The following tables set forth our selected historical consolidated financial information for the periods ended and as of the dates indicated. These selected historical consolidated results are not necessarily indicative of results to be expected in any future period. You should read the following selected consolidated financial information together with the other information contained in this report, including the section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes included elsewhere in this report.
The income statement data for the years ended December 31, 2014, 2013 and 2012 and the balance sheet data as of December 31, 2014 and 2013 are derived from our audited financial statements included elsewhere in this report. The income statement data for the years ended December 31, 2011 and 2010 and the balance sheet data as of December 31, 2012, 2011 and 2010 are derived from our audited financial statements that are not included in this report.
As a result of the Company’s conversion to a C Corporation, the deferred tax asset increased by approximately $14.5 million primarily due to the effects of eliminating deferred tax balances on the insurance subsidiaries related to intercompany transactions. This excludes the tax effect related to contract modification expense as discussed in note (8) below.
During the periods presented, we made special compensation payments to our co-founders and principal executive officers, Lonnie Ledbetter and Terry Ledbetter, in recognition of their service to our Company. We refer to these payments as “founder special compensation.” Following the completion of the private placement, we ceased paying founder special compensation.
Adjusted net income is considered a non-GAAP financial measure because it reflects the following adjustments to net income, which is the most directly comparable measure calculated in accordance with GAAP: the pro forma provision for income taxes as if the Company had been treated as a C Corporation for each period presented, and the exclusion (net of tax benefit) of the increase in the Company’s deferred tax asset as a result of the conversion to C Corporation status, the amount of founder special compensation and the non-recurring, infrequent or unusual offering-related expenses and contract modification expense related to the amendment to our alliance agreement with CUNA Mutual. Management believes this measure is helpful to investors because it provides comparability in evaluating core financial performance between periods. Management uses adjusted net income to evaluate core financial performance against historical results without the effect of these items.
Our reinsurance recoverables are based on estimates, and our actual liabilities may exceed the amount that we are able to recover from our reinsurers or any collateral securing the liabilities. This could occur because the loss experience based on the policy terms is higher than expected or due to litigation, regulatory or other extra-contractual liabilities. SNIC, NSIC, and USIC remain liable for unearned premiums and unpaid losses and loss
adjustment expenses with respect to reinsurance ceded should the reinsurer be unable to meet its obligations. Management considers the possibility of a reinsurer becoming unable to meet its obligations as remote due to the reinsurers’ financial stability, A.M. Best Company rating, size, security funds available, and other factors as appropriate.
We are a leading specialty provider of property and casualty insurance operating in two niche markets across the United States. In our Program Services segment, we leverage our “A” (Excellent) A.M. Best rating, expansive licenses and reputation to provide access to the U.S. property and casualty insurance market in exchange for a ceding fee. In our Lender Services segment, we specialize in providing collateral protection insurance, or CPI, which insures personal automobiles and other vehicles held as collateral for loans made by credit unions, banks and specialty finance companies.
Our Program Services segment generates significant fee income, in the form of ceding fees, by offering issuing carrier capacity to both specialty general agents and other producers (“GAs”), who sell, control, and administer books of insurance business that are supported by third parties that assume reinsurance risk. These reinsurers are domestic and foreign insurers and institutional risk investors (“capacity providers”) that want to access specific lines of U.S. property and casualty insurance business. Issuing carrier (“fronting”) arrangements refer to our business in which we write insurance on behalf of a capacity provider and then reinsure the risk under these policies with the capacity provider in exchange for ceding fees. We reinsure substantially all of the underwriting and operating risks in connection with our fronting arrangements to our capacity providers. As such, this segment generates very large gross premium with little net premium (except for the run-off of the retained business as described below). In many cases, we hold significant collateral to secure the associated reinsurance recoverables. Furthermore, since the funds related to settling balances (premiums, commissions and losses) between the GAs and the reinsurers do not flow through the Company, no receivables or payables are reflected in the Company’s financial statements for these amounts. In exchange for providing our insurance capacity, licensing and rating to our GA and insurer clients, we receive ceding fees averaging in excess of 5% of gross written premiums.
