HERITAGE INSURANCE HOLDINGS, INC. Please read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and related notes included under Part II, Item 8 of this Annual Report on Form 10-K.
Overview
Heritage Insurance Holdings, Inc. , is a super-regional property and casualty insurance holding company that primarily provides personal and commercial residential insurance products across its multi-state footprint. We provide personal residential insurance in sixteen states and commercial residential insurance in three of those states, while maintaining licenses in one additional state. As a vertically integrated insurer, we control or manage substantially all aspects of underwriting, customer service, actuarial analysis, distribution and claims processing and adjusting. Our financial strength ratings are important to the Company in establishing our competitive position and can impact our ability to write policies. The discussion of our financial condition and results of operations that follows provides information that will assist the reader in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles, policies and estimates affect our consolidated financial statements. This discussion should be read in conjunction with our consolidated financial statements and the related notes that appear elsewhere in this document.
COVID-19 and Other Matters
With regard to the COVID-19 pandemic, our first priority remains the health and safety of our employees and their families. Approximately 78% of our total personnel are either working from home full-time or on a hybrid schedule between office and home. Our corporate and remote offices remain operational, we are practicing social distancing, and have enhanced cleaning protocols and are using personal protective equipment in addition to employing other preventative measures. We continue to monitor the short-and long-term impacts of COVID-19 virus and its variants, a global pandemic that has caused a significant slowdown in the global economy beginning inMarch 2020 . For the year endedDecember 31, 2020 , we saw virtually no impact to our business. As a residential property insurer, we view our business as somewhat insulated because property owners and renters generally view our products as a necessity. The majority of our gross and net premiums written are from renewals of expiring policies. New business, which accounts for a smaller portion of our revenue, may be impacted if consumers are not buying as many new homes in our geographies, but this could be partially or fully offset by increased retention in our renewal portfolio. In a prolonged recessionary and social-distancing environment, we could experience disruptions to our independent agency distribution channel, which may have a negative impact on our revenues and financial condition. Although we have not experienced a significant amount of payment delays, or non-payment, there may be delays in premium payments in geographies that require us to grant policyholders additional time to pay their premiums and, under prolonged recessionary economic conditions, we could experience more significant delays in premium payments and possibly non-payment of premiums. Global credit and financial markets experienced extreme volatility and disruptions during the second quarter of 2020 as a result of the COVID-19 pandemic, including diminished liquidity and credit availability, declines in consumer confidence, increases in unemployment rates and uncertainty about economic stability. Although we were relatively unaffected by the condition of the credits markets, if the credit and financial markets again experience significant deterioration at a time when we need additional liquidity, it may make any necessary debt or equity financing more difficult, more costly, and more dilutive. Notwithstanding these actual and potential impacts, we currently believe that our cash on hand, revolving credit facility and expected earnings give us sufficient liquidity to fund our operations. However, if we need additional liquidity at a time when equity and credit markets deteriorate, it may make any necessary debt or equity financing more difficult, more costly, and more dilutive.
Coronavirus Aid, Relief, and Economic Security Act
The CARES Act was enacted onMarch 27, 2020 inthe United States . The CARES Act and related notices include several significant provisions, including delaying certain payroll tax payments, mandatory transition tax payments under the TCJ Act, and estimated income tax payments that we are deferring to future periods. We do not currently expect the CARES Act to have a material impact on our liquidity or our financial results, except for the benefit associated with a 5 year carryback of our 2020 tax net operating loss. We will continue to monitor and assess the impact the CARES Act and similar legislation may have on our business and financial results. 28
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Key Components of our Results of Operations
Revenue
Gross premiums written represent, with respect to a period, the sum of direct premiums written (premiums from policies written during the period, net of any midterm cancellations and renewals of voluntary policies) and assumed premiums written (primarily premiums from state fair plan policies), in each case prior to ceding premiums to reinsurers. Gross premiums earned represent the total premiums earned during a period from policies written. Premiums associated with new and renewal policies are earned ratably over the twelve-month term of the policy and premiums associated with assumed policies are earned ratably over the remaining term of the policy. Ceded premiums represent the cost of our reinsurance during a period. We recognize the cost of our reinsurance program ratably over term of the arrangement, which is typically twelve months. Our catastrophe excess of loss reinsurance generally inceptsJune 1 and runs throughMay 31 of the following year. Our net quota share treaty inceptsDecember 31 . Our other reinsurance programs may be purchased on a calendar or fiscal year basis.
Net premiums earned reflect gross premiums earned less ceded premiums during the period.
Net investment income represents interest earned on fixed maturity securities, short term securities and other investments, dividends on equity securities, realized gains or losses on investment sales and unrealized gains or losses on equity securities. Other revenue includes rental income due under non-cancelable leases for space at the Company's commercial property inClearwater, Florida , and all policy and pay-plan fees. Our regulators have approved a policy fee on each policy written for certain states; to the extent these fees are not subject to refund, the Company recognizes the income immediately when collected. The Company also charges pay-plan fees to policyholders that pay premiums in more than one installment and record the fees as income when collected.
Expenses
Losses and loss adjustment expenses ("LAE") reflect losses paid, expenses paid
to resolve claims, such as fees paid to adjusters, attorneys and investigators,
and changes in our reserves for unpaid losses and loss adjustment expenses
during the period, in each case net of losses ceded to reinsurers. Our reserves
for unpaid losses and loss adjustment expenses represent the estimated ultimate
cost of resolving all reported claims plus all losses we incurred related to
insured events that we assume have occurred as of the reporting date, but that
policyholders have not yet reported to us (which are commonly referred to as
incurred but not reported, or "IBNR"). We estimate our reserves for unpaid
losses using individual case-based estimates for reported claims and actuarial
estimates for IBNR losses. We continually review and adjust our estimated losses
as necessary based on our evolving claims experience, new information obtained
and industry development trends. If our unpaid losses and loss adjustment
expenses are considered deficient or redundant, we increase or decrease the
liability in the period in which we identify the difference and reflect the
change in our current period results of operations.
