| SEABRIGHT INSURANCE HOLDINGS INC Item 1A Risk Factors |
| You should carefully consider the risks described below, together with all of the other information included in this annual report |
| The risks and uncertainties described below are not the only ones facing our company |
| Any of the risks described below could result in a significant or material adverse effect on our financial condition or results of operations, and a corresponding decline in the market price of our common stock |
| You could lose all or part of your investment |
| The risks discussed below also include forward-looking statements and our actual results may differ substantially from those discussed in those forward-looking statements |
| Please refer to the discussion under the heading “Note on Forward-Looking Statements” in Item 1 |
| Risks Related to Our Business Our loss reserves are based on estimates and may be inadequate to cover our actual losses |
| If we fail to accurately assess the risks associated with the businesses that we insure, our loss reserves may be inadequate to cover our actual losses and we may fail to establish appropriate premium rates |
| We 35 _________________________________________________________________ [85]Table of Contents establish loss reserves in our financial statements that represent an estimate of amounts needed to pay and administer claims with respect to insured events that have occurred, including events that have not yet been reported to us |
| Loss reserves are estimates and are inherently uncertain; they do not and cannot represent an exact measure of liability |
| Accordingly, our loss reserves may prove to be inadequate to cover our actual losses |
| Any changes in these estimates are reflected in our results of operations during the period in which the changes are made, with increases in our loss reserves resulting in a charge to our earnings |
| Our loss reserve estimates are based on estimates of the ultimate cost of individual claims and on actuarial estimation techniques |
| Several factors contribute to the uncertainty in establishing these estimates |
| Judgment is required in actuarial estimation to ascertain the relevance of historical payment and claim settlement patterns under current facts and circumstances |
| Key assumptions in the estimation process are the average cost of claims over time, which we refer to as severity trends, including the increasing level of medical, legal and rehabilitation costs, and costs associated with fraud or other abuses of the medical claim process |
| If there are unfavorable changes in severity trends, we may need to increase our loss reserves, as described above |
| Our geographic concentration ties our performance to the business, economic and regulatory conditions in California, Hawaii and Alaska |
| Any single catastrophe or other condition affecting losses in these states could adversely affect our results of operations |
| Our business is concentrated in California (approximately 64dtta8prca of direct premiums written for the year ended December 31, 2005), Alaska (approximately 12dtta0prca of direct premiums written for the same period) and Hawaii (approximately 7dtta4prca of direct premiums written for the same period) |
| Accordingly, unfavorable business, economic or regulatory conditions in those states could negatively impact our business |
| For example, California, Hawaii and Alaska are states that are susceptible to severe natural perils, such as tsunamis, earthquakes and hurricanes, along with the possibility of terrorist acts |
| Accordingly, we could suffer losses as a result of catastrophic events in those states |
| Although geographic concentration has not adversely affected our business in the past, we may in the future be exposed to economic and regulatory risks or risks from natural perils that are greater than the risks faced by insurance companies that conduct business over a greater geographic area |
| This concentration of our business could have a material adverse effect on our financial condition or results of operations |
| If we are unable to obtain or collect on our reinsurance protection, our business, financial condition and results of operations could be materially adversely affected |
| We buy reinsurance coverage to protect us from the impact of large losses |
| Reinsurance is an arrangement in which an insurance company, called the ceding company, transfers insurance risk by sharing premiums with another insurance company, called the reinsurer |
| Conversely, the reinsurer receives or assumes reinsurance from the ceding company |
| We currently participate in a workers’ compensation and employers’ liability excess of loss reinsurance treaty program covering all of the business that we write pursuant to which our reinsurers are liable for varying percentages of the ultimate net losses in excess of dlra500cmam000 for the business we write, up to a dlra50dtta0 million limit, subject to certain exclusions and limitations |
| The treaty program provides coverage in several layers |
| See the discussion under the heading “Reinsurance” in Item 1 |
| The availability, amount and cost of reinsurance depend on market conditions and may vary significantly |
| As a result of catastrophic events, such as the events of September 11, 2001, we may incur significantly higher reinsurance costs, more restrictive terms and conditions, and decreased availability |
| For example, the second layer of our current excess of loss reinsurance treaty program provides a sub-limit on our reinsurers’ maximum liability in the amount of dlra4dtta0 million for losses arising out of, or caused by, occupational disease or other disease or cumulative trauma, and the second, third and fourth layers of our reinsurance program provide sub-limits for losses caused by any act of terrorism, as defined in the Terrorism Risk Act |
| Because of these sub-limits and exclusions, which are common in the wake of the events of September 11, 2001, we have significantly greater exposure to losses resulting from acts of 36 _________________________________________________________________ [86]Table of Contents terrorism |
| The incurrence of higher reinsurance costs and more restrictive terms could materially adversely affect our business, financial condition and results of operations |
| The agreements for our current workers’ compensation excess of loss reinsurance treaty program expire on October 1, 2006 |
| Although we currently expect to renew the program upon its expiration, any decrease in the amount of our reinsurance at the time of renewal, whether caused by the existence of more restrictive terms and conditions or decreased availability, will also increase our risk of loss and, as a result, could materially adversely affect our business, financial condition and results of operations |
| We have not experienced difficulty in qualifying for or obtaining sufficient reinsurance to appropriately cover our risks in the past |
