Our executive offices are located at 14050 N.W. 14th Street, Suite 180, Sunrise, Florida 33323 in an 18,554 square foot office facility. Our lease for this office space is scheduled to expire in December 2022. Refer to Note 9. Commitments and Contingencies, in the Notes to Consolidated Financial Statements set forth in Part II, Item 8. Financial Statements and Supplementary Data of this Annual Report, for further information regarding our leases.
(1) Prior years reflect revisions of our previously issued financial statements. Refer to Note 1. Organization, Consolidation and Basis of Presentation within the Revisions of Previously Issued Financial Statements section, in the Notes to Consolidated Financial Statements set forth in Part II, Item 8. Financial Statements and Supplementary Data of this Annual Report, for information regarding the adjustments.
Total revenue increased $84.1 million, or 27.4%, to $391.7 million for the year ended December 31, 2017, as compared to $307.5 million for the year ended December 31, 2016. The increase in revenue was due to higher gross earned premiums and lower ceded premiums as described below.
Commissions and other underwriting expenses increased $24.5 million, or 27.1%, to $114.9 million for the year ended December 31, 2017, as compared to $90.4 million for the year ended December 31, 2016. The increase was due primarily to a reduction in ceding commissions as a result of the termination of our 30% Florida-only property quota share treaty on July 1, 2016. The remaining increase is due to higher gross premiums earned in Homeowners, as discussed above.
General and administrative expenses increased $2.8 million, or 16.2%, to $20.0 million for the year ended December 31, 2017, as compared to $17.2 million for the year ended December 31, 2016. The increase in general and administrative expenses was primarily due to higher legal and professional fees, including audit, tax and actuarial fees.
Interest expense was unchanged at $0.3 million for the years ended December 31, 2017 and 2016. In late December 2017, the Company issued $45.0 million of senior notes. Refer to Note 7. Long-Term Debt, in the Notes to Consolidated Financial Statements set forth in Part II, Item 8. Financial Statements and Supplementary Data of this Annual Report, for further information regarding the senior notes. As a result, interest expense will increase substantially in 2018 to approximately $4.0 million, based on the level of three-month LIBOR as of December 31, 2017.
Income taxes increased $3.0 million, or 561.4%, to $3.6 million for the year ended December 31, 2017, as compared to $0.5 million for the year ended December 31, 2016. The increase in income taxes was primarily due to an increase in taxable income. The revaluation of our net deferred tax asset as during the fourth quarter of 2017 pursuant to Tax Act added $0.3 million of expense to our 2017 tax provision. Due to the decrease in the federal corporate tax rate from 35% to 21%, effective January 1, 2018, we expect our effective tax to decline approximately 14 points in 2018, which will benefit our earnings in the coming year. Refer to Note 8. Income Taxes, in the Notes to Consolidated Financial Statements set forth in Part II, Item 8. Financial Statements and Supplementary Data of this Annual Report, for additional information on federal income tax reform.
Operating Results Overview - Year Ended December 31, 2016 Compared to Year Ended December 31, 2015
Gross premiums written increased $111.7 million, or 22.6%, to $605.5 million for the year ended December 31, 2016, as compared to $493.8 million for the same period in 2015. The increase predominantly reflects market share growth in Homeowners and Automobile. Homeowners gross premiums written increased $63.0 million, or 14.0%, to $512.7 million for the year ended December 31, 2016, as compared to $449.8 million in 2015. Gross premiums written for Automobile increased by $47.6 million to $69.5 million in 2016, compared to $21.9 million in 2015. This increase is also reflected in the increase in our Homeowners in-force policy count to 279,109 as of December 31, 2016, as compared to 254,105 as of 2015. These increases reflected management’s strategy in 2016 to grow in Homeowners and Automobile by expanding operations outside of Florida. With the expansion into areas outside of Florida, we were able to continue to leverage our personnel and, at the same time, diversify our insurance risk.
Ceded premiums earned increased by $84.8 million, or 38.7%, to $304.1 million for the year ended December 31, 2016, as compared to $219.2 million in the same twelve-month period last year. This increase is driven by the additional excess-of-loss reinsurance costs recorded in 2016 as compared to 2015 related to Homeowners premium growth. Additionally, we recorded increased ceded premiums related to the premium growth in Automobile in 2016, which is generally ceded at 75% through various quota share agreements. These increases were offset by lower ceded premiums in 2016 as compared to 2015 due to the expiration of the 30% Florida-only property quota share treaty, which ended on July 1, 2016.
Net investment income increased $1.8 million, or 25.4%, to $9.1 million for the year ended December 31, 2016, as compared to $7.2 million for the year ended December 31, 2015. The improvement was mainly due to a year-over-year overall growth of our investment portfolio, specifically growth in the fixed income securities. Our debt securities investment yields, net, remained steady year over year at 2.3% for the years ended December 31, 2016 and 2015, respectively.
Losses and LAE increased $85.1 million, or 75.5%, to $197.8 million for the year ended December 31, 2016, as compared to $112.7 million for the year ended December 31, 2015.
