TREAN INSURANCE GROUP, INC. The following discussion and analysis of financial condition and results of operations for the three and nine months endedSeptember 30, 2021 is qualified by reference to and should be read in conjunction with the accompanying unaudited condensed consolidated financial statements and the related notes included herein and the audited consolidated financial statements and notes included in our 2020 Form 10-K. The discussion and analysis below are based on comparisons between our historical financial data for different periods and include certain forward-looking statements about our business, operations, and financial performance. These forward-looking statements are subject to risks, uncertainties, assumptions and other factors described in Item 1A - "Risk Factors" in our 2020 Form 10-K. Our actual results may differ materially from those expressed in, or implied by, those forward-looking statements. See "Forward-Looking Statements." All references to "we," "us," "our," "the Company," "Trean ," or similar terms refer to (i)Trean , BIC and their subsidiaries before the consummation of the reorganization transactions in anticipation of our IPO and (ii)Trean Insurance Group, Inc. and its subsidiaries after such reorganization transactions, unless the context otherwise requires. The information contained in this quarterly report is not a complete description of our business or the risks associated with an investment in our common stock.
The Company defines increases or decreases greater than 200% as "NM" or not meaningful.
Forward-Looking Statements
This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the federal securities laws, which statements involve substantial risks and uncertainties. Forward-looking statements generally relate to future events or our future financial performance or operating performance. In some cases, you can identify forward-looking statements because they contain words such as "may," "will," "should," "expects," "plans," "anticipates," "could," "intends," "target," "projects," "contemplates," "believes," "estimates," "predicts," "would," "potential," or "continue" or the negative of these words or other similar terms or expressions that concern our expectations, strategy, plans, or intentions. These forward-looking statements include, among others, statements relating to our future financial performance, our business prospects and strategy, anticipated financial position, liquidity and capital needs, and other similar matters. Forward-looking statements are based on management's current expectations and assumptions about future events, which are inherently subject to uncertainties, risks, and changes in circumstances that are difficult to predict. The outcome of the events described in these forward-looking statements is subject to risks, uncertainties, and assumptions, which in many cases are beyond our control, as described in "Item 1A - Risk Factors" in our 2020 Form 10-K and in this Quarterly Report on Form 10-Q. Our statements reflecting these risks and uncertainties are not exhaustive, and other risks and uncertainties may currently exist or may arise in the future that could have material effects on our business, operations and financial condition. We cannot assure you that the results, events, and circumstances reflected in the forward looking statements reflected in this Quarterly Report on Form 10-Q and our other public statements and securities filings will be achieved or occur, and actual results, events or circumstances could differ materially from those described in the forward looking statements. These forward-looking statements speak only as of the date on which such statements are made. We undertake no obligation, and do not intend, to update any forward looking statements after the date of this Quarterly Report on Form 10-Q or to conform such statements to actual results or revised expectations, except as required by applicable securities laws or the rules and regulations of theSEC . Overview We are a provider of products and services to the specialty insurance market. We underwrite specialty casualty insurance products both through ourProgram Partners and also through our Owned MGAs. We also provide ourProgram Partners with a variety of services, including issuing carrier services, claims administration, and reinsurance brokerage, from which we generate recurring fee-based revenues. We have one reportable segment. We provide our insurance products and services to ourProgram Partners and Owned MGAs focused on specialty lines. We target a diversified portfolio of small to medium programs, typically with less than$30 million of premiums, that focus on niche segments of the specialty casualty insurance market and that we believe have strong underwriting track records. 34
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Table of Contents
Initial Public Offering and Reorganization
OnJuly 20, 2020 ,Trean Insurance Group, Inc. closed the sale of 10,714,286 shares of its common stock in its IPO, comprised of 7,142,857 shares issued and sold byTrean Insurance Group, Inc. and 3,571,429 shares sold by selling stockholders. OnJuly 22, 2020 ,Trean Insurance Group, Inc. closed the sale of an additional 1,207,142 shares by certain selling stockholders in the IPO pursuant to the exercise of the underwriters' option to purchase additional shares to cover over-allotments. The aggregate proceeds to the Company from all shares sold by the Company in the IPO were approximately$107,142 and the aggregate IPO proceeds from all shares sold by the selling stockholders in the IPO were approximately$71,678 . The shares began trading on the Nasdaq Global Select Market onJuly 16, 2020 under the symbol "TIG." Prior to the completion of the above IPO, the Company effected the following reorganization transactions: (i) each ofTrean and BIC contributed all of their respective assets and liabilities toTrean Insurance Group, Inc. , a newly formed direct subsidiary of BIC, in exchange for shares of common stock inTrean Insurance Group, Inc. and (ii) upon the completion of the transfers byTrean and BIC,Trean and BIC were dissolved and distributed in-kind common shares to the pre-IPO unitholders. In conjunction with the IPO and corporate restructuring, the Company made a payment toAltaris Capital Partners, LLC in connection with the termination of the Company's consulting and advisory agreements as well as paid bonuses to employees and pre-IPO unitholders for the successful completion of the IPO. The aggregate amount of these payments totaled$11,054 .
Secondary Offering of Common Stock
OnMay 19, 2021 ,Trean Insurance Group, Inc. closed the sale of 5,000,000 shares of its common stock, comprised entirely of shares sold by selling stockholders. We did not receive any proceeds from the sale of shares of our common stock by the selling stockholders in this offering. As a result of this offering, the Altaris Funds no longer beneficially own more than 50% of the outstanding common stock of the Company. Acquisition of Compstar EffectiveJuly 15, 2020 ,Trean Compstar Holdings LLC purchased the remaining 55% ownership interest in Compstar, a holding company, along with its wholly owned subsidiary,Compstar Insurance Services , a managing general agent, by issuing 6,613,606 shares of the Company's common stock with a market price of$15 per share on the date of acquisition. Prior to the acquisition date, the Company held a 45% ownership interest in Compstar and accounted for its investment under the equity method. As of the acquisition date, the fair value attributable to the Company's previous equity interest was$81,167 and the carrying value was$11,321 . As a result, the Company recorded a gain of$69,846 from the remeasurement of its previous equity interest. The fair value of the Company's previous equity interest was revalued on the acquisition date using the market price of the shares issued as consideration for the acquisition.
Acquisition of 7710
EffectiveOctober 1, 2020 ,Benchmark Holding Company acquired 100% ownership of 7710Insurance Company as well as its associated program manager and agency, 7710Service Company, LLC andCreekwood Insurance Agency, LLC , for a purchase price of$12,140 . 7710Insurance Company underwrites workers' compensation primarily for emergency services, including firefighters, and EMS. 7710Insurance Company focuses on reducing costs and claims through the implementation of a propriety safety preparedness and loss control program, created and staffed by experienced firefighters and EMS professionals.
Western Integrated Care
EffectiveJuly 6, 2021 ,Trean Corp acquired 100% ownership of WIC for a total purchase price of$5,500 . WIC is a managed care organization that offers services to workers' compensation insurers to enable employees who are injured on the job to access qualified medical treatment. 35 -------------------------------------------------------------------------------- Table of Contents Embedded Derivatives During the second quarter of 2021, the Company determined that its funds held agreements with reinsurers contain embedded derivatives relating to a total return swap on the underlying investments. As a result, the Company has revised the presentation of its financial results to report the change in fair value of the embedded derivatives in gains (losses) on embedded derivatives in the condensed consolidated statements of operations. In addition, the effect of investment earnings and realized capital gains (losses) related to funds held accounts will also be reported in gains (losses) on embedded derivatives in the condensed consolidated statements of operations, whereas previously these were reported as an offset to net investment income and net realized capital gains (losses), respectively. While the prior period amounts have been corrected for comparability, the correction was not material to the previously reported condensed consolidated and condensed combined financial statements.
Coronavirus ("COVID-19") Impact
We are monitoring the impact of the ongoing continuation of the COVID-19 pandemic on our business, including how it may impact our premium revenue, loss experience and loss expense, liquidity, and our regulatory capital and surplus, and operations. Workforce Operations Following the emergence of the COVID-19 pandemic in early 2020, we took a number of actions to protect the health of the public and our employees and to comply with directives and advice of governmental authorities and public health experts. We responded by developing a Preparedness Plan that outlined both corporate-wide and location-specific modifications to working conditions and operations in our offices. This multi-faceted plan included elements such as restricting business travel and transitioning from an office-based company to primarily a remote working culture. As most of our employees already had secure remote working connections, we took additional measures to ensure all employees who wanted or needed to work remotely were able to do so securely with limited connectivity disruption. We also provided our employees education and training with respect to cybersecurity issues that may arise relating to COVID-19 and working remotely in conjunction with the goal of serving the operational needs of a remote workforce and continuing to serve our customers. We implemented safeguards for employees who play critical roles to ensure operational reliability and established protocols for employees who interact directly with the public. As state, city, and county guidelines progress, we have implemented new health and safety in-office procedures and have launched our "Return to Office" plan to transition our workforce back to working in our offices while continuing to monitor the progression of the COVID-19 Delta Variant.
