Underwriting,
Acquisition and Insurance Expenses
In our
insurance subsidiary, we refer to the expenses that we incur to underwrite
risks as underwriting, acquisition and insurance expenses. Such expenses
consist of commission expenses, premium taxes and fees and other underwriting
expenses incurred in writing and maintaining our business. We pay commission
expense in our insurance subsidiary to our brokers for the premiums that they
produce for us. We pay state and local taxes based on premiums; licenses and
fees; assessments; and contributions to workers compensation security funds.
Other underwriting expenses consist of general administrative expenses such as
salaries and employee benefits, rent and all other operating expenses not
otherwise classified separately, and boards, bureaus and assessments of
statistical agencies for policy service and administration items such as rating
manuals, rating plans and experience data.
Interest
Expense
We incur
interest expense on $12.0 million in surplus notes that our insurance
subsidiary issued in May 2004. The interest expense is paid quarterly in
arrears. The interest expense for each interest payment period is based on the
three-month LIBOR rate two London banking days prior to the interest payment
period plus 400 basis points.
Results of Operations
Three
Months Ended March 31, 2008 and 2007
Gross
Premiums Written.
Gross premiums written for the three
months ended March 31, 2008 totaled $63.6 million, an increase of $3.7 million,
or 6.2%, over $59.9 million of gross premiums written in the same period of
2007 even though we continued to experience rate reductions in California, our
largest market, as well as in other states. Excluding work we perform as the
servicing carrier for the Washington USL&H Assigned Risk Plan, the number
of customers we serviced increased 31.8% from 745 at March 31, 2007 to 982 at
March 31, 2008 and in-force payrolls, one of the factors used in determining
premium charges, increased 32.5% from $4.3 billion at March 31, 2007 to $5.7
billion one year later. California continues to be our largest market,
accounting for approximately $109.3 million, or 40.7%, of our in-force premiums
at March 31, 2008. This represents a decrease of $1.7 million, or 1.5%, from
approximately $111.0 million, or 49.0%, of in-force premiums at March 31, 2007.
Illinois
is our second largest market and accounted for approximately $29.4 million
(11.0%) of our in-force premiums at March 31, 2008, representing an increase of
$7.9 million (36.7%) from $21.5 million (9.5%) at March 31, 2007. Louisiana is
our third largest market, accounting for approximately $22.2 million (8.2%) of
our in-force premiums as of March 31, 2008, representing an increase of $6.2
million (38.8%) from $16.0 million (7.1%) as of March 31, 2007. The remaining
states in our top five markets were Alaska and Hawaii, which accounted for
approximately $18.0 million (6.7%) and $12.9 million (4.8%) of our in-force
premiums at March 31, 2008, respectively, compared to $21.6 million (9.5%) and
$14.2 million (6.3%), respectively, of our in-force premiums at March 31, 2007.
We have
experienced significant reductions in our California premium rates over the
past four years. In 2007, in response to continued reductions in California
workers compensation claim costs, we reduced our rates by an average 14.2% for
new and renewal insurance policies written in California on or after July 1,
2007. This was the eighth California rate reduction we have filed since October
1, 2003, resulting in a net cumulative reduction of our California rates of
approximately 54.8%. Rate reductions have also been adopted in other states in
which we operate. For example, effective January 1, 2008, we adopted the
following rate decreases recommended by the NCCI: 10.9% in Alaska, 19.3% in
Hawaii and 18.4% in Florida. Effective July 1, 2007, we adopted the Louisiana
Insurance Commissioners recommendation of a 15.8% reduction in Louisiana,
which is 2.0% more than the 13.8% rate decrease recommended by the NCCI. On
February 5, 2008, the Louisiana Insurance Commissioner approved an
NCCI-proposed rate reduction of 8.6%, effective May 1, 2008. On March 7, 2008,
after completing a study of our Louisiana loss data, we filed with the
Louisiana Insurance Commissioner our new rates reflecting an average reduction
of 11.6% from prior rates for new and renewal workers compensation insurance
policies written in Louisiana on or after May 1, 2008.
We have also recently adopted
rate increases in
some
states.
For example, effective
October 1, 2007
, we
adopted
a 4.1% rate increase
in Arizona and
on January 1, 2008
, we adopted a 4.0%
rate
increase in
Illinois.
Net
Premiums Written.
Net premiums written totaled $60.3
million for the three months ended March 31, 2008 compared to $56.3 million in
the same period in 2007, representing an increase of $4.0 million, or 7.1%. Net
premiums written are affected by premiums ceded under reinsurance agreements.
Ceded written premiums for the three months ended March 31, 2008 totaled $3.2
million (5.0% of gross premiums written) compared to $3.7 million
- 20 -
(6.2% of gross
premiums written) in the same period of 2007. The decrease in ceded premiums as
a percentage of gross premiums written resulted primarily from the renewal of
our excess of loss reinsurance program on October 1, 2007 at average rates that
are approximately 25.6% lower than rates under the prior reinsurance program.
Net
Premiums Earned.
Net premiums earned totaled $56.7
million for the three months ended March 31, 2008 compared to $48.6 million for
the same period in 2007, representing an increase of $8.1 million, or 16.7%. We
record the entire annual policy premium as unearned premium when written and
earn the premium over the life of the policy, which is generally twelve months.
Consequently, the amount of premiums earned in any given year depends on when
during the current or prior year the underlying policies were written. Our
direct premiums earned increased $7.2 million, or 14.3%, to $57.4 million at
March 31, 2008 from $50.2 million at March 31, 2007 due to our premium growth
as described above. Net premiums earned are also affected by premiums ceded
under reinsurance agreements. Ceded premiums earned at March 31, 2008 totaled
$3.3 million compared to $3.6 million at March 31, 2007, representing a
decrease of $0.3 million, or 8.3%. A decrease in ceded premiums earned is an
increase to our overall net premiums earned. Also adding to the increase in net
premiums earned is an increase in the amount of premiums we involuntarily
assume on residual market business from the NCCI, which operates residual
market programs on behalf of many states. Assumed premiums earned increased
$0.6 million from $2.0 million at March 31, 2007 to $2.6 million at March 31,
2008.
Net
Investment Income.
Net investment income was $5.7 million
for the three months ended March 31, 2008 compared to $4.8 million for the same
period in 2007, representing an increase of $0.9 million, or 18.8%. Average
invested assets increased $87.8 million, or 20.4%, from $429.5 million as of
March 31, 2007 to $517.3 million as of March 31, 2008. The increase in net
investment income is due primarily to a larger portfolio base at March 31, 2008
as a result of strong cash flow from operations of $94.6 million for the year
ended December 31, 2007 and $11.5 million for the three months ended March 31,
2008. Our yield on average invested assets for the three months ended March 31,
2008 and 2007 was approximately 4.4%.
Service
Income.
Service income totaled $422,000 for the three
months ended March 31, 2008 compared to $580,000 for the same period in 2007,
representing a decrease of $158,000, or 27.2%. Our service income results
primarily from service arrangements we have with LMC for claims processing and
policy administration services that we perform for Eagles insurance policies
and from claims processing services that we perform for other unrelated
companies. Average monthly fees from Eagle are declining as the volume of work
decreases as a result of the run off of our predecessors business. Service income
related to our arrangements with LMC decreased $40,000, or 13.8%, to $250,000
for the three months ended March 31, 2008 from $290,000 for the same period in
2007. Service income related to claims processing services that we perform for
other unrelated companies decreased approximately $130,000 and accounted for
approximately 38.8% of our service income for the three months ended March 31,
2008, compared to 50.0% of service income in the same period of 2007.
Other
Income.