| We currently have 13 reinsurers participating in our excess of loss reinsurance treaty program, and believe that this is a sufficient number of reinsurers to provide us with reinsurance in the volume that we require |
| However, it is possible that one or more of our current reinsurers could cancel participation, or we could find it necessary to cancel the participation of one of our reinsurers, in our excess of loss reinsurance treaty program |
| In either of those events, if our reinsurance broker is unable to spread the cancelled or terminated reinsurance among the remaining reinsurers in the program, we estimate that it could take approximately one to three weeks to identify and negotiate appropriate documentation with a replacement reinsurer |
| During this time, we would be exposed to an increased risk of loss, the extent of which would depend on the volume of cancelled reinsurance |
| In addition, we are subject to credit risk with respect to our reinsurers |
| Reinsurance protection that we receive does not discharge our direct obligations under the policies we write |
| We remain liable to our policyholders, even if we are unable to make recoveries to which we believe we are entitled under our reinsurance contracts |
| Losses may not be recovered from our reinsurers until claims are paid, and, in the case of long-term workers’ compensation cases, the creditworthiness of our reinsurers may change before we can recover amounts to which we are entitled |
| Although we have not experienced problems in the past resulting from the failure of a reinsurer to pay our claims in a timely manner, if we experience these problems in the future, our costs would increase and our revenues would decline |
| As of December 31, 2005, we had dlra14dtta4 million of amounts recoverable from our reinsurers that we would be obligated to pay if our reinsurers failed to pay us |
| The insurance business is subject to extensive regulation and legislative changes, which impact the manner in which we operate our business |
| Our insurance business is subject to extensive regulation by the applicable state agencies in the jurisdictions in which we operate, perhaps most significantly by the Illinois Division of Insurance and the California Department of Insurance |
| These state agencies have broad regulatory powers designed to protect policyholders, not stockholders or other investors |
| These powers include, among other things, the ability to: • place limitations on our ability to transact business with our affiliates; • regulate mergers, acquisitions and divestitures involving our insurance company subsidiary; • require SeaBright Insurance Company and PointSure to comply with various licensing requirements and approvals that affect our ability to do business; • approve or reject our policy coverage and endorsements; • place limitations on our investments and dividends; • set standards of solvency to be met and maintained; • regulate rates pertaining to our business; • require assessments for the provision of funds necessary for the settlement of covered claims under certain policies provided by impaired, insolvent or failed insurance companies; • require us to comply with medical privacy laws; and • prescribe the form and content of, and examine, our statutory financial statements |
| 37 _________________________________________________________________ [87]Table of Contents Our ability to transact business with our affiliates and to enter into mergers, acquisitions and divestitures involving our insurance company subsidiary is limited by the requirements of the insurance holding company laws of Illinois and California |
| To comply with these laws, we are required to file notices with the Illinois Division of Insurance and the California Department of Insurance to seek their respective approvals at least 30 days before engaging in any intercompany transactions, such as sales, purchases, exchanges of assets, loans, extensions of credit, cost sharing arrangements and extraordinary dividends or other distributions to stockholders |
| Under these holding company laws, any change of control transaction also requires prior notification and approval |
| Because these governmental agencies may not take action or give approval within the 30 day period, these notification and approval requirements may subject us to business delays and additional business expense |
| If we fail to give these notifications, we may be subject to significant fines and penalties and damaged working relations with these governmental agencies |
| In addition, workers’ compensation insurance is statutorily provided for in all of the states in which we do business |
| State laws and regulations provide for the form and content of policy coverage and the rights and benefits that are available to injured workers, their representatives and medical providers |
| For example, in California, on January 1, 2003, workers’ compensation legislation became effective that provided for increases in the benefits payable to injured workers |
| Also, in California, workers’ compensation legislation intended to reduce certain costs was enacted in September 2003 and April 2004 |
| Among other things, this legislation established an independent medical review process for resolving medical disputes, tightened standards for determining impairment ratings by applying specific medical treatment guidelines, capped temporary total disability payments to 104 weeks from first payment and enabled injured workers to access immediate medical care up to dlra10cmam000 but required them to get medical care through a network of doctors chosen by the employer |
| The implementation of these reforms affects the manner in which we coordinate medical care costs with employers and the manner in which we oversee treatment plans |
| However, the reforms are subject to continuing opposition in the California legislature, in the courts and by ballot initiatives, any of which could overturn or substantially amend the reforms and regulatory rules applicable to the legislation |
| We cannot predict the ultimate impact of the reforms |
| Our business is also affected by federal laws, including the USL&H Act, which is administered by the Department of Labor, and the Merchant Marine Act of 1920, or Jones Act |
| The USL&H Act contains various provisions affecting our business, including the nature of the liability of employers of longshoremen, the rate of compensation to an injured longshoreman, the selection of physicians, compensation for disability and death and the filing of claims |
| Currently, builders of recreational boats over 65 feet in length are subject to the USL&H Act |
| A proposed amendment to the USL&H Act would eliminate builders of recreational boats from the reach of the USL&H Act |
| If this proposed amendment is adopted, we expect that we would lose a total of approximately dlra3dtta0 million in annual direct written premiums from policies currently providing USL&H Act coverage |
| The proposed amendment would not have a material impact on our policies providing coverage under the Jones Act, which gives certain employees at sea the right to sue their employers if such employees are injured |
