Item 1.
Terrorism Reinsurance
As extended and amended, the Terrorism Risk Act is effective through December 31, 2014. The Terrorism Risk Act may provide us with reinsurance protection under certain circumstances and subject to certain limitations. The Secretary of the Treasury must declare the act to be a “certified act of terrorism” for it to be covered under this federal program. As amended in 2007, the definition of terrorism for purposes of the Terrorism Risk Act includes acts of terror perpetrated by domestic, as well as foreign, persons or interests. No federal compensation will be paid under the Terrorism Risk Act unless aggregate insured losses from the act for the entire insurance industry exceed certain threshold amounts ($100.0 million for terrorism losses occurring in 2007 and for the remainder of the program). Each insurance company is responsible for a deductible based on a percentage of the direct earned premiums of its affiliated group in the previous calendar year for commercial lines policies (except for certain excluded lines such as commercial auto) covering risks in the United States. This deductible amount is 20.0% of such premiums for losses occurring in 2007 and subsequent years. For losses in excess of the deductible, the federal government will reimburse 85% of the insurer’s loss occurring in 2007 and subsequent years. As stated above, all layers of our reinsurance program contain sublimits for losses caused by an act of terrorism, as defined in the Terrorism Risk Act, subject to certain absolute exclusions.
Competition
We operate in niche markets where we believe we have few competitors with a similar focus. The insurance industry in general is highly competitive and there is significant competition in the national workers’ compensation industry. Competition in the insurance business is based on many factors, including premiums charged, services provided, financial strength ratings assigned by independent rating agencies, speed of claims payments, reputation, perceived financial strength and general experience. Many of the insurers with which we compete have significantly greater financial, marketing and management resources and experience than we do. In addition, our competitive advantage may be limited due to the small number of insurance products that we offer. Some of our competitors have additional competitive leverage because of the wide array of insurance products that they offer. For example, it may be more convenient for a potential customer to purchase numerous different types of insurance products from one insurance carrier. We do not offer a wide array of insurance products due to our targeted market niches, and we may lose potential customers to our larger, more diverse competitors as a result. We may also compete with new market entrants in the future.
While more than 400 insurance companies participate in the national workers’ compensation market, our competitors are relatively few in number because we operate in niche markets. We compete with regional and national insurance companies and state-sponsored insurance funds, as well as potential insureds that have decided to self-insure. Our primary competitors vary slightly based on the type of product and by region. We have a number of competitors that limit their writings on a geographic basis. For our maritime product, our primary competitors are American International Group (“AIG”), American Longshore Mutual Association Ltd. and Signal Mutual Indemnity Association Ltd. Additional competitors by region are Alaska National Insurance
Company in our Western Region; Louisiana Workers Compensation Company (“LWCC”) and Texas Mutual in our Gulf Region; and Liberty Mutual in our Northeastern Region. For our state act construction product, our primary competitors are AIG, Zurich and Liberty Mutual in all of our regions. Additional competitors by region are State Compensation Insurance Fund of California (“SCIF”), Arizona State Fund and Travelers in our Western Region; Texas Mutual, LWCC and Amerisafe in our Gulf Region; Acuity Group in our Midwestern Region; Hartford and PMA in our Northeastern Region; and Bridgefield, FCCI and Zenith in our Southeastern Region . For our ADR product, our primary competitors are AIG, Zurich and SCIF. In Hawaii, our primary competition is AIG and Hawaii Employers Mutual Insurance Company.
We believe our competitive advantages are our strong reputation in our niche markets, our local knowledge in the markets where we operate, our specialized underwriting expertise, our client-driven claims and loss control service capabilities, our focus on niche markets, our loyal brokerage distribution, our low operating expense ratio and our customized systems. In addition to these competitive advantages, as discussed above, we offer our maritime customers regulated insurance coverage without the joint-and-several liability associated with coverage provided by offshore mutual organizations.
Ratings
Many insurance buyers, agents and brokers use the ratings assigned by A.M. Best and other rating agencies to assist them in assessing the financial strength and overall quality of the companies from which they are considering purchasing insurance. We have been rated “A−” (Excellent) by A.M. Best since the completion of the Acquisition. An “A−” rating is the fourth highest of 15 rating categories used by A.M. Best. In evaluating a company’s financial and operating performance, A.M. Best reviews the company’s profitability, indebtedness and liquidity, as well as its book of business, the adequacy and soundness of its reinsurance, the quality and estimated fair value of its assets, the adequacy of its loss reserves, the adequacy of its surplus, its capital structure, the experience and competence of its management and its market presence. This rating is intended to provide an independent opinion of an insurer’s ability to meet its obligations to policyholders and is not an evaluation directed at investors.
Regulation
Holding Company Regulation
As a member of an insurance holding company, SeaBright Insurance Company, our insurance company subsidiary, is subject to regulation by the states in which it is domiciled or transacts business. SeaBright Insurance Company is domiciled in Illinois and is considered to be commercially domiciled in California. An insurer is deemed “commercially domiciled” in California if, during the three preceding fiscal years, or a lesser period of time if the insurer has not been licensed in California for three years, the insurer has written an average of more gross premiums in California than it has written in its state of domicile, and such gross premiums written constitute 33% or more of its total gross premiums written in the United States for such period. Pursuant to the insurance holding company laws of Illinois and California, SeaBright Insurance Company is required to register with the Illinois Division of Insurance and the California Department of Insurance. In addition, SeaBright Insurance Company is required to periodically report certain financial, operational and management data to the Illinois Division of Insurance and the California Department of Insurance. All transactions within a holding company system affecting an insurer must have fair and reasonable terms, charges or fees for services performed must be reasonable, and the insurer’s policyholder surplus following any transaction must be both reasonable in relation to its outstanding liabilities and adequate for its needs. Notice to, and in some cases approval from, insurance regulators in Illinois and California is required prior to the consummation of certain affiliated and other transactions involving SeaBright Insurance Company.
Changes of Control
In addition, the insurance holding company laws of Illinois and California require advance approval by the Illinois Division of Insurance and the California Department of Insurance of any change in control of
SeaBright Insurance Company. “Control” is generally presumed to exist through the direct or indirect ownership of 10% or more of the voting securities of a domestic insurance company or of any entity that controls a domestic insurance company. In addition, insurance laws in many states contain provisions that require prenotification to the insurance commissioners of a change in control of a non-domestic insurance company licensed in those states. Any future transactions that would constitute a change in control of SeaBright Insurance Company, including a change of control of us, would generally require the party acquiring control to obtain the prior approval of the Illinois Division of Insurance and the California Department of Insurance and may require pre-acquisition notification in applicable states that have adopted pre-acquisition notification provisions. Obtaining these approvals may result in a material delay of, or deter, any such transaction.
These laws may discourage potential acquisition proposals and may delay, deter or prevent a change of control of SeaBright, including through transactions, and in particular unsolicited transactions, that some or all of the stockholders of SeaBright might consider to be desirable.
State Insurance Regulation
Insurance companies are subject to regulation and supervision by the department of insurance in the state in which they are domiciled and, to a lesser extent, other states in which they conduct business. SeaBright Insurance Company is primarily subject to regulation and supervision by the Illinois Division of Insurance and the California Department of Insurance. These state agencies have broad regulatory, supervisory and administrative powers, including, among other things, the power to: grant and revoke licenses to transact business; license agents; set the standards of solvency to be met and maintained; determine the nature of, and limitations on, investments and dividends; approve policy forms and rates in some states; periodically examine an insurance company’s financial condition; determine the form and content of required financial statements; and periodically examine market conduct.
Detailed annual and quarterly financial statements and other reports are required to be filed with the departments of insurance of the states in which we are licensed to transact business. The financial statements and condition of SeaBright Insurance Company are subject to periodic examination by the Illinois Division of Insurance and the California Department of Insurance. In 2007, the Illinois Division of Insurance completed a routine comprehensive examination of our 2005 statutory annual statement. On June 21, 2007, the Division officially adopted, without fines or penalties assessed, its Report of Examination as of December 31, 2005.
In addition, many states have laws and regulations that limit an insurer’s ability to withdraw from a particular market. For example, states may limit an insurer’s ability to cancel or not renew policies. Furthermore, certain states prohibit an insurer from withdrawing one or more lines of business from the state, except pursuant to a plan that is approved by the state insurance department. The state insurance department may disapprove a plan that may lead to market disruption. Laws and regulations that limit cancellation and non-renewal and that subject program withdrawals to prior approval requirements may restrict our ability to exit unprofitable markets.
Federal Laws and Regulations
As a provider of maritime workers’ compensation insurance, we are subject to the USL&H Act, which generally covers exposures on the navigable waters of the United States and in adjoining waterfront areas, including exposures resulting from loading and unloading vessels, and the Jones Act, which covers exposures at sea. We are also subject to regulations related to the USL&H Act and the Jones Act.
The USL&H Act, which is administered by the U.S. Department of Labor, provides medical benefits, compensation for lost wages and rehabilitation services to longshoremen, harbor workers and other maritime workers who are injured during the course of employment or suffer from diseases caused or worsened by conditions of employment. The Department of Labor has the authority to require us to make deposits to serve as collateral for losses incurred under the USL&H Act. Several other statutes extend the provisions of the USL&H Act to cover other classes of private-industry workers. These include workers engaged in the extraction of natural resources from the outer continental shelf, employees on American defense bases, and
those working under contracts with the U.S. government for defense or public-works projects, outside of the continental United States. Our authorizations to issue workers’ compensation insurance from the various state departments of insurance regulating SeaBright Insurance Company are augmented by our U.S. Department of Labor certificates of authority to ensure payment of compensation under the USL&H Act and extensions of the USL&H Act, including the OCSLA and the Nonappropriated Fund Instrumentalities Act. This coverage, which we write as an endorsement to workers’ compensation and employers liability insurance policies, provides employment-injury and occupational disease protection to workers who are injured or contract occupational diseases while working on the navigable waters of the United States, or in adjoining areas, and for certain other classes of workers covered by the extensions of the USL&H Act.
The Jones Act is a federal law, the maritime employer provisions of which provide injured offshore workers, or seamen, with the right to seek compensation for injuries resulting from the negligence of their employers or co-workers during the course of their employment on a ship or vessel. In addition, an injured offshore worker may make a claim against a vessel owner on the basis that the vessel was not seaworthy. Our authorizations to issue workers’ compensation insurance from the various state departments of insurance regulating SeaBright Insurance Company allow us to write Jones Act coverage for our maritime customers. We are not required to have a certificate from the U.S. Department of Labor to write Jones Act coverage.
We also offer extensions of coverage under the OCSLA, a federal workers’ compensation act that provides workers’ compensation coverage for the death or disability of an employee resulting from any injury occurring as a result of working on an off-shore drilling platform on the Outer Continental Shelf, where required by a prospective policyholder.
As a condition of authorization effective August 25, 2005, the U.S. Department of Labor implemented new regulations requiring insurance carriers authorized to write insurance under the USL&H Act or any of its extensions to deposit security to secure compensation payment obligations. The Department of Labor determines the amount of this deposit annually by calculating the carrier’s USL&H and extension Act obligation by state and by the percentage of those obligations deemed unsecured by those states’ guaranty funds. SeaBright’s current deposit obligation is approximately $1.9 million.
Privacy Regulations
In 1999, the United States Congress enacted the Gramm-Leach-Bliley Act, which, among other things, protects consumers from the unauthorized dissemination of certain personal information. Subsequently, a majority of states have implemented additional regulations to address privacy issues. These laws and regulations apply to all financial institutions, including insurance and finance companies, and require us to maintain appropriate procedures for managing and protecting certain personal information of our customers and to fully disclose our privacy practices to our customers. We may also be exposed to future privacy laws and regulations, which could impose additional costs and impact our financial condition or results of operations. For example, a National Association of Insurance Commissioners, or NAIC, initiative that impacted the insurance industry in 2001 was the adoption in 2000 of the Privacy of Consumer Financial and Health Information Model Regulation, which assisted states in promulgating regulations consistent with the Gramm-Leach-Bliley Act. In 2002, to further facilitate the implementation of the Gramm-Leach-Bliley Act, the NAIC adopted the Standards for Safeguarding Customer Information Model Regulation. Several states have now adopted similar provisions regarding the safeguarding of customer information. Our insurance subsidiary has established procedures to comply with Gramm-Leach-Bliley privacy requirements.
Federal and State Legislative and Regulatory Changes
From time to time, various regulatory and legislative changes have been proposed in the insurance industry. Among the proposals that have in the past been or are at present being considered are the possible introduction of federal regulation in addition to, or in lieu of, the current system of state regulation of insurers and proposals in various state legislatures (some of which proposals have been enacted) to conform portions of their insurance laws and regulations to various model acts adopted by the NAIC. We are unable to predict whether any of these laws and regulations will be adopted, the form in which any such laws and regulations
would be adopted, or the effect, if any, these developments would have on our operations and financial condition.
On November 26, 2002, in response to the tightening of supply in certain insurance and reinsurance markets resulting from, among other things, the September 11, 2001 terrorist attacks, the Terrorism Risk Insurance Act of 2002 was enacted. In 2005, this law was extended and amended. The Terrorism Risk Act is designed to ensure the availability of insurance coverage for losses resulting from certain acts of terror in the United States of America. As extended in 2005, the law established a federal assistance program through the end of 2007 to help the property and casualty insurance industry cover claims related to future terrorism-related losses and required such companies to offer coverage for certain acts of terrorism. On December 26, 2007, the President signed an Extension Bill which extended the Terrorism Risk Act to December 31, 2014. The terms and conditions applying during each of the extension years are essentially the same as those applied during 2007, except that acts of terror perpetrated on behalf of domestic, as well as foreign, persons or interests are now subject to the Terrorism Risk Act. By law, SeaBright Insurance Company may not exclude coverage for terrorism losses from its workers’ compensation policies. Although SeaBright Insurance Company is protected by federally funded terrorism reinsurance to the extent provided for in the Terrorism Risk Act, there are limitations and restrictions on this protection, including a substantial deductible that must be met, which could have an adverse effect on our financial condition or results of operations. Potential future changes to the Terrorism Risk Act could also adversely affect us by causing our reinsurers to increase prices or withdraw from certain markets where terrorism coverage is required.
Collectively bargained workers’ compensation insurance programs in California were enabled by S.B. 983, the workers’ compensation reform bill passed in 1993, and greatly expanded by the passage of S.B. 228 in 2003. Among other things, this legislation amended the California Labor Code to include the specific requirements for the creation of an ADR program for the delivery of workers’ compensation benefits. The passage of S.B. 228 made these programs available to all unionized employees, where previously they were available only to unionized employees in the construction industry.
Our workers’ compensation operations are subject to legislative and regulatory actions. In California, where we have our largest concentration of business, significant workers’ compensation legislation was enacted twice in recent years. Effective January 1, 2003, legislation became effective which provides for increases in indemnity benefits to injured workers. In September 2003 and April 2004, workers’ compensation legislation was enacted in California with the principal objective of reducing costs. The legislation contains provisions which primarily seek to reduce medical costs and does not directly impact indemnity payments to injured workers. The principal changes in the legislation that impact medical costs are as follows: 1) a reduction in the reimbursable amount for certain physician fees, outpatient surgeries, pharmaceutical products and certain durable medical equipment; 2) a limitation on the number of chiropractor or physical therapy office visits; 3) the introduction of medical utilization guidelines; 4) a requirement for second opinions on certain spinal surgeries; and 5) a repeal of the presumption of correctness afforded to the treating physician, except where the employee has pre-designated a treating physician. Since the passage of the 2003 and 2004 reforms, bills have been introduced to roll back many areas of significant reform. Some compromise measures have succeeded. For example, on October 13, 2007, new legislation became effective that removed caps on physical therapy but only when the administrative director adopts new guidelines for occupational therapy and chiropractic care for post-surgical care.
On March 30, 2007, the California Workers’ Compensation Insurance Rating Bureau (the “WCIRB”) submitted a filing with the California Insurance Commissioner recommending an 11.3% decrease in advisory pure premium rates on new and renewal policies effective on or after July 1, 2007. The filing was based on a review of loss and loss adjustment experience through December 31, 2006 and was made in response to continued reductions in California workers’ compensation claim costs. On May 29, 2007, the California Insurance Commissioner recommended a 14.2% decrease in rates effective July 1, 2007. On June 8, 2007, after completing a study of our California loss data, we filed with the California Insurance Commissioner our new rates reflecting an average reduction of 14.2% from prior rates for new and renewal workers’ compensation insurance policies written in California on or after July 1, 2007. The filing was approved on June 12, 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%. On September 20, 2007, the WCIRB submitted a filing with the California Insurance Commissioner recommending a 4.2% increase in advisory pure premium rates on new and renewal policies effective on or after January 1, 2008. The filing was based on a review of loss and loss adjustment experience through June 30, 2007. On October 19, 2007, the WCIRB amended its filing, increasing the proposed rate increase to 5.2% based on the projected impact of Assembly Bill No. 338 (“AB 338”) that was signed into law on October 13, 2007. AB 338 increases the period of time, from two years to five years, from the date of injury during which disability benefits, limited to a maximum of 104 weeks, may be provided. A public hearing to consider the proposed rate increase was held on October 23, 2007. In December 2007, the California Insurance Commissioner recommended no overall change to workers’ compensation premium rates in 2008. On November 30, 2007, we followed the Commissioner’s recommendation and filed for no change in our rates effective on January 1, 2008. The filing was approved on December 12, 2007.
The 2007 rate reductions are primarily in response to emerging favorable trends in loss costs resulting from reform legislation. If any of our competitors adopt premium rate reductions that are greater than ours, we may be unable to compete effectively and our business, financial condition and results of operations could be materially adversely affected.
The National Association of Insurance Commissioners
The NAIC is a group formed by state insurance commissioners to discuss issues and formulate policy with respect to the regulation, reporting and accounting of insurance companies. Although the NAIC has no legislative authority and insurance companies are at all times subject to the laws of their respective domiciliary states and, to a lesser extent, other states in which they conduct business, the NAIC is influential in determining the form in which such laws are enacted. Model Insurance Laws, Regulations and Guidelines (the “Model Laws”) have been promulgated by the NAIC as a minimum standard by which state regulatory systems and regulations are measured. Adoption of state laws which provide for substantially similar regulations to those described in certain of the Model Laws is a requirement for accreditation by the NAIC. The NAIC provides authoritative guidance to insurance regulators on current statutory accounting issues by promulgating and updating a codified set of statutory accounting practices in its Accounting Practices and Procedures Manual. The Illinois Division of Insurance and the California Department of Insurance have adopted these codified statutory accounting practices.
Illinois and California have also adopted laws substantially similar to the NAIC’s “risk based capital” (“RBC”) laws, which require insurers to maintain minimum levels of capital based on their investments and operations. These RBC requirements provide a standard by which regulators can assess the adequacy of an insurance company’s capital and surplus relative to its operations. Among other requirements, an insurance company must maintain capital and surplus of at least 200% of the RBC computed by the NAIC’s RBC model (known as the “Authorized Control Level” of RBC). At December 31, 2007, the capital and surplus of SeaBright Insurance Company exceeded 200% of the Authorized Control Level of RBC.
The NAIC’s Insurance Regulatory Information System (“IRIS”) key financial ratios, developed to assist insurance departments in overseeing the financial condition of insurance companies, are reviewed by experienced financial examiners of the NAIC and state insurance departments to select those companies that merit highest priority in the allocation of the regulators’ resources. IRIS identifies twelve industry ratios and specifies “usual values” for each ratio. Departure from the usual values on four or more of the ratios can lead to inquiries from individual state insurance commissioners as to certain aspects of an insurer’s business.
The 2007 IRIS results for SeaBright Insurance Company showed no results outside the “usual” range for such ratios; as such ranges are determined by the NAIC.
