UNITED STATES SECURITIES AND
 EXCHANGE COMMISSION
Washington, D.C. 20549
 


FORM 10-Q

(Mark One)
[X] 
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended June 30, 2012
or

[ ]
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period from ________ to ________

Commission File Number 001-34204

SeaBright Holdings, Inc.
(Exact name of registrant as specified in its charter)

Delaware
56-2393241
(State or other jurisdiction of incorporation
or organization)
(IRS Employer Identification No.)

1501 4th Avenue, Suite 2600
Seattle, WA 98101
 (Address of principal executive offices, including zip code)

(206) 269-8500
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.
Yes [X]    No [   ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes [X]    No [   ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer [   ]    Accelerated filer [X]     Non-accelerated filer [   ]     Smaller reporting company [   ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):   Yes [   ]   No [X]

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:
Class
 
Shares outstanding as of August 7, 2012
Common Stock, $0.01 Par Value
 
22,436,562
 


 
 

 
SeaBright Holdings, Inc.

Index to Form 10-Q
 
   
Page
Part I.
Financial Information
 
     
Item 1.
Financial Statements (unaudited)
2
     
 
Condensed Consolidated Balance Sheets as of June 30, 2012 and December 31, 2011
2
     
 
Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) for the Three Months and Six Months Ended June 30, 2012 and 2011
3
     
 
Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2012 and 2011
4
     
 
Notes to Unaudited Condensed Consolidated Financial Statements
5
     
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
16
     
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
23
     
Item 4.
Controls and Procedures
24
     
Part II.
Other Information
 
     
Item 1A.
Risk Factors
24
     
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
26
     
Item 6.
Exhibits
26
     
Signatures
27
 
 
- 1 -

 
 
PART I – FINANCIAL INFORMATION
Item 1. Financial Statements

SEABRIGHT HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
 (Unaudited)

   
June 30,
2012
   
December 31,
2011
 
         
(As adjusted)
 
   
(in thousands, except share and per share amounts)
 
ASSETS
           
             
Fixed income securities available for sale, at fair value (amortized cost $671,218 in 2012 and $665,891 in 2011)
  $ 699,672     $ 700,346  
Cash and cash equivalents
    50,452       28,503  
Premiums receivable, net
    14,428       18,332  
Deferred premiums, net
    147,394       142,486  
Reinsurance recoverables
    107,459       94,173  
Federal income tax recoverable
    6,112       12,823  
Deferred income taxes, net
    23,874       21,681  
Deferred policy acquisition costs, net
    14,513       14,844  
Goodwill
    2,794       2,794  
Other assets
    34,727       38,314  
Total assets
  $ 1,101,425     $ 1,074,296  
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
                 
Liabilities:
               
Unpaid loss and loss adjustment expense
  $ 527,086     $ 518,044  
Unearned premiums
    138,061       130,300  
Reinsurance funds withheld and balances payable
    7,664       7,079  
Premiums payable
    6,487       6,351  
Accrued expenses and other liabilities
    56,509       51,553  
Surplus notes
    12,000       12,000  
Total liabilities
    747,807       725,327  
                 
Contingencies (Note 7)
               
                 
Stockholders’ equity:
               
Series A preferred stock, $0.01 par value; 750,000 shares authorized; no shares issued and outstanding
           
Undesignated preferred stock, $0.01 par value; 10,000,000 shares authorized; no shares issued and outstanding
           
Common stock, $0.01 par value; 75,000,000 shares authorized; issued and outstanding – 22,436,562 shares at June 30, 2012 and 22,327,749 shares at December 31, 2011
    224       223  
Paid-in capital
    215,038       213,746  
Accumulated other comprehensive income
    19,386       23,269  
Retained earnings
    118,970       111,731  
Total stockholders’ equity
    353,618       348,969  
Total liabilities and stockholders’ equity
  $ 1,101,425     $ 1,074,296  

See accompanying notes to unaudited condensed consolidated financial statements.
 
 
- 2 -

 
 
SEABRIGHT HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME (LOSS)
(Unaudited)


   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
         
(as adjusted)
         
(as adjusted)
 
   
(in thousands, except share and per share information)
 
Revenue:
                       
Premiums earned
  $ 56,628     $ 62,088     $ 115,717     $ 118,818  
Claims service income
    222       303       526       636  
Net investment income
    4,426       5,297       9,449       10,672  
Net realized gains
    2,089       109       10,062       407  
Other income
    952       1,230       1,884       2,294  
Total revenue
    64,317       69,027       137,638       132,827  
Losses and expenses:
                               
Loss and loss adjustment expenses
    43,293       72,657       86,679       115,923  
Underwriting, acquisition and insurance expenses
    16,726       19,127       33,644       38,104  
Interest expense
    136       129       272       259  
Other expenses
    2,593       2,077       4,425       4,047  
Total losses and expenses
    62,748       93,990       125,020       158,333  
Income (loss) before taxes
    1,569       (24,963 )     12,618       (25,506 )
                                 
Income tax expense (benefit)
    188       (9,281 )     3,142       (9,706 )
Net income (loss)
    1,381       (15,682 )     9,476       (15,800 )
                                 
Other comprehensive income (loss):
                               
Increase in net unrealized gains on investment securities available for sale
    5,857       10,905       4,061       9,586  
Less: Reclassification adjustment for net realized gains recorded into net income
    (2,089 )     (109 )     (10,062 )     (407 )
Income tax expense (benefit) related to items of other comprehensive income
    (1,330 )     (3,854 )     2,118       (3,277 )
Other comprehensive income (loss)
    2,438       6,942       (3,883 )     5,902  
Comprehensive income (loss)
  $ 3,819     $ (8,740 )   $ 5,593     $ (9,898 )
                                 
Basic earnings (loss) per share
  $ 0.06     $ (0.74 )   $ 0.45     $ (0.75 )
Diluted earnings (loss) per share
  $ 0.06     $ (0.74 )   $ 0.43     $ (0.75 )
                                 
Dividends declared per share
  $ 0.05     $ 0.05     $ 0.10     $ 0.10  
                                 
Weighted average basic shares outstanding
    21,385,599       21,174,768       21,281,179       21,063,407  
Weighted average diluted shares outstanding
    21,879,164       21,174,768       21,833,600       21,063,407  
 
See accompanying notes to unaudited condensed consolidated financial statements.
 
 
- 3 -

 
 
SEABRIGHT HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)


   
Six Months Ended June 30,
 
   
2012
   
2011
 
         
(As adjusted)
 
   
(in thousands)
 
             
Cash flows from operating activities:
           
Net income (loss)
  $ 9,476     $ (15,800 )
Adjustments to reconcile net income to cash provided by operating activities:
               
Amortization of deferred policy acquisition costs
    16,140       17,421  
Policy acquisition costs deferred
    (15,809 )     (17,246 )
Depreciation and amortization
    5,031       4,226  
Compensation cost on restricted shares of common stock
    1,802       2,421  
Compensation cost on stock options
    273       350  
Net realized gain on investments
    (10,062 )     (407 )
Deferred income tax benefit
    (75 )     (4,259 )
Changes in certain assets and liabilities:
               
Unpaid loss and loss adjustment expense
    9,042       50,010  
Federal income tax recoverable
    6,711       (994 )
Reinsurance recoverables, net of reinsurance withheld
    (11,332 )     (24,814 )
Unearned premiums, net of deferred premiums and premiums receivable
    6,757       (5,559 )
Other assets and other liabilities
    1,533       2,027  
Net cash provided by operating activities
    19,487       7,376  
                 
Cash flows from investing activities:
               
Purchases of investments
    (218,064 )     (80,559 )
Sales of investments
    183,932       61,276  
Maturities and redemption of investments
    40,462       29,258  
Purchases of property and equipment
    (856 )     (926 )
Net cash provided by investing activities
    5,474       9,049  
                 
Cash flows from financing activities:
               
Stockholder dividends paid
    (2,229 )     (2,216 )
Proceeds from exercise of stock options
    25        
Grant of restricted shares of common stock
    2       5  
Surrender of stock in connection with restricted stock vesting
    (810 )     (962 )
Net cash used in financing activities
    (3,012 )     (3,173 )
                 
Net increase in cash and cash equivalents
    21,949       13,252  
Cash and cash equivalents at beginning of period
    28,503       15,958  
Cash and cash equivalents at end of period
  $ 50,452     $ 29,210  
                 
Supplemental disclosures:
               
Interest paid on surplus notes
  $ 271     $ 259  
Federal income taxes recovered, net
    (3,518 )     (4,470 )
Accrual for unsettled purchases of investments
    5,614       2,165  
Receivable from sale of investments
    1,932       1,000  
 
See accompanying notes to unaudited condensed consolidated financial statements.
 
 
- 4 -

 
 
SEABRIGHT HOLDINGS, INC. AND SUBSIDIARIES
 
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
1.    Basis of Presentation
 
The accompanying unaudited condensed consolidated financial statements include the accounts of SeaBright Holdings, Inc. (“SeaBright”) and its wholly owned subsidiaries, SeaBright Insurance Company (“SBIC”), PointSure Insurance Services, Inc. (“PointSure”), and Paladin Managed Care Services, Inc. (“PMCS”) (collectively, the “Company,” “we” or “us”). All significant intercompany transactions among these affiliated entities have been eliminated in consolidation.
 
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and pursuant to the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. The condensed consolidated balance sheet at December 31, 2011 has been derived from the audited financial statements at that date but does not include all of the information and notes required by GAAP for complete financial statements. The 2011 financial statements have been revised to reflect the impact of retrospective adoption on January 1, 2012 of Accounting Standards Update (“ASU”) 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. See Note 2.e. for additional disclosure regarding these adjustments. These unaudited condensed consolidated financial statements and notes should be read in conjunction with the audited financial statements and accompanying notes as of and for the year ended December 31, 2011 included in the Company’s Annual Report on Form 10-K, which was filed with the U.S. Securities and Exchange Commission (the “SEC”) on March 5, 2012.
 
