EMPLOYERS HOLDINGS, INC. 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 EHI, together with its subsidiaries. In this Quarterly Report on Form 10-Q, the Company and its management discuss and make statements based on currently available information regarding their intentions, beliefs, current expectations, and projections of, among other things, the Company's future performance, including the effects of the COVID-19 pandemic, business growth, retention rates, loss costs, claim trends and the impact of key business initiatives, future technologies and planned investments. Certain of these statements may constitute "forward-looking" statements as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts and are often identified by words such as "may," "will," "could," "would," "should," "expect," "plan," "anticipate," "target," "project," "intend," "believe," "estimate," "predict," "potential," "pro forma," "seek," "likely," or "continue," or other comparable terminology and their negatives. The Company and its management caution investors that such forward-looking statements are not guarantees of future performance. Risks and uncertainties are inherent in the Company's future performance. Factors that could cause the Company's actual results to differ materially from those indicated by such forward-looking statements include, among other things, those discussed or identified from time to time in the Company's public filings with theSEC , including the risks detailed in the Company's Annual Reports on Form 10-K and in Part II, Item 1A of this report. Except as required by applicable securities laws, the Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. Overview We are aNevada 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 throughoutthe United States , with a concentration inCalifornia , where 45% of our in-force premiums are generated. Our revenues are primarily comprised of net premiums earned, net investment income, and net realized and unrealized 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 theU.S. workers' compensation insurance industry in general. We believe we are able to price our policies at levels that are competitive and profitable over the long-term given our expertise in underwriting and claims handling in this market segment. Our underwriting approach is to consistently underwrite small business accounts at appropriate and competitive prices without sacrificing long-term profitability and stability for short-term top-line revenue growth. Our strategy is to pursue profitable growth opportunities across market cycles and maximize total investment returns within the constraints of prudent portfolio management. We pursue profitable growth opportunities by focusing on disciplined underwriting and claims management, utilizing medical provider networks designed to produce superior medical and indemnity outcomes, establishing and maintaining strong, long-term relationships with independent insurance agencies, developing and implementing new technologies designed to transform the way small businesses and insurance agents utilize digital capabilities, and developing important alternative distribution channels. We continue to execute a number of ongoing business initiatives, including: achieving internal and customer-facing business process excellence; diversifying our risk exposure across geographic markets; and utilizing a multi-company pricing platform and territory-specific pricing. Additionally, we continue to execute our plan to develop and implement new technologies and capabilities that we believe will fundamentally transform and enhance the digital experience of our customers, including: (i) continued investments in new technology, data analytics, and process improvement capabilities focused on improving the agent experience and enhancing agent efficiency; and (ii) the launch and further development of digital insurance solutions, including direct-to-customer workers' compensation coverage. The insurance industry is highly competitive, and there is significant competition in the national workers' compensation industry that is based on price and quality of services. We compete with other specialty workers' compensation carriers, state agencies, multi-line insurance companies, professional employer organizations, self-insurance funds, and state insurance pools. Coronavirus Disease (COVID-19) Considerations The COVID-19 pandemic has caused a reduction in business activity, widespread unemployment, supply chain interruptions, and overall economic instability. All states, includingCalifornia , where we generated 45% of our in-force premiums as ofSeptember 30, 2021 , have, in recent times, imposed various restrictions on business operations and social gatherings. Certain classes of business that we insure, especially those related to the restaurant and hospitality industries, continue to be affected by these restrictions. 27 -------------------------------------------------------------------------------- While new business premium production did not meet our expectations earlier in the year, we remain encouraged by the rebound we have experienced since May of 2021. We closed another quarter with a record number of policies in-force, which demonstrates that our policyholders have endured the pandemic and small businesses are actively shopping for workers' compensation coverage, and our year-over-year new business premium has increased. As widespread vaccinations continue and labor market shortages improve, we remain confident that rising payrolls will bring further improvement to our top line. In support of this anticipated recovery, we have continued to pursue and advance the significant investments that we have made in delivering a superior customer experience for our independent and digital agents. We continually review and adjust to changes in our policyholders' payrolls, economic conditions, and seasonality, as experience develops or new information becomes known. Any such adjustments are included in our current operations and are made periodically through mid-term endorsements and/or premium audits. We increased our final audit premium accruals by$4.7 million during the three months endedSeptember 30, 2021 , as our payroll exposure improved with the labor market strengthening. Despite government mandates and legislative changes related to the COVID-19 pandemic, including the presumption of COVID-19 compensability for all or certain occupational groups in many states, we experienced a decline in the frequency of compensable indemnity claims during the first nine months of 2021. This decline was experienced in nearly all states. While vaccination efforts are underway and most businesses have now reopened, the continued impact of the COVID-19 pandemic, including any increases in infection rates, new variants and renewed governmental action to slow the spread of COVID-19, cannot be estimated at this time. Results of Operations Our results of operations are as follows: Three Months Ended Nine Months Ended September 30, September 30, 2021 2020 2021 2020 (in millions) Gross premiums written$ 152.3 $ 131.3 $ 447.7 $ 456.2 Net premiums written$ 149.8 $ 129.6 $ 442.7 $ 452.0 Net premiums earned$ 147.1 $ 144.4 $ 418.0 $ 463.8 Net investment income 18.4 18.5 54.9 58.3 Net realized and unrealized gains (losses) on investments 2.7 19.1 29.6 (2.3) Other income (loss) 0.1 (0.1) 0.8 0.5 Total revenues 168.3 181.9 503.3 520.3 Losses and LAE 91.2 77.1 244.5 254.5 Commission expense 19.9 19.4 54.7 59.9 Underwriting and general and administrative expenses 37.4 46.4 121.0 137.9 Interest and financing expenses 0.1 - 0.4 - Other expenses 1.1 0.7 4.1 0.7 Total expenses 149.7 143.6 424.7 453.0 Income tax expense 3.6 7.2 14.1 11.5 Net income$ 15.0 $ 31.1 $ 64.5 $ 55.8 Overview Our net income was$15.0 million and$64.5 million for the three and nine months endedSeptember 30, 2021 , respectively, compared to$31.1 million and$55.8 million for the corresponding periods of 2020. The key factors that affected our financial performance during the three and nine months endedSeptember 30, 2021 , compared to the same periods of 2020 included: •Net premiums earned increased 1.9% and decreased 9.9%, respectively; •Losses and LAE increased 18.3% and decreased 3.9%, respectively; •Underwriting and general and administrative expenses decreased 19.4% and 12.3%, respectively; •Net investment income decreased 0.5% and 5.8%, respectively; and •Net realized and unrealized gains (losses) on investments were$2.7 million and$29.6 million compared to$19.1 million and$(2.3) million , respectively. 