The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes appearing elsewhere in this Annual Report. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. The actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those which are not within our control.
Overview: We are a property and casualty insurance holding company headquartered in Clearwater, Florida and, through our insurance subsidiary, we provide personal residential insurance for single-family homeowners and condominium owners, rental property insurance and commercial residential insurance in the state of Florida and North Carolina. We are vertically integrated and control or manage substantially all aspects of insurance underwriting, customer service, actuarial analysis, distribution and claims processing and adjusting. We are led by an experienced senior management team with an average of 31 years of insurance industry experience. Heritage P&C is currently rated “A” (“Exceptional”) by Demotech, Inc. (“Demotech”), a rating agency specializing in evaluating the financial stability of insurers.
In addition to Heritage P&C, our other subsidiaries include: Heritage MGA, LLC, the managing general agent that manages substantially all aspects of our insurance subsidiary’s business; Contractors’ Alliance Network, LLC, (“CAN”) our vendor network manager that also houses with BRC Restoration Specialists (“BRC”) our provider of restoration, emergency and recovery services; Skye Lane Properties, LLC, our property management subsidiary; First Access Insurance Group, LLC, our retail agency; Osprey Re Ltd (“Osprey”); our reinsurance subsidiary that provides a portion of the reinsurance protection purchased by our insurance subsidiary; and Heritage Insurance Claims, LLC an inactive subsidiary reserved for future development.
Combined ratio of 74.9% on a gross basis and 65.0% on a net basis
Cash, cash equivalents and investments of $636.4 million, with total assets of $837.4 million
Retroactive reinsurance income of $26.0 million during the year ended December 31, 2013 represents premiums earned, net of losses, for the period from January 1, 2013 through May 31, 2013 from a retroactive reinsurance quota share agreement entered into in connection with our assumption of approximately 39,000 policies from Citizens in June 2013. See Note 2 to our consolidated financial statements included elsewhere in this Annual Report.
Results of Operations - Year Ended December 31, 2014 Compared to Year Ended December 31, 2015
Gross premiums written increased from $436.4 million for the year ended December 31, 2014 to $586.1 million for the year ended December 31, 2015. The increase in gross premiums written was due to the renewal of a significant number of policies previously assumed from Citizens and SSIC, the growing number of new voluntary policies written and the assumption of approximately 68,200 personal residential policies from Citizens, as well as approximately 100 commercial residential policies from Citizens in 2015. Of our gross premiums written for the year ended December 31, 2015, $487.6 million represents direct premiums written and $98.5 million represents assumed premiums written. Of the $487.6 million of direct premiums written, renewals of policies previously assumed from Citizens accounted for $393.5 million and renewals of policies previously assumed from SSIC accounted for $41.4 million, while voluntary business accounted for $92.7 million. The assumed premiums written of $98.5 million was comprised of policies assumed from Citizens.
Other revenue increased from $6.1 million for the year ended December 31, 2014 to $9.6 million for the year ended December 31, 2015. The increase in other revenue between the comparable periods is primarily attributable to the policy fees generated by our growing portfolio of new and renewed policies. Also, the rental income received pursuant to non-cancelable leases for our commercial property in Clearwater, Florida, and revenue earned from non-insurance claims generated by our restoration subsidiary contributed to the increase.
Losses and loss adjustment expenses increased from $89.6 million for the year ended December 31, 2014 to $141.2 million for the year ended December 31, 2015. The increase in losses and loss adjustment expenses resulted primarily from an increase in the number of policies in force between the respective periods, partially offset by a 1.8 percentage point decrease in the gross loss ratio. Losses and loss adjustment expenses for the year ended December 31, 2015 include losses paid of $57.5 million and a $32.3 million increase in unpaid losses and loss adjustment expenses, including the addition of $16.8 million of IBNR reserves. As of December 31, 2015, we reported $83.7 million in unpaid losses and loss adjustment expenses which included $46.9 million attributable to IBNR, or 56% of total reserves for unpaid losses and loss adjustment expenses.
Our net loss ratio decreased from 40.1% for the year ended December 31, 2014 to 37.5% for the year ended December 31, 2015, primarily as a result of the increase in commercial residential business in 2015.
year ended December 31, 2015. The changes in our combined ratio, on both a gross and net basis, are primarily as a result of the improvement of the loss and expense ratios to earned premiums, as discussed above.
Ceded premiums increased from $44.8 million for the year ended December 31, 2013 to $87.9 million for the year ended December 31, 2014. The increase in ceded premiums is primarily a result of the significant increase in the policies in force noted above, partially offset by lower reinsurance costs due to favorable reinsurance market conditions and the availability of lower cost reinsurance related to $200 million of catastrophe bonds issued by a Citrus Re, and improved geographic spread of risk. Additionally, prior to June 1, 2013, our reinsurance costs were significantly lower because we purchased reinsurance limited to non-hurricane losses through May 31, 2013.
