The objective of management's discussion and analysis is to provide material information relevant to the assessment of the financial condition and results of operations of the Company including an evaluation of the amounts and certainty of cash flows from operations and from outside sources. This discussion and analysis focuses specifically on material events and uncertainties known to management that are reasonably likely to cause reported financial information not to be necessarily indicative of future operating results or of future financial condition. This includes descriptions and amounts of matters that have had a material impact on reported operations, as well as matters that are reasonably likely based on management's assessment to have a material impact on future operations. This discussion and analysis covers the financial statements and other statistical data that the Company believes will enhance the understanding of the Company's financial condition, cash flows and other changes in financial condition and results of operations. This discussion and analysis will provide a view of the Company from management's perspective. The following discussion and analysis of financial condition and results of operations for the year endedDecember 31, 2022 is qualified by reference to and should be read in conjunction with the accompanying consolidated financial statements and the related notes included herein. 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 the section "Item 1A - Risk Factors." 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 toTrean Insurance Group, Inc. and its subsidiaries, unless the context otherwise requires.
The Company defines increases or decreases greater than 200% as "NM" or not meaningful.
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.
Pending Merger
As previously disclosed, onDecember 15, 2022 , we entered into the Merger Agreement, by and among the Company, Parent and Merger Sub providing for the acquisition of the Company by affiliates of Altaris, subject to the terms and conditions set forth in the Merger Agreement. Pursuant to the terms of the Merger Agreement and subject to the satisfaction or waiver of certain conditions set forth in the Merger Agreement, Merger Sub will be merged with and into the Company effective as of the effective time of the Merger. As a result of the Merger, Merger Sub will cease to exist, and the Company will survive as a wholly-owned subsidiary of Parent. As a result of the Merger, at the Effective Time, subject to any applicable withholding taxes, each share of our Common Stock, issued and outstanding immediately prior to the Effective Time, other than Cancelled Shares (as defined in the Merger Agreement) and Dissenting Shares (as defined in the Merger Agreement), will be converted into the right to receive$6.15 in cash, without interest. The consummation of the Merger is subject to the satisfaction or waiver of various customary conditions set forth in the Merger Agreement, including, but not limited to: (i) the adoption of the Merger Agreement and approval of the Merger and the other transactions by (x) the holders representing a majority of the aggregate voting power of the outstanding shares of our Common Stock beneficially owned by the Unaffiliated Stockholders (as defined in the Merger Agreement) entitled to vote thereon as well as (y) the holders representing a majority of the aggregate voting power of the outstanding shares of 53 -------------------------------------------------------------------------------- Table of Contents Common Stock entitled to vote thereon; (ii) all required insurance regulatory approvals (or the applicable regulatory authorities' non-objection to requests for exemptions in respect thereof) shall have been obtained; (iii) the expiration or termination of any applicable waiting period (or any extensions thereof) under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (the "HSR Act"); (iv) the absence of any restraint or law preventing or prohibiting the consummation of the Merger; (v) the accuracy of Parent's, Merger Sub's, and the Company's representations and warranties (subject to certain materiality qualifiers); (vi) Parent's, Merger Sub's, and the Company's compliance in all material respects with their respective obligations under the Merger Agreement; and (vii) the absence of any Company Material Adverse Effect (as defined in the Merger Agreement) since the date of the Merger Agreement.
Merger-related expenses recognized during the year ended
See "Part I-Item 1A Risk Factors-Risks Related to the Proposed Merger" for a discussion of certain risks related to the Merger.
Initial Public Offering and Reorganization
OnJuly 20, 2020 ,Trean Insurance Group, Inc. closed the sale of 10,714,286 shares of Common Stock in the 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 and is included in other expenses on the consolidated statement of operations.
Secondary Offering of Common Stock
OnMay 19, 2021 , we 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 our outstanding Common Stock, and we are no longer a "controlled company" within the meaning of the Nasdaq listing rules.
Acquisition of 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.
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 subsidiaryCompstar Insurance Services , a managing general agent, by issuing 6,613,606 shares of our 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 54 -------------------------------------------------------------------------------- Table of Contents equity interest, which is included in gain on revaluation of Compstar investment on the consolidated statement of operations. 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 emergency medical services (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.
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 of
•new business submissions to our
•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 equity 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.
Net realized gains/losses: Net realized 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 (LAE): 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;
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Table of Contents •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 business 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 (time, market and performance-based) 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) our surplus notes (See "Financial Condition, Liquidity and capital resources - Debt and Credit Agreements").Goodwill impairment: The goodwill impairment charge relates to the excess carrying amount of the Company's net assets compared to their estimated fair value.Goodwill is not amortized but is reviewed for impairment at least annually or more frequently if events occur or circumstances change that would indicate that a triggering event for a potential impairment has occurred.
Other income: Other income consists primarily of sublease revenue and other miscellaneous income items.
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 gains or losses, intangible asset amortization, goodwill impairment, noncash stock compensation, noncash changes in fair value of 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 noncash intangible asset amortization and stock compensation, goodwill impairment, noncash changes in fair value of embedded derivatives, other expenses and gains or losses that we believe do not reflect our core operating performance, 56 -------------------------------------------------------------------------------- Table of Contents 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 total 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. 57 -------------------------------------------------------------------------------- Table of Contents Results of Operations This section of Form 10-K generally discusses fiscal year 2022 and 2021 items and year-to-year comparisons between 2022 and 2021. Discussions of fiscal year 2020 items and year-to-year comparisons between 2021 and 2020 that are not included in this Form 10-K can be found in Item 7 of Part II of our 2020 Annual Report on Form 10-K for the year endedDecember 31, 2021 , which was filed with theU.S. Securities and Exchange Commission onMarch 16, 2022 and which is available free of charge on theSEC's website at https://www.sec.gov and our website at https://www.trean.com, on the Investor Relations' page under "Financial Info-Annual Reports."