In the opinion of management, the unaudited condensed consolidated financial statements include all adjustments (including normal recurring adjustments) necessary to state fairly the financial information set forth therein. Results of operations for the three months and six months ended June 30, 2012 are not necessarily indicative of the results expected for the full fiscal year or for any future period.
 
2.    Summary of Significant Accounting Policies
 
a.    Use of Estimates
 
The preparation of the consolidated financial statements in conformity with GAAP requires management of the Company to make a number of estimates and assumptions relating to the reported amount of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates. The Company has used significant estimates in determining unpaid loss and loss adjustment expenses, including losses that have occurred but were not reported to us by the financial reporting date; the amount and recoverability of reinsurance recoverable balances; goodwill and other intangibles; retrospective premiums; earned but unbilled premiums; deferred policy acquisition costs; income taxes; and the valuation and other-than-temporary impairments of investment securities.

b.    Earnings Per Share
 
The following table provides the reconciliation of basic and diluted weighted average shares outstanding used in calculating earnings per share for the three month and six month periods ended June 30, 2012 and 2011:
 
   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(in thousands)
 
Basic weighted average shares outstanding
    21,386       21,175       21,281       21,063  
Weighted average shares issuable upon exercise of outstanding stock options and vesting of nonvested restricted stock
    493             553        
Diluted weighted average shares outstanding
    21,879       21,175       21,834       21,063  
 
 
- 5 -

 
SEABRIGHT HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
The effect of including certain shares issuable upon the exercise of outstanding stock options and the vesting of non-vested restricted stock was anti-dilutive for the three month and six month periods ended June 30, 2012 and 2011. Therefore, such shares have been excluded from the calculation of diluted weighted average shares outstanding for these periods. The numbers of such shares excluded were as follows:

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(in thousands)
 
Shares issuable upon exercise of outstanding stock options and vesting of nonvested restricted stock
    1,192       2,731       1,278       2,731  

c.    Stockholder Dividends
 
On May 8, 2012, the Company’s Board of Directors declared a quarterly dividend of $0.05 per common share. The dividend was paid on July 13, 2012 to stockholders of record on June 29, 2012. Any future determination to pay cash dividends on the Company’s common stock will be at the discretion of its Board of Directors and will be dependent on the Company’s earnings; financial condition; operating results; capital requirements; any contractual, regulatory or other restrictions on the payment of dividends by the Company’s subsidiaries; and other factors that the Company’s Board of Directors deems relevant.

d.    Other Significant Accounting Policies
 
For a more complete discussion of the Company’s significant accounting policies, please see Note 2 to the Company’s consolidated financial statements as of and for the year ended December 31, 2011 in Part II, Item 8 of the Company’s 2011 Annual Report on Form 10-K filed with the SEC on March 5, 2012.
 
e.    Accounting Pronouncements
 
In October 2010, the Financial Accounting Standards Board (the “FASB”) issued ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. This ASU allows insurance entities to defer only direct incremental costs associated with successful insurance contract acquisitions or renewals. All other costs related to the acquisition of new or renewal insurance contracts are required to be expensed as incurred. The Company adopted this guidance retrospectively effective January 1, 2012 and has adjusted its previously issued financial information.

The effect of adoption of this new guidance on the consolidated balance sheet as of December 31, 2011 and on stockholders’ equity as of December 31, 2010 was as follows:

   
As Previously
Reported
   
Effect of
Change
   
As Currently
Reported
 
   
(in thousands)
 
December 31, 2011:
                 
Deferred policy acquisition costs, net
  $ 21,834     $ (6,990 )   $ 14,844  
Deferred income taxes, net
    19,233       2,448       21,681  
Retained earnings
    116,273       (4,542 )     111,731  
Total stockholders’ equity
    353,511       (4,542 )     348,969  
                         
December 31, 2010:
                       
Retained earnings
    135,265       (4,487 )     130,778  
Total stockholders’ equity
    351,017       (4,487 )     346,530  
 
 
- 6 -

 
 
SEABRIGHT HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
The effect of adoption of this new guidance on the condensed consolidated statement of operations and comprehensive income (loss) for the three month and six month periods ended June 30, 2011 was as follows:

   
As Previously
Reported
   
Effect of
Change
   
As Currently
Reported
 
   
(in thousands)
 
Three Months Ended June 30, 2011:
                 
Underwriting, acquisition and insurance expenses
  $ 19,328     $ (201 )   $ 19,127  
Income tax expense (benefit)
    (9,352 )     71       (9,281 )
Net income (loss)
    (15,812 )     130       (15,682 )
Basic earnings (loss) per share
    (0.75 )     0.01       (0.74 )
Diluted earnings (loss) per share
    (0.75 )     0.01       (0.74 )
                         
Six Months Ended June 30, 2011:
                       
Underwriting, acquisition and insurance expenses
  $ 37,742     $ 362     $ 38,104  
Income tax expense (benefit)
    (9,580 )     (126 )     (9,706 )
Net income (loss)
    (15,564 )     (236 )     (15,800 )
Basic earnings (loss) per share
    (0.74 )     (0.01 )     (0.75 )
Diluted earnings (loss) per share
    (0.74 )     (0.01 )     (0.75 )

3.    Investments
 
The consolidated cost or amortized cost, gross unrealized gains and losses, and estimated fair value of investment securities available for sale at June 30, 2012 and December 31, 2011 were as follows:

 
 
 
Cost or
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
 
Estimated
Fair Value
 
   
(in thousands)
 
June 30, 2012:
     
U.S. Treasury securities
  $ 27,921     $ 1,560     $     $ 29,481  
Government sponsored agency securities
    33,939       895       (7 )     34,827  
Corporate securities
    172,790       6,052       (236 )     178,606  
Taxable municipal securities
    22,759       1,684       (40 )     24,403  
Tax-exempt municipal securities
    267,189       15,488       (31 )     282,646  
Mortgage pass-through securities
    84,878       2,333       (6 )     87,205  
Collateralized mortgage obligations
    10,059       63       (43 )     10,079  
Asset-backed securities
    51,683       764       (22 )     52,425  
Total investment securities available for sale
  $ 671,218     $ 28,839     $ (385 )   $ 699,672  
                                 
December 31, 2011:
                               
U.S. Treasury securities
  $ 24,989     $ 1,579     $     $ 26,568  
Government sponsored agency securities
    15,567       1,330             16,897  
Corporate securities
    144,503       8,109       (578 )     152,034  
Taxable municipal securities
    22,622       1,573             24,195  
Tax-exempt municipal securities
    308,953       17,903       (1 )     326,855  
Mortgage pass-through securities
    77,532       3,399             80,931  
Collateralized mortgage obligations
    14,546       168       (54 )     14,660  
Asset-backed securities
    57,179       1,052       (25 )     58,206  
Total investment securities available for sale
  $ 665,891     $ 35,113     $ (658 )   $ 700,346  

The Company regularly reviews its investment portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of its investments. A number of criteria are considered during this process including, but not limited to: the current fair value as compared to amortized cost or cost, as appropriate, of the security; the length of time the security’s fair value has been below amortized cost or cost; the likelihood that the Company will be required to sell the security before recovery of its cost basis; objective information supporting recovery in a reasonable period of time; specific credit issues related to the issuer; and current economic conditions. The Company has the ability and intent to hold impaired investments to maturity or for a period of time sufficient for recovery of their carrying amount. For the three month and six month periods ended June 30, 2012 and 2011, the Company recognized no other-than-temporary impairment losses related to investments in debt securities.
 
 
- 7 -

 
SEABRIGHT HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
The following table presents information about investment securities with unrealized losses at June 30, 2012:
 
   
Less Than 12 Months
   
12 Months or More
   
Total
 
   
Aggregate Fair Value
   
Aggregate
Unrealized
Loss
   
Aggregate Fair Value
   
Aggregate
Unrealized
Loss
   
Aggregate Fair Value
   
Aggregate
Unrealized
Loss
 
         
(in thousands)
       
Investment Category
                 
Government sponsored agency securities (1)
  $ 4,504     $ (7 )   $     $     $ 4,504     $ (7 )
Corporate securities
    48,341       (203 )     2,026       (33 )     50,367       (236 )
Taxable municipal securities
    2,641       (40 )                 2,641       (40 )
Tax-exempt municipal securities
    7,505       (31 )                 7,505       (31 )
Mortgage pass-through securities (2)
    3,744       (6 )                 3,744       (6 )
Collateralized mortgage obligations
    4,722       (11 )     138       (32 )     4,860       (43 )
Asset-backed securities
    9,988       (22 )                 9,988       (22 )
Total
  $ 81,445     $ (320 )   $ 2,164     $ (65 )   $ 83,609     $ (385 )
 

(1) Government sponsored agency securities are not backed by the full faith and credit of the U.S. Government.
(2) Includes adjustable rate mortgage securities.

The following table presents information regarding gross realized gains and losses resulting from the sale of investment securities in the three month and six month periods ended June 30, 2012 and 2011:

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(in thousands)
 
                         
Gross realized gains
  $ 2,122     $ 308     $ 10,109     $ 832  
Gross realized losses
    (33 )     (199 )     (47 )     (425 )
Net realized gains
  $ 2,089     $ 109     $ 10,062     $ 407  
                                 
Proceeds
  $ 39,003     $ 24,383     $ 183,932     $ 61,276  

The related reclassification adjustments in other comprehensive income on the condensed consolidated statements of operations and comprehensive income (loss) were determined by specific identification.
 