| Moreover, changes in federal tax laws could also impact our business |
| In addition, we are impacted by the Terrorism Risk Act and by the Gramm-Leach-Bliley Act of 2002 related to disclosure of personal information |
| The Terrorism Risk Act requires that commercial property and casualty insurance companies offer coverage for certain acts of terrorism and has established a federal assistance program through the end of 2007 to help insurers cover claims arising out of such acts |
| The Terrorism Risk Act only covers certified acts of terrorism, and the US Secretary of the Treasury must declare the act to be a “certified act of terrorism” for it to be covered under this federal program |
| In addition, no federal compensation will be paid under the Terrorism Risk Act unless aggregate insured losses from the act for the entire insurance industry exceed certain threshold amounts (dlra5dtta0 million for terrorism losses occurring prior to April 1, 2006, dlra50dtta0 million for terrorism losses occurring from April 1, 2006 to December 31, 2006, and dlra100dtta0 million for terrorism losses occurring in 2007) |
| Under this program, the federal government covers 90prca of the losses from covered certified acts of terrorism (85prca for terrorism losses occurring in 2007) on commercial risks in the United States only, in excess of the applicable deductible amount |
| This deductible is calculated based on a percentage of an affiliated 38 _________________________________________________________________ [88]Table of Contents insurance group’s prior year direct earned premiums on commercial lines policies (except for certain excluded lines such as commercial auto) covering risks in the United States |
| This deductible amount is 17dtta5prca of such premiums for losses occurring in 2006 and 20dtta0prca of such premiums for losses occurring in 2007 |
| The Terrorism Risk Act is scheduled to expire on December 31, 2007 and may not be renewed, or if it is renewed, it may provide reduced protection against the financial impact of acts of terrorism by, among other things, increasing the aggregate loss event trigger and the amount of statutory deductible insurers would be required to pay |
| This extensive regulation of our business may affect the cost or demand for our products and may limit our ability to obtain rate increases or to take other actions that we might desire to increase our profitability |
| In addition, we may be unable to maintain all required approvals or comply fully with the wide variety of applicable laws and regulations, which are continually undergoing revision, or the relevant authority’s interpretation of such laws and regulations |
| A downgrade in the AM Best rating of our insurance subsidiary could reduce the amount of business we are able to write |
| Our insurance company subsidiary currently has a rating of “A-” (Excellent) from AM Best, which is the rating agency that we believe has the most influence on our business |
| The ratings of AM Best are subject to periodic review using, among other things, proprietary capital adequacy models, and are subject to revision or withdrawal at any time |
| Insurance ratings are directed toward the concerns of policyholders and insurance agents and are not intended for the protection of investors or as a recommendation to buy, hold or sell any of our securities |
| Our competitive position relative to other companies is determined in part by our AM Best rating |
| We believe that our business is particularly sensitive to our AM Best rating because we focus on larger customers which tend to give substantial weight to the AM Best rating of their insurers |
| We expect that any reduction in our AM Best rating below “A-” would cause a reduction in the number of policies we write and could have a material adverse effect on our results of operations and our financial position |
| The effects of emerging claim and coverage issues on our business are uncertain |
| As industry practices and legal, judicial, social and other environmental conditions change, unexpected and unintended issues related to claims and coverage may emerge |
| These issues may adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the number or size of claims |
| In some instances, these changes may not become apparent until some time after we have issued insurance contracts that are affected by the changes |
| As a result, the full extent of liability under our insurance contracts may not be known for many years after a contract is issued |
| For example, the number or nature of existing occupational diseases may expand beyond our expectation |
| In addition, medical claims costs associated with permanent and partial disabilities may inflate more rapidly or higher than we currently expect |
| Expansions of this nature may expose us to more claims than we anticipated when we wrote the underlying policy |
| Intense competition could adversely affect our ability to sell policies at rates we deem adequate |
| In most of the states in which we operate, we face significant competition which, at times, is intense |
| If we are unable to compete effectively, our business and financial condition could be materially adversely affected |
| Competition in our businesses is based on many factors, including premiums charged, services provided, financial strength ratings assigned by independent rating agencies, speed of claims payments, reputation, perceived financial strength and general experience |
| We compete with regional and national insurance companies and state-sponsored insurance funds, as well as potential insureds that have decided to self-insure |
| Our principal competitors include AIG, Alaska National Insurance Company, Signal Mutual Indemnity Association Ltd, Zurich and the State Compensation Insurance Fund of California |
| Many of our competitors have substantially greater financial and marketing resources than we do, and some of our competitors, including the State Compensation Insurance Fund of California, benefit financially by not 39 _________________________________________________________________ [89]Table of Contents being subject to federal income tax |
| Intense competitive pressure on prices can result from the actions of even a single large competitor, such as the State Compensation Insurance Fund of California or AIG In addition, our competitive advantage may be limited due to the small number of insurance products that we offer |
| Some of our competitors, such as AIG, have additional competitive leverage because of the wide array of insurance products that they offer |
| For example, it may be more convenient for a potential customer to purchase numerous different types of insurance products from one insurance carrier |
| We do not offer a wide array of insurance products due to our targeted market niches, and we may lose potential customers to our larger, more diverse competitors as a result |