Premium Revenue, Claims and Losses
We have not experienced a material impact to our premium revenue in the first nine months of 2021 as a result of the COVID-19 pandemic. During the quarter endedSeptember 30, 2021 , compared to the quarter endedSeptember 30, 2020 , gross written premiums increased 34.3%, primarily driven by growth in our existing Program Partner business as well as the addition of newProgram Partners , and gross earned premiums increased 36.4%, primarily driven by the increase in gross written premiums. During the nine months endedSeptember 30, 2021 , compared to the nine months endedSeptember 30, 2020 , gross written premiums increased by 37.5% and gross earned premiums increased by 34.1%, primarily driven by both significant growth in our existing Program Partner business as well as the addition of newProgram Partners . Because a majority of our gross written premiums are related to workers' compensation insurance, we expect that future revenue trends could be impacted. However, a significant portion of our workers' compensation premiums are pay-as-you-go programs, which reduces our downside risk from future premium audits or refunds. We also have not experienced a material impact in our reported claims or incurred losses in the first nine months of 2021 as a specific result of the COVID-19 pandemic. Our loss ratio increased to 61.8% and 61.5%, respectively, during the three and nine months endingSeptember 30, 2021 from 55.9% and 56.7%, respectively, for the comparable 2020 periods. The increases in our loss ratios are attributable to a number of large unusual losses primarily incurred on our workers' compensation line of business as well as property losses incurred during the first half of 2021coupled with continued current year loss development. 36 -------------------------------------------------------------------------------- Table of Contents Investment Portfolio With respect to our investment portfolio, we seek to hold a high-quality, diversified portfolio of investments, which are primarily in fixed maturity and available-for-sale investments and, as such, our investment portfolio has limited exposure to the recent equity market volatility. For the nine months endedSeptember 30, 2021 , we experienced a decrease of$8,670 , or 2.1%, in the fair value of our investment portfolio due to a reduction in unrealized gains on the value of our fixed maturity investments. The decline in the fair value of our fixed maturity investments is primarily attributable to rising interest rates following 2020 COVID-19 driven lower rates as opposed to underlying credit risk within our investment portfolio. If there were to be continued equity and debt financial market volatility, which in turn could create mark-to-market investment valuation decreases, we expect there could be additional or increased unrealized losses recorded during the balance of the year. However, given the conservative nature of our investment portfolio, we expect that any adverse impact on the value of our investment portfolio, as it relates to COVID-19, will be temporary, and we do not expect a long-term negative impact on our financial condition, results of operations or cash flows.
Other Concerns
Adverse events such as adverse changes in the overall public health environment resulting from changing infection patterns and other factors, variant strains of COVID-19, health-related concerns about working in our offices, ongoing restrictions on travel, the potential impact on our business partners and customers, and other matters affecting the general work and business environment could harm our business and delay the implementation of our business strategy. We cannot anticipate all the ways in which the current global health crisis and financial market conditions could adversely impact our business in the future.
Significant Components of Results of Operations
Gross written premiums: Gross written premiums are the amounts received or to be received for insurance policies written or assumed by us during a specific period of time without reduction for general and administrative expenses (including policy acquisition costs), reinsurance costs, or other deductions. The volume of our gross written premiums in any given period is generally influenced by: •addition and retention ofProgram Partners ; •new business submissions to ourProgram Partners ; •binding of new business submissions into policies; •renewals of existing policies; and •average size and premium rate of bound policies. Gross earned premiums: Gross earned premiums are the earned portion of gross written premiums. We earn insurance premiums on a pro rata basis over the term of the policy. Our insurance policies generally have a term of one year. Ceded earned premiums: Ceded earned premiums are the amount of gross earned premiums ceded to reinsurers. We enter into reinsurance contracts to limit our maximum losses and diversify our exposure and provide statutory surplus relief. The volume of our ceded earned premiums is affected by the level of our gross earned premiums and any decision we make to increase or decrease limits, retention levels, and co-participations. Net earned premiums: Net earned premiums represent the earned portion of our gross written premiums, less that portion of our gross written premiums that is earned and ceded to third-party reinsurers, including ourProgram Partners and professional reinsurers, under our reinsurance agreements. Net investment income: We earn investment income on our portfolio of cash and invested assets. Our cash and invested assets are primarily comprised of fixed maturities, including other investments and short-term investments. Our net investment income includes interest income on our invested assets, income on funds held investments as well as unrealized gains and losses on our equity portfolio. 37 -------------------------------------------------------------------------------- Table of Contents Net realized capital gains/losses: Net realized capital gains/losses are a function of the difference between the amount received by us on the sale of a security and the security's recorded value as well as any "other-than-temporary impairments" relating to fixed maturity investments recognized in earnings.
Other revenue: Other revenue includes brokerage, third-party administrative, management and consulting, and other fee-based revenues, which are commonly based on written premiums.
Loss and loss adjustment expenses: Losses and LAE are net of reinsurance and 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. In general, our losses and LAE are affected by: •frequency of claims associated with the particular types of insurance contacts that we write; •trends in the average size of losses incurred on a particular type of business; •mix of business written by us; •changes in the legal or regulatory environment related to the business we write; •trends in legal defense costs; •wage inflation; and •inflation in medical costs.
Losses and LAE are based on an actuarial analysis of the estimated losses, including losses incurred during the period and changes in estimates from prior periods. Losses and LAE may be paid out over a period of years.
General and administrative expenses: General and administrative expenses include net commissions, insurance-related expenses, and general and administrative operating expenses. Net commissions consist of policy acquisition costs and other underwriting expenses, net of ceding commissions. Policy acquisition costs are principally comprised of the commissions we pay our brokers and program managers. Policy acquisition costs that are directly related to the successful acquisition or reinsurance of those policies are deferred. All policy acquisition costs are charged to expense in proportion to premium earned over the policy life. We receive ceding commissions on business ceded under our reinsurance contracts. Insurance-related expenses largely consist of state premium taxes. General and administrative operating expenses include employee salaries and benefits, corporate insurance costs, technology costs, office rent, and professional services fees such as legal, accounting, audit, tax and actuarial services. Intangible asset amortization: Intangible asset amortization consists of expenses incurred related to the amortization of intangible assets recorded as a result of business acquisitions and consists of trade names, customer lists and relationships, and non-compete agreements.
Noncash stock compensation: Noncash stock compensation includes expenses related to the fair value and issuance of restricted stock units and stock options.
Gains (losses) on embedded derivatives: Gains (losses) on embedded derivatives consist of the change in fair value of derivatives, the effect of net investment income on funds held investments, and the effect of realized gains and loss on funds held investments. Interest expense: Interest expense consists primarily of interest paid on (i) our term loan facility and (ii) the preferred capital securities issued by the Trust (See "Financial Condition, Liquidity and capital resources - Debt and Credit Agreements").
Other income: Other income consists primarily of sublease revenue and other miscellaneous income items.
Equity earnings in affiliates, net of tax: Equity earnings in affiliates, net of tax includes the Company's share of earnings from equity method investments.
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Key Metrics
We discuss certain key financial and operating metrics, described below, which provide useful information about our business and the operational factors underlying our financial performance.
Underwriting income is a non-GAAP financial measure defined as income before taxes excluding net investment income, investment revaluation gains, net realized capital gains or losses, intangible asset amortization, noncash stock compensation, gains and losses on embedded derivatives, interest expense, other revenue, and other income and expenses. See "Reconciliation of Non-GAAP Financial Measures" for a reconciliation of underwriting income to income before taxes in accordance with GAAP. Adjusted net income is a non-GAAP financial measure defined as net income excluding the impact of certain items, including the consummation of the reorganization transactions in connection with our IPO, noncash intangible asset amortization and stock compensation, noncash unrealized gains and losses on embedded derivatives, other expenses and gains or losses that we believe do not reflect our core operating performance, which items may have a disproportionate effect in a given period, affecting comparability of our results across periods. See "Reconciliation of Non-GAAP Financial Measures" for a reconciliation of adjusted net income to net income in accordance with GAAP.
Loss ratio, expressed as a percentage, is the ratio of losses and LAE to net earned premiums.
Expense ratio, expressed as a percentage, is the ratio of general and administrative expenses to net earned premiums.
Combined ratio is the sum of the loss ratio and the expense ratio. A combined ratio under 100% generally indicates an underwriting profit. A combined ratio over 100% generally indicates an underwriting loss.
Return on equity is net income expressed on an annualized basis as a percentage of average beginning and ending stockholders' equity during the period.
Adjusted return on equity is a non-GAAP financial measure defined as adjusted net income expressed on an annualized basis as a percentage of average beginning and ending stockholders' equity during the period. See "Reconciliation of Non-GAAP Financial Measures" for a reconciliation of adjusted return on equity to return on equity in accordance with GAAP.
Tangible stockholders' equity is defined as stockholders' equity less goodwill and other intangible assets.
Return on tangible equity is a non-GAAP financial measure defined as net income
expressed on an annualized basis as a percentage of average beginning and ending
tangible stockholders' equity during the period. See "Reconciliation of Non-GAAP
Financial Measures" for a reconciliation of return on tangible equity to return
on equity in accordance with GAAP.