28 -------------------------------------------------------------------------------- Summary of Consolidated Financial Results Gross Premiums Written Gross premiums written were$152.3 million and$447.7 million for the three and nine months endedSeptember 30, 2021 , respectively, compared to$131.3 million and$456.2 million for the corresponding periods of 2020. The year-over-year changes were primarily related to our Employers segment. See "-Summary of Financial Results by Segment -Employers". Net Premiums Written Net premiums written are gross premiums written less reinsurance premiums ceded. Net Premiums Earned Net premiums earned are primarily a function of the amount and timing of net premiums previously written. Net Investment Income and Net Realized and Unrealized Gains and Losses on Investments We invest in fixed maturity securities, equity securities, other invested assets, short-term investments, and cash equivalents. Net investment income includes interest and dividends earned on our invested assets and amortization of premiums and discounts on our fixed maturity securities, less bank service charges and custodial and portfolio management fees. We have established a high quality/short duration bias in our investment portfolio. Net investment income decreased 0.5% and 5.8% for the three and nine months endedSeptember 30, 2021 , respectively, compared to the same periods of 2020. The decreases were primarily due to lower interest rates year-over-year impacting bond yields. The average pre-tax book yield on invested assets remained flat at 3.0% as ofSeptember 30, 2021 , compared toSeptember 30, 2020 . Average invested assets, including cash and cash equivalents decreased versus that of the corresponding periods of 2020. Realized and unrealized gains and losses on our investments are reported separately from our net investment income. Realized gains and losses on investments include the gain or loss on a security at the time of sale compared to its original or adjusted cost (equity securities) or amortized cost (fixed maturity securities). Realized losses are also recognized for changes in our expected credit loss allowance or when securities are written down as a result of an other-than-temporary impairment. Changes in fair value of equity securities and other invested assets are also included in Net realized and unrealized gains (losses) on investments on our Consolidated Statements of Comprehensive Income. Net realized and unrealized gains (losses) on investments were$2.7 million and$29.6 million for three and nine months endedSeptember 30, 2021 , respectively, compared to$19.1 million and$(2.3) million for the corresponding periods of 2020. The net realized and unrealized gains on investments for the three months endedSeptember 30, 2021 and 2020 included$1.9 million and$17.4 million of net realized and unrealized gains on equity securities and other investments, respectively, and$0.8 million and$1.7 million of net realized gains on fixed maturity securities, respectively. The net realized and unrealized gains on investments for the nine months endedSeptember 30, 2021 and 2020 included$25.9 million and$(4.6) million of net realized and unrealized gains (losses) on equity securities and other investments, respectively, and$3.7 million and$2.3 million of net realized gains on fixed maturity securities, respectively. The net investment gains and losses on our equity securities during the three and nine months endedSeptember 30, 2021 and 2020 were largely consistent with the performance ofU.S. equity markets. Our net gains on fixed maturity securities during the three and nine months endedSeptember 30, 2020 were largely the result of decreases in market interest rates during the periods. The net investment gains on our fixed maturity securities for the nine months endedSeptember 30, 2021 increased by$0.6 million , related to the change in allowance for expected credit losses. The net investment gains on our fixed maturity securities for the nine months endedSeptember 30, 2020 were reduced by a$1.2 million allowance for expected credit losses. Additional information regarding our Investments is set forth under "-Liquidity and Capital Resources-Investments." Other Income (loss) Other income (loss) consists of net gains and losses on fixed assets, non-investment interest, installment fee revenue, and other miscellaneous income. Losses and LAE Losses and LAE represents our largest expense item and includes claim payments made, amortization of the Deferred Gain, estimates for future claim payments and changes in those estimates for current and prior periods, and costs associated with investigating, defending, and adjusting claims. The quality of our financial reporting depends in large part on accurately predicting our losses and LAE, which are inherently uncertain as they are estimates of the ultimate cost of individual claims based on actuarial estimation techniques. 29 -------------------------------------------------------------------------------- Our current accident year loss estimate considered year-over-year decreases in indemnity claims frequency throughSeptember 30, 2021 . Our current accident year loss and LAE ratio continues to reflect the impact of our key business initiatives, including an emphasis on the accelerated settlement of open claims; diversifying our risk exposure across geographic markets; and leveraging data-driven strategies to target, underwrite, and price profitable classes of business across all markets. We believe our current accident year loss estimate is adequate; however, ultimate losses will not be known with any certainty for many years. See "-Summary of Financial Results by Segment -Employers". Commission Expenses Commission expenses include direct commissions to our agents and brokers, including our partnerships and alliances, for the premiums that they produce for us, as well as incentive payments, other marketing costs, and fees. See "-Summary of Financial Results by Segment -Employers". Underwriting and General and Administrative Expenses Underwriting expenses represent those costs that we incur to underwrite and maintain the insurance policies we issue, excluding commissions. Direct underwriting expenses, such as premium taxes, policyholder dividends, and those expenses that vary directly with the production of new or renewal business, are recognized as the associated premiums are earned. Indirect underwriting expenses, such as the operating expenses of each of the Company's subsidiaries, do not vary directly with the production of new or renewal business and are recognized as incurred. General and administrative expenses of the holding company are excluded in determining the underwriting expense ratios of our reportable segments. Interest and Financing Expenses Interest and financing expenses include credit facility fees and interest, letter of credit fees, finance lease interest, and other financing fees. Other Expenses During the three and nine months endedSeptember 30, 2021 , we recorded$0.1 million and$3.1 million , respectively, of employee severance costs resulting from a 2021 reduction-in-force. This action was taken to better align our expenses with our current revenues. Additionally, during the three months endedSeptember 30, 2021 , we wrote off$1.0 million of previously capitalized costs relating to information technologies identified as no longer being utilized. This charge was the result of our continual evaluation of ongoing technology initiatives. During the three months endedSeptember 30, 2020 , we recorded charges of$0.7 million related to the abandonment of operating leases as a result of reducing our real estate footprint. Income Tax Expense Income tax expense was$3.6 million and$14.1 million for the three and nine months endedSeptember 30, 2021 , respectively, compared to$7.2 million and$11.5 million for the corresponding periods of 2020. The effective tax rates were 19.4% and 17.9% for the three and nine months endedSeptember 30, 2021 , respectively, compared to 18.8% and 17.1% for the corresponding periods of 2020. The effective rates during each of the periods presented included income tax benefits and exclusions associated with tax-advantaged investment income, LPT adjustments, and deferred gain amortization. 