	$	33,917		$	116,618	$	96,002
Net investment income		892		1,013			2,906		2,947
Change in equity interest in limited partnerships		290		(354	)		738		291
Net realized investment gains (losses)		1,023		(1,306	)		1,511		500
Other revenue		84		86			239		348
Total revenue		43,686		33,356			122,012		100,088
EXPENSES
Losses and loss adjustment expenses incurred		27,849		21,051			76,335		61,216
Acquisition and other underwriting expenses		5,486		3,630			15,391		10,356
Other expenses		6,224		6,265			18,119		18,197
Amortization of intangibles		202		254			605		762
Policyholder dividend expense		493		204			715		823
Segregated portfolio dividend expense		29		1,007			1,414		2,196
Total expenses		40,283		32,411			112,579		93,550
Income from continuing operations before income taxes		3,403		945			9,433		6,538
Income tax expense from continuing operations		617		289			2,377		2,011
Net income from continuing operations		2,786		656			7,056		4,527
Discontinued operations:
Income tax benefit		—		(368	)		—		(368	)
Net income from discontinued operations		—		368			—		368
Net income	$	2,786	$	1,024		$	7,056	$	4,895
Other comprehensive income (loss)
Unrealized holding gains (losses) arising during period, net of tax of $682, $(912), $1,180 and $(183)		1,267		(1,694	)		2,191		(339	)
Amortization of unrecognized benefit plan amounts, net of tax of $2, $123, $7, and $126		4		229			13		234
Less: Reclassification adjustment for gains included in net income, net of tax of $149, $77, $305, and $657		238		142			531		1,268
Other comprehensive income (loss)		1,033		(1,607	)		1,673		(1,373	)
Comprehensive income (loss)	$	3,819	$	(583	)	$	8,729	$	3,522

	Three Months Ended September 30				Nine Months Ended September 30
Earnings per share (See Note 3):	2012		2011		2012		2011
Basic earnings per share:
Income from continuing operations	$	0.37	$	0.08	$	0.92	$	0.56
Income from discontinued operations		N/A	$	0.05		N/A	$	0.05
Diluted earnings per share:
Income from continuing operations	$	0.36	$	0.08	$	0.90	$	0.56
Income from discontinued operations		N/A	$	0.05		N/A	$	0.04

See accompanying notes to unaudited consolidated financial statements.

4

EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY

For the Three and Nine Months Ended September 30, 2012

(Unaudited, in thousands, except share data)

Three Months Ended September 30, 2012

	Outstanding Shares																	Accumulated Other
	Series A Preferred Stock		Common Capital Stock		Common Capital Stock		Unearned ESOP Compensation			Additional Paid-In Capital		Treasury Stock			Retained Earnings			Comprehensive Income, Net of Tax		Total
Balance, July 1, 2012		—		7,910,609		—	$	(2,991	)	$	116,772	$	(56,532	)	$	70,112		$	3,190	$	130,551
ESOP shares released		—		—		—		188			130		—			—			—		318
Equity awards		—				—		—			201		—			—			—		201
Income taxes related to equity awards		—		—		—		—			8		—			—			—		8
Shareholder dividend		—		—		—		—			—		—			(552	)		—		(552	)
Net income		—		—		—		—			—		—			2,786			—		2,786
Other comprehensive income, net of tax		—		—		—		—			—		—			—			1,033		1,033
Balance, September 30, 2012		—		7,910,609		—	$	(2,803	)	$	117,111	$	(56,532	)	$	72,346		$	4,223	$	134,345

Nine Months Ended September 30, 2012

	Outstanding Shares																		Accumulated Other
	Series A Preferred Stock		Common Capital Stock			Common Capital Stock		Unearned ESOP Compensation			Additional Paid-In Capital		Treasury Stock			Retained Earnings			Comprehensive Income, Net of Tax		Total
Balance, January 1, 2012		—		7,935,446			—	$	(3,364	)	$	116,272	$	(54,109	)	$	66,910		$	2,550	$	128,259
ESOP shares released		—		—			—		561			318		—			—			—		879
Equity awards		—		141,700			—		—			510		—			—			—		510
Income taxes related to equity awards		—		—			—		—			11		—			—			—		11
Repurchase of common stock		—		(166,537	)		—		—			—		(2,423	)		—			—		(2,423	)
Shareholder dividend		—		—			—		—			—		—			(1,620	)		—		(1,620	)
Net income		—		—			—		—			—		—			7,056			—		7,056
Other comprehensive income, net of tax		—		—			—		—			—		—			—			1,673		1,673
Balance, September 30, 2012		—		7,910,609			—	$	(2,803	)	$	117,111	$	(56,532	)	$	72,346		$	4,223	$	134,345

See accompanying notes to unaudited consolidated financial statements

5

EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY

For the Three and Nine Months Ended September 30, 2011

(Unaudited, in thousands, except share data)

Three Months Ended September 30, 2011

	Outstanding Shares																		Accumulated Other
	Series A Preferred Stock		Common Capital Stock			Common Capital Stock		Unearned ESOP Compensation			Additional Paid-In Capital		Treasury Stock			Retained Earnings			Comprehensive Income, Net of Tax			Total
Balance, July 1, 2011		—		8,232,770			—	$	(3,741	)	$	115,263	$	(50,161	)	$	64,118		$	4,055		$	129,534
ESOP shares released		—		—			—		189			60		—			—			—			249
Equity awards		—		1,500			—		—			392		—			—			—			392
Repurchase of common stock		—		(271,828	)		—		—			—		(3,590	)		—			—			(3,590	)
Shareholder dividend		—		—			—		—			—		—			(562	)		—			(562	)
Net income		—		—			—		—			—		—			1,024			—			1,024
Other comprehensive loss, net of tax		—		—			—		—			—		—			—			(1,607	)		(1,607	)
Balance, September 30, 2011		—		7,962,442			—	$	(3,552	)	$	115,715	$	(53,751	)	$	64,580		$	2,448		$	125,440

Nine Months Ended September 30, 2011

	Outstanding Shares																		Accumulated Other
	Series A Preferred Stock		Common Capital Stock			Common Capital Stock		Unearned ESOP Compensation			Additional Paid-In Capital		Treasury Stock			Retained Earnings			Comprehensive Income, Net of Tax			Total
Balance, January 1, 2011		—		8,964,344			—	$	(4,111	)	$	114,472	$	(40,835	)	$	61,364		$	3,821		$	134,711
ESOP shares released		—		—			—		559			139		—			—			—			698
Equity awards		—		1,500			—		—			1,104		—			—			—			1,104
Repurchase of common stock		—		(1,003,402	)		—		—			—		(12,916	)		—			—			(12,916	)
Shareholder dividend		—		—			—		—			—		—			(1,679	)		—			(1,679	)
Net income		—		—			—		—			—		—			4,895			—			4,895
Other comprehensive loss, net of tax		—		—			—		—			—		—			—			(1,373	)		(1,373	)
Balance, September 30, 2011		—		7,962,442			—	$	(3,552	)	$	115,715	$	(53,751	)	$	64,580		$	2,448		$	125,440

See accompanying notes to unaudited consolidated financial statements

6

EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Nine Months Ended September 30, 2012 and 2011

(Unaudited, in thousands)

	2012			2011
Cash flows from operating activities:
Net income from continuing operations	$	7,056		$	4,527
Adjustments to reconcile net income from continuing operations to net cash provided by operating activities:
Depreciation and amortization		599			547
Amortization of bond premium/discount		900			505
Net realized investment gains		(1,511	)		(613	)
Change in equity interest in limited partnerships		(738	)		(291	)
Deferred tax benefit		(1,519	)		(536	)
Stock compensation		1,389			1,825
Intangible asset amortization		605			762
Changes in assets and liabilities:
Accrued investment income		(87	)		84
Premiums receivable		(15,809	)		(13,818	)
Reinsurance recoverable on paid and unpaid losses and loss adjustment expenses		(2,750	)		(860	)
Deferred acquisition costs		(797	)		(1,970	)
Other assets		(1,896	)		(2,127	)
Reserves for unpaid losses and loss adjustment expenses		9,608			8,788
Unearned and advance premium		16,196			15,225
Ceded reinsurance balances payable		(636	)		2,303
Accounts payable and accrued expenses		278			967
Segregated portfolio cell dividend payable		1,243			1,944
Policyholder dividends payable		263			330
Federal income taxes recoverable/payable		(165	)		1,070
Net cash provided by operating activities		12,229			18,662
Cash flows from investing activities:
Purchase of fixed income securities		(37,383	)		(34,903	)
Purchase of equity securities		(7,246	)		(9,646	)
Proceeds from sale of fixed income securities		17,274			30,711
Proceeds from maturities/calls of fixed income securities		9,865			10,858
Proceeds from sale of equity securities		5,582			3,908
Proceeds from sale other long-term investments		1,248			—
Purchase of equipment, net		(617	)		(701	)
Net cash (used in) provided by investing activities		(11,277	)		227
Cash flows from financing activities:
Repurchase of common stock		(2,423	)		(12,916	)
Shareholder dividend		(1,620	)		(1,679	)
Income taxes related to equity awards		11			(23	)
Net cash used in financing activities		(4,032	)		(14,618	)
Net (decrease) increase in cash and cash equivalents		(3,080	)		4,271
Cash and cash equivalents, beginning of period		52,448			45,855
Cash and cash equivalents, end of period	$	49,368		$	50,126

See accompanying notes to unaudited consolidated financial statements.

7

Eastern Insurance Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

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

1. Background and Nature of Operations

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

The Company currently operates in three segments: workers’ compensation insurance, segregated portfolio cell reinsurance, and corporate/other.