Dividend Limitations
SeaBright Insurance Company’s ability to pay dividends is subject to restrictions contained in the insurance laws and related regulations of Illinois and California. The insurance holding company laws in these states require that ordinary dividends be reported to the Illinois Division of Insurance and the California
Department of Insurance prior to payment of the dividend and that extraordinary dividends be submitted for prior approval. An extraordinary dividend is generally defined as a dividend that, together with all other dividends made within the past 12 months, exceeds the greater of 10% of its statutory policyholders’ surplus as of the preceding year end or the net income of the company for the preceding year. Statutory policyholders’ surplus, as determined under statutory accounting principles is the amount remaining after all liabilities, including loss and loss adjustment expenses, are subtracted from all admitted assets. Admitted assets are assets of an insurer prescribed or permitted by a state insurance regulator to be recognized on the statutory balance sheet. Insurance regulators have broad powers to prevent the reduction of statutory surplus to inadequate levels, and there is no assurance that extraordinary dividend payments will be permitted.
Statutory Accounting Practices
Statutory accounting practices (“SAP”) are a basis of accounting developed to assist insurance regulators in monitoring and regulating the solvency of insurance companies. SAP is primarily concerned with measuring an insurer’s surplus available for policyholders. Accordingly, statutory accounting focuses on valuing assets and liabilities of insurers at financial reporting dates in accordance with appropriate insurance law and regulatory provisions applicable in each insurer’s domiciliary state.
U.S. generally accepted accounting principles (“GAAP”) are concerned with a company’s solvency, but such principles are also concerned with other financial measurements, such as income and cash flows. Accordingly, GAAP gives more consideration to appropriate matching of revenue and expenses and accounting for management’s stewardship of assets than does SAP. As a direct result, different assets and liabilities and different amounts of assets and liabilities will be reflected in financial statements prepared in accordance with GAAP as opposed to SAP.
Statutory accounting practices established by the NAIC and adopted, in part, by the Illinois and California regulators, determine, among other things, the amount of statutory surplus and statutory net income or loss of SeaBright Insurance Company and thus determine, in part, the amount of funds it has available to pay dividends to us.
Guaranty Fund Assessments
In Illinois, California and in most of the states where SeaBright Insurance Company is licensed to transact business, there is a requirement that property and casualty insurers doing business within each such state participate in a guaranty association, which is organized to pay contractual benefits owed pursuant to insurance policies issued by impaired, insolvent or failed insurers. These associations levy assessments, up to prescribed limits, on all member insurers in a particular state on the basis of the proportionate share of the premium written by member insurers in the lines of business in which the impaired, insolvent or failed insurer is engaged. Some states permit member insurers to recover assessments paid through full or partial premium tax offsets or policy surcharges.
Property and casualty insurance company insolvencies or failures may result in additional security fund assessments to SeaBright Insurance Company at some future date. At this time we are unable to determine the impact, if any, such assessments may have on the financial position or results of operations of SeaBright Insurance Company. We have established liabilities for guaranty fund assessments with respect to insurers that are currently subject to insolvency proceedings.
PointSure
The brokerage and third party administrator activities of PointSure are subject to licensing requirements and regulation under the laws of each of the jurisdictions in which it operates. PointSure is authorized to act as an insurance broker under firm or officer licenses in 49 states and the District of Columbia. PointSure’s business depends on the validity of, and continued good standing under, the licenses and approvals pursuant to which it operates, as well as compliance with pertinent regulations. PointSure therefore devotes significant effort toward maintaining its licenses to ensure compliance with a diverse and complex regulatory structure.
Licensing laws and regulations vary from state to state. In all states, the applicable licensing laws and regulations are subject to amendment or interpretation by regulatory authorities. Generally such authorities are vested with relatively broad and general discretion as to the granting, renewing and revoking of licenses and approvals. Licenses may be denied or revoked for various reasons, including the violation of such regulations, conviction of crimes and the like. Possible sanctions which may be imposed include the suspension of individual employees, limitations on engaging in a particular business for specified periods of time, revocation of licenses, censures, redress to clients and fines. In some instances, PointSure follows practices based on interpretations of laws and regulations generally followed by the industry, which may prove to be different from the interpretations of regulatory authorities.
Employees
As of December 31, 2007, we had 236 full-time equivalent employees. We have employment agreements with some of our executive officers, which are described in our proxy statement for the 2008 annual meeting of stockholders and incorporated by reference into Part III, Item 11 of this annual report. We believe that our employee relations are good.
Corporate Website
Through our Internet website at www.sbic.com, we provide free access to our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission (the “SEC”). A copy of the materials will be mailed to you free of charge upon request to SeaBright Insurance Holdings, Inc., Investor Relations, 1501 4th Avenue, Suite 2600, Seattle, WA 98101. The following corporate governance materials are also available on our website:
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Audit Committee, Compensation Committee, and Nominating and Corporate Governance Committee charters;
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Code of Ethics for Senior Financial Employees;
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Conflict of Interest & Code of Conduct Policy; and
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Insider Trading Policy.
If we waive or substantially change any material provision of our Code of Ethics for Senior Financial Employees, we will disclose that fact on our website within four business days of the waiver or change.
Note on Forward-Looking Statements
Some of the statements in Part I, Item 1 of this annual report, some of the statements in this Item 1A, some of the statements under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operation” in Part II, Item 7 of this annual report and statements elsewhere in this annual report, may include forward-looking statements that reflect our current views with respect to future events and financial performance. These statements include forward-looking statements both with respect to us specifically and the insurance sector in general. Statements that include the words “expect,” “intend,” “plan,” “believe,” “project,” “estimate,” “may,” “should,” “anticipate,” “will” and similar statements of a future or forward-looking nature identify forward-looking statements for purposes of the federal securities laws or otherwise.
All forward-looking statements address matters that involve risks and uncertainties. Accordingly, there are or will be important factors that could cause our actual results to differ materially from those indicated in these statements. We believe that these factors include but are not limited to the following:
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ineffectiveness or obsolescence of our business strategy due to changes in current or future market conditions;
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increased competition on the basis of pricing, capacity, coverage terms or other factors;
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greater frequency or severity of claims and loss activity, including as a result of natural or man-made catastrophic events, than our underwriting, reserving or investment practices anticipate based on historical experience or industry data;
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the effects of acts of terrorism or war;
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developments in financial and capital markets that adversely affect the performance of our investments;
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changes in regulations or laws applicable to us, our subsidiaries, brokers or customers;
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our dependency on a concentrated geographic market;
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changes in the availability, cost or quality of reinsurance and failure of our reinsurers to pay claims timely or at all;
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decreased demand for our insurance products;
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loss of the services of any of our executive officers or other key personnel;
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the effects of mergers, acquisitions and divestitures that we may undertake;
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changes in rating agency policies or practices;
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changes in legal theories of liability under our insurance policies;
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changes in accounting policies or practices; and
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changes in general economic conditions, including inflation and other factors.
The foregoing factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are included in this annual report. We undertake no obligation to publicly update or review any forward-looking statement, whether as a result of new information, future developments or otherwise.
If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may vary materially from what we project. Any forward-looking statements you read in this annual report reflect our views as of the date of this annual report with respect to future events and are subject to these and other risks, uncertainties and assumptions relating to our operations, results of operations, growth strategy and liquidity. Before making an investment decision, you should carefully consider all of the factors identified in this annual report that could cause actual results to differ.
Item 1A.
Item 1A.
Risk Factors.
You should carefully consider the risks described below, together with all of the other information included in this annual report. The risks and uncertainties described below are not the only ones facing our company. If any of the following risks actually occurs, our business, financial condition or operating results could be harmed. Any of the risks described below 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. The risks discussed below 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 “Note on Forward-Looking Statements” in Part I, Item 1 of this annual report.
Risks Related to Our Business
Our loss reserves are based on estimates and may be inadequate to cover our actual losses.
If we fail to accurately assess the risks associated with the businesses that we insure, our loss reserves may be inadequate to cover our actual losses and we may fail to establish appropriate premium rates. We establish loss reserves in our financial statements that represent an estimate of amounts needed to pay and administer claims with respect to insured events that have occurred, including events that have not yet been
reported to us. Loss reserves are estimates and are inherently uncertain; they do not and cannot represent an exact measure of liability. Accordingly, our loss reserves may prove to be inadequate to cover our actual losses. Any changes in these estimates are reflected in our results of operations during the period in which the changes are made, with increases in our loss reserves resulting in a charge to our earnings.
Our loss reserve estimates are based on estimates of the ultimate cost of individual claims and on actuarial estimation techniques. Several factors contribute to the uncertainty in establishing these estimates. Judgment is required in actuarial estimation to ascertain the relevance of historical payment and claim settlement patterns under current facts and circumstances. Key assumptions in the estimation process are the average cost of claims over time, which we refer to as severity trends; the increasing level of medical, legal and rehabilitation costs; and costs associated with fraud or other abuses of the medical claim process. If there are unfavorable changes in severity trends, we may need to increase our loss reserves, as described above.
Our geographic concentration ties our performance to the business, economic and regulatory conditions in California, Illinois and Louisiana. Any single catastrophe or other condition affecting losses in these states could adversely affect our results of operations.
Our business is concentrated in California (approximately 40.2% of direct premiums written for the year ended December 31, 2007), Illinois (approximately 9.3% of direct premiums written for the same period) and Louisiana (approximately 8.8% of direct premiums written for the same period). Accordingly, unfavorable business, economic or regulatory conditions in those states could negatively impact our business. For example, California, Illinois, and Louisiana are states that are susceptible to severe natural perils, such as tsunamis, earthquakes, tornados and hurricanes, along with the possibility of terrorist acts. Accordingly, we could suffer losses as a result of catastrophic events in those states. Although geographic concentration has not adversely affected our business in the past, we may in the future be exposed to economic and regulatory risks or risks from natural perils that are greater than the risks faced by insurance companies that conduct business over a greater geographic area. This concentration of our business could have a material adverse effect on our financial condition or results of operations.
If we are unable to obtain or collect on our reinsurance protection, our business, financial condition and results of operations could be materially adversely affected.
We buy reinsurance coverage to protect us from the impact of large losses. Reinsurance is an arrangement in which an insurance company, called the ceding company, transfers insurance risk by sharing premiums with another insurance company, called the reinsurer. Conversely, the reinsurer receives or assumes reinsurance from the ceding company. In the ordinary course of our business we participate in a workers’ compensation and employers’ liability excess of loss reinsurance treaty program covering all of the business that we write or renew pursuant to which our reinsurers are liable for varying percentages of the ultimate net losses in excess of $1.0 million for the business we write, up to a $75.0 million limit, subject to certain exclusions and limitations. The treaty program provides coverage in several layers. See the discussion under the heading “Reinsurance” in Part I, Item 1 of this annual report. The availability, amount and cost of reinsurance depend on market conditions and may vary significantly. As a result of catastrophic events, such as the events of September 11, 2001, we may incur significantly higher reinsurance costs, more restrictive terms and conditions, and decreased availability. For example, each layer of our reinsurance treaty program contains an aggregate limit for all claims under that layer over which our reinsurers will not be liable (e.g., $8.0 million under the first layer, $12.0 million under the second layer and $15.0 million under the third layer). In addition, each layer of our reinsurance treaty program covers acts of terrorism only up to a modest limit (e.g., $1.0 million per occurrence under the first layer, $3.0 million per occurrence under the second layer and $5.0 million under the third layer). Because of these sub-limits and terrorism exclusions included in our policies, which are common in the wake of the events of September 11, 2001, we have significantly greater exposure to losses resulting from acts of terrorism. The incurrence of higher reinsurance costs and more restrictive terms could materially adversely affect our business, financial condition and results of operations.
The agreements for our current workers’ compensation excess of loss reinsurance treaty program expire on October 1, 2008. Although we currently expect to renew the program upon its expiration, any decrease in
the amount of our reinsurance at the time of renewal, whether caused by the existence of more restrictive terms and conditions or decreased availability, will also increase our risk of loss and, as a result, could materially adversely affect our business, financial condition and results of operations. We have not experienced difficulty in qualifying for or obtaining sufficient reinsurance to appropriately cover our risks in the past. We currently have 11 reinsurers participating in our excess of loss reinsurance treaty program, and believe that this is a sufficient number of reinsurers to provide us with reinsurance in the volume that we require. However, it is possible that one or more of our current reinsurers could cancel participation, or we could find it necessary to cancel the participation of one of our reinsurers, in our excess of loss reinsurance treaty program. In either of those events, if our reinsurance broker is unable to spread the cancelled or terminated reinsurance among the remaining reinsurers in the program, we estimate that it could take approximately one to three weeks or longer to identify and negotiate appropriate documentation with a replacement reinsurer. During this time, we would be exposed to an increased risk of loss, the extent of which would depend on the volume of cancelled reinsurance.
In addition, we are subject to credit risk with respect to our reinsurers. Reinsurance protection that we receive does not discharge our direct obligations under the policies we write. We remain liable to our policyholders, even if we are unable to make recoveries to which we believe we are entitled under our reinsurance contracts. Losses may not be recovered from our reinsurers until claims are paid, and, in the case of long-term workers’ compensation cases, the creditworthiness of our reinsurers may change before we can recover amounts to which we are entitled. Although we have not experienced problems in the past resulting from the failure of a reinsurer to pay our claims in a timely manner, if we experience this problem in the future, our costs would increase and our revenues would decline. As of December 31, 2007, we had $14.2 million of amounts recoverable from our reinsurers, excluding the receivable on our adverse development cover, that we would be obligated to pay if our reinsurers failed to pay us.
The insurance business is subject to extensive regulation and legislative changes, which impact the manner in which we operate our business.
Our insurance business is subject to extensive regulation by the applicable state agencies in the jurisdictions in which we operate, perhaps most significantly by the Illinois Division of Insurance and the California Department of Insurance. These state agencies have broad regulatory powers designed to protect policyholders, not stockholders or other investors. These powers include, among other things, the ability to:
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place limitations on our ability to transact business with our affiliates;
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regulate mergers, acquisitions and divestitures involving our insurance company subsidiary;
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require SeaBright Insurance Company, PointSure and THM to comply with various licensing requirements and approvals that affect our ability to do business;
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approve or reject our policy coverage and endorsements;
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place limitations on our investments and dividends;
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set standards of solvency to be met and maintained;
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regulate rates pertaining to our business;
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require assessments for the provision of funds necessary for the settlement of covered claims under certain policies provided by impaired, insolvent or failed insurance companies;
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require us to comply with medical privacy laws; and
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prescribe the form and content of, and examine, our statutory financial statements.
On June 21, 2007, the Illinois Division of Insurance adopted its Report of Examination as of December 31, 2005 after completing a routine comprehensive examination of our 2005 statutory annual statement. No fines or penalties were assessed.
Our ability to transact business with our affiliates and to enter into mergers, acquisitions and divestitures involving our insurance company subsidiary is limited by the requirements of the insurance holding company laws of Illinois and California. To comply with these laws, we are required to file notices with the Illinois Division of Insurance and the California Department of Insurance to seek their respective approvals at least 30 days before engaging in any intercompany transactions, such as sales, purchases, exchanges of assets, loans, extensions of credit, cost sharing arrangements and extraordinary dividends or other distributions to stockholders. Under these holding company laws, any change of control transaction also requires prior notification and approval. Because these governmental agencies may not take action or give approval within the 30 day period, these notification and approval requirements may subject us to business delays and additional business expense. If we fail to give these notifications, we may be subject to significant fines and penalties and damaged working relations with these governmental agencies.
In addition, 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. For example, in California, on January 1, 2003, workers’ compensation legislation became effective that provided for increases in the benefits payable to injured workers. Also, in California, workers’ compensation legislation intended to reduce certain costs was enacted in September 2003 and April 2004. Among other things, this legislation established an independent medical review process for resolving medical disputes, tightened standards for determining impairment ratings by applying specific medical treatment guidelines, capped temporary total disability payments to 104 weeks from first payment and enabled injured workers to access immediate medical care up to $10,000 but required them to get medical care through a network of doctors chosen by the employer. The implementation of these reforms affects the manner in which we coordinate medical care costs with employers and the manner in which we oversee treatment plans. However, the reforms are subject to continuing opposition in the California legislature, in the courts and by ballot initiatives, any of which could overturn or substantially amend the reforms and regulatory rules applicable to the legislation. Since the passage of the 2003 and 2004 reforms, bills have been introduced to roll back many areas of significant reform. Some compromise measures have succeeded. For example, on October 13, 2007, new legislation became effective that removed caps on physical therapy but only when the administrative director adopts new guidelines for occupational therapy and chiropractic care for post-surgical care. We cannot predict the ultimate impact of the reforms or of any amendments to them.
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.
In addition, we are impacted by the Terrorism Risk Act and by the Gramm-Leach-Bliley Act of 2002 related to disclosure of personal information. The Terrorism Risk Act requires that commercial property and casualty insurance companies offer coverage for certain acts of terrorism and has established a federal assistance program through the end of 2014 to help insurers cover claims arising out of such acts. The Terrorism Risk Act only covers certified acts of terrorism, and the U.S. Secretary of the Treasury must declare the act to be a “certified act of terrorism” for it to be covered under this federal program. In addition, no federal compensation will be paid under the Terrorism Risk Act unless aggregate insured losses from the act for the entire insurance industry exceed certain threshold amounts ($100.0 million for terrorism losses occurring in 2007 and for the remainder of the program). Under this program, the federal government covers 85% of the losses from covered certified acts of terrorism occurring in 2007 and for the remainder of the program on commercial risks in the United States only, in excess of the applicable deductible amount. This deductible is calculated based on a percentage of an affiliated insurance group’s prior year direct earned premiums on commercial lines policies (except for certain excluded lines such as commercial auto) covering risks in the United States. This deductible amount is 20.0% of such premiums for losses occurring in 2007 and subsequent years.
This extensive regulation of our business may affect the cost or demand for our products and may limit our ability to obtain rate increases or to take other actions that we might desire to increase our profitability. In addition, we may be unable to maintain all required approvals or comply fully with the wide variety of applicable laws and regulations, which are continually undergoing revision, or the relevant authority’s interpretation of such laws and regulations.
A downgrade in the A.M. Best rating of our insurance subsidiary could reduce the amount of business we are able to write.
Rating agencies rate insurance companies based on each company’s ability to pay claims. Our insurance company subsidiary currently has a rating of “A−” (Excellent) from A.M. Best, which is the rating agency that we believe has the most influence on our business. The ratings of A.M. Best are subject to periodic review using, among other things, proprietary capital adequacy models, and are subject to revision or withdrawal at any time. Insurance ratings are directed toward the concerns of policyholders and insurance agents and are not intended for the protection of investors or as a recommendation to buy, hold or sell any of our securities. Our competitive position relative to other companies is determined in part by our A.M. Best rating. We believe that our business is particularly sensitive to our A.M. Best rating because we focus on larger customers which tend to give substantial weight to the A.M. Best rating of their insurers. We expect that any reduction in our A.M. Best rating below “A−” would cause a reduction in the number of policies we write and could have a material adverse effect on our results of operations and our financial position.
The effects of emerging claim and coverage issues on our business are uncertain.
As industry practices and legal, judicial, social and other environmental conditions change, unexpected and unintended issues related to claims and coverage may emerge. These issues may adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the number or size of claims. In some instances, these changes may not become apparent until some time after we have issued insurance contracts that are affected by the changes. As a result, the full extent of liability under our insurance contracts may not be known for many years after a contract is issued. For example, the number or nature of existing occupational diseases may expand beyond our expectation. In addition, medical claims costs associated with permanent and partial disabilities may inflate more rapidly or higher than we currently expect. Expansions of this nature may expose us to more claims than we anticipated when we wrote the underlying policy.