Our Lender Services segment generates premium primarily from providing collateral protection insurance, or CPI, to our credit union, bank and specialty finance companies. Lenders purchase CPI to provide coverage for automobiles or other vehicles of borrowers who do not uphold their obligation to insure the collateral underlying the loan. Our lender clients pay us directly for CPI and then add the cost of CPI to the borrower’s loan. Our CPI business is fully vertically integrated: we manage all aspects of the CPI business cycle, including sales and marketing, policy issuance, policy administration, underwriting and claims handling.
On July 15, 2014, we filed a resale registration statement with the Securities and Exchange Commission in order to satisfy our obligations under a registration rights agreement we entered into in connection with the private placement for the benefit of the holders of the shares sold in the private placement. The resale registration statement was declared effective on October 30, 2014, and our common stock began trading on the Nasdaq Global Select Market on November 3, 2014.
Subchapter S Corporation Status. Prior to the completion of the private placement, we elected for our parent company to be taxed for federal income tax purposes as a “Subchapter S corporation” under the Internal Revenue Code and our subsidiaries (other than our insurance subsidiaries and intermediate holding company) to be pass-through entities for federal income tax purposes. As a result, prior to the completion of the private placement, the income for our parent company and pass-through subsidiaries was not subject to, and we did not pay, U.S. federal income taxes, and no provision or liability for federal or state income tax for our parent company and pass-through subsidiaries has been included in our consolidated financial statements. The tax provision, assets and liabilities that are reflected in our consolidated financial statements for periods prior to the completion of the private placement represent those for our insurance subsidiaries, SNIC, NSIC, and USIC, and their intermediate holding company, State National Intermediate Holdings, Inc. (“SNIH”), as those entities were “C” Corporations. Despite the Subchapter S corporation status, the impact of taxes on our parent company are included in the financial statements in that our shareholders were provided with the cash to pay the taxes that passed through to the shareholders. Prior to the completion of the private placement, we made periodic cash distributions to our shareholders that have included amounts necessary for them to pay their estimated personal U.S. federal income tax liabilities relating to the items of our income, gain, deductions and losses that pass through to them. Upon the completion of the private placement, our parent company’s status as a Subchapter S corporation terminated and our parent company became a “C” Corporation for U.S. tax purposes and became subject to a combined federal and state corporate income tax rate between approximately 35% and 38%. We invest a portion of our investment portfolio in tax-exempt municipal securities, which investment may have the effect of lowering our effective tax rate.
Founder Special Compensation. Prior to the completion of the private placement, we paid special compensation to our co-founders and principal executive officers, Lonnie Ledbetter and Terry Ledbetter, in recognition of their service to our Company. We refer to these payments as “founder special compensation.” Founder special compensation payments were discretionary and determined by the Company’s owners in the first or second quarter of the year in which they were made, based on current period considerations including capital position, estimated capital needs and liquidity, and earnings for the prior year. We paid founder special compensation in the aggregate amount of $17.9 million, $10.2 million and $10.7 million for the years ended December 31, 2014, 2013 and 2012, respectively. Following the completion of the private placement in June 2014, we ceased paying founder special compensation.
Commissions. Commission expenses are primarily related to our Lender Services segment. A significant portion of these amounts are paid to financial institutions as a means to reimburse the financial institution for costs associated with operating a CPI program. These commissions are partially offset by a 21% ceding commissions received under our quota reinsurance agreement with CUNA Mutual and the reimbursement we received from CUNA Mutual for 30% of the direct commission expense. This quota share reimbursement rate changed to 30% from 50% for business written on or after July 1, 2014. The ceding commission compensates us for expenses, such as underwriting and policy acquisition expenses, that we incur in connection with the writing of the ceded business.
management and employees in connection with the private placement, recognized on a pro rata basis over the vesting period. Upon completion of the private placement, the Company made grants of non-qualified stock options to our executive officers to purchase an aggregate of 2,783,873 shares of our common stock. In addition to the grants of non-qualified stock options, the Company made grants of 12,000 shares of restricted stock to our non-employee directors and 38,500 shares of stock to our employees. The non-qualified stock options and restricted stock grants are classified as equity based awards and will be recognized on a straight-line basis over the vesting period of 3 years and 1 year, respectively. The stock grants made to employees were expensed at their fair value and had no vesting or performance requirements.
