SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
Quarterly Report pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
for the Quarterly Period Ended March 31, 2012,
or
Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
for the Transition Period from to
Commission File Number No. 001-32899
EASTERN INSURANCE HOLDINGS, INC.
Incorporated in Pennsylvania | I.R.S. Employer Identification No. 20-2653793 | |
25 Race Avenue, Lancaster, Pennsylvania 17603-3179 (717) 396-7095 |
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer | ¨ | Accelerated filer | x | |||
Non-accelerated filer | ¨ | Smaller reporting company | ¨ |
Indicate by check mark if the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Title of Each Class |
Number of Shares Outstanding as of May 2, 2012 | |
Common Stock, No Par Value | 8,064,146 (Outstanding Shares) |
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PART I – FINANCIAL INFORMATION | 2 | |||||
Item 1. |
2 | |||||
Item 2. |
Management’s Discussion and Analysis of Financial Condition and Results of Operations |
15 | ||||
Item 3. |
27 | |||||
Item 4. |
27 | |||||
28 | ||||||
Item 1. |
28 | |||||
Item 1A. |
28 | |||||
Item 2. |
28 | |||||
Item 3. |
28 | |||||
Item 4. |
28 | |||||
Item 5. |
28 | |||||
Item 6. |
29 |
1
PART I – FINANCIAL INFORMATION
Item 1. | Financial Statements |
EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands, except share data)
March 31 2012 |
December 31 2011 |
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ASSETS |
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Investments: |
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Fixed income securities, at estimated fair value (amortized cost, $131,062; $128,619) |
$ | 135,695 | $ | 133,422 | ||||
Convertible bonds, at estimated fair value (amortized cost, $17,233; $16,856) |
18,973 | 17,574 | ||||||
Equity securities, at estimated fair value (cost, $15,849; $16,566) |
18,063 | 17,629 | ||||||
Other long-term investments, at estimated fair value (cost, $8,100; $8,100) |
10,539 | 10,209 | ||||||
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Total investments |
183,270 | 178,834 | ||||||
Cash and cash equivalents |
50,140 | 52,448 | ||||||
Accrued investment income |
1,012 | 972 | ||||||
Premiums receivable (net of allowance, $306; $225) |
68,749 | 56,443 | ||||||
Reinsurance recoverable on paid and unpaid losses and loss adjustment expenses |
19,054 | 15,720 | ||||||
Deferred acquisition costs |
9,956 | 9,206 | ||||||
Deferred income taxes, net |
1,683 | 1,768 | ||||||
Federal income taxes recoverable |
— | 731 | ||||||
Intangible assets |
4,935 | 5,137 | ||||||
Goodwill |
10,752 | 10,752 | ||||||
Other assets |
15,084 | 13,668 | ||||||
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Total assets |
$ | 364,635 | $ | 345,679 | ||||
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LIABILITIES |
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Reserves for unpaid losses and loss adjustment expenses |
$ | 107,773 | $ | 106,077 | ||||
Unearned premium reserves |
78,563 | 63,432 | ||||||
Advance premium |
182 | 747 | ||||||
Accounts payable and accrued expenses |
15,891 | 18,892 | ||||||
Ceded reinsurance balances payable |
11,840 | 10,265 | ||||||
Segregated portfolio cell dividend payable |
16,206 | 15,774 | ||||||
Policyholder dividends payable |
2,214 | 2,233 | ||||||
Federal income taxes payable |
180 | — | ||||||
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Total liabilities |
232,849 | 217,420 | ||||||
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Commitments and contingencies (Note 9) |
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SHAREHOLDERS’ EQUITY |
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Series A preferred stock, par value $0, auth. shares – 5,000,000; no shares issued and outstanding |
— | — | ||||||
Common capital stock, par value $0, auth. shares – 20,000,000; issued – 11,914,714 and 11,786,014, respectively; outstanding – 8,064,146 and 7,935,446, respectively |
— | — | ||||||
Unearned ESOP compensation |
(3,178 | ) | (3,364 | ) | ||||
Additional paid in capital |
116,475 | 116,272 | ||||||
Treasury stock, at cost (3,850,568 and 3,850,568 shares, respectively) |
(54,109 | ) | (54,109 | ) | ||||
Retained earnings |
69,268 | 66,910 | ||||||
Accumulated other comprehensive income, net |
3,330 | 2,550 | ||||||
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Total shareholders’ equity |
131,786 | 128,259 | ||||||
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Total liabilities and shareholders’ equity |
$ | 364,635 | $ | 345,679 | ||||
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See accompanying notes to unaudited consolidated financial statements.
2
EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME
For the Three Months Ended March 31, 2012 and 2011
(Unaudited, in thousands, except per share data)
For the Three Months Ended March 31, |
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2012 | 2011 | |||||||
REVENUE |
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Net premiums earned |
$ | 36,486 | $ | 29,877 | ||||
Net investment income |
950 | 1,025 | ||||||
Change in equity interest in limited partnerships |
330 | 551 | ||||||
Net realized investment gains |
1,691 | 830 | ||||||
Other revenue |
84 | 183 | ||||||
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Total revenue |
39,541 | 32,466 | ||||||
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EXPENSES |
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Losses and loss adjustment expenses incurred |
22,915 | 19,345 | ||||||
Acquisition and other underwriting expenses |
5,432 | 3,418 | ||||||
Other expenses |
5,687 | 5,889 | ||||||
Amortization of intangibles |
202 | 254 | ||||||
Policyholder dividend expense |
183 | 313 | ||||||
Segregated portfolio dividend expense |
996 | 526 | ||||||
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Total expenses |
35,415 | 29,745 | ||||||
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Income before income taxes |
4,126 | 2,721 | ||||||
Income tax expense |
1,204 | 841 | ||||||
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Net income |
$ | 2,922 | $ | 1,880 | ||||
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Other comprehensive income: |
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Unrealized holding gains arising during period, net of tax of $492 and $265 |
914 | 492 | ||||||
Amortization of unrecognized benefit plan amounts, net of tax of $3 and $1 |
4 | 2 | ||||||
Less: Reclassification adjustment for gains included in net income, net of tax of $71 and $129 |
138 | 240 | ||||||
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Other comprehensive income |
780 | 254 | ||||||
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Comprehensive income |
$ | 3,702 | $ | 2,134 | ||||
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Three Months Ended March 31, 2012 |
Three Months Ended March 31, 2011 |
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Earnings per share (See Note 3): |
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Basic earnings per share |
$ | 0.38 | $ | 0.22 | ||||
Diluted earnings per share |
$ | 0.37 | $ | 0.22 | ||||
Cash dividends per share |
$ | 0.07 | $ | 0.07 |
See accompanying notes to unaudited consolidated financial statements
3
EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY
For the Three Months Ended March 31, 2012 and 2011
(Unaudited, in thousands, except share data)
Outstanding Shares | Common Capital Stock |
Unearned ESOP Compensation |
Additional Paid-In Capital |
Treasury Stock |
Retained Earnings |
Accumulated Other |
Total | |||||||||||||||||||||||||||||
Series A Preferred Stock |
Common Capital Stock |
Comprehensive Income, Net of Tax |
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Balance, January 1, 2012 |
— | 7,935,446 | — | $ | (3,364 | ) | $ | 116,272 | $ | (54,109 | ) | $ | 66,910 | $ | 2,550 | $ | 128,259 | |||||||||||||||||||
ESOP shares released |
— | — | — | 186 | 80 | — | — | — | 266 | |||||||||||||||||||||||||||
Equity awards |
— | 128,700 | — | — | 120 | — | — | — | 120 | |||||||||||||||||||||||||||
Income taxes related to equity awards |
— | — | — | — | 3 | — | — | — | 3 | |||||||||||||||||||||||||||
Shareholder dividend |
— | — | — | — | — | — | (564 | ) | — | (564 | ) | |||||||||||||||||||||||||
Net income |
— | — | — | — | — | — | 2,922 | — | 2,922 | |||||||||||||||||||||||||||
Other comprehensive income, net of tax |
— | — | — | — | — | — | — | 780 | 780 | |||||||||||||||||||||||||||
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Balance, March 31, 2012 |
— | 8,064,146 | — | $ | (3,178 | ) | $ | 116,475 | $ | (54,109 | ) | $ | 69,268 | $ | 3,330 | $ | 131,786 | |||||||||||||||||||
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Series A Preferred Stock |
Common Capital Stock |
Common Capital Stock |
Unearned ESOP Compensation |
Additional Paid-In Capital |
Treasury Stock |
Retained Earnings |
Accumulated Other Comprehensive Income, Net of Tax |
Total | ||||||||||||||||||||||||||||
Balance, January 1, 2011 |
— | 8,964,344 | — | $ | (4,111 | ) | $ | 114,472 | $ | (40,835 | ) | $ | 61,364 | $ | 3,821 | $ | 134,711 | |||||||||||||||||||
ESOP shares released |
— | — | — | 184 | 29 | — | — | — | 213 | |||||||||||||||||||||||||||
Equity awards |
— | — | — | — | 370 | — | — | — | 370 | |||||||||||||||||||||||||||
Income taxes related to equity awards |
— | — | — | — | (16 | ) | — | — | — | (16 | ) | |||||||||||||||||||||||||
Repurchase of common stock |
— | (519,233 | ) | — | — | — | (6,533 | ) | — | — | (6,533 | ) | ||||||||||||||||||||||||
Shareholder dividend |
— | — | — | — | — | — | (603 | ) | — | (603 | ) | |||||||||||||||||||||||||
Net income |
— | — | — | — | — | — | 1,880 | — | 1,880 | |||||||||||||||||||||||||||
Other comprehensive income, net of tax |
— | — | — | — | — | — | — | 254 | 254 | |||||||||||||||||||||||||||
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Balance, March 31, 2011 |
— | 8,445,111 | — | $ | (3,927 | ) | $ | 114,855 | $ | (47,368 | ) | $ | 62,641 | $ | 4,075 | $ | 130,276 | |||||||||||||||||||
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See accompanying notes to unaudited consolidated financial statements
4
EASTERN INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Three Months Ended March 31, 2012 and 2011
(Unaudited, in thousands)
2012 | 2011 | |||||||
Cash flows from operating activities: |
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Net income |
$ | 2,922 | $ | 1,880 | ||||
Adjustments to reconcile net income to net cash provided by operating activities: |
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Depreciation and amortization |
191 | 159 | ||||||
Amortization of bond premium/discount |
264 | 85 | ||||||
Net realized investment gains |
(1,691 | ) | (914 | ) | ||||
Change in equity interest in limited partnerships |
(330 | ) | (551 | ) | ||||
Deferred tax (benefit) expense |
(212 | ) | 24 | |||||
Stock compensation |
386 | 583 | ||||||
Intangible asset amortization |
202 | 254 | ||||||
Changes in assets and liabilities: |
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Accrued investment income |
(40 | ) | 52 | |||||
Premiums receivable |
(12,306 | ) | (10,224 | ) | ||||
Reinsurance recoverable on paid and unpaid losses and loss adjustment expenses |
(3,334 | ) | (712 | ) | ||||
Deferred acquisition costs |
(750 | ) | (1,431 | ) | ||||
Other assets |
(1,408 | ) | (1,923 | ) | ||||
Reserves for unpaid losses and loss adjustment expenses |
1,696 | 2,803 | ||||||
Unearned and advance premium |
14,566 | 13,163 | ||||||
Ceded reinsurance balances payable |
1,575 | 1,829 | ||||||
Accounts payable and accrued expenses |
(2,994 | ) | (465 | ) | ||||
Segregated portfolio cell dividend payable |
534 | (106 | ) | |||||
Policyholder dividends payable |
(19 | ) | 43 | |||||
Federal income taxes recoverable/payable |
911 | 835 | ||||||
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Net cash provided by operating activities |
163 | 5,384 | ||||||
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Cash flows from investing activities: |
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Purchase of fixed income securities |
(11,631 | ) | (6,532 | ) | ||||
Purchase of equity securities |
(3,881 | ) | (2,908 | ) | ||||
Proceeds from sale of fixed income securities |
4,857 | 8,917 | ||||||
Proceeds from maturities/calls of fixed income securities |
3,921 | 4,045 | ||||||
Proceeds from sale of equity securities |
5,023 | 162 | ||||||
Purchase of equipment, net |
(199 | ) | (175 | ) | ||||
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Net cash (used in) provided by investing activities |
(1,910 | ) | 3,509 | |||||
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Cash flows from financing activities: |
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Repurchase of common stock |
— | (6,533 | ) | |||||
Shareholder dividend |
(564 | ) | (603 | ) | ||||
Income taxes related to equity awards |
3 | (16 | ) | |||||
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Net cash used in financing activities |
(561 | ) | (7,152 | ) | ||||
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Net (decrease) increase in cash and cash equivalents |
(2,308 | ) | 1,741 | |||||
Cash and cash equivalents, beginning of period |
52,448 | 45,855 | ||||||
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Cash and cash equivalents, end of period |
$ | 50,140 | $ | 47,596 | ||||
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See accompanying notes to unaudited consolidated financial statements.