The increase in losses and LAE is driven by $40.0 million of losses due to increased earned premiums in Homeowners and Automobile, $33.3 million incurred in catastrophe losses resulting from a series of tornadoes and severe weather events that impacted the state of Florida and South Carolina (i.e., Hurricane Matthew, Hurricane Hermine, Tropical Storm Colin), and $16.0 million of losses related to increasing the Company’s Florida homeowners attritional loss ratio throughout 2016. Additionally, losses and LAE were impacted by unfavorable development of $11.0 million for the 2015 accident year in our homeowners coverage in the state of Florida as a result of AOB and other related adjusting expenses. The factors listed above were partially offset by ceded losses pertaining to the Florida-only property quota-share treaties.
Commissions and other underwriting expenses increased $37.5 million, or 71.0%, to $90.4 million for the year ended December 31, 2016, as compared to $52.9 million for the year ended December 31, 2015. The increase is related to the premium growth in Homeowners and Automobile, with homeowners non-Florida and Automobile carrying higher acquisition costs as a result of the different distribution models we employ to market our insurance products.
General and administrative expenses increased $2.5 million, or 16.9%, to $17.2 million for the year ended December 31, 2016, as compared to $14.7 million for the year ended December 31, 2015. The increase primarily reflects expenses incurred of $1.9 million in connection with the resignation of our former Chief Financial Officer during 2016.
Income taxes decreased $23.5 million, or 97.8%, to $0.5 million for the year ended December 31, 2016, as compared to $24.1 million for the year ended December 31, 2015. The change was primarily due to a decrease in taxable income.
Historically, we have met our liquidity requirements primarily through cash generated from operations. In December 2017, we received proceeds of $25.0 million principal amount of Senior Unsecured Floating Rate Notes due 2027 (the “2027 Notes”), pursuant to an indenture dated as of December 28, 2017 (the “Indenture”), as supplemented by a supplemental indenture dated as of December 28, 2017. In December 2017, we also received proceeds of $20.0 million of Senior Unsecured Fixed Rate Notes due 2022 (the “2022 Notes”), pursuant to the Indenture, as supplemented by a supplemental indenture dated as of December 29, 2017. A portion of the proceeds from the 2027 Notes and 2022 Notes was used on February 28, 2018 to infuse capital into FNIC. Refer to Note 17. Subsequent Events, in the Notes to Consolidated Financial Statements set forth set forth in Part II, Item 8. Financial Statements and Supplementary Data of this Annual Report, for additional information regarding the capital infusion. The remaining proceeds are available to repurchase shares of our common stock, and for general corporate purposes, including managing the capital needs of our subsidiaries.
Among other things, the Indenture limits the Company's ability to incur additional debt without the approval of the existing noteholders. The supplemental indentures limit the Company's debt to equity ratio to 35%. The Company's actual debt to equity ratio at December 31, 2017 was approximately 22%.
As described more fully in Part I, Item 1. Business, Regulation of this Annual Report, our insurance operations are subject to the laws and regulations of the states in which we operate. The Florida OIR and their regulatory counterparts in other states utilize the NAIC RBC requirements, and the resulting RBC ratio, as a key metric in the exercise of their regulatory oversight. The RBC ratio is a measure of the sufficiency of an insurer’s statutory capital and surplus. In addition, the RBC ratio is used by insurance industry ratings services in the determination of the financial strength ratings (i.e. claims paying ability) they assign to insurance companies. At December 31, 2017, FNIC’s statutory surplus was $162.2 million and its RBC ratio was 301.9%.
Based upon the 2017 and 2016 statutory financial statements for FNIC and MNIC, statutory surplus exceeded the regulatory action levels established by the NAIC’s RBC requirements.
We believe that existing cash and investment balances, when combined with anticipated cash flows and the proceeds of our debt offering as described above, will be adequate to meet our expected liquidity needs in both the short-term and the reasonably foreseeable future. We believe the combined balances will be sufficient to meet our ongoing operating requirements and anticipated cash needs, and satisfy debt requirements. Future growth strategies may require additional external financing and we may from time to time seek to obtain external financing. We cannot assure that additional sources of financing will be available to us on favorable terms, or at all, or that any such financing would not negatively impact our results of operations. We expect to continue declaring and paying dividends at comparable levels, subject to our future liquidity needs and reserve requirements.
Subject to our compliance with capital requirements as described above, we may consider various opportunities to deploy our capital, including repurchases of our common stock if such repurchases represent a more favorable use of available capital.
Net cash provided by operating activities of $69.8 million for the year ended December 31, 2016, as compared to net cash provided by operating activities of $52.9 million for the year ended December 31, 2015. The change was primarily due to the decrease in the prepaid reinsurance premium account and increase loss and LAE reserves for the year ended December 31, 2016, partly offset by decreases in reinsurance recoverables, unearned premiums, and deferred acquisition costs, as compared to the prior year.
Net cash from financing activities was net cash provided by financing activities of $30.2 million for the year ended December 31, 2017, as compared to net cash used of $15.0 million for the year ended December 31, 2016. The change was due to the proceeds from borrowings of notes payable in December 2017 of $45.0 million for the year ended December 31, 2017, as compared to the absence of any proceeds from borrowing in the prior year. The change was slightly offset by the lower repurchases of our common stock of $10.6 million for the year ended December 31, 2017, as compared to the common stock repurchases of $11.3 million for the year ended December 31, 2016, and the lower amount of dividends paid of $4.3 million for the year ended December 31, 2017, as compared to $4.7 million paid during the prior year.
