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EIHI > SEC Filings for EIHI > Form 10-Q on 1-Nov-2012All Recent SEC Filings

Show all filings for EASTERN INSURANCE HOLDINGS, INC.

Form 10-Q for EASTERN INSURANCE HOLDINGS, INC.


1-Nov-2012

Quarterly Report


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

The following discussion and analysis of financial condition and results of operations should be read in conjunction with the unaudited interim consolidated financial statements of Eastern Insurance Holdings, Inc. (the "Company") and the related notes thereto included in Item 1 of this Part 1. The information contained in this quarterly report is not a complete description of the Company's business or the risks associated with an investment in the Company's common stock. You should carefully review and consider the various disclosures made by the Company in this quarterly report and in the Company's Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 12, 2012.

Forward-looking Statements

The Company may from time to time make written or oral "forward-looking statements," including statements contained in the Company's filings with the U.S. Securities and Exchange Commission (including this Quarterly Report on Form 10-Q and the exhibits hereto), in its reports to shareholders and in other communications by the Company, which are made in good faith by the Company pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995.

These forward-looking statements include statements with respect to the Company's beliefs, plans, objectives, goals, expectations, anticipations, estimates and intentions, that are subject to significant risks and uncertainties, and are subject to change based on various factors (some of which are beyond the Company's control). The words "may," "could," "should," "would," "believe," "anticipate," "estimate," "expect," "intend," "plan" and similar expressions are intended to identify forward-looking statements. The following factors, among others, could cause the Company's financial performance to differ materially from the plans, objectives, expectations, estimates and intentions expressed in such forward-looking statements:

the ability to carry out our business plans;

future economic conditions in the regional and national markets in which we compete that are less favorable than expected;

the effect of legislative, judicial, economic, demographic and regulatory events in the states in which we do business;

the ability to obtain licenses and enter new markets successfully and capitalize on growth opportunities either through mergers or the expansion of our producer network;

financial market conditions, including, but not limited to, changes in interest rates and the credit and equity markets causing a reduction of investment income or investment gains, an acceleration of the amortization of deferred policy acquisition costs, reduction in the value of our investment portfolio or a reduction in the demand for our products;

the impact of acts of terrorism and acts of war;

the effects of terrorist related insurance legislation and laws;

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

the cost, availability and collectibility of reinsurance;

estimates and adequacy of loss reserves and trends in losses and LAE;

heightened competition, including specifically the intensification of price competition, increased underwriting capacity and the entry of new competitors and the development of new products by new and existing competitors;

the effects of mergers, acquisitions and dispositions;

changes in the coverage terms selected by insurance customers, including higher deductibles and lower limits;

changes in the underwriting criteria that we use resulting from competitive pressures;

our inability to obtain regulatory approval of, or to implement, premium rate increases;

the potential impact on our reported earnings that could result from the adoption of future accounting standards issued by the FASB or other standard setting bodies;

our inability to carry out marketing and sales plans, including, among others, development of new products or changes to existing products and acceptance of the new or revised products in the market;

unanticipated changes in industry trends and ratings assigned by nationally recognized rating organizations;

adverse litigation or arbitration results including, without limitation, the AIG Arbitration; and

adverse changes in applicable laws, regulations or rules governing insurance holding companies and insurance companies, and tax or accounting matters including limitations on premium levels, increases in minimum capital and reserves, and other financial viability requirements, and changes that affect the cost of, or demand for our products.


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The Company cautions that the foregoing list of important factors is not exclusive. Readers are also cautioned not to place undue reliance on these forward-looking statements, which reflect management's analysis only as of the date of this report. The Company does not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of the Company.

Overview

The Company reported net income from continuing operations of $2.8 million and $7.1 million for the three and nine months ended September 30, 2012, compared to net income from continuing operations of $656,000 and $4.5 million for the same periods in 2011. The Company's consolidated combined ratio was 97.2% and 95.3% for the three and nine months ended September 30, 2012, compared to 92.6% and 95.2% for the same periods in 2011.