Consolidated Results of Operations for the Year Ended
The following table summarizes our results of operations for the year ended
Year Ended December 31, Percentage Change (in thousands, except for percentages) 2022 2021 Change (1)
Revenues
Gross written premiums$ 651,303 $ 634,164 $ 17,139 2.7 % Increase in gross unearned premiums (9,074) (61,911) 52,837 (85.3) % Gross earned premiums 642,229 572,253 69,976 12.2 % Ceded earned premiums (357,605) (373,573) 15,968 (4.3) % Net earned premiums 284,624 198,680 85,944 43.3 % Net investment income 10,087 8,721 1,366 15.7 % Net realized gains 285 49 236 NM Other revenue 8,246 10,240 (1,994) (19.5) % Total revenue 303,242 217,690 85,552 39.3 % Expenses Losses and loss adjustment expenses 203,877 130,772 73,105 55.9 % General and administrative expenses 86,210 54,706 31,504 57.6 % Other expenses 3,349 845 2,504 NM Intangible asset amortization 5,998 5,826 172 3.0 % Noncash stock compensation 1,496 1,522 (26) (1.7) % Interest expense 3,270 1,685 1,585 94.1 % Goodwill impairment (2) 76,053 - 76,053 NM Total expenses 380,253 195,356 184,897 94.6 % Gains (losses) on embedded derivatives 12,024 2,226 9,798 NM Other income 106 219 (113) (51.6) % Income (loss) before taxes (64,881) 24,779 (89,660) NM Income tax expense 1,074 5,449 (4,375) (80.3) % Net income (loss)$ (65,955) $ 19,330 $ (85,285) NM (1) The Company defines increases or decreases greater than 200% as "NM" or not meaningful. (2) See "Financial Condition, Liquidity and Capital Resources-Financial Condition-Goodwill and intangible asset valuation" below for additional information. 58
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Year Ended December 31, (in thousands, except for percentages) 2022 2021 Key metrics: Underwriting income (loss) (1)$ (5,463) $ 13,202 Adjusted net income (1)$ 7,860 $ 22,132 Loss ratio 71.6 % 65.8 % Expense ratio 30.3 % 27.5 % Combined ratio 101.9 % 93.3 % Return on equity (17.9) % 4.6 % Adjusted return on equity (1) 2.1 % 5.3 % Return on tangible equity (1) (34.0) % 9.7 % Adjusted return on tangible equity (1) 4.1 %
11.0 %
(1) Adjusted net income, adjusted return on equity, return on tangible equity, adjusted return on tangible equity and underwriting income are non-GAAP financial measures. See "Reconciliation of Non-GAAP Financial Measures" below for a reconciliation to the applicable GAAP measure. The table below shows the total premiums earned on a gross and net basis for the respective annual periods: Year Ended December 31, Percentage Change (in thousands, except percentages) 2022 2021 Change (1)
Revenues:
Gross written premiums$ 651,303 $ 634,164 $ 17,139 2.7 % Increase in gross unearned premiums (9,074) (61,911) 52,837 (85.3) % Gross earned premiums 642,229 572,253 69,976 12.2 % Ceded earned premiums (357,605) (373,573) 15,968 (4.3) % Net earned premiums$ 284,624 $ 198,680 $ 85,944 43.3 %
(1) The Company defines increases or decreases greater than 200% as "NM" or not meaningful.
Gross written premiums: Gross written premiums increased$17,139 , or 2.7%, to$651,303 for the year endedDecember 31, 2022 , compared to$634,164 for the year endedDecember 31, 2021 . The increase reflects the growth in our Program Partner business. Gross written premium included the following: Workers' compensation represented 56.6% of total gross written premiums for the year endedDecember 31, 2022 , compared to 59.4% for the year endedDecember 31, 2021 . Workers' compensation gross written premiums decreased$8,411 , or 2.2%, to$368,408 compared with$376,819 for the year endedDecember 31, 2021 , reflecting the intentional decrease inCalifornia business that resulted from the Company's measures undertaken to reduce certain unfavorable risks in 2021 in keeping with our overall strategy to prioritize underwriting discipline. All other non-workers' compensation liability represented 43.4% of our gross written premiums for the year endedDecember 31, 2022 , compared to 40.6% for the year endedDecember 31, 2021 . All other non-workers' compensation liability gross written premiums increased$25,550 , or 9.9%, to$282,895 for the year endedDecember 31, 2022 compared with$257,345 for the year endedDecember 31, 2021 . The increase is due primarily to growth in our accident & health, commercial, and commercial auto lines, partially offset by decreases in our other liability and homeowners lines, which are a result of continued line of business diversification. Gross earned premiums: Gross earned premiums increased$69,976 , or 12.2%, to$642,229 for the year endedDecember 31, 2022 , compared to$572,253 for the year endedDecember 31, 2021 . The increase reflects the increase in gross written premiums of$17,139 and the change in the increase in gross unearned premiums of$52,837 . Gross earned premiums as a percentage of gross written premiums was 98.6% for the year endedDecember 31, 2022 , compared to 90.2%, for the year endedDecember 31, 2021 . 59
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Ceded earned premiums: Ceded earned premiums decreased$15,968 , or 4.3%, to$357,605 for the year endedDecember 31, 2022 , compared to$373,573 for the year endedDecember 31, 2021 , reflecting the Company's strategic decision to retain more gross written premiums. This resulted in total ceded earned premiums as a percentage of gross earned premiums of 55.7% for the year endedDecember 31, 2022 , compared to 65.3% for the year endedDecember 31, 2021 . Net earned premiums: Net earned premiums increased$85,944 , or 43.3%, to$284,624 for the year endedDecember 31, 2022 , compared to$198,680 for the year endedDecember 31, 2021 . The increase is primarily 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 increased$1,366 , or 15.7%, to$10,087 for the year endedDecember 31, 2022 , compared to$8,721 for the year endedDecember 31, 2021 . The increase reflects the reinvestment of cash flows from lower to higher yielding investments in a rising interest rate environment and having a larger average investment balance which included the investment of the surplus notes proceeds. The increase was partially offset by unrealized losses of$4,797 on equity securities. Net realized gains: Net realized gains were$285 for the year endedDecember 31, 2022 , compared to$49 for the year endedDecember 31, 2021 . Net realized gains for the year endedDecember 31, 2022 includes earn-out proceeds received of$1,415 related to