2. Significant Accounting Policies

Basis of Presentation

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X of the U.S. Securities and Exchange Commission. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments, being normal, recurring adjustments, necessary for a fair statement of the financial position and results of operations of the Company for the periods presented have been included. The results of operations for an interim period are not necessarily indicative of the results for an entire year. These financial statements should be read in conjunction with the Company’s audited financial statements and notes thereto as of and for the year ended December 31, 2011 included in the Company’s Annual Report on Form 10-K, which was filed with the U.S. Securities and Exchange Commission on March 12, 2012.

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

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

Use of Estimates

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

Recent Accounting Pronouncements

Accounting Standards Update 2012-03

In August 2012, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2012-03, “Technical Amendments and Corrections to SEC Sections: Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin (“SAB”) No. 114, Technical Amendments Pursuant to SEC Release No. 33-9250, and Corrections Related to FASB ASU 2010-22” (“ASU 2012-03). This update amends various SEC paragraphs pursuant to the issuance of SAB No. 114. The adoption of ASU 2012-03 is not expected to have a material impact on the Company’s financial condition or results of operations.

Presentation of Comprehensive Income

In June 2011, the FASB issued ASU 2011-05, “Presentation of Comprehensive Income” (“ASU 2011-05”). ASU 2011-05 requires entities to present net income and comprehensive income in either a single continuous statement or in two separate, but consecutive, statements of net income and other comprehensive income. The option to present items of other comprehensive income in the statement of changes in equity was eliminated. ASU 2011-05 was effective for public entities as of the beginning of a fiscal year that began after December 15, 2011 (including interim periods) and is effective for nonpublic entities for fiscal years ending after December 15, 2012 and interim and annual periods thereafter. Early adoption was permitted and retrospective application is required. The Company adopted ASU 2011-05 effective January 1, 2012. The Company presents comprehensive income in the consolidated statement of operations and comprehensive income; therefore, the adoption of ASU 2011-05 did not change the Company’s presentation of comprehensive income.

8

Fair Value Measurement and Disclosure Requirements

In May 2011, the FASB issued ASU 2011-04, “Fair Value Measurements and Disclosures – Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.” ASU 2011-04 clarifies the application of existing fair value measurement and disclosure requirements, changes certain principles related to measuring fair value, and requires additional disclosures about fair value measurements. ASU 2011-04 was effective for periods beginning after December 15, 2011. The Company adopted ASU 2011-04 effective January 1, 2012. The adoption of ASU 2011-04 did not affect the Company’s financial condition or results of operations.

Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts

In October 2010, the FASB issued ASU 2010-26, “Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts” (“ASU 2010-26”). ASU 2010-26 provides specific types of costs that should be capitalized in connection with the acquisition or renewal of insurance contracts. Those costs include incremental direct costs of contract acquisition incurred in connection with independent third parties and certain costs related to activities performed by the insurer for the contract, including underwriting, policy issuance and processing, medical and inspection, and sales force contract selling. Under ASU 2010-26, costs incurred by an entity related to unsuccessful acquisition or renewal efforts must be charged to expense as incurred. ASU 2010-26 was effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011 and is to be applied prospectively. Retrospective application to all prior periods upon the date of adoption was permitted, but not required. The Company adopted ASU 2010-26 effective January 1, 2012 and applied it prospectively. As a result of adoption, the Company expensed certain underwriting salaries totaling approximately $566 ($368, net of tax) and $1,511 ($982, net of tax) for the three and nine months ended September 30, 2012, respectively, that would have been capitalized under the previous accounting guidance to give effect to unsuccessful acquisition or renewal activities. If the new accounting guidance had been adopted effective January 1, 2011, the Company would have recognized additional expense related to underwriting salaries totaling $340 ($221, net of tax) and $1,278 ($831, net of tax) for the three and nine months ended September 30, 2011, respectively.

3. Earnings Per Share

Basic earnings per share are computed by dividing net income (loss) by the weighted average number of shares outstanding for the respective period. Diluted earnings per share are computed by dividing net income (loss) by the weighted average number of shares outstanding for the period, including dilutive potential common shares outstanding for the period.

Consolidated net income, basic shares outstanding, diluted shares outstanding, basic earnings per share, diluted earnings per share and cash dividends per share for the three and nine months ended September 30, 2012 and 2011 were as follows (unaudited, in thousands, except share and per share data):

	Three Months Ended September 30, 2012			Three Months Ended September 30, 2011			Nine Months Ended September 30, 2012			Nine Months Ended September 30, 2011
Net income for basic and diluted earnings per share	$	2,786		$	1,024		$	7,056		$	4,895
Less: Dividends declared – common and unvested restricted share units		(552	)		(562	)		(1,620	)		(1,679	)
Undistributed earnings		2,234			462			5,436			3,216
Percent allocated to common shareholders		98.1	%		99.3	%		98.1	%		99.3	%
		2,192			459			5,333			3,193
Add: Dividends declared – common shares		543			558			1,589			1,668
	$	2,735		$	1,017		$	6,922		$	4,861
Denominator for basic earnings per share		7,480,526			7,694,403			7,539,870			7,967,230
Effect of dilutive securities		146,340			115,679			139,633			113,124
Denominator for diluted earnings per common share		7,626,866			7,810,082			7,679,503			8,080,354
Basic earnings per share:
Income from continuing operations	$	0.37		$	0.08		$	0.92		$	0.56
Income from discontinued operations		N/A			0.05			N/A			0.05
Diluted earnings per share:
Income from continuing operations	$	0.36		$	0.08		$	0.90		$	0.56
Income from discontinued operations		N/A			0.05			N/A			0.04
Cash dividends per share	$	0.07		$	0.07		$	0.21		$	0.21

9

The following table provides a summary of the equity awards that were not included in the Company’s earnings per share calculation because to do so would have been anti-dilutive (unaudited):

	Three Months Ended September 30, 2012			Three Months Ended September 30, 2011			Nine Months Ended September 30, 2012			Nine Months Ended September 30, 2011
Total outstanding equity awards		1,387,000			1,031,765			1,387,000			1,031,765
Dilutive equity awards		(146,340	)		(115,679	)		(139,633	)		(113,124	)
Equity awards excluded from earnings per share calculation		1,240,660			916,086			1,247,367			918,641

4. Stock-Based Compensation

On February 24, 2012, the Company granted non-qualified stock options and restricted stock awards to certain employees and directors. Stock options and restricted stock awards granted totaled 218,500 and 128,700, respectively, and were issued under the Company’s 2006 Stock Incentive Plan. The closing price of the Company’s common stock on the grant date was $14.45. On May 18, 2012, the Company issued an additional 13,000 restricted stock awards and 17,503 stock options with a grant date fair value of $14.68. The terms of the stock options and restricted stock are consistent with prior grants issued by the Company.

5. Goodwill

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, 2012 to its workers’ compensation insurance segment.

The Company performs its annual goodwill impairment test as of September 30.

For the 2012 annual impairment test, the fair value of the workers’ compensation insurance segment was estimated using a discounted cash flow analysis, using management’s internal five-year forecast for the workers’ compensation insurance segment and a terminal value estimated using 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.

The estimated fair value of the workers’ compensation insurance segment, based on the discounted cash flow analysis, exceeded its carrying value as of September 30, 2012; therefore, goodwill was considered not impaired, and the second step of the impairment test was not necessary.

6. 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 sheets as of September 30, 2012 and December 31, 2011:

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 can 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, corporate bonds, mortgage-backed securities, collateralized mortgage obligations, asset-backed securities, 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.

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The following table provides a summary of the fair value measurements of the Company’s fixed income securities, convertible bonds, and equity securities, as of September 30, 2012 (unaudited) and December 31, 2011, excluding the segregated portfolio cell reinsurance segment (in thousands):

			Fair Value Measurements at Reporting Date Using
	9/30/12		Level 1		Level 2		Level 3
Fixed income securities – available for sale:
U.S. Treasuries and government agencies	$	16,937	$	12,712	$	4,225	$	—
States, municipalities, and political subdivisions		47,445		—		47,445		—
Corporate securities		18,795		—		18,795		—
Residential mortgage-backed securities		21,293		—		21,293		—
Commercial mortgage-backed securities		169		—		169		—
Collateralized mortgage obligations		11,561		—		11,561		—
Other structured securities		1,027		—		1,027		—
Convertible bonds		18,866		—		18,866		—
Equity securities – available for sale		14,314		14,314		—		—
Total	$	150,407	$	27,026	$	123,381	$	—

			Fair Value Measurements at Reporting Date Using
	12/31/11		Level 1		Level 2		Level 3
Fixed income securities – available for sale:
U.S. Treasuries and government agencies	$	16,143	$	9,676	$	6,467	$	—
States, municipalities, and political subdivisions		42,316		—		42,316		—
Corporate securities		21,509		—		21,509		—
Residential mortgage-backed securities		22,360		—		22,360		—
Commercial mortgage-backed securities		206		—		206		—
Collateralized mortgage obligations		5,876		—		5,876		—
Other structured securities		1,023		—		1,023		—
Convertible bonds		17,574		—		17,574		—
Equity securities – available for sale		12,939		12,939		—		—
Total	$	139,946	$	22,615	$	117,331	$	—

There were no transfers between Level 1 and Level 2 securities for the three and nine months ended September 30, 2012.

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. 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 did not adjust security prices during the three or nine months ended September 30, 2012 and 2011. Management has controls in place to validate the reasonableness of fair values provided by the independent pricing service, including testing the fair value of a sample of securities on a quarterly basis by comparing fair values from different pricing sources. Fixed income securities include U.S. Treasuries, agencies backed by the U.S. Government, municipal bonds, corporate bonds, mortgage-backed securities, collateralized mortgage obligations, and asset-backed securities.