5
Eastern Insurance Holdings, Inc. and Subsidiaries
Condensed Notes to Consolidated Financial Statements
(Unaudited, dollars in thousands except share and per share data)
1. Background and Nature of Operations
Eastern Insurance Holdings, Inc. (“EIHI”) is an insurance holding company offering workers’ compensation insurance and reinsurance products through its direct and indirect wholly-owned subsidiaries, Global Alliance Holdings, Ltd. (“Global Alliance”), Eastern Alliance Insurance Company (“Eastern Alliance”), Allied Eastern Indemnity Company (“Allied Eastern”), Eastern Advantage Assurance Company (“Eastern Advantage”), Employers Security Insurance Company (“Employers Security”), Employers Alliance, Inc. (“Employers Alliance”), Eastern Re Ltd., SPC (“Eastern Re”), and Eastern Services Corporation (“Eastern Services”), collectively referred to as the “Company.”
The Company currently operates in three segments: workers’ compensation insurance, segregated portfolio cell reinsurance, and corporate/other.
2. Significant Accounting Policies
Basis of Presentation
The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities and Exchange Act of 1934, as amended. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments, being normal, recurring adjustments, necessary for a fair statement of the financial position and results of operations of the Company for the periods presented have been included. The results of operations for an interim period are not necessarily indicative of the results for an entire year. These financial statements should be read in conjunction with the Company’s audited financial statements and notes thereto as of and for the year ended December 31, 2011 included in the Company’s Annual Report on Form 10-K, which was filed with the U.S. Securities and Exchange Commission on March 12, 2012.
All inter-company transactions and related account balances have been eliminated in consolidation.
Certain amounts in the prior year consolidated financial statements have been reclassified to conform to the current year presentation.
Use of Estimates
The preparation of the unaudited interim consolidated financial statements requires management to make estimates and assumptions that affect the amount of reported assets and liabilities and disclosures of contingent assets and liabilities as of the date of the unaudited interim consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. The most significant estimates in the unaudited interim consolidated financial statements include reserves for unpaid losses and loss adjustment expenses (“LAE”), earned but unbilled premium, deferred acquisition costs, return premiums under reinsurance contracts, and current and deferred income taxes. Actual results could differ from these estimates.
Recent Accounting Pronouncements
Presentation of Comprehensive Income
In June 2011, the FASB issued ASU 2011-05, “Presentation of Comprehensive Income” (“ASU 2011-05”). ASU 2011-05 requires entities to present net income and comprehensive income in either a single continuous statement or in two separate, but consecutive, statements of net income and other comprehensive income. The option to present items of other comprehensive income in the statement of changes in equity was eliminated. ASU 2011-05 was effective for public entities as of the beginning of a fiscal year that began after December 15, 2011 (including interim periods) and is effective for nonpublic entities for fiscal years ending after December 15, 2012 and interim and annual periods thereafter. Early adoption was permitted and retrospective application is required. The Company adopted ASU 2011-05 effective January 1, 2012. The Company presents comprehensive income in the consolidated statement of operations and comprehensive income; therefore, the adoption of ASU 2011-05 did not change the Company’s presentation of comprehensive income.
Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts
In October 2010, the FASB issued ASU 2010-26, “Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts” (“ASU 2010-26”). ASU 2010-26 provides specific types of costs that should be capitalized in connection with the acquisition or renewal of insurance contracts. Those costs include incremental direct costs of contract acquisition incurred in connection with independent third parties and certain costs related to activities performed by the insurer for the contract, including
6
underwriting, policy issuance and processing, medical and inspection, and sales force contract selling. Under ASU 2010-26, costs incurred by an entity related to unsuccessful acquisition or renewal efforts must be charged to expense as incurred. ASU 2010-26 was effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011 and is to be applied prospectively. Retrospective application to all prior periods upon the date of adoption was permitted, but not required. The Company adopted ASU 2010-26 effective January 1, 2012 and applied it prospectively. As a result of adoption, the Company expensed underwriting salaries totaling approximately $726,000 ($472,000 net of tax) that would have been capitalized under the previous accounting guidance to give effect to unsuccessful acquisition or renewal activities. The adoption of ASU 2012-26 increased the Company’s consolidated expense ratio by 2.0 percentage points for the three months ended March 31, 2012. If the new accounting guidance had been adopted effective January 1, 2011, the Company would have recognized additional expense related to underwriting salaries totaling $499,000 ($324,000 net of tax) for the three months ended March 31, 2011, which would have increased the Company’s consolidated expense ratio by 1.7 percentage points.
3. Earnings Per Share
Basic earnings per share are computed by dividing net income (loss) by the weighted average number of shares outstanding for the respective period. Diluted earnings per share are computed by dividing net income (loss) by the weighted average number of shares outstanding for the period, including dilutive potential common shares outstanding for the period. For the three months ended March 31, 2012 and 2011, there were 1,230,026 and 955,452 equity awards, respectively, that were not included in the Company’s earnings per share calculation because to do so would have been anti-dilutive.
Consolidated net income, basic shares outstanding, diluted shares outstanding, basic earnings per share, diluted earnings per share and cash dividends per share for the three months ended March 31, 2012 and 2011 were as follows (in thousands, except share and per share data):
Three Months Ended March 31, 2012 |
Three Months Ended March 31, 2011 |
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Net income for basic and diluted earnings per share |
$ | 2,922 | $ | 1,880 | ||||
Less: Dividends declared – common and unvested restricted share units |
(564 | ) | (603 | ) | ||||
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Undistributed earnings |
2,358 | 1,277 | ||||||
Percent allocated to common shareholders |
98.2 | % | 99.3 | % | ||||
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2,316 | 1,268 | |||||||
Add: Dividends declared – common shares |
554 | 599 | ||||||
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$ | 2,870 | $ | 1,867 | |||||
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Denominator for basic earnings per share |
7,603,017 | 8,334,511 | ||||||
Effect of dilutive securities |
126,471 | 96,944 | ||||||
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Denominator for diluted earnings per common share |
7,729,488 | 8,431,455 | ||||||
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Basic earnings per share |
$ | 0.38 | $ | 0.22 | ||||
Diluted earnings per share |
$ | 0.37 | $ | 0.22 | ||||
Cash dividends per share |
$ | 0.07 | $ | 0.07 |
4. Stock-Based Compensation
On February 24, 2012, the Company granted non-qualified stock options and restricted stock awards to certain employees and directors. Stock options and restricted stock awards granted totaled 218,500 and 128,700, respectively, and were issued under the Company’s 2006 Stock Incentive Plan. The closing price of the Company’s common stock on the grant date was $14.45. The terms of the stock options and restricted stock are consistent with prior grants issued by the Company.
5. Fair Value Measurements
The Company’s assets and liabilities that are measured at fair value on a recurring basis are segregated between those assets and liabilities that are valued based on quoted prices (unadjusted) in active markets for identical assets or liabilities, which the reporting entity can access at the measurement date (Level 1), direct or indirect observable inputs other than Level 1 quoted prices (Level 2), or unobservable inputs to the extent that observable inputs are not available (Level 3).
7
The following is a description of the Company’s categorization of the inputs used in the recurring fair value measurements of its financial assets included in its consolidated balance sheets as of March 31, 2012 and December 31, 2011:
Level 1 – Represents financial assets whose fair value is determined based upon observable unadjusted quoted market prices for identical financial assets in active markets that the Company has the ability to access. An example of a Level 1 input utilized to measure fair value includes the closing price of one share of common stock on an active exchange market. The Company considers U.S. Treasuries and equity securities as Level 1 assets.
Level 2 – Represents financial assets whose fair value is determined based upon: quoted market prices for similar assets in active markets; quoted market prices for identical assets in inactive markets; inputs other than quoted market prices that are observable for the asset such as interest rates or yield curves; or other inputs derived principally from or corroborated from other observable market information. An example of a Level 2 input utilized to measure fair value, specifically for the Company’s fixed income portfolio, is “matrix pricing.” “Matrix pricing” relies on observable inputs from active markets other than quoted market prices including, but not limited to, benchmark securities and yields, latest reported trades, quotes from brokers or dealers, issuer spreads, bids, offers, and other relevant reference data to determine fair value. “Matrix pricing” is used to measure the fair value of fixed income securities where obtaining individual quoted market prices is impractical. The Company considers U.S. Government agencies, municipal bonds, corporate bonds, mortgage-backed securities, collateralized mortgage obligations, asset-backed securities, and convertible bonds as Level 2 assets.
Level 3 – Represents financial assets whose fair value is determined based upon inputs that are unobservable, including the Company’s own determinations of the assumptions that a market participant would use in pricing the asset.
The following table provides a summary of the fair value measurements of the Company’s fixed income securities, convertible bonds, and equity securities, as of March 31, 2012 (unaudited) and December 31, 2011, excluding the segregated portfolio cell reinsurance segment (in thousands):
Fair Value Measurements at Reporting Date Using |
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3/31/12 | Level 1 | Level 2 | Level 3 | |||||||||||||
Fixed income securities – available for sale: |
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U.S. Treasuries and government agencies |
$ | 17,462 | $ | 11,008 | $ | 6,454 | $ | — | ||||||||
States, municipalities, and political subdivisions |
46,101 | — | 46,101 | — | ||||||||||||
Corporate securities |
18,261 | — | 18,261 | — | ||||||||||||
Residential mortgage-backed securities |
21,144 | — | 21,144 | — | ||||||||||||
Commercial mortgage-backed securities |
171 | — | 171 | — | ||||||||||||
Collateralized mortgage obligations |
7,363 | — | 7,363 | — | ||||||||||||
Other structured securities |
1,027 | — | 1,027 | — | ||||||||||||
Convertible bonds |
18,973 | — | 18,973 | — | ||||||||||||
Equity securities – available for sale |
14,215 | 14,215 | — | — | ||||||||||||
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|
|||||||||
Total |
$ | 144,717 | $ | 25,223 | $ | 119,494 | $ | — | ||||||||
|
|
|
|
|
|
|
|
|||||||||
Fair Value Measurements at Reporting Date Using |
||||||||||||||||
12/31/11 | Level 1 | Level 2 | Level 3 | |||||||||||||
Fixed income securities – available for sale: |
||||||||||||||||
U.S. Treasuries and government agencies |
$ | 16,143 | $ | 9,676 | $ | 6,467 | $ | — | ||||||||
States, municipalities, and political subdivisions |
42,316 | — | 42,316 | — | ||||||||||||
Corporate securities |
21,509 | — | 21,509 | — | ||||||||||||
Residential mortgage-backed securities |
22,360 | — | 22,360 | — | ||||||||||||
Commercial mortgage-backed securities |
206 | — | 206 | — | ||||||||||||
Collateralized mortgage obligations |
5,876 | — | 5,876 | — | ||||||||||||
Other structured securities |
1,023 | — | 1,023 | — | ||||||||||||
Convertible bonds |
17,574 | — | 17,574 | — | ||||||||||||
Equity securities – available for sale |
12,939 | 12,939 | — | — | ||||||||||||
|
|
|
|
|
|
|
|
|||||||||
Total |
$ | 139,946 | $ | 22,615 | $ | 117,331 | $ | — | ||||||||
|
|
|
|
|
|
|
|
There were no transfers between Level 1 and Level 2 securities for the three months ended March 31, 2012.