the Company's sale of TRI in 2021. The net realized gain was offset by a repositioning strategy to sell lower-yielding assets and purchase higher-yielding investments resulting in a realized loss of$1,022 during the first quarter of 2022. Other revenue: Other revenue decreased$1,994 , or 19.5%, to$8,246 for the year endedDecember 31, 2022 , compared to$10,240 for the year endedDecember 31, 2021 . The decrease is primarily driven by a decrease in brokerage revenue of$1,331 , due to lower placement fees reflecting the Company's increase in retention during the year. In addition, managing general agent fees, third-party administrator fees, consulting and other fee-based revenue were all lower during the year. Losses and loss adjustment expenses: Losses and LAE increased$73,105 , or 55.9%, to$203,877 for the year endedDecember 31, 2022 , compared to$130,772 for the year endedDecember 31, 2021 . The increase is primarily attributable to the growth in earned premiums and the increased retention experienced during 2022. The Company's retention rate increased to 44.3% in 2022 compared to 34.7% in 2021. The Company's loss ratio was 71.6% for the year endedDecember 31, 2022 compared to 65.8% for the year endedDecember 31, 2021 . The loss ratio increase reflects elevated losses on our owned businesses and also reflects the impact of unfavorable development relating primarily to the 2021 accident year and its effect on expected losses for 2022. General and administrative expenses: General and administrative expenses increased$31,504 , or 57.6%, to$86,210 for the year endedDecember 31, 2022 , compared to$54,706 for the year endedDecember 31, 2021 . This resulted in an expense ratio of 30.3% for the year endedDecember 31, 2022 , compared to 27.5% for the year endedDecember 31, 2021 .
The table below shows the components of general and administrative expenses for:
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Table of Contents The year ended December 31, 2022 2021 Change Direct commissions$ 114,866 $ 105,965 $ 8,901 Ceding commissions (102,759) (120,688) 17,929 Net commissions 12,107 (14,723) 26,830 Insurance-related expenses 22,790 20,732 2,058 General and administrative operating expenses 51,313 48,697 2,616 Total general and administrative expenses$ 86,210 $
54,706
General and administrative expenses - % of gross written premiums 7.9 % 7.7 % 0.2 % Retention rate (1) 44.3 % 34.7 % 9.6 % Direct commission rate (2) 17.9 % 18.5 % (0.6) % Ceding commission rate (3) 28.7 % 32.3 % (3.6) %
(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$8,901 primarily due to an increase in gross earned premiums. Ceding commissions decreased$17,929 due to an increase in retention. Insurance-related expenses increased$2,058 primarily as a result of the increase in gross earned premiums. General and administrative operating expenses increased$2,616 , reflecting (i) an increase in salaries and benefits of$2,945 , which related primarily to a general increase in salaries and higher health insurance costs; (ii) an increase in travel expense of$429 ; and (iii) a decrease in professional fees of$332 . Other expenses: Other expenses were$3,349 for the year endedDecember 31, 2022 which primarily relates to merger-related expenses of approximately$3,081 and management transition costs of$268 . Other expenses for the year endedDecember 31, 2021 were$845 which primarily relates to secondary offering costs of$555 and executive transition costs totaling$290 . Intangible asset amortization: Intangible asset amortization increased$172 to$5,998 for the year endedDecember 31, 2022 , compared to$5,826 for the year endedDecember 31, 2021 . The increase is primarily driven by the addition of intangible assets acquired in the acquisition of WIC in the third quarter of 2021. Noncash stock compensation: Noncash stock compensation was$1,496 and$1,522 for the years endedDecember 31, 2022 and 2021. 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. Interest expense: Interest expense increased$1,585 , or 94.1%, to$3,270 for the year endedDecember 31, 2022 , compared to$1,685 for the year endedDecember 31, 2021 . The increase includes additional interest expense of$1,222 related to the Surplus Notes issued during the third quarter of 2022. The remainder of the increase was due to higher interest rates on our variable rate Secured Credit Facility during the year endedDecember 31, 2022 .Goodwill impairment: A goodwill impairment charge of$76,053 was recognized during the year endedDecember 31, 2022 . As a result of the Merger Agreement, the estimation of the nonrecurring fair value measurement of the Company based on the implied equity value of the Company at the negotiated purchase price of$6.15 per common share. 61 -------------------------------------------------------------------------------- Table of Contents Gains (losses) on embedded derivatives:
The table below shows the components of gains (losses) on embedded derivatives
for the years ended
The
Year Ended
2022 2021 Change Change in fair value of embedded derivatives$ 15,682 $ 4,666 $ 11,016 Effect of net investment income on funds held investments (3,668) (2,338) (1,330) Effect of realized losses (gains) on funds held investments 10 (102) 112 Gains on embedded derivatives$ 12,024
Gains on embedded derivatives were$12,024 for the year endedDecember 31, 2022 , compared to$2,226 for the year endedDecember 31, 2021 . The increased gain of$9,798 reflected the change in the fair value of the embedded derivatives of$11,016 and the effect of realized losses on funds held investments of$112 , partially offset by the effect of investment income on funds held investments of$1,330 . Income tax expense: Income tax expense was$1,074 for the year endedDecember 31, 2022 , which resulted in an effective tax rate of (1.7)%, compared to$5,449 for the year endedDecember 31, 2021 , which resulted in an effective tax rate of 22.0%. The effective tax rate differed from the statutory rate of 21% for the year endedDecember 31, 2022 primarily due to the non-deductible costs incurred in connection with the Merger Agreement and the non-deductible portion of the goodwill impairment charge. The increase in the effective tax rate from the statutory rate of 21% for the year endedDecember 31, 2021 is primarily due to the impact of recording our 2020 tax return accrual to return true up in the third quarter.