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 exchange traded funds for which there is an active market and quoted market prices; therefore, the Company has classified its exchange traded funds as Level 1 securities. The estimated fair values of the Company’s exchange traded funds are based on net asset value (“NAV”) per share. The Company’s exchange traded funds include a large value fund, a large growth fund, a foreign large value fund, a foreign large growth fund, a foreign large blend fund, and two diversified emerging markets funds.

Other long-term investments include the Company’s interest in various limited partnerships, including a low volatility multi-strategy fund of funds, a natural resource limited partnership, a structured finance opportunity fund, and an open-ended investment fund. The Company records its investment in the limited partnerships using the equity method. The carrying value of the Company’s limited

11

partnership investments are based on the Company’s allocable share of the limited partnerships’ NAV. Changes in the Company’s investments are based on statements received directly from the limited partnership and/or the limited partnership’s administrator. The estimated fair values of the underlying investments in the limited partnerships may be based on Level 1, Level 2, or Level 3 inputs, or a combination thereof.

As of September 30, 2012 and December 31, 2011, the estimated fair values of the Company’s limited partnership investments, by investment strategy, were as follows (unaudited, in thousands):

	9/30/12		12/31/11
Multi-strategy fund of funds	$	5,931	$	5,578
Natural resources		—		1,262
Structured finance opportunity fund		3,127		2,769
Open-ended investment fund		646		600
Total	$	9,704	$	10,209

The activity in the Company’s limited partnership investments for the three and nine months ended September 30, 2012 and 2011 was as follows (unaudited, in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Balance, beginning of period	$	10,657		$	12,080		$	10,209		$	11,435
Contributions		—			—			—			—
Withdrawals		(1,243	)		—			(1,243	)		—
Unrealized change in interest		290			(354	)		738			291
Balance, end of period	$	9,704		$	11,726		$	9,704		$	11,726

The change in interest in the Company’s limited partnership investments is included in the change in equity interest in limited partnerships in the consolidated statements of operations and comprehensive income.

7. Investments

The following tables provide the amortized cost and estimated fair value of the Company’s fixed income and equity securities as of September 30, 2012 and December 31, 2011 (unaudited, in thousands):

September 30, 2012	Cost or Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
U.S. Treasuries and government agencies	$	19,661	$	516	$	—		$	20,177
States, municipalities, and political subdivisions		44,426		3,021		(2	)		47,445
Corporate securities		41,605		940		—			42,545
Residential mortgage-backed securities		20,219		1,074		—			21,293
Commercial mortgage-backed securities		148		21		—			169
Collateralized mortgage obligations		11,392		181		(12	)		11,561
Other structured securities		1,000		27		—			1,027
Total fixed income securities		138,451		5,780		(14	)		144,217
Equity securities		18,549		2,802		(32	)		21,319
Total fixed income and equity securities	$	157,000	$	8,582	$	(46	)	$	165,536

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December 31, 2011	Cost or Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
U.S. Treasuries and government agencies	$	15,524	$	619	$	—		$	16,143
States, municipalities, and political subdivisions		39,904		2,416		(4	)		42,316
Corporate securities		44,748		752		(2	)		45,498
Residential mortgage-backed securities		21,499		861		—			22,360
Commercial mortgage-backed securities		187		19		—			206
Collateralized mortgage obligations		5,753		134		(11	)		5,876
Other structured securities		1,004		19		—			1,023
Total fixed income securities		128,619		4,820		(17	)		133,422
Equity securities		16,566		1,546		(483	)		17,629
Total fixed income and equity securities	$	145,185	$	6,366	$	(500	)	$	151,051

Corporate securities include an investment in a fixed income mutual fund, held by the segregated portfolio cell reinsurance segment, with a cost and estimated fair value of 23,623 and $23,750, respectively, as of September 30, 2012. The fixed income mutual fund’s investment objective is to provide a total return that is consistent with the preservation of capital through investing in high grade U.S. Dollar fixed income securities with a maximum maturity not exceeding five years.

Other structured securities include other asset-backed securities collateralized by auto loan receivables, equipment and manufactured homes.

	Less Than 12 Months							12 Months or More							Total
September 30, 2012	Estimated Fair Value		Gross Unrealized Losses			# of Securities		Estimated Fair Value		Gross Unrealized Losses			# of Securities		Estimated Fair Value		Gross Unrealized Losses			# of Securities
States, municipalities, and political subdivisions	$	436	$	(2	)		2	$	—	$	—			—	$	436	$	(2	)		2
Collateralized mortgage obligations		1,244		(9	)		2		172		(3	)		2		1,416		(12	)		4
Total fixed income securities		1,680		(11	)		4		172		(3	)		2		1,852		(14	)		6
Equity securities		852		(32	)		2		—		—			—		852		(32	)		2
Total fixed income and equity securities	$	2,532	$	(43	)		6	$	172	$	(3	)		2	$	2,704	$	(46	)		8

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 sheets and consolidated statement of operations and comprehensive income (loss), 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.

	Less Than 12 Months							12 Months or More						Total
December 31, 2011	Estimated Fair Value		Gross Unrealized Losses			# of Securities		Estimated Fair Value		Gross Unrealized Losses		# of Securities		Estimated Fair Value		Gross Unrealized Losses			# of Securities
States, municipalities, and political subdivisions	$	1,604	$	(4	)		4	$	—	$	—		—	$	1,604	$	(4	)		4
Collateralized mortgage obligations		375		(11	)		2		—		—		—		375		(11	)		2
Total fixed income securities		1,979		(15	)		6		—		—		—		1,979		(15	)		6
Equity securities		3,302		(374	)		6		—		—		—		3,302		(374	)		6
Total fixed income and equity securities	$	5,281	$	(389	)		12	$	—	$	—		—	$	5,281	$	(389	)		12

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Management has evaluated the unrealized losses related to its fixed income securities and determined that they are primarily due 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 September 30, 2012.

Management has evaluated the unrealized losses related to its equity securities and determined that they are primarily related to the current market conditions and not due to underlying issues related to the issuer or the industry in which the issuer operates. The equity securities have been in an unrealized loss position for less than twelve months and none of the securities had an estimated fair value less than 80% of its cost basis. The Company does not intend to sell the equity securities and it is not more likely than not that the Company will be required to sell the equity securities before recovery of their cost bases; therefore, management does not consider the equity securities to be other-than-temporarily impaired as of September 30, 2012.

The Company recognized an other-than-temporary impairment of $40,000 related to one equity security during the three months ended September 30, 2012. The Company recognized other-than-temporary impairments of $127,000 related to two equity securities during nine months ended September 30, 2012. The impairments related equity securities that had been in an unrealized loss position for more than 12 months. The Company did not recognize any other-than-temporary impairments for the three and nine months ended September 30, 2011.

8. Reserves for Unpaid Losses and Loss Adjustment Expenses

The following table provides a summary of the activity in the Company’s reserves for unpaid losses and LAE for the three and nine months ended September 30, 2012 and 2011 (unaudited, in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Balance, beginning of period	$	111,521		$	100,637		$	106,077		$	95,963
Reinsurance recoverables on unpaid losses and LAE		14,539			8,484			11,805			7,864
Net balance, beginning of period		96,982			92,153			94,272			88,099
Incurred related to:
Current year		28,549			21,823			76,877			62,208
Prior year		(700	)		(772	)		(542	)		(992	)
Total incurred		27,849			21,051			76,335			61,216
Paid related to:
Current year		13,181			8,906			25,246			19,465
Prior year		10,952			8,599			44,663			34,151
Total paid		24,133			17,505			69,909			53,616
Net balance, end of period		100,698			95,699			100,698			95,699
Reinsurance recoverables on unpaid losses and LAE		14,987			9,052			14,987			9,052
Balance, end of period	$	115,685		$	104,751		$	115,685		$	104,751

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Incurred losses by segment were as follows for the three and nine months ended September 30, 2012 and 2011, respectively (unaudited, in thousands):

Three Months Ended September 30, 2012

September 30, 2012	Workers’ Compensation Insurance Segment			Segregated Portfolio Cell Reinsurance Segment			Total
Incurred related to:
Current year, gross of discount	$	22,544		$	6,327		$	28,871
Current period discount		(179	)		(143	)		(322	)
Prior year, gross of discount		—			(781	)		(781	)
Accretion of prior period discount		—			81			81
Total incurred	$	22,365		$	5,484		$	27,849

Three Months Ended September 30, 2011

September 30, 2011	Workers’ Compensation Insurance Segment			Segregated Portfolio Cell Reinsurance Segment			Total
Incurred related to:
Current year, gross of discount	$	17,000		$	5,467		$	22,467
Current period discount		(474	)		(170	)		(644	)
Prior year, gross of discount		—			(1,260	)		(1,260	)
Accretion of prior period discount		370			118			488
Total incurred	$	16,896		$	4,155		$	21,051

Nine Months Ended September 30, 2012

September 30, 2012	Workers’ Compensation Insurance Segment			Segregated Portfolio Cell Reinsurance Segment			Total
Incurred related to:
Current year, gross of discount	$	61,979		$	17,384		$	79,363
Current period discount		(1,929	)		(557	)		(2,486	)
Prior year, gross of discount		—			(2,361	)		(2,361	)
Accretion of prior period discount		1,430			389			1,819
Total incurred	$	61,480		$	14,855		$	76,335

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Nine Months Ended September 30, 2011

September 30, 2011	Workers’ Compensation Insurance Segment			Segregated Portfolio Cell Reinsurance Segment			Total
Incurred related to:
Current year, gross of discount	$	49,912		$	14,691		$	64,603
Current period discount		(1,819	)		(576	)		(2,395	)
Prior year, gross of discount		—			(2,691	)		(2,691	)
Accretion of prior period discount		1,159			540			1,699
Total incurred	$	49,252		$	11,964		$	61,216

The Company recognized favorable development in its segregated portfolio cell reinsurance segment of $781 and $2,361 for the three and nine months ended September 30, 2012, compared to favorable development of $1,260 and $2,691 for the same periods in 2011. The favorable development primarily reflects the impact of claim settlements for amounts at, or less than, previously established case and IBNR reserves. Prior period reserve development in the segregated portfolio cell reinsurance segment results in an increase or decrease in the segment’s losses and LAE incurred, and a corresponding decrease or increase in the segregated portfolio cell dividend expense.

