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| CRMH > SEC Filings for CRMH > Form 10-K on 19-Mar-2009 | All Recent SEC Filings |
19-Mar-2009
Annual Report
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our audited financial statements and related notes included in Item 8 of this annual report. We caution you that our results of operation for prior periods are not indicative of the actual results that may be achieved in future periods. In addition, some of the information contained in this discussion and analysis includes forward-looking statements that involve risks and uncertainties. Many factors may cause our actual results to differ materially from those anticipated or implied by these forward-looking statements including, but not limited to, those discussed in "Risk Factors." You should read the information under "Risk Factors" as presented in Item 1A for information about material risks and uncertainties that affect us, our business and our common shares and the cautionary note regarding "Forward-Looking Statements" which precedes Item 1 in this annual report.
Overview
We are a provider of workers' compensation insurance products. Our main business activities include underwriting primary workers' compensation policies, underwriting workers' compensation reinsurance and excess insurance policies, and providing fee-based management and other services to self-insured entities. We provide primary workers' compensation insurance to employers in California, Arizona, Florida, Nevada, New Jersey, New York, and other states. We reinsure some of the primary business we underwrite and provide excess workers' compensation coverage for self-insured organizations. We provide fee-based management services to self-insured groups in California.
We report our business in the following four segments: (1) primary insurance;
(2) reinsurance; (3) fee-based management services; and (4) corporate and other.
Our primary insurance segment was added with our acquisition of Embarcadero on
November 14, 2006. Effective September 8, 2008, the results of operations of our
subsidiaries, CRM and Eimar, which historically were reported in the fee-based
management services segment, are reported as discontinued operations for all
periods presented.
Workers' Compensation Insurance Market Conditions
Our business segments are affected by the trends of the workers' compensation insurance market. The workers' compensation insurance market has historically fluctuated with periods of low premium rates and excess underwriting capacity resulting from increased competition, followed by periods of high premium rates and shortages of underwriting capacity resulting from decreased competition. Our revenues have historically been generated primarily in California and New York.
California's Premium Rates. The most recent market conditions suggest a stabilizing workers' compensation market in California. Prior to this, we had experienced a significant downward trending in the premium rates charged by insurers. California Bill 899 was passed in April 2004 with the goal of reducing over time the medical and indemnity expenses incurred by insurance companies under workers' compensation policies. This legislation allowed insurers to reduce rates. During 2006 and the first half of 2007, the California Insurance Commissioner approved three workers' compensation advisory pure premium rate decreases. The California Insurance Commissioner first approved a 16% rate decrease for policies written after June 30, 2006, followed by a 9% rate decrease for policies written after December 31, 2006, which was followed by another 14.2% rate decrease for policies written after June 30, 2007.
In November 2007, the California Insurance Commissioner recommended that there be no overall change in workers' compensation advisory pure premium rates for policies written on or after January 1, 2008. This was the first recommendation of no rate decrease by the California Insurance Commissioner since the adoption of the reforms of 2003 and 2004. In May 2008, the California Insurance Commissioner announced that stability in the workers' compensation insurance marketplace had eliminated the immediate need for an interim pure premium rate advisory for policies written on or after June 30, 2008. In August 2008, the Workers' Compensation Insurance Rating Bureau of California, or "WCIRB," an industry-backed private organization that provides statistical analysis, submitted a pure premium rate filing to the California Insurance Commissioner recommending a 16% increase in advisory pure premium rates for policies written on or after January 1, 2009. WCIRB's recommended increase was based primarily on rising medical costs and loss adjustment expenses. In October 2008, the California Insurance Commissioner announced a 5% increase in advisory pure premium rates for policies written on or after January 1, 2009. The California Insurance Commissioner's decisions are advisory only and insurance companies may choose whether or not to adopt the new rates.