Other income totaled $1.4 million for the
three months ended March 31, 2008 compared to $1.0 million for the same period
in 2007, representing an increase of $0.4 million, or 40.0%. Other income is
derived primarily from the operations of PointSure, our wholesale broker and third
party administrator subsidiary which, due to the expansion of its portfolio of
insurance products during 2007, has been able to increase the amount of income
from external sources and THM, a provider of medical bill review, utilization review, nurse case management and
related services that we acquired in December 2007. PointSure represents
20 insurance companies at March 31, 2008 and 2007.
Loss
and Loss Adjustment Expenses.
Loss and loss adjustment
expenses totaled $30.4 million for the three months ended March 31, 2008
compared to $25.9 million for the same period in 2007, representing an increase
of $4.5 million, or 17.4%. Our net loss ratio, which is calculated by dividing
loss and loss adjustment expenses less claims service income by premiums
earned, for the three months ended March 31, 2008 was 52.9% compared to 52.2%
for the same period in 2007. Included in the 2008 loss ratio was a reduction of
approximately $7.9 million of previously recorded direct net loss reserves to
reflect a continuation of deflation trends in the paid loss data for recent
accident years. In the quarter ended March 31, 2007, we reduced loss reserves
by approximately $7.2 million. Our direct net loss reserves are net of
reinsurance and exclude reserves associated with KEIC and the business that we
involuntarily assume from the NCCI. Approximately $3.1 million of the reserve
adjustment related to accident year 2007, approximately $3.6 million related to
accident year 2006 and approximately $1.2 million related to accident years
2005 and prior.
There
is uncertainty about whether recent lower paid loss trends, which result
primarily from California legislative reforms enacted in 2003 and 2004, will be
sustained, particularly in light of current efforts to change or
- 21 -
repeal
portions of the reforms. We will not know the full impact of these reforms with
a high degree of confidence for several years. We have established loss
reserves at March 31, 2008 that are based upon our current best estimate of
loss costs, taking into consideration the recent lower paid loss claim data,
incurred loss trends and the uncertainty regarding the permanence of recent
legislative reforms. For further information regarding our loss and loss
adjustment expenses, including amounts paid and unpaid, see the discussion
under the heading Critical Accounting Policies, Estimates and Judgments
Unpaid Loss and Loss Adjustment Expenses in this Item 2 of Part I of this quarterly report.
As
of March 31, 2008, we had recorded a receivable of approximately $2.5 million
for adverse loss development under the adverse development cover since the date
of the Acquisition. We do not expect this receivable to have any material
adverse effect on our future cash flows if LMC fails to perform its obligations
under the adverse development cover. At March 31, 2008, we had access to
approximately $3.6 million under the collateralized reinsurance trust in the
event that LMC fails to satisfy its obligations under the adverse development
cover. The balance of the Trust, including interest, was $3.5 million at
December 31, 2007. In April 2008, LMC
submitted a request to withdraw approximately $0.8 million of excess funds on
deposit in the Trust. After due evaluation, we complied with LMCs request,
resulting in a balance in the Trust account of approximately $2.7 million
immediately following the withdrawal.
Underwriting
Expenses.
Underwriting expenses totaled $15.6 million
for the three months ended March 31, 2008, compared to $12.6 million for the
same period in 2007, representing an increase of $3.0 million, or 23.8%. Our
net underwriting expense ratio, which is calculated by dividing underwriting,
acquisition and insurance expenses less other service income by premiums
earned, for the three months ended March 31, 2008 was 27.6%, compared to 25.9%
for the same period in 2007. The increase in the expense ratio is primarily the
result of increased staffing costs and other premium production related
expenses as we invest in the geographic expansion and development of our
business. The total number of employees grew from 197 at March 31, 2007 to 259
at March 31, 2008, representing an increase of 31.5%.
Commission
expense as a percentage of net earned premiums averaged 9.6% for the three
months ended March 31, 2008 compared to 9.2% in the same period of 2007. These
increases are driven primarily by the California market, as well as other
markets that have experienced rate reductions, as brokers negotiate higher
commission rates during a period of declining premium rates.
Interest
Expense
. Interest expense related to the surplus notes
issued by our insurance subsidiary in May 2004 totaled $251,000 for the three
months ended March 31, 2008, compared to $281,000 for the same period in 2007,
representing a decrease of $30,000, or 10.7%. The surplus notes interest rate,
which is calculated at the beginning of each interest payment period using the
3-month LIBOR rate plus 400 basis points, decreased from 9.36% at March 31,
2007 to 7.09% at March 31, 2008.
Other
Expenses.
Other expenses totaled $2.0 million for the
three months ended March 31, 2008, compared to $1.6 million for same period in
2007, representing an increase of $0.4 million, or 25.0%. Other expenses are
derived primarily from the operations of PointSure, our non-insurance
subsidiary which experienced direct costs associated with the expansion of
insurance products they offer and, to a lesser extent, from the operations of
THM.
Income Tax Expense.
The effective tax rate for the
three months ended March 31, 2008 was 31.6% compared to 30.5% for the same
period in 2007. Our effective tax rate for the three months ended March 31,
2008 and 2007 was lower than the statutory tax rate of 35.0% primarily as a
result of tax exempt interest income. At March 31, 2008, approximately 53.2% of
our fixed-income portfolio was invested in tax-exempt securities, compared to
approximately 51.1% at March 31, 2007.
Net
Income.
Net income was $10.9 million for the three
months ended March 31, 2008, compared to $10.1 million for the same period in
2007, representing an increase of $0.8 million, or 7.9%. The increase in net
income resulted primarily from increases in premiums earned and investment
income and reserve releases recognized in the period, offset by increases in
loss and loss adjustment expenses; underwriting, acquisition and insurance
expenses; and other expenses.
- 22 -
Liquidity and Capital Resources
Our
principal sources of funds are underwriting operations, investment income and
proceeds from sales and maturities of investments. Our primary use of funds is
to pay claims and operating expenses and to purchase investments.
Our
investment portfolio is structured so that investments mature periodically over
time in reasonable relation to current expectations of future claim payments.
Since we have a limited claims history, we have derived our expected future
claim payments from industry and predecessor trends and included a provision
for uncertainties. Our investment portfolio as of March 31, 2008 has an
effective duration of 5.0 years with individual maturities extending out to 30
years. Currently, we make claim payments from positive cash flow from
operations and invest excess cash in securities with appropriate maturity dates
to balance against anticipated future claim payments. As these securities
mature, we intend to invest any excess funds in investments with appropriate
durations to match against expected future claim payments.
At
March 31, 2008, our portfolio was made up almost entirely of investment grade
fixed income securities with fair values subject to fluctuations in interest
rates. The remainder of our investment portfolio consisted of investments in
equity securities, which consist of investments in exchange traded funds
designed to correspond to the performance of certain indexes based on domestic
or international stocks, and preferred stocks. In November 2006, our investment
policy was revised to allow for investment in domestic and international
equities of up to 4% and 1%, respectively, of our statutory consolidated
capital and surplus. All of the securities in our investment portfolio are
accounted for as available for sale securities. While we have structured our
investment portfolio to provide an appropriate matching of maturities with
anticipated claim payments, if we decide or are required in the future to sell
securities in a rising interest environment, we would expect to incur losses
from such sales.
We
had no direct sub-prime mortgage exposure in our investment portfolio as of
March 31, 2008 and approximately $0.9 million of indirect exposure to sub-prime
mortgages. The average credit quality of our $266.6 million fixed income
municipal portfolio was AA+ (AA based on the issuers underlying ratings).
Insured municipal bonds totaled $205.6 million and had a weighted average
credit rating of AA+ (AA based on the issuers underlying ratings). The
remaining $61.0 million in uninsured municipal bonds carried a weighted average
credit rating of AA. Consequently, we do not expect a material impact to our
investment portfolio or financial position as a result of the problems
currently facing monoline bond insurers.