Policy acquisition costs ("PAC") consist of: (i) commissions paid to outside
agents at the time of policy issuance, (ii) policy administration fees paid to a
third-party administrator at the time of policy issuance, (iii) premium taxes
and (iv) inspection fees. We recognize policy acquisition costs ratably over the
term of the underlying policy. We earn ceding commissions on our net quota share
reinsurance contract and certain other reinsurance contracts, which are reported
as a reduction to policy acquisition costs and general and administrative
expenses based upon the proportion these costs bear to production of new
business. Refer to Note 11 "Deferred Policy Acquisition Costs" to our
consolidated financial statements under Item 8 of this Annual Report on Form
10K. Ceding commission income is deferred and earned over the contract period.
The amount and rate of ceding commissions earned on the net quota share contract
can slide within a prescribed minimum and maximum, depending on loss performance
and how future losses develop.
General and administrative expenses ("G&A") include compensation and related
benefits, professional fees, office lease and related expenses, information
system expenses, corporate insurance, and other general and administrative
costs. As noted above, a certain portion of our ceding commissions are allocated
to general and administrative expenses.
Provision for income taxes consists of federal and state corporate level income
taxes. The effective tax rate can fluctuate throughout the year as estimates
used in the quarterly tax provision are updated with additional information
throughout the year. The effective tax rate can vary from the 26.5% statutory
federal and state blended rate depending on the amount of pretax income in
proportion to permanent tax differences as well as state tax apportionment. The
2020 effective tax rate was favorably impacted by the rate benefit associated
with the 2020 tax loss carrybacks afforded through the CARES Act enactment.
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Ratios
Ceded premium ratio represents ceded premiums earned as a percentage of gross premiums earned.
Net loss ratio represents net losses and LAE as a percentage of net premiums earned.
Net expense ratio represents PAC and G&A expenses as a percentage of net premiums earned. Ceding commission income is reported as a reduction of policy acquisition costs and G&A expenses.
Net combined ratio represents the sum of the net loss and expense ratio. The net combined ratio is a key measure of underwriting performance traditionally used in the property and casualty insurance industry. A net combined ratio under 100% generally reflects profitable underwriting results.
Financial Results Highlights for the Year Ended
• Net income was$9.3 million , or$0.33 per diluted share. • Book value per share increased to$15.94 , up 1.8% from year-end 2019.
• Gross premiums written and gross premiums in force of
gross premiums written up 15.2% year-over-year, including 15.8% growth
outside Florida and 14.6% growth in Florida .
• Policies-in-force of 581,046, up 9.2% year-over-year.
• Realized capital gains of
year.
• Favorable prior year reserve development of $19.6 million .
• Net current accident year weather losses of $134.2 million , up
substantially from
weather losses include
million in the prior year, and
from
• Repurchased 930,356 shares for
per share, 32.6% below year-end 2020 book value per share.
• Extended the Company's existing share repurchase authorization by one year
to a December 31, 2021 expiration and increased the authorization from
$23.8 million to $50.0 million .
• Total capital returned to shareholders of
per share regular quarterly dividend.
• Began writing homeowners insurance in
Results of Operations
In the following section, we discuss the results of our operations for the year endedDecember 31, 2020 compared to the year endedDecember 31, 2019 . For a discussion of the year endedDecember 31, 2019 compared to the year endedDecember 31, 2018 , please Refer to Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year endedDecember 31, 2019 , which was filed with theSEC onMarch 10, 2020 . Please read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and related notes included under Part II, Item 8 of this Annual Report on Form 10-K. 30
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Consolidated Results of Operations
The following table summarizes our results of operations for the periods
indicated:
Year Ended December 31,
2020 2019 $ Change % Change
(in thousands, expect per share amounts)
REVENUE:
Gross premiums written $ 1,080,100 $ 937,937 $ 142,163 15.2 %
Change in gross unearned premiums (83,258 ) (13,690 ) (69,568 ) NM
Gross premiums earned 996,842 924,247 72,595 7.9 %
Ceded premiums (452,120 ) (445,534 ) (6,586 ) 1.5 %
Net premiums earned 544,722 478,713 66,009 13.8 %
Net investment income 12,302 14,432 (2,130 ) (14.8 %)
Net realized and unrealized gains 22,395 4,163 18,232 NM
Other revenue 13,966 13,997 (31 ) (0.2 %)
Total revenue $ 593,385 $ 511,305 $ 82,080 16.1 %
OPERATING EXPENSES:
Losses and loss adjustment
expenses $ 373,387 $ 273,288 $ 100,099 36.6 %
Policy acquisition costs, net 128,276 107,906 20,370 18.9 %
General and administrative
expenses, net 81,537 80,544 993 1.2 %
Total operating expenses 583,200 461,738 121,462 26.3 %
Operating income 10,185 49,567 (39,382 ) (79.5 %)
Interest expense, net 7,972 8,523 (551 ) (6.5 %)
Other non-operating expense, net - 48 (48 ) NM
Income before income taxes 2,213 40,996 (38,783 ) (94.6 %)
(Benefit) provision for income
taxes (7,113 ) 12,360 (19,473 ) (157.5 %)
Net income $ 9,326 $ 28,636 $ (19,310 ) (67.4 %)
Basic net income per share $ 0.33 $ 0.98 $ (0.65 ) (66.0 %)
Diluted net income per share $ 0.33 $ 0.98 $ (0.65 ) (66.0 %)
NM - not meaningful
Gross premiums written
Gross premiums written of $1.1 billion , up 15.2% year-over-year, including 15.8%
growth outside Florida and 14.6% growth in Florida . The overall increase relates
to growth in each state in which we conduct business as well as expansion to
California , Delaware , Mississippi , and Maryland . Growth in existing states was
organic, including growth via independent agents and strategic partnerships with
national carriers. Rate increases materially benefited 2020 gross premiums
written growth, particularly in Florida .