The Company's results of operations for the three and nine months ended September 30, 2012, when compared to the same periods in 2011, reflect the following:

Net premiums earned increased 22.1% and 21.5% for the three and nine months ended September 30, 2012, compared to the same period in 2011. The increase primarily reflects new business writings, an increase in audit premium and renewal rate increases, partially offset by a decrease in the renewal retention rate.

Net realized investment gains (losses) for the three and nine months ended September 30, 2012 reflect an increase in the estimated fair value of the Company's convertible bond portfolio of $589,000 and $803,000 for the three and nine months ended September 30, 2012, compared to a decrease in the estimated fair value of $1.5 million for the same periods in 2011. Net realized investment gains for the nine months ended September 30, 2012 include a realized loss of $641,000 related to the commutation of the SprinklerPro contract during the second quarter.

The increase in the combined ratio from 2011 to 2012 primarily reflects an increase in the accident period loss ratio in both the workers' compensation insurance and segregated portfolio cell reinsurance segments. The consolidated expense ratio decreased from 2011 to 2012, primarily reflecting the increase in net premiums earned and a decrease in stock compensation expense, partially offset by the change in accounting related to deferred acquisition costs.

Effective January 1, 2012, the Company adopted ASU 2010-26, which resulted in a decrease in the amount of underwriting salaries capitalized and deferred over the life of the underlying workers' compensation insurance policies. The change in accounting resulted in the Company expensing underwriting salaries of approximately $566,000 ($368,000, net of tax) and $1,511,000 ($982,000 net of tax) for the three and nine months ended September 30, 2012 that would have been capitalized and deferred prior to the adoption of ASU 2010-26. The adoption of ASU 2012-26 increased the Company's consolidated expense ratio by 1.4 and 1.3 percentage points for the three and nine months ended September 30, 2012, respectively.

Principal Revenue and Expense Items

The Company derives its revenue primarily from net premiums earned, including assumed premiums earned, net investment income and net realized investment gains.

Direct and net premiums written. Direct premiums written is the sum of both direct premiums and assumed premiums before the effect of ceded reinsurance. Direct premiums written include all premiums billed during a specific policy period. Net premiums written is the difference between direct premiums written and premiums ceded or paid to reinsurers (ceded premiums written). In the segregated portfolio cell reinsurance segment, assumed premiums are derived from insurance contracts written by the Company and ceded to the segregated portfolio cells. In the run-off specialty reinsurance segment, assumed premiums are premiums that are received from a third party under a reinsurance agreement, which are reported to the Company directly from the broker one quarter in arrears.

Net premiums earned. Net premiums earned are the earned portion of the Company's net premiums written. Premiums are earned over the term of the related policies. At the end of each accounting period, the portion of the premiums that are not yet earned are included in unearned premiums and are realized as revenue in subsequent periods over the remaining term of the policy. The Company's workers' compensation policies typically have a term of twelve months. Thus, for example, for a policy that is written on July 1, 2011, one-half of the premiums would be earned in 2011 and the other half would be earned in 2012. Workers' compensation premiums are determined based upon the payroll of the insured, the applicable premium rates and, where applicable, an experience based modification factor. An audit of the policyholders' records is conducted after policy expiration, to make a final determination of applicable premiums. Included with net premiums earned is an estimate for earned but unbilled final audit premiums. The Company can estimate earned but unbilled premiums because it keeps track, by policy, of how much additional premium is billed (or returned to insureds as a result of payroll reductions) in final audit invoices as a percentage to estimate the probable additional amount that it has earned but not yet billed as of the balance sheet date.


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Net investment income and realized gains and losses on investments. The Company invests its surplus and the funds supporting its insurance liabilities (including unearned premiums and unpaid losses and loss adjustment expenses) in cash, cash equivalents, fixed income securities, convertible bonds, equity securities, and other long-term investments. Investment income includes interest earned on invested assets, including the impact of premium amortization and discount accretion. Realized gains and losses on invested assets are reported separately from net investment income. The Company recognizes realized gains when invested assets are sold for an amount greater than their cost or amortized cost (in the case of fixed income securities) and recognizes realized losses when investment securities are written down as a result of an other than temporary impairment or sold for an amount less than their cost or amortized cost. Realized gains and losses also include the change in fair value of convertible bonds.