Our
ability to adequately provide funds to pay claims comes from our disciplined
underwriting and pricing standards and the purchase of reinsurance to protect
us against severe claims and catastrophic events. Effective October 1, 2007,
our reinsurance program provides us with reinsurance protection for each loss
occurrence in excess of $1.0 million, up to $75.0 million, subject to various
additional limitations and exclusions as more fully described in Note 5.a. to
our unaudited condensed consolidated financial statements in Part I, Item 1 of
this quarterly report and in the reinsurance agreements. Given industry and
predecessor trends, we believe that we are sufficiently capitalized to cover our
retained losses.
Our
insurance subsidiary is required by law to maintain a certain minimum level of
surplus on a statutory basis. Surplus is calculated by subtracting total
liabilities from total admitted assets. The National Association of Insurance
Commissioners has a risk-based capital standard designed to identify property
and casualty insurers that may be inadequately capitalized based on inherent
risks of each insurers assets and liabilities and its mix of net premiums
written. Insurers falling below a calculated threshold may be subject to
varying degrees of regulatory action. As of December 31, 2007, the last date
that we were required to update the annual risk-based capital calculation, the
statutory surplus of our insurance subsidiary was in excess of the prescribed
risk-based capital requirements that correspond to any level of regulatory
action.
SIH
is a holding company with minimal unconsolidated revenue. Currently, there are
no plans to have SBIC or other subsidiaries pay a dividend to SIH.
Our
unaudited consolidated net cash provided by operating activities for the three
months ended March 31, 2008 was $11.5 million, compared to our cash flow from
operations of $18.7 million for the same period in 2007. The decrease resulted
primarily from the decreases in unpaid loss and loss adjustment expense and
deferred income tax benefit, increases in policy acquisition costs deferred and
other assets and liabilities, offset by increases in the amortization of policy
acquisition costs and balances related to reinsurance recoverables and unearned
premium reserves, all as a result of the growth of our business and the
continued favorable development of our loss reserves.
- 23 -
We
used net cash of $24.9 million for investing activities in the three months
ended March 31, 2008, compared to $21.8 million for the same period in 2007.
The difference between periods is primarily attributable to maintaining a lower
overall cash balance.
For
the three months ended March 31, 2008, financing activities provided cash of
$101,000, compared to $56,000 in the same period in 2007.
Contractual Obligations and Commitments
The
following table identifies our contractual obligations by payment due period as
of March 31, 2008:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Payments
Due by Period
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
Less
than
1 Year
|
|
1-3
Years
|
|
4-5
Years
|
|
More
than
5 Years
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(in
thousands)
|
|
Long term
debt obligations:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Surplus
notes
|
|
$
|
12,000
|
|
$
|
|
|
$
|
|
|
$
|
|
|
$
|
12,000
|
|
Loss and
loss adjustment expenses
|
|
|
255,095
|
|
|
84,181
|
|
|
109,946
|
|
|
23,469
|
|
|
37,499
|
|
Operating
lease obligations
|
|
|
14,484
|
|
|
2,627
|
|
|
5,968
|
|
|
1,672
|
|
|
4,217
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
281,579
|
|
$
|
86,808
|
|
$
|
115,914
|
|
$
|
25,141
|
|
$
|
53,716
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The
loss and loss adjustment expense payments due by period in the table above are
based upon the loss and loss adjustment expense estimates as of March 31, 2008
and actuarial estimates of expected payout patterns and are not contractual
liabilities as to time certain. Our contractual liability is to provide
benefits under the policies we write. As a result, our calculation of loss and
loss adjustment expense payments due by period is subject to the same
uncertainties associated with determining the level of unpaid loss and loss
adjustment expenses generally and to the additional uncertainties arising from
the difficulty of predicting when claims (including claims that have not yet
been reported to us) will be paid. For a discussion of our unpaid loss and loss
adjustment expense process, see the heading Critical Accounting Policies,
Estimates and Judgments Unpaid Loss and Loss Adjustment Expenses in this
Part I, Item 2 of this quarterly report. Actual payments of loss and loss
adjustment expenses by period will vary, perhaps materially, from the above
table to the extent that current estimates of loss and loss adjustment expenses
vary from actual ultimate claims amounts and as a result of variations between
expected and actual payout patterns.
Off-Balance Sheet Arrangements
As
of March 31, 2008, we had no off-balance sheet arrangements that have or are
reasonably likely to have a material current or future effect on our financial
condition, changes in financial condition, revenues or expenses, results of
operations, liquidity, capital expenditures or capital resources.
Critical Accounting Policies, Estimates and
Judgments
It
is important to understand our accounting policies in order to understand our
unaudited financial statements. We consider some of these policies to be
critical to the presentation of our financial results, since they require
management to make estimates and assumptions. These estimates and assumptions
affect the reported amounts of assets, liabilities, revenues, expenses and
related disclosures at the financial reporting date and throughout the period
being reported upon. Some of the estimates result from judgments that can be
subjective and complex, and consequently, actual results reflected in future
periods might differ from these estimates.
The
most critical accounting policies involve the reporting of unpaid loss and loss
adjustment expenses, including losses that have occurred but were not reported
to us by the financial reporting date; the amount and recoverability of
reinsurance recoverable balances; deferred policy acquisition costs; income
taxes; the impairment of investment securities; earned but unbilled premiums;
and retrospective premiums. The following should be read in conjunction with
the notes to our financial statements.
Unpaid
Loss and Loss Adjustment Expenses
Unpaid
loss and loss adjustment expenses represent our estimate of the expected cost
of the ultimate settlement and administration of losses, based on known facts
and circumstances. Included in unpaid loss and loss adjustment expenses are
amounts for case-based insurance liabilities, including estimates of future
developments on these claims; claims incurred but not yet reported to us;
second injury fund expenses; allocated claim adjustment expenses; and
unallocated claim adjustment expenses. We use actuarial methodologies to assist
us in establishing these estimates, including judgments relative to estimates
of future claims severity and frequency, length of time to
- 24 -
achieve
ultimate resolution, judicial theories of liability and other third-party
factors that are often beyond our control. Due to the inherent uncertainty
associated with the cost of unsettled and unreported claims, the ultimate
liability may differ from the original estimates. These estimates are regularly
reviewed and updated and any resulting adjustments are included in the current
periods operating results.
Following
is a summary of the gross loss and loss adjustment expense reserves by line of
business as of March 31, 2008 and December 31, 2007. The workers compensation
line of business comprises over 99% of our total loss reserves as of both
dates.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As of
March 31, 2008
|
|
As of
December 31, 2007
|
|
|
|
|
|
|
|
Line of
Business
|
|
Case
|
|
IBNR
|
|
Total
|
|
Case
|
|
IBNR
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(in
thousands
)
|
|
Workers
Compensation
|
|
$
|
99,679
|
|
$
|
153,685
|
|
$
|
253,364
|
|
$
|
93,457
|
|
$
|
155,042
|
|
$
|
248,499
|
|
Ocean Marine
|
|
|
319
|
|
|
1,412
|
|
|
1,731
|
|
|
564
|
|
|
1,022
|
|
|
1,586
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
99,998
|
|
$
|
155,097
|
|
$
|
255,095
|
|
$
|
94,021
|
|
$
|
156,064
|
|
$
|
250,085
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Actuarial
Loss Reserve Estimation Methods
We
use a variety of actuarial methodologies to assist us in establishing the
reserve for unpaid loss and loss adjustment expense. We also make judgments
relative to estimates of future claims severity and frequency, length of time
to achieve ultimate resolution, judicial theories of liability and other
third-party factors that are often beyond our control.