Adjusted return on tangible equity is a non-GAAP financial measure defined as
adjusted net income expressed on an annualized basis as a percentage of average
beginning and ending tangible stockholders' equity during the period. See
"Reconciliation of Non-GAAP Financial Measures" for a reconciliation of adjusted
return on tangible equity to return on tangible equity in accordance with GAAP.
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Results of Operations
Consolidated Results of Operations for the Three Months Ended
The following table summarizes our results of operations for the three months
ended
Three Months Ended September 30, Percentage Change
(in thousands, except for percentages) 2021 2020 Change (1)
Revenues
Gross written premiums $ 177,624$ 132,284 $ 45,340 34.3 % Increase in gross unearned premiums (28,478) (22,963) (5,515) 24.0 % Gross earned premiums 149,146 109,321 39,825 36.4 % Ceded earned premiums (97,191) (81,465) (15,726) 19.3 % Net earned premiums 51,955 27,856 24,099 86.5 % Net investment income 2,187 2,364 (177) (7.5) % Gain on revaluation of Compstar investment - 69,846 (69,846) (100.0) % Net realized capital gains 49 115 (66) (57.4) % Other revenue 2,799 5,401 (2,602) (48.2) % Total revenue 56,990 105,582 (48,592) (46.0) % Expenses Losses and loss adjustment expenses 32,129 15,564 16,565 106.4 % General and administrative expenses 13,788 6,995 6,793 97.1 % Other expenses - 11,054 (11,054) (100.0) % Intangible asset amortization 1,499 1,120 379 33.8 % Noncash stock compensation 468 307 161 52.4 % Interest expense 419 520 (101) (19.4) % Total expenses 48,303 35,560 12,743 35.8 % Gains (losses) on embedded derivatives (121) (367) 246 (67.0) % Other income 35 209 (174) (83.3) % Income before taxes 8,601 69,864 (61,263) (87.7) % Income tax expense 2,083 817 1,266 155.0 % Equity earnings in affiliates, net of tax - 401 (401) (100.0) % Net income $ 6,518$ 69,448 $ (62,930) (90.6) %
(1) The Company defines increases or decreases greater than 200% as "NM" or not meaningful.
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Three Months Ended September 30,
(in thousands, except for percentages) 2021 2020
Key metrics:
Underwriting income(1) $ 6,038 $ 5,297
Adjusted net income(1) $ 7,678 $ 10,477
Loss ratio 61.8 % 55.9 %
Expense ratio 26.5 % 25.1 %
Combined ratio 88.3 % 81.0 %
Return on equity 6.2 % 102.7 %
Adjusted return on equity(1) 7.3 % 15.5 %
Return on tangible equity(1) 12.7 % 171.4 %
Adjusted return on tangible equity(1) 15.0 % 25.9 %
(1) This metric represents a non-GAAP financial measure. See 'Reconciliation of Non-GAAP Financial Measures' for a reconciliation of this metric to the applicable GAAP metric.
The table below shows the total premiums earned on a gross and net basis for the respective three-month periods:
Three Months Ended September 30, Percentage Change
(in thousands, except percentages) 2021 2020 Change (1)
Revenues:
Gross written premiums $ 177,624$ 132,284 $ 45,340 34.3 % Increase in gross unearned premiums (28,478) (22,963) (5,515) 24.0 % Gross earned premiums 149,146 109,321 39,825 36.4 % Ceded earned premiums (97,191) (81,465) (15,726) 19.3 % Net earned premiums $ 51,955$ 27,856 $ 24,099 86.5 %
(1) The Company defines increases or decreases greater than 200% as "NM" or not meaningful.
Gross written premiums: Gross written premiums increased$45,340 , or 34.3%, to$177,624 for the three months endedSeptember 30, 2021 , compared to$132,284 for the three months endedSeptember 30, 2020 . The increase is primarily attributable to the growth in our existing Program Partner business and the addition of newProgram Partners . The changes in gross written premiums were due to the following: Workers' compensation represented 54.3% of our gross written premiums for the three months endedSeptember 30, 2021 , compared to 72.7% for the three months endedSeptember 30, 2020 , primarily as a result of our ongoing strategic effort to diversify our lines of business. For the three months endedSeptember 30, 2021 , gross written premiums for workers' compensation increased by$343 , or 0.4%, compared to the same period in 2020. All other non-workers' compensation liability represented 45.7% of our gross written premiums for the three months endedSeptember 30, 2021 , compared to 27.3% for the three months endedSeptember 30, 2020 . For the three months endedSeptember 30, 2021 , gross written premiums for all other non-workers' compensation liability increased$44,997 , or 124.4%, compared to the same period in 2020. The increase is due to growth in our other liability, accident & health, commercial auto and homeowners lines of business in keeping with our diversification. Gross earned premiums: Gross earned premiums increased$39,825 , or 36.4%, to$149,146 for the three months endedSeptember 30, 2021 , compared to$109,321 for the three months endedSeptember 30, 2020 . The increase in gross earned premiums reflects the increase in gross written premiums of$45,340 net of an increase in gross unearned premiums of$5,515 . The increase in gross unearned premiums is directly attributable to the growth in gross written premiums. Gross 41 -------------------------------------------------------------------------------- Table of Contents earned premiums as a percentage of gross written premiums decreased to 84.0% for the three months endedSeptember 30, 2021 , compared to 82.6%, for the three months endedSeptember 30, 2020 . Ceded earned premiums: Ceded earned premiums increased$15,726 , or 19.3%, to$97,191 for the three months endedSeptember 30, 2021 , compared to$81,465 for the three months endedSeptember 30, 2020 . The increase in ceded earned premiums is driven by the growth in gross earned premiums as described above, partially offset by an increase in our retention. Ceded earned premiums as a percentage of gross earned premiums decreased to 65.2% for the three months endedSeptember 30, 2021 , compared to 74.5% for the three months endedSeptember 30, 2020 , reflecting the Company's strategic decision to retain more gross written premiums. Net earned premiums: Net earned premiums increased$24,099 , or 86.5%, to$51,955 for the three months endedSeptember 30, 2021 , compared to$27,856 for the three months endedSeptember 30, 2020 . The increase is due to the growth in gross earned premiums as described above and the Company's strategic decision to retain more gross written premiums. Net investment income: Net investment income decreased$177 , or 7.5%, to$2,187 for the three months endedSeptember 30, 2021 , compared to$2,364 for the three months endedSeptember 30, 2020 . The decrease largely reflects the reinvestment of funds from higher yielding maturities into lower yielding investments due to lower interest rates. Net realized capital gains: Net realized capital gains decreased$66 to$49 for the three months endedSeptember 30, 2021 , compared to$115 for the three months endedSeptember 30, 2020 . The decrease is driven by a loss of$112 realized in the third quarter of 2021 on the Company's sale of its remaining investment in TRI. Other revenue: Other revenue decreased$2,602 , or 48.2%, to$2,799 for the three months endedSeptember 30, 2021 , compared to$5,401 for the three months endedSeptember 30, 2020 . The decrease is driven by a reduction in brokerage revenue of$2,433 due to due to a$2.2 million increase in estimated premiums and the timing of effective dates for brokered reinsurance contracts recognized in the third quarter of 2020. In addition, brokerage revenue was also reduced in 2021 due to the Company's higher retention of brokered reinsurance contracts compared to the same prior-year period. Losses and loss adjustment expenses: Losses and LAE increased$16,565 , or 106.4%, to$32,129 for the three months endedSeptember 30, 2021 , compared to$15,564 for the three months endedSeptember 30, 2020 . The increase is attributable to the growth in gross earned premiums and increased retention during the three months endedSeptember 30, 2021 . This resulted in a loss ratio of 61.8% for the three months endedSeptember 30, 2021 compared to 55.9% for the three months endedSeptember 30, 2020 . The increase is attributable to a number of unusually large losses experienced during the first half of 2021, resulting in a higher overall loss ratio pick related to the 2021 accident year. General and administrative expenses: General and administrative expenses increased$6,793 , or 97.1%, to$13,788 for the three months endedSeptember 30, 2021 , compared to$6,995 for the three months endedSeptember 30, 2020 . The expense ratio was 26.5% for the three months endedSeptember 30, 2021 , compared to 25.1% for the three months endedSeptember 30, 2020 . 42 -------------------------------------------------------------------------------- Table of Contents The table below shows the components of general and administrative expenses for the respective three month periods: Three Months Ended September 30, 2021 2020 Change Direct commissions$ 27,594 $ 18,879 $ 8,715 Ceding commissions (31,655) (26,314) (5,341) Net commissions (4,061) (7,435) 3,374 Insurance-related expenses 5,371 3,925 1,446 General and administrative operating expenses 12,478 10,505 1,973 Total general and administrative expenses$ 13,788
General and administrative expenses - % of gross written premiums 7.0 % 7.9 % Retention rate (1) 34.8 % 25.5 % Direct commission rate (2) 18.5 % 17.3 % Ceding commission rate (3) 32.6 % 32.3 %
(1) Net earned premium as a percentage of gross earned premiums. (2) Direct commissions as a percentage of gross earned premiums. (3) Ceding commissions as a percentage of ceded earned premiums.
