UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

þ

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

For the quarterly period ended September 30, 2008

OR

o

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

For the transition period ended _________________ to _________________ 

Commission file number: 001-33245

EMPLOYERS HOLDINGS, INC.

(Exact name of registrant as specified in its charter)

 

  Nevada
(State or other jurisdiction of incorporation or
organization)

  04-3850065
(I.R.S. Employer Identification No.)
 

10375 Professional Circle, Reno, Nevada 89521

(Address of principal executive offices and zip code)

(888) 682-6671

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yesþ No o

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

 

Large accelerated filer o

Accelerated filer o

Non-accelerated filer þ

Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No þ

 

Class

 

November 5, 2008

Common Stock, $0.01 par value per share

 

48,830,140 shares outstanding


 

TABLE OF CONTENTS

 

 

 

 

 

Page
No.

 

 

PART I – FINANCIAL INFORMATION

 

 

Item 1

 

Consolidated Financial Statements

 

 

 

 

Consolidated Balance Sheets as of September 30, 2008 (Unaudited) and December 31, 2007.

 

3

 

 

Unaudited Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2008 and 2007

 

5

 

 

Unaudited Consolidated Statements of Stockholders’ Equity for the Nine Months Ended September 30, 2008 and 2007

 

6

 

 

Unaudited Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2008 and 2007

 

7

 

 

Unaudited Notes to Consolidated Financial Statements

 

8

Item 2

 

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

 

17

Item 3

 

Quantitative and Qualitative Disclosures About Market Risk

 

39

Item 4

 

Controls and Procedures

 

40

 

 

PART II – OTHER INFORMATION

 

 

Item 1

 

Legal Proceedings

 

41

Item 1A

 

Risk Factors

 

41

Item 2

 

Unregistered Sales of Equity Securities and Use of Proceeds

 

43

Item 3

 

Defaults Upon Senior Securities

 

43

Item 4

 

Submission of Matters to a Vote of Security Holders

 

43

Item 5

 

Other Information

 

43

Item 6

 

Exhibits

 

44

 

 

2

 


PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

Employers Holdings, Inc. and Subsidiaries

Consolidated Balance Sheet

(in thousands, except share data)

 

 

 

As of
September 30,
2008

 

As of
December 31,
2007

 

 

 

(unaudited)

 

 

 

Assets

 

 

 

 

 

 

 

Available for sale:

 

 

 

 

 

 

 

Fixed maturity investments at fair value (amortized cost $1,530,282 at September 30, 2008
and $1,594,159 at December 31, 2007)

 

$

1,500,206

 

$

1,618,903

 

Equity securities at fair value (cost $54,552 at September 30, 2008 and $60,551 at December 31, 2007)

 

 

79,452

 

 

 107,377

 

Short-term investments at fair value (amortized cost $70,884 at September 30, 2008)

 

 

70,386

 

 

 

 

 

 


 

 


 

Total investments

 

 

1,650,044

 

 

 1,726,280

 

               

Cash and cash equivalents

 

 

311,793

 

 

 149,703

 

Accrued investment income

 

 

18,853

 

 

 19,345

 

Premiums receivable, less bad debt allowance of $5,320 at September 30, 2008 and $6,037 at December 31, 2007

 

 

24,612

 

 

 36,402

 

Reinsurance recoverable for:

 

 

 

 

 

 

 

Paid losses

 

 

10,766

 

 

 10,218

 

Unpaid losses, less allowance of $1,308 at each period

 

 

1,024,871

 

 

 1,051,333

 

Funds held by or deposited with reinsureds

 

 

90,067

 

 

 95,884

 

Deferred policy acquisition costs

 

 

14,611

 

 

 14,901

 

Deferred income taxes, net

 

 

80,482

 

 

 59,730

 

Property and equipment, net

 

 

19,199

 

 

 14,133

 

Other assets

 

 

19,843

 

 

 13,299

 

 

 



 



 

Total assets

 

$

3,265,141

 

$

3,191,228

 

 

 



 



 

Liabilities and stockholders’ equity

 

 

 

 

 

 

 

Claims and policy liabilities:

 

 

 

 

 

 

 

Unpaid losses and loss adjustment expenses

 

$

2,212,400

 

$

2,269,710

 

Unearned premiums

 

 

59,061

 

 

 63,924

 

Policyholders’ dividends accrued

 

 

149

 

 

 386

 

 

 



 



 

Total claims and policy liabilities

 

 

2,271,610

 

 

 2,334,020

 

               

Commissions and premium taxes payable

 

 

5,381

 

 

 7,493

 

Federal income taxes payable

 

 

2,140

 

 

 13,884

 

Accounts payable and accrued expenses

 

 

18,490

 

 

 20,682

 

Deferred reinsurance gain - LPT Agreement

 

 

411,094

 

 

 425,002

 

Note payable

 

 

150,000

 

 

 

Other liabilities

 

 

11,818

 

 

 10,694

 

 

 



 



 

Total liabilities

 

 

2,870,533

 

 

 2,811,775

 

See accompanying unaudited notes to consolidated financial statements.

 

 

3

 


Employers Holdings, Inc. and Subsidiaries

Consolidated Balance Sheets

(in thousands, except share data)

 

 

 

As of
September 30,
2008

 

As of
December 31,
2007

 

 

 

 

(unaudited) 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

               

Stockholders’ equity:

 

 

 

 

 

 

 

Common stock, $0.01 par value; 150,000,000 shares authorized; 53,528,207 and 53,527,907
shares issued and 48,830,140 and 49,616,635 shares outstanding at
September 30, 2008, and at December 31, 2007, respectively

 

 

535

 

 

535

 

Preferred stock, $0.01 par value; 25,000,000 shares authorized; none issued

 

 

 

 

 

Additional paid-in capital

 

 

305,329

 

 

302,862

 

Retained earnings

 

 

181,584

 

 

104,536

 

Accumulated other comprehensive (loss) income, net

 

 

(3,688

)

 

46,520

 

Treasury stock, at cost (4,698,067 shares at September 30, 2008 and 3,911,272 shares at December 31, 2007)

 

 

(89,152

)

 

(75,000

)

 

 



 



 

Total stockholders’ equity

 

 

394,608

 

 

379,453

 

 

 



 



 

Total liabilities and stockholders’ equity

 

$

3,265,141

 

$

3,191,228

 

 

 



 



 

See accompanying unaudited notes to consolidated financial statements.

 

 

4

 


Employers Holdings, Inc. and Subsidiaries

Consolidated Statements of Income

(in thousands, except per share data)

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

(unaudited)

 

Revenues

 

 

 

 

 

 

 

 

 

 

 

 

 

Net premiums earned

 

$

73,131

 

$

88,527

 

$

222,842

 

$

262,436

 

Net investment income

 

 

18,474

 

 

19,246

 

 

55,915

 

 

59,386

 

Realized (losses) gains on investments, net

 

 

(1,504

)

 

146

 

 

(3,211

)

 

(322

)

Other income

 

 

295

 

 

861

 

 

1,155

 

 

3,047

 

 

 



 



 



 



 

Total revenues

 

 

90,396

 

 

108,780

 

 

276,701

 

 

324,547

 

                           

Expenses

 

 

 

 

 

 

 

 

 

 

 

 

 

Losses and loss adjustment expenses

 

 

25,588

 

 

40,867

 

 

80,344

 

 

111,336

 

Commission expense

 

 

10,121

 

 

12,411

 

 

30,465

 

 

35,797

 

Underwriting and other operating expense

 

 

21,907

 

 

21,726

 

 

66,614

 

 

67,778

 

 

 



 



 



 



 

Total expenses

 

 

57,616

 

 

75,004

 

 

177,423

 

 

214,911

 

 

 



 



 



 



 

Net income before income taxes

 

 

32,780

 

 

33,776

 

 

99,278

 

 

109,636

 

Income tax (benefit) expense

 

 

(289

)

 

3,896

 

 

13,349

 

 

21,117

 

 

 



 



 



 



 

Net income

 

$

33,069

 

$

29,880

 

$

85,929

 

$

88,519

 

 

 



 



 



 



 

Net income after date of conversion (Note 2)

 

 

 

 

 

 

 

 

 

 

$

82,048

 

 

 

 

 

 

 

 

 

 

 

 



 

Earnings per common share (Note 12):

 

 

 

For the Three
Months Ended
September 30,

 

For the Nine
Months Ended

 

For the Period
February 5,
2007 through

 

 

 

 

 September 30,

 

 September 30,

 

 

 

 

2008

 

 

2007

 

 

2008

 

 

2007

 

Basic

 

$

0.67

 

$

0.58

 

$

1.74

 

$

1.55

 

 

 



 



 



 



 

Diluted

 

$

0.67

 

$

0.58

 

$

1.74

 

$

1.55

 

 

 



 



 



 



 

 

 

 

 

 

 

 

 

 

 

 

 

Pro Forma
for the Nine
Months Ended
September 30, 2007

 

Basic

 

 

 

 

 

 

 

 

 

 

$

1.69

 

 

 

 

 

 

 

 

 

 

 

 



 

Diluted

 

 

 

 

 

 

 

 

 

 

$

1.69

 

 

 

 

 

 

 

 

 

 

 

 



 

Cash dividends declared per common share

 

$

0.06

 

$

0.06

 

$

0.18

 

$

0.12

 

 

 



 



 



 



 

See accompanying unaudited notes to consolidated financial statements.

 

 

5

 


Employers Holdings, Inc. and Subsidiaries

 

Consolidated Statements of Stockholders’ Equity

(in thousands, except share data)

 

 

 

Common Stock

 

Additional

 

 

 

Accumulated
Other
Comprehensive
(Loss)

 

Treasury

 

Total

 

 

 

 

Paid-In

 

Retained

 

Income,

 

Stock,

 

Stockholders’

 

 

 

Shares

 

Amount

 

Capital

 

Earnings

 

Net

 

at Cost

 

Equity

 

    (unaudited)  

Balance, January 1, 2007

 

 

$

 

$

 

$

274,602

 

$

29,175

 

$

 

$

303,777

 

Conversion transaction (Note 2)

 

22,765,407

 

 

227

 

 

(182,143

)

 

(281,073

)

 

 

 

 

 

(462,989

)

Initial public offering transaction (Note 2)

 

30,762,500

 

 

308

 

 

483,285

 

 

 

 

 

 

 

 

483,593

 

Stock-based compensation (Note 11)

 

 

 

 

 

902

 

 

 

 

 

 

 

 

902

 

Acquisition of treasury stock (Note 10)

 

 

 

 

 

 

 

 

 

 

 

(69,043

)

 

(69,043

)

Dividends to common stockholders

 

 

 

 

 

 

 

(6,299

)

 

 

 

 

 

(6,299

)

Comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income before conversion

 

 

 

 

 

 

 

6,471

 

 

 

 

 

 

6,471

 

Net income after conversion

 

 

 

 

 

 

 

82,048

 

 

 

 

 

 

82,048

 

                   

             

 

Net income for the period

 

 

 

 

 

 

 

88,519

 

 

 

 

 

 

88,519

 

