EIG-9.30.2011-10Q


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 September 30, 2011

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
 
October 31, 2011
Common Stock, $0.01 par value per share
 
34,878,399 shares outstanding



TABLE OF CONTENTS
 
 
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
 
 
September 30,
2011
 
December 31,
2010
Assets
 
(unaudited)
 
 
Available for sale:
 
 
 
 
Fixed maturity securities at fair value (amortized cost $1,805,866 at September 30, 2011
and $1,901,778 at December 31, 2010)
 
$
1,960,353

 
$
2,000,364

Equity securities at fair value (amortized cost $50,119 at September 30, 2011
and $49,281 at December 31, 2010)
 
74,422

 
80,130

Total investments
 
2,034,775

 
2,080,494

Cash and cash equivalents
 
206,834

 
119,825

Restricted cash and cash equivalents
 
6,192

 
16,949

Accrued investment income
 
20,252

 
23,022

Premiums receivable, less bad debt allowance of $6,207 at September 30, 2011 and $7,603
at December 31, 2010
 
154,714

 
109,987

Reinsurance recoverable for:
 
 

 


Paid losses
 
10,621

 
14,415

Unpaid losses
 
927,670

 
956,043

Funds held by or deposited with reinsureds
 
1,615

 
3,701

Deferred policy acquisition costs
 
39,161

 
32,239

Federal income taxes recoverable
 
8,260

 
4,048

Deferred income taxes, net
 
25,146

 
38,078

Property and equipment, net
 
11,517

 
11,712

Intangible assets, net
 
12,076

 
13,279

Goodwill
 
36,192

 
36,192

Other assets
 
19,021

 
20,136

Total assets
 
$
3,514,046

 
$
3,480,120

 
 
 
 
 
Liabilities and stockholders’ equity
 
 

 
 

Claims and policy liabilities:
 
 

 
 

Unpaid losses and loss adjustment expenses
 
$
2,249,264

 
$
2,279,729

Unearned premiums
 
194,218

 
149,485

Policyholders’ dividends accrued
 
4,154

 
5,218

Total claims and policy liabilities
 
2,447,636

 
2,434,432

Commissions and premium taxes payable
 
26,086

 
17,313

Accounts payable and accrued expenses
 
29,226

 
18,601

Deferred reinsurance gain—LPT Agreement
 
357,357

 
370,341

Notes payable
 
132,000

 
132,000

Other liabilities
 
15,645

 
17,317

Total liabilities
 
3,007,950

 
2,990,004

 
 
 
 
 
Commitments and contingencies
 


 


 
 
 
 
 
Stockholders’ equity:
 
 

 
 

Common stock, $0.01 par value; 150,000,000 shares authorized; 53,930,227 and 53,779,118
shares issued and 36,230,399 and 38,965,126 shares outstanding at September 30, 2011 and
December 31, 2010, respectively
 
539

 
538

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

 

Additional paid-in capital
 
317,761

 
314,212

Retained earnings
 
340,823

 
319,341

Accumulated other comprehensive income, net
 
115,801

 
84,133

Treasury stock, at cost (17,699,828 shares at September 30, 2011 and 14,813,992 shares
at December 31, 2010)
 
(268,828
)
 
(228,108
)
Total stockholders’ equity
 
506,096

 
490,116

Total liabilities and stockholders’ equity
 
$
3,514,046

 
$
3,480,120

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
 
Nine Months Ended
 
 
September 30,
 
September 30,
 
 
2011
 
2010
 
2011
 
2010
Revenues
 
(unaudited)
Net premiums earned
 
$
92,601

 
$
80,695

 
$
263,156

 
$
238,221

Net investment income
 
19,584

 
20,689

 
60,383

 
62,592

Realized gains on investments, net
 
647

 
8

 
1,983

 
900

Other income
 
82

 
393

 
205

 
600

Total revenues
 
112,914

 
101,785

 
325,727

 
302,313

 
 
 
 
 
 
 
 
 
Expenses
 
 

 
 

 
 
 
 
Losses and loss adjustment expenses
 
67,438

 
52,764

 
191,009

 
138,097

Commission expense
 
10,968

 
9,971

 
32,368

 
29,052

Dividends to policyholders
 
840

 
1,584

 
2,766

 
3,386

Underwriting and other operating expenses
 
25,334

 
25,722

 
77,212

 
83,132

Interest expense
 
906

 
1,632

 
2,731

 
4,832

Total expenses
 
105,486

 
91,673

 
306,086

 
258,499

 
 
 
 
 
 
 
 
 
Net income before income taxes
 
7,428

 
10,112

 
19,641

 
43,814

Income tax expense (benefit)
 
(4,355
)
 
58

 
(8,738
)
 
1,164

Net income
 
$
11,783

 
$
10,054

 
$
28,379

 
$
42,650

 
 
 
 
 
 
 
 
 
Comprehensive income
 
 
 
 
 
 
 
 
Unrealized gains during the period, before taxes
 
$
26,053

 
$
39,769

 
$
51,339

 
$
68,295

Less: reclassification adjustment for realized gains in net income
 
647

 
8

 
1,983

 
900

Other comprehensive income, before tax
 
25,406

 
39,761

 
49,356

 
67,395

Income tax expense (benefit) related to:
 