| On May 31, 2005, the California Insurance Commissioner issued a decision adopting an advisory pure premium rate reduction of 18prca for California workers’ compensation policies incepting on or after July 1, 2005 |
| Pure premium is that portion of an insurance premium necessary to cover the cost of paying claims, such as medical and indemnity costs and allocated and unallocated loss adjustment expenses |
| The decision was issued in response to reductions in 2004 workers’ compensation claim costs in California, as well as anticipated future claim cost reductions, as a result of reform legislation enacted primarily in 2003 and 2004 |
| The California Insurance Commissioner’s decision is advisory only and insurance companies may choose whether or not to adopt the new rates |
| On June 6, 2005, after completing a study of our California loss data, we filed with the California Department of Insurance our rates for new and renewal workers’ compensation insurance policies written in California on or after July 1, 2005 |
| The filing was approved on June 28, 2005 |
| The new rates reflect an average reduction of 14dtta2prca from prior rates and are in response to emerging favorable trends in loss costs resulting from reform legislation |
| If any of our competitors adopt premium rate reductions that are greater than ours, we may be unable to compete effectively and our business, financial condition and results of operations could be materially adversely affected |
| On September 15, 2005, the Workers’ Compensation Insurance Rating Bureau (“WCIRB”), an industry-backed private organization that provides statistical analysis, submitted an amended filing with the California Insurance Commissioner recommending a 15dtta9prca decrease in advisory pure premium rates on new and renewal policies effective January 1, 2006 |
| As described above, such rates, if adopted by the California Insurance Commissioner, are advisory only and insurance companies may choose whether or not to adopt the new rates |
| The rate decrease was proposed following the WCIRB’s review of accident year experience valued as of June 30, 2005 and the cost impact of the January 1, 2005 permanent disability rating schedule |
| On November 10, 2005, the Commissioner recommended a 15dtta3prca decrease in rates, and on November 28, 2005 we filed new rates reflecting an average reduction of 11dtta8prca from prior rates for new and renewal workers’ compensation insurance policies written in California on or after January 1, 2006 |
| The filing was approved on December 22, 2005 |
| Rate reductions have also been proposed in other states in which we operate |
| At this time, we are unable to predict the impact that the proposed rate reductions, if approved and adopted by us, might have on our future financial position and results of operations |
| If we are unable to realize our investment objectives, our financial condition may be adversely affected |
| Investment income is an important component of our revenues and net income |
| The ability to achieve our investment objectives is affected by factors that are beyond our control |
| For example, United States participation in hostilities with other countries and large-scale acts of terrorism may adversely affect the economy generally, and our investment income could decrease |
| Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic and international economic and political conditions |
| These and other factors also affect the capital markets, and, consequently, the value of the securities we own |
| The outlook for our investment income is dependent on the future direction of interest rates and the amount of cash flows from operations that are available for investment |
| The fair values of fixed maturity investments that are “available-for-sale” fluctuate with changes in interest rates and cause fluctuations in our stockholders’ equity |
| Any significant decline in our investment income as a result of rising interest rates or general market conditions would have an adverse effect on our net income and, as a result, on our stockholders’ equity and our policyholders’ surplus |
| 40 _________________________________________________________________ [90]Table of Contents We could be adversely affected by the loss of one or more principal employees or by an inability to attract and retain staff |
| Our success will depend in substantial part upon our ability to attract and retain qualified executive officers, experienced underwriting talent and other skilled employees who are knowledgeable about our business |
| We rely substantially upon the services of our senior management team and key employees, consisting of John G Pasqualetto, Chairman, President and Chief Executive Officer; Richard J Gergasko, Executive Vice President — Operations; Joseph S De Vita, Senior Vice President, Chief Financial Officer and Assistant Secretary; Richard W Seelinger, Senior Vice President — Policyholder Services; Marc B Miller, MD, Senior Vice President and Chief Medical Officer; D Drue Wax — Senior Vice President, General Counsel and Corporate Secretary; Jeffrey C Wanamaker, Vice President — Underwriting; James L Borland, III, Vice President and Chief Information Officer; M Philip Romney, Vice President — Finance, Principal Accounting Officer and Assistant Secretary and Chris A Engstrom, President — PointSure |
| Although we are not aware of any planned departures or retirements, if we were to lose the services of members of our management team, our business could be adversely affected |
| Were we to lose any of these employees, it may be challenging for us to attract a replacement employee with comparable skills and experience in our market niches |
| We have employment agreements with some of our executive officers, which are described under the heading “Employment Contracts and Termination of Employment and Change-in-Control Arrangements” contained in our proxy statement for the 2006 annual meeting of stockholders and incorporated by reference into Part III, Item 11 of this annual report |
| We do not currently maintain key man life insurance policies with respect to any member of our senior management team or other employees |
| We may require additional capital in the future, which may not be available or only available on unfavorable terms |
| Our future capital requirements depend on many factors, including our ability to write new business successfully and to establish premium rates and loss reserves at levels sufficient to cover losses |
| To the extent that the funds generated by the initial public offering of 8cmam625cmam000 shares of our common stock in January 2005 and the follow-on offering of 3cmam910cmam000 shares of common stock in February 2006 are insufficient to support future operating requirements and/or cover claim losses, we may need to raise additional funds through financings or curtail our growth |
| We believe that the net proceeds to us from the above offerings will satisfy our capital requirements for the foreseeable future |
| However, because the timing and amount of our future needs for capital will depend on our growth and profitability, we cannot provide any assurance in that regard |