Direct commissions increased$8,715 primarily due to an increase in gross earned premiums. Ceding commissions increased$5,341 due to an increase in ceded earned premiums reflecting the increase in gross earned premiums, partially offset by an increase in retention. Insurance-related expenses increased$1,446 , primarily as a result of an increase in gross earned premiums. General and administrative operating expenses increased$1,973 , primarily as a result of: (i) an increase in salaries and benefits of$1,833 , of which$668 directly resulted from acquisitions made in the second half of 2020 and a general increase in workforce and (ii) additional IT software and systems costs totaling$344 related to new software implementation and automation initiatives; partially offset by a decrease in professional fees of$245 . Other expenses: Other expenses were$0 for the nine months endedSeptember 30, 2021 , compared to$11,054 for the three months endedSeptember 30, 2020 which consisted of one-time IPO bonuses and the termination of the Company's consultant and advisory agreement withAltaris Capital Partners, LLC . Intangible asset amortization: Intangible asset amortization increased$379 to$1,499 for the three months endedSeptember 30, 2021 , compared to$1,120 for the three months endedSeptember 30, 2020 . The increase is driven by the addition of intangible assets acquired as a result of the purchase of 7710Insurance Company in the fourth quarter of 2020 and WIC in the third quarter of 2021. Noncash stock compensation: Noncash stock compensation was$468 for the three months endedSeptember 30, 2021 , compared to$307 for the three months endedSeptember 30, 2020 . Expenses incurred during both periods relates to the fair value of restricted stock units and stock options granted under the Company's 2020 Omnibus Plan amortized over appropriate and applicable vesting periods. 43 -------------------------------------------------------------------------------- Table of Contents Gains (losses) on embedded derivatives:
The table below shows the components of gains (losses) on embedded derivatives for the respective three month periods:
Three
Months Ended
2021 2020 Change
Change in fair value of embedded derivatives $573 $140 $433
Effect of net investment income on funds held
investments (585) (507) (78)
Effect of realized gains on funds held
investments (109) - (109)
Total gains (losses) on embedded derivatives $(121) $(367) $246
Losses on embedded derivatives decreased $246 to $121 for the three months ended
September 30, 2021 , compared to $367 for the three months ended September 30,
2020 . The decrease reflects an increase in the fair value of embedded
derivatives of $433 partially offset by the effect of realized gains on funds
held investments of $109 and the effect of investment income on funds held
investments of $78 .
Income tax expense: Income tax expense was $2,083 for the three months ended
September 30, 2021 , which resulted in an effective tax rate of 24.2%. The
increase in the effective tax rate from the statutory rate of 21% is due
primarily to the impact of recording our 2020 tax return accrual to return
true-up in the third quarter of 2021. For the three months ended September 30,
2020 income tax expense was $817 , which resulted in an effective tax rate of
1.2%. The decrease in the effective tax rate from the statutory rate of 21% is
due primarily to the non-tax impact of the $69,846 gain recorded on the
revaluation of the Company's original 45% investment in Compstar, offset by
certain IPO-related expenses not deductible for tax purposes.
Equity earnings in affiliates, net of tax: Equity earnings in affiliates, net of
tax decreased $401 to $0 for the three months ended September 30, 2021 , compared
to $401 for the three months ended September 30, 2020 . This decrease is due to
the reduction in the Company's share of earnings in Compstar of $401 as a result
of the acquisition of the remaining ownership interest during the third quarter
of 2020.
Owned MGA's and Program Partner Premiums:
The following table shows the total premiums earned on a gross and net basis for
Three
Months Ended
Owned MGAs Program Partner Total
Gross written premiums 69,857 107,767 177,624
Increase in gross unearned premiums (2,569) (25,909) (28,478)
Gross earned premiums 67,288 81,858 149,146
Ceded earned premiums (36,013) (61,178) (97,191)
Net earned premiums 31,275 20,680 51,955
Direct commissions 7,855 19,739 27,594
Ceding commissions (10,829) (20,826) (31,655)
Net Commissions (2,974) (1,087) (4,061)
Direct commissions rate(1) 11.7 % 24.1 % 18.5 %
Ceding commissions rate(2) 30.1 % 34.0 % 32.6 %
(1) Direct commissions as a percentage of gross earned premiums (2) Ceded commissions as a percentage of gross earned premiums
We utilize both quota share and catastrophe XOL contracts in our reinsurance strategy for ourOwned MGAs andProgram Partners . Direct commissions forProgram Partners include third-party agent commissions and MGA service fees, while 44 -------------------------------------------------------------------------------- Table of Contents Owned MGAs direct commissions includes only third-party agent commissions, while the expenses associated with MGA services are included in general and administrative operating expenses. The ceding commission rates vary based on a number of factors including: the line of business, negotiated reinsurance terms, and program cost structures. For the three months endedSeptember 30, 2021 , the Company retained 46.5% of gross earned premiums for Owned MGAs compared to 25.3% forProgram Partners . The loss ratios forOwned MGAs andProgram Partners for the three months endedSeptember 30 , 2021was 59.3% and 65.6% respectively, resulting in a consolidated loss ratio of 61.8%. The higher loss ratio forProgram Partners was primarily attributable to calendar year loss experience.
Consolidated Results of Operations for the Nine Months Ended
The following table summarizes our results of operations for the nine months
ended
Nine Months Ended September 30, Percentage Change
(in thousands, except for percentages) 2021 2020 Change (1)
Revenues
Gross written premiums$ 480,905 $ 349,755 $ 131,150 37.5 % Increase in gross unearned premiums (64,836) (39,601) (25,235) 63.7 % Gross earned premiums 416,069 310,154 105,915 34.1 % Ceded earned premiums (275,037) (238,460) (36,577) 15.3 % Net earned premiums 141,032 71,694 69,338 96.7 % Net investment income 6,562 9,134 (2,572) (28.2) % Gain on revaluation of Compstar investment - 69,846 (69,846) (100.0) % Net realized capital gains 72 3,345 (3,273) (97.8) % Other revenue 8,683 11,323 (2,640) (23.3) % Total revenue 156,349 165,342 (8,993) (5.4) % Expenses Losses and loss adjustment expenses 86,735 40,681 46,054 113.2 % General and administrative expenses 40,946 23,437 17,509 74.7 % Other expenses 845 11,054 (10,209) (92.4) % Intangible asset amortization 4,326 1,154 3,172 NM Noncash stock compensation 1,098 307 791 NM Interest expense 1,271 1,482 (211) (14.2) % Total expenses 135,221 78,115 57,106 73.1 % Gains (losses) on embedded derivatives 1,869 (5,547) 7,416 (133.7) % Other income 191 263 (72) (27.4) % Income before taxes 23,188 81,943 (58,755) (71.7) % Income tax expense 5,102 4,035 1,067 26.4 % Equity earnings in affiliates, net of tax - 2,333 (2,333) (100.0) % Net income $ 18,086$ 80,241 $ (62,155) (77.5) %
(1) The Company defines increases or decreases greater than 200% as "NM" or not meaningful.
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Nine Months Ended September 30,
(in thousands, except for percentages) 2021 2020
Key metrics:
Underwriting income(1) $ 13,351 $ 7,576
Adjusted net income(1) $ 20,103 $ 21,600
Loss ratio 61.5 % 56.7 %
Expense ratio 29.0 % 32.7 %
Combined ratio 90.5 % 89.4 %
Return on equity 5.8 % 39.4 %
Adjusted return on equity(1) 6.4 % 10.6 %
Return on tangible equity(1) 12.1 % 65.4 %
Adjusted return on tangible equity(1) 13.4 % 17.6 %
(1) This metric represents a non-GAAP financial measure. See 'Reconciliation of Non-GAAP Financial Measures' for a reconciliation of this metric to the applicable GAAP metric.
The table below shows the total premiums earned on a gross and net basis for the respective nine-month periods:
Nine Months Ended September 30, Percentage Change
(in thousands, except percentages) 2021 2020 Change (1)
Revenues:
Gross written premiums$ 480,905 $ 349,755 $ 131,150 37.5 % Increase in gross unearned premiums (64,836) (39,601) (25,235) 63.7 % Gross earned premiums 416,069 310,154 105,915 34.1 % Ceded earned premiums (275,037) (238,460) (36,577) 15.3 % Net earned premiums$ 141,032 $ 71,694 $ 69,338 96.7 %
(1) The Company defines increases or decreases greater than 200% as "NM" or not meaningful.