Net cash provided by financing activities was $21.6 million for the year ended December 31, 2016, as compared to net cash provided of $12.9 million for the year ended December 31, 2015. The change was primarily due to proceeds from non-controlling interest equity investment of $18.7 million and the issuance of debt in our consolidated VIE of $5.0 million during the year ended December 31, 2015. The change was also due to the common stock repurchases and dividends paid during the year ended December 31, 2016, as compared to the prior year.
Insurance premiums are established before we know the amount of loss and LAE and the extent to which inflation may affect such expenses. Consequently, we attempt to anticipate the future impact of inflation when establishing rate levels. While we attempt to charge adequate premiums, we may be limited in raising premium levels for competitive and regulatory reasons. Inflation may also affect the market value of our investment portfolio and the investment rate of return. Any future economic changes that result in prolonged and increasing levels of inflation could cause increases in the dollar amount of incurred loss and LAE and thereby materially adversely affect future liability requirements.
The table sets forth a summary of long-term contractual obligations as of December 31, 2017, and includes amounts that represent estimates of gross undiscounted amounts payable over time, as follows:
(3) One of the senior notes has a floating interest rate based on three-month LIBOR. These estimates reflect such rate as of December 31, 2017.
We prepare our consolidated financial statements in accordance with U.S. GAAP, which requires us to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results may materially differ from those estimates.
Held-to-maturity investments are recorded at the amortized cost, reflecting the ability and intent to hold the securities to maturity. All other securities were classified as available-for-sale and recorded at fair value. Unrealized gains and losses during the year, net of the related tax effect applicable to available-for-sale, are excluded from income and reflected in other comprehensive income, and the cumulative effect is reported as a separate component of shareholders’ equity until realized. If a decline in fair value is deemed to be other-than-temporary, the investment is written down to its fair value and the amount of the write-down is recorded as an OTTI loss on the statement of income. Any portion of such decline related to debt securities that is believed to arise from factors other than credit is recorded as a component of other comprehensive income rather than against income.
Our insurance companies provide coverage on both a claims-made and occurrence basis. Claims-made policies generally require that claims occur and be reported during the coverage period of the policy. Occurrence policies allow claims which occur during a policy’s coverage period to be reported after the coverage period, and as a result, these claims can have a very long claim tail, occasionally extending for decades. Casualty claims can have a very long claim tail, in certain situations extending for many years. In addition, casualty claims are more susceptible to litigation and the legal environment and can be significantly affected by changing contract interpretations, all of which contribute to extending the claim tail. For long-tail casualty lines of business, estimating the ultimate liabilities for unpaid loss and LAE is a more complex process and depends on a number of factors, including the line and volume of the business involved. For these reasons, our insurance companies will generally use actuarial projections in setting reserves for all casualty lines of business.
We believe that the reserves for unpaid loss and LAE established by our insurance companies are adequate as of December 31, 2017; however, additional reserves, which could have a material impact upon our financial condition, results of operations and cash flows, may be necessary in the future.
Expected Loss Ratio Method: Expected loss ratios are applied to premiums earned, based on historical company experience, or historical insurance industry results when company experience is deemed not to be sufficient; and
Loss frequency and severity are measures of loss activity that are considered in determining the key assumptions described above. Loss frequency is a measure of the number of claims per unit of insured exposure, and loss severity is a measure of the average size of claims. Factors affecting loss frequency include the effectiveness of loss controls and safety programs and changes in economic conditions or weather patterns. Factors affecting loss severity include changes in policy limits, retentions, rate of inflation and judicial interpretations. Another factor affecting estimates of loss frequency and severity is the loss reporting lag, which is the period of time between the occurrence of a loss and the date the loss is reported to our insurance companies. The length of the loss reporting lag affects their ability to accurately predict loss frequency (loss frequencies are more predictable for lines with short reporting lags), as well as the amount of reserves needed for IBNR. If the actual level of loss frequency and severity is higher or lower than expected, the ultimate losses will be different than management’s estimates.
Our insurance companies continually evaluate the potential for changes, both favorable and unfavorable, in their estimates of their loss and LAE liabilities and use the results of these evaluations to adjust both recorded liabilities and underwriting criteria. With respect to liabilities for unpaid loss and LAE established in prior years, these liabilities are periodically analyzed and their expected ultimate cost adjusted, where necessary, to reflect favorable or unfavorable development in loss experience and new information, including, for certain catastrophe events, revised industry estimates of the magnitude of a catastrophe. Adjustments to previously recorded liabilities for unpaid loss and LAE, both favorable and unfavorable, are reflected in our financial results in the periods in which these adjustments are made and are referred to as prior accident year reserve development. We adjusted our prior year loss and LAE reserve estimates based on current information that differed from previous assumptions made at the time such loss and LAE reserves were previously estimated.
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and operating loss, capital loss and tax-credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income or expense in the period that includes the enactment date. Such a change occurred in the fourth quarter of 2017. Refer to Note 8. Income Taxes, in the Notes to Consolidated Financial Statements set forth in Part II, Item 8. Financial Statements and Supplementary Data of this Annual Report, for additional information regarding our income taxes.