For
the current accident year, we establish the initial reserve for claims
incurred-but-not-reported (IBNR) using an expected loss ratio (ELR) method.
The ELR method is based on an analysis of historical loss ratios adjusted for
current pricing levels, exposure growth, anticipated trends in claim frequency
and severity, the impact of reform activity and any other factors that may have
an impact on the loss ratio. The actual paid and incurred loss data for the
accident year is reviewed each quarter and changes to the ELR may be made based
on the emerging data, although changes are typically not made until the end of
the accident year when the loss data can be analyzed as a complete accident
year. The ELR is multiplied by the year-to-date earned premium to determine the
ultimate losses for the current accident year. The actual paid and case
outstanding losses are subtracted from the ultimate losses to determine the IBNR
for the accident year. As the accident year matures, we incorporate a standard
actuarial reserving methodology referred to as the Bornhuetter-Ferguson method.
This method blends the loss development and expected loss ratio methods by
assigning partial weight to the initial expected losses, calculated from the
expected loss ratio method, with the remaining weight applied to the actual
losses, either paid or incurred. The weights assigned to the initial expected
losses decrease as the accident year matures. A reserve estimate implies a
pattern of expected loss emergence. If this emergence does not occur as
expected, it may cause us to revisit our previous assumptions. We may adjust
loss development patterns, the various method weights or the expected loss ratios
used in our analysis. Management employs judgment in each reserve valuation as
to how to make these adjustments to reflect current information.
For
all other accident years, the estimated ultimate losses are developed using a
variety of actuarial techniques as described below. In reviewing this
information, we consider the following factors to be especially important at
this time because they increase the variability risk factors in our loss
reserve estimates:
|
|
|
|
|
We wrote our
first policy on October 1, 2003 and, as a result, our total reserve portfolio
is relatively immature when compared to other industry data.
|
|
|
|
|
|
We have been
growing consistently since we began operations and have entered into several
new states that are not included in our predecessors historical data.
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At March 31,
2008, approximately $156.3 million, or 49.5%, of our direct loss reserves
were related to business written in California. Over the last several years,
three significant comprehensive legislative reforms were enacted in
California: AB 749 was enacted in February 2002; AB 227 and SB 228 were
enacted in September 2003; and SB 899 was enacted in April 2004. This reform
activity has resulted in uncertainty regarding the impact of the reforms on loss
payments, loss development and, ultimately, loss reserves, making historical
data less reliable as an indicator of future loss. All four bills enacted
structural changes to the benefit delivery system in California, in addition
to changes in the indemnity and medical benefits afforded injured workers. In
response to the reform legislation and a continuing drop in the frequency of
workers compensation claims, the pure premium rates approved by the
California Insurance
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Commissioner
effective January 1, 2008 were 65.1% lower than the pure premium rates in
effect as of July 1, 2003.
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Key elements
of the reforms as they relate to indemnity and medical benefits were as
follows:
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Indemnity
Benefits
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AB 749
significantly increased most classes of workers compensation indemnity
benefits over a four-year period beginning in 2003.
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AB 227 and
SB 228 repealed the mandatory vocational rehabilitation benefits and replaced
them with a system of non-transferable education vouchers.
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SB 899
required the Division of Workers Compensation (DWC) Administrative
Director to adopt, on or before January 1, 2005, a new permanent disability
rating schedule (PDRS) based in part on American Medical Association
guidelines. Also, temporary disability was limited to a duration of two
years.
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SB 899
provided that, effective April 19, 2004, apportionment of disability for
purposes of permanent disability determination must be based on causation.
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Medical
Benefits
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AB 749
repealed the presumption given to the primary treating physician (except when
the worker has pre-designated a personal physician), effective for injuries
occurring on or after January 1, 2003. (SB 228 and SB 899 later extended this
to all future medical treatment on earlier injuries.)
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SB 228
required the DWC Administrative Director to establish, by December 1, 2004,
an Official Medical Treatment Utilization Schedule meeting specific criteria.
SB 228 also provided that beginning three months after the publication date
of the updated American College of Occupational and Environmental Medical
(ACOEM) Practice Guidelines and continuing until such time as the DWC
Administrative Director establishes an Official Medical Treatment Utilization
Schedule, the ACOEM standards will be presumed to be correct regarding the
extent and scope of all medical treatment. The DWC Administrative Director
has subsequently adopted the ACOEM Guidelines as the Official Medical
Treatment Utilization Schedule.
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SB 228
limited the number of chiropractic visits and the number of physical therapy
visits to 24 each per claim.
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SB 228
established a prescription medication fee schedule set at 100% of Medi-Cal
Schedule amounts.
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SB 228
provided that the maximum facility fee for services performed in an
ambulatory surgical center may not exceed 120% of the Medicare fees for the
same service performed in a hospital outpatient facility.
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SB 899
provided that after January 1, 2005, an employer or insurer may establish
medical provider networks meeting certain conditions and, with limited
exceptions, medical treatment can be provided within those networks.
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These
reforms are a source of variability in the reserve estimates as legislative
changes affecting benefit levels not only impact the cost of benefits but also
the rate at which accident year benefits or losses develop over time. In
addition, the PDRS, one of the most significant reforms, faces ongoing
challenges. The PDRS was revised effective January 1, 2005. The revised
schedule has resulted in significantly reduced permanent disability awards,
leading to concerns that injured workers may not be adequately compensated for
their work related permanent injuries. The PDRS is currently being challenged
on three fronts legislative, administrative and legal. Legislation has been
proposed in the 2008 legislative session that would modify the formula used to
determine the amount of permanent disability benefits. It is too early to
determine what impact the legislation may have on permanent disability
benefits, or if it will be enacted into law. A prior legislative effort to
modify the PDRS was vetoed by the Governor of California in 2007. On the
administrative front, the California Division of Workers Compensation has undertaken
a review of the PDRS. The nature and extent of proposed changes, if any, are
not yet known. The Division of Workers Compensation has not published a
schedule to communicate their
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recommendations.
Finally, recent court decisions continue to lend uncertainty to the
interpretation and application of the PDRS. All of these factors contribute to
the uncertainty of California workers compensation claim costs.
Workers
compensation is considered a long-tail line of business, as it takes a
relatively long period of time to finalize claims from a given accident year.
Management believes that it generally takes workers compensation losses
approximately 48 to 60 months after the start of an accident year until the
data is viewed as fully credible for paid and incurred reserve evaluation
methods. Workers compensation losses can continue to develop beyond 60 months
and in some cases claims can remain open more than 20 years. As indicated
above, we wrote our first policy on October 1, 2003 so our first complete
accident year is 2004. As of March 31, 2008, accident year 2004 is 51 months
developed, accident year 2005 is 39 months developed and accident year 2006 is
27 months developed. Our loss reserve estimates are subject to considerable variation
due to the relative immaturity of the accident years from a development
standpoint.
We
review the following significant components of loss reserves on a quarterly
basis:
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IBNR
reserves for losses This includes amounts for the medical and indemnity
components of the workers compensation claim payments, net of subrogation
recoveries and deductibles;
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IBNR
reserves for defense and cost containment expenses (DCC, also referred to
as allocated loss adjustment expenses (ALAE)), net of subrogation
recoveries and deductibles;
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reserve for
adjusting and other expenses, also known as unallocated loss adjustment
expenses (ULAE); and
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reserve for
loss based assessments, also referred to as the 8F reserve in reference to
Section 8, Compensation for Disability, subsection (f), Injury increasing
disability, of the United States Longshore and Harbor Workers Compensation
Act (USL&H) Act.