Gross written premiums: Gross written premiums increased$131,150 , or 37.5%, to$480,905 for the nine months endedSeptember 30, 2021 , compared to$349,755 for the nine months endedSeptember 30, 2020 . The increase is primarily attributable to the growth in our existing Program Partner business, the addition of newProgram Partners and the acquisition of 7710Insurance Company in the fourth quarter of 2020. The changes in gross written premiums were due to the following: Workers' compensation represented 60.2% of our gross written premiums for the nine months endedSeptember 30, 2021 , compared to 76.8% for the nine months endedSeptember 30, 2020 , primarily as a result of our ongoing strategic effort to diversify our lines of business. For the nine months endedSeptember 30, 2021 , gross written premiums for workers' compensation increased by$20,987 , or 7.8%, compared to the same period in 2020. All other non-workers' compensation liability represented 39.8% of our gross written premiums for the nine months endedSeptember 30, 2021 , compared to 23.2% for the nine months endedSeptember 30, 2020 . For the nine months endedSeptember 30, 2021 , gross written premiums for all other non-workers' compensation liability increased$110,163 , or 135.9%, compared to the same period in 2020. The increase is due primarily to growth in our other liability, commercial auto, homeowners and accident & health lines of business in keeping with our diversification strategy. Gross earned premiums: Gross earned premiums increased$105,915 , or 34.1%, to$416,069 for the nine months endedSeptember 30, 2021 , compared to$310,154 for the nine months endedSeptember 30, 2020 . The increase in gross earned premiums reflects the increase in gross written premiums of$131,150 net of an increase in gross unearned premiums of$25,235 . The increase in gross unearned premiums is directly attributable to the growth in gross written premiums. Gross 46 -------------------------------------------------------------------------------- Table of Contents earned premiums as a percentage of gross written premiums decreased to 86.5% for the nine months endedSeptember 30, 2021 , compared to 88.7% for the nine months endedSeptember 30, 2020 . Ceded earned premiums: Ceded earned premiums increased$36,577 , or 15.3%, to$275,037 for the nine months endedSeptember 30, 2021 , compared to$238,460 for the nine months endedSeptember 30, 2020 . The increase in ceded earned premiums is driven by the growth in gross earned premiums as described above, partially offset by an increase in our retention. The total ceded earned premiums as a percentage of gross earned premiums decreased to 66.1% for the nine months endedSeptember 30, 2021 , compared to 76.9% for the nine months endedSeptember 30, 2020 , reflecting the Company's strategic decision to retain more gross written premiums. Net earned premiums: Net earned premiums increased$69,338 , or 96.7%, to$141,032 for the nine months endedSeptember 30, 2021 , compared to$71,694 for the nine months endedSeptember 30, 2020 . The increase is due to the growth in gross earned premiums as described above and the Company's strategic decision to retain more gross written premiums. Net investment income: Net investment income decreased$2,572 , or 28.2%, to$6,562 for the nine months endedSeptember 30, 2021 , compared to$9,134 for the nine months endedSeptember 30, 2020 . The decrease is primarily attributable to the fair value re-measurement and common stock investment reclassification of the Company's investment in TRI during the first quarter of 2020, which was previously classified as an equity method investment and resulted in a gain of$2,000 . The decrease also reflects the reinvestment of funds from higher yielding maturities into lower yielding investments due to lower interest rates, partially offset by an increased in our invested balance. Net realized capital gains: Net realized capital gains decreased$3,273 to$72 for the nine months endedSeptember 30, 2021 , compared to$3,345 for the nine months endedSeptember 30, 2020 . The decrease is primarily due to the recording of a$3,115 realized gain on the sale of a portion of the Company's investment in TRI during the first quarter of 2020 and partially offset by a loss of$112 realized in the third quarter of 2021 on the Company's sale of its remaining investment in TRI. Other revenue: Other revenue decreased$2,640 , or 23.3%, to$8,683 for the nine months endedSeptember 30, 2021 , compared to$11,323 for the nine months endedSeptember 30, 2020 . The decrease is largely driven by a reduction in brokerage revenue of$2,656 due to a$2.2 million increase in estimated premiums and the timing of effective dates for brokered reinsurance contracts recognized in the third quarter of 2020. In addition, brokerage revenue was also reduced in 2021 due to the Company's higher retention of brokered reinsurance contracts compared to the same prior-year period. Losses and loss adjustment expenses: Losses and LAE increased$46,054 , or 113.2%, to$86,735 for the nine months endedSeptember 30, 2021 , compared to$40,681 for the nine months endedSeptember 30, 2020 . The increase is attributable to the growth in earned premiums and increased retention during the nine months endedSeptember 30, 2021 . This resulted in a loss ratio of 61.5% for the nine months endedSeptember 30, 2021 compared to 56.7% for the nine months endedSeptember 30, 2020 . The increase is attributable to a number of unusually large losses experienced during the first half of 2021, resulting in a higher overall loss ratio pick related to the 2021 accident year. General and administrative expenses: General and administrative expenses increased$17,509 , or 74.7%, to$40,946 for the nine months endedSeptember 30, 2021 , compared to$23,437 for the nine months endedSeptember 30, 2020 . The expense ratio was 29.0% for the nine months endedSeptember 30, 2021 , compared to 32.7% for the nine months endedSeptember 30, 2020 . 47 -------------------------------------------------------------------------------- Table of Contents The table below shows the components of general and administrative expenses for the respective nine-month periods: Nine Months Ended September 30, 2021 2020 Change Direct commissions$ 78,304 $ 62,817 $ 15,487 Ceding commissions (89,547) (79,075) (10,472) Net commissions (11,243) (16,258) 5,015 Insurance-related expenses 14,796 11,486 3,310 General and administrative operating expenses 37,393 28,209 9,184 Total general and administrative expenses$ 40,946
General and administrative expenses - % of gross written premiums 7.8 % 8.1 % Retention rate (1) 33.9 % 23.1 % Direct commission rate (2) 18.8 % 20.3 % Ceding commission rate (3) 32.6 % 33.2 %
(1) Net earned premium as a percentage of gross earned premiums. (2) Direct commissions as a percentage of gross earned premiums. (3) Ceding commissions as a percentage of ceded earned premiums.
Direct commissions increased$15,487 primarily due to an increase in gross earned premiums. Ceding commissions increased$10,472 due to an increase in ceded earned premiums reflecting the increase in gross earned premiums, partially offset by an increase in retention. Insurance-related expenses increased$3,310 primarily as a result of an increase in gross earned premiums. General and administrative operating expenses increased$9,184 , primarily as a result of (i) an increase in salaries and benefits of$6,718 , of which$3,423 directly resulted from acquisitions made in the second half of 2020 and a general increase in workforce; (ii) additional rent and office-related expenses totaling$1,771 due to an increase in business insurance expense as well as the addition of new office locations; and (iii) additional IT software and systems costs totaling$1,347 related to new software implementation and automation initiatives; partially offset by a decrease in professional fees of$1,220 as a result of the Company's IPO readiness effort in 2020. Other expenses: Other expenses were$845 for the nine months endedSeptember 30, 2021 , which primarily relates to secondary offering costs of$555 and executive transition costs totaling$290 . Other expenses were$11,054 for the nine months endedSeptember 30, 2020 , which consisted of one-time IPO bonuses and the termination of the Company's consultant and advisory agreement withAltaris Capital Partners, LLC . Intangible asset amortization: Intangible asset amortization increased$3,172 to$4,326 for the nine months endedSeptember 30, 2021 , compared to$1,154 for the nine months endedSeptember 30, 2020 . The increase is driven by the addition of intangible assets acquired as a result of the purchase of the remaining equity interest of Compstar in the third quarter of 2020 and 7710Insurance Company in the fourth quarter of 2020 and WIC in the third quarter of 2021. Noncash stock compensation: Noncash stock compensation was$1,098 for the nine months endedSeptember 30, 2021 , compared with$307 for the nine months endedSeptember 30, 2020 . Expenses incurred during both periods relates to the fair value of restricted stock units and stock options granted under the Company's 2020 Omnibus Plan amortized over appropriate and applicable vesting periods.
Gains (losses) on embedded derivatives:
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The table below shows the components of gains (losses) on embedded derivatives
for the respective nine-month periods:
Nine Months
Ended
2021 2020 Change
Change in fair value of embedded derivatives $ 3,761 $ (3,066) $ 6,827
Effect of net investment income on funds held
investments (1,783) (2,481) 698
Effect of realized gains on funds held
investments (109) - (109)
Total gains (losses) on embedded derivatives
Gains on embedded derivatives increased$7,416 to$1,869 for the nine months endedSeptember 30, 2021 , compared to losses of$5,547 for the nine months endedSeptember 30, 2020 . The gain reflected an increase in the fair value of embedded derivatives of$6,827 and the effect of investment income on funds held investments of$698 , partially offset by the effect of realized gains on funds held investments of$109 . Income tax expense: Income tax expense was$5,102 for the nine months endedSeptember 30, 2021 , which resulted in an effective tax rate of 22.0%. The increase in the effective tax rate from the statutory rate of 21% is due primarily to the impact of recording our 2020 tax return accrual to return true-up in the third quarter of 2021. For the nine months endedSeptember 30, 2020 , income tax expense was$4,035 , which resulted in an effective tax rate of 4.9%. The increase in the effective tax rate from the statutory rate of 21% is due primarily to the impact of state taxes and the deferred tax effect of a tax accounting method change on excess ceding commissions. Equity earnings in affiliates, net of tax: Equity earnings in affiliates, net of tax decreased$2,333 to$0 for the nine months endedSeptember 30, 2021 , compared to$2,333 for the nine months endedSeptember 30, 2020 . This decrease is due to the reduction in the Company's share of earnings in Compstar of$2,333 as a result of the acquisition of the remaining ownership interest during the third quarter of 2020.
