Income Taxes
For any uncertain tax positions not meeting the “more likely than not” recognition threshold, accounting standards require recognition, measurement, and disclosure in the financial statements. There were no uncertain tax positions at September 30, 2016 and December 31, 2015.
Stock-based Compensation
Compensation expense for stock-based payments is recognized based on the measurement-date fair value for awards that will settle in shares. Compensation expense for restricted stock grants and stock option awards that contain a service condition are recognized on a straight line pro rata basis over the vesting period. For restricted stock awards that contain a performance condition, the expense is recognized based on the awards expected to vest and the cumulative expense is adjusted whenever the estimate of the number of awards to vest changes. See Note 7 — “Stock-based Payments” for related disclosures.
Recent Accounting Pronouncements
In May 2014, the FASB issued an accounting standards update (ASU 2014-09), “Revenue from Contracts with Customers” (Topic 606). The core guidance of the ASU presents a comprehensive revenue recognition model that requires a company to recognize revenue to depict the transfer of goods or services to a customer at an amount that reflects the consideration it expects to receive in exchange for those goods or services. The ASU provides a five-step analysis of transactions to determine when and how revenue is recognized and requires additional disclosures sufficient to describe the nature, amount, timing and uncertainty of revenue and cash flows for these transactions. In August 2015, the FASB issued ASU 2015-14 to defer the effective date to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that period. Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. As insurance contracts are excluded from this ASU, the Company is currently evaluating what impact, if any, this ASU will have on financial results and disclosures and which adoption method to apply.
In April 2015, the FASB issued an accounting standards update (ASU 2015-03), “Interest – Imputation of Interest” (Topic 835). The new guidance requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The guidance in ASU 2015-03 does not address presentation or subsequent measurement of debt issuance costs related to line-of-credit arrangements. The FASB therefore issued ASU 2015-15 “Interest—Imputation of Interest (Subtopic 835-30): Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements,” which clarified that the SEC staff would not object to an entity deferring and presenting debt issuance costs as an asset and subsequently amortizing the deferred debt issuance costs ratably over the term of the line-of-credit arrangement, regardless of whether there are any outstanding borrowings on the line-of-credit arrangement. For public business entities, the guidance is effective for annual and interim periods beginning after December 15, 2015. The Company adopted ASU 2015-03 on January 1, 2016.
In May 2015, the FASB issued an accounting standards update (ASU 2015-09), “Disclosures about Short-Duration Contracts” (Topic 944) intended to make targeted improvements to disclosure requirements for insurance companies that issue short-duration contracts. The amendments in this update are expected to increase transparency of significant estimates made in measuring those liabilities, improve comparability by requiring consistent disclosure of information, and provide financial statement users with additional information to facilitate analysis of the amount, timing, and uncertainty of cash flows arising from contracts issued by insurance entities and the development of loss reserve estimates. This ASU will be effective for annual periods beginning after December 15, 2015, and interim periods within annual periods beginning after December 15, 2016. The Company is currently evaluating what impact this ASU will have on disclosures.
In September 2015, the FASB issued an accounting standards update (ASU 2015-16), “Business Combinations - Simplifying the Accounting for Measurement-Period Adjustments” (Topic 805) which applies to all entities that have
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking and Other Statements
Various statements contained in this Form 10-Q are forward-looking statements made pursuant to the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements may include projections and estimates concerning the timing and success of specific projects and the Company’s future production, revenues, income and capital spending. The Company’s forward-looking statements are generally, but not always, accompanied by words such as “estimate,” “believe,” “expect,” “will,” “plan,” “target,” “could” or other words that convey the uncertainty of future events or outcomes.
There can be no assurance that actual developments will be those anticipated by us, and therefore you are cautioned not to place undue reliance on the Company’s forward-looking statements. Actual results may differ materially from those expressed or implied in these statements as a result of significant risks and uncertainties, including, but not limited to, our ability to recover from our capacity providers, the cost and availability of reinsurance coverage, challenges to our use of issuing carrier or fronting arrangements by regulators or changes in state or federal insurance or other statutes or regulations, our dependence on a limited number of business partners, potential regulatory scrutiny of collateral protection insurance, level of new car sales, availability of credit for vehicle purchases and other factors affecting automobile financing, our ability to compete effectively, a downgrade in the financial strength ratings of our insurance subsidiaries, our ability to accurately underwrite and price our products and to maintain and establish accurate loss reserves, changes in interest rates or other changes in the financial markets, the effects of emerging claim and coverage issues, changes in the demand for our products, the effect of general economic conditions, breaches in data security or other disruptions with our technology, and changes in pricing or other competitive environments.
Forward-looking statements involve inherent risks and uncertainties that are difficult to predict and many of which are beyond the Company’s control. The Company cautions readers that various factors could cause its actual financial and operational results to differ materially from those indicated by forward-looking statements made from time-to-time in news releases, reports, proxy statements, registration statements, and other written communications, as well as oral statements made from time to time by representatives of the Company. These and other important factors, including those contained in Item 1A, "Risk Factors” in the 2015 Annual Report on Form 10-K, may cause our actual results, performance or achievements to differ materially from any future results, performance or achievements expressed or implied by these forward-looking statements. The forward-looking statements contained in this Form 10-Q speak only as of the date hereof, and the Company undertakes no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future developments or otherwise, except as may be required by law.
Overview
We are a leading specialty provider of property and casualty insurance services operating in two niche markets across the United States. In our Program Services segment, we leverage our “A” (Excellent) A.M. Best rating, expansive licenses and reputation to provide access to the U.S. property and casualty insurance market in exchange for ceding fees. In our Lender Services segment, we specialize in providing collateral protection insurance “CPI”, which insures personal automobiles and other vehicles held as collateral for loans made by credit unions, banks and specialty finance companies.
Our Program Services segment generates significant fee income, in the form of ceding fees, by offering issuing carrier (“fronting”) capacity to both specialty general agents and other producers (“GAs”), who sell, control, and administer books of insurance business that are supported by third parties that assume reinsurance risk. These reinsurers are domestic and foreign insurers and institutional risk investors (“capacity providers”) that want to access specific lines of U.S. property and casualty insurance business. Issuing carrier arrangements refer to our business in which we write insurance on behalf of a capacity provider and then reinsure the risk under these policies with the capacity provider in exchange for ceding fees. We reinsure substantially all of the underwriting risks in connection with our fronting arrangements to our capacity providers. As such, this segment generates very large gross premiums with no net premiums (except for the run-off of the retained business as described below). In many cases, we hold significant collateral to secure the associated reinsurance recoverables. Furthermore, to the extent funds related to settling balances
(premiums, commissions and losses) between the GAs and the reinsurers are not the obligation of the Company, no receivables or payables are reflected in the Company’s financial statements for these amounts. In exchange for providing our insurance capacity, licensing and rating to our GA and insurer clients, we receive ceding fees averaging in excess of 5% of gross written premiums.
Our Lender Services segment generates premiums primarily from providing collateral protection insurance or CPI to our credit union, bank and specialty finance company clients. Lenders purchase CPI to provide coverage for automobiles or other vehicles of borrowers who do not uphold their obligation to insure the collateral underlying the loan. Our lender clients pay us directly for CPI and then add the cost of CPI to the borrower’s loan. Our CPI business is fully vertically integrated: we manage all aspects of the CPI business cycle, including sales and marketing, policy issuance, policy administration, underwriting and claims handling.
Recent Developments
On October 12, 2015, the Company announced a share repurchase program authorizing the repurchase of up to $50 million in shares of the Company's common stock through December 31, 2016. Repurchases are made in accordance with the guidelines specified under Rule 10b-18 and may be made under Rule 10b5-1, under the Securities Exchange Act of 1934. During the nine months ended September 30, 2016, the Company purchased 697,098 shares of its common stock at an aggregate purchase price including commissions of $7.1 million. The excess cost of the repurchased shares over par value was charged to retained earnings.