30 -------------------------------------------------------------------------------- Summary of Financial Results by Segment EMPLOYERS The components of Employers' net income before income taxes are set forth in the following table: Three Months Ended Nine Months Ended September 30, September 30, 2021 2020 2021 2020 (dollars in millions) Gross premiums written$ 152.0 $ 131.2 $ 446.7 $ 456.1 Net premiums written$ 149.5 $ 129.5 $ 441.7 $ 451.9 Net premiums earned$ 146.9 $ 144.4 $ 417.6 $ 463.7 Net investment income 17.5 17.5 52.5 54.9 Net realized and unrealized gains on investments 3.1 19.2 29.7 0.1 Other income (loss) 0.1 (0.1) 0.8 0.5 Total revenues 167.6 181.0 500.6 519.2 Losses and LAE 93.1 79.5 250.3 261.8 Commission expense 19.9 19.4 54.7 59.9 Underwriting expenses 31.1 38.6 99.9 116.2 Other expenses 1.1 0.7 4.1 0.7 Total expenses 145.2 138.2 409.0 438.6 Net income before income taxes$ 22.4 $ 42.8 $ 91.6 $ 80.6 Underwriting income$ 2.8 $ 6.9 $ 12.7 $ 25.8 Combined ratio 98.1 % 95.2 % 96.9 % 94.5 % Underwriting Results Gross Premiums Written Gross premiums written were$152.0 million and$446.7 million for the three and nine months endedSeptember 30, 2021 , respectively, compared to$131.2 million and$456.1 million for the corresponding periods of 2020. The quarter-over-quarter increase was primarily driven by both increases in new policies written and increases in final audit premiums. The year-over-year decrease was primarily driven by the impacts of the COVID-19 pandemic experienced in the first quarter of 2021, including declines in payrolls for many of our insureds, upon which our premiums are based, particularly in our restaurant and hospitality classes. Additionally, non-renewals of certain unprofitable accounts and year-over-year decreases in average rates in many of the states in which we do business further impacted our gross premiums written. We increased our final audit premium accruals by$4.7 million during the three months endedSeptember 30, 2021 , as our payroll exposure improved with the labor market strengthening. We have experienced year-over-year increases in new business submissions, quotes and binds in the majority of the states in which we operate, includingCalifornia where increases have occurred since the second quarter of 2021. Whereas our in-force policies have increased throughout 2021, our in-force premiums have only begun to increase since May of 2021. In addition, our retention rate has remained strong throughout the first nine months of 2021. Net premiums written were$149.5 million and$441.7 million for the three and nine months endedSeptember 30, 2021 , respectively, compared to$129.5 million and$451.9 million for the corresponding periods of 2020. Reinsurance premiums ceded were$2.5 million and$5.0 million for the three and nine months endedSeptember 30, 2021 , respectively, compared to$1.7 million and$4.2 million for the corresponding periods of 2020. Net Premiums Earned Net premiums earned were$146.9 million and$417.6 million for the three and nine months endedSeptember 30, 2021 , respectively, compared to$144.4 million and$463.7 million for the corresponding periods of 2020. 31 -------------------------------------------------------------------------------- The following table shows the percentage change in Employers' in-force premiums, policy count, average policy size, and payroll exposure upon which our premiums are based, overall, forCalifornia , where 45% of our premiums were generated, and for all other states, excludingCalifornia : As of September 30, 2021 Year-to-Date Change Year-Over-Year Change All Other All Other Overall California States Overall California States In-force premiums (2.1) % (2.3) % (2.0) % (4.6) % (6.5) % (3.0) % In-force policy count 5.5 1.4 8.0 5.5 (1.0) 9.8 Average in-force policy size (7.2) (3.7) (9.2) (9.6) (5.5) (11.6) In-force payroll exposure 4.6 6.5 3.7 4.5 3.8 4.9 The following table shows Employers' in-force premiums and number of policies in-force for each of our largest states and all other states combined for the periods presented: September 30, 2021 December 31, 2020 September 30, 2020 December 31, 2019 In-force Policies In-force Policies In-force Policies In-force Policies State Premiums In-force Premiums In-force Premiums In-force Premiums In-force (dollars in millions) California$ 256.0 40,160$ 262.0 39,610$ 273.6 40,567$ 329.8 43,079 Florida 40.0 7,837 37.9 6,898 37.0 6,680 36.3 5,822 New York 25.5 7,117 26.7 6,657 27.8 6,625 31.7 5,679 Other (43 states and D.C.) 244.0 53,814 251.1 50,124 254.3 49,342 266.7 44,019 Total$ 565.5 108,928$ 577.7 103,289$ 592.7 103,214$ 664.5 98,599 Alternative distribution channels generated$156.7 million and$159.2 million , or 27.7% and 26.9%, of our in-force premiums as ofSeptember 30, 2021 and 2020, respectively. We believe that the bundling of payroll-related products and services through these relationships contributes to higher retention rates than business generated by our independent agents. 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 actively seek new partnerships and alliances. Losses and LAE, Commission Expenses, and Underwriting Expenses The following table presents calendar year combined ratios for our Employers segment. Three Months Ended Nine Months Ended September 30, September 30, 2021 2020 2021 2020 Loss and LAE ratio 63.4 % 55.1 % 59.9 % 56.5 %
Commission expense ratio 13.5 13.4 13.1 12.9
Underwriting expense ratio 21.2 26.7
23.9 25.1
Combined Ratio 98.1 % 95.2 % 96.9 % 94.5 %
Loss and LAE Ratio. We analyze our loss and LAE ratios on both a calendar year
and accident year basis.
The calendar year loss and LAE ratio is calculated by dividing the losses and
LAE recorded during the calendar year, regardless of when the underlying insured
event occurred, by the net premiums earned during that calendar year. The
calendar year loss and LAE ratio includes changes made during the calendar year
in reserves for losses and LAE established for insured events occurring in the
current and prior years. The calendar year loss and LAE ratio for a particular
year will not change in future periods.
The accident year loss and LAE ratio is calculated by dividing cumulative losses
and LAE for reported events that occurred during a particular year by the net
premiums earned for that year. The accident year loss and LAE ratio for a
particular year can decrease or increase when recalculated in subsequent periods
as the reserves established for insured events occurring during that year
develop favorably or unfavorably. The accident year loss and LAE ratio is based
on our statutory financial statements and is not derived from our GAAP financial
information.
We analyze our calendar year loss and LAE ratio to measure our profitability in
a particular year and to evaluate the adequacy of our premium rates charged in a
particular year to cover expected losses and LAE from all periods, including
development
32
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(whether favorable or unfavorable) of reserves established in prior periods. In
contrast, we analyze our accident year loss and LAE ratios to evaluate our
underwriting performance and the adequacy of the premium rates we charged in a
particular year in relation to ultimate losses and LAE from insured events
occurring during that year. The loss and LAE ratios provided in this report are
on a calendar year basis, except where they are expressly identified as accident
year loss and LAE ratios.
The table below reflects prior accident year loss and LAE reserve adjustments
and the impact to loss ratio.