Reconciliation of Non-GAAP Financial Measures
Underwriting income (loss)
We define underwriting income (loss) as income (loss) before taxes excluding net investment income, noncash changes in fair value of embedded derivatives, investment revaluation gains, net realized capital gains or losses, noncash intangible asset amortization, goodwill impairment, noncash stock compensation, interest expense, other revenue and other income and expenses. Underwriting income (loss) represents the pre-tax profitability of our underwriting operations and allows us to evaluate our underwriting performance without regard to the above listed items. We use this metric because we believe it gives our management and other users of our financial information useful insight into our underwriting business performance by adjusting for these expenses and sources of income. Underwriting income (loss) should not be viewed as a substitute for net income (loss) calculated in accordance with GAAP, and other companies may define underwriting income differently. 62
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Year Ended December 31, Percentage Change (in thousands, except percentages) 2022 2021 (1) Net income (loss)$ (65,955) $ 19,330 NM Income tax expense 1,074 5,449 (80.3) % Income (loss) before taxes (64,881) 24,779 NM Other revenue (8,246) (10,240) (19.5) % Change in fair value of embedded derivatives (12,024) (2,226) NM Net investment income (10,087) (8,721) 15.7 % Realized gain on sale of investments (285) (49) NM Interest expense 3,270 1,685 94.1 % Other expenses 3,349 845 NM Goodwill impairment (2) 76,053 - NM Intangible asset amortization 5,998 5,826 3.0 % Noncash stock compensation 1,496 1,522 (1.7) % Other income (106) (219) (51.6) % Underwriting income (loss)$ (5,463) $ 13,202 (141.4) % (1) The Company defines increases or decreases greater than 200% as "NM" or not meaningful. (2) See "Financial Condition, Liquidity and Capital Resources-Financial Condition-Goodwill and intangible asset valuation" below for additional information.
Adjusted net income (loss)
We define adjusted net income (loss) as net income (loss) excluding the impact of certain items, including noncash intangible asset amortization, stock compensation, goodwill impairment, noncash changes in fair value of 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 an expected effective tax rate for the applicable years. We use adjusted net income (loss) 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 (loss) should not be viewed as a substitute for net income (loss) calculated in accordance with GAAP, and other companies may define adjusted net income (loss) differently. Year Ended December 31, Percentage Change (in thousands, except percentages) 2022 2021 (1) Net income (loss)$ (65,955) $ 19,330 NM Intangible asset amortization 5,998 5,826 3.0 % Noncash stock compensation 1,496 1,522 (1.7) % Change in fair value of embedded derivatives (15,682) (4,666) NM Unrealized losses on equity securities 4,797 - NM Realized loss (gain) on sale of investment (1,415) 112 NM Other expenses 3,349 845 NM Goodwill impairment (2) 76,053 - NM Total adjustments 74,596 3,639 NM Tax impact of adjustments (781) (837) (6.7) % Adjusted net income$ 7,860 $ 22,132 (64.5) %
(1) the Company defines increases or decreases greater than 200% as "NM" or not meaningful.
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Table of Contents (2) See "Financial Condition, Liquidity and Capital Resources-Financial Condition-Goodwill and intangible asset valuation" below for additional information.
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. Year Ended December 31, 2022 2021 Adjusted return on equity calculation: Numerator: adjusted net income$ 7,860 $ 22,132 Denominator: average equity 368,464 416,008 Adjusted return on equity 2.1 % 5.3 % Return on equity (17.9) % 4.6 %
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 (loss) 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. Year Ended December 31, 2022 2021 Return on tangible equity calculation: Numerator: net income (loss)$ (65,955) $ 19,330 Denominator: Average stockholders' equity 368,464 416,008
Less: average goodwill and other intangible assets 174,436 215,709 Average tangible stockholders' equity
194,028 200,299 Return on tangible equity (34.0) % 9.7 % Return on equity (17.9) % 4.6 % 64
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Table of Contents Year Ended December 31, 2022 2021 Adjusted return on tangible equity calculation: Numerator: adjusted net income$ 7,860 $ 22,132 Denominator: average tangible equity 194,028
200,299
Adjusted return on tangible equity 4.1 % 11.0 % Return on equity (17.9) % 4.6 %
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 ; 7710, which is domiciled inSouth Carolina ; and BSIC, which is domiciled inArkansas . 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.