New York's Premium Rates. Workers' compensation rates in New York have experienced significant pricing pressure since the legislative reforms adopted in March 2007. Following almost two years of relatively stable rates, in July 2007, the New York State Superintendent of Insurance ordered that overall policyholders' costs for workers' compensation be reduced by an average of 20.5% effective October 1, 2007. This 20.5% reduction included both changes in the workers' compensation rates set by the New York State Workers' Compensation Board as well as a change to the New York State assessment. The rate reduction was based upon an analysis of the impact of the reforms and market trends associated with New York's 2007 Workers' Compensation Reform Act signed into law in March 2007, which was intended to create a significantly less expensive system of workers' compensation in New York while increasing the weekly benefits paid to injured workers. In addition, in February 2008, New York State enacted related legislation that requires workers' compensation insurers to establish premiums based on loss cost multipliers instead of a mandate rate. In August 2008, it was announced that workers' compensation rates in New York will be reduced by an additional 5% percent for 2009, bringing the total reduction to about 25% from the 2007 pre-reform rates.
Principal Revenue and Expense Items
Our revenues consist primarily of the following:
Primary Insurance Net Premiums Earned. Primary insurance premiums earned are the elapsed portion of our net premiums written. Net premiums written is the difference between gross premiums written and premiums ceded or paid to reinsurers. Gross premiums written is the sum of both direct premiums and assumed premiums before the effect of ceded reinsurance. Premiums are earned over the terms of the related policies. At the end of each accounting period, the portion of the premiums that are not yet earned is included in unearned premiums and is realized as revenue in subsequent periods over the remaining terms of the policies.
Reinsurance Net Premiums Earned. Reinsurance premiums are earned over the terms of the related policies. At the end of each accounting period, the portion of the premiums that are not yet earned is included in unearned premiums and is realized as revenue in subsequent periods over the remaining terms of the policies. These premiums are reported in our reinsurance segment.
Management Fees. Our fee-based management service revenues include management fees received from our groups for management and other services. Our fees are based on a percentage of premiums paid by members to the groups we manage.
Investment Income. Our investment income is dependent upon the average invested assets in our portfolio and the yield that we earn on those invested assets. Our investment yield depends on market interest rates and the credit quality and maturity period of our invested assets. In addition, we realize capital gains or losses on sales of investments and realize losses on impairment of investments as a result of changing market conditions, including changes in market interest rates and changes in the credit quality of our invested assets.
Our expenses consist primarily of the following:
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses reflect our best estimate, using various actuarial analyses, of ultimate losses and loss adjustment expenses, net of any reinsurance recoverables, that we expect to incur on each primary insurance and reinsurance contract written. Actual losses and loss adjustment expenses will depend on actual costs to settle our claims.
Policy Acquisition Costs. Policy acquisition costs consist principally of commissions, premium taxes and certain underwriting and other policy issuance costs related to the production of new and renewal business.
Fees Paid to General Agents and Brokers. Fees paid to general agents and brokers consist primarily of commissions paid to general agents and brokers for binding the coverage of members in the self-insured groups we manage.
Selling, General and Administrative Expenses. Selling, general and administrative expenses consist primarily of personnel expenses, professional fees and other operating costs.
Income Taxes. CRM USA Holdings and its U.S. subsidiaries are subject to U.S. federal, state and local income taxes, which reduce our net income. CRM Holdings and Twin Bridges have each received an undertaking from the Bermuda government exempting each company from all tax computed on profits or income, or computed on any capital asset, gain or appreciation, or any tax in the nature of estate duty or inheritance tax until March 28, 2016.
Critical Accounting Policies and Estimates
It is important to understand our accounting policies in order to understand our financial statements. Management considers some of these policies to be critical to the presentation of our financial results, since they require management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures at the financial reporting date and throughout the period being reported upon. Some of the estimates result from judgments that can be subjective and complex, consequently, actual results reflected in future periods might differ from these estimates and could differ by material amounts. In addition, if factors such as those described above in Item 1A under the heading "Risk Factors" cause actual events to differ materially from management's assumptions used in applying the relevant accounting policy, there could be a material adverse effect on our financial condition and results of operations.
We believe that the most critical accounting policies relate to the reporting of reserves for loss and loss adjustment expenses, including losses that have occurred but have not been reported to us prior to the reporting date, amounts recoverable from third party reinsurers, investments, premiums receivable, deferred policy acquisition costs, goodwill, deferred income taxes and the valuation of share based compensation. The following description of our critical accounting policies should be read in conjunction with the notes to our consolidated financial statements.