The Company had no direct sub-prime mortgage exposure in its investment portfolio as of June 30, 2012 and approximately $11.5 million of indirect exposure to sub-prime mortgages. The following table provides a breakdown of ratings on the bonds in the Company’s municipal portfolio as of June 30, 2012:

   
Insured Bonds
   
Uninsured
Bonds
   
Total Municipal
Portfolio (1) Based On
 
   
Insured
Ratings
   
Underlying
Ratings
   
Ratings
   
Overall
Ratings (2)
   
Underlying
Ratings
 
   
(in thousands)
 
Rating
     
AAA                                                     
  $ 4,793     $ 4,793     $ 25,437     $ 30,230     $ 30,230  
AA+                                                     
    8,075       5,792       57,374       65,449       63,166  
AA                                                     
    10,353       11,047       68,102       78,455       79,149  
AA-                                                     
    27,853       24,464       42,783       70,636       67,247  
A+                                                     
    9,053       15,049       5,333       14,386       20,382  
A                                                     
    2,240       2,240       20,526       22,766       22,766  
A-                                                     
    2,038       1,020       5,990       8,028       7,010  
BBB                                                     
                3,004       3,004       3,004  
Pre-refunded (3)                                                     
    10,058       10,058       4,037       14,095       14,095  
Total
  $ 74,463     $ 74,463     $ 232,586     $ 307,049     $ 307,049  
 

(1)
Consists of $282.6 million of tax-exempt municipal bonds and $24.4 million of taxable municipal bonds.
 
(2)
Represents insured ratings on insured bonds and ratings on uninsured bonds.
 
(3)
These bonds have been pre-refunded by the issuer depositing highly rated government-issued securities into irrevocable trust funds established for payment of principal and interest.
 
- 8 -

 
 
SEABRIGHT HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
As of June 30, 2012, the Company had no direct investments in any bond insurer, and the following bond insurer insured more than 10% of the municipal bond investments in the Company’s portfolio:
 
       
Insurer Ratings 
  Average
Underlying
   
Fair Value
 
S&P          
 
Moody’s 
 
Bond Rating 
   
(Millions)
   
Bond Insurer        
National Public Finance Guarantee Corporation
  $ 34.1  
BBB
 
Baa2
 
AA-

The Company does not expect a material impact to its investment portfolio or financial position as a result of the problems currently facing monoline bond insurers.
 
The amortized cost and estimated fair value of fixed income securities available for sale at June 30, 2012, by contractual maturity, are set forth below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.

   
Cost or
Amortized Cost
   
Estimated
Fair Value
 
   
(in thousands)
 
Maturity      
Due in one year or less
  $ 22,128     $ 22,449  
Due after one year through five years
    217,356       224,702  
Due after five years through ten years
    265,483       281,800  
Due after ten years
    19,631       21,013  
Securities not due at a single maturity date
    146,620       149,708  
Total fixed income securities
  $ 671,218     $ 699,672  

The consolidated amortized cost of investment securities available for sale deposited with various regulatory authorities at June 30, 2012 was $304.4 million.
 
4.    Premiums
 
Direct premiums written totaled $69.6 million and $67.5 million for the three month periods ended June 30, 2012 and 2011, respectively, and $134.9 million and $135.8 million for the six month periods then ended, respectively.
 
Premiums receivable consisted of the following at June 30, 2012 and December 31, 2011:

   
June 30,
2012
   
December 31,
2011
 
   
(in thousands)
 
Current:
     
Premiums receivable
  $ 15,703     $ 19,362  
Allowance for doubtful accounts
    (1,275 )     (1,030 )
Premiums receivable, net of allowance
  $ 14,428     $ 18,332  

   
June 30,
2012
   
December 31,
2011
 
   
(in thousands)
 
Deferred:
     
Premiums receivable
  $ 147,621     $ 142,713  
Allowance for doubtful accounts
    (227 )     (227 )
Premiums receivable, net of allowance
  $ 147,394     $ 142,486  

5.    Reinsurance
 
Under reinsurance agreements, the Company cedes various amounts of risk to nonaffiliated insurance companies for the purpose of limiting the maximum potential loss arising from the underlying insurance risks. These reinsurance treaties do not relieve the Company from its obligations to policyholders.
 
 
- 9 -

 
 
SEABRIGHT HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
On October 1, 2011, the Company entered into reinsurance agreements with nonaffiliated reinsurers wherein it retains the first $0.5 million of each loss occurrence. The next $0.5 million of losses per occurrence (excess of the first $0.5 million of losses per occurrence retained by the Company) are 50% reinsured. Losses in excess of $1.0 million per loss occurrence are fully reinsured through the program limit of $75.0 million per loss occurrence, subject to various deductibles, limitations and exclusions as more fully described in the treaties. The new reinsurance program is effective through September 30, 2012. The ceding rate for the new program decreased approximately 50% from the expiring rate primarily as a result of eliminating coverage for losses between $0.25 million and $0.5 million. The Company had different reinsurance programs in place in periods prior to October 1, 2011, as set forth in Note 8 to the Company’s consolidated financial statements as of and for the year ended December 31, 2011 in Part II, Item 8 of the Company’s Annual Report on Form 10-K filed with the SEC on March 5, 2012.
 
6.    Unpaid Loss and Loss Adjustment Expenses
 
The following table summarizes the activity in unpaid loss and loss adjustment expense for the three month and six month periods ended June 30, 2012 and 2011:
 
   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(in thousands)
 
Beginning balance:
                       
Unpaid loss and loss adjustment expense
  $ 520,008     $ 446,977     $ 518,044     $ 440,919  
Reinsurance recoverable
    (97,113 )     (63,564 )     (93,710 )     (56,350 )
Net balance, beginning of period
    422,895       383,413       424,334       384,569  
Incurred related to:
                               
Current period
    44,336       45,536       87,677       87,567  
Prior periods
    (1,043 )     27,121       (998 )     28,356  
Total incurred
    43,293       72,657       86,679       115,923  
Paid related to:
                               
Current period
    (7,501 )     (9,306 )     (10,218 )     (13,383 )
Prior periods
    (38,425 )     (35,928 )     (80,533 )     (76,273 )
Total paid
    (45,926 )     (45,234 )     (90,751 )     (89,656 )
Net balance, end of period
    420,262       410,836       420,262       410,836  
Reinsurance recoverable
    106,824       80,093       106,824       80,093  
Unpaid loss and loss adjustment expense
  $ 527,086     $ 490,929     $ 527,086     $ 490,929  
 
As a result of changes in estimates of insured events in prior periods, unpaid loss and loss adjustment expenses decreased by a net amount of approximately $1.0 million in the three months and six months ended June 30, 2012. The net favorable development in the second quarter of 2012 consisted of unfavorable loss development of approximately $2.0 million, offset by approximately $3.0 million of net favorable development of other amounts such as unallocated loss adjustment expense (“ULAE”), loss based assessments and losses assumed from National Council on Compensation Insurance (“NCCI”) residual market pools.
 
7.    Contingencies
 
a.   SBIC is subject to guaranty fund and other assessments by the states in which it writes business. Guaranty fund assessments are accrued at the time premiums are written. Other assessments are accrued either at the time of assessment or in the case of premium-based assessments, at the time the premiums are written, or in the case of loss-based assessments, at the time the losses are incurred. As of June 30, 2012, SBIC had a liability for guaranty fund and other assessments of $7.6 million and a guaranty fund receivable of $0.4 million, which are reported as accrued expenses and other liabilities and other assets, respectively, in the accompanying condensed consolidated balance sheets. These amounts represent management’s best estimate based on information received from the states in which it writes business and may change due to many factors, including the Company’s share of the ultimate cost of current and future insolvencies. The majority of assessments are paid out in the year following the year in which the premium is written or the losses are paid. Guaranty fund receivables and other surcharge items are generally realized by a charge to new and renewing policyholders in the year following the year in which the related assessments were paid.
 
 
- 10 -

 
 
SEABRIGHT HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

b.   The Company is involved in various claims and lawsuits arising in the ordinary course of business. Management believes the outcome of these matters will not have a material adverse effect on the Company’s consolidated financial position or results of operations.

c.   On July 3, 2012, the Illinois Department of Insurance (the “DOI”) announced that it had entered an Agreed Order of Rehabilitation against Lumbermens Mutual Casualty Company (LMC) and an affiliated company, American Manufacturers Mutual Insurance Company. The companies had previously commenced a voluntary run-off plan in 2003 and had been operating under a run-off plan filed with and approved by the DOI since 2004. Under Illinois law, the DOI’s Director was appointed statutory rehabilitator of both companies involved. This restructuring, or run-off, involves taking over the affairs of a company but no longer taking on new obligations or issuing new or renewing policies. The Director is vested with title to the company’s property, assets, rights of action or lawsuits, books, records and premises. The Company is unable to predict what impact this Order of Rehabilitation might have on its business dealings with LMC, which include primarily an adverse development cover and related collateralized reinsurance trust, a claims administration services agreement and an administrative services agreement.

d.   On April 17, 2012, the Company was notified by the Internal Revenue Service that it had commenced a routine examination of the consolidated federal income tax return of SeaBright Holdings, Inc. and Subsidiaries for the years ended December 31, 2010 and 2008. The examination is currently in the planning and risk assessment phase. The Company is in the process of gathering and providing information in response to this examination.

8.    Share-Based Payment Arrangements
 
At June 30, 2012, the Company had outstanding stock options and nonvested restricted stock granted according to the terms of two equity incentive plans. The stockholders and Board of Directors approved the 2003 Stock Option Plan (the “2003 Plan”) in September 2003, and amended and restated the 2003 Plan in February 2004 and April 2008, and approved the 2005 Long-Term Equity Incentive Plan (the “2005 Plan” and, together with the 2003 Plan, the “Stock Option Plans”) in December 2004, and amended and restated the 2005 Plan in April 2007, May 2010 and April 2012.
 
