XNYS:EIG Employers Holdings Inc Quarterly Report 10-Q Filing - 3/31/2012

Effective Date 3/31/2012

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549


FORM 10-Q

R  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the Quarterly Period Ended March 31, 2012

OR

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from ____  to ____

Commission file number: 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 Number)
 
 
 
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. Yes R No o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes R 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 R
Accelerated filer o
Non-accelerated filer o
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 R
 
Class
 
April 30, 2012
Common Stock, $0.01 par value per share
 
31,613,958 shares outstanding




 
 
Page
No.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


2



PART IFINANCIAL INFORMATION
Item 1.  Consolidated Financial Statements
Employers Holdings, Inc. and Subsidiaries
Consolidated Balance Sheets
(in thousands, except share data)
 
 
As of
 
As of
 
 
March 31,
2012
 
December 31,
2011
Assets
 
(unaudited)
 
 
Available for sale:
 
 
 
 
Fixed maturity securities at fair value (amortized cost $1,739,320 at March 31, 2012
and $1,706,216 at December 31, 2011)
 
$
1,881,346

 
$
1,852,699

Equity securities at fair value (cost $80,064 at March 31, 2012 and $64,962 at
December 31, 2011)
 
125,126

 
98,046

Total investments
 
2,006,472

 
1,950,745

Cash and cash equivalents
 
201,555

 
252,300

Restricted cash and cash equivalents
 
10,611

 
6,299

Accrued investment income
 
18,901

 
19,537

Premiums receivable (less bad debt allowance of $5,761 at March 31, 2012 and $5,546 at December 31, 2011)
 
186,361

 
160,443

Reinsurance recoverable for:
 
 

 


Paid losses
 
10,719

 
10,729

Unpaid losses
 
929,349

 
940,840

Funds held by or deposited with reinsureds
 
496

 
1,102

Deferred policy acquisition costs
 
38,763

 
37,524

Federal income taxes recoverable
 
972

 
1,993

Deferred income taxes, net
 
24,656

 
22,140

Property and equipment, net
 
11,998

 
11,360

Intangible assets, net
 
11,425

 
11,728

Goodwill
 
36,192

 
36,192

Other assets
 
17,621

 
18,812

Total assets
 
$
3,506,091

 
$
3,481,744

 
 
 
 
 
Liabilities and stockholders’ equity
 
 

 
 

Claims and policy liabilities:
 
 

 
 

Unpaid losses and loss adjustment expenses
 
$
2,271,422

 
$
2,272,363

Unearned premiums
 
225,698

 
194,933

Policyholders’ dividends accrued
 
3,734

 
3,838

Total claims and policy liabilities
 
2,500,854

 
2,471,134

Commissions and premium taxes payable
 
31,267

 
28,905

Accounts payable and accrued expenses
 
17,357

 
16,446

Deferred reinsurance gain—LPT Agreement
 
349,038

 
353,194

Notes payable
 
122,000

 
122,000

Other liabilities
 
19,855

 
15,879

Total liabilities
 
3,040,371

 
3,007,558

 
 
 
 
 
Commitments and contingencies
 


 


 
 
 
 
 
Stockholders’ equity:
 
 

 
 

Common stock, $0.01 par value; 150,000,000 shares authorized; 53,969,903 and 53,948,442
shares issued and 31,935,474 and 32,996,809 shares outstanding at March 31, 2012 and
December 31, 2011, respectively
 
540

 
540

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

 

Additional paid-in capital
 
320,086

 
318,989

Retained earnings
 
362,972

 
358,693

Accumulated other comprehensive income, net
 
121,607

 
116,719

Treasury stock, at cost (22,034,429 shares at March 31, 2012 and 20,951,633 shares
at December 31, 2011)
 
(339,485
)
 
(320,755
)
Total stockholders’ equity
 
465,720

 
474,186

Total liabilities and stockholders’ equity
 
$
3,506,091

 
$
3,481,744

See accompanying unaudited notes to the consolidated financial statements.

3



Employers Holdings, Inc. and Subsidiaries
Consolidated Statements of Comprehensive Income
(in thousands, except per share data)
 
 
 
Three Months Ended
 
 
March 31,
 
 
2012
 
2011
Revenues
 
(unaudited)
Net premiums earned
 
$
109,900

 
$
82,427

Net investment income
 
18,385

 
20,493

Realized gains on investments, net
 
1,778

 
234

Other income
 
81

 
120

Total revenues
 
130,144

 
103,274

 
 
 
 
 
Expenses
 
 

 
 

Losses and loss adjustment expenses
 
80,923

 
59,421

Commission expense
 
13,529

 
10,281

Policyholder dividends
 
847

 
1,012

Underwriting and other operating expenses
 
32,142

 
25,678

Interest expense
 
902

 
917

Total expenses
 
128,343

 
97,309

 
 
 
 
 
Net income before income taxes
 
1,801

 
5,965

Income tax (benefit)
 
(4,421
)
 
(2,380
)
Net income
 
$
6,222

 
$
8,345


 
 
 
 
Comprehensive income
 
 
 
 
Unrealized gains (losses) during the period (net of taxes of $3,255 and $(1,530) for the three months ended March 31, 2012 and March 31, 2011, respectively)
 
$
6,044

 
$
(2,844
)
Less: reclassification adjustment for realized gains in net income (net of taxes of $622 and $82 for the three months ended March 31, 2012 and March 31, 2011, respectively)
 
1,156

 
152

Other comprehensive income (loss), net of tax
 
4,888

 
(2,996
)
 
 
 
 
 
Total comprehensive income
 
$
11,110

 
$
5,349

 
 
 
 
 
Earnings per common share (Note 10):
 
 
 
 
Basic
 
$
0.19

 
$
0.22

Diluted
 
$
0.19

 
$
0.21

Cash dividends declared per common share
 
$
0.06

 
$
0.06

 
 
 
 
 
Realized gains on investments, net
 
 
 
 
Net realized gains on investments before credit related impairments on fixed maturity securities
 
$
2,246

 
$
234

Other than temporary impairment, credit losses recognized in earnings
 
(468
)
 

Portion of impairment recognized in other comprehensive income
 

 

Realized gains on investments, net
 
$
1,778

 
$
234


See accompanying unaudited notes to the consolidated financial statements.

4



Employers Holdings, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(in thousands)
 
 
Three Months Ended
 
 
March 31,
 
 
2012
 
2011
Operating activities
 
(unaudited)
Net income
 
$
6,222

 
$
8,345

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

 
 

Depreciation and amortization
 
1,414

 
1,841

Stock-based compensation
 
1,241

 
640

Amortization of premium on investments, net
 
1,533

 
2,017

Allowance for doubtful accounts
 
215

 
(599
)
Deferred income tax expense
 
(5,149
)
 
(1,397
)
Realized gains on investments, net
 
(1,778
)
 
(234
)
Realized losses on retirement of assets
 
346

 
68

Change in operating assets and liabilities:
 
 

 
 

Accrued investment income
 
636

 
1,597

Premiums receivable
 
(26,133
)
 
(19,196
)
Reinsurance recoverable for paid and unpaid losses
 
11,501

 
11,419

Funds held by or deposited with reinsureds
 
606

 
1,019

Federal income taxes recoverable
 
1,021

 
(997
)
Unpaid losses and loss adjustment expenses
 
(941
)
 
(11,990
)
Unearned premiums
 
30,765

 
18,086

Accounts payable, accrued expenses and other liabilities
 
4,886

 
467

Deferred reinsurance gain – LPT Agreement
 
(4,156
)
 
(4,519
)
Other
 
2,211

 
(1,252
)
Net cash provided by operating activities
 
24,440

 
5,315

Investing activities
 
 

 
 

Purchase of fixed maturities
 
(108,315
)
 
