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EX-23.1 - EXHIBIT 23.1 - SeaBright Holdings, Inc.ex_23-1.htm
EX-21.1 - EXHIBIT 21.1 - SeaBright Holdings, Inc.ex_21-1.htm
EX-31.1 - EXHIBIT 31.1 - SeaBright Holdings, Inc.ex_31-1.htm
EX-32.1 - EXHIBIT 32.1 - SeaBright Holdings, Inc.ex_32-1.htm
EX-32.2 - EXHIBIT 32.2 - SeaBright Holdings, Inc.ex_32-2.htm
EX-31.2 - EXHIBIT 31.2 - SeaBright Holdings, Inc.ex_31-2.htm


UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
________________
 
Form 10-K
________________
 
(Mark One)
R
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
 
For the fiscal year ended December 31, 2010
   
OR
   
£
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
 
For the transition period from to         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
98101
Seattle, Washington
(Address of principal executive offices)
(Zip code)

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

Securities registered pursuant to Section 12(b) of the Act:

Title of each class
Name of each exchange on which registered
Common stock, par value $0.01 per share
New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:
None

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act:  Yes £     No R

Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act:  Yes £     No R

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

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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes £     No £

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  £

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 R
Non-accelerated filer £
Smaller reporting company £
    (Do not check if a smaller reporting company)  

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

The aggregate market value of the common stock held by non-affiliates of the registrant, based on the closing price of the common stock on June 30, 2010 as reported by the New York Stock Exchange, was $194,842,032.

The number of shares of the registrant’s common stock outstanding as of March 11, 2011 was 22,066,306.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the SeaBright Holdings, Inc. definitive Proxy Statement for its 2011 annual meeting of stockholders to be filed with the Commission pursuant to Regulation 14A not later than 120 days after December 31, 2010 are incorporated by reference in Part III of this Form 10-K.
 


 
 
 

 


SEABRIGHT HOLDINGS, INC.
INDEX TO FORM 10-K

 
 
Page 
PART I
 
Item 1.
Business
1
Item 1A.
Risk Factors
32
Item 1B.
Unresolved Staff Comments
43
Item 2.
Properties
43
Item 3.
Legal Proceedings
43
Item 4.
Removed and Reserved
43
Item 4.1.
Executive Officers of the Registrant
43
PART II
 
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
44
Item 6.
Selected Financial Data
47
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
49
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
70
Item 8.
Financial Statements and Supplementary Data
72
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
104
Item 9A.
Controls and Procedures
104
Item 9B.
Other Information
106
PART III
 
Item 10.
Directors, Executive Officers and Corporate Governance
106
Item 11.
Executive Compensation
106
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
106
Item 13.
Certain Relationships and Related Transactions, and Director Independence
106
Item 14.
Principal Accounting Fees and Services
106
PART IV
 
Item 15.
Exhibits, Financial Statement Schedules
107
 
 
 

 
 
PART I

In this annual report:

 
references to the “Acquisition” refer to the series of transactions that occurred on September 30, 2003 described under the heading “Our History” in Item 1 of this Part I;

 
references to our “predecessor,” for periods prior to the date of the Acquisition, refer collectively to PointSure Insurance Services, Inc., Eagle Pacific Insurance Company and Pacific Eagle Insurance Company;

 
references to the “Company,” “we,” “us” or “our” refer to SeaBright Holdings, Inc. and its subsidiaries, SeaBright Insurance Company, PointSure Insurance Services, Inc. and Paladin Managed Care Services,  and prior to the date of the Acquisition, include references to our predecessor;

 
the term “our business” refers to the business conducted by the Company since October 1, 2003 and with respect to periods prior to October 1, 2003, to the business conducted by our predecessor; and

 
references to “SeaBright” refer solely to SeaBright Holdings, Inc., unless the context suggests otherwise.

Item 1.  Business.

Overview

We are a specialty provider of multi-jurisdictional workers’ compensation insurance and, on a limited basis, general liability insurance. We are domiciled in Illinois, commercially domiciled in California and headquartered in Seattle, Washington. We are licensed in 49 states, the District of Columbia and Guam, to write workers’ compensation and other lines of insurance. Traditional providers 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. In 2008, we began providing general liability insurance on a limited basis and only in conjunction with workers’ compensation insurance we provide for major construction projects written under a controlled insurance program (commonly known as “wrap-up” programs). At December 31, 2010, we had four general liability insurance policies in force with estimated annual premium of $0.4 million. Since our general liability insurance business is small, the majority of discussion in this annual report on Form 10-K focuses on our workers’ compensation line of business.

Our workers’ compensation policies are issued to employers who also pay the premiums. The policies provide payments to covered, injured employees of the policyholder for, among other things, temporary or permanent disability benefits, death benefits and medical and hospital expenses. The benefits payable and the duration of such benefits are set by statute and vary by jurisdiction and with the nature and severity of the injury or disease and the wages, occupation and age of the employee.

SeaBright Holdings, Inc. was formed in 2003 by members of our current management and entities affiliated with Summit Partners, a leading private equity and venture capital firm, for the purpose of acquiring from Lumbermens Mutual Casualty Company (“LMC”) and certain of its affiliates the renewal rights and substantially all of the operating assets and employees of Eagle Pacific Insurance Company and Pacific Eagle Insurance Company, which we collectively refer to as Eagle or the Eagle Entities (the “Acquisition”). Eagle began writing specialty workers’ compensation insurance in the mid-1980’s. The Acquisition gave us renewal rights to an existing portfolio of business, representing a valuable asset given the customer renewal rates of our business, and a fully operational infrastructure that would have taken many years to develop. These renewal rights gave us access to Eagle’s customer lists and the right to seek to renew Eagle’s continuing in-force insurance contracts. These renewal rights were valued at the date of the Acquisition.

 
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Introduction to Insurance Terms

Throughout this annual report, we refer to certain terms that are commonly used in the insurance industry. The following terms when used herein have the following meanings:

Accident year or accident year losses
The year in which an accident or loss occurred, regardless of when the accident was reported or when the related loss amount was recognized in our financial statements. Losses grouped by accident year are referred to as accident year losses.
   
Assume
To receive from a ceding company all or a portion of a risk in consideration of receipt of a premium.
   
Assumed premiums written
Premiums that we have received from an authorized state-mandated pool in connection with our involuntary assumption of a portion of the insurance written by the pool.
   
Cede
To transfer to an assuming company, or reinsurer, all or a portion of a risk in consideration of payment of a premium.
   
Ceded premiums written
The portion of our gross premiums written that is ceded to reinsurers in return for the portion of our risk that they reinsure. Also included in ceded premiums written are premiums related to policies that we write on behalf of the Washington State USL&H Compensation Act Assigned Risk Plan (the “Washington USL&H Plan”).
   
Commutation
An agreement between the ceding insurer and the reinsurer that provides for the valuation, payment and complete discharge of some or all current and future obligations between the parties under particular reinsurance contract(s).
   
Development
The amount by which estimated losses, measured subsequently by reference to payments and additional estimates, differ from those originally reported for a period. Development is favorable when losses ultimately settle for less than the amount reserved or subsequent estimates indicate a basis for reducing loss reserves on open claims. Development is unfavorable when losses ultimately settle for more than the levels at which they were reserved or subsequent estimates indicate a basis for reserve increases on open claims. Favorable or unfavorable development of loss reserves is reflected in our Consolidated Statement of Operations in the period in which the change is made.
   
Direct loss reserves
Loss reserves related to business written directly by us, as opposed to loss reserves related to business that is assumed or ceded by us.
   
Direct premiums written
All premiums, billed and unbilled, written by us during a specified policy period. Premiums are earned over the terms of the related policies. At the end of each accounting period, the portions of premiums that are not yet earned are included in unearned premiums and are realized as revenue in subsequent periods over the remaining terms of the policies.
   
Excess of loss reinsurance
A form of reinsurance in which the reinsurer pays all or a specified percentage of a loss caused by a particular occurrence or event in excess of a fixed amount and up to a stipulated limit.
   
Gross premiums written
The sum of direct premiums written and assumed premiums written during a specified period.
   
Incurred but not reported claims
Claims relating to insured events that have occurred but have not yet been reported to us.
   
In-force premiums
The current annual gross premiums written on all active or unexpired policies, excluding premiums received from the Washington USL&H Plan.
 
 
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Loss adjustment expenses
The expenses of investigating, administering and settling claims, including legal expenses.
   
Loss reserves
The liability representing estimates of amounts needed to pay reported and unreported claims and related loss adjustment expenses.
   
Net combined ratio
The sum of the net loss ratio and the net underwriting expense ratio.
   
Net loss ratio
A key financial measure that we use in monitoring our profitability. Calculated by dividing loss and loss adjustment expenses for the period less claims service income by premiums earned for the period.
   
Net premiums written
Equal to gross premiums written minus ceded premiums written.
   
Net underwriting expense ratio
A key profitability measure. Calculated by dividing underwriting, acquisition and insurance expenses for the period less other service income by premiums earned for the period.
   
Reinsurance
A contract by which one insurer transfers all or part of a risk to another insurer in exchange for all or part of the premium paid by the insured.
   
Retention
The amount of losses from a single occurrence or event, or an aggregate amount, which is paid by the company prior to the attachment of excess of loss reinsurance.
   
Retrospectively-rated policy
A policy containing a provision for determining the insurance premium for a specified policy period on the basis of the loss experience for the same period.
   
Treaty
A reinsurance contract.
   
Washington USL&H Plan
The Washington USL&H Compensation Act Assigned Risk Plan, for which SeaBright Insurance Company is the servicing carrier. All of the premiums, minus the servicing carrier fees that we retain, and losses associated with this business are ceded to the Washington USL&H Plan. Accordingly, this business is excluded from the discussion of our operations and results in various places in this annual report, as indicated.

Industry Background

Workers’ compensation is a statutory system under which an employer is required to pay for its employees’ medical, disability, vocational rehabilitation and death benefits costs for work-related injuries or illnesses. Most employers comply with this requirement by purchasing workers’ compensation insurance. The principal concept underlying workers’ compensation laws is that an employee injured in the course of his or her employment has only the legal remedies available under workers’ compensation law and does not have any other recourse against his or her employer. Generally, workers are covered for injuries that occur in the course and within the scope of their employment. An employer’s obligation to pay workers’ compensation does not depend on any negligence or wrongdoing on the part of the employer and exists even for injuries that result from the negligence or wrongdoings of another person, including the employee.

Workers’ compensation insurance policies generally provide that the carrier will pay all benefits that the insured employer may become obligated to pay under applicable workers’ compensation laws. Each state has a regulatory and adjudicatory system that quantifies the level of wage replacement to be paid, determines the level of medical care required to be provided and the cost of permanent impairment and specifies the options in selecting healthcare providers available to the injured employee or the employer. Coverage under the United States Longshore and Harbor Workers’ Compensation Act (“USL&H” or the “USL&H Act”) is similar to the state statutory system, but is administered on a federal level by the U.S. Department of Labor. This coverage is required for maritime employers with employees working on or near the waterfront in coastal areas of the United States and its inland waterways. As benefits under the USL&H Act are generally more generous than in the individual state systems, the rates charged for this coverage are higher than those charged for comparable land-based employment. These state and federal laws generally require two types of benefits for injured employees: (1) medical benefits, which include expenses related to diagnosis and treatment of the injury, as well as any required rehabilitation and (2) indemnity payments, which consist of temporary wage replacement, permanent disability payments and death benefits to surviving family members. To fulfill these mandated financial obligations, virtually all employers are required to purchase workers’ compensation insurance or, if permitted by state law or approved by the U.S. Department of Labor, to self-insure. In most states, employers may purchase workers’ compensation insurance from a private insurance carrier, a state-sanctioned assigned risk pool or a self-insurance fund (an entity that allows employers to obtain workers’ compensation coverage on a pooled basis, typically subjecting each employer to joint and several liability for the entire fund). Some states, including North Dakota, Ohio, Washington, and Wyoming, are known as “monopolistic” states, meaning that employers in those states are generally required to buy workers’ compensation insurance from the state or, in some cases, may be allowed to self-insure.

 
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Our History

On July 14, 2003, SeaBright entered into a purchase agreement with Kemper Employers Group, Inc. (“KEG”), LMC and the Eagle Entities. Pursuant to the purchase agreement, we acquired 100% of the issued and outstanding capital stock of Kemper Employers Insurance Company (“KEIC”) and PointSure Insurance Services, Inc. (“PointSure”), a wholesale insurance broker and third party claims administrator, and acquired tangible assets, specified contracts, renewal rights and intellectual property rights from LMC and the Eagle Entities. We acquired KEIC, a shell company with no in-force policies or employees, solely for the purpose of acquiring its workers’ compensation licenses in 43 states and the District of Columbia and for its certification with the United States Department of Labor. SeaBright paid approximately $6.5 million for KEIC’s insurance licenses, Eagle’s renewal rights, internally developed software and other assets and PointSure and approximately $9.2 million for KEIC’s statutory surplus and capital, for a total purchase price of $15.7 million. In September 2004 we paid to LMC a purchase price adjustment in the amount of $771,116 based on the terms of the purchase agreement.

The Acquisition was completed on September 30, 2003, at which time entities affiliated with Summit Partners, certain co-investors and members of our management team invested approximately $45.0 million in SeaBright and received convertible preferred stock in return. See “Certain Relationships and Related Transactions, and Director Independence” in Part III, Item 13 of this annual report. These proceeds were used to pay for the assets under the purchase agreement and to contribute additional capital to KEIC, which was renamed “SeaBright Insurance Company.” SeaBright Insurance Company received an “A-” (Excellent) rating from A.M. Best Company (“A.M. Best”) following completion of the Acquisition. See the discussion under the heading “Ratings” in this Item 1.

On January 26, 2005, we closed the initial public offering of 8,625,000 shares of our common stock at a price of $10.50 per share for net proceeds of approximately $80.8 million, after deducting underwriters’ fees, commissions and offering costs totaling approximately $9.8 million. Approximately $74.8 million of the net proceeds were contributed to SeaBright Insurance Company. In connection with our initial public offering, all 508,365.25 outstanding shares of our Series A preferred stock were converted into 7,777,808 shares of common stock.

On February 1, 2006, we closed a follow-on public offering of 3,910,000 shares of common stock at a price of $15.75 per share for net proceeds of approximately $57.7 million, after deducting underwriters’ fees, commissions and offering costs totaling approximately $3.9 million. Following the closing of this offering, we contributed $50.0 million of the net proceeds to SeaBright Insurance Company, which used the capital to expand its business in its core markets and to new territories.

In December 2007, we completed the acquisition of Total HealthCare Management, Inc. (“THM”), a privately held California provider of medical bill review, utilization review, nurse case management and related services. The total purchase price was $1.5 million, of which $1.2 million was paid at closing. The remaining $0.3 million was scheduled to be paid in three equal installments on the first three anniversaries of the closing date, provided that THM achieved certain revenue objectives in 2008, 2009 and 2010. Based on THM’s performance in 2008, 2009 and 2010, these installments were not paid. Goodwill recognized in connection with this acquisition totaled approximately $1.4 million. Following the acquisition, THM became a wholly owned subsidiary of SeaBright. In September 2010, THM was rebranded and changed its name to Paladin Managed Care Services (“PMCS”) as a “doing business as” designation.
 
 
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In July 2008, PointSure acquired 100% of the outstanding common stock of Black/White and Associates, Inc., Black/White and Associates of Nevada and Black/White Rockridge Insurance Services, Inc. (referred to collectively as “BWNV”), a privately held managing general agent and wholesale insurance broker. Also included in the transaction was a covenant not to compete from key principals of BWNV and other intangible assets. The preliminary purchase price paid at closing was $1.7 million, of which $0.5 million was allocated to the purchase of BWNV capital stock. The Company recorded goodwill of approximately $0.5 million in connection with this acquisition. Following the acquisition, BWNV became a wholly owned subsidiary of PointSure. The stock purchase agreement provided for a contingent purchase price to be paid by (or refunded to) the Company approximately 13 months following the closing date, depending on whether BWNV revenue in the 12 months following closing exceeded (or was less than) the base revenue assumed at the time of the closing. The Company paid approximately $159,000 as additional purchase consideration upon completion of the contingency period in 2009. In November 2010, PointSure reorganized its corporate structure and directly assumed the business and operations of BWNV. The BWNV legal entities were subsequently dissolved.

Corporate Structure

Our corporate structure was as follows at December 31, 2010:
 
Image
 
SeaBright Insurance Company is our insurance company subsidiary and a specialty provider of multi-jurisdictional workers’ compensation insurance. PointSure acts primarily as an in-house wholesale broker and third party administrator for SeaBright Insurance Company. Paladin Managed Care Services is a provider of medical bill review, utilization review, physician case management and related services.

Services Arrangements

In connection with the Acquisition, we entered into services agreements with LMC and certain of its affiliates that require us to provide certain service functions to the Eagle Entities in exchange for fee income. The services that we are required to provide to the Eagle Entities under these agreements include administrative services, such as underwriting, billing, collection, safety and accounting services, and claims services, including claims administration, claims investigation and loss adjustment and settlement services. For the years ended December 31, 2010, 2009 and 2008, we received approximately $0.2 million, $0.3 million, and $0.3 million, respectively, in service fee income from LMC and its affiliates under these services arrangements.

At the time of the Acquisition, we entered into a service agreement with Broadspire Services, Inc. (“Broadspire”), a third-party claims administrator and former subsidiary of LMC, pursuant to which Broadspire provided us with claims services for the claims that we acquired from KEIC in connection with the Acquisition. In 2008, we terminated our arrangement with Broadspire and assumed responsibility for administering these claims.

Issues Relating to a Potential LMC Receivership

LMC and its affiliates had traditionally offered a wide array of personal, risk management and commercial property and casualty insurance products. However, due to the distressed financial situation of LMC and its affiliates, LMC is no longer writing new business and has been operating under a voluntary run-off plan approved by the Illinois Department of Insurance in 2004. “Run-off” is the professional management of an insurance company’s discontinued, distressed or non-renewed lines of insurance and associated liabilities outside of a judicial proceeding. Under the run-off plan, LMC has instituted aggressive expense control measures in order to reduce its future loss exposure and allow it to meet its obligations to current policyholders.

In the event that LMC is placed into receivership, a receiver may seek to recover certain payments made by LMC to us in connection with the Acquisition under applicable voidable preference and fraudulent transfer laws. However, we believe that there are factors that would mitigate the risk to us resulting from a potential voidable preference or fraudulent conveyance action brought by a receiver of LMC, including the fact that we believe LMC and KEIC were solvent at the time of the Acquisition and that the Acquisition was negotiated at arms length and for fair value, the fact that the Director of the Illinois Department of Insurance approved the Acquisition notwithstanding LMC’s financial condition and the fact that a substantial period of time has elapsed since the date of the Acquisition.

 
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In addition, if LMC is placed into receivership, various arrangements that we established with LMC in connection with the Acquisition, including the servicing arrangements, the commutation agreement, the adverse development cover, and the collateralized reinsurance trust, could be adversely affected. For a discussion of the risks relating to a potential LMC receivership, see the risks described under “Risks Related to Our Business — In the event LMC is placed into receivership, we could lose our rights to fee income and protective arrangements that were established in connection with the Acquisition, our reputation and credibility could be adversely affected and we could be subject to claims under applicable voidable preference and fraudulent transfer laws” in Part I, Item 1A of this annual report.