| If we had to raise additional capital, equity or debt financing may not be available at all or may be available only on terms that are not favorable to us |
| In the case of equity financings, dilution to our stockholders could result, and in any case such securities may have rights, preferences and privileges that are senior to those of the shares currently outstanding |
| If we cannot obtain adequate capital on favorable terms or at all, we may be unable to support future growth or operating requirements and, accordingly, our business, financial condition or results of operations could be materially adversely affected |
| Our status as an insurance holding company with no direct operations could adversely affect our ability to pay dividends in the future |
| We are a holding company that transacts our business through our operating subsidiaries, SeaBright Insurance Company and PointSure |
| Our primary assets are the stock of these operating subsidiaries |
| Our ability to pay expenses and dividends depends, in the long run, upon the surplus and earnings of our subsidiaries and the ability of our subsidiaries to pay dividends to us |
| Payment of dividends by SeaBright Insurance Company is restricted by state insurance laws, including laws establishing minimum solvency and liquidity thresholds, and could be subject to contractual restrictions in the future, including those imposed by indebtedness we may incur in the future |
| SeaBright Insurance Company is required to report any ordinary dividends to the Illinois Division of Insurance and the California Department of Insurance 41 _________________________________________________________________ [91]Table of Contents prior to the payment of the dividend |
| In addition, SeaBright Insurance Company is not authorized to pay any extraordinary dividends to us under Illinois or California insurance laws without prior regulatory approval from the Illinois Division of Insurance or the California Department of Insurance |
| As a result, at times, we may not be able to receive dividends from SeaBright Insurance Company and we may not receive dividends in amounts necessary to pay dividends on our capital stock |
| In addition, the payment of dividends by us is within the discretion of our board of directors and will depend on numerous factors, including our financial condition, our capital requirements and other factors that our board of directors considers relevant |
| Currently, we do not intend to pay dividends on our capital stock |
| We rely on independent insurance brokers to distribute our products |
| Our business depends in part on the efforts of independent insurance brokers to market our insurance programs successfully and produce business for us and on our ability to offer insurance programs and services that meet the requirements of the clients and customers of these brokers |
| The majority of the business in our workers’ compensation operations is produced by a group of approximately 111 licensed insurance brokers |
| Brokers are not obligated to promote our insurance programs and may sell competitors’ insurance programs |
| Several of our competitors, including AIG and Zurich, offer a broader array of insurance programs than we do |
| Accordingly, our brokers may find it easier to promote the broader range of programs of our competitors than to promote our niche selection of insurance products |
| If our brokers fail or choose not to market our insurance programs successfully or to produce business for us, our growth may be limited and our financial condition and results of operations may be negatively affected |
| We have a limited operating history as a stand-alone entity and may experience difficulty in transitioning to an independent public company |
| We commenced operations in October 2003 after acquiring KEIC, the renewal rights from, and substantially all of the operating assets, systems and employees of, the Eagle entities and PointSure |
| See the discussion under the heading “Our History” in Item 1 |
| Although our management team is primarily the same management team that operated the Eagle entities and PointSure for approximately five years prior to the Acquisition, we have a limited operating history as a stand-alone entity and do not have the same resources available to us that the Eagle entities and PointSure had prior to the Acquisition |
| Accordingly, our future results of operations or financial condition as a stand-alone entity may vary from the results realized by the Eagle entities and PointSure prior to the Acquisition |
| An investor in our common stock should consider that our history as a stand-alone entity is relatively short and that there is a limited basis for evaluating our performance |
| In addition, upon completion of our initial public offering in January 2005, we became a publicly-traded company and are now responsible for complying with the various federal and state legal and regulatory requirements applicable to public companies |
| We have incurred and will incur increased costs as a result of being a public company, particularly in light of recently enacted and proposed changes in laws, regulations and listing requirements, including those related to the Sarbanes-Oxley Act of 2002 |
| Our business and financial condition may be adversely affected if we are unable to effectively manage these increased costs |
| Assessments and other surcharges for guaranty funds and second injury funds and other mandatory pooling arrangements may reduce our profitability |
| Virtually all states require insurers licensed to do business in their state to bear a portion of the unfunded obligations of impaired or insolvent insurance companies |
| These obligations are funded by assessments that are expected to continue in the future as a result of insolvencies |
| Assessments are levied by guaranty associations within the state, up to prescribed limits, on all member insurers in the state on the basis of the proportionate share of the premium written by member insurers in the lines of business in which the impaired, insolvent or failed insurer is engaged |
| See the discussion under the heading “Regulation” in Item 1 |
| Accordingly, the assessments levied on us may increase as we increase our 42 _________________________________________________________________ [92]Table of Contents premiums written |
| Further, Washington state legislation enacted on April 20, 2005 created a separate account within the Guaranty Fund for USL&H Act claims and authorized prefunding of potential insolvencies in order to establish a cash balance |
| Many states also have laws that established second injury funds to provide compensation to injured employees for aggravation of a prior condition or injury, which are funded by either assessments based on paid losses or premium surcharge mechanisms |
| For example, Alaska requires insurers to contribute to its second injury fund annually an amount equal to the compensation the injured employee is owed multiplied by a contribution rate based on the fund’s reserve rate |