Change in net unrealized gains on investments, net of taxes

 

 

 

 

 

 

 

 

 

3,294

 

 

 

 

3,294

 

                                     

 

Total comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

91,813

 

 

 


 



 



 



 



 



 



 

Balance, September 30, 2007

 

53,527,907

 

$

535

 

$

302,044

 

$

75,749

 

$

32,469

 

$

(69,043

)

$

341,754

 

 

 


 



 



 



 



 



 



 

                                           

Balance, January 1, 2008

 

53,527,907

 

$

535

 

$

302,862

 

$

104,536

 

$

46,520

 

$

(75,000

)

$

379,453

 

Stock-based compensation (Note 11)

 

 

 

 

 

2,459

 

 

 

 

 

 

 

 

2,459

 

Stock options exercised

 

300

 

 

 

 

5

 

 

 

 

 

 

 

 

5

 

Acquisition of treasury stock (Note 10)

 

 

 

 

 

 

 

 

 

 

 

(14,152

)

 

(14,152

)

Dividends to common stockholders

 

 

 

 

 

3

 

 

(8,881

)

 

 

 

 

 

(8,878

)

Comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income for the period

 

 

 

 

 

 

 

85,929

 

 

 

 

 

 

85,929

 

Change in net unrealized losses on investments, net of taxes

 

 

 

 

 

 

 

 

 

(50,208

)

 

 

 

(50,208

)

                                     

 

Total comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

35,721

 

 

 


 



 



 



 



 



 



 

Balance, September 30, 2008

 

53,528,207

 

$

535

 

$

305,329

 

$

181,584

 

$

(3,688

)

$

(89,152

)

$

394,608

 

 

 


 



 



 



 



 



 



 

See accompanying unaudited notes to the consolidated financial statements.

 

 

6

 


Employers Holdings, Inc. and Subsidiaries

Consolidated Statements of Cash Flow

(in thousands)

 

 

 

Nine Months Ended
September 30,

 

 

 

2008

 

2007

 

 

 

(unaudited)

 

Operating activities

 

 

 

 

 

 

 

Net income

 

$

85,929

 

$

88,519

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

 

 

Depreciation and amortization

 

 

5,334

 

 

4,517

 

Stock-based compensation

 

 

2,459

 

 

902

 

Amortization of premium on investments, net

 

 

4,814

 

 

4,848

 

Allowance for doubtful accounts – premiums receivable

 

 

(717

)

 

780

 

Deferred income tax expense

 

 

6,284

 

 

5,160

 

Realized losses on investments, net

 

 

3,211

 

 

322

 

Realized losses on retirement of assets

 

 

16

 

 

 

Change in operating assets and liabilities:

 

 

 

 

 

 

 

Accrued investment income

 

 

492

 

 

(310

)

Premiums receivable

 

 

12,507

 

 

5,753

 

Reinsurance recoverable on paid and unpaid losses

 

 

25,914

 

 

36,748

 

Funds held by or deposited with reinsureds

 

 

5,817

 

 

5,283

 

Unpaid losses and loss adjustment expenses

 

 

(57,310

)

 

(25,264

)

Unearned premiums

 

 

(4,863

)

 

(2,442

)

Federal income taxes payable

 

 

(11,744

)

 

(14,245

)

Accounts payable, accrued expenses and other liabilities

 

 

(1,967

)

 

(11,400

)

Deferred reinsurance gain – LPT Agreement

 

 

(13,908

)

 

(13,694

)

Other

 

 

(7,073

)

 

(3,041

)

 

 



 



 

Net cash provided by operating activities

 

 

55,195

 

 

82,436

 

Investing activities

 

 

 

 

 

 

 

Purchase of fixed maturities

 

 

(208,730

)

 

(214,197

)

Purchase of equity securities

 

 

(558

)

 

(1,021

)

Proceeds from sale of fixed maturities

 

 

149,487

 

 

156,471

 

Proceeds from sale of equity securities

 

 

4,010

 

 

2,744

 

Proceeds from maturities and redemptions of investments

 

 

41,462

 

 

40,650

 

Capitalized acquisition costs

 

 

(1,260

)

 

 

Capital expenditures and other, net

 

 

(4,116

)

 

(3,993

)

 

 



 



 

Net cash used in investing activities

 

 

(19,705

)

 

(19,346

)

Financing activities

 

 

 

 

 

 

 

Issuance of common stock, net

 

 

 

 

486,670

 

Cash paid to eligible policyholders under plan of conversion

 

 

 

 

(462,989

)

Proceeds from exercise of stock options

 

 

5

 

 

 

Acquisition of treasury stock

 

 

(14,152

)

 

(67,288

)

Dividends paid to stockholders

 

 

(8,878

)

 

(6,299

)

Debt issuance costs

 

 

(375

)

 

 

Proceeds from note payable

 

 

150,000

 

 

 

 

 



 



 

Net cash provided by (used in) financing activities

 

 

126,600

 

 

(49,906

)

 

 



 



 

Net increase in cash and cash equivalents

 

 

162,090

 

 

13,184

 

Cash and cash equivalents at the beginning of the period

 

 

149,703

 

 

79,984

 

 

 



 



 

Cash and cash equivalents at the end of the period

 

$

311,793

 

$

93,168

 

 

 



 



 

Schedule of non-cash transactions

 

 

 

 

 

 

 

Stock issued in exchange for membership interest

 

$

 

$

281,073

 

 

 



 



 

See accompanying unaudited notes to consolidated financial statements.

 

 

7

 


Employers Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Unaudited)

1. Basis of Presentation and Summary of Significant Accounting Policies

Basis of Presentation

Employers Holdings, Inc. (EHI) is a holding company and successor to EIG Mutual Holding Company (EIG), which was incorporated in Nevada in 2005. EHI conducts substantially all its business through its two wholly-owned insurance subsidiaries, Employers Insurance Company of Nevada (EICN) and Employers Compensation Insurance Company (ECIC), which are domiciled in Nevada and California, respectively. Unless otherwise indicated, all references to the “Company” refer to EHI, together with its subsidiaries.

The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities 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 (consisting of normal, recurring adjustments) necessary for a fair presentation of the Company’s financial position and results of operations 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 have been prepared consistent with the accounting policies described in the Company’s 2007 Annual Report on Form 10-K (Annual Report) for the year ended December 31, 2007, and should be read together with the Annual Report.

In accordance with Statement of Financial Accounting Standards (SFAS) No. 131, Disclosures About Segments of an Enterprise and Related Information, the Company considers an operating segment to be any component of its business whose operating results are regularly reviewed by the Company’s chief operating decision makers to make decisions about resources to be allocated to the segment and assess its performance based on discrete financial information. Currently, the Company has one operating segment: workers’ compensation insurance and related services.

Estimates and Assumptions

The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. As a result, actual results could differ from these estimates. The most significant areas that require management judgment are the estimate of unpaid losses and loss adjustment expenses (LAE), evaluation of reinsurance recoverables, recognition of premium revenue, deferred policy acquisition costs, deferred income taxes and the valuation of investments.

New Accounting Standards

In December 2007, the Financial Accounting Standards Board (FASB) issued SFAS No. 141 (Revised 2007), Business Combinations (SFAS No. 141(R)). SFAS No. 141(R) significantly changes the accounting for business combinations and requires the acquiring entity in the transaction to recognize the acquired assets and assumed liabilities at the acquisition-date fair value with limited exceptions. SFAS No. 141(R) is effective as of the beginning of an entity’s first fiscal year that begins after December 15, 2008, which, for the Company, would include business combinations that are completed after January 1, 2009. Early adoption is prohibited. The adoption of SFAS No. 141(R) will have an impact on the consolidated financial statements for any business combinations completed after January 1, 2009.

In March 2008, the FASB issued SFAS No. 161 Disclosures About Derivative Instruments and Hedging Activities – an Amendment of FASB No. 133 (SFAS No. 161). SFAS No. 161 expands the disclosure requirements in SFAS No. 133 Accounting for Derivative Instruments and Hedging Activities about an entity’s derivative instruments and hedging activities. SFAS No. 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments and disclosures about credit-risk related contingent features in derivative agreements. SFAS No. 161 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2008, which, for the Company, would be January 1, 2009. The Company is currently assessing the impact SFAS No. 161 will have on the consolidated financial statements.

 

 

8

 


2. Conversion and Initial Public Offering

Effective February 5, 2007, under the terms of the plan of conversion, EIG converted from a mutual insurance holding company to a stock company (the Conversion). All membership interests in EIG were extinguished on that date and eligible members of EIG received, in aggregate, 22,765,407 shares of EHI’s common stock and $463.0 million of cash.

In addition, effective February 5, 2007, EHI completed its Initial Public Offering (IPO) in which it issued 30,762,500 shares of its common stock at a price of $17.00 per share. The cash proceeds of the IPO, after underwriting discounts and commission of $34.0 million and offering and conversion costs of $16.3 million, were $472.7 million, of which $9.7 million was retained by EHI and was used for working capital, payment of dividends on common stock, repurchase of shares of common stock and other general corporate purposes.

Upon completion of EHI’s IPO, the capitalized issuance costs related to the IPO of $5.4 million were netted against the IPO proceeds in additional paid-in capital in the accompanying consolidated balance sheets. The costs related to the Conversion were $10.9 million. Conversion expenses consisted primarily of printing and mailing costs and the aggregate cost of engaging independent accounting, actuarial, financial, investment banking, legal and other consultants. These costs had no tax benefit and were expensed as incurred.

3. Income Taxes

During the three months ended September 30, 2008, the Company reversed the remaining $10.6 million of liabilities for previously unrecognized tax benefits (including $2.3 million of related accrued interest of which $0.4 million was recognized in the nine months ended September 30, 2008), as a result of certain statutory periods expiring. The reversal decreased the Company’s effective tax rate by 26.3 and 8.7 percentage points for the three and nine months ended September 30, 2008, respectively. Tax years 2005 through 2007 are subject to examination by the federal taxing authority. There are no income tax examinations currently in progress.

4. Fair Value of Financial Instruments

On January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements (SFAS No. 157), which provides a common definition of fair value and establishes a framework to make the measurement of fair value more consistent and comparable. The Company’s adoption of SFAS No. 157 did not have a material impact on its consolidated financial statements or results of operations.

Additionally, on January 1, 2008, the Company adopted SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities (SFAS No. 159). SFAS No. 159 permits an entity to choose to measure many financial instruments and certain items at fair value. The Company’s adoption of SFAS No. 159 did not have a material impact on its consolidated financial statements or results of operations.

The following table presents the items on the accompanying consolidated balance sheet that are stated at fair value and the fair value measurements used as of September 30, 2008. The interest rate swap, a level 2 measurement (Note 8), has been omitted from the table because it had no fair value at September 30, 2008.