Refer to Note 2. Summary of Significant Accounting Policies - Recent Accounting Pronouncements, in the Notes to Consolidated Financial Statements set forth in Part II, Item 8. Financial Statements and Supplementary Data of this Annual Report, for a discussion of recent accounting pronouncements and their effect, if any, on our company.
We have audited the accompanying consolidated balance sheets of Federated National Holding Company and subsidiaries (the "Company") as of December 31, 2017 and 2016, the related consolidated statements of operations, comprehensive income (loss), changes in shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2017, and the related notes and the financial statement schedules listed in the index at Item 15 (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.
Federated National Insurance Company (“FNIC”), one of our wholly owned insurance subsidiaries, is licensed as an admitted carrier, to write specific lines of insurance by the state’s insurance departments, in Florida, Louisiana, Texas, Georgia, South Carolina and Alabama. Monarch National Insurance Company (“MNIC”), our other insurance subsidiary, is licensed as an admitted carrier in Florida. Admitted carriers are bound by rate and form regulations, and are strictly regulated to protect policyholders from a variety of illegal and unethical practices. Admitted carriers are also required to financially contribute to the state guarantee fund used to pay for losses if an insurance carrier becomes insolvent or unable to pay loss amounts due to their policyholders.
On November 27, 2017, the Company entered into a purchase and sale agreement with Crosswinds Investor and TransRe, whereby the Company agreed to purchase Crosswinds Investor’s 42.4% Class A membership interest and 50.0% voting interest for $12.3 million, and TransRe’s 15.2% non-voting membership interest in Monarch Delaware for $4.4 million.
Also pursuant to the purchase and sale agreement, Crosswinds AUM LLC (“Crosswinds AUM”), a subsidiary of Crosswinds Holdings, will continue to serve as a consultant to FNHC for a quarterly fee of $75,000 through December 31, 2018, and each of a subsidiary of Crosswinds Holdings and TransRe have a right of first refusal through December 31, 2018, to participate in FNIC’s catastrophe excess of loss reinsurance program, at market rates and terms, up to a placement of $10.0 million in reinsurance limit in the aggregate from Crosswinds Holdings and to a placement of $10.0 million in reinsurance limit in excess of its placement on FNIC’s current catastrophe excess of loss reinsurance program from TransRe.
The Company is a party to an insurance agency master agreement with Ivantage Select Agency, Inc. (“ISA”), an affiliate of Allstate Insurance Company (“Allstate”), pursuant to which the Company has been authorized by ISA to appoint Allstate agents to offer the Company’s homeowners and commercial general liability insurance products to consumers in Florida. As a percentage of the total homeowners premiums we underwrote, 23.8%, 24.1% and 25.4%, were from Allstate’s network of Florida agents, for the years ended December 31, 2017, 2016 and 2015, respectively.
The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States (“U.S. GAAP”). The consolidated financial statements include the accounts of FNHC and its wholly-owned subsidiaries and all entities in which the Company has a controlling financial interest and any variable interest entity (“VIE”) of which the Company is the primary beneficiary. The Company’s management believes the consolidated financial statements reflect all material adjustments, including normal recurring adjustments, necessary to fairly state the financial position, results of operations and cash flows of the Company for the periods presented. All significant intercompany accounts and transactions have been eliminated in consolidation.
The Company believes that these errors are not material to any of the Company’s previously-issued financial statements based on an analysis of quantitative and qualitative factors in accordance with the Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”) Nos. 99 and 108. However, correcting the errors in 2017 would be material to the Company’s consolidated financial statements for the year ended December 31, 2017. Accordingly, the Company has concluded that an amendment of previously-filed periodic reports is not required. Rather, the Company made revisions to the historical periods in the Company’s Annual Report for the fiscal year ended December 31, 2017, and to the historical periods that will be presented in the Company's prospective filings.
The nature and description of each of these adjustments is as follows:
Income statement reclassifications: As previously disclosed and reclassified in the Company’s Quarterly Report on Form 10-Q (“Quarterly Report”) for the period ended June 30, 2017, the Company re-assessed the income statement classification of ceded commission income and salaries and wages from our claims department. As a result, the Company adjusted ceded commission from other income to commissions and other underwriting expenses and salaries and wages from the Company’s claims department from commissions and other underwriting expenses to loss and LAE. Refer to the Company’s Quarterly Report for the period ended June 30, 2017, for more detailed information.
The following tables summarize the impact of the revisions to the Company’s previously reported consolidated balance sheet as of December 31, 2016, and the Company’s previously reported consolidated statements of operations for the years ended December 31, 2016 and 2015.
Similar to other property and casualty insurers, the Company’s liability for loss and LAE reserves, although supported by actuarial projections and other data, is ultimately based on management’s reasoned expectations of future events. Although considerable variability is inherent in these estimates, the Company believes that the liability and LAE reserve is adequate. The Company reviews and evaluates its estimates and assumptions regularly and makes adjustments, reflected in current operations, as necessary, on an on-going basis.
Refer to Note 4. Investments, in these notes to consolidated financial statements, for additional information regarding investments.