Other revenue. Other revenue includes claim administration, risk management, and cell rental fees earned. There are other revenue items that the Company recognizes on a segmental basis that are eliminated in consolidation. Such items consist primarily of fees paid by the segregated portfolio cells to other entities within the consolidated group. The segregated portfolio cells recognize an expense for such items (included as part of its ceding commission) and a corresponding revenue item is recognized by the affiliate providing the service. For segment reporting purposes, such revenue items primarily include claims administration, risk management, and cell rental fees. Fronting fees are included in acquisition and other underwriting expenses as an offset to the direct costs incurred. For segment reporting purposes, such fees are recognized ratably over the period in which the service is provided, which generally corresponds to the earned portion of net premiums written for the underlying policies.

The Company's expenses consist primarily of losses and LAE, acquisition and other underwriting expenses, policyholder dividends, other expenses, and income taxes:

Losses and LAE. Losses and LAE represent the largest expense item and include:
(1) claim payments made, (2) estimates for future claim payments and changes in those estimates from prior periods, and (3) costs associated with investigating, defending and adjusting claims.

Acquisition and other underwriting expenses. In the workers' compensation insurance segment, expenses incurred to underwrite risks are referred to as acquisition and other underwriting expenses, which consist of commissions, premium taxes and fees and other underwriting expenses incurred in acquiring, writing and administering the Company's business. In the segregated portfolio cell reinsurance and run-off specialty reinsurance segments, acquisition and other underwriting expenses consist of ceding commissions earned under the respective reinsurance agreements. Ceding commissions received are netted against acquisition and other underwriting expenses.

Other expenses. Other expenses consist of general administrative expenses such as salaries, rent, office supplies, depreciation and all other operating expenses not otherwise classified separately. Other expenses also include interest expense related primarily to the Company's loan payable.

Policyholder dividend expense. Policyholder dividends represent the amount of dividends incurred during the period that are expected to be returned to policyholders. The dividend expense is based on the loss experience of the underlying workers' compensation insurance policy.

Income tax expense. EIHI and certain of its subsidiaries pay federal, state and local income taxes. Income tax expense includes an amount for both current and deferred income taxes. Current income tax expense includes an amount for the Company's current year federal income tax liability and any adjustments related to differences between the prior year federal income tax estimate and the actual income tax expense reported in the tax return. Deferred tax expense represents the change in the Company's net deferred tax asset, exclusive of the tax effect related to changes in unrealized gains and losses in the Company's investment portfolio and changes in the unrecognized amounts related to the Company's benefit plan liabilities.

Key Financial Measures

The Company evaluates its insurance operations by monitoring certain key measures of growth and profitability. The Company measures growth by monitoring changes in direct premiums written and net premiums written. The Company measures underwriting profitability by examining loss, expense and combined ratios. On a segmental basis, the Company measures a segment's operating results by examining net income, diluted earnings per share, and return on average equity.

Loss ratio. The loss ratio is the ratio (expressed as a percentage) of losses and LAE incurred to net premiums earned and measures the underwriting profitability of a company's insurance business. The Company measures the loss ratio on an accident year and calendar year loss basis to measure underwriting profitability. An accident year loss ratio measures losses and LAE for insured events occurring in a particular year, regardless of when they are reported, as a percentage of net premiums earned during that year. A calendar year loss ratio measures losses and LAE for insured events occurring during a particular year and the change in loss reserves from prior accident years as a percentage of net premiums earned during that year.


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Expense ratio. The expense ratio is the ratio (expressed as a percentage) of the sum of the acquisition and other underwriting expenses and other expenses to net premiums earned and measures the Company's operational efficiency in producing, underwriting and administering its insurance business.