Intense competition could adversely affect our ability to sell policies at rates we deem adequate.
In most of the states in which we operate, we face significant competition which, at times, is intense. If we are unable to compete effectively, our business and financial condition could be materially adversely affected. Competition in our businesses is based on many factors, including premiums charged, services provided, financial strength ratings assigned by independent rating agencies, speed of claims payments, reputation, perceived financial strength and general experience. We compete with regional and national insurance companies and state-sponsored insurance funds, as well as potential insureds that have decided to self-insure. Our principal competitors include AIG, Liberty Mutual, Zurich, Signal Mutual Indemnity Association Ltd., and American Longshore Mutual Association Ltd. Many of our competitors have substantially greater financial and marketing resources than we do, and some of our competitors, including the State Compensation Insurance Fund of California, benefit financially by not being subject to federal income tax. Intense competitive pressure on prices can result from the actions of even a single large competitor, such as the State Compensation Insurance Fund of California or AIG.
In addition, our competitive advantage may be limited due to the small number of insurance products that we offer. Some of our competitors, such as AIG, have additional competitive leverage because of the wide array of insurance products that they offer. For example, it may be more convenient for a potential customer to purchase numerous different types of insurance products from one insurance carrier. We do not offer a wide array of insurance products due to our targeted market niches, and we may lose potential customers to our larger, more diverse competitors as a result.
On March 30, 2007, the California Workers’ Compensation Insurance Rating Bureau (the “WCIRB”) submitted a filing with the California Insurance Commissioner recommending an 11.3% decrease in advisory pure premium rates on new and renewal policies effective on or after July 1, 2007. The filing was based on a review of loss and loss adjustment experience through December 31, 2006 and was made in response to continued reductions in California workers’ compensation claim costs. On May 29, 2007, the California Insurance Commissioner recommended a 14.2% decrease in rates effective July 1, 2007. On June 8, 2007, after completing a study of our California loss data, we filed with the California Insurance Commissioner our new rates reflecting an average reduction of 14.2% from prior rates for new and renewal workers’ compensation insurance policies written in California on or after July 1, 2007. The filing was approved on June 12, 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%. On September 20, 2007, the WCIRB submitted a filing with the California Insurance Commissioner recommending a 4.2% increase in advisory pure premium rates on new and renewal policies effective on or after January 1, 2008. The filing was based on a review of loss and loss adjustment experience through June 30, 2007. On October 19, 2007, the WCIRB amended its filing, increasing the proposed rate increase to 5.2% based on the projected impact of AB 338 that was signed into law on October 13, 2007. AB 338 increases the period of time, from two years to five years, from the date of injury during which disability benefits, limited to a maximum of 104 weeks, may be provided. A public hearing to consider the proposed rate increase was held on October 23, 2007. In December 2007, the California Insurance Commissioner recommended no overall change to workers’ compensation premium rates in 2008. On November 30, 2007, we followed the Commissioner’s recommendation and filed for no change in our rates effective on January 1, 2008. The filing was approved on December 12, 2007.
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 National Council for Compensation Insurance (the “NCCI”): 10.9% in Alaska, 19.3% in Hawaii and 18.4% in Florida. Effective July 1, 2007, we adopted the Louisiana Insurance Commissioner’s recommendation of a 15.8% reduction in Louisiana, which is 2.0% more than the 13.8% rate decrease recommended by the NCCI. On February 5, 2008, the Louisiana Insurance Commissioner approved an NCCI-proposed rate reduction of 8.6%, effective May 1, 2008. On March 7, 2008, after completing a study of our Louisiana loss data, we filed with the Louisiana Insurance Commissioner our new rates reflecting an average reduction of 8.6% 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.
If we are unable to realize our investment objectives, our financial condition may be adversely affected.
Investment income is an important component of our revenues and net income. The ability to achieve our investment objectives is affected by factors that are beyond our control. For example, United States participation in hostilities with other countries and large-scale acts of terrorism may adversely affect the economy generally, and our investment income could decrease. Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic and international economic and political conditions. These and other factors also affect the capital markets, and, consequently, the value of the securities we own. The outlook for our investment income is dependent on the future direction of interest rates and the amount of cash flows from operations that are available for investment. The fair values of fixed maturity investments that are “available-for-sale” fluctuate with changes in interest rates and cause fluctuations in our stockholders’ equity. Any significant decline in our investment income as a result of rising interest rates or general market conditions would have an adverse effect on our net income and, as a result, on our stockholders’ equity and our policyholders’ surplus. See “Investments” in Part I, Item 1 of this annual report for a discussion of the limited exposure in our investment portfolio at December 31, 2007 to sub-prime mortgages and problems currently facing monoline bond insurers.
We could be adversely affected by the loss of one or more principal employees or by an inability to attract and retain staff.
Our success will depend in substantial part upon our ability to attract and retain qualified executive officers, experienced underwriting talent and other skilled employees who are knowledgeable about our business. We rely substantially upon the services of our senior management team and key employees, consisting of John G. Pasqualetto, Chairman, President and Chief Executive Officer; Richard J. Gergasko, Executive Vice President - Operations; Joseph S. De Vita, Senior Vice President, Chief Financial Officer and Assistant Secretary; D. Drue Wax - Senior Vice President, General Counsel and Corporate Secretary; Richard W. Seelinger, Senior Vice President - Policyholder Services; Marc B. Miller, M.D., Senior Vice President and Chief Medical Officer; Jeffrey C. Wanamaker, Senior Vice President - Underwriting; James L. Borland, III, Vice President and Chief Information Officer; M. Philip Romney, Vice President - Finance, Principal Accounting Officer and Assistant Secretary and Craig A. Pankow, President - PointSure. Although we are not aware of any planned departures or retirements, if we were to lose the services of members of our management team, our business could be adversely affected. Many of our principal employees possess skills and extensive experience relating to our market niches. Were we to lose any of these employees, it may be challenging for us to attract a replacement employee with comparable skills and experience in our market niches. We have employment agreements with some of our executive officers, which are described in our proxy statement for the 2008 annual meeting of stockholders and incorporated by reference into Part III, Item 11 of this annual report. We do not currently maintain key man life insurance policies with respect to any member of our senior management team or other employees.
We may require additional capital in the future, which may not be available or only available on unfavorable terms.
Our future capital requirements depend on many factors, including our ability to write new business successfully and to establish premium rates and loss reserves at levels sufficient to cover losses. To the extent that the funds generated by the initial public offering of 8,625,000 shares of our common stock in January 2005 and the follow-on offering of 3,910,000 shares of common stock in February 2006 are insufficient to support future operating requirements and/or cover claim losses, we may need to raise additional funds through financings or curtail our growth. We believe that the net proceeds to us from the above offerings and cash provided by operations will satisfy our capital requirements for the foreseeable future. However, because the timing and amount of our future needs for capital will depend on our growth and profitability, we cannot provide any assurance in that regard. If we had to raise additional capital, equity or debt financing may not be available at all or may be available only on terms that are not favorable to us. In the case of equity financings, dilution to our stockholders could result, and in any case such securities may have rights, preferences and privileges that are senior to those of the shares currently outstanding. If we cannot obtain adequate capital on favorable terms or at all, we may be unable to support future growth or operating requirements and, accordingly, our business, financial condition or results of operations could be materially adversely affected.
Our status as an insurance holding company with no direct operations could adversely affect our ability to pay dividends in the future.
We are a holding company that transacts our business through our operating subsidiaries, SeaBright Insurance Company, PointSure and THM. Our primary assets are the stock of these operating subsidiaries. Our ability to pay expenses and dividends depends, in the long run, upon the surplus and earnings of our subsidiaries and the ability of our subsidiaries to pay dividends to us. Payment of dividends by SeaBright Insurance Company is restricted by state insurance laws, including laws establishing minimum solvency and liquidity thresholds, and could be subject to contractual restrictions in the future, including those imposed by indebtedness we may incur in the future. SeaBright Insurance Company is required to report any ordinary dividends to the Illinois Division of Insurance and the California Department of Insurance prior to the payment of the dividend. In addition, SeaBright Insurance Company is not authorized to pay any extraordinary dividends to us under Illinois or California insurance laws without prior regulatory approval from the Illinois Division of Insurance or the California Department of Insurance. See the discussion under the heading “Regulation - Dividend Limitations” in Part I, Item 1 of this annual report. As a result, at times, we may not be able to receive dividends from SeaBright Insurance Company and we may not receive dividends in amounts
necessary to pay dividends on our capital stock. In addition, the payment of dividends by us is within the discretion of our Board of Directors and will depend on numerous factors, including our financial condition, our capital requirements and other factors that our Board of Directors considers relevant. Currently, we do not intend to pay dividends on our capital stock.
We rely on independent insurance brokers to distribute our products.
Our business depends in part on the efforts of independent insurance brokers to market our insurance programs successfully and produce business for us and on our ability to offer insurance programs and services that meet the requirements of the clients and customers of these brokers. The majority of the business in our workers’ compensation operations is produced by a group of licensed insurance brokers that totaled approximately 208 at December 31, 2007. Brokers are not obligated to promote our insurance programs and may sell competitors’ insurance programs. Several of our competitors, including AIG and Zurich, offer a broader array of insurance programs than we do. Accordingly, our brokers may find it easier to promote the broader range of programs of our competitors than to promote our niche selection of insurance products. If our brokers fail or choose not to market our insurance programs successfully or to produce business for us, our growth may be limited and our financial condition and results of operations may be negatively affected.
Assessments and other surcharges for guaranty funds and second injury funds and other mandatory pooling arrangements may reduce our profitability.
Virtually all states require insurers licensed to do business in their state to bear a portion of the unfunded obligations of impaired or insolvent insurance companies. These obligations are funded by assessments that are expected to continue in the future as a result of insolvencies. Assessments are levied by guaranty associations within the state, up to prescribed limits, on all member insurers in the state on the basis of the proportionate share of the premium written by member insurers in the lines of business in which the impaired, insolvent or failed insurer is engaged. See the discussion under the heading “Regulation” in Part I, Item 1 of this annual report. Accordingly, the assessments levied on us may increase as we increase our premiums written. Further, Washington state legislation enacted on April 20, 2005 created a separate account within the Guaranty Fund for USL&H Act claims and authorized prefunding of potential insolvencies in order to establish a cash balance. Many states also have laws that established second injury funds to provide compensation to injured employees for aggravation of a prior condition or injury, which are funded by either assessments based on paid losses or premium surcharge mechanisms. For example, Alaska requires insurers to contribute to its second injury fund annually an amount equal to the compensation the injured employee is owed multiplied by a contribution rate based on the fund’s reserve rate. In addition, as a condition of the ability to conduct business in some states, including California, insurance companies are required to participate in mandatory workers’ compensation shared market mechanisms or pooling arrangements, which provide workers’ compensation insurance coverage from private insurers. Although we price our products to account for the obligations that we may have under these pooling arrangements, we may not be successful in estimating our liability for these obligations. Accordingly, our prices may not fully account for our liabilities under pooling arrangements, which may cause a decrease in our profits. As we write policies in new states that have pooling arrangements, we will be required to participate in additional pooling arrangements. Further, the insolvency of other insurers in these pooling arrangements would likely increase the liability for other members remaining in the pool. The effect of these assessments and mandatory shared market mechanisms or changes in them could reduce our profitability in any given period or limit our ability to grow our business.
In the event LMC is placed into receivership, we could lose our rights to fee income and protective arrangements that were established in connection with the Acquisition, our reputation and credibility could be adversely affected and we could be subject to claims under applicable voidable preference and fraudulent transfer laws.
The assets that SeaBright acquired in the Acquisition were acquired from LMC and certain of its affiliates. LMC and its insurance company affiliates are currently operating under a voluntary “run off” plan approved by the Illinois Division of Insurance. “Run off” is the professional management of an insurance company’s discontinued, distressed or non-renewed lines of insurance and associated liabilities outside of a judicial proceeding. Under the run off plan, LMC has instituted aggressive expense control measures in order
to reduce its future loss exposure and allow it to meet its obligations to current policyholders. According to LMC’s statutory financial statements as of and for the year ended December 31, 2007, LMC had a statutory surplus of $150.7 million (unaudited), a decrease of approximately $22.9 million from its surplus of $173.6 million (audited) as of December 31, 2006. In connection with the Acquisition, we established various arrangements with LMC and certain of its affiliates, including (1) servicing arrangements entitling us to fee income for providing claims administration services for Eagle and (2) other protective arrangements designed to minimize our exposure to any past business underwritten by KEIC, the shell entity that we acquired from LMC for its insurance licenses, and any adverse developments in KEIC’s loss reserves as they existed at the date of the Acquisition. See the discussion under the heading “Loss Reserves - KEIC Loss Reserves” in Part I, Item 1 of this annual report. In the event LMC is placed into receivership, our business could be adversely affected in the following ways:
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A receiver could seek to reject or terminate one or more of the services agreements that were established in connection with the Acquisition between us and LMC or its affiliates, including Eagle. In that event, we could lose the revenue we currently receive under these services agreements.
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As discussed under “Loss Reserves - KEIC Loss Reserves” in Part I, Item 1 of this annual report, to minimize our exposure to any past business underwritten by KEIC, we entered into an arrangement with LMC at the time of the Acquisition requiring LMC to indemnify us in the event of adverse development of the loss reserves in KEIC’s balance sheet as they existed on the date of closing of the Acquisition. We refer to this arrangement as the adverse development cover. To support LMC’s obligations under the adverse development cover, LMC funded a trust account at the time of the Acquisition. The minimum amount that must be maintained in the trust account is equal to the greater of (a) $1.6 million or (b) 102% of the then existing quarterly estimate of LMC’s total obligations under the adverse development cover. We refer to this trust account as the collateralized reinsurance trust because the funds on deposit in the trust account serve as collateral for LMC’s potential future obligations to us under the adverse development cover. At December 31, 2007, the liability of LMC under the adverse development cover was approximately $2.5 million. LMC initially funded the trust account with $1.6 million to support its obligations under the adverse development cover. In accordance with the terms of the protective arrangements that we have established with LMC, on December 23, 2004, LMC deposited into the collateralized reinsurance trust an additional $3.2 million, resulting in a total balance in the trust account of $4.8 million. In February 2007, LMC submitted a request to withdraw approximately $1.8 million of excess funds on deposit in the trust account. After due evaluation, we complied with LMC’s request, resulting in a balance in the trust account of approximately $3.4 million immediately following the withdrawal. The balance of the trust account, including accumulated interest, at December 31, 2007 was $3.5 million. If LMC is placed in receivership and the amount held in the collateralized reinsurance trust is inadequate to satisfy the obligations of LMC to us under the adverse development cover, it is unlikely that we would recover any future amounts owed by LMC to us under the adverse development cover in excess of the amounts currently held in trust because the director of the Illinois Division of Insurance would have control of the assets of LMC.
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Some of our customers are insured under Eagle insurance policies that we service pursuant to the claims administration servicing agreement described above. Although SeaBright is a separate legal entity from LMC and its affiliates, including Eagle, Eagle’s policyholders may not readily distinguish SeaBright from Eagle and LMC if those policies are not honored in the event LMC is found to be insolvent and placed into court-ordered liquidation. If that were to occur, our market reputation, credibility and ability to renew the underlying policies could be adversely affected.
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In connection with the Acquisition, LMC and its affiliates made various transfers and payments to SeaBright, including approximately $13.0 million under the commutation agreement and an initial amount of approximately $1.6 million to fund the collateralized reinsurance trust. In the event that LMC is placed into receivership, it is possible that a receiver or creditor could assert a claim seeking to unwind or recover these payments under applicable voidable preference and fraudulent transfer laws.
Risks Related to Our Industry
We may face substantial exposure to losses from terrorism for which we are required by law to provide coverage.
Under our workers’ compensation policies, we are required to provide workers’ compensation benefits for losses arising from acts of terrorism. The impact of any terrorist act is unpredictable, and the ultimate impact on us would depend upon the nature, extent, location and timing of such an act. Notwithstanding the protection provided by the reinsurance we have purchased and any protection provided by the Terrorism Risk Act, the risk of severe losses to us from acts of terrorism has not been eliminated because, as discussed above, our excess of loss reinsurance treaty program contains various sub-limits and exclusions limiting our reinsurers’ obligation to cover losses caused by acts of terrorism. Accordingly, events may not be covered by, or may exceed the capacity of, our reinsurance protection and any protection offered by the Terrorism Risk Act or any successor legislation. Thus, any acts of terrorism could materially adversely affect our business and financial condition.
The threat of terrorism and military and other actions may result in decreases in our net income, revenue and assets under management and may adversely affect our investment portfolio.
The threat of terrorism, both within the United States and abroad, and military and other actions and heightened security measures in response to these types of threats, may cause significant volatility and declines in the equity markets in the United States and abroad, as well as loss of life, property damage, additional disruptions to commerce and reduced economic activity. Actual terrorist attacks could cause a decrease in our stockholders’ equity, net income and/or revenue. The effects of these changes may result in a decrease in our stock price. In addition, some of the assets in our investment portfolio may be adversely affected by declines in the bond markets and declines in economic activity caused by the continued threat of terrorism, ongoing military and other actions and heightened security measures.
We cannot predict at this time whether and the extent to which industry sectors in which we maintain investments may suffer losses as a result of potential decreased commercial and economic activity, or how any such decrease might impact the ability of companies within the affected industry sectors to pay interest or principal on their securities, or how the value of any underlying collateral might be affected.
We can offer no assurances that terrorist attacks or the threat of future terrorist events in the United States and abroad or military actions by the United States will not have a material adverse effect on our business, financial condition or results of operations.
Our results of operations and revenues may fluctuate as a result of many factors, including cyclical changes in the insurance industry, which may cause the price of our common stock to be volatile.
The results of operations of companies in the insurance industry historically have been subject to significant fluctuations and uncertainties. Our profitability can be affected significantly by:
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competition;
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rising levels of loss costs that we cannot anticipate at the time we price our products;
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volatile and unpredictable developments, including man-made, weather-related and other natural catastrophes or terrorist attacks;
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changes in the level of reinsurance capacity and capital capacity;
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changes in the amount of loss reserves resulting from new types of claims and new or changing judicial interpretations relating to the scope of insurers’ liabilities; and
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fluctuations in interest rates, inflationary pressures and other changes in the investment environment, which affect returns on invested assets and may impact the ultimate payout of losses.
The availability of insurance is related to prevailing prices, the level of insured losses and the level of industry surplus which, in turn, may fluctuate in response to changes in rates of return on investments being
earned in the insurance industry. As a result, the insurance business historically has been a cyclical industry characterized by periods of intense price competition due to excessive underwriting capacity as well as periods when shortages of capacity permitted favorable premium levels. During 1998, 1999 and 2000, the workers’ compensation insurance industry experienced substantial pricing competition, and this pricing competition greatly affected the ability of our predecessor to increase premiums. Beginning in 2001, we witnessed a decrease in pricing competition in the industry, which enabled us to raise our rates. Although rates for many products increased from 2000 to 2003, legislative reforms caused premium rates in certain states, including California, to decrease in 2004 through 2007, and rates may continue to decrease. In addition, the availability of insurance has and may continue to increase, either by capital provided by new entrants or by the commitment of additional capital by existing insurers, which may perpetuate rate decreases. Any of these factors could lead to a significant reduction in premium rates, less favorable policy terms and fewer submissions for our underwriting services. In addition to these considerations, changes in the frequency and severity of losses suffered by insureds and insurers may affect the cycles of the insurance business significantly, and we expect to experience the effects of such cyclicality. This cyclicality may cause the price of our securities to be volatile.
Risks Related to Our Common Stock
The price of our common stock may decrease.