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 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 gains). Dividends shall not include pro rata distributions of any class of ALIC's own securities. UnderSouth Carolina law, dividends payable from 7710 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 7710's surplus as regards policyholders as shown in 7710's most recent annual statement; or (ii) the net income, not including net realized gains or losses as shown in the 7710's most recent annual statement; or (b) when paid from earned surplus must not exceed the greater of: (i) 10% of 7710's surplus as regards policyholders as shown in 7710's most recent annual statement; or (ii) the net income, not including net realized gains or losses as shown in the 7710's most recent annual statement. Dividends shall not include pro rata distributions of any class of 7710's own securities. UnderArkansas law, dividends payable from BSIC without the prior approval of the applicable insurance commissioner must not exceed the lesser of (i) 10% of BSIC's surplus as shown on the last statutory financial statement on file with theArkansas Insurance Department ; or (ii) 100% of net income during the applicable twelve- month period (not including realized gains). Dividends shall not include pro rata distributions of any class of BSIC's own securities. The maximum amount of dividends the insurance subsidiaries were able to pay us during 2022 without regulatory approval is approximately$17 million . Insurance regulators have broad powers to ensure that statutory surplus remains at adequate levels, and there is no assurance that dividends of the maximum amount calculated under any applicable formula would be permitted. In the future, state insurance regulatory authorities that have jurisdiction over the payment of dividends by the insurance subsidiaries may adopt statutory provisions more restrictive than those currently in effect. 65 -------------------------------------------------------------------------------- Table of Contents Our insurance subsidiaries are also required by state law to maintain a minimum level of policyholder's surplus.Kansas ,Utah ,Arkansas andSouth Carolina utilize a risk-based capital requirement as promulgated by theNational Association of Insurance Commissioners . Such requirements are designed to identify the various business risks (e.g., investment risk, underwriting profitability risk, etc.) of insurance companies and their subsidiaries. As ofDecember 31, 2022 andDecember 31, 2021 , the total adjusted capital of our insurance subsidiaries was in excess of their respective prescribed risk-based capital requirements.
As of
Management believes that we have sufficient liquidity available to meet our operating cash needs and obligations and committed capital expenditures for the next 12 months.
Cash Flows Our most significant source of cash is from premiums received from insureds, net of the related commission amount for the policies. Our most significant cash outflow is for claims that arise when a policyholder incurs an insured loss. Because the payment of claims occurs after the receipt of the premium, often years later, we invest the cash in various investment securities that generally earn interest and dividends. The table below summarizes our net cash flows. Year
Ended
2022 2021 Cash, cash equivalents and restricted cash provided by (used in): Operating activities$ 108,947 $ 94,359 Investing activities (175,440) (120,156) Financing activities 45,583 (1,453) Net increase (decrease) in cash, cash equivalents and restricted cash$ (20,910) $ (27,250) Operating Activities: Net cash provided by operating activities for the year endedDecember 31, 2022 was$108,947 compared to$94,359 for the same period in 2021. Net cash provided by operating activities includes net income (loss) as adjusted for depreciation and amortization, stock compensation, unrealized and realized gains and losses, bond amortization and accretion, the change in deferred income taxes, amortization of deferred financing costs and goodwill impairment. Net cash provided by operating activities during the year endedDecember 31, 2022 reflects increases in unpaid loss and loss adjustment expenses of$88,590 , funds held under reinsurance agreements of$58,191 , unearned premiums of$9,172 and reinsurance premiums payable of$5,731 ; and decreased prepaid reinsurance premiums of$5,142 ; partially offset by increases in reinsurance recoverables of$31,281 , premiums and other receivable of$18,362 , other assets of$11,553 , income taxes receivable of$5,381 and accrued investment income of$1,382 . Unpaid loss and loss adjustment expenses increased primarily due to growth in gross earned premiums, an increase in our 2022 loss ratio, and an increase in our retention. Funds held under reinsurance agreements increased due to a reduction in the derivatives and 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 prepaid software. Investing Activities: Net cash used in investing activities for the year endedDecember 31, 2022 was$175,440 compared to$120,156 for the same period in 2021. Net cash used in investing activities for the year endedDecember 31, 2022 includes$175,101 net cash used in the purchase and sale of investments and$339 in capital expenditures. Net cash used in investing activities for the year endedDecember 31, 2021 includes$116,247 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, and$346 in capital expenditures, partially offset by$232 received for the return of capital on equity method investments. Financing Activities: Net cash provided by financing activities for the year endedDecember 31, 2022 was$45,583 compared to net cash used in financing activities of$1,453 for the year endedDecember 31, 2021 . The cash provided by financing activities in 2022 primarily includes$48,455 of net cash proceeds received from the issuance of surplus notes, partially offset by principal payment made on the Company's debt of$1,650 , an earn-out payment of$750 related to our 2021 acquisition of WIC, payments for deferred financing costs of$276 and a payment for our interest rate cap of$173 . Cash used in financing activities in the prior year primarily included principal payment made on the Company's debt of$1,444 . 66
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Debt and Credit Agreements
First Horizon Credit Agreement
InApril 2018 , the Company entered into a credit agreement withFirst Horizon Bank that includes a term loan facility totaling$27.5 million and a revolving credit facility of$3.0 million . Borrowings are secured by substantially all of the assets of the Company and its subsidiaries. OnJuly 16, 2020 , the Company entered into a new Second Amended and Restated Credit Agreement withFirst Horizon Bank that, 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 . OnMay 6, 2022 , we entered into a First Amendment to the Credit Agreement to, among other things, facilitate the approval of certain internal distributions among the Company and certain of its subsidiaries as part of the Company's overall capital management strategy. OnSeptember 28, 2022 , we entered into a Second Amendment to the Credit Agreement that, among other things, replaced LIBOR as the benchmark rate with Term SOFR (as defined in the Credit Agreement), reduced the applicable margin under the Credit Agreement on Eurodollar loans from 4.50% to 3.50% and on ABR loans from 3.50% to 2.50%, and converted all extant Eurodollar loans under the Credit Agreement to Term SOFR loans. The loan has a variable interest rate plus applicable margin, which was 7.59%, 4.64% and 4.72% as ofDecember 31, 2022 , 2021 and 2020, respectively. 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 Company's subsidiaries (other thanBenchmark Holding Company and its subsidiaries) have been pledged as collateral. In addition, and in conjunction with, the execution of the Second Amended and Restated Credit Agreement, the Company made dividend distribution payments toTrean members totaling$18,154 inMay 2020 .