Competitive Strengths

We believe we enjoy the following competitive strengths:

 
Niche Product Offering.  Our specialized workers’ compensation insurance products in maritime, alternative dispute resolution (“ADR”) and selected state act markets enable us to address the needs of underserved markets. Our management team and staff have extensive experience serving the specific and complex needs of these customers.

 
Specialized Underwriting Expertise.  We identify individual risks with complex workers’ compensation needs, such as multi-jurisdictional coverage, and negotiate customized coverage plans to meet those needs. Our underwriting professionals average approximately 22 years of insurance industry experience.

 
Focus on Larger Accounts.  We target a relatively small number of larger, more safety-conscious employers (businesses with 50 to 400 employees) within our niche markets. We had over 1,640 customers with an average estimated annual premium size of approximately $177,000 at December 31, 2010 compared to approximately $198,000 at December 31, 2009, a reflection of lower premium rates in many jurisdictions, the continuing impact of a slow recovery from the economic recession and the expansion of our Alternative Markets and Small Maritime Program products (referred to as our “Program Business”). We believe this focus, together with our specialized underwriting expertise, increases the profitability of our book of business primarily because the more extensive loss history of larger customers enables us to better predict future losses, allowing us to price our policies more accurately. Our focus on larger accounts also enables us to provide individualized attention to our customers, which we believe leads to higher satisfaction and long-term loyalty.

 
Proactive Loss Control and Claims Management.  We consult with employers on workplace safety, accident and illness prevention and safety awareness training. We also offer employers medical and disability management tools that help injured employees return to work more quickly. These tools include access to a national network of physicians, case management nurses and a national discount pharmacy benefit program. Our strong focus on proven claims management practices helps minimize attorney involvement and expedites the settlement of valid claims. In addition, our branch office network affords us extensive local knowledge of claims and legal environments, further enhancing our ability to achieve favorable results on claims. As of December 31, 2010, approximately 99.0% of our total time loss claims were handled in-house as opposed to being handled by third-party administrators. Our claims managers and claims examiners are highly experienced, with an average of over 20 years in the workers’ compensation insurance industry.

 
Experienced Management Team.  The members of our senior management team, consisting of John G. Pasqualetto, Richard J. Gergasko, Scott H. Maw, Richard W. Seelinger, Marc B. Miller, M.D., D. Drue Wax, Esq., and Jeffrey C. Wanamaker, average over 23 years of insurance industry experience, and over 20 years of workers’ compensation insurance experience.

 
Strong Distribution Network.  We market our products through independent brokers and through PointSure. This two-tiered distribution system provides us with flexibility in originating premiums and managing our commission expense. PointSure produced approximately 23.8% of our direct premiums written in 2010 and 21.8% of our customers as of December 31, 2010. We are highly selective in establishing relationships with independent brokers. As of December 31, 2010, we had appointed 241 independent brokers to represent our products. In addition, we negotiate commissions for the placement of all risks that we underwrite, either through independent brokers or through PointSure. For the year ended December 31, 2010, our ratio of net commission expense to net premiums earned was 9.3% including business assumed from the National Council on Compensation Insurance, Inc., or NCCI, residual market pools.

 
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Strategy

We pursue profitable growth and favorable returns on equity through the following strategies:

 
Geographic Location.  We believe our experience with maritime coverage issues in the states in which we operate can be readily applied to other areas of the country that we do not currently serve. Ten states have enabling legislation for collectively bargained ADR that is similar to the ADR legislation in California. In 2008, we expanded our business by writing policies in several more of the approved states in which we are licensed to do business.

 
Expand Business in Target Markets.  Excluding approximately $4.4 million of direct premiums written under the Washington USL&H Plan, we wrote approximately 51.8% of our direct premiums in California, 10.8% in Louisiana and 5.9% in Alaska for the year ended December 31, 2010. Texas and Pennsylvania accounted for 5.6% and 3.3%, respectively, of our direct premiums written in 2010. Cash provided by operations has provided us with the necessary capital to enable us to increase the amount of insurance business that we are able to write in these and other markets. We believe that our product offerings, combined with our specialized underwriting expertise and niche market focus, have positioned us to increase our market share in our target markets when doing so is desirable.

 
We have also formed several operating divisions to focus on the development and expansion of business in several key niches. In 2007, we formed the Construction Division, headquartered in Needham, Massachusetts, to focus on providing construction project coverage on a per-project basis (commonly known as “wrap-ups”). In the first quarter of 2008, we formed a dedicated Energy Division, headquartered in Houston, Texas, to increase our presence in the national energy sector. In the second quarter of 2008, we formed the Alternative Markets Division, headquartered in Needham, Massachusetts, to seek opportunities to partner with select managing general agents who write Program Business, or large numbers of similar risks in a given industry group.

 
Increase Distribution and Leverage Key Relationships.  We are focusing our marketing efforts on developing relationships with brokers that have expertise in our product offerings. We also seek strategic partnerships with unions and union employers to increase acceptance of our ADR product in new markets.

 
Effectively Manage Overall Medical Claims Cost.  With the help of our Chief Medical Officer, we are working within medical provider networks to expand our own network of physicians that we believe will consistently produce the best outcome for injured workers and permit them to return to work more quickly. We believe this strategy enhances our profitability over time by reducing our overall claims cost.

 
Focus on Profitability.  We continue our focus on underwriting discipline and profitability by selecting risks prudently, pricing our products appropriately and focusing on larger accounts in our target markets.

 
Continue to Develop Scalable Technology.  Our in-house technology department has developed effective and customized analytical tools that we believe significantly enhance our ability to write profitable business and administer claims in a cost-effective manner. In addition, these tools allow for seamless connectivity with our branch offices. We intend to continue making investments in advanced and reliable technological infrastructure.

Customers

We currently provide workers’ compensation insurance to the following types of customers:

 
Maritime employers with complex coverage needs over land, shore and navigable waters. This involves underwriting liability exposures subject to various state and federal statutes and applicable maritime common law. Our customers in this market are engaged primarily in ship building and repair, pier and marine construction, stevedoring, offshore oil and gas development and exploration.
 
 
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Employers who are obligated to pay insurance benefits specifically under state workers’ compensation laws. We primarily target employers in states that we believe are underserved, such as the construction markets in California and Louisiana, and the states of Texas, Alaska and Florida.

 
Employers, particularly in the construction industry in California, who are party to collectively bargained workers’ compensation agreements that provide for settlement of claims out of court in a negotiated process.

State Act Customers

We provide workers’ compensation insurance to employers who are obligated to pay benefits to employees under state workers’ compensation laws. Approximately 81.1% of our state act business is written in California, Alaska, Pennsylvania, New Jersey and Texas. We provide coverage under state statutes that prescribe the benefits that employers are required to provide to their employees who may be injured in the course of their employment. Our policies are issued to employers. The policies provide payments to covered, injured employees of the policyholder for, among other things, temporary or permanent disability benefits, death benefits, medical benefits and hospital expenses. The benefits payable and the duration of these benefits are set by statute and vary by state and with the nature and severity of the injury or disease and the wages, occupation and age of the employee. We are one of a few insurance carriers that have a local claim office in Alaska and Hawaii and, as such, we do not need to rely on third party administrators in these two markets.

For the year ended December 31, 2010, we received approximately $147.5 million, or 57.3%, of our direct premiums written from state act customers. We define a state act customer as a customer whose exposure arises only under state workers’ compensation laws and is not a maritime customer or an ADR customer.

Maritime Customers

Providing workers’ compensation insurance to maritime customers with multi-jurisdictional liability exposures was the core of the business of Eagle Pacific Insurance Company, which began writing specialty workers’ compensation insurance over 25 years ago, and remains a key component of our business today. We are authorized by the U.S. Department of Labor to write maritime coverage under the USL&H Act in all federal districts, and believe, based primarily on the experience of our management team, that we are highly qualified underwriters in this niche in the United States. The USL&H Act is a federal law that provides benefits to any person engaged in maritime employment, including longshoreman or others engaged in long shoring operations and any harbor workers including shipbuilders, ship repairers and ship breakers. The employee’s injury or death must occur upon navigable waters of the United States, including any adjoining pier, wharf, dry dock, terminal, building way, marine railway or other adjoining area customarily used by an employer in loading, unloading, repairing, dismantling or building a vessel.

One of the coverage extensions that we provide under the USL&H Act is for exposures under the Outer Continental Shelf Lands Act (“OCSLA”). OCSLA is a federal workers’ compensation act that provides access to federal benefits to those offshore workers whose duties include research, exploration, development and extraction of natural resources from fixed platforms attached to the seabed of the Outer Continental Shelf.

In conjunction with our USL&H Act writings, we also underwrite Maritime Employers’ Liability coverage which falls under the Merchant Marine Act of 1920, more commonly known as the Jones Act. This tort liability coverage provides remedies to injured offshore workers, or qualified Jones Act seamen, and satisfies the maritime employer’s obligation to those employees. These remedies include an action against their employer for injuries arising from negligent acts of the employer or co-workers during the course of employment on a ship or vessel.

The availability of maritime coverage has declined in recent years due to several factors, including market tightening and insolvency of insurers providing this type of insurance. Offshore mutual organizations have increasingly become the default mechanism for insuring exposures for maritime employers due to the withdrawal of several traditional insurance carriers from this market segment. Maritime employers that obtain coverage through offshore mutual organizations are not able to rely on the financial security of a rated domestic insurance carrier. Accordingly, these employers are exposed to joint-and-several liability along with other members of the mutual organization. We offer maritime employers cost-competitive insurance coverage (usually under one policy) for liabilities under various state and federal statutes and applicable maritime common law without the uncertain financial exposure associated with joint-and-several liability. We believe we have very few competitors who focus on maritime employers with multi-jurisdictional liability exposures.

 
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For the year ended December 31, 2010, we received approximately $76.2 million, or 29.6%, of our direct premiums written from our maritime customers. We define a maritime customer as a customer whose total workers’ compensation exposure consists of at least 10% of maritime exposure. When we use the term maritime exposure in this annual report, we refer to exposure under the USL&H Act and its extensions, including the OCSLA, the Jones Act, or both. Not all of the gross premiums written from our maritime customers are for maritime exposures. For the year ended December 31, 2010, approximately 82.5% of our direct premiums written for maritime customers were for maritime exposures. Our experience writing maritime coverage attracts maritime customers for whom we can also write state act and ADR coverage.

Employers Party to Collectively Bargained Workers’ Compensation Agreements

We also provide workers’ compensation coverage for employers, particularly in the construction industry in California, that are party to collectively bargained workers’ compensation agreements with trade unions, also known as ADR programs. These programs use informal arbitration instead of litigation to resolve disputes out of court in a negotiated process. ADR insurance programs in California were made possible by legislation passed in 1993 and expanded by legislation passed in 2003. In 2003, these ADR programs became available to all unionized employees in California, where previously they were available only to unionized employees in the construction industry. We are recognized by 18 labor/management programs as authorized to provide coverage for employers that are party to collectively bargained workers’ compensation agreements with trade unions. We are aware of 11 states, including California, Florida and Hawaii, which have enabling legislation allowing for the creation of ADR collectively bargained workers’ compensation insurance programs. SeaBright has played an active role in gaining enabling legislation in some of these states, including Nevada.

The primary objectives of an ADR program are to reduce litigation costs, improve the quality of medical care, improve the delivery of benefits, promote safety and increase the productivity of union workers by reducing workers’ compensation costs. The ADR process is generally handled by an ombudsman, who is typically experienced in the workers’ compensation system. The ombudsman gathers the facts and evidence in a dispute and attempts to use his or her experience to resolve the dispute among the employer, employee and insurance carrier. If the ombudsman is unable to resolve the dispute, the case goes to mediation or arbitration.

ADR programs have had many positive effects on the California workers’ compensation process. For example, a 2009 study conducted by the California Workers’ Compensation Institute revealed that attorney involvement decreased by 35% for claims handled under ADR programs as opposed to claims handled under California’s statutory workers’ compensation system. We are one of the few insurance companies that offer this product in the markets that we serve.

For the year ended December 31, 2010, we received approximately $33.6 million, or 13.0%, of our direct premiums written from customers who participate in ADR programs. We define an ADR customer as any customer who pays us a premium for providing the customer with insurance coverage in connection with an ADR program. Not all of the gross premiums written from our ADR customers are for ADR exposures. Our experience writing ADR coverage attracts ADR customers for whom we can also write state act and maritime coverage. For the year ended December 31, 2010, approximately 58.5% of our direct premiums written for ADR customers were for ADR exposures. We believe we are a leading provider of the ADR product.

Customer Concentration

For the year ended December 31, 2010, our largest customer had annual direct premiums written of approximately $6.3 million, or 2.5% of our total direct premiums written. We are not dependent on any single customer, the loss of whom would have a material adverse effect on our business. For the year ended December 31, 2010, we had direct premiums written of $257.6 million, excluding premiums written under the Washington USL&H Plan. Our three largest customers had combined 2010 annual direct premiums written of $11.4 million, or 4.4%  of our total direct premiums written for the year ended December 31, 2010. We do not expect the size of our largest customers to increase significantly over time. Accordingly, as we grow in the future, we believe our largest customers will account for a decreasing percentage of our total direct premiums written.

 
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Distribution

We distribute our products primarily through independent brokers we have identified as having well-established maritime or construction expertise. As of December 31, 2010, we had a network of approximately 241 appointed insurance brokers. For the year ended December 31, 2010, no broker, excluding PointSure, accounted for more than 6.9% of our direct premiums written. We do not employ sales representatives and make limited use of third-party managing general agents in marketing to our Program Business customers (employers within homogenous classes, such as agriculture and health care). Our managing general agents do not have authority to underwrite, bind coverage or pay claims.

The licensed insurance brokers with whom we contract are compensated by a commission set as a percentage of premiums. Our standard broker agreement does not contain a commission schedule because all commissions are specifically negotiated as part of our underwriting process. Our ratio of net commissions to net premiums earned for the year ended December 31, 2010 was 9.3%. Brokers do not have authority to underwrite or bind coverage on our behalf, and they are contractually bound by our broker agreement.

We also distribute our products through PointSure, our licensed in-house wholesale insurance broker and third-party administrator. PointSure is a wholly-owned subsidiary of SeaBright. PointSure had approximately 2,372 sub-producer agreements as of December 31, 2010 compared to 2,702 as of December 31, 2009, representing a decrease of 12.2%. PointSure is authorized to act as an insurance broker in 50 states and the District of Columbia, under corporate licenses or licenses held by one of its officers. In addition to enhancing distribution for SeaBright Insurance Company, PointSure provides SeaBright Insurance Company with a cost-effective source of business. It provides the flexibility needed to avoid the costly and time consuming process of appointing brokers directly in both existing and new territories. For the year ended December 31, 2010 excluding premiums for the Washington USL&H Plan, PointSure’s direct premiums written with SeaBright Insurance Company were $61.3 million (23.8% of total direct premiums written) compared to $49.3 million in 2009 (17.5% of total direct premiums written), and $42.5 million in 2008 (16.4% of total direct premiums written).

PointSure acts in a variety of capacities for SeaBright Insurance Company and for third parties. PointSure provides SeaBright Insurance Company with marketing, sales, distribution, and some policyholder services for its brokers that are not directly appointed with SeaBright Insurance Company. PointSure also performs services for third parties unaffiliated with SeaBright. For example, PointSure acts as a third party administrator for self-insured employers and as a wholesale insurance broker for non-affiliated insurance companies. For these services, PointSure receives commissions from insurance carriers and/or brokerage fees on policies placed through PointSure. Incentive commissions may also be received from non-affiliated carriers based on the achievement of certain premium growth, retention and profitability objectives.
 
 
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The following table provides the geographic distribution of our risks insured as represented by direct premiums written by customer type for the year ended December 31, 2010, excluding premiums written under the Washington USL&H Plan which are ceded 100% back to the plan. See the discussion under the heading “Customers” in this Item 1 for an explanation of how we classify our customers. Not all direct premiums written from our maritime and ADR customers are for maritime and ADR exposures.
 
   
Direct Premiums Written In Year Ended December 31, 2010
 
State
 
Maritime
   
Alternative
Dispute
Resolution
   
 
State Act
   
 
General
Liability
   
Total
   
Percent of
Total
 
   
(Dollars in thousands)
 
Alaska
  $ 3,676     $ 113     $ 11,368     $     $ 15,157       5.9 %
California
    15,699       29,352       88,337             133,388       51.8 %
Connecticut
    535       1       3,052             3,588       1.4 %
Florida
    3,898       1,756       2,748             8,402       3.3 %
Hawaii
    1,936       1,014       2,718             5,668       2.2 %
Louisiana
    24,636       19       3,245             27,900       10.8 %
New Jersey
    1,143             6,357             7,500       2.9 %
Pennsylvania
    380       15       8,102             8,497       3.3 %
Texas
    8,742       99       5,516             14,357       5.6 %
Washington
    7,272             (51 )           7,221       2.8 %
All others
    8,280       1,192       16,113       354       25,939       10.0 %
Totals
  $ 76,197     $ 33,561     $ 147,505     $ 354     $ 257,617          
Percent of Total
    29.6 %     13.0 %     57.3 %     0.1 %     100.0 %        

Underwriting

We underwrite business on a guaranteed-cost basis. We also underwrite dividend and loss sensitive policies that make use of deductible and retrospective rating plans. Guaranteed cost plans allow for fixed premium rates for the term of the insurance policy. Although the premium rates are fixed, the final premium on a guaranteed cost plan will vary based on the difference between the estimated term payroll at the time the policy is issued and the final audited payroll after the policy expires. Dividend plans allow a policyholder to earn a cash dividend if its individual loss experience is lower than predetermined levels established at the inception of the policy. Policyholder dividends are payable only if declared by the Board of Directors of SeaBright Insurance Company. Loss sensitive plans, on the other hand, provide for a variable premium rate for the policy term. The variable premium is based on the customer’s actual loss experience for claims occurring during the policy period, subject to a minimum and maximum premium. The final premium for the policy may not be known for five to seven years or longer after the expiration of the policy. For business written on retrospective rating plans, the premium is recalculated at 12-month intervals beginning six months following expiration of the policy to reflect development on reported claims. Our loss sensitive plans allow our customers to choose to actively manage their insurance premium costs by sharing risk with us. For the year ended December 31, 2010 approximately 87.9% of our direct premiums written came from customers on guaranteed cost plans, 1.1% from customers on dividend plans and the remaining 11.0% from customers on loss sensitive plans.

We have developed small account programs that comprise less than 4% of our in-force estimated annual premium as of December 31, 2010.  These programs are available only for specified classes of business as determined by our underwriting management team.  Submissions are screened through a proprietary series of questions designed to identify acceptable exposures. Submissions which do not pass the screening process are either automatically declined or referred to a desk underwriter for further evaluation. Our underwriting strategy is to identify and target individual risks with specialized workers’ compensation needs. We negotiate individual coverage plans to meet those needs with competitive pricing and supportive underwriting, risk management and customer service. Our underwriting is tailored to each individual risk, and involves a financial evaluation, loss exposure analysis and review of management control and involvement. Each account that we underwrite is evaluated for its acceptability, coverage, pricing and program design. We make use of risk sharing (or loss sensitive) plans to align our interests with those of the insured. Our underwriting department monitors the performance of each account throughout the coverage period, and upon renewal, the profitability of each account is reviewed and integrated into the terms and conditions of coverage going forward.