The trading price of shares of our common stock may decline for many reasons, some of which are beyond our control, including, among others:
•
quarterly variations in our results of operations;
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changes in expectations as to our future results of operations, including financial estimates by securities analysts and investors;
•
announcements of claims against us by third parties;
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changes in law and regulation;
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results of operations that vary from those expected by securities analysts and investors; and
•
future sales of shares of our common stock.
In addition, the stock market in recent years has experienced substantial price and volume fluctuations that sometimes have been unrelated or disproportionate to the operating performance of companies whose shares are traded. As a result, the trading price of shares of our common stock may decrease and you may not be able to sell your shares at or above the price you pay to purchase them.
Applicable insurance laws may make it difficult to effect a change of control of our company.
Our insurance company subsidiary is domiciled in the state of Illinois and commercially domiciled in the state of California. The insurance holding company laws of Illinois and California require advance approval by the Illinois Division of Insurance and the California Department of Insurance of any change in control of SeaBright Insurance Company. “Control” is generally presumed to exist through the direct or indirect ownership of 10% or more of the voting securities of a domestic insurance company or of any entity that controls a domestic insurance company. In addition, insurance laws in many states contain provisions that require prenotification to the insurance commissioners of a change in control of a non-domestic insurance company licensed in those states. Any future transactions that would constitute a change in control of SeaBright Insurance Company, including a change of control of us, would generally require the party acquiring control to obtain the prior approval of the Illinois Division of Insurance and the California Department of Insurance and may require pre-acquisition notification in applicable states that have adopted pre-acquisition notification provisions. Obtaining these approvals may result in a material delay of, or deter, any such transaction. See the discussion under the heading “Regulation” in Part I, Item 1 of this annual report.
These laws may discourage potential acquisition proposals and may delay, deter or prevent a change of control of us, including through transactions, and in particular unsolicited transactions, that some or all of our stockholders might consider to be desirable.
Anti-takeover provisions in our amended and restated certificate of incorporation and by-laws and under the laws of the State of Delaware could impede an attempt to replace or remove our directors or otherwise effect a change of control of our company, which could diminish the value of our common stock.
Our amended and restated certificate of incorporation and by-laws contain provisions that may make it more difficult for stockholders to replace directors even if the stockholders consider it beneficial to do so. In addition, these provisions could delay or prevent a change of control that a stockholder might consider favorable. For example, these provisions may prevent a stockholder from receiving the benefit from any premium over the market price of our common stock offered by a bidder in a potential takeover. Even in the absence of an attempt to effect a change in management or a takeover attempt, these provisions may adversely affect the prevailing market price of our common stock if they are viewed as discouraging takeover attempts in the future. In addition, Section 203 of the Delaware General Corporation Law may limit the ability of an “interested stockholder” to engage in business combinations with us. An interested stockholder is defined to include persons owning 15% or more of any class of our outstanding voting stock.
Our amended and restated certificate of incorporation and by-laws contain the following provisions that could have an anti-takeover effect:
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stockholders have limited ability to call stockholder meetings and to bring business before a meeting of stockholders;
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stockholders may not act by written consent; and
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our Board of Directors may authorize the issuance of preferred stock with such rights, powers and privileges as the board deems appropriate.
These provisions may make it difficult for stockholders to replace management and could have the effect of discouraging a future takeover attempt which is not approved by our Board of Directors but which individual stockholders might consider favorable.
Item 1B.
Item 1B.
Unresolved Staff Comments.
None.
Item 2.
Item 2.
Properties.
Our principal executive offices are located in approximately 35,600 square feet of leased office space in Seattle, Washington. We also lease office space consisting of approximately 8,300 square feet in Orange, California; 6,100 square feet in Concord, California; 4,100 square feet in Phoenix, Arizona; 4,000 square feet in Duluth, Georgia; 3,900 square feet in Irvine, California; 3,900 square feet in Radnor, Pennsylvania; 3,700 square feet in Needham, Massachusetts; 3,300 square feet in Houston, Texas; 3,000 square feet in Chicago, Illinois; 2,650 square feet in Honolulu, Hawaii; 2,500 square feet in Anchorage, Alaska; and 1,800 square feet in Tampa, Florida. We conduct claims and underwriting operations in our branch offices, with the exception of our Honolulu office, where we conduct only claims and loss control operations, and our Needham office, where we conduct only underwriting and marketing operations. We do not own any real property. We consider our leased facilities to be adequate for our current operations.
Item 3.
Item 3.
Legal Proceedings.
We are, from time to time, involved in various legal proceedings in the ordinary course of business. We believe we have sufficient loss reserves and reinsurance to cover claims under policies issued by us. Accordingly, we do not believe that the resolution of any currently pending legal proceedings, either individually or taken as a whole, will have a material adverse effect on our business, financial condition or results of operations.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders.
None.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Our common stock has been quoted on the NASDAQ Global Select Market (formerly the Nasdaq National Market) under the symbol “SEAB” since our initial public offering on January 21, 2005. Prior to that time, there was no public market for our common stock. The following table sets forth, for the periods indicated, the high and low sales prices for our common stock as quoted on the NASDAQ Global Select Market.
As of March 14, 2008, there were approximately 33 holders of record of our common stock.
Dividend Policy
We do not expect to pay any cash dividends on our common stock for the foreseeable future. We currently intend to retain any additional future earnings to finance our operations and growth. Any future determination to pay cash dividends on our common stock will be at the discretion of our Board of Directors and will be dependent on our earnings, financial condition, operating results, capital requirements, any contractual restrictions, regulatory and other restrictions on the payment of dividends by our subsidiaries to us, and other factors that our Board of Directors deems relevant.
We are a holding company and have no direct operations. Our ability to pay dividends in the future depends on the ability of our operating subsidiaries to pay dividends to us. Our subsidiary, SeaBright Insurance Company, is a regulated insurance company and therefore is subject to significant regulatory restrictions limiting its ability to declare and pay dividends.
SeaBright Insurance Company’s ability to pay dividends is subject to restrictions contained in the insurance laws and related regulations of Illinois and California. The insurance holding company laws in these states require that ordinary dividends be reported to the Illinois Division of Insurance and the California Department of Insurance prior to payment of the dividend and that extraordinary dividends be submitted for prior approval. See “Regulation” in Part I, Item 1 of this annual report.
For information regarding restrictions on the payment of dividends by us and SeaBright Insurance Company, see the discussion under the heading “Liquidity and Capital Resources” in Part II, Item 7 and the discussion under the heading “Business - Regulation - Dividend Limitations” in Part I, Item 1 of this annual report.
Purchases of Equity Securities
We did not purchase any of our equity securities during 2007.
Performance Graph
The following graph and table compare the total return on $100 invested in SeaBright common stock for the period commencing on January 21, 2005 (the date of our initial public offering) and ending on December 31, 2007 with the total return on $100 invested in each of the Nasdaq Stock Market (U.S.) Index and in the Nasdaq Insurance Index. The closing market price for SeaBright common stock at the end of fiscal year 2007 was $15.08.
Comparison of 35 Month Cumulative Total Return*
Among SeaBright Insurance Holdings, Inc., The NASDAQ Composite Index
And The NASDAQ Insurance Index
*
$100 invested on January 21, 2005 in stock or on December 31, 2004 in index, including reinvestment of dividends. Fiscal year ending December 31.
The information in the graph and table above is not “soliciting material,” is not deemed “filed” with the SEC and is not to be incorporated by reference in any of our filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended (the “Exchange Act”), whether made before or after the date of this annual report and irrespective of any general incorporation language in any such filing, except to the extent that we specifically incorporate such information by reference.
Item 6.
Item 6.
Selected Financial Data.
The following table sets forth our selected historical financial information and that of our predecessor for the periods ended and as of the dates indicated. This information comes from our consolidated financial statements and those of our predecessor. You should read the following selected financial information along with the information contained in this annual report, including Part II, Item 7
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operation.
The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements and the notes to those statements included elsewhere in this annual report. The discussion and analysis below includes forward-looking statements that are subject to risks, uncertainties and other factors described in Part I, Item 1A of this annual report that could cause our actual results of operations, performance and business prospects and opportunities in 2008 and beyond to differ materially from those expressed in, or implied by those forward-looking statements. See “Note on Forward-Looking Statements” in Part I, Item 1 of this annual report.
Overview
We provide workers’ compensation insurance coverage for prescribed benefits that employers are required to provide to their employees who may be injured in the course of their employment. We currently provide workers’ compensation insurance to customers in the maritime, ADR and state act markets.
Principal Revenue and Expense Items
We derive our revenue from premiums earned, service fee income, net investment income and net realized gains and losses from investments.
Premiums Earned
Gross premiums written include all premiums billed and unbilled by an insurance company during a specified policy period. Premiums are earned over the terms of the related policies. At the end of each accounting period, the portion of the premiums that are not yet earned is included in unearned premiums and is realized as revenue in subsequent periods over the remaining terms of the policies. Our policies typically have terms of 12 months. Thus, for example, for a policy that is written on July 1, 2007, one-half of the premiums would be earned in 2007 and the other half would be earned in 2008.
Premiums earned is the earned portion of our net premiums written. Net premiums written is the difference between gross premiums written and premiums ceded or paid to reinsurers (ceded premiums written). Our gross premiums written is the sum of both direct premiums and assumed premiums before the effect of ceded reinsurance. Assumed premiums are premiums that we have received from another company under a reinsurance agreement or from an authorized state mandated pool.
We earn our direct premiums written from our maritime, ADR and state act customers. We also earn a small portion of our direct premiums written from employers who participate in the Washington USL&H Plan. We immediately cede 100% of those premiums, net of our expenses, and 100% of the losses in connection with that business to the plan. We do not include premiums from the Washington USL&H Plan in our direct premiums written because it is not indicative of our core business or material to our results of operation.
Net Investment Income and Realized Gains and Losses on Investments
We invest our statutory surplus and the funds supporting our insurance liabilities (including unearned premiums and unpaid loss and loss adjustment expenses) in cash, cash equivalents, fixed income securities and, to a lesser degree, in equity securities and preferred stock. Our investment income includes interest and dividends earned on our invested assets. Realized gains and losses on invested assets are reported separately from net investment income. We earn realized gains when invested assets are sold for an amount greater than their amortized cost in the case of fixed maturity securities and recognize realized losses when investment securities are written down as a result of an other-than-temporary impairment or sold for an amount less than their carrying value.
Claims Service Income
We receive claims service income in return for providing claims administration services for other companies. The claims service income we receive for providing these services approximates our costs. For the
years ended December 31, 2007, 2006, and 2005, approximately 52.6%, 66.8%, and 85.5%, respectively, of our claims service income was generated by contracts we have with LMC to provide claims handling services for the policies written by the Eagle Entities prior to the Acquisition. We expect income from these contracts to decrease substantially over the next several years as transactions related to the Eagle Entities diminish.
Other Service Income
Following the Acquisition, we entered into servicing arrangements with LMC to provide policy administration and accounting services for the policies written by the Eagle Entities prior to the Acquisition. The fee income we receive for providing these services approximates our costs and will decrease substantially over the next several years as transactions related to the Eagle Entities diminish.
Our expenses consist primarily of:
Loss and Loss Adjustment Expenses
Loss and loss adjustment expenses represent our largest expense item and include (1) claim payments made, (2) estimates for future claim payments and changes in those estimates for current and prior periods and (3) costs associated with investigating, defending and adjusting claims. For further information regarding our loss and loss adjustment expenses, including amounts paid and unpaid, see the discussion under the heading “Critical Accounting Policies, Estimates and Judgments - Unpaid Loss and Loss Adjustment Expenses” in Part II, Item 7 of this annual report.
Underwriting, Acquisition and Insurance Expenses
In our insurance subsidiary, we refer to the expenses that we incur to underwrite risks as underwriting, acquisition and insurance expenses. Underwriting 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. Certain of these costs that vary with and are primarily related to the acquisition of insurance contracts (“deferred acquisition costs”) are initially deferred and amortized over the typical policy term of 12 months. Therefore, with respect to deferred acquisition costs, there are timing differences between when the costs are incurred or paid and when the related expense is recognized in our statements of operations.
Interest Expense
Included in other expense is interest expense we incur 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
Year Ended December 31, 2007 Compared to Year Ended December 31, 2006
Gross Premiums Written. Gross premiums written totaled $282.7 million in 2007 compared to $230.3 million in 2006, representing an increase of $52.4 million, or 22.8%, even though we continued to experience rate reductions in California, our largest market, as well as in other states. The average renewal rate change for our state act, excluding California, and maritime markets for the full year of 2007 was −10.8% and −3.5%, respectively. Excluding work we perform as the servicing carrier for the Washington USL&H Plan, the number of customers we serviced at December 31, 2007 increased 45.7% to 953 from 654 at
December 31, 2006 and year-end in-force payrolls, one of the factors used in determining premium charges, increased 44.6% from 2006 to 2007. California continues to be our largest market, accounting for approximately $108.0 million (40.2%) of our direct premiums written in 2007, compared to $113.4 million (52.3%) of our direct premiums written in 2006. The reduction in our California premium resulted from rate reductions, the effects of competition and the growth of our business in other geographies. Illinois and Louisiana were our second and third largest markets in 2007, together accounting for approximately $48.7 million (18.1%) of our total direct premiums written, up from $33.5 million (15.5%) in 2006.
In 2007, we continued our geographical expansion program by opening new offices in Phoenix, Arizona and Duluth, Georgia. We expect these new offices to make a significant contribution to our written premiums over the next 12-24 months. Direct premiums written in these two states in 2007 were approximately $12.8 million, or 4.7% of our total direct premiums written.
We have experienced significant reductions in our California premium rates over the past four years. In 2007, in response to continued reductions in California workers’ compensation claim costs, we reduced our rates by an average 14.2% for new and renewal insurance policies written in California on or after July 1, 2007. This was the eighth California rate reduction we have filed since October 1, 2003, resulting in a net cumulative reduction of our California rates of approximately 54.8%. Rate reductions have also been adopted in other states in which we operate. For example, effective January 1, 2008, we adopted the following rate decreases recommended by the NCCI: 10.9% in Alaska, 19.3% in Hawaii and 18.4% in Florida. Effective July 1, 2007, we adopted the Louisiana Insurance Commissioner’s recommendation of a 15.8% reduction in Louisiana, which is 2.0% more than the 13.8% rate decrease recommended by the NCCI. On February 5, 2008, the Louisiana Insurance Commissioner approved an NCCI-proposed rate reduction of 8.6%, effective May 1, 2008. On March 7, 2008, after completing a study of our Louisiana loss data, we filed with the Louisiana Insurance Commissioner our new rates reflecting an average reduction of 8.6% 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 $267.4 million in 2007 compared to $214.8 million in 2006, representing an increase of $52.6 million, or 24.5%. Net premiums written were affected by premiums ceded under reinsurance agreements. Ceded written premiums in 2007 totaled $15.3 million, or 5.4% of gross premiums written, compared to $15.5 million, or 6.7%, of gross premiums written, in 2006. 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, 2006 at average rates that were approximately 16.8% lower than rates under the prior reinsurance program. Effective October 1, 2007, we renewed our reinsurance program at average rates that are approximately 25.6% lower than the expiring rates.
Net Premiums Earned. Net premiums earned totaled $228.0 million in 2007 compared to $185.6 million in 2006, representing an increase of $42.4 million, or 22.8%. We record the entire annual policy premium as unearned premium at inception 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 $38.8 million or 19.8% to $234.5 million in 2007 from $195.7 million in 2006 due to our premium growth as described above. Net premiums earned are also affected by premiums ceded under reinsurance agreements. Ceded premiums earned in 2007 totaled $15.0 million compared to $15.6 million in 2006, representing a decrease of $0.6 million or 3.8%. A decrease in ceded premiums earned is an increase to our overall net premiums earned. Also adding to the increase in net premiums earned was 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 $3.1 million from $5.5 million in 2006 to $8.6 million in 2007.
Service Income. Service income was $1.9 million in 2007 compared to $2.1 million in 2006, representing a decrease of $0.2 million, or 9.5%. Our service income resulted primarily from service arrangements we have with LMC for claims processing services, policy administration and administrative services we performed for the Eagle Entities’ insurance policies and from claims processing services we perform for other unrelated
companies. Average monthly fees declined as the volume of work required for policy administration decreased as a result of the run off of our predecessor’s business. Service income related to our arrangements with LMC decreased $100,000, or 10.0%, from $1.0 million in 2006 to $0.9 million in 2007. Service income related to claims processing services that we perform for other unrelated companies decreased approximately $215,000 in 2007.
Net Investment Income. Net investment income was $20.3 million in 2007 compared to $15.2 million in 2006, representing an increase of $5.1 million, or 33.6%. Average invested assets increased $120.7 million, or 34.8%, from $346.8 million in 2006 to $467.5 million in 2007. This increase in our investment portfolio is due primarily to cash flow from operations of $94.6 million for the year ended December 31, 2007, which was invested primarily in fixed income securities. Net investment income as a percentage of average invested assets decreased slightly from 4.4% in 2006 to 4.3% in 2007.
Other Income. Other income totaled $4.4 million in 2007 compared to $3.4 million in 2006, representing an increase of $1.0 million, or 29.4%. Other income results primarily from the operations of PointSure, our wholesale broker and third party administrator subsidiary whose total revenues for the year ended December 31, 2007 increased approximately 21.4% over the same period in 2006, and THM, a provider of medical bill review, utilization review, nurse case management and related services that we acquired in December 2007.
Loss and Loss Adjustment Expenses. Loss and loss adjustment expenses totaled $128.2 million in 2007 compared to $107.9 million in 2006, representing an increase of $20.3 million, or 18.8%. The higher loss and loss adjustment expenses in 2007 are attributable to the increase in premiums earned for the period, offset by a reduction of approximately $27.7 million of previously recorded direct net loss reserves to reflect a continuation of deflation trends in the paid loss data for recent accident years. 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 $17.3 million of the reserve adjustment related to accident year 2006 and approximately $11.6 million related to accident year 2005. These reductions were offset by adverse development of $1.2 million in the 2004 accident year. As a result of these reserve changes, our net loss ratio decreased from 57.0% in 2006 to 55.5% in 2007.
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 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 December 31, 2007 that are based upon our current best estimate of ultimate 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. See the discussion under the headings “Loss Reserves” in Part I, Item 1 and “Critical Accounting Policies, Estimates and Judgments - Unpaid Loss and Loss Adjustment Expenses” in this Item 7 for a further discussion of our loss reserving process.
As of December 31, 2007, 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 effect on our future cash flows if LMC fails to perform its obligations under the adverse development cover. At December 31, 2007, we had access to approximately $3.5 million under the collateralized reinsurance trust in the event that LMC fails to satisfy its obligations under the adverse development cover. See the discussion under the heading “Loss Reserves - KEIC Loss Reserves” in Part I, Item 1 of this annual report.
Underwriting Expenses. Underwriting expenses totaled $58.9 million in 2007 compared to $42.3 million in 2006, representing an increase of $16.6 million, or 39.2%. Our net underwriting expense ratio was 25.8% in 2007 compared to 22.7% in 2006. The increase in the expense ratio was driven by $7.7 million in increased staffing costs and other premium production related expenses as we invest in the geographic expansion of our business. Increases of approximately $6.7 million in commission costs, driven in part by the increase in premiums written, and $1.5 million in equity compensation costs related to the grant of additional stock options and restricted stock also contributed to the increase in our underwriting expense ratio.
Interest Expense. Interest expense related to the surplus notes issued by our insurance subsidiary in May 2004 totaled $1.1 million in 2007 and 2006. 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, ranged between 9.03% and 9.50% in 2007.
Other Expenses. Other expenses totaled $7.8 million in 2007 compared to $6.2 million in 2006, representing an increase of $1.6 million, or 25.8%. Other expenses result primarily from the operations of PointSure, our wholesale broker and third party administrator subsidiary which experienced increases in commissions and other operating expenses associated with the expansion of its business. Additionally, we incurred $0.6 million in acquisition related costs in 2007.