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The
reserves for losses and DCC are also reviewed gross and net of reinsurance
(referred to as net). For gross losses, the claims for the Washington
USL&H Plan, the KEIC claims assumed in the Acquisition and claims assumed
from the NCCI residual market pools are excluded from this discussion.
IBNR
reserves include a provision for future development on known claims, a reopened
claims reserve, a provision for claims incurred but not reported and a
provision for claims in transit (incurred and reported but not recorded).
Our
analysis is done separately for the indemnity, medical and DCC components of
the total loss reserves within each accident year. In addition, the analysis is
completed separately for the following three categories: State Act California;
State Act excluding California; and USL&H. The business is divided into
these three categories for the determination of ultimate losses due to
differences in the laws that cover each of these categories.
Workers
compensation insurance is statutorily provided for in all of the states in which
we do business. State laws and regulations provide for the form and content of
policy coverage and the rights and benefits that are available to injured
workers, their representatives and medical providers. Because the benefits are
established by state statute there can be significant variation in these
benefits by state. We refer to this coverage as State Act.
Our
business is also affected by federal laws including the USL&H Act, which is
administered by the Department of Labor, and the Merchant Marine Act of 1920,
or Jones Act. The USL&H Act contains various provisions affecting our
business, including the nature of the liability of employers of longshoremen,
the rate of compensation to an injured longshoreman, the selection of physicians,
compensation for disability and death and the filing of claims. We refer to the
business covered under the USL&H Act and the Jones Act as USL&H.
Because
there are different laws and benefit levels that affect the State Act versus
USL&H business, there is a strong likelihood that these categories will
exhibit different loss development characteristics which will influence the
ultimate loss calculations. Separating the data into the State Act and
USL&H categories allows us to use actuarial methods that contemplate these
differences.
The
State Act category is further split into California and excluding
non-California groupings. This is due to the extensive reform activity that has
taken place in California as discussed above. Since the California data is
subject to
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additional
variation due to the reform activity, separating the data in this fashion
allows us to review the non-California State Act data with no impact from the
California reform activity.
Development
factors, expected loss rates and expected loss ratios are derived from the
combined experience of us and our predecessor.
Gross
ultimate loss (indemnity, medical and ALAE separately) for each category is
estimated using the following actuarial methods:
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paid loss
(or ALAE) development;
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incurred loss (or ALAE) development;
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Bornhuetter-Ferguson
using ultimate premiums and paid loss (or ALAE); and
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Bornhuetter-Ferguson
using ultimate premiums and incurred loss (or ALAE).
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A
gross ultimate value is selected by reviewing the various ultimate estimates
and applying actuarial judgment to achieve a reasonable point estimate of the
ultimate liability. The gross IBNR reserve equals the selected gross ultimate
loss minus the gross paid losses and gross case reserves as of the valuation
date. The selected gross ultimate loss and ALAE are reviewed and updated on a
quarterly basis.
Variation
in Ultimate Loss Estimates
In
light of our short operating history and uncertainties concerning the effects
of recent legislative reforms, specifically as they relate to our California
workers compensation experience, the actuarial techniques discussed above use
the historical experience of our predecessor as well as industry information in
the analysis of loss reserves. We are able to effectively draw on the
historical experience of our predecessor because most of the current members of
our management and adjusting staff also served as the management and adjusting
staff of our predecessor. Over time, we expect to place more reliance on our
own developed loss experience and less on our predecessors and industry
experience.
These
techniques recognize, among other factors:
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our claims
experience and that of our predecessor;
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the
industrys claim experience;
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historical
trends in reserving patterns and loss payments;
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the impact
of claim inflation and/or deflation;
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the pending
level of unpaid claims;
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the cost of
claim settlements;
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legislative
reforms affecting workers compensation;
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the overall
environment in which insurance companies operate; and
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trends in
claim frequency and severity.
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In
addition, there are loss and loss adjustment expense risk factors that affect
workers compensation claims that can change over time and also cause our loss
reserves to fluctuate. Some examples of these risk factors include, but are not
limited to, the following:
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recovery
time from the injury;
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degree of
patient responsiveness to treatment;
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use of
pharmaceutical drugs;
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type and
effectiveness of medical treatments;
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frequency of visits to healthcare providers;
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changes in
costs of medical treatments;
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availability
of new medical treatments and equipment;
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types of
healthcare providers used;
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availability
of light duty for early return to work;
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attorney
involvement;
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wage
inflation in states that index benefits; and
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changes in
administrative policies of second injury funds.
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Variation
can also occur in the loss reserves due to factors that affect our book of
business in general. Some examples of these risk factors include, but are not limited
to, the following:
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injury type
mix;
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change in
mix of business by state;
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change in
mix of business by employer type;
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small volume
of internal data; and
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significant
exposure growth over recent data periods.
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Impact
of Changes in Key Assumptions on Reserve Volatility
The
most significant factor currently impacting our loss reserve estimates is the
reliance on historical reserving patterns and loss payments from our
predecessor and the industry, also referred to as loss development. This is due
to our limited operating history as discussed above. The actuarial methods that
we use depend at varying levels on loss development patterns based on past
information. Development is defined as the difference, on successive valuation
dates, between observed values of certain fundamental quantities that may be
used in the loss reserve estimation process. For example, the data may be paid
losses, case incurred losses and the change in case reserves or claim counts,
including reported claims, closed claims or reopened claims. Development can be
expected, meaning it is consistent with prior results; favorable (better than
expected); or unfavorable (worse than expected). In all cases, we are comparing
the actual development of the data in the current valuation with what was
expected based on the historical patterns in the underlying data. Favorable
development indicates a basis for reducing the estimated ultimate loss amounts
while unfavorable development indicates a basis for increasing the estimated
ultimate loss amounts. We reflect the favorable or unfavorable development in
loss reserves in the results of operations in the period in which the ultimate
loss estimates are changed.
Due
to the relative immaturity of our book of business, the challenge has been to
give the right weight in the ultimate loss estimation process to the new data
as it becomes available. As discussed above, management believes that it
generally takes workers compensation losses approximately 48 to 60 months
after the start of an accident year until the data is viewed as fully credible
for paid and incurred reserve evaluation methods. Due to our limited operating
history, we have four complete accident years that were developed 51 months, 39
months, 27 months and 15 months (2004, 2005, 2006 and 2007, respectively) at
March 31, 2008. Our oldest complete accident year was 51 months old as of March
31, 2008. For accident years 2003 through 2007, we are using a Bornhuetter-Ferguson
approach, which blends the loss development and expected loss ratio methods.
Due to the favorable development exhibited by the data for accident years 2004
and 2005 at 17 to 18 months of development, management began to place more
weight on the results of the Bornhuetter-Ferguson method in its ultimate loss
estimates for accident years 2005, 2006 and 2007. As new data emerges and
continues to demonstrate favorable development, this adds credibility to the
existing data which enables management to reflect it more fully in its
estimation process. For all accident years, we have not completely relied on
the most recent data points in our loss development selections.
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Because of
recent favorable development trends, we believe this has the effect of
increasing our estimated reserves as compared to reserves calculated with
complete reliance on these data points. Estimating loss reserves is an
uncertain and complex process which involves actuarial techniques and
management judgment. Actuarial analysis generally assumes that past patterns
demonstrated in the data will repeat themselves and that the data provides a
basis for estimating future loss reserves. However, since conditions and trends
that have affected losses in the past may not occur in the future in the same
manner, if at all, future results may not be reliably predicted by the prior
data.