(23,925
)
Purchase of equity securities
 
(18,520
)
 
(1,054
)
Proceeds from sale of fixed maturities
 
28,657

 
22,099

Proceeds from sale of equity securities
 
3,497

 
1,096

Proceeds from maturities and redemptions of investments
 
46,721

 
49,457

Proceeds from sale of fixed assets
 
42

 

Capital expenditures and other
 
(2,138
)
 
(863
)
Restricted cash and cash equivalents (used in) provided by investing activities
 
(4,312
)
 
5,628

Net cash (used in) provided by investing activities
 
(54,368
)
 
52,438

Financing activities
 
 

 
 

Acquisition of treasury stock
 
(18,730
)
 
(8,591
)
Cash transactions related to stock-based compensation
 
(148
)
 
554

Dividends paid to stockholders
 
(1,939
)
 
(2,310
)
Net cash used in financing activities
 
(20,817
)
 
(10,347
)
Net (decrease) increase in cash and cash equivalents
 
(50,745
)
 
47,406

Cash and cash equivalents at the beginning of the period
 
252,300

 
119,825

Cash and cash equivalents at the end of the period
 
$
201,555

 
$
167,231

 See accompanying unaudited notes to the consolidated financial statements.

5



Employers Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
 (Unaudited)
1. Basis of Presentation and Summary of Operations
Employers Holdings, Inc. (EHI) is a Nevada holding company. Through its wholly owned insurance subsidiaries, Employers Insurance Company of Nevada (EICN), Employers Compensation Insurance Company (ECIC), Employers Preferred Insurance Company (EPIC), and Employers Assurance Company (EAC), EHI is engaged in the commercial property and casualty insurance industry, specializing in workers' compensation products and services. 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 consolidated 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 Annual Report on Form 10-K for the year ended December 31, 2011.
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.
Use of Estimates
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 revenues 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 income taxes, investments, and the valuation of goodwill and intangible assets.
Reclassifications
Certain prior period information has been reclassified to conform to the current period presentation.
2. Deferred Policy Acquisition Costs (DAC)
In October 2010, the Financial Accounting Standards Board (FASB) issued guidance on Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts that became effective in 2012. This guidance changed the definition of acquisition costs which may be capitalized to specify costs that relate directly to the successful acquisition of new or renewal insurance contracts, including underwriting, policy issuance and processing, medical and inspection, and sales force contract selling. It also defines incremental direct costs that must be capitalized as costs that result directly from contract transactions that are essential to contract issuance, which would not have been incurred had the contract transaction not occurred. All other costs are expensed as incurred. Capitalized costs are amortized over the life of the contract.
The Company adopted this standard on a prospective basis on January 1, 2012. During the first quarter of 2012, the Company capitalized $22.1 million of acquisition costs under the new guidance. Under the previous guidance, the amount capitalized would have been $25.7 million. During the first quarter of 2012, the total effect of implementing this guidance was a $3.6 million decrease in the amount capitalized and a $0.6 million decrease in the amortization expense. The total amortization expense during the first quarter of 2012 was $20.8 million. The Company expects that the total impact of this new guidance for 2012 will be approximately $7 million in increased underwriting and other operating expenses.

6



3. Fair Value of Financial Instruments
The carrying value and the estimated fair value of the Company’s financial instruments were as follows:
 
 
March 31, 2012
 
December 31, 2011
 
 
Carrying Value
 
Estimated Fair Value
 
Carrying Value
 
Estimated Fair Value
 
 
(in thousands)
Financial assets
 
 
 
 
 
 
 
 
Investments
 
$
2,006,472

 
$
2,006,472

 
$
1,950,745

 
$
1,950,745

Cash and cash equivalents
 
201,555

 
201,555

 
252,300

 
252,300

Restricted cash and cash equivalents
 
10,611

 
10,611

 
6,299

 
6,299

Financial liabilities
 
 

 
 

 
 
 
 
Notes payable
 
122,000

 
125,877

 
122,000

 
130,447

The Company's estimates of fair value for financial liabilities are based on a combination of the variable interest rates for the Company's existing line of credit and notes with similar durations to discount the projection of future payments on notes payable, and have been determined to be Level 2 fair value measurements, as defined below. Assets and liabilities recorded at fair value on the consolidated balance sheets are categorized based upon the levels of judgment associated with the inputs used to measure their fair value. Level inputs are defined as follows:
Level 1 - Inputs are unadjusted quoted market prices for identical assets or liabilities in active markets at the measurement date.
Level 2 - Inputs other than Level 1 prices that are observable for similar assets or liabilities through corroboration with market data at the measurement date.
Level 3 - Inputs that are unobservable that reflect management's best estimate of what market participants would use in pricing the assets or liabilities at the measurement date.
The following methods and assumptions were used to determine the fair value of each class of assets and liabilities recorded at fair value in the consolidated balance sheets:
Fair values of available-for-sale fixed maturity and equity securities are based on quoted market prices, where available. These fair values are obtained primarily from third party pricing services, who generally use Level 1 or Level 2 inputs. The Company obtains a quoted price for each security from third party pricing services. The quoted prices are derived through recently reported trades for identical or similar securities. For securities not actively traded, the third party pricing services may use quoted market prices of similar instruments or discounted cash flow analyses, incorporating inputs that are currently observable in the markets for similar securities. Inputs that are often used in the valuation methodologies include, but are not limited to, broker quotes, benchmark yields, credit spreads, default rates, and prepayment speeds. The Company also performs quarterly analysis on the prices received from third parties to determine whether the prices are reasonable estimates of fair value, including confirming the fair values of these securities through observable market prices using an alternative pricing source. If unusual fluctuations are noted in this review, the Company may obtain additional information from other pricing services to validate the quoted price. There were no adjustments to prices obtained from third party pricing services as of March 31, 2012 or December 31, 2011 that were material to the consolidated financial statements.
If quoted market prices and an estimate determined by using objectively verifiable information are unavailable, the Company produces an estimate of fair value based on internally developed valuation techniques, which, depending on the level of observable market inputs, will render the fair value estimate as Level 2 or Level 3. The Company bases all of its estimates of fair value for assets on the bid price as it represents what a third party market participant would be willing to pay in an arm's length transaction.
These methods of valuation will only produce an estimate of fair value if there is objectively verifiable information to produce a valuation. If objectively verifiable information is not available, the Company would be required to produce an estimate of fair value using some of the same methodologies, making assumptions for market based inputs that are unavailable.
Most estimates of fair value for fixed maturity securities are based on estimates using objectively verifiable information and are included in the amount disclosed in Level 2 of the hierarchy. The fair value estimates for determining Level 3 fair value include the Company's assumptions about risk assessments and market participant assumptions based on the best information available, including quotes from market makers and other broker/dealers recognized as market participants, using standard or trade derived inputs, new issue data, monthly payment information, cash flow generation, prepayment speeds, spread adjustments, or rating updates.

7



The following table presents the items on the accompanying consolidated balance sheets that are stated at fair value and the fair value measurements.
 