Other revenue increased from $2.9 million for the year ended December 31, 2013 to $6.1 million for the year ended December 31, 2014. The increase in other revenue between the comparable periods is primarily attributable to the policy fees generated by our growing portfolio of new and renewed policies. Also, the rental income received pursuant to non-cancelable leases for our commercial property in Clearwater, Florida that we purchased in April 2013, contributed to the increase in other revenue.
Total revenue increased from $124.8 million for the year ended December 31, 2013 to $233.8 million for the year ended December 31, 2014. The increase in total revenue was due primarily to the growth in net premiums earned resulting from the significant increase in the number of policies in force throughout the year ended December 31, 2014 as compared to the prior year.
Our results of operations for the year ended December 31, 2014 reflect net income of $47.1 million, or $1.82 earnings per diluted common share, compared to net income of $34.2 million, or $2.36 earnings per diluted common share, for the year ended December 31, 2013. The weighted average shares outstanding on a diluted basis increased from 14.5 million shares as of December 31, 2013 to 25.8 million shares as of December 31, 2014, primarily due to the Company’s IPO on May 22, 2014 and related warrant exercises. This caused the reduced earnings per diluted share in 2014, despite the increase in net income.
Our ceded premium ratio decreased from 32.0% for the year ended December 31, 2013 to 28.2% for the year ended December 31, 2014. This decrease is primarily due to lower reinsurance costs due to favorable reinsurance market conditions, the availability of lower cost reinsurance related to $200 million of catastrophe bonds issued by a Citrus Re and improved geographic spread of risk.
Our gross loss ratio increased from 27.5% for the year ended December 31, 2013 to 28.7% for the year ended December 31, 2014, primarily due to an increase in IBNR.
Our combined ratio on a gross basis decreased from 81.6% for the year ended December 31, 2013 to 79.4% for the year ended December 31, 2014. Our combined ratio on a net basis decreased from 72.9% for the year ended December 31, 2013 to 71.4% for the year ended December 31, 2014. The changes in our combined ratio, on both a gross and net basis, are primarily as a result of the improvement of the ceded premium ratio to gross earned premiums.
As of December 31, 2015, we had $236.3 million of cash and cash equivalents, which primarily consisted of cash and money market accounts. We intend to hold substantial cash balances during hurricane season to meet seasonal liquidity needs and the collateral requirements of Osprey Re Ltd, our captive reinsurance company described below. We also had $13.1 million in restricted cash to meet our contractual obligations related to the Catastrophe bonds issued by Citrus Re. We will continue to hold the cash balances in early 2016 to fund the $120 million Zephyr acquisition, which is expected to close during the first quarter of 2016 and pay reinsurance payables of $60 million due in January and April of 2016.
Osprey Re Ltd is required to maintain a collateral trust account equal to the risk that it assumes from Heritage P&C, less amounts collateralized through a letter of credit. As of December 31, 2015, $25 million was held in Osprey’s trust account and $10 million was collateralized with a letter of credit. At December 31, 2015, Osprey Re Ltd’s total reinsurance coverage provided to Heritage P&C was $35 million.
Net cash provided by financing activities for the year ended December 31, 2014 was $101.3 million, as compared to $8.9 million for the year ended December 31, 2015. On May 29, 2014 we completed our IPO, which along with the concurrent private placement, raised $78.6 million. In addition, and in connection with the IPO, $22.5 million was raised from the exercise of warrants from existing stockholders.
We report a deferred tax asset arising from the portion (20%) of unearned premiums that are otherwise recognized as taxable income in advance of being earned for financial reporting purposes. Accordingly, our income taxes currently paid and payable also reflect this temporary difference between taxable income and earned income reported in our financial statements. The increases in our deferred tax asset from December 31, 2014 through December 31, 2015 reflect the significant unearned premiums arising from our assumption transactions and the additional resulting temporary differences due to certain amounts being taxable in advance of being recognized as earned for financial reporting purposes.
Reserves for Unpaid Losses and Loss Adjustment Expenses. Reserves for unpaid losses and loss adjustment expenses, also referred to as loss reserves, represent the most significant accounting estimate inherent in the preparation of our financial statements. These reserves represent management’s best estimate of the amount we will ultimately pay for losses and loss adjustment expenses and we base the amount upon the application of various actuarial reserve estimation techniques as well as considering other material facts and circumstances known at the balance sheet date.