The estimated fair values of the Company’s investments in fixed income securities, convertible bonds, and equity securities are based on prices provided by an independent, nationally recognized pricing service. The prices provided by the independent pricing service
8
are based on quoted market prices, when available, non-binding broker quotes, or matrix pricing. The independent pricing service provides a single price or quote per security and the Company did not adjust security prices during the three months ended March 31, 2012 and 2011. Management has controls in place to validate the reasonableness of fair values provided by the independent pricing service, including testing the fair value of a sample of securities on a quarterly basis by comparing fair values from different pricing sources. Fixed income securities include U.S. Treasuries, agencies backed by the U.S. Government, municipal bonds, corporate bonds, mortgage-backed securities, collateralized mortgage obligations, and asset-backed securities.
The Company’s fixed income securities and convertible bonds consist primarily of publicly traded securities for which there are observable inputs and/or broker quotes. Most fixed income security prices provided by the independent pricing service are based on observable inputs and, therefore, are classified as Level 2 securities. The Company does not hold any fixed income securities, for which pricing was based on significant unobservable inputs; therefore, the Company has not classified any of its fixed income securities as Level 3 securities.
The Company’s equity securities consist primarily of mutual fund instruments for which there is an active market and quoted market prices; therefore, the Company has classified its mutual fund investments as Level 1 securities.
Other long-term investments include the Company’s interest in various limited partnerships, including a low volatility multi-strategy fund of funds, a natural resource limited partnership, a structured finance opportunity fund, and an open-ended investment fund. The Company records its investment in the limited partnerships using the equity method. The carrying value of the Company’s limited partnership investments are based on the Company’s allocable share of the limited partnerships’ net asset value. Changes in the Company’s investments are based on statements received directly from the limited partnership and/or the limited partnership’s administrator. The estimated fair values of the underlying investments in the limited partnerships may be based on Level 1, Level 2, or Level 3 inputs, or a combination thereof.
As of March 31, 2012 (unaudited) and December 31, 2011, the estimated fair values of the Company’s limited partnership investments, by investment strategy, were as follows (in thousands):
3/31/12 | 12/31/11 | |||||||
Multi-strategy fund of funds |
$ | 5,722 | $ | 5,578 | ||||
Natural resources |
1,263 | 1,262 | ||||||
Structured finance opportunity fund |
2,910 | 2,769 | ||||||
Open-ended investment fund |
644 | 600 | ||||||
|
|
|
|
|||||
Total |
$ | 10,539 | $ | 10,209 | ||||
|
|
|
|
The activity in the Company’s limited partnership investments for the three months ended March 31, 2012 and 2011 was as follows (unaudited, in thousands):
3/31/12 | 3/31/11 | |||||||
Balance, beginning of period |
$ | 10,209 | $ | 11,435 | ||||
Contributions |
— | — | ||||||
Withdrawals |
— | — | ||||||
Change in interest |
330 | 551 | ||||||
|
|
|
|
|||||
Balance, end of period |
$ | 10,539 | $ | 11,986 | ||||
|
|
|
|
The change in interest in the Company’s limited partnership investments is included in the change in equity interest in limited partnerships in the consolidated statements of operations and comprehensive income.
9
6. Investments
The following tables provide the amortized cost and estimated fair value of the Company’s fixed income and equity securities as of March 31, 2012 (unaudited) and December 31, 2011 (in thousands):
March 31, 2012 |
Cost or Amortized Cost |
Gross Unrealized Gains |
Gross Unrealized Losses |
Estimated Fair Value |
||||||||||||
U.S. Treasuries and government agencies |
$ | 16,937 | $ | 537 | $ | (12 | ) | $ | 17,462 | |||||||
States, municipalities, and political subdivisions |
43,728 | 2,409 | (36 | ) | 46,101 | |||||||||||
Corporate securities |
41,759 | 700 | (32 | ) | 42,427 | |||||||||||
Residential mortgage-backed securities |
20,278 | 869 | (3 | ) | 21,144 | |||||||||||
Commercial mortgage-backed securities |
152 | 19 | — | 171 | ||||||||||||
Collateralized mortgage obligations |
7,205 | 166 | (8 | ) | 7,363 | |||||||||||
Other structured securities |
1,003 | 24 | — | 1,027 | ||||||||||||
|
|
|
|
|
|
|
|
|||||||||
Total fixed income securities |
131,062 | 4,724 | (91 | ) | 135,695 | |||||||||||
Equity securities |
15,849 | 2,296 | (82 | ) | 18,063 | |||||||||||
|
|
|
|
|
|
|
|
|||||||||
Total fixed income and equity securities |
$ | 146,911 | $ | 7,020 | $ | (173 | ) | $ | 153,758 | |||||||
|
|
|
|
|
|
|
|
December 31, 2011 |
Cost or Amortized Cost |
Gross Unrealized Gains |
Gross Unrealized Losses |
Estimated Fair Value |
||||||||||||
U.S. Treasuries and government agencies |
$ | 15,524 | $ | 619 | $ | — | $ | 16,143 | ||||||||
States, municipalities, and political subdivisions |
39,904 | 2,416 | (4 | ) | 42,316 | |||||||||||
Corporate securities |
44,748 | 752 | (2 | ) | 45,498 | |||||||||||
Residential mortgage-backed securities |
21,499 | 861 | — | 22,360 | ||||||||||||
Commercial mortgage-backed securities |
187 | 19 | — | 206 | ||||||||||||
Collateralized mortgage obligations |
5,753 | 134 | (11 | ) | 5,876 | |||||||||||
Other structured securities |
1,004 | 19 | — | 1,023 | ||||||||||||
|
|
|
|
|
|
|
|
|||||||||
Total fixed income securities |
128,619 | 4,820 | (17 | ) | 133,422 | |||||||||||
Equity securities |
16,566 | 1,546 | (483 | ) | 17,629 | |||||||||||
|
|
|
|
|
|
|
|
|||||||||
Total fixed income and equity securities |
$ | 145,185 | $ | 6,366 | $ | (500 | ) | $ | 151,051 | |||||||
|
|
|
|
|
|
|
|
Corporate securities include an investment in a fixed income mutual fund, held by the segregated portfolio cell reinsurance segment, with a cost and estimated fair value of $24,110 and $24,166, respectively, as of March 31, 2012, and $23,991 and $23,989, respectively, as of December 31, 2011. The fixed income mutual fund’s investment objective is to provide a total return that is consistent with the preservation of capital through investing in high grade U.S. Dollar fixed income securities with a maximum maturity not exceeding five years.
Other structured securities include other asset-backed securities collateralized by auto loan receivables, equipment and manufactured homes.
The gross unrealized losses and estimated fair value of fixed income and equity securities, excluding those securities in the segregated portfolio cell reinsurance segment, classified as a available-for-sale by category and length of time an individual security has been in a continuous unrealized position as of March 31, 2012 (unaudited) and December 31, 2011 are as follows (in thousands):
Less Than 12 Months | 12 Months or More | Total | ||||||||||||||||||||||
March 31, 2012 |
Estimated Fair Value |
Gross Unrealized Losses |
Estimated Fair Value |
Gross Unrealized Losses |
Estimated Fair Value |
Gross Unrealized Losses |
||||||||||||||||||
U.S. Treasuries and government agencies |
$ | 2,654 | $ | (12 | ) | $ | — | $ | — | $ | 2,654 | $ | (12 | ) | ||||||||||
States, municipalities, and political subdivisions |
2,958 | (36 | ) | — | — | 2,958 | (36 | ) | ||||||||||||||||
Corporate securities |
1,835 | (32 | ) | — | — | 1,835 | (32 | ) | ||||||||||||||||
Residential mortgage-backed securities |
357 | (3 | ) | — | — | 357 | (3 | ) | ||||||||||||||||
Collateralized mortgage obligations |
865 | (8 | ) | — | — | 865 | (8 | ) | ||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
Total fixed income securities |
8,669 | (91 | ) | — | — | 8,669 | (91 | ) | ||||||||||||||||
Equity securities |
944 | (82 | ) | — | — | 944 | (82 | ) | ||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
Total fixed income and equity securities |
$ | 9,613 | $ | (173 | ) | $ | — | $ | — | $ | 9,613 | $ | (173 | ) | ||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
10
Less Than 12 Months | 12 Months or More | Total | ||||||||||||||||||||||
December 31, 2011 |
Estimated Fair Value |
Gross Unrealized Losses |
Estimated Fair Value |
Gross Unrealized Losses |
Estimated Fair Value |
Gross Unrealized Losses |
||||||||||||||||||
States, municipalities, and political subdivisions |
$ | 1,604 | $ | (4 | ) | $ | — | $ | — | $ | 1,604 | $ | (4 | ) | ||||||||||
Collateralized mortgage obligations |
375 | (11 | ) | — | — | 375 | (11 | ) | ||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
Total fixed income securities |
1,979 | (15 | ) | — | — | 1,979 | (15 | ) | ||||||||||||||||
Equity Securities |
3,302 | (374 | ) | — | — | 3,302 | (374 | ) | ||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
Total fixed income and equity securities |
$ | 5,281 | $ | (389 | ) | $ | — | $ | — | $ | 5,281 | $ | (389 | ) | ||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
Note: The Company has excluded the segregated portfolio cell reinsurance segment’s gross unrealized losses from the above tables because changes in the estimated fair value of the segregated portfolio cell reinsurance segment’s fixed income and equity securities inures to the segregated portfolio cell dividend participant and, accordingly, is included in the segregated portfolio cell dividend payable and the related segregated portfolio dividend expense in the Company’s consolidated balance sheets and consolidated statement of operations, respectively. Management believes the exclusion of the segregated portfolio cell reinsurance segment from this disclosure provides a more transparent understanding of gross unrealized losses in the Company’s fixed income and equity security portfolios that could impact its consolidated financial position or results of operations.
As of March 31, 2012, the Company held 30 fixed income securities with gross unrealized losses totaling $91. Management has evaluated the unrealized losses related to those fixed income securities and determined that they are primarily due to a fluctuation in interest rates and not to credit issues of the issuer or the underlying assets in the case of asset-backed securities. The Company does not intend to sell the fixed income securities and it is not more likely than not that the Company will be required to sell the fixed income securities before recovery of their amortized cost bases, which may be maturity; therefore, management does not consider the fixed income securities to be other–than-temporarily impaired as of March 31, 2012.
As of March 31, 2012, the Company held 2 equity securities with gross unrealized losses totaling $82. These securities have been in an unrealized loss position for less than twelve months. The Company does not intend to sell the equity securities and it is not more likely than not that the Company will be required to sell the equity securities before recovery of their cost bases; therefore, management does not consider the equity securities to be other-than-temporarily impaired as of March 31, 2012.
There were no other-than-temporary impairments for the three months ended March 31, 2012 and 2011.