 
March 31, 2012
 
December 31, 2011
 
 
Level 1
 
Level 2
 
Level 3
 
Level 1
 
Level 2
 
Level 3
 
 
(in thousands)
Fixed maturity securities
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasuries
 
$

 
$
149,572

 
$

 
$

 
$
137,365

 
$

U.S. Agencies
 

 
100,965

 

 

 
108,448

 

States and municipalities
 

 
758,181

 

 

 
789,636

 

Corporate
 

 
547,636

 

 

 
501,669

 

Residential mortgage-backed securities
 

 
279,714

 

 

 
281,511

 

Commercial mortgage-backed securities
 

 
33,069

 

 

 
21,665

 

Asset-backed securities
 

 
12,209

 

 

 
12,405

 

Total fixed maturity securities
 
$

 
$
1,881,346

 
$

 
$

 
$
1,852,699

 
$

Equity securities
 
$
125,126

 
$

 
$

 
$
98,046

 
$

 
$

4. Investments
The cost or amortized cost, gross unrealized gains, gross unrealized losses, and estimated fair value of the Company’s investments were as follows:
 
 
Cost or Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
At March 31, 2012
 
(in thousands)
Fixed maturity securities
 
 
 
 
 
 
 
 
U.S. Treasuries
 
$
137,091

 
$
12,609

 
$
(128
)
 
$
149,572

U.S. Agencies
 
94,432

 
6,546

 
(13
)
 
100,965

States and municipalities
 
693,261

 
64,920

 

 
758,181

Corporate
 
508,602

 
39,505

 
(471
)
 
547,636

Residential mortgage-backed securities
 
261,965

 
18,227

 
(478
)
 
279,714

Commercial mortgage-backed securities
 
32,169

 
951

 
(51
)
 
33,069

Asset-backed securities
 
11,800

 
409

 

 
12,209

Total fixed maturity securities
 
1,739,320

 
143,167

 
(1,141
)
 
1,881,346

Equity securities
 
80,064

 
45,407

 
(345
)
 
125,126

Total investments
 
$
1,819,384

 
$
188,574

 
$
(1,486
)
 
$
2,006,472

At December 31, 2011
 
 
Fixed maturity securities
 
 
 
 
 
 
 
 
U.S. Treasuries
 
$
122,144

 
$
15,222

 
$
(1
)
 
$
137,365

U.S. Agencies
 
101,520

 
6,942

 
(14
)
 
108,448

States and municipalities
 
719,431

 
70,391

 
(186
)
 
789,636

Corporate
 
467,470

 
35,745

 
(1,546
)
 
501,669

Residential mortgage-backed securities
 
262,961

 
19,154

 
(604
)
 
281,511

Commercial mortgage-backed securities
 
20,756

 
910

 
(1
)
 
21,665

Asset-backed securities
 
11,934

 
471

 

 
12,405

Total fixed maturity securities
 
1,706,216

 
148,835

 
(2,352
)
 
1,852,699

Equity securities
 
64,962

 
34,639

 
(1,555
)
 
98,046

Total investments
 
$
1,771,178

 
$
183,474

 
$
(3,907
)
 
$
1,950,745

The amortized cost and estimated fair value of fixed maturity securities at March 31, 2012, by contractual maturity, are shown

8



below. Expected maturities differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
 
Amortized Cost
 
Estimated Fair Value
 
 
(in thousands)
Due in one year or less
 
$
86,826

 
$
88,391

Due after one year through five years
 
607,076

 
646,971

Due after five years through ten years
 
549,776

 
610,977

Due after ten years
 
189,708

 
210,015

Mortgage and asset-backed securities
 
305,934

 
324,992

Total
 
$
1,739,320

 
$
1,881,346


9



The following is a summary of investments that have been in a continuous unrealized loss position for less than 12 months and those that have been in a continuous unrealized loss position for 12 months or greater as of March 31, 2012 and December 31, 2011.
 
 
March 31, 2012
 
December 31, 2011
 
 
Estimated Fair Value
 
Gross Unrealized Losses
 
Number of Issues
 
Estimated Fair Value
 
Gross Unrealized Losses
 
Number of Issues
Less than 12 months:
 
(dollars in thousands)
Fixed maturity securities
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasuries
 
$
26,822

 
$
(97
)
 
7

 
$
5,076

 
$
(1
)
 
2

U.S. Agencies
 
5,150

 
(13
)
 
1

 
11,124

 
(14
)
 
3

States and municipalities
 

 

 

 
5,094

 
(185
)
 
1

Corporate
 
34,524

 
(462
)
 
18

 
64,846

 
(1,481
)
 
30

Residential mortgage-backed securities
 
22,027

 
(102
)
 
19

 
4,916

 
(20
)
 
14

Commercial mortgage-backed securities
 
12,529

 
(51
)
 
4

 
1,464

 
(1
)
 
1

Total fixed maturity securities
 
101,052

 
(725
)
 
49

 
92,520

 
(1,702
)
 
51

Equity securities
 
8,297

 
(340
)
 
39

 
12,443

 
(1,462
)
 
57

Total less than 12 months
 
$
109,349

 
$
(1,065
)
 
88

 
$
104,963

 
$
(3,164
)
 
108

 
 
 
 
 
 
 
 
 
 
 
 
 
Greater than 12 months:
 
 
 
 
 
 
 
 
 
 
 
 
Fixed maturity securities
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasuries
 
$
4,309

 
$
(31
)
 
2

 
$

 
$

 

States and municipalities
 

 

 

 
1,049

 
(1
)
 
1

Corporate
 
1,077

 
(9
)
 
1

 
1,024

 
(65
)
 
1

Residential mortgage-backed securities
 
2,849

 
(376
)
 
5

 
2,692

 
(584
)
 
5

Total fixed maturity securities
 
8,235

 
(416
)
 
8

 
4,765

 
(650
)
 
7

Equity securities
 
96

 
(5
)
 
2

 
452

 
(93
)
 
4

Total greater than 12 months
 
$
8,331

 
$
(421
)
 
10

 
$
5,217

 
$
(743
)
 
11

 
 
 
 
 
 
 
 
 
 
 
 
 
Total available-for-sale:
 
 
 
 
 
 
 
 
 
 
 
 
Fixed maturity securities
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasuries
 
$
31,131

 
$
(128
)
 
9

 
$
5,076

 
$
(1
)
 
2

U.S. Agencies
 
5,150

 
(13
)
 
1

 
11,124

 
(14
)
 
3

States and municipalities
 

 

 

 
6,143

 
(186
)
 
2

Corporate
 
35,601

 
(471
)
 
19

 
65,870

 
(1,546
)
 
31

Residential mortgage-backed securities
 
24,876

 
(478
)
 
24

 
7,608

 
(604
)
 
19

Commercial mortgage-backed securities
 
12,529

 
(51
)
 
4

 
1,464

 
(1
)
 
1

Total fixed maturity securities
 
109,287

 
(1,141
)
 
57

 
97,285

 
(2,352
)
 
58

Equity securities
 
8,393

 
(345
)
 
41

 
12,895

 
(1,555
)
 
61

Total available-for-sale
 
$
117,680

 
$
(1,486
)
 
98

 
$
110,180

 
$
(3,907
)
 
119

Based on reviews of the fixed maturity securities, the Company determined that unrealized losses as of March 31, 2012 were primarily the result of changes in prevailing interest rates and not the credit quality of the issuers. The fixed maturity securities whose total fair value was less than amortized cost were not determined to be other-than-temporarily impaired given the severity and duration of the impairment, the credit quality of the issuers, the Company’s intent on not selling the securities, and a determination that it is not more likely than not that the Company will be required to sell the securities until fair value recovers to above cost, or to maturity.