 
 
 
 
 
 
 
Unrealized gains (losses) during the period
 
9,118

 
12,877

 
18,382

 
24,274

Realized gains in net income
 
226

 
3

 
694

 
315

Other comprehensive income, net of tax
 
16,514

 
26,887

 
31,668

 
43,436

 
 
 
 
 
 
 
 
 
Total comprehensive income
 
$
28,297

 
$
36,941

 
$
60,047

 
$
86,086

 
 
 
 
 
 
 
 
 
Earnings per common share (Note 10):
 
 

 
 

 
 
 
 
Basic
 
$
0.31

 
$
0.25

 
$
0.74

 
$
1.02

Diluted
 
$
0.31

 
$
0.25

 
$
0.74

 
$
1.01

Cash dividends declared per common share
 
$
0.06

 
$
0.06

 
$
0.18

 
$
0.18

 
 
 
 
 
 
 
 
 
Realized gains on investments, net
 
 

 
 

 
 
 
 
Net realized gains on investments before credit related impairments on fixed maturity securities
 
$
647

 
$
8

 
$
1,983

 
$
900

Other than temporary impairment, credit losses recognized in earnings
 

 

 

 

Portion of impairment recognized in other comprehensive income
 

 

 

 

Realized gains on investments, net
 
$
647

 
$
8

 
$
1,983

 
$
900


See accompanying unaudited notes to the consolidated financial statements.

4



Employers Holdings, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(in thousands)
 
 
Nine Months Ended
 
 
September 30,
 
 
2011
 
2010
Operating activities
 
(unaudited)
Net income
 
$
28,379

 
$
42,650

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

 
 

Depreciation and amortization
 
4,861

 
5,477

Stock-based compensation
 
2,738

 
2,982

Amortization of premium on investments, net
 
5,791

 
4,238

Allowance for doubtful accounts
 
(1,396
)
 
(1,764
)
Deferred income tax expense
 
(4,756
)
 
5,045

Realized gains on investments, net
 
(1,983
)
 
(900
)
Realized losses on retirement of assets
 
128

 
252

Change in operating assets and liabilities:
 
 

 
 

Accrued investment income
 
2,770

 
1,779

Premiums receivable
 
(43,331
)
 
13,180

Reinsurance recoverable on paid and unpaid losses
 
32,167

 
57,059

Funds held by or deposited with reinsureds
 
2,086

 
3,047

Federal income taxes recoverable
 
(4,212
)
 
(5,360
)
Unpaid losses and loss adjustment expenses
 
(30,465
)
 
(99,827
)
Unearned premiums
 
44,733

 
(5,057
)
Accounts payable, accrued expenses and other liabilities
 
9,979

 
(1,014
)
Deferred reinsurance gain – LPT Agreement
 
(12,984
)
 
(13,514
)
Other
 
1,472

 
(2,672
)
Net cash provided by operating activities
 
35,977

 
5,601

Investing activities
 
 

 
 

Purchase of fixed maturities
 
(112,895
)
 
(165,273
)
Purchase of equity securities
 
(4,314
)
 
(454
)
Proceeds from sale of fixed maturities
 
98,400

 
77,859

Proceeds from sale of equity securities
 
4,490

 
567

Proceeds from maturities and redemptions of investments
 
104,990

 
94,521

Capital expenditures and other
 
(3,591
)
 
(1,684
)
Restricted cash and cash equivalents provided by (used in) investing activities
 
10,757

 
(2,189
)
Net cash provided by investing activities
 
97,837

 
3,347

Financing activities
 
 

 
 

Proceeds from exercise of stock options
 

 
74

Acquisition of treasury stock
 
(40,720
)
 
(50,000
)
Cash transactions related to stock-based compensation
 
800

 
(1,229
)
Dividends paid to stockholders
 
(6,885
)
 
(7,554
)
Net cash used in financing activities
 
(46,805
)
 
(58,709
)
Net increase (decrease) in cash and cash equivalents
 
87,009

 
(49,761
)
Cash and cash equivalents at the beginning of the period
 
119,825

 
188,833

Cash and cash equivalents at the end of the period
 
$
206,834

 
$
139,072

 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
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, 2010.
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. New Accounting Standards
In October 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) Number 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. This update changes the definition of acquisition costs which may be capitalized to specify costs which relate directly to the successful acquisition of new or renewal insurance contracts; adds to the definition the concept of incremental costs; further restricts costs to be capitalized by identifying only those costs which may be capitalized; and requires additional granularity in the disclosures related to the type of acquisition costs capitalized during the period. This guidance becomes effective for interim and annual reporting periods beginning after December 15, 2011. The Company has not yet determined if it will adopt the standard on a prospective or retrospective basis and is evaluating the impact that retrospective adoption will have on its financial statements. Currently, the Company estimates that prospective adoption of ASU 2010-06 would increase its underwriting and other operating expenses by $7.0 million to $8.0 million in 2012 and decrease total assets on the consolidated balance sheet by the same amount.
In May 2011, the FASB issued ASU Number 2011-04, Fair Value Measurement. This update is a result of efforts by the FASB and the International Accounting Standards Board (IASB) to develop common requirements for measuring fair value and for disclosing information about fair value measurements in GAAP and International Financial Reporting Standards (IFRS). This update changes the wording used to describe many of the requirements in GAAP for measuring fair value and for disclosing information about fair value measurements. The intent was to clarify existing fair value measurement and disclosure requirements and to ensure that GAAP and IFRS fair value measurements and disclosures are described in the same way. This update also requires additional disclosures related to valuation processes and the sensitivity of Level 3 financial assets and liabilities. It does not require additional fair value measures, nor does the FASB expect the amendment to affect current practice. This guidance becomes effective for interim and annual periods beginning after December 15, 2011 and early adoption is not permitted. The Company does not expect the adoption to have a material impact, if any, on its consolidated financial condition and results of operations.