The Company recognizes premiums as revenue on a pro-rata basis over the term of the insurance policy. Assumed reinsurance premiums written and earned are based on reports received from ceding companies for pro-rata treaty contracts and are generally recorded as written based on contract terms for excess-of-loss and quota share contracts. Premiums are earned ratably over the terms of the related coverage.
Reinsurance is used to mitigate the exposure to losses, manage capacity and protect capital resources. Reinsuring loss exposures does not relieve a ceding entity from its obligations to policyholders and cedants. Reinsurance recoverables (including amounts related to claims incurred but not reported) and ceded unearned premiums are reported as assets. To minimize exposure to losses from a reinsurer’s inability to pay, the financial condition of such reinsurer is evaluated initially upon placement of the reinsurance and periodically thereafter. In addition to considering the financial condition of the reinsurer, the collectability of the reinsurance recoverables is evaluated (and where appropriate, whether an allowance for estimated uncollectible reinsurance recoverables is to be established) based upon a number of other factors. Such factors include the amounts outstanding, length of collection periods, disputes, any collateral or letters of credit held and other relevant factors. To the extent that an allowance for uncollectible reinsurance recoverable is established, amounts deemed to be uncollectible are written off against the allowance for estimated uncollectible reinsurance recoverables. As of December 31, 2017 and 2016, the Company did have any allowances for uncollectible reinsurance recoverables.
Ceded commissions reduce commissions, brokerage and other underwriting expenses and ceded losses incurred reduce net loss and LAE incurred over the applicable periods of the various reinsurance contracts with third party reinsurers. If premiums or commissions are subject to adjustment (for example, retrospectively-rated or experience-rated), the Company records adjustments to the premiums or ceding commission revenue in the period that changes in the estimated losses are determined.
The acquisition costs are deferred and amortized over the period in which the related premiums written are earned, generally twelve months for homeowners and commercial general liability policies and six months for automobile policies. It is grouped consistent with the manner in which the insurance contracts are acquired, serviced and measured for profitability and is reviewed for recoverability based on the profitability of the underlying insurance contracts. Investment income is anticipated in assessing the recoverability of deferred acquisition costs. The Company assesses the recoverability of deferred acquisition costs on an annual basis or more frequently if circumstances indicate impairment may have occurred.
The estimates of the liability for loss and LAE reserves are subject to the effect of trends in claims severity and frequency and are continually reviewed. As part of this process, the Company review historical data and consider various factors, including known and anticipated legal developments, inflation and economic conditions. As experience develops and other data become available, these estimates are revised, as required, resulting in increases or decreases to the existing liability for loss and LAE reserves. Adjustments are reflected in the results of operations in the period in which they are made and the liabilities may deviate substantially from prior estimates.
The Company incurs specific incremental costs, other than those paid to lenders, in connection with the issuance of the Company’s debt instruments. These deferred financing costs include loan origination costs, issue costs and other direct costs payable to third parties and are recorded as a direct deduction from the carrying value of the associated debt liability in the consolidated balance sheets, when the debt liability is recorded. The Company amortizes the deferred financing costs as interest expense over the term of the related debt using the effective interest method in the consolidated statements of operations.
The Company’s management makes assumptions, estimates and judgments, which are subject to change, in accounting for income taxes. The Company’s management also considers events and transactions on an on-going basis and the laws enacted as of the Company’s reporting date. The U.S. Tax Cuts and Jobs Act of 2017 (the “Tax Act”) was signed into law on December 22, 2017, and the effect of changes in federal tax law and applicable statutory rates is recorded in the consolidated financial statements in the period of enactment. The recent changes in the tax law have affected the Company’s income tax provision in the consolidated statement of operations for the year ended December 31, 2017 and the deferred income tax assets and liabilities balances in the consolidated balance sheet as of December 31, 2017. Refer to Note 8. Income Taxes, in these notes to consolidated financial statements, for further information regarding income taxes.
Basic net income per share is computed by dividing net income available to common shareholders by the weighted average number of common shares, while diluted net income per share is computed by dividing net income available to common shareholders by the weighted average number of such common shares and dilutive share equivalents result from the assumed exercise of employee stock options and vesting of restricted common stock and are calculated using the treasury stock method.
In January 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which addresses certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. Most notably, this new guidance requires equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. The effect of adopting this guidance was principally affected by the level of unrealized gains or losses associated with equity investments with readily determinable market values. Such unrealized gains or losses have been recognized upon adoption as a cumulative-effect adjustment with future unrealized gains or losses reflected in the statement of income and comprehensive income. ASU 2016-01 is effective for annual reporting periods beginning after December 15, 2017. The Company adopted the guidance effective January 1, 2018. The primary impact will be
based on the unrealized gains and losses on the Company’s equity securities, which will be recognized through net income instead of through other comprehensive income.
In February 2018, the FASB issued ASU 2018-03, Technical Corrections and Improvements to Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The update provides corrections and improvements and clarifies certain aspects of the guidance issued in ASU 2016-01. The update is effective for annual reporting periods beginning after December 15, 2017. The adoption of this guidance is not expected to have a material impact on the Company’s consolidated financial position or results of operations.