7. Reserves for Unpaid Losses and Loss Adjustment Expenses
The following table provides a summary of the activity in the Company’s reserves for unpaid losses and LAE for the three months ended March 31, 2012 and 2011 (unaudited, in thousands):
2012 | 2011 | |||||||
Balance, beginning of period |
$ | 106,077 | $ | 95,963 | ||||
Reinsurance recoverables on unpaid losses and LAE |
11,805 | 7,864 | ||||||
|
|
|
|
|||||
Net balance, beginning of period |
94,272 | 88,099 | ||||||
Incurred related to: |
||||||||
Current year |
22,507 | 19,459 | ||||||
Prior year |
408 | (114 | ) | |||||
|
|
|
|
|||||
Total incurred |
22,915 | 19,345 | ||||||
Paid related to: |
||||||||
Current year |
3,226 | 2,822 | ||||||
Prior year |
19,873 | 14,918 | ||||||
|
|
|
|
|||||
Total paid |
23,099 | 17,740 | ||||||
|
|
|
|
|||||
Net balance, end of period |
94,088 | 89,704 | ||||||
Reinsurance recoverables on unpaid losses and LAE |
13,685 | 9,062 | ||||||
|
|
|
|
|||||
Balance, end of period |
$ | 107,773 | $ | 98,766 | ||||
|
|
|
|
11
Incurred losses by segment were as follows for the three months ended March 31, 2012 and 2011, respectively (unaudited, in thousands):
March 31, 2012 |
Workers’ Compensation Insurance Segment |
Segregated Portfolio Cell Reinsurance Segment |
Total | |||||||||
Incurred related to: |
||||||||||||
Current year, gross of discount |
$ | 18,849 | $ | 4,921 | $ | 23,770 | ||||||
Current period discount |
(1,052 | ) | (211 | ) | (1,263 | ) | ||||||
Prior year, gross of discount |
— | (566 | ) | (566 | ) | |||||||
Accretion of prior period discount |
769 | 205 | 974 | |||||||||
|
|
|
|
|
|
|||||||
Total incurred |
$ | 18,566 | $ | 4,349 | $ | 22,915 | ||||||
|
|
|
|
|
|
March 31, 2011 |
Workers’ Compensation Insurance Segment |
Segregated Portfolio Cell Reinsurance Segment |
Total | |||||||||
Incurred related to: |
||||||||||||
Current year, gross of discount |
$ | 15,985 | $ | 4,382 | $ | 20,367 | ||||||
Current period discount |
(680 | ) | (228 | ) | (908 | ) | ||||||
Prior year, gross of discount |
— | (699 | ) | (699 | ) | |||||||
Accretion of prior period discount |
337 | 248 | 585 | |||||||||
|
|
|
|
|
|
|||||||
Total incurred |
$ | 15,642 | $ | 3,703 | $ | 19,345 | ||||||
|
|
|
|
|
|
The Company’s results of operations include favorable development in its segregated portfolio cell reinsurance segment of $566 for the three months ended March 31, 2012, compared to favorable development of $699 for the same period in 2011. The favorable development primarily reflects the impact of claim settlements for amounts at, or less than, previously established case and incurred but not reported (“IBNR”) reserves.
8. Segment Information
The Company currently operates in three business segments.
Workers’ Compensation Insurance
The Company offers traditional workers’ compensation insurance coverage to employers, primarily in the Mid-Atlantic, Southeast and Midwest regions of the continental United States. The Company’s workers’ compensation products include guaranteed cost policies, policyholder dividend policies, retrospectively-rated policies and deductible policies.
Segregated Portfolio Cell Reinsurance
The Company offers alternative market workers’ compensation solutions to individual companies, groups and associations (referred to as “segregated portfolio cell dividend participants”) through the creation of segregated portfolio cells. The segregated portfolio cells are segregated pools of assets that function as insurance companies within an insurance company. The pool of assets and associated liabilities of each segregated portfolio cell are solely for the benefit of the segregated portfolio cell dividend participants, and the pool of assets of one segregated portfolio cell are statutorily protected from the creditors of the others. This permits the Company to provide customers with a turn-key alternative markets solution that includes program design, fronting, claims administration, risk management, segregated portfolio cell rental, asset management and segregated portfolio management services. The Company outsources the asset management and segregated portfolio cell management services to a third party. The segregated portfolio cell structure provides dividend participants the opportunity to share in both underwriting profit and investment income derived from their respective segregated portfolio cell’s financial results. The segregated portfolio cell reinsurance segment generated fee revenue to the Company’s workers’ compensation insurance and corporate/other segments totaling approximately $1,956 and $1,661 for the three months ended March 31, 2012 and 2011, respectively.
The Company is a preferred shareholder in certain of the segregated portfolio cells. For those segregated portfolio cells in which the Company participates, the Company shares in the operating and investment results of those cells and recognizes its share of the segregated portfolio dividend in the consolidated statements of operations and comprehensive income. The Company’s share of the segregated portfolio dividend totaled $289 and $269 for the three months ended March 31, 2012 and 2011, respectively, and is included in the corporate/other segment.
12
Corporate/Other
The corporate/other segment primarily includes the expenses of the holding company, the third party administration activities of the Company, and the results of operations of Eastern Re, as well as certain eliminations necessary to reconcile the segment information to the consolidated statements of operations and comprehensive income. The Company cancelled the remaining reinsurance contracts at Eastern Re in 1999 on a run-off basis and continues to have exposure for outstanding claims as of March 31, 2012. The corporate/other segment also includes the Company’s 10% interest in a segregated portfolio cell with an unaffiliated primary carrier that writes insurance coverage for sprinkler contractors, known as “SprinklerPro”. The Company non-renewed the contract for its 10% interest in SprinklerPro on a run-off basis effective April 1, 2009.
The following table represents the segment results for the three months ended March 31, 2012 (unaudited, in thousands):
Workers’ Compensation Insurance |
Segregated Portfolio Cell Reinsurance |
Corporate/ Other |
Total | |||||||||||||
Revenue: |
||||||||||||||||
Net premiums earned |
$ | 28,996 | $ | 7,490 | $ | — | $ | 36,486 | ||||||||
Net investment income |
798 | 88 | 64 | 950 | ||||||||||||
Change in equity interest in limited partnerships |
259 | — | 71 | 330 | ||||||||||||
Net realized investment gains |
1,204 | 460 | 27 | 1,691 | ||||||||||||
Other revenue |
— | — | 84 | 84 | ||||||||||||
|
|
|
|
|
|
|
|
|||||||||
Total revenue |
31,257 | 8,038 | 246 | 39,541 | ||||||||||||
|
|
|
|
|
|
|
|
|||||||||
Expenses: |
||||||||||||||||
Losses and LAE incurred |
18,566 | 4,349 | — | 22,915 | ||||||||||||
Acquisition and other underwriting expenses |
3,266 | 2,292 | (126 | ) | 5,432 | |||||||||||
Other expenses |
4,559 | 98 | 1,030 | 5,687 | ||||||||||||
Amortization of intangibles |
— | — | 202 | 202 | ||||||||||||
Policyholder dividend expense |
169 | 14 | — | 183 | ||||||||||||
Segregated portfolio dividend expense |
— | 1,285 | (289 | ) | 996 | |||||||||||
|
|
|
|
|
|
|
|
|||||||||
Total expenses |
26,560 | 8,038 | 817 | 35,415 | ||||||||||||
|
|
|
|
|
|
|
|
|||||||||
Income (loss) before income taxes |
4,697 | — | (571 | ) | 4,126 | |||||||||||
Income tax expense (benefit) |
1,549 | — | (345 | ) | 1,204 | |||||||||||
|
|
|
|
|
|
|
|
|||||||||
Net income (loss) |
$ | 3,148 | $ | — | $ | (226 | ) | $ | 2,922 | |||||||
|
|
|
|
|
|
|
|
|||||||||
Total assets |
$ | 323,420 | $ | 66,342 | $ | (25,127 | ) | $ | 364,635 | |||||||
|
|
|
|
|
|
|
|
13
The following table represents the segment results for the three months ended March 31, 2011 (unaudited, in thousands):
Workers’ Compensation Insurance |
Segregated Portfolio Cell Reinsurance |
Corporate/ Other |
Total | |||||||||||||
Revenue: |
||||||||||||||||
Net premiums earned |
$ | 23,582 | $ | 6,295 | $ | — | $ | 29,877 | ||||||||
Net investment income |
877 | 109 | 39 | 1,025 | ||||||||||||
Change in equity interest in limited partnerships |
468 | — | 83 | 551 | ||||||||||||
Net realized investment gains |
760 | 37 | 33 | 830 | ||||||||||||
Other revenue |
— | — | 183 | 183 | ||||||||||||
|
|
|
|
|
|
|
|
|||||||||
Total revenue |
25,687 | 6,441 | 338 | 32,466 | ||||||||||||
|
|
|
|
|
|
|
|
|||||||||
Expenses: |
||||||||||||||||
Losses and LAE incurred |
15,642 | 3,703 | — | 19,345 | ||||||||||||
Acquisition and other underwriting expenses |
2,108 | 1,874 | (564 | ) | 3,418 | |||||||||||
Other expenses |
3,697 | 64 | 2,128 | 5,889 | ||||||||||||
Amortization of intangibles |
— | — | 254 | 254 | ||||||||||||
Policyholder dividend expense |
308 | 5 | — | 313 | ||||||||||||
Segregated portfolio dividend expense |
— | 795 | (269 | ) | 526 | |||||||||||
|
|
|
|
|
|
|
|
|||||||||
Total expenses |
21,755 | 6,441 | 1,549 | 29,745 | ||||||||||||
|
|
|
|
|
|
|
|
|||||||||
Income (loss) before income taxes |
3,932 | — | (1,211 | ) | 2,721 | |||||||||||
Income tax expense (benefit) |
1,276 | — | (435 | ) | 841 | |||||||||||
|
|
|
|
|
|
|
|
|||||||||
Net income (loss) |
$ | 2,656 | $ | — | $ | (776 | ) | $ | 1,880 | |||||||
|
|
|
|
|
|
|
|
|||||||||
Total assets |
$ | 291,193 | $ | 60,239 | $ | (15,796 | ) | $ | 335,636 | |||||||
|
|
|
|
|
|
|
|
9. Commitments and Contingencies
Legal Proceedings
The Company is subject to legal proceedings and claims that arise in the ordinary course of its business and have not been finally adjudicated. Although there can be no assurance as to the ultimate disposition of these matters, it is the opinion of the Company’s management, based upon the information available at this time, that the expected outcome of these matters, individually or in the aggregate, will not have a material adverse effect on the Company’s results of operations or financial condition.
AIG Arbitration Update
The arbitration proceedings initiated by the Company against AIG Companies are on-going and there has been no further action during the first quarter of 2012 related to the arbitration process.
During the first quarter of 2012, the Company received quarterly claims data from AIG Companies that reflected unfavorable claim development under the reinsurance treaties. The Company is unable to substantiate the reliability of the claims data reported by AIG Companies and, as a result, has not adjusted its consolidated financial statements for the amounts reported by AIG Companies. The Company continues to believe it has adequately reserved the claims at issue and that it is entitled to audit the books and records of AIG Companies to examine the bases of certain paid losses and loss reserves ceded by AIG Companies to the Company. It is reasonably possible that the final outcome of the arbitration could go against the Company, which could result in a material, adverse effect on the Company’s results of operations and financial condition.
10. Subsequent Events
Management performed an evaluation of subsequent events and determined there were no recognized or unrecognized subsequent events that would require an adjustment and/or additional disclosure in the consolidated financial statements as of March 31, 2012.
14
Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
The following discussion and analysis of financial condition and results of operations should be read in conjunction with the unaudited interim consolidated financial statements of Eastern Insurance Holdings, Inc. (the “Company”) and the related notes thereto included in Item 1 of this Part 1. The information contained in this quarterly report is not a complete description of the Company’s business or the risks associated with an investment in the Company’s common stock. You should carefully review and consider the various disclosures made by the Company in this quarterly report and in the Company’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 12, 2012.
Forward-looking Statements
The Company may from time to time make written or oral “forward-looking statements,” including statements contained in the Company’s filings with the U.S. Securities and Exchange Commission (including this Quarterly Report on Form 10-Q and the exhibits hereto), in its reports to shareholders and in other communications by the Company, which are made in good faith by the Company pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995.