When we establish our reserves, we analyze various factors such as the evolving historical loss experience of the insurance industry as well as our experience, claims frequency and severity, our business mix, our claims processing procedures, legislative enactments, judicial decisions and legal developments in imposition of damages, and general economic conditions, including inflation. A change in any of these factors from the assumptions implicit in our estimates will cause our ultimate loss experience to be better or worse than indicated by our reserves, and the difference could be material. Due to the interaction of the foregoing factors, there is no precise method for evaluating the impact of any one specific factor in isolation, and an element of judgment is ultimately required. Due to the uncertain nature of any future projections, the ultimate amount we will pay for losses will be different from the reserves we record.
We determine our ultimate loss reserves by selecting a point estimate within a relevant range of indications that we calculate using generally accepted actuarial techniques. Our selection of the point estimate is influenced by the analysis of our paid losses and incurred losses since inception, as well as industry information relevant to the population of exposures drawn from Citizens. At our current level of experience, industry information strongly influences the basis for estimates of claims related factors. We expect that our loss experience will be of growing significance in future periods.
Policy Acquisition Costs. We incur policy acquisition costs that vary with, and are directly related to, the production of new business. Policy acquisition costs consist of the following four items: (i) commissions paid to outside agents at the time of policy issuance, (ii) policy administration fees paid to a third-party administrator at the time of policy issuance, (iii) premium taxes and (iv) inspection fees. We capitalize policy acquisition costs to the extent recoverable, then we amortize those costs over the contract period of the related policy.
We estimate uncollectible amounts receivable from reinsurers based on an assessment of factors including the creditworthiness of the reinsurers and the adequacy of collateral obtained, where applicable. We recorded no uncollectible amounts under our reinsurance program or bad debt expense related to reinsurance for the years ended December 31, 2015 and December 31, 2014.
Subsequent to our acquisition of available-for-sale securities, we record changes in value through the date of disposition as unrealized holding gains and losses, net of tax effects, and include them as a component of other comprehensive income. We include realized gains and losses, which we calculate using the specific-identification method for determining the cost of securities sold, in net income. We amortize any premium or discount on investments over the remaining maturity period of the related investments using the effective interest method, and we report the amortization in net investment income. We recognize dividends and interest income when earned.
A large portion of our investment portfolio consists of fixed maturity securities, which may be adversely affected by changes in interest rates as a result of governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control. A rise in interest rates would decrease the net unrealized holding gains of our investment portfolio, offset by our ability to earn higher rates of return on funds reinvested. Conversely, a decline in interest rates would increase the net unrealized holding gains of our investment portfolio, offset by lower rates of return on funds reinvested.
We estimate the fair value of our investments using the closing prices on the last business day of the reporting period, obtained from active markets. For securities for which quoted prices in active markets are unavailable, we use observable inputs such as quoted prices in inactive markets, quoted prices in active markets for similar instruments, benchmark interest rates, broker quotes and other relevant inputs. We do not have any investments in our portfolio which require us to use unobservable inputs. Our estimates of fair value reflect the interest rate environment that existed as of the close of business on December 31, 2015 and December 31, 2014. Changes in interest rates subsequent to December 31, 2015 may affect the fair value of our investments.
The carrying amounts for the following financial instruments approximate their fair values at December 31, 2015 and December 31, 2014 because of their short-term nature: cash and cash equivalents, accrued investment income, premiums receivable, reinsurance payable, and accounts payable and accrued expenses.
installments over a range of one to five year periods following the date of grant for employee options. If a participant’s employment relationship ends, the participant’s vested awards will remain exercisable for the shorter of a period of 30 days or the period ending on the latest date on which such award could have been exercisable. The fair value of each option grant is separately estimated for each grant date. The fair value of each option is amortized into compensation expense on a straight-line basis between the grant date for the award and each vesting date. The Company estimates the fair value of all stock option awards as of the date of the grant by applying the Black-Scholes-Merton multiple-option pricing valuation model. The application of this valuation model involves assumptions that are judgmental and highly sensitive in the determination of compensation expense. We recorded $2.6 million, $3.3 million and $5.7 million of stock-based compensation in 2015, 2014 and 2013, respectively.
In May 2014, the FASB issued ASU Topic 2014-09, Revenue from Contracts with Customers (Topic 606). The ASU creates a new topic, Topic 606, to provide guidance on revenue recognition for entities that enter into contracts with customers to transfer goods or services or enter into contracts for the transfer of nonfinancial assets. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Additional disclosures are required to provide quantitative and qualitative information regarding the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The new guidance is effective for annual reporting periods, and interim reporting periods within those annual periods, beginning after December 15, 2017. Early adoption is not permitted. The Company is evaluating the impact of the new guidance on its consolidated financial statements.