For a reconciliation of these non-GAAP financial measures, see “Management’s Discussion and Analysis of Financial Condition and Results of Operation-Results of Operations-Consolidated Results of Operations.”
Net loss ratio. The net loss ratio is a measure of the underwriting profitability of our Lender Services segment. Expressed as a percentage, this is the ratio of net loss and LAE incurred to net premiums earned. For the years ended December 31, 2014, 2013 and 2012, our net loss ratio was 42.0%, 37.3% and 33.9%, respectively.
Minimum ceding fees earned are based on estimates of annual premiums to be written for those programs that are subject to a minimum premium levels and related ceding fees. These estimates are based upon various assumptions made regarding the production plans for the underlying program. These assumptions are continually reviewed by management and the amount of annual premiums expected to be written are re-estimated each quarter. As actual premiums emerge and revisions are made to earlier estimates, minimum ceding fees are earned or reversed and are reflected in current operations.
During the periods presented, we made special compensation payments to our co-founders and principal executive officers, Lonnie Ledbetter and Terry Ledbetter in recognition of their service to our Company. We refer to these as “founder special compensation.” Following the completion of the private placement, we ceased paying founder special compensation.
Upon the completion of the private placement, our parent company’s status as a Subchapter S corporation terminated and our consolidated income became fully subject to U.S. federal income taxes. This adjustment represents estimated income taxes as if the Company had been treated as a C Corporation for each period presented. The estimated tax was calculated assuming the Company’s blended statutory federal and state income tax rates of 37.5% for the year ended December 31, 2014 and 38.1% for the year ended December 31, 2013, respectively.
Consolidated Results of Operations for the Year Ended December 31, 2014 compared to the Year Ended December 31, 2013
Other income. Other income increased by $1.9 million, or 76.2%, from $2.5 million for the year ended December 31, 2013 to $4.4 million for the year ended December 31, 2014. This increase consists primarily of an early termination fee related to an operating lease. In November 2013, the Company received an early termination notice from an unaffiliated third party relating to the operating lease between the parties. The early termination notice was in compliance with the terms of the lease. The Company recognized $1.5 million in lease termination fees in 2014 due to the early termination of the lease. The lease was considered an operating lease through the early termination date of November 30, 2014. In
addition, we recognized a gain of $0.6 million for the year ended December 31, 2014 related to the auction and repurchase of one of the Company’s subordinated debentures. The Company repurchased a $7.5 million subordinated debenture for $6.8 million. This transaction resulted in a $0.6 million gain after deducting the unamortized portion of the initial issuance costs from the difference in the par value and the purchase price.
Commissions. Commissions increased by $1.5 million or 63.2%, from $2.4 million for the year ended December 31, 2013 to $3.9 million for the year ended December 31, 2014, primarily due to the increase in Lender Services premiums earned and a reduction to ceding commissions related to the amendment to the CUNA Mutual alliance.
General and administrative expense. General and administrative expense increased by $5.5 million or 10.2%, from $53.4 million for the year ended December 31, 2013 to $58.9 million for the year ended December 31, 2014, primarily due to an increase in direct personnel costs, including stock-based compensation expense incurred in 2014. The Company did not have stock-based compensation expense in 2013.
Deferred tax expense (benefit). Deferred tax benefit increased by $19.1 million for the year ended December 31, 2014 compared to the year ended December 31, 2013 primarily due to the recognition of a deferred tax benefit of $20.4 million resulting from the conversion of the Company’s tax status to a C Corporation.
Premiums earned. Premiums earned increased by $6.3 million, or 8.0%, from $78.1 million for the year ended December 31, 2012 to $84.4 million for the year ended December 31, 2013. This increase is primarily due to the growth in the loan portfolio of existing Lender Services accounts as a result of rising automobile sales, higher average auto loan sizes and increasing credit availability. This was partially offset by the Program Services segment, which recorded a $2.1
Net investment income. Net investment income decreased by $0.6 million, or 11.3%, from $5.5 million for the year ended December 31, 2012 to $4.9 million for the year ended December 31, 2013. This is primarily due to an overall decrease in bond yields.