| In addition, as a condition of the ability to conduct business in some states, including California, insurance companies are required to participate in mandatory workers’ compensation shared market mechanisms or pooling arrangements, which provide workers’ compensation insurance coverage from private insurers |
| Although we price our products to account for the obligations that we may have under these pooling arrangements, we may not be successful in estimating our liability for these obligations |
| Accordingly, our prices may not fully account for our liabilities under pooling arrangements, which may cause a decrease in our profits |
| As we write policies in new states that have pooling arrangements, we will be required to participate in additional pooling arrangements |
| Further, the insolvency of other insurers in these pooling arrangements would likely increase the liability for other members remaining in the pool |
| The effect of these assessments and mandatory shared market mechanisms or changes in them could reduce our profitability in any given period or limit our ability to grow our business |
| In the event LMC is placed into receivership, we could lose our rights to fee income and protective arrangements that were established in connection with the Acquisition, our reputation and credibility could be adversely affected and we could be subject to claims under applicable voidable preference and fraudulent transfer laws |
| The assets that SeaBright acquired in the Acquisition were acquired from LMC and certain of its affiliates |
| LMC and its insurance company affiliates are currently operating under a three-year “run off” plan approved by the Illinois Division of Insurance |
| “Run off” is the professional management of an insurance company’s discontinued, distressed or non-renewed lines of insurance and associated liabilities outside of a judicial proceeding |
| Under the run off plan, LMC is attempting to buy back some of its commercial line policies and institute aggressive expense control measures in order to reduce its future loss exposure and allow it to meet its obligations to current policyholders |
| According to LMC’s statutory financial statements as of and for the year ended December 31, 2005, LMC had a statutory surplus of dlra168dtta3 million (unaudited), an increase of approximately dlra106dtta3 million from its surplus of dlra62dtta0 million (audited) as of December 31, 2004 |
| In connection with the Acquisition, we established various arrangements with LMC and certain of its affiliates, including (1) servicing arrangements entitling us to fee income for providing claims administration services for Eagle and (2) other protective arrangements designed to minimize our exposure to any past business underwritten by KEIC, the shell entity that we acquired from LMC for its insurance licenses, and any adverse developments in KEIC’s loss reserves as they existed at the date of the Acquisition |
| See the discussion under the heading “Our History” in Item 1 |
| In the event LMC is placed into receivership, our business could be adversely affected in the following ways: • A receiver could seek to reject or terminate one or more of the services agreements that were established in connection with the Acquisition between us and LMC or its affiliates, including Eagle |
| In that event, we could lose the revenue we currently receive under these services agreements |
| • As discussed under “Our History” in Item 1, to minimize our exposure to any past business underwritten by KEIC, we entered into an arrangement with LMC at the time of the Acquisition requiring LMC to indemnify us in the event of adverse development of the loss reserves in KEIC’s balance sheet as they existed on the date of closing of the Acquisition |
| We refer to this arrangement as the adverse development cover |
| To support LMC’s obligations under the adverse development cover, LMC funded a trust account at the time of the Acquisition |
| The minimum amount that must be maintained in the trust account is equal to the greater of (a) dlra1dtta6 million or 43 _________________________________________________________________ [93]Table of Contents (b) 102prca of the then existing quarterly estimate of LMC’s total obligations under the adverse development cover |
| We refer to this trust account as the collateralized reinsurance trust because the funds on deposit in the trust account serve as collateral for LMC’s potential future obligations to us under the adverse development cover |
| At December 31, 2005, the liability of LMC under the adverse development cover was approximately dlra3dtta4 million |
| LMC initially funded the trust account with dlra1dtta6 million to support its obligations under the adverse development cover |
| In September 2004, we and LMC retained an independent actuary to determine the appropriate amount of loss reserves that are subject to the adverse development cover as of September 30, 2004 |
| In accordance with the terms of the protective arrangements that we have established with LMC, on December 23, 2004, LMC deposited into the collateralized reinsurance trust an additional dlra3dtta2 million, resulting in a total balance in the trust account of dlra4dtta8 million |
| The balance in the trust account totaled dlra4dtta9 million at December 31, 2005 |
| If LMC is placed in receivership and the amount held in the collateralized reinsurance trust is inadequate to satisfy the obligations of LMC to us under the adverse development cover, it is unlikely that we would recover any future amounts owed by LMC to us under the adverse development cover in excess of the amounts currently held in trust because the director of the Illinois Division of Insurance would have control of the assets of LMC • Some of our customers are insured under Eagle insurance policies that we service pursuant to the claims administration servicing agreement described above |
| Although SeaBright is a separate legal entity from LMC and its affiliates, including Eagle, Eagle’s policyholders may not readily distinguish SeaBright from Eagle and LMC if those policies are not honored in the event LMC is found to be insolvent and placed into court-ordered liquidation |
| If that were to occur, our market reputation, credibility and ability to renew the underlying policies could be adversely affected |
| • In connection with the Acquisition, LMC and its affiliates made various transfers and payments to SeaBright, including approximately dlra13dtta0 million under the commutation agreement and an initial amount of approximately dlra1dtta6 million to fund the collateralized reinsurance trust |
| In the event that LMC is placed into receivership, it is possible that a receiver or creditor could assert a claim seeking to unwind or recover these payments under applicable voidable preference and fraudulent transfer laws |
| Risks Related to Our Industry We may face substantial exposure to losses from terrorism for which we are required by law to provide coverage |