Three Months Ended Nine Months Ended
September 30, September 30,
2021 2020 2021 2020
(dollars in millions)
Losses and LAE $ 93.1 $ 79.5 $ 250.3 $ 261.8
Prior accident year favorable development,
net 0.1 14.8 15.6 41.9
Current accident year losses and LAE $ 93.2 $ 94.3 Current accident year loss and LAE ratio 63.4 % 65.3 % 63.7 % 65.5 % As part of our continued technology and process improvements initiative, we implemented a new comprehensive claims system during the quarter, which we believe has enhanced and streamlined our claims handling processes. The increase in our total losses and LAE during the three months endedSeptember 30, 2021 , as compared to the same period of 2020, was primarily due to less net favorable prior year loss reserve development recognized during the current period. Favorable prior year accident loss reserve development totaled$0.1 million and$14.8 million during the three months endedSeptember 30, 2021 and 2020, respectively, which included$0.1 million of favorable development and$0.2 million of unfavorable development on our assigned risk business, respectively. The favorable prior accident year loss development recognized during the three months endedSeptember 30, 2020 was the result of observed favorable loss cost trends across most prior accident years. The decrease in our total losses and LAE during the nine months endedSeptember 30, 2021 , as compared to the same period of 2020, was primarily due to lower earned premiums and less net favorable development recognized during the current period. Favorable prior accident year loss development totaled$15.6 million and$41.9 million during the nine months endedSeptember 30, 2021 and 2020, respectively, which included$0.6 million and$0.4 million of favorable development on our assigned risk business, respectively. The favorable prior accident year loss development recognized during the nine months endedSeptember 30, 2021 was primarily the result of observed favorable paid loss cost trends related primarily to accident years 2017 and prior, partially offset by$8.0 million of unfavorable loss development associated with two catastrophic non-COVID claims in accident year 2020. The favorable prior accident year loss development recognized on our voluntary business during the nine months endedSeptember 30, 2020 was the result of observed favorable loss cost trends across most prior accident years. We continue to believe that the economic conditions resulting from the COVID-19 pandemic introduced an increased risk of latent claims reporting, particularly for the more recent prior accident years. As a result, since the first quarter of 2020, we have limited the recognition of observed favorable development for accident years subsequent to 2010, which were not impacted by the last recession. Our current accident year loss and LAE ratio was 63.4% and 63.7% for the three and nine months endedSeptember 30, 2021 , respectively, compared to 65.3% and 65.5% for the corresponding periods of 2020. The decreases in our current accident year ratio during the three and nine months endedSeptember 30, 2021 were primarily due to a decline in indemnity claim frequency. Our current accident year loss and LAE ratio continues to reflect the impact of our key business initiatives, including an emphasis on the accelerated settlement of open claims; diversifying our risk exposure across geographic markets; and leveraging data-driven strategies to target, underwrite, and price profitable classes of business across all markets. Commission Expense Ratio. The commission expense ratio was 13.5% and 13.1% for the three and nine months endedSeptember 30, 2021 , respectively, compared to 13.4% and 12.9% for each of the corresponding periods of 2020. Our commission expenses were$19.9 million and$54.7 million for the three and nine months endedSeptember 30, 2021 , respectively, compared to$19.4 million and$59.9 million for the corresponding periods of 2020. Our commission expense ratio increased 0.1 and 0.2 percentage points, or 0.7% and 1.6%, for the three and nine months endedSeptember 30, 2021 , respectively, compared to the same periods of 2020, primarily the result of increased commissions on new business writings. Underwriting Expenses Ratio. The underwriting expense ratio was 21.2% and 23.9% for the three and nine months endedSeptember 30, 2021 , respectively, compared to 26.7% and 25.1% for the corresponding periods of 2020. Our underwriting expenses were$31.1 million and$99.9 million for the three and nine months endedSeptember 30, 2021 , respectively, compared to$38.6 million and$116.2 million for the corresponding periods of 2020. 33 -------------------------------------------------------------------------------- During the three months endedSeptember 30, 2021 , compensation-related expenses decreased$3.2 million , bad debt expenses decreased$1.6 million , premium taxes and assessments decreased$0.7 million and professional fees decreased$0.5 million , each compared to the same period of 2020. During the nine months endedSeptember 30, 2021 , bad debt expenses decreased$5.5 million , compensation-related expenses decreased$5.0 million , professional fees decreased$3.1 million , and premium taxes and assessments decreased$2.9 million , each compared to the same period of 2020. The 2021 decreases in underwriting expenses resulted from planned expense reductions and employee reductions and departures, which reduced our fixed expenses such as compensation and professional fees, as well as reductions in variable expenses, such as premium taxes and assessments and bad debt expenses, resulting from the decrease in premiums earned. The decrease in the underwriting expense ratio for the three months and nine months endedSeptember 30, 2021 , versus that of the comparable 2020 period, resulted from the decreases in expenses listed above, partially offset by a reduction in premiums earned during the nine months endedSeptember 30, 2021 . Underwriting Income Underwriting income for our Employers segment was$2.8 million and$12.7 million for the three and nine months endedSeptember 30, 2021 , respectively, compared to$6.9 million and$25.8 million for the corresponding periods of 2020. Underwriting income or loss is determined by deducting losses and LAE, commission expense, and underwriting expenses from net premiums earned. Non-Underwriting Income and Expenses For a further discussion of non-underwriting related income and expenses, including Net Investment Income and Net Realized and Unrealized Gains and Losses on Investments, Other Income, Interest and Financing Expenses and Other Expenses see "-Results of Operations -Summary of Consolidated Financial Results". CERITY The components of Cerity's net loss before income taxes are set forth in the following table: Three Months Ended Nine Months Ended September 30, September 30, 2021 2020 2021 2020 (in millions) Gross premiums written$ 0.3 $ 0.1 $ 1.0 $ 0.1 Net premiums written$ 0.3 $ 0.1 $ 1.0 $ 0.1 Net premiums earned$ 0.2 $ -$ 0.4 $ 0.1 Net investment income 0.7 0.8 2.1 2.5 Net realized and unrealized gains (losses) on investments (0.1) (0.1) 0.2 (0.5) Total revenues 0.8 0.7 2.7 2.1 Losses and LAE 0.2 0.1 0.3 0.1 Underwriting expenses 3.3 3.8 9.6 11.9 Total expenses 3.5 3.9 9.9 12.0 Net loss before income taxes$ (2.7) $ (3.2) $ (7.2) $ (9.9) Underwriting loss$ (3.3) $ (3.9) $ (9.5) $ (11.9) Combined ratio n/m n/m n/m n/m n/m - not meaningful Underwriting Results Gross Premiums Written and Net Premiums Written Gross premiums written and net premiums written were$0.3 million and$1.0 million for the three and nine months endedSeptember 30, 2021 , respectively, compared to$0.1 million for each of the three and nine months endedSeptember 30, 2020 . Net Premiums Earned Net premiums earned were$0.2 million and$0.4 million for the three and nine months endedSeptember 30, 2021 , respectively, compared to less than$0.1 million and$0.1 million for the three and nine months endedSeptember 30, 2020 . 34 -------------------------------------------------------------------------------- Underwriting Expenses Underwriting expenses for our Cerity segment were$3.3 million and$9.6 million for the three and nine months endedSeptember 30, 2021 , respectively, compared to$3.8 million and$11.9 million for the same periods of 2020. During the three and nine months endedSeptember 30, 2021 , our compensation-related expenses decreased$0.7 million and$2.7 million , each compared to the same periods of 2020. The 2021 decreases in compensation expenses resulted primarily from employee reductions and departures. Underwriting Loss Underwriting losses for our Cerity segment were$3.3 million and$9.5 million for the three and nine months endedSeptember 30, 2021 , respectively, compared to$3.9 million and$11.9 million for the same periods of 2020. Underwriting income or loss is determined by deducting losses and LAE, commission expense, and underwriting expenses from net premiums earned. Non-Underwriting Income For a further discussion of non-underwriting related income, including Net Investment Income and Net Realized and Unrealized Gains and Losses on Investments, see "-Results of Operations -Summary of Consolidated Financial Results Consolidated." CORPORATE AND OTHER The components of Corporate and Other's net income (loss) before income taxes are set forth in the following table: Three Months Ended Nine Months Ended September 30, September 30, 2021 2020 2021 2020 (in millions) Net investment income 0.2 0.2 0.3 0.9 Net realized and unrealized losses on investments (0.3) - (0.3) (1.9) Total revenues (0.1) 0.2 - (1.0) Losses and LAE - LPT (2.1) (2.5) (6.1) (7.4) General and administrative expenses 3.0 4.0 11.5 9.8 Interest and financing expenses 0.1 - 0.4 - Total expenses 1.0 1.5 5.8 2.4 Net loss before income taxes$ (1.1) $ (1.3) $ (5.8) $ (3.4)
Losses and LAE - LPT The table below reflects the impact of the LPT on Losses and LAE, which are recorded as a reduction to Losses and LAE incurred on our Consolidated Statements of Comprehensive Income.