At June 30, 2012, the Company reserved 776,458 shares of common stock for issuance under the 2003 Plan, of which options to purchase 479,946 shares had been granted, and 3,952,105 shares for issuance under the 2005 Plan, of which 3,187,256 shares had been granted. In January 2006, the Compensation Committee of the Board of Directors terminated the ability to grant future stock options awards under the 2003 Plan. Therefore, the Company anticipates that all future awards will be made under the 2005 Plan.
 
a.    Stock Options
 
The following table summarizes stock option activity for the six months ended June 30, 2012:
 
   
Shares
Subject to
Options
   
Weighted
Average Exer-
cise Price
per Share
   
Weighted
Average Re-
maining Con-
tractual Life
(years)
   
Aggregate
Intrinsic
Value
(in thousands)
 
Outstanding at December 31, 2011
    1,474,040     $ 10.94       5.1     $ 404  
Granted
    43,838       8.49              
Forfeited
    (5,812 )     9.75              
Exercised
    (3,825 )     6.54              
Cancelled
    (7,251 )     14.93              
Outstanding at June 30, 2012
    1,500,990       10.87       4.8       867  
                                 
Exercisable at June 30, 2012
    1,221,719       11.07       3.9       846  
 
 
- 11 -

 
 
SEABRIGHT HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
The June 30, 2012 aggregate intrinsic values in the table above are based on the Company’s closing stock price of $8.89 on June 29, 2012. Proceeds from the exercise of stock options during the quarter ended June 30, 2012 totaled approximately $25,000.
 
As of June 30, 2012, there was approximately $0.8 million of total unrecognized compensation cost related to stock options granted under the 2005 Plan. That cost is expected to be recognized over a weighted-average period of approximately 2.3 years.
 
b.    Restricted Stock
 
The following table summarizes restricted stock activity for the six months ended June 30, 2012:
 
   
Number of
Shares
   
Weighted
Average
Grant Date
Fair Value
 
Outstanding at December 31, 2011
    1,160,556     $ 10.15  
Granted
    204,576       8.86  
Vested
    (332,480 )     10.38  
Forfeited
    (9,750 )     8.97  
Outstanding at June 30, 2012
    1,022,902       9.83  

During the six months ended June 30, 2012, the Company granted, for the first time, shares of performance-based restricted stock to certain executives of the Company. These performance-based shares, which totaled 145,715, were issued under the 2005 Plan and will vest in varying amounts if the Company’s tangible book value per share, adjusted to exclude unrealized gains and losses and adjusted for dividends and share repurchases, as of December 31, 2012 equals or exceeds certain levels of improvement. The number of shares granted was based upon achievement of the target level of improvement, at which 100% will vest. The actual level of achievement of the performance-based goal will be determined using the Company’s consolidated GAAP financial statements as of and for the year ending December 31, 2012 and may range from 50% of target at the threshold level to 200% of target at the maximum improvement level. If the threshold level of improvement is not achieved, all performance-based awards will be forfeited. Any shares that are earned through achievement of the performance-based goal will vest in three equal installments on the following dates: the date in early 2013 on which the Company publicly releases its results for fiscal year 2012; December 31, 2013; and December 31, 2014. Grantees must remain employed in good standing by the Company at the vesting dates in order to receive the vested shares. Because the Company’s restricted stock awards do not qualify as liability awards under the FASB Accounting Standards Codification (“ASC”) Topic 718, Compensation – Stock Compensation, they are accounted for as equity awards.

As of June 30, 2012, there was approximately $4.7 million of total unrecognized compensation cost related to restricted stock granted under the 2005 Plan. That cost is expected to be recognized over a weighted-average period of approximately 1.8 years.
 
c.    Restricted Stock Units
 
In April 2012, the Company granted, for the first time, restricted stock units (“RSUs”) to certain employees. Unlike restricted stock awards, RSUs do not represent shares of equity ownership in the Company, either at the grant date or upon vesting. Within 30 days following vesting, each RSU will be settled in cash based on the closing price of SeaBright’s common stock as reported on the New York Stock Exchange (the “NYSE”) on the date of vesting, or on the last trading day prior to the date of vesting if vesting occurs on a date when the NYSE is closed for trading. The RSUs are all subject to cliff vesting on the third anniversary of the grant date (similar to restricted stock). Holders of RSUs will not receive dividends declared on SeaBright’s common stock, nor do they have any voting rights or other rights typically associated with equity ownership.
 
 
- 12 -

 
 
SEABRIGHT HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
Because RSUs are settled in cash, they are required to be accounted for as liability awards and will be remeasured at each financial statement date using the closing price of SeaBright’s common stock at the end of the period, adjusted to account for the fact that RSU holders do not receive stockholder dividends. Compensation cost will be recognized using the proportionate amount of the awards’ fair value that has been earned through service to date.
 
The following table summarizes RSU activity for the six months ended June 30, 2012:
 
   
Number of
Shares
   
Weighted
Average
Fair Value
 
Outstanding at December 31, 2011
        $  
Granted
    51,000       8.31  
Vested
           
Forfeited
           
Outstanding at June 30, 2012
    51,000     $ 8.34  

As of June 30, 2012, there was approximately $0.4 million of total unrecognized compensation cost (based on a dividend-adjusted common stock price on June 29, 2012 of $8.34) related to RSUs granted under the 2005 Plan. That cost is expected to be recognized over a weighted-average period of approximately 2.8 years.
 
d.    Stock-Based Compensation
 
Total stock-based compensation expense recognized in the unaudited condensed consolidated statements of operations and comprehensive income (loss) for the three month and six month periods ended June 30, 2012 and 2011 is shown in the following table. No stock-based compensation cost was capitalized during the periods shown.
 
   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(in thousands)
 
Stock-based compensation expense related to:
                       
Nonvested restricted stock
  $ 822     $ 1,053     $ 1,774     $ 2,421  
Restricted stock units
    28             28        
Stock options
    117       168       273       351  
Total
  $ 967     $ 1,221     $ 2,075     $ 2,772  
                                 
Total related tax benefit
  $ 317     $ 388     $ 673     $ 888  

9.    Fair Values of Assets and Liabilities
   
 
Estimated fair value amounts, defined as the exit price of willing market participants, have been determined using available market information and other appropriate valuation methodologies. However, considerable judgment is required in developing the estimates of fair value. Accordingly, these estimates are not necessarily indicative of the amounts that could be realized in a current market exchange. The use of different market assumptions or estimating methodologies may have an effect on the estimated fair value amounts.

The following methods and assumptions were used by the Company in estimating the fair value disclosures for financial instruments in the accompanying consolidated financial statements and notes:

 
Cash and cash equivalents, premiums receivable, accrued expenses, other liabilities and surplus notes: The carrying amounts for these financial instruments, as reported in the accompanying condensed consolidated balance sheets, approximate their fair values.

 
Investment securities:   The Company measures and reports its financial assets and liabilities, including investment securities, in accordance with ASC Topic 820, Fair Value Measurements and Disclosures.  The estimated fair values for available-for-sale securities are generally based on quoted market prices for securities traded in the public marketplace. The Company also considers the impact of a significant decrease in volume and level of activity for an asset or liability when compared with normal activity. Additional information with respect to fair values of the Company’s investment securities is disclosed in Note 3.
 
 
- 13 -

 
 
SEABRIGHT HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
Other financial instruments qualify as insurance-related products and are specifically exempted from fair value disclosure requirements.

The Company groups its financial assets and financial liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

 
Level 1 — Valuations for assets and liabilities traded in active exchange markets, such as the NYSE. Level 1 consists of U.S. Treasury securities that are traded by dealers or brokers in active markets. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.

 
Level 2 — Valuations for assets and liabilities traded in less active dealer or broker markets. Level 2 valuations are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market. Level 2 includes government sponsored agency securities, corporate fixed-income securities, municipal bonds, mortgage pass-through securities, collateralized mortgage obligations and asset-backed securities.

 
Level 3 — Valuations for assets and liabilities that are derived from other valuation methodologies, including discounted cash flow models and similar techniques, and not based on market exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities. As of June 30, 2012, the Company had no Level 3 financial assets or liabilities.

The tables below present the June 30, 2012 and December 31, 2011 balances of assets and liabilities measured at fair value on a recurring basis.
 
June 30, 2012:
   
Total
   
Level 1
   
Level 2
   
Level 3
 
   
(In thousands)
 
U.S. Treasury securities
  $ 29,481     $ 29,481     $     $  
Government sponsored agency securities
    34,827             34,827        
Corporate securities
    178,606             178,606        
Taxable municipal securities
    24,403             24,403        
Tax-exempt municipal securities
    282,646             282,646        
Mortgage pass-through securities
    87,205             87,205        
Collateralized mortgage obligations
    10,079             10,079        
Asset-backed securities
    52,425             52,425        
Total
  $ 699,672     $ 29,481     $ 670,191     $  

December 31, 2011:

   
Total
   
Level 1
   
Level 2
   
Level 3
 
   
(In thousands)
 
U.S. Treasury securities
  $ 26,568     $ 26,568     $     $  
Government sponsored agency securities
    16,897             16,897        
Corporate securities
    152,034             152,034        
Taxable municipal securities
    24,195             24,195        
Tax-exempt municipal securities
    326,855             326,855        
Mortgage pass-through securities
    80,931             80,931        
Collateralized mortgage obligations
    14,660             14,660        
Asset-backed securities
    58,206             58,206        
Total
  $ 700,346     $ 26,568     $ 673,778     $  

At June 30, 2012 and December 31, 2011, there were no liabilities measured at fair value on a recurring basis.
 
 
- 14 -

 
 
SEABRIGHT HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Active markets are those in which transactions occur with sufficient frequency and volume to provide reliable pricing information on an ongoing basis. Inactive markets are those in which there are few transactions for the asset, prices are not current, price quotations vary substantially either over time or among market makers, or in which little information is released publicly. When the market for an investment is judged to be inactive, appropriate adjustments must be made to observable inputs to account for such inactivity. As of June 30, 2012, the Company’s investment portfolio consisted of securities that it considered to be traded in active markets. Therefore, no adjustment for market inactivity or illiquidity was necessary. There were no transfers between levels during the three months and six months ended June 30, 2012.
 