On September 28, 2016, the Company entered into an agreement to acquire a non-admitted property and casualty shell company. The agreement is subject to regulatory approvals and customary closing conditions.
On September 30, 2016, the Company acquired 100% of the outstanding common shares of United National Specialty Insurance Company (“UNSIC”), an admitted shell company with licenses in 49 states.
The purpose of the acquisition is to provide exclusive capacity for one of our programs.
Factors Affecting Our Operating Results
Trending Market Opportunities.
We believe that macroeconomic conditions will provide us with growth opportunities in each of our business segments. Increasing automobile sales should expand lenders’ loan portfolios to improve our Lender Services results. Over the past decade, alternative capital has been entering the reinsurance market at an accelerating pace. This influx of capital has had the effect of compressing rates for reinsurance, which in the past was primarily written to reinsure catastrophe-exposed property insurance. These lower reinsurance rates are now driving industry capital to seek opportunity in U.S. primary insurance markets for both property and casualty lines. These market dynamics should provide growth opportunities in our Program Services segment.
In our Lender Services business, we believe that organic growth from our existing lender clients will be driven by overall growth in lenders’ portfolios as a result of rising automobile sales, higher average auto loan balances and an aging U.S. automobile fleet. We expect that new sales from our alliance with CUNA Mutual and potential new business from banks and specialty finance companies will produce additional premiums.
We believe that the increased role of capital market alternatives to reinsurance, including the capitalization of hedge fund-backed reinsurers and the availability of capital in the non-U.S. reinsurance market, is driving demand for our Program Services, as these firms typically do not have direct access to the U.S. insurance market. We are well positioned to meet this demand due to our highly rated and broadly licensed insurance subsidiaries in addition to our proven model to provide fronting for a fee.
We currently have a significant program with Nephila Capital, Ltd. (“Nephila”) under which we granted Nephila the exclusive right to utilize the Company as issuing carrier for U.S. catastrophe exposed property insurance from 2015 through 2019. Nephila is a hedge fund with approximately $11 billion in assets under management that participates in the market for catastrophe exposed property business. In exchange for this exclusive right, Nephila has agreed to pay State National contractual minimum ceding fees totaling $51.5 million through 2019. The minimum ceding fees are
subject to State National maintaining its “A” A.M. Best rating and potential reductions to the extent that State National is unable to provide production year capacity or is otherwise constrained from writing premium. Also, under certain circumstances, Nephila may terminate the exclusivity, which would reduce the contractual minimum ceding fees to a total of $32.5 million for 2016 through 2019. In the event of such a termination, State National would have the ability to write the catastrophe exposed property business for other capacity providers. The timing and actual amount of gross premiums written for Nephila will impact the timing and amount of ceding fees earned each period under this program. See “—Principal Revenue and Expense Items—Minimum ceding fees.” In addition, State National and Nephila have an alliance under which State National acquired one admitted property and casualty insurance shell company and has entered into an agreement to acquire one non-admitted property and casualty insurance shell company, which will be used exclusively to write the direct business produced by Nephila. Nephila will have a three year option to purchase these companies beginning three years after the shell companies first write premium. In the event that the option is exercised, contractual minimum payments to State National will extend for an additional two years.
Run-off of the Retained Business
. In the past, the Company has participated to a limited extent on a quota share basis in certain programs in the Program Services segment. From 2007 until 2011, California had required USIC to retain 10% of the risks written. After this requirement was lifted in early 2012, the Company reinsured to inception the retained business under most of the active contracts, but others continue to run-off. The Company has no active retained contracts and has no present intention of participating in future contracts. We refer to this business as “the run-off of the retained business.” As of September 30, 2016, we had net reserves of $3.8 million related to this business.
Seasonality of Our Business
. Our Lender Services segment typically experiences seasonal fluctuations in written premium. The fourth quarter tends to generate the greatest amount of written premium, whereas the first quarter of the year tends to generate the least. We believe this trend follows loan delinquency patterns for the industry. We generally do not experience seasonality in our Program Services segment.
Principal Revenue and Expense Items
Premiums earned.
Premiums earned are the earned portion of our net premiums written, which are predominately CPI premiums. As the CPI product is not a traditional insurance product, the premium recognition is likewise different. We do not record premiums until we collect them from our accounts since they have the right to waive the placement of insurance on any of their loans. There is a high level of policy cancellations since borrowers often purchase insurance at the traditional rates that provides protection for them in addition to their lender. Due to this high level of policy cancellations, we split the premium into two pieces: (1) an allowance for future cancellations and (2) premiums that we expect to earn, which we refer to as “stick premiums.” We earn stick premiums on a pro rata basis over the terms of the policies. The CPI premiums written as presented in this document reflect the effects of the allowance for policy cancellations including any adjustments related to re-estimation of the allowance. As such, our recorded CPI premiums written are those that we expect to earn while those that are expected to cancel are included in the allowance for policy cancellations. At the end of each reporting period, stick premium written that is not earned is classified as unearned premium, which is earned in subsequent periods over the remaining terms of the policies. Our policies typically have a term of one year, although the average duration of our CPI policies is typically less than six months due to policy cancellations.
Ceding fees.
Ceding fees are fees we receive in the Program Services segment in exchange for providing access to the U.S. property and casualty insurance market and are based on the gross premiums we write on behalf of our GA and capacity provider clients. We earn ceding fees in a manner consistent with the recognition of the gross premiums earned on the underlying insurance policies, generally on a pro-rata basis over the terms of the policies reinsured, which policies often have a one year term.
Minimum ceding fees.
Minimum ceding fees are fees we receive pursuant to contractual minimum premium requirements for certain of our programs where either significant premium capacity is reserved for that program or where the expected premium volume is not reasonably assured. For those programs where a minimum applies, the ceding fees are considered as two distinct pieces (1) “premium related fees,” which are earned as the associated gross written premium is earned, typically pro rata on an annual basis; and (2) “capacity fees,” which are determined based on
the shortfall, if any, between the program’s contractual annual premium minimum and the amount of premium that we estimate will be written in the contract year, which fees are earned over the contract year.
At the end of each quarter during the program contract year, we adjust the capacity fee based upon the re-estimated or actual amount of gross premiums that we expect will be written or that were written for that program for the full contract year. If the estimated annual gross written premiums fall below the minimum contract level in a given period, capacity fees associated with the estimated premium shortfall for that period are earned in that period. If the estimated annual gross written premiums equal or exceed the required minimum level for a given period, no capacity fees are recognized for that period, and the premium related fees are earned as the associated gross written premium is earned. In connection with our re-estimation process, if in a subsequent period we increase our estimate of the amount of gross premiums that we expect will be written under a program for the full contract year, we will reverse a portion of the capacity fees earned in a prior period. Conversely, to the extent that we decrease our estimate of gross premiums, we will recognize capacity fees associated with the additional shortfall in the current period.
Losses and loss adjustment expenses.
Losses and loss adjustment expenses (“LAE”) include claims paid, estimates of future claim payments, changes in those estimates from prior reporting periods and costs associated with investigating, defending and servicing claims. We record loss and LAE related to estimates of future claim payments based on historical experience. We seek to establish all reserves at the most likely ultimate exposure based on historical claims experience. We revise our estimates as we receive additional information about claims and the total costs of settlement.
Commissions.
Substantially all commission expenses are related to our Lender Services segment. A significant portion of these amounts are paid to financial institutions as a means to reimburse the financial institution for costs associated with operating a CPI program. These commissions are partially offset by a 21% ceding commission received under our quota reinsurance agreement with CUNA Mutual and the reimbursement we received from CUNA Mutual for 30% of direct commissions and other reimbursable expenses paid to accounts. The ceding commission compensates us for expenses, such as underwriting and policy acquisition expenses, that we incur in connection with the writing of the ceded business.