In September 2015, the FASB issued ASU Topic 2015-16, Business Combinations (Topic 805): Simplifying the Accounting for Measurement-Period Adjustments, which allows an entity to recognize adjustments to provisional amounts that in a business combination in the reporting period in which the adjustment amounts are determined. ASU Topic No. 2015-16 is effective for our fiscal year 2017. We do not expect the adoption of this standard to have a material impact on our financial statements.
In January 2016, the FASB issued ASU Topic 2016-1, Financial Statements - Overall (Topic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, which requires equity investments to be measured at fair value with changes in fair value recognized in income; use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements; present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk; and eliminates the requirement disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet. ASU 2016-01 is effective for annual periods beginning after December 15, 2017, including interim periods within those annual periods, with early adoption permitted for certain requirements. We are assessing the impact of adopting this new accounting standard on our consolidated financial statements and related disclosures.
Consolidated Statements of Changes in Stockholders’ Equity for the Years Ended December 31, 2015, 2014 and 2013
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heritage Insurance Holdings, Inc. and subsidiaries as of December 31, 2015 and 2014, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2015 in conformity with accounting principles generally accepted in the United States of America.
The Company’s primary products are personal and commercial residential insurance, which the Company currently offers only in Florida under authorization from the Florida Office of Insurance Regulation (“FLOIR”). The Company conducts its operations under one business segment.
On May 22, 2014, the Company’s registration statement on Form S-1 was declared effective, pursuant to which it sold 6,900,000 shares of common stock to the public at a price of $11.00 per share, including 900,000 shares sold pursuant to the underwriters’ over-allotment option (the “IPO”). Concurrent with the IPO, the Company completed a private placement (the “Private Placement”) with Ananke Ltd, an affiliate of Nephila Capital Ltd, to purchase $10 million of the Company’s common stock at a price per share equal to the IPO price. The Company’s total net proceeds from the IPO and the Private Placement were $78.6 million, after deducting underwriting discounts and other costs.
The Company’s cash and cash equivalents include demand deposits with financial institutions and short-term, highly-liquid instruments with original maturities of three months or less when purchased. The carrying amounts reported in the consolidated balance sheets for interest bearing deposits approximate their fair value because of the short maturity of these investments.
A large portion of the Company’s investment portfolio consists of fixed maturity securities, which may be adversely affected by changes in interest rates as a result of governmental monetary policies, domestic and international economic and political conditions and other factors beyond its control. A rise in interest rates would decrease the net unrealized holding gains of our investment portfolio, offset by the Company’s ability to earn higher rates of return on funds reinvested. Conversely, a decline in interest rates would increase the net unrealized holding gains of our investment portfolio, offset by lower rates of return on funds reinvested.
Level 3-Certain inputs are unobservable (supported by little or no market activity) and significant to the fair value measurement. Unobservable inputs reflect the Company’s best estimate of what hypothetical market participants would use to determine a transaction price for the asset or liability at the reporting date based on the best information available in the circumstances.
The Company incurs policy acquisition costs that vary with, and are directly related to, the production of new business. Policy acquisition costs consist of the following four items: (i) commissions paid to outside agents at the time of policy issuance; (ii) policy
administration fees paid to a third-party administrator at the time of policy issuance; (iii) premium taxes; and (iv) inspection fees. The Company capitalizes policy acquisition costs to the extent recoverable, then the Company amortizes those costs over the contract period of the related policy.
Goodwill is subject to evaluation for impairment using a fair value based test. This evaluation is performed annually, during the fourth quarter or more frequently if facts and circumstances warrant. The Company uses a qualitative approach to test goodwill for impairment by first assessing qualitative factors to determine whether it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. The Company applied this qualitative approach to its insurance operations reporting unit. If required following the qualitative assessment, the first step in the goodwill impairment test involves comparing the fair value of each of its reporting units to the carrying value of those reporting units. If the carrying value of a reporting unit exceeds the fair value of the reporting unit, the Company is required to proceed to the second step. In the second step, the fair value of the reporting unit would be allocated to the assets (including unrecognized intangibles) and liabilities of the reporting unit, with any residual representing the implied fair value of goodwill. An impairment loss would be recognized if, and to the extent that, the carrying value of goodwill exceeded the implied value. The Company reviews amortizable intangible assets for impairment whenever events or circumstances indicate that carrying amounts may not be recoverable. If the Company concludes that impairment exists, the carrying amount is reduced to fair value.
Other revenue represents rental income due under non-cancelable leases for space at the Company’s commercial property in Clearwater, Florida that we acquired in April 2013, and all policy and pay-plan fees. Florida law allows insurers to charge policyholders a $25 policy fee on each policy written; these fees are not subject to refund, and the Company recognizes the income immediately when collected. The Company also charges pay-plan fees to policyholders that pay its premiums in more than one installment and record the fees as income when collected. In addition, the Company records revenue earned from its restoration subsidiary for non-insurance construction as services performed.