6



In September 2011, the FASB issued ASU Number 2011-08, Intangibles - Goodwill and Other. This update is a result of efforts by the FASB to reduce complexity and costs for an entity testing goodwill impairment. This update will permit an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step goodwill impairment test described in Accounting Standard Codification Topic 350. If an entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. This guidance becomes effective for interim and annual periods beginning after December 15, 2011, and early adoption is permitted. The Company will adopt this update for interim and annual periods beginning after December 15, 2011. The Company does not expect the adoption to have a material impact, if any, on its consolidated financial condition and results of operations.
3. Investments
The amortized cost, gross unrealized gains, gross unrealized losses, and estimated fair value of the Company’s investments were as follows:
 
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
At September 30, 2011
 
(in thousands)
Fixed maturity securities
 
 
 
 
 
 
 
 
U.S. Treasuries
 
$
129,381

 
$
19,601

 
$

 
$
148,982

U.S. Agencies
 
97,247

 
7,510

 

 
104,757

States and municipalities
 
863,954

 
72,587

 
(79
)
 
936,462

Corporate
 
438,369

 
35,617

 
(1,841
)
 
472,145

Residential mortgage-backed securities
 
242,843

 
20,110

 
(471
)
 
262,482

Commercial mortgage-backed securities
 
22,143

 
871

 
(3
)
 
23,011

Asset-backed securities
 
11,929

 
585

 

 
12,514

Total fixed maturity securities
 
1,805,866

 
156,881

 
(2,394
)
 
1,960,353

Equity securities
 
 

 
 

 
 

 
 

Consumer goods
 
19,659

 
7,042

 
(432
)
 
26,269

Energy and utilities
 
4,675

 
4,665

 
(36
)
 
9,304

Financial
 
6,532

 
1,595

 
(1,097
)
 
7,030

Technology and communications
 
8,099

 
9,199

 
(295
)
 
17,003

Industrial and other
 
11,154

 
4,735

 
(1,073
)
 
14,816

Total equity securities
 
50,119

 
27,236

 
(2,933
)
 
74,422

Total investments
 
$
1,855,985

 
$
184,117

 
$
(5,327
)
 
$
2,034,775



7



 
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
At December 31, 2010
 
(in thousands)
Fixed maturity securities
 
 
 
 
 
 
 
 
U.S. Treasuries
 
$
135,265

 
$
9,619

 
$
(159
)
 
$
144,725

U.S. Agencies
 
116,747

 
7,142

 
(87
)
 
123,802

States and municipalities
 
927,668

 
43,054

 
(4,720
)
 
966,002

Corporate
 
453,851

 
28,655

 
(3,082
)
 
479,424

Residential mortgage-backed securities
 
230,518

 
16,926

 
(688
)
 
246,756

Commercial mortgage-backed securities
 
23,877

 
1,201

 
(1
)
 
25,077

Asset-backed securities
 
13,852

 
727

 
(1
)
 
14,578

Total fixed maturity securities
 
1,901,778

 
107,324

 
(8,738
)
 
2,000,364

Equity securities
 
 

 
 

 
 

 
 

Consumer goods
 
19,141

 
7,550

 
(45
)
 
26,646

Energy and utilities
 
5,106

 
5,160

 
(1
)
 
10,265

Financial
 
6,603

 
2,916

 
(19
)
 
9,500

Technology and communications
 
7,499

 
8,500

 
(9
)
 
15,990

Industrial and other
 
10,932

 
6,841

 
(44
)
 
17,729

Total equity securities
 
49,281

 
30,967

 
(118
)
 
80,130

Total investments
 
$
1,951,059

 
$
138,291

 
$
(8,856
)
 
$
2,080,494

The amortized cost and estimated fair value of fixed maturity securities at September 30, 2011, by contractual maturity, are shown 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
 
$
129,921

 
$
132,378

Due after one year through five years
 
478,905

 
515,067

Due after five years through ten years
 
631,926

 
695,267

Due after ten years
 
288,199

 
319,634

Mortgage and asset-backed securities
 
276,915

 
298,007

Total
 
$
1,805,866

 
$
1,960,353


8



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 September 30, 2011 and December 31, 2010.
 