Our
paid loss data for state act indemnity, both California and excluding
California, displayed decreasing, or deflationary, trends over recent
valuations. The decreasing trends are exhibited in the paid loss development
data for the 15 months to 51 months development period. The decisions to
decrease the estimated ultimate losses for accident years 2005, 2006 and 2007
at March 31, 2008 were made, as the underlying loss data showed sustained and
continued improvement over the prior twelve months, which we determined was an
appropriate amount of time to be considered reliable for our estimate. We
believe that our loss development factor selections are appropriate given the
relative immaturity of our data. Over time, as the data for these accident
years mature and uncertainty surrounding the ultimate outcome of the claim costs
diminishes, the full impact of the actual loss development will be factored
into our assumptions and selections.
In
the first quarter of 2008, we experienced development in all three categories.
For State Act California, there was favorable development for accident years
2005, 2006 and 2007 that resulted in a reduction of our gross ultimate loss
estimates of $1.5 million, $2.7 million and $1.0 million, respectively. For
accident year 2004 there was unfavorable development for ALAE which resulted in
an increase in our gross ultimate ALAE estimate of $0.4 million. For
non-California State Act, there was favorable development for accident year
2006 and 2007 that resulted in a reduction of our gross ultimate loss estimate
of 0.6 million and $1.5 million, respectively. For USL&H, there was
favorable development for accident years 2006 and 2007 that resulted in a
reduction of our gross ultimate loss estimates by $0.3 million and $0.7
million, respectively. For accident years 2005 and 2004, there was unfavorable
development which resulted in an increase in our gross ultimate loss estimates
of $0.2 million and $0.1 million, respectively. For all other accident years,
the development was at expected levels which did not warrant a change to our
gross ultimate loss estimates.
Reserve
Sensitivities
Although
many factors influence the actual cost of claims and the corresponding unpaid
loss and loss adjustment expense estimates, we do not measure and estimate
values for all of these variables individually. This is due to the fact that
many of the factors that are known to impact the cost of claims cannot be
measured directly. This is the case for the impact of economic inflation on
claim costs, coverage interpretations and jury determinations. In most
instances, we rely on historical experience or industry information to estimate
values for the variables that are explicitly used in the unpaid loss and loss
adjustment expense analysis. We assume that the historical effect of these
unmeasured factors, which is embedded in our experience or industry experience,
is representative of future effects of these factors. It is important to note
that actual claims costs will vary from our estimate of ultimate claim costs,
perhaps by substantial amounts, due to the inherent variability of the business
written, the potentially significant claim settlement lags and the fact that
not all events affecting future claim costs can be estimated.
As discussed in
the previous section, there are a number of variables that can impact,
individually or in combination, the adequacy of our loss and loss adjustment
expense liabilities. While the actuarial methods employed factor in amounts for
these circumstances, the loss reserves may prove to be inadequate despite the actuarial
methods used. Several examples are provided below to highlight the potential
variability present in our loss reserves. Each of these examples represents
scenarios that are reasonably likely to occur over time. For example, there may
be a number of claims where the unpaid loss and loss adjustment expense
associated with future medical treatment proves to be inadequate because the
injured workers do not respond to medical treatment as expected by the claims
examiner. If we assume this affects 10% of the open claims and, on average, the
unpaid loss and loss adjustment expenses on these claims are 20% inadequate,
this would result in our unpaid loss and loss adjustment expense liability
being inadequate by approximately $5.1 million, or 2%, as of March 31, 2008.
Another example is claim inflation. Claim inflation can result from medical
cost inflation or wage inflation. As discussed above, the actuarial methods
employed include an amount for claim inflation based on historical experience.
We assume that the historical effect of this factor, which is embedded in our
experience and industry experience, is representative of future effects for
claim inflation. To the extent that the historical factors, and the actuarial
methods utilized, are inadequate to recognize future inflationary trends, our
unpaid loss and loss adjustment expense liabilities may be inadequate. If our
estimate of future medical trend is two percentage points inadequate (e.g., if
we estimate a 9% annual trend and the actual trend is 11%), our unpaid loss and
loss adjustment expense liability could be inadequate.
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The amount of
the inadequacy would depend on the mix of medical and indemnity payments and
the length of time until the claims are paid. For example, if we assume that
50% of the unpaid loss and loss adjustment expense is associated with medical
payments and an average payout period of 5 years, our unpaid loss and loss
adjustment expense liabilities would be inadequate by approximately $12.8
million on a pre-tax basis, or 5%, as of March 31, 2008. Under these
assumptions, the inadequacy of approximately $12.8 million represents
approximately 4.2% of total stockholders equity at March 31, 2008. The impact
of any reserve deficiencies, or redundancies, on our reported results and
future earnings is discussed below.
In
the event that our estimates of ultimate unpaid loss and loss adjustment
expense liabilities prove to be greater or less than the ultimate liability,
our future earnings and financial position could be positively or negatively
impacted. Future earnings would be reduced by the amount of any deficiencies in
the year(s) in which the claims are paid or the unpaid loss and loss adjustment
expense liabilities are increased. For example, if we determined our unpaid
loss and loss adjustment expense liability of $255.1 million as of March 31,
2008 to be 5% inadequate, we would experience a pre-tax reduction in future
earnings of approximately $12.8 million. This reduction could be realized in
one year or multiple years, depending on when the deficiency is identified. The
deficiency, after tax effects, would also impact our financial position because
our statutory surplus would be reduced by an amount equivalent to the reduction
in net income. Any deficiency is typically recognized in the unpaid loss and
loss adjustment expense liability and, accordingly, it typically does not have
a material effect on our liquidity because the claims have not been paid. Since
the claims will typically be paid out over a multi-year period, we have
generally been able to adjust our investments to match the anticipated future
claim payments. Conversely, if our estimates of ultimate unpaid loss and loss
adjustment expense liabilities prove to be redundant, our future earnings and
financial position would be improved.
Reinsurance
Recoverables
Reinsurance
recoverables on paid and unpaid losses represent the portion of the loss and
loss adjustment expenses that is assumed by reinsurers. These recoverables are
reported on our balance sheet separately as assets, as reinsurance does not
relieve us of our legal liability to policyholders and ceding companies. We are
required to pay losses even if a reinsurer fails to meet its obligations under
the applicable reinsurance agreement. Reinsurance recoverables are determined
based in part on the terms and conditions of reinsurance contracts, which could
be subject to interpretations that differ from ours based on judicial theories
of liability. We calculate amounts recoverable from reinsurers based on our
estimates of the underlying loss and loss adjustment expenses, which themselves
are subject to significant judgments and uncertainties described above under
the heading Unpaid Loss and Loss Adjustment Expenses. Changes in the estimates
and assumptions underlying the calculation of our loss reserves may have an
impact on the balance of our reinsurance recoverables. In general, one would
expect an increase in our underlying loss reserves on claims subject to
reinsurance to have an upward impact on our reinsurance recoverables. The
amount of the impact on reinsurance recoverables would depend on a number of
considerations including, but not limited to, the terms and attachment points
of our reinsurance contracts and the incurred amount on various claims subject
to reinsurance. We also bear credit risk with respect to our reinsurers, which
can be significant considering that some claims may remain open for an extended
period of time.
We
periodically evaluate our reinsurance recoverables, including the financial
ratings of our reinsurers, and revise our estimates of such amounts as
conditions and circumstances change. Changes in reinsurance recoverables are
recorded in the period in which the estimate is revised. As of March 31, 2008
and December 31, 2007, we had no reserve for uncollectible reinsurance
recoverables. We assessed the collectibility of our period-end receivables and
believe that all amounts are collectible based on currently available
information.