Reserve for Losses and Loss Adjustment Expenses
We record reserves for estimated losses under insurance policies that we write and for loss adjustment expenses related to the investigation and settlement of policy claims. Our reserves for losses and loss adjustment expenses represent the estimated cost of all reported and unreported losses and loss adjustment expenses incurred and unpaid at any given point in time based on known facts and circumstances. In establishing our reserves, we do not use loss discounting, which would involve recognizing the time value of money and offsetting estimates of future payments by future expected investment income. Our reserves for loss and loss adjustment expenses are estimated using case-by-case valuations and statistical analyses. Additional information regarding our reserves for losses and loss adjustment expenses and our processes for establishing the reserves can be found in Item 1 above under the headings "Business - Primary Insurance Segment - Reserves for Losses and Loss Adjustment Expenses" and "Business - Reinsurance Segment - Reserves for Losses and Loss Adjustment Expenses."
Variation in Ultimate Loss Estimates. The actuarial techniques that we use to establish our loss reserves are based upon a combination of our historical experience as well as industry information. These techniques recognize, among other factors:
• our claims experience;
• the industry's claim experience;
• historical trends in reserving patterns and loss payments;
• the impact of claim inflation and/or deflation;
• the pending level of unpaid claims;
• the cost of claim settlements;
• legislative reforms affecting workers' compensation;
• the overall environment in which insurance companies operate; and
• trends in claim frequency and severity.
In addition, there are loss and loss adjustment expense risk factors that affect workers' compensation claims that can change over time and also cause our loss reserves to fluctuate. Some examples of these risk factors include, but are not limited to, the following:
• recovery time from the injury;
• degree of patient responsiveness to treatment;
• use of pharmaceutical drugs;
• type and effectiveness of medical treatments;
• frequency of visits to healthcare providers;
• changes in costs of medical treatments;
• availability of new medical treatments and equipment;
• types of healthcare providers used;
• availability of light duty for early return to work;
• attorney involvement;
• legislative reform;
• wage inflation in states that index benefits; and
• changes in administrative policies of second injury funds.
Our loss reserve estimates can also vary due to factors that affect our book of primary insurance and reinsurance business. Some examples of these risk factors include, but are not limited to, the following:
• mix of injury type;
• change in mix of business by state;
• change in mix of business by employer type;
• small volume of internal data; and
• significant exposure growth over recent data periods.
Impact of Changes in Key Assumptions on Reserve Volatility. The most significant factor currently impacting our loss reserve estimates is the reliance on historical reserving patterns and loss payments from Majestic and Twin Bridges and the industry, also referred to as loss development patterns. The actuarial methods that we use depend at varying levels on loss development patterns based on past information. Development is defined as the difference, on successive valuation dates, between observed values of certain fundamental metrics that may be used in the loss reserve estimation process. For example, the data may be paid losses, case incurred losses and the change in case reserves or claim counts, including reported claims, closed claims or reopened claims. Development can be expected, meaning it is consistent with prior results; favorable (better than expected); or unfavorable (worse than expected). In all cases, we are comparing the actual development of the data in the current valuation with what was expected based on the historical patterns in the underlying data. Favorable development indicates a basis for reducing the estimated ultimate loss amounts, thereby increasing net income, while unfavorable development indicates a basis for increasing the estimated ultimate loss amounts, thereby decreasing net income. We reflect the favorable or unfavorable development in loss reserves in the results of operations in the period in which the ultimate loss estimates are changed.
The predictive ability of loss development factors is dependent on consistent underwriting, claims handling, and inflation, among other factors, and predictable legislatively and judicially imposed legal requirements. If all things remain equal, losses incurred in 2008 should develop similarly to losses incurred in 2007 and prior years. Thus, if the net loss ratio, which is calculated by dividing the loss and loss adjustment expense by net premiums earned, for premiums written in year one is 67% we expect that the net loss ratio for premiums written in year 2 also would be 67%. However, due to the inherent uncertainty in the loss development factors, our actual liabilities may differ significantly from our original estimates.