Our Board of Directors determined in 2013 that a bonus pool was appropriate based on an 8.5% of earnings before interest, taxes, depreciation and amortization. For the year ended December 31, 2015 the Board of Directors approved approximately $14.1 million in bonuses to be paid to officers and employees and for the years ended December 31, 2014 and 2013, the Board of Directors approved approximately $7.2 million and an aggregate of $11.5 million paid in cash and equity, respectively.
The Company records any income tax penalties and income-tax-related interest as income tax expense in the period incurred. The Company did not incur any material tax penalties or income-tax-related interest for the years ended December 31, 2015, 2014, and 2013, respectively.
The Company reports both basic earnings per share and diluted earnings per share. To calculate basic earnings per share, the Company divides net income attributable to common shareholders by the weighted-average number of shares outstanding during the period, including vested and unvested restricted shares. The Company calculates diluted earnings per share by dividing net income attributable to common shareholders by the weighted-average number of shares, and the effect of share equivalents, and vested and unvested restricted shares outstanding during the period using the treasury stock method to calculate common stock equivalents.
The Company calculates the gain or loss realized on the sale of investments by comparing the sales price (fair value) to the cost or adjusted/amortized cost of the security sold. The Company determines the cost or adjusted/ amortized cost of the security sold using the specific-identification method. The following tables detail the Company’s realized gains (losses) by major investment category as of December 31, 2015 and 2014, respectively:
The table below summarizes the Company’s fixed maturities at December 31, 2015 by contractual maturity periods. Actual results may differ as issuers may have the right to call or prepay obligations, with or without penalties, prior to the contractual maturity of those obligations.
The following table summarizes the Company’s net investment income by major investment category for the years ended December 31, 2015 and 2014, and 2013 respectively:
We believe the carrying amounts of our cash and cash equivalents, accounts receivable, accounts payable, accrued expenses and other current liabilities approximate their fair values at December 31, 2015 and December 31, 2014, due to the immediate or short term maturity of these instruments.
Assets and liabilities that are measured at fair value on a non-recurring basis include intangible assets and goodwill which are recognized at fair value during the period in which an acquisition is completed, from updated estimates and assumptions during the measurement period, or when they are considered to be impaired. These non-recurring fair value measurements, primarily for intangible assets acquired, were based on Level 3 unobservable inputs. During 2015 these non-recurring fair values inputs consisted of customer relations, non-compete, brand name and goodwill. In the event of an impairment, we determine the fair value of the goodwill and intangible assets using a combination of a discounted cash flow approach and market approaches, which contain significant unobservable inputs and therefore is considered a Level 3 fair value measurement. The unobservable inputs in the analysis generally include future cash flow projections and a discount rate.
There were no non-recurring fair value adjustments to intangible assets and goodwill during 2015, 2014 and 2013 except for certain fair value measurements to reassign goodwill to the initial fair value estimates of the assets acquired assumed at the acquisition date from updated estimates and assumptions completed during the measurement period. The measurement period may be up to one year from the acquisition date. We record any measurement period adjustments to the fair value of assets acquired and liabilities assumed, with the corresponding offset to goodwill.
Depreciation expense for the years ended December 31, 2015, 2014 and 2013 was $1.3 million, $0.8 million, $0.2 million, respectively. The Company’s real estate consists of 13 acres of land, two buildings with a gross area of 148,000 square feet and a parking garage. The Company relocated to these facilities during March 2014. These facilities and the related existing tenant lease agreements were acquired in April 2013 for a total purchase price of $9.8 million paid in cash.
The Company currently leases space to non-affiliates and occupies space in one of the buildings.
On July 31, 2015, the Company acquired BRC Restoration Specialists, Inc., a Florida based provider of restoration services and emergency and recovery assistance for a purchase price in aggregate of $8 million in cash and common stock. The Company issued 79,850 shares of its common stock to BRC at a fair value of $2.0 million as part of the purchase price and paid in cash $6.0 million. For the purchase price allocation the Company utilized a third party to calculate the valuation. The excess of the cost of the BRC acquisition over the net of amounts assigned to the fair value of the assets acquired is recorded as goodwill. Based on the fair valuation, the purchase price is allocated as follows:
The Company anticipates that its DPAC costs will be fully recoverable in the near term. The table below depicts the activity with regard to DPAC for the years ended December 31, 2015 and 2014:
During April 2014, Heritage P&C entered into two catastrophe reinsurance agreements with Citrus Re Ltd, a newly-formed Bermuda special purpose insurer. The agreements provide for three years of coverage from catastrophe losses caused by certain named storms, including hurricanes, beginning on June 1, 2014. The limit of coverage of $200 million is fully collateralized by a reinsurance trust account for the benefit of Heritage P&C. Heritage P&C pays a periodic premium to Citrus Re Ltd during this three-year risk period. Citrus Re Ltd issued $200 million of principal-at-risk variable notes due April 2017 to fund the reinsurance trust account and its obligations to Heritage P&C under the reinsurance agreements. The maturity date of the notes may be extended up to two additional years to satisfy claims for catastrophic events occurring during the three-year term of the reinsurance agreements. The Company has determined that, while Citrus Re Ltd is a variable interest entity, the Company does not have any variable interests in Citrus Re Ltd Accordingly, consolidation of or disclosures associated with Citrus Re Ltd are not applicable.