Level 2 - Quoted market prices for similar assets or liabilities and valuations, using models or other valuation techniques using observable market data. Significant other observable that can be corroborated by observable market data; and,
Obligations of States and Political Subdivisions: In determining the fair value for state and municipal securities, the Company uses the market approach utilizing primary valuation inputs including reported trades, dealer quotes for identical or similar assets in markets that are not active, benchmark yields, credit spreads, reference data and industry and economic events.
Expected maturities and contractual maturities may differ because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Gross unrealized losses and related fair values for debt and equity securities, grouped by duration of time in a continuous unrealized loss position, consisted of the following:
Investments, the majority of which were debt securities, with fair values of approximately $12.9 million and $7.9 million were deposited with governmental authorities and into custodial bank accounts as required by law or contractual obligations as of December 31, 2017 and 2016, respectively.
Additionally, our private market excess of loss treaties became effective June 1, 2016 and July 1, 2016, and all private layers, except the FHCF supplemental layer reinsurance contract, have prepaid automatic reinstatement protection, which afforded us with additional coverage against multiple catastrophic events in the same hurricane season. We obtained multiple year protection for a portion of its program; as a result, some of the coverage expired on June 30, 2017, and a portion of the coverage will remain in-force one additional treaty year until June 30, 2018. These private market excess of loss treaties structure coverage into layers, with a cascading feature such that substantially all private layers attach after $18.5 million in losses for FNIC’s Florida exposure. If the aggregate limit of the preceding layer is exhausted, the next layer drops down (cascades) in its place. Additionally, any unused layer protection drops down for subsequent events until exhausted.
MNIC’s 2016-2017 catastrophe reinsurance program, which ran from either June 1 to May 31 or June 1 to June 30 (13 month period), consisted of the FHCF and private market excess of loss treaties. All private layers had prepaid automatic reinstatement protection, which afforded MNIC additional coverage, and had a cascading feature such that substantially all layers attached at $3.4 million for MNIC’s Florida exposure.
FNIC’s private market excess of loss treaties, covering both Florida and non-Florida exposures, became effective June 1, 2017 and July 1, 2017. All private layers have prepaid automatic reinstatement protection, except the FHCF supplemental layer reinsurance contract, which affords FNIC additional coverage for subsequent events. The reinsurance program includes multiple year protection with $89.0 million of new multiple year protection this year and $156.0 million of renewing multiple year protection from last year. As in our 2016-2017 program, these private market excess of loss treaties structure coverage into layers, with a cascading feature such that substantially all layers attach after $25.1 million in losses for FNIC’s exposure. FNIC purchased an underlying limit of protection for $7.1 million excess of $18.0 million with prepaid automatic reinstatement protection. These treaties are with reinsurers that currently have an A.M. Best Company (“A.M. Best”) or Standard & Poor’s rating of “A-” or better, or have fully collateralized their maximum potential obligations in dedicated trusts.
FNIC’s non-Florida excess of loss reinsurance treaties affords us up to an additional $21.0 million of aggregate coverage with first event coverage totaling $5.0 million and second event coverage up to $16.0 million. The non-Florida retention is lowered to $13.0 million for the first event and $2.0 million for the second event (for hurricane losses only) on a gross basis, though the retention is reduced to $6.5 million and to $1.0 million on a net basis after taking into account the profit share agreement that FNIC has with our non-affiliated managing general underwriter that writes our non-Florida property business. FNIC’s non-Florida reinsurance program cost includes $1.7 million for this private reinsurance, including prepaid automatic premium reinstatement protection.
are accounted for as retrospectively rated contracts whereby the estimated ultimate premium or commission is recognized over the period of the contracts.
On July 1, 2017, FNIC bound a new 10% quota-share on its Florida homeowners book of business, which excludes named storms. This treaty is not subject to accounting as a retrospectively rated contract.
Our private passenger automobile quota share treaties are typically one year programs which become effective at different points in the year and cover automobile policies across several states. These automobile quota share treaties cede approximately 75% of all written premiums entered into by the Company, subject to certain limitations including but not limited to premium and other caps.
As of December 31, 2017, the Company has $88.0 million in reinsurance recoverables as a result of Hurricane Irma. Hurricane Irma made landfall in the United States as a Category 4 hurricane on September 10, 2017. Approximately 15% of the reinsurance recoverable at December 31, 2017, was concentrated in one reinsurer related to Hurricane Irma. This one reinsurer and all other reinsurers in our excess-of-loss reinsurance programs have an A.M. Best or Standard & Poor’s rating of “A-“ or better, or have fully collateralized their maximum potential obligations in dedicated trusts.
During the year ended December 31, 2017, the Company experienced $13.9 million of unfavorable loss and LAE reserve development on prior accident years primarily in its personal automobile and homeowners lines of businesses. The adverse development in personal automobile of approximately $8.0 million was driven primarily by adjustments to cession percentages in certain auto reinsurance treaties. Additionally, the adverse development in homeowners of approximately $8.0 million was primarily caused by the continued impact of assignment of benefits (“AOB”) and related ligation costs in 2015 and other accident years.