General and administrative expense.
General and administrative expense is composed of all other operating expenses, including various departmental salaries and benefits expense for employees. General and administrative expense also includes expenses related to our office space, postage, telephone and information technology charges, as well as legal and auditing fees and corporate travel. In addition, general and administrative expense includes those charges that are related to the amortization of tangible and intangible assets.
Stock-based compensation expense.
Compensation expense for stock-based payments is recognized based on the measurement-date fair value for awards that will settle in shares. Compensation expense for awards that are settled in equity is recognized on a straight line pro rata basis over the vesting period.
Ratios
Program Services Ratios
Program gross expense ratio
. The program gross expense ratio is a measure of our ability to earn increasing amounts of ceding fees with only minimal incremental expense in our Program Services business. Expressed as a percentage, this is the ratio of general and administrative expense incurred to gross written premium. Our GAs and capacity providers are responsible for providing all underwriting, policy administration, claims handling and other traditional insurance company services. As a result, we are able to produce significant premium volume with only minimal operating expenses. In addition, our fixed costs are a large component of the operating expenses while the incremental costs are small and are dependent upon the size and complexity of the programs being supported. Our program gross expense ratio was 1.1% for the nine months ended September 30, 2016 and 2015. Our objective is to produce a gross expense ratio in a range of 1.0% to 1.5%.
Gross leverage.
Gross leverage for the Company is the ratio of gross written premiums and gross liabilities to surplus. A significant portion of our capital is used to support the gross premium and insurance liabilities in our Program Services segment. Because we retain virtually no risk other than the credit risk of the capacity providers and we maintain strict credit underwriting standards, broad indemnification agreements and collateral requirements we are able to maintain significant ceded reinsurance business on a relatively small amount of capital compared to our peers. For the year ended December 31, 2015, our gross leverage ratio was 14 to 1. Our objective is to produce a total company gross leverage ratio of between 13 to 1 and 15 to 1.
Lender Services Insurance Ratios
Net loss ratio
. The net loss ratio is a measure of the underwriting profitability of our Lender Services segment. Expressed as a percentage, this is the ratio of net losses and LAE incurred to net premiums earned. For the nine months ended September 30, 2016 and 2015, our net loss ratio was 44.1% and 45.7%, respectively. This decrease is primarily due to an increase in premiums earned, resulting in part from pricing adjustments on our CPI product.
Net expense ratio
. The net expense ratio is a component of our operational efficiency in administering our Lender Services segment. Expressed as a percentage, this is the ratio of net expenses (commissions, taxes, licenses, and fees and general and administrative) to net premiums earned. Our expense ratio is higher than that for most traditional insurance products due to the labor and systems intensive processes involved in monitoring the insurance statuses for the loan portfolios of our Lender Services clients. For the nine months ended September 30, 2016 and 2015, our net expense ratio was 40.4% and 42.1%, respectively.
Net combined ratio
. The net combined ratio is a measure of the overall profitability of our Lender Services segment. This is the sum of the net loss ratio and the net expense ratio. For the nine months ended September 30, 2016 and 2015, our net combined ratio was 84.5% and 87.8%, respectively. Our objective is to price our products to achieve a net combined ratio between 85% to 90%.
Financial Ratios
Return on equity.
One of the key financial measures that we use to evaluate our operating performance is return on equity. We calculate return on equity by dividing net income by the average GAAP equity. Our return on equity at December 31, 2015 was 17.7%. Our overall financial objective is to produce a return on equity of at least 15% over the long-term.
Financial leverage ratios.
Our financial leverage ratio at September 30, 2016 was 15.0%, as compared to 16.6% at December 31, 2015. Our objective is to maintain a financial leverage ratio in the range of 20% to 35% over the long-term.
Critical Accounting Estimates
Our consolidated financial statements include amounts that, either by their nature or due to the requirements of generally accepted accounting principles in the U.S. (“GAAP”), are determined using estimates and assumptions. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances. While we believe that the amounts included in our consolidated financial statements reflect our best judgment, actual amounts could ultimately materially differ from those currently presented. We believe the items that require the most subjective and complex estimates are: unpaid losses and LAE reserves, allowance for policy cancellations, unearned premium reserve, reinsurance recoverable, valuation of our investment portfolio, assessment of other-than-temporary impairments (“OTTI”) and minimum ceding fees.
There were no significant changes to our critical accounting policies and estimation processes during the nine months ended September 30, 2016. Our critical accounting policies and estimation processes are described in our audited consolidated financial statements and the related notes in the Company’s 2015 Annual Report on Form 10-K.
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Consolidated Results of Operations
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Three Months Ended
|
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Nine Months Ended
|
|
|
September 30,
|
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September 30,
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($ in thousands)
|
|
2016
|
|
2015
|
|
2016
|
|
2015
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|
|
|
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|
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Revenues:
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|
|
|
|
|
|
|
|
|
|
|
Premiums earned
|
|
$
|
33,700
|
|
$
|
30,156
|
|
$
|
94,293
|
|
$
|
85,145
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Commission income
|
|
|
389
|
|
|
340
|
|
|
1,015
|
|
|
1,074
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Ceding fees
|
|
|
19,263
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|
|
18,837
|
|
|
52,424
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|
|
49,360
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Net investment income
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|
|
2,001
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|
|
2,008
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|
|
6,141
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|
|
5,961
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Realized net investment gains (losses)
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|
|
2,063
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|
|
(571)
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|
|
1,707
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|
|
880
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Other income
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|
|
501
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|
|
381
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|
|
1,416
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|
|
1,228
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Total revenues
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57,917
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51,151
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156,996
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143,648
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Expenses:
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Losses and loss adjustment expenses
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13,755
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|
|
14,773
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|
|
42,587
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|
|
40,955
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Commissions
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|
|
1,408
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|
|
1,207
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|
|
4,235
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|
|
3,964
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Taxes, licenses, and fees
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|
|
960
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|
|
910
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|
|
2,466
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|
|
2,185
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General and administrative
|
|
|
17,235
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|
|
14,456
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|
|
51,377
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|
|
46,649
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Interest expense
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|
|
565
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|
|
510
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|
|
1,655
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|
|
1,515
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Total expenses
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|
|
33,923
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|
31,856
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|
|
102,320
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|
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95,268
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Income (loss) before income taxes
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|
|
23,994
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|
|
19,295
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|
|
54,676
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|
|
48,380
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|
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|
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|
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Income tax expense (benefit)
|
|
|
8,671
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|
|
6,899
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|
|
19,695
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|
|
17,628
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|
|
|
|
|
|
|
|
|
|
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|
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Net income (loss)
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|
$
|
15,323
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|
$
|
12,396
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|
$
|
34,981
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|
$
|
30,752
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Consolidated Results of Operations for the Three Months Ended September 30, 2016 compared with the Three Months Ended September 30, 2015
Premiums earned.
Premiums earned increased by $3.5 million, from $30.2 million for the three months ended September 30, 2015 to $33.7 million for the three months ended September 30, 2016. This increase was due to an increase in Lender Services premiums earned. Factors contributing to this increase are new sales, pricing adjustments and growth in the loan portfolios of existing accounts driven by rising automobile sales and higher average auto loan balances.
Realized net investment gains (losses).
Realized net investment gains increased by $2.7 million, from a loss of $0.6 million for the three months ended September 30, 2015 to a gain of $2.1 million for the three months ended September 30, 2016. This is partially related to the liquidation of fixed maturity securities for the purchase of UNSIC and expected acquisition of a non-admitted shell company. Also, contributing to the increase is the change in fair value of embedded derivatives on the Company’s convertible securities.
Losses and loss adjustment expenses.