During the second quarter of 2014, the Company placed its reinsurance program for the period from June 1, 2014 through May 31, 2015. The Company’s reinsurance program, which is segmented into layers of coverage, protects it for excess property catastrophe losses and loss adjustment expenses. The Company’s current reinsurance program incorporates the mandatory coverage required by law to be placed with FHCF. The Company also purchased private reinsurance below, alongside and above the FHCF layer, as well as aggregate reinsurance coverage. The following describes the various layers of the Company’s June 1, 2014 to May 31, 2015 reinsurance program.
Layers Below FHCF. Immediately above the Company’s retention, the Company purchased $185 million of reinsurance from third party reinsurers. Through the payment of a reinstatement premium, the Company was able to reinstate the full amount of this reinsurance one time. To the extent that $185 million or a portion thereof was exhausted in a first catastrophic event, the Company purchased reinstatement premium protection insurance to pay the required premium necessary for the reinstatement of this coverage. A portion of this coverage wraps around the FHCF and provides coverage alongside the FHCF.
Aggregate Coverage. In addition to the layers described above, the Company purchased $105 million of aggregate reinsurance coverage for losses and loss adjustment expenses in excess of $825.0 million for a first catastrophic event. To the extent that this coverage was not fully exhausted in the first catastrophic event, it provided coverage commencing at its reduced retention levels for second and subsequent events and where underlying coverage had been previously exhausted. There was no reinstatement of the aggregate reinsurance coverage once exhausted, but it does provide coverage for multiple events. Osprey Re Ltd provides $20 million of protection in the layer above $940 million.
During the second quarter of 2015, the Company placed its reinsurance program for the period from June 1, 2015 through May 31, 2016. The Company’s reinsurance program, which is segmented into layers of coverage, protects it for excess property catastrophe losses and loss adjustment expenses. The Company’s 2015-2016 reinsurance program incorporates the mandatory coverage required by law to be placed with FHCF. For the 2015 hurricane season, the Company selected 75% participation in the FHCF. The Company also purchased private reinsurance below, alongside and above the FHCF layer, as well as aggregate reinsurance coverage. The following describes the various layers of the Company’s June 1, 2015 to May 31, 2016 reinsurance program.
Layers Below FHCF. Immediately above the Company’s retention, the Company has purchased $440 million of reinsurance from third party reinsurers. Through the payment of a reinstatement premium, the Company is able to reinstate the full amount of this reinsurance one time. To the extent that $440 million or a portion thereof is exhausted in a first catastrophic event, the Company has purchased reinstatement premium protection insurance to pay the required premium necessary for the reinstatement of this coverage. A portion of this coverage wraps around the FHCF and provides coverage alongside and above the FHCF.
For a first catastrophic event, our reinsurance program provides coverage for $1.8 billion of losses and loss adjustment expenses, including our retention, and we are responsible for all losses and loss adjustment expenses in excess of such amount. For subsequent catastrophic events, our total available coverage depends on the magnitude of the first event, as we may have coverage remaining from layers that were not previously fully exhausted. We have also purchased reinstatement premium protection insurance to provide an additional $440.0 million of coverage. Our aggregate reinsurance layer also provides coverage for second and subsequent events to the extent not exhausted in prior events. In total, we have purchased $2.3 billion of potential reinsurance coverage, including our retention, for multiple catastrophic events. Our ability to access this coverage, however, will be subject to the severity and frequency of such events. As of August 31, 2015, the peak of the hurricane season, our total insured value was $76.9 billion, and we may experience significant losses and loss adjustment expenses in excess of our retention. The chart below provides a graphic illustration of the structure and operations of our 2015-2016 catastrophe reinsurance program.
The Company also purchased property per risk coverage for losses and loss adjustment expenses in excess of $1 million per claim. The limit recovered for an individual loss is $9 million and total limit for all losses is $27 million. There are two reinstatements available with additional premium due based on the amount of the layer exhausted. In addition, the Company purchased facultative reinsurance in excess of $10 million for any commercial properties it insured that the total insured value exceeded $10 million.