Income Tax Expense. Our effective tax rate in 2007 was 31.7% compared to 31.3% in 2006. Our effective tax rate for 2007 was lower than the statutory tax rate of 35.0% primarily as a result of tax exempt interest income of 4.4% in 2007 and 6.6% in 2006.
Net Income. Net income totaled $39.9 million in 2007 compared to $33.2 million in 2006, representing an increase of $6.7 million, or 20.2%. The 2007 increase in net income resulted primarily from the increase in premiums earned and investment income for the period, offset by related increases in loss and loss adjustment expenses, underwriting acquisition and insurance expenses, and other expenses.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
Gross Premiums Written. Gross premiums written were $230.3 million in 2006 compared to $204.7 million in 2005, representing an increase of $25.6 million, or 12.5%, even though we continued to experience rate reductions in California, our largest market, as well as in other states. The average renewal rate change for our state act and maritime markets, excluding California, for the full year of 2006 was -7.3% and -10.1%, respectively. Excluding work we perform as the servicing carrier for the Washington USL&H Plan, the number of customers we serviced at December 31, 2006 increased 39.7% to 654 from 468 at December 31, 2005 and in-force payrolls, one of the factors used in determining premium charges, increased 54.6% from 2005. California continues to be our largest market, accounting for approximately $113.4 million (52.3%) of our direct premiums written in 2006. Illinois became our third largest market, accounting for $19.9 million (9.2%) or our direct premiums written in 2006. This represents an increase of $16.7 million (521.9%) from $3.2 million in direct premiums written in 2005.
On December 21, 2006, we announced the division of our Southern region into two markets, allowing us to devote greater focus and resources to further develop our key states in this region. Our new Southeast region will pursue business in selected southeastern states, including Florida. We opened an office in Atlanta, Georgia in early 2007. As a result of this division, the Gulf region, which is based in Houston, Texas, will focus primarily on Texas and Louisiana. By dividing the southern states in this manner, we substantially improved the resource level dedicated to these regions and clarified the focus on our target markets in each of the critical states. During the fourth quarter of 2006, we opened an office in Radnor, Pennsylvania, a Philadelphia suburb. This new office contributed approximately $838,000 to our direct premiums written in 2006.
Net Premiums Written. Net premiums written totaled $214.8 million in 2006 compared to $185.7 million in 2005, representing an increase of $29.1 million, or 15.7%. Net premiums written were affected by premiums ceded under reinsurance agreements. Ceded written premiums in 2006 totaled $15.5 million, or 6.7% of gross premiums written, compared to $19.1 million, or 9.3%, of gross premiums written, in 2005. 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, 2006 at average rates that are approximately 16.8% lower than rates under the prior reinsurance program. We were able to achieve savings at the lower tiers of our program while increasing our catastrophe coverage from $50.0 million to $75.0 million.
Net Premiums Earned. Net premiums earned totaled $185.6 million in 2006 compared to $158.9 million in 2005, representing an increase of $26.7 million, or 16.8%. 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 $22.9 million or 13.3% to $195.7 million in 2006 from $172.8 million in 2005 due to our premium growth as described above. Net premiums earned are also affected by premiums ceded under reinsurance agreements. Ceded premiums earned in 2006 totaled $15.6 million compared to $22.3 million in 2005, representing a decrease of $6.7 million or 30.0%. A decrease in ceded premiums earned is an increase to our overall net premiums earned. Offsetting the increases in net premiums earned is a decrease 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 decreased $2.9 million from $8.4 million in 2005 to $5.5 million in 2006.
Net Investment Income. Net investment income was $15.2 million in 2006 compared to $7.8 million in 2005, representing an increase of $7.4 million, or 94.9%. Average invested assets increased $153.2 million (79.1%) from $193.6 million in 2005 to $346.8 million in 2006. Approximately $57.6 million of the increase resulted from the net proceeds of the follow-on offering of our common stock in February 2006. During the first quarter of 2006, yields on fixed income securities were at very high levels compared to 2005 and a significant portion of the net proceeds from the follow-on offering were invested at these higher yields. Another contributing factor to the increase in net investment income is realized positive cash flow from operations of $90.3 million in 2006, which was invested in fixed income securities with higher yields in 2006 compared to 2005. Net investment income as a percentage of average invested assets rose from 4.0% in 2005 to 4.4% in 2006, reflecting the rising interest rate environment.
Service Income. Service income was $2.1 million in 2006 compared to $2.5 million in 2005, representing a decrease of $0.4 million, or 16.0%. Our service income resulted primarily from service arrangements we have with LMC for claims processing services, policy administration and administrative services we performed for the Eagle Entities’ insurance policies and from claims processing services we perform for other unrelated companies. Average monthly fees declined as the volume of work required for policy administration decreased as a result of the run off of our predecessor’s business. Service income related to our arrangements with LMC decreased $0.7 million (33.3%) to $1.4 million in 2006 from $2.1 million in 2005. Service income related to claims processing services that we perform for other unrelated companies increased approximately $0.3 million in 2006 due to the addition of one new high volume customer in early 2006.
Other Income. Other income totaled $3.4 million in 2006 compared to $3.3 million in 2005, representing an increase of $0.1 million, or 3.0%. Other income is derived primarily from the operations of PointSure, our non-insurance subsidiary, which expanded its portfolio of insurance products during 2006 to accelerate income growth from sources other than us. The number of insurance companies that PointSure represents increased by 11 to a total of 19 in 2006.
Loss and Loss Adjustment Expenses. Loss and loss adjustment expenses totaled $107.9 million in 2006 compared to $105.8 million in 2005, representing an increase of $2.1 million, or 2.0%. The higher loss and loss adjustment expenses in 2006 are attributable to the increase in premiums earned for the period, offset by a reduction of approximately $20.4 million of previously recorded direct net loss reserves to reflect a continuation of deflation trends in the paid loss data for recent accident years. 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 $14.6 million of the reserve adjustment related to accident year 2005 and approximately $5.9 million related to accident year 2004. These reductions were offset by modest adverse development of $0.1 million in the 2003 accident year. As a result of these reserve changes, our net loss ratio decreased from 65.1% in 2005 to 57.0% in 2006.
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 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 December 31, 2006 that are based upon our current best estimate of ultimate 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. See the
discussion under the heading “Loss Reserves” in Part I, Item 1 of this annual report for a further discussion of our loss reserve process.
As of December 31, 2006, we had recorded a receivable of approximately $2.8 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 effect on our future cash flows if LMC fails to perform its obligations under the adverse development cover. At March 2, 2007, we had access to approximately $3.4 million under the collateralized reinsurance trust in the event that LMC fails to satisfy its obligations under the adverse development cover. See the discussion under the heading “Loss Reserves - KEIC Loss Reserves” in Part I, Item 1 of this annual report.
Underwriting Expenses. Underwriting expenses totaled $42.3 million in 2006 compared to $33.8 million in 2005, representing an increase of $8.5 million, or 25.1%. Our net underwriting expense ratio was 22.7% in 2006 compared to 21.2% in 2005. 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 of our business. In addition, we incurred increased professional consulting and audit fees related to our initial compliance with Section 404 of the Sarbanes-Oxley Act of 2002 and costs related to restricted stock and the implementation of SFAS No. 123R, Share-Based Payment.
Interest Expense. Interest expense related to the surplus notes issued by our insurance subsidiary in May 2004 totaled $1.1 million in 2006 compared to $0.9 in 2005, representing an increase of $0.2 million, or 22.2%. 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, increased steadily throughout 2006 from 8.39% at the beginning of 2006 to 9.37% at the end of the year.
Other Expenses. Other expenses totaled $6.2 million in 2006 compared to $5.0 million in 2005, representing an increase of $1.2 million, or 24.0%. Other expenses are derived primarily from the operations of PointSure, our non-insurance subsidiary which experienced direct costs associated with the expansion of the insurance products they offer. In October 2006, we incurred a one time charge of $305,000 related to the settlement of a legal matter.
Income Tax Expense. Our effective tax rate in 2006 was 31.3% compared to 31.6% in 2005. Our effective tax rate for 2006 was lower than the statutory tax rate of 35.0% primarily as a result of tax exempt interest income. The effective tax rate decreased in 2006 primarily as a result of a reduction in the proportion of investment income generated from investments in tax-exempt bonds and a related true-up in the amount of taxes due with our 2005 Federal income tax return.
Net Income. Net income totaled $33.2 million in 2006 compared to $18.3 million in 2005, representing an increase of $14.9 million, or 81.4%. The 2006 increase in net income resulted primarily from the increase in premiums earned and investment income for the period, offset by related increases in loss and loss adjustment expenses, underwriting acquisition and insurance expenses, and other expenses, including interest expense related to the surplus notes and amortization expense related to intangible assets acquired in the Acquisition.
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 December 31, 2007 has an effective duration of 4.9 years with individual maturities extending out to 29 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 with appropriate durations to match against expected future claim payments.
At December 31, 2007, approximately 96.0% of our investment portfolio consisted of primarily 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 rate environment, we would expect to incur losses from such sales.
We had no direct sub-prime mortgage exposure in our investment portfolio as of December 31, 2007 and less than $800,000 of indirect exposure to sub-prime mortgages. The average credit quality of our $250.9 million fixed income municipal portfolio was AA+ (AA− based on the issuers’ underlying ratings). Insured municipal bonds totaled $192.8 million and had a weighted average credit rating of AAA (AA− based on the issuers’ underlying ratings). The remaining $58.1 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 $1.0 million, up to $75.0 million, subject to various deductibles and exclusions. Our reinsurance program that was effective October 1, 2006 to October 1, 2007, provides us with the same levels of reinsurance protection as our 2007-2008 program, subject to similar deductibles and exclusions. See the discussion under the heading “Reinsurance” in Part I, Item 1 of this annual report. Given industry and predecessor trends, we believe we are sufficiently capitalized to retain 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 NAIC has a risk-based capital standard designed to identify property and casualty insurers that may be inadequately capitalized based on inherent risks of each insurer’s assets and liabilities and its mix of net premiums written. Insurers falling below a calculated threshold may be subject to varying degrees of regulatory action. As of December 31, 2007, the statutory surplus of our insurance subsidiary was in excess of the prescribed risk-based capital requirements that correspond to any level of regulatory action.
SeaBright is a holding company with minimal unconsolidated revenue and expenses. Currently there are no plans to have our insurance or other subsidiaries pay a dividend to SeaBright.
Net cash provided by operating activities in 2007 totaled $94.6 million, an increase of $4.3 million, or 4.8%, from $90.3 million in 2006, which increased $7.6 million, or 9.2%, from $82.7 million in 2005. These increases are mainly attributable to increases in unpaid loss and loss adjustment expense, amortization of deferred policy acquisition costs and taxes payable, offset by increases in policy acquisition costs deferred and deferred taxes, all as a result of our growth.
We used net cash of $95.1 million for investing activities in 2007 compared to $139.6 million in 2006 and $159.7 million in 2005. The reduction in 2007 from 2006 and 2005 is primarily attributable to a reduction in funds available for investing activities. In 2006, we invested net proceeds totaling approximately $57.6 million resulting from a follow-on public offering of 3,910,000 shares of our common stock described below. In 2005, we invested net proceeds totaling approximately $80.8 million resulting from the sale of 8,625,000 shares of common stock in our initial public offering.
Cash provided by financing activities totaled $0.4 million in 2007, a decrease of $57.2 million from $57.6 million in 2006, which decreased $23.2 million from $80.8 million in 2005. As described below, the
majority of cash provided by financing activities in 2006 and 2005 resulted from the sale of our common stock and, to a much lesser degree, from the exercise of common stock options by our employees. In 2006, we received net proceeds of approximately $57.6 million from a follow-on public offering of 3,910,000 shares of our common stock and in 2005, we received net proceeds of approximately $80.8 million from the initial public offering of our common stock.
Contractual Obligations and Commitments
The following table identifies our contractual obligations by payment due period as of December 31, 2007:
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 December 31, 2007 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 “Loss Reserves” in Part I, Item 1 of this annual report and “Critical Accounting Policies, Estimates and Judgments - Unpaid Loss and Loss Adjustment Expenses” in Part II, Item 7 of this annual 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. See the discussion under the heading “Risks Related to our Business - Our loss reserves are based on estimates and may be inadequate to cover our actual losses” in Part I, Item 1A of this annual report for a discussion of the uncertainties associated with estimating unpaid loss and loss adjustment expenses.
Off-Balance Sheet Arrangements
As of December 31, 2007, we had no off-balance sheet arrangements that have or are reasonably likely to have a 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 financial statements. Management considers 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 investments, earned but unbilled premiums and retrospective premiums. The following should be read in conjunction with the notes to our consolidated financial statements.
Unpaid Loss and Loss Adjustment Expenses
Unpaid loss and loss adjustment expense represents our estimate of the expected cost of the ultimate settlement and administration of losses, based on known facts and circumstances. Our policy is to record the liability for unpaid claims and claim adjustment expense equal to the point estimate determined by our internal actuaries. Included in unpaid loss and loss adjustment expense are amounts for case-based reserves, including estimates of future developments on those claims, and claims incurred but not yet reported to us, second injury fund expenses, and allocated and unallocated claim adjustment expenses. Due to the inherent uncertainty associated with the cost of unsettled and unreported claims, the ultimate liability may differ, perhaps materially, from the original estimate. These estimates are regularly reviewed and updated and any resulting adjustments are included in the current period’s operating results.
Following is a summary of the gross loss and loss adjustment expense reserves by line of business as of December 31, 2007 and 2006. The workers’ compensation line of business comprises over 99% of our total loss reserves as of December 31, 2007.
Actuarial Loss Reserve Estimation Methods
We use a variety of actuarial methodologies to assist us in establishing the reserve for unpaid loss and loss adjustment expense. We also make judgments relative to estimates of future claims severity and frequency, length of time to achieve ultimate resolution, judicial theories of liability and other third-party factors that are often beyond our control.
For the current accident year, we establish the initial reserve for claims incurred-but-not-reported (“IBNR”) using an expected loss ratio (“ELR”) method. The ELR method is based on an analysis of historical loss ratios adjusted for current pricing levels, exposure growth, anticipated trends in claim frequency and severity, the impact of reform activity and any other factors that may have an impact on the loss ratio. The actual paid and incurred loss data for the accident year is reviewed each quarter and changes to the ELR may be made based on the emerging data, although changes are typically not made until the end of the accident year when the loss data can be analyzed as a complete accident year. The ELR is multiplied by the year-to-date earned premium to determine the ultimate losses for the current accident year. The actual paid and case outstanding losses are subtracted from the ultimate losses to determine the IBNR for the accident year. As the accident year matures, we incorporate a standard actuarial reserving methodology referred to as the Bornhuetter-Ferguson method. This method blends the loss development and expected loss ratio methods by assigning partial weight to the initial expected losses, calculated from the expected loss ratio method, with the remaining weight applied to the actual losses, either paid or incurred. The weights assigned to the initial expected losses decrease as the accident year matures. A reserve estimate implies a pattern of expected loss emergence. If this emergence does not occur as expected, it may cause us to revisit our previous assumptions. We may adjust loss development patterns, the various method weights or the expected loss ratios used in our analysis. Management employs judgment in each reserve valuation as to how to make these adjustments to reflect current information.
For all other accident years, the estimated ultimate losses are developed using a variety of actuarial techniques as described below. In reviewing this information, we consider the following factors to be especially important at this time because they increase the variability risk factors in our loss reserve estimates:
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We wrote our first policy on October 1, 2003 and, as a result, our total reserve portfolio is relatively immature when compared to other industry data.
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We have been growing consistently since we began operations and have entered into several new states that are not included in our predecessor’s historical data.
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At December 31, 2007, approximately $102.5 million, or 51.5%, 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 Commissioner effective January 1, 2008 were 65.1% lower than the pure premium rates in effect as of July 1, 2003.
Key elements of the reforms as they relate to indemnity and medical benefits were as follows:
Indemnity Benefits
AB 749 significantly increased most classes of workers’ compensation indemnity benefits over a four-year period beginning in 2003.
AB 227 and SB 228 repealed the mandatory vocational rehabilitation benefits and replaced them with a system of non-transferable education vouchers.
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.
SB 899 provided that, effective April 19, 2004, apportionment of disability for purposes of permanent disability determination must be based on causation.
Medical Benefits
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.)
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.
SB 228 limited the number of chiropractic visits and the number of physical therapy visits to 24 each per claim.
SB 228 established a prescription medication fee schedule set at 100% of Medi-Cal Schedule amounts.
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.
SB 899 provided that after January 1, 2005, an employer or insurer may establish medical provider networks meeting certain conditions and, with limited exceptions, medical treatment can be provided within those networks.
These reforms are a source of variability in the reserve estimates as legislative changes affecting benefit levels not only impact the cost of benefits but also the rate at which accident year benefits or losses develop over time. In addition, the PDRS, one of the most significant reforms, faces ongoing challenges. The PDRS was revised effective January 1, 2005. The revised schedule has resulted in significantly reduced permanent disability awards, leading to concerns that injured workers may not be adequately compensated for their work related permanent injuries. The PDRS is currently being challenged on three fronts - legislative, administrative and legal. Legislation has been proposed in the 2008 legislative session that would modify the formula used to determine the amount of permanent disability benefits. It is too early to determine what impact the legislation may have on permanent disability benefits, or if it will be enacted into law. A prior legislative effort to modify the PDRS was vetoed by the Governor of California in 2007. On the administrative front, the California Division of Workers’ Compensation has undertaken a review of the PDRS. The nature and extent of proposed changes, if any, are not yet known. The Division of Workers’ Compensation has not published a schedule to communicate their recommendations. Finally, recent court decisions continue to lend uncertainty to the interpretation and application of the PDRS. All of these factors add uncertainty to this key driver 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 December 31, 2007, accident year 2004 is 48 months developed, accident year 2005 is 36 months developed, accident year 2006 is 24 months developed and accident year 2007 is 12 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.
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 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).
A gross ultimate value is selected by reviewing the various ultimate estimates and applying actuarial judgment to achieve a reasonable point estimate of the ultimate liability. The gross IBNR reserve equals the selected gross ultimate loss minus the gross paid losses and gross case reserves as of the valuation date. The selected gross ultimate loss and ALAE are reviewed and updated on a quarterly basis.
Variation in Ultimate Loss Estimates
In light of our short operating history and uncertainties concerning the effects of recent legislative reforms, specifically as they relate to our California workers’ compensation experience, the actuarial techniques discussed above use the historical experience of our predecessor as well as industry information in the analysis of loss reserves. We are able to effectively draw on the historical experience of our predecessor because most of the current members of our management and adjusting staff also served as the management and adjusting staff of our predecessor. Over time, we expect to place more reliance on our own developed loss experience and less on our predecessor’s and industry experience.
These techniques recognize, among other factors:
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our claims experience and that of our predecessor;
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the industry’s 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.
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.
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.
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 48 months, 36 months, 24 months and 12 months (2004, 2005, 2006 and 2007, respectively) at December 31, 2007. Our oldest complete accident year was 48 months old as of December 31, 2007. The estimated ultimate losses for accident year 2007 are based on the ELR method described earlier. This is consistent with our reserving approach for the current accident year at prior year-end valuations. For accident years 2003 through 2006, 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 and 2006. 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. 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 the most recent three valuations at December 31, 2007. The decreasing trends are exhibited in the paid loss development data for the 11 months to 48 months development period. The decisions to decrease the estimated ultimate losses for accident years 2004 and 2005 at December 31, 2006 and for accident years 2005 and 2006 at December 31, 2007 were appropriately 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.