 
September 30, 2011
 
 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
 
Estimated
Fair
Value
 
Gross
Unrealized
Losses
 
Estimated
Fair
Value
 
Gross
Unrealized
Losses
 
Estimated
Fair
Value
 
Gross
Unrealized
Losses
 
 
(in thousands)
Fixed maturity securities
 
 
 
 
 
 
 
 
 
 
 
 
States and municipalities
 
$
4,187

 
$
(52
)
 
$
1,025

 
$
(27
)
 
$
5,212

 
$
(79
)
Corporate
 
59,488

 
(1,803
)
 
4,944

 
(38
)
 
64,432

 
(1,841
)
Residential mortgage-backed securities
 
4,929

 
(26
)
 
3,059

 
(445
)
 
7,988

 
(471
)
Commercial mortgage-backed securities
 
2,113

 
(3
)
 

 

 
2,113

 
(3
)
Total fixed maturity securities
 
70,717

 
(1,884
)
 
9,028

 
(510
)
 
79,745

 
(2,394
)
Equity securities
 
 

 
 

 
 

 
 

 
 
 
 

Consumer goods
 
4,161

 
(432
)
 

 

 
4,161

 
(432
)
Energy and utilities
 
211

 
(36
)
 

 

 
211

 
(36
)
Financial
 
2,695

 
(1,044
)
 
76

 
(53
)
 
2,771

 
(1,097
)
Technology and communications
 
1,682

 
(295
)
 

 

 
1,682

 
(295
)
Industrial and other
 
4,992

 
(1,064
)
 
124

 
(9
)
 
5,116

 
(1,073
)
Total equity securities
 
13,741

 
(2,871
)
 
200

 
(62
)
 
13,941

 
(2,933
)
Total investments
 
$
84,458

 
$
(4,755
)
 
$
9,228

 
$
(572
)
 
$
93,686

 
$
(5,327
)

 
 
December 31, 2010
 
 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
 
Estimated
Fair
Value
 
Gross
Unrealized
Losses
 
Estimated
Fair
Value
 
Gross
Unrealized
Losses
 
Estimated
Fair
Value
 
Gross
Unrealized
Losses
 
 
(in thousands)
Fixed maturity securities
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasuries
 
$
4,548

 
$
(159
)
 
$

 
$

 
$
4,548

 
$
(159
)
U.S. Agencies
 
14,500

 
(87
)
 

 

 
14,500

 
(87
)
States and municipalities
 
124,245

 
(4,720
)
 

 

 
124,245

 
(4,720
)
Corporate
 
123,216

 
(3,082
)
 

 

 
123,216

 
(3,082
)
Residential mortgage-backed securities
 
15,161

 
(304
)
 
3,465

 
(384
)
 
18,626

 
(688
)
Commercial mortgage-backed securities
 
1,365

 
(1
)
 

 

 
1,365

 
(1
)
Asset-backed securities
 
923

 
(1
)
 

 

 
923

 
(1
)
Total fixed maturity securities
 
283,958

 
(8,354
)
 
3,465

 
(384
)
 
287,423

 
(8,738
)
Equity securities
 
 

 
 

 
 

 
 

 
 

 
 

Consumer goods
 
4,993

 
(45
)
 

 

 
4,993

 
(45
)
Energy and utilities
 
163

 
(1
)
 

 

 
163

 
(1
)
Financial
 
1,695

 
(16
)
 
66

 
(3
)
 
1,761

 
(19
)
Technology and communications
 
801

 
(9
)
 

 

 
801

 
(9
)
Industrial and other
 
2,999

 
(44
)
 

 

 
2,999

 
(44
)
Total equity securities
 
10,651

 
(115
)
 
66

 
(3
)
 
10,717

 
(118
)
Total investments
 
$
294,609

 
$
(8,469
)
 
$
3,531

 
$
(387
)
 
$
298,140

 
$
(8,856
)

9



Based on reviews of the fixed maturity securities, the Company determined that unrealized losses as of September 30, 2011 and December 31, 2010 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.
Based on reviews of the equity securities as of September 30, 2011 and December 31, 2010, the Company determined that the unrealized losses as of those dates were not considered to be other-than-temporary due to the financial condition and near-term prospects of the issuers.
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
 
Nine Months Ended
 
 
September 30,
 
September 30,
 
 
2011
 
2010
 
2011
 
2010
 
 
(in thousands)
Realized gains on investments, net
 
 
 
 
 
 
 
 
Fixed maturity securities
 
 
 
 
 
 
 
 
Gross gains from sales
 
$
185

 
$
8

 
$
1,117

 
$
8,597

Gross losses from sales
 

 

 
(148
)
 
(7,977
)
Realized gains on fixed maturity securities, net
 
$
185

 
$
8

 
$
969

 
$
620

Equity securities
 
 
 
 
 
 
 
 
Gross gains from sales
 
$
479

 
$

 
$
1,034

 
$
280

Gross losses from sales
 
(17
)
 

 
(20
)
 

Realized gains on equity securities, net
 
$
462

 
$

 
$
1,014

 
$
280

Total
 
$
647

 
$
8

 
$
1,983

 
$
900

Change in unrealized gains (losses)
 
 

 
 

 
 
 
 
Fixed maturity securities
 
$
36,444

 
$
31,015

 
$
55,902

 
$
62,135

Equity securities
 
(11,038
)
 
7,936

 
(6,546
)
 
3,080

Total
 
$
25,406

 
$
38,951

 
$
49,356

 
$
65,215

Net investment income was as follows:
 