The following table depicts written premiums, earned premiums and losses, showing the effects that the Company’s assumption transactions have on these components of the Company’s consolidated statements of income and comprehensive income:
The statute of limitations related to our federal and state income tax returns remains open from our first filings for 2012 through 2014. No taxing authorities are currently examining any of our federal or state income tax returns.
The reinsurance affiliate, which is based in Bermuda, made an irrevocable election under section 953(d) of the U.S. Internal Revenue Code of 1986, as amended, to be treated as a domestic insurance company for U.S. Federal income tax purposes. As a result of this election, our reinsurance subsidiary is subject to United States income tax as if it were a U.S. corporation.
As of December 31, 2015, the Company had no uncertain tax positions or unrecognized tax benefits that, if recognized, would impact the effective income tax rate.
The Company’s insurance subsidiary, Heritage P&C, files with the insurance regulatory authorities an “Annual Statement”. For the years ended December 31, 2015 and 2014, the Company’s insurance subsidiary recorded statutory net income of $45.4 million and $9.8 million, respectively. The Company’s insurance subsidiary is domiciled in Florida, and the laws of that state require that the Company’s insurance subsidiary maintain capital and surplus equal to the greater of $15 million or 10% of its liabilities. The Company’s statutory capital surplus was $216.6 million and $172.7 million at December 31, 2015 and 2014, respectively. State law also requires the Company’s insurance subsidiary to adhere to prescribed premium-to-capital surplus ratios, with which the subsidiary is in compliance.
Authorized Control Level-If RBC is between 70%-100%, this is the first point that the regulator may take control of the insurer even if the insurer is still technically solvent and is in addition to all the remedies available at the higher action levels.
At December 31, 2014, the ratio of adjusted capital to authorized control level risk based capital was 368%.
authorizing our commencement of operations precludes us from paying dividends without the prior approval of FLOIR until July 31, 2017.
The Company reported its insurance subsidiary’s assets, liabilities and results of operations in accordance with GAAP, which varies from statutory accounting principles prescribed or permitted by state laws and regulations, as well as by general industry practices. The following items are principal differences between statutory accounting and GAAP:
The Company’s reinsurance subsidiary, Osprey Re Ltd (“Osprey”), which was incorporated on April 23, 2013, is licensed as a Class 3a Insurer under The Bermuda Insurance Act 1978 and related regulations. Osprey is required to maintain statutory capital and surplus of at least $1.0 million and maintain liquid resources or have access to liquid resources equal to its maximum obligation for which it is responsible under the terms of any reinsurance arrangement to which it is a party. In May 2013, the Company contributed $1.7 million in cash to Osprey. Osprey secures its reinsurance obligations to our insurance subsidiary with an irrevocable letter of credit in the amount of $10 million. These resources, in addition to premiums ceded to it by our insurance subsidiary are sufficient to comply with regulatory requirements as of December 31, 2015. Bermuda’s standard for financial statement reporting is U.S. GAAP.
The Company is involved in claims-related legal actions arising in the ordinary course of business. The Company accrues amounts resulting from claims-related legal actions in unpaid losses and loss adjustment expenses during the period that it determines an unfavorable outcome becomes probable and it can estimate the amounts. Management makes revisions to its estimates based on its analysis of subsequent information that the Company receives regarding various factors, including: (i) per claim information; (ii) company and industry historical loss experience; (iii) judicial decisions and legal developments in the awarding of damages; and
(iv) trends in general economic conditions, including the effects of inflation. When determinable, the Company discloses the range of possible losses in excess of those accrued and for reasonably possible losses.
At December 31, 2015 and 2014, other liabilities included approximately $4.9 million and $21.1 million related to amounts owed to Citizens for policies assumed by the Company, where the policyholder subsequently opted-out of the assumption program.
The Company leased the space that it had occupied through March 2014 at 700 Central Avenue, Ste. 500 St. Petersburg, Florida from a real estate management company controlled by a stockholder. The Company leased the space without obligation to continue doing so in the future. For the years ended December 31, 2015, 2014 and 2013 the Company incurred rent expense of approximately $0, $70,000 and $488,000 respectively.
The Company has entered into an agreement with a real estate management company controlled by one of its directors to manage its Clearwater office space. Management services are provided at a fixed fee, plus ordinary and necessary out of pocket expenses. As of December 31, 2015 and 2014, the Company has made payments of $113,400 and $93,000 under this agreement, respectively. Fees for additional services, such as the oversight of construction activity, are provided for on an as needed basis.
The Company entered into an agreement for the construction of a parking facility for its Clearwater property with a relative of one of its directors. As of December 31, 2014, the Company has made payments of approximately $2.6 million for engineering, construction and architectural services. The project was completed during September 2014.