Owned MGA's and Program Partner Premiums:
The following table shows the total premiums earned on a gross and net basis for
Nine
Months Ended
Owned MGAs Program Partner Total
Gross written premiums 209,640 271,265 480,905
Increase in gross unearned premiums (6,263) (58,573) (64,836)
Gross earned premiums 203,377 212,692 416,069
Ceded earned premiums (113,396) (161,641) (275,037)
Net earned premiums 89,981 51,051 141,032
Direct Commission 25,962 52,342 78,304
Ceding Commission (33,740) (55,807) (89,547)
Net Commissions (7,778) (3,465) (11,243)
Direct commissions rate(1) 12.8 % 24.6 % 18.8 %
Ceding commissions rate(2) 29.8 % 34.5 % 32.6 %
(1) Direct commissions as a percentage of gross earned premiums. (2) Ceding commissions as a percentage of ceded earned premiums.
We utilize both quota share and catastrophe XOL contracts in our reinsurance strategy for ourOwned MGAs andProgram Partners . Direct commissions forProgram Partners include third-party agent commissions and MGA service fees, while Owned MGAs direct commissions includes only third-party agent commissions, while the expenses associated with MGA services are included in general and administrative operating expenses. The ceding commission rates vary based on a number 49 -------------------------------------------------------------------------------- Table of Contents of factors including: the line of business, negotiated reinsurance terms, and program cost structures. For the nine months endedSeptember 30, 2021 , the Company retained 44.2% of gross earned premiums for Owned MGAs compared to 24.0% forProgram Partners . The loss ratios forOwned MGAs andProgram Partners for the nine months endedSeptember 30 , 2021was 59.8% and 64.4% respectively, resulting in a consolidated loss ratio of 61.5%. The higher loss ratio forProgram Partners was primarily attributable to calendar year loss experience.
Reconciliation of Non-GAAP Financial Measures
Underwriting income
We define underwriting income as income before taxes excluding net investment
income, investment revaluation gains, net realized capital gains or losses,
IPO-related expenses, intangible asset amortization, noncash stock compensation,
gains and losses on embedded derivatives, interest expense, other revenue, and
other income and expenses. Underwriting income represents the pre-tax
profitability of our underwriting operations and allows us to evaluate our
underwriting performance without regard to investment income, IPO-related
expenses, intangible asset amortization, noncash stock compensation, interest
expense, other revenue and other income and expenses. We use this metric because
we believe it gives our management and other users of our financial information
useful insight into our underwriting business performance by adjusting for these
expenses and sources of income. Underwriting income should not be viewed as a
substitute for net income calculated in accordance with GAAP, and other
companies may define underwriting income differently.
Three Months Ended September 30, Percentage Change
(in thousands, except percentages) 2021 2020 (1)
Net income $ 6,518 $ 69,448 (90.6) %
Income tax expense 2,083 817 155.0 %
Equity earnings in affiliates, net of tax - (401) (100.0) %
Income before taxes 8,601 69,864 (87.7) %
Other revenue (2,799) (5,401) (48.2) %
Gains (losses) on embedded derivatives 121 367 (67.0) %
Net investment income (2,187) (2,364) (7.5) %
Gain on revaluation of Compstar investment - (69,846) (100.0) %
Net realized capital gains (49) (115) (57.4) %
Other expenses - 11,054 (100.0) %
Interest expense 419 520 (19.4) %
Intangible asset amortization 1,499 1,120 33.8 %
Noncash stock compensation 468 307 52.4 %
Other income (35) (209) (83.3) %
Underwriting income $ 6,038 $ 5,297 14.0 %
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Nine Months Ended September 30, Percentage Change
(in thousands, except percentages) 2021 2020 (1)
Net income $ 18,086 $ 80,241 (77.5) %
Income tax expense 5,102 4,035 26.4 %
Equity earnings in affiliates, net of tax - (2,333) (100.0) %
Income before taxes 23,188 81,943 (71.7) %
Other revenue (8,683) (11,323) (23.3) %
Gains (losses) on embedded derivatives (1,869) 5,547 (133.7) %
Net investment income (6,562) (9,134) (28.2) %
Gain on revaluation of Compstar investment - (69,846) (100.0) %
Net realized capital gains (72) (3,345) (97.8) %
Other expenses 845 11,054 (92.4) %
Interest expense 1,271 1,482 (14.2) %
Intangible asset amortization 4,326 1,154 NM
Noncash stock compensation 1,098 307 NM
Other income (191) (263) (27.4) %
Underwriting income $ 13,351 $ 7,576 76.2 %
(1) The Company defines increases or decreases greater than 200% as "NM" or not meaningful.
Adjusted net income
We define adjusted net income as net income excluding the impact of certain
items, including the consummation of the reorganization transactions in
connection with our IPO, noncash intangible asset amortization and stock
compensation, noncash unrealized gains and losses on embedded derivatives, other
expenses, and gains or losses that we believe do not reflect our core operating
performance, which items may have a disproportionate effect in a given period,
affecting comparability of our results across periods. We calculate the tax
impact only on adjustments that would be included in calculating our income tax
expense using the effective tax rate at the end of each period. We use adjusted
net income as an internal performance measure in the management of our
operations because we believe it gives our management and other users of our
financial information useful insight into our results of operations and our
underlying business performance by eliminating the effects of these items.
Adjusted net income should not be viewed as a substitute for net income
calculated in accordance with GAAP, and other companies may define adjusted net
income differently.
Three Months Ended September 30, Percentage Change
(in thousands, except percentages) 2021 2020 (1)
Net income $ 6,518 $ 69,448 (90.6) %
Intangible asset amortization 1,499 1,120 33.8 %
Noncash stock compensation 468 307 52.4 %
Change in fair value of embedded derivative (573) (140) NM
Other expenses - 11,054 (100.0) %
Expenses associated with IPO and other one-time
legal and consulting expenses - 645 (100.0) %
FMV adjustment of remaining investment in
affiliate - (69,846) (100.0) %
Net loss (gain) on purchase & disposal of
affiliates 112 - NM
Total adjustments 1,506 (56,860) (102.6) %
Tax impact of adjustments (346) (2,111) (83.6) %
Adjusted net income $ 7,678 $ 10,477 (26.7) %
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Nine Months Ended September 30, Percentage Change
(in thousands, except percentages) 2021 2020 (1)
Net income $ 18,086 $ 80,241 (77.5) %
Intangible asset amortization 4,326 1,154 NM
Noncash stock compensation 1,098 307 NM
Change in fair value of embedded derivative (3,761) 3,066 NM
Other expenses 845 11,054 (92.4) %
Expenses associated with Altaris management fee,
including cash bonuses paid to unit holders - 883 (100.0) %
Expenses associated with IPO and other one-time
legal and consulting expenses - 1,845 (100.0) %
Expenses related to debt issuance costs - 135 (100.0) %
FMV adjustment of remaining investment in
affiliate - (71,846) (100.0) %
Net loss (gain) on purchase & disposal of
affiliates 112 (3,115) (103.6) %
Total adjustments 2,620 (56,517) (104.6) %
Tax impact of adjustments (603) (2,124) (71.6) %
Adjusted net income $ 20,103 $ 21,600 (6.9) %
(1) The Company defines increases or decreases greater than 200% as "NM" or not meaningful.
Adjusted return on equity
We define adjusted return on equity as adjusted net income expressed on an
annualized basis as a percentage of average beginning and ending stockholders'
equity during the period. We use adjusted return on equity as an internal
performance measure in the management of our operations because we believe it
gives our management and other users of our financial information useful insight
into our results of operations and our underlying business performance by
adjusting for items that we believe do not reflect our core operating
performance and that may diminish comparability across periods. Adjusted return
on equity should not be viewed as a substitute for return on equity calculated
in accordance with GAAP, and other companies may define adjusted return on
equity differently.
Three Months Ended September 30, Nine Months Ended September 30,
(in thousands, except
percentages) 2021 2020 2021 2020
Adjusted return on equity
calculation:
Numerator: adjusted net income $ 7,678 $ 10,477 $ 20,103 $ 21,600
Denominator: average equity 419,818 270,519 416,200 271,684
Adjusted return on equity 7.3 % 15.5 % 6.4 % 10.6 %
Return on equity 6.2 % 102.7 % 5.8 % 39.4 %
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Return on tangible equity and adjusted return on tangible equity
We define tangible stockholders' equity as stockholders' equity less goodwill
and other intangible assets. We define return on tangible equity as net income
expressed on an annualized basis as a percentage of average beginning and ending
tangible stockholders' equity during the period. We define adjusted return on
tangible equity as adjusted net income expressed on an annualized basis as a
percentage of average beginning and ending tangible stockholders' equity during
the period. We regularly evaluate acquisition opportunities and have
historically made acquisitions that affect stockholders' equity. We use return
on tangible equity and adjusted return on tangible equity as internal
performance measures in the management of our operations because we believe they
give our management and other users of our financial information useful insight
into our results of operations and our underlying business performance by
adjusting for the effects of acquisitions on our stockholders' equity and, in
the case of adjusted return on tangible equity, by adjusting for the items that
we believe do not reflect our core operating performance and that may diminish
comparability across periods. Return on tangible equity and adjusted return on
tangible equity should not be viewed as a substitute for return on equity or
return on tangible equity, respectively, calculated in accordance with GAAP, and
other companies may define return on tangible equity and adjusted return on
tangible equity differently.