 
Three Months Ended
 
Nine Months Ended
 
 
September 30,
 
September 30,
 
 
2011
 
2010
 
2011
 
2010
 
 
(in thousands)
Fixed maturity securities
 
$
19,247

 
$
20,781

 
$
60,140

 
$
63,139

Equity securities
 
449

 
344

 
1,367

 
1,025

Cash equivalents and restricted cash
 
525

 
165

 
721

 
231

 
 
20,221

 
21,290

 
62,228

 
64,395

Investment expenses
 
(637
)
 
(601
)
 
(1,845
)
 
(1,803
)
Net investment income
 
$
19,584

 
$
20,689

 
$
60,383

 
$
62,592

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 September 30, 2011 and December 31, 2010, securities having a fair value of $521.0 million and $558.6 million, respectively, were on deposit. These laws and regulations govern not only the amount, but also the type of security that is 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 September 30, 2011 and December 31, 2010 was $41.2 million and $52.9 million, respectively. The Company's debt was secured by fixed maturity securities and restricted cash and cash equivalents that had a fair value of $127.5 million and $131.0 million at September 30, 2011 and December 31, 2010, respectively.

10



4. Fair Value of Financial Instruments
The carrying value and the estimated fair value of the Company’s financial instruments as of September 30, 2011, were as follows:
 
 
Carrying Value
 
Estimated Fair Value
 
 
(in thousands)
Financial assets
 
 
 
 
Investments
 
$
2,034,775

 
$
2,034,775

Cash and cash equivalents
 
206,834

 
206,834

Restricted cash and cash equivalents
 
6,192

 
6,192

Financial liabilities
 
 

 
 

Notes payable
 
132,000

 
145,382

As of December 31, 2010, the estimated fair value of the Company’s financial assets was also equal to the carrying value, while the carrying value and estimated fair value of the Company's notes payable were $132.0 million and $150.6 million, respectively.  The Company's estimates of fair value for financial liabilities is based on the variable interest rate for the Company's existing line of credit to discount future payments on notes payable.
The Company's estimates of fair value for financial assets and liabilities are based on the inputs used in the valuations and give the highest priority to quoted prices in active markets and require that observable inputs be used in the valuations when available. The disclosure of fair value estimates is based on whether the significant inputs into the valuations are observable. In determining the level of the hierarchy in which the estimate is disclosed, the highest priority is given to unadjusted quoted prices in active markets and the lowest priority to unobservable inputs that reflect the Company's significant market assumptions.
The three levels of the hierarchy are as follows:
Level 1 - Valuations based on unadjusted quoted market prices for identical assets or liabilities in active markets. The Company uses the quoted market prices as fair value and includes these prices in the amounts disclosed in Level 1 of the hierarchy.
Level 2 - Valuations based on observable inputs (other than Level 1 prices), such as quoted market prices for similar assets or liabilities at the measurement date; quoted prices in inactive markets; or other inputs that are observable, either directly or indirectly. When quoted market prices are unavailable, the Company estimates fair value based on objectively verifiable information, if available, and these estimates are included in the amount disclosed in Level 2 of the hierarchy.
Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement and involve management judgment. The fair value of certain privately held or thinly traded securities is determined using internal analytical methods based on the best information available.
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. The valuation methods used by the Company, by type of investment, are described below.
Equity Securities. The Company utilizes market quotations for equity securities that have quoted prices in active markets.
Fixed Maturity Securities, Short-Term Investments. Fair value measurements for these securities are estimated using relevant inputs, including available market information, benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing. An Option Adjusted Spread model is also used to develop prepayment and interest rate scenarios. Industry standard models are used to analyze and value securities with embedded options or prepayment sensitivities.
Each asset class is evaluated based on relevant market information, credit information, perceived market movements, and sector news. The market inputs utilized in the pricing evaluation include: benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, reference data, and industry and economic events. The extent of the use of each market input depends on the asset class and the market conditions.
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,

11



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.
The following table presents the items on the accompanying consolidated balance sheets that are stated at fair value and the fair value measurements.
 
 
Level 1
 
Level 2
 
Level 3
At September 30, 2011
 
(in thousands)
Fixed maturity securities
 
 
 
 
 
 
U.S. Treasuries
 
$

 
$
148,982

 
$

U.S. Agencies
 

 
104,757

 

States and municipalities
 

 
936,462

 

Corporate
 

 
472,145

 

Residential mortgage-backed securities
 

 
262,482

 

Commercial mortgage-backed securities
 

 
23,011

 

Asset-backed securities
 

 
12,514

 

Total fixed maturity securities
 
$

 
$
1,960,353

 
$

Equity securities
 
 

 
 

 
 

Consumer goods
 
$
26,269

 
$

 
$

Energy and utilities
 
9,304

 

 

Financial
 
7,030

 

 

Technology and communications
 
17,003

 

 

Industrial and other
 
14,816

 

 

Total equity securities
 
$
74,422

 
$

 
$


 
 
Level 1
 
Level 2
 
Level 3
At December 31, 2010
 
(in thousands)
Fixed maturity securities
 
 
 
 
 
 
U.S. Treasuries
 
$

 
$
144,725

 
$

U.S. Agencies
 

 
123,802

 

States and municipalities
 

 
966,002

 

Corporate
 

 
479,424

 

Residential mortgage-backed securities
 

 
246,756

 

Commercial mortgage-backed securities
 

 
25,077

 