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 $5.0 million, or 2%, as of December 31, 2007. 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. 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 $12.5 million on a pre-tax basis, or 5%, as of December 31, 2007. Under these assumptions, the inadequacy of approximately $12.5 million represents approximately 4.2% of total stockholders’ equity at December 31, 2007. 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 $250.1 million as of December 31, 2007 to be 5% inadequate, we would experience a pre-tax reduction in future earnings of approximately $12.5 million. This reduction could be realized in one year or multiple years, depending on when the deficiency is identified. The deficiency would also impact our financial position because our statutory surplus would be reduced by an amount equivalent to the reduction in net income. Any deficiency is typically recognized in the 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. We assessed the collectibility of our year-end receivables and believe that all amounts are collectible based on currently available information. Therefore, as of December 31, 2007 and 2006, we had no reserve for uncollectible reinsurance recoverables.
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 costs as of December 31, 2007 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 income statement in the period that includes the enactment date.
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. This analysis requires management to make various estimates and assumptions, including the scheduled reversal of deferred tax liabilities, projected future taxable income and the effect of tax planning strategies. If actual results differ from management’s estimates and assumptions, we may be required to establish a valuation allowance to reduce the deferred tax assets to the amounts more likely than not to be realized. The establishment of a valuation allowance could have a significant impact on our financial position and results of operations in the period in which it is deemed necessary. To date, we have not needed to record a valuation allowance against our deferred tax assets. We anticipate that our deferred tax assets will increase as our business continues to grow. We will continue to monitor the balance of our deferred tax assets for realizability.
Effective January 1, 2007, we adopted the Financial Accounting Standards Board (“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 the January 1, 2007 date of adoption of FIN 48 and as of 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 and 2006.
Impairment of Investment Securities
Impairment of investment securities results in a charge to operations when the fair value of a security declines below our cost and is deemed to be other-than-temporary. We regularly review our investment portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. A number of criteria are considered during this process, including but not limited to the following: the current fair value as compared to amortized cost or cost, as appropriate, of the security; the length of time the security’s fair value has been below amortized cost; our intent and ability to retain the investment for a period of time sufficient to allow for an anticipated recovery in value; specific credit issues related to the issuer; and current economic conditions, including interest rates.
In general, we focus on those securities whose fair value was less than 80% of their amortized cost or cost, as appropriate, for six or more consecutive months. We also analyze the entire portfolio for other factors that might indicate a risk of impairment. Other-than-temporary impairment losses result in a permanent reduction of the carrying value of the underlying investment. To date, we have not needed to record any other-than-temporary impairments of our investment securities. Please refer to the tables in Note 3 of the consolidated financial statements in Part II, Item 8 of this annual report for additional information on unrealized losses on our investment securities. Please refer to Part II, Item 7A
Item 7A of this annual report for tables showing the sensitivity of the fair value of our fixed-income investments to selected hypothetical changes in interest rates. See “Investments” in Part I, Item 1 of this annual report for a discussion of the limited exposure in our investment portfolio at December 31, 2007 to sub-prime mortgages and problems currently facing monoline bond insurers.
Earned But Unbilled Premiums
Shortly following the expiration of an insurance policy, we perform a final payroll audit of each insured 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 zero and $1.2 million in 2007 and between $1.2 million and $1.7 million in 2006. The balance of our accrual for premiums earned but unbilled totaled approximately $44,000 and $1.5 million at December 31, 2007 and 2006, respectively. Although considerable variability is inherent in such estimates, management believes that the accrual for earned but unbilled premiums is reasonable. The estimates are reviewed quarterly and adjusted as necessary as experience develops or new information becomes known. Any such adjustments are included in current operations.
Retrospective Premiums
The premiums for our retrospectively rated loss sensitive plans are reflective of the customer’s loss experience because, beginning six months after the expiration of the relevant insurance policy, and annually thereafter, we recalculate the premium payable during the policy term based on the current value of the known losses that occurred during the policy term. While the typical retrospectively rated policy has around five annual adjustment or measurement periods, premium adjustments continue until mutual agreement to cease future adjustments is reached with the policyholder. Retrospective premiums for primary and reinsured risks are included in income as earned on a pro rata basis over the effective period of the respective policies. Earned premiums on retrospectively rated policies are based on our estimate of loss experience as of the measurement date. Unearned premiums are deferred and include that portion of premiums written that is applicable to the unexpired period of the policies in force and estimated adjustments of premiums on policies that have retrospective rating endorsements.
We bear credit risk with respect to retrospectively rated policies. Because of the long duration of our loss sensitive plans, there is a risk that the customer will fail to pay the additional premium. Accordingly, we obtain collateral in the form of letters of credit or deposits to mitigate credit risk associated with our loss sensitive plans. If we are unable to collect future retrospective premium adjustments from an insured, we would be required to write-off the related amounts, which could impact our financial position and results of operations. To date, there have been no such write-offs. Retrospectively rated policies accounted for approximately 11.9% of direct premiums written in 2007 and approximately 17.0% of direct premiums written in 2006.
Recent Accounting Pronouncements
In September 2005, the American Institute of Certified Public Accountants (“AICPA”) released Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (“SOP 05-1”). SOP 05-1 requires identification of transactions that result in a substantial change in an insurance contract. If it is determined that a substantial change to an insurance contract has occurred, the related unamortized deferred policy acquisition costs, unearned premiums and other related balances must be written off. SOP 05-1 is effective for fiscal years beginning after December 15, 2006. We adopted the provisions of SOP 05-1 as of January 1, 2007, which did not have a material effect on the consolidated financial condition or results of operations.
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109 (“FIN 48”), which provides for the recognition, measurement, presentation and disclosure of uncertain tax positions. A tax benefit from an uncertain position may be recognized only if it is more likely than not that the position is sustainable based on its technical merits. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. We adopted the provisions of FIN 48 as of January 1, 2007, which did not have a material effect on the consolidated financial condition or results of operations.
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. Early adoption is permitted. We must adopt these new requirements no later than its first fiscal quarter of 2008. We expect that SFAS No. 157 will not have a material effect on our consolidated financial condition or result of operations. In February 2008, the FASB issued FASB Staff Position (“FSP”) No. FAS 157-2, Effective Date of FASB Statement No. 157, to partially defer the effective date of SFAS No. 157 for one year for nonfinancial assets and nonfinancial liabilities that are disclosed at fair value in the financial statements on a non-recurring basis. The FSP does not defer the recognition and disclosure requirements for financial or nonfinancial assets and liabilities that are measured at least annually.
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. Early adoption is permitted. The Company must adopt these new requirements no later than its first fiscal quarter of 2008. The Company is currently evaluating the impact that adoption of SFAS No. 159 will have on its consolidated financial condition and results of operations.
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk.
Market risk is the potential economic loss principally arising from adverse changes in the fair value of financial instruments. The major components of market risk affecting us are credit risk and interest rate risk.
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 generally in fixed-income securities which are rated “A” or higher by Standard & Poor’s. We also independently, and through our outside investment managers, monitor the financial condition of all of the issuers of fixed-income securities in the portfolio. To limit our exposure to risk we employ stringent diversification rules that limit the credit exposure to any single issuer or business sector. See “Investments” in this Part I, Item 1 of this annual report for a discussion of the limited exposure in our investment portfolio at December 31, 2007 to sub-prime mortgages and problems currently facing monoline bond insurers.
Interest Rate Risk
We had fixed-income investments with a fair value of $474.8 million at December 31, 2007 that are subject to interest rate risk compared with $399.1 million at December 31, 2006. 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 December 31, 2007 and December 31, 2006. It illustrates the sensitivity of the fair value of fixed-income investments to selected hypothetical changes in interest rates as of December 31, 2007 and December 31, 2006. 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 stockholders’ equity.
Interest Rate Risk as of December 31, 2007:
Interest Rate Risk as of December 31, 2006:
Item 8.
Item 8.
Financial Statements and Supplementary Data.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
SeaBright Insurance Holdings, Inc.:
We have audited the accompanying consolidated balance sheets of SeaBright Insurance Holdings, Inc. and subsidiaries (the Company) as of December 31, 2007 and 2006, and the related consolidated statements of operations, changes in stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of SeaBright Insurance Holdings, Inc. and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 2 of the consolidated financial statements, effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123(R), Share-Based Payment.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), SeaBright Insurance Holdings, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 17, 2008 expressed an unqualified opinion on the effectiveness of SeaBright Insurance Holdings, Inc and subsidiaries’ internal control over financial reporting.
/s/ KPMG LLP
Seattle, Washington
March 17, 2008
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements.
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes to consolidated financial statements.
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
AND COMPREHENSIVE INCOME
See accompanying notes to consolidated financial statements.
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.
Organization
SeaBright Insurance Holdings, Inc. (“SIH”), a Delaware corporation, was formed in June 2003. On July 14, 2003, SIH entered into a purchase agreement, effective September 30, 2003, with Kemper Employers Group, Inc. (“KEG”), Eagle Insurance Companies (“Eagle”), and Lumbermens Mutual Casualty Company (“LMC”), the ultimate owner of KEG and Eagle (the “Acquisition”). Under this agreement, SIH acquired Kemper Employers Insurance Company (“KEIC”), PointSure Insurance Services, Inc. (“PointSure”), and certain assets of Eagle, primarily renewal rights.
At the time of the Acquisition, KEIC was licensed to write workers’ compensation insurance in 45 states and the District of Columbia. Domiciled in the State of Illinois and commercially domiciled in the State of California, it wrote both state act workers’ compensation insurance and United States Longshore and Harborworkers’ Compensation insurance (“USL&H”). Prior to the Acquisition, beginning in 2000, KEIC wrote business only in California. In May 2002, KEIC ceased writing business and by December 31, 2003, all premiums related to business prior to the Acquisition were 100% earned. As further discussed in Note 8.a., in connection with the Acquisition, KEIC and LMC entered into an agreement whereby LMC agreed to indemnify KEIC in the event of adverse development of the reserves stated on KEIC’s balance sheet at the Acquisition date, for a period of approximately eight years. In addition, KEIC agreed to share with LMC any positive development of those reserves. December 31, 2011 is the date to which the parties will look to determine whether the loss and loss adjustment expenses with respect to KEIC’s insurance policies in effect at the date of the Acquisition have increased or decreased from the amount existing at the date of the Acquisition.
KEIC resumed writing business effective October 1, 2003, primarily targeting policy renewals for former Eagle business in the States of California, Hawaii and Alaska. In November 2003, permission was granted by the Illinois Department of Financial and Professional Regulation, Division of Insurance (the “Illinois Division of Insurance”) for KEIC to change its name to SeaBright Insurance Company (“SBIC”).
PointSure is engaged primarily in administrative and brokerage activities. Eagle consists of Eagle Pacific Insurance Company, Inc. and Pacific Eagle Insurance Company, Inc., both writers of state act workers’ compensation insurance and USL&H that are in run-off as of December 31, 2007.
In December 2007, SIH acquired 100% of the outstanding common stock of Total HealthCare Management, Inc., a privately held California based provider of medical bill review, utilization review, nurse case management and other related services.
2.
Summary of Significant Accounting Policies
a.
Basis of Presentation
The accompanying consolidated financial statements include the accounts of SIH and its wholly owned subsidiaries, SBIC, PointSure and THM (collectively, the “Company”). All significant intercompany transactions among these affiliated entities have been eliminated in consolidation.
The consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and include amounts based on the best estimates and judgments of management. Such estimates and judgments could change in the future, as more information becomes known which could impact the amounts reported and disclosed herein.
In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 131, Disclosures About Segments of an Enterprise and Related Information, the Company considers an operating segment to be any component of its business whose operating results are regularly reviewed by the Company’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance. Currently, the Company has one operating segment, workers’ compensation insurance and related services.
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
b.
Investment Securities
Investment securities are classified as available-for-sale and carried at fair value, adjusted for other-than-temporary declines in fair value, with changes in unrealized gains and losses recorded in other comprehensive income (loss), net of applicable income taxes. The estimated fair value of investments in available-for-sale securities is generally based on quoted market prices for securities traded in the public marketplace. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. The estimated fair value of all of our investment securities at December 31, 2007 was based on quoted market prices.
The Company regularly reviews its investment portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. In general, the Company focuses on those securities whose fair values were less than 80% of their amortized cost or cost, as appropriate, for six or more consecutive months. The Company also analyzes the entire portfolio for other factors that might indicate a risk of impairment, including credit ratings and interest rates. A decline in the fair value of any available-for-sale security below cost that is deemed to be other-than-temporary results in a reduction in the carrying amount of the security to fair value. The impairment is charged to earnings and a new cost basis for the security is established.
Mortgage-backed securities represent participating interests in pools of first mortgage loans originated and serviced by the issuers of securities. These securities are carried at fair value. Premiums and discounts are amortized using a method that approximates the level yield method over the remaining period to contractual maturity, adjusted for anticipated prepayments. To the extent that the estimated lives of such securities change as a result of changes in prepayment rates, the adjustment is also included in net investment income. Prepayment assumptions used for mortgage-backed and asset-backed securities were obtained from an external securities information service and are consistent with the current interest rate and economic environment.
Investment income is recorded when earned. For the purpose of determining realized gains and losses, which arise principally from the sale of investments, the cost of securities sold is based on specific-identification as of the trade date.
c.
Cash and Cash Equivalents
Cash and cash equivalents, which consist primarily of amounts deposited in banks and financial institutions, and all highly liquid investments with maturities of 90 days or less when purchased, are stated at cost. Cash in excess of daily requirements is invested in money market funds and repurchase agreements with maturities of 90 days or less. Such investments are deemed to be cash equivalents for purposes of the consolidated balance sheets and statements of cash flows. The Company had $20.6 million and $19.2 million of cash equivalents at December 31, 2007 and 2006, respectively.
d.
Use of Estimates
The preparation of the consolidated financial statements in conformity with GAAP requires management of the Company to make a number of estimates and assumptions relating to the reported amount of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates. The Company has used significant estimates in determining fair value and impairment of investment securities, unpaid loss and loss adjustment expenses, goodwill and other intangibles, earned premiums on retrospectively rated policies, earned but unbilled premiums, deferred acquisition costs, federal income taxes and certain amounts related to reinsurance.
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
e.
Premiums Receivable
Premiums receivable are recorded at the invoiced amount as they are earned over the life of the contract in proportion to the amount of insurance protection provided. The allowance for doubtful accounts is the Company’s best estimate of the amount of uncollectible premium in the Company’s existing premiums receivable balance. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.
f.
Deferred Policy Acquisition Costs
Acquisition costs related to premiums written are deferred and amortized over the periods in which the premiums are earned. Such acquisition costs vary with and are primarily related to the acquisition of insurance contracts and include commissions, premium taxes, and certain underwriting and policy issuance costs. Deferred policy acquisition costs are limited to amounts recoverable from unearned premiums and anticipated investment income.
g.
Property and Equipment
Furniture and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful lives, which range from three to five years. Leasehold improvements are depreciated on a straight-line basis over ranging from approximately two to seven years, which is the shorter of their estimated useful lives or the remaining term of the respective lease. Depreciation expense totaled $965,000, $435,000 and $310,000 for the years ended December 31, 2007, 2006, and 2005, respectively.
h.
Goodwill and Other Intangible Assets
Goodwill represents the excess of costs over fair value of assets of businesses acquired. Goodwill and other intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but are instead tested for impairment at least annually. No impairments were identified as of December 31, 2007 and 2006. Intangible assets with estimable useful lives are amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 144, Accounting for Impairment or Disposal of Long-Lived Assets.
i.
Revenue Recognition
Premiums for primary and reinsured risks are included in revenue over the life of the contract in proportion to the amount of insurance protection provided (i.e., ratably over the policy period). The portion of the premium that is applicable to the unexpired period of a policy in-force is not included in revenue but is deferred and recorded as unearned premium in the liability section of the balance sheet. Deferred premiums represent the unbilled portion of annual premiums.
Earned premiums on retrospectively rated policies are based on the Company’s estimate of loss experience as of the measurement date. Loss experience includes known losses specifically identifiable to a retrospective policy as well as provisions for future development on known losses and for losses incurred but not yet reported using actuarial loss development factors and is consistent with how the Company projects losses in general. For retrospectively rated policies, the governing contractual minimum and maximum rates are established at policy inception and are made a part of the insurance contract. While the typical retrospectively rated policy has five annual adjustment or measurement periods, premium adjustments continue until mutual agreement to cease future adjustments is reached with the policyholder. For the years ended December 31, 2007, 2006 and 2005, approximately 11.9%, 17.0% and 25.9%, respectively, of direct premiums written related to retrospectively rated policies.
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company estimates the amount of premiums that have been earned but are unbilled at the end of the period by analyzing historical earned premium adjustments made and applying an adjustment percentage against premiums earned for the period. Included in deferred premiums at December 31, 2007 and 2006 and premiums earned for the years then ended are accruals for earned but unbilled premiums of $44,000 and $1.5 million, respectively.
Service income generated from various underwriting and claims service agreements with third parties is recognized as income in the period in which services are performed.
j.
Unpaid Loss and Loss Adjustment Expense
Unpaid loss and loss adjustment expense represents an estimate of the ultimate net cost of all unpaid losses incurred through the specified period. Loss adjustment expenses are estimates of unpaid expenses to be incurred in settlement of the claims included in the liability for unpaid losses. These liabilities, which anticipate salvage and subrogation recoveries and are presented gross of amounts recoverable from reinsurers, include estimates of future trends in claim severity and frequency and other factors that could vary as the losses are ultimately settled. Liabilities for unpaid loss and loss adjustment expenses are not discounted to account for the time value of money.
In light of the Company’s short operating history, and uncertainties concerning the effects of legislative reform specifically as it relates to the Company’s California workers compensation class of business, actuarial techniques are applied that use the historical experience of the Company’s predecessor as well as industry information in the analysis of unpaid loss and loss adjustment expense. These techniques recognize, among other factors:
•
the Company’s claims experience and that of its predecessor;
•
the industry’s claims experience;
•
historical trends in reserving patterns and loss payments;
•
the impact of claim inflation and/or deflation;
•
the pending level of unpaid claims;
•
the cost of claim settlements;
•
legislative reforms affecting workers’ compensation;
•
the environment in which insurance companies operate; and
•
trends in claim frequency and severity.
Although it is not possible to measure the degree of variability inherent in such estimates, management believes that the liability for unpaid loss and loss adjustment expense is reasonable. The estimates are reviewed periodically and any necessary adjustments are included in the results of operations of the period in which the adjustment is determined.
k.
Reinsurance
The Company protects itself from excessive losses by reinsuring certain levels of risk in various areas of exposure with nonaffiliated reinsurers. Regardless of type, reinsurance does not legally discharge the ceding insurer from primary liability for the full amount due under the reinsured policies. Reinsurance premiums, commissions, expense reimbursements and reserves related to ceded business are accounted for on a basis consistent with the accounting for the original policies issued and the terms of reinsurance contracts. The unpaid loss and loss adjustment expense subject to the adverse development cover with LMC is calculated on
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
a quarterly basis using generally accepted actuarial methodologies for estimating unpaid loss and loss adjustment expense liabilities, including incurred loss and paid loss development methods. Amounts recoverable in excess of acquired reserves at September 30, 2003 are recorded gross in unpaid loss and loss adjustment expense in accordance with SFAS No. 141, Business Combinations, with a corresponding amount receivable from the seller. Amounts are shown net in the statement of operations. Premiums ceded to other companies are reported as a reduction of premiums written and earned. Reinsurance recoverables are determined based on the terms and conditions of the reinsurance contracts.