For the three and nine months ended September 30, 2012, the estimates of ultimate losses and LAE for prior accident periods produced from our actuarial methods were reasonably consistent with the estimates we prepared as of June 30, 2012 and December 31, 2011, and therefore we have not changed our best estimate of these amounts. Accordingly, the Company did not recognize any development on prior accident period workers compensation insurance reserves for the three and nine months ended September 30, 2012.

9. Segment Information

The Company currently operates in three business segments.

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, deductible policies and alternative market programs.

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, asset management and segregated portfolio management services. The Company outsources the asset management and segregated portfolio cell management services to a third party. 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 following table provides the fee revenue generated by the segregated portfolio cell reinsurance segment and included in the Company’s workers’ compensation insurance and corporate/other segments for the three and nine months ended September 30, 2012 and 2011, respectively (unaudited, in thousands):

	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
Workers’ compensation insurance segment	$	1,231	$	840	$	4,095	$	2,664
Corporate/other segment		194		543		629		1,597
Total	$	1,425	$	1,383	$	4,724	$	4,261

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The fee revenue earned by the workers’ compensation insurance and corporate/other segments are included in acquisition and other underwriting expenses in the consolidated statements of operations and comprehensive income (loss).

The Company is a preferred shareholder in certain of the segregated portfolio cells. For those segregated portfolio cells in which the Company participates, the Company shares in the operating and investment results of those cells and recognizes its share of the segregated portfolio dividend in the consolidated statements of operations and comprehensive income.

The Company’s share of the segregated portfolio dividend, which is included in the corporate/other segment, was as follows for the three and six months ended September 30, 2012 and 2011, respectively (unaudited, in thousands):

	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
Segregated portfolio dividend income	$	256	$	110	$	778	$	648

Corporate/Other

The corporate/other segment primarily includes the expenses of the holding company, the third party administration activities of the Company, and the results of operations of Eastern Re, as well as certain eliminations necessary to reconcile the segment information to the consolidated statements of operations and comprehensive income (loss). The Company cancelled the remaining reinsurance contracts at Eastern Re in 1999 on a run-off basis and continues to have exposure for outstanding claims as of September 30, 2012. The corporate/other segment also included the Company’s interest in a segregated portfolio cell with an unaffiliated primary carrier that wrote insurance coverage for sprinkler contractors, known as “SprinklerPro”. The Company non-renewed the SprinklerPro contract on a run-off basis effective April 1, 2009. The Company commuted the SprinklerPro contract during the second quarter of 2012 and recognized a realized loss of $641,000 related to the commutation.

The following table represents the segment results for the three months ended September 30, 2012 (unaudited, in thousands):

	Workers’ Compensation Insurance		Segregated Portfolio Cell Reinsurance		Corporate/ Other			Total
Revenue:
Net premiums earned	$	33,181	$	8,216	$	—		$	41,397
Net investment income		749		75		68			892
Change in equity interest in limited partnerships		258		—		32			290
Net realized investment (losses) gains		1,022		40		(39	)		1,023
Other revenue		—		—		84			84
Total revenue		35,210		8,331		145			43,686
Expenses:
Losses and LAE incurred		22,365		5,484		—			27,849
Acquisition and other underwriting expenses		3,198		2,482		(194	)		5,486
Other expenses		5,090		54		1,080			6,224
Amortization of intangibles		—		—		202			202
Policyholder dividend expense		467		26		—			493
Segregated portfolio dividend expense		—		285		(256	)		29
Total expenses		31,120		8,331		832			40,283
Income (loss) from continuing operations before income taxes		4,090		—		(687	)		3,403
Income tax expense (benefit) from continuing operations		1,003		—		(386	)		617
Net income (loss) from continuing operations	$	3,087	$	—	$	(301	)	$	2,786
Total assets	$	332,694	$	68,124	$	(21,875	)	$	378,943

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The following table represents the segment results for the three months ended September 30, 2011 (unaudited, in thousands):

	Workers’ Compensation Insurance			Segregated Portfolio Cell Reinsurance			Corporate/ Other			Total
Revenue:
Net premiums earned	$	26,388		$	7,529		$	—		$	33,917
Net investment income		808			99			106			1,013
Change in equity interest in limited partnerships		(269	)		—			(85	)		(354	)
Net realized investment (losses) gains		(1,436	)		(22	)		152			(1,306	)
Other revenue		—			—			86			86
Total revenue		25,491			7,606			259			33,356
Expenses:
Losses and LAE incurred		16,896			4,155			—			21,051
Acquisition and other underwriting expenses		1,903			2,270			(543	)		3,630
Other expenses		4,106			56			2,103			6,265
Amortization of intangibles		—			—			254			254
Policyholder dividend expense		196			8			—			204
Segregated portfolio dividend expense		—			1,117			(110	)		1,007
Total expenses		23,101			7,606			1,704			32,411
Income (loss) from continuing operations before income taxes		2,390			—			(1,445	)		945
Income tax expense (benefit) from continuing operations		875			—			(586	)		289
Net income (loss) from continuing operations	$	1,515		$	—		$	(859	)	$	656
Total assets	$	301,443		$	61,225		$	(20,728	)	$	341,940

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The following table represents the segment results for the nine months ended September 30, 2012 (unaudited, in thousands):

	Workers’ Compensation Insurance		Segregated Portfolio Cell Reinsurance		Corporate/ Other			Total
Revenue:
Net premiums earned	$	92,818	$	23,800	$	—		$	116,618
Net investment income		2,385		249		272			2,906
Change in equity interest in limited partnerships		620		—		118			738
Net realized investment gains		1,618		506		(613	)		1,511
Other revenue		—		—		239			239
Total revenue		97,441		24,555		16			122,012
Expenses:
Losses and LAE incurred		61,480		14,855		—			76,335
Acquisition and other underwriting expenses		8,793		7,227		(629	)		15,391
Other expenses		14,790		218		3,111			18,119
Amortization of intangibles		—		—		605			605
Policyholder dividend expense		652		63		—			715
Segregated portfolio dividend expense		—		2,192		(778	)		1,414
Total expenses		85,715		24,555		2,309			112,579
Income (loss) from continuing operations before income taxes		11,726		—		(2,293	)		9,433
Income tax expense (benefit) from continuing operations		3,278		—		(901	)		2,377
Net income (loss) from continuing operations	$	8,448	$	—	$	(1,392	)	$	7,056
Total assets	$	332,694	$	68,124	$	(21,875	)	$	378,943

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The following table represents the segment results for the nine months ended September 30, 2011 (unaudited, in thousands):

	Workers’ Compensation Insurance		Segregated Portfolio Cell Reinsurance		Corporate/ Other			Total
Revenue:
Net premiums earned	$	75,089	$	20,913	$	—		$	96,002
Net investment income		2,568		351		28			2,947
Change in equity interest in limited partnerships		273		—		18			291
Net realized investment gains		204		45		251			500
Other revenue		—		—		348			348
Total revenue		78,134		21,309		645			100,088
Expenses:
Losses and LAE incurred		49,252		11,964		—			61,216
Acquisition and other underwriting expenses		5,678		6,275		(1,597	)		10,356
Other expenses		11,839		205		6,153			18,197
Amortization of intangibles		—		—		762			762
Policyholder dividend expense		802		21		—			823
Segregated portfolio dividend expense		—		2,844		(648	)		2,196
Total expenses		67,571		21,309		4,670			93,550
Income (loss) from continuing operations before income taxes		10,563		—		(4,025	)		6,538
Income tax expense (benefit) from continuing operations		3,520		—		(1,509	)		2,011
Net income (loss) from continuing operations	$	7,043	$	—	$	(2,516	)	$	4,527
Total assets	$	301,443	$	61,225	$	(20,728	)	$	341,940

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10. Segregated Portfolio Cell Reinsurance Segment

The segregated portfolio cell reinsurance segment’s assets and liabilities as of September 30, 2012 (unaudited) and December 31, 2011 (unaudited), which are included in the Company’s consolidated balance sheets, were as follows:

	September 30 2012		December 31 2011
ASSETS
Investments:
Fixed income securities, at estimated fair value (amortized cost, $26,862; $23,991)	$	26,990	$	23,989
Equity securities, at estimated fair value (cost, $6,504; $4,305)		7,005		4,690
Total investments		33,995		28,679
Cash and cash equivalents		5,679		8,696
Reinsurance recoverable on paid and unpaid losses and LAE		5,290		2,517
Deferred acquisition costs		4,439		3,746
Other assets		4,579		3,938
Due from affiliates, net		14,142		11,699
Total assets	$	68,124	$	59,275
LIABILITIES
Reserves for unpaid losses and LAE	$	28,317	$	24,762
Unearned premium reserves		16,528		13,458
Accounts payable and accrued expenses		145		153
Segregated portfolio cell dividend payable		17,263		15,774
Policyholder dividends payable		128		66
Due to affiliates, net		5,718		5,037
Total liabilities		68,099		59,250
SHAREHOLDERS’ EQUITY
Preferred stock outstanding		25		25
Total shareholders’ equity		25		25
Total liabilities and shareholders’ equity	$	68,124	$	59,275

11. Commitments and Contingencies

Legal Proceedings

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

AIG Arbitration

On September 6, 2011, the Company served a written demand (the “Arbitration Demand”) initiating arbitration proceedings against various AIG Companies under 24 reinsurance treaties pursuant to which the Company reinsured AIG Companies for certain pollution liability risks related to underground storage tanks for the policy years 1990 through 1999 (the “Treaties”). The Treaties were cancelled by Eastern Re in 1999. In the Arbitration Demand, the Company seeks an award from the arbitration panel compelling AIG Companies to permit the Company to examine the bases for certain paid losses and loss reserves ceded by AIG Companies to Eastern Re under the Treaties. The Company believes that the Treaties permit such an audit.