 

 

 

Fixed Maturities

 

 

Equity Securities

 

Short-Term Investments

     

(in thousands)

Level 1: Quoted prices in active markets for identical assets

 

$

 

 

$

79,452

 

$

Level 2: Significant other observable inputs

 

 

1,492,856

 

 

 

 

 

70,386

Level 3: Unobservable inputs

 

 

7,350

 

 

 

 

 

 

 



 

 



 



Balance, September 30, 2008

 

$

1,500,206

 

 

$

79,452

 

$

70,386

 

 



 

 



 



 

 

9

 


The following table provides a reconciliation of the beginning and ending balances, for the above items, that are measured using Level 3: Unobservable inputs for the nine months ended September 30, 2008:

 

 

 

Fixed Maturities

 

 

(in thousands)

Balance, January 1, 2008

 

$

7,384

 

Unrealized losses in other comprehensive loss

 

 

(34

)

 

 



 

Balance, September 30, 2008

 

$

7,350

 

 

 



 

Other-Than-Temporary Impairment

The Company reviews its investment portfolio quarterly for securities that may have incurred an other-than-temporary impairment (OTTI). For any investment security deemed to have an OTTI, the investment’s cost or amortized cost is written down to its fair value and the amount written down is recorded in earnings as a realized loss on investments.

Net realized (losses) gains on investments for the three and nine months ended September 30, 2008 include write-downs of $3.8 million and $5.5 million on 34 and 47 securities, respectively, for which the Company determined the declines in fair value were other-than-temporary due to the amount and length of time that fair values were below cost. Based on the Company’s review of the other securities, the Company has the intent and ability to hold the securities until fair value recovers above cost or to maturity.

5. Liability for Unpaid Losses and Loss Adjustment Expenses

The following table represents a reconciliation of changes in the liability for unpaid losses and LAE for the nine months ended:

 

 

 

September 30,

 

 

 

2008

 

2007

 

 

 

( in thousands)

Unpaid losses and LAE, gross of reinsurance, at beginning of period

 

$

2,269,710

 

 

$

2,307,755

 

Less reinsurance recoverables, excluding bad debt allowance, on unpaid losses and LAE

 

 

1,052,641

 

 

 

1,098,103

 

 

 



 

 



 

Net unpaid losses and LAE at beginning of period

 

 

1,217,069

 

 

 

1,209,652

 

Losses and LAE, net of reinsurance, incurred in:

 

 

 

 

 

 

 

 

Current period

   

147,569

     

168,481

 

Prior periods

 

 

(53,317

)

 

 

(43,451

)

 

 



 

 



 

Total net losses and LAE incurred during the period

 

 

94,252

 

 

 

125,030

 

 

 



 

 



 

Deduct payments for losses and LAE, net of reinsurance, related to:

 

 

 

 

 

 

 

 

Current period

 

 

25,860

 

 

 

26,702

 

Prior periods

 

 

99,240

 

 

 

87,239

 

 

 



 

 



 

Total net payments for losses and LAE during the period

 

 

125,100

 

 

 

113,941

 

 

 



 

 



 

Ending unpaid losses and LAE, net of reinsurance

 

 

1,186,221

 

 

 

1,220,741

 

Reinsurance recoverable, excluding bad debt allowance, on unpaid losses and LAE

 

 

1,026,179

 

 

 

1,061,750

 

 

 



 

 



 

Unpaid losses and LAE, gross of reinsurance, at end of period

 

$

2,212,400

 

 

$

2,282,491

 

 

 



 

 



 

The above table excludes the impact of the amortization of the deferred reinsurance gain–LPT Agreement (Deferred Gain) (Note 6). The Company amortized $13.9 million and $13.7 million of the Deferred Gain for the nine months ended September 30, 2008 and 2007, respectively, which are reflected in losses and LAE incurred in the consolidated statements of income. For the nine months ended September 30, 2008 and 2007, no reductions were made to the ceded reserves on the Deferred Gain.

The reduction in the liability for unpaid losses and LAE attributable to insured events of prior periods was $53.3 million and $43.4 million for the nine months ended September 30, 2008 and 2007, respectively. The major sources of this favorable development are actual paid losses being less than expected and the impact of new information on selected

 

 

10

 


claim payments and emergence patterns used in the projection of future loss payments in the Company’s California and Nevada business as more information becomes known.

6. LPT Agreement

The Company is a party to a 100% quota share retroactive reinsurance agreement (LPT Agreement) under which $1.5 billion in liabilities for losses and LAE related to claims incurred prior to July 1, 1995 were reinsured for consideration of $775.0 million. The LPT Agreement provides coverage up to $2.0 billion. The Deferred Gain is recorded as a liability in the accompanying consolidated balance sheets and is being amortized using the recovery method, whereby the amortization is determined by the proportion of actual reinsurance recoveries to total estimated recoveries. The Company amortized $4.5 million and $13.9 million of the Deferred Gain for the three and nine months ended September 30, 2008, respectively, and $4.6 million and $13.7 million of the Deferred Gain for the three and nine months ended September 30, 2007, respectively. The adjustments to the Deferred Gain are recorded in losses and LAE in the accompanying consolidated statements of income. The remaining Deferred Gain was $411.1 million and $425.0 million as of September 30, 2008 and December 31, 2007, respectively, and is included in the accompanying consolidated balance sheets as deferred reinsurance gain–LPT Agreement.

7. Note Payable

Effective September 30, 2008, EHI and Wells Fargo Bank, National Association (Wells Fargo) entered into a Second Amended and Restated Secured Revolving Credit Facility (Amended Credit Facility). The Amended Credit Facility provides the Company with: (a) $150.0 million line of credit through December 31, 2009; (b) $100.0 million line of credit from January 1, 2010 through December 31, 2010; and (c) $50.0 million line of credit from January 1, 2011 through March 26, 2011. Amounts outstanding bear interest at a rate equal to, at the Company’s option: (a) a fluctuating rate of 1.25% above Wells Fargo’s prime rate or (b) a fixed rate that is 1.25% above the LIBOR rate then in effect. The Company previously paid a non-refundable commitment fee of $375.0 thousand, which is being amortized over 12 months. In addition, the Company is required to pay a quarterly commitment fee equal to a per annum rate of 0.10% on any portion of the Amended Credit Facility that is unused. The Amended Credit Facility contains customary non-financial covenants and requires EHI to maintain $7.5 million of cash and cash equivalents.

On September 30, 2008, EHI borrowed $150.0 million through the Amended Credit Facility with an interest rate of 5.25%. The proceeds borrowed under the Amended Credit Facility will be used to finance the acquisition of AmCOMP Incorporated (Note 13) and for general working capital purposes. The Amended Credit Facility is secured by fixed maturity securities which had a fair value of $186.7 million at September 30, 2008.

8. Derivative

Interest Rate Swap

On September 30, 2008, the Company, in connection with the borrowings through the Amended Credit Facility (Note 7), executed an interest rate swap with Wells Fargo with a notional amount of $100.0 million. Execution of the interest rate swap established a fixed interest rate of 4.84%, on the notional amount, through September 30, 2010. The Company uses this interest rate swap to mitigate the risks associated with unexpected cash outflows resulting from shifts in variable interest rates. As of September 30, 2008, the same date the derivative was established, the interest rate swap had no fair value.

 

 

11

 


9. Accumulated Other Comprehensive (Loss) Income

Accumulated other comprehensive (loss) income is comprised of unrealized (depreciation) appreciation on investments classified as available-for-sale. The following table summarizes the components of accumulated other comprehensive (loss) income:

 

 

 

September 30,

 

 

 

2008

 

 

2007

 

 

 

(in thousands)

 

Net unrealized (loss) gain on investment, before taxes

 

$

(5,674

)

 

$

49,953

 

Deferred tax benefit (expense)

 

 

1,986

 

 

 

(17,484

)

 

 



 

 



 

Total accumulated other comprehensive (loss) income, net of taxes net of taxes

 

$

(3,688

)

 

$

32,469

 

 

 



 

 



 

The following table summarizes changes in the components of total comprehensive income for the stated periods:

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

( in thousands)

 

Unrealized (losses) gains arising during the period, before taxes

 

$

(43,805

)

$

29,059

 

$

(80,455

)

$

4,746

 

Less: income tax (benefit) expense

 

 

(15,331

)

 

10,131

 

 

(28,159

)

 

1,661

 

   

 

 

 

 

Unrealized (losses) gains arising during the period, net of taxes

 

 

(28,474

)

 

18,928

 

 

(52,296

)

 

3,085

 

Less reclassification adjustment:

 

 

 

 

 

 

 

 

 

 

 

 

 

(Losses) gains realized in net income

 

 

(1,504

)

 

146

 

 

(3,211

)

 

(322

)

Income tax (benefit) expense

 

 

(526

)

 

51

 

 

(1,123

)

 

(113

)

   

 

 

 

 

Reclassification adjustment for (losses) gains realized in net income

 

 

(978

)

 

95

 

 

(2,088

)

 

(209

)

   

 

 

 

 

Other comprehensive (loss) gain

 

 

(27,496

)

 

18,833

 

 

(50,208

)

 

3,294

 

Net income

 

 

33,069

 

 

29,880

 

 

85,929

 

 

88,519

 

   

 

 

 

 

Total comprehensive income

 

$

5,573

 

$

48,713

 

$

35,721

 

$

91,813

 

   

 

 

 

 

10. Stockholders’ Equity

Stock Repurchase Program

On February 21, 2008, the EHI Board of Directors authorized a stock repurchase program (the 2008 Program). The 2008 Program authorizes the Company to repurchase up to $100.0 million of the Company’s common stock through June 30, 2009. As of September 30, 2008, the Company repurchased 786,795 shares at a cost of $14.2 million. EHI may repurchase shares from time to time at prevailing market prices in open market or private transactions. The repurchases may be commenced or suspended from time to time without prior notice.

 

 

12

 


11. Stock-Based Compensation

The Company accounts for stock-based compensation according to the provisions of SFAS No. 123(R), Share-Based Payment. Net stock-based compensation expense recognized in the accompanying consolidated statements of income is as follows:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

September 30,

 

September 30,

 

 

2008

 

2007

 

2008

 

2007

 

(in thousands)

Stock-based compensation related to:

 

 

 

 

 

 

 

 

 

 

 

 

Nonqualified stock options

 

$

375

 

$

351

 

$

878

 

$

557

Restricted stock units

 

 

301

 

 

80

 

 

601

 

 

80

Performance shares

 

 

296

 

 

265

 

 

980

 

 

265

 

 



 



 



 



Total

 

 

972

 

 

696

 

 

2,459

 

 

902

Less: related tax benefit

 

 

333

 

 

244

 

 

851

 

 

316

 

 



 



 



 



Net stock-based compensation expense

 

$

639

 

$

452

 

$

1,608

 

$

586

 

 



 



 



 



Nonqualified Stock Options

On May 29, 2008, the Company awarded 475,167 options to the officers of the Company. These options have a service vesting period of four years and vest 25% on May 29, 2009, and the subsequent three anniversaries of such date. The options are subject to accelerated vesting in certain limited circumstances, such as death or disability of the holder, or in connection with a change of control of the Company. The options expire seven years from the date of grant. The per share exercise price of these options is equal to the fair value of the stock on the grant date, or $19.21.