Deferred
Policy Acquisition Costs
We
defer commissions, premium taxes and certain other costs that vary with and are
primarily related to the acquisition of insurance contracts. These costs are
capitalized and charged to expense in proportion to the recognition of premiums
earned. The method followed in computing deferred policy acquisition costs
limits the amount of these deferred costs to their estimated realizable value,
which gives effect to the premium to be earned, related estimated investment income,
anticipated losses and settlement expenses and certain other costs we expect to
incur as the premium is earned. Judgments regarding the ultimate recoverability
of these deferred costs are highly dependent upon the estimated future costs
associated with our unearned premiums. If our expected claims and expenses,
after considering investment income, exceed our unearned premiums, we would be
required to write-off a portion of deferred policy acquisition costs. To date,
we have not needed to write-off any portion of our deferred acquisition costs.
If our estimate of anticipated losses and related costs was 10% inadequate, our
deferred acquisition
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costs as of
March 31, 2008 would still be fully recoverable and no write-off would be
necessary. We will continue to monitor the balance of deferred acquisition
costs for recoverability.
Income
Taxes
We
use the asset and liability method of accounting for income taxes. Under this
method, deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases and operating loss and tax credit carry-forwards. Deferred tax assets and
liabilities are measured using tax rates expected to apply to taxable income in
the years in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in the statement of operations in the period that includes
the enactment date.
In
assessing the realizability of deferred tax assets, management considers
whether it is more likely than not that some portion or all of the deferred tax
assets will not be realized. The ultimate realization of deferred tax assets is
dependent upon the generation of future taxable income during the periods in
which those temporary differences become deductible. This analysis requires
management to make various estimates and assumptions, including the scheduled
reversal of deferred tax liabilities, projected future taxable income and the
effect of tax planning strategies. If actual results differ from managements
estimates and assumptions, we may be required to establish a valuation
allowance to reduce the deferred tax assets to the amounts more likely than not
to be realized. The establishment of a valuation allowance could have a
significant impact on our financial position and results of operations in the
period in which it is deemed necessary. To date, we have not needed to record a
valuation allowance against our deferred tax assets. We anticipate that our
deferred tax assets will increase as our business continues to grow. We will
continue to monitor the balance of our deferred tax assets for realizability.
Effective
January 1, 2007, we adopted FASB Interpretation No. 48,
Accounting for Uncertainties in Income Taxes, an
Interpretation of FASB Statement No. 109
(FIN 48), and it did not
have a significant impact on our financial position or results of operations.
FIN 48 prescribes a recognition threshold and measurement process for financial
statement recognition and measurement of a tax position taken or expected to be
taken in a tax return, and also provides guidance on the derecognition of
previously recorded benefits and their classification, as well as the proper
recording of interest and penalties, accounting in interim periods, disclosures
and transition. As of March 31, 2008 and December 31, 2007, we had no
unrecognized tax benefits. We do not anticipate that the amount of unrecognized
tax benefits will significantly increase in the next 12 months. Our policy is
to recognize interest and penalties on unrecognized tax benefits as an element
of income tax expense (benefit) in our consolidated statements of operations.
We file consolidated U.S. federal and state income tax returns. The tax years
which remain subject to examination by the taxing authorities are the years
ending December 31, 2004, 2005, 2006 and 2007.
Impairment
of Investment Securities
Impairment
of investment securities results in a charge to operations when the fair value
of a security declines below our cost and is deemed to be other-than-temporary.
We regularly review our investment portfolio to evaluate the necessity of
recording impairment losses for other-than-temporary declines in the fair value
of investments. A number of criteria are considered during this process,
including but not limited to the following: the current fair value as compared
to amortized cost or cost, as appropriate, of the security; the length of time
the securitys fair value has been below amortized cost; our intent and ability
to retain the investment for a period of time sufficient to allow for an
anticipated recovery in value; specific credit issues related to the issuer;
and current economic conditions, including interest rates.
In
general, we focus on those securities whose fair value was less than 80% of
their amortized cost or cost, as appropriate, for six or more consecutive
months. We also analyze the entire portfolio for other factors that might
indicate a risk of impairment. Other-than-temporary impairment losses result in
a permanent reduction of the carrying value of the underlying investment. To
date, we have not needed to record any other-than-temporary impairments of our
investment securities. Please refer to the tables in Note 3 of the unaudited
condensed consolidated financial statements in Part I, Item 1 of this quarterly
report for additional information on unrealized losses on our investment
securities. Please refer to Part I, Item 3 of this quarterly report for tables
showing the sensitivity of the fair value of our fixed-income investments to
selected hypothetical changes in interest rates.
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Earned
But Unbilled Premiums
Shortly
following the expiration of an insurance policy, we perform a final payroll
audit of our insureds to determine the final premium to be billed and earned. These
final audits generally result in an audit adjustment, either increasing or
decreasing the estimated premium earned and billed to date. We estimate the
amount of premiums that have been earned but are unbilled at the end of a
reporting period by analyzing historical earned premium adjustments made at
final audit for the preceding 12 months and applying the average adjustment
percentage against our in-force earned premium for the period. These estimates
are subject to changes in policyholders payrolls due to growth, economic
conditions, seasonality and other factors and to fluctuations in our in-force
premium. For example, the amount of our accrual for premiums earned but
unbilled fluctuated between $0 and $1.2 million in 2007 and between $1.2
million and $1.8 million in 2006. The balance of our accrual for premiums
earned but unbilled was a $0 and $44,000 at March 31, 2008 and December 31,
2007, respectively. Although considerable variability is inherent in such
estimates, management believes that the accrual for earned but unbilled
premiums is reasonable. The estimates are reviewed quarterly and adjusted as
necessary as experience develops or new information becomes known. Any such
adjustments are included in current operations.
Retrospective
Premiums
The
premiums for our retrospectively rated loss sensitive plans are reflective of
the customers loss experience because, beginning six months after the
expiration of the relevant insurance policy, and annually thereafter, we
recalculate the premium payable during the policy term based on the current
value of the known losses that occurred during the policy term. While the
typical retrospectively rated policy has around five annual adjustment or
measurement periods, premium adjustments continue until mutual agreement to
cease future adjustments is reached with the policyholder. Retrospective
premiums for primary and reinsured risks are included in income as earned on a
pro rata basis over the effective period of the respective policies. Earned
premiums on retrospectively rated policies are based on our estimate of loss
experience as of the measurement date. Unearned premiums are deferred and
include that portion of premiums written that is applicable to the unexpired
period of the policies in force and estimated adjustments of premiums on
policies that have retrospective rating endorsements.
We
bear credit risk with respect to retrospectively rated policies. Because of the
long duration of our loss sensitive plans, there is a risk that the customer
will fail to pay the additional premium. Accordingly, we obtain collateral in
the form of letters of credit or deposits to mitigate credit risk associated
with our loss sensitive plans. If we are unable to collect future retrospective
premium adjustments from an insured, we would be required to write-off the
related amounts, which could impact our financial position and results of
operations. To date, there have been no such write-offs. Retrospectively rated
policies accounted for approximately 9.3% of direct premiums written in the
three months ended March 31, 2008 and approximately 11.9% of direct premiums
written in the year ended December 31, 2007.
Recent Accounting Pronouncements
In
September 2006, the FASB issued SFAS No. 157,
Fair
Value Measurements
, which defines fair value and establishes a
framework for measuring fair value in GAAP and expands disclosures about fair
value measurements. The provisions for SFAS No. 157 are effective for fiscal
years beginning after November 15, 2007, and interim periods within those
fiscal years. We adopted the provisions of SFAS No. 157 as of January 1, 2008,
which did not have a material effect on our consolidated financial condition or
results of operations.