On October 3, 2011, AIG Companies responded to the Arbitration Demand by advising that they will seek an award from the arbitration panel of approximately $1.9 million plus future amounts that may become due under the Treaties before the final hearing in the arbitration. Both the Company and AIG Companies seek attorney’s fees and costs in the arbitration.

Both the Company and AIG Companies have appointed arbitrators. The parties are currently in the process of attempting to select an umpire.

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The arbitration proceedings initiated by the Company against AIG Companies are on-going and there has been no further action in 2012 related to the arbitration process.

During the first quarter of 2012, the Company received quarterly claims data from AIG Companies that reflected unfavorable claim development under the reinsurance treaties. The Company is unable to substantiate the reliability of the claims data reported by AIG Companies and, as a result, has not adjusted its consolidated financial statements for the amounts reported by AIG Companies. The Company continues to believe it has adequately reserved the claims at issue.

The Company commenced an audit of the claims covered under the Treaties during the third quarter of 2012. The claim audit is on-going and there has been no additional information yet reported by the auditors that would cause the Company to revise its estimates or position with respect to the pending arbitration.

It is reasonably possible that the final outcome of the arbitration could go against the Company, which could result in a material, adverse effect on the Company’s results of operations and financial condition.

12. Subsequent Events

Management performed an evaluation of subsequent events through the issuance date of the consolidated financial statements 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 September 30, 2012.

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

The following discussion and analysis of financial condition and results of operations should be read in conjunction with the unaudited interim consolidated financial statements of Eastern Insurance Holdings, Inc. (the “Company”) and the related notes thereto included in Item 1 of this Part 1. The information contained in this quarterly report is not a complete description of the Company’s business or the risks associated with an investment in the Company’s common stock. You should carefully review and consider the various disclosures made by the Company in this quarterly report and in the Company’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 12, 2012.

Forward-looking Statements

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

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

• the ability to carry out 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 FASB or other standard setting bodies;

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

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

• adverse litigation or arbitration results including, without limitation, the AIG Arbitration; and

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

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

Overview

The Company reported net income from continuing operations of $2.8 million and $7.1 million for the three and nine months ended September 30, 2012, compared to net income from continuing operations of $656,000 and $4.5 million for the same periods in 2011. The Company’s consolidated combined ratio was 97.2% and 95.3% for the three and nine months ended September 30, 2012, compared to 92.6% and 95.2% for the same periods in 2011.

The Company’s results of operations for the three and nine months ended September 30, 2012, when compared to the same periods in 2011, reflect the following:

• Net premiums earned increased 22.1% and 21.5% for the three and nine months ended September 30, 2012, compared to the same period in 2011. The increase primarily reflects new business writings, an increase in audit premium and renewal rate increases, partially offset by a decrease in the renewal retention rate.

• Net realized investment gains (losses) for the three and nine months ended September 30, 2012 reflect an increase in the estimated fair value of the Company’s convertible bond portfolio of $589,000 and $803,000 for the three and nine months ended September 30, 2012, compared to a decrease in the estimated fair value of $1.5 million for the same periods in 2011. Net realized investment gains for the nine months ended September 30, 2012 include a realized loss of $641,000 related to the commutation of the SprinklerPro contract during the second quarter.

• The increase in the combined ratio from 2011 to 2012 primarily reflects an increase in the accident period loss ratio in both the workers’ compensation insurance and segregated portfolio cell reinsurance segments. The consolidated expense ratio decreased from 2011 to 2012, primarily reflecting the increase in net premiums earned and a decrease in stock compensation expense, partially offset by the change in accounting related to deferred acquisition costs.

• Effective January 1, 2012, the Company adopted ASU 2010-26, which resulted in a decrease in the amount of underwriting salaries capitalized and deferred over the life of the underlying workers’ compensation insurance policies. The change in accounting resulted in the Company expensing underwriting salaries of approximately $566,000 ($368,000, net of tax) and $1,511,000 ($982,000 net of tax) for the three and nine months ended September 30, 2012 that would have been capitalized and deferred prior to the adoption of ASU 2010-26. The adoption of ASU 2012-26 increased the Company’s consolidated expense ratio by 1.4 and 1.3 percentage points for the three and nine months ended September 30, 2012, respectively.

Principal Revenue and Expense Items

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

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

Net premiums earned.Net premiums earned are the earned portion of the Company’s net premiums written. Premiums are earned over the term of the related policies. At the end of each accounting period, the portion of the premiums that are not yet earned are included in unearned premiums and are realized as revenue in subsequent periods over the remaining term of the policy. The Company’s workers’ compensation policies typically have a term of twelve months. Thus, for example, for a policy that is written on July 1, 2011, one-half of the premiums would be earned in 2011 and the other half would be earned in 2012. 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 (or returned to insureds as a result of payroll reductions) 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.

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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 loss adjustment expenses) in cash, cash equivalents, fixed income securities, convertible bonds, equity securities, and other long-term investments. Investment income includes interest earned on invested assets, including the impact 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 from prior periods, and (3) costs associated with investigating, defending and adjusting claims.

Acquisition and other underwriting expenses.In the workers’ compensation insurance segment, expenses incurred to underwrite risks are referred to as acquisition and other underwriting expenses, which consist of commissions, premium taxes and fees and other underwriting expenses incurred in acquiring, writing and administering the Company’s business. 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 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 tax return. Deferred tax expense represents the change in the Company’s net deferred tax asset, exclusive of the tax effect related to changes in unrealized gains and losses in the Company’s investment portfolio and changes in the unrecognized amounts related to the Company’s benefit plan liabilities.

Key Financial Measures

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

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

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

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

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

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

Critical Accounting Policies and Estimates

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

Reserves for Unpaid Losses and LAE

The Company establishes reserves for unpaid losses and LAE for its workers’ compensation insurance, segregated portfolio cell reinsurance 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 continues to be a complex and imprecise process, requiring the use of informed estimates and judgments. The Company’s estimates and judgments may be revised as additional experience and other data becomes available and are reviewed, as new or improved methodologies are developed, or as current laws change. Any such revisions could result in future changes in estimates of losses or reinsurance recoverable and would be reflected in the Company’s results of operations in the period in which the estimates are changed. Estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates and judgments using data currently available. If ultimate losses, net of reinsurance, prove to be substantially higher than the amounts recorded as of September 30, 2012, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.

The Company discounts its workers’ compensation reserves, using a discount rate of approximately 3.0%. As of September 30, 2012 and December 31, 2011, the Company’s reserves for unpaid losses and LAE were reduced by $6.2 million and $5.7 million, respectively, related to the effects of discounting.

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The Company’s reserves for unpaid losses and LAE in its workers’ compensation insurance, segregated portfolio cell reinsurance and corporate/other segments as of September 30, 2012 (unaudited) and December 31, 2011 are summarized below (in thousands):

September 30, 2012	Workers’ Compensation Insurance Segment			Segregated Portfolio Cell Reinsurance Segment			Corporate/ Other		Total
Case / tabular reserves	$	44,754		$	8,785		$	—	$	53,539
Case incurred development, IBNR, and unallocated LAE reserves		38,020			15,157			206		53,383
Amount of discount		(5,027	)		(1,197	)		—		(6,224	)
Net reserves		77,747			22,745			206		100,698
Reinsurance recoverables on unpaid losses and LAE		9,415			5,572			—		14,987
Reserves for unpaid losses and LAE	$	87,162		$	28,317		$	206	$	115,685

December 31, 2011	Workers’ Compensation Insurance Segment			Segregated Portfolio Cell Reinsurance Segment			Corporate/ Other		Total
Case / tabular reserves	$	39,380		$	10,229		$	—	$	49,609
Case incurred development, IBNR, and unallocated LAE reserves		37,249			12,931			206		50,386
Amount of discount		(4,527	)		(1,196	)		—		(5,723	)
Net reserves		72,102			21,964			206		94,272
Reinsurance recoverables on unpaid losses and LAE		9,007			2,798			—		11,805
Reserves for unpaid losses and LAE	$	81,109		$	24,762		$	206	$	106,077

“Other Than Temporary” Investment Impairments

Unrealized investment gains or losses on investments carried at estimated fair value, net of applicable income taxes, are reflected directly in shareholders’ equity as a component of accumulated other 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 at the balance sheet date. The amount written down is recorded as a realized loss in the consolidated statements of operations and comprehensive income (loss). 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. The Company recognized other-than-temporary impairments, excluding impairments in the segregated portfolio cell reinsurance segment, of $40,000 and $127,000 during the three and nine months ended September 30, 2012. There were no impairments during the three and nine months ended September 30, 2011. There were no other-than-temporary impairments in the segregated portfolio cell reinsurance segment during the three and nine months ended September 30, 2012. Other-than-temporary impairments in the segregated portfolio cell reinsurance segment totaled $35,000 and $36,000 for the three and nine months ended September 30, 2011, respectively.