Policyholder dividend expense ratio. The policyholder dividend expense ratio is the ratio (expressed as a percentage) of policyholder dividend expense to net premiums earned and measures the impact of the Company's policyholder dividend policies on its workers' compensation insurance segment.

Combined ratio. The combined ratio is the sum of the loss ratio and the expense ratio and measures the Company's overall underwriting profit. If the combined ratio is below 100%, the Company is making an underwriting profit. If the Company's combined ratio is at or above 100%, the Company is not profitable without investment income and may not be profitable if investment income is insufficient.

Net income, diluted earnings per share, and return on average equity. The Company uses net income and diluted earnings per share to measure its profits and return on average equity to measure its effectiveness in utilizing shareholders' equity to generate net income. In determining return on average equity for a given year, net income is divided by the average of the beginning and ending shareholders' equity for that year.

Critical Accounting Policies and Estimates

The preparation of financial statements in accordance with U.S. GAAP requires both the use of estimates and judgment relative to the application of appropriate accounting policies. The Company is required to make estimates and assumptions in certain circumstances that affect amounts reported in the consolidated financial statements and related footnotes. The Company evaluates these estimates and assumptions on an on-going basis based on historical developments, market conditions, industry trends and other information that is believed to be reasonable under the circumstances. There can be no assurance that actual results will conform to the estimates and assumptions and that reported results of operations will not be materially adversely affected by the need to make accounting adjustments to reflect changes in these estimates and assumptions from time to time. The Company believes the following policies are the most sensitive to estimates and judgments.

Reserves for Unpaid Losses and LAE

The Company establishes reserves for unpaid losses and LAE for its workers' compensation insurance, segregated portfolio cell reinsurance and run-off specialty reinsurance products, which are estimates of future payments of reported and unreported claims for losses and related expenses. The adequacy of the Company's reserves for unpaid losses and LAE are inherently uncertain because the ultimate amount that the Company may pay under many of the claims incurred as of the balance sheet date will not be known for many years. Establishing reserves continues to be a complex and imprecise process, requiring the use of informed estimates and judgments. The Company's estimates and judgments may be revised as additional experience and other data becomes available and are reviewed, as new or improved methodologies are developed, or as current laws change. Any such revisions could result in future changes in estimates of losses or reinsurance recoverable and would be reflected in the Company's results of operations in the period in which the estimates are changed. Estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management's informed estimates and judgments using data currently available. If ultimate losses, net of reinsurance, prove to be substantially higher than the amounts recorded as of September 30, 2012, the related adjustments could have a material adverse effect on the Company's financial condition, results of operations or liquidity.

The Company discounts its workers' compensation reserves, using a discount rate of approximately 3.0%. As of September 30, 2012 and December 31, 2011, the Company's reserves for unpaid losses and LAE were reduced by $6.2 million and $5.7 million, respectively, related to the effects of discounting.


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The Company's reserves for unpaid losses and LAE in its workers' compensation insurance, segregated portfolio cell reinsurance and corporate/other segments as of September 30, 2012 (unaudited) and December 31, 2011 are summarized below (in thousands):

                                                                   Segregated
                                                 Workers'           Portfolio
                                               Compensation           Cell
                                                Insurance          Reinsurance        Corporate/
September 30, 2012                               Segment             Segment            Other           Total
Case / tabular reserves                       $       44,754      $       8,785      $         -      $  53,539
Case incurred development, IBNR, and
unallocated LAE reserves                              38,020             15,157               206        53,383
Amount of discount                                    (5,027 )           (1,197 )              -         (6,224 )

Net reserves                                          77,747             22,745               206       100,698
Reinsurance recoverables on unpaid losses
and LAE                                                9,415              5,572                -         14,987

Reserves for unpaid losses and LAE            $       87,162      $      28,317      $        206     $ 115,685

                                                                   Segregated
                                                 Workers'           Portfolio
                                               Compensation           Cell
                                                Insurance          Reinsurance        Corporate/
December 31, 2011                                Segment             Segment            Other           Total
Case / tabular reserves                       $       39,380      $      10,229      $         -      $  49,609
Case incurred development, IBNR, and
unallocated LAE reserves                              37,249             12,931               206        50,386
Amount of discount                                    (4,527 )           (1,196 )              -         (5,723 )