Gross premiums earned
Gross premiums earned were
Ceded premiums
Ceded premiums were$452.1 million for the year endedDecember 31, 2020 , up 1.5% compared to$445.5 million in the prior year. The increase is primarily attributable to an increase in the cost of our catastrophe excess of loss reinsurance program, an increase in total insured value ("TIV") associated with premium growth and a modest increase to our net quota share reinsurance coverage in the northeast. Net premiums earned Net premiums earned were$544.7 million for the year endedDecember 31, 2020 , up 13.8% compared to$478.7 million in the prior year. The increase primarily stems from higher gross premiums earned associated with expansion of our business in existing states and to new states, partly offset by higher ceded premiums. 31
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Net investment income
Net investment income, inclusive of realized investment gains (losses) and unrealized gains (losses) on equity securities, was$34.7 million for the year endedDecember 31, 2020 , up 86.6% compared to$18.6 million in the prior year. The increase relates primarily to higher realized gains as well as improved pricing on invested assets, and a higher average invested asset balance, partly offset by a lower yield on invested assets, a function of the continued low interest rate environment.
Other revenue
Other revenue was
Total revenue
Total revenue was$593.4 million for the year endedDecember 31, 2020 , up 16.1% compared to$511.3 million in the prior year. The increase primarily stems from higher net premiums earned and net investment income, as described above. Year Ended December 31, 2020 2019 $ Change % Change OPERATING EXPENSES: Losses and loss adjustment expenses$ 373,387 $ 273,288 $ 100,099 36.6 % Policy acquisition costs 128,276 107,906 20,370 18.9 % General and administrative expenses 81,537 80,544 993 1.2 % Total operating expenses$ 583,200 $ 461,738 $ 121,462 26.3 %
Losses and loss adjustment expenses
Losses and LAE were$373.4 million for the year endedDecember 31, 2020 , up 36.6% compared to$273.3 million in the prior year. The increase primarily stems from higher current accident year catastrophe and non-catastrophe weather losses and lower income from vertically integrated operations which serves to offset losses. Our net losses include claims from six hurricanes, catastrophic non-hurricane losses from severe convective storms, and other weather losses amounting to$134.2 million and$75.9 million for the years endedDecember 31, 2020 and 2019, respectively.
Policy acquisition costs
Policy acquisition costs were$128.3 million for the year endedDecember 31, 2020 , up 18.9% compared to$107.9 million in the prior year. Higher acquisition costs relate to the increase in gross premiums written.
General and administrative expenses
General and administrative expenses were$81.5 million for the year endedDecember 31, 2020 , up 1.2% compared to$80.5 million in the prior year. The increase relates to separation payments to two of our named executive officers, partially offset by reductions in travel related costs, intangible amortization, and purchases of non-capitalized equipment. Year Ended December 31, 2020 2019 $ Change % Change Operating income$ 10,185 $ 49,567 $ (39,382 ) (79.5 %) Interest expense, net 7,972 8,523 (551 ) (6.5 %) Other non-operating expense, net - 48 (48 ) NM Income before income taxes 2,213 40,996 (38,783 ) (94.6 %) (Benefit) provision for income taxes (7,113 ) 12,360 (19,473 ) (157.5 %) Net income$ 9,326 $ 28,636 $ (19,310 ) (67.4 %) Basic net income per share$ 0.33 $ 0.98 $ (0.65 ) (66.0 %) Diluted net income per share$ 0.33 $ 0.98 $ (0.65 ) (66.0 %)
Interest expense and amortization of debt issuance costs
Interest expense and amortization of debt issuance costs were$8.0 million for the twelve months endedDecember 31, 2020 , down 6.5% from$8.5 million in the prior year. The decrease primarily reflects lower interest rates on our debt. 32
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(Benefit)/Provision for income taxes
The benefit for income taxes was$7.1 million for the twelve months endedDecember 31, 2020 compared to a provision for income taxes of$12.4 million for the twelve months endedDecember 31, 2019 . The effective tax rate for the current year is (321.3)% compared to 30.1% for the prior year. The variance in the effective tax rate relates to a tax net operating loss for the year endedDecember 31, 2020 , which was carried back five years under The CARES Act and deductible at a 35% corporate income tax rate rather than the current 21% statutory rate. Additionally, the effective tax rate can fluctuate throughout the year as estimates used in the quarterly tax provision are updated with additional information throughout the year, including changes to pre-tax income.
Net income
Net income for the twelve months endedDecember 31, 2020 was$9.3 million ($0.33 per diluted share), down 67.4% from$28.6 million ($0.98 per diluted share) in the prior year. The decrease primarily reflects a higher loss ratio, partly offset by the benefit of the tax net operating loss carryback. Ratios Year Ended December 31, 2020 2019 Ceded premium ratio 45.4 % 48.2 % Net loss and LAE ratio 68.5 % 57.1 % Net expense ratio 38.5 % 39.4 % Net combined ratio 107.0 % 96.5 % Ceded premium ratio The ceded premium ratio was 45.4% for the twelve months endedDecember 31, 2020 , down 2.8 points from 48.2% in the prior year. The decrease primarily stems from the increase in gross earned premiums over the prior year, partially offset by higher reinsurance costs, as described above.