The Company obtains fair value inputs for securities in its investment portfolio from independent, nationally recognized pricing services. The pricing services utilize multidimensional pricing models that vary by asset class and incorporate relevant inputs such as available trade, bid and quote market data for identical or similar instruments, model-based valuation techniques for which significant assumptions were observable and other market information to arrive at a fair value price for each security. This process takes into consideration the relevance of observable inputs based on factors such as the level of trading activity and the volume and currency of available prices and includes appropriate adjustments for nonperformance and liquidity risks.
 
The Company also seeks input from independent portfolio managers and financial advisors engaged by the Company to assist in the management and oversight of its investment portfolio. The Company and an independent portfolio manager engaged by the Company review such amounts for reasonableness in relation to the following considerations, among others: recent trades of a particular security; the Company’s independent observations of recent developments affecting the economy in general and certain issuers in particular; and fair values from other sources, such as statements from the Company’s custodial banks.
 
The Company holds a limited amount ($21.3 million at June 30, 2012) of privately placed corporate bonds and estimates the fair value of these bonds using an internal matrix that is based in part on market information regarding interest rates, credit spreads and liquidity. The pricing matrix begins with current U.S. Treasury rates and uses credit spreads received from third-party sources to estimate fair value. The Company includes the fair value estimates of these corporate bonds in Level 2, since all significant inputs are market observable. As some of these securities are issued by public companies, the Company compares the estimates of fair value to the fair values of these companies’ publicly traded debt to test the validity of the internal pricing matrix.
 
 
- 15 -

 
 
Item 2.         Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Cautionary Statement

You should read the following discussion and analysis in conjunction with our unaudited condensed consolidated financial statements and the related notes thereto included in Item 1 of Part I of this quarterly report. The information contained in this quarterly report is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this quarterly report and in our other reports filed with the U.S. Securities and Exchange Commission (the “SEC”), including our Annual Report on Form 10-K for the year ended December 31, 2011 filed with the SEC on March 5, 2012.

The discussion under the heading “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2011 and in this Quarterly Report on Form 10-Q, and similar discussions in our other SEC filings, describe some of the important risk factors that may affect our business, results of operations and financial condition. You should carefully consider those risks, in addition to the other information in this report and in our other filings with the SEC, before deciding to purchase, hold or sell our common stock.
 
Some of the statements in this Item 2 and elsewhere in this quarterly report may include forward-looking statements that reflect our current views with respect to future events and financial performance. These statements include forward-looking statements, both with respect to us specifically and the insurance sector in general, and include statements about our expectations for future periods with respect to payroll levels, rate changes in states where we write business, our adverse development cover with Lumbermens Mutual Casualty Company (“LMC”), stockholder dividends, our capital needs and the expected effect of operational changes and cost savings initiatives. Statements that include the words “expect,” “intend,” “plan,” “believe,” “project,” “estimate,” “may,” “should,” “anticipate,” “will” and similar statements of a future or forward-looking nature identify forward-looking statements for purposes of the federal securities laws or otherwise.
 
All forward-looking statements address matters that involve risks and uncertainties. Accordingly, there are or will be important factors that could cause our actual results to differ materially from those indicated in these statements. We believe that these factors include but are not limited to the following:

 
greater frequency or severity of claims and loss activity, including as a result of catastrophic events, than our underwriting, reserving or investment practices anticipate based on historical experience or industry data;

 
changes in the U.S. economy and workforce levels, including the length of the economic recovery;

 
our dependency on a concentrated geographic market;

 
changes in the availability, cost or quality of reinsurance and failure of our reinsurers to pay claims timely or at all;

 
changes in regulations or laws applicable to us, our subsidiaries, brokers or customers;

 
uncertainty about the effect of rules and regulations to be promulgated under the Dodd-Frank Wall Street Reform and Consumer Protection Act on us and the economy and the financial services sector in particular;

 
potential downgrades in our rating or changes in rating agency policies or practices;

 
ineffectiveness or obsolescence of our business strategy due to changes in current or future market conditions;

 
unexpected issues relating to claims or coverage and changes in legal theories of liability under our insurance policies;

 
increased competition on the basis of pricing, capacity, coverage terms or other factors;

 
developments in financial and capital markets that adversely affect the performance of our investments;

 
loss of the services of any of our executive officers or other key personnel;
 
 
- 16 -

 
 
 
our inability to raise capital in the future;

 
our status as an insurance holding company with no direct operations;

 
our reliance on independent insurance brokers;

 
increased assessments or other surcharges by states in which we write policies;

 
our potential exposure to losses;

 
the effects of mergers, acquisitions and divestitures that we may undertake;

 
failure of our customers to pay additional premium under our retrospectively rated policies;

 
the effects of acts of terrorism or war;

 
cyclical changes in the insurance industry;

 
changes in accounting policies or practices; and

 
changes in general economic conditions, including inflation and other factors.

The foregoing factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are included in this quarterly report. We undertake no obligation to publicly update or review any forward-looking statement, whether as a result of new information, future developments or otherwise.
 
If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may vary materially from what we project. Any forward-looking statements you read in this quarterly report reflect our views as of the date of this quarterly report with respect to future events and are subject to these and other risks, uncertainties and assumptions relating to our operations, results of operations, growth strategy and liquidity. Before making an investment decision, you should carefully consider all of the factors identified in this quarterly report that could cause actual results to differ.
 
Additional information concerning these and other factors is contained in our SEC filings, including, but not limited to, our 2011 Annual Report on Form 10-K.

Overview
 
We are a holding company whose wholly-owned subsidiary, SeaBright Insurance Company, operates as a specialty provider of multi-jurisdictional workers’ compensation insurance. Through our other wholly-owned subsidiaries, PointSure Insurance Services, Inc. and Paladin Managed Care Services, Inc., we also provide related wholesale brokerage services and integrated managed medical care services. SeaBright Insurance Company is domiciled in Illinois, commercially domiciled in California and headquartered in Seattle, Washington. SeaBright Insurance Company is licensed in 49 states, the District of Columbia and Guam, to write workers’ compensation and other lines of insurance. Traditional underwriters of workers’ compensation insurance provide coverage to employers under one or more state workers’ compensation laws, which prescribe benefits that employers are obligated to provide to their employees who are injured arising out of or in the course of employment. We focus on employers with complex workers’ compensation exposures and provide coverage under multiple state and federal acts, applicable common law or negotiated agreements. We also provide traditional state act coverage in markets we believe are underserved. Our workers’ compensation policies are issued to employers who also pay the premiums.
 
Our operations and financial performance have been impacted by changes in the U.S. economy. The significant downturn in the U.S. economy from 2008 through 2010 led to lower reported payrolls, which has had a negative impact on our gross premiums written, and the recovery that began in 2010 has not resulted in a significant improvement in reported payrolls. The economic downturn had a particularly severe impact on the construction industry. When our customers reduce their workforce levels, the level of workers’ compensation insurance coverage they require and, as a result the premiums that we charge, are reduced, and if our customers cease operations, they may cancel or choose not to renew their policies. The economic downturn and high levels of unemployment have the effect of increasing claims and claim severity and duration, which drives up our medical, indemnity and litigation costs. The economic downturn has also diminished opportunities for injured workers to return to transitional, modified duty positions during their recoveries, which has lengthened the periods of their recoveries and increased our medical, indemnity and litigation costs, particularly in California. The longer a claim remains open, the more exposed we become to the effects of medical cost inflation. All of these factors have had, and could continue to have, a significant negative impact on our claims costs.
 
 
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If we fail to accurately assess our future claims costs, our loss reserves may be inadequate to cover our actual losses. As discussed under “Management's Discussion and Analysis of Financial Condition and Results of Operations  –  Critical Accounting Policies, Estimates and Judgments – Unpaid Loss and Loss Adjustment Expenses” in our 2011 Annual Report on Form 10-K, there are many variables that can impact the adequacy of our loss and loss adjustment expense liabilities and we continually refine our loss reserve estimates. Quarterly, management determines what, if any, adjustments to prior accident years’ loss reserves are necessary after considering the results of actuarial studies performed by internal and/or consulting actuaries; the impact of recent operational initiatives on our claims costs and loss reserves; discussions with key executives in Underwriting, Claims, and other relevant functional areas; changing environmental conditions; and other factors. In response to the factors described in the preceding paragraph, we strengthened our net loss reserves for prior accident years by $28.4 million in 2011 and lowered our net reserves by $1.0 million in the first six months of 2012. We may ultimately conclude that our current estimate of loss reserves is inadequate, if the negative claim trends experienced over the last several years described above continue or worsen. Future adverse development could require us to increase our loss reserves, which could have a material adverse effect on our earnings and financial position in the periods in which such increases are made.
 
It is uncertain if economic conditions will deteriorate further, or when economic conditions will show significant improvement. If the recovery from the recent economic recession continues to be slow, or the recovery fails to positively impact employment levels, or if we experience another recession, it could further reduce payrolls and increase our claims costs, which could have a significant negative impact on our business, financial condition or results of operations.
 
Results of Operations
 
Three Months and Six Months Ended June 30, 2012 and 2011
 
Gross Premiums Written.  Gross premiums written consists of direct premiums written and premiums assumed from the NCCI residual market pools. The number of customers we service, in-force payrolls and in-force premiums represent some of the factors we consider when analyzing gross premiums written.

Gross premiums written for the three months ended June 30, 2012 totaled $66.9 million, a decrease of $0.9 million, or 1.3%, from $67.8 million of gross premiums written in the same period of 2011. Gross premiums written for the six months ended June 30, 2012 totaled $133.6 million, a decrease of $3.7 million, or 2.7%, from $137.3 million of gross premiums written in the same period of 2011.