These forward-looking statements include statements with respect to the Company’s beliefs, plans, objectives, goals, expectations, anticipations, estimates and intentions, that are subject to significant risks and uncertainties, and are subject to change based on various factors (some of which are beyond the Company’s control). The words “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan” and similar expressions are intended to identify forward-looking statements. The following factors, among others, could cause the Company’s financial performance to differ materially from the plans, objectives, expectations, estimates and intentions expressed in such forward-looking statements:
• | the ability to carry out our business plans; |
• | future economic conditions in the regional and national markets in which we compete that are less favorable than expected; |
• | the effect of legislative, judicial, economic, demographic and regulatory events in the states in which we do business; |
• | the ability to obtain licenses and enter new markets successfully and capitalize on growth opportunities either through mergers or the expansion of our producer network; |
• | financial market conditions, including, but not limited to, changes in interest rates and the credit and equity markets causing a reduction of investment income or investment gains, an acceleration of the amortization of deferred policy acquisition costs, reduction in the value of our investment portfolio or a reduction in the demand for our products; |
• | the impact of acts of terrorism and acts of war; |
• | the effects of terrorist related insurance legislation and laws; |
• | changes in general economic conditions, including inflation, unemployment, interest rates and other factors; |
• | the cost, availability and collectibility of reinsurance; |
• | estimates and adequacy of loss reserves and trends in losses and LAE; |
• | heightened competition, including specifically the intensification of price competition, increased underwriting capacity and the entry of new competitors and the development of new products by new and existing competitors; |
• | the effects of mergers, acquisitions and dispositions; |
• | changes in the coverage terms selected by insurance customers, including higher deductibles and lower limits; |
• | changes in the underwriting criteria that we use resulting from competitive pressures; |
• | our inability to obtain regulatory approval of, or to implement, premium rate increases; |
• | the potential impact on our reported earnings that could result from the adoption of future accounting standards issued by the FASB or other standard setting bodies; |
• | our inability to carry out marketing and sales plans, including, among others, development of new products or changes to existing products and acceptance of the new or revised products in the market; |
• | unanticipated changes in industry trends and ratings assigned by nationally recognized rating organizations; |
• | adverse litigation or arbitration results including, without limitation, the AIG Arbitration; and |
• | adverse changes in applicable laws, regulations or rules governing insurance holding companies and insurance companies, and tax or accounting matters including limitations on premium levels, increases in minimum capital and reserves, and other financial viability requirements, and changes that affect the cost of, or demand for our products. |
15
The Company cautions that the foregoing list of important factors is not exclusive. Readers are also cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date of this report. The Company does not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of the Company.
Overview
The Company reported net income of $2.9 million for the three months ended March 31, 2012, compared to net income of $1.9 million for the same period in 2011. The improvement in the Company’s financial results primarily reflects an increase in net premiums earned, a reduction in the combined ratio and an increase in net realized investment gains, partially offset by a change in accounting for deferred acquisition costs.
The consolidated combined ratio was 94.3% for the three months ended March 31, 2012, compared to a combined ratio of 97.8% for the same period in 2011. The decrease in the combined ratio primarily reflects growth in net premiums earned, the impact of audit premium and a reduction in the calendar period loss ratio. The increase in net premiums earned primarily reflects new business writings, renewal rate increases, and an increase in audit premium. For the three months ended March 31, 2012, the Company recognized additional audit premium from customers totaling $884,000, compared to audit premium returned to customers of $134,000 for the same period in 2011. The calendar period loss ratio decreased from 64.7% in 2011 to 62.8% in 2012, which primarily reflects the impact of the increase in audit premium.
The increase in net realized investment gains primarily reflects an increase in the estimated fair value of the Company’s convertible bond portfolio and gains recognized on the sale of equity securities in the segregated portfolio cell reinsurance segment.
Effective January 1, 2012, the Company adopted ASU 2010-26, which resulted in a decrease in the amount of underwriting salaries capitalized and deferred over the life of the underlying workers’ compensation insurance policies. The change in accounting resulted in the Company expensing underwriting salaries of approximately $726,000 ($472,000 net of tax) that would have been capitalized and deferred prior to the adoption of ASU 2010-26.
Principal Revenue and Expense Items
The Company derives its revenue primarily from net premiums earned, including assumed premiums earned, net investment income and net realized investment gains.
Direct and net premiums written. Direct premiums written is the sum of both direct premiums and assumed premiums before the effect of ceded reinsurance. Direct premiums written include all premiums billed during a specific policy period. Net premiums written is the difference between direct premiums written and premiums ceded or paid to reinsurers (ceded premiums written). In the segregated portfolio cell reinsurance segment, assumed premiums are derived from insurance contracts written by the Company and ceded to the segregated portfolio cells.
Net premiums earned. Net premiums earned are the earned portion of the Company’s net premiums written. Premiums are earned over the term of the related policies. At the end of each accounting period, the portion of the premiums that are not yet earned are included in unearned premiums and are realized as revenue in subsequent periods over the remaining term of the policy. The Company’s workers’ compensation policies typically have a term of twelve months. Workers’ compensation premiums are determined based upon the payroll of the insured, the applicable premium rates and, where applicable, an experience based modification factor. An audit of the insured’s records is conducted after policy expiration, to make a final determination of applicable premiums. Included with net premiums earned is an estimate for earned but unbilled (“EBUB”) premiums. The Company can estimate EBUB premiums because it keeps track, by policy, of how much additional premium is billed in final audit invoices to estimate the probable additional amount that it has earned but not yet billed as of the balance sheet date.
Net investment income and realized gains and losses on investments. The Company invests its surplus and the funds supporting its insurance liabilities (including unearned premiums and unpaid losses and LAE) in cash, cash equivalents, fixed income securities, convertible bonds, equity securities, and limited partnership investments. Investment income includes interest earned on invested assets, including the impact of premium amortization and discount accretion. Realized gains and losses on invested assets are reported separately from net investment income. The Company recognizes realized gains when invested assets are sold for an amount greater than their cost or amortized cost (in the case of fixed income securities) and recognizes realized losses when investment securities are written down as a result of an other than temporary impairment or sold for an amount less than their cost or amortized cost. Realized gains and losses also include the change in fair value of convertible bonds.
Other revenue. Other revenue includes fees earned for claim administration and risk management services provided to self-insured property/casualty customers. There are other revenue items that the Company recognizes on a segmental basis that are eliminated in consolidation. Such items consist primarily of fees paid by the segregated portfolio cells to other entities within the consolidated group. The segregated portfolio cells recognize an expense for such items (included as part of its ceding commission) and a
16
corresponding revenue item is recognized by the affiliate providing the service. For segment reporting purposes, such revenue items primarily include claims administration, risk management, and cell rental fees. Fronting fees are included in acquisition and other underwriting expenses as an offset to the direct costs incurred. For segment reporting purposes, such fees are recognized ratably over the period in which the service is provided, which generally corresponds to the earned portion of net premiums written for the underlying policies.
The Company’s expenses consist primarily of losses and LAE, acquisition and other underwriting expenses, other expenses, policyholder dividends, and income taxes:
Losses and LAE. Losses and LAE represent the largest expense item and include: (1) claim payments made, (2) estimates for future claim payments and changes in those estimates for prior periods, and (3) costs associated with investigating, defending and adjusting claims.
Acquisition and other underwriting expenses. In the workers’ compensation insurance segment, expenses incurred to underwrite risks are referred to as acquisition and other underwriting expenses, which consist of commissions, premium taxes, assessments and fees and other underwriting expenses incurred in acquiring, writing and administering the Company’s business. In the segregated portfolio cell reinsurance segment, acquisition and other underwriting expenses consist of ceding commissions incurred under the respective reinsurance agreements. Ceding commissions received in the workers’ compensation insurance segment are netted against acquisition and other underwriting expenses.
Other expenses. Other expenses consist of general administrative expenses such as salaries, stock compensation, rent, office supplies, depreciation and all other operating expenses not otherwise classified separately.
Policyholder dividend expense. Policyholder dividends represent the amount of dividends incurred during the period that are expected to be returned to policyholders. The dividend expense is based on the loss experience of the underlying workers’ compensation insurance policy.
Income tax expense. EIHI and certain of its subsidiaries pay federal, state and local income taxes. Income tax expense includes an amount for both current and deferred income taxes. Current income tax expense includes an amount for the Company’s current year federal income tax liability and any adjustments related to differences between the prior year federal income tax estimate and the actual income tax expense reported in the federal income tax return. Deferred tax expense represents the change in the Company’s net deferred tax asset, exclusive of the tax effect related to changes in unrealized gains and losses in the Company’s investment portfolio and changes in the unrecognized amounts related to the Company’s benefit plan liabilities.
Key Financial Measures
The Company evaluates its insurance operations by monitoring certain key measures of growth and profitability. The Company measures growth by monitoring changes in direct premiums written and net premiums written. The Company measures underwriting profitability by examining loss, expense, policyholder dividend expense and combined ratios. On a segmental basis, the Company measures a segment’s operating results by examining net income, diluted earnings per share, and return on average equity.
Loss ratio. The loss ratio is the ratio (expressed as a percentage) of losses and LAE incurred to net premiums earned and measures the underwriting profitability of a company’s insurance business. The Company measures the loss ratio on an accident year and calendar year loss basis to measure underwriting profitability. An accident year loss ratio measures losses and LAE for insured events occurring in a particular year, regardless of when they are reported, as a percentage of net premiums earned during that year. A calendar year loss ratio measures losses and LAE for insured events occurring during a particular year and the change in loss reserves from prior accident years as a percentage of net premiums earned during that year.
Expense ratio. The expense ratio is the ratio (expressed as a percentage) of the sum of the acquisition and other underwriting expenses and other expenses to net premiums earned and measures the Company’s operational efficiency in producing, underwriting and administering its insurance business.
Policyholder dividend expense ratio. The policyholder dividend expense ratio is the ratio (expressed as a percentage) of policyholder dividend expense to net premiums earned and measures the impact of the Company’s policyholder dividend policies on its workers’ compensation segment.
Combined ratio. The combined ratio is the sum of the loss ratio, expense ratio and policyholder dividend expense ratio and measures the Company’s overall underwriting profit. If the combined ratio is below 100%, the Company is making an underwriting profit. If the Company’s combined ratio is at or above 100%, the Company is not profitable without investment income and may not be profitable if investment income is insufficient.
17
Net income, diluted earnings per share, and return on average equity. The Company uses net income and diluted earnings per share to measure its profits and return on average equity to measure its effectiveness in utilizing shareholders’ equity to generate net income. In determining return on average equity for a given year, net income is divided by the average of the beginning and ending shareholders’ equity for that year.
Critical Accounting Policies and Estimates
The preparation of financial statements in accordance with U.S. GAAP requires both the use of estimates and judgment relative to the application of appropriate accounting policies. The Company is required to make estimates and assumptions in certain circumstances that affect amounts reported in the consolidated financial statements and related footnotes. The Company evaluates these estimates and assumptions on an on-going basis based on historical developments, market conditions, industry trends and other information that is believed to be reasonable under the circumstances. There can be no assurance that actual results will conform to the estimates and assumptions and that reported results of operations will not be materially adversely affected by the need to make accounting adjustments to reflect changes in these estimates and assumptions from time to time. The Company believes the following policies are the most sensitive to estimates and judgments.
Reserves for Unpaid Losses and LAE
The Company establishes reserves for unpaid losses and LAE for its workers’ compensation and segregated portfolio cell reinsurance products, which are estimates of future payments of reported and unreported claims for losses and related expenses. The adequacy of the Company’s reserves for unpaid losses and LAE are inherently uncertain because the ultimate amount that the Company may pay under many of the claims incurred as of the balance sheet date will not be known for many years. Establishing reserves is an imprecise process, requiring the use of informed estimates and judgments. The Company’s estimates and judgments may be revised as additional experience and other data becomes available and are reviewed, as new or improved methodologies are developed, or as current laws change. Any such revisions could result in future changes in estimates of losses or reinsurance recoverables and would be reflected in the Company’s results of operations in the period in which the estimates are changed. Estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management’s informed estimates and judgments using data currently available. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded as of March 31, 2012, the related adjustments could have a material adverse effect on the Company’s financial condition, results of operations or liquidity.