 
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The underwriting of each piece of business begins with the selection process. Except for our small account programs, where submissions are entered into our proprietary system electronically by a limited number of producers as a result of our selection process, all of our underwriting submissions are initially sent to the local underwriting office based on the location of the insurance broker. A submission is an application for insurance coverage by a broker on behalf of a prospective policyholder. Our underwriting professionals screen each submission to ensure that the potential customer is an employer in a class of business that is among those that we have identified as being acceptable to us, such as a maritime employer, an employer involved in an ADR program, or an employer governed by a state workers’ compensation act with a record of successfully controlling high hazard workers’ compensation exposures. Except for our small account programs where our minimum premium requirements are as low as $10,000, the submission generally must meet a minimum premium size of $75,000 (higher for some classes of business) and must not involve operations prohibited by our underwriting guidelines. For example, we deem diving, ship breaking, employee leasing and asbestos and lead abatement to be prohibited operations that we generally do not insure. Once a submission passes the initial clearance hurdle, members of our loss control and underwriting departments jointly determine whether to accept the account. If our underwriting department preliminarily decides to accept the account, our loss control department conducts a prospect survey. We require a positive loss control survey before any piece of new business is bound, unless otherwise approved by our underwriting department management. Our loss control consultants independently verify the information contained in the submission and communicate with our underwriters to confirm the decision to accept the account.

We use a customized loss-rating model as the foundation for determining the premium adequacy on a particular account. We compare the loss history of each customer to the expected losses underlying the rates in each state and jurisdiction. Our loss projections are based on comparing actual losses to expected losses across multiple policy years. We estimate the annual premium by adding our expenses and profit to the loss projection selected by our underwriters. This process helps to ensure that the premiums we charge are adequate for the risk insured.

Our underwriting department is managed by experienced underwriters who specialize in the classes of business that we pursue. We have underwriting offices in Seattle, Washington; Orange, California; Anchorage, Alaska; Houston, Texas; Concord, California; Phoenix, Arizona; Lake Mary, Florida; Radnor, Pennsylvania; Chicago, Illinois; Needham, Massachusetts; and New Orleans, Louisiana. As of December 31, 2010, we had a total of 77 employees in our underwriting department, consisting of 49 underwriting professionals and 28 support-level staff members. Our underwriting professionals average approximately 22 years of insurance industry experience. We use audits and “authority letters” to help ensure the quality of our underwriting decisions. Our authority letters set forth the underwriting authority for each individual underwriting staff member based on their level of experience and demonstrated knowledge of the product and market. We also maintain a table of underwriting authority controls in our custom-built quote and issue system that are designed to alert underwriters of pricing and coverage conflicts that are outside their granted underwriting authority. These controls compare the underwriter’s authority for premium size, commission level, pricing deviation, premium plan design and coverage jurisdiction to the terms that are being proposed for the specific policyholder. Proposals that are outside an underwriter’s authority require appropriate review and approval from our senior underwriting personnel, allowing our senior underwriting personnel to mentor and manage the individual performance of our underwriters and to monitor the selection of new accounts.

Loss Control

We place a strong emphasis on our loss control function as an integral part of the underwriting process as well as a competitive differentiator. Our loss control department delivers risk level evaluations to our underwriters with respect to the degree of an employer’s management commitment to safety and acts as a resource for our customers to effectively promote a safe workplace and prevent losses. Our staff has extensive experience in insurance loss control and safety. Our loss control staff consists of 25 employees as of December 31, 2010, averaging 23 years of experience in the industry. We believe this experience benefits us by allowing us to serve our customers more efficiently and effectively. Specifically, we evaluate each customer’s safety program elements and key loss exposures, and provide explanations in an internal report to the appropriate underwriter. Our loss control staff prepares risk improvement recommendations as applicable and provides a loss control opinion of risk with supporting comments.

All policyholders have a designated assigned loss control resource. We prepare customized loss control service plans designed to prevent losses for designated policyholders based upon identified servicing needs, and work closely with those policyholders in a collaborative effort. A nationally recognized risk assessment contractor is utilized to conduct periodic risk inspections on a sampling of our smaller policyholders to assist with underwriting decisions and loss prevention efforts. Our corporate office “Loss Control Service Center” maintains a library of technical support materials, and provides periodic phone contacts to designated policyholders to supplement the field services provided by our staff. Policyholders have access to our web based safety publications consisting of Risky Business (safety newsletter), Supervisors’ Safety Updates, and Safety Meeting Outlines. Our web based BrightVIEW Interactive Loss Information System provides our loss control staff and policyholders with access to loss information, and offers a broad variety of loss reporting and sorting options to assist in loss analysis.

 
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Our loss control staff works closely with Marc B. Miller, M.D., our Chief Medical Officer, to assist our customers in developing tailored medical cost management strategies. We believe that by analyzing our loss data, our medical management needs and the current legal and regulatory environment, our Chief Medical Officer helps us reduce our payments for medical costs and improve the delivery of medical care to our policyholders’ employees.

We conduct large loss investigation visits on site for traumatic or fatal incidents whenever possible. Our loss control staff also conducts comprehensive re-evaluation visits prior to the expiration of a policy term on designated policies to assist the underwriter in making decisions on coverage renewal and risk improvement.

We have loss control staff located within, or in close proximity to, our offices in Anchorage, Alaska; Chicago, Illinois; Honolulu, Hawaii; Houston, Texas; New Orleans, Louisiana; Orange, California; Lake Mary, Florida; Radnor, Pennsylvania; Phoenix, Arizona; San Francisco, California; and Seattle, Washington. The majority of our loss control staff work from resident offices. A small network of well-vetted independent consultants provides supplemental loss control service support as needed.

Pricing

Our underwriting department determines expected ultimate losses for each of our prospective accounts and renewals using one of two customized loss-rating models developed by staff actuaries. These loss-rating models project expected losses for future policy periods by weighing expected losses underlying specific workers’ compensation class codes against our customer’s historical payroll and loss information. Our underwriting department uses these projections to produce an expected loss amount for each account. This loss amount provides the foundation for developing overall pricing terms for the account. After the ultimate expected losses are calculated, our underwriting department determines the appropriate premium for the risk after adding specific expense elements to the expected loss amount, including loss control expenses, commissions, reinsurance cost, taxes and underwriting margins.

We also own a customized pricing model developed completely in-house that we use to calculate insurance terms for our loss sensitive plans. This program uses industry-published excess loss factors and tables of insurance charges, as well as company-specific expenses, to calculate the appropriate pricing terms. As discussed above under the heading “Underwriting,” our loss sensitive plans align our interests with our customers’ interests by providing our customers with the opportunity to pay a premium that is lower (if they are able to keep their losses below an expected level) than the premium they would otherwise pay under a guaranteed cost plan. The premiums for our retrospectively rated loss sensitive plans are reflective of the customer’s loss experience because, beginning six months after expiration of the insurance policy and annually thereafter, we recalculate the premium for the policy term based on the current value of the known losses that occurred during the policy term. Because of the long duration of our loss sensitive plans, there is a risk that the customer will fail to pay additional premiums as they are billed in the years following policy expiration. Accordingly, we obtain collateral (typically in the form of letters of credit) to mitigate credit risk associated with our loss sensitive plans.

We monitor the overall price adequacy of all new and renewal policies using a weekly price monitoring report. Our rates upon renewal were up 2.5% and 0.1% in 2010 and 2009, respectively, and down 10.2% in 2008. The reductions in 2008 and prior were driven primarily by our California business, where rates have declined since 2004 as a result of reform legislation enacted primarily in 2003 and 2004. Following eight straight reductions, totaling 65.1%, in the advisory pure premium rates approved by the California Insurance Commissioner, in 2008, the California Insurance Commissioner approved a 5.0% rate increase effective January 1, 2009, which we adopted. The pure premium rates approved by the California Insurance Commissioner effective January 1, 2009 were 63.4% lower than the pure premium rates in effect as of July 1, 2003. More recent data has indicated the need for an increase in rates in California. The Workers’ Compensation Insurance Rating Bureau of California (the “WCIRB”) filed for rate changes on both July 1, 2009 and January 1, 2010 that were rejected by the California Insurance Commissioner. SeaBright Insurance Company filed for a 10.6% rate increase effective August 1, 2009 and a 15.3% rate increase effective September 1, 2010, which were approved by the California Department of Insurance.

 
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Claims

We believe we are particularly well qualified to handle multi-jurisdictional workers’ compensation claims. Our claims operation is organized around our unique product mix and customer needs. We believe that we can achieve quality claims outcomes because of our niche market focus, our local market knowledge and our superior claims handling practices. We have claims staff located in Seattle, Washington; Orange and Concord, California; Anchorage, Alaska; Phoenix, Arizona; Honolulu, Hawaii; Houston, Texas; Lake Mary, Florida; Chicago, Illinois; and Radnor, Pennsylvania. We also maintain resident claim examiners in San Diego, California, and Western Washington to better serve our client base.

Our maritime claims are handled by our Seattle, Washington and Houston, Texas offices. Upon completion of a thorough investigation, our maritime claims staff is able to promptly determine the appropriate jurisdiction for the claim and initiate benefit payments to the injured worker. We believe our ability to handle both USL&H Act and Jones Act claims in one integrated process results in reduced legal costs for our customers and improved benefit delivery to injured workers.

Claims for our California ADR product are handled by our Orange, California office. Claims for our Hawaii ADR product are handled by our Honolulu, Hawaii office and claims for our Florida ADR product are handled in our Lake Mary, Florida office. By centralizing these claims in key regional locations, we have developed tailored claims handling processes, systems and procedures. We believe this claims centralization also results in enhanced focus and improved claims execution.

Claims for our state act products are handled by our regional claims offices located in Anchorage, Alaska; Phoenix, Arizona; Honolulu, Hawaii; Orange and Concord, California; Houston, Texas; Chicago, Illinois; Lake Mary, Florida; and Radnor, Pennsylvania. We believe in maintaining a local market presence for our claims handling process. Our regional claims staff has developed a thorough knowledge of the local medical and legal community, enabling them to make more informed claims handling decisions.

We seek to maintain an effective claims management strategy through the application of sound claims handling practices. We are devoted to maintaining a quality, professional staff with a high level of technical proficiency. We practice a team approach to claims management, seeking to distribute each claim to the most appropriate level of technical expertise in order to obtain the best possible outcome. Our claims examiners are supported by claims assistants, at a ratio of approximately one claims assistant for every two claims examiners. Claims assistants perform a variety of routine tasks to assist our claims examiners. This support enables our claims examiners to focus on the more complex tasks associated with our unique products, including analyzing jurisdictional issues; investigating, negotiating and settling claims; considering causal connection issues; and managing the medical, disability, litigation and benefit delivery aspects of the claims process. We believe that it is critical for our claims professionals to have regular customer contact, to develop relationships with owners and risk management personnel of the employer and to be familiar with the activities of the employer.

Having a highly-experienced claims staff with manageable work loads is integral to our business model. Our claims staff is experienced in the markets in which we compete. As of December 31, 2010, we had a total of 72 employees in our claims department, including 50 claim management and technical staff and 22 support-level staff members. Our claims managers and examiners average 21 years of experience in the insurance industry and over 20 years of experience with workers’ compensation coverage.  In addition, our in-house claims examiners maintain manageable work loads so they can more fully investigate individual claims.

Our claims examiners are focused on early return to work, timely and effective medical treatment and prompt claim resolution. Newly-hired examiners are assigned to experienced supervisors who monitor all activity and decision making to verify skill levels. Like our underwriting department, we use audits and “authority letters” in our claims department to help ensure the quality of our claims decisions. The authority letters set forth the claims handling authority for each individual claims professional based on their level of experience and demonstrated knowledge of the product and market. We believe that our audits are a valuable tool in measuring execution against performance standards and the resulting impact on our business. Our home office audit function conducts an annual review of each claims office for compliance with our claims handling best practices, policies and procedures.

Our claims staff also works closely with Marc B. Miller, M.D., our Chief Medical Officer, to better manage medical costs. Our Chief Medical Officer performs a variety of functions for us, including providing counsel and direction on cases involving complex medical issues and assisting with the development and implementation of innovative medical cost management strategies tailored to the unique challenges of our market niches.

 
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We have an electronic claims management system that we believe enables us to provide prompt, responsive service to our customers. We offer a variety of claim reporting options, including telephone, facsimile, e-mail and online reporting from our website. This information flows into Compass, our automated claims management system.

In those states where we do not have claims staff, we have made arrangements with local third party administrators to handle state act claims only. As of December 31, 2010, approximately 99.0% of our time loss claims were being handled in-house as opposed to being handled by third-party administrators. To help ensure the appropriate level of claims expertise, we allow only our own claims personnel to handle maritime claims, regardless of where the claim occurs.

Until July 2008, Broadspire Services, a third-party claims administrator, handled losses associated with a small run-off book of KEIC business acquired in the Acquisition. “Run-off” is the professional management of an insurance company’s discontinued, distressed or non-renewed lines of insurance and associated liabilities outside of a judicial proceeding. In July 2008, we assumed the responsibility for servicing all remaining open claims. As of December 31, 2010, there were 40 open claims in the book of claims we acquired in the Acquisition, compared to 49 open claims at December 31, 2009. Outstanding loss reserves related to claims we assumed in the Acquisition totaled $3.1 million (gross) and $1.7 million (net of reinsurance) at December 31, 2010.

Loss Reserves

We maintain amounts for the payment of claims and expenses related to adjusting those claims. Unpaid losses are estimates at a given point in time of amounts that an insurer expects to pay for claims which have been reported and for claims which have occurred but are unreported. We take into consideration the facts and circumstances for each claim file as then known by our claims department, as well as actuarial estimates of aggregate unpaid losses and loss expenses.

Our unpaid losses consist of case amounts, which are for reported claims, and amounts for claims that have been incurred but have not yet been reported (“IBNR”) as well as adjustments to case amounts for ultimate expected losses. The amount of unpaid loss for reported claims is based primarily upon a claim-by-claim evaluation of coverage, liability or injury severity, and any other information considered pertinent to estimating the exposure presented by the claim. The amounts for unreported claims and unpaid loss adjustment expenses are determined using historical information, adjusted to current conditions using actuarial judgment. Unpaid loss adjustment expense is intended to cover the ultimate cost of settling claims, including investigation and defense of lawsuits resulting from such claims. The amount of loss reserves is determined by us on the basis of industry information, historical loss information and anticipated future conditions. A loss reserve committee, comprised of senior executives from our Executive, Actuarial, Underwriting, Claims and Finance departments, meets quarterly to review our loss reserves and to make necessary recommendations regarding such amounts. Although we review our loss reserve estimates on a quarterly basis and believe that our estimates at any point in time are reasonable and appropriate, loss reserves are estimates and are inherently uncertain; they do not and cannot represent an exact measure of liability. For further discussion of the considerations and methodology relating to the estimation of our loss reserves, see the related discussion under the heading “Critical Accounting Policies, Estimates and Judgments — Unpaid Loss and Loss Adjustment Expense” in Part II, Item 7 of this annual report.

 
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Reconciliation of Loss Reserves

The table below shows the reconciliation of our loss reserves on a gross and net basis for the periods indicated, reflecting changes in losses incurred and paid losses.
 
 
 
Year Ended December 31,
 
 
 
2010
   
2009
   
2008
 
   
(In thousands)
 
Beginning balance:
                 
Unpaid loss and loss adjustment expense
  $ 351,890     $ 292,027     $ 250,085  
Reinsurance recoverables
    (34,080 )     (18,231 )     (14,034 )
Net balance, beginning of year
    317,810       273,796       236,051  
Incurred related to:
                       
Current year
    191,034       174,566       168,559  
Prior years
    31,971       (1,411 )     (24,978 )
Total incurred
    223,005       173,155       143,581  
Receivable under adverse development cover
    45       1,169       (1,646 )
Total incurred
    223,050       174,324       141,935  
Paid related to:
                       
Current year
    (47,803 )     (45,331 )     (42,253 )
Prior years
    (108,443 )     (83,810 )     (63,583 )
Total paid
    (156,246 )     (129,141 )     (105,836 )
Receivable under adverse development cover
    (45 )     (1,169 )     1,646  
Net balance, end of year
    384,569       317,810       273,796  
Reinsurance recoverables
    56,350       34,080       18,231  
Unpaid loss and loss adjustment expense
  $ 440,919     $ 351,890     $ 292,027  
 
Our practices for determining loss reserves are designed to set amounts that in the aggregate are adequate to pay all claims at their ultimate settlement value. Our loss reserves are not discounted for interest or other factors. For a discussion of the development of our loss reserves, see the discussion under Note 9, “Unpaid Loss and Loss Adjustment Expense” in Part II, Item 8 of this annual report.

The figures in the above table include the development of the KEIC loss reserves. See the discussion under the heading “Our History” in this Item 1. Prior to the Acquisition, KEIC had a limited operating history writing small business workers’ compensation policies in California and had established loss reserves in the amount of approximately $16.0 million for these policies at September 30, 2003. In an effort to minimize our exposure to this past business underwritten by KEIC and any adverse developments to KEIC’s loss reserves as they existed at the date of the Acquisition, we entered into various protective arrangements in connection with the Acquisition, including the adverse development cover and the collateralized reinsurance trust. For a discussion of the development of KEIC’s loss reserves and related matters, see the discussion under the heading “Loss Reserves — KEIC Loss Reserves” in this Item 1.

SeaBright Insurance Company Loss Reserves

SeaBright Insurance Company began writing insurance policies on October 1, 2003. Shown below is the loss development related to policies written from 2003 through 2010. The first line of the table shows, for the years indicated, the gross liability including the incurred but not reported losses as originally estimated. For example, as of December 31, 2004 it was estimated that $46.0 million would be sufficient to settle all claims not already settled that had occurred through that date, whether reported or unreported. The next section of the table shows, by year, the cumulative amounts of loss reserves paid as of the end of each succeeding year. For example, with respect to the gross loss reserves of $46.0 million as of December 31, 2004, by December 31, 2010 (six years later) $30.7 million had actually been paid in settlement of the claims which pertain to the liabilities as of December 31, 2004. The next section of the table sets forth the re-estimates in later years of incurred losses, including payments, for the years indicated. For example, with respect to the gross loss reserves of $46.0 million as of December 31, 2004, $41.2 million is the re-estimated gross loss reserve, including payments, as of December 31, 2010.

The “cumulative redundancy/(deficiency)” represents, as of December 31, 2010, the difference between the latest re-estimated liability and the amounts as originally estimated. A redundancy means the original estimate was higher than the current estimate; a deficiency means that the current estimate is higher than the original estimate. For example, with respect to the gross loss reserves of $46.0 million as of December 31, 2004, $4.8 million is the cumulative redundancy as of December 31, 2010.