Our “core” product lines contributed $50.8 million, or 75.9%, of the total gross premiums written for the three months ended June 30, 2012 compared to $50.9 million, or 75.1%, in the same period of 2011. The slight decrease in our core product lines was accompanied by a net $0.3 million decrease in our “Program Business,” which contributed $16.9 million of gross premiums written for the quarter ended June 30, 2012. Our Program Business includes alternative markets and small maritime and small energy programs. For the six months ended June 30, 2012, our core product lines contributed $95.1 million, or 71.2%, of gross premiums written in the period, essentially flat as compared to the same period in 2011. Our Program Business contributed $38.6 million, or 28.9%, of gross premiums written in the six months ended June 30, 2012, a decrease of $3.5 million from the $42.1 million of gross premiums written in the same period in 2011.

The reductions in written premiums and customer count resulted in part from our previously announced efforts to reduce our concentration in the California construction and agriculture markets. Our average California renewal retention rate over the four most recent quarters was 58.5% compared to 68.8% in the prior four quarters. Our overall renewal retention rate for the second quarter of 2012 was 81.0%, up from 63.0% in the first quarter of 2012 and 75.0% in the second quarter of 2011.

Excluding work we perform as the servicing carrier for the Washington State USL&H Compensation Act Assigned Risk Plan (the “Washington USL&H Plan”), the total number of customers we serviced decreased from approximately 1,580 at June 30, 2011 to approximately 1,400 at June 30, 2012. The majority of the customer decrease was in our core business, which was offset by an increase of approximately 60 customers in our Program Business. By design, our Program Business will have a larger number of customers with a smaller average premium size than our core business. Our average premium size at June 30, 2012 was approximately $297,000 in our core business and approximately $93,000 in our Program Business, compared to approximately $249,000 in our core business and approximately $105,000 in our Program Business one year earlier.
 
 
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Total in-force payrolls, a factor used in determining premiums charged, decreased 1.5% from $6.8 billion at June 30, 2011 to $6.7 billion a year later. California continues to be our largest market, accounting for approximately $103.9 million, or 41.8%, of our in-force premiums at June 30, 2012. This represents a decrease of $38.8 million, or 27.2%, from approximately $142.7 million, or 50.4% of total in-force premiums in California at June 30, 2011.

Premiums assumed from the NCCI residual market pools for the three months ended June 30, 2012 totaled $(2.7) million, a decrease of $3.0 million from $0.3 million during the same period in 2011. For the six months ended June 30, 2012, assumed premiums decreased $2.8 million, or 186.7%, to $(1.3) million from $1.5 million for the same period in 2011. The decreases for the three months and six months ended June 30, 2012 were primarily the result of true-ups of our actuarial estimates for prior policy years based on current NCCI data and reapportionment figures. The balance of our gross premiums written (consisting of Washington USL&H Plan, general liability and other miscellaneous amounts) for the three month and six month periods ended June 30, 2012 totaled $1.9 million and $1.2 million, respectively, compared to $(0.5) million and $(1.3) million, respectively, in the same periods in 2011.

Net Premiums Written.  Net premiums written totaled $63.6 million for the three months ended June 30, 2012 compared to $58.0 million in the same period in 2011, representing an increase of $5.6 million, or 9.7%. For the six months ended June 30, 2012, net premiums written totaled $123.9 million, an increase of $6.3 million, or 5.4%, from $117.6 million in the same period of 2011. The increase in net premiums written for the three months and six months ended June 30, 2012 was primarily attributable to a decrease in ceded premiums written of $10.0 million as a result of a lower ceding rate in our excess of loss reinsurance program that renewed in October 2011, offset by a $3.7 million decrease in gross premiums written. Our ceding rate decreased by approximately 50% as a result of raising the attachment point from $0.25 million to $0.5 million and reducing maximum coverage from $100.0 million to $75.0 million. The coverage provided by the reinsurance program that renewed in October 2011 is more in line with historical levels.
 
Net Premiums Earned.  Net premiums earned totaled $56.6 million for the three months ended June 30, 2012 compared to $62.1 million for the same period in 2011, representing a decrease of $5.5 million, or 8.8%. For the six months ended June 30, 2012, net premiums earned totaled $115.7 million, a decrease of $3.1 million, or 2.6%, from $118.8 million in the same period of 2011. We record the entire annual policy premium as unearned premium when written and earn the premium over the life of the policy, which is generally twelve months. Consequently, the amount of premiums earned in any given year depends on when during the current or prior year the underlying policies were written and the actual reported payroll of the underlying policies. Our direct premiums earned totaled $62.6 million for the three months ended June 30, 2012, a decrease of $8.9 million, or 12.4%, from $71.5 million for the same period in 2011. Our direct premiums earned totaled $126.5 million for the six months ended June 30, 2012, a decrease of $10.0 million, or 7.3%, from $136.5 million for the same period in 2011.

The following is a summary of our top five markets based on direct premiums earned:

    Six Months Ended June 30,  
    2012     2011  
   
Direct
Premiums
Earned
   
%
   
Direct
Premiums
Earned
   
%
 
   
($ in thousands)
 
California
  $ 53,040       41.8 %   $ 67,364       49.4 %
Louisiana
    12,474       9.9       12,524       9.2  
Texas
    8,549       6.8       7,894       5.8  
Alaska
    6,061       4.8       7,849       5.8  
Pennsylvania
    5,095       4.0       4,516       3.3  
Total
  $ 85,219       67.3 %   $ 100,147       73.5 %
 
 
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Net premiums earned are also affected by premiums ceded under reinsurance agreements. Ceded premiums earned for the three months ended June 30, 2012 totaled $3.0 million compared to $9.8 million for the same period in 2011, representing a decrease of $6.8 million, or 69.4%. Ceded premiums earned for the six months ended June 30, 2012 totaled $9.1 million compared to $19.3 million for the same period in 2011, representing a decrease of $10.2 million, or 52.8%.This decrease was primarily attributable to lower ceding rates under our October 2011 reinsurance program. The decrease in ceded premiums earned was offset by a decrease in premiums assumed from the NCCI for residual market business. Assumed premiums earned decreased $3.3 million from $1.6 million for the six months ended June 30, 2011 to $(1.7) million in the same period in 2012. This decrease was primarily due to true-ups of our actuarial estimates for prior policy years based on current NCCI data and reapportionment figures.

Net Investment Income.  Net investment income was $4.4 million for the three months ended June 30, 2012 compared to $5.3 million for the same period in 2011, representing a decrease of $0.9 million, or 17.0%. Net investment income was $9.4 million for the six months ended June 30, 2012, compared to $10.7 million for the same period in 2011, representing a decrease of $1.2 million, or 11.5%. Average invested assets were $749.2 million for the three months ended June 30, 2012, an increase of $53.8 million, or 7.7%, from $695.4 million for the same period in 2011. For the six months ended June 30, 2012, average invested assets were $739.5 million, an increase of $45.2 million, or 6.5%, from $694.3 million for the same period in 2011. Our yield on average invested assets decreased from approximately 3.0% for the three months ended June 30, 2011 to approximately 2.4% for the same period in 2012, driven mainly by reduced reinvestment rates and sales of higher-yielding investment securities. For the six months ended June 30, 2012, our yield on average invested assets was 2.6% compared to approximately 3.1% for the same period in 2011.

Net Realized Gains.  Net realized gains totaled $2.1 million for the three months ended June 30, 2012 compared to $0.1 million for the same period in 2011. For the six months ended June 30, 2012, net realized gains totaled $10.1 million compared to $0.4 million in the same period in 2011. The increase in net realized gains for the three months and six months ended June 30, 2012 resulted from the sale of investment securities in order to reduce exposure to interest rate risk and realize a portion of our tax loss carry forwards. The majority of proceeds from these sales were reinvested in taxable securities in a continuing effort to shorten the overall portfolio duration and reduce the municipal exposure.
 
Other Income.  Other income totaled $1.0 million for the three months ended June 30, 2012 compared to $1.2 million for the same period in 2011, representing a decrease of $0.2 million, or 22.6%. For the six months ended June 30, 2012, other income totaled $1.9 million compared to $2.3 million in the same period in 2011, representing a decrease of $0.4 million, or 17.9%. Other income is derived primarily from the operations of PointSure, our wholesale insurance broker, and PMCS, our provider of medical bill review, utilization review, nurse case management and related services.
 
Loss and Loss Adjustment Expenses.  Loss and loss adjustment expenses totaled $43.3 million for the three months ended June 30, 2012 compared to $72.7 million for the same period in 2011, representing a decrease of $29.4 million, or 40.4%. For the six months ended June 30, 2012, loss and loss adjustment expenses totaled $86.7 million, compared to $115.9 million for the same period in 2011, representing a decrease of $29.2 million, or 25.2%. Our net loss ratio, which is calculated by dividing loss and loss adjustment expenses less claims service income by premiums earned, for the three months ended June 30, 2012 was 76.1% compared to 116.5% for the same period in 2011. Our net loss ratio for the six months ended June 30, 2012 was 74.5% compared to 97.0% for the same period in 2011. The decrease in our net loss ratio for the three months ended June 30, 2012 was primarily attributable to $1.0 million of favorable development of prior accident years’ loss reserves recorded in the three months ended June 30, 2012 compared with $27.1 million adverse development in the three months ended June 30, 2011. Net favorable development of prior years’ reserves in the six months ended June 30, 2012 totaled $1.0 million compared to $28.4 million adverse development in the same period of 2011.
 
As discussed under the heading “Critical Accounting Policies, Estimates and Judgments – Unpaid Loss and Loss Adjustment Expenses – Actuarial Loss Reserve Estimation Methods” in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2011, we use an expected loss ratio (“ELR”) method to establish the loss reserves for the current accident year. Once the accident year is complete and begins to age, the ELR method is blended with the actual paid and incurred loss development to determine the revised estimated ultimate losses for the accident year.
 