Asset-backed securities
 

 
14,578

 

Total fixed maturity securities
 
$

 
$
2,000,364

 
$

Equity securities
 
 

 
 

 
 

Consumer goods
 
$
26,646

 
$

 
$

Energy and utilities
 
10,265

 

 

Financial
 
9,500

 

 

Technology and communications
 
15,990

 

 

Industrial and other
 
17,729

 

 

Total equity securities
 
$
80,130

 
$

 
$

5. Income Taxes
Income tax expense for interim periods is measured using an estimated effective tax rate for the annual period. During the nine months ended September 30, 2011 and 2010, the Company recognized net income before taxes of $19.6 million and $43.8 million and an income tax (benefit) expense of $(8.7) million and $1.2 million, yielding effective tax rates of (44.5)% and 2.7%, respectively.

12



The following is a reconciliation of the federal statutory income tax rate to the Company’s effective tax rates for the periods presented.
 
 
Nine Months Ended
 
 
September 30,
 
 
2011
 
2010
Expense computed at statutory rate
 
35.0
 %
 
35.0
 %
Dividends received deduction and tax-exempt interest
 
(47.4
)
 
(20.2
)
LPT Agreement
 
(26.7
)
 
(11.7
)
Pre-privatization reserve adjustments
 
(6.6
)
 
(2.4
)
Stock based compensation
 
0.3

 
0.5

Other
 
0.9

 
1.5

Effective tax rate
 
(44.5
)%
 
2.7
 %
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.
 
 
Nine Months Ended
 
 
September 30,
 
 
2011
 
2010
 
 
(in thousands)
Unpaid losses and LAE, gross of reinsurance, at beginning of period
 
$
2,279,729

 
$
2,425,658

Less reinsurance recoverables, excluding bad debt allowance, on unpaid losses and LAE
 
956,043

 
1,052,505

Net unpaid losses and LAE at beginning of period
 
1,323,686

 
1,373,153

Losses and LAE, net of reinsurance, incurred in:
 
 

 
 

Current period
 
203,362

 
166,618

Prior periods
 
631

 
(15,007
)
Total net losses and LAE incurred during the period
 
203,993

 
151,611

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

 
 

Current period
 
33,477

 
33,797

Prior periods
 
172,608

 
161,953

Total net payments for losses and LAE during the period
 
206,085

 
195,750

Ending unpaid losses and LAE, net of reinsurance
 
1,321,594

 
1,329,014

Reinsurance recoverable, excluding bad debt allowance in 2010, on unpaid losses and LAE
 
927,670

 
996,817

Unpaid losses and LAE, gross of reinsurance, at end of period
 
$
2,249,264

 
$
2,325,831

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 change in the liability for unpaid losses and LAE attributable to insured events for prior periods was $0.6 million and $(15.0) million for the nine months ended September 30, 2011 and 2010, respectively. The increase in the nine months ended September 30, 2011 was related to the Company's assigned risk business, while the major sources of favorable development in the nine months ended September 30, 2010 were actual paid losses being less than expected and the impact of new information on selected claim payments and emergence patterns used in the projection of future loss payments. The commutation of certain reinsurance treaties during the third quarter of 2010 increased losses and LAE incurred in prior periods by $1.6 million for the nine months ended September 30, 2010 and is included in the $(15.0) million prior period development.
7. LPT Agreement
The Company is party to a 100% quota share retroactive reinsurance agreement (LPT Agreement) under which $1.53 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 $2.00 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 $4.8 million of the Deferred Gain for the three months ended September 30, 2011 and 2010, respectively, and amortized $13.0 million and $13.5 million of the Deferred Gain for the nine months ended September 30, 2011

13



and 2010, 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 $357.4 million and $370.3 million as of September 30, 2011 and December 31, 2010, respectively, and is included in the accompanying consolidated balance sheets.
8. Accumulated Other Comprehensive Income, net
Accumulated other comprehensive income is comprised of unrealized gains on investments classified as available-for-sale and unrealized losses on an interest rate swap, net of deferred tax expense. The following table summarizes the components of accumulated other comprehensive income, net:
 
 
September 30,
 
 
2011
 
2010
 
 
(in thousands)
Net unrealized gain on investments, before taxes
 
$
178,790

 
$
195,765

Deferred tax expense on net unrealized gains
 
(62,989
)
 
(68,517
)
Total accumulated other comprehensive income, net
 
$
115,801

 
$
127,248

9. Stock-Based Compensation
On March 16, 2011, 355,063 stock options and 126,975 restricted stock units (RSUs) were awarded to certain officers of the Company. The fair value of the RSUs on the grant date and the per share exercise price of the stock options was $19.81. The stock options have a service vesting period of four years and vest 25% on March 16, 2012, and 25% on each of the subsequent three anniversaries of such date. The stock options and RSUs are subject to accelerated vesting in circumstances of death or disability of the holder or in connection with a change of control of the Company and are subject to partial accelerated vesting in the case of retirement. The stock options expire seven years from the date of grant. The aggregate fair value of the stock options and RSUs on the date of grant was $2.5 million and $2.5 million, respectively.
On May 26, 2011, 29,440 RSUs were awarded to the directors of the Company. The fair value of the RSUs on the grant date was $16.30 per share and the aggregate fair value on the date of grant was $0.5 million.
During the first quarter of 2010, the EHI Board of Directors certified the performance period results of the performance share units (PSUs) awarded in 2007, resulting in the vesting of 196,071 shares of common stock.
A total of 74,431 and 7,783 stock options were exercised during the nine months ended September 30, 2011 and the year ended December 31, 2010, 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 common shares outstanding used in the earnings per common share calculations for the periods presented.
 