 
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Analysis of SeaBright Loss Reserve Development
 
   
Year Ended December 31,
 
   
2003
   
2004
   
2005
   
2006
   
2007
   
2008
   
2009
   
2010
 
   
(In thousands)
 
Gross liability as originally estimated:
  $ 2,054     $ 45,981     $ 124,713     $ 184,253     $ 236,822     $ 281,520     $ 344,075     $ 434,214  
Gross cumulative payments as of:
                                                               
One year later
    609       11,693       25,691       40,166       63,306       84,457       111,437          
Two years later
    1,087       18,814       40,259       64,146       102,961       144,252                  
Three years later
    1,574       23,456       50,447       81,907       130,942                          
Four years later
    1,685       27,354       57,722       93,234                                  
Five years later
    1,803       29,536       61,525                                          
Six years later
    1,914       30,725                                                  
Seven years later
    2,046                                                          
Gross liability re-estimated as of:
                                                               
One year later
    2,819       43,125       100,952       149,039       217,567       288,233       380,882          
Two years later
    3,453       36,779       86,850       142,476       214,961       308,715                  
Three years later
    3,336       38,207       87,535       137,603       224,571                          
Four years later
    3,354       41,464       85,062       141,461                                  
Five years later
    3,409       40,854       87,001                                          
Six years later
    3,334       41,184                                                  
Seven years later
    3,576                                                          
Cumulative redundancy/(deficiency):
    (1,522 )     4,797       37,712       42,792       12,251       (27,195 )     (36,807 )        

The $36.8 million of adverse development on 2009 gross reserves was primarily due to increases in underlying direct reserves, partially offset by redundancies recognized in our unallocated loss adjustment expense (“ULAE”), loss based assessment and NCCI pool reserves. Of the total $36.8 million of adverse development, $16.3 million related to accident year 2009, consisting of a $17.1 million increase to underlying direct reserves, offset by a $0.8 million reduction to ULAE, loss based assessment and NCCI Pool reserves. For accident year 2008, we had $10.9 million of adverse development, consisting of an $11.3 million increase to underlying direct reserves, offset by a $0.4 million reduction to ULAE, loss based assessment and NCCI pool reserves. For accident year 2007, we had $5.8 million of adverse development, consisting of a $5.9 million increase to underlying direct reserves, offset by $0.1 million reduction to ULAE, loss based assessment and NCCI Pool reserves.  For accident years 2006 and prior, the adverse development on direct reserves was $3.8 million.

Of the total $27.2 million of adverse development on 2008 gross reserves, $20.2 million related to accident year 2008, consisting of a $25.0 million increase to underlying direct reserves, offset by a $4.8 million reduction to ULAE, loss based assessment and NCCI Pool reserves. For accident year 2007, we had $8.0 million of adverse development, consisting of a $12.3 million increase to underlying direct reserves, offset by a $4.3 million reduction to ULAE, loss based assessment and NCCI Pool reserves. For accident years 2006 and prior, we had $1.0 million of favorable development, consisting of a $5.1 million increase to underlying direct reserves, offset by a $6.1 million reduction to ULAE, loss based assessment and NCCI pool reserves. For further discussion of the considerations and methodology relating to the estimation of our unpaid loss and loss adjustment expenses, see the related discussion under the heading “Critical Accounting Policies, Estimates and Judgments — Unpaid Loss and Loss Adjustment Expense” in Part II, Item 7 of this annual report.

 
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KEIC Loss Reserves

Shown below is the loss development from 2000 through 2010 related to KEIC policies written from 2000 through 2002. The last direct policy written by KEIC was effective in May 2002 and expired in May 2003. KEIC has claim activity in accident years 2000, 2001, 2002 and 2003.

Analysis of KEIC Loss Reserve Development

   
Year Ended December 31,
 
   
2000
   
2001
   
2002
   
2003
   
2004
   
2005
   
2006
   
2007
   
2008
   
2009
   
2010
 
   
(In thousands)
 
Gross liability as originally estimated:
  $ 3,258     $ 14,458     $ 30,748     $ 27,677     $ 22,248     $ 17,497     $ 14,126     $ 13,261     $ 10,508     $ 7,818     $ 6,706  
Gross cumulative payments as of:
                                                                                       
One year later
    723       7,525       (4,130 )     6,815       4,822       2,998       2,184       1,843       900       859          
Two years later
    2,070       4,443       2,283       11,637       7,820       5,182       4,027       2,743       1,759                  
Three years later
    1,438       8,107       6,884       14,635       10,004       7,025       4,927       3,602                          
Four years later
    1,792       10,312       9,651       16,819       11,847       7,925       5,786                                  
Five years later
    2,304       11,701       11,552       18,662       12,747       8,784                                          
Six years later
    2,584       12,646       13,314       19,562       13,606                                                  
Seven years later
    2,712       13,408       14,134       20,421                                                          
Eight years later
    2,858       13,840       14,917                                                                  
Nine years later
    2,901       14,389                                                                          
Ten years later
    2,970                                                                                  
Gross liability re-estimated as of:
                                                                                       
One year later
    3,013       19,562       23,374       29,063       23,319       17,124       15,445       12,351       8,718       7,565          
Two years later
    3,426       17,523       23,321       29,134       21,946       18,444       14,535       10,561       8,465                  
Three years later
    3,329       18,138       23,739       28,761       23,266       17,533       12,745       10,308                          
Four years later
    3,235       19,068       23,136       30,081       22,355       15,743       12,492                                  
Five years later
    3,394       18,465       24,237       29,170       20,565       15,490                                          
Six years later
    3,391       18,666       22,878       27,380       20,312                                                  
Seven years later
    3,798       18,757       21,378       27,127                                                          
Eight years later
    4,004       17,816       21,190                                                                  
Nine years later
    3,498       17,846                                                                          
Ten years later
    3,413                                                                                  
Cumulative redundancy/(deficiency):
    (155 )     (3,388 )     9,558       550       1,936       2,007       1,634       2,953       2,043       253          

The acquired book of business related to KEIC had gross reserves of $6.7 million as of December 31, 2010. These reserves represent a potential liability to us if the protective arrangements that we have established prove to be inadequate. Our initial source of protection is our external reinsurance, which is described under the heading “Reinsurance” in this Item 1. The total reserves net of external reinsurance at December 31, 2010 were $3.6 million. The ceded reserves of $3.1 million as of December 31, 2010 are subject to collection from our external reinsurers. To the extent we are not able to collect on our reinsurance recoverables, these liabilities become our responsibility. See the discussion under the heading “Risks Related to Our Business — Our loss reserves are based on estimates and may be inadequate to cover our actual losses” in Part I, Item 1A of this annual report.

The net reserves as of December 31, 2010 of $3.6 million are subject to the various protective arrangements that we entered into in connection with the Acquisition. Prior to the Acquisition, KEIC had a limited operating history in California writing small business workers’ compensation policies with an average annual premium size of approximately $4,100 per customer. KEIC had established loss reserves in the amount of approximately $16.0 million for these policies at September 30, 2003. In light of the deteriorating financial condition of LMC and its affiliates, we entered into a number of protective arrangements in connection with the Acquisition for the purpose of minimizing our exposure to this past business underwritten by KEIC and any adverse developments to KEIC’s loss reserves as they existed at the date of the Acquisition. One of our primary objectives in establishing these arrangements was to create security at the time of the Acquisition with respect to LMC’s potential obligations to us as opposed to having a mere future contractual right against LMC with respect to these obligations. The protective arrangements we established included a commutation agreement, an adverse development cover and a collateralized reinsurance trust.

Commutation Agreement.  Prior to the Acquisition, LMC and KEIC had entered into a reinsurance agreement requiring LMC to reinsure 80% of certain risks insured by KEIC in exchange for a premium paid to LMC. To help insulate us from the effects of a potential insolvency of LMC and the possibility that LMC may not continue to have the ability to make reinsurance payments to KEIC in the future, in connection with the Acquisition, KEIC entered into a commutation agreement with LMC to terminate the previously established reinsurance agreement. Under the commutation agreement, LMC paid us approximately $13.0 million in cash in exchange for being released from its obligations under the reinsurance agreement, and KEIC reassumed all of the risks previously reinsured by LMC.

Adverse Development Cover.  At the time of the Acquisition and after the commutation agreement, KEIC had loss reserves in the amount of approximately $16.0 million. In connection with the Acquisition, we entered into an agreement with LMC under which we both agreed to indemnify each other with respect to development of these loss reserves over a period of approximately eight years. 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. If the loss reserves have increased, LMC must indemnify us in the amount of the increase. If they have decreased, we must indemnify LMC in the amount of the decrease.

 
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Collateralized Reinsurance Trust.  Because of the poor financial condition of LMC and its affiliates, we required LMC to fund a trust account in connection with the Acquisition. The funds in the trust account serve as current security for potential future obligations of LMC under the adverse development cover. 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, requiring LMC to fund additional amounts into the trust account on a quarterly basis, if necessary, based on a quarterly review of LMC’s obligations. We are entitled to access the funds in the trust account from time to time to satisfy LMC’s obligations under the adverse development cover in the event that LMC fails to satisfy its obligations.

As of December 31, 2010, we had recorded a receivable of approximately $3.0 million for adverse loss development under the adverse development cover since the date of the Acquisition. The balance in the trust account, including accumulated interest, totaled approximately $3.8 million at December 31, 2010. We continue to assess the reasonableness of reserves related to this business and believe that the trust balance at December 31, 2010 is adequate to cover LMC’s present liability to us for adverse development.

Due to the distressed financial condition of LMC and its affiliates, LMC is no longer writing new business and is now operating under a voluntary run-off plan which has been approved by the Illinois Department of Insurance. If LMC is placed into receivership, various of the protective arrangements, including the adverse development cover, the collateralized reinsurance trust and the commutation agreement, could be adversely affected. If LMC is placed into receivership and the amount held in the collateralized reinsurance trust is inadequate to satisfy the obligations of LMC to us under the adverse development cover, it is unlikely that we would recover any future amounts owed by LMC to us under the adverse development cover in excess of the amounts currently held in trust because the director of the Illinois Department of Insurance would have control of the assets of LMC. In addition, it is possible that a receiver or creditor could assert a claim seeking to unwind or recover the $13.0 million payment made by LMC to us under the commutation agreement or the funds deposited by LMC into the collateralized reinsurance trust under applicable voidable preference or fraudulent transfer laws. See “Risks Related to Our Business — In the event LMC is placed into receivership, we could lose our rights to fee income and protective arrangements that were established in connection with the Acquisition, our reputation and credibility could be adversely affected and we could be subject to claims under applicable voidable preference and fraudulent transfer laws” in Part I, Item 1A of this annual report.

If LMC is placed into receivership in the near future, we will be responsible for the amount of any adverse development of KEIC’s loss reserves in excess of the collateral that is then currently available to us, including the $3.8 million on deposit as of December 31, 2010 and any future amounts deposited in the collateralized reinsurance trust. For example, if LMC is placed into receivership at a time when the amount on deposit in the collateralized reinsurance trust is deficient by $1.0 million, we would have to absorb that amount. Because the $13.0 million that we received under the commutation agreement was not discounted for present value at the time of payment, the earnings on these funds, if any, will help us to absorb any adverse development on KEIC’s loss reserves in excess of amounts on deposit under the collateralized reinsurance trust. We believe that there are several factors that would mitigate the risk to us resulting from a potential voidable preference or fraudulent conveyance action brought by a receiver, but if a receiver is successful under applicable voidable preference and fraudulent transfer laws in recovering from us the collateral that we received in connection with the Acquisition, those funds would not be available to us to offset any adverse development in KEIC’s loss reserves. See “Our History — Issues Relating to a Potential LMC Receivership” in this Item 1.

Investments

We derive investment income from our invested assets. We invest our statutory surplus and funds to support our loss reserves and our unearned premiums. As of December 31, 2010, the amortized cost of our investment portfolio was $665.8 million and the fair value of the portfolio was $673.0 million.

 
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The following table shows the fair values of various categories of invested assets, the percentage of the total fair value of our invested assets represented by each category and the tax equivalent book yield based on the fair value of each category of invested assets as of December 31, 2010.

Category
 
Fair Value
   
Percent of
Total
   
Yield
 
   
(In thousands)
       
Fixed income securities:
                 
U.S. Treasury securities
  $ 26,977       4.0 %     2.7 %
Government sponsored agency securities
    24,071       3.6       3.9  
Corporate securities
    156,269       23.2       4.0  
Tax-exempt municipal securities
    310,712       46.2       4.7  
Mortgage pass-through securities
    75,304       11.2       4.1  
Collateralized mortgage obligations
    17,465       2.6       2.4  
Asset-backed securities
    62,170       9.2       3.7  
Total investment securities available-for-sale
  $ 672,968       100.0 %     4.2 %

The average credit rating for our fixed maturity portfolio at December 31, 2010, using ratings assigned by Standard and Poor’s, was AA. The following table shows the ratings distribution of our fixed income portfolio as of December 31, 2010, as a percentage of total fair value.

 
 
Rating
 
Percentage of
Total Fair
Value
 
“AAA”
    39.0 %
“AA”
    36.0  
“A”
    17.0  
“BBB”
     8.0  
Total
    100.0 %

The following table shows the composition of our fixed income securities by remaining time to maturity at December 31, 2010. For securities that are redeemable at the option of the issuer and have a market price that is greater than par value, the maturity used for the table below is the earliest redemption date. For securities that are redeemable at the option of the issuer and have a market price that is less than par value, the maturity used for the table below is the final maturity date. For mortgage-backed securities, mortgage prepayment assumptions are utilized to project the expected principal redemptions for each security, and the maturity used in the table below is the average life based on those projected redemptions.
 
 
 
Remaining Time to Maturity
 
 
 
Fair Value
   
Percentage of
Total
Fair Value
 
   
(In thousands)
       
Due in one year or less
  $ 16,016       2.4 %
Due after one year through five years
    190,837       28.4  
Due after five years through ten years
    271,070       40.2  
Due after ten years
    40,106       6.0  
Securities not due at a single maturity date
    154,939       23.0  
Total fixed income securities available-for-sale
  $ 672,968       100.0 %

Our investment strategy is to conservatively manage our investment portfolio by investing primarily in readily marketable, investment grade fixed income securities. Our investment portfolio is managed by a registered investment advisory firm. We pay a variable fee based on assets under management. Our Board of Directors has established investment guidelines and periodically reviews portfolio performance for compliance with our guidelines. Our investment policy currently allows for investment of at least 90% of the portfolio in core investment grade fixed income securities, up to 7.5% in common stocks (up to 6% domestic and 1.5% international) and up to 5% in convertible securities. Our investment policy contains additional limitations and guidelines relating to, for example, sector diversification, duration and credit rating.

We regularly review our investment portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. A number of criteria are considered during this process, including but not limited to the following: whether we intend to sell the security; 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; the likelihood that we will be required to sell the security before recovery of its cost basis; specific credit issues related to the issuer; and current economic conditions, including interest rates.

 
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In general, we review all securities that are impaired by 5% or more at the end of the period. We focus our review of securities with no stated maturity date on securities that were impaired by 20% or more at the end of the period or have been impaired 10% or more continuously for six months or longer as of the end of the period. We also analyze the entire portfolio for other factors that might indicate a risk of impairment, including credit ratings, liquidity of the issuer and interest rates. If a decline in value is deemed temporary, we record the decline as an unrealized loss in other comprehensive income (loss) on our consolidated statements of changes in stockholders’ equity and comprehensive income and in accumulated other comprehensive income (loss) on our consolidated balance sheets. If declines in fair value are deemed “other than temporary,” we write down the carrying value of the investment and record a realized loss in our consolidated statements of operations for the credit loss component and record the amount due to all other factors in other comprehensive income. Significant changes in the factors considered when evaluating investments for impairment losses, such as those described above, could result in a significant change in impairment losses reported in the financial statements.

In 2010, there were no other-than-temporary impairment charges. As of December 31, 2010, no security had a fair value less than 80% of its amortized cost or cost. As of December 31, 2010, the net unrealized gain on our investment portfolio totaled $7.2 million ($15.0 million gross unrealized gains and $7.8 million gross unrealized losses) compared to net unrealized gains of $18.4 million ($20.6 million gross unrealized gains and $2.2 million gross unrealized losses) as of December 31, 2009. We recognized other-than-temporary impairment charges of approximately $0.3 million in 2009 and $10.2 million in 2008 on our investments in preferred stocks (nearly all of which were issued by Fannie Mae and Freddie Mac) and approximately $3.2 million in 2008 on our investment in equity indexed securities exchange-traded funds.

Despite recording no impairment losses in 2010, it is possible that we could recognize future impairment losses on some securities we owned at December 31, 2010 if future events, information and the passage of time result in a determination that a decline in value is other-than-temporary.

We had no direct exposure to sub-prime mortgage exposure in our investment portfolio as of December 31, 2010 and $9.1 million of indirect exposure to sub-prime mortgages. As of December 31, 2010, our portfolio included $113.2 million of insured municipal bonds and $219.2 million of uninsured municipal bonds. For further information about our investment portfolio, please see the related discussion under the heading “Liquidity and Capital Resources” in Part II, Item 7 of this annual report.

Reinsurance

We purchase reinsurance to reduce our net liability on individual risks and to protect against possible catastrophes. Reinsurance involves an insurance company transferring, or “ceding,” a portion of its exposure on a risk to another insurer, the reinsurer. The reinsurer assumes the exposure in return for a portion of the premium. The cost and limits of reinsurance we purchase can vary from year to year based upon the availability of quality reinsurance at an acceptable price and our desired level of retention, or the amount of risk that we retain for our own account. In excess of loss reinsurance, losses in excess of the retention level up to the upper limit of the program, if any, are paid by the reinsurer.

Regardless of type, reinsurance does not legally discharge the ceding insurer from primary liability for the full amount due under the reinsured policies. However, the assuming reinsurer is obligated to indemnify the ceding company to the extent of the coverage ceded. To reduce our risk of the possibility of a reinsurer becoming unable to fulfill its obligations under the reinsurance contracts, we select financially strong reinsurers with an A.M. Best rating of “A” (Excellent) or better and continue to evaluate their financial condition and monitor various credit risks to minimize our exposure to losses from reinsurer insolvencies. All of the reinsurers included in our current excess-of-loss reinsurance program at December 31, 2010 had A.M. Best ratings of “A” or higher.

Our Excess of Loss Reinsurance Treaty Program

Excess of loss reinsurance is reinsurance that indemnifies the reinsured against all or a specified portion of losses on underlying insurance policies in excess of a specified amount, which is called an “attachment level” or “retention.” Excess of loss reinsurance may be written in layers, in which a reinsurer or group of reinsurers accepts a band of coverage up to a specified amount. Any liability exceeding the upper limit of the program reverts to the ceding company, or the company seeking reinsurance. The ceding company also bears the credit risk of a reinsurer’s insolvency. In the ordinary course of our business, we entered into new reinsurance agreements with nonaffiliated reinsurers wherein we reinsure losses between $0.25 million per occurrence and $100.0 million per occurrence, subject to various limits, deductibles and exclusions as more fully explained below.  The program provides coverage for losses occurring between October 1, 2010 and September 30, 2011 for business written by us and classified as workers’ compensation, employers’ liability and maritime employers’ liability, except in the case of the fifth through eighth layers, when classified by us as ocean marine. The third, fourth and fifth layers also include general liability coverage. All layers exclude our NCCI residual market assumed business. In order for coverage to attach, we must report all losses to our reinsurers before October 1, 2018 or, in the case of general liability losses, by October 1, 2021. We have reviewed the terms of our excess of loss reinsurance treaties and have concluded that they provide sufficient transfer of risk and meet other requirements necessary to qualify them for reinsurance accounting under the Insurance Activities Topic of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”).
 