Changes in outstanding stock options for the nine months ended September 30, 2008 were as follows:

 

 

 

Number of
Options

 

 

 

Weighted
Average
Exercise
Price

 

Weighted
Average
Remaining
Contractual
Life

 

 

 

 

 

 

 

 

(in years)

Options outstanding at January 1, 2008

 

584,850

 

 

$

18.29

 

6.4

Granted

 

475,167

 

 

 

19.21

 

6.7

Exercised

 

(300

)

 

 

17.00

 

 

Expired

 

(4,755

)

 

 

17.86

 

 

Forfeited

 

(30,152

)

 

 

18.40

 

 

 

 


 

 

 

 

 

 

Options outstanding at September 30, 2008

 

1,024,810

 

 

 

18.71

 

6.1

 

 


 

 

 

 

 

 

Exercisable at September 30, 2008

 

158,877

 

 

 

18.18

 

5.5

 

 


 

 

 

 

 

 

Restricted Stock Units

On May 29, 2008, 23,760 restricted stock units (RSUs), awarded to the non-employee members of the Board of Directors during 2007, vested in connection with the annual stockholders meeting. The vested RSUs will be settled in common stock six months following the awardee’s termination of service from the Board of Directors. Prior to settlement, dividend equivalents are paid with respect to these vested RSUs and are credited as additional vested RSUs. On September 4, 2008, in connection with the Company’s dividend to its stockholders, an aggregate of 72 RSUs were credited to vested RSU holders.

 

 

13

 


Additionally, on May 29, 2008, the Company awarded the non-employee members of the Board of Directors, in aggregate, 24,984 RSUs. These RSUs vest on May 29, 2009, except for accelerated vesting in the case of death or disability of the director or in connection with a change of control. Vested RSUs will be settled in common stock within 30 days after the vesting date or can be deferred until six months following the awardee’s termination of service from the Board of Directors, at the awardee’s election. In the event of a deferral election, dividend equivalents are paid with respect to vested RSUs and are credited as additional vested RSUs. The aggregate fair value of the RSUs on the date of grant was $479.9 thousand.

On May 29, 2008, the Company awarded 152,564 RSUs to the officers of the Company. The RSUs have a service vesting period of four years and vest 25% on May 29, 2009, and the subsequent three anniversaries of such date. The RSUs are subject to accelerated vesting in certain limited circumstances, such as: death or disability of the holder, or in connection with a change of control of the Company. The aggregate fair value of the RSUs on the date of grant was $2.9 million.

Changes in outstanding RSUs for the nine months ended September 30, 2008 were as follows:

 

 

 

Number of
RSUs

 

 

 

Weighted
Average
Grant Date
Fair Value

RSUs outstanding at January 1, 2008

 

23,760

 

 

$

16.83

Granted

 

177,692

 

 

 

19.21

Forfeited

 

(1,667

)

 

 

19.21

 

 


 

 

 

 

RSUs outstanding at September 30, 2008

 

199,785

 

 

 

18.93

 

 


 

 

 

 

Vested but unsettled RSUs at September 30, 2008

 

23,904

 

 

 

16.84

 

 


 

 

 

 

12. Earnings Per Share

SFAS No. 128, Earnings per Share, provides for the calculation of Basic and Diluted earnings per share. Basic earnings per share includes no dilution and is computed by dividing income applicable to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the potential dilution of securities that could share in the earnings of equity. Diluted earnings per common share includes common shares assumed issued under the “treasury stock method,” which reflects the potential dilution that would have occurred had shares been repurchased from the proceeds of potentially dilutive shares.

 

 

14

 


The following table presents the net income and the weighted average common shares outstanding used in the earnings per common share calculations for the periods presented:

 

 

Three Months Ended
September 30,

 

Nine Months
Ended
September 30,

 

 

February 5, 2007
through
September 30,

 

 

Pro Forma
Nine Months
Ended
September 30,

 

 

 

 

 

 

2008

 

2007

 

2008

 

2007

 

2007

 

(in thousands, except share and per share data)

Net income available to common stockholders – basic and diluted

$

33,069

 

$

29,880

 

$

85,929

 

$

82,048

 

$

88,519

 



 



 



 



 



Weighted average number of common shares outstanding – basic

 

49,005,235

 

 

51,720,231

 

 

49,339,966

 

 

52,818,747

 

 

52,457,369

                             

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Performance share awards

 

66,246

 

 

4,465

 

 

48,454

 

 

1,726

 

 

1,505

Unvested restricted stock units

 

3,433

 

 

2,320

 

 

1,174

 

 

897

 

 

782

 



 



 



 



 



Dilutive potential common shares

 

69,679

 

 

6,785

 

 

49,628

 

 

2,623

 

 

2,287

 



 



 



 



 



Weighted average number of common shares outstanding – diluted

 

49,074,914

 

 

51,727,016

 

 

49,389,594

 

 

52,821,370

 

 

52,459,656

 



 



 



 



 



Earnings per common share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

$

0.67

 

$

0.58

 

$

1.74

 

$

1.55

 

$

1.69

Diluted

$

0.67

 

$

0.58

 

$

1.74

 

$

1.55

 

$

1.69

For the three months ended September 30, 2008 and 2007, and nine months ended September 30, 2008, earnings per common share — basic — was calculated using net income for the period and the weighted average common shares outstanding, including contingently issuable shares for which all necessary conditions for issuance have been met. Earnings per common share — diluted — is based on the basic weighted average common shares outstanding increased by the number of additional common shares that would have been outstanding had potentially dilutive common shares been issued and reduced by the number of common shares that could have been repurchased from the proceeds of the potentially dilutive shares. The Company’s outstanding options have been excluded in computing the diluted earnings per share for the three months ended September 30, 2008 and 2007 and nine months ended September 30, 2008, because their inclusion would be anti-dilutive.

The earnings per common share — basic — for the period February 5, 2007 through September 30, 2007 was calculated using only the net income available to common stockholders for the period after the IPO, as shown on the consolidated statements of income, and the basic weighted average common shares outstanding during the same period. Earnings per common share — diluted — is based on the basic weighted average common shares outstanding increased by the number of additional common shares that would have been outstanding had potentially dilutive common shares been issued and reduced by the number of common shares that could have been repurchased from the proceeds of the potentially dilutive shares. The Company’s outstanding options have been excluded in computing the diluted earnings per share for the period February 5, 2007 through September 30, 2007 because their inclusion would be anti-dilutive.

The pro forma earnings per common share for the nine months ended September 30, 2007, presented on the accompanying consolidated statements of income is intended to depict relative earnings per common share for the period, irrespective of the impact of the Conversion because neither EHI, nor its predecessor, EIG, had, prior to the Conversion, any outstanding common shares. The pro forma earnings per common share — basic — for the nine months ended September 30, 2007 was calculated using the weighted average common shares of 50,000,002 for the period prior to the Conversion and 52,818,747 for the period after the Conversion through September 30, 2007. Pro forma earnings per common share — diluted — for the nine months ended September 30, 2007, is based on the pro forma weighted average common shares outstanding — basic — adjusted by the number of additional common shares that would have been outstanding had potentially dilutive common shares been issued and reduced by the number of common shares that could have been repurchased from the proceeds of the potentially dilutive shares. The Company’s outstanding options have

 

 

15

 


been excluded in computing the pro forma diluted earnings per share for the nine months ended September 30, 2007 because their inclusion would be anti-dilutive.

13. Subsequent Events

Acquisition of AmCOMP Incorporated

On October 31, 2008, EHI acquired 100% of the outstanding common stock of AmCOMP Incorporated (AmCOMP) for $188.4 million (the Acquisition). The Company believes the Acquisition will provide significant opportunity to accelerate the execution of its strategic goals and achieve its vision of being the leader in the property and casualty insurance industry specializing in workers’ compensation. The accompanying unaudited consolidated statements of income for the three and nine months ended September 30, 2008 do not include the results of AmCOMP.

Pursuant to the terms of Amendment No. 2 to the Agreement and Plan of Merger, as executed on August 29, 2008, the Company paid a cash amount of $12.15 per share in exchange for the 15,295,462 outstanding shares of AmCOMP common stock. The 844,650 AmCOMP stock options that were outstanding immediately prior to the effective time of the Acquisition were vested by virtue of the Acquisition and exchanged for the right to receive cash consideration equal to the net amount of the excess, if any, of $12.15 per share over the exercise price per share of the option.

The total estimated purchase price of the Acquisition was as follows:

 

 

 

Amount

 

 

(in thousands)

Cash for outstanding shares

 

$

185,840

Cash for stock options

 

 

2,529

 

 



Total cash used to acquire the outstanding equity interests of AmCOMP

 

 

188,369

Estimated acquisition related costs

 

 

4,964

 

 



Total estimated purchase price

 

$

193,333

 

 



The Company will allocate the total purchase price to tangible and identifiable intangible assets acquired and liabilities assumed based on their estimated fair values. The excess of the purchase price over the aggregate fair values will be recorded as goodwill, which is not deductible for federal income tax purposes. The Company is in the process of determining the fair value of the assets acquired and liabilities assumed. The results of AmCOMP for the period October 31, 2008 through December 31, 2008 will be included in the Company’s 2008 Annual Report on Form 10-K, along with an allocation of the purchase price.

Stockholder Dividend

On November 6, 2008, the Board of Directors declared a $0.06 dividend per share, payable December 4, 2008, to stockholders of record on November 20, 2008.

 

 

16

 


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

You should read the following discussion and analysis in conjunction with our consolidated financial statements and the related notes thereto included in Item 1 of Part I. Unless otherwise indicated, all references to “we,” “us,” “our,” “the Company” or similar terms refer to Employers Holdings, Inc. (EHI), together with its subsidiaries. The information contained in this quarterly report is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this quarterly report and in our other reports filed with the Securities and Exchange Commission (SEC), including our 2007 Annual Report on Form 10-K for the year ended December 31, 2007 (Annual Report).

The discussion under the heading “Risk Factors” in our Annual Report, as updated by the discussion in Part II, Item 1A of this quarterly report and similar discussions in our other SEC filings, describe some of the important risk factors that may affect our business, results of operations and financial condition. You should carefully consider those risks in addition to the other information in this report and in our other filings with the SEC before deciding to purchase, hold, or sell our common stock.

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and 21E of the Securities Exchange Act of 1934. You should not place undue reliance on these statements. These forward-looking statements include those related to our expected financial position, business, financing plans, litigation, future premiums, revenues, earnings, pricing, investments, business relationships, expected losses, loss reserves, acquisitions, competition, and rate increases with respect to our business and the insurance industry in general. Statements that include the words “expect,” “intend,” “plan,” “believe,” “project,” “estimate,” “may,” “should,” “continue,” “potential,” “forecast,” “anticipate,” “will” and similar statements of a future or forward-looking nature identify forward-looking statements.