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.

The Company recognized an other-than-temporary impairment of $40,000 related to one equity security during the three months ended September 30, 2012. The Company recognized other-than-temporary impairments of $127,000 related to two equity securities during nine months ended September 30, 2012. The impairments related equity securities that had been in an unrealized loss position for more than 12 months. The Company did not recognize any other-than-temporary impairments related to its equity security portfolio for the three and nine months ended September 30, 2011.

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As of September 30, 2012, the Company held equity securities, excluding equity securities in the segregated portfolio cell reinsurance segment, with gross unrealized losses of $32,000, none of which were in an unrealized loss position for more than twelve months. The Company does not intend to sell the equity securities and it is not more likely than not that the Company will be required to sell the equity securities before recovery of their cost bases; therefore, management does not consider the equity securities to be other-than-temporarily impaired as of September 30, 2012. Adverse investment market conditions, or poor operating results of underlying investments, could result in impairment charges in the future.

Fixed income securities. A fixed income security is considered to be other-than-temporarily impaired when the security’s estimated 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.

There were no other-than-temporary impairments related to the Company’s fixed income security portfolio during the three and nine months ended September 30, 2012 or 2011.

As of September 30, 2012, the Company held fixed income securities, excluding fixed income securities in the segregated portfolio cell reinsurance segment, with gross unrealized losses of $14,000, of which $3,000 were in an unrealized loss position for more than twelve months. Management has evaluated the unrealized losses related to those fixed income securities and determined that they are primarily due 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 September 30, 2012. Adverse investment market conditions, or poor operating results of underlying investments, could result in impairment charges in the future.

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 limited partnerships in the consolidated statement of operations and comprehensive income (loss).

There were no other-than-temporary impairments related to the Company’s limited partnership investments during the three and nine months ended September 30, 2012 or 2011.

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, 2012 to its workers’ compensation insurance segment.

The Company performs its annual goodwill impairment test as of September 30.

For the 2012 annual impairment test, the fair value of the workers’ compensation insurance segment was estimated using a discounted cash flow analysis, using management’s internal five-year forecast for the workers’ compensation insurance segment and a terminal value estimated using 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.

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The estimated fair value of the workers’ compensation insurance segment, based on the discounted cash flow analysis, exceeded its carrying value as of September 30, 2012; therefore, goodwill was considered not impaired, and the second step of the impairment test 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 an estimated 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 September 30, 2012, the Company recorded a net deferred tax asset of $2.6 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 September 30, 2012, the Company has not recognized any future tax benefit related to its foreign operations at Eastern Re. The unrecognized tax benefit, which represents the excess of the tax basis over the amount for financial reporting (i.e., outside basis difference) of Eastern Re, was $10.7 million as of September 30, 2012. 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.

Reinsurance Recoverables

Amounts recoverable from the Company’s reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Amounts paid for reinsurance contracts are expensed over the contract period during which insured events are covered by the reinsurance contracts. Reinsurance balances recoverable on paid and unpaid 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.

Recent Accounting Pronouncements

Accounting Standards Update 2012-03

In August 2012, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2012-03, “Technical Amendments and Corrections to SEC Sections: Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin (“SAB”) No. 114, Technical Amendments Pursuant to SEC Release No. 33-9250, and Corrections Related to FASB ASU 2010-22” (“ASU 2012-03). This update amends various SEC paragraphs pursuant to the issuance of SAB No. 114. The adoption of ASU 2012-03 is not expected to have a material impact on the Company’s financial condition or results of operations.

Presentation of Comprehensive Income

In June 2011, the FASB issued ASU 2011-05, “Presentation of Comprehensive Income” (“ASU 2011-05”). ASU 2011-05 requires entities to present net income and comprehensive income in either a single continuous statement or in two separate, but consecutive, statements of net income and other comprehensive income. The option to present items of other comprehensive income in the statement of changes in equity was eliminated. ASU 2011-05 was effective for public entities as of the beginning of a fiscal year that began after December 15, 2011 (including interim periods) and is effective for nonpublic entities for fiscal years ending after December 15, 2012 and interim and annual periods thereafter. Early adoption was permitted and retrospective application is required. The Company adopted ASU 2011-05 effective January 1, 2012. The Company presents comprehensive income in the consolidated statement of operations and comprehensive income; therefore, the adoption of ASU 2011-05 did not change the Company’s presentation of comprehensive income.

Fair Value Measurement and Disclosure Requirements

In May 2011, the FASB issued ASU 2011-04, “Fair Value Measurements and Disclosures – Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.” ASU 2011-04 clarifies the application of existing fair value measurement and disclosure requirements, changes certain principles related to measuring fair value, and requires additional disclosures about fair value measurements. ASU 2011-04 was effective for periods beginning after December 15, 2011. The Company adopted ASU 2011-04 effective January 1, 2012. The adoption of ASU 2011-04 did not affect the Company’s financial condition or results of operations.

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Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts

In October 2010, the FASB issued ASU 2010-26, “Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts” (“ASU 2010-26”). ASU 2010-26 provides specific types of costs that should be capitalized in connection with the acquisition or renewal of insurance contracts. Those costs include incremental direct costs of contract acquisition incurred in connection with independent third parties and certain costs related to activities performed by the insurer for the contract, including underwriting, policy issuance and processing, medical and inspection, and sales force contract selling. Under ASU 2010-26, costs incurred by an entity related to unsuccessful acquisition or renewal efforts must be charged to expense as incurred. ASU 2010-26 was effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011 and is to be applied prospectively. Retrospective application to all prior periods upon the date of adoption was permitted, but not required. The Company adopted ASU 2010-26 effective January 1, 2012 and applied it prospectively. As a result of adoption, the Company expensed certain underwriting salaries totaling approximately $566,000 ($368,000, net of tax) and $1,511,000 ($982,000 net of tax) for the three and nine months ended September 30, 2012, respectively, that would have been capitalized under the previous accounting guidance to give effect to unsuccessful acquisition or renewal activities. If the new accounting guidance had been adopted effective January 1, 2011, the Company would have recognized additional expense related to underwriting salaries totaling $340,000 ($221,000, net of tax) and $1,278,000 ($831,000 net of tax) for the three and nine months ended September 30, 2011, respectively.

RESULTS OF OPERATIONS

The major components of consolidated revenue were as follows for the three and nine months ended September 30, 2012 and 2011 (unaudited, in thousands):

	Three Months Ended September 30,					Nine Months Ended September 30,
	2012		2011			2012		2011
Net premiums written	$	45,026	$	37,863		$	133,396	$	111,621
Net premiums earned		41,397		33,917			116,618		96,002
Net investment income		892		1,013			2,906		2,947
Change in equity interest in limited partnerships		290		(354	)		738		291
Net realized investment gains (losses)		1,023		(1,306	)		1,511		500
Other revenue		84		86			239		348
Consolidated revenue	$	43,686	$	33,356		$	122,012	$	100,088

The increase in consolidated revenue from 2011 to 2012 primarily reflects the increase in net premiums earned and net realized investment gains, partially offset by a decrease in net investment income and other revenue.

The components of consolidated net income from continuing operations, by segment, for the three and nine months ended September 30, 2012 and 2011 were as follows (unaudited, in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Workers’ compensation insurance	$	3,087		$	1,515		$	8,448		$	7,043
Segregated portfolio cell reinsurance		—			—			—			—
Corporate / other		(301	)		(859	)		(1,392	)		(2,516	)
Consolidated net income from continuing operations	$	2,786		$	656		$	7,056		$	4,527

The increase in net income in the workers’ compensation insurance segment primarily reflects the increase in net premiums earned and the increase in the estimated fair value of the convertible bond portfolio, partially offset by a decrease in net investment income and an increase in the combined ratio.

The decrease in the net loss in the corporate/other segment primarily reflects a change in the Company’s internal organizational structure and a decrease in stock compensation expense. The decrease in the net loss for the nine months ended September 30, 2012 was partially offset by the realized loss related to the commutation of the SprinklerPro contract.