Losses and LAE decreased by $1.0 million, from $14.8 million for the three months ended September 30, 2015 to $13.8 million for the three months ended September 30, 2016, which is due to prior year strengthening of reserves on the run-off of the retained business for Program Services.
General and administrative expense
. General and administrative expense increased by $2.7 million, from $14.5 million for the three months ended September 30, 2015 to $17.2 million for the three months ended September 30, 2016, reflecting investment in strategic growth, increased public company expenses, professional fees and stock-based compensation.
Income tax expense.
Income tax expense increased by $1.8 million, from $6.9 million for the three months ended September 30, 2015 to $8.7 million for the three months ended September 30, 2016, primarily due to the overall increase in net income before tax.
Consolidated Results of Operations for the Nine Months ended September 30, 2016 compared with the Nine Months ended September 30, 2015
Premiums earned.
Premiums earned increased by $9.2 million, from $85.1 million for the nine months ended September 30, 2015 to $94.3 million for the nine months ended September 30, 2016. This increase was due to an increase in Lender Services premiums earned. Factors contributing to this increase are new sales, pricing adjustments and growth in the loan portfolios of existing accounts driven by rising automobile sales and higher average auto loan balances.
Ceding fees.
Ceding fees increased by $3.0 million, from $49.4 million for the nine months ended September 30, 2015 to $52.4 million for the nine months ended September 30, 2016, primarily due to an increase in Program gross premiums earned. Program Services gross premiums earned increased from $745.4 million for the nine months ended September 30, 2015 to $872.1 million for the nine months ended September 30, 2016, resulting in an increase in premium related ceding fees of $5.2 million from new and existing accounts. Capacity fees decreased $2.1 million for the nine months ended September 30, 2016 compared to September 30, 2015 due to an increase in premium-related fees and a decrease in minimum contractual fees for 2016 compared to 2015.
Realized net investment gains (losses).
Realized net investment gains increased by $0.8 million, from a gain of $0.9 million for the nine months ended September 30, 2015 to a gain of $1.7 million for the nine months ended September 30, 2016. This is partially related to the liquidation of fixed maturity securities for the purchase of UNSIC and expected acquisition of a non-admitted shell company. Also, contributing to the increase is the change in fair value of embedded derivatives on the Company’s convertible securities.
Losses and loss adjustment expenses.
Losses and LAE increased by $1.6 million, from $41.0 million for the nine months ended September 30, 2015 to $42.6 million for the nine months ended September 30, 2016, which is primarily the result of increased exposure due to higher earned premiums and an increase in claim severity for the Lender Services segment. A strengthening economy, an aging automobile fleet, and easier access to credit have contributed to an increase in vehicle sales, resulting in higher loan balances which are the bases upon which we pay claims.
General and administrative expense
. General and administrative expense increased by $4.8 million, from $46.6 million for the nine months ended September 30, 2015 to $51.4 million for the nine months ended September 30, 2016, reflecting investment in strategic growth, increased public company expenses, professional fees and stock-based compensation.
Income tax expense.
Income tax expense increased by $2.1 million, from $17.6 million for the nine months ended September 30, 2015 to $19.7 million for the nine months ended September 30, 2016, primarily due to the overall increase in net income before tax.
Program Services Segment - Results of Operations
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Three Months Ended
|
|
|
Nine Months Ended
|
|
|
|
September 30,
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|
|
September 30,
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($ in thousands)
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2016
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|
2015
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2016
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2015
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenues:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Premiums earned
|
|
$
|
3
|
|
$
|
4
|
|
|
$
|
3
|
|
$
|
(10)
|
|
Ceding fees
|
|
|
19,263
|
|
|
18,837
|
|
|
|
52,424
|
|
|
49,360
|
|
Total revenues
|
|
|
19,266
|
|
|
18,841
|
|
|
|
52,427
|
|
|
49,350
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Expenses:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Losses and loss adjustment expenses
|
|
|
96
|
|
|
1,090
|
|
|
|
1,001
|
|
|
2,057
|
|
Commissions
|
|
|
2
|
|
|
—
|
|
|
|
5
|
|
|
2
|
|
Taxes, licenses, and fees
|
|
|
2
|
|
|
(1)
|
|
|
|
13
|
|
|
8
|
|
General and administrative
|
|
|
3,681
|
|
|
2,857
|
|
|
|
10,800
|
|
|
8,990
|
|
Total expenses
|
|
|
3,781
|
|
|
3,946
|
|
|
|
11,819
|
|
|
11,057
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income (loss) before income taxes
|
|
$
|
15,485
|
|
$
|
14,895
|
|
|
$
|
40,608
|
|
$
|
38,293
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Program gross expense ratio
|
|
|
1.1
|
%
|
|
1.0
|
%
|
|
|
1.1
|
%
|
|
1.1
|
%
|
Gross premiums written
|
|
$
|
350,541
|
|
$
|
280,975
|
|
|
$
|
957,962
|
|
$
|
842,033
|
|
Gross premiums earned
|
|
$
|
311,463
|
|
$
|
258,621
|
|
|
$
|
872,090
|
|
$
|
745,407
|
|
Program Services Segment Results of Operations for the Three Months Ended September 30, 2016 compared with the Three Months Ended September 30, 2015
Losses and loss adjustment expenses.
Losses and LAE decreased by $1.0 million, from $1.1 million for the three months ended September 30, 2015 to $0.1 million for the three months ended September 30, 2016, which is due to prior year strengthening of reserves on the run-off of the retained business.
General and administrative expense
. General and administrative expense increased by $0.8 million, from $2.9 million for the three months ended September 30, 2015 to $3.7 million for the three months ended September 30, 2016, reflecting investment in strategic growth and increased professional fees.
Program Services Segment Results of Operations for the Nine Months ended September 30, 2016 compared with the Nine Months ended September 30, 2015
Ceding fees.
Ceding fees increased by $3.0 million, from $49.4 million for the nine months ended September 30, 2015 to $52.4 million for the nine months ended September 30, 2016, primarily due to an increase in Program gross premiums earned. Program Services gross premiums earned increased from $745.4 million for the nine months ended September 30, 2015 to $872.1 million for the nine months ended September 30, 2016, resulting in an increase in premium related ceding fees of $5.2 million from new and existing accounts. Capacity fees decreased $2.1 million for the nine months ended September 30, 2016 compared to September 30, 2015 due to an increase in premium-related fees and a decrease in minimum contractual fees for 2016 compared to 2015.
Losses and loss adjustment expenses.
Losses and LAE decreased by $1.1 million, from $2.1 million for the nine months ended September 30, 2015 to $1.0 million for the nine months ended September 30, 2016, which is due to prior year strengthening of reserves on the run-off of the retained business.
General and administrative expense
. General and administrative expense increased by $1.8 million, from $9.0 million for the nine months ended September 30, 2015 to $10.8 million for the nine months ended September 30, 2016, reflecting investment in strategic growth and increased professional fees.