Balances due from reinsurers on unpaid loss and loss adjustment expenses, including an estimate of such recoverables related to reserves for IBNR losses, are reported as assets and are included in reinsurance recoverables even though amounts due on unpaid loss and loss adjustment expenses are not recoverable from the reinsurer until such losses are paid. The Company monitors the financial condition of its reinsurers and does not believe that it is currently exposed to any material credit risk through its reinsurance agreements because most of its reinsurance is recoverable from large, well-capitalized reinsurance companies. Historically, no amounts from reinsurers have been written-off as uncollectible.
l.
Income Taxes
The asset and liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that are estimated to be in effect when the differences are expected to reverse, net of any applicable valuation allowances. The Company evaluates the necessity of a deferred tax asset valuation allowance by determining, based on the weight of available evidence, whether it is more likely than not that some portion or all of the deferred tax asset will not be realized. When necessary, a valuation allowance is recorded to reduce the deferred tax asset to the amount that is more likely than not to be realized.
m.
Earnings Per Share
The following table provides the reconciliation of weighted average common share equivalents outstanding used in calculating earnings per share for the years ended December 31, 2007, 2006, and 2005:
n.
Stock Based Compensation
The Company adopted SFAS No. 123R, Share-Based Payment, on January 1, 2006, using the modified-prospective transition method. Prior to adoption, the Company measured its employee stock-based compensation arrangements using the provisions outlined in Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, which is an intrinsic value-based method of recognizing compensation costs, and adopted the disclosure-only provisions of SFAS No. 123, Accounting for Stock-based Compensation. None of the Company’s stock options granted prior to adoption had an intrinsic value at grant date and, accordingly, no compensation cost was recognized for its stock option plan activity prior to adoption.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Under the modified-prospective transition method, stock-based compensation cost is recognized in the consolidated financial statements for granted, modified, or settled share-based payments. Compensation cost recognized includes the estimated cost for stock options granted on or after January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R, and the estimated expense for the portion of awards granted prior to January 1, 2006 vesting in the current period, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123. Results for prior periods have not been restated, as provided for under the modified-prospective method.
Total stock-based compensation expense recognized in the consolidated statement of operations for the years ended December 31, 2007 and 2006 are shown in the following table. No compensation cost was capitalized during years ended December 31, 2007 and 2006.
Disclosures for the years ended December 31, 2007 and 2006 are not presented because the amounts are recognized in the consolidated financial statements. The compensation cost included in pro forma net income is not likely to be representative of the effect on reported net income for future years because options vest over several years and additional awards may be made each year.
The following table presents the impact of our adoption of SFAS No. 123R on selected line items from our consolidated financial statements for the year ended December 31, 2006:
o.
Recent Accounting Pronouncements
In September 2005, the American Institute of Certified Public Accountants (“AICPA”) released Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (“SOP 05-1”). SOP 05-1 requires identification of transactions that result in a substantial change in an insurance contract. If it is determined that a substantial
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
change to an insurance contract has occurred, the related unamortized deferred policy acquisition costs, unearned premiums and other related balances must be written off. SOP 05-1 is effective for fiscal years beginning after December 15, 2006. The Company adopted the provisions of SOP 05-1 as of January 1, 2007, which did not have a material effect on the consolidated financial condition or results of operations.
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109 (“FIN 48”), which provides for the recognition, measurement, presentation and disclosure of uncertain tax positions. A tax benefit from an uncertain position may be recognized only if it is more likely than not that the position is sustainable based on its technical merits. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. The Company adopted the provisions of FIN 48 as of January 1, 2007, which did not have a material effect on the consolidated financial condition or results of operations.
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. Early adoption is permitted. The Company must adopt these new requirements no later than its first fiscal quarter of 2008 and expects that the adoption of SFAS No. 157 will not have a material effect on its consolidated financial condition or result of operations. In February 2008, the FASB issued FASB Staff Position (“FSP”) No. FAS 157-2, Effective Date of FASB Statement No. 157, to partially defer the effective date of SFAS No. 157 for one year for nonfinancial assets and nonfinancial liabilities that are disclosed at fair value in the financial statements on a non-recurring basis. The FSP does not defer the recognition and disclosure requirements for financial or nonfinancial assets and liabilities that are measured at least annually.
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. Early adoption is permitted. The Company must adopt these new requirements no later than its first fiscal quarter of 2008 and expects that the adoption of SFAS No. 159 will not have a material effect on its consolidated financial condition and results of operations.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
3.
Investments
The consolidated cost or amortized cost, gross unrealized gains and losses, and estimated fair value of investment securities available-for-sale at December 31, 2007 and 2006 are as follows:
Equity securities at December 31, 2007 and 2006 consist of investments in exchange traded funds designed to correspond to the performance of certain indexes based on domestic or international stocks. The
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Company had no direct investments in equity securities at December 31, 2007 or 2006. The following table presents information about investment securities with unrealized losses at December 31, 2007 and 2006.
Unrealized losses at December 31, 2007:
Unrealized losses at December 31, 2006:
Of the $45.5 million of securities with unrealized losses of 12 months or longer at December 31, 2007 in the above table, only two securities with a combined fair value of $585,000 had fair values that were less than 90% of the securities’ amortized cost. The combined unrealized loss on those securities is $181,000.
The Company regularly reviews its investment portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. A number of criteria are considered during this process including, but not limited to, the following: the current fair value as compared to amortized cost or cost, as appropriate, of the security; the length of time the security’s fair value has been below amortized cost; the Company’s intent and ability to retain the investment for a period of time sufficient to
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
allow for an anticipated recovery in value; specific credit issues related to the issuer; and current economic conditions.
In general, the Company focuses on those securities whose fair values were less than 80% of their amortized cost or cost, as appropriate, for six or more consecutive months. Other-than-temporary impairment losses result in a permanent reduction of the carrying amount of the underlying investment. Significant changes in the factors considered when evaluating investments for impairment losses could result in a significant change in impairment losses reported in the financial statements. At December 31, 2007 and 2006, the Company evaluated investment securities with fair values less than amortized cost and has determined that the decline in value is temporary and is related primarily to the change in market rates since purchase or to other market anomalies that are expected to correct themselves over time. Furthermore, the Company has the ability to hold the impaired investments to maturity or for a period of time sufficient for recovery of their carrying amount. Therefore, no other-than-temporary impairment losses were recorded in the years ended December 31, 2007, 2006 and 2005.
The Company had no direct sub-prime mortgage exposure in its investment portfolio as of December 31, 2007 and less than $800,000 of indirect exposure to sub-prime mortgages. The average credit quality of the Company’s $250.9 million fixed income portfolio was AA+ (AA− based on the issuers’ underlying ratings). Insured municipal bonds totaled $192.8 million and had a weighted average credit rating of AAA (AA− based on the issuers’ underlying ratings). The remaining $58.1 million in uninsured municipal bonds carried a weighted average credit rating of AA. Consequently, the Company does not expect a material impact to our investment portfolio or financial position as a result of the problems currently facing monoline bond insurers.
The amortized cost and estimated fair value of fixed income securities and preferred stock available-for-sale at December 31, 2007, by contractual maturity, are set forth below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
The consolidated amortized cost of fixed income securities available-for-sale deposited with various regulatory authorities was $179.7 million and $118.8 million at December 31, 2007 and 2006, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Major categories of consolidated net investment income are summarized as follows for the years ended December 31, 2007, 2006, and 2005:
Proceeds from the sales of fixed income and equity securities, related realized gains and losses and changes in unrealized gains (losses) were as follows:
4.
Fair Value of Financial Instruments
Estimated fair value amounts, defined as the quoted market price of a financial instrument, have been determined using available market information and other appropriate valuation methodologies. However, considerable judgment is required in developing the estimates of fair value. Accordingly, these estimates are not necessarily indicative of the amounts that could be realized in a current market exchange. The use of different market assumptions or estimating methodologies may have an effect on the estimated fair value amounts.
The following methods and assumptions were used by the Company in estimating the fair value disclosures for financial instruments in the accompanying consolidated financial statements and notes:
•
Cash and cash equivalents, premiums receivable, accrued expenses, other liabilities and surplus notes: The carrying amounts for these financial instruments as reported in the accompanying consolidated balance sheets approximate their fair values.
•
Investment securities: The estimated fair values for available-for-sale securities generally represent quoted market value prices for securities traded in the public marketplace. Additional information with respect to fair values of the Company’s investment securities is disclosed in Note 3.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Other financial instruments qualify as insurance-related products and are specifically exempted from fair value disclosure requirements.
5.
Premiums
Direct premiums written totaled $273.0 million, $221.8 million, and $195.5 million for the years ended December 31, 2007, 2006 and 2005, respectively.
Premiums receivable consisted of the following at December 31, 2007 and 2006:
The activity in the allowance for doubtful accounts for the years ended December 31, 2007, 2006, and 2005 is as follows (in thousands):
6.
Property and Equipment
Property and equipment consisted of the following at December 31, 2007 and 2006:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
7.
Deferred Policy Acquisition costs
The following reflects the amounts of policy acquisition costs deferred and amortized for the years ended December 31, 2007, 2006, and 2005:
8.
Reinsurance
a.
Reinsurance Ceded
Under reinsurance agreements, the Company cedes various amounts of risk to nonaffiliated insurance companies for the purpose of limiting the maximum potential loss arising from the underlying insurance risks. These reinsurance contracts do not relieve the Company from its obligations to policyholders. For the period from October 1, 2006 through October 1, 2007 and for the period from October 1, 2007 through October 1, 2008, the Company entered into reinsurance agreements with nonaffiliated reinsurers wherein it retains the first $1.0 million of each loss occurrence. Losses in excess of $1.0 million up to $75.0 million are reinsured as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
As of December 31, 2007, the Company’s current excess of loss reinsurance treaties were placed with the following reinsurers:
Effective from October 1, 2005 through October 1, 2006, the Company entered into reinsurance agreements wherein it retains the first $500,000 of each loss occurrence. Losses in excess of $500,000 up to $50.0 million are reinsured with nonaffiliated reinsurers as follows:
Effective from October 1, 2004 through October 1, 2005, the Company entered into reinsurance agreements wherein it retains the first $500,000 of each loss occurrence. Losses in excess of $500,000 up to $100.0 million are 100% reinsured with nonaffiliated reinsurers.
Effective from October 1, 2003 through October 1, 2004, the Company entered into reinsurance agreements wherein it retains the first $500,000 of each loss occurrence. The next $500,000 of such loss occurrence is 50% retained by SBIC after meeting a $1.5 million aggregate deductible. Losses in excess of $1.0 million up to $100.0 million are 100% reinsured with nonaffiliated reinsurers.
All of the reinsurance policies described in this Note 8 are subject to various additional limitations and exclusions as more fully described in the reinsurance agreements.
SBIC has in place a series of reinsurance agreements that were entered into prior to its acquisition by SIH which are as follows: Effective from January 1, 1999 through January 1, 2001, SBIC retains the first
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
$250,000 of each loss occurrence; the next $750,000 of such loss occurrence is 100% reinsured with nonaffiliated reinsurers. Losses in excess of $1.0 million up to $4.0 million for this time period are 100% reinsured with nonaffiliated reinsurers. Effective July 1, 2000 through July 1, 2002, SBIC retains the first $500,000 of each loss occurrence; the next $500,000 of such loss occurrence is 100% reinsured with nonaffiliated reinsurers. Effective January 1, 2001 through January 1, 2002, SBIC retains the first $1.0 million of each loss occurrence; losses up to $5.0 million are 100% reinsured with nonaffiliated reinsurers. Effective October 1, 2000 through October 1, 2001, SBIC has a quota-share agreement whereby 10% of the first $250,000 loss plus a pro-rata share of expenses are 100% reinsured with Swiss Reinsurance Company. Effective January 1, 2002 through May 31, 2002, 100% of all losses are 100% quota-shared to Argonaut Insurance Company.
As part of the Acquisition, SIH and LMC entered into an adverse development excess of loss reinsurance agreement (the “Agreement”). The Agreement, after taking into account any recoveries from third party reinsurers, calls for LMC to reimburse SBIC 100% of the excess of the actual loss at December 31, 2011 over the initial loss reserves at September 30, 2003. The Agreement also calls for SBIC to reimburse LMC 100% of the excess of the initial loss reserves at September 30, 2003 over the actual loss results at December 31, 2011. The amount of adverse loss development under the Agreement was $2.5 million at December 31, 2007 and $2.8 million at December 31, 2006. The decrease in the amount receivable from LMC is netted against loss and loss adjustment expense in the accompanying consolidated statements of operations.
As part of the Agreement, LMC placed into trust (the “Trust”) $1.6 million, equal to 10% of the balance sheet reserves of SBIC at the date of the Acquisition. Thereafter, the Trust shall be adjusted each quarter, if warranted, to an amount equal to the greater of (a) $1.6 million or (b) 102% of LMC’s obligations under the Agreement. The balance of the Trust, including accumulated interest, was $3.5 million at December 31, 2007 and $5.2 million at December 31, 2006.
b.
Reinsurance Assumed
The Company involuntarily assumes residual market business either directly from various states that operate their own residual market programs or indirectly from the National Council for Compensation Insurance, which operates residual market programs on behalf of some states. The states in which the Company assumed residual market business in 2007 and 2006 include the following: Alabama, Alaska, Arizona, Arkansas, Connecticut, Delaware, the District of Columbia, Georgia, Idaho, Illinois, Iowa, Kansas, Massachusetts, Michigan, Nevada, New Jersey, New Mexico, Oregon, South Carolina, and Virginia.
c.
Reinsurance Recoverables and Income Statement Effects
Balances affected by reinsurance transactions are reported gross of reinsurance in the balance sheets. Reinsurance recoverables comprise the following amounts at December 31, 2007 and 2006:
The Company evaluates the financial condition of its reinsurers and monitors concentrations of credit risk arising from activities or economic characteristics of the reinsurers to minimize its exposure to losses from reinsurer insolvencies. In the event a reinsurer is unable to meet its obligations, the Company would be liable for the losses under the agreement.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table summarizes the Company’s top ten reinsurers, based on net amount recoverable, as of December 31, 2007:
*
Participant in current excess of loss reinsurance treaty program or individual risk reinsurance placements.
The Company recorded no write-offs of uncollectible reinsurance recoverables in the years ended December 31, 2007, 2006, and 2005.
The effects of reinsurance are as follows for the years ended December 31, 2007, 2006, and 2005:
The Company did not commute any reinsurance agreements in the years ended December 31, 2007, 2006 and 2005.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
9.
Unpaid Loss and Loss Adjustment Expenses
The following table summarizes the activity in unpaid loss and loss adjustment expense for the years ended December 31, 2007, 2006 and 2005:
As a result of changes in estimates of insured events in prior periods, the unpaid loss and loss adjustment expenses decreased by approximately $19.5 million in 2007 due to positive development on previously reported claims in accident year 2006 and $15.1 million due to positive development on previously reported claims in accident year 2005. For accident years 2004 and prior, unpaid loss and loss adjustment expenses increased $560,000 as a result of unfavorable development on previously reported claims due to the small base of claims and losses assumed from the NCCI pools. According to the terms of the adverse development cover, the Company is obligated to reimburse LMC for $248,000 of the positive development of KEIC reserves existing at the date of the Acquisition. In connection with the Acquisition, KEIC and LMC entered into an agreement to indemnify each other with respect to developments in KEIC’s unpaid loss and loss adjustment expenses over a period of approximately eight years. December 31, 2011 is the date to which the parties will look to determine whether the loss and loss adjustment expenses with respect to KEIC’s insurance policies in effect at the Acquisition have increased or decreased from the amount existing at the date of the Acquisition.
As a result of changes in estimates of insured events in prior periods, the unpaid loss and loss adjustment expenses decreased by approximately $16.0 million in 2006 due to positive development on previously reported claims in accident year 2005 and $6.3 million due to positive development on previously reported claims in accident year 2004. For accident years 2003 and prior, unpaid loss and loss adjustment expenses decreased $486,000 due to positive development on previously reported claims. According to the terms of the adverse development cover, the Company is obligated to reimburse LMC for $571,000 of the prior period positive development.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Approximately $3.6 million of the $2.1 million reduction in 2005 related to positive development on previously reported claims in accident year 2004. This adjustment was offset by an increase of approximately $1.5 million in reserves for reported claims in accident year 2003 and prior. Of that amount, the Company was entitled to recover from LMC, according to the terms of the adverse development cover, approximately $499,000 of adverse development of KEIC losses. Approximately $385,000 of the $451,000 adverse development in 2004 related to KEIC claims, which the Company was entitled to recover from LMC according to the terms of the adverse development cover. The remaining amount of $66,000 related to adverse development of the Company’s reserves for reported claims in accident year 2003.
At December 31, 2007 and 2006, the Company reduced unpaid loss and loss adjustment expense by $4.3 million and $3.3 million, respectively, for anticipated salvage and subrogation recoveries.
10.
Surplus Notes
On May 26, 2004, SBIC issued in a private placement $12.0 million in subordinated floating rate Surplus Notes due in 2034. The transaction was underwritten by Morgan Stanley & Company and Cochran & Caronia Securities, LLC. The note holder is ICONS, Ltd. and Wilmington Trust Company acts as Trustee. Interest, paid quarterly in arrears, is calculated at the beginning of the interest payment period using the 3-month LIBOR rate plus 400 basis points. The quarterly interest rate cannot exceed the initial interest rate by more than 10% per year, cannot exceed the corporate base (prime) rate by more than 2% and cannot exceed the highest rate permitted by New York law. The rate or amount of interest required to be paid in any quarter is also subject to limitations imposed by the Illinois Insurance Code. Interest amounts not paid as a result of these limitations become “Excess Interest,” which the Company may be required to pay in the future, subject to the same limitations and all other provisions of the Surplus Notes Indenture. To date, there has been no Excess Interest. The interest rate at December 31, 2007 was 9.03%. Interest and principal may be paid only upon the prior approval of the Illinois Division of Insurance. In the event of default, as defined, or failure to pay interest due to lack of Illinois Division of Insurance approval, the Company cannot pay dividends on its capital stock, is limited in its ability to redeem, purchase or acquire any of its capital stock and cannot make payments of interest or principal on any debt issued by the Company which ranks equal with or junior to the Surplus Notes. If an event of default occurs and is continuing, the principal and accrued interest can become immediately due and payable. Interest expense for the years ended December 31, 2007, 2006, and 2005 was $1.1 million, $1.1 million, and $888,000, respectively.
The notes are redeemable prior to 2034 by the Company, in whole or in part, from time to time, on or after May 24, 2009 on an interest payment date or at any time prior to May 24, 2009, in whole but not in part, upon the occurrence and continuation of a tax event as defined in the agreement. The Company may not exercise its option to redeem with respect to a tax event unless it pays a premium in addition to the redemption price.
Issuance costs of $591,000 incurred in connection with the Surplus Notes are being amortized over the life of the notes using the effective interest method. Amortization expense for the years ended December 31, 2007, 2006, and 2005 was $56,000, $54,000 and $44,000, respectively.
11.
Income Taxes
The operations of SIH and its subsidiaries are included in a consolidated federal income tax return.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following is a reconciliation of the difference between the “expected” income tax computed by applying the federal statutory income tax rate to income before income taxes and the total income taxes reflected on the books for the years ended December 31, 2007, 2006, and 2005:
Deferred federal income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and those amounts used for federal income tax reporting purposes. The significant components of the deferred tax assets and liabilities at December 31, 2007 and 2006 are as follows:
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
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tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based upon the projections of future taxable income over the periods in which the deferred taxes are deductible, management believes it is more likely than not that the Company will realize the benefits of these deductible differences.
As of December 31, 2007, the Company has capital loss carryforwards of approximately $682,000. Approximately $146,000 expires in 2010, $431,000 expires in 2011 and $105,000 expires in 2012.
12.