 
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The first reinsurance layer affords coverage up to $0.25 million for each loss occurrence in excess of $0.25 million for each loss occurrence, subject to an aggregate deductible of $5.0 million. The aggregate limit for all claims under the first layer is $30.0 million. In addition, under the first layer of reinsurance, there is a sub-limit of $1.0 million for losses caused by foreign acts of terrorism, as defined in the Terrorism Risk Insurance Act of 2002, as extended and amended by the Terrorism Risk Insurance Extension Act of 2005 and the Terrorism Risk Insurance Program Reauthorization Act of 2007 (collectively referred to in this annual report as the “Terrorism Risk Act”); and maximum employer’s liability policy limits of $1.0 million ($2.0 million in Hawaii), or $5.0 million where case law provides for unlimited coverage.

The second layer, for which we are 75% reinsured, affords coverage up to $0.5 million for each loss occurrence in excess of $0.5 million for each loss occurrence. The aggregate limit for all claims under the second layer is $17.0 million. In addition, under the second layer of reinsurance, there is a sub-limit of $1.5 million for losses caused by foreign acts of terrorism, as defined in the Terrorism Risk Act, and  maximum employer’s liability policy limits of $1.0 million ($2.0 million in Hawaii), or $5.0 million where case law provides for unlimited coverage.

The third layer affords coverage up to $1.0 million for each loss occurrence in excess of $1.0 million for each loss occurrence. The aggregate limit for all claims under the third layer is $10.0 million. In addition, the third layer has a sub-limit of $2.0 million for losses caused by foreign acts of terrorism, as defined in the Terrorism Risk Act; a sub-limit of $1.0 million for losses caused by occupational disease or other disease or cumulative trauma; maximum employer’s liability policy limits of $1.0 million ($2.0 million in Hawaii), or $5.0 million where case law provides for unlimited coverage; and a sub-limit of $1.0 million per policy, per occurrence for general liability losses.

The fourth layer affords coverage up to $3.0 million for each loss occurrence in excess of $2.0 million for each loss occurrence. The aggregate limit for all claims under the fourth layer is $12.0 million. In addition, the fourth layer has a sub-limit of $6.0 million for losses caused by foreign acts of terrorism, as defined in the Terrorism Risk Act; maximum employer’s liability policy limits of $1.0 million ($2.0 million in Hawaii), or $5.0 million where case law provides for unlimited coverage; and a sub-limit of $2.0 million per policy, per occurrence for general liability losses.

The fifth layer affords coverage up to $5.0 million for each loss occurrence in excess of $5.0 million for each loss occurrence. The aggregate limit for all claims under the fifth layer is $15.0 million.  In addition, the fifth layer has a sub-limit of $5.0 million for losses caused by foreign acts of terrorism, as defined in the Terrorism Risk Act and a sub-limit of $2.0 million per policy, per occurrence for general liability losses.

The sixth, seventh and eighth layers in our excess of loss reinsurance treaty program afford coverage up to $90.0 million for each loss occurrence in excess of $10.0 million.  The sixth layer affords coverage up to $10.0 million for each loss occurrence in excess of $10.0 million for each loss occurrence, subject to an aggregate limit of $20.0 million. The sixth layer has a sub-limit of $10.0 million for losses caused by foreign acts of terrorism, as defined in the Terrorism Risk Act. The seventh layer affords coverage up to $30.0 million for each loss occurrence in excess of $20.0 million for each loss occurrence, subject to an aggregate limit of $60.0 million. The seventh layer has a sub-limit of $30.0 million for losses caused by foreign acts of terrorism, as defined in the Terrorism Risk Act. The eighth layer affords coverage up to $50.0 million for each loss occurrence in excess of $50.0 million, subject to an aggregate limit of $100.0 million. The eighth layer has a sub-limit of $50.0 million for losses caused by foreign acts of terrorism, as defined in the Terrorism Risk Act. Under the sixth, seventh and eighth layers, the maximum amount applicable to the ultimate net loss for any one loss suffered by any one employee is $10.0 million.

 
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Under the reinsurance treaty program, we are required to pay our reinsurers an aggregate deposit premium of approximately $29.5 million for the term of the agreements. The agreements for the first, second, third, fourth and fifth layers in our excess of loss reinsurance treaty program have profit-sharing provisions allowing us to commute the treaties, solely at our discretion and within 24 months following expiration, in return for payment by the reinsurers of a portion of the reinsurers’ profit on the treaty, calculated according to the terms of the contract. For example, during 2010, we commuted the third layer (covering losses from $5.0 million to $10.0 million) of our 2007-2008 reinsurance program in return for a profit commission of approximately $0.6 million from the reinsurers. As part of the commutation, we assume all losses occurring in that treaty year with incurred amounts between $5.0 million and $10.0 million. In 2009, we commuted the treaty covering losses from $5.0 million to $10.0 million in our 2006-2007 reinsurance program in return for a profit commission of approximately $0.6 million. In addition, under each layer of our reinsurance treaty program, we are required to pay to our reinsurers the pro rata share of the amount, if any, by which any financial assistance paid to us under the Terrorism Risk Act for acts of terrorism occurring during any one program year, combined with our total private-sector reinsurance recoveries for those acts of terrorism, exceeds the amount of insured losses paid by us for those acts of terrorism.

Under each layer of our reinsurance treaty program, we may terminate any reinsurer’s share under the applicable agreement at any time by giving written notice to the reinsurer under certain circumstances, including if the reinsurer’s A.M. Best rating is downgraded below “A-” and/or its Standard & Poor’s rating is downgraded below “BBB+”. As of December 31, 2010, there had been no such downgrades of reinsurers in our current reinsurance treaty program. Each layer of our reinsurance treaty program includes various exclusions in addition to the specific exclusions described here, including an exclusion for war in specified circumstances, an exclusion for reinsurance assumed and exclusions for losses with respect to biological, chemical, radioactive or nuclear explosion, pollution, contamination or fire.

Please refer to Note 8, “Reinsurance” of the consolidated financial statements in Part II, Item 8 of this annual report for a listing of participants in our current excess of loss reinsurance treaty program and a listing of our top ten reinsurers, based on net amount recoverable, as of December 31, 2010.

Reinsurance Arrangements Established in Connection with Past Transactions

In addition to the reinsurance program described above, we have existing reinsurance arrangements which were established in connection with past transactions into which we have entered. In March 2002, KEIC sold the assets and business of its commercial compensation specialty operation to Argonaut Insurance Company. In connection with the sale, KEIC entered into a reinsurance agreement effective March 31, 2002 with Argonaut pursuant to which KEIC ceded and Argonaut assumed a 100% quota share participation in the transferred insurance policies. Certain reinsurance-type arrangements, including the commutation agreement and the adverse development cover, were also established with LMC in connection with the Acquisition. See “Loss Reserves — KEIC Loss Reserves” in this Item 1.

Terrorism Reinsurance

As extended and amended, the Terrorism Risk Act is effective through December 31, 2014. The Terrorism Risk Act may provide us with reinsurance protection under certain circumstances and subject to certain limitations. The Secretary of the Treasury must declare the act to be a “certified act of terrorism” for it to be covered under this federal program. As amended in 2007, the definition of terrorism for purposes of the Terrorism Risk Act includes acts of terror perpetrated by domestic, as well as foreign, persons or interests. No federal compensation will be paid under the Terrorism Risk Act unless aggregate insured losses from the act for the entire insurance industry exceed certain threshold amounts ($100.0 million for terrorism losses occurring in 2007 and for the remainder of the program). Each insurance company is responsible for a deductible based on a percentage of the direct earned premiums of its affiliated group in the previous calendar year for commercial lines policies (except for certain excluded lines such as commercial auto) covering risks in the United States. This deductible amount is 20.0% of such premiums for losses occurring in 2007 and subsequent years. For losses in excess of the deductible, the federal government will reimburse 85% of the insurer’s loss occurring in 2007 and subsequent years. As stated above, all layers of our reinsurance program contain sublimits for losses caused by an act of terrorism, as defined in the Terrorism Risk Act, subject to certain absolute exclusions.

Competition

The insurance industry in general is highly competitive and there is significant competition in the national workers’ compensation market as well. Competition in the insurance business is based on many factors, including premiums charged, services provided, financial strength ratings assigned by independent rating agencies, speed of claims payments, reputation, perceived financial strength and general experience. Many of the insurers with whom we compete have significantly greater financial, marketing and management resources, and experience than we have. In addition, our competitive advantage may be limited due to the relatively small number of insurance products that we offer. Some of our competitors have additional competitive leverage because they offer a wide array of insurance products. For example, it may be more convenient or cost effective for a potential customer to purchase numerous types of insurance products from one insurance carrier. We do not offer a broad range of insurance products due to our exclusive focus on the workers’ compensation line and our targeted market niches, and we may lose potential customers to our larger, more diverse competitors as a result. We may also compete with new market entrants in the future.
 
 
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We operate in niche markets where we believe we have fewer competitors with a similar focus. While more than 400 insurance companies participate in the national workers’ compensation market, our competitors are relatively few in number because we operate in niche markets. We compete with regional and national insurance companies and state-sponsored insurance funds, as well as individual and group self-insurance programs. Our primary competitors are Chartis (AIG), Hartford, Liberty Mutual, Old Republic, Travelers and Zurich.  These primary competitors may vary slightly according to the type of product and by region, and some competitors limit their writings on a geographic basis.

We believe our competitive advantages are our strong reputation in our niche markets, our local knowledge in the markets in which we operate, our specialized underwriting expertise, our client-driven claims and loss control service capabilities, our innovative medical cost management strategies, our focus on niche markets, our loyal brokerage distribution, and our customized computer systems. In addition to these competitive advantages, we offer our maritime customers regulated insurance coverage without the joint-and-several liability associated with coverage provided by offshore mutual organizations.

Ratings

Many insurance buyers, agents and brokers use the ratings assigned by A.M. Best and other rating agencies to assist them in assessing the financial strength and overall quality of the companies from which they are considering purchasing insurance. We have been rated “A-” (Excellent) by A.M. Best since the completion of the Acquisition. This rating was most recently affirmed in December 2010. An “A-” rating is the fourth highest of 15 rating categories used by A.M. Best, and is “assigned to companies that have, in (A.M. Best’s) opinion, an excellent ability to meet their ongoing insurance obligations.”  In evaluating a company’s financial and operating performance, A.M. Best reviews a company’s profitability, indebtedness and liquidity, as well as its book of business, the adequacy and soundness of its reinsurance, the quality and estimated fair value of its assets, the adequacy of its loss reserves, the adequacy of its surplus, its capital structure, the experience and competence of its management and its market presence. This rating is intended to provide an independent opinion of an insurer’s ability to meet its obligations to policyholders and is not an evaluation directed at investors.

Regulation

Holding Company Regulation

As a member of an insurance holding company, SeaBright Insurance Company, our insurance company subsidiary, is subject to regulation by the states in which it is domiciled or transacts business. SeaBright Insurance Company is domiciled in Illinois and is considered to be commercially domiciled in California. An insurer is deemed “commercially domiciled” in California if, during the three preceding fiscal years, or a lesser period of time if the insurer has not been licensed in California for three years, the insurer has written an average of more gross premiums in California than it has written in its state of domicile, and such gross premiums written constitute 33% or more of its total gross premiums written in the United States for such period. Pursuant to the insurance holding company laws of Illinois and California, SeaBright Insurance Company is required to register with the Illinois Department of Insurance and the California Department of Insurance. In addition, SeaBright Insurance Company is required to periodically report certain financial, operational and management data to the Illinois Department of Insurance and the California Department of Insurance. All transactions within a holding company system affecting an insurer must have fair and reasonable terms, charges or fees for services performed must be reasonable, and the insurer’s policyholder surplus following any transaction must be both reasonable in relation to its outstanding liabilities and adequate for its needs. Notice to, and in some cases approval from, insurance regulators in Illinois and California is required prior to the consummation of certain affiliated and other transactions involving SeaBright Insurance Company.

 
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Changes of Control

In addition, the insurance laws of Illinois and California require advance approval by the Illinois Department of Insurance and the California Department of Insurance of any change in control of SeaBright Insurance Company. “Control” is generally presumed to exist through the direct or indirect ownership of 10% or more of the voting securities of a domestic insurance company or of any entity that controls a domestic insurance company. In addition, insurance laws in many states contain provisions that require prenotification to the insurance commissioners of a change in control of a non-domestic insurance company licensed in those states. Any future transactions that would constitute a change in control of SeaBright Insurance Company, including a change of control of us, would generally require the party acquiring control to obtain the prior approval of the Illinois Department of Insurance and the California Department of Insurance and may require pre-acquisition notification in applicable states that have adopted pre-acquisition notification provisions. Obtaining these approvals may result in a material delay of, or deter, any such transaction.

State Insurance Regulation

Insurance companies are subject to regulation and supervision by the department of insurance in the state in which they are domiciled and, to a lesser extent, other states in which they conduct business. SeaBright Insurance Company is primarily subject to regulation and supervision by the Illinois Department of Insurance and the California Department of Insurance. These state agencies have broad regulatory, supervisory and administrative powers, including, among other things, the power to: grant and revoke licenses to transact business; license agents; set the standards of solvency to be met and maintained; determine the nature of, and limitations on, investments and dividends; approve policy forms and rates in some states; periodically examine an insurance company’s financial condition; determine the form and content of required financial statements; and periodically examine market conduct.

Detailed annual and quarterly financial statements and other reports are required to be filed with the departments of insurance of the states in which we are licensed to transact business. The financial statements and condition of SeaBright Insurance Company are subject to periodic examination by the Illinois Department of Insurance and the California Department of Insurance. In 2007, the Illinois Department of Insurance completed a routine comprehensive examination of our 2005 statutory annual statement. On June 21, 2007, the Department officially adopted, without fines or penalties assessed, its Report of Examination as of December 31, 2005.

In addition, many states have laws and regulations that limit an insurer’s ability to withdraw from a particular market. For example, states may limit an insurer’s ability to cancel or not renew policies. Furthermore, certain states prohibit an insurer from withdrawing one or more lines of business from the state, except pursuant to a plan that is approved by the state insurance department. The state insurance department may disapprove a plan that may lead to market disruption. Laws and regulations that limit cancellation and non-renewal and that subject program withdrawals to prior approval requirements may restrict our ability to exit unprofitable markets.

Federal Laws and Regulations

As a provider of maritime workers’ compensation insurance, we are subject to the USL&H Act, which generally covers exposures on the navigable waters of the United States and in adjoining waterfront areas, including exposures resulting from loading and unloading vessels, and the Jones Act, which covers exposures at sea. We are also subject to regulations related to the USL&H Act and the Jones Act.

The USL&H Act, which is administered by the U.S. Department of Labor, provides medical benefits, compensation for lost wages and rehabilitation services to longshoremen, harbor workers and other maritime workers who are injured during the course of employment or suffer from diseases caused or worsened by conditions of employment. The Department of Labor has the authority to require us to make deposits to serve as collateral for losses incurred under the USL&H Act. Several other statutes extend the provisions of the USL&H Act to cover other classes of private-industry workers. These include workers engaged in the extraction of natural resources from the outer continental shelf, employees on American defense bases, and those working under contracts with the U.S. government for defense or public-works projects, outside of the continental United States. Our authorizations to issue workers’ compensation insurance from the various state departments of insurance regulating SeaBright Insurance Company are augmented by our U.S. Department of Labor certificates of authority to ensure payment of compensation under the USL&H Act and extensions of the USL&H Act, including the OCSLA and the Nonappropriated Fund Instrumentalities Act. This coverage, which we write as an endorsement to workers’ compensation and employers liability insurance policies, provides employment-injury and occupational disease protection to workers who are injured or contract occupational diseases while working on the navigable waters of the United States, or in adjoining areas, and for certain other classes of workers covered by the extensions of the USL&H Act.

 
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The Jones Act is a federal law, the maritime employer provisions of which provide injured offshore workers, or seamen, with the right to seek compensation for injuries resulting from the negligence of their employers or co-workers during the course of their employment on a ship or vessel. In addition, an injured offshore worker may make a claim against a vessel owner on the basis that the vessel was not seaworthy. Our authorizations to issue workers’ compensation insurance from the various state departments of insurance regulating SeaBright Insurance Company allow us to write Jones Act coverage for our maritime customers. We are not required to have a certificate from the U.S. Department of Labor to write Jones Act coverage.

We also offer extensions of coverage under the OCSLA, a federal workers’ compensation act that provides workers’ compensation coverage for the death or disability of an employee resulting from any injury occurring as a result of working on an off-shore drilling platform on the Outer Continental Shelf, where required by a prospective policyholder.

As a condition of authorization effective August 25, 2005, the U.S. Department of Labor implemented new regulations requiring insurance carriers authorized to write insurance under the USL&H Act or any of its extensions to deposit security to secure compensation payment obligations. The Department of Labor determines the amount of this deposit annually by calculating the carrier’s USL&H and extension Act obligation by state and by the percentage of those obligations deemed unsecured by those states’ guaranty funds.

Privacy Regulations

In 1999, the United States Congress enacted the Gramm-Leach-Bliley Act, which, among other things, protects consumers from the unauthorized dissemination of certain personal information. Subsequently, a majority of states have implemented additional regulations to address privacy issues. These laws and regulations apply to all financial institutions, including insurance and finance companies, and require us to maintain appropriate procedures for managing and protecting certain personal information of our customers and to fully disclose our privacy practices to our customers. We may also be exposed to future privacy laws and regulations, which could impose additional costs and impact our financial condition or results of operations.
 
Federal and State Legislative and Regulatory Changes

From time to time, various regulatory and legislative changes have been proposed in the insurance industry. Among the proposals that have in the past been or are at present being considered are the possible introduction of federal regulation in addition to, or in lieu of, the current system of state regulation of insurers and proposals in various state legislatures (some of which proposals have been enacted) to conform portions of their insurance laws and regulations to various model acts adopted by the National Association of Insurance Commissioners (the “NAIC”). We are unable to predict whether any of these laws and regulations will be adopted, the form in which any such laws and regulations would be adopted, or the effect, if any, these developments would have on our operations and financial condition.