All forward-looking statements address matters that involve risks and uncertainties. Accordingly, there are or will be important factors that could cause our actual results to differ materially from those indicated in these statements. We believe that these factors include, but are not limited to, the following:

 

impact of the extraordinary conditions in the financial markets;

 

adequacy and accuracy of our pricing methodologies;

 

our dependence on concentrated geographic areas and on the workers’ compensation industry;

 

developments in the frequency or severity of claims and loss activity that our underwriting, reserving or investment practices do not anticipate based on historical experience or industry data;

 

changes in rating agency policies or practices;

 

negative developments in the workers’ compensation insurance industry;

 

increased competition on the basis of coverage availability, claims management, safety services, payment terms, premium rates, policy terms, types of insurance offered, overall financial strength, financial ratings and reputation;

 

changes in the availability, cost or quality of reinsurance and failure of our reinsurers to pay claims timely or at all;

 

changes in regulations or laws applicable to us, our policyholders or the agencies that sell our insurance;

 

changes in legal theories of liability under our insurance policies;

 

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

 

effects of acts of war, terrorism, or natural or man-made catastrophes;

 

non-receipt of expected payments;

 

performance of the financial markets and their effects on investment income and the fair values of investments;

 

possible failure of our information technology or communication systems;

 

adverse state and federal judicial decisions;

 

litigation and government proceedings;

 

possible loss of the services of any of our executive officers or other key personnel;

 

 

17

 


 

cyclical nature of the insurance industry;

 

investigations into issues and practices in the insurance industry;

 

changes in demand for our products;

 

the possibility that the operations acquired from AmCOMP Incorporated (AmCOMP) will not be integrated successfully or cost effectively; and

 

possible disruption from the AmCOMP transaction making it more difficult to maintain relationships with customers, employees, agents and producers.

The foregoing factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are included in this report.

These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical or anticipated results, depending on a number of factors. These risks and uncertainties include, but are not limited to, those listed under the heading “Risk Factors” in our Annual Report, as updated by the discussion in Part II, Item 1A of this quarterly report. All subsequent written and oral forward-looking statements attributable to us or individuals acting on our behalf are expressly qualified in their entirety by these cautionary statements. We caution you not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. Before making an investment decision, you should carefully consider all of the factors identified in this report that could cause actual results to differ.

Overview

EHI is a Nevada holding company and is the successor to EIG Mutual Holding Company (EIG), which was incorporated in Nevada in 2005. EHI’s principal executive offices are located at 10375 Professional Circle, Reno, Nevada.

On October 31, 2008, we completed our acquisition of AmCOMP Incorporated (the Acquisition). We believe this acquisition will provide significant opportunity to accelerate the execution of our strategic goals and achieve our vision of being the leader in the property casualty insurance industry specializing in workers’ compensation.

We are a specialty provider of workers’ compensation insurance focused on select small businesses engaged in low to medium hazard industries. Workers’ compensation is a statutory system under which an employer is required to provide coverage for its employees’ medical, disability, vocational rehabilitation and death benefit costs for work-related injuries or illnesses. Our business, which has historically targeted small businesses located primarily in several western states, with a concentration in California and Nevada, now also includes a concentration in Florida with the acquisition of AmCOMP. We continue to distribute our products almost exclusively through independent agents and brokers and our strategic distribution partners.

On August 29, 2008, we entered into Amendment No. 2 to the Agreement and Plan of Merger (Amended Merger Agreement), as previously amended April 28, 2008, with AmCOMP. Under the Amended Merger Agreement, which was approved by the Boards of Directors of both companies, approximately 15.3 million outstanding common shares received consideration of $12.15 in cash for each share of AmCOMP common stock. The Florida Office of Insurance Regulation (FOIR) approved the Acquisition pursuant to the terms of the Amended Merger Agreement on August 29, 2008.

On October 29, 2008, the stockholders of AmCOMP approved the Acquisition, and on October 31, 2008, we acquired 100% of the outstanding common stock of AmCOMP for $188.4 million pursuant to the terms of the Amended Merger Agreement. We used $188.4 million in available cash, including funds available through the Second Amended and Restated Secured Revolving Credit Facility (Amended Credit Facility) entered into with Wells Fargo Bank, National Association (Wells Fargo). We will allocate the total purchase price to tangible and identifiable intangible assets acquired and liabilities assumed based on their estimated fair values. The excess of the purchase price over the aggregate fair values will be recorded as goodwill, which is not deductible for federal income tax purposes. We are in the process of determining the fair value of the assets acquired and the liabilities assumed. The results of AmCOMP for the period October 31, 2008 through December 31, 2008 will be included in our 2008 Annual Report on Form 10-K, along with an allocation of the purchase price.

The acquired insurance subsidiaries, AmCOMP Preferred Insurance Company and AmCOMP Assurance Corporation, are mono-line workers’ compensation insurance companies focused on small to mid-sized businesses,

 

 

18

 


primarily in Southeastern and Midwestern states. Domiciled in Florida, the insurance subsidiaries are licensed in a combined 29 states and the District of Columbia and currently write business in 21 states with Florida representing approximately 29% of the $220.6 million in direct premiums written in 2007.

As a result of the Acquisition, we expanded from two to four insurance subsidiaries:

 

 

 

State of Domicile

Employers Insurance Company of Nevada (EICN)

 

Nevada

Employers Compensation Insurance Company (ECIC) 

 

California

AmCOMP Preferred Insurance Company (EPIC)(1)

 

Florida

AmCOMP Assurance Corporation (EAC)(1)

 

Florida

______________

(1)

On November 3, 2008 we filed an application to change the names of AmCOMP Preferred Insurance Company and AmCOMP Assurance Corporation to Employers Preferred Insurance Company (EPIC) and Employers Assurance Company (EAC), respectively.

We also acquired the following non-insurance subsidiaries:

 

Pinnacle Administrative Company

Pinnacle Benefits, Inc. 

AmSERV, Inc. 

We now operate in a single reportable segment with 17 territorial offices serving 29 states.

Revenues

We derive our revenues primarily from the following:

Net Premiums Earned. Our net premiums earned have historically been generated primarily in California and Nevada. In California, we have reduced our premium rates by 62.5% from September 2003 through September 30, 2008, including a decline of 38.5% since January 1, 2006 based on our internal actuarial analysis of current and anticipated loss cost trends. This compared with the recommendation of the California Commissioner of Insurance (California Commissioner) of a 45.0% rate decline since January 1, 2006. In November 2007, the California Commissioner recommended that there be no overall change in pure premium rates for policies written on or after January 1, 2008. This was the first recommendation of no rate decrease by the California Commissioner since the adoption of the benefit reforms of 2003 and 2004. On May 9, 2008, the California Commissioner announced that stability in the workers’ compensation insurance marketplace had eliminated the need for an interim pure premium rate advisory.

On September 12, 2008, the California Workers’ Compensation Insurance Rating Bureau (WCIRB) submitted an amended filing with the California Department of Insurance (CDOI) recommending a 16.0% increase in pure premium rates effective January 1, 2009. The filing was based on insurer loss and loss adjustment expense experience valued as of March 31, 2008. According to the WCIRB, the recommended increase was primarily due to medical cost inflation and increasing loss adjustment expenses. On October 24, 2008, the California Commissioner issued a decision on the amended filing approving a 5.0% average increase in pure premium rates on new and renewal policies dated January 1, 2009. Decisions of the California Commissioner are advisory only and insurance companies may choose whether or not to adopt the loss costs. The California Commissioner has adopted the term “Workers’ Compensation Claims Cost Benchmark” to describe the overall change in pure premium rates.

The recommendation of the WCIRB does not reflect the cost impact of the proposed changes to the Permanent Disability Rating Schedule (PDRS). If the proposed changes are adopted, the WCIRB has indicated that it will amend its recommendation to increase pure premium rates by an additional 3.7%. The WCIRB has also indicated that it will recommend that pure premium rates applicable to the unexpired portion of the 2008 policies be increased by 3.7% for the PDRS change.

Based on our most recent analysis of California loss trends, medical cost inflation and the competitive market, we have filed new rates based upon our actuarial analysis for new or renewal policies incepting on or after February 1, 2009. If the PDRS change is adopted, we will re-evaluate the adequacy of our rate level and may decide to amend our filing.

On December 19, 2007, the Nevada Commissioner of Insurance (Nevada Commissioner) announced that the National Council on Compensation Insurance (NCCI) submitted a filing for an average voluntary loss cost decrease of

 

 

19

 


10.5% for new and renewal policies incepting on or after March 1, 2008. On February 6, 2008, the Nevada Commissioner approved the filing. The Nevada Commissioner cited decreasing claim frequency as the primary driver of the decrease, which more than offset increasing indemnity and medical costs per claim and cost of living benefit adjustments. In our last filed Nevada rate change, we adopted the approved loss costs effective for new and renewal policies incepting on or after March 1, 2008 with a revised loss cost modifier, the combination of which we expected would produce an average overall decrease of 5.0% on our rate level.

The following table sets forth our direct premiums written by state and as a percentage of total direct premiums written for the periods presented:

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

State

 

2008

 

Percentage
of 2008
Total

 

2007

 

Percentage
of 2007
Total

 

2008

 

Percentage
of 2008
Total

 

2007

 

Percentage
of 2007

Total

(in thousands, except percentages)

California

 

$

56,011

 

74.9

%

 

$

63,526

 

71.9

%

 

$

169,496

 

74.1

%

 

$

189,018

 

70.5

%

Nevada

 

 

8,822

 

11.8

 

 

 

14,214

 

16.1

 

 

 

30,187

 

13.2

 

 

 

51,504

 

19.2

 

Colorado

 

 

2,428

 

3.2

 

 

 

3,322

 

3.8

 

 

 

7,851

 

3.4

 

 

 

9,433

 

3.5

 

Utah

 

 

1,314

 

1.8

 

 

 

2,145

 

2.4

 

 

 

4,814

 

2.1

 

 

 

6,163

 

2.3

 

Idaho

 

 

1,529

 

2.1

 

 

 

1,674

 

1.9

 

 

 

4,700

 

2.0

 

 

 

5,028

 

1.9

 

Montana

 

 

1,569

 

2.1

 

 

 

1,784

 

2.0

 

 

 

3,614

 

1.6

 

 

 

3,464

 

1.3

 

Arizona

 

 

1,221

 

1.6

 

 

 

770

 

0.9

 

 

 

3,180

 

1.4

 

 

 

1,823

 

0.7

 

Illinois

 

 

1,040

 

1.4

 

 

 

412

 

0.4

 

 

 

2,634

 

1.2

 

 

 

677

 

0.2

 

Other

 

 

821

 

1.1

 

 

 

486

 

0.6

 

 

 

2,404

 

1.0

 

 

 

1,083

 

0.4

 

 

 



 


 

 



 


 

 



 


 

 



 


 

Total

 

$

74,755

 

100.0

%

 

$

88,333

 

100.0

%

 

$

228,880

 

100.0

%

 

$

268,193

 

100.0

%

 

 



 


 

 



 


 

 



 


 

 



 


 

The decline in our overall premium revenue in California and Nevada is reflective of the impact of rate reductions and increased price competition. Challenging economic conditions, evidenced by slowing or declining employment and payroll, have also affected premium revenue in certain states in which we operate other than California. The decline was partially offset by the growth in premium volume in our seven smallest states, which resulted in a nine month period over period increase of nearly 70% in direct premiums written in those seven states. We continue to operate in an increasingly competitive market. California and Nevada accounted for 87.3% of our direct premiums written for the nine months ended September 30, 2008 compared to 89.7% of our direct premiums written for the nine months ended September 30, 2007.