Hedging Arrangement
InSeptember 2022 , we entered into the Interest Rate Cap Agreement that became effectiveSeptember 30, 2022 , to hedge cash flows associated with interest rate fluctuations on our secured credit facility, with a termination date ofMay 31, 2024 . The Interest Rate Cap Agreement has a notional amount of$29,700 that effectively converted the outstanding balance of the secured credit facility from variable rate debt to capped variable rate debt, resulting in a change in the applicable interest rate from an interest rate of one-month SOFR plus the applicable margin (as provided by the secured credit facility) to one-month SOFR interest rate, capped at 5.00%, plus the applicable margin. The notional amount of the Interest Rate Cap Agreement decreases quarterly in proportion to the quarterly principal payments on the secured credit facility. The Interest Rate Cap Agreement is designated as a cash flow hedge and the change in fair value is recorded in accumulated other comprehensive income and is subsequently reclassified to interest expense in the period when the hedged forecasted interest payments affect earnings. The Company paid a fixed amount of$173 for the Interest Rate Cap Agreement.
Surplus Notes
OnAugust 24, 2022 , Benchmark issued Surplus Notes which consisted of$50,000 in aggregate principal amount of 6.75% surplus notes due 2042 in a private placement exempt from registration under the Securities Act. In connection with the issuance of the Surplus Notes, Benchmark entered into theFiscal Agency Agreement with The Bank of New York Mellon, as fiscal agent, paying agent, registrar and transfer agent, providing for the terms of the Surplus Notes. The Surplus Notes are unsecured, subordinated debt obligations of the Company and are reflected as debt on our consolidated balance sheets. All payments of principal and interest, which accrues at the rate of 6.75% per year and is payable quarterly, on the Surplus Notes are subject to prior approval by the Commissioner of theKansas Insurance Department .
Junior Subordinated Debt
InJune 2006 , the Trust issued 7,500 shares of preferred capital securities toBear Stearns Securities Corp. and 232 common securities toTrean Corporation . The proceeds of such issuances were invested by the Trust in$7,732 aggregate principal amount of the Subordinated Notes. The Subordinated Notes compromise the sole assets of the Trust. OnOctober 7, 2020 ,Trean Corp redeemed all of the Subordinated Notes for a total payoff amount of$7,807 . 67 -------------------------------------------------------------------------------- Table of Contents Oak Street Loan In conjunction with the acquisition of Compstar, the Company acquired a loan fromOak Street Funding with a total principle of$19,740 . InJuly 2020 , upon completion of the acquisition, the Company paid this loan off in full.
PPP Loans
In conjunction with the acquisition of WIC, the Company acquired two Federal Paycheck Protection Program ("PPP Loans") with a principal balance of$243 . As ofDecember 31, 2021 , both loans had been fully forgiven.
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." 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.
Contractual Obligations and Commitments
Reserves for losses and loss adjustment expenses
The Company estimates the liability for the expected ultimate cost of unpaid loss and LAE as of the balance sheet date. Our reserves for unpaid loss and LAE represent the cost of all reported loss and LAE expenses as well as those that have been incurred but not yet reported. The estimated losses and LAE are regularly reviewed and adjusted as necessary based on historical experience and as the Company obtains new information. Actual losses and settlement expenses paid may deviate 68 -------------------------------------------------------------------------------- Table of Contents from the reserve estimates. Similarly, the timing for payment of our estimated losses is not fixed and is not determinable on an individual or aggregate basis due to the uncertainty inherent in the process of estimating such payments. See Note 15 of Notes to the Consolidated Financial Statements and "Critical Accounting Estimates" below for a discussion of estimates and assumptions related to the reserves for unpaid losses and loss adjustment expenses.
Credit facility
As ofDecember 31, 2022 , we had$29,288 principal outstanding on our term loan under the Second Amended and Restated Credit Agreement withFirst Horizon Bank . The loan has a variable interest rate of SOFR plus 3.50%, which was 7.59% as ofDecember 31, 2022 . The outstanding principal balance of the loan is to be repaid in quarterly installments that escalate from approximately$206 to$825 untilMarch 2025 . See Note 12 of the Notes to the Consolidated Financial Statements for further details regarding our credit facility.
Surplus Notes
As ofDecember 31, 2022 , we had$50,000 principal outstanding on our Surplus Notes due 2042. Interest on the Surplus Notes accrues at the rate of 6.75% per year, and is payable quarterly. See Note 12 of the Notes to the Consolidated Financial statements for further details regarding our Surplus Notes.