Accident year 2012 is incomplete, as only six months of the year have been earned as of June 30, 2012. An ELR was established for each jurisdiction and type of loss (indemnity, medical, ALAE) and was multiplied by the booked accident year earned premium to produce the ultimate losses to date. The ELR selections are reviewed quarterly with each internal reserve study. Given the short experience period for the current accident year, the ELRs are usually maintained at least through the first 12 months of the accident year and revised thereafter as the underlying data matures. The net ELR used in the first six months of 2012 was 65.0%, compared to 62.5% used in the first six months of the 2011 accident year. The 2011 net ELR was subsequently increased to 65.0% in the fourth quarter of 2011, after reviewing the year-to-date results for the 2011 accident year and considering the adverse development in recent accident years. The 2012 accident year ELR takes into consideration factors including, but not limited to: the development of recent accident years, the impact of recent rate increases, and provisions of the excess-of-loss reinsurance treaty that we entered into on October 1, 2011.
 
 
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For prior accident years, the net ultimate loss estimates at June 30, 2012 were lower when compared to March 31, 2012 and resulted in a net decrease of $1.0 million in our loss reserves in the second quarter of 2012, compared to a net increase of $27.1 million recorded in the same period of last year. Adverse development of prior years’ direct loss reserves totaled $2.0 million and related to the following accident years: $6.9 million in 2010 and $2.0 million in 2009, offset by favorable development of $2.9 million in 2011, $2.5 million in 2008, and $1.5 million in 2007 and prior. This adverse development was offset by $3.0 million of net favorable development of other amounts such as ULAE, loss based assessments and losses assumed from the NCCI pools. In the three months ended June 30, 2011, we increased our loss reserves by a net amount of $27.1 million. Adverse development of prior years’ direct loss reserves totaled $28.5 million and related to the following accident years: $2.4 million in 2010, $8.4 million in 2009, $8.8 million in 2008, $6.7 million in 2007, and $2.2 million in 2006 and prior. This adverse development was partially offset by $1.4 million of net favorable development of ULAE, loss based assessments and NCCI pool reserves.
 
As of June 30, 2012, we had recorded a receivable of approximately $3.1 million for KEIC loss development under the adverse development cover we entered into with LMC on September 30, 2003, the date we acquired KEIC from LMC. We do not expect this receivable to have any material adverse effect on our future cash flows if LMC fails to perform its obligations under the adverse development cover. At June 30, 2012, we had access to approximately $3.1 million under the related collateralized reinsurance trust in the event that LMC fails to satisfy its obligations under the adverse development cover. December 31, 2011 was the date as of which the parties are to settle amounts due under the adverse development cover. We are currently working through the final settlement of the receivable from LMC. For an update regarding the status of LMC, see the discussion under Note 7.c., “Contingencies” in Item 1 of this Part I.

Underwriting, Acquisition and Insurance Expenses.  Underwriting expenses totaled $16.7 million for the three months ended June 30, 2012, compared to $19.1 million for the same period in 2011, representing a decrease of $2.4 million, or 12.6%. For the six months ended June 30, 2012, underwriting expenses totaled $33.6 million, a decrease of $4.5 million, or 11.7%, from $38.1 million for the same period in 2011. Our net underwriting expense ratio, which is calculated by dividing underwriting, acquisition and insurance expenses by premiums earned, for the three months ended June 30, 2012 was 29.5%, compared to 30.8% for the same period in 2011. For the six months ended June 30, 2012, our net underwriting expense ratio was 29.1%, compared to 32.1% for the same period in 2011. The primary driver of the decreases in underwriting expenses was a reduction in commission expense, of which approximately $1.0 million resulted from true-ups of our actuarial estimates of commissions assumed from the NCCI pools for prior policy years. Direct commission expense for the six months ended June 30, 2012 decreased approximately $1.3 million from the same period in 2011 due to a change in product mix and lower commission rates. Contingent commissions for the six months ended June 30, 2012 decreased approximately $0.9 million from the same period in 2011.

Interest Expense.  Interest expense related to the surplus notes issued by our insurance subsidiary in May 2004 totaled $136,000 for the three months ended June 30, 2012, compared to $129,000 for the same period in 2011, representing an increase of $7,000, or 5.4%. For the six months ended June 30, 2012, interest expense totaled $272,000, an increase of $13,000, or 5.0%, from $259,000 in the same period of 2011. The surplus notes interest rate, which is calculated at the beginning of each interest payment period using the 3-month LIBOR plus 400 basis points, was 4.5% at June 30, 2012 compared to 4.3% at June 30, 2011.

Other Expenses. Other expenses totaled $2.6 million for the three months ended June 30, 2012 compared to $2.1 million for the same period in 2011, representing an increase of $0.5 million, or 24.8%. For the six months ended June 30, 2012, other expenses totaled $4.4 million compared to $4.0 million in the same period of 2011. Other expenses result primarily from the operations of PointSure and PMCS, which together accounted for approximately $1.9 million and $3.3 million of expenses for the three months and six months ended June 30, 2012, compared to approximately $1.7 million and $3.4 million for the same periods in 2011.
 
 
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Income Tax Expense.  The effective tax rate for the three months ended June 30, 2012 was 12.0%, compared to 37.2% for the same period in 2011. The effective tax rate for the six months ended June 30, 2012 was 24.9% compared to 38.1% in the same period of 2011. Our effective tax rate differed from the statutory tax rate of 35.0% primarily as a result of tax exempt interest income. At June 30, 2012, approximately 40.4% of our investment portfolio was invested in tax exempt municipal bonds, compared to approximately 44.1% at June 30, 2011.

 Net Income (Loss).  Net income was $1.4 million for the three months ended June 30, 2012, compared to a net loss of $15.7 million for the same period in 2011. Net income for the six months ended June 30, 2012 totaled $9.5 million, a difference of $25.3 million from a net loss of $15.8 million in the same period of 2011. The increase in net income for the three months and six months ended June 30, 2012 was primarily the result of decreases in loss and loss adjustment expenses and increases in net realized gains.

Liquidity and Capital Resources

Our principal sources of funds are underwriting operations, investment income and proceeds from sales and maturities of investments. Our primary use of funds is to pay claims and operating expenses, to purchase investments and to pay declared common stock dividends.

Our investment portfolio is structured so that investments mature periodically over time in reasonable relation to current expectations of future claim payments. Since we have limited claims history, we have derived our expected future claim payments from industry and predecessor trends. Our investment portfolio as of June 30, 2012 had an effective duration of 4.1 years with individual maturities extending out to 29 years. Currently, we make claim payments from positive cash flow from operations and invest excess cash in securities with appropriate maturity dates to balance against anticipated future claim payments. As these securities mature, we intend to invest any excess funds in investments with appropriate durations to match against expected future claim payments.

At June 30, 2012, our investment portfolio consisted of investment-grade fixed income securities with fair values subject to fluctuations in interest rates, as well as other factors such as credit. All of the securities in our investment portfolio are accounted for as “available for sale” securities. While we have structured our investment portfolio to provide an appropriate matching of maturities with anticipated claim payments, if we decide or are required in the future to sell securities in a rising interest rate environment, we would expect to incur losses from such sales.

Our ability to adequately provide funds to pay claims comes from our disciplined underwriting and pricing standards and the purchase of reinsurance to protect us against severe claims and catastrophic events. Effective October 1, 2011, our reinsurance program provides for retention of the first $0.5 million of each loss occurrence. The next $0.5 million of losses per occurrence (excess of the first $0.5 million of losses retained by us) are 50% reinsured. Losses in excess of $1.0 million per loss occurrence are fully reinsured through the program limit of $75.0 million per loss occurrence, subject to various deductibles, limitations and exclusions as more fully described in the treaties. The new reinsurance program is effective through September 30, 2012. Given industry and predecessor trends, we believe we are sufficiently capitalized to cover our retained losses.

SeaBright is a holding company with minimal unconsolidated revenue. As SeaBright pays stockholder dividends and has other capital needs in the future, we anticipate that it will be necessary for our insurance subsidiary to pay additional dividends to SeaBright. Our insurance subsidiary is required by law to maintain a certain minimum level of surplus on a statutory basis. The payment of such dividends will be regulated as described in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of Part II of our Annual Report on Form 10-K for the year ended December 31, 2011.

Our condensed consolidated net cash provided by operating activities for the six months ended June 30, 2012 was $19.5 million, compared to $7.4 million for the same period in 2011. The increase is mainly attributable to an increase in premium collections.
 
Net cash provided by investing activities was $5.5 million in the six months ended June 30, 2012, compared to $9.0 million in the same period in 2011. The decrease in net cash provided by investing activities was primarily driven by lower net investment sales activity (sales and maturities, net of purchases).
 
For the six months ended June 30, 2012, cash used in financing activities totaled $3.0 million, compared to $3.2 million in the same period in 2011. The decrease was primarily due to a decrease in tax withholding obligations associated with the vesting of restricted stock.
 
As of June 30, 2012, SBIC’s statutory surplus totaled $303.3 million, compared to $286.4 million as of June 30, 2011.
 
 
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Contractual Obligations and Commitments
 
During the six months ended June 30, 2012, there were no material changes to our contractual obligations and commitments.

Off-Balance Sheet Arrangements
 
As of June 30, 2012, we had no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
 
Critical Accounting Policies, Estimates and Judgments
 
It is important to understand our accounting policies in order to understand our financial statements. Management considers some of these policies to be critical to the presentation of our financial results, since they require management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures at the financial reporting date and throughout the period being reported upon. Some of the estimates result from judgments that can be subjective and complex, and consequently, actual results reflected in future periods might differ from these estimates.

The most critical accounting policies involve the reporting of unpaid loss and loss adjustment expenses including losses that have occurred but were not reported to us by the financial reporting date, the amount and recoverability of reinsurance recoverable balances, deferred policy acquisition costs, income taxes, the valuation of goodwill, the impairment of investment securities, earned but unbilled premiums and retrospective premiums. These critical accounting policies are described in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of Part II of our Annual Report on Form 10-K for the year ended December 31, 2011.

