(1) Series A preferred unit distributions were redeemed in September 2010.
(3) All years have been adjusted to reflect the disposal of our manufactured home community properties and related business, except for NLASCO.
Unless the context otherwise indicates, all references in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, or MD&A, to the “Company,”“Hilltop,” “HTH,” “we,” “us,” “our” or “ours” or similar words are to Hilltop Holdings Inc.(formerly known as Affordable Residential Communities Inc.) and its direct and indirect wholly-owned subsidiaries.
At December 31, 2010, HTH is a holding company that owns all of the outstanding shares of NLASCO, Inc., or NLASCO. NLASCO, in turn, owns National Lloyds Insurance Company, or NLIC, and American Summit Insurance Company, or ASIC, both of which are licensed property and casualty insurers operating in multiple states. In addition, NLASCO also owns the NALICO GA, a general agency that operates in Texas. NLIC commenced business in 1949 and currently operates in 15 states, with its largest market being the state of Texas. NLIC carries a financial strength rating of “A” (Excellent) by A.M. Best. ASIC was formed in 1955 and currently operates in 12 states, its largest market being the state of Arizona. ASIC carries a financial strength rating of “A” (Excellent) by A.M. Best. Both of these companies are regulated by the Texas Department of Insurance.
On March 11, 2010, Gerald J. Ford submitted his resignation as President and Chief Executive Officer to the Board of Directors to the Company. Gerald J. Ford, however, will remain Chairman of the Board of the Company. As a result of this resignation, the Board of Directors appointed Jeremy B. Ford as the President and Chief Executive Officer of the Company, as well as director of the Company.
On October 27, 2010, NLASCO renewed its line of credit with a financial institution. The line allows for borrowings by NLASCO up to $5.0 million and is secured by substantially all of NLASCO’s assets. The line of credit bears interest equal to a base rate, plus 3.75% (5.01% at December 31, 2010), which is due quarterly. This line of credit will expire in October 2011. As of December 31, 2010, there was no outstanding balance on the note.
Our results for 2010 include the $5.9 million liquidation preference on the redemption of preferred stock, which occurred on September 6, 2010.
Paid and Reported Bornhuetter-Ferguson Methods. The Bornhuetter-Ferguson, or BF, Method is a procedure that weights an expected ultimate loss and LAE amount, and the result of the loss development method. This method is useful when loss data is immature or sparse because it is not as sensitive as the loss development method to unusual variations in the paid or reported amounts. The BF method requires an initial estimate of expected ultimate losses and LAE. For each year, the expected ultimate losses and LAE is based on a review of the ultimate loss ratios indicated in the companies’ historical data and applicable insurance industry ultimate loss ratios. Each loss development factor, paid or reported, implies a certain percent of the ultimate losses and LAE is still unpaid or unreported. The amounts of unpaid or unreported losses and LAE by year are estimated as the percentage unpaid or unreported, times the expected ultimate loss and LAE amounts. To project ultimate losses and LAE, the actual paid or reported losses and LAE to date are added to the estimated unpaid or unreported amounts.
The combination of the methodologies described above is used for all lines of business, regardless of whether the line is a short-tailed or long-tailed line of business, though specific parameter selections within the methods vary to reflect the nature of the underlying line of business. ASIC and NLIC specialize in writing fire and extended coverage for low-value dwellings, mobile homes and homeowners, which generally are considered short-tailed coverages. In addition, ASIC and NLIC write a small amount of commercial risks, which are still predominantly property coverages, along with some low-limit liability coverages.
The estimated unpaid losses and LAE equal the estimated ultimate loss and LAE amounts, described above, less the cumulative paid amounts on known claims for each year. This estimate of unpaid losses and LAE is further segmented into case reserves on known claims and incurred-but-not-reported, or IBNR, reserves. IBNR reserves are calculated by reducing the estimate of unpaid losses and LAE by the case reserve amounts. In the normal course of operations, each case reserve is initially set at a standard amount determined from past payments for that type of loss. Individual case reserves may be adjusted based on information indicating that the loss amount is actually over, or under, the standard amount. Most case reserves are not adjusted until the receipt of documentation concerning the amount to be paid on the loss. This usually occurs within seven days of the reporting of the claim, longer in the case of large scale catastrophic events.