Program Services Segment Results of Operations for the Year Ended December 31, 2014 compared to the Year Ended December 31, 2013
Program Services Segment Results of Operations for the Year Ended December 31, 2013 compared to the Year Ended December 31, 2012
Premiums earned. Premiums earned decreased by $2.1 million, from $1.6 million for the year ended December 31, 2012 to negative $0.5 million for the year ended December 31, 2013. This decrease resulted from reinsuring 100% of the risk to inception on the one remaining active retained program in 2013.
begun to generate a significant amount of gross premiums earned. Gross written premium increased from $530.6 million for the year ended December 31, 2012 to $691.1 million for the year ended December 31, 2013.
Commission income. Commission income decreased by $0.5 million, or 24.5%, from $2.0 million for the year ended December 31, 2013 to $1.5 million for the year ended December 31, 2014 primarily due to a cancellation of an ancillary line program.
Losses and loss adjustment expenses. Losses and LAE increased by $9.0 million, or 28.4%, from $31.6 million for the year ended December 31, 2013 to $40.6 million for the year ended December 31, 2014, which is partly the result of higher premiums earned. A strengthening economy, an aging automobile fleet, and easier access to credit have contributed to an increase in vehicle sales, resulting in higher loan balances which are the bases upon which we pay claims. The net loss ratio increased from 37.3% to 42.0% for the years ended December 31, 2013 and December 31, 2014, respectively. This increase is also due to an increase in claims volume and severity.
Commissions. Commissions increased by $1.9 million or 95.1%, from $2.0 million for the year ended December 31, 2013 to $3.9 million for the year ended December 31, 2014, primarily due to an increase in Lender Services premiums earned and a reduction to ceding commissions related to the amendment to the CUNA Mutual alliance.
Premiums earned. Premiums earned increased by $8.4 million, or 11.0%, from $76.5 million for the year ended December 31, 2012 to $84.9 million for the year ended December 31, 2013. This increase is primarily due to the growth in the loan portfolio of existing accounts as a result of rising automobile sales, higher average auto loan sizes and increasing credit availability.
Loss and loss adjustment expenses. Loss and LAE increased by $5.7 million, or 22.0% from $25.9 million for the year ended December 31, 2012 to $31.6 million for the year ended December 31, 2013 partly due to the increased premium as discussed above. A strengthening economy, an aging automobile fleet, and easier access to credit have contributed to an increase in vehicle sales, resulting in higher loan balances which are the bases upon which we pay claims. The net loss ratio increased from 33.9% for the year ended December 31, 2012 to 37.3% for the year ended December 31, 2013. The variance is partly attributable to an increase in claims volume as the number of loans insured rises as credit becomes more readily available. The variance is also due to an increase in claims severity.
Taxes, licenses and fees. Taxes, licenses and fees increased by $0.2 million, or 9.4%, from $2.4 million for the year ended December 31, 2012 to $2.6 million for the year ended December 31, 2013 which is directly related to the higher premium in 2013.
Corporate Segment Results of Operations for the Year Ended December 31, 2014 compared to the Year Ended December 31, 2013
Realized net investment gains. Realized net investment gains decreased by $0.5 million, or 25.7% from $1.8 million for the year ended December 31, 2013 to $1.3 million for the year ended December 31, 2014 primarily due to lower gains in 2014 on sales of bonds, primarily industrial and miscellaneous Bonds.
Founder special compensation. Founder special compensation increased by $7.7 million or 75.6% from $10.2 million for the year ended December 31, 2013 compared to $17.9 million for the year ended December 31, 2014. The increase in discretionary founder special compensation was primarily due to the favorable capital position and liquidity during the period as well as our expected liquidity needs prior to the completion of the private placement in 2014. This favorable position was partly due to the increased earnings achieved for 2013 as compared to 2012. The assessment was made by the Company’s owners in the first and second quarters and was considered along with the capital needs for the coming periods.
Income tax (benefit) expense. Income taxes decreased by $12.5 million from $2.8 million expense for the year ended December 31, 2013 to $9.7 million benefit for the year ended December 31, 2014 from the conversion of the Company’s tax status to a C Corporation.
Investment income. Investment income decreased by $0.6 million, or 11.3%, from $5.5 million for the year ended December 31, 2012 to $4.9 million for the year ended December 31, 2013. This is primarily due to an overall decrease in bond yields.