Our estimated ultimate losses for accident year 2008 are based on a combination of the three primary methods described in Item 1 above under the heading "Business - Primary Insurance Segment - Reserves for Losses and Loss Adjustment Expenses," plus consideration of trended premiums. This is consistent with our reserving approach for the current accident year at prior year-end valuations. During the year ended December 31, 2008, we adjusted our current year estimated loss ratio in the primary insurance segment to 77% from 68%. We adjusted the estimated loss ratio for 2008 due to previous rate reductions in California and higher than expected losses associated with certain business underwritten in New York.
For all other accident years, the estimated ultimate losses are developed using a variety of actuarial techniques. In reviewing this information, we consider certain factors to be especially important because they increase the variability risk factors in our loss reserve estimates. Majestic's written premiums have grown consistently since our acquisition in November 2006. Part of this growth results from our geographic diversification of Majestic's product offerings to three new states (New Jersey, New York and Florida) that were not included in Majestic's historical data. In addition, a significant portion of Majestic's loss reserves are related to business written in California, which is based largely on Majestic's book of business prior to our acquisition. Over the last several years, three significant comprehensive legislative reforms were enacted in California which resulted in uncertainty regarding the impact of the reforms on loss payments, loss development and, ultimately, loss reserves. Therefore, Majestic's historical data is less reliable as an indicator of future loss. In response to the reform legislation and a continuing drop in the frequency of workers' compensation claims, the pure premium rates approved by the California Insurance Commissioner effective January 1, 2008 were 65.1% lower than the pure premium rates in effect as of July 1,
2003. We consider all of these factors to be important in our review of the data because they increase the variability risk factors in our loss reserve estimates.
In our primary insurance segment, our paid loss data for state act indemnity for California displayed decreasing, or deflationary, trends over the most recent valuations at December 31, 2008. The decreasing trends are exhibited in the paid loss development data for the 2004 through 2007 accident years. The decisions to decrease the estimated ultimate losses for accident years 2004 and 2005 at December 31, 2006, and for accident years 2005 and 2006 at December 31, 2007, and for accident years 2006 and 2007 at December 31, 2008, were appropriately made, as the underlying loss data showed sustained and continued improvement over the prior twelve months, which we determined was an appropriate amount of time to be considered reliable for our estimate. We believe that our loss development factor selections are appropriate given the relative immaturity of our data. Over time, as the data for these accident years mature and uncertainty surrounding the ultimate outcome of the claim costs diminishes, the full impact of the actual loss development will be factored into our assumptions and selections.
In our reinsurance segment, since we have limited historical experience, prior year losses were estimated based on industry data and resulted in reinsurance loss ratios ranging from 32% to 66%. We reevaluated the loss ratios at December 31, 2007 and December 31, 2008 and recognized favorable development for the years ended December 31, 2008 and 2007. The favorable development relates primarily to accident years 2005 and 2006 for which actual results have been better than industry excess of loss factors. We establish our reinsurance segment loss reserves at the actuary's best estimate of expected outcomes for most direct and assumed risks, and at a higher, moderately conservative level for risks originating from the self-insured groups in New York.
Reserve Sensitivities. Although many factors influence the actual cost of claims and the corresponding unpaid loss and loss adjustment expense estimates, we do not measure and estimate values for all of these variables individually. This is due to the fact that many of the factors that are known to impact the cost of claims cannot be measured directly. One such factor is the impact of economic inflation on claim costs and coverage interpretations. In most instances, we rely on historical experience or industry information to estimate values for the variables that are explicitly used in the unpaid loss and loss adjustment expense analysis. We assume that the historical effect of these unmeasured factors, which is embedded in our experience or industry experience, is representative of future effects of these factors. Nevertheless, actual claims costs will vary from our estimate of ultimate claim costs, perhaps by substantial amounts, due to the inherent variability of the business written, the potentially significant claim settlement lags and the fact that not all events affecting future claim costs can be estimated.