Three Months Ended September 30, Nine Months Ended September 30,
(in thousands, except percentages) 2021 2020 2021 2020
Return on tangible equity
calculation:
Numerator: net income $ 6,518 $ 69,448 $ 18,086 $ 80,241
Denominator:
Average stockholders' equity 419,818 270,519 416,200 271,684
Less: average goodwill and other
intangible assets 214,942 108,476 216,356 107,994
Average tangible stockholders'
equity 204,876 162,043 199,844 163,690
Return on tangible equity 12.7 % 171.4 % 12.1 % 65.4 %
Return on equity 6.2 % 102.7 % 5.8 % 39.4 %
Three Months Ended September 30, Nine Months Ended September 30,
(in thousands, except
percentages) 2021 2020 2021 2020
Adjusted return on tangible
equity calculation:
Numerator: adjusted net income $ 7,678 $ 10,477 $ 20,103 $ 21,600
Denominator: average tangible
equity 204,876 162,043 199,844 163,690
Adjusted return on tangible
equity 15.0 % 25.9 % 13.4 % 17.6 %
Return on equity 6.2 % 102.7 % 5.8 % 39.4 %
Financial Condition, Liquidity and Capital Resources
Sources and Uses of Funds
We are organized as a holding company with our operations conducted through our subsidiaries, including our wholly owned insurance subsidiaries: Benchmark, which is domiciled inKansas and commercially domiciled inCalifornia ; ALIC, which is domiciled inUtah ; and 7710Insurance Company , which is domiciled inSouth Carolina . Accordingly, the holding company may receive cash through: (i) loans from banks, (ii) draws on a revolving loan agreement, (iii) issuance of equity and debt securities, (iv) corporate service fees from our operating subsidiaries, (v) payments from our subsidiaries pursuant to our consolidated tax allocation agreement and other transactions and (vi) dividends from our non-insurance subsidiaries and, subject to certain limitations discussed below, dividends from our insurance subsidiaries. We also may use the proceeds from these sources to contribute funds to the insurance subsidiaries in order to support premium growth, reduce our reliance on reinsurance, pay taxes, and for other general business purposes. 53
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State insurance laws restrict the ability of insurance companies to declare stockholder dividends without prior regulatory approval. State insurance regulators require insurance companies to maintain specified levels of statutory capital and surplus.
UnderKansas andCalifornia law, dividends payable from Benchmark without the prior approval of the applicable insurance commissioner must not exceed the greater of (i) 10% of Benchmark's surplus as shown on the last statutory financial statement on file with theKansas Insurance Department and theCalifornia Department of Insurance , respectively, or (ii) 100% of net income during the applicable twelve-month period (not including realized capital gains). Dividends shall not include pro rata distributions of any class of Benchmark's own securities. UnderUtah law, dividends payable from ALIC without the prior approval of the applicable insurance commissioner must not exceed the lesser of: (i) 10% of ALIC's surplus as shown on the last statutory financial statement on file with theUtah Insurance Department or (ii) 100% of net income during the applicable twelve- month period (not including realized capital gains). UnderSouth Carolina law, dividends payable from 7710Insurance Company without the prior approval of the applicable insurance commissioner are limited to the following during the preceding twelve months: (a) when paid from other than earned surplus must not exceed the lesser of: (i) 10% of 7710Insurance Company's surplus as regards policyholders as shown in 7710Insurance Company's most recent annual statement; or (ii) the net income, not including net realized capital gains or losses as shown in 7710Insurance Company's most recent annual statement; or (b) when paid from earned surplus must not exceed the greater of: (i) 10% of 7710Insurance Company's surplus as regards policyholders as shown in 7710Insurance Company's most recent annual statement; or (ii) the net income, not including net realized capital gains or losses as shown in the 7710Insurance Company's most recent annual statement. The maximum amount of dividends the insurance subsidiaries can pay us during 2021 without regulatory approval is$23,859 . Insurance regulators have broad powers to ensure that statutory surplus remains at adequate levels, and there is no assurance that dividends of the maximum amount calculated under any applicable formula would be permitted. In the future, state insurance regulatory authorities that have jurisdiction over the payment of dividends by the insurance subsidiaries may adopt statutory provisions more restrictive than those currently in effect. Our insurance subsidiaries are also required by state law to maintain a minimum level of policyholders' surplus.Kansas ,Utah , andSouth Carolina utilize a risk-based capital requirement as promulgated by theNational Association of Insurance Commissioners . Such requirements are designed to identify the various business risks (e.g., investment risk, underwriting profitability risk, etc.) of insurance companies and their subsidiaries. As ofSeptember 30, 2021 andDecember 31, 2020 , the total adjusted capital of our insurance subsidiaries was in excess of their respective prescribed risk-based capital requirements.
As of
Management believes that we have sufficient liquidity available to meet our operating cash needs and obligations and committed capital expenditures for the next 12 months.
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Cash Flows
Our most significant source of cash is from premiums received from insureds, net
of the related commission amount for the policies. Our most significant cash
outflow is for claims that arise when a policyholder incurs an insured loss.
Because the payment of claims occurs after the receipt of the premium, often
years later, we invest the cash in various investment securities that generally
earn interest and dividends. The table below summarizes our net cash flows.
Nine Months
Ended
2021 2020
Cash, cash equivalents and restricted cash provided by
(used in):
Operating activities $ 53,410 $ 32,208
Investing activities (71,131) 18,492
Financing activities (1,125) 59,662
Net increase (decrease) in cash, cash equivalents and
restricted cash $ (18,846) $ 110,362
Operating Activities: Net cash provided by operating activities for the nine
months ended September 30, 2021 was $53,410 , compared to $32,208 for the same
period in 2020. Net cash provided by operating activities includes net income as
adjusted for depreciation and amortization, stock compensation, unrealized gains
and losses on embedded derivatives, net capital gains and losses, bond
amortization and accretion, the change in deferred income taxes, and
amortization of deferred financing costs. Net cash provided by operating
activities for the nine months ended September 30, 2021 reflects increases in
unpaid loss and loss adjustment expenses of $52,975 , unearned premiums of
$64,879 , and funds held under reinsurance agreements of $19,585 ; partially
offset by increases in premiums and other receivables of $25,167 , reinsurance
recoverables of $18,460 , prepaid reinsurance premiums of $30,252 , other assets
of $10,863 and decreases in reinsurance premiums payable of $7,829 , and accounts
payable and accrued expenses of $11,430 . Unpaid loss and loss adjustment
expenses and unearned premiums increased primarily due to an increase in gross
written premiums. The increases in premiums and other receivables and
reinsurance recoverables were primarily a result of an increase in gross written
premiums during the period. Other assets increased as a result of increases in
our deferred acquisition costs and contract asset balances. Funds held under
reinsurance agreements decreased due to an arbitration settlement in the fourth
quarter of 2020, resulting in the non-cash transfer of certain investments held
as collateral. Excluding non-cash transfers, funds held under reinsurance
agreements increased as a result of an increase in gross written premium. Net
cash provided by operating activities for the nine months ended September 30,
2020 reflects distributions received from equity method investments and
incremental cash received for operating assets and liabilities.
Investing Activities: Net cash used in investing activities for the nine months
ended September 30, 2021 was $71,131 compared to net cash provided by investing
activities of $18,492 for the same period in 2020. Net cash used in investing
activities for the nine months ended September 30, 2021 includes $67,476 net
cash used in the purchase and sale of investments, $3,795 in cash used in the
acquisition of a subsidiary, net of cash received, $232 received for the return
of capital on equity method investments and $92 in capital expenditures.
Additionally, the nine months ended September 30, 2021 includes non-cash
transfers of investments to settle amounts owed for funds held for reinsurance
agreements by $13,562 and accounts payable and accrued expenses by $26,211 . Net
cash provided by investing activities for the nine months ended September 30,
2020 includes $5,249 net cash received from the purchase and sale of
investments, $11,891 cash received in the acquisition of Compstar, $3,000 in
cash received for the sale of equity method investments, $115 received for the
return of capital on equity method investments, $1,098 in cash used in the
acquisition of a subsidiary, net of cash received and $665 in capital
expenditures.
Financing Activities: Net cash used in financing activities for the nine months
ended September 30, 2021 was $1,125 compared to net cash provided by financing
activities of $59,662 for the same period in 2020. Net cash used in financing
activities for the nine months ended September 30, 2021 primarily includes the
principal payments made on the Company's debt. Net cash provided by financing
activities for the nine months ended September 30, 2020 included by $99,643 of
net cash proceeds received from the Company's IPO, $19,496 in distributions to
pre-IPO unitholders, $9,336 in cash for principal payments, net of proceeds from
the credit agreement, cash paid for deferred offering costs of $5,839 , and cash
used in the buyback of redeemable preferred stock $5,100 .