Net loss ratio
The net loss and LAE ratio was 68.5% for the twelve months ended
Net expense ratio
The net expense ratio was 38.5% for the twelve months endedDecember 31, 2020 , down .9 points from 39.4% in the prior year. The decrease primarily stems from net premiums earned growth that outpaced expense growth in the current year.
Net combined ratio
The net combined ratio was 107.0% for the twelve months endedDecember 31, 2020 , up 10.6 points from 96.5% in the prior year. The increase stems from a higher net loss ratio, partly offset by a decrease in the expense ratio, as described above.
Liquidity and Capital Resources
Our principal sources of liquidity include cash flows generated from operations, our cash, cash equivalents, our marketable securities balances and borrowings available under our credit facilities. As ofDecember 31, 2020 , we held$446.4 million in cash and cash equivalents and$589.0 million in investments, compared to$283.0 million and$595.2 million as ofDecember 31, 2019 . The increase in cash and cash equivalents in 2020 was due primarily to increases in gross written premiums and collection of reinsurance recoveries, as well as proceeds from strategic sales of fixed incomed securities, partially offset by loss payments.
We believe that our sources of cash are adequate to meet our cash requirements for at least the next twelve months.
We may continue to pursue the acquisition of complementary businesses and make
strategic investments. We may increase capital expenditures consistent with our
investment plans and anticipated growth strategy. Cash and cash equivalents may
not be sufficient to fund such expenditures. As such, in addition to the use of
our existing Credit Facilities, we may need to utilize additional debt to secure
funds for such purposes.
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Statement of Cash Flows
The net increases (decreases) in cash and cash equivalents are summarized in the
following table:
For the Year Ended December 31,
2020 vs 2019 2019 vs 2018
2020 2019 2018 Change ChangeNet cash provided by (used in): (in thousands) Operating activities$ 170,211 $ 119,657 $ 96,338 $ 50,554 $ 23,319 Investing activities 22,062 (53,585 ) 23,455 75,647 (77,040 ) Financing activities (28,898 ) (45,434 ) (31,953 ) 16,536 (13,481 ) Net change in cash, cash equivalents,
and restricted cash
142,737
Operating Activities
Net cash provided by operating activities for
Investing Activities
Net cash provided by investing activities for the year endedDecember 31, 2020 was$22.1 million as compared to net cash used in of$53.6 million in the prior year. The variance relates primarily to proceeds from strategic sales of fixed income securities during the year.
Financing Activities
Net cash used in financing activities for the year ended
Credit Facilities
OnDecember 14, 2018 , the Company entered into a credit agreement (the "Credit Agreement") by and among the Company, as borrower, certain subsidiaries of the Company from time to time party thereto as guarantors, the lenders from time to time party thereto (the "Lenders"),Regions Bank , as Administrative Agent and Collateral Agent,BMO Harris Bank N.A ., as Syndication Agent,Hancock Whitney Bank and Canadian Imperial Bank of Commerce, as Co-Documentation Agents, andRegions Capital Markets andBMO Capital Markets Corp. , as Joint Lead Arrangers and Joint Bookrunners. Pursuant to the Credit Agreement, the participating Lenders agreed to provide (1) a five-year senior secured term loan facility in an aggregate principal amount of$75 million (the "Term Loan Facility") and (2) a five-year senior secured revolving credit facility in an aggregate principal amount of$50 million (inclusive of a$5 million sublimit for the issuance of letters of credit and a$10 million sublimit for swingline loans) (the "Revolving Credit Facility" and together with the Term Loan Facility, the "Credit Facilities"). As ofDecember 31, 2020 , the Company had in aggregate$60.0 million principal outstanding under the Term Loan Facility and$10.0 million of borrowings outstanding under the Revolving Credit Facility. At our option, borrowings under the Credit Facilities bear interest at rates equal to either (1) a rate determined by reference to LIBOR (based on one, two, three or six-month interest periods), adjusted for statutory reserve requirements, plus an applicable margin (equal to 3.25% as of the Closing Date) or (2) a base rate determined by reference to the greatest of (a) the "prime rate" ofRegions Bank , (b) the federal funds rate plus 0.50%, and (c) the LIBOR index rate applicable for an interest period of one month plus 1.00%, plus an applicable margin (equal to 2.25%). The applicable margin for loans under the Credit Facilities varies from 3.25% per annum to 3.75% per annum (for LIBOR loans) and 2.25% to 2.75% per annum (for base rate loans) based on our consolidated leverage ratio. Interest payments with respect to the Credit Facilities are required either on a quarterly basis (for base rate loans) or at the end of each interest period (for LIBOR loans) or, if the duration of the applicable interest period exceeds three months, then every three months. As ofDecember 31, 2020 , the borrowing under our Credit Facilities were accruing interest at a rate of 3.475% per annum. In addition to paying interest on outstanding borrowings under the Revolving Credit Facility, we are required to pay a quarterly commitment fee based on the unused portion of the Revolving Credit Facility, which is determined by our consolidated leverage ratio. 34