10



Based on reviews of the equity securities as of March 31, 2012, the Company recognized total impairments of $0.5 million in the fair values of six equity securities as a result of the severity and duration of the change in fair values of those securities.
Realized gains on investments, net and the change in unrealized gains (losses) on fixed maturity and equity securities are determined on a specific-identification basis and were as follows:
 
 
Three Months Ended
 
 
March 31,
 
 
2012
 
2011
 
 
(in thousands)
Realized gains on investments, net
 
 
 
 
Fixed maturity securities
 
 
 
 
Gross gains
 
$
1,703

 
$
67

Gross losses
 
(5
)
 
(94
)
Realized gains (losses) on fixed maturity securities, net
 
$
1,698

 
$
(27
)
Equity securities
 
 
 
 
Gross gains
 
$
548

 
$
264

Gross losses
 
(468
)
 
(3
)
Realized gains on equity securities, net
 
$
80

 
$
261

Total
 
$
1,778

 
$
234

Change in unrealized gains (losses)
 
 

 
 

Fixed maturity securities
 
$
(4,457
)
 
$
(8,937
)
Equity securities
 
11,978

 
4,329

Total
 
$
7,521

 
$
(4,608
)
Net investment income was as follows:
 
 
Three Months Ended
 
 
March 31,
 
 
2012
 
2011
 
 
(in thousands)
Fixed maturity securities
 
$
18,218

 
$
20,544

Equity securities
 
648

 
449

Cash equivalents and restricted cash
 
154

 
105

 
 
19,020

 
21,098

Investment expenses
 
(635
)
 
(605
)
Net investment income
 
$
18,385

 
$
20,493

The Company is required by various state laws and regulations to keep securities or letters of credit in depository accounts with the states in which it does business. As of March 31, 2012 and December 31, 2011, securities having a fair value of $520.7 million and $522.6 million, respectively, were on deposit. These laws and regulations govern not only the amount, but also the types of securities that are eligible for deposit. The deposits are limited to fixed maturity securities in all states. Additionally, certain reinsurance contracts require Company funds to be held in trust for the benefit of the ceding reinsurer to secure the outstanding liabilities assumed by the Company. The fair value of securities held in trust for reinsurance at March 31, 2012 and December 31, 2011 was $39.3 million and $40.3 million, respectively. The Company's debt was secured by fixed maturity securities and restricted cash and cash equivalents that had a fair value of $117.6 million and $126.7 million at March 31, 2012 and December 31, 2011, respectively.

11



5. Income Taxes
Income tax expense for interim periods is measured using an estimated effective tax rate for the annual period. The following is a reconciliation of the federal statutory income tax rate to the Company’s effective tax rates for the periods presented.
 
 
Three Months Ended
 
 
March 31,
 
 
2012
 
2011
Expense computed at statutory rate
 
35.0
 %
 
35.0
 %
Dividends received deduction and tax-exempt interest
 
(165.6
)
 
(49.4
)
LPT Agreement
 
(115.9
)
 
(26.8
)
Other
 
1.0

 
1.3

Effective tax rate
 
(245.5
)%
 
(39.9
)%
6. Liability for Unpaid Losses and Loss Adjustment Expenses 
The following table represents a reconciliation of changes in the liability for unpaid losses and LAE.
 
 
Three Months Ended
 
 
March 31,
 
 
2012
 
2011
 
 
(in thousands)
Unpaid losses and LAE, gross of reinsurance, at beginning of period
 
$
2,272,363

 
$
2,279,729

Less reinsurance recoverables for unpaid losses and LAE
 
940,840

 
956,043

Net unpaid losses and LAE at beginning of period
 
1,331,523

 
1,323,686

Losses and LAE, net of reinsurance, incurred in:
 
 

 
 

Current period
 
84,554

 
63,110

Prior periods
 
525

 
830

Total net losses and LAE incurred during the period
 
85,079

 
63,940

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

 
 

Current period
 
4,521

 
3,690

Prior periods
 
70,008

 
62,818

Total net payments for losses and LAE during the period
 
74,529

 
66,508

Ending unpaid losses and LAE, net of reinsurance
 
1,342,073

 
1,321,118

Reinsurance recoverable for unpaid losses and LAE
 
929,349

 
946,621

Unpaid losses and LAE, gross of reinsurance, at end of period
 
$
2,271,422

 
$
2,267,739

Total net losses and LAE included in the above table excludes the impact of the amortization of the deferred reinsurance gain—LPT Agreement (Deferred Gain) (Note 7).
The increase in the estimates of incurred losses and LAE attributable to insured events for prior periods was entirely related to the Company's assigned risk business.
7. LPT Agreement
The Company is 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 by EICN prior to July 1, 1995 were reinsured for consideration of $775.0 million. The LPT Agreement provides coverage up to $2.0 billion. The initial Deferred Gain resulting from the LPT Agreement was 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 $4.2 million and $4.5 million of the Deferred Gain for the three months ended March 31, 2012 and 2011, respectively. Any adjustments to the Deferred Gain are recorded in losses and LAE incurred in the accompanying consolidated statements of comprehensive income. No adjustments occurred in the current period. The remaining Deferred Gain was $349.0 million and $353.2 million as of March 31, 2012 and December 31, 2011, respectively, and is included in the accompanying consolidated balance sheets. The estimated remaining liabilities subject to the LPT Agreement were $798.0 million and $807.5 million as of March 31, 2012 and December 31, 2011, respectively. Losses and LAE paid with respect to the LPT Agreement totaled $579.4 million and $569.9 million through March 31, 2012 and December 31, 2011, respectively.

12



8. Accumulated Other Comprehensive Income, net
Accumulated other comprehensive income is comprised of unrealized gains on investments classified as available-for-sale, net of deferred tax expense. The following table summarizes the components of accumulated other comprehensive income, net:
 
 
March 31, 2012
 
December 31, 2011
 
 
(in thousands)
Net unrealized gain on investments, before taxes
 
$
187,088

 
$
179,567

Deferred tax expense on net unrealized gains
 
(65,481
)
 
(62,848
)
Total accumulated other comprehensive income, net
 
$
121,607

 
$
116,719

9. Stock-Based Compensation
In March 2012, the Company awarded stock options, restricted stock units (RSUs) and performance share awards (PSAs) to certain officers of the Company as follows:
 
Number Awarded
 
Fair Value on Date of Grant
 
Exercise Price
 
Aggregate Fair Value on Date of Grant
 
 
 
 
 
 
 
(in millions)
Stock options(1)
242,300

 
$
5.64

 
$
17.02

 
$
1.4

Restricted stock units(1)
79,450

 
17.02

 

 
1.4

Performance share awards(2)
158,900

 
17.02

 

 
2.7

(1)
The stock options and RSUs have a service vesting period of four years after the date awarded and vest 25% on each of the subsequent four anniversaries of the grant date. The stock options and RSUs are subject to accelerated vesting in certain circumstances, such as: death or disability, or in connection with change of control of the Company. The stock options expire seven years from the date of grant.
(2)
The PSAs have a performance period of three years and are subject to certain performance goals with payouts that range from 0% to 200% of the target awards.
A total of 315 and 92,646 stock options were exercised during the three months ended March 31, 2012 and the year ended December 31, 2011, respectively.
10. Earnings Per Share
Basic earnings per share includes no dilution and is computed by dividing income applicable to stockholders by the weighted average number of shares outstanding for the period. Diluted earnings per share reflects the potential dilutive impact of all convertible securities on earnings per share. Diluted earnings per share includes shares assumed issued under the “treasury stock method,” which reflects the potential dilution that would occur if outstanding options were to be exercised.The following table presents the net income and the weighted average shares outstanding used in the earnings per common share calculations.
 
 
Three Months Ended
 
 
March 31,
 
 
2012

2011
 
 
(in thousands, except share data)
Net income available to stockholders—basic and diluted
 
$
6,222

 
$
8,345

Weighted average number of shares outstanding—basic
 
32,649,205

 
38,674,176

Effect of dilutive securities:
 
 
 
 
Performance share awards
 
1,847

 

Stock options
 
90,217

 
92,847

Restricted stock units
 
84,822

 
110,101

Dilutive potential shares
 
176,886


202,948

Weighted average number of shares outstanding—diluted
 
32,826,091

 
38,877,124


13



Diluted earnings per share exclude outstanding options and other common stock equivalents in periods where the inclusion of such potential common stock instruments would be anti-dilutive. The following table presents options and RSUs that were excluded from diluted earnings per share.
 