 
Three Months Ended
 
Nine Months Ended
 
 
September 30,
 
September 30,
 
 
2011
 
2010
 
2011
 
2010
 
 
(in thousands, except share data)
Net income available to stockholders—basic and diluted
 
$
11,783

 
$
10,054

 
$
28,379

 
$
42,650

Weighted average number of shares outstanding—basic
 
37,623,935

 
40,765,528

 
38,251,561

 
41,991,051

Effect of dilutive securities:
 
 
 
 
 
 
 
 
Stock options
 

 
11,828

 
61,055

 

Restricted stock units
 
12,577

 
142,372

 
67,751

 
107,593

Dilutive potential shares
 
12,577

 
154,200

 
128,806

 
107,593

Weighted average number of shares outstanding—diluted
 
37,636,512

 
40,919,728

 
38,380,367

 
42,098,644


14



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. For the three and nine months ended September 30, 2011, 1.5 million and 1.1 million stock options, respectively, were excluded from diluted earnings per share, as the options exercise price was greater than the average market price of the common stock during the period, compared to 0.7 million and 1.2 million for the corresponding periods of 2010. For both the three and nine months ended September 30, 2011, 0.7 million and 0.5 million outstanding RSUs and stock options, respectively, were excluded from diluted earnings per share under the treasury method, as the potential proceeds on settlement or exercise was greater than the value of shares acquired, compared to 0.4 million and 0.5 million for the corresponding periods of 2010.
11. Subsequent Events
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). On November 2, 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 program through June 30, 2013. The timing and actual number of shares repurchased will depend on a variety of factors, including the share price, corporate and regulatory requirements, and other market and economic conditions. Repurchases under the 2011 Program may be commenced, modified, or suspended from time-to-time without prior notice, and the program may be suspended or discontinued at any time.

15



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, 2010 (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 30 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 which are competitive and profitable over the long-term. Our underwriting approach is to consistently underwrite small business accounts at an appropriate and competitive price without sacrificing long-term profitability and stability for short-term top-line revenue growth.
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 (NFIB).
Results of Operations
Overall, net income was $11.8 million and $28.4 million for the three and nine months ended September 30, 2011, respectively, compared to $10.1 million and $42.7 million for the corresponding periods of 2010. We recognized underwriting losses of $12.0 million and $40.2 million for the three and nine months ended September 30, 2011, respectively, compared to underwriting losses of $9.3 million and $15.4 million for the same periods of 2010. 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 and nine months ended September 30, 2011, compared to the same periods of 2010, include:
26% increase in gross premiums written during the third quarter and 30% increase year-to-date (15% and 10% increase in net earned premium for the same periods);
28% increase in losses and LAE during the third quarter and 38% increase year-to-date (due to increased earned premium, favorable prior accident year loss development in 2010, and an increase in our current accident year loss estimate to 77.2% and 77.3% for the third quarter and year-to-date 2011, respectively);
Income tax benefit of $4.4 million and $8.7 million for the third quarter and year-to-date 2011, respectively, compared to income tax expense of $0.1 million and $1.2 million for the same periods of 2010.

16



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. Our stockholders’ equity, including the Deferred Gain, was $863.5 million and $860.5 million at September 30, 2011 and December 31, 2010, respectively. 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. Stockholders’ equity on a GAAP basis was $506.1 million and $490.1 million at September 30, 2011 and December 31, 2010, respectively. Shares outstanding declined to 36,230,399 from 38,965,126 for the nine months ended September 30, 2011, as a result of accretive share repurchases. Additionally, we have returned $6.9 million to shareholders in 2011 through quarterly dividends.
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 most recent economic recession. The pace of recovery remains persistently slow and, although it appears to us that the declines in total employment and payroll have leveled-off, we do not believe the situation will significantly improve in the near-term.
The comparative components of net income are set forth in the following table:
 
 
Three Months Ended
 
Nine Months Ended
 
 
September 30,
 
September 30,
 
 
2011
 
2010
 
2011
 
2010
 
 
(in thousands)
Gross premiums written
 
$
104,514

 
$
83,265

 
$
315,571

 
$
242,064

Net premiums written
 
102,557

 
81,312

 
309,249

 
234,812

 
 
 
 
 
 
 
 
 
Net premiums earned
 
$
92,601

 
$
80,695

 
$
263,156

 
$
238,221

Net investment income
 
19,584

 
20,689

 
60,383

 
62,592

Realized gains on investments
 
647

 
8

 
1,983

 
900

Other income
 
82

 
393

 
205

 
600

Total revenues
 
112,914

 
101,785

 
325,727

 
302,313

 
 
 
 
 
 
 
 