| Under our workers’ compensation policies, we are required to provide workers’ compensation benefits for losses arising from acts of terrorism |
| The impact of any terrorist act is unpredictable, and the ultimate impact on us would depend upon the nature, extent, location and timing of such an act |
| Notwithstanding the protection provided by the reinsurance we have purchased and any protection provided by the Terrorism Risk Act, the risk of severe losses to us from acts of terrorism has not been eliminated because, as discussed above, our excess of loss reinsurance treaty program contains various sub-limits and exclusions limiting our reinsurers’ obligation to cover losses caused by acts of terrorism |
| Furthermore, the Terrorism Risk Act is scheduled to expire on December 31, 2007 and may not be renewed, or if it is renewed, it may provide reduced protection against the financial impact of acts of terrorism |
| Accordingly, events may not be covered by, or may exceed the capacity of, our reinsurance protection and any protection offered by the Terrorism Risk Act or any successor legislation |
| Thus, any acts of terrorism could materially adversely affect our business and financial condition |
| The threat of terrorism and military and other actions may result in decreases in our net income, revenue and assets under management and may adversely affect our investment portfolio |
| The threat of terrorism, both within the United States and abroad, and military and other actions and heightened security measures in response to these types of threats, may cause significant volatility and 44 _________________________________________________________________ [94]Table of Contents declines in the equity markets in the United States and abroad, as well as loss of life, property damage, additional disruptions to commerce and reduced economic activity |
| Actual terrorist attacks could cause a decrease in our stockholders’ equity, net income and/or revenue |
| In addition, some of the assets in our investment portfolio may be adversely affected by declines in the bond markets and declines in economic activity caused by the continued threat of terrorism, ongoing military and other actions and heightened security measures |
| We cannot predict at this time whether and the extent to which industry sectors in which we maintain investments may suffer losses as a result of potential decreased commercial and economic activity, or how any such decrease might impact the ability of companies within the affected industry sectors to pay interest or principal on their securities, or how the value of any underlying collateral might be affected |
| We can offer no assurances that terrorist attacks or the threat of future terrorist events in the United States and abroad or military actions by the United States will not have a material adverse effect on our business, financial condition or results of operations |
| Our results of operations and revenues may fluctuate as a result of many factors, including cyclical changes in the insurance industry, which may cause the price of our common stock to be volatile |
| The results of operations of companies in the insurance industry historically have been subject to significant fluctuations and uncertainties |
| Our profitability can be affected significantly by: • competition; • rising levels of loss costs that we cannot anticipate at the time we price our products; • volatile and unpredictable developments, including man-made, weather-related and other natural catastrophes or terrorist attacks; • changes in the level of reinsurance capacity and capital capacity; • changes in the amount of loss reserves resulting from new types of claims and new or changing judicial interpretations relating to the scope of insurers’ liabilities; and • fluctuations in interest rates, inflationary pressures and other changes in the investment environment, which affect returns on invested assets and may impact the ultimate payout of losses |
| The availability of insurance is related to prevailing prices, the level of insured losses and the level of industry surplus which, in turn, may fluctuate in response to changes in rates of return on investments being earned in the insurance industry |
| As a result, the insurance business historically has been a cyclical industry characterized by periods of intense price competition due to excessive underwriting capacity as well as periods when shortages of capacity permitted favorable premium levels |
| During 1998, 1999 and 2000, the workers’ compensation insurance industry experienced substantial pricing competition, and this pricing competition greatly affected the ability of our predecessor to increase premiums |
| Beginning in 2001, we witnessed a decrease in pricing competition in the industry, which enabled us to raise our rates |
| Although rates for many products increased from 2000 to 2003, legislative reforms caused premium rates in certain states, including California, to decrease in 2004 and 2005, and rates may continue to decrease |
| In addition, the availability of insurance has and may continue to increase, either by capital provided by new entrants or by the commitment of additional capital by existing insurers, which may perpetuate rate decreases |
| Any of these factors could lead to a significant reduction in premium rates, less favorable policy terms and fewer submissions for our underwriting services |
| In addition to these considerations, changes in the frequency and severity of losses suffered by insureds and insurers may affect the cycles of the insurance business significantly, and we expect to experience the effects of such cyclicality |
| This cyclicality may cause the price of our securities to be volatile |
| 45 _________________________________________________________________ [95]Table of Contents Risks Related to Our Common Stock The price of our common stock may decrease |
| The trading price of shares of our common stock may decline for many reasons, some of which are beyond our control, including, among others: • quarterly variations in our results of operations; • changes in expectations as to our future results of operations, including financial estimates by securities analysts and investors; • announcements of claims against us by third parties; • changes in law and regulation; • results of operations that vary from those expected by securities analysts and investors; and • future sales of shares of our common stock |
| In addition, the stock market in recent years has experienced substantial price and volume fluctuations that sometimes have been unrelated or disproportionate to the operating performance of companies whose shares are traded |
| Future sales of shares of our common stock may affect their market price and the future exercise of options may depress our stock price and result in dilution of your investment |
| We cannot predict what effect, if any, future sales of shares of our common stock, or the availability of shares for future sale, will have on the market price of our common stock |