 
Three Months Ended
 
 
March 31,
 
 
2012
 
2011
Options excluded as the exercise price was greater than the average market price
 
936,680

 
1,074,635

Options and RSUs excluded under the treasury method, as the potential proceeds on settlement or exercise price was greater than the value of shares acquired
 
556,055

 
456,435


14



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 Annual Report on Form 10-K for the year ended December 31, 2011 (Annual Report).
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements if accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those discussed. You should not place undue reliance on these statements, which speak only as of the date of this report. 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 including words such as “expect,” “intend,” “plan,” “believe,” “estimate,” “may,” “anticipate,” “will” or similar statements of a future or forward-looking nature identify forward-looking statements.
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. All forward-looking statements address matters that involve 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 described in our Annual Report and other documents that we have filed with the SEC.
Overview
We are a Nevada holding company. Through our insurance subsidiaries, we provide workers’ compensation insurance coverage to select, small businesses in low to medium hazard industries. Workers’ compensation insurance is provided under a statutory system wherein most employers are required to provide coverage for their employees’ medical, disability, vocational rehabilitation, and/or death benefit costs for work-related injuries or illnesses. We provide workers’ compensation insurance in 31 states and the District of Columbia, with a concentration in California. Our revenues are primarily comprised of net premiums earned, net investment income, and net realized gains on investments.
We target small businesses, as we believe that this market is traditionally characterized by fewer competitors, more attractive pricing, and stronger persistency when compared to the U.S. workers’ compensation insurance industry in general. We believe we are able to price our policies at levels that are competitive and profitable over the long-term. Our underwriting approach is to consistently underwrite small business accounts at appropriate and competitive prices without sacrificing long-term profitability and stability for short-term top-line revenue growth.
Our goal is to maintain our focus on disciplined underwriting and to continue to pursue profitable growth opportunities across market cycles; however, we continue to be affected by the impacts of the 2008-2009 recession. The pace of recovery remains persistently slow and, although total employment and payroll are increasing, we do not believe overall economic conditions will change significantly in the near-term.
We market and sell our workers' compensation insurance products through independent local, regional, and national agents and brokers; through our strategic partnerships and alliances, including our principal partners ADP, Inc. and Anthem Blue Cross of California; and through relationships with national and regional trade groups and associations, including the National Federation of Independent Business.
Results of Operations
Overall, net income was $6.2 million and $8.3 million for the three months ended March 31, 2012 and 2011, respectively. We recognized underwriting losses of $17.5 million and $14.0 million for the same periods, respectively. Underwriting income or loss is determined by deducting losses and LAE, commission expense, dividends to policyholders, and underwriting and other operating expenses from net premiums earned. Key factors that affected our financial performance during the three months ended March 31, 2012, compared to the same period of 2011, include:
Gross premiums written increased 38%;
Net premiums earned increased 33%;
Losses and LAE increased 36%;
Underwriting and other operating expenses increased 25%; and
Income tax benefit increased to $4.4 million in 2012, from $2.4 million in 2011.

15



Additionally, the Financial Accounting Standards Board issued guidance that, beginning in 2012, changed the definition of policy acquisition costs which may be capitalized. Our underwriting and other operating expenses increased $3.0 million during the three months ended March 31, 2012 as a result of this change (see Note 2 in the Notes to Consolidated Financial Statements for additional information). We expect that the total impact for 2012 will be approximately $7 million in increased underwriting and other operating expenses.
We measure our performance by our ability to increase stockholders’ equity, including the impact of the deferred reinsurance gain–LPT Agreement (Deferred Gain), over the long-term. The following table shows our stockholders' equity including the Deferred Gain, stockholders' equity on a GAAP basis, and number of common shares outstanding at:
 
 
March 31, 2012
 
December 31, 2011
 
 
(in thousands, expect share data)
Stockholders' equity including the Deferred Gain(1)

 
$
814,758

 
$
827,380

GAAP stockholders' equity
 
$
465,720

 
$
474,186

Common shares outstanding
 
31,935,474

 
32,996,809

(1)
Stockholders' equity, including the Deferred Gain, is a non-GAAP measure that is defined as total stockholders' equity plus the Deferred Gain, which we believe is an important supplemental measure of our capital position.
The comparative components of net income are set forth in the following table:
 
 
Three Months Ended
 
 
March 31,
 
 
2012
 
2011
 
 
(in thousands)
Gross premiums written
 
$
142,794

 
$
103,227

Net premiums written
 
$
140,364

 
$
101,126

 
 
 
 
 
Net premiums earned
 
$
109,900

 
$
82,427

Net investment income
 
18,385

 
20,493

Realized gains on investments
 
1,778

 
234

Other income
 
81

 
120

Total revenues
 
130,144


103,274

 
 
 
 
 
Losses and LAE
 
80,923

 
59,421

Commission expense
 
13,529

 
10,281

Policyholder dividends
 
847

 
1,012

Underwriting and other operating expenses
 
32,142

 
25,678

Interest expense
 
902

 
917

Income tax benefit
 
(4,421
)
 
(2,380
)
Total expenses
 
123,922

 
94,929

Net income
 
$
6,222

 
$
8,345

Less impact of the Deferred Gain
 
$
4,156

 
$
4,519

Net income before impact of the Deferred Gain(1)
 
$
2,066

 
$
3,826

(1)
We define net income before impact of the Deferred Gain as net income less: (a) amortization of Deferred Gain and (b) adjustments to LPT Agreement ceded reserves. Deferred Gain 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 Gain, with the net effect being an increase or decrease, as the case may be, to net income. Net income before impact of the Deferred Gain is not a measurement of financial performance under GAAP, but rather reflects the difference in accounting treatment between statutory and GAAP, and should not be considered in isolation or as an alternative to net income before income taxes, net income, or any other measure of performance derived in accordance with GAAP.
We present net income before impact of the Deferred Gain 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 and the Deferred Gain does not result in ongoing cash benefits. Consequently, we believe this presentation is useful in providing

16



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 on our current and ongoing operations.
Net Premiums Earned
Net premiums earned increased 33.3% for the three months ended March 31, 2012, compared to the corresponding period in 2011. This increase is primarily due to increasing policy count as we continue to execute our growth strategy.
The following table shows the percentage change in our in-force premium, policy count, average policy size, payroll exposure upon which our premiums are based, and net rate.
 
As of March 31, 2012
 
Year-to-Date Increase (Decrease)
 
Year-Over-Year Increase (Decrease)
In-force premiums
10.0
%
 
32.6
 %
In-force policy count
9.7

 
38.7

Average in-force policy size
0.3

 
(4.4
)
In-force payroll exposure
8.8

 
31.8

Net rate(1)
1.2

 
0.6

(1)
Net rate, defined as total premium in-force divided by total insured payroll exposure, is a function of a variety of factors, including rate changes, underwriting risk profiles and pricing, and changes in business mix related to economic and competitive pressures.
Our in-force premiums and number of policies in-force by select states were as follows:
 