-------------------------------------------------------------------------------- Each of the Revolving Credit Facility and the Term Loan Facility mature onDecember 14, 2023 . The principal amount of the Term Loan Facility amortizes in quarterly installments, which began with the close of the fiscal quarter endedMarch 31, 2019 , in an amount equal to$1,875,000 per quarter, payable monthly or quarterly, with the balance payable at maturity. The Company may prepay the loans under the Credit Facilities, in whole or in part, at any time without premium or penalty, subject to certain conditions including minimum amounts and reimbursement of certain costs in the case of prepayments of LIBOR loans. In addition, the Company is required to prepay the loan under the Term Loan Facility with the proceeds from certain financing transactions, involuntary dispositions or asset sales (subject, in the case of asset sales, to reinvestment rights). All obligations under the Credit Facilities are or will be guaranteed by each existing and future direct and indirect wholly owned domestic subsidiary of the Company, other than all of the Company's current and future regulated insurance subsidiaries (collectively, the "Guarantors"). The Company and the Guarantors entered into a Pledge and Security Agreement, onDecember 14, 2018 (the "Security Agreement"), in favor ofRegions Bank , as collateral agent. Pursuant to the Security Agreement, amounts borrowed under the Credit Facilities are secured on a first priority basis by a perfected security interest in substantially all of the present and future assets of the Company and each Guarantor (subject to certain exceptions), including all of the capital stock of the Company's domestic subsidiaries, other than its regulated insurance subsidiaries. The Credit Agreement contains, among other things, covenants, representations and warranties and events of default customary for facilities of this type. The Company is required to maintain, as of each fiscal quarter (1) a maximum consolidated leverage ratio of 3.25 to 1.00 for each fiscal quarter ending on or beforeDecember 31, 2019 , stepping down on each of the three anniversaries thereafter; (2) a minimum consolidated fixed charge coverage ratio of 1.20 to 1.00 and (3) a minimum consolidated net worth for the Company and its subsidiaries. Events of default include, among other events, (i) nonpayment of principal, interest, fees or other amounts; (ii) failure to perform or observe certain covenants set forth in the Credit Agreement; (iii) breach of any representation or warranty; (iv) cross-default to other indebtedness; (v) bankruptcy and insolvency defaults; (vi) monetary judgment defaults and material nonmonetary judgment defaults; (vii) customary ERISA defaults; (viii) a change of control of the Company; and (ix) failure to maintain specified catastrophe retentions in each of the Company's regulated insurance subsidiaries.
Convertible Notes
OnAugust 10, 2017 , the Company andHeritage MGA, LLC (the "Notes Guarantor") entered into a purchase agreement (the "Purchase Agreement") withCitigroup Global Markets Inc. , as the initial purchaser (the "Initial Purchaser"), pursuant to which the Company agreed to issue and sell, and the Initial Purchaser agreed to purchase,$125.0 million aggregate principal amount of the Company's 5.875% Convertible Senior Notes due 2037 (the "Convertible Notes") in a private placement transaction pursuant to Rule 144A under the Securities Act, as amended (the "Securities Act") (the "Offering"). The Purchase Agreement contained customary representations, warranties and agreements of the Company and the Notes Guarantor and customary conditions to closing, indemnification rights and obligations of the parties and termination provisions. The net proceeds from the Offering, after deducting discounts and commissions and estimated offering expenses payable by the Company, were approximately$120.5 million . The Offering was completed onAugust 16, 2017 . The Company issued the Convertible Notes under an Indenture (the "Convertible Note Indenture"), datedAugust 16, 2017 , by and among the Company, as issuer, the Notes Guarantor, as guarantor, andWilmington Trust, National Association , as trustee (the "Trustee"). The Convertible Notes bear interest at a rate of 5.875% per year. Interest began accruing onAugust 16, 2017 and is payable semi-annually in arrears, onFebruary 1 andAugust 1 of each year, starting onFebruary 1, 2018 . The Convertible Notes are senior unsecured obligations of the Company that rank senior in right of payment to the Company's future indebtedness that is expressly subordinated in right of payment to the Convertible Notes; equal in right of payment to the Company's unsecured indebtedness that is not so subordinated; effectively junior to any of the Company's secured indebtedness to the extent of the value of the assets securing such indebtedness; and structurally junior to all indebtedness or other liabilities incurred by the Company's subsidiaries other than the Notes Guarantor, which fully and unconditionally guarantee the Convertible Notes on a senior unsecured basis.
The Convertible Notes mature on
Holders may convert their Convertible Notes at any time prior to the close of business on the business day immediately precedingFebruary 1, 2037 , other than during the period from, and including,February 1, 2022 to the close of business on the second business day immediately precedingAugust 5, 2022 , only under the following circumstances: (1) during any calendar quarter commencing after the calendar quarter ending onSeptember 30, 2017 , if the closing sale price of the Company's common stock, for at least 20 trading days (whether or not consecutive) in the period of 30 consecutive trading days ending on the last trading day of the calendar quarter immediately preceding the calendar quarter in which the conversion occurs, is more than 130% of the conversion price of the Convertible Notes in effect on each applicable trading day; (2) during the ten consecutive business-day period following any five consecutive trading-day period in which the trading price for the Convertible Notes for each such trading day was less than 98% of the closing sale price of the Company's common stock on such date multiplied by the then-current conversion rate; (3) if the 35