On November 26, 2002, in response to the tightening of supply in certain insurance and reinsurance markets resulting from, among other things, the September 11, 2001 terrorist attacks, the Terrorism Risk Insurance Act of 2002 was enacted. In 2005, this law was extended and amended. The Terrorism Risk Act is designed to ensure the availability of insurance coverage for losses resulting from certain acts of terror in the United States of America. As extended in 2005, the law established a federal assistance program through the end of 2007 to help the property and casualty insurance industry cover claims related to future terrorism-related losses and required such companies to offer coverage for certain acts of terrorism. On December 26, 2007, President George W. Bush signed an Extension Bill which extended the Terrorism Risk Act to December 31, 2014. The terms and conditions applying during each of the extension years are essentially the same as those applied during 2007, except that acts of terror perpetrated on behalf of domestic, as well as foreign, persons or interests are now subject to the Terrorism Risk Act. By law, SeaBright Insurance Company may not exclude coverage for terrorism losses from its workers’ compensation policies. Although SeaBright Insurance Company is protected by federally funded terrorism reinsurance to the extent provided for in the Terrorism Risk Act, there are limitations and restrictions on this protection, including a substantial deductible that must be met, which could have an adverse effect on our financial condition or results of operations. Potential future changes to the Terrorism Risk Act could also adversely affect us by causing our reinsurers to increase prices or withdraw from certain markets where terrorism coverage is required.

 
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Our workers’ compensation operations are subject to legislative and regulatory actions. In California, where we have our largest concentration of business, significant workers’ compensation legislation was enacted in recent years. Effective January 1, 2003, legislation became effective which provides for increases in indemnity benefits to injured workers. In September 2003 and April 2004, workers’ compensation legislation was enacted in California with the principal objectives of reducing medical costs and implementing a more predictable and equitable permanent partial disability rating schedule.

The principal changes in the legislation that impact medical costs are as follows: 1) a reduction in the reimbursable amount for certain physician fees, outpatient surgeries, pharmaceutical products and certain durable medical equipment; 2) a limitation on the number of chiropractor or physical therapy office visits; 3) the introduction of medical utilization guidelines; 4) a requirement for second opinions on certain spinal surgeries; and 5) a repeal of the presumption of correctness afforded to the treating physician, except where the employee has pre-designated a treating physician. Since the passage of the 2003 and 2004 reforms, bills have been introduced to roll back many areas of significant reform. Some compromise measures have succeeded. For example, on October 13, 2007, new legislation became effective that removed caps on physical therapy but only when the administrative director adopts new guidelines for occupational therapy and chiropractic care for post-surgical care.

In February of 2009, the California Workers’ Compensation Appeals Board (the “Appeals Board”) rendered an en banc decision on a series of cases, commonly referred to as Almarez, Guzman and Ogilvie. Allowing a rebuttal of the American Medical Association (“AMA”) Guides (an accepted standard for impairment and disability assessment in the United States and a majority of the other English-speaking countries), the decision has a material impact on the value of permanent disability awards. The en banc decision led to considerable comment and debate in the Workers’ Compensation community. In September of 2009, the Appeals Board reaffirmed most aspects of its prior work, with some clarifications to its February decisions. Its decision is considered final with details to be determined by case law and through appeal. In November of 2010, the California Supreme Court declined to review the Guzman case. An appeal of the Almarez case to the Fifth Circuit Court of Appeals is pending.

We experienced significant reductions in our California premium rates from 2003 to 2008. Our 14.2% rate reduction for new and renewal insurance policies written in California on or after July 1, 2007 was the eighth California rate reduction we had filed since October 1, 2003, resulting in a net cumulative reduction of our California rates of approximately 54.8%. In August 2008, the WCIRB submitted a filing with the California Insurance Commissioner recommending a 16.0% increase in advisory pure premium rates on new and renewal policies effective on or after January 1, 2009. In response to this recommendation, on October 24, 2008, the California Insurance Commissioner approved a 5.0% increase in advisory pure premium rates effective January 1, 2009. With the California Department of Insurance’s approval, we adopted this 5.0% increase effective January 1, 2009.

In March 2009, the WCIRB submitted a filing with the California Insurance Commissioner recommending a 24.4% increase in advisory pure premium rates on new and renewal policies effective on or after July 1, 2009. In April 2009, the WCIRB amended its filing to reduce the proposed rate increase to 23.7%. In July 2009, the California Insurance Commissioner announced his rejection of any increase in advisory pure premium rates. Rating decisions made by the California Insurance Commissioner are advisory only and insurance companies may choose whether or not to adopt approved or disapproved rates. After completing an internal study of our California loss costs, in June 2009, we filed with the California Department of Insurance revised rates for new and renewal workers’ compensation insurance policies written in the state of California on or after August 1, 2009. The new rates reflected an average increase of 10.6% from prior rates and were in response to increased projected medical costs and recent decisions by the Workers’ Compensation Appeals Board. In July 2009, the California Department of Insurance approved our filing for the rate increase. In August 2009, the WCIRB submitted a filing with the California Insurance Commissioner recommending a 22.8% increase in advisory pure premium rates on new and renewal policies effective on or after January 1, 2010. In November 2009, the California Insurance Commissioner announced his rejection of any increase in advisory pure premium rates.

In July 2010, we filed with the California Department of Insurance revised rates for new and renewal workers’ compensation insurance policies written in the state of California on or after September 1, 2010. The new rates reflected an average increase of 15.3% from prior rates. In August 2010, the California Department of Insurance approved our filing for the rate increase. On August 18, 2010, the WCIRB submitted a filing with the California Insurance Commissioner recommending a 27.7% increase in advisory pure premium rates on new and renewal policies effective on or after January 1, 2011. On November 19, 2010, the California Insurance Commissioner announced his decision to approve no change in advisory pure premium rates.

 
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Rate changes have also been adopted in other states in which we operate. For example, in Alaska we adopted rate decreases of 2.5% and 10.3% effective January 1, 2011 and 2010, respectively. In Louisiana, we adopted commissioner-approved rate decreases of 0.6% and 17.4% effective September 1, 2010 and May 1, 2009, respectively. In Texas, we adopted rate decreases of 10.0% and 7.7% effective May 1, 2009 and January 1, 2008, respectively. We adopted a rate increase of 7.8% and a rate decrease of 6.8% in Florida effective January 1, 2011 and 2010, respectively. In Washington USL&H, we adopted a rate increase of 21.0% effective December 1, 2009.

If other insurers do not adopt rate increases similar to those described above, the rate increases adopted by SeaBright Insurance Company may have a negative effect on our ability to compete in California and other states.

The National Association of Insurance Commissioners

The NAIC is a group formed by state insurance commissioners to discuss issues and formulate policy with respect to the regulation, reporting and accounting of insurance companies. Although the NAIC has no legislative authority and insurance companies are at all times subject to the laws of their respective domiciliary states and, to a lesser extent, other states in which they conduct business, the NAIC is influential in determining the form in which such laws are enacted. Model Insurance Laws, Regulations and Guidelines (the “Model Laws”) have been promulgated by the NAIC as a minimum standard by which state regulatory systems and regulations are measured. Adoption of state laws which provide for substantially similar regulations to those described in certain of the Model Laws is a requirement for accreditation by the NAIC. The NAIC provides authoritative guidance to insurance regulators on current statutory accounting issues by promulgating and updating a codified set of statutory accounting practices in its Accounting Practices and Procedures Manual. The Illinois Department of Insurance and the California Department of Insurance have adopted these codified statutory accounting practices.

Illinois and California have also adopted laws substantially similar to the NAIC’s “risk based capital” (“RBC”) laws, which require insurers to maintain minimum levels of capital based on their investments and operations. These RBC requirements provide a standard by which regulators can assess the adequacy of an insurance company’s capital and surplus relative to its operations. Among other requirements, an insurance company must maintain capital and surplus of at least 200% of the RBC computed by the NAIC’s RBC model (known as the “Authorized Control Level” of RBC). At December 31, 2010, the capital and surplus of SeaBright Insurance Company exceeded 200% of the RBC requirements.

The NAIC’s Insurance Regulatory Information System (“IRIS”) key financial ratios, developed to assist insurance departments in overseeing the financial condition of insurance companies, are reviewed by experienced financial examiners of the NAIC and state insurance departments to select those companies that merit highest priority in the allocation of the regulators’ resources. IRIS identifies twelve industry ratios and specifies “usual values” for each ratio. Departure from the usual values on four or more of the ratios can lead to inquiries from individual state insurance commissioners as to certain aspects of an insurer’s business.

The 2010 IRIS results for SeaBright Insurance Company showed no results outside the “usual” range for these ratios.

Dividend Limitations

SeaBright Insurance Company’s ability to pay dividends is subject to restrictions contained in the insurance laws and related regulations of Illinois and California. The insurance holding company laws in these states require that ordinary dividends be reported to the Illinois Department of Insurance and the California Department of Insurance prior to payment of the dividend and that extraordinary dividends be submitted for prior approval. An extraordinary dividend is generally defined as a dividend that, together with all other dividends made within the past 12 months, exceeds the greater of 10% of its statutory policyholders’ surplus as of the preceding year end or the net income of the company for the preceding year. Statutory policyholders’ surplus, as determined under statutory accounting principles is the amount remaining after all liabilities, including loss and loss adjustment expenses, are subtracted from all admitted assets. Admitted assets are assets of an insurer prescribed or permitted by a state insurance regulator to be recognized on the statutory balance sheet. Insurance regulators have broad powers to prevent the reduction of statutory surplus to inadequate levels, and there is no assurance that extraordinary dividend payments will be permitted.

 
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Statutory Accounting Practices

Statutory accounting practices (“SAP”) are a basis of accounting developed to assist insurance regulators in monitoring and regulating the solvency of insurance companies. SAP is primarily concerned with measuring an insurer’s surplus available for policyholders. Accordingly, statutory accounting focuses on valuing assets and liabilities of insurers at financial reporting dates in accordance with appropriate insurance law and regulatory provisions applicable in each insurer’s domiciliary state.

U.S. generally accepted accounting principles (“GAAP”) are concerned with a company’s solvency, but such principles are also concerned with other financial measurements, such as income and cash flows. Accordingly, GAAP gives more consideration to appropriate matching of revenue and expenses and accounting for management’s stewardship of assets than does SAP. As a direct result, different assets and liabilities and different amounts of assets and liabilities will be reflected in financial statements prepared in accordance with GAAP as opposed to SAP.

Statutory accounting practices established by the NAIC and adopted, in part, by the Illinois and California regulators, determine, among other things, the amount of statutory surplus and statutory net income or loss of SeaBright Insurance Company and thus determine, in part, the amount of funds it has available to pay dividends to us.

Guaranty Fund Assessments

In Illinois, California and in most of the states where SeaBright Insurance Company is licensed to transact business, there is a requirement that property and casualty insurers doing business within each such state participate in a guaranty association, which is organized to pay contractual benefits owed pursuant to insurance policies issued by impaired, insolvent or failed insurers. These associations levy assessments, up to prescribed limits, on all member insurers in a particular state on the basis of the proportionate share of the premium written by member insurers in the lines of business in which the impaired, insolvent or failed insurer is engaged. Some states permit member insurers to recover assessments paid through full or partial premium tax offsets or policy surcharges.

Property and casualty insurance company insolvencies or failures may result in additional security fund assessments to SeaBright Insurance Company at some future date. At this time we are unable to determine the impact, if any, such assessments may have on the financial position or results of operations of SeaBright Insurance Company. We have established liabilities for guaranty fund assessments with respect to insurers that are currently subject to insolvency proceedings.

PointSure

The brokerage and third party administrator activities of PointSure are subject to licensing requirements and regulation under the laws of each of the jurisdictions in which it operates. PointSure is authorized to act as an insurance broker under firm or officer licenses in 50 states and the District of Columbia. PointSure’s business depends on the validity of, and continued good standing under, the licenses and approvals pursuant to which it operates, as well as compliance with pertinent regulations. PointSure therefore devotes significant effort toward maintaining its licenses to ensure compliance with a diverse and complex regulatory structure.

Licensing laws and regulations vary from state to state. In all states, the applicable licensing laws and regulations are subject to amendment or interpretation by regulatory authorities. Generally such authorities are vested with relatively broad and general discretion as to the granting, renewing and revoking of licenses and approvals. Licenses may be denied or revoked for various reasons, including the violation of such regulations, conviction of crimes and the like. Possible sanctions which may be imposed include the suspension of individual employees, limitations on engaging in a particular business for specified periods of time, revocation of licenses, censures, redress to clients and fines. In some instances, PointSure follows practices based on interpretations of laws and regulations generally followed by the industry, which may prove to be different from the interpretations of regulatory authorities.

Employees

As of December 31, 2010, we had 335 full-time equivalent employees. We have employment agreements with some of our executive officers, which will be described in our proxy statement for the 2011 annual meeting of stockholders and incorporated by reference into Part III, Item 11 of this annual report. We believe that our employee relations are good.

 
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Corporate Website

Through our Internet website at www.sbic.com, we provide free access to our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission (the “SEC”). The following corporate governance materials are also available on our website:

 
Audit Committee, Compensation Committee, and Nominating and Corporate Governance Committee charters;

 
Code of Ethics for Senior Financial Employees;

 
Conflict of Interest & Code of Conduct Policy; and

 
Insider Trading Policy.

If we waive or substantially change any material provision of our Code of Ethics for Senior Financial Employees, we will disclose that fact on our website within four business days of the waiver or change. Information on our website is not part of this annual report or any other report filed with the SEC.

Note on Forward-Looking Statements

Some of the statements in Part I, Item 1 of this annual report, some of the statements in this Item 1A, some of the statements under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operation” in Part II, Item 7 of this annual report and statements elsewhere in this annual report, may include forward-looking statements that reflect our current views with respect to future events and financial performance, including statements about our expectations for future periods with respect to customer concentration, impact of rate change and legislative reforms, our adverse development cover with LMC, our claims service income, payroll levels, stockholder dividends and our capital needs. These statements include forward-looking statements both with respect to us specifically and the insurance sector in general. 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;
 
 
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increased or sustained 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;

 
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 if LMC were to be placed into receivership;

 
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 annual 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 annual report reflect our views as of the date of this annual 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 annual report that could cause actual results to differ.

 
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Item 1A.  Risk Factors.

You should carefully consider the risks described below, together with all of the other information included in this annual report. The risks and uncertainties described below are not the only ones facing our company. If any of the following risks actually occurs, our business, financial condition or operating results could be harmed. Any of the risks described below could result in a significant or material adverse effect on our financial condition or results of operations, and a corresponding decline in the market price of our common stock. You could lose all or part of your investment. The risks discussed below also include forward-looking statements and our actual results may differ substantially from those discussed in those forward-looking statements. Please refer to the discussion under the heading “Note on Forward-Looking Statements” in Part I, Item 1 of this annual report.

Risks Related to Our Business

Our loss reserves are based on estimates and may be inadequate to cover our actual losses.

If we fail to accurately assess the risks associated with the businesses 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, in 2010, we increased loss reserves for prior accident years by approximately $32.0 million. See the discussion under the heading “Loss Reserves” in Part I, Item 1 of this annual report.

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.

Our operations could be further affected by a severe downturn in the U.S. economy.

Our operations and financial performance may be further 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. If our customers reduce their workforce levels, the level of workers’ compensation insurance coverage they require and, as a result the premiums that we charge would be reduced, and if our customers cease operations, they will not renew their policies. 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 if we experience another recession, it could further reduce payrolls, which could have a significant negative impact on our business, financial condition or results of operations. 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 claims costs. A further decay of economic conditions, or a lengthy continuation of current economic conditions, could have a significant negative impact on our future claims costs.

The insurance business is subject to extensive regulation and legislative changes, which impact the manner in which we operate our business.

Our insurance business is subject to extensive regulation by the applicable state agencies in the jurisdictions in which we operate, perhaps most significantly by the Illinois Department of Insurance and the California Department of Insurance. These state agencies have broad regulatory powers designed to protect policyholders, not stockholders or other investors. These powers include, among other things, the ability to:
 
 
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place limitations on our ability to transact business with our affiliates;

 
regulate mergers, acquisitions and divestitures involving our insurance company subsidiary;

 
require SeaBright Insurance Company, PointSure, and PMCS to comply with various licensing requirements and approvals that affect our ability to do business;

 
approve or reject our policy coverage and endorsements;

 
place limitations on our investments and dividends;

 
set standards of solvency to be met and maintained;

 
regulate rates pertaining to our business;

 
require assessments for the provision of funds necessary for the settlement of covered claims under certain policies provided by impaired, insolvent or failed insurance companies;

 
require us to comply with medical privacy laws; and

 
prescribe the form and content of, and examine, our statutory financial statements.

Our ability to transact business with our affiliates and to enter into mergers, acquisitions and divestitures involving our insurance company subsidiary is limited by the requirements of the insurance holding company laws of Illinois and California. To comply with these laws, we are required to file notices with the Illinois Department of Insurance and the California Department of Insurance to seek their respective approvals at least 30 days before engaging in any intercompany transactions, such as sales, purchases, exchanges of assets, loans, extensions of credit, cost sharing arrangements and extraordinary dividends or other distributions to stockholders. Under these holding company laws, any change of control transaction also requires prior notification and approval. Because these governmental agencies may not take action or give approval within the 30 day period, these notification and approval requirements may subject us to business delays and additional business expense. If we fail to give these notifications, we may be subject to significant fines and penalties and damaged working relations with these governmental agencies.

In addition, workers’ compensation insurance is statutorily provided for in all of the states in which we do business. State laws and regulations provide for the form and content of policy coverage and the rights and benefits that are available to injured workers, their representatives and medical providers. For example, in California, on January 1, 2003, workers’ compensation legislation became effective that provided for increases in the benefits payable to injured workers. Also, in California, workers’ compensation legislation intended to reduce certain costs was enacted in September 2003 and April 2004. Among other things, this legislation established an independent medical review process for resolving medical disputes, tightened standards for determining impairment ratings by applying specific medical treatment guidelines, capped temporary total disability payments to 104 weeks from first payment and enabled injured workers to access immediate medical care up to $10,000 but required them to get medical care through a network of doctors chosen by the employer. The implementation of these reforms affects the manner in which we coordinate medical care costs with employers and the manner in which we oversee treatment plans. However, the reforms are subject to continuing opposition in the California legislature, in the courts and by ballot initiatives, any of which could overturn or substantially amend the reforms and regulatory rules applicable to the legislation. Since the passage of the 2003 and 2004 reforms, bills have been introduced to roll back many areas of significant reform. Some compromise measures have succeeded. For example, on October 13, 2007, new legislation became effective that removed caps on physical therapy but only when the administrative director adopts new guidelines for occupational therapy and chiropractic care for post-surgical care. We cannot predict the ultimate impact of the reforms or of any amendments to them.

Our business is also affected by federal laws, including the USL&H Act, which is administered by the Department of Labor, and the Merchant Marine Act of 1920, or Jones Act. The USL&H Act contains various provisions affecting our business, including the nature of the liability of employers of longshoremen, the rate of compensation to an injured longshoreman, the selection of physicians, compensation for disability and death and the filing of claims.