 
March 31, 2012
 
December 31, 2011
 
March 31, 2011
 
December 31, 2010
State
 
Premiums
In-force
 
Policies
In-force
 
Premiums
In-force
 
Policies
In-force
 
Premiums
In-force
 
Policies
In-force
 
Premiums
In-force
 
Policies
In-force
 
 
(dollars in thousands)
California
 
$
247,762

 
39,931

 
$
221,910

 
36,867

 
$
177,482

 
30,996

 
$
172,621

 
29,244

Illinois
 
27,075

 
2,813

 
24,744

 
2,433

 
19,927

 
1,213

 
18,617

 
932

Georgia
 
18,240

 
2,301

 
16,393

 
2,050

 
11,607

 
1,056

 
10,772

 
757

Nevada
 
15,510

 
3,819

 
14,639

 
3,718

 
16,197

 
3,577

 
16,940

 
3,596

Florida
 
15,476

 
2,499

 
15,226

 
2,399

 
15,096

 
2,133

 
15,071

 
1,963

Other
 
109,391

 
15,245

 
101,009

 
13,226

 
86,549

 
9,053

 
87,116

 
8,069

Total
 
$
433,454

 
66,608

 
$
393,921

 
60,693

 
$
326,858

 
48,028

 
$
321,137

 
44,561

Our strategic partnerships and alliances generated $102.4 million and $71.9 million, or 23.6% and 22.0%, of our in-force premiums as of March 31, 2012 and 2011, respectively. This increase was primarily due to the higher retention rates for this business than for business produced by our independent agents. We believe that the bundling of products and services through these relationships has contributed to the higher retention rates. These relationships also allow us to access new customers that we may not have access to through our independent agent distribution channel. We continue to expand our existing relationships and actively seek new partnerships and alliances.
As of March 31, 2012, over one-half of our business was generated in California, where our policy count increased 8.3% year-to-date.
In April 2011, the Workers' Compensation Insurance Rating Bureau (WCIRB) of California provided an informational filing highlighting the cost drivers that indicated a cumulative 39.8% increase in the claims cost benchmark since January 1, 2009 based on an analysis of December 31, 2010 loss experience. This included deterioration of more than 12 percentage points in the claims cost benchmark since the WCIRB's previous recommendation for a 27.7% increase based on an analysis of June 30, 2010 loss experience. The WCIRB indicated that this further deterioration was due to: (a) continued adverse loss development on the 2009 accident year; (b) high emerging costs on the 2010 accident year, primarily due to increased claims frequency; (c) less optimistic forecasts for statewide wage growth in California; and (d) increased LAE that is likely as a result of certain Workers' Compensation Appeals Board decisions.
In August 2011, the WCIRB modified its benchmark for pure premium rates. The WCIRB's pure premium rate filings are now based on the industry average filed pure premium rate, rather than the pure premium rate approved by the California Commissioner of Insurance. The WCIRB submitted its benchmark for the proposed advisory pure premium rate to be effective January 1, 2012. The WCIRB noted that while 2012 projected claims costs continue to be below pre-reform highs and the proposed pure premium

17



rate was slightly less than the industry average filed rate, these rates reflected significant deterioration in projected losses and LAE and less optimistic economic forecasts, compared to the prior year.
In April 2012, the WCIRB submitted its pure premium rate filing recommending an increase in advisory pure premium rates to be effective July 1, 2012. That filing proposed a 4.1% increase over the industry average filed pure premium rate as of January 1, 2012. The filing was based on an analysis of December 31, 2011 experience and reflects increased loss development on the 2010 and 2011 accident years, increased LAE, and lower forecasts of wage growth in California for 2012 and 2013.
We set our own premium rates in California based upon actuarial analyses of current and anticipated loss trends with a goal of maintaining underwriting profitability. Due to increasing loss costs, primarily medical cost inflation, we have increased our filed premium rates in California by a cumulative 41.3% since February 1, 2009, including a 6.0% rate increase to be effective for new and renewal policies incepting on or after June 15, 2012.
The following table sets forth the percentage increases to our filed California rates effective for new and renewal policies incepting on or after the dates shown.
Effective Date
 
Premium Rate Change
Filed in California
February 1, 2009
 
10.0
%
August 15, 2009
 
10.5

March 15, 2010
 
3.0

March 15, 2011
 
2.5

September 15, 2011
 
3.9

June 15, 2012
 
6.0

We expect that total premiums in 2012 will continue to reflect:
overall rate increases;
increasing policy count as we continue to execute our growth strategy;
increasing average policy size; and
lessened competitive pressures.
Net Investment Income and Realized Gains on Investments
We invest our holding company assets, statutory surplus, and the funds supporting our insurance liabilities, including unearned premiums and unpaid losses and LAE. We invest in fixed maturity securities, equity securities, and cash equivalents. Net investment income includes interest and dividends earned on our invested assets and amortization of premiums and discounts on our fixed maturity securities, less bank service charges and custodial and portfolio management fees. We have established a high quality/short duration bias in our investment portfolio.
Net investment income decreased 10.3% for the three months ended March 31, 2012, compared to the corresponding period of 2011. The decrease was primarily related to the timing of purchases of $126.8 million in fixed maturity and equity securities during the first quarter of 2012 and a decrease in the average pre-tax book yield on invested assets to 4.1% for the three months ended March 31, 2012, compared to 4.3% for the three months ended 2011. The tax-equivalent yield on invested assets decreased to 4.9% at March 31, 2012, compared to 5.3% at March 31, 2011.
Realized gains and losses on our investments are reported separately from our net investment income. Realized gains and losses on investments include the gain or loss on a security at the time of sale compared to its original or adjusted cost (equity securities) or amortized cost (fixed maturity securities). Realized losses are also recognized when securities are written down as a result of an other-than-temporary impairment.
Net realized gains on investments were $1.8 million and $0.2 million for the three months ended March 31, 2012 and 2011, respectively.
Additional information regarding our Investments is set forth under “—Liquidity and Capital Resources—Investments.”
Combined Ratio
The combined ratio, expressed as a percentage, is a key measurement of underwriting profitability. The combined ratio is the sum of the loss and LAE ratio, the commission expense ratio, policyholder dividends ratio, and underwriting and other operating expenses ratio. When the combined ratio is below 100%, we have recorded underwriting income, and conversely, when the combined ratio is greater than 100%, we cannot be profitable without investment income. Because we only have one operating segment, holding company expenses are included in our calculation of the combined ratio.

18



The following table provides the calculation of our calendar year combined ratios.
 
 
Three Months Ended
 
 
March 31,
 
 
2012
 
2011
Loss and LAE ratio
 
73.6
%
 
72.1
%
Underwriting and other operating expenses ratio
 
29.3

 
31.1

Commission expense ratio
 
12.3

 
12.5

Policyholder dividends ratio
 
0.8

 
1.2

Combined ratio
 
116.0
%
 
116.9
%
Loss and LAE Ratio. Expressed as a percentage, this is the ratio of losses and LAE to net premiums earned.
Losses and LAE represents our largest expense item and includes claim payments made, amortization of the Deferred Gain, 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 California, we are experiencing an increase in indemnity claims frequency (the number of claims expressed as a percentage of payroll). Our loss experience also indicates an upward trend in medical and indemnity costs that are reflected in our current accident year loss estimate. We are seeing increased medical and indemnity costs in many of our other states, partially offset by continuing favorable loss cost trends in Nevada. We believe our current accident year loss estimate is adequate; however, ultimate losses will not be known with any certainty for many years. We assume that increasing medical and indemnity cost trends will continue to impact our long-term claims costs and current accident year loss estimate.
Overall, losses and LAE increased 36.2% for the three months ended March 31, 2012, compared to the same period of 2011, primarily due to an increase in net earned premiums. Prior accident year loss development in both periods was entirely related to our assigned risk business. Our current accident year loss estimates were 76.9% and 76.6% for the three months ended March 31, 2012 and 2011, respectively.
The table below reflects the losses and LAE reserve adjustments.
 