Lender Services Segment — Results of Operations
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
|
Nine Months Ended
|
|
|
September 30,
|
|
|
September 30,
|
($ in thousands)
|
|
2016
|
|
2015
|
|
|
2016
|
|
2015
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenues:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Premiums earned
|
|
$
|
33,697
|
|
$
|
30,152
|
|
|
$
|
94,290
|
|
$
|
85,155
|
|
Commission income
|
|
|
389
|
|
|
340
|
|
|
|
1,015
|
|
|
1,074
|
|
Other income
|
|
|
491
|
|
|
381
|
|
|
|
1,410
|
|
|
1,103
|
|
Total revenues
|
|
|
34,577
|
|
|
30,873
|
|
|
|
96,715
|
|
|
87,332
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Expenses:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Losses and loss adjustment expenses
|
|
|
13,659
|
|
|
13,683
|
|
|
|
41,586
|
|
|
38,898
|
|
Commissions
|
|
|
1,406
|
|
|
1,207
|
|
|
|
4,230
|
|
|
3,962
|
|
Taxes, licenses, and fees
|
|
|
958
|
|
|
911
|
|
|
|
2,453
|
|
|
2,177
|
|
General and administrative
|
|
|
10,262
|
|
|
9,550
|
|
|
|
31,397
|
|
|
29,681
|
|
Total expenses
|
|
|
26,285
|
|
|
25,351
|
|
|
|
79,666
|
|
|
74,718
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income (loss) before income taxes
|
|
$
|
8,292
|
|
$
|
5,522
|
|
|
$
|
17,049
|
|
$
|
12,614
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net loss ratio
|
|
|
40.5
|
%
|
|
45.4
|
%
|
|
|
44.1
|
%
|
|
45.7
|
%
|
Net expense ratio
|
|
|
37.5
|
%
|
|
38.7
|
%
|
|
|
40.4
|
%
|
|
42.1
|
%
|
Net combined ratio
|
|
|
78.0
|
%
|
|
84.1
|
%
|
|
|
84.5
|
%
|
|
87.8
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross premiums written
|
|
$
|
45,746
|
|
$
|
40,522
|
|
|
$
|
114,688
|
|
$
|
102,635
|
|
Net premiums written
|
|
$
|
37,517
|
|
$
|
33,039
|
|
|
$
|
94,433
|
|
$
|
84,452
|
|
Lender Services Segment Results of Operations for the Three Months Ended September 30, 2016 compared with the Three Months Ended September 30, 2015
Premiums earned.
Premiums earned increased by $3.5 million, from $30.2 million for the three months ended September 30, 2015 to $33.7 million for the three months ended September 30, 2016. Factors contributing to this increase are new sales, pricing adjustments and growth in the loan portfolios of existing accounts driven by rising automobile sales and higher average auto loan balances.
Losses and loss adjustment expenses.
Losses and LAE remained flat for the three months ended September 30, 2016 when compared to the three months ended September 30, 2015, despite an increase in premiums earned. The increase in premiums earned is attributed primarily to pricing adjustments while claim severity slightly decreased.
General and administrative expense
. General and administrative expense increased by $0.7 million, from $9.6 million for the three months ended September 30, 2015 to $10.3 million for the three months ended September 30, 2016, reflecting investment in strategic growth and increased professional fees.
Lender Services Segment Results of Operations for the Nine Months ended September 30, 2016 compared with the Nine Months ended September 30, 2015
Premiums earned.
Premiums earned increased by $9.1 million, from $85.2 million for the nine months ended September 30, 2015 to $94.3 million for the nine months ended September 30, 2016. Factors contributing to this increase are new sales, pricing adjustments and growth in the loan portfolios of existing accounts driven by rising automobile sales and higher average auto loan balances.
Losses and loss adjustment expenses.
Losses and LAE increased by $2.7 million, from $38.9 million for the nine months ended September 30, 2015 to $41.6 million for the nine months ended September 30, 2016, which is primarily the result of increased exposure due to higher earned premiums and an increase in claim severity. A strengthening economy, an aging automobile fleet, and easier access to credit have contributed to an increase in vehicle sales, resulting in higher loan balances which are the bases upon which we pay claims.
General and administrative expense
. General and administrative expense increased by $1.7 million, from $29.7 million for the nine months ended September 30, 2015 to $31.4 million for the nine months ended September 30, 2016, reflecting investment in strategic growth and increased professional fees.
Corporate Segment — Results of Operations
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
Nine Months Ended
|
|
|
|
September 30,
|
|
September 30,
|
|
($ in thousands)
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenues:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net investment income
|
|
$
|
2,001
|
|
$
|
2,008
|
|
$
|
6,141
|
|
$
|
5,961
|
|
Realized net investment gains (losses)
|
|
|
2,063
|
|
|
(571)
|
|
|
1,707
|
|
|
880
|
|
Other income
|
|
|
10
|
|
|
—
|
|
|
6
|
|
|
125
|
|
Total revenues
|
|
|
4,074
|
|
|
1,437
|
|
|
7,854
|
|
|
6,966
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Expenses:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
General and administrative
|
|
|
3,292
|
|
|
2,049
|
|
|
9,180
|
|
|
7,978
|
|
Interest expense
|
|
|
565
|
|
|
510
|
|
|
1,655
|
|
|
1,515
|
|
Total expenses
|
|
|
3,857
|
|
|
2,559
|
|
|
10,835
|
|
|
9,493
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income (loss) before income taxes
|
|
|
217
|
|
|
(1,122)
|
|
|
(2,981)
|
|
|
(2,527)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income tax expense (benefit)
|
|
|
8,671
|
|
|
6,899
|
|
|
19,695
|
|
|
17,628
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss)
|
|
$
|
(8,454)
|
|
$
|
(8,021)
|
|
$
|
(22,676)
|
|
$
|
(20,155)
|
|
Corporate Segment Results of Operations for the Three Months Ended September 30, 2016 compared with the Three Months Ended September 30, 2015
Realized net investment gains (losses).
Realized net investment gains increased by $2.7 million, from a loss of $0.6 million for the three months ended September 30, 2015 to a gain of $2.1 million for the three months ended September 30, 2016. This is partially related to the liquidation of fixed maturity securities for the purchase of UNSIC and expected acquisition of a non-admitted shell company. Also, contributing to the increase is the change in fair value of embedded derivatives on the Company’s convertible securities.
General and administrative expense
. General and administrative expense increased by $1.3 million, from $2.0 million for the three months ended September 30, 2015 to $3.3 million for the three months ended September 30, 2016, reflecting investment in strategic growth, increased professional fees and stock-based compensation.
Income tax expense.
Income tax expense increased by $1.8 million, from $6.9 million for the three months ended September 30, 2015 to $8.7 million for the three months ended September 30, 2016, primarily due to the overall increase in net income before tax.
Corporate Segment Results of Operations for the Nine Months ended September 30, 2016 compared with the Nine Months ended September 30, 2015
Realized net investment gains (losses).
Realized net investment gains increased by $0.8 million, from a gain of $0.9 million for the nine months ended September 30, 2015 to a gain of $1.7 million for the nine months ended September 30, 2016. This is partially related to the liquidation of fixed maturity securities for the purchase of UNSIC and expected acquisition of a non-admitted shell company. Also, contributing to the increase is the change in fair value of embedded derivatives on the Company’s convertible securities.
General and administrative expense
. General and administrative expense increased by $1.2 million, from $8.0 million for the nine months ended September 30, 2015 to $9.2 million for the nine months ended September 30, 2016, reflecting investment in strategic growth, increased professional fees and stock-based compensation.
Income tax expense.
Income tax expense increased by $2.1 million, from $17.6 million for the nine months ended September 30, 2015 to $19.7 million for the nine months ended September 30, 2016, primarily due to the overall increase in net income before tax.
Investment Portfolio
Our investment strategy emphasizes, first, the preservation of capital and, second, the generation of an appropriate risk-adjusted return. We seek to generate investment returns using investment guidelines that stress prudent allocation among cash and cash equivalents, fixed-maturity securities and, to a lesser extent, equity securities. Cash and cash equivalents include cash on deposit and short-term money market funds. As of September 30, 2016, the tax adjusted yield on our fixed maturity and equity securities was 2.7%. Convertible securities represent 13.6% of the portfolio at September 30, 2016, compared to 12.3% at December 31, 2015. The average duration, excluding convertible securities, was approximately 4 years and included obligations of the U.S. Treasury or U.S. government agencies, obligations of U.S. and Canadian corporations, mortgages guaranteed by the Federal National Mortgage Association, the Government National Mortgage Association, the Federal Home Loan Mortgage Corporation, Federal Farm Credit entities, and asset-backed securities and commercial mortgage obligations. Our equity securities include preferred stock and common stock of U.S. corporations. Our investment portfolio is managed by Asset Allocation & Management Company, LLC and AAM Advisors, Inc. (collectively, “AAM”). AAM operates under written investment guidelines approved by our board of directors. We pay AAM an investment management fee based on the market value of assets under management.