Three Months Ended Nine Months Ended
September 30, September 30,
2021 2020 2021 2020
(inmillions)
Amortization of the Deferred Gain related to losses$ 1.7 $ 2.0 $ 5.0 $ 6.1 Amortization of the Deferred Gain related to contingent commission 0.4 0.5 1.1 1.3 Total impact of the LPT$ 2.1 $ 2.5 $ 6.1 $ 7.4 General and Administrative Expenses General and administrative expenses primarily consist of compensation related expenses, professional fees, and other corporate expenses at the holding company level. General and administrative expenses were$3.0 million and$11.5 million for the three and nine months endedSeptember 30, 2021 , respectively, compared to$4.0 million and$9.8 million for the three and nine months endedSeptember 30, 2020 , respectively. During the three and nine months endedSeptember 30, 2021 , compensation-related expenses decreased$0.6 million and increased$2.1 million each compared to the same periods of 2020, respectively. The increase in compensation expenses during 35 -------------------------------------------------------------------------------- the nine months of 2021 related primarily to theApril 1, 2021 retirement ofDouglas D. Dirks , our former President and Chief Executive Officer, and reflected: (i) an acceleration of certain ofMr. Dirks' outstanding share-based awards pursuant to the retirement provisions of such awards; and (ii) additional vesting of certain ofMr. Dirks' outstanding share-based awards. Non-Underwriting Income and Expenses For a further discussion of non-underwriting related income and expenses, including Net Investment Income and Net Realized and Unrealized Gains and Losses on Investments, and Interest and Financing Expenses see "-Results of Operations -Summary of Consolidated Financial Results". Liquidity and Capital Resources COVID-19 Considerations The impacts of the COVID-19 pandemic on theU.S. economy and our current operations have been significant. Nonetheless we believe that the liquidity available to our holding company and its operating subsidiaries remains adequate and we do not currently foresee a need to: (i) suspend ordinary dividends or forego repurchases of our common stock; (ii) seek a capital infusion; or (iii) seek any material non-investment asset sales. Furthermore, the holding company has no outstanding debt obligations and its operating subsidiaries have no interest-bearing debt obligations. Holding Company Liquidity We are a holding company and our ability to fund our operations is contingent upon existing capital and the ability of our subsidiaries to pay dividends up to the holding company. Payment of dividends by our insurance subsidiaries is restricted by state insurance laws and regulations, including laws establishing minimum solvency and liquidity thresholds. We require cash to pay stockholder dividends, repurchase common stock, provide additional surplus to our insurance subsidiaries, and fund our operating expenses. Our insurance subsidiaries' ability to pay dividends to their parent is based on reported capital, surplus, and dividends paid within the prior twelve months. During the first quarter of 2021, EICN made a$12.5 million cash dividend payment to its parent company. As a result of that payment, EICN cannot pay any dividends for the remainder of 2021 without prior regulatory approval. During the second quarter of 2021, EPIC made a$22.9 million cash dividend payment and EAC made a$21.1 million cash dividend payment to their parent company. As a result of those payments, EPIC and EAC cannot pay any dividends for the remainder of 2021 without prior regulatory approval. During the third quarter of 2021, CIC made a$3.0 million cash dividend payment, and ECIC made a$32.1 million cash dividend payment to their respective parent companies. As a result of those payments, CIC and ECIC cannot pay any dividends for the remainder of 2021 without prior regulatory approval. Total cash and investments at the holding company were$61.0 million atSeptember 30, 2021 , consisting of$35.7 million of cash and cash equivalents,$10.2 million of fixed maturity securities, and$15.1 million of equity securities. OnDecember 15, 2020 , EHI entered into a Credit Agreement (the Credit Agreement) with a syndicate of financial institutions. The Credit Agreement provides EHI with a$75.0 million three-year revolving credit facility. Borrowings under the Credit Agreement may be used for working capital and general corporate purposes. Pursuant to the Credit Agreement, EHI has the option to request an increase of the credit available under the facility, up to a maximum facility amount of$125.0 million , subject to the consent of lenders and the satisfaction of certain conditions. EHI borrowed and subsequently repaid$27.0 million under the Credit Agreement during the nine months endedSeptember 30, 2021 . EHI had no outstanding advances under the Credit Agreement atSeptember 30, 2021 . The interest rates applicable to loans under the Credit Agreement are generally based on a base rate plus a specified margin, ranging from 0.25% to 1.25%, or the Eurodollar rate (which will convert to an alternative reference rate once LIBOR is discontinued) plus a specified margin, ranging from 1.25% to 2.25%. Total interest paid during the three and nine months endedSeptember 30, 2021 was$0.1 million and$0.2 million , respectively. The Credit Agreement contains covenants that require us to maintain: (i) a minimum consolidated net worth of no less than 70% of our stockholders' equity as ofSeptember 30, 2020 , plus 50% of our aggregate net income thereafter; and (ii) a debt to total capitalization ratio of no more than 35%, in each case as determined in accordance with the Credit Agreement. AtSeptember 30, 2021 , we were in compliance with all debt covenants. Operating Subsidiaries' Liquidity The primary sources of cash for our operating subsidiaries, which include our insurance and other operating subsidiaries, are premium collections, investment income, sales and maturities of investments, proceeds from FHLB advances, and reinsurance recoveries. The primary uses of cash for our operating subsidiaries are payments of losses and LAE, commission expenses, underwriting and general and administrative expenses, ceded reinsurance, repayments of FHLB advances, investment purchases and dividends paid to their parent. 36 -------------------------------------------------------------------------------- Total cash and investments held by our operating subsidiaries was$2,746.8 million atSeptember 30, 2021 , consisting of$60.2 million of cash and cash equivalents,$2,351.5 million of fixed maturity securities,$281.8 million of equity securities,$53.0 million of other invested assets, and$0.3 million of short-term investments. Sources of immediate and unencumbered liquidity at our operating subsidiaries as ofSeptember 30, 2021 consisted of$60.2 million of cash and cash equivalents,$276.1 million of publicly traded equity securities whose proceeds are available within three business days,$864.4 million of highly liquid fixed maturity securities whose proceeds are available within three business days, and$0.3 million of short-term investments whose proceeds are available within three business days. We believe that our subsidiaries' liquidity needs over the next 24 months will be met with cash from operations, investment income, and maturing investments. EICN, ECIC, EPIC, and EAC are members of the FHLB. Membership allows our subsidiaries access to collateralized advances, which may be used to support and enhance liquidity management. The amount of advances that may be taken is dependent on statutory admitted assets on a per company basis. During the second quarter of 2020, the FHLB announced its Zero Interest Recovery Advance Program (the FHLB Advance Program). The FHLB Advance Program is a zero percent interest, six-month or one-year credit product that members can use to provide immediate relief to property owners, businesses, and other customers struggling with the financial impacts of the COVID-19 pandemic. Each member was allocated up to$10.0 million in advances under the FHLB Advance Program. OnMay 11, 2020 , our insurance subsidiaries received a total of$35.0 million of advances under the FHLB Advance Program. The advances were secured by collateral previously pledged to the FHLB by our insurance subsidiaries in support of our existing collateralized advance facility, which has been reduced by the amount of these outstanding advances. Our insurance subsidiaries repaid$15.0 million onNovember 4, 2020 ,$5.0 million onMarch 31, 2021 , and$15.0 million onMay 4, 2021 . As ofSeptember 30, 2021 , we have no outstanding advances. FHLB membership also allows our insurance subsidiaries access to standby Letter of Credit Agreements. OnJanuary 26, 2021 , we chose to amend our existing Letter of Credit Agreements among the FHLB, EPIC and EAC to decrease their respective credit amounts. The current Letter of Credit Agreements, as amended, are in the amounts of$50.0 million for EAC,$70.0 million for ECIC, and$10.0 million for EPIC. The amended Letter of Credit Agreements will expire onMarch 31, 2022 . The Letter of Credit Agreements may only be used to satisfy, in whole or in part, insurance deposit requirements with theState of California and are fully secured with eligible collateral at all times (See Note 10). We purchase reinsurance to protect us against the costs of severe claims and catastrophic events, including pandemics. OnJuly 1, 2021 , we entered into a new reinsurance program that is effective throughJune 30, 2022 . The reinsurance program consists of one treaty covering excess of loss and catastrophic loss events in four layers of coverage. Our reinsurance coverage is$190.0 million in excess of our$10.0 million retention on a per occurrence basis, subject to certain exclusions. We believe that our reinsurance program meets our needs and that we are sufficiently capitalized. We further believe that we will not trigger a recovery under our current excess of loss reinsurance program in connection with the COVID-19 pandemic. Various state laws and regulations require us to hold investment securities or letters of credit on deposit with certain states in which we do business. Securities having a fair value of$868.0 million and$768.7 million were on deposit atSeptember 30, 2021 andDecember 31, 2020 , respectively. These laws and regulations govern both the amount and types of investment securities that are eligible for deposit. Additionally, standby letters of credit from the FHLB have been issued in lieu of$130.0 million and$275.0 million of securities on deposit atSeptember 30, 2021 andDecember 31, 2020 , respectively. Certain reinsurance contracts require company funds to be held in trust for the benefit of the ceding reinsurer to secure the outstanding liabilities we assumed. The fair value of fixed maturity securities held in trust for the benefit of our ceding reinsurers was$3.1 million and$3.2 million atSeptember 30, 2021 andDecember 31, 2020 , respectively. Sources of Liquidity We monitor the cash flows of each of our subsidiaries individually, as well as collectively as a consolidated group. We use trend and variance analyses to project future cash needs, making adjustments to our forecasts as appropriate. The table below shows our net cash flows for the nine months ended: September 30, 2021 2020 (in millions) Cash, cash equivalents, and restricted cash provided by (used in): Operating activities$ (9.3) $ 47.6 Investing activities 22.5 107.0 Financing activities
(78.0) (72.2)
(Decrease) increase in cash, cash equivalents, and restricted cash
37
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For additional information regarding our cash flows, see Item 1, Consolidated
Statements of Cash Flows.
Operating Activities
Net cash used in operating activities for the nine months ended September 30,
2021 included net premiums received of $418.5 million and investment income
received of $60.0 million . These operating cash inflows were offset by net
claims payments of $298.7 million , underwriting and general and administrative
expenses paid of $112.1 million , commissions paid of $52.7 million , and federal
income taxes paid of $23.9 million .
Net cash provided by operating activities for the nine months ended
September 30, 2020 included net premiums received of $480.6 million and
investment income received of $65.2 million . These operating cash inflows were
partially offset by net claims payments of $295.0 million , underwriting and
general and administrative expenses paid of $126.1 million , commissions paid of
$63.0 million , and federal income taxes paid of $13.3 million .
Investing Activities
Net cash provided by investing activities for the nine months ended
September 30, 2021 and September 30, 2020 were primarily related to sales,
maturities, and redemptions of investments whose proceeds were used to fund
claims payments, underwriting and general and administrative expenses,
stockholder dividend payments, and common stock repurchases, partially offset by
the investment of premiums received and reinvestment of funds from investment
sales, maturities, redemptions, and interest income.
Financing Activities
Net cash used in financing activities for the nine months ended September 30,
2021 was primarily related to common stock repurchases, stockholder dividend
payments, and repayments of FHLB advances. During the nine months ended
September 30, 2021 , we borrowed and subsequently repaid $27.0 million under the
Credit Agreement.
Net cash used in financing activities for the nine months ended September 30,
2020 was primarily related to common stock repurchases and stockholder dividend
payments, partially offset by cash received from the FHLB Advance Program.
Dividends
We paid $21.5 million and $23.3 million in dividends to our stockholders for the
nine months ended September 30, 2021 and 2020, respectively. The declaration and
payment of future dividends to common stockholders will be at the discretion of
our Board of Directors and will depend upon many factors including our financial
position, capital requirements of our operating subsidiaries, legal and
regulatory requirements, and any other factors our Board of Directors deem
relevant. On October 27, 2021 , the Board of Directors declared a $0.25 dividend
per share, payable November 24, 2021 , to stockholders of record on November 10,
2021 .
Share Repurchases
We repurchased 327,402 shares of our common stock for $13.2 million during the
three months ended September 30, 2021 and 876,284 shares of our common stock for
$33.3 million during the nine months ended September 30, 2021 . On July 21, 2021 ,
our Board of Directors authorized a new share repurchase authorization for
repurchases of up to $50.0 million of our common stock from July 27, 2021
through December 31, 2022 (the 2021 Program). The 2021 Program replaces the 2018
Program, which expired on June 30, 2021 . Future repurchases of our common stock
will be at the discretion of our Board of Directors and will depend upon many
factors, including our financial position, capital requirements of our operating
subsidiaries, general business and social economic conditions, legal, tax,
regulatory, and/or contractual restrictions, and any other factors that our
Board of Directors deems relevant.
Capital Resources
As of September 30, 2021 , the capital resources available to us consisted of
$1,189.9 million of stockholders' equity and the $119.2 million Deferred Gain.