 
Three Months Ended
 
 
March 31,
 
 
2012
 
2011
 
 
(in millions)
Prior accident year loss development, net
 
$
(0.5
)
 
$
(0.8
)
LPT amortization of the deferred reinsurance gain
 
$
4.2

 
$
4.5

Excluding the impact from the LPT Agreement, losses and LAE would have been $85.1 million and $63.9 million, or 77.4% and 77.6% of net premiums earned, for the three months ended March 31, 2012 and 2011, respectively.
Underwriting and Other Operating Expenses Ratio. The underwriting and other operating expenses ratio is the ratio (expressed as a percentage) of underwriting and other operating expenses to net premiums earned and measures an insurance company's operational efficiency in producing, underwriting, and administering its insurance business.
Underwriting and other operating expenses are those costs that we incur to underwrite and maintain the insurance policies we issue, excluding commission. These expenses include premium taxes and certain other general expenses that vary with, and are primarily related to, producing new or renewal business. Other underwriting expenses include changes in estimates of future write-offs of premiums receivable, general administrative expenses such as salaries and benefits, rent, office supplies, depreciation, and all other operating expenses not otherwise classified separately. Policy acquisition costs are variable based on premiums earned; however, other operating costs are more fixed in nature and become a smaller percentage of net premiums earned as premiums increase.
Underwriting and other operating expenses increased 25.2% for the three months ended March 31, 2012, compared to the same period of 2011. During the three months ended March 31, 2012, compensation related expenses increased $1.1 million, premium taxes and assessments increased $0.8 million, and our bad debt expense increased $0.7 million, compared to the same period of 2011. Additionally, implementation of the new accounting guidance for deferred policy acquisition costs resulted in a $3.0 million increase in our underwriting and other operating expenses for the three months ended March 31, 2012. Excluding the impact of this new guidance, underwriting and other operating expenses would have increased 13.5% for the three months ended March 31, 2012, compared to the same period of 2011.

19



Commission Expense Ratio. The commission expense ratio is the ratio (expressed as a percentage) of commission expense to net premiums earned and measures the cost of compensating agents and brokers for the business we have underwritten.
Commission expense includes direct commissions to our agents and brokers for the premiums that they produce for us, as well as incentive payments, other marketing costs, and fees. Commission expense is net of contingent profit commission income related to the LPT Agreement.
Commission expense increased 31.6% for the three months ended March 31, 2012, compared to the corresponding period of 2011, primarily due to higher net premiums earned in 2012.
Policyholder Dividends Ratio. The policyholder dividends ratio is the ratio (expressed as a percentage) of the policyholder dividends to net premiums earned and measures the cost of returning premium to policyholders in the form of dividends.
In administered pricing states such as Florida and Wisconsin, insurance rates are set by state insurance regulators. Rate competition generally is not permitted and policyholder dividend programs are an important competitive factor in these states. We offer dividend programs to eligible policyholders, under which a portion of the policyholders' premium may be returned in the form of dividends.
Policyholder dividends were $0.8 million and $1.0 million for the three months ended March 31, 2012 and 2011, respectively. Policyholder dividends may fluctuate from time to time due to changes in premium levels on dividend policies and the eligibility of policyholders to receive dividend payments.
Income Tax Benefit
Income tax benefit was $4.4 million and $2.4 million for the three months ended March 31, 2012 and 2011, respectively. The effective tax rates were (245.5)% and (39.9)% for the three months ended March 31, 2012 and 2011, respectively. The increased tax benefit was primarily due to increased tax exempt interest income as a percentage of pretax net income to 351% for the three months ended March 31, 2012, from 139% for the three months ended March 31, 2011.
Liquidity and Capital Resources
Parent Company
Operating Cash and Cash Equivalents. We are a holding company and our ability to fund our operations is contingent upon our insurance subsidiaries and their ability to pay dividends up to the holding company. Payment of dividends by our insurance subsidiaries is restricted by state insurance laws, including laws establishing minimum solvency and liquidity thresholds. We require cash to pay stockholder dividends, repurchase common stock, make interest and principal payments on our outstanding debt obligations, and fund our operating expenses. We may also use cash to support our growth strategy and maintain the financial strength ratings of our operating subsidiaries.
As of March 31, 2012, the holding company had $146.3 million of cash and cash equivalents and fixed maturity securities maturing within the next 24 months. Ten million dollars of our line of credit is payable on each of December 31, 2012 and 2013. We believe that the liquidity needs of the holding company over the next 24 months will be met with cash, maturing investments, and dividends from our insurance subsidiaries.
Share Repurchases. In November 2010, the EHI Board of Directors (Board of Directors) authorized a share repurchase program for repurchases of up to $100 million of the Company's common stock from November 8, 2010 through June 30, 2012 (the 2011 Program). In November 2011, the Board of Directors authorized a $100 million expansion of the 2011 Program, to $200 million, and extended the repurchase authority pursuant to the 2011 Program through June 30, 2013. Repurchases under the 2011 Program may be commenced or suspended from time-to-time without prior notice, and the 2011 Program may be suspended or discontinued at any time. From inception of the 2011 Program through March 31, 2012, we repurchased a total of 8,087,586 shares of common stock at an average price of $15.55 per share, including commissions, for a total of $125.8 million.
Outstanding Debt. In December 2010, we entered into the Third Amended and Restated Credit Agreement with Wells Fargo (Amended Credit Facility) under which we were provided with: (a) $100.0 million line of credit through December 31, 2011; (b) $90.0 million line of credit from January 1, 2012 through December 31, 2012; (c) $80.0 million line of credit from January 1, 2013 through December 31, 2013; (d) $70.0 million line of credit from January 1, 2014 through December 31, 2014; and (e) $60.0 million line of credit from January 1, 2015 through December 31, 2015. Amounts outstanding bear interest at a rate equal to, at our option: (a) a fluctuating rate of 1.75% above prime rate or (b) a fixed rate that is 1.75% above the LIBOR rate then in effect. The Amended Credit Facility is secured by fixed maturity securities and restricted cash and cash equivalents that had a fair value of $117.6 million and $126.7 million at March 31, 2012 and December 31, 2011, respectively. The Amended Credit Facility contains customary non-financial covenants and requires us to maintain $5.0 million of cash and cash equivalents at all times at the holding company. We are currently in compliance with all applicable covenants.
Our capital structure is comprised of outstanding debt and stockholders’ equity. As of March 31, 2012, our capital structure consisted of $90.0 million principal balance on our Amended Credit Facility, $32.0 million in surplus notes maturing in 2034, and $814.8

20



million of stockholders’ equity, including the Deferred Gain. Outstanding debt was 13.0% of total capitalization, including the Deferred Gain, as of March 31, 2012.
Operating Subsidiaries
Operating Cash and Cash Equivalents. The primary sources of cash for our insurance operating subsidiaries are funds generated from underwriting operations, investment income, and maturities and sales of investments. The primary uses of cash are payments of claims and operating expenses, purchases of investments, and payments of dividends to the parent holding company, which are subject to state insurance laws and regulations.
Our insurance subsidiaries had total cash and cash equivalents and fixed maturity securities of $272.8 million maturing within the next 24 months at March 31, 2012. We believe that our subsidiaries’ liquidity needs over the next 24 months will be met with cash from operations, investment income, and maturing investments.
We purchase reinsurance to protect us against the costs of severe claims and catastrophic events. On July 1, 2011, we entered into a new reinsurance program that is effective through June 30, 2012. The reinsurance program consists of one treaty covering excess of loss and catastrophic loss events in five layers of coverage. Our reinsurance coverage is $195 million in excess of our $5.0 million retention on a per occurrence basis, subject to a $2.0 million annual aggregate deductible and certain exclusions. We believe that our reinsurance program meets our needs and that we are sufficiently capitalized.
Various state regulations require us to keep securities or letters of credit on deposit with the states in which we do business. Securities having a fair value of $520.7 million and $522.6 million were on deposit at March 31, 2012 and December 31, 2011, respectively. These laws and regulations govern both the amount and types of fixed maturity securities that are eligible for deposit. Additionally, certain reinsurance contracts require Company funds to be held in trust for the benefit of the ceding reinsurer to secure the outstanding liabilities we assumed. The fair value of securities held in trust for reinsurance was $39.3 million and $40.3 million at March 31, 2012 and December 31, 2011, respectively.
Cash Flows
We monitor cash flows at both the consolidated and subsidiary levels. We use trend and variance analyses to project future cash needs, making adjustments to our forecasts as appropriate.
The table below shows our net cash flows for the three months ended:
 