The Company provides for its employees’ healthcare benefits. During the third quarter of 2015 the Company changed the healthcare plan from a fully insured plan to a partially self-insured plan. For the years ended December 31, 2015 and 2014, the Company incurred medical premium costs in aggregate of $1.4 million and $646,900, respectively. The Company also recorded approximately $238,000 as unpaid claims as of December 31, 2015. A stop loss reinsurance policy caps the maximum loss that could be incurred by the Company under the self-insured Plan. The Company’s stop loss coverage per employee is $60,000 for which any excess cost would be covered by the reinsurer. There is an aggregate limit for losses in excess of $1.5 million which would provide up to $1.0 million of coverage. Any excess of the $1.5 million retention and the $1 million of aggregate coverage would be borne by the Company. The aggregate stop loss commences once our expenses exceeds 125% of the annual aggregate expected claims.
Holders of common stock are entitled to one vote for each share held on all matters subject to a vote of stockholders, subject to the rights of holders of any outstanding preferred stock. Accordingly, holders of a majority of the shares of common stock entitled to vote in any election of directors may elect all of the directors standing for election, subject to the rights of holders of any outstanding preferred stock. Holders of common stock will be entitled to receive ratably any dividends that the board of directors may declare out of funds legally available therefor, subject to any preferential dividend rights of outstanding preferred stock. Upon the Company’s liquidation, dissolution or winding up, the holders of common stock will be entitled to receive ratably its net assets available after the payment of all debts and other liabilities and subject to the prior rights of holders of any outstanding preferred stock. Holders of common stock have no preemptive, subscription, redemption or conversion rights. There are no redemption or sinking fund provisions applicable to the common stock. All outstanding shares of the Company’s capital stock (excluding restricted stock) are fully paid and nonassessable.
In May 2015, the Company issued 30,600 shares of common stock upon the exercise of 30,600 warrants for gross proceeds of $180,000 or an exercise price of $5.88 per share of common stock.
In July and August 2015, the Company issued an aggregate of 210,000 shares of common stock upon the exercise of 60,000 and 150,000 stock options, which were granted at an exercise price of $14.02 and $16.89 per share and received proceeds of $841,195 and $2,533,485, respectively.
In August 2015, in connection with the acquisition of BRC Restoration Specialists, Inc., (“BRC”) the Company issued 79,850 shares of common stock with a fair value of approximately $2,000,000.
In November and December 2015, the Company issued an aggregate of 156,000 shares of common stock upon the exercise of 120,000 and 36,000 stock options, which were granted at an exercise price of $16.89 and $14.02 per share and received proceeds of $2,026,800 and $504,720, respectively.
On September 24, 2014, the Company granted options to purchase 359,000 shares to certain employees and directors. No stock options were granted in 2013. These options were awarded with the strike price set at the fair market value at the grant date, and vested on March 15, 2015 with an expiration date of September 24, 2017. The fair value of each option grant, which was $2.70 per option granted in 2014, was estimated on the date of grant using the Black-Scholes option-pricing model.
The following table provides the assumptions utilized in the Black-Scholes model for options granted during the year ended December 31, 2014. No options were granted during the years ended December 31, 2015 and 2013.
A summary of information related to stock options outstanding at December 31, 2015 is as follows:
The Company has recognized $1.9 million and $3.3 million of compensation expense during the years ended December 31, 2015 and 2014 relative to the stock options granted above.
The Company has also granted shares of its common stock subject to certain restrictions under the Plan. Restricted stock awards granted to employees vest in equal installments generally over a five year period from the grant date subject to the recipient’s continued employment. The fair value of restricted stock awards are estimated by the market price at the date of grant and amortized on a straight-line basis to expense over the period of vesting. Recipients of restricted stock awards have the right to receive dividends. No restricted stock was granted during the years ended December 31, 2014 and 2013. Restricted stock activity during the year ended December 31, 2015 is as follows:
Awards are being amortized to expense over the five year vesting period.
The following table summarizes information about deferred tax benefits recognized and tax benefits realized to restricted stock awards and related paid dividends, and the fair value of vested restricted stock for the year ended December 31, 2015 and 2014, respectively.
Heritage Insurance Holdings, Inc. (the “parent company”) has no long term debt obligations, guarantees or material contingencies as of December 31, 2015, 2014 and 2013. The following summarizes the major categories of the parent company’s financial statements (in thousands, except share and per share data):
The Company received authorization to write business in South Carolina in January 2016 and began writing business in North Carolina in January 2016. The Company has also submitted applications Massachusetts, Mississippi, Georgia and Alabama.
On March 1, 2016, the Company’s Board of Directors declared a $0.05 per share quarterly cash dividends payable on April 5, 2016, to stockholders of record on March 15, 2016.