| Future sales of substantial amounts of our common stock in the public market, or the perception that such sales could occur, could adversely affect the market price of our common stock and may make it more difficult for you to sell your shares at a time and price which you deem appropriate |
| As of March 27, 2006, there were 20cmam539cmam974 shares of our common stock outstanding |
| Moreover, 804cmam524 additional shares of our common stock will be issuable upon the full exercise or conversion of options outstanding at December 31, 2005 |
| In the event that any outstanding options are exercised, you will suffer dilution of your investment |
| Applicable insurance laws may make it difficult to effect a change of control of our company |
| Our insurance company subsidiary is domiciled in the state of Illinois and commercially domiciled in the state of California |
| The insurance holding company laws of Illinois and California require advance approval by the Illinois Division of Insurance and the California Department of Insurance of any change in control of SeaBright Insurance Company |
| “Control” is generally presumed to exist through the direct or indirect ownership of 10prca or more of the voting securities of a domestic insurance company or of any entity that controls a domestic insurance company |
| In addition, insurance laws in many states contain provisions that require prenotification to the insurance commissioners of a change in control of a non-domestic insurance company licensed in those states |
| Any future transactions that would constitute a change in control of SeaBright Insurance Company, including a change of control of us, would generally require the party acquiring control to obtain the prior approval of the Illinois Division of Insurance and the California Department of Insurance and may require pre-acquisition notification in applicable states that have adopted pre-acquisition notification provisions |
| Obtaining these approvals may result in a material delay of, or deter, any such transaction |
| See the discussion under the heading “Regulation” in Item 1 |
| These laws may discourage potential acquisition proposals and may delay, deter or prevent a change of control of us, including through transactions, and in particular unsolicited transactions, that some or all of our stockholders might consider to be desirable |
| 46 _________________________________________________________________ [96]Table of Contents Entities affiliated with Summit Partners have the ability to significantly influence our business, which may be disadvantageous to other stockholders and adversely affect the trading price of our common stock |
| Following the completion of a secondary offering of our common stock in February 2006, entities affiliated with Summit Partners, collectively, beneficially own approximately 20dtta2prca of our outstanding common stock |
| As a result, these stockholders, acting together, will have the ability to exert substantial influence over all matters requiring approval by our stockholders, including the election and removal of directors and any proposed merger, consolidation or sale of all or substantially all of our assets and other corporate transactions |
| In addition, these stockholders may have interests that are different from ours |
| Under our amended and restated certificate of incorporation, none of the Summit entities or any director, officer, stockholder, member, manager or employee of the Summit entities has any duty to refrain from engaging directly or indirectly in the same or similar business activities or lines of business that we do |
| In the event that any Summit entity acquires knowledge of a potential transaction or matter which may be a corporate opportunity for itself and us, the Summit entity will not have any duty to communicate or offer such opportunity to us and will not be liable to us or our stockholders for breach of any fiduciary duty relating to such corporate opportunity |
| Two of our directors, Peter Y Chung and J Scott Carter, are affiliated with Summit Partners |
| Our officers, directors and principal stockholders could delay or prevent an acquisition or merger even if the transaction would benefit other stockholders |
| Moreover, this concentration of stock ownership may make it difficult for stockholders to replace management |
| In addition, this significant concentration of stock ownership may adversely affect the trading price of our common stock because investors often perceive disadvantages in owning stock in companies with significant or controlling stockholders |
| This concentration could be disadvantageous to other stockholders with interests different from those of our officers, directors and principal stockholders and the trading price of shares of our common stock could be adversely affected |
| Anti-takeover provisions in our amended and restated certificate of incorporation and by-laws and under the laws of the State of Delaware could impede an attempt to replace or remove our directors or otherwise effect a change of control of our company, which could diminish the value of our common stock |
| Our amended and restated certificate of incorporation and by-laws contain provisions that may make it more difficult for stockholders to replace directors even if the stockholders consider it beneficial to do so |
| In addition, these provisions could delay or prevent a change of control that a stockholder might consider favorable |
| For example, these provisions may prevent a stockholder from receiving the benefit from any premium over the market price of our common stock offered by a bidder in a potential takeover |
| Even in the absence of an attempt to effect a change in management or a takeover attempt, these provisions may adversely affect the prevailing market price of our common stock if they are viewed as discouraging takeover attempts in the future |
| In addition, Section 203 of the Delaware General Corporation Law may limit the ability of an “interested stockholder” to engage in business combinations with us |
| An interested stockholder is defined to include persons owning 15prca or more of any class of our outstanding voting stock |
| Our amended and restated certificate of incorporation and by-laws contain the following provisions that could have an anti-takeover effect: • stockholders have limited ability to call stockholder meetings and to bring business before a meeting of stockholders; • stockholders may not act by written consent; and • our board of directors may authorize the issuance of preferred stock with such rights, powers and privileges as the board deems appropriate |
| 47 _________________________________________________________________ [97]Table of Contents These provisions may make it difficult for stockholders to replace management and could have the effect of discouraging a future takeover attempt which is not approved by our board of directors but which individual stockholders might consider favorable |