For the nine months ended September 30, 2008, we wrote 74.1% and 13.2% of our direct premiums written in California and Nevada, respectively. Prior to the acquisition of AmCOMP we were writing business in ten other states (Arizona, Colorado, Florida, Idaho, Illinois, Montana, Oregon, Pennsylvania, Texas and Utah) and were licensed to write business in five additional states (Georgia, Maryland, Massachusetts, New Mexico and New York). We entered into a new strategic relationship and began writing business through the Small Business Payroll Services Group of Wells Fargo Bank, National Association in August, 2008.

The number of policies in force, at the specified dates, was as follows:

 

States

 

September 30, 2008

 

December 31, 2007

 

September 30, 2007

California

 

27,615

 

24,986

 

24,441

Nevada

 

5,468

 

6,147

 

6,241

Other

 

3,019

 

2,566

 

2,345

 

 


 


 


Total

 

36,102

 

33,699

 

33,027

 

 


 


 


During the nine months ended September 30, 2008, we realized an increase of 2,403 policies, or 7.1%, over the total number of policies in force at December 31, 2007. For the same nine month period, policies in California increased by 2,629, or 10.5%, and policies in states other than California and Nevada increased by 453, or 17.7%, which was offset by a decline in policies in Nevada of 679, or 11.0%.

 

 

20

 


During the 12 months ended September 30, 2008, our policies in force increased by 3,075 policies, or 9.3%, over the total number of policies in force at September 30, 2007. For the same 12 month period, policies in California increased by 3,174, or 13.0%, and policies in states other than California and Nevada increased by 674 or 28.7%, which was offset by a decline in policies in Nevada of 773, or 12.4%. We believe the decline in policy count in Nevada is a direct result of economic conditions and competitive pressures. We have not observed a similar impact on policy count in California.

On October 23, 2008, the NCCI made an amended rate filing providing for an overall average premium rate level decrease of 18.6% as ordered by the Florida Commissioner of the Office of Insurance Regulation (Florida Commissioner). In its original filing, the NCCI cited a significant drop in claims frequency and a reduction in the cost of claims as reasons for recommending a decrease. On October 28, 2008, the Florida Commissioner entered an order approving the NCCI’s amended filing.

Also on October 23, 2008, the Florida Supreme Court issued a decision that has the effect of removing a measure from the state’s workers’ compensation insurance laws enacted in 2003, and according to the Florida Commissioner, might significantly erode cost savings. The court, in the case of Emma Murray v. Mariners Health/ACE USA, interpreted attorneys fees provisions in Florida’s workers’ compensation statutes. The Florida Commissioner has indicated he expects the NCCI to make a new filing in support of the rate impact the NCCI believes will result from this decision. We are in the process of evaluating the impact this decision may have on our Florida book of business.

The financial statements included in this quarterly report on Form 10-Q do not include significant results from operations in Florida. Including the acquired operations of AmCOMP, approximately 10% of our business will be generated in Florida. Florida is an “Administered Pricing” state and rate changes adopted by the Florida Commissioner will affect the rates that we are able to charge in that state.

Rate changes have been adopted in other states in which we operate. We believe policy count in California and other states will continue to grow. However, that increase may not completely offset the decline in total premiums written. We cannot precisely determine how these trends will ultimately impact our financial position and results of operations.

Expenses

Our expenses consist of the following:

Losses and Loss Adjustment Expenses (LAE). Losses and LAE represent our largest expense item and include claim payments made, estimates for future claim payments and changes in those estimates for current and prior periods and costs associated with investigating, defending, and adjusting claims. The quality of our financial reporting depends in large part on accurately predicting our losses and LAE, which are inherently uncertain as they are estimates of the ultimate cost of individual claims based on actuarial estimation techniques. In states other than Nevada, we have a short operating history and must rely on a combination of industry experience and our specific experience to establish our best estimate of losses and LAE reserves. The interpretation of historical data can be impacted by external forces, principally legislative changes, economic fluctuations and legal trends. In recent years, we experienced lower losses and LAE in California than we anticipated due to factors such as regulatory reform designed to reduce loss costs in that market. As we continue to gain experience in the California market, we rely more on our own loss experience and place less reliance on industry experience.

Commission Expense. Commission expense includes direct commissions to our agents and brokers for the premiums that they produce for us. Also included in commission expense are incentive payments, other direct marketing costs and fees. Commission expense is net of contingent commission income related to the retroactive 100% quota share reinsurance agreement (LPT Agreement). Also, commissions paid to our agents and brokers are deferred and amortized to commission expense in our consolidated statements of income as the premiums generating these commissions are earned. We pay commissions that we believe are competitive with other workers’ compensation insurers.

Underwriting and Other Operating Expense. Underwriting and other operating expense includes the costs to acquire and maintain an insurance policy (excluding commissions) consisting of premium taxes and certain other general expenses that vary with, and are primarily related to, producing new or renewal business. These acquisition costs are deferred and amortized to underwriting and other operating expense in the consolidated statements of income as the related premiums are earned. Other underwriting expenses consist of policyholder dividends and general adminxstrative expenses such as salaries and benefits, rent, office supplies, depreciation and all other operating expenses not otherwise classified separately, and fees and assessments of boards, bureaus and statistical agencies for policy service and administration items such as manuals, rating plans and experience data. Our underwriting and other operating expense is

 

 

21

 


a reflection of our operating efficiency in producing, underwriting and administering our business. Over recent periods, our underwriting and other operating expense has remained relatively flat in the face of increasing policy volume. We continue to pursue technological improvements that will, over time, reduce transaction costs and support future profitable growth.

 

 

22

 


Results of Operations

Three Months Ended September 30, 2008 and 2007

The following table summarizes our consolidated financial results for the three months ended September 30, 2008 and 2007:

 

 

 

2008

 

2007

 

Increase
(Decrease)
2008 over
2007

 

Percentage
Increase
(Decrease)
2008 over
2007

 

 

 

(in thousands, except for percentages)

Selected Financial Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross premiums written

 

$

75,092

 

$

90,265

 

$

(15,173

)

 

(16.8

)%

Net premiums written

 

 

72,311

 

 

87,319

 

 

(15,008

)

 

(17.2

)

Net premiums earned

 

$

73,131

 

$

88,527

 

$

(15,396

)

 

(17.4

)%

Net investment income

 

 

18,474

 

 

19,246

 

 

(772

)

 

(4.0

)

Realized (losses) gains on investments, net

 

 

(1,504

)

 

146

 

 

(1,650

)

 

n/a

 

Other income

 

 

295

 

 

861

 

 

(566

)

 

(65.7

)

 

 



 



 



 

 

 

 

Total revenues

 

 

90,396

 

 

108,780

 

 

(18,384

)

 

(16.9

)

Losses and LAE

 

 

25,588

 

 

40,867

 

 

(15,279

)

 

(37.4

)

Commission expense

 

 

10,121

 

 

12,411

 

 

(2,290

)

 

(18.5

)

Underwriting and other operating expense

 

 

21,907

 

 

21,726

 

 

181

 

 

0.8

 

Income tax (benefit) expense

 

 

(289

)

 

3,896

 

 

(4,185

)

 

n/a

 

 

 



 



 



 

 

 

 

Total expenses

 

 

57,327

 

 

78,900

 

 

(21,573

)

 

(27.3

)

 

 



 



 



 

 

 

 

Net income

 

$

33,069

 

$

29,880

 

$

3,189

 

 

10.7

%

 

 



 



 



 

 

 

 

Selected Operating Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

Combined ratio(1)

 

 

78.8

%

 

84.7

%

 

(5.9

)%

 

n/a

 

Net income before impact of LPT Agreement (2)

 

$

28,520

 

$

25,323

 

$

3,197

 

 

12.6

%

______________

(1)

The combined ratio is calculated by dividing the sum of losses and LAE, commission expense and underwriting and other operating expense by net premiums earned.

(2)

We define net income before impact of LPT Agreement as net income less: (a) amortization of deferred reinsurance gain—LPT Agreement and (b) adjustments to LPT Agreement ceded reserves. Deferred reinsurance gain—LPT Agreement reflects the unamortized gain from our LPT Agreement. Under GAAP, this gain is deferred and is being amortized using the recovery method, whereby the amortization is determined by the proportion of actual reinsurance recoveries to total estimated recoveries, and the amortization is reflected in losses and LAE. We periodically reevaluate the remaining direct reserves subject to the LPT Agreement. Our reevaluation results in corresponding adjustments, if needed, to reserves, ceded reserves, reinsurance recoverables and the deferred reinsurance gain, with the net effect being an increase or decrease, as the case may be, to net income. Net income before impact of LPT Agreement is not a measurement of financial performance under GAAP and should not be considered in isolation or as an alternative to net income before income taxes and net income or any other measure of performance derived in accordance with GAAP.

We present net income before impact of LPT Agreement because we believe that it is an important supplemental measure of operating performance to be used by analysts, investors and other interested parties in evaluating us. The LPT Agreement was a non-recurring transaction which does not result in ongoing cash benefits, and, consequently, we believe this presentation is useful in providing a meaningful understanding of our operating performance. In addition, we believe this non-GAAP measure, as we have defined it, is helpful to our management in identifying trends in our performance because the excluded item has limited significance in our current and ongoing operations.

 

 

23

 


The table below shows the reconciliation of net income to net income before impact of LPT Agreement for the three months ended:

 

 

 

September 30,

 

 

 

2008

 

2007

 

 

 

(in thousands)

Net income

 

$

33,069

 

$

29,880

 

Less impact of LPT Agreement:

 

 

 

 

 

 

 

Amortization of deferred reinsurance gain—LPT Agreement

 

 

4,549

 

 

4,557

 

Adjustment to LPT Agreement ceded reserves(a)

 

 

 

 

 

 

 



 



 

Net income before impact of LPT Agreement

 

$

28,520

 

$

25,323

 

 

 



 



 

______________

(a)

Any adjustment to the estimated direct reserves ceded under the LPT Agreement is reflected in losses and LAE for the period during which the adjustment is determined, with a corresponding increase or decrease in net income in the period. There is a corresponding change to the reinsurance recoverables on unpaid losses as well as the deferred reinsurance gain. A cumulative adjustment to the amortization of the deferred gain is also then recognized in earnings so that the deferred reinsurance gain reflects the balance that would have existed had the revised reserves been recognized at the inception of the LPT Agreement. See Note 6 in the notes to our consolidated financial statements which are included elsewhere in this report.