38
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Contractual Obligations and Commitments
The following table identifies our contractual obligations and commitments as of
September 30, 2021 .
Payment Due By Period
Less Than More Than
Total 1-Year 1-3 Years 4-5 Years 5 Years
(in millions)Operating leases$ 18.6 $ 3.5 $ 9.7 $ 2.8 $ 2.6 Non-cancellable contracts 23.2 6.9 13.1 3.2 - Finance leases 0.6 0.1 0.4 0.1 - Unpaid losses and LAE reserves (1)(2) 2,002.1 314.5 377.4 230.8 1,079.4 Unfunded investment commitments 49.9 49.9 - - - Total contractual obligations$ 2,094.4 $ 374.9 $ 400.6 $ 236.9 $ 1,082.0 (1)Estimated losses and LAE reserve payment patterns have been computed based on historical information. Our calculation of loss and LAE reserve payments by period is subject to the same uncertainties associated with determining the level of reserves and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. Actual payments of losses and LAE by period will vary, perhaps materially, from the above table to the extent that current estimates of losses and LAE reserves vary from actual ultimate claims amounts due to variations between expected and actual payout patterns. (2)The unpaid losses and LAE reserves are presented gross of reinsurance recoverables for unpaid losses, which were as follows for each of the periods presented above: Recoveries Due By Period Less Than More Than Total 1-Year 1-3 Years 4-5 Years 5 Years (in millions) Reinsurance recoverables on unpaid losses and LAE$ (478.4) $ (31.4) $ (54.3) $ (48.6) $ (344.1) Investments Our investment portfolio is structured to support our need for: (i) optimizing our risk-adjusted total return; (ii) providing adequate liquidity; (iii) facilitating financial strength and stability; and (iv) ensuring regulatory and legal compliance. These investments provide a steady source of income, which may fluctuate with changes in interest rates and our current investment strategies. As ofSeptember 30, 2021 , our investment portfolio consisted of 87% fixed maturity securities. We strive to limit the interest rate risk associated with fixed maturity investments by managing the duration of these securities. Our fixed maturity securities (excluding cash and cash equivalents) had a duration of 3.5 atSeptember 30, 2021 . To minimize interest rate risk, our portfolio is weighted toward short-term and intermediate-term bonds; however, our investment strategy balances consideration of duration, yield, and credit risk. Our investment guidelines require that the minimum weighted average quality of our fixed maturity securities portfolio be "A+," using ratings assigned byStandard & Poor's (S&P) or an equivalent rating assigned by another nationally recognized statistical rating agency. Our fixed maturity securities portfolio had a weighted average quality of "A+" as ofSeptember 30, 2021 . Other securities within fixed maturity securities consist of bank loans, which are classified as AFS and are reported at fair value. Our investment portfolio also contains equity securities. We strive to limit the exposure to equity price risk associated with publicly traded equity securities by diversifying our holdings across several industry sectors. These equity securities had a fair value of$291.3 million atSeptember 30, 2021 , which represented 11% of our investment portfolio at that time. We also have a$5.7 million investment in FHLB stock which we record at cost. We receive periodic dividends from the FHLB for this investment, when declared, which can vary from period to period. Our Other invested assets made up 2% of our investment portfolio as ofSeptember 30, 2021 and include private equity limited partnerships and convertible preferred shares of real estate investment trusts. Our investments in private equity limited partnerships totaled$33.0 million atSeptember 30, 2021 and are generally not redeemable by the investees and cannot be sold without prior approval of the general partner. These investments have a fund term of 10 to 12 years, subject to two or three one-year extensions at the general partner's discretion. We expect to receive distributions of proceeds from dividends and interest from fund investments, as well as from the disposition of a fund investment or portion thereof, from time-to-time during the full course of the fund term. As ofSeptember 30, 2021 , we had unfunded commitments to these private equity limited partnerships totaling$49.9 million . Our investments in convertible preferred shares of real estate investment trusts totaled$20.0 million at 39 --------------------------------------------------------------------------------September 30, 2021 and are non-redeemable until conversion and are periodically evaluated for impairment based on the ultimate recovery of the investment. We believe that our current asset allocation meets our strategy to preserve capital for claims and policy liabilities and to provide sufficient capital resources to support and grow our ongoing insurance operations. The following table shows the estimated fair value, the percentage of the fair value to total invested assets, and the average ending book yield, (each based on the book value of each category of invested assets) as ofSeptember 30, 2021 . Estimated Fair Percentage Category Value of Total Book Yield (in millions, except percentages) U.S. Treasuries $ 71.6 2.7 % 1.8 % U.S. Agencies 2.4 0.1 2.9 States and municipalities 411.6 15.5 3.0 Corporate securities 1,094.4 41.3 3.3 Residential mortgage-backed securities 353.5 13.3 2.2 Commercial mortgage-backed securities 95.1 3.6 3.1 Asset-backed securities 57.0 2.1 3.5 Collateralized loan obligations 85.4 3.2 1.9 Foreign government securities 12.2 0.5 2.9 Other securities 178.5 6.7 3.7 Equity securities 291.3 11.0 1.3 Short-term investments 0.3 - 3.6 Total investments at fair value$ 2,653.3 100.0 % Weighted average yield 3.0 % The following table shows the percentage of total estimated fair value of our fixed maturity securities as ofSeptember 30, 2021 by credit rating category, using the lower of the ratings assigned by Moody's Investors Service or S&P. Percentage of Total Rating Estimated Fair Value "AAA" 7.1 % "AA" 36.6 "A" 29.9 "BBB" 15.9 Below Investment Grade 10.5 Total 100.0 % Investments that we currently own could be subject to default by the issuer. We regularly assess individual securities as part of our ongoing portfolio management, including the identification of credit related losses. Our assessment includes reviewing the extent of declines in fair value of investments below amortized cost, historical and projected financial performance and near-term prospects of the issuer, the outlook for industry sectors, credit rating, and macro-economic changes, including those caused by the COVID-19 pandemic. We also make a determination as to whether it is not more likely than not that we will be required to sell the security before its fair value recovers to above cost, or maturity. In addition to recognizing realized gains and losses upon the disposition of an investment security, we also recognize realized gains or losses on AFS debt securities for changes in expected credit losses. As ofSeptember 30, 2021 , we have a$0.1 million allowance for expected credit losses on AFS debt securities. During the nine months endedSeptember 30, 2021 , we recognized a$0.6 million decrease in our allowance for expected credit losses on AFS debt securities due to price recoveries and reductions in the allowance from disposals. The remaining fixed maturity securities whose total fair value was less than amortized cost atSeptember 30, 2021 , were those in which we had no intent, need, or requirement to sell at an amount less than their amortized cost. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements. Critical Accounting Policies The unaudited interim consolidated financial statements included in this quarterly report include amounts based on the use of estimates and judgments of management for those transactions that are not yet complete. We believe that the estimates and judgments that were most critical to the preparation of the consolidated financial statements involved the following: (a) reserves 40 -------------------------------------------------------------------------------- for losses and LAE; (b) reinsurance recoverables; (c) recognition of premium income; (d) deferred income taxes; and (e) valuation of investments. These estimates and judgments require the use of assumptions about matters that are highly uncertain and therefore are subject to change as facts and circumstances develop. Our accounting policies are discussed under "Critical Accounting Policies" in Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report. Item 3. Quantitative and Qualitative Disclosures About Market Risk Market risk is the risk of potential economic loss principally arising from adverse changes in the fair value of financial instruments. The major components of market risk affecting us are credit risk, interest rate risk, and equity price risk. Credit Risk Our fixed maturity securities, equity securities, other invested assets and cash equivalents are exposed to credit risk, which we attempt to manage through issuer and industry diversification. Our investment guidelines include limitations on the minimum rating of fixed maturity securities and concentrations of a single issuer. We also bear credit risk with respect to the reinsurers, which can be significant considering that some loss reserves remain outstanding for an extended period of time. We are required to pay losses even if a reinsurer refuses or fails to meet its obligations to us under the applicable reinsurance agreement(s). We continually monitor the financial condition and financial strength ratings of our reinsurers. Additionally, we bear credit risk with respect to premiums receivable, which is generally diversified due to the large number of entities comprising our policyholder base and their dispersion across many different industries and geographies. The economic disruptions caused by the COVID-19 pandemic have impacted the credit risk associated with certain of our investment holdings, reinsurance recoverables and premiums receivable. As ofSeptember 30, 2021 , we have a$0.1 million allowance for expected credit losses on our fixed maturity portfolio. See Note 5 to the consolidated financial statements. Interest Rate Risk Investments The fair value of our fixed maturity portfolio is exposed to interest rate risk, which is the risk of a change in fair value resulting from changes in prevailing interest rates, which we strive to limit by managing duration. Our fixed maturity investments (excluding cash and cash equivalents) had a duration of 3.5 atSeptember 30, 2021 . To minimize interest rate risk, our portfolio is weighted toward short-term and intermediate-term bonds; however, our investment strategy balances consideration of duration, yield and credit risk. We continually monitor the changes in interest rates and the impact on our liquidity and ability to meet our obligations. Sensitivity Analysis The fair values or cash flows of market sensitive instruments are subject to potential losses in future earnings resulting from changes in interest rates and other market conditions. Our sensitivity analysis applies a hypothetical parallel shift in market rates and reflects what we believe are reasonably possible near-term changes in those rates (covering a period of time going forward up to one year from the date of the consolidated financial statements). Actual results may differ from the hypothetical change in market rates assumed in this disclosure. This sensitivity analysis does not reflect the results of any action that we may take to mitigate such hypothetical losses in fair value. We use fair values to measure our potential loss in this model, which includes fixed maturity securities and short-term investments. For invested assets, we use modified duration modeling to calculate changes in fair values. Durations on invested assets are adjusted for call, put, and interest rate reset features. Invested asset portfolio durations are calculated on a market value weighted basis, excluding accrued investment income, using holdings as ofSeptember 30, 2021 . The estimated changes in fair values on our fixed maturity securities and short-term investments, which had an aggregate value of$2,362.0 million as ofSeptember 30, 2021 , based on specific changes in interest rates are as follows: Estimated Pre-tax Increase (Decrease) in Hypothetical Changes in Interest Rates
Fair Value
(in millions, except percentages)
300 basis point rise $ (196.3) (9.4) %
200 basis point rise (132.1) (6.3)
100 basis point rise (66.4) (3.2)
50 basis point decline 41.5 2.0
100 basis point decline 74.7 3.6
41-------------------------------------------------------------------------------- The most significant assessment of the effects of hypothetical changes in interest rates on investment income would be based on GAAP guidance related to "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases," which requires amortization adjustments for mortgage-backed securities. The rates at which the mortgages underlying mortgage-backed securities are prepaid, and therefore the average life of mortgage-backed securities, can vary depending on changes in interest rates (for example, mortgages are prepaid faster and the average life of mortgage-backed securities falls when interest rates decline). Adjustments for changes in amortization are based on revised average life assumptions and would have an impact on investment income if a significant portion of our commercial and residential mortgage-backed securities were purchased at significant discounts or premiums to par value. As ofSeptember 30, 2021 , the par value of our commercial and residential mortgage-backed securities holdings was$423.2 million , and the amortized cost was 103.0% of par value. Since a majority of our mortgage-backed securities were purchased at a premium or discount that is significant as a percentage of par, an adjustment could have a significant effect on investment income. The commercial and residential mortgage-backed securities portion of the portfolio totaled 16.9% of total investments as ofSeptember 30, 2021 . Agency-backed residential mortgage pass-throughs totaled$337.0 million , or 84.0%, of the residential mortgage-backed securities portion of the portfolio as ofSeptember 30, 2021 . Equity Price Risk Equity price risk is the risk that we may incur losses in the fair value of the equity securities we hold in our investment portfolio. Adverse changes in the market prices of the equity securities we hold in our investment portfolio would result in decreases in the fair value of our total assets on our Consolidated Balance Sheets and in net realized and unrealized gains and losses on our Consolidated Statements of Comprehensive Income. Economic and market disruptions caused by the COVID-19 pandemic have resulted in volatility in the fair value of our equity securities. We minimize our exposure to equity price risk by investing primarily in the equity securities of mid-to-large capitalization issuers and by diversifying our equity holdings across several industry sectors. The table below shows the sensitivity of our equity securities at fair value to price changes as ofSeptember 30, 2021 : Pre-tax Impact on Pre-tax Impact on 20% Fair Value Total Equity 20% Fair Value Total Equity (in millions) Cost Fair Value Decrease Securities Increase Securities Equity securities$ 187.9 $ 291.3 $ 233.0 $ (58.3)$ 349.6 $ 58.3 Effects of Inflation The COVID-19 pandemic has created increased uncertainty about the path of theU.S. economy, consumer behavior, and workplace norms for the years ahead. Recent supply and demand shocks and dramatic changes in fiscal policy may lead to higher levels of inflation in future periods. Higher levels of inflation could significantly impact our financial statements and results of operations. Our estimates for losses and LAE include assumptions about the timing of closure and future payment of claims and claims handling expenses, such as medical treatments and litigation costs. To the extent that inflation causes these costs to increase above established reserves, we will be required to increase those reserves for losses and LAE, reducing our earnings in the period in which the deficiency is identified. We consider inflation in the reserving process by reviewing cost trends and our historical reserving results. We also consider current indemnity and medical cost trends in determining the adequacy of our rates. Higher levels of wage inflation can specifically impact the payrolls of our insureds, which is the basis for the premiums we charge, as well as amount of future indemnity losses we may incur. Higher levels of inflation could also impact our operating expenses and, in the case of wage inflation, could impact our payroll expenses. Fluctuations in rates of inflation also influence interest rates, which in turn may impact the market value of our fixed maturity investment portfolio and yields on new investments. Item 4. Controls and Procedures Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (Exchange Act)) as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report. 42 -------------------------------------------------------------------------------- Despite the Company being in work-from-home status, there have not been any changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 43
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