-------------------------------------------------------------------------------- Company calls any or all of the Convertible Notes for redemption, at any time prior to the close of business on the second business day immediately preceding the redemption date; or (4) upon the occurrence of specified corporate events. During the period from and includingFebruary 1, 2022 to the close of business on the second business day immediately precedingAugust 5, 2022 , and on or afterFebruary 1, 2037 until the close of business on the second business day immediately precedingAugust 1, 2037 , holders may surrender their Convertible Notes for conversion at any time, regardless of the foregoing circumstances. The conversion rate for the Convertible Notes was initially 67.0264 shares of common stock per$1,000 principal amount of Convertible Notes (equivalent to an initial conversion price of approximately$14.92 per share of common stock). The conversion rate is subject to adjustment in certain circumstances and is subject to increase for holders that elect to convert their Convertible Notes in connection with certain corporate transactions (but not, at the Company's election, a public acquirer change of control (as defined in the Convertible Note Indenture)) that occur prior toAugust 5, 2022 . Upon the occurrence of a fundamental change (as defined in the Convertible Note Indenture) (but not, at the Company's election, a public acquirer change of control (as defined in the Convertible Note Indenture), holders of the Convertible Notes may require the Company to repurchase for cash all or a portion of their Convertible Notes at a fundamental change repurchase price equal to 100% of the principal amount of the Convertible Notes to be repurchased, plus accrued and unpaid interest to, but excluding, the fundamental change repurchase date. Except as described below, the Company may not redeem the Convertible Notes prior toAugust 5, 2022 . On or afterAugust 5, 2022 but prior toFebruary 1, 2037 , the Company may redeem for cash all or any portion of the Convertible Notes, at the Company's option, at a redemption price equal to 100% of the principal amount of the Convertible Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date. No sinking fund is provided for the Convertible Notes, which means that the Company is not required to redeem or retire the Convertible Notes periodically. Holders of the Convertible Notes are able to cause the Company to repurchase their Convertible Notes for cash on any ofAugust 1, 2022 ,August 1, 2027 andAugust 1, 2032 , in each case at 100% of their principal amount, plus accrued and unpaid interest to, but excluding, the relevant repurchase date. The Convertible Note Indenture contains customary terms and covenants and events of default. If an Event of Default (as defined in the Indenture) occurs and is continuing, the Trustee by notice to the Company, or the holders of at least 25% in aggregate principal amount of the Convertible Notes then outstanding by notice to the Company and the Trustee, may declare 100% of the principal of, and accrued and unpaid interest, if any, on, all the Convertible Notes to be immediately due and payable. In the case of certain events of bankruptcy, insolvency or reorganization (as set forth in the Convertible Note Indenture) with respect to the Company, 100% of the principal of, and accrued and unpaid interest, if any, on, the Notes automatically become immediately due and payable. In the second quarter of 2018, the Company repurchased$10.6 million principal amount of Convertible Notes for cash. In the fourth quarter of 2018 and first quarter of 2019, the Company repurchased Convertible Notes in the aggregate principal amount of$81.6 million for a combination of cash and the issuance of an aggregate of 3,880,653 shares of the Company's common stock, valued at$53.0 million , leaving$23.4 million in aggregate principal amount outstanding. There were no repurchases of Convertible Notes subsequent to the first quarter of 2019.
FHLB Loan Agreements
InDecember 2018 , a subsidiary of the Company pledgedU.S. government and agency fixed maturity securities with an estimated fair value of$31.0 million as collateral and received$19.2 million in a cash loan under an advance agreement with the FHLB Atlanta. The loan originated onDecember 12, 2018 and bears a fixed interest rate of 3.094% with interest payments due quarterly commencing inMarch 2019 . The principal balance on the loan has a maturity date ofDecember 13, 2023 . In connection with the agreement, the subsidiary became a member of FHLB. Membership in the FHLB required an investment in FHLB's common stock which was purchased onDecember 31, 2018 and valued at$1.4 million . The subsidiary is permitted to withdraw any portion of the pledged collateral over the minimum collateral requirement at any time, other than in the event of a default by the subsidiary. The proceeds from the loan was used to prepay the Company's Senior Secured Notes due 2023 in 2018. 36
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Contractual Obligations and Commitments
The following table summarizes our material contractual obligations and
commitments as of
Contractual Obligations and Less Than 1 More than
Commercial Commitments Total Year 1-3Years 3-5 Years 5 - Years
(in thousands)
Term loans, notes and interest (1)$ 77,281 $ 10,315 $ 66,966 $ - $ - Convertible debt (1) 37,169 1,376 2,751 2,751 30,291 Mortgage loan (1) 19,495 893 1,786 1,786 15,030 FHLB agreement (1) 21,005 630 20,375 - - Operating lease obligations 9,799 1,636 3,189 2,068 2,906
Total Contractual Obligations
(1) Amounts represent principal and interest payments to debt obligations.
Debt obligations are classified based on their stated maturity date. For
further information on long-term debt, Refer to Note 14 "Long Term Debt"
of the Notes to Consolidated Financial Statements included in Part II,
Item 8 of this Annual Report on Form 10-K.
The expected timing of payments of the obligations in the preceding table is
estimated based on current information. Timing of payments and actual amounts
paid may be different due to changes to agreed-upon amounts for some
obligations.