Regulation
 
On July 21, 2010, the President signed into law the Dodd Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which has significant implications for the insurance industry. In addition to imposing a number of new compliance obligations on publicly traded companies, the Dodd-Frank Act established the Financial Services Oversight Council (“FSOC”), which is authorized to recommend that certain systemically significant non-bank financial companies, including insurance companies, be regulated by the Board of Governors of the Federal Reserve. The Dodd-Frank Act also created within the United States Department of the Treasury a new Federal Insurance Office (“FIO”) and authorizes the federal preemption of certain state insurance laws. The FSOC and the FIO are authorized to study, monitor and report to Congress on the U.S. insurance industry and the significance of global reinsurance to the U.S. insurance market. Many sections of the Dodd-Frank Act become effective over time, and certain provisions of the Dodd-Frank Act require the implementation of regulations that have not yet been adopted. The potential impact of the Dodd-Frank Act on the U.S. insurance industry is not clear. However, our business could be affected by changes to the U.S. system of insurance regulation or our designation or the designation of insurers or reinsurers with which we do business as systemically significant non-bank financial companies.

As previously disclosed, on July 29, 2011, we were notified by the Illinois Department of Insurance that our insurance subsidiary was due for a routine comprehensive examination of its condition and affairs as of and for the five year period ended December 31, 2010. The field work portion of the comprehensive financial examination began on August 29, 2011 and concluded this year. On June 29, 2012, the Illinois Director of Insurance officially adopted, without fines or penalties assessed, the Report of Examination prepared by the Illinois Department of Insurance. On July 9, 2012, we were notified by the Illinois Department of Insurance that due to concerns arising in connection with its December 31, 2010 examination, it intends to conduct an actuarial examination of our reserves for unpaid loss and loss adjustment expense as of December 31, 2011. That work has not yet commenced.
 
Item 3.         Quantitative and Qualitative Disclosures About Market Risk

Credit Risk
 
Credit risk is the potential economic loss principally arising from adverse changes in the financial condition of a specific debt issuer. We address this risk by investing generally in fixed-income securities which are rated “A” or higher by Standard & Poor’s or another major rating agency. We also independently, and through our outside investment managers, monitor the financial condition of all of the issuers of fixed-income securities in the portfolio. To limit our exposure to risk, we employ stringent diversification rules that limit the credit exposure to any single issuer or business sector.
 
 
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Interest Rate Risk
 
We had fixed-income investments with a fair value of $699.7 million at June 30, 2012 and $700.3 million at December 31, 2011 that are subject to interest rate risk. We manage the exposure to interest rate risk through a disciplined asset/liability matching and capital management process. In the management of this risk, the characteristics of duration, credit and variability of cash flows are critical elements. These risks are assessed regularly and balanced within the context of the liability and capital position.

Since December 31, 2011, there have been no material changes in the quantitative or qualitative aspects of our market risk profile. For additional information regarding our exposure to certain market risks, see Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” in our Annual Report on Form 10-K for the year ended December 31, 2011, filed with the SEC on March 5, 2012.
 
Item 4.         Controls and Procedures
 
Disclosure Controls and Procedures
 
Under the supervision and with the participation of management, including our Chief Executive Officer and our Chief Financial Officer, we carried out an evaluation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Based on that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report to ensure that information we are required to disclose in reports that are filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms specified by the SEC and is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting
 
There were no changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during our second fiscal quarter of 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 
PART II – OTHER INFORMATION
 
Item  1A.  Risk Factors
 
The disclosures set forth below are material changes from the specific risk factors previously disclosed in Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2011, filed with the SEC on March 5, 2012. Other than as described below, there were no material changes to the risk factors set forth in such report.
 
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 we insure, our loss reserves may be inadequate to cover our actual losses and we may fail to establish appropriate premium rates. We 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 and a reduction of our statutory surplus. For example, we increased loss reserves for prior accident years by approximately $30.9 million in 2011 and approximately $32.0 million in 2010. See the discussion under the heading “Loss Reserves” in Part I, Item 1 of our 2011 annual report on Form 10-K. On July 9, 2012, we were notified by the Illinois Department of Insurance, one of our two principal regulators, that due to concerns arising in connection with its December 31, 2010 examination, it intends to conduct an actuarial examination of our reserves for unpaid loss and loss adjustment expense as of December 31, 2011. That work has not yet commenced. We cannot assure you that the examination will not result in future increases of our loss reserve estimates.
 
 
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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; frequency of claims; the length of time to achieve ultimate resolution; judicial theories of liabilities; and other third-party factors beyond our control. If there are unfavorable changes in severity trends, we may need to increase our loss reserves, as described above. If we need to increase our loss reserves in the future, it would have a negative impact on our net income and comprehensive income in the period in which our loss estimates are revised, and any material increase to our loss reserve estimates may result in a downgrade in the A.M. Best rating of our insurance subsidiary. See the risk factor “A downgrade in the A.M. Best rating of our insurance subsidiary could reduce the amount of business we are able to write” in our 2011 annual report on Form 10-K.
 
Because LMC has been placed into rehabilitation, 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 in 2003. 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 “Loss Reserves — KEIC Loss Reserves” in Part I, Item 1 of our 2011 annual report on Form 10-K.

Until recently, LMC and its insurance company affiliates have operated under a voluntary “run-off” plan approved by the Illinois Department of Insurance in 2004. However, on July 2, 2012, LMC and one of its affiliates, American Manufacturers Mutual Insurance Company (“AMM”), were placed into rehabilitation by order of the Circuit Court of Cook County, Illinois. By virtue of that order, the Illinois Director of Insurance (acting through a special deputy receiver) became the rehabilitator of LMC and AMM and was vested with title to all of the property, contracts and rights of action of LMC and AMM, as well as authority to deal with the property, business and affairs of LMC and AMM. Rehabilitation may reorganize the business of a company so that it can be restored to normal operation. However, a company in rehabilitation can be found to be insolvent or otherwise incapable of being rehabilitated, in which case the Director of Insurance would apply to the circuit court for an order placing the company into liquidation. In a liquidation, the Director of Insurance would be charged with winding up the business of the company, marshaling its assets, identifying claims and eventually distributing its assets in accordance with the distribution priority prescribed by the Illinois Insurance Code.

Because LMC has been placed into rehabilitation, our business could be adversely affected in the following ways:

 
The special deputy 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 “Loss Reserves — KEIC Loss Reserves” in Part I, Item 1 of our 2011 annual report on Form 10-K, 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) $1.6 million or (b) 102% 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. The liability of LMC under the adverse development cover was approximately $3.1 million at December 31, 2011 and approximately $3.0 million at December 31, 2010. The balance of the trust account, including accumulated interest, at December 31, 2011 was approximately $3.1 million. December 31, 2011 is the date to which the parties will look to determine whether the loss reserves with respect to KEIC’s insurance policies in effect at the date of the Acquisition have increased or decreased from the $16.0 million balance existing at the date of the Acquisition. Given that LMC has been placed into rehabilitation, if 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 special deputy receiver now has control of the assets of LMC.

 
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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 or otherwise incapable of being rehabilitated and is 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 in 2003, including approximately $13.0 million under the commutation agreement and an initial amount of approximately $1.6 million to fund the collateralized reinsurance trust. Given that LMC has been placed into rehabilitation, it is possible that the special deputy receiver or a creditor could assert a claim seeking to unwind or recover these payments under applicable voidable preference and fraudulent transfer laws.
 
Item 2.         Unregistered Sales of Equity Securities and Use of Proceeds
 
The following table sets forth information in connection with purchases made by, or on behalf of, us or any affiliated purchaser, of shares of our common stock during the three months ended June 30, 2012:
 
   
(a)
Total Number of Shares (or Units) Purchased
   
(b)
Average Price Paid per Share (or Unit)
   
(c)
Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans or Programs
   
(d)
Maximum Number (or Approximate Dollar Value) of Shares (or Units) that May Yet Be Purchased Under the Plans or Programs
 
Month #1 (April 1, 2012 through April 30, 2012)
    17,835     $ 9.02              
Month #2 (May 1, 2012 through May 31, 2012)
    1,416       8.76              
Month # 3 (June 1, 2012 through June 30, 2012)
    2,783       8.45              
 
We did not repurchase any of our common stock on the open market as part of a stock repurchase program during the six months ended June 30, 2012. The above shares of common stock were surrendered by our employees to satisfy their tax withholding obligations in connection with the vesting of restricted stock awards issued under our 2005 Plan.

Item 6.         Exhibits
 
The list of exhibits in the Exhibit Index to this quarterly report is incorporated herein by reference.
 
 
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SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
SEABRIGHT HOLDINGS, INC.
 
     
Date: August 8, 2012
     
 
By:
/s/ John G. Pasqualetto  
    John G. Pasqualetto  
    Chairman, President and Chief Executive Officer  
    (Principal Executive Officer)  
       
  By:
/s/ Neal A. Fuller
 
   
Neal A. Fuller
 
   
Senior Vice President – Chief Financial Officer and
Assistant Secretary
 
   
(Principal Financial Officer)
 
 
 
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EXHIBIT INDEX

The list of exhibits in the Exhibit Index to this quarterly report on Form 10-Q is incorporated herein by reference. Exhibits 31.1 and 31.2 are being filed as part of this quarterly report on Form 10-Q. Exhibits 32.1 and 32.2 are being furnished with this quarterly report on Form 10-Q.
 

 
Exhibit
Number
  Description 
31.1*   Rule 13a-14(a) Certification (Chief Executive Officer)
     
31.2*   Rule 13a-14(a) Certification (Chief Financial Officer)
     
32.1*   Section 1350 Certification (Chief Executive Officer)
     
32.2*   Section 1350 Certification (Chief Financial Officer)
     
101    Interactive Data Files
     

*      Filed herewith.