In arriving at our best estimate of the unpaid losses and LAE, and based on management discussion with our actuaries, we would consider reasonably likely changes in the key assumptions, such as the underlying loss development pattern or the expected loss ratio, to have an impact on our best estimate by +/- 10%. As of December 31, 2010, this equates to approximately +/- $1.5 million, which represents approximately 0.2% of equity and 11.2% of calendar year 2010 losses.
The following table presents our gross loss and LAE reserve amounts at December 31, 2010 and 2009 for each of NLIC and ASIC by line of business (dollars in thousands):
Investment Securities. At December 31, 2010, investment securities consist of U.S. Government, mortgage-backed, corporate debt and equity securities. We classify our fixed maturities in one of three categories: trading, available-for-sale or held-to-maturity. Our equity securities are classified as trading or available-for-sale. Trading securities are bought and held principally for the purpose of selling them in the near term. Held-to-maturity debt securities are those securities in which we have the ability, and intent, to hold the security until maturity. All securities not included in trading or held-to-maturity are classified as available-for-sale.
Income Taxes. We have been in a taxable loss position since our inception and, as a result, we have substantial net operating loss carry-forwards to offset taxable income and capital gains from the sale of discontinued operations. We have established a tax provision beginning on January 1, 2006.
ASC 740, specifically 740-10-25, Recognition, clarifies the accounting for uncertainty in income taxes recognized in financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC 740 requires that we determine whether the benefits of our tax positions are more likely than not of being sustained upon audit based on the technical merits of the tax position. For tax positions that are more likely than not of being sustained upon audit, we recognize the largest amount of the benefit that is more likely than not of being sustained in our consolidated financial statements. For tax positions that are not more likely than not of being sustained upon audit, we do not recognize any portion of the benefits in our consolidated financial statements.
Deferred tax assets, including net operating loss and tax credit carry forwards, are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that any portion of these tax attributes will not be realized. As a result of the allocation of the purchase price for the real estate assets we sold in 2007 by the purchaser, we reallocated $34.1 million of gain recognized to those assets in the quarter ended September 30, 2008, the period in which the purchase price allocation was finalized. This reallocation resulted in a deferred tax benefit of $4.6 million as of December 31, 2008. There is no valuation allowance as of December 31, 2010.
Goodwill and Other Indefinite Lived Intangible Assets. Goodwill for HTH represents the excess of the cost over the fair value of the assets of NLASCO. Goodwill is tested annually for impairment and is tested more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value.
The goodwill impairment analysis is a two-step test. The first step (Step #1), used to identify potential impairment involves comparing each reporting unit’s estimated fair value to its carrying value, including goodwill. If the estimated fair value of a reporting unit exceeds its carrying value, goodwill is considered not to be impaired. If the carrying value exceeds estimated fair value, there is an indication of potential impairment and the second step is performed to measure the amount of impairment. The Company has estimated fair values of reporting units based on a market approach using historic, normalized actual and forecast results. Management determined that HTH has two reporting units, which are the Parent (the holding company) and NLASCO (the insurance company).
At December 31, 2010, we determined that the estimated fair value of our reporting units exceeded their carrying values and, therefore, we did not perform the second step as described above. Consequently, we determined that no impairment existed with respect to goodwill and intangible assets at December 31, 2010.
Results of insurance operations. The following table shows the underwriting gain or loss, as well as other revenue and expense items included in the financial results of NLASCO for the year ended December 31, 2010 and 2009 (in thousands). NLASCO’s underwriting gain or loss consists of net premiums earned, less loss and LAE and policy acquisition and other underwriting expenses. NLASCO’s underwriting performance is one of the most important factors in evaluating the overall results of operations given the fluctuations that can occur in loss and LAE due to weather related events, as well as the uncertainties involved in the process of estimating reserves for losses and LAE. The underwriting results and fluctuations in other revenue and expense items of NLASCO are discussed in greater detail below.
Revenue. Revenue for the year ended December 31, 2010 was $131.7 million, compared to $128.8 million for the year ended 2009. This increase is due to net premiums earned of $117.2 for the year ended 2010, compared to $115.2 million for the year ended 2009, $7.7 million of net investment income for the year ended 2010 compared to $6.5 million for the year ended 2009, $6.7 million of other income for the year ended 2010 compared to $6.9 million in 2009 and $0.1 million in net realized investment gains for the year ended 2010 as compared to $0.3 million for the year ended 2009.