Critical Accounting Policies and Estimates
The following discussion and analysis presents the more significant factors that affected our financial conditions as ofDecember 31, 2020 and 2019 and results of operations for each of the years then ended. The preparation of financial statements in conformity with accounting principles of generally accepted inthe United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. While we base estimates on historical experience, current information and other factors deemed to be relevant, actual results could differ from those estimates. We consider accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain and (ii) different estimates that management reasonably could have used for the accounting estimates in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on our consolidated financial statements.Goodwill and Intangible Assets.Goodwill represents the excess of costs over the fair value of net assets acquired.Goodwill is subject to evaluation for impairment using a fair value-based test. This evaluation is performed annually, during the fourth quarter or more frequently if facts and circumstances warrant. We use a qualitative approach to test goodwill for impairment by first assessing qualitative factors to determine whether it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. We apply this qualitative approach as ofOctober 1 annually to any and all reporting units. If required following the qualitative assessment, the first step in the goodwill impairment test involves comparing the fair value of each of a reporting unit to the carrying value of a reporting unit. If the carrying value of a reporting unit exceeds the fair value of the reporting unit, we are required to proceed to the second step. In the second step, the fair value of the reporting unit would be allocated to the assets (including unrecognized intangibles) and liabilities of the reporting unit, with any residual representing the implied fair value of goodwill. An impairment loss would be recognized if, and to the extent that, the carrying value of goodwill exceeded the implied value. We review amortizable intangible assets for impairment whenever events or circumstances indicate that carrying amounts may not be recoverable. If we have concluded that impairment exists, the carrying amount is reduced to fair value. No impairment was recognized in any period presented. Impairment of Long-Lived Assets Including Intangible Assets Subject to Amortization. We assess the recoverability of long-lived assets when events or circumstances indicate that the assets might have become impaired. We determine whether the assets can be recovered from undiscounted future cash flows and, if not recoverable, we would recognize impairment to reduce the carrying value to fair value. Recoverability of long-lived assets is dependent upon, among other things, our ability to maintain profitability, so as to be able to meet its obligations when they become due. No impairment was recognized in any period presented. Premiums. We recognize direct and assumed premiums written as revenue, net of ceded amounts, on a daily pro rata basis over the contract period of the related policies that are in force. For any portion of premiums not earned at the end of the reporting period, we record an unearned premium liability. Premiums receivable represents amounts due from our policyholders for billed premiums and related policy fees. Our billing system is equity based such that policies are cancelled if the unpaid premium exceeds the amount of premium earned. When we receive payments on amounts previously charged off, we credit bad debt expense in the period we receive the payment. Balances in premiums receivable and the associated allowance account are removed upon cancellation of the policy due to non-payment. We 37
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recorded approximately
When we receive premium payments from policyholders prior to the effective date of the related policy, we record an advance premium liability. On the policy effective date, we reduce the advance premium liability and record the premiums as described above. Reserves for Unpaid Losses and Loss Adjustment Expenses. Reserves for unpaid losses and loss adjustment expenses, also referred to as loss reserves, represent the most significant accounting estimate inherent in the preparation of our financial statements. These reserves represent management's best estimate of the amount we will ultimately pay for losses and loss adjustment expenses and we base the amount upon the application of various actuarial reserve estimation techniques as well as considering other material facts and circumstances known at the balance sheet date. We establish two categories of loss reserves as follows: Case reserves-When a claim is reported, we establish an initial estimate of the losses that will ultimately be paid on the reported claim. Our initial estimate for each claim is based upon the judgment of our claims professionals who are familiar with property and liability losses associated with the coverage offered by our policies. Then, our claims personnel perform an evaluation of the type of claim involved, the circumstances surrounding each claim and the policy provisions relating to the loss and adjust the reserve, as necessary. As claims mature, we increase or decrease the reserve estimates as deemed necessary by our claims department based upon additional information we receive regarding the loss, the results of on-site reviews and any other information we gather while reviewing the claims. IBNR reserves-Our IBNR reserves include true IBNR reserves plus "bulk" reserves. True IBNR reserves represent amounts related to claims for which a loss occurred on or before the date of the financial statements, but which have not yet been reported to us. Bulk reserves represent additional amounts that cannot be allocated to particular claims, but which are necessary to estimate ultimate losses on known claims. We estimate our IBNR reserves by projecting our ultimate losses using industry accepted actuarial methods and then deducting actual loss payments and case reserves from the projected ultimate losses. We review and adjust our IBNR reserves on a quarterly basis based on information available to us at the balance sheet date. When we establish our reserves, we analyze various factors such as the evolving historical loss experience of the insurance industry as well as our experience, claims frequency and severity, our business mix, our claims processing procedures, legislative enactments, judicial decisions and legal developments in imposition of damages, and general economic conditions, including inflation. A change in any of these factors from the assumptions implicit in our estimates will cause our ultimate loss experience to be better or worse than indicated by our reserves, and the difference could be material. Due to the interaction of the foregoing factors, there is no precise method for evaluating the impact of any one specific factor in isolation, and an element of judgment is ultimately required. Due to the uncertain nature of any future projections, the ultimate amount we will pay for losses will be different from the reserves we record.
We determine our ultimate loss reserves by selecting an estimate within a relevant range of indications that we calculate using generally accepted actuarial techniques. Our selection of the point estimate is influenced by the analysis of our paid losses and incurred losses since inception.
Our external reserving actuaries evaluated the adequacy of our reserves as ofDecember 31, 2020 and concluded that our reported loss reserves would meet the requirements of the insurance laws of the states in which our insurance subsidiaries are domiciled, be consistent with reserves computed in accordance with accepted loss reserving standards and principles, and make a reasonable provision for all unpaid loss and loss adjustment expense obligations under the terms of our contracts and agreements. In addition to$353.6 million of recorded case reserves, we recorded$305.8 million of IBNR reserves as ofDecember 31, 2020 to achieve overall gross reserves of$659.3 million . Gross IBNR for hurricane claims was$61.0 million atDecember 31, 2020 . AtDecember 31, 2020 , ceded IBNR and net IBNR were$105.1 million and$200.7 million , respectively. The process of establishing our reserves is complex and inherently imprecise, as it involves using judgment that is affected by many variables. We believe a reasonably likely change in almost any of the factors we evaluate as part of our loss reserve analysis could have an impact on our reported results, financial position and liquidity. The following table quantifies the pro forma impact of hypothetical changes in our net loss reserves on our net income and stockholders' equity as of and for the year endedDecember 31, 2020 (in thousands): % Change % Change Low from High from Actual Estimate Actual Estimate Actual Net Loss Reserves$ 261,653 $ 201,915 $ 313,716 Impact on: Net income$ 9,326 $ 31,538 238.2 %$ (25,068 ) (368.8 )% Stockholders' equity$ 442,344 $ 464,556 5.0 %$ 407,950 (7.8 )% Cash, cash equivalents and investments(1)$ 1,029,975 $ 1,052,186 -$ 995,580 -
(1) Estimated cash, cash equivalents and investments is intended to reflect the
impact of loss reserves, net of taxes.