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Debt and Credit Agreements
First Horizon Credit Agreement
InApril 2018 ,Trean Corporation and Trean Compstar entered into a credit agreement withFirst Horizon Bank (formerly,First Tennessee Bank National Association ) (the "2018 First Horizon Credit Agreement"), which included a term loan facility totaling$27.5 million and a revolving credit facility of$3.0 million . OnMay 26, 2020 , the Company entered into an Amended and Restated Credit Agreement withFirst Horizon Bank , which, among other things, extended the Company's credit facility for a period of five years throughMay 26, 2025 and increased its term loan facility by$11,707 , resulting in a total term loan debt amount of$33,000 and a revolving credit facility of$2,000 . Borrowings under the facility are secured by substantially all of the assets of the Company other thanBenchmark Holding Company and its subsidiaries. The loan has a variable interest rate of 3-month LIBOR plus 4.50%, which was 4.65% as ofSeptember 30, 2021 and 4.72% as ofDecember 31, 2020 (under the 2018 First Horizon Credit Agreement). The outstanding principal balance of the loan is to be repaid in quarterly installments that escalate from approximately$206 to$825 untilMarch 2025 . All equity securities of the subsidiaries of the Company (other thanBenchmark Holding Company and its subsidiaries) have been pledged as collateral.
Reinsurance
We cede a portion of the risk we accept on our balance sheet to third-party reinsurers through a variety of reinsurance arrangements. We manage these arrangements to align risks with ourProgram Partners , optimize our net retention relative to our financial objectives, balance sheet size and ratings requirements, as well as to limit our maximum loss resulting from a single program or a single event. We utilize both quota share and excess of loss ("XOL") reinsurance as tools in our overall risk management strategy to achieve these goals, usually in conjunction with each other. Quota share reinsurance involves the proportional sharing of premiums and losses of each defined program. We utilize quota share reinsurance for several purposes, including (i) to cede risk toProgram Partners , which allows us to share economics and align incentives and (ii) to cede risk to third-party reinsurers in order to manage our net written premiums appropriately based on our financial objectives, capital base,A.M. Best financial strength rating and risk appetite. It is a core pillar of our underwriting philosophy thatProgram Partners retain a portion of the underwriting risk of their program. We believe this best aligns interests, attracts higher quality programs, and leads to better underwriting results. Under XOL reinsurance, losses in excess of a retention level are paid by the reinsurer, subject to a limit, and are customized per program or across multiple programs. We utilize XOL reinsurance to protect against catastrophic or other unforeseen extreme loss activity that could otherwise negatively impact our profitability and capital base. The majority of our exposure to catastrophe risk stems from the workers' compensation premium we retain. Potential catastrophic events include an earthquake, terrorism, or another event that could cause more than one covered employee working at the same location to be injured in the event. We believe we mitigate this risk by our focus on small- to mid-sized accounts, which means that we generally do not have concentrated employee counts at single locations that could be exposed to a catastrophic loss. The cost and limits of the reinsurance coverage we purchase vary from year to year based on the availability of quality reinsurance at an acceptable price and our desired level of retention.
Ratings
We have a financial strength rating of "A" (Excellent) fromA.M. Best .A.M. Best assigns 16 ratings to insurance companies, which currently range from "A++" (Superior) to "S" (Rating Suspended). "A" (Excellent) is the third highest rating issued byA.M. Best . The "A" (Excellent) rating is assigned to insurers that have, inA.M. Best's opinion, an excellent ability to meet their ongoing obligations to policyholders. This rating is intended to provide an independent opinion of an insurer's ability to meet its obligation to policyholders and is not an evaluation directed at investors. See also "Risk factors - Risks related to our business and industry - A downgrade in theA.M. Best financial strength ratings of our insurance company subsidiaries may negatively affect our business." in our 2020 Form 10-K. The financial strength ratings assigned byA.M. Best have an impact on the ability of the insurance companies to attract and retain agents and brokers and on the risk profiles of the submissions for insurance that the insurance companies receive. The "A" (Excellent) rating obtained by us is consistent with our business plan and allows us to actively pursue relationships with the agents and brokers identified in our marketing plan. 56 -------------------------------------------------------------------------------- Table of Contents Contractual Obligations and Commitments
There have been no material changes in the Company's contractual obligations as
of
Financial condition
Stockholders' Equity
As of
We had
Investment Portfolio
Our invested asset portfolio consists of fixed maturities, equity securities, other investments, and short-term investments. The majority of the investment portfolio was comprised of fixed maturity securities of$425,596 atSeptember 30, 2021 , that were classified as available-for-sale. Available-for-sale investments are carried at fair value with unrealized gains and losses on these securities, net of applicable taxes, reported as a separate component of accumulated other comprehensive income. Our investment portfolio objectives are to maintain liquidity, facilitating financial strength and stability and ensuring regulatory and legal compliance. Our investment portfolio consists of available-for-sale fixed maturities and other equity investments, all of which are carried at fair value. We seek to hold a high-quality portfolio of investments that is managed by a professional investment advisory management firm in accordance with the Company's investment policy and routinely reviewed by our management team. Our investments, however, are subject to general economic conditions and market risks as well as risks inherent to particular securities. The Company's investment portfolio has the following objectives: •meet insurance regulatory requirements with respect to investments under the applicable insurance laws; •maintain an appropriate level of liquidity to satisfy the cash requirements of current operations and long-term obligations; •adjust investment risk to offset or complement insurance risk based on our total corporate risk tolerance; and •realize the highest possible levels of investment income, while generating superior after-tax total rates of return. 57 -------------------------------------------------------------------------------- Table of Contents The composition of our investment portfolio is shown in the following table as ofSeptember 30, 2021 andDecember 31, 2020 . September 30, 2021 Cost or Amortized Cost Fair Value Fixed maturities: U.S. government and government securities$ 26,811 $ 26,947 Foreign governments 2,500 2,500 States, territories and possessions 7,937 8,116 Political subdivisions of states, territories and possessions 31,709 32,552 Special revenue and special assessment obligations 88,998 91,568 Industrial and public utilities 97,169 100,815 Commercial mortgage-backed securities 104,888 104,435 Residential mortgage-backed securities 15,010 16,006 Other loan-backed securities 42,161 42,545 Hybrid securities 105 112 Total fixed maturities 417,288 425,596 Equity securities: Preferred stock 243 231 Common stock 741 741 Total equity securities 984 972 Total investments$ 418,272 $ 426,568 December 31, 2020 Cost or Amortized Cost Fair Value Fixed maturities: U.S. government and government securities$ 17,135 $ 17,471 Foreign governments 300 302 States, territories and possessions 7,500 7,774 Political subdivisions of states, territories and possessions 31,759 33,212 Special revenue and special assessment obligations 77,329 81,714 Industrial and public utilities 107,017 113,741 Commercial mortgage-backed securities 16,242 18,066 Residential mortgage-backed securities 91,478 93,017 Other loan-backed securities 39,293 39,945 Hybrid securities 356 362 Total fixed maturities 388,409 405,604 Equity securities: Preferred stock 243 240 Common stock 1,554 3,534 Total equity securities 1,797 3,774 Total investments$ 390,206 $ 409,378 58
-------------------------------------------------------------------------------- Table of Contents The following table shows the percentage of the total estimated fair value of our fixed maturity securities as ofSeptember 30, 2021 andDecember 31, 2020 by credit rating category, using the lower of ratings assigned by Moody's Investor Service or S&P. September 30, 2021 (in thousands, except percentages) Fair Value % of Total AAA $ 74,036 17.4 % AA 242,911 57.1 % A 75,596 17.8 % BBB 32,049 7.5 % BB 954 0.2 % Below investment grade 50 - % Total fixed maturities $ 425,596 100.0 % December 31, 2020 (in thousands, except percentages) Fair Value % of Total AAA $ 59,887 14.8 % AA 224,371 55.3 % A 89,975 22.2 % BBB 29,404 7.2 % BB 1,921 0.5 % Below investment grade 46
- %
Total fixed maturities $ 405,604 100.0 %
Critical Accounting Policies and Estimates
The unaudited interim condensed consolidated financial statements included in this Quarterly Report on Form 10-Q include amounts based on the use of estimates and judgments of management. We identified the accounting estimates that are critical to the understanding of our financial position and results of operations. Critical accounting estimates are defined as those estimates that are both important to the portrayal of our financial condition and results of operations and require us to exercise significant judgment. We use significant judgment concerning future results and developments in applying these critical accounting estimates and in preparing our condensed consolidated financial statements. These judgments and estimates affect our reported amounts of assets, liabilities, revenues and expenses and the disclosure of our material contingent assets and liabilities. Actual results may differ materially from the estimates and assumptions used in preparing the condensed consolidated financial statements. We evaluate our estimates regularly using information that we believe to be relevant. The estimates and judgments that are most critical to the preparation of the condensed consolidated financial statements include: (a) reserves for unpaid loss and LAE; (b) reinsurance recoveries; (c) investment fair value measurements; (d) goodwill and intangible assets; and (e) business combinations. For a detailed discussion of our accounting policies, see the "Notes to the Consolidated and Combined Financial Statements" included in our 2020 Form 10-K.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements as of
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