Gross Premiums Written. Gross premiums written decreased $15.2 million, or 16.8%, to $75.1 million for the three months ended September 30, 2008, from $90.3 million for the three months ended September 30, 2007. The decrease in gross premiums written was primarily due to the overall reduction in our average policy size as a result of the impacts of rate reductions, the effects of increased competition and changes in economic and business conditions. Compared to the third quarter of 2007, the average rate level of premiums written during the third quarter of 2008 was 7.8% lower in California due to rate decreases in January 2007 of 9.9% and September 2007 of 4.5%. The average overall in force policy premium at September 30, 2008 decreased to $8,006, or 22.2%, from $10,296 at September 30, 2007. Total policy count, however, has increased 9.3% from September 30, 2007, mainly in California, lessening the impact of the change in policy size. The policy count increase was primarily attributable to sales and marketing efforts in our California market. The number of in force policies in California increased 13.0%, or 3,174 from September 30, 2007.

Net Premiums Written. Net premiums written decreased $15.0 million, or 17.2%, to $72.3 million for the three months ended September 30, 2008, from $87.3 million for the three months ended September 30, 2007. The decrease was primarily attributable to a $15.2 million decrease in gross premiums written. Ceded premiums were $2.8 million and $2.9 million, or 3.7% and 3.3%, of gross premiums written for the three months ended September 30, 2008 and September 30, 2007, respectively.

Net Premiums Earned. Net premiums earned decreased $15.4 million, or 17.4%, to $73.1 million for the three months ended September 30, 2008, from $88.5 million for the three months ended September 30, 2007. The decrease in net premiums earned was primarily the result of the decrease in net premiums written.

Net Investment Income. Net investment income decreased $0.7 million, or 4.0%, to $18.5 million for the three months ended September 30, 2008, from $19.2 million for the three months ended September 30, 2007. The decrease in investment income was primarily attributable to a decrease in investment yield which was partially offset by income earned on increased invested assets. The average pre-tax book yield on invested assets decreased approximately $1.5 million, or 33 basis points, to 3.98% at September 30, 2008, as compared to 4.31% at September 30, 2007, due to an increase in short-term investments and cash and cash equivalents.

Realized (Losses) Gains on Investments. Realized losses on investments for the three months ended September 30, 2008, totaled $1.5 million as compared to realized gains of $0.1 million for the three months ended September 30, 2007. The increase was the result of other-than-temporary impairments on equity and fixed maturity securities of $3.8 million for the three months ended September 30, 2008. The other-than-temporary impairments were primarily due to the decline in the fair value of equity securities and one fixed maturity security. These losses were partially offset by net gains of $2.3 million realized on the sale of equity securities.

Losses and LAE. Losses and LAE decreased $15.3 million, or 37.4%, to $25.6 million for the three months ended September 30, 2008, from $40.9 million for the three months ended September 30, 2007. The decrease was primarily due to favorable prior accident year loss development of $25.0 million for the three months ended September 30, 2008, compared with $7.4 million for the three months ended September 30, 2007. The third quarter 2007 development also included an increase to net losses of $1.6 million related to a commutation of excess loss reinsurance agreements with GLOBAL Reinsurance Corporation of America. The quarter over quarter change in net premiums earned reduced losses

 

 

24

 


and LAE by approximately $9.2 million. These reductions were partially offset by an increase to the current year loss estimate.

During the three months ended September 30, 2008, we adjusted the current accident year loss estimate 4.5 percentage points from 61.7% for the six months ended June 30, 2008 to 66.2% for the nine months ended September 30, 2008.

The table below reflects the losses and LAE reserve adjustments for the three months ended:

 

 

 

September 30,

 

 

 

2008

 

2007

 

 

 

(in millions)

Prior accident year favorable development, net

 

$

25.0

 

$

7.4

 

 

 



 



 

LPT reserve favorable change

 

$

 

$

 

LPT amortization of the deferred reinsurance gain

 

$

4.5

 

$

4.6

 

 

 

 

 

 

 

 

 

There was no adjustment in either period to the direct reserves subject to the LPT Agreement. Losses and LAE include amortization of deferred reinsurance gain—LPT Agreement of $4.5 million and $4.6 million for each of the three month periods ended September 30, 2008 and 2007, respectively. Excluding the impact from the LPT Agreement, losses and LAE would have been $30.1 million and $45.5 million, or 41.2% and 51.4%, of net premiums earned for the three months ended September 30, 2008 and 2007, respectively.

Commission Expense. Commission expense decreased $2.3 million, or 18.5%, to $10.1 million for the three months ended September 30, 2008, from $12.4 million for the three months ended September 30, 2007. Commission expense was 13.8% and 14.0% of net premiums earned for the three months ended September 30, 2008 and 2007, respectively. The reduction in commission expense was due to a decrease in net premiums earned and agency incentive commissions.

Underwriting and Other Operating Expense. Underwriting and other operating expense increased $0.2 million, or 0.8%, to $21.9 million for the three months ended September 30, 2008, from $21.7 million for the three months ended September 30, 2007. There were no significant changes to underwriting and other operating expense quarter over quarter.

Income Taxes. Income taxes decreased $4.2 million, resulting in a net tax benefit of $0.3 million for the three months ended September 30, 2008, which compares to $3.9 million in expense for the three months ended September 30, 2007. The decrease in income taxes was primarily due to a change of $4.8 million in the final reversal of the liability for previously unrecognized tax benefits. The effective tax rate for the three months ended September 30, 2008, was a tax benefit rate of 0.9% compared to a tax rate of 11.5% for the same period in 2007. The decrease of 12.4 percentage points in the effective tax rate was primarily due to the reversal of the liability, including interest.

Net Income. Net income increased $3.2 million, or 10.7%, to $33.1 million for the three months ended September 30, 2008, from $29.9 million for the three months ended September 30, 2007. The increase in net income was primarily due to favorable prior accident year loss development of $25.0 million for the three months ended September 30, 2008, compared with $7.4 million for the three months ended September 30, 2007 and the reversal of the tax liability. This was partially offset by lower net premiums earned and related expenses.

Net income includes amortization of deferred reinsurance gain—LPT Agreement of $4.5 million and $4.6 million for the three month periods ended September 30, 2008 and 2007, respectively. Excluding the LPT Agreement amortization, net income would have been $28.5 million and $25.3 million for the three months ended September 30, 2008 and 2007, respectively.

Combined Ratio. The combined ratio improved 5.9 percentage points, to 78.8%, for the three months ended September 30, 2008, from 84.7% for the three months ended September 30, 2007. As a percentage of net premiums earned, reductions in losses and LAE related to prior year favorable loss adjustments more than offset increases in the underwriting and other operating expense ratio.

 

 

25

 


Results of Operations

Nine Months Ended September 30, 2008 and 2007

The following table summarizes our consolidated financial results for the nine months ended September 30, 2008 and 2007:

 

 

 

2008

 

2007

 

Increase
(Decrease)
2008 over
2007

 

Percentage
Increase
(Decrease)
2008 over
2007

 

 

 

(in thousands, except for percentages)

Selected Financial Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross premiums written

 

$

229,918

 

$

271,312

 

$

(41,394

)

 

(15.3

)%

Net premiums written

 

 

221,804

 

 

262,032

 

 

(40,228

)

 

(15.4

)

Net premiums earned

 

$

222,842

 

$

262,436

 

$

(39,594

)

 

(15.1

)%

Net investment income

 

 

55,915

 

 

59,386

 

 

(3,471

)

 

(5.8

)

Realized losses on investments, net

 

 

(3,211

)

 

(322

)

 

(2,889

)

 

n/a

 

Other income

 

 

1,155

 

 

3,047

 

 

(1,892

)

 

(62.1

)

 

 



 



 



 

 

 

 

Total revenues

 

 

276,701

 

 

324,547

 

 

(47,846

)

 

(14.7

)

Losses and LAE

 

 

80,344

 

 

111,336

 

 

(30,992

)

 

(27.8

)

Commission expense

 

 

30,465

 

 

35,797

 

 

(5,332

)

 

(14.9

)

Underwriting and other operating expense

 

 

66,614

 

 

67,778

 

 

(1,164

)

 

(1.7

)

Income tax expense

 

 

13,349

 

 

21,117

 

 

(7,768

)

 

(36.8

)

 

 



 



 



 

 

 

 

Total expenses

 

 

190,772

 

 

236,028

 

 

(45,256

)

 

(19.2

)

 

 



 



 



 

 

 

 

Net income

 

$

85,929

 

$

88,519

 

$

(2,590

)

 

(2.9

)%

 

 



 



 



 

 

 

 

Selected Operating Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

Combined ratio(1)

 

 

79.6

%

 

81.9

%

 

(2.3

)%

 

n/a

 

Net income before impact of LPT Agreement (2)

 

$

72,021

 

$

74,825

 

$

(2,804

)

 

(3.7

)%

______________

(1)

The combined ratio is calculated by dividing the sum of losses and LAE, commission expense and underwriting and other operating expense by net premiums earned.

(2)

We define net income before impact of LPT Agreement as net income less: (a) amortization of deferred reinsurance gain—LPT Agreement and (b) adjustments to LPT Agreement ceded reserves. Deferred reinsurance gain—LPT Agreement reflects the unamortized gain from our LPT Agreement. Under GAAP, this gain is deferred and is being amortized using the recovery method, whereby the amortization is determined by the proportion of actual reinsurance recoveries to total estimated recoveries, and the amortization is reflected in losses and LAE. We periodically reevaluate the remaining direct reserves subject to the LPT Agreement. Our reevaluation results in corresponding adjustments, if needed, to reserves, ceded reserves, reinsurance recoverables and the deferred reinsurance gain, with the net effect being an increase or decrease, as the case may be, to net income. Net income before impact of LPT Agreement is not a measurement of financial performance under GAAP and should not be considered in isolation or as an alternative to net income before income taxes and net income or any other measure of performance derived in accordance with GAAP.

We present net income before impact of LPT Agreement because we believe that it is an important supplemental measure of operating performance to be used by analysts, investors and other interested parties in evaluating us. The LPT Agreement was a non-recurring transaction which does not result in ongoing cash benefits, and, consequently, we believe this presentation is useful in providing a meaningful understanding of our operating performance. In addition, we believe this non-GAAP measure, as we have defined it, is helpful to our management in identifying trends in our performance because the excluded item has limited significance in our current and ongoing operations.

 

 

26

 


The table below shows the reconciliation of net income to net income before impact of LPT Agreement for the nine months ended:

 

 

September 30,

 

2008

 

2007

 

(in thousands)

Net income

$

85,929

 

$

88,519

Less impact of LPT Agreement:

 

 

 

 

 

Amortization of deferred reinsurance gain—LPT Agreement

 

13,908

 

 

13,694

Adjustment to LPT Agreement ceded reserves(a)

 

 

 

 



 



Net income before impact of LPT Agreement

$

72,021

 

$

74,825

 



 



______________

 

(a)

Any adjustment to the estimated direct reserves ceded under the LPT Agreement is reflected in losses and LAE for the period during which the adjustment is determined, with a corresponding increase or decrease in net income in the period. There is a corresponding change to the reinsurance recoverables on unpaid losses as well as the deferred reinsurance gain. A cumulative adjustment to the amortization of the deferred gain is also then recognized in earnings so that the deferred reinsurance gain reflects the balance that would have existed had the revised reserves been recognized at the inception of the LPT Agreement. See Note 6 in the notes to our consolidated financial statements which are included elsewhere in this report.