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-------------------------------------------------------------------------------- Policy Acquisition Costs. We incur policy acquisition costs that vary with, and are directly related to, the production of new business. Policy acquisition costs consist of the following four items: (i) commissions paid to outside agents at the time of policy issuance, (ii) policy administration fees paid to a third-party administrator at the time of policy issuance, (iii) premium taxes and (iv) inspection fees. We capitalize policy acquisition costs to the extent recoverable, then we amortize those costs over the contract period of the related policy. We also earn ceding commission on our quota share reinsurance contracts, which is presented as a reduction of policy acquisition costs with any excess unearned ceding commission recognized as a liability. Ceding commission income is deferred and earned over the contract period. The amount and rate of ceding commissions earned on the net quota share contract can slide within a prescribed minimum and maximum, depending on loss performance and how future losses develop. We earn ceding commission on its gross and net quota share reinsurance contracts. Our accounting policy is to allocate ceding commission between policy acquisition costs and general and administrative expenses for financial reporting purposes. Ceding commission is allocated between policy acquisition costs and general and administrative expenses based upon the proportion these costs bear to production of new business. For the years endedDecember 31, 2020 , 2019 and 2018, we earned ceding commission income of$57.1 million ,$62.4 million and$73.0 million of which$43.0 million ,$47.0 million and$54.9 million was allocable to policy acquisition costs. Provision for Premium Deficiency. At each reporting date, we determine whether we have a premium deficiency. A premium deficiency would result if the sum of our expected losses, deferred policy acquisition costs and policy maintenance costs (such as costs to store records and costs incurred to collect premiums and pay commissions) exceeded our related unearned premiums plus investment income. Should we determine that a premium deficiency exists, we would write off the unrecoverable portion of deferred policy acquisition costs. No accruals for premium deficiency were considered necessary as ofDecember 31, 2020 and 2019. Reinsurance. We follow industry practice of reinsuring a portion of our risks. Reinsurance involves transferring, or "ceding", all or a portion of the risk exposure on policies we write to another insurer, known as a reinsurer. To the extent that our reinsurers are unable to meet the obligations they assume under our reinsurance agreements, we remain liable for the entire insured loss.
Our reinsurance agreements are prospective contracts. We record an asset, prepaid reinsurance premiums, and a liability, reinsurance payable, for the entire contract amount upon commencement of our new reinsurance agreements. We amortize our prepaid reinsurance premiums over the 12-month contract period.
In the event that we incur losses recoverable under our reinsurance program, we record amounts recoverable from our reinsurers on paid losses plus an estimate of amounts recoverable on unpaid losses. The estimate of amounts recoverable on unpaid losses is a function of our liability for unpaid losses associated with the reinsured policies; therefore, the amount changes in conjunction with any changes to our estimate of unpaid losses. In the event that we incur losses recoverable under the reinsurance program, the estimate of amounts recoverable from reinsurers on unpaid losses may change at any point in the future because of its relation to our reserves for unpaid losses. We estimate uncollectible amounts receivable from reinsurers based on an assessment of factors including the creditworthiness of the reinsurers and the adequacy of collateral obtained, where applicable. We had no uncollectible amounts under our reinsurance program or bad debt expense related to reinsurance for the years endedDecember 31, 2020 , 2019 and 2018.
Recent Accounting Pronouncements Not Yet Effective
The Company describes the recent pronouncements that have had or may have a significant effect on its financial statements or on its disclosures. The Company does not discuss recent pronouncements that a) are not anticipated to have an impact on, or b) are unrelated to its financial condition, results of operations, or related disclosures. For accounting pronouncements not yet adopted, Refer to Note 1 "Basis of Presentation, Nature of Business and Significant Accounting Policies and Practices" to our consolidated financial statements included in this Annual Report on Form 10-K, for further information.
Off-Balance Sheet Arrangements
As ofDecember 31, 2020 , we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K, that have or are reasonably likely to have a current or future effect on our financial condition, changes in our financial condition, revenues, or expenses, results of operations, liquidity or capital resources that is material to investors.
Seasonality of our Business
Our insurance business is seasonal; hurricanes typically occur during the period fromJune 1 through November 30 and winter storms generally impact the first and fourth quarters each year. With our catastrophe reinsurance program effective onJune 1 each year, any variation in the cost of our reinsurance, whether due to changes to reinsurance rates or changes in the total insured value of our policy base will occur and be reflected in our financial results beginningJune 1 of each year, subject to certain adjustments. 39
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Impact of Inflation and Changing Prices
The consolidated financial statements and related data presented herein have been prepared in accordance with generally accepted accounting principles which require the measurement of financial position and operating results in terms of historical dollars without considering changes in the relative purchasing power of money over time due to inflation. Our primary assets are monetary in nature. As a result, interest rates may have a more significant impact on our performance than the effects of the general levels of inflation. Interest rates do not necessarily move in the same direction or with the same magnitude as the cost of paying losses and LAE. Insurance premiums are established before we know the amount of loss and LAE and the extent to which inflation may affect such expenses. Consequently, we attempt to anticipate the future impact of inflation when establishing rate levels. While we attempt to charge adequate rates, we may be limited in raising our premium levels for competitive and regulatory reasons. Inflation also affects the market value of our investment portfolio and the investment rate of return. Any future economic changes which result in prolonged and increasing levels of inflation could cause increases in the dollar amount of incurred loss and LAE and thereby materially adversely affect future liability requirements.
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