As discussed above, there are a number of variables that can impact, individually or in combination, the adequacy of our loss and loss adjustment expense liabilities. While the actuarial methods employed factor in amounts for these circumstances, the loss reserves may prove to be inadequate despite the actuarial methods used. An example is provided below to highlight the potential variability present in our loss reserves
Claim cost inflation can result from medical cost inflation, wage inflation and severity of injury. As discussed above, the actuarial methods employed include an amount for claim cost inflation based on historical experience with some adjustment in cases of legislative reforms. We assume that the historical effect of this factor, which is embedded in our experience and industry experience, is representative of future effects for claim inflation. To the extent that the historical factors, and the actuarial methods utilized, are inadequate to recognize future inflationary trends, our unpaid loss and loss adjustment expense liabilities may be inadequate. The more recent accident years are subject to greater variability. If our estimate of future loss cost trends is three percentage points inadequate (e.g., if we estimate a 6% inflation annual trend and the actual trend is 9%), our unpaid loss and loss adjustment expense liability in our primary insurance segment would be inadequate by approximately $6.0 million on a pre-tax basis, or 2%, as of December 31, 2008. Using the same assumptions for our reinsurance segment, our unpaid loss and loss adjustment expense liabilities in our reinsurance segment would be inadequate by approximately $1.0 million on a pre-tax basis, or 3%, as of December 31, 2008. Under these assumptions, the inadequacy of approximately $7.0 million represents approximately 7% of total shareholders' equity at December 31, 2008. The impact of any reserve deficiencies, or redundancies, on our reported results and future earnings is discussed below.
We review our reserves on a quarterly basis to determine whether they are consistent with our actual results. In the event of a discrepancy, we would seek to determine the causes (underwriting, claims, inflation, regulatory) and would adjust our reserves accordingly. In the event that our estimates of ultimate unpaid loss and loss adjustment
expense liabilities prove to be greater or less than the ultimate liability, our future earnings and financial position could be positively or negatively impacted. Future earnings would be reduced by the amount of any deficiencies in the year(s) in which the claims are paid or the unpaid loss and loss adjustment expense liabilities are increased. For example, if we determined our unpaid loss and loss adjustment expense liability in our primary insurance segment of $214.4 million as of December 31, 2008 to be 5% inadequate, we would experience a pre-tax reduction in future earnings of approximately $10.7 million. If we determined our unpaid loss and loss adjustment expense liability in our reinsurance segment of $31.2 million as of December 31, 2008 to be 5% inadequate, we would experience a pre-tax reduction in future earnings of approximately $1.6 million. The reduction could be realized in one year or multiple years, depending on when the deficiency is identified. The deficiency would also impact our financial position because our statutory surplus would be reduced by an amount equal to the reduction in net income. Any deficiency is typically recognized in the unpaid loss and loss adjustment expense liability and, accordingly, it typically does not have a material effect on our liquidity because the claims have not been paid. Since the claims will typically be paid out over a multi-year period, we have generally been able to adjust our investments to match the anticipated future claim payments. Conversely, if our estimates of ultimate unpaid loss and loss adjustment expense liabilities prove to be redundant, our future earnings and financial position would be improved.
Reinsurance Recoverable
Amounts recoverable from reinsurers are estimated on an individual contract basis, in a manner consistent with the associated reserve for losses and loss adjustment expenses. Included in reinsurance recoverables are paid losses recoverable from reinsurers and prepaid reinsurance premiums to reinsurers. Such recoverables are reported net of any allowance for estimated uncollectible reinsurance recoverables. We evaluate and monitor the financial condition of our reinsurers to minimize our exposure to significant losses from reinsurer insolvencies. We calculate amounts recoverable from reinsurers based on our estimates of the underlying loss and loss adjustment expenses, which themselves are subject to significant judgments and uncertainties described above under the heading "Reserve for Losses and Loss Adjustment Expenses." Changes in the estimates and assumptions underlying the calculation of our loss reserves may have an impact on the balance of our reinsurance recoverables. In general, one would expect an increase in our underlying loss reserves on claims subject to reinsurance to increase our reinsurance recoverables. The amount of the increase would depend on a number of considerations including, but not limited to, the terms and attachment points of our reinsurance contracts and the incurred amount on various claims subject to reinsurance. Changes in reinsurance recoverables are recorded in the period in which the estimate is revised. We assessed the collectability of our year-end receivables and believe that all amounts are collectible based on currently available information. Therefore, as of . . .
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