As previously disclosed, the Company entered into 30% and 10% retrospectively-rated Florida-only property quota share treaties, which ended on July 1, 2016 and 2017, respectively. These agreements included a profit share (experience account) provision, under which the Company will receive ceded premium adjustments at the end of the treaty to the extent there is a positive balance in the experience account. This experience account is based on paid losses rather than incurred losses. Due to the retrospectively-rated nature of this treaty, when the experience account is positives the Company cedes losses under these treaties as the claims are paid with an equal and offsetting adjustment to ceded premiums (in recognition of the related change to the experience account receivable),
with no impact on net income. Conversely, when the experience account is negative, the Company cedes losses on an incurred basis with no offsetting adjustment to ceded premiums, which impacts net income. Loss development can be either favorable or unfavorable regardless of whether the experience account is in a positive or negative position.
Beginning in 2017, for purposes of the total incurred loss, net of reinsurance line within this disclosure, the Company has classified paid losses related to these retrospectively rated quota share treaties which were ceded during the indicated year but relating to a prior accident year in a separate line. The related amounts in the previous year have been adjusted to conform to this presentation. Prior to 2017, these amounts were included in the current year incurred line item in the table above. Total amounts of incurred losses presented for 2016 and 2015 remain unchanged.
AOB is a legal construct that allows a third party to step into the shoes of the insured and is then paid directly by an insurance company for services rendered on behalf of the insured for a covered loss. Absent an AOB, the insured would pay the third party and those costs would be reimbursed by the insurance company to the insured. AOB is commonly used when a homeowner experiences a water loss, for example a leaky pipe, an overflow from a sink, or a damaged appliance, and contacts a contractor or water remediation company.
Accordingly, the challenge described above together with the change in the Company’s historical trend on AOB claims were the main drivers of the prior year development in 2016.
The following tables provide incurred losses and ALAE and cumulative paid losses and ALAE, net of reinsurance, for the prior 10 accident years, and the total of IBNR reserves plus expected development on reported claims and the cumulative number of reported claims (in thousands, except number of reported claims and severity), as of the most recent reporting period, by the Company’s significant lines of business, which are Homeowners, Commercial General Liability and Automobile.
(2) Calculated severity amounts by accident year are based on inception-to-date incurred less IBNR and expected development dollars on reported claims. Note the older accident years are more developed than recent accident years.
The following table provides supplementary information about the average annual percentage payout of incurred losses and ALAE, net of reinsurance, for Commercial General Liability policies, as of December 31, 2017:
The following table provides supplementary information about the average annual percentage payout of incurred losses and ALAE, net of reinsurance, for Automobile policies, as of December 31, 2017:
Management establishes a liability on an aggregate basis to provide for the estimated IBNR. The estimates of the liability for loss and LAE reserves are subject to the effect of trends in claims severity and frequency and are continually reviewed. As part of this process, we review historical data and consider various factors, including known and anticipated legal developments, inflation and economic conditions. As experience develops and other data become available, these estimates are revised, as required, resulting in increases or decreases to the existing liability for loss and LAE reserves. Adjustments are reflected in results of operations in the period in which they are made and the liabilities may deviate substantially from prior estimates.
If a change in control of the Company, as defined in the Indenture, occurs, the holders of the 2027 Notes and 2022 Notes will have the right to require the Company to purchase all or a portion of their notes at a price in cash equal to 102% of the principal amount thereof, plus any accrued but unpaid interest.
On March 17, 2015, Monarch Holding, a wholly owned subsidiary of Monarch Delaware, the Company’s consolidated VIE, issued a promissory note with a principal amount of $5.0 million bearing 6% annual interest, due March 17, 2021, with interest payable on an annual basis due March 17 each year. The debt was issued to TransRe and is being carried at the unpaid principal balance net of deferred financing costs; any accrued and unpaid interest is recognized in other liabilities in the consolidated statement of operations.
The actual income tax expense differs from the “expected” income tax expense (computed by applying the combined applicable effective federal and state tax rates to income before income tax expense) as follows:
The Company does not have a valuation allowance as of December 31, 2017 and 2016.
The Company files a federal income tax return and various state and local tax returns. The Company’s consolidated federal and state income tax returns for 2014 - 2016 are open for review by the Internal Revenue Service (“IRS”) and other state taxing authorities. Monarch Holding, a wholly owned subsidiary of Monarch Delaware, the Company’s consolidated VIE, was audited by the IRS for the tax year 2016 and there were no findings.
The Company reviews the outstanding matters, if any, on a quarterly basis. The Company accrues for estimated losses and contingent obligations in the consolidated financial statements if and when the obligation or potential loss from any litigation, legal proceeding or claim is considered probable and the amount of the potential exposure is reasonably estimable. The Company records such probable and estimable losses, through the establishment of legal expense reserves. As events evolve, facts concerning litigation and contingencies become know and as additional information becomes available, the Company’s management reassesses its potential liabilities related to pending claims and litigation and may revise its previous estimates and make appropriate adjustment to the financial statements. Estimates that require judgment are subject to change and are based on management’s assessment, including the advice of legal counsel, the expected outcome of litigation and legal proceedings or other dispute resolution proceedings or the expected resolution of contingencies. The Company’s management believes that the Company’s accruals for probable and estimable losses are reasonable and that the amounts accrued do not have a material effect on the Company’s consolidated financial statements.