For each period specified below, the cost, fair value, and gross unrealized gains and losses on available-for-sale securities were as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cost or
|
|
Gross
|
|
Gross
|
|
|
|
|
September 30, 2016
|
|
Amortized
|
|
Unrealized
|
|
Unrealized
|
|
Fair
|
|
($ in thousands)
|
|
Cost
|
|
Gains
|
|
Losses
|
|
Value
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total fixed-maturity securities
|
|
$
|
327,823
|
|
$
|
11,075
|
|
$
|
(1,330)
|
|
$
|
337,568
|
|
Total equity securities
|
|
|
3,266
|
|
|
116
|
|
|
(106)
|
|
|
3,276
|
|
Total investments
|
|
$
|
331,089
|
|
$
|
11,191
|
|
$
|
(1,436)
|
|
$
|
340,844
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cost or
|
|
Gross
|
|
Gross
|
|
|
|
|
December 31, 2015
|
|
Amortized
|
|
Unrealized
|
|
Unrealized
|
|
Fair
|
|
($ in thousands)
|
|
Cost
|
|
Gains
|
|
Losses
|
|
Value
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total fixed-maturity securities
|
|
$
|
327,764
|
|
$
|
5,486
|
|
$
|
(3,728)
|
|
$
|
329,522
|
|
Total equity securities
|
|
|
4,796
|
|
|
836
|
|
|
(88)
|
|
|
5,544
|
|
Total investments
|
|
$
|
332,560
|
|
$
|
6,322
|
|
$
|
(3,816)
|
|
$
|
335,066
|
|
The table below summarizes the credit quality of our fixed-maturity securities as of September 30, 2016, as rated by Standard and Poor’s.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Percentage of
|
|
|
Amortized
|
|
Fair
|
|
Fixed-Maturity
|
($ in thousands)
|
|
Cost
|
|
Value
|
|
Securities
|
|
|
|
|
|
|
|
|
|
|
U.S. Treasury
|
|
$
|
28,024
|
|
$
|
28,492
|
|
|
8.44%
|
AAA
|
|
|
89,804
|
|
|
92,621
|
|
|
27.44%
|
AA, AA+, AA-
|
|
|
99,125
|
|
|
101,976
|
|
|
30.21%
|
A, A+, A-
|
|
|
44,456
|
|
|
46,137
|
|
|
13.67%
|
BBB, BBB+, BBB-
|
|
|
47,226
|
|
|
48,962
|
|
|
14.50%
|
BB+ and lower
|
|
|
19,188
|
|
|
19,380
|
|
|
5.74%
|
Total
|
|
$
|
327,823
|
|
$
|
337,568
|
|
|
100.00%
|
The amortized cost and fair value of available-for-sale debt securities held as of September 30, 2016, by contractual maturity, are shown in the table below. Actual maturities may differ from contractual maturities because some borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
|
|
|
|
|
|
|
|
|
|
|
|
|
Fair
|
|
($ in thousands)
|
|
Amortized Cost
|
|
Value
|
|
|
|
|
|
|
|
|
|
Due in one year or less
|
|
$
|
13,278
|
|
$
|
13,437
|
|
Due after one year through five years
|
|
|
127,022
|
|
|
130,139
|
|
Due after five years through ten years
|
|
|
83,800
|
|
|
86,968
|
|
Due after ten years
|
|
|
14,364
|
|
|
15,489
|
|
Residential mortgage-backed securities
|
|
|
54,558
|
|
|
55,647
|
|
Commercial mortgage-backed securities
|
|
|
34,801
|
|
|
35,888
|
|
|
|
$
|
327,823
|
|
$
|
337,568
|
|
The tables below summarize the gross unrealized losses of fixed-maturity and preferred securities by the length of time the security had continuously been in an unrealized loss position for each year or shorter period specified below:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Less than 12 Months
|
|
12 Months or More
|
|
Total
|
|
September 30, 2016
|
|
Fair
|
|
Unrealized
|
|
Fair
|
|
Unrealized
|
|
Fair
|
|
Unrealized
|
|
($ in thousands)
|
|
Value
|
|
Losses
|
|
Value
|
|
Losses
|
|
Value
|
|
Losses
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total fixed-maturity securities
|
|
$
|
21,386
|
|
$
|
(520)
|
|
$
|
10,722
|
|
$
|
(810)
|
|
$
|
32,108
|
|
$
|
(1,330)
|
|
Total equity securities
|
|
|
646
|
|
|
(20)
|
|
|
914
|
|
|
(86)
|
|
|
1,560
|
|
|
(106)
|
|
Total investments
|
|
$
|
22,032
|
|
$
|
(540)
|
|
$
|
11,636
|
|
$
|
(896)
|
|
$
|
33,668
|
|
$
|
(1,436)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Less than 12 Months
|
|
12 Months or More
|
|
Total
|
|
December 31, 2015
|
|
Fair
|
|
Unrealized
|
|
Fair
|
|
Unrealized
|
|
Fair
|
|
Unrealized
|
|
($ in thousands)
|
|
Value
|
|
Losses
|
|
Value
|
|
Losses
|
|
Value
|
|
Losses
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total fixed-maturity securities
|
|
$
|
124,036
|
|
$
|
(2,626)
|
|
$
|
18,031
|
|
$
|
(1,102)
|
|
$
|
142,067
|
|
$
|
(3,728)
|
|
Total equity securities
|
|
|
2,820
|
|
|
(88)
|
|
|
—
|
|
|
—
|
|
|
2,820
|
|
|
(88)
|
|
Total investments
|
|
$
|
126,856
|
|
$
|
(2,714)
|
|
$
|
18,031
|
|
$
|
(1,102)
|
|
$
|
144,887
|
|
$
|
(3,816)
|
|
There were 70 and 237 securities at September 30, 2016 and December 31, 2015, respectively, that account for the gross unrealized loss, none of which we deemed to be other-than-temporarily impaired. Management believes that the temporary impairments are primarily the result of widening credit spreads, and that despite the wider credit spreads, the securities are only temporarily impaired due to the strength of the issuing companies’ balance sheets, as well as their available liquidity options. We do not intend to sell or believe we will be required to sell any of our temporarily-
impaired fixed maturities before recovery of their amortized cost basis. Management has the intent and ability to hold the equity securities in an unrealized loss position until the recovery of their fair value. Therefore, Management does not consider these investments to be other-than-temporarily impaired.
We are required to maintain deposits in various states where the insurance subsidiaries are licensed to operate. These deposits are fixed maturity securities at fair values totaling $76.9 million and $53.5 million at September 30, 2016 and December 31, 2015, respectively. The increase in the amounts on deposit at September 30, 2016 is due to an increase in the required deposits for workers’ compensation business and deposits acquired in the acquisition of UNSIC.
Fair value of financial instruments.
ASC 820, “Fair Value Measurements and Disclosures”, provides a definition of fair value, establishes a framework for measuring fair value, and requires expanded disclosures about fair value measurements. The standard applies when GAAP requires or allows assets or liabilities to be measured at fair value; therefore, it does not expand the use of fair value in any new circumstance. Investments measured at fair value on a recurring basis at September 30, 2016 and December 31, 2015 are all considered level 2 investments.