 
Losses and LAE
 
67,438

 
52,764

 
191,009

 
138,097

Commission expense
 
10,968

 
9,971

 
32,368

 
29,052

Dividends to policyholders
 
840

 
1,584

 
2,766

 
3,386

Underwriting and other operating expenses
 
25,334

 
25,722

 
77,212

 
83,132

Interest expense
 
906

 
1,632

 
2,731

 
4,832

Income tax expense (benefit)
 
(4,355
)
 
58

 
(8,738
)
 
1,164

Total expenses
 
101,131

 
91,731

 
297,348

 
259,663

Net income
 
$
11,783

 
$
10,054

 
$
28,379

 
$
42,650

Less impact of the deferred reinsurance gain— LPT Agreement
 
$
4,203

 
$
4,792

 
$
12,984

 
$
13,514

Net income before impact of the deferred reinsurance gain— LPT Agreement(1)
 
$
7,580

 
$
5,262

 
$
15,395

 
$
29,136

(1)
We define net income before impact of the deferred reinsurance gain—LPT Agreement 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 recoverable, and the deferred reinsurance gain, with the net effect being an increase or decrease, as the case may be, to net income.  Net income before impact of the deferred reinsurance gain—LPT Agreement 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 and net income or any other measure of performance derived in accordance with GAAP.
We present net income before impact of the deferred reinsurance gain—LPT Agreement because we believe that it is an important supplemental measure of operating performance to be used by analysts, investors and other interested parties in evaluating us.  The LPT Agreement was a non-recurring transaction, which does not result in ongoing cash benefits, and, consequently, we believe this presentation is useful in providing a meaningful understanding of our operating performance.  In addition, we believe this non-GAAP measure, as we have defined it, is helpful to our management in identifying trends in our performance because the excluded item has limited significance on our current and ongoing operations.

17



Net Premiums Earned
Net premiums earned increased 14.8% and 10.5% for the three and nine months ended September 30, 2011, respectively, compared to the corresponding periods of 2010. The year-over-year change in the accrual for final audit premium decreased our net premiums earned by $0.6 million for the three months ended September 30, 2011, compared to the same period of 2010. The change in the accrual for final audit premiums increased our net premiums earned by $15.1 million for the nine months ended September 30, 2011, compared to the same period of 2010. Changes in the accrual for final audit premium are driven by various factors, including general economic factors such as unemployment and payroll trends.
The following table shows the percentage change in our in-force premium, policy count, average policy size, and payroll exposure upon which our premiums are based, and net rate.
 
September 30, 2011
 
Year-to-Date Percentage Increase (Decrease)
 
Year-Over-Year Percentage Increase (Decrease)
In-force premium
14.8
 %
 
12.3
 %
In-force policy count
27.0

 
30.1

Average in-force policy size
(9.6
)
 
(13.7
)
In-force payroll exposure
17.4

 
16.2

Net rate(1)
(2.3
)
 
(3.4
)
(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 total in-force premiums and number of policies in-force for our five largest states and all other states combined are shown in the table below as of the dates shown.
 
 
September 30, 2011
 
December 31, 2010
 
September 30, 2010
 
December 31, 2009
State
 
Premium
In-force
 
Policies
In-force
 
Premium
In-force
 
Policies
In-force
 
Premium
In-force
 
Policies
In-force
 
Premium
In-force
 
Policies
In-force
 
 
(dollars in thousands)
California
 
$
206,272

 
35,139

 
$
172,621

 
29,244

 
$
172,693

 
28,586

 
$
180,474

 
27,812

Illinois
 
23,041

 
2,045

 
18,617

 
932

 
19,150

 
850

 
19,389

 
801

Florida
 
14,993

 
2,309

 
15,071

 
1,963

 
15,724

 
1,932

 
27,964

 
2,630

Nevada
 
14,675

 
3,630

 
16,940

 
3,596

 
18,624

 
3,662

 
24,050

 
4,119

Georgia
 
14,530

 
1,716

 
10,773

 
757

 
11,118

 
537

 
12,744

 
539

Other
 
95,080

 
11,762

 
87,115

 
8,068

 
90,992

 
7,944

 
120,404

 
8,253

Total
 
$
368,591

 
56,601

 
$
321,137

 
44,560

 
$
328,301

 
43,511

 
$
385,025

 
44,154

Our strategic partnerships and alliances generated $87.9 million and $70.4 million, or 23.8% and 21.4%, of our in-force premiums as of September 30, 2011 and 2010, 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 September 30, 2011, over one-half of our business was generated in California, where our policy count increased 20.2% 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 includes 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 benchmark is now based on the industry average

18



filed pure premium rate, rather than the pure premium rate approved by the California Commissioner of Insurance. The WCIRB submitted its new proposed pure premium rate proposed to be effective January 1, 2012. The WCIRB noted that while 2012 projected costs continue to be below pre-reform highs and the new proposed pure premium rate is slightly less than the industry average filed rate, these new proposed rates reflect significant deterioration in projected losses and LAE and less optimistic economic forecasts, compared to last year.
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 by a cumulative 33.3% since February 1, 2009.
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

We expect that premiums in 2011 will continue to reflect the following:
rate changes (increases and reductions) in the states in which we operate;
increasing policy count as we continue to execute our growth strategy;
lower average policy size;
competitive pressures; and
the residual effects of the recession.
Net Investment Income and Realized Gains on Investments.
We invest our holding company assets, s