Net reserves                                          72,102             21,964               206        94,272
Reinsurance recoverables on unpaid losses
and LAE                                                9,007              2,798                -         11,805

Reserves for unpaid losses and LAE            $       81,109      $      24,762      $        206     $ 106,077

"Other Than Temporary" Investment Impairments

Unrealized investment gains or losses on investments carried at estimated fair value, net of applicable income taxes, are reflected directly in shareholders' equity as a component of accumulated other comprehensive income (loss) and, accordingly, have no effect on net income. When, in the opinion of management, a decline in the fair value of an investment below its cost or amortized cost is considered to be "other-than-temporary," such investment is written down to its fair value at the balance sheet date. The amount written down is recorded as a realized loss in the consolidated statements of operations and comprehensive income (loss). Generally, the determination of other-than-temporary impairment includes, in addition to other relevant factors, a presumption that if the market value is below cost by a significant amount for a period of time, a write-down is necessary. Notwithstanding this presumption, the determination of other-than-temporary impairment requires judgment about future prospects for an investment and is therefore a matter of inherent uncertainty. The Company recognized other-than-temporary impairments, excluding impairments in the segregated portfolio cell reinsurance segment, of $40,000 and $127,000 during the three and nine months ended September 30, 2012. There were no impairments during the three and nine months ended September 30, 2011. There were no other-than-temporary impairments in the segregated portfolio cell reinsurance segment during the three and nine months ended September 30, 2012. Other-than-temporary impairments in the segregated portfolio cell reinsurance segment totaled $35,000 and $36,000 for the three and nine months ended September 30, 2011, respectively.

The Company generally applies the following standards in determining whether the decline in fair value of an investment is other-than-temporary:

Equity securities. An equity security is considered impaired when one of the following conditions exist: 1) an equity security's market value is less than 80% of its cost for a continuous period of 6 months, 2) an equity security's market value is less than 50% of its cost, regardless of the amount of time the security's market value has been below cost, and 3) an equity security's market value has been less than cost for a continuous period of 12 months or more, regardless of the magnitude of the decline in market value. Equity securities that are in an unrealized loss position, but do not meet the above quantitative thresholds are evaluated to determine if the decline in market value is other than temporary.

The Company recognized an other-than-temporary impairment of $40,000 related to one equity security during the three months ended September 30, 2012. The Company recognized other-than-temporary impairments of $127,000 related to two equity securities during nine months ended September 30, 2012. The impairments related equity securities that had been in an unrealized loss position for more than 12 months. The Company did not recognize any other-than-temporary impairments related to its equity security portfolio for the three and nine months ended September 30, 2011.


Table of Contents

As of September 30, 2012, the Company held equity securities, excluding equity securities in the segregated portfolio cell reinsurance segment, with gross unrealized losses of $32,000, none of which were in an unrealized loss position for more than twelve months. The Company does not intend to sell the equity securities and it is not more likely than not that the Company will be required to sell the equity securities before recovery of their cost bases; therefore, management does not consider the equity securities to be other-than-temporarily impaired as of September 30, 2012. Adverse investment market conditions, or poor operating results of underlying investments, could result in impairment charges in the future.

Fixed income securities. A fixed income security is considered to be other-than-temporarily impaired when the security's estimated fair value is less than its amortized cost basis and 1) the Company intends to sell the security,
2) it is more likely than not that the Company will be required to sell the security before recovery of the security's amortized cost basis, or 3) the Company believes it will be unable to recover the entire amortized cost basis of the security (i.e., a credit loss has occurred). When the Company determines a credit loss has been incurred, but the Company does not intend to sell the security and it is not more likely than not that the Company will be required to sell the security before recovery of the security's amortized cost basis, the portion of the other-than-temporary impairment that is credit related is recorded as a realized loss in the consolidated statements of operations and . . .

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