Liquidity
We are organized as a holding company with four domestic insurance company subsidiaries, as well as a wholly-owned subsidiary that operates in an agency capacity. Our principal sources of operating funds are premiums, ceding fees, investment income and proceeds from sales and maturities of investments. Our primary uses of operating funds include payments of claims and operating expenses. We pay claims using cash flow from operations and invest our excess cash primarily in fixed-income securities. We expect that projected cash flows from operations and our revolving credit facility will provide us with sufficient liquidity to fund our anticipated growth and to pay claims and operating expenses, interest on debt facilities and other holding company expenses for the foreseeable future. However, if our growth attributable to potential acquisitions, internally generated growth, or a combination of these factors, exceeds our expectations, we may have to raise additional capital in the near term. If we cannot obtain adequate capital on favorable terms or at all, we may be unable to support future growth or operating requirements and, as a result, our business, financial condition and results of operations could be adversely affected. We may generate liquidity through the issuance of debt or equity securities or financing through borrowings under credit facilities, or a combination thereof.
Our insurance subsidiaries are subject to statutory and regulatory restrictions imposed on insurance companies by their states of domicile which limit the amount of cash dividends or distributions that they may pay to us unless special permission is received from the insurance regulator of the relevant domiciliary state. The aggregate limit imposed by the various domiciliary states of our insurance subsidiaries was approximately $23.0 million and $21.6 million as of December 31, 2015 and 2014, respectively. In addition, we are able to generate substantial cash flow outside of our regulated insurance company subsidiaries through intercompany agency and management agreements between our insurance subsidiaries and our agency, TBA. TBA functions as a managing general agent for SNIC and NSIC in connection with the Lender Services segment. Under the management agreement TBA provides business development, financial monitoring and other oversight functions to our insurance subsidiaries.
The following table is a summary of our consolidated statements of cash flows:
|
|
|
|
|
|
|
|
|
|
Nine Months Ended
|
|
|
|
September 30,
|
|
($ in thousands)
|
|
2016
|
|
2015
|
|
|
|
|
|
|
|
|
|
Cash and cash equivalents provided by (used in):
|
|
|
|
|
|
|
|
Operating activities
|
|
$
|
48,938
|
|
$
|
40,843
|
|
Investing activities
|
|
|
(5,921)
|
|
|
(27,919)
|
|
Financing activities
|
|
|
(15,025)
|
|
|
(3,540)
|
|
Net change in cash and equivalents
|
|
$
|
27,992
|
|
$
|
9,384
|
|
Comparison of Nine Months Ended September 30, 2016 and 2015
Net cash used in operating activities increased $8.1 million for the nine months ended September 30, 2016 compared to the nine months ended September 30, 2015, primarily due to an increase in Lender Services and Program Services operating results.
Net cash used in investing activities decreased $22.0 million for the nine months ended September 30, 2016 compared to the nine months ended September 30, 2015, primarily due to the liquidation of investments related to the acquisition of UNSIC and expected acquisition of a non-admitted shell company. These decreases were largely offset by the purchase of UNSIC on September 30, 2016 in the amount of $17.3 million, net of cash acquired.
Net cash used in financing activities increased $11.5 million for the nine months ended September 30, 2016 compared to the nine months ended September 30, 2015, primarily due to the settlement of $9.9 million in stock repurchases in 2016 and an increase of $1.5 million in dividends paid in 2016.
Other Material Changes in Financial Position
|
|
|
|
|
|
|
|
|
|
September 30,
|
|
December 31,
|
|
($ in thousands)
|
|
2016
|
|
2015
|
|
Selected Assets:
|
|
|
|
|
|
|
|
Accounts receivable from agents, net
|
|
$
|
32,541
|
|
$
|
23,913
|
|
Reinsurance recoverable on paid losses
|
|
|
1,237
|
|
|
1,187
|
|
Reinsurance recoverables
|
|
|
2,291,175
|
|
|
1,911,660
|
|
Goodwill and intangible assets, net
|
|
|
12,768
|
|
|
5,958
|
|
Deferred income taxes, net
|
|
|
25,207
|
|
|
26,208
|
|
|
|
|
|
|
|
|
|
Selected Liabilities:
|
|
|
|
|
|
|
|
Unpaid losses and loss adjustment expenses
|
|
$
|
1,654,905
|
|
$
|
1,364,774
|
|
Unearned premiums
|
|
|
673,677
|
|
|
585,448
|
|
Allowance for policy cancellations
|
|
|
64,742
|
|
|
59,610
|
|
Deferred ceding fees
|
|
|
32,700
|
|
|
29,119
|
|
Debt, net
|
|
|
43,772
|
|
|
43,740
|
|
Other liabilities
|
|
|
33,086
|
|
|
35,151
|
|
Accounts receivable from agents, net.
This balance reflects ceding fees, premiums and premium taxes receivable. During the nine months ended September 30, 2016, accounts receivable from agents increased $8.6 million from December 31, 2015, primarily as a result of an increase in Program Services receivables. This increase partially relates to an agreement with Nephila we entered into effective January 1, 2016. For Nephila, we will, at Nephila’s request, transfer certain exposures that are otherwise reinsured by Nephila’s quota share reinsurer to excess reinsurers. In instances where this agreement is utilized, State National enters into an agreement directly with excess reinsurers, and Nephila guarantees the obligation of those excess reinsurers and pays the premiums on our behalf on a quarterly basis in arrears. We purchased one excess reinsurance policy under this agreement during 2016. The remainder of the increase relates to one of our arrangements under which we are responsible to certain reinsurers for the collection and payment of premiums. As a result, the related premiums receivable and payable are reflected in our balance sheet.
Goodwill and intangible assets, net.
As of September 30, 2016, goodwill and intangible assets increased $6.8 million compared to September 30, 2015 primarily due to an increase in indefinite-lived intangible assets of $7.4 million related to the UNSIC acquisition.
Reinsurance recoverables, unpaid losses and loss adjustment expenses and unearned premiums.
As of September 30, 2016, we held $2.3 billion in collateral securing $1.7 billion in reinsurance recoverables. In addition, we had $640.1 million of unsecured reinsurance recoverables, of which $632.8 million related to the Program Services segment and $7.3 million related to our quota share reinsurance with CUNA Mutual, an A.M. Best “A” rated carrier. During the nine
months ended September 30, 2016, reinsurance recoverables increased $379.5 million from December 31, 2015, which was primarily a result of the increase in gross premiums written for Program Services business due to the addition of new programs and expansion of existing programs. These factors also caused an increase in the corresponding unearned premiums and unpaid losses and loss adjustment expenses of $88.2 million and $290.1 million, respectively.
Allowance for policy cancellations.
As of September 30, 2016, the allowance for policy cancellations increased by $5.1 million from December 31, 2015, primarily due to the volume and timing of CPI premiums written in the most recent three months of 2016 compared to the last three months of 2015. The fourth quarter tends to generate the greatest amount of written premium, whereas the first quarter of the year tends to generate the least. On a quarterly basis, we review our estimates for allowance for policy cancellations to determine whether further adjustments are appropriate. Any resulting adjustments are included in the current period’s operating results. The allowance for policy cancellations for the nine months ended September 30, 2016 and 2015 included upward revisions to prior year estimates of $1.5 million and $0.8 million, respectively. Because of the interplay between the allowance for policy cancellations and the related unearned premium reserve, changes in the allowance for policy cancellations are partially offset by related changes in the unearned premium reserve and amounts ceded to reinsurers. After taking into account the associated changes in unearned premium and amounts ceded to reinsurers, the net impact to the balance sheet and the corresponding reduction in net income from the revised estimates for the nine months ended September 30, 2016 and 2015 was approximately $0.7 million and $0.5 million, respectively.
Other liabilities.
As of September 30, 2016, other liabilities decreased by $2.1 million from December 31, 2015, primarily due to settlements of the annual executive bonuses, stock repurchases and a decrease in funds held related to payments made for a run off program. This is partially offset by a $2.5 million quarterly dividend accrual as of September 30, 2016.