Gross Premiums Written. Gross premiums written decreased $41.4 million, or 15.3%, to $229.9 million for the nine months ended September 30, 2008, from $271.3 million for the nine months ended September 30, 2007. The decrease in gross premiums written was primarily due to the overall reduction in our average policy size as a result of the impacts of rate reductions, the effects of increased competition and changes in economic and business conditions. Compared to the first nine months of 2007, the average rate level of premiums written during the first nine months of 2008 was 11.9% lower in California due to rate decreases in April 2006 of 10.5%, July 2006 of 12.7%, January 2007 of 9.9% and September 2007 of 4.5%. The average overall in force policy premium at September 30, 2008 decreased to $8,006, or 22.2%, from $10,296 at September 30, 2007. The policy count, however, has increased 9.3% from September 30, 2007, mainly in California, lessening the impact of the change in policy size. The policy count increase was primarily attributable to sales and marketing efforts in our California market. The number of in force policies in California increased 13.0%, or 3,174 from September 30, 2007.

Net Premiums Written. Net premiums written decreased $40.2 million, or 15.4%, to $221.8 million for the nine months ended September 30, 2008, from $262.0 million for the nine months ended September 30, 2007. The decrease was primarily attributable to a $41.4 million decrease in gross premiums written. Ceded premiums were $8.1 million and $9.3 million, or 3.5% and 3.4%, of gross premiums written for the nine months ended September 30, 2008 and 2007, respectively.

Net Premiums Earned. Net premiums earned decreased $39.6 million, or 15.1%, to $222.8 million for the nine months ended September 30, 2008, from $262.4 million for the nine months ended September 30, 2007. The decrease in net premiums earned was primarily the result of the decrease in net premiums written.

Net Investment Income. Net investment income decreased $3.5 million, or 5.8%, to $55.9 million for the nine months ended September 30, 2008, from $59.4 million for the nine months ended September 30, 2007. The decrease was primarily attributable to one-time interest income from the net proceeds of our IPO, a decrease in investment yield as well as a slight decrease in the underlying invested assets. The net proceeds from the IPO generated $1.8 million of interest income prior to distribution to eligible members in 2007. The average pre-tax book yield on invested assets decreased approximately $1.5 million, or approximately 10 basis points, to 4.04% at September 30, 2008, from 4.14% at September 30, 2007, due to an increase in short-term investments and cash and cash equivalents.

Realized Losses on Investments. Realized losses on investments for the nine months ended September 30, 2008, totaled $3.2 million compared to $0.3 million for the nine months ended September 30, 2007. The increase was the result of other-than-temporary impairments on equity and fixed maturity securities of $5.5 million for the nine months ended September 30, 2008. The other-than-temporary impairments were primarily due to the decline in the fair value of equity securities and one fixed maturity security. These losses were partially offset by net gains of $2.3 million realized on the sale of equity securities.

Losses and LAE. Losses and LAE decreased $31.0 million, or 27.8%, to $80.3 million for the nine months ended September 30, 2008, from $111.3 million for the nine months ended September 30, 2007. The decrease was primarily due to the period over period change in net premiums earned which reduced losses and LAE by approximately $25.4 million. Additionally, favorable prior accident year loss development was $53.3 million for the nine months ended

 

 

27

 


September 30, 2008, compared with $43.4 million for the nine months ended September 30, 2007. The offsetting increase of $4.3 million was primarily related to an increase in the current year loss estimate.

Our current year loss estimate was 66.2% for the nine months ended September 30, 2008, as compared with 64.2% for the nine months ended September 30, 2007.

The table below reflects the losses and LAE reserve adjustments for the nine months ended:

 

 

September 30,

 

2008

 

 

2007

 

(in millions)

Prior accident year favorable development, net

$

53.3

 

 

$

43.4

 



 

 



LPT reserve favorable change

$

 

 

$

LPT amortization of the deferred reinsurance gain

$

13.9

 

 

$

13.7

There was no adjustment in either period to the direct reserves subject to the LPT Agreement. Losses and LAE include amortization of deferred reinsurance gain—LPT Agreement of $13.9 million and $13.7 million for the nine months ended September 30, 2008 and 2007, respectively. Excluding the impact from the LPT Agreement, losses and LAE would have been $94.2 million and $125.0 million, or 42.3% and 47.6%, of net premiums earned for the nine months ended September 30, 2008 and 2007, respectively.

Commission Expense. Commission expense decreased $5.3 million, or 14.9%, to $30.5 million for the nine months ended September 30, 2008, from $35.8 million for the nine months ended September 30, 2007. Commission expense was 13.7% and 13.6% of net premiums earned for the nine months ended September 30, 2008 and 2007, respectively. The decrease in commission expense was primarily due to the decrease in net premiums earned.

Underwriting and Other Operating Expense. Underwriting and other operating expense decreased $1.2 million, or 1.7%, to $66.6 million for the nine months ended September 30, 2008, from $67.8 million for the nine months ended September 30, 2007. Premium taxes declined $2.0 million as a result of lower net premiums earned. There was a reduction of $2.8 million in one-time consulting and professional fees related to Sarbanes-Oxley Act compliance and the conversion from a mutual insurance holding company to a stock company in 2007. Additionally, there was a $1.6 million decrease in the allowance for bad debts. These decreases were partially offset by an increase of $3.8 million in salaries and related benefits. Salary and benefit increases included annual salary increases, higher benefit costs for medical coverage and expenses related to the equity and incentive plans.

Income Taxes. Income taxes decreased $7.8 million, or 36.8%, to $13.3 million for the nine months ended September 30, 2008, from $21.1 million for the nine months ended September 30, 2007. The decrease in income taxes was primarily due to a change of $4.8 million for the final reversal of the liability for previously unrecognized tax benefits including interest. The effective tax rate for the nine months ended September 30, 2008, was 13.4% compared to 19.3% for the same period in 2007. The decrease of 5.9 percentage points in the effective tax rate was primarily due to the reversal of the liability.

Net Income. Net income decreased $2.6 million, or 2.9%, to $85.9 million for the nine months ended September 30, 2008, from $88.5 million for the nine months ended September 30, 2007. The decrease in net income was primarily due to reductions in net premiums earned and investment income, partially offset by reduced losses and LAE and income taxes as a result of the reversal of the tax liability.

Net income includes amortization of deferred reinsurance gain—LPT Agreement of $13.9 million and $13.7 million for the nine months ended September 30, 2008 and 2007, respectively. Excluding the LPT Agreement amortization, net income would have been $72.0 million and $74.8 million for the nine months ended September 30, 2008 and 2007, respectively.

Combined Ratio. The combined ratio improved by 2.3 percentage points for the nine months ended September 30, 2008, to 79.6% compared to 81.9% for the nine months ended September 30, 2007. As a percentage of net premiums earned, reductions in losses and LAE related to prior year favorable loss adjustments more than offset increases in the underwriting and other operating expense ratio.

 

 

28

 


Liquidity and Capital Resources

Parent Company. We are a holding company and substantially all of our operations have historically been conducted through our insurance subsidiaries, EICN and ECIC. On October 31, 2008, we completed the acquisition of AmCOMP and, as a result, added two new insurance subsidiaries: EPIC and EAC. Dividends to EHI from our insurance subsidiaries are contingent upon our subsidiaries’ earnings and subject to business considerations and regulatory requirements. The primary uses of cash are to pay stockholder dividends, repurchase common stock, and support general operating expenses.

EICN received approval from the Nevada Commissioner on December 18, 2007, for a $200.0 million extraordinary dividend from EICN special surplus to be paid in 2008. On May 15, 2008, EICN requested and received approval from the Nevada Commissioner to increase the $200.0 million extraordinary dividend to $275.0 million subject to maintaining the risk-based capital (RBC) total adjusted capital of EICN above a specified level on the date of payment after giving effect to such payment. On August 18, 2008, EICN requested and received approval from the Nevada Commissioner to increase the extraordinary dividend from $275.0 million to a total of $355.0 million subject to the same terms and conditions. The additional extraordinary dividend provides capital management flexibility. As of September 30, 2008, $297.0 million in extraordinary dividend had been paid to EHI.

Effective September 30, 2008, EHI and Wells Fargo entered into the Amended Credit Facility. The Amended Credit Facility provides EHI with (a) $150.0 million line of credit through December 31, 2009; (b) $100.0 million line of credit from January 1, 2010 through December 31, 2010; and (c) $50.0 million line of credit from January 1, 2011 through March 26, 2011. Amounts outstanding bear interest at a rate equal to, at our option: (a) a fluctuating rate of 1.25% above Wells Fargo’s prime rate or (b) a fixed rate that is 1.25% above the LIBOR rate then in effect. The Amended Credit Facility is secured by fixed maturity securities that had a fair value of $186.7 million at September 30, 2008. The Amended Credit Facility contains customary non-financial covenants and requires EHI to maintain $7.5 million of cash and cash equivalents at all times. We are currently in compliance with all applicable covenants.

On September 30, 2008, EHI borrowed $150.0 million of funds through the line of credit provided by the Amended Credit Facility to facilitate the acquisition of AmCOMP and for general corporate purposes. In connection with the borrowing, EHI and Wells Fargo entered into an interest rate swap agreement providing that $100.0 million of the amount borrowed will bear interest at approximately 4.9% per annum. The remaining $50.0 million will bear interest at a fluctuating rate based on LIBOR plus 1.25%. Previously, EHI had no amounts outstanding under the Amended Credit Facility.

On October 31, 2008, EHI assumed control of a Loan and Security Agreement (Loan Agreement) previously entered into by AmCOMP and Regions Bank on May 23, 2008. The Loan Agreement provides for term loans of up to $30.0 million in aggregate principal amount to be made by Regions Bank to AmCOMP at any time until May 23, 2010. The scheduled maturity date of any borrowings under the Loan Agreement is May 23, 2017. Proceeds under the Loan Agreement may be used for strategic and general corporate purposes.  Amounts outstanding under the Loan Agreement bear interest at a fluctuating rate based on LIBOR plus 1.60%. The obligations under the Loan Agreement are secured by a pledge of the stock of EPIC and by a pledge of certain surplus notes issued by each of EPIC and EAC. The Loan Agreement contains financial covenants relating to the insurance subsidiaries’ ratio of net written premiums to policyholders’ surplus and combined ratio as well as customary representations, warranties and affirmative and negative covenants. Our obligations under the Loan Agreement are guaranteed by our non-insurance subsidiaries, AmSERV, Inc., Pinnacle Benefits, Inc. and Pinnacle Administrative Company. We have no amounts borrowed under the Loan Agreement and are currently in compliance with all applicable covenants.

Historically, we have met our cash requirements and financed our growth principally from underwriting operations, asset maturities, and investment income. The recent acquisition of AmCOMP was funded through a combination of available cash and funds provided by the Amended Credit Facility.

On February 21, 2008, EHI’s Board of Directors authorized a stock repurchase program (the 2008 Program). The 2008 Program authorizes us to repurchase up to $100 million of our common stock through June 30, 2009. We ex