 
March 31,
 
 
2012
 
2011
 
 
(in thousands)
Cash and cash equivalents provided by (used in):
 
 
 
 
Operating activities
 
$
24,440

 
$
5,315

Investing activities
 
(54,368
)
 
52,438

Financing activities
 
(20,817
)
 
(10,347
)
(Decrease) increase in cash and cash equivalents
 
$
(50,745
)
 
$
47,406

Operating Activities. Major components of net cash provided by operating activities for the three months ended March 31, 2012 included net premiums received of $114.7 million, investment income received of $20.6 million, and amounts recovered from reinsurers of $10.2 million. These were partially offset by claims payments of $84.7 million, underwriting and other operating expenses paid of $24.7 million (including premium taxes paid of $6.3 million), and commissions paid of $9.7 million.
Major components of net cash provided by operating activities for the three months ended March 31, 2011 included net premiums received of $80.7 million and investment income received of $24.1 million. These were partially offset by claims payments of $64.5 million and underwriting and other operating expenses paid of $35.0 million.
Investing Activities. The major sources of net cash used in investing activities for the three months ended March 31, 2012 included the purchase of fixed maturity and equity securities.
The major sources of net cash provided by investing activities for the three months ended March 31, 2011 included the sales, maturities, and redemptions of certain fixed maturity securities.
Financing Activities. The majority of cash used in financing activities for the three months ended March 31, 2012 and 2011 was to repurchase $18.7 million and $8.6 million, respectively, of our common stock, and to pay dividends to stockholders.
Investments
The amortized cost of our investment portfolio was $1.8 billion and the fair value was $2.0 billion as of March 31, 2012.

21



We employ an investment strategy that emphasizes asset quality and considers the durations of fixed maturity securities against anticipated claim payments and expenditures, other liabilities, and capital needs. Our investment portfolio is structured so that investments mature periodically in reasonable relation to current expectations of future claim payments. Currently, we make claim payments from positive cash flow from operations and use excess cash to invest in operations, invest in marketable securities, return capital to our stockholders (through dividends and share repurchases), and fund growth.
As of March 31, 2012, our investment portfolio, which is classified as available-for-sale, consisted of 93.8% fixed maturity securities whose fair values may fluctuate due to interest rate changes. We strive to limit interest rate risk by managing the duration of our fixed maturity securities. Our fixed maturity securities (excluding cash and cash equivalents) had a duration of 4.3 at March 31, 2012. To minimize interest rate risk, our portfolio is weighted toward short-term and intermediate-term bonds; however, our investment strategy balances consideration of duration, yield, and credit risk. Our investment guidelines require that the minimum weighted average quality of our fixed maturity securities portfolio be "AA." Our fixed maturity securities portfolio had a weighted average quality of “AA” as of March 31, 2012, with 68.5% of the portfolio rated “AA” or better, based on market value.
We carry our portfolio of equity securities on our balance sheet at fair value. We minimize our exposure to equity price risk by investing primarily in the equity securities of mid-to-large capitalization issuers and by diversifying our equity holdings across several industry sectors. Equity securities represented 6.2% of our investment portfolio at March 31, 2012.
Given the economic uncertainty and continued market volatility, we believe that our asset allocation best meets our strategy to preserve capital for policyholders, to provide sufficient income to support insurance operations, and to effectively grow book value over a long-term investment horizon.
We seek to maximize total investment returns within the constraints of prudent portfolio management. The asset allocation is reevaluated by the Finance Committee of the Board of Directors on a quarterly basis. We employ Conning Asset Management (Conning) to act as our independent investment manager. Conning follows our written investment guidelines based upon strategies approved by the Board of Directors. In addition to the construction and management of the portfolio, we utilize the investment advisory services of Conning. These services include investment accounting and company modeling using Dynamic Financial Analysis (DFA). The DFA tool is utilized to develop portfolio targets and objectives, which in turn are used in constructing an optimal portfolio.
The following table shows the estimated fair value, the percentage of the fair value to total invested assets, and the average tax equivalent yield based on the fair value of each category of invested assets as of March 31, 2012.
Category
 
Estimated Fair
Value
 
Percentage
of Total
 
Yield
 
 
(in thousands, except percentages)
U.S. Treasuries
 
$
149,572

 
7.5
%
 
2.7
%
U.S. Agencies
 
100,965

 
5.1

 
3.2

States and municipalities
 
758,181

 
37.8

 
6.0

Corporate securities
 
547,636

 
27.3

 
4.4

Residential mortgage-backed securities
 
279,714

 
13.9

 
4.6

Commercial mortgage-backed securities
 
33,069

 
1.6

 
4.0

Asset-backed securities
 
12,209

 
0.6

 
4.1

Equity securities
 
125,126

 
6.2

 
5.0

Total
 
$
2,006,472

 
100.0
%
 
 

Weighted average yield
 
 

 
 

 
4.9
%
The following table shows the percentage of total estimated fair value of our fixed maturity securities as of March 31, 2012 by credit rating category, using the lower of ratings assigned by Moody's Investor Services and/or S&P.
Rating
 
Percentage of Total
Estimated Fair Value
“AAA”
 
10.4
%
“AA”
 
58.1

“A”
 
20.1

“BBB”
 
11.2

Below investment grade
 
0.2

Total
 
100.0
%

22



Investments that we currently own could be subject to default by the issuer or could suffer declines in fair value that become other-than-temporary. We regularly assess individual securities as part of our ongoing portfolio management, including the identification of other-than-temporary declines in fair value. Our other-than-temporary assessment includes reviewing the extent and duration of declines in fair value of investments below amortized cost, historical and projected financial performance and near-term prospects of the issuer, the outlook for industry sectors, credit rating, and macro-economic changes. We also make a determination as to whether it is not more likely than not that we will be required to sell the security before its fair value recovers above cost, or to maturity.
Based on our review of fixed maturity and equity securities, we believe that we appropriately identified the declines in the fair values of our unrealized losses at March 31, 2012. We determined that the unrealized losses on fixed maturity securities were primarily the result of prevailing interest rates and not the credit quality of the issuers. The fixed maturity securities whose fair value was less than amortized cost were not determined to be other-than-temporarily impaired given the severity and duration of the impairment, the credit quality of the issuers, the Company’s intent on not selling the securities, and a determination that it is not more likely than not that the Company will be required to sell the securities until fair value recovers to above cost, or to maturity.
Based on reviews of the equity securities as of March 31, 2012 , the Company recognized total impairments of $0.5 million in the fair values of six equity securities as a result of the severity and duration of the change in fair values of those securities.
The cost or amortized cost, gross unrealized gains, gross unrealized losses, and estimated fair value of our investments were as follows:
 
 
Cost or Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
March 31, 2012
 
(in thousands)
Fixed maturity securities
 
 
 
 
 
 
 
 
U.S. Treasuries
 
$
137,091

 
$
12,609

 
$
(128
)
 
$
149,572

U.S. Agencies
 
94,432

 
6,546

 
(13
)
 
100,965

States and municipalities
 
693,261

 
64,920

 

 
758,181

Corporate
 
508,602

 
39,505

 
(471
)
 
547,636

Residential mortgaged-backed securities
 
261,965

 
18,227

 
(478
)
 
279,714

Commercial mortgaged-backed securities
 
32,169

 
951

 
(51
)
 
33,069

Asset-backed securities
 
11,800

 
409

 

 
12,209

Total fixed maturity securities
 
1,739,320

 
143,167

 
(1,141
)
 
1,881,346

Equity securities
 
80,064

 
45,407

 
(345
)
 
125,126

Total investments
 
$
1,819,384

 
$
188,574

 
$
(1,486
)
 
$
2,006,472

Contractual Obligations and Commitments
The following table identifies our long-term debt and contractual obligations as of March 31, 2012:
 
 
Payment Due By Period