30

WORKERS’ COMPENSATION INSURANCE

The following table represents the operations of the workers’ compensation insurance segment for the three and nine months ended September 30, 2012 and 2011 (unaudited, in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Revenue:
Direct premiums written	$	48,407		$	41,750		$	143,581		$	121,298
Reinsurance premiums assumed		840			457			2,313			1,608
Ceded premiums written		(11,864	)		(11,473	)		(39,367	)		(35,331	)
Net premiums written		37,383			30,734			106,527			87,575
Change in unearned premiums		(4,202	)		(4,346	)		(13,709	)		(12,486	)
Net premiums earned		33,181			26,388			92,818			75,089
Net investment income		749			808			2,385			2,568
Change in equity interest in limited partnerships		258			(269	)		620			273
Net realized investment gains (losses)		1,022			(1,436	)		1,618			204
Total revenue		35,210			25,491			97,441			78,134
Expenses:
Losses and LAE incurred		22,365			16,896			61,480			49,252
Acquisition and other underwriting expenses		3,198			1,903			8,793			5,678
Other expenses		5,090			4,106			14,790			11,839
Policyholder dividend expense		467			196			652			802
Total expenses		31,120			23,101			85,715			67,571
Income before income taxes		4,090			2,390			11,726			10,563
Income tax expense		1,003			875			3,278			3,520
Net income	$	3,087		$	1,515		$	8,448		$	7,043

The workers’ compensation insurance ratios were as follows for the three and nine months ended September 30, 2012 and 2011:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Loss and LAE ratio		67.4	%		64.0	%		66.2	%		65.6	%
Expense ratio		25.0	%		22.8	%		25.4	%		23.3	%
Policyholder dividend expense ratio	��	1.4	%		0.7	%		0.7	%		1.1	%
Combined ratio		93.8	%		87.5	%		92.3	%		90.0	%

Premiums

The increase in direct premiums written primarily reflects new business sales $29.8 million, an increase in audit premium and renewal rate increases of 3.5%, partially offset by a decrease in the renewal retention rate. For the three and nine months ended September 30, 2012, the Company recognized audit premium from customers totaling $1.6 million and $3.6 million, respectively, in the aggregate related to its traditional and alternative market books of business, compared to audit premium from customers of $983,000 and $1.4 million for the same periods in 2011, respectively. The Company’s traditional book of business recognized audit premium from customers of $1.5 million and $3.4 million for the three and nine months ended September 30, 2012, compared to audit premium from customers of $727,000 and $1.3 million for the same periods in 2011, respectively. In addition to audit premium from customers, the Company increased its EBUB estimate by $400,000 and $650,000 for the three and nine months ended September 30, 2012, compared to $350,000 for the same periods in 2011. The renewal retention rate decreased from 88.4% in 2011 to 83.9% in 2012. The decrease in the renewal retention rate primarily reflects the loss of seven accounts with total annual premiums of approximately $4.3 million in 2012.

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Net Investment Income

The decrease in net investment income primarily reflects a decrease in dividend income and the decrease in the average yield on the fixed income portfolio. The decrease in dividend income primarily reflects the decrease in the Company’s equity security holdings from 2011 to 2012. The average yield on the fixed income portfolio was 2.84% as of September 30, 2012, compared to 3.33% as of September 30, 2011.

Net Realized Investment (Losses) Gains

The increase in net realized investment (losses) gains for the three and nine months ended September 30, 2012 primarily reflect the increase in the estimated fair value of the Company’s convertible bond portfolio. Net realized investment gains for the nine months ended September 30, 2011 include a realized gain of $959,000 related to the sale of an interest in an international equity fund that experienced an other-than-temporary write down prior to 2011.

Losses and LAE

The increase in the calendar period loss ratio for the three months ended September 30, 2012, compared to the same period in 2011, reflects an increase in the accident period loss ratio, partially offset by the impact of audit premium, which reduced the 2012 loss and LAE ratio by 4.1 percentage points, compared to a reduction of 2.8 percentage points in 2011. The increase in the calendar period loss and LAE ratio for the nine months ended September 30, 2012, compared to the same period in 2011, reflects and increase in the accident period loss ratio, partially offset by the impact of audit premium, which reduced the 2012 loss and LAE ratio by 3.1 percentage points, compared to a reduction of 1.5 percentage points in 2011. There was no prior year reserve development recognized in 2012 or 2011.

Acquisition and Other Underwriting Expenses and Other Expenses

The acquisition and other underwriting expense ratio was 9.6% and 9.5% for the three and nine months ended September 30, 2012, respectively, compared to 7.2% and 7.6% for the same periods in 2011. The increase primarily reflects the change in accounting for deferred acquisition costs, which increased the expense ratio for the three and nine months ended September 30, 2012 by 1.7 and 1.6 percentage points, respectively.

The other expense ratio was 15.3% and 15.9% for the three and nine months ended September 30, 2012, respectively, compared to 15.6% and 15.8% for the same periods in 2011. The decrease in the other expense ratio for the three months ended September 30, 2012 primarily reflects the increase in net premiums earned. The increase in the other expense ratio for the nine months ended September 30, 2012 primarily reflects an increase in audit and legal fees and the write-off of a customer receivable balance, partially offset by an increase in net premiums earned.

Policyholder Dividends

The increase in the policyholder dividend expense primarily reflects the loss experience of dividend paying policies. For the nine months ended September 30, 2012 and 2011, 12.1% and 11.9%, respectively, of all policies were written on a dividend policy basis.

Tax Expense

The effective tax rate for the three and nine months ended September 30, 2012 was 24.5% and 28.0%, respectively, compared to an effective tax rate of 36.6% and 33.3% for the same periods in 2011. The decrease in the effective tax rate from 2011 to 2012 primarily reflects the prior year tax return adjustment that decreased tax expense in 2012, compared to an increase in tax expense in 2011. The primary difference between the statutory rate of 35.0% and the effective tax rate reflects tax-exempt income on municipal bond securities.

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SEGREGATED PORTFOLIO CELL REINSURANCE

The following table represents the operations of the segregated portfolio cell reinsurance segment for the three and nine months ended September 30, 2012 and 2011 (unaudited, in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Revenue:
Reinsurance premiums assumed	$	8,763		$	8,149		$	30,098		$	26,909
Ceded premiums written		(1,120	)		(1,020	)		(3,229	)		(2,863	)
Net premiums written		7,643			7,129			26,869			24,046
Change in unearned premiums		573			400			(3,069	)		(3,133	)
Net premiums earned		8,216			7,529			23,800			20,913
Net investment income		75			99			249			351
Net realized investment gains (losses)		40			(22	)		506			45
Total revenue		8,331			7,606			24,555			21,309
Expenses:
Losses and LAE incurred		5,484			4,155			14,855			11,964
Acquisition and other underwriting expenses		2,482			2,270			7,227			6,275
Other expenses		54			56			218			205
Policyholder dividend expense		26			8			63			21
Segregated portfolio dividend expense (1)		285			1,117			2,192			2,844
Total expenses		8,331			7,606			24,555			21,309
Net income (1)	$	—		$	—		$	—		$	—

(1) The workers’ compensation insurance 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 results of operations 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 LAE, acquisition and other underwriting expenses, other expense and policyholder dividend expense is accrued as a segregated portfolio dividend expense. As a result, the segregated portfolio cell reinsurance segment has no net income for the period presented in this table.

The segregated portfolio cell reinsurance ratios were as follows for the three and nine months ended September 30, 2012 and 2011:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Loss and LAE ratio		66.7	%		55.2	%		62.4	%		57.2	%
Expense ratio		30.9	%		30.9	%		31.3	%		31.0	%
Policyholder dividend expense ratio		0.3	%		0.1	%		0.3	%		0.1	%
Combined ratio		97.9	%		86.2	%		94.0	%		88.3	%

Reinsurance Premiums Assumed

The increase in reinsurance premiums assumed primarily reflects new business sales of $3.9 million, renewal rate increases of 4.3%, and an increase in the renewal retention rate, partially offset by a decrease in audit premium. For the three and nine months ended September 30, 2012, the Company recognized audit premium from customers totaling $93,000 and $181,000, respectively, compared to audit premium from customers of $256,000 and $114,000 for the same periods in 2011, respectively. The renewal retention rate was 90.8% in 2011, compared to 91.9% in 2012.

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Net Investment Income

The decrease in net investment income primarily reflects the sale of the segregated cells’ fixed income securities and reinvestment of the proceeds into a fixed income mutual fund during the fourth quarter of 2011. The fixed income mutual fund invests in high grade U.S. Dollar fixed income securities with maturities not exceeding five years.

Net Realized Investment Gains (Losses)

Net realized investment gains (losses) primarily reflect investment sale activity in 2012 and 2011. Net realized gains for the nine months ended September 30, 2012 primarily reflect the sale of individual equity securities in the first quarter of 2012. The proceeds from the sale of the equity securities were used to purchase equity mutual funds.

Losses and LAE

The increase in the calendar period loss and LAE ratio primarily reflects an increase in the accident period loss ratio and a decrease in favorable loss reserve development on prior accident periods. The accident period loss ratio was 76.3% and 72.3% for the three and nine months ended September 30, 2012, respectively, compared to an accident period loss ratio of 71.9% and 70.1% for the same periods in 2011, respectively. The increase in the accident period loss ratio primarily reflects the emergence of increased claim activity in two of the segregated portfolio cells. Favorable loss reserve development totaled $781,000 and $2.4 million for the three and nine months ended September 30, 2012, respectively, compared to favorable development of $1.3 million and $2.7 million for the same periods in 2011, respectively.

Acquisition and Other Underwriting Expenses

The expense ratios are consistent with the contractual ceding commissions for the three and nine months ended September 30, 2012 and 2011.

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.

CORPORATE/OTHER

The following table represents the operations of the corporate/other segment for the three and nine months ended September 30, 2012 and 2011 (unaudited, in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Revenue:
Net investment income	$	68		$	106		$	272		$	28
Change in equity interest in limited partnerships		32			(85	)		118			18
Net realized investment (losses) gains		(39	)		152			(613	)		251
Other revenue		84			86			239			348
Total revenue		145			259			16			645
Expenses:
Acquisition and other underwriting expenses		(194	)		(543	)		(629	)		(1,597	)
Other expenses		1,080			2,103			3,111			6,153
Amortization of intangibles		202			254			605			762
Segregated portfolio dividend expense		(256	)		(110	)		(778	)		(648	)
Total expenses		832			1,704			2,309			4,670
Loss before income taxes		(687	)		(1,445	)		(2,293	)		(4,025	)
Income tax benefit		(386	)		(586	)		(901	)		(1,509	)
Net loss	$	(301	)	$	(859	)	$	(1,392	)	$	(2,516	)

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Revenue

The decrease in revenue for the nine months ended September 30, 2012 primarily reflects the realized loss related to the commutation of the SprinklerPro program, partially offset by an increase in net investment income. The commutation of the SprinklerPro program resulted in a realized loss of $641,000. Net investment income for the three and nine months ended September 30, 2011 reflects a decline in the equity interest in SprinklerPro totaling $1,000 and $377,000, respectively.