Operating lease obligations
As ofDecember 31, 2022 , we leased office space and equipment in 12 states. Our leases have remaining terms ranging from one month to 54 months and some of our leases include options to extend the lease for up to 5 years. Future expected cash obligations include$1,940 ,$1,064 ,$164 ,$44 and$2 during the years endedDecember 31, 2023 , 2024, 2025, 2026 and 2027, respectively. See Note 17 of the Notes to the Consolidated Financial Statements for further details regarding our leases. Financial condition Stockholders' Equity As ofDecember 31, 2022 , total stockholders' equity was$315,019 , compared to$421,909 as ofDecember 31, 2021 , a decrease of$106,890 . The decrease in stockholders' equity over the period was driven primarily by$108,362 of comprehensive loss. We had$2,279 of unrecognized stock compensation as ofDecember 31, 2022 related to non-vested stock compensation granted. The Company recognized$1,496 of stock compensation during the year endedDecember 31, 2022 .
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$552,243 atDecember 31, 2022 , that were classified as available-for-sale. Available-for-sale investments are carried at fair value with unrealized gains and losses on these securities, net of applicable taxes, reported as a separate component of accumulated other comprehensive income. Our investment portfolio objectives are to maintain liquidity, facilitating financial strength and stability and ensuring regulatory and legal compliance. Our investment portfolio consists of available-for-sale fixed maturities and other equity investments, all of which are carried at fair value. We seek to hold a high-quality portfolio of investments that is managed by a professional investment advisory management firm in accordance with the Company's investment policy and routinely reviewed by our management team. Our investments, however, are subject to general economic conditions and market risks as well as risks inherent to particular securities. The Company's investment portfolio has the following objectives:
•meet insurance regulatory requirements with respect to investments under the applicable insurance laws;
•maintain an appropriate level of liquidity to satisfy the cash requirements of current operations and long-term obligations;
•adjust investment risk to offset or complement insurance risk based on our total corporate risk tolerance; and
•realize the highest possible levels of investment income and after-tax total rates of return.
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The composition of our investment portfolio is shown in the following table as
of
December 31, 2022 Cost or Amortized Cost Fair Value Fixed maturities: U.S. government and government securities$ 65,405 $ 62,552 Foreign governments 400 395 States, territories and possessions 17,310 15,854 Political subdivisions of states, territories and possessions 38,167 33,904 Special revenue and special assessment obligations 115,696 103,639 Industrial and public utilities 131,769 125,540 Commercial mortgage-backed securities 145,471 128,105 Residential mortgage-backed securities 26,716 25,112 Other loan-backed securities 53,231 51,613 Hybrid securities 6,233 5,529 Total fixed maturities 600,398 552,243 Equity securities 39,882 35,041 Total investments$ 640,280 $ 587,284 December 31, 2021 Cost or Amortized Cost Fair Value Fixed maturities: U.S. government and government securities$ 41,490 $ 41,434 Foreign governments 2,500 2,490 States, territories and possessions 10,593 10,766 Political subdivisions of states, territories and possessions 39,170 40,002 Special revenue and special assessment obligations 93,664 95,991 Industrial and public utilities 100,774 103,257 Commercial mortgage-backed securities 119,378 118,218 Residential mortgage-backed securities 16,549 17,368 Other loan-backed securities 41,236 41,425 Hybrid securities 105 110 Total fixed maturities 465,459 471,061 Equity securities 984 969 Total investments$ 466,443 $ 472,030 The following table shows the percentage of the total estimated fair value of our fixed maturity securities as ofDecember 31, 2022 andDecember 31, 2021 by credit rating category, using the lower of ratings assigned by Moody's Investor Service or S&P. 70
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December 31, 2022 (in thousands, except percentages) Fair Value % of Total AAA$ 106,254 19.2 % AA 312,903 56.7 % A 98,963 17.9 % BBB 30,122 5.5 % BB 3,965 0.7 % Below investment grade 36 - % Total fixed maturities$ 552,243 100.0 % December 31, 2021 (in thousands, except percentages) Fair Value % of Total AAA $ 80,455 17.1 % AA 278,557 59.1 % A 77,097 16.4 % BBB 33,959 7.2 % BB 947 0.2 % Below investment grade 46
- %
Total fixed maturities$ 471,061 100.0 % Critical Accounting Estimates The consolidated financial statements included in this Annual Report include amounts based on the use of estimates and judgments of management. The Company's accounting policies are described in the Notes to the Consolidated Financial Statements. 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 made in accordance with GAAP that are both reasonably likely to have or have had a material impact on 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 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 consolidated financial statements. We evaluate our estimates regularly using information that we believe to be relevant.