Net premiums earned are up $2.0 million for the year ended 2010 as compared to the year ended 2009 due to higher net written premiums offset by greater change in net unearned premiums. Net investment income increased $1.2 million for the year ended 2010 as compared to the year ended 2009 due to higher yields on the cash held at the parent (HTH).
For the twelve months ended December 30, 2010 and 2009, the Company had incurred losses related to two 2008 catastrophes, Hurricane Ike and Hurricane Dolly. Gross losses incurred from these storms were $26.0 million for the year ended December 31, 2010, compared to $24.3 million for the same period in 2009. The losses in the year ended December 31, 2010 relate primarily to lawsuits filed in response to the pending expiration of the statute of limitations. These losses have no effect on net loss and LAE incurred because the catastrophic events exceeded our retention and are fully recoverable. The primary financial effect is additional reinstatement premium payable to the affected reinsurers. For the year ended December 31, 2010 and 2009, the Company incurred reinstatement premiums of $2.5 million and $1.0 million, respectively.
Direct premiums written by major product line for the year ended December 31, 2010 and 2009 are presented in the table below (in thousands):
Net premiums written by major product line for the year ended December 31, 2010 and 2009 are presented in the table below (in thousands):
Total net premiums written increased for the year ended December 31, 2010 for all lines of business, except fire and other, due to higher direct written premiums of $8.0 million, offset in part by an increase in ceded premiums of $1.2 million. Ceded premiums increased as a result of higher reinstatement premiums of $1.5 million in 2010 as compared to 2009.
Net premiums earned by major product line for the year ended December 31, 2010 and 2009 are presented in the table below (in thousands):
General and Administrative Expense. General and administrative expense for 2010 was $7.4 million, as compared to $7.1 million for 2009, an increase of $0.3 million, or 3.9%. This increase is primarily due to an increase in professional fees of $0.9 million, offset by decreases in salaries and benefits and management fees. The increase in professional fees is due to an increase in acquisition costs related to due diligence costs in 2010.
Depreciation and Amortization Expense. Depreciation and amortization expense was $1.8 million for the year ended December 31, 2010, as compared to $2.0 million in 2009.
Interest Expense. Interest expense was $9.0 million for 2010, as compared to $9.7 million for 2009, a decrease of $0.7 million, or 7.2%. The decrease in interest expense is due to a decrease in the payable to the prior owner for redundant reserves as a result of a payment in February 2010.
Net Loss Attributable to Common Stockholders. As a result of the foregoing, our net loss attributable to common stockholders was $13.5 million for 2010, as compared to $12.4 million for 2009, an increase of $1.1 million. The majority of this difference is due higher loss and LAE of $0.6 million, higher policy acquisition and other underwriting expenses of $1.0 million and loss on redemption of preferred stock of $5.9 million, offset by higher revenues of $2.9 million and lower preferred stock dividend of $3.3 million.
Underwriting Results. The following table shows the components of NLASCO’s underwriting gain for the year ended December 31, 2009 and 2008. NLASCO’s underwriting gain or loss consists of net premiums earned, less loss and LAE and policy acquisition and other underwriting expenses. The underwriting results are discussed below (in thousands).
The industry aggregate for combined ratio for 2008, was 104.7%, which is slightly below the combined ratio for NLIC and ASIC of 105.4%, for the same period.
The Company seeks to operate at a combined ratio of 85.0%, excluding Property Claim Services (PCS) catastrophic events. If PCS identifies a catastrophic event and the Company’s losses exceed $250,000 for that event, then management will internally identify the PCS event. Catastrophic events, including those that do not exceed our reinsurance retention, affect the Company’s loss ratios. For the twelve months ended December 31, 2009, catastrophic events that did not exceed our reinsurance retention accounted for $9.8 million of the total loss and loss adjustment expense, as compared to $12.0 million for the same period in 2008. Excluding catastrophic events, our combined ratios for the twelve months ended December 31, 2009 and 2008 would have been 88.2% and 95.0%, respectively.
For the twelve months ended December 31, 2009 and 2008, the Company had incurred losses related to two 2008 catastrophes, Hurricane Ike and Hurricane Dolly. Gross losses incurred from these storms were $24.3 million for the year ended December 31, 2009, compared to $70.0 million for the same period in 2008. These losses have no effect on net loss and LAE incurred because the catastrophic events exceeded our retention and are fully recoverable. The primary financial effect is additional reinstatement premium payable to the affected reinsurers. For the year ended December 31, 2009 and 2008, the Company incurred reinstatement premiums of $2.5 million and $8.2 million, respectively.