 
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In addition, we are impacted by the Terrorism Risk Act and by the Gramm-Leach-Bliley Act of 2002 related to disclosure of personal information. The Gramm-Leach-Bliley Act, which, among other things, protects consumers from the unauthorized dissemination of certain personal information, and various state laws and regulations addressing privacy issues, require us to maintain appropriate procedures for managing and protecting certain personal information of our customers and to fully disclose our privacy practices to our customers. The Terrorism Risk Act requires that commercial property and casualty insurance companies offer coverage for certain acts of terrorism and has established a federal assistance program through the end of 2014 to help insurers cover claims arising out of such acts. The Terrorism Risk Act only covers certified acts of terrorism, and the U.S. Secretary of the Treasury must declare the act to be a “certified act of terrorism” for it to be covered under this federal program. In addition, no federal compensation will be paid under the Terrorism Risk Act unless aggregate insured losses from the act for the entire insurance industry exceed certain threshold amounts ($100.0 million for terrorism losses occurring in 2007 and for the remainder of the program). Under this program, the federal government covers 85% of the losses from covered certified acts of terrorism occurring in 2007 and for the remainder of the program on commercial risks in the United States only, in excess of the applicable deductible amount. This deductible is calculated based on a percentage of an affiliated insurance group’s prior year direct earned premiums on commercial lines policies (except for certain excluded lines such as commercial auto) covering risks in the United States. This deductible amount is 20.0% of such premiums for losses occurring in 2007 and subsequent years.

For the past several years, the financial markets have experienced a period of extreme turmoil, including the bankruptcy, restructuring or sale of certain financial institutions, which resulted in unprecedented intervention by the U.S. federal government, including unprecedented levels of direct investment by the federal government in certain financial and insurance institutions. While the ultimate outcome of governmental initiatives intended to alleviate the recent financial crisis cannot be predicted, it is likely that governmental authorities may seek to exercise their supervisory or enforcement power in new or more robust ways, which could affect our business and the way we manage our capital, and may require us to satisfy increased capital requirements or impose additional restrictions on us.

This extensive regulation of our business may affect the cost or demand for our products and may limit our ability to obtain rate increases or to take other actions that we might desire to increase our profitability. In addition, we may be unable to maintain all required approvals or comply fully with the wide variety of applicable laws and regulations, which are continually undergoing revision, or the relevant authority’s interpretation of such laws and regulations.

Our geographic concentration ties our performance to the business, economic and regulatory conditions in California, Louisiana, Alaska and Texas. Any single catastrophe or other condition affecting losses in these states could adversely affect our results of operations.

Our business is concentrated in California (approximately 51.8% of direct premiums written for the year ended December 31, 2010), Louisiana (approximately 10.8% of direct premiums written for the same period), Alaska (approximately 5.9% of direct premiums written for the same period) and Texas (approximately 5.6% of direct premiums written for the same period). Accordingly, unfavorable business, economic or regulatory conditions in those states could negatively impact our business. For example, California, Louisiana, Alaska and Texas are states that are susceptible to severe natural perils, such as tsunamis, earthquakes, tornados and hurricanes, along with the possibility of terrorist acts. Accordingly, we could suffer losses as a result of catastrophic events in those states. Although geographic concentration has not adversely affected our business in the past, we may in the future be exposed to economic and regulatory risks or risks from natural perils that are greater than the risks faced by insurance companies that conduct business over a greater geographic area. This concentration of our business could have a material adverse effect on our financial condition or results of operations.

If we are unable to obtain or collect on our reinsurance protection, our business, financial condition and results of operations could be materially adversely affected.

We buy reinsurance coverage to protect us from the impact of large losses. Reinsurance is an arrangement in which an insurance company, called the ceding company, transfers insurance risk by sharing premiums with another insurance company, called the reinsurer. Conversely, the reinsurer receives or assumes reinsurance from the ceding company. In the ordinary course of our business we participate in a workers’ compensation and employers’ liability excess of loss reinsurance treaty program covering all of the business that we write or renew pursuant to which our reinsurers are liable for varying percentages of the ultimate net losses in excess of $0.25 million for the business we write, up to a limit of $100.0 million, subject to certain exclusions and limitations. The treaty program provides coverage in several layers. See the discussion under the heading “Reinsurance” in Part I, Item 1 of this annual report. The availability, amount and cost of reinsurance depend on market conditions and may vary significantly. As a result of catastrophic events, such as the events of September 11, 2001, we may incur significantly higher reinsurance costs, more restrictive terms and conditions, and decreased availability. For example, each layer of our reinsurance treaty program contains an aggregate limit for all claims under that layer over which our reinsurers will not be liable (e.g., $30.0 million under the first layer, $17.0 million under the second layer and $10.0 million under the third layer). In addition, each layer of our reinsurance treaty program covers acts of terrorism only up to a modest limit (e.g., $1.0 million per occurrence under the first layer, $1.5 million per occurrence under the second layer and $2.0 million under the third layer). Because of these sub-limits and terrorism exclusions included in our treaties, which are common in the wake of the events of September 11, 2001, we have significantly greater exposure to losses resulting from acts of terrorism. The incurrence of higher reinsurance costs and more restrictive terms could materially adversely affect our business, financial condition and results of operations.

 
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The agreements for our current workers’ compensation excess of loss reinsurance treaty program expire on September 30, 2011. Any decrease in the amount of our reinsurance at the time of renewal, whether caused by the existence of more restrictive terms and conditions or decreased availability, will also increase our risk of loss and, as a result, could materially adversely affect our business, financial condition and results of operations. We have not experienced difficulty in qualifying for or obtaining sufficient reinsurance to appropriately cover our risks in the past. We currently have nine reinsurers participating in our excess of loss reinsurance treaty program, and believe that this is a sufficient number of reinsurers to provide us with reinsurance in the volume that we require. However, it is possible that one or more of our current reinsurers could cancel participation, or we could find it necessary to cancel the participation of one of our reinsurers, in our excess of loss reinsurance treaty program. In either of those events, if our reinsurance broker is unable to spread the cancelled or terminated reinsurance among the remaining reinsurers in the program, we estimate that it could take approximately one to three weeks or longer to identify and negotiate appropriate documentation with a replacement reinsurer. During this time, we could be exposed to an increased risk of loss, the extent of which would depend on the volume of cancelled reinsurance.

In addition, we are subject to credit risk with respect to our reinsurers. Reinsurance protection that we receive does not discharge our direct obligations under the policies we write. We remain liable to our policyholders, even if we are unable to make recoveries to which we believe we are entitled under our reinsurance contracts. Losses may not be recovered from our reinsurers until claims are paid, and, in the case of long-term workers’ compensation cases, the creditworthiness of our reinsurers may change before we can recover amounts to which we are entitled. Although we have not experienced problems in the past resulting from the failure of a reinsurer to pay our claims in a timely manner, if we experience this problem in the future, our costs would increase and our revenues would decline. As of December 31, 2010, we had $56.7 million of amounts recoverable from our reinsurers, excluding the receivable on our adverse development cover, that we would be obligated to pay if our reinsurers failed to pay us.

A downgrade in the A.M. Best rating of our insurance subsidiary could reduce the amount of business we are able to write.

Rating agencies rate insurance companies based on each company’s ability to pay claims. Our insurance company subsidiary currently has a rating of “A-” (Excellent) from A.M. Best, which is the rating agency that we believe has the most influence on our business. The ratings of A.M. Best are subject to periodic review using, among other things, proprietary capital adequacy models, and are subject to revision or withdrawal at any time. Insurance ratings are directed toward the concerns of policyholders and insurance agents and are not intended for the protection of investors or as a recommendation to buy, hold or sell any of our securities. Our competitive position relative to other companies is determined in part by our A.M. Best rating. We believe that our business is particularly sensitive to our A.M. Best rating because we focus on larger customers which tend to give substantial weight to the A.M. Best rating of their insurers. We expect that any reduction in our A.M. Best rating below “A-” would cause a reduction in the number of policies we write and could have a material adverse effect on our results of operations and our financial position.

The effects of emerging claim and coverage issues on our business are uncertain.

As industry practices and legal, judicial, social and other environmental conditions change, unexpected and unintended issues related to claims and coverage may emerge. These issues may adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the number or size of claims. In some instances, these changes may not become apparent until some time after we have issued insurance contracts that are affected by the changes. As a result, the full extent of liability under our insurance contracts may not be known for many years after a contract is issued. For example, the number or nature of existing occupational diseases may expand beyond our expectation. In addition, medical claims costs associated with permanent and partial disabilities may inflate more rapidly or higher than we currently expect. Expansions of this nature may expose us to more claims than we anticipated when we wrote the underlying policy.

 
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Intense competition could adversely affect our ability to sell policies at rates we deem adequate.

In most of the states in which we operate, we face significant competition which, at times, is intense. If we are unable to compete effectively, our business and financial condition could be materially adversely affected. Competition in our businesses is based on many factors, including premiums charged, services provided, financial strength ratings assigned by independent rating agencies, speed of claims payments, reputation, perceived financial strength and general experience. We compete with regional and national insurance companies and state-sponsored insurance funds, as well as potential insureds that have decided to self-insure. Our principal competitors include Chartis (AIG), Hartford, Liberty Mutual, Old Republic, Travelers, and Zurich.  Many of our competitors have substantially greater financial and marketing resources than we do, and some of our competitors, including the State Compensation Insurance Fund of California, benefit financially by not being subject to federal income tax.

In addition, our competitive advantage may be limited due to the small number of insurance products we offer. Some of our competitors, such as Chartis (AIG) or Zurich, have additional competitive leverage because of the wide array of insurance products they offer. For example, a potential customer may consider it more convenient to purchase multiple types of insurance products from one insurance carrier. We do not offer a wide array of insurance products due to our targeted market niches, and we may lose potential customers to our larger, more diverse competitors as a result.

As explained under the heading “Regulation – Federal and State Legislative and Regulatory Changes” in Part I, Item 1 of this annual report, we have experienced significant changes in our premium rates since 2003. Most recently, we increased our premium rates for business written in California, our largest state by premiums volume, by an average of 5.0% effective January 1, 2009, 10.6% effective August 1, 2009, and 15.3% effective September 1, 2010. We have also increased our premium rates in other states. If other insurers do not adopt rate changes similar to ours, we may be unable to compete effectively and our business, financial condition and results of operations could be materially adversely affected.

If we are unable to realize our investment objectives, our financial condition may be adversely affected.

Investment income is an important component of our revenues and net income. The ability to achieve our investment objectives is affected by factors that are beyond our control. For example, the significant downturn in the United States economy generally could cause our investment income to decrease. Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic and international economic and political conditions. The United States’ participation in hostilities with other countries, acts of terrorism or large-scale natural disasters or catastrophic events may further adversely affect the economy generally. These and other factors also affect the capital markets, and, consequently, the value of the securities we own. The outlook for our investment income is dependent on the future direction of interest rates and the amount of cash flows from operations that are available for investment. The fair values of fixed maturity investments that are “available-for-sale” fluctuate with changes in interest rates and cause fluctuations in our stockholders’ equity. Any significant decline in our investment income as a result of rising interest rates or general market conditions would have an adverse effect on our net income and, as a result, on our stockholders’ equity and our policyholders’ surplus. See “Liquidity and Capital Resources” in Part II, Item 7 of this annual report for a discussion of the limited exposure in our investment portfolio at December 31, 2010 to sub-prime mortgages.

The capital markets in the United States and elsewhere experienced extreme volatility and disruption in 2008 and 2009, and, to a lesser extent, in 2010. We are exposed to significant capital markets risk, including changes in interest rates, credit spreads, equity prices and foreign exchange rates. Our investment portfolio has been affected by these changes in the capital markets. For example, for the year ended December 31, 2008, we recorded an impairment charge of $13.4 million for other-than-temporary losses related principally to our preferred stock investments and holdings of equity indexed securities exchange-traded funds. In addition, changes in interest rates and credit quality may result in fluctuations in the income derived from, or the valuation of, our fixed income securities. Our investment portfolio is also subject to credit and cash flow risk, including risks associated with our investment in asset-backed and mortgage-backed securities, and the risk that issuers in our portfolio may cease operations or other events may cause our investments to become illiquid. Further adverse changes in the capital markets could result in other-than-temporary impairments in the future, which may affect our financial condition, or could reduce our investment income, which would adversely affect our results of operations.

 
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A substantial portion of our investment portfolio is invested in tax-exempt municipal securities. The value of investments in fixed maturity securities is subject to impairment as a result of deterioration in the credit worthiness of the issuer, default by the issuer (including states and municipalities) in the performance of its obligations with respect to the securities and/or increases in market interest rates. To a large degree, the credit risk we face is a function of the economy; accordingly, we face a greater risk in an economic downturn or recession. Although the historical rates of default on state and municipal securities have been relatively low, our state and municipal fixed maturity securities could be subject to a higher risk of default or impairment due to declining municipal tax bases and revenue. The economic downturn has resulted in many states and municipalities operating under deficits or projected deficits, the severity and duration of which could have an adverse impact on both the valuation of our state and municipal fixed maturity securities and the issuer’s ability to perform its obligations thereunder.

We could be adversely affected by the loss of one or more principal employees or by an inability to attract and retain staff.

Our success will depend in substantial part upon our ability to attract and retain qualified executive officers, experienced underwriting talent and other skilled employees who are knowledgeable about our business. We rely substantially upon the services of our senior management team and key employees, consisting of John G. Pasqualetto, Chairman, President and Chief Executive Officer; Richard J. Gergasko, Chief Operating Officer; Scott H. Maw, Senior Vice President, Chief Financial Officer and Assistant Secretary; D. Drue Wax,  Senior Vice President, General Counsel and Corporate Secretary; Richard W. Seelinger, Senior Vice President — Policyholder Services; Marc B. Miller, M.D., Senior Vice President and Chief Medical Officer; Jeffrey C. Wanamaker, Senior Vice President — Underwriting; Christopher Desautel, Senior Vice President and Chief Information Officer; M. Philip Romney, Vice President — Finance, Principal Accounting Officer and Assistant Secretary; and Craig A. Pankow, President — PointSure. Although we are not aware of any planned departures or retirements, if we were to lose the services of members of our management team, our business could be adversely affected. Many of our principal employees possess skills and extensive experience relating to our market niches. Were we to lose any of these employees, it may be challenging for us to attract a replacement employee with comparable skills and experience in our market niches. We have employment agreements with some of our executive officers, which will be described in our proxy statement for the 2011 annual meeting of stockholders and incorporated by reference into Part III, Item 11 of this annual report. We do not currently maintain key man life insurance policies with respect to any member of our senior management team or other employees.

We may require additional capital in the future, which may not be available or only available on unfavorable terms.

Our future capital requirements depend on many factors, including our ability to write new business successfully and to establish premium rates and loss reserves at levels sufficient to cover losses. We believe that cash provided by operations will satisfy our capital requirements for the foreseeable future. However, because the timing and amount of our future needs for capital will depend on our growth and profitability, we cannot provide any assurance in this regard. If we had to raise additional capital, equity or debt financing may not be available at all or may be available only on terms that are not favorable to us. In the case of equity financings, dilution to our stockholders could result, and in any case such securities may have rights, preferences and privileges that are senior to those of the shares currently outstanding. If we cannot obtain adequate capital on favorable terms or at all, we may be unable to support future growth or operating requirements and, accordingly, our business, financial condition or results of operations could be materially adversely affected.

Our status as an insurance holding company with no direct operations could adversely affect our ability to pay dividends in the future.

We are a holding company that transacts our business through our operating subsidiaries, SeaBright Insurance Company, PointSure, and PMCS. Our primary assets are the stock of these operating subsidiaries. Our ability to pay expenses and dividends depends, in the long run, upon the surplus and earnings of our subsidiaries and the ability of our subsidiaries to pay dividends to us. Payment of dividends by SeaBright Insurance Company is restricted by state insurance laws, including laws establishing minimum solvency and liquidity thresholds, and could be subject to contractual restrictions in the future, including those imposed by indebtedness we may incur in the future. SeaBright Insurance Company is required to report any ordinary dividends to the Illinois Department of Insurance and the California Department of Insurance prior to the payment of the dividend. In addition, SeaBright Insurance Company is not authorized to pay any extraordinary dividends to us under Illinois or California insurance laws without prior regulatory approval from the Illinois Department of Insurance or the California Department of Insurance. See the discussion under the heading “Regulation — Dividend Limitations” in Part I, Item 1 of this annual report. As a result, at times, we may not be able to receive dividends from SeaBright Insurance Company and we may not receive dividends in amounts necessary to pay dividends on our capital stock. In addition, the payment of dividends by us is within the discretion of our Board of Directors and will depend on numerous factors, including our financial condition, our capital requirements and other factors that our Board of Directors considers relevant.

 
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We rely on independent insurance brokers to distribute our products.

Our business depends in part on the efforts of independent insurance brokers to market our insurance programs successfully and produce business for us, as well as our ability to offer insurance programs and services that meet the requirements of the clients and customers of these brokers. The majority of the business in our workers’ compensation operations is produced by a group of licensed insurance brokers that totaled approximately 241 at December 31, 2010. Brokers are not obligated to promote our insurance programs and may sell competitors’ insurance programs. Several of our competitors, including Chartis (AIG) and Zurich, offer a broader array of insurance programs than we do. Accordingly, our brokers may find it easier to promote the broader range of programs of our competitors than to promote our niche selection of insurance products. If our brokers fail or choose not to market our insurance programs successfully or to produce business for us, our growth may be limited and our financial condition and results of operations may be negatively affected.

Assessments and other surcharges for guaranty funds and second injury funds and other mandatory pooling arrangements may reduce our profitability.

Virtually all states require insurers licensed to do business in their state to bear a portion of the unfunded obligations of impaired or insolvent insurance companies. These obligations are funded by assessments that are expected to continue in the future as a result of insolvencies. Assessments are levied by guaranty associations within the state, up to prescribed limits, on all member insurers in the state on the basis of the proportionate share of the premium written by member insurers in the lines of business in which the impaired, insolvent or failed insurer is engaged. See the discussion under the heading “Regulation” in Part I, Item 1 of this annual report. Accordingly, the assessments levied on us may increase as we increase our premiums written. Further, Washington state legislation enacted on April 20, 2005 created a separate account within the Guaranty Fund for USL&H Act claims and authorized prefunding of potential insolvencies in order to establish a cash balance. Many states also have laws that established second injury funds to provide compensation to injured employees for aggravation of a prior condition or injury, which are funded by either assessments based on paid losses or premium surcharge mechanisms. For example, Alaska requires insurers to contribute to its second injury fund annually an amount equal to the compensation the injured employee is owed multiplied by a contribution rate based on the fund’s reserve rate. In addition, as a condition of the ability to conduct business in some states, including California, insurance companies are required to participate in mandatory workers’ compensation shared market mechanisms or pooling arrangements, which provide workers’ compensation insurance coverage from private insurers. Although we price our products to account for the obligations that we may have under these pooling arrangements, we may not be successful in estimating our liability for these obligations. Accordingly, our prices may not fully account for our liabilities under pooling arrangements, which may cause a decrease in our profits. As we write policies in new states that have pooling arrangements, we will be required to participate in additional pooling arrangements. Further, the insolvency of other insurers in these pooling arrangements would likely increase the liability for other members remaining in the pool. The effect of these assessments and mandatory shared market mechanisms or changes in them could reduce our profitability in any given period or limit our ability to grow our business.
 
 
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In the event LMC is placed into receivership, we could lose our rights to fee income and protective arrangements that were established in connection with the Acquisition, our reputation and credibility could be adversely affected and we could be subject to claims under applicable voidable preference and fraudulent transfer laws.
 