The Company discounts its workers’ compensation insurance reserves, using a discount rate of approximately 3.0%. As of March 31, 2012 and December 31, 2011, the Company’s reserves for unpaid losses and LAE were reduced by $6.0 million and $5.7 million, respectively, related to the effects of discounting.
The Company’s reserves for unpaid losses and LAE in its workers’ compensation insurance, segregated portfolio cell reinsurance and corporate/other segments as of March 31, 2012 (unaudited) and December 31, 2011 are summarized below (in thousands):
March 31, 2012 |
Workers’ Compensation Insurance |
Segregated Portfolio Cell Reinsurance |
Corporate/Other | Total | ||||||||||||
Case/tabular reserves |
$ | 41,092 | $ | 8,989 | $ | — | $ | 50,081 | ||||||||
Case incurred development, IBNR, and unallocated LAE reserves |
36,151 | 13,676 | 206 | 50,033 | ||||||||||||
Amount of discount |
(4,810 | ) | (1,216 | ) | — | (6,026 | ) | |||||||||
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|
|
|
|
|||||||||
Net reserves |
72,433 | 21,449 | 206 | 94,088 | ||||||||||||
Reinsurance recoverables on unpaid losses and LAE |
9,277 | 4,408 | — | 13,685 | ||||||||||||
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|
|
|
|
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Reserves for unpaid losses and LAE |
$ | 81,710 | $ | 25,857 | $ | 206 | $ | 107,773 | ||||||||
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December 31, 2011 |
Workers’ Compensation Insurance |
Segregated Portfolio Cell Reinsurance |
Corporate/Other | Total | ||||||||||||
Case/tabular reserves |
$ | 39,380 | $ | 10,229 | $ | — | $ | 49,609 | ||||||||
Case incurred development, IBNR, and unallocated LAE reserves |
37,249 | 12,931 | 206 | 50,386 | ||||||||||||
Amount of discount |
(4,527 | ) | (1,196 | ) | — | (5,723 | ) | |||||||||
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Net reserves |
72,102 | 21,964 | 206 | 94,272 | ||||||||||||
Reinsurance recoverables on unpaid losses and LAE |
9,007 | 2,798 | — | 11,805 | ||||||||||||
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Reserves for unpaid losses and LAE |
$ | 81,109 | $ | 24,762 | $ | 206 | $ | 106,077 | ||||||||
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18
“Other Than Temporary” Investment Impairments
Unrealized investment gains or losses on investments carried at estimated fair value, net of applicable income taxes, are reflected directly in shareholders’ equity as a component of accumulated other comprehensive income (loss) and, accordingly, have no effect on net income. When, in the opinion of management, a decline in the fair value of an investment below its cost or amortized cost is considered to be “other-than- temporary,” such investment is written down to its fair value at the balance sheet date. The amount written down is recorded as a realized loss in the consolidated statements of operations and comprehensive income (loss). Generally, the determination of other-than-temporary impairment includes, in addition to other relevant factors, a presumption that if the market value is below cost by a significant amount for a period of time, a write-down is necessary. Notwithstanding this presumption, the determination of other-than-temporary impairment requires judgment about future prospects for an investment and is therefore a matter of inherent uncertainty. For the three months ended March 31, 2012, the Company did not record any other-than-temporary impairments, excluding impairments in the segregated portfolio cell reinsurance segment. Other-than-temporary impairments in the segregated portfolio cell reinsurance segment totaled $0 and $1,000 for the three months ended March 31, 2012 and 2011, respectively.
The Company generally applies the following standards in determining whether the decline in fair value of an investment is other-than-temporary:
Equity securities. An equity security is considered impaired when one of the following conditions exist: 1) an equity security’s market value is less than 80% of its cost for a continuous period of 6 months, 2) an equity security’s market value is less than 50% of its cost, regardless of the amount of time the security’s market value has been below cost, and 3) an equity security’s market value has been less than cost for a continuous period of 12 months or more, regardless of the magnitude of the decline in market value. Equity securities that are in an unrealized loss position, but do not meet the above quantitative thresholds are evaluated to determine if the decline in market value is other than temporary.
There were no other-than-temporary impairments related to the Company’s equity security portfolio for the three months ended March 31, 2012 or 2011.
As of March 31, 2012, the Company held equity securities, excluding equity securities in the segregated portfolio cell reinsurance segment, with gross unrealized losses of $82,000, none of which were in an unrealized loss position for more than twelve months. The Company does not intend to sell the equity securities and it is not more likely than not that the Company will be required to sell the equity securities before recovery of their cost bases; therefore, management does not consider the equity securities to be other-than-temporarily impaired as of March 31, 2012. Adverse investment market conditions, or poor operating results of underlying investments, could result in impairment charges in the future.
Fixed income securities. A fixed income security is considered to be other-than-temporarily impaired when the security’s estimated fair value is less than its amortized cost basis and 1) the Company intends to sell the security, 2) it is more likely than not that the Company will be required to sell the security before recovery of the security’s amortized cost basis, or 3) the Company believes it will be unable to recover the entire amortized cost basis of the security (i.e., a credit loss has occurred). When the Company determines a credit loss has been incurred, but the Company does not intend to sell the security and it is not more likely than not that the Company will be required to sell the security before recovery of the security’s amortized cost basis, the portion of the other-than-temporary impairment that is credit related is recorded as a realized loss in the consolidated statements of operations and comprehensive income (loss), and the portion of the other-than-temporary impairment that is not credit related is included in other comprehensive income (loss). A fixed income security is reviewed for potential credit loss if any of the following situations occur:
• | A review of the financial condition and prospects of the issuer indicates that the security should be evaluated; |
• | Moody’s or Standard & Poor’s rate the security below investment grade; or |
• | The security has a market value below 80% of amortized cost due to deterioration in credit quality. |
There were no other-than-temporary impairments related to the Company’s fixed income security portfolio for the three months ended March 31, 2012 or 2011.
As of March 31, 2012, the Company held fixed income securities, excluding fixed income securities in the segregated portfolio cell reinsurance segment, with gross unrealized losses of $91,000, none of which were in an unrealized loss position for more than twelve months. Management has evaluated the unrealized losses related to those fixed income securities and determined that they are primarily due to a fluctuation in interest rates and not to credit issues of the issuer or the underlying assets in the case of asset-backed securities. The Company does not intend to sell the fixed income securities and it is not more likely than not that the Company will be required to sell the fixed income securities before recovery of their amortized cost bases, which may be maturity; therefore, management does not consider the fixed income securities to be other–than-temporarily impaired as of March 31, 2012. Adverse investment market conditions, or poor operating results of underlying investments, could result in impairment charges in the future.
19
Limited partnerships. A limited partnership investment is generally written down if the Company is unable to hold or otherwise intends to sell its interest in the limited partnership at a loss, or if management has received information that suggests the Company will be unable to recover its original investment in the limited partnership. The amount written down is recorded in the change in equity interest in limited partnerships in the consolidated statement of operations and comprehensive income (loss).
There were no other-than-temporary impairments related to the Company’s limited partnership investments for the three months ended March 31, 2012 or 2011.
Goodwill
In accordance with the requirements of ASC 350, Intangibles – Goodwill and Other, goodwill is not amortized but is tested for impairment at the reporting unit level, which is at the operating segment level or one level below an operating segment. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. Goodwill is required to be tested for impairment annually and between annual tests if events or circumstances change, such as adverse changes in the business climate, that would more likely than not reduce the fair value of the reporting unit below its carrying value.
Goodwill is assigned to one or more reporting units at the date of acquisition. The Company has allocated 100% of the goodwill recorded on its consolidated balance sheet as of March 31, 2012 to its workers’ compensation insurance segment.
The Company performs its annual goodwill impairment test as of September 30. The Company adopted Accounting Standards Update No. 2011-08 (“ASU 2011-08”), “Testing Goodwill for Impairment”, effective September 30, 2011. Under ASU 2011-08, the Company assessed certain qualitative factors to determine if it was more likely than not that the fair value of the workers’ compensation insurance segment was less than its carrying amount. As a result of this assessment, it was determined that it was not more likely than not that fair value of the workers’ compensation insurance segment was less than its carrying amount; therefore, the performance of the two-step impairment test was not required.
We did not evaluate goodwill for impairment as of March 31, 2012 as no events occurred or circumstances changed that would have more likely than not reduced the fair value of the workers’ compensation insurance segment below its carrying amount since September 30, 2011.
In the event the operating results of the Company’s workers’ compensation insurance segment were to be adversely impacted by a significant loss of business or higher than expected losses and LAE, management’s internal forecast may need to be re-evaluated, which could result in a fair value that is less than the carrying value of the workers’ compensation insurance segment and the need to recognize a goodwill impairment.
Deferred Income Taxes
The temporary differences between the tax and book bases of assets and liabilities are recorded as deferred income taxes. Management evaluates the recoverability of the net deferred tax asset based on historical trends of generating taxable income or losses, as well as expectations of future taxable income or loss. As of March 31, 2012, the Company recorded a net deferred tax asset of $1.7 million. Management expects that the net deferred tax asset is fully recoverable. If this assumption were to change, any amount of the net deferred tax asset that the Company could not expect to recover would be provided for as an allowance and would be reflected as an increase in income tax expense in the period in which it was established.
As of March 31, 2012, the Company has not recognized any future tax benefit related to its foreign operations at Eastern Re. The unrecognized tax benefit, which represents the excess of the tax basis over the amount for financial reporting (i.e., outside basis difference) of Eastern Re, was $11,136 as of March 31, 2012. The outside basis difference primarily arises from losses at Eastern Re recognized for financial statement purposes, which have not yet been recognized for tax purposes. Management presently believes that the Company will not be able to recognize these tax benefits in the foreseeable future and, therefore, has not recognized the future tax benefits as of March 31, 2012.
Reinsurance Recoverables
Amounts recoverable from the Company reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Amounts paid for reinsurance contracts are expensed over the contract period during which insured events are covered by the reinsurance contracts. Reinsurance balances recoverable on paid and unpaid losses and LAE are reported separately as assets, instead of being netted with the appropriate liabilities, because reinsurance does not relieve the Company of its legal liability to its policyholders. Reinsurance balances recoverable are subject to credit risk associated with the particular reinsurer. Additionally, the same uncertainties associated with estimating unpaid losses and LAE affect the estimates for the ceded portion of these liabilities. The Company continually monitors the financial condition of its reinsurers.
20
Recent Accounting Pronouncements
Presentation of Comprehensive Income
In June 2011, the FASB issued ASU 2011-05, “Presentation of Comprehensive Income” (“ASU 2011-05”). ASU 2011-05 requires entities to present net income and comprehensive income in either a single continuous statement or in two separate, but consecutive, statements of net income and other comprehensive income. The option to present items of other comprehensive income in the statement of changes in equity was eliminated. ASU 2011-05 was effective for public entities as of the beginning of a fiscal year that began after December 15, 2011 (including interim periods) and is effective for nonpublic entities for fiscal years ending after December 15, 2012 and interim and annual periods thereafter. Early adoption was permitted and retrospective application is required. The Company adopted ASU 2011-05 effective January 1, 2012. The Company presents comprehensive income in the consolidated statement of operations and comprehensive income; therefore, the adoption of ASU 2011-05 did not change the Company’s presentation of comprehensive income.
Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts
In October 2010, the FASB issued ASU 2010-26, “Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts” (“ASU 2010-26”). ASU 2010-26 provides specific types of costs that should be capitalized in connection with the acquisition or renewal of insurance contracts. Those costs include incremental direct costs of contract acquisition incurred in connection with independent third parties and certain costs related to activities performed by the insurer for the contract, including underwriting, policy issuance and processing, medical and inspection, and sales force contract selling. Under ASU 2010-26, costs incurred by an entity related to unsuccessful acquisition or renewal efforts must be charged to expense as incurred. ASU 2010-26 was effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011 and is to be applied prospectively. Retrospective application to all prior periods upon the date of adoption was permitted, but not required. The Company adopted ASU 2010-26 effective January 1, 2012 and applied it prospectively. As a result of adoption, the Company expensed underwriting salaries totaling approximately $726,000 ($472,000 net of tax) that would have been capitalized under the previous accounting guidance to give effect to unsuccessful acquisition or renewal activities. The adoption of ASU 2012-26 increased the Company’s consolidated expense ratio by 2.0 percentage points for the three months ended March 31, 2012. If the new accounting guidance had been adopted effective January 1, 2011, the Company would have recognized additional expense related to underwriting salaries totaling $499,000 ($324,000 net of tax) for the three months ended March 31, 2011, which would have increased the Company’s consolidated expense ratio by 1.7 percentage points.
THREE MONTHS ENDED MARCH 31, 2012 COMPARED TO THREE MONTHS ENDED MARCH 31, 2011
RESULTS OF OPERATIONS
The major components of consolidated revenue were as follows for the three months ended March 31, 2012 and 2011 (unaudited, in thousands):
2012 | 2011 | |||||||
Net premiums written |
$ | 51,617 | $ | 43,348 | ||||
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Net premiums earned |
$ | 36,486 | $ | 29,877 | ||||
Net investment income |
950 | 1,025 | ||||||
Change in equity interest in limited partnerships |
330 | 551 | ||||||
Net realized investment gains |
1,691 | 830 | ||||||
Other revenue |
84 | 183 | ||||||
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Consolidated revenue |
$ | 39,541 | $ | 32,466 | ||||
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The increase in consolidated revenue primarily reflects the increase in net premiums written and net realized investment gains, partially offset by a decrease in net investment income, the change in equity interest in limited partnerships and other revenue.
The components of consolidated net income, by segment, for the three months ended March 31, 2012 and 2011 were as follows (unaudited, in thousands):
2012 | 2011 | |||||||
Workers’ compensation insurance |
$ | 3,148 | $ | 2,656 | ||||
Segregated portfolio cell reinsurance |
— | — | ||||||
Corporate/other |
(226 | ) | (776 | ) | ||||
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Consolidated net income |
$ | 2,922 | $ | 1,880 | ||||
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The increase in consolidated net income primarily reflects the decrease in the workers’ compensation insurance loss ratio and an increase in net realized investment gains in the workers’ compensation insurance segment, and a decrease in stock compensation expense in the corporate/other segment. The decrease in stock compensation expense primarily reflects the full vesting of stock options and restricted stock granted to employees and directors in January 2007, partially offset by stock compensation expense related to the stock options and restricted stock granted in February 2012.
21
WORKERS’ COMPENSATION INSURANCE
The following table represents the operations of the workers’ compensation insurance segment for the three months ended March 31, 2012 and 2011 (unaudited, in thousands):
2012 | 2011 | |||||||
Revenue: |
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Direct premiums written |
$ | 55,659 | $ | 46,601 | ||||
Reinsurance premiums assumed |
535 | 332 | ||||||
Ceded premiums written |
(16,757 | ) | (13,967 | ) | ||||
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Net premiums written |
39,437 | 32,966 | ||||||
Change in unearned premiums |
(10,441 | ) | (9,384 | ) | ||||
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Net premiums earned |
28,996 | 23,582 | ||||||
Net investment income |
798 | 877 | ||||||
Change in equity interest in limited partnerships |
259 | 468 | ||||||
Net realized investment gains |
1,204 | 760 | ||||||
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Total revenue |
$ | 31,257 | $ | 25,687 | ||||
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Expenses: |
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Losses and LAE incurred |
$ | 18,566 | $ | 15,642 | ||||
Acquisition and other underwriting expenses |
3,266 | 2,108 | ||||||
Other expenses |
4,559 | 3,697 | ||||||
Policyholder dividend expense |
169 | 308 | ||||||
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Total expenses |
26,560 | 21,755 | ||||||
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Income before income taxes |
4,697 | 3,932 | ||||||
Income tax expense |
1,549 | 1,276 | ||||||
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Net income |
$ | 3,148 | $ | 2,656 | ||||
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The workers’ compensation insurance ratios were as follows for the three months ended March 31, 2012 and 2011:
2012 | 2011 | |||||||
Loss and LAE ratio |
64.0 | % | 66.3 | % | ||||
Expense ratio |
27.0 | % | 24.6 | % | ||||
Policyholder dividend expense ratio |
0.6 | % | 1.3 | % | ||||
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Combined ratio |
91.6 | % | 92.2 | % | ||||
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Premiums
The increase in direct premiums written primarily reflects new business sales of $10.6 million, renewal rate increases of 4.0%, and an increase in audit premium, partially offset by a decline in the renewal retention rate from 2011 to 2012. The renewal retention rate decreased from 90.4% in 2011 to 84.7% in 2012. For the three months ended March 31, 2012, the Company recognized additional audit premium from customers totaling $884,000 in the aggregate related to its traditional and alternative market books of business, compared to audit premium returned to customers of $134,000 for the same period in 2011. The Company recognized additional audit premium from customers of $1.1 million related to its traditional book of business for the three months ended March 31, 2012, compared to additional audit premium of $272,000 for the same period in 2011.
Net Investment Income
The decrease in net investment income primarily reflects a decrease in the average yield on the fixed income portfolio. The average yield was 2.97% as of March 31, 2012, compared to 3.34% as of March 31, 2011.
Net Realized Investment Gains
The increase in net realized investment gains primarily reflects an increase in the estimated fair value of the Company’s convertible bond portfolio. The estimated fair value of the convertible bond portfolio increased $1.0 million for the three months ended March 31, 2012, compared to $421,000 for the same period in 2011.
22
Losses and LAE
The decrease in the calendar period loss and LAE ratio primarily reflects the impact of audit premium. Audit premium reduced the 2012 loss and LAE ratio by 2.5 percentage points, compared to a reduction of 0.8 percentage points in 2011. There was no prior year reserve development recognized in 2012 or 2011.
Acquisition and Other Underwriting Expenses and Other Expenses
The acquisition and other underwriting expense ratio increased from 8.9% in 2011 to 11.3% in 2012. The increase primarily reflects the change in accounting for deferred acquisition costs, which increased the expense ratio for the three months ended March 31, 2012 by 2.5 percentage points.
The other expense ratio remained consistent at 15.7% from 2011 to 2012.
Policyholder Dividends
The increase in the policyholder dividend expense primarily reflects the loss experience of underlying policies related to policies with a 2012 and 2011 policy effective date, partially offset by a decrease in expense related to policies with a 2010 policy effective date. For the three months ended March 31, 2012 and 2011, 8.8% and 10.6%, respectively, of all policies were written on a dividend policy basis.
Tax Expense
The effective tax rate for the three months ended March 31, 2012 and 2011 was 33.0% and 32.5%, respectively. The primary difference between the statutory rate of 35.0% and the effective tax rate reflects tax-exempt income on municipal bond securities.
SEGREGATED PORTFOLIO CELL REINSURANCE
The following table represents the operations of the segregated portfolio cell reinsurance segment for the three months ended March 31, 2012 and 2011 (unaudited, in thousands):
2012 | 2011 | |||||||
Revenue: |
||||||||
Reinsurance premiums assumed |
$ | 13,190 | $ | 11,244 | ||||
Ceded premiums written |
(1,010 | ) | (862 | ) | ||||
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|
|
|
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Net premiums written |
12,180 | 10,382 | ||||||
Change in unearned premiums |
(4,690 | ) | (4,087 | ) | ||||
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|
|
|
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Net premiums earned |
7,490 | 6,295 | ||||||
Net investment income |
88 | 109 | ||||||
Net realized investment gains |
460 | 37 | ||||||
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|
|
|||||
Total revenue |
$ | 8,038 | $ | 6,441 | ||||
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|
|
|
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Expenses: |
||||||||
Losses and LAE incurred |
$ | 4,349 | $ | 3,703 | ||||
Acquisition and other underwriting expenses |
2,292 | 1,874 | ||||||
Other expenses |
98 | 64 | ||||||
Policyholder dividend expense |
14 | 5 | ||||||
Segregated portfolio dividend expense (1) |
1,285 | 795 | ||||||
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|
|
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Total expenses |
8,038 | 6,441 | ||||||
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|
|
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Net income (1) |
$ | — | $ | — | ||||
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(1) | The workers’ compensation insurance and corporate/other segments provide services to the segregated portfolio cell reinsurance segment. The fees paid by the segregated portfolio cell reinsurance segment for these services are included in the revenue of the segment providing the service. The segregated portfolio cell reinsurance segment records the fees associated with these services as ceding expense, which is included in its underwriting expenses. The difference between total revenue for the segregated portfolio cell reinsurance segment for each period and the sum of losses and LAE, acquisition and other underwriting expenses, other expenses, and policyholder dividend expense is accrued as a segregated portfolio dividend expense. As a result, the segregated portfolio cell reinsurance segment has no net income for the period presented in this table. |
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The segregated portfolio cell reinsurance ratios were as follows for the three months ended March 31, 2012 and 2011:
2012 | 2011 | |||||||
Loss and LAE ratio |
58.1 | % | 58.8 | % | ||||
Expense ratio |
31.9 | % | 30.8 | % | ||||
Policyholder dividend expense ratio |
0.2 | % | 0.1 | % | ||||
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|
|
|
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Combined ratio |
90.2 | % | 89.7 | % | ||||
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|
|
Reinsurance Premiums Assumed
The increase in reinsurance premiums assumed primarily reflects new business sales of $1.4 million, renewal rate increases of 4.2%, an improvement in audit premium, and an increase in the renewal retention rate from 2011 to 2012. The renewal retention rate increased from 91.6% in 2011 to 94.4% in 2012. For the three months ended March 31, 2012, the Company returned premium to customers totaling $195,000, compared to return premium of $406,000 for the same period in 2011.
Net Investment Income
The decrease in net investment income primarily reflects the sale of the segregated cells’ fixed income securities and reinvestment of the proceeds into a fixed income mutual fund during the fourth quarter of 2011. The fixed income mutual fund invests in high grade U.S. Dollar fixed income securities with maturities not exceeding five years.
Net Realized Investment Gains
The increase in net realized investment gains primarily reflects the sale of the segregated cells’ equity securities and reinvestment of the proceeds into various equity mutual funds during the first quarter of 2012.
Losses and LAE
The decrease in the calendar period loss and LAE ratio primarily reflects a decrease in the accident period loss ratio and the impact of audit premium, partially offset by decrease in favorable loss reserve development on prior accident periods. Audit premium increased the 2012 loss and LAE ratio by 1.5 percentage points, compared to an increase of 3.5 percentage points in 2011. The accident period loss ratio was 65.6% and 69.9% for the three months ended March 31, 2012 and 2011, respectively. Favorable loss reserve development totaled $566,000 and $699,000 for the three months ended March 31, 2012 and 2011, respectively.
Acquisition and Other Underwriting Expenses
The expense ratios are consistent with the contractual ceding commissions for the three months ended March 31, 2012 and 2011.
Segregated Portfolio Dividend Expense
The segregated portfolio dividend expense represents the amount of net income or loss in a specific period that may be payable to the segregated portfolio dividend participants.