Income tax (benefit) expense. Income taxes decreased by $1.9 million, or 40.1% from $4.7 million for the year ended December 31, 2012 to $2.8 million for the year ended December 31, 2013 primarily due to the filing amended returns related to a change in the apportionment method for Texas franchise tax.
We are required to maintain deposits in various states where the insurance subsidiaries are licensed to operate. These deposits are fixed maturity securities at fair values totaling $36.9 million and $28.8 million at December 31, 2014 and December 31, 2013, respectively.
Fair value of financial instruments. ASC 820, “Fair Value Measurements and Disclosures”, provides a definition of fair value, establishes a framework for measuring fair value, and requires expanded disclosures about fair value measurements. The standard applies when GAAP requires or allows assets or liabilities to be measured at fair value; therefore, it does not expand the use of fair value in any new circumstance. Investments measured at fair value on a recurring basis at December 31, 2014 and December 31, 2013 are all considered level 2 investments.
The following table is a summary of our consolidated statements of cash flows:
Net cash provided by operating activities was approximately $33.9 million for the year ended December 31, 2013, compared with $27.1 million provided by operating activities for the same period in 2012. The increase of $6.8 million is directly related to the increase in net income for 2013 compared to 2012.
Allowance for policy cancellations. Allowance for policy cancellations increased by $15.9 million in 2014 due primarily to higher gross CPI premiums written in 2014 and the amendment to the CUNA Mutual alliance on July 1, 2014. On a quarterly basis, we review our estimates for allowance for policy cancellations to determine whether further adjustments are required. Any resulting adjustments are included in the current period’s operating results. The allowance for policy cancellations for the year ended December 31, 2014 and December 31, 2013 included upward revisions to prior year estimates of $4.2 million and $2.8 million, respectively. Because of the interplay between the allowance for policy cancellations and the related unearned premium reserve, changes in the allowance for policy cancellations are partially offset by related changes in the unearned premium reserve and amounts ceded to reinsurers. After taking into account the associated changes in unearned premium and amounts ceded to reinsurers, the net negative impact to the balance sheet and the corresponding reduction in net income from the revised estimates for the year ended December 31, 2014 and 2013 was approximately $2.2 million and $1.6 million, respectively.
All of the debentures mature between 2032 and 2034. We currently have the option to call any or all of the debentures at par plus unpaid interest accrued, if any. The interest rate on the $17.5 million of the subordinated debentures issued in December 2002 is equal to the 3-month LIBOR plus 4.00%; the interest rate on the $12.0 million of the subordinated debentures issued in December 2003 is equal to the 3-month LIBOR plus 4.10%; and the interest rate on the $15 million of the subordinated debentures issued in May 2004 is equal to the 3-month LIBOR plus 3.80%. Interest is set and payable quarterly. The three-month LIBOR at December 31, 2014, was 0.26%.
On October 8, 2014, we repurchased one of our subordinated debentures with a carrying value of $7.5 million for $6.8 million and recorded a gain of $0.6 million after deducting the unamortized portion of the initial issuance costs from the difference in the par value and the purchase price. The debentures were issued on May 15, 2003 and accrued interest at LIBOR plus 4.10%. This repurchase reduced the Company’s outstanding subordinated debentures to $44.5 million.
The loss and LAE payments due by period in the table above are based upon the loss and LAE estimates as of December 31, 2014 and actuarial estimates of expected payout patterns and are not contractual liabilities with finite maturities. Our contractual liability is to provide benefits under the policy. As a result, our calculation of loss and LAE payments due by period is subject to the same uncertainties associated with determining the level of loss and LAE generally and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. For a discussion of our loss and LAE estimation process, see “Business-Loss Reserves” in Item 1 of this report. Actual payments of loss and LAE by period will vary, perhaps materially, from the table above to the extent that current estimates of loss and LAE vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns. See “Risk Factors-Risks Relating to Our Business-If we are unable to establish and maintain accurate loss reserves, our business, financial condition, results of operations and prospects may be materially and adversely affected.” for a discussion of the uncertainties associated with estimating loss and LAE in Item 1A of this report.