Total net premiums written increased for the year ended December 31, 2009, in the mobile home and commercial lines of business. Reinstatement premiums related to Hurricanes Dolly, Gustav and Ike of $8.2 million decreased net premiums written in 2008, partially offset by higher reinsurance costs and lower direct premiums in 2009.
The Company’s net loss and LAE and the gross loss and LAE ratios for the year ended December 31, 2009 and 2008 are shown in the tables below (in thousands, except claim count figures):
Policy Acquisition and Other Underwriting Expenses. Policy acquisition and other underwriting expenses for the year ended December 31, 2009 and 2008 were as follows (in thousands):
HTH is a holding company whose assets primarily consist of the stock of its subsidiaries and invested assets with a combined value of $940 million at December 31, 2010. HTH’s primary investment objectives, as a holding company, are to preserve capital and have available cash resources to utilize in making opportunistic acquisitions, and, if necessary or appropriate, from additional equity or debt financing sources.
In September 2010, the Company redeemed all of its outstanding shares of Series A preferred stock at a cash redemption price of $25.2063 per share, representing the liquidation preference of $25.00 per share, plus accrued and unpaid dividends to, and including, the date of redemption.
Our insurance operating subsidiary, NLASCO, has primary investment objectives to preserve capital and manage for a total rate of return in excess of a specified benchmark portfolio. NLASCO’s strategy is to purchase securities in sectors that represent the most attractive relative value. Bonds, cash and short-term investments constituted $188.2 million, or 95.5%, of NLASCO’s $197.0 million in investments at December 31, 2010. NLASCO had $8.8 million, or 4.5% of its investments, in equity investments as of December 31, 2010. We currently do not have any significant concentration in both direct and indirect guarantor exposure. NLASCO has no investments in subprime mortgages. NLASCO has custodial agreements with A.G. Edwards and Wells Fargo Bank and an investment management agreement with DTF Holdings, LLC.
Regulations of the Texas Department of Insurance require insurance companies to maintain minimum levels of statutory surplus to ensure their ability to meet their obligations to policyholders. At December 31, 2010, NLASCO’s insurance subsidiaries had statutory surplus in excess of the minimum required.
Cash used in financing activities was $133.8 million in 2010, as compared with $10.3 million in 2009. The increase in cash used in financing activities primarily was due to the redemption of preferred stock in 2010 of $125 million.
At December 31, 2010 the following table shows our outstanding commitments for leases (in thousands).
NLASCO’s loss reserves do not have contractual maturity dates. Based on historical payment patterns, however, the following table estimates when management expects the loss reserves to be paid. The timing of payments is subject to significant uncertainty. NLASCO maintains a portfolio of investments with varying maturities to provide adequate cash flows for the payment of claims.
The following table sets forth certain information with respect to our indebtedness outstanding as of December 31, 2010 and 2009 excluding indebtedness related to assets held for sale (in thousands):
In July 2010, the FASB issued ASU-2010-20 to amend Topic 310 to improve the disclosures that an entity provides about the credit quality of its financing receivables and the related allowance for credit losses. As a result of these amendments, an entity is required to disaggregate by portfolio segment or class certain existing disclosures and provide certain new disclosures about its financing receivables and related allowance for credit losses. The updated guidance is effective for periods ending after December 15, 2010. The adoption of this guidance is not expected to have a material impact on the Company’s financial statements.
In October 2010, the FASB issued ASU-2010-26 to address the diversity in practice for the accounting for costs associated with acquiring or renewing insurance contracts. This guidance modifies the definition of acquisition costs to specify that a cost must be directly related to the successful acquisition of a new or renewal insurance contract in order to be deferred. The updated guidance is effective for periods ending after December 15, 2011. The adoption of this guidance is not expected to have a material impact on the Company’s financial statements.
In December 2010, the FASB issued ASU-2010-29 to address diversity in practice about the interpretation of the pro forma revenue and earnings disclosure requirements for business combinations. The amendments in the update specify that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. The amendments also expand the supplemental pro forma disclosures to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The amendments in this update are effective