Statutory Net Income and Stockholders’ Equity
SBIC is required to file annually with state regulatory insurance authorities financial statements prepared on an accounting basis as prescribed or permitted by such authorities (statutory basis accounting or “SAP”). Statutory net income and capital and surplus (stockholders’ equity) differ from amounts reported in accordance with GAAP, primarily because of the following accounting treatments prescribed by SAP: policy acquisition costs are expensed when incurred; certain assets designated as “nonadmitted” for statutory purposes are charged to surplus; fixed-income securities are reported primarily at amortized cost or fair value based on their rating by the National Association of Insurance Commissioners (“NAIC”); policyholders’ dividends are expensed as declared rather than accrued as incurred; deferred income taxes are charged or credited directly to unassigned surplus; and any change in the admitted net deferred tax asset is offset to equity. Following is a summary of SBIC’s statutory net gain for the years ended December 31, 2007, 2006, and 2005 and statutory capital and surplus as of December 31, 2007, 2006 and 2005:
The maximum amount of dividends that can be paid to stockholders by insurance companies domiciled in the State of Illinois without prior approval of regulatory authorities is restricted if such dividend, together with other distributions during the 12 preceding months, would exceed the greater of 10% of the insurer’s statutory surplus as of the preceding December 31 or the statutorily adjusted net income for the preceding calendar year. If the limitation is exceeded, then such proposed dividend must be reported to the Director of Insurance at least 30 days prior to the proposed payment date and may be paid only if not disapproved. The Illinois insurance laws also permit payment of dividends only out of earned surplus, exclusive of most unrealized gains. At December 31, 2007, SBIC had statutory earned surplus of $42.0 million. Consequently, SBIC would be able to pay up to $33.7 million of stockholder dividends in 2008 without the prior approval of the regulators.
In June 2007, the Illinois Division of Insurance completed a comprehensive financial examination of SBIC’s 2005 statutory annual statement. The examination report contained three findings, none of which resulted in any fines, penalties or adjustments to SBIC’s financial statements. Prior to this examination, KEIC was last examined by the Illinois Division of Insurance as of December 31, 2000.
The State of Illinois imposes minimum risk-based capital requirements that were developed by the NAIC. The formulas for determining the amount of risk-based capital specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of the enterprise’s regulatory total adjusted capital to certain minimum capital amounts as defined by the NAIC. Enterprises below specified trigger points or ratios are classified within certain levels, each of which requires specified corrective action. SBIC exceeded the minimum risk-based capital requirements at December 31, 2007 and 2006.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
13.
Commitments
The Company leases certain office space for its headquarters and regional offices under agreements that are accounted for as operating leases. Lease expense totaled $1.3 million, $1.0 million and $1.1 million for the years ended December 31, 2007, 2006, and 2005, respectively. Total rent, including the effect of rent increases and concessions, is expensed on a straight-line basis over the respective lease terms.
Future minimum payments required under the agreements are as follows:
14.
Retirement Plan
The Company maintains a defined contribution 401(k) retirement savings plan covering substantially all of its employees. In 2007 and 2006, the Company matched 100% of the first five percent of eligible compensation contributed to the plan on a pre-tax basis. In 2005, the Company matched 100% of the first three percent and 50% of the next two percent of such compensation. For the years ended December 31, 2007, 2006, and 2005, the Company made additional contributions equal to one percent of compensation for all persons who were employed at the end of the year. Additionally, the Company made discretionary year-end contributions of one percent for 2005 to the accounts of all persons who were employed at the end of year. Employees are 100% vested in all matching contributions when they are made. Contribution expense for the years ended December 31, 2007, 2006, and 2005 was $824,000, $640,000 and $571,000, respectively.
15.
Contingencies
a. SBIC is subject to guaranty fund and other assessments by the states in which it writes business. Guaranty fund assessments are accrued at the time premiums are written. Other assessments are accrued either at the time of assessment or in the case of premium-based assessments, at the time the premiums are written, or in the case of loss-based assessments, at the time the losses are incurred. SBIC has accrued a liability for guaranty fund and other assessments of $3.5 million at December 31, 2007 and has recorded a related asset for premium tax offset and policy surcharges of $3.8 million at that date. This amount represents management’s best estimate based on information received from the states in which it writes business and may change due to many factors including the Company’s share of the ultimate cost of current insolvencies. Most assessments are paid out in the year following the year in which the premium is written or the losses are paid. Policy surcharges are generally collected in the year following assessment and premium tax offsets are generally recognized over a period of up to five years following the year of assessment.
b. The Company is involved in various claims and lawsuits arising in the ordinary course of business. Management believes the outcome of these matters will not have a material adverse effect on the Company’s financial position.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
16.
Retrospectively Rated Contracts
On October 1, 2003, the Company began selling workers’ compensation insurance policies for which the premiums vary based on loss experience. Accrued retrospective premiums are determined based upon the loss experience of business subject to such experience rating adjustment. Accrued retrospectively rated premiums are determined by and allocated to individual policyholder accounts. Accrued retrospective premiums and return retrospective premiums are recorded as additions to and reductions from written premium, respectively. Approximately 11.9%, 17.0% and 25.9% of the Company’s direct premiums written for the years ended December 31, 2007, 2006 and 2005, respectively, related to retrospectively rated contracts. The Company accrued $9.3 million for retrospective premiums receivable and $17.8 million for return retrospective premiums at December 31, 2007 and $9.6 million for retrospective premiums receivable and $12.7 million for return retrospective premiums at December 31, 2006.
17.
Acquisitions
On July 14, 2003, SIH entered into a purchase agreement, effective September 30, 2003, with KEG, Eagle and LMC, all ultimately owned by KIC. In the Acquisition, SIH acquired PointSure, KEIC, and the renewal rights and substantially all of the operating assets and employees of Eagle Pacific Insurance Company and Pacific Eagle Insurance Company. Eagle Pacific Insurance Company began writing specialty workers’ compensation insurance approximately 20 years ago. The Acquisition gave SIH renewal rights to an existing portfolio of business, representing a valuable asset given the renewal nature of the workers’ compensation insurance business, and a fully-operational infrastructure that would have taken many years to develop. These renewal rights gave the Company access to customer lists and the right to seek to renew its continuing in-force insurance contracts. In addition, KEIC provided the requisite insurance licenses needed to write business.
The initial aggregate purchase price, including acquisition costs of $1.3 million, was $16.0 million. The acquired assets and liabilities were recorded on the Company’s books at their respective fair values as of the date of Acquisition. Goodwill, the excess of the purchase price over the net fair value of the assets and liabilities acquired, was $2.1 million.
The Company and LMC negotiated a final purchase price adjustment settlement on September 28, 2004. Included in the original purchase price allocation was an estimated purchase price settlement amount of $1.1 million. The final purchase price adjustment settlement of $771,000 reduced the October 1, 2003 balance of reinsurance recoverables by $155,000 and increased the liability for unpaid loss and loss adjustment expenses by $226,000. The Company was required to pay interest expense of $30,000 related to the settlement period. In addition, the Company recorded an entry to increase other assets and reduce goodwill by $535,000.
On December 17, 2007, the Company completed the acquisition of Total Health Care Management, Inc. (“THM”), a provider of medical bill review, utilization review, nurse case management and other related services. The total purchase price was $1.5 million, of which $1.2 million was paid at closing. The remaining $0.3 million is scheduled to be paid in three equal installments on the first three anniversaries of the closing date, provided that THM achieves certain revenue objectives in 2008, 2009 and 2010. As a result of this acquisition, the Company recorded additional goodwill of $1.4 million.
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
18.
Intangible Assets
Intangible assets, other than goodwill, consist of the following at December 31, 2007 and 2006 (dollar amounts in thousands):
The weighted average amortization period for all intangible assets subject to amortization is 2.6 years. Aggregate amortization expense was $10,000, $246,000 and $629,000 for the years ended December 31, 2007, 2006, and 2005, respectively. Estimated remaining amortization expense is $7,500 in 2008.
19.
Stockholders’ Equity
On February 1, 2006, the Company closed a follow-on public offering of 3,910,000 shares of common stock, including the underwriters’ over-allotment option to purchase 510,000 shares of common stock, at a price of $15.75 per share for net proceeds of approximately $57.6 million, after deducting underwriters’ fees, commissions and offering costs totaling approximately $4.0 million. The Company contributed $50.0 million of the net proceeds to SBIC, which is using the capital to expand its business in its core markets and to new territories. The remaining proceeds are being used for general corporate purposes, including supporting the growth of PointSure. The use of proceeds from the offering does not represent a material change from the use of proceeds described in the prospectus that was included in the related Registration Statement on Form S-1. Except for the contribution of proceeds to SBIC, no proceeds or expenses were paid to the Company’s directors, officers, ten percent shareholders or affiliates.
20.
Share-Based Payment Arrangements
At December 31, 2007, the Company had outstanding stock options and nonvested stock granted according to the terms of two equity incentive plans. The stockholders and Board of Directors approved the 2003 Stock Option Plan (the “2003 Plan”) in September 2003, and amended and restated the 2003 Plan in February 2004, and approved the 2005 Long-Term Equity Incentive Plan (the “2005 Plan” and, together with the 2003 Plan, the “Stock Option Plans”) in December 2004. In April 2007, the Board of Directors further amended the 2003 Plan and amended the 2005 Plan.
The Board of Directors reserved an initial total of 776,458 shares of common stock under the 2003 Plan and 1,047,755 shares of common stock under the 2005 Plan, plus an automatic annual increase on the first day of each fiscal year beginning in 2006 and ending in 2015 equal to the lesser of: (i) 2% of the shares of common stock outstanding on the last day of the immediately preceding fiscal year or (ii) such lesser number of shares as determined by the Board of Directors. At December 31, 2007, the Company reserved 776,458 shares of common stock for issuance under the 2003 Plan, of which options to purchase 481,946 shares had been granted, and 1,787,046 shares for issuance under the 2005 Plan, of which 1,051,669 shares had been
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
granted. In January 2006, the Compensation Committee of the Board of Directors terminated the ability to grant future stock options awards under the 2003 Plan. Therefore, the Company anticipates that all future awards will be made under the 2005 Plan.
The 2005 Plan provides for the grant of incentive or non-qualified stock options, restricted stock, restricted stock units, deferred stock units, performance awards, or any combination of the foregoing. The Board of Directors has the authority to determine all matters relating to awards granted under the Stock Option Plans, including designation as incentive or nonqualified stock options, the selection of individuals to be granted options, the number of shares subject to each grant, the exercise price, the term and the vesting period, if any. Options to purchase the Company’s common stock are granted at prices at or above the fair value of the common stock on the date of grant, generally vest 25% per year on each of the first four anniversaries of the vesting start date, and expire 10 years from the date of grant. Options granted to non-employee directors generally vest one-third on the first anniversary of the grant date and the remaining two-thirds in equal monthly installments over the following 24 months. Nonvested stock issued to employees and directors generally vests on the third anniversary of the grant date, assuming the holder is still employed by or providing service to the Company and satisfies all other conditions of the grant. Generally, stock options granted to employees are incentive stock options, while options granted to non-employee directors are non-qualified stock options.
The Company issues new shares of common stock upon exercise of stock options or award of nonvested shares.
a.
Stock Options
The fair values of stock options granted during the years ended December 31, 2007, 2006 and 2005 were determined on the dates of grant using the Black-Scholes-Merton option valuation model with the following weighted average assumptions:
For 2006 and 2007, the expected term of options was determined using the “simplified method,” which averages an award’s weighted average vesting period and its contractual term and expected stock price volatility was based on a weighted average of the Company’s historical stock price volatility since the initial public offering of its common stock in January 2005 and the historical volatility of a peer company’s stock for a period of time equal to the expected term of the option. Prior to the adoption of SFAS No. 123R, expected term was based on the Company’s historical experience and future expectations and price volatility was estimated using the Company’s historical volatility. The risk-free interest rate is based on the yield of U.S. Treasury securities with an equivalent remaining term. The Company has not paid stockholder dividends in the past and has no current plan to pay any stockholder dividends in the future.
The assumptions used to calculate the fair value of options granted are evaluated and revised, as necessary, to reflect market conditions and the Company’s historical experience and future expectations. The calculated fair value is recognized as compensation cost in the Company’s financial statements over the requisite service period of the entire award. Compensation cost is recognized only for those options expected to vest, with forfeitures estimated at the date of grant and evaluated and adjusted periodically to reflect the Company’s historical experience and future expectations. Any change in the forfeiture assumption is accounted
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
for as a change in estimate, with the cumulative effect of the change on periods previously reported being reflected in the financial statements of the period in which the change is made.
The following table summarizes stock option activity for the years ended December 31, 2007 and 2006:
The aggregate intrinsic values in the table above are before applicable income taxes and are based on the Company’s closing stock price of $15.08 and $18.01 at December 31, 2007 and 2006, respectively. As of December 31, 2007, total unrecognized stock-based compensation cost related to nonvested stock options was approximately $1.4 million, which is expected to be recognized over a weighted average period of approximately 30.4 months. Proceeds from the exercise of stock options totaled approximately $310,000 in 2007 and approximately $32,400 in 2006. The total intrinsic value of stock options exercised was approximately $373,500 in 2007 and approximately $42,300 in 2006.
As of December 31, 2007, there were 735,377 shares of common stock available for issuance of future share-based awards. The following table presents additional information regarding options outstanding as of December 31, 2007:
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
b.
Nonvested Stock
The following table summarizes nonvested stock activity for the years ended December 31, 2007 and 2006:
As of December 31, 2007, there was $4.9 million of total unrecognized compensation cost related to nonvested stock granted under the 2005 Plan. That cost is expected to be recognized over a weighted-average period of 23.4 months.
SEABRIGHT INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
21.
Quarterly Financial Information (unaudited)
The following table summarizes selected unaudited quarterly financial data for each quarter of the years ended December 31, 2007, 2006 and 2005.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A.
Controls and Procedures.
Disclosure Controls and Procedures
Under the supervision and with the participation of management, including our Chief Executive Officer and our 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 Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this annual 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 Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Management’s Report on Internal Control Over Financial Reporting
The management of SeaBright Insurance Holdings, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting as required by the Sarbanes-Oxley Act of 2002 and as defined in Exchange Act Rule 13a-15(f). Our system of internal control over financial reporting is designed to provide reasonable assurance to our management and Board of Directors regarding the preparation and fair presentation of published financial statements. A system of internal control can provide only reasonable, not absolute assurance, that the objectives of the control system are met. Our management, including our Chief Executive Officer and Chief Financial Officer, conducted an assessment of the design and operating effectiveness of our internal control over financial reporting based on the framework in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, our management has concluded that, as of December 31, 2007, our internal control over financial reporting was effective.
KPMG LLP, an independent registered public accounting firm, has audited the effectiveness of our internal control over financial reporting as of December 31, 2007, which is included in this Item 9A.
Changes in Internal Controls
There have not been any changes in our internal controls over financial reporting during our fourth fiscal quarter of 2007 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
SeaBright Insurance Holdings, Inc.:
We have audited SeaBright Insurance Holdings, Inc and subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, SeaBright Insurance Holdings, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of SeaBright Insurance Holdings, Inc. and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of operations, changes in stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2007, and our report dated March 17, 2008 expressed an unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
Seattle, Washington
March 17, 2008
Item 9B.
Item 9B.
Other Information.
We had no information that was required to be disclosed in a report on Form 8-K during the fourth quarter of 2007, but that was not disclosed.
PART III
Item 10.
Item 10.
Directors, Executive Officers and Corporate Governance.
The information required by this item is incorporated by reference from the sections captioned “Board of Directors and Corporate Governance” and “Common Stock Ownership” contained in our proxy statement for the 2008 annual meeting of stockholders, to be filed with the Commission pursuant to Regulation 14A not later than 120 days after December 31, 2007.
Item 11.
Item 11.
Executive Compensation.
The information required by this item is incorporated by reference from the sections captioned “Executive Compensation” and “Director Compensation” contained in our proxy statement for the 2008 annual meeting of stockholders, to be filed with the Commission pursuant to Regulation 14A not later than 120 days after December 31, 2007.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The information required by this item is incorporated by reference from the sections captioned “Common Stock Ownership” and “Executive Compensation” contained in our proxy statement for the 2008 annual meeting of stockholders, to be filed with the Commission pursuant to Regulation 14A not later than 120 days after December 31, 2007.
Item 13.
Item 13.
Certain Relationships and Related Transactions, and Director Independence.
The information required by this item is incorporated by reference from the section captioned “Certain Relationships and Related Transactions” contained in our proxy statement for the 2008 annual meeting of stockholders, to be filed with the Commission pursuant to Regulation 14A not later than 120 days after December 31, 2007.
Item 14.
Item 14.
Principal Accounting Fees and Services.
The information required by this item is incorporated by reference from the sections captioned “Principal Accounting Fees and Services” contained in our proxy statement for the 2008 annual meeting of stockholders, to be filed with the Commission pursuant to Regulation 14A not later than 120 days after December 31, 2007.
PART IV
Item 15.
Item 15.
Exhibits, Financial Statement Schedules.
The following documents are being filed as part of this annual report.
(a) (1) Financial Statements. The following financial statements and notes are filed under Part II, Item 8 of this annual report.
(2) Financial Statement Schedules.
SeaBright Insurance Holdings, Inc.
Schedule II - Condensed Financial Information of Registrant
Schedule IV - Reinsurance
Schedule VI - Supplemental Information Concerning Insurance Operations
All other schedules for which provision is made in the applicable accounting requirements of the Securities and Exchange Commission are not required or the required information has been included within the financial statements or the notes thereto.
(3) Exhibits. The list of exhibits in the Exhibit Index to this annual report is incorporated herein by reference.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
SEABRIGHT INSURANCE HOLDINGS, INC.
By:
/s/ John G. Pasqualetto
John G. Pasqualetto
Chairman, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities indicated below on March 17, 2008.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
SeaBright Insurance Holdings, Inc.:
Under date of March 17, 2008, we reported on the consolidated balance sheets of SeaBright Insurance Holdings, Inc. and subsidiaries (the “Company”) as of December 31, 2007 and 2006, and the related consolidated statements of operations, changes in stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2007, which report is included in this annual report on Form 10-K. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedules in this annual report on Form 10-K. These financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statement schedules based on our audits.
As noted on Schedule II (condensed statements of cash flows), equity in earnings of subsidiaries for 2005 has been corrected.
In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
As discussed in Note 2 of the consolidated financial statements, effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123(R), Share-Based Payment.
/s/ KPMG LLP
Seattle, Washington
March 17, 2008
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
SEABRIGHT INSURANCE HOLDINGS, INC.
CONDENSED BALANCE SHEETS
See report of independent registered public accounting firm.
SEABRIGHT INSURANCE HOLDINGS, INC.
CONDENSED STATEMENTS OF OPERATIONS
See report of independent registered public accounting firm.
SEABRIGHT INSURANCE HOLDINGS, INC.
CONDENSED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
AND COMPREHENSIVE INCOME
See report of independent registered public accounting firm.
SEABRIGHT INSURANCE HOLDINGS, INC.
CONDENSED STATEMENTS OF CASH FLOWS
Note: Equity in earnings of subsidiaries for the year ended December 31, 2005 has been corrected as follows:
See report of independent registered public accounting firm.
SCHEDULE IV - REINSURANCE
SEABRIGHT INSURANCE HOLDINGS, INC.
See report of independent registered public accounting firm.
SCHEDULE VI - SUPPLEMENTAL INFORMATION
CONCERNING INSURANCE OPERATIONS
SEABRIGHT INSURANCE HOLDINGS, INC.
(1)
Net unearned premium represents unearned premiums minus prepaid reinsurance.
See report of independent registered public accounting firm.
EXHIBIT INDEX
The list of exhibits in the Exhibit Index to this annual report is incorporated herein by reference.
*
Filed herewith.

Indicates a management contract, compensatory plan, contract or arrangement required to be filed pursuant to Item 601 of Regulation S-K.