In
February 2007, the FASB issued SFAS No. 159,
The
Fair Value Option for Financial Assets and Financial Liabilities Including an
Amendment of FASB Statement No. 115
, which permits entities to
choose to measure many financial instruments and certain other items at fair
value in order to mitigate volatility in reported earnings caused by measuring
related assets and liabilities differently and without having to apply complex
hedge accounting provisions. The provisions for SFAS No. 159 are effective for
fiscal years beginning after November 15, 2007, and interim periods within
those fiscal years. We adopted the provisions of SFAS No. 159 as of January 1,
2008, which did not have a material effect on our consolidated financial
condition or results of operations.
|
|
Item 3
.
|
Quantitative and Qualitative Disclosures About Market Risk
|
Market
risk is the potential economic loss principally arising from adverse changes in
the fair value of financial instruments. The major components of market risk
affecting us are credit risk and interest rate risk.
- 33 -
Credit Risk
Credit
risk is the potential economic loss principally arising from adverse changes in
the financial condition of a specific debt issuer. We address this risk by
investing primarily in fixed-income securities which are rated A or higher by
Standard & Poors. We also independently, and through our outside
investment managers, monitor the financial condition of all of the issuers of
fixed-income securities in the portfolio. To limit our exposure to risk, we
employ stringent diversification rules that limit the credit exposure to any
single issuer or business sector.
Interest Rate Risk
We
had fixed-income investments with a fair value of $493.0 million at March 31,
2008 that are subject to interest rate risk, compared with $474.8 million at
December 31, 2007. We manage the exposure to interest rate risk through a
disciplined asset/liability matching and capital management process. In the
management of this risk, the characteristics of duration, credit and
variability of cash flows are critical elements. These risks are assessed
regularly and balanced within the context of the liability and capital
position.
The
table below summarizes our interest rate risk as of March 31, 2008 and December
31, 2007. It illustrates the sensitivity of the fair value of fixed-income
investments to selected hypothetical changes in interest rates as of March 31,
2008 and December 31, 2007. The selected scenarios are not predictions of
future events, but rather illustrate the effect that such events may have on
the fair value of our fixed-income portfolio and shareholders equity.
Interest Rate Risk as of March 31, 2008
|
|
|
|
|
|
|
|
|
|
|
|
|
Hypothetical Change in Interest
Rates
|
|
Estimated
Change in
Fair Value
|
|
Fair
Value
|
|
Hypothetical
Percentage
Increase
(Decrease) in
Portfolio
Value
|
|
|
|
|
|
|
|
|
|
|
|
($ in
thousands)
|
|
200 basis
point increase
|
|
$
|
(44,347
|
)
|
$
|
448,630
|
|
|
|
(9.0
|
)%
|
|
100 basis
point increase
|
|
|
(21,672
|
)
|
|
471,305
|
|
|
|
(4.4
|
)%
|
|
No change
|
|
|
|
|
|
492,977
|
|
|
|
|
|
|
100 basis
point decrease
|
|
|
20,651
|
|
|
513,628
|
|
|
|
4.2
|
%
|
|
200 basis
point decrease
|
|
|
40,299
|
|
|
533,276
|
|
|
|
8.2
|
%
|
|
Interest Rate
Risk as of December 31, 2007
|
|
|
|
|
|
|
|
|
|
|
|
|
Hypothetical Change in Interest
Rates
|
|
Estimated
Change in
Fair Value
|
|
Fair
Value
|
|
Hypothetical
Percentage
Increase
(Decrease) in
Portfolio
Value
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
($ in
thousands)
|
|
|
|
|
|
|
200 basis
point increase
|
|
$
|
(40,927
|
)
|
$
|
433,829
|
|
|
|
(8.6
|
)%
|
|
100 basis
point increase
|
|
|
(20,041
|
)
|
|
454,715
|
|
|
|
(4.2
|
)%
|
|
No change
|
|
|
|
|
|
474,756
|
|
|
|
|
|
|
100 basis
point decrease
|
|
|
19,195
|
|
|
493,951
|
|
|
|
4.0
|
%
|
|
200 basis
point decrease
|
|
|
37,545
|
|
|
512,301
|
|
|
|
7.9
|
%
|
|
|
|
Item 4.
|
Controls and Procedures
|
Disclosure Controls
and Procedures
Under
the supervision and with the participation of management, including our Chief
Executive Officer and our former Chief Financial Officer, we have carried out
an evaluation of our disclosure controls and procedures (as defined in Rule
13a-15(e) under the Exchange Act). Based on that evaluation, our Chief Executive
Officer and our former Chief Financial Officer concluded that our disclosure
controls and procedures were effective as of the end of the period covered by
this report to ensure that information we are required to disclose in reports
that are filed or submitted under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in the rules and
forms specified by the SEC and is accumulated and communicated to our
management, including our Chief Executive Officer and our former Chief
Financial Officer, as appropriate to allow timely decisions regarding required
disclosure.
- 34 -
Changes
in Internal Control over Financial Reporting
There
have not been any changes in our internal control over financial reporting (as
such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)
during our first fiscal quarter of 2008 that have materially affected, or are
reasonably likely to materially affect, our internal control over financial reporting.
PART II
OTHER INFORMATION
You
should carefully consider the risks described below and in our Annual Report on
Form 10-K filed with the SEC on March 17, 2008, together with all of the other
information included in this quarterly report. Such risks and uncertainties are
not the only ones facing us. If any such risks actually occur, our business,
financial condition or operating results could be harmed. Any such risks could
result in a significant or material adverse effect on our financial condition
or results of operations, and a corresponding decline in the market price of
our common stock. You could lose all or part of your investment. Such risks
also include forward-looking statements and our actual results may differ
substantially from those discussed in those forward-looking statements. Please
refer to the discussion under the heading Cautionary Statement in Part I,
Item 2 of this quarterly report.
Under
the heading Item 1A. Risk Factors Risk Related to Our Business We could be
adversely affected by the loss of one or more principal employees or by an
inability to attract or retain staff in our Annual Report on Form 10-K filed
with the SEC on March 17, 2008, we included a discussion about the potential
adverse impact to our business of losing a member of our senior management
team, including our chief financial officer. Joseph S. De Vita, our senior vice
president and chief financial officer, passed away unexpectedly on Sunday,
April 20, 2008. We have begun the process of selecting a new chief financial
officer but are unable to predict how long the selection process, which could
be challenging, will take and when we will name a new chief financial officer.
In the meantime, the duties of the chief financial officer are being handled by
other senior officers on whom we will be more dependent during this transition
period.
|
|
Item 2.
|
Unregistered Sales of Equity Securities and Use of Proceeds
|
We
did not purchase any of our equity securities during the three months ended
March 31, 2008.
The
list of exhibits in the Exhibit Index to this quarterly report is incorporated
herein by reference.
- 35 -
SIGNATURES
Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
|
|
|
|
|
SEABRIGHT INSURANCE HOLDINGS, INC.
|
|
|
Date: May 12, 2008
|
|
|
|
|
|
|
|
|
By:
|
/s/ John G. Pasqualetto
|
|
|
|
|
|
|
|
John G. Pasqualetto
|
|
|
|
Chairman, President and Chief
Executive Officer
|
|
|
|
(Principal Executive Officer)
|
|
|
|
|
|
|
By:
|
/s/ M. Philip Romney
|
|
|
|
|
|
|
|
M. Philip Romney
|
|
|
|
Vice President Finance, Principal Accounting
|
|
|
|
Officer and Assistant Secretary
|
|
|
|
(Chief Accounting Officer)
|
|
- 36 -
EXHIBIT INDEX
The
list of exhibits in the Exhibit Index to this quarterly report on Form 10-Q is
incorporated herein by reference. Exhibits 31.1 and 31.2 are being filed as
part of this quarterly report on Form 10-Q. Exhibits 32.1 and 32.2 are being
furnished with this quarterly report on Form 10-Q.