Capital Resources
The Company has three statutory business trusts that were formed between 2002 and 2004, for the sole purpose of issuing $44.5 million of trust preferred securities in private offering transactions. The trusts used the proceeds from these offerings, together with the equity proceeds received upon their initial formation from TBA, an indirect wholly-owned subsidiary of State National, to purchase variable-rate subordinated debentures issued by TBA. All voting securities of the trusts are owned by TBA, and the debentures are the sole assets of the trusts. The trusts meet the obligations of the trust preferred securities with the interest and principal paid on the debentures. These debentures’ interest rates range from 3.80% to 4.10% plus the 3-month LIBOR. The three month LIBOR at September 30, 2016, was 0.85%. All of the debentures mature between 2032 and 2034.
On March 31, 2016, the Company, through TBA, entered into a loan agreement, which provides for a secured revolving credit facility in an aggregate principal amount of $15 million. The credit agreement matures on April 30, 2018. Under the credit agreement, TBA may request advances up to the aggregate amount of the unused commitment under the credit facility, on a revolving basis, prior to the maturity of the credit agreement. Borrowings under the credit agreement will bear interest at a variable rate equal to LIBOR plus 1.85% per annum; provided, however, that LIBOR shall be subject to a floor of 0.15%. TBA shall also pay a commitment fee on the daily average unused commitment amount for the period running from the closing date to the maturity date at a rate of 0.125% per annum. The credit agreement contains customary representations, warranties, covenants, and events of default, as well as a financial covenant requiring TBA and the Company to maintain a consolidated tangible net worth of at least $150 million.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Liquidity Risk
Liquidity risk represents our potential inability to meet all payment obligations when they become due. We maintain sufficient cash and marketable securities to fund claim payments and operations.
Credit Risk
We are exposed to credit risk from potential losses arising principally from the financial condition of our third party reinsurers, and also from potential losses in our investment portfolio. Although our third party reinsurers are obligated to reimburse us to the extent we cede risk to them, we are ultimately liable to our policyholders on all risks we have ceded. As a result, reinsurance contracts do not limit our ultimate obligations to pay claims covered under the insurance policies we issue and we might not collect amounts recoverable from our reinsurers. We generally address this credit risk by either (1) selecting reinsurers that have an A.M. Best rating of “A-” (Excellent) or better, have $300 million in equity and/or capital and surplus and are a Texas or Delaware (for USIC) authorized reinsurer at the time we enter into the agreement, or (2) requiring that the reinsurer post substantial collateral to secure the reinsured risks. Security can take the form of collateral (in the form of security posted with a trustee pursuant to a related agreement, or evergreen letter of credit), or guaranty by a related third party that we believe has the ability to pay. The security amount is a function of the policyholder liabilities (unearned premiums, losses and LAE reserves) or other amounts that are more representative of the amounts at risk. Excess security is required when a reinsurer does not meet the above financial requirements to provide a “cushion” for inadequate estimates of policyholder liabilities. Unless there is some mitigating factor, we control the ability to set policyholder liability amounts for security purposes.
Security is also immediately required if a reinsurer falls below the benchmark rating during the term of a reinsurance agreement. Existing security may be increased if a reinsurer is downgraded during the term of a reinsurance agreement or experiences a significant loss in policyholder equity and/or capital and surplus.
Collateral levels are reviewed weekly on each reinsurer on which security is required. Collateral calculations are adjusted as monthly activity reports are received on individual programs and collateral account balance information is available. Collateral is generally obtained a quarter in advance at the end of each calendar quarter.
We also evaluate the credit risk of our investment portfolio. The primary measure we utilize to mitigate credit risk (the risk of principal default on the securities we invested in) involves the credit quality of our portfolio. Approximately 66% of our portfolio is rated AA- or higher (rated by Standard & Poor’s), which is consistent with the guidelines provided to our asset managers. Additionally, our Investment Committee reviews the portfolio on a quarterly basis and discusses any securities which have been downgraded in the previous quarter.
Market Risk
The risk of underperformance in the market is addressed by having a quality asset manager administering our portfolio. Additionally, our portfolio is diversified to eliminate exposure to any one particular segment. Finally, as the bulk of our assets support either our surplus or short tailed lines of business, investment performance is a relatively small portion of our profits relative to other property and casualty companies.
Our investment policy is reviewed periodically and updated to meet current needs. However, the primary goal and philosophy of the policy is to be conservative in nature to provide preservation of principal and provide necessary liquidity.
Interest Rate Risk
This is a two-fold risk involving loss of market value due to a rising interest rate environment coupled with a need to liquidate those securities to provide liquidity for operations. Our exposure to extreme shifts in interest rates is mitigated to some extent by selecting a duration target for the portfolio which is relatively short (i.e., approximately four years). The exposure to actually selling underwater securities to gain liquidity is managed by maintaining a laddered portfolio whereby we have securities maturing over the next few years. Further mitigation is provided by maintaining the convexity (i.e., how the duration of a bond changes as the interest rate changes) of the portfolio at relatively low levels.
We had fixed-maturity securities with a fair value of $337.6 million and an amortized cost of $327.8 million as of September 30, 2016 that are subject to interest rate risk. Interest rate risk is the risk that we may incur losses due to
adverse changes in interest rates. Fluctuations in interest rates have a direct impact on the market valuation of our fixed-maturity securities. In the management of this risk, the characteristics of duration, credit and variability of cash flows are critical elements.
The table below summarizes the interest rate risk associated with our fixed-maturity securities by illustrating the sensitivity of the fair value of our fixed-maturity securities as of September 30, 2016 to selected hypothetical changes in interest rates, and the associated impact on our shareholders’ equity. We anticipate that we will continue to meet our obligations from operating cash flows. We classify our fixed-maturity securities and equity securities as available-for-sale. Temporary changes in the fair value of our fixed-maturity securities impact the carrying value of these securities and are reported in our shareholders’ equity as a component of other comprehensive income, net of deferred taxes. The selected scenarios in the table below are not predictions of future events, but rather are intended to illustrate the effect such events may have on the fair value and carrying value of our fixed-maturity securities and on our shareholders’ equity, each as of September 30, 2016.
|
|
|
|
|
|
|
|
|
|
Hypothetical Change
|
|
Fair
|
|
Estimated Change in
|
|
Total
|
in Interest Rates
|
|
Value
|
|
Fair Value
|
|
Return %
|
(
$ in thousands)
|
|
|
|
|
|
|
|
|
|
300 basis point increase
|
|
$
|
299,827
|
|
$
|
(37,741)
|
|
-11.18
|
%
|
200 basis point increase
|
|
|
311,802
|
|
|
(25,766)
|
|
-7.63
|
%
|
100 basis point increase
|
|
|
324,446
|
|
|
(13,122)
|
|
-3.89
|
%
|
No change
|
|
|
337,568
|
|
|
—
|
|
—
|
|
100 basis point decrease
|
|
|
350,862
|
|
|
13,294
|
|
3.94
|
%
|
200 basis point decrease
|
|
|
364,840
|
|
|
27,272
|
|
8.08
|
%
|
300 basis point decrease
|
|
|
379,609
|
|
|
42,041
|
|
12.45
|
%
|
Changes in interest rates would affect the fair value of our fixed-rate debt instruments but would not have an impact on our earnings or cash flow. As of September 30, 2016, we had $44.5 million of debt instruments, gross of debt issuance costs. A fluctuation of 100 basis points in interest on our variable-rate debt instruments, which are tied to LIBOR, would affect our earnings and cash flows by $0.4 million before income tax, on an annual basis, but would not affect the fair value of the variable-rate debt.
Item 4:
Controls and Procedures
Under the supervision and with the participation of our Management, including our chief executive officer and chief financial officer, we have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on that evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report to provide reasonable assurance that information we are required to disclose in reports that are filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. We note that the design of any system of controls is based in part upon assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving the stated goals under all potential future conditions.
There were no changes in our internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) as of the end of the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.