The assets that SeaBright acquired in the Acquisition were acquired from LMC and certain of its affiliates. LMC and its insurance company affiliates are currently operating under a voluntary “run-off” plan approved by the Illinois Department of Insurance. Under the run-off plan, LMC has instituted aggressive expense control measures to reduce its future loss exposure and allow it to meet its obligations to current policyholders. According to LMC’s statutory financial statements, as of and for the year ended December 31, 2010, LMC, and another company under common management with LMC, had a combined statutory surplus of $45.2 million (unaudited), an increase of approximately $25.9 million from its surplus of $19.3 million (audited) as of December 31, 2009. 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 this annual report. In the event LMC is placed into receivership, our business could be adversely affected in the following ways:

 
A receiver could seek to reject or terminate one or more of the services agreements that were established in connection with the Acquisition between us and LMC or its affiliates, including Eagle. In that event, we could lose the revenue we currently receive under these services agreements.

 
As discussed under “Loss Reserves — KEIC Loss Reserves” in Part I, Item 1 of this annual report, 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. At December 31, 2010 and 2009, the liability of LMC under the adverse development cover was approximately $3.0 million. The balance of the trust account, including accumulated interest, at December 31, 2010 was $3.8 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. If LMC is placed into receivership and the amount held in the collateralized reinsurance trust is inadequate to satisfy the obligations of LMC to us under the adverse development cover, it is unlikely that we would recover any future amounts owed by LMC to us under the adverse development cover in excess of the amounts currently held in trust because the director of the Illinois Department of Insurance would have control of the assets of LMC.

 
Some of our customers are insured under Eagle insurance policies that we service pursuant to the claims administration servicing agreement described above. Although SeaBright is a separate legal entity from LMC and its affiliates, including Eagle, Eagle’s policyholders may not readily distinguish SeaBright from Eagle and LMC if those policies are not honored in the event LMC is found to be insolvent and placed into court-ordered liquidation. If that were to occur, our market reputation, credibility and ability to renew the underlying policies could be adversely affected.

 
In connection with the Acquisition, LMC and its affiliates made various transfers and payments to SeaBright, including approximately $13.0 million under the commutation agreement and an initial amount of approximately $1.6 million to fund the collateralized reinsurance trust. In the event that LMC is placed into receivership, it is possible that a receiver or creditor could assert a claim seeking to unwind or recover these payments under applicable voidable preference and fraudulent transfer laws.

We may pursue strategic mergers, acquisitions, and divestitures which could have an adverse impact on our business.

In December 2007, we acquired PMCS, a provider of medical bill review, utilization review, nurse case management and other related services, and in July 2008 we acquired BWNV, a privately held managing general agent and wholesale insurance broker. We may, from time to time, consider acquiring additional complementary companies or businesses. To do so, we would need to identify suitable acquisition candidates and negotiate acceptable acquisition terms. Pursuit of an acquisition may divert management’s attention and resources, and completion of an acquisition will require use of our capital and may require additional financing. If we complete additional acquisitions, we may have difficulty integrating acquired businesses into our existing businesses, which could adversely affect our operations, particularly in the fiscal quarters immediately following the acquisition as they are integrated into our operations.

 
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If we are unable to collect future retrospective premium adjustments under our retrospectively rated policies, our financial position and results of operations may be adversely affected.

Retrospectively rated policies accounted for approximately 5.9% and 7.2% of direct premiums written in the years ended December 31, 2010 and 2009, respectively. Beginning six months after the expiration of the relevant insurance policy, and annually thereafter, we recalculate the premium during the policy term based on the current value of the known losses that occurred during the policy term. While the typical retrospectively rated policy has around five annual adjustment or measurement periods, premium adjustments continue until mutual agreement to cease future adjustments is reached with the policyholder. We bear credit risk with respect to retrospectively rated policies. Because of the long duration of our loss sensitive plans, there is a risk that the customer will fail to pay the additional premium. Accordingly, we obtain collateral in the form of letters of credit or deposits to mitigate credit risk associated with our loss sensitive plans. If we are unable to collect future retrospective premium adjustments from an insured, we would be required to write off the related amounts, which could impact our financial position and results of operations.

Risks Related to Our Industry

We may face substantial exposure to losses from terrorism for which we are required by law to provide coverage.

Under our workers’ compensation policies, we are required to provide workers’ compensation benefits for losses arising from acts of terrorism. The impact of any terrorist act is unpredictable, and the ultimate impact on us would depend upon the nature, extent, location and timing of such an act. Notwithstanding the protection provided by the reinsurance we have purchased and any protection provided by the Terrorism Risk Act, the risk of severe losses to us from acts of terrorism has not been eliminated because, as discussed above, our excess of loss reinsurance treaty program contains various sub-limits and exclusions limiting our reinsurers’ obligation to cover losses caused by acts of terrorism. Accordingly, events may not be covered by, or may exceed the capacity of, our reinsurance protection and any protection offered by the Terrorism Risk Act or any successor legislation. Thus, any acts of terrorism could materially adversely affect our business and financial condition.

The threat of terrorism and military and other actions may result in decreases in our net income, revenue and assets under management and may adversely affect our investment portfolio.

The threat of terrorism, both within the United States and abroad, and military and other actions and heightened security measures in response to these types of threats, may cause significant volatility and declines in the equity markets in the United States and abroad, as well as loss of life, property damage, additional disruptions to commerce and reduced economic activity. Actual terrorist attacks could cause a decrease in our stockholders’ equity, net income and/or revenue. The effects of these changes may result in a decrease in our stock price. In addition, some of the assets in our investment portfolio may be adversely affected by declines in the bond markets and declines in economic activity caused by the continued threat of terrorism, ongoing military and other actions and heightened security measures.

We cannot predict at this time whether and the extent to which industry sectors in which we maintain investments may suffer losses as a result of potential decreased commercial and economic activity, or how any such decrease might impact the ability of companies within the affected industry sectors to pay interest or principal on their securities, or how the value of any underlying collateral might be affected.

We can offer no assurances that terrorist attacks or the threat of future terrorist events in the United States and abroad or military actions by the United States will not have a material adverse effect on our business, financial condition or results of operations.

 
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Our results of operations and revenues may fluctuate as a result of many factors, including cyclical changes in the insurance industry, which may cause the price of our common stock to be volatile.

The results of operations of companies in the insurance industry historically have been subject to significant fluctuations and uncertainties. Our profitability can be affected significantly by:

 
competition;

 
decreased demand for our products;

 
rising levels of loss costs that we cannot anticipate at the time we price our products;

 
volatile and unpredictable developments, including man-made, weather-related and other natural catastrophes or terrorist attacks;

 
changes in the level of reinsurance capacity and capital capacity;

 
changes in the amount of loss reserves resulting from new types of claims and new or changing judicial interpretations relating to the scope of insurers’ liabilities; and

 
fluctuations in interest rates, inflationary pressures and other changes in the investment environment, which affect returns on invested assets and may impact the ultimate payout of losses.

The availability of insurance is related to prevailing prices, the level of insured losses and the level of industry surplus which, in turn, may fluctuate in response to changes in rates of return on investments being earned in the insurance industry. As a result, the insurance business historically has been a cyclical industry characterized by periods of intense price competition due to excessive underwriting capacity as well as periods when shortages of capacity permitted favorable premium levels. During 1998, 1999 and 2000, the workers’ compensation insurance industry experienced substantial pricing competition, and this pricing competition greatly affected the ability of our predecessor to increase premiums. Beginning in 2001, our predecessor witnessed a decrease in pricing competition in the industry, which enabled them to raise their rates. Although rates for many products increased from 2000 to 2003, legislative reforms caused premium rates in certain states, including California, to decrease in 2004 through 2008, and rates may decrease again or may decrease in other states. In addition, the availability of insurance has and may continue to increase, either by capital provided by new entrants or by the commitment of additional capital by existing insurers, which may perpetuate rate decreases. Any of these factors could lead to a significant reduction in premium rates, less favorable policy terms and fewer submissions for our underwriting services. In addition to these considerations, changes in the frequency and severity of losses suffered by insureds and insurers may affect the cycles of the insurance business significantly, and we expect to experience the effects of such cyclicality. This cyclicality may cause the price of our securities to be volatile.

Risks Related to Our Common Stock

The price of our common stock may decrease.

The trading price of shares of our common stock may decline for many reasons, some of which are beyond our control, including, among others:

 
quarterly variations in our results of operations;

 
changes in expectations as to our future results of operations, including financial estimates by securities analysts and investors;

 
announcements of claims against us by third parties;

 
changes in law and regulation;

 
results of operations that vary from those expected by securities analysts and investors; and

 
future sales of shares of our common stock.

 
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In addition, the stock market has recently experienced substantial price and volume fluctuations that sometimes have been unrelated or disproportionate to the operating performance of companies whose shares are traded. The trading price of shares of our common stock may decrease if our future operating results fail to meet or exceed the expectations of market analysts and investors or current economic or market conditions persist or worsen.

Applicable insurance laws may make it difficult to effect a change of control of our company.

Our insurance company subsidiary is domiciled in the state of Illinois and commercially domiciled in the state of California. The insurance holding company laws of Illinois and California require advance approval by the Illinois Department of Insurance and the California Department of Insurance of any change in control of SeaBright Insurance Company. “Control” is generally presumed to exist through the direct or indirect ownership of 10% or more of the voting securities of a domestic insurance company or of any entity that controls a domestic insurance company. In addition, insurance laws in many states contain provisions that require prenotification to the insurance commissioners of a change in control of a non-domestic insurance company licensed in those states. Any future transactions that would constitute a change in control of SeaBright Insurance Company, including a change of control of us, would generally require the party acquiring control to obtain the prior approval of the Illinois Department of Insurance and the California Department of Insurance and may require pre-acquisition notification in applicable states that have adopted pre-acquisition notification provisions. Obtaining these approvals may result in a material delay of, or deter, any such transaction. See the discussion under the heading “Regulation” in Part  I, Item 1 of this annual report.

These laws may discourage potential acquisition proposals and may delay, deter or prevent a change of control of us, including through transactions, and in particular unsolicited transactions, that some or all of our stockholders might consider to be desirable.

Anti-takeover provisions in our amended and restated certificate of incorporation and by-laws and under the laws of the State of Delaware could impede an attempt to replace or remove our directors or otherwise effect a change of control of our company, which could diminish the value of our common stock.

Our amended and restated certificate of incorporation and by-laws contain provisions that may make it more difficult for stockholders to replace directors even if the stockholders consider it beneficial to do so. In addition, these provisions could delay or prevent a change of control that a stockholder might consider favorable. For example, these provisions may prevent a stockholder from receiving the benefit from any premium over the market price of our common stock offered by a bidder in a potential takeover. Even in the absence of an attempt to effect a change in management or a takeover attempt, these provisions may adversely affect the prevailing market price of our common stock if they are viewed as discouraging takeover attempts in the future. In addition, Section 203 of the Delaware General Corporation Law may limit the ability of an “interested stockholder” to engage in business combinations with us. An interested stockholder is defined to include persons owning 15% or more of any class of our outstanding voting stock.

Our amended and restated certificate of incorporation and by-laws contain the following provisions that could have an anti-takeover effect:

 
stockholders have limited ability to call stockholder meetings and to bring business before a meeting of stockholders;

 
stockholders may not act by written consent; and

 
our Board of Directors may authorize the issuance of preferred stock with such rights, powers and privileges as the board deems appropriate.

These provisions may make it difficult for stockholders to replace management and could have the effect of discouraging a future takeover attempt which is not approved by our Board of Directors but which individual stockholders might consider favorable.

 
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Item 1B.  Unresolved Staff Comments.

None.

Item 2.  Properties.

Our principal executive offices are located in approximately 36,000 square feet of leased office space in Seattle, Washington. We also lease office space consisting of approximately 2,500 square feet in Anchorage, Alaska; 2,600 square feet in Baton Rouge, Louisiana; 5,650 square feet in Chicago, Illinois; 6,100 square feet in Concord, California; 5,700 square feet in Henderson, Nevada; 2,650 square feet in Honolulu, Hawaii; 3,300 square feet in Houston, Texas; 3,400 square feet in Lake Mary, Florida; 3,700 square feet in Needham, Massachusetts; 8,300 square feet in Orange, California; 6,260 square feet in Phoenix, Arizona; 3,900 square feet in Radnor, Pennsylvania; 8,800 square feet in Santa Ana, California; and executive suites in New Orleans, Louisiana; and Yucca Valley, California. We conduct claims and underwriting operations in our branch offices, with the exception of our Honolulu office, where we conduct only claims and loss control operations. We do not own any real property. We consider our leased facilities to be adequate for our current operations.

Item 3.  Legal Proceedings.

We are, from time to time, involved in various legal proceedings in the ordinary course of business. We believe we have sufficient loss reserves and reinsurance to cover claims under policies issued by us. Accordingly, we do not believe that the resolution of any currently pending legal proceedings, either individually or taken as a whole, will have a material adverse effect on our business, financial condition or results of operations.

Item 4.  Removed and Reserved.

Item 4.1.  Executive Officers of the Registrant.

The information required by this item is incorporated by reference from the section captioned “Executive Officers and Key Employees” contained in our proxy statement for the 2011 annual meeting of stockholders, to be filed with the Commission pursuant to Regulation 14A not later than 120 days after December 31, 2010.

 
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PART II

Item 5.  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Our common stock is listed on the New York Stock Exchange under the symbol “SBX”. The following table sets forth, for the periods indicated, the high and low sales prices for our common stock as quoted on the New York Stock Exchange.

 
 
High
   
Low
 
2010:
           
First quarter
  $ 11.88     $ 9.58  
Second quarter
    11.52       9.46  
Third quarter
    10.09       6.53  
Fourth quarter
    9.46       7.62  
2009:
               
First quarter
  $ 12.81     $ 7.70  
Second quarter
    11.73       7.91  
Third quarter
    11.70       9.23  
Fourth quarter
    12.10       10.36  

As of March 11, 2011, there were 84 holders of record of our common stock.

Dividend Policy

In 2010, our Board of Directors declared quarterly cash dividends of $0.05 per common share on March 2, May 11, August 10 and November 9. Any future determination to pay cash dividends on our common stock will be at the discretion of our Board of Directors and will be dependent on our earnings, financial condition, operating results, capital requirements, any contractual restrictions, regulatory and other restrictions on the payment of dividends by our subsidiaries to us, and other factors that our Board of Directors deems relevant.

We are a holding company and have no direct operations. Our ability to pay dividends in the future depends on the ability of our operating subsidiaries to pay dividends to us. Our subsidiary, SeaBright Insurance Company, is a regulated insurance company and therefore is subject to significant regulatory restrictions limiting its ability to declare and pay dividends.

SeaBright Insurance Company’s ability to pay dividends is subject to restrictions contained in the insurance laws and related regulations of Illinois and California. The insurance holding company laws in these states require that ordinary dividends be reported to the Illinois Department of Insurance and the California Department of Insurance prior to payment of the dividend and that extraordinary dividends be submitted for prior approval. See “Regulation” in Part I, Item 1 of this annual report.

For information regarding restrictions on the payment of dividends by us and SeaBright Insurance Company, see the discussion under the heading “Liquidity and Capital Resources” in Part II, Item 7 and the discussion under the heading “Business — Regulation — Dividend Limitations” in Part I, Item 1 of this annual report.

 
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Purchases of Equity Securities by the Issuer

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 December 31, 2010:

   
(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 (October 1, 2010 through October 31, 2010)
                       
Month # 2 (November 1, 2010 through November 30, 2010)
    951     $ 8.85              
Month # 3 (December 1, 2010 through December 31, 2010)
                       

We did not repurchase any of our common stock on the open market as part of a stock repurchase program during the three months ended December 31, 2010; however, our employees surrendered 951 shares of our common stock to satisfy their tax withholding obligations in connection with the vesting of restricted stock awards issued under our Amended and Restated 2005 Long-Term Equity Incentive Plan.

Performance Graph
 
The following graph and table compare the total return on $100 invested in SeaBright common stock for the period commencing on December 31, 2005 and ending on December 31, 2010 with the total return on $100 invested in each of the New York Stock Exchange Composite Index and the Dow Jones U.S. Property & Casualty Insurance TSM Index. The closing market price for SeaBright common stock at the end of fiscal year 2010 was $9.22.
 
Image
________________
 
*
Based on $100 invested on December 31, 2005, the last trading day before the beginning of the fifth preceding fiscal year and, for purposes of the indexes, assumes the reinvestment of dividends.

 
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Cumulative Total Return
 
   
SeaBright
Holdings, Inc.
   
NYSE
Composite
Index
   
Dow Jones
U.S. Property & Casualty
Insurance TSM Index
 
12/31/05
  $ 100.00     $ 100.00     $ 100.00  
3/31/06
    104.75       106.72       99.66  
6/30/06
    96.87       106.64       100.69  
9/30/06
    84.00       111.10       106.83  
12/31/06
    108.30       120.47       114.32  
3/31/07
    110.64       122.68       111.56  
6/30/07
    105.11       131.67       117.72  
9/30/07
    102.65       134.51       110.58  
12/31/07
    90.68       131.15       103.54  
3/31/08
    88.57       119.18       90.27  
6/30/08
    87.07       118.18       86.70  
9/30/08
    78.17       103.42       90.10  
12/31/08
    70.60       79.67       77.49  
3/31/09
    62.90       69.44       63.30  
6/30/09
    60.91       83.07       68.98  
9/30/09
    68.67       97.77       83.92  
12/31/09
    69.09       102.20       84.82  
3/31/10
    66.49       106.50       91.18  
6/30/10
    57.55       93.14       85.00  
9/30/10
    49.23       105.41       84.10  
12/31/10
    56.62       115.87       100.62  

The information in the graph and table above is not “soliciting material,” is not deemed “filed” with the SEC and is not to be incorporated by reference in any of our filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended (the “Exchange Act”), whether made before or after the date of this annual report and irrespective of any general incorporation language in any such filing, except to the extent that we specifically incorporate such information by reference.

 
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Item 6.  Selected Financial Data.

The following table sets forth our selected historical financial information for the periods ended and as of the dates indicated. This information comes from our consolidated financial statements. Certain reclassifications have been made to prior year financials statements to conform to classifications used in the current year. For further information, see Part II, Item 8, Note 2, “Summary of Significant Accounting Policies”. You should read the following selected financial information along with the information contained in this annual report, including Part II, Item 7 of this annual report entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the combined and consolidated financial statements and related notes and the reports of the independent registered public accounting firm included in Part II, Item 8 and elsewhere in this annual report. These historical results are not necessarily indicative of results to be expected from any future period.

   
Year Ended December 31,
 
   
2010
   
2009
   
2008
   
2007
   
2006
 
   
($ in thousands, except share and per share data)
 
Income Statement Data:
                             
Gross premiums written
  $ 264,323     $ 290,002     $ 270,344     $ 282,658     $ 230,253  
Ceded premiums written
    (24,109 )     (27,234 )     (14,520 )     (15,300 )     (15,490 )
Net premiums written
  $ 240,214     $ 262,768     $ 255,824     $ 267,358     $ 214,763