Unpaid loss and loss adjustment expenses
The Company estimates the liability for the expected ultimate cost of unpaid loss and LAE as of the balance sheet date. Our reserves for unpaid loss and LAE represent the cost of all reported loss and LAE expenses as well as those that have been incurred but not yet reported. The estimated losses and LAE are regularly reviewed and adjusted as necessary based on historical experience and as the Company obtains new information. We categorize our reserves for unpaid loss and LAE into two types: case reserves and incurred but not yet reported (IBNR). We establish our case reserves based on claims information reported to us through our claims administrator. Our case reserves include an estimate of the ultimate losses from the claims including administrative costs associated with the settlement of the claim. Our claims department uses their knowledge of the specific claim along with internal and external experts, including underwriters and independent actuaries, to estimate the expected ultimate losses. In addition to case reserves, we establish a reserve for IBNR. With the assistance of an independent actuarial firm, we estimate the total loss and LAE related to IBNR which is comprised of: (a) future payments on claims that existed as of the balance sheet date but had not yet been reported to us; (b) a reserve for the additional development on claims that have been reported to us; and (c) a provision for additional payments on closed claims that may reopen. These estimates are based on 71 -------------------------------------------------------------------------------- Table of Contents historical information, industry information and estimates of trends that may impact the ultimate frequency and severity of IBNR claims. In order to limit the Company's maximum losses and diversify its exposure, we cede a portion of our obligations for losses and LAE through reinsurance treaties with third party reinsurers. The amount of reinsurance that will be recoverable on our losses and LAE includes both the reinsurance recoverables on our excess of loss reinsurance contracts as well as reinsurance recoverables under our quota share contracts. Our loss reserves, including the main components of such reserves, were as follows: December 31, 2022 2021 Case reserves$ 288,203 $ 256,383 IBNR reserves 344,707 287,937 Gross unpaid loss and loss adjustment expenses 632,910 544,320
Less: reinsurance recoverables on unpaid loss and loss adjustment expenses
(378,455)
(369,008)
Net unpaid loss and loss adjustment expenses$ 254,455
The process of estimating the reserves for unpaid loss and LAE expenses requires a high degree of judgment. Estimates are prepared using several generally accepted actuarial methodologies for estimating loss reserves including, but not limited to, the incurred development method, paid development method, incurred Bornhuetter-Ferguson method, hindsight IBNR/case reserve ratios, and loss ratio method. The methods used vary based on the line of business and the Partner Program or general agency that generated the business. Considering each of the alternative ultimate estimates, we determine the appropriate estimate of ultimate loss for each line of business and Program Partner.
Reinsurance recoverables
Reinsurance recoverables represent the portion of our unpaid loss and LAE that are ceded to third party reinsurers. The ceding of insurance does not relieve the Company of its primary liability to policyholders. We are required to pay claims even if a reinsurer fails to pay the Company under the terms of a reinsurance contract. We calculate the amounts recoverable from reinsurers based on our estimates of the underlying loss and LAE expenses as well as the terms and conditions of the reinsurance contracts.
Investment fair value measurements
Our investments in fixed maturity securities are classified as available-for-sale and are reported at fair value with unrealized gains and losses reported as a component of other comprehensive income, net of deferred taxes. Our investments in equity securities are reported at fair value with unrealized gains and losses reported as net investment income in the Consolidated Statement of Operations. In determining the fair value of investments, we utilize a hierarchy based on the quality of inputs used to measure the fair value. The three levels of the fair value hierarchy are as follows:
Level 1: Fair values primarily based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date.
Level 2: Fair values primarily based on observable inputs, other than quoted prices included in Level 1, or based on prices for similar assets and liabilities.
Level 3: Fair values primarily based on valuations derived when one or more of the significant inputs are unobservable. With little or no observable market, the determination of fair value uses considerable judgment and represents the Company's best estimate of an amount that could be realized in a market exchange for the asset or liability. We utilize a third-party pricing service to assist us with the valuation of our investments. The fair value of our available-for-sale fixed maturity and equity securities are based on quoted market prices, where available. These fair values are obtained primarily from our third-party pricing service, which generally include Level 1 or Level 2 inputs. Inputs often used in the valuation methodologies include, but are not limited to, transaction data, yield, quality, coupon rate, maturity, issue type, trading characteristics and market activity. 72
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The Company regularly reviews its investment portfolio to determine if other-than-temporary impairment exists for any fixed maturity securities. An investment is impaired when the fair value of the investment declines to an amount less than the cost or amortized cost of that investment. If a security is impaired, the Company bifurcates the impairment into (a) the amount of impairment related to credit loss and (b) the amount of impairment related to other factors. The amount of impairment related to credit loss is recorded as an impairment loss and is included in net income. The impairment related to all other factors is recorded as a reduction in the fair value of the security and is included in accumulated other comprehensive income.
We prepare an impairment analysis for goodwill and other intangible assets. In evaluating for impairment, we identify whether events or circumstances have occurred that may impact the carrying value of these assets and make assumptions regarding future events such as cash flows and profitability. If the carrying amount of the assets are deemed to be not recoverable, the Company records an impairment loss. Differences in the assumptions of recoverability and actual results could materially impact the carrying amount of these assets and our operating results. As a result of the Merger Agreement entered into onDecember 15, 2022 , the calculated fair value of the Company exceeded the book value and resulted in an impairment charge of$76,053 recognized during the year endedDecember 31, 2022 . The fair value measurement was based on the implied equity value of the Company at the purchase price of$6.15 per common share.
Business combinations
The Company strategically identifies opportunities to grow through acquisition. Such business combinations include the identification and valuation of certain assets acquired and liabilities assumed including the valuation of goodwill and intangible assets. Valuations are determined using a market participant assumption and generally include the following valuation approaches: The Cost Approach is based on replacement value using the acquired company's balance sheet as the basis for valuing the business or individual assets. Under this approach, the appraiser must determine the potential value that is attainable from the sale of all assets or individual assets less the repayment of any associated debt. Separate valuations are performed for each item on the balance sheet and all tangible and intangible assets and liabilities are adjusted to their respective values. The Income Approach measures the value of an ownership interest in a company or asset as the present value of the future economic benefits of ownership. The future ownership benefits may be represented by the expected earnings or cash flow of a company or asset over an investment period. The expected earnings or cash flow are then converted to their net present value using a rate of return suitable for the risks associated with realizing those future benefits. The Market Approach asserts that the value of property of any kind is equal to the cost of obtaining an equally desired substitute. Under this approach, the appraisal is based on transactions of assets similar to the subject asset. Value multiples from these transactions are applied to the subject asset's data to arrive at the asset's value.
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