Expenses

The decrease in expenses primarily reflects a change in the Company’s internal organizational structure and a decrease in stock compensation expense. Effective January 1, 2012, expenses related to the Company’s executive officers are included in the workers’ compensation insurance segment. Executive expenses included in the corporate/other segment for the three and nine months ended September 30, 2011 totaled approximately $485,000 and $1.6 million, respectively. Stock compensation expense totaled $519,000 and $1.4 million for the three and nine months ended September 30, 2012, compared to $641,000 and $1.8 million for the same periods in 2011. The decrease in stock compensation expense primarily reflects the full vesting of options and restricted stock issued in January 2007, partially offset by the recognition of stock compensation expense related to options and restricted stock issued in 2012.

Income Tax Benefit

The effective tax rate was 56.2% and 39.3% for the three and nine months ended September 30, 2012, compared to 40.6% and 37.5% for the same periods in 2011. The increase in the income tax benefit from 2011 to 2012 primarily reflects the Company’s outside basis difference in its foreign operations.

CONSOLIDATED FINANCIAL POSITION

Consolidated assets totaled $378.9 million at September 30, 2012, compared to $345.7 million at December 31, 2011. The increase in consolidated assets primarily reflects an increase in investments, premiums receivable, the reinsurance recoverable and other assets. The increase in investments primarily reflects purchases during 2012 and an increase in the estimated fair value of investments. The increase in premiums receivable primarily reflects the increase in direct premiums written. The increase in the reinsurance recoverable primarily reflects amounts due from reinsurers related to two large claims in the segregated portfolio cell reinsurance segment. The increase in other assets primarily reflects an increase in the Company’s interest in certain segregated portfolio cells and deductibles receivable. The increase in the Company’s interest in the segregated portfolio cells reflects the cells’ 2012 operating results.

Consolidated liabilities totaled $244.6 million at September 30, 2012, compared to $217.4 million at December 31, 2011. The increase in consolidated liabilities primarily reflects an increase in loss and LAE reserves, unearned premiums, and the segregated portfolio cell dividend payable. The increase in loss and LAE reserves primarily reflects the increase in net premiums earned. The increase in unearned premiums primarily reflects the increase in direct premiums written. The increase in the segregated portfolio cell dividend payable reflects the 2012 results of operations of the segregated portfolio cell reinsurance segment, partially offset by dividends paid to the preferred shareholders of certain segregated cells.

Consolidated equity totaled $134.3 million at September 30, 2012, compared to $128.3 million at December 31, 2011. The increase in consolidated equity primarily reflects net income for the nine months ended September 30, 2012 and an increase in the estimated fair value of the Company’s equity securities, partially offset by common stock repurchases and shareholder dividends.

LIQUIDITY AND CAPITAL RESOURCES

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. Currently, claim payments are made from operating cash flows, with excess cash invested in investment securities. As securities mature, management intends to invest excess cash with appropriate durations to fund anticipated future claim payments. Management does not anticipate having to sell securities in its investment portfolios to fund claims or operating expenses. In the event the sale of securities becomes necessary, the Company may incur losses on those sales, which would adversely affect its results of operations and could reduce net investment income.

The Company has a $10.0 million revolving line of credit available to provide additional liquidity if needed. The line of credit matures on May 2, 2013 and may be renewed annually for additional periods expiring on May 1 at the lender’s discretion. Outstanding balances under the line of credit bear interest at an adjustable monthly rate equal to LIBOR plus 2.0% per annum. There were no outstanding balances under the line of credit as of September 30, 2012.

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

35

Pennsylvania Insurance Department and the Indiana Insurance Department is limited to the greater of 10.0% 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

Cash flows from continuing operations for the nine months ended September 30, 2012 and 2011 were as follows (unaudited, in thousands):

	2012			2011
Cash flows provided by operating activities	$	12,229		$	18,662
Cash flows provided by investing activities		(11,277	)		227
Cash flows used in financing activities		(4,032	)		(14,618	)
Net (decrease) increase in cash and cash equivalents	$	(3,080	)	$	4,271

Cash flows from operating activities consist primarily of cash receipts and disbursements related to premiums, investment income, claims and related adjustment expenses, operating expenses, policyholder dividends and income taxes. Cash flows from investing activities consist primarily of purchases and sales of investments and purchases of fixed assets. Cash flows from financing activities primarily consist of cash disbursements for repurchases of the Company’s common stock and shareholder dividends.

The decrease in cash flows provided by operating activities from 2011 to 2012 primarily reflects an increase in claims paid, an increase in deposit premiums paid to reinsurers, an increase in estimated federal income tax payments, and an increase in personnel costs, partially offset by an increase in premiums collected.

The increase in cash flows used in investing activities from 2011 to 2012 primarily reflects an increase in fixed income security purchases and a decrease in the sale of fixed income securities. The decrease in the sale of fixed income securities primarily reflects the decrease in common stock repurchases. During 2011, the Company sold fixed income securities in order to repurchase its common stock.

The decrease in cash used in financing activities from 2011 to 2012 primarily reflects the decrease in common stock repurchases.

OFF-BALANCE SHEET ARRANGEMENTS

The Company has no off-balance sheet arrangements that have or are reasonably likely to have a current or, as of September 30, 2012, future effect on the Company’s financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The Company is subject to market risk with respect to its fixed income investment portfolio. The most significant components of market risk affecting the Company are credit risk and interest rate risk. The Company is also subject to equity risk with respect to its investment in equity securities.

There have been no material changes in the Company’s market risk since December 31, 2011. Additional disclosures related to the Company’s market risk are discussed under “Quantitative and Qualitative Disclosures About Market Risk” in Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 12, 2012.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Under the supervision and with the participation of our management, including the President and Chief Executive Officer, the Executive Vice President, Treasurer and Chief Financial Officer and the Vice President of Finance, we have evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a – 15(e) and 15 d – 15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report. Based on that evaluation, the President and Chief Executive Officer, the Executive Vice President, Treasurer and Chief Financial Officer and the Vice President of Finance have concluded that, as of the end of such period, these disclosure controls and procedures are effective.

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Changes in Internal Control Over Financial Reporting

There have not been any changes in our internal control over financial reporting (as such term is defined in Rules 13a – 15(f) and 15d – 15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II – OTHER INFORMATION

Item 1. Legal Proceedings

None

Item 1A. Risk Factors

There are no material changes from the risk factors previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, SEC File No. 001-32899.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Issuer Purchases of Equity Securities

As of September 30, 2012, the Company has repurchased 4,017,105 shares of its common stock. Under the current plan, authorized by The Company’s Board of Directors, the Company may repurchase up to an additional 920,030 shares. The share repurchases will be held as treasury stock and are available for issuance in connection with the Company’s Stock Incentive Plan.

The following table presents information with respect to those purchases of our common stock made during the nine months ended September 30, 2012 and 2011.

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, 2012		—	$	—		—		1,086,567
February 1-29, 2012		—	$	—		—		1,086,567
March 1-31, 2012		—	$	—		—		1,086,567
April 1-30, 2012		—	$	—		—		1,086,567
May 1-31, 2012		166,537	$	14.49		166,537		920,030
June 1-30, 2012		—	$	—		—		920,030
July 1-31, 2012		—	$	—		—		920,030
August 1-31, 2012		—	$	—		—		920,030
September 1-30, 2012		—	$	—		—		920,030
Total		166,537	$	14.49		166,537

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, 2011		129,110	$	12.34		129,110		987,855
February 1-28, 2011		31,976	$	13.02		31,976		955,879
March 1-31, 2011		360,832	$	12.57		360,832		595,047
April 1-30, 2011		72,948	$	12.86		72,948		522,099
May 1-31, 2011		111,984	$	13.24		111,984		410,115
June 1-30, 2011		26,405	$	13.21		26,405		383,710
July 1-31, 2011		70,063	$	13.24		70,063		313,647
August 1-31, 2011		123,012	$	13.10		123,012		1,190,635
September 1-30, 2011		79,998	$	13.14		79,998		1,110,637
Total		1,006,328	$	12.82		1,006,328

37

Item 3. Defaults Upon Senior Securities

None

Item 4. Mine Safety Disclosures

None

Item 5. Other Information

None

Item 6. Exhibits

Exhibits

Exhibit No.	Title
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)
31.1	Certification of Chief Executive Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of Chief Executive Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification of Chief Financial Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002
101	Interactive data files pursuant to Rule 405 of Regulation S-T: (i) the Consolidated Balance Sheets as of September 30, 2012 and December 31, 2011, (ii) the Consolidated Statements of Operations and Comprehensive Income (Loss) for the three and nine months ended September 30, 2012 and 2011, (iii) the Consolidated Statements of Changes in Equity for the three and nine months ended September 30, 2012 and 2011, (iv) the Consolidated Statements of Cash Flows for the nine months ended September 30, 2012 and 2011, and (v) the Condensed Notes to Consolidated Financial Statements.

38

SIGNATURES

In accordance with the requirements of the Exchange Act, the Registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	EASTERN INSURANCE HOLDINGS, INC. (Registrant)
Dated: November 1, 2012	By:	/s/ Michael L. Boguski
		Michael L. Boguski,
		President and Chief Executive Officer
Dated: November 1, 2012	By:	/s/ Kevin M. Shook
		Kevin M. Shook,
		Executive Vice President, Treasurer & Chief Financial Officer

39