24
CORPORATE/OTHER
The following table represents the operations of the corporate/other segment for the three months ended March 31, 2012 and 2011 (unaudited, in thousands):
3/31/12 | 3/31/11 | |||||||
Revenue: |
||||||||
Net investment income |
$ | 64 | $ | 39 | ||||
Change in equity interest in limited partnerships |
71 | 83 | ||||||
Net realized investment gains |
27 | 33 | ||||||
Other revenue |
84 | 183 | ||||||
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|
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Total revenue |
$ | 246 | $ | 338 | ||||
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|
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|
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Expenses: |
||||||||
Acquisition and other underwriting expenses |
$ | (126 | ) | $ | (564 | ) | ||
Other expenses |
1,030 | 2,128 | ||||||
Amortization of intangibles |
202 | 254 | ||||||
Segregated portfolio dividend expense |
(289 | ) | (269 | ) | ||||
|
|
|
|
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Total expenses |
$ | 817 | $ | 1,549 | ||||
|
|
|
|
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Loss before income taxes |
(571 | ) | (1,211 | ) | ||||
Income tax benefit |
(345 | ) | (435 | ) | ||||
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|
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|
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Net loss |
$ | (226 | ) | $ | (776 | ) | ||
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|
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Revenue
The decrease in revenue primarily reflects the loss of a large third party administration customer in the first quarter of 2011.
Expenses
The decrease in expenses primarily reflects a change in the Company’s internal organizational structure and a decrease in stock compensation expense. Effective January 1, 2012, expenses related to the Company’s executive officers are included in the workers’ compensation insurance segment. Executive expenses included in the corporate/other segment for the three months ended March 31, 2011 totaled approximately $660,000. Stock compensation expense totaled $386,000 for the three months ended March 31, 2012, compared to $583,000 for the same period in 2011.
Income Tax Benefit
The effective tax rate was 60.4% for the three months ended March 31, 2012, compared to 35.9% for the same period in 2011. The increase in the income tax benefit from 2011 to 2012 primarily relates to the Company’s outside basis difference in its foreign operations.
CONSOLIDATED FINANCIAL POSITION
Consolidated assets totaled $364.6 million at March 31, 2012, compared to $345.7 million at December 31, 2011. The increase in consolidated assets primarily reflects an increase in investments, premiums receivable, reinsurance recoverables, and other assets, partially offset by a decrease in cash and cash equivalents and federal income taxes recoverable. The increase in investments primarily reflects the increase in the estimated fair value of the Company’s convertible bond and equity securities and the purchase of fixed income securities. Premiums receivable are higher as of March 31 as a result of the high volume of workers’ compensation business with a January 1 effective date. The increase in reinsurance recoverables primarily reflects amounts due from reinsurers related to two large claims in the segregated portfolio cell reinsurance segment. The increase in other assets primarily reflects an increase in prepaid reinsurance premiums and deductibles receivable. The increase in prepaid reinsurance premiums reflects January 1 renewals, while the increase in the deductible receivable reflects the timing of claims paid on deductible policies that are due from insureds. The decrease in cash primarily reflects the settlement of a large number of outstanding claims during the first quarter of 2012, the purchase of investments and the payment of the first quarter shareholder dividend. The decrease in the federal income tax recoverable primarily reflects the estimated tax liability based on the Company’s results of operations for the three months ended March 31, 2012.
Consolidated liabilities totaled $232.8 million at March 31, 2012, compared to $217.4 million at December 31, 2011. The increase in consolidated liabilities primarily reflects an increase in loss and LAE reserves, unearned premiums and ceded reinsurance balances payable, partially offset by a decrease in advance premium and accounts payable and accrued expenses. The increase in loss and LAE reserves primarily reflects the increase in net premiums earned, partially offset by the claim settlements noted above. Unearned premiums and ceded reinsurance balances payable are higher as of March 31 as a result of the high volume of workers’ compensation business with a January 1 effective date. The decrease in advance premium primarily reflects the timing of premium receipts prior to the policy effective date, which is typically higher at December 31 due to the volume of January 1 policy renewals. The decrease in accounts payable and accrued expenses primarily reflects the payment of the 2010 Pennsylvania employer assessment, 2011 premium tax liabilities, and 2011 employee bonuses in the first quarter of 2012.
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Consolidated equity totaled $131.8 million at March 31, 2012, compared to $128.3 million at December 31, 2011. The increase in consolidated equity primarily reflects net income for the three months ended March 31, 2012 and an increase in the estimated fair value of the Company’s equity securities, partially offset by the first quarter 2012 shareholder dividend.
LIQUIDITY AND CAPITAL RESOURCES
The Company’s principal sources of funds are premiums, investment income, and proceeds from sales and maturities of investments. The Company’s primary use of funds is to pay claims and operating expenses and to purchase investments.
The Company’s investment portfolio is structured so that investments mature periodically over time in reasonable relation to current expectations of future claim payments. Currently, claim payments are made from operating cash flows, with excess cash invested in investment securities. As securities mature, management intends to invest excess cash with appropriate durations to fund anticipated future claim payments. Management does not anticipate having to sell securities in its investment portfolios to fund claims or operating expenses. In the event the sale of securities becomes necessary, the Company may incur losses on those sales, which would adversely affect its results of operations and could reduce net investment income.
The Company has a $10.0 million revolving line of credit available to provide additional liquidity if needed. The line of credit matures on May 2, 2013 and may be renewed annually for additional periods expiring on May 1 at the lender’s discretion. Outstanding balances under the line of credit bear interest at an adjustable monthly rate equal to LIBOR plus 2.0% per annum. There were no outstanding balances under the line of credit as of March 31, 2012.
Our domestic insurance subsidiaries’ ability to pay dividends to EIHI is limited by the insurance laws and regulations of Pennsylvania and Indiana. The maximum annual dividends that the domestic insurance entities may pay without prior approval from the Pennsylvania Insurance Department and the Indiana Insurance Department is limited to the greater of 10.0% of statutory surplus or 100% of statutory net income for the most recently filed annual statement. Eastern Re must receive approval from the Cayman Islands Monetary Authority before it can pay any dividend to the Company.
CASH FLOWS
Cash flows for the three months ended March 31, 2012 and 2011 were as follows (unaudited, in thousands):
2012 | 2011 | |||||||
Cash flows provided by operating activities |
$ | 163 | $ | 5,384 | ||||
Cash flows (used in) provided by investing activities |
(1,910 | ) | 3,509 | |||||
Cash flows used in financing activities |
(561 | ) | (7,152 | ) | ||||
|
|
|
|
|||||
Net (decrease) increase in cash and cash equivalents |
$ | (2,308 | ) | $ | 1,741 | |||
|
|
|
|
Cash flows from operating activities consist primarily of cash receipts and disbursements related to premiums, investment income, claims and related adjustment expenses, operating expenses, policyholder dividends and income taxes. Cash flows from investing activities consist primarily of purchases and sales of investments and purchases of fixed assets. Cash flows from financing activities primarily consist of cash disbursements for repurchases of the Company’s common stock and shareholder dividends.
The decrease in cash provided by operating activities from 2011 to 2012 primarily reflects the settlement of a large number of outstanding claims and the payment of 2011 employee bonuses during the first quarter of 2012, partially offset by an increase in net premiums written.
The increase in cash used in investing activities from 2011 to 2012 primarily reflects the liquidation of investments at EIHI to fund the Company’s repurchase of its common stock during the first quarter of 2011. The increase in cash used to purchase fixed income securities primarily reflects purchases in the workers’ compensation insurance segment. The increase in proceeds from the sale of equity securities primarily reflects the sale of equity securities in the segregated portfolio reinsurance segment.
The decrease in cash flows used in financing activities primarily reflects a decrease in stock repurchases. The Company did not repurchase any of its common stock in 2012, compared to repurchases totaling $6.5 million in 2011.
OFF-BALANCE SHEET ARRANGEMENTS
The Company has no off-balance sheet arrangements that have or are reasonably likely to have a current or, as of March 31, 2012, future effect on the Company’s financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
26
Item 3. | Quantitative and Qualitative Disclosures About Market Risk |
The Company is subject to market risk with respect to its fixed income investment portfolio. The most significant components of market risk affecting the Company are credit risk and interest rate risk. The Company is also subject to equity risk with respect to its investment in equity securities.
There have been no material changes in the Company’s market risk since December 31, 2011. Additional disclosures related to the Company’s market risk are discussed under “Quantitative and Qualitative Disclosures About Market Risk” in Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 12, 2012.
Item 4. | Controls and Procedures |
Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including the President and Chief Executive Officer, the Executive Vice President, Treasurer and Chief Financial Officer and the Vice President of Finance, we have evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a – 15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report. Based on that evaluation, the President and Chief Executive Officer, the Executive Vice President, Treasurer and Chief Financial Officer and the Vice President of Finance have concluded that, as of the end of such period, these disclosure controls and procedures are effective.
Changes in Internal Control Over Financial Reporting
There have not been any changes in our internal control over financial reporting (as such term is defined in Rules 13a – 15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
27
Item 1. | Legal Proceedings |
None
Item 1A. | Risk Factors |
There are no material changes from the risk factors previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, SEC File No. 001-32899.
Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds |
Issuer Purchases of Equity Securities
As of March 31, 2012, the Company has repurchased 3,850,568 shares of its common stock. Under the current plan, authorized by the Company’s Board of Directors, the Company may repurchase up to an additional 1,086,567 shares. The share repurchases will be held as treasury stock and are available for issuance in connection with the Company’s Stock Incentive Plan.
There were no purchases of our common stock during the three months ended March 31, 2012. The following table presents information with respect to those purchases of our common stock made during the three months ended March 31, 2011.
Period |
Total number
of shares purchased |
Average price paid per share |
Total number
of shares purchases as part of publicly announced plans or programs |
Maximum number (or approximate dollar value) of shares that may yet be purchased under the plans or programs (a) |
||||||||||||
January 1-31, 2011 |
129,110 | $ | 12.34 | 129,110 | 988,506 | |||||||||||
February 1-28, 2011 |
31,976 | $ | 13.02 | 31,976 | 956,530 | |||||||||||
March 1-31, 2011 |
358,147 | $ | 12.57 | 358,147 | 598,383 | |||||||||||
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|
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|
|
|
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Total |
519,233 | $ | 12.54 | 519,233 | ||||||||||||
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|
|
|
|
Item 3. | Defaults Upon Senior Securities |
None
Item 4. | Mine Safety Disclosures |
Not applicable.
Item 5. | Other Information |
None
28
Item 6. | Exhibits |
Exhibits
Exhibit No. |
Title | |
3.1 | Articles of Incorporation of Eastern Insurance Holdings, Inc. (Incorporated by reference from Exhibit 3.1 to the Eastern Insurance Holdings, Inc. Registration Statement No. 333-128913 on Form S-1) | |
3.2 | Bylaws of Eastern Insurance Holdings, Inc. (Incorporated by reference from Exhibit 3.2 to the Eastern Insurance Holdings, Inc. Registration Statement No. 333-128913 on Form S-1) | |
31.1 | Certification of Chief Executive Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002 | |
31.2 | Certification of Chief Financial Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002 | |
32.1 | Certification of Chief Executive Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002 | |
32.2 | Certification of Chief Financial Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002 | |
101 | Interactive data files pursuant to Rule 405 of Regulation S-T: (i) the Consolidated Balance Sheets as of March 31, 2012 and December 31, 2011, (ii) the Consolidated Statements of Operations and Comprehensive Income (Loss) for the three months ended March 31, 2012 and 2011, (iii) the Consolidated Statements of Changes in Shareholders’ Equity for the three months ended March 31, 2012 and 2011, (iv) the Consolidated Statements of Cash Flows for the three months ended March 31, 2012 and 2011, and (v) the Notes to Consolidated Financial Statements, tagged as blocks of text. |
29
SIGNATURES
In accordance with the requirements of the Exchange Act, the Registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
EASTERN INSURANCE HOLDINGS, INC. (Registrant) | ||||||
Dated: May 3, 2012 | By: | /s/ Michael L. Boguski | ||||
Michael L. Boguski, | ||||||
President and Chief Executive Officer | ||||||
Dated: May 3, 2012 | By: | /S/ KEVIN M. SHOOK | ||||
Kevin M. Shook, | ||||||
Executive Vice President, Treasurer and Chief Financial Officer |
30