The Company is a party to a Co-Existence Agreement effective as of August 30, 2013 (the “Co-Existence Agreement”) with Federated Mutual Insurance Company (“Mutual”) pursuant to which we agreed to certain restrictions on its use of the word “FEDERATED” without the word “NATIONAL” when referring to the Company and FNIC. In response to Mutual’s allegations that our use of the word “FED” as part of our federally registered “FEDNAT” trademark infringes on Mutual’s federal and common law trademark rights, in July 2016 we filed a declaratory judgment action for non-infringement of trademark in the U.S. District Court for the Southern District of Florida seeking a declaration that our federally registered trademark “FEDNAT” does not infringe any alleged trademark rights of Mutual and that Mutual does not own any trademark rights to the name or mark “FED” in connection with insurance services outside of Owatonna, Minnesota. In response to Mutual’s demand for arbitration against us alleging a breach of the Co-Existence Agreement, on February 16, 2018 the arbitrator agreed that our “FEDNAT” trademark does not infringe on Mutual’s federal or common law trademark rights. As a result, we have begun the process of re-branding the Company to use the FEDNAT name. The arbitrator also required us to cease using the Federated National name within 90 days. Unless the Company is able to reach agreement with Mutual regarding the timing of the name change, the Company intends to challenge that portion of the arbitration award in federal court.
The Company may repurchase shares in open market transaction or under Rule 10b5-1 trading plans from time to time in its discretion, based on ongoing assessments of the Company’s capital needs, the market price of its common stock and general market conditions. The amount and timing of all repurchase transactions are contingent upon market conditions, applicable legal requirements and other factors.
In March 2017, the Company’s Board of Directors authorized an additional $10.0 million share buyback program to repurchase shares of common stock through March 31, 2018.
A summary of the Company’s stock option activity includes the following:
The weighted average grant date fair value is measured at the closing price of FNHC common stock on the grant date, as reported on the NASDAQ Global Market.
For the years ended December 31, 2017 and 2016, the Company made no additional profit-sharing contribution.
The Company paid investment fees to Crosswinds AUM, a wholly owned subsidiary of Crosswinds Holdings, of $0.3 million, $0.2 million and $0.2 million, for the years ended December 31, 2017, 2016 and 2015, respectively.
Bruce F. Simberg, the Company’s Chairman of the Board, is a partner of the Hollywood, Florida law firm of Conroy Simberg, which specializes in insurance defense and coverage matters. The Company paid legal fees to Conroy Simberg for services rendered in the amount of $0, $72,198 and $26,286 for the years ended December 31, 2017, 2016 and 2015, respectively. We believe that the fees charged for services provided by Conroy Simberg are on terms as those that we could secure from a non-affiliated law firm. The firm has handled only a limited number of matters for the Company. Mr. Simberg has not been personally involved in any of the legal matters handled by the firm for the Company and he received de minimis direct personal benefit from the fees paid to the firm by the Company. The firm is no longer working any current cases for the Company and we do not, at this time, anticipate retaining the firm for future matters.
The computations of basic and diluted net income per share are as follows:
In June 2017, the Company’s Board of Directors declared a dividend of $0.08 per common share, paid in September 2017, totaling $1.1 million.
The carrying amounts of Monarch Delaware, which can only be used to settle obligations of Monarch Delaware, and liabilities of Monarch Delaware for which creditors do not have recourse include the following:
Earned premiums and loss and LAE, attributable to Monarch Delaware, were $9.4 million and $12.5 million, $4.7 million and $2.9 million, and $0.6 million and $0.3 million, for the years ended December 31, 2017, 2016 and 2015, respectively.
The net cash flows generated by Monarch Delaware are reflected in cash flows from operations in the consolidated statements of cash flows. Cash flows used in operating activities by Monarch Delaware were $3.8 million for the year ended December 31, 2017, as compared to cash flows provided by operating activities by Monarch Delaware of $6.8 million and $4.7 million for the years ended and December 31, 2016 and 2015, respectively.
preceding calendar year, not including realized capital gains, plus a 2 years carryforward or 10.0% of statutory unassigned surplus as of the preceding year end. A dividend may also be taken without prior regulatory approval if (a) the dividend is equal to or less than the greater of (i) 10.0% of the insurer’s surplus as to policyholders derived from realized net operating profits on its business and net realized capital gains; or (ii) the insurer’s entire net operating profits and realized net capital gains derived during the immediately preceding calendar year; (b) the insurer will have surplus as to policyholders equal to or exceeding 115 percent of the minimum required statutory surplus as to policyholders after the dividend or distribution is made; and (c) the insurer has filed notice with the Florida OIR at least 10 business days prior to the dividend payment or distribution, or such shorter period of time as approved by the Florida OIR on a case-by-case basis. These dividends are referred to as “ordinary dividends.” However, if a dividend, together with other dividends paid within the preceding 12 months, exceeds this statutory limit or is paid from sources other than earned surplus, the entire dividend is generally considered an “extraordinary dividend” and must receive prior regulatory approval before such dividend can be paid.
The revisions as follows will appear in the Company’s applicable 2018 quarterly financial statements in the Quarterly Reports, when filed.
On February 21, 2018, FNIC closed on its acquisition of the interest in Monarch Delaware held by the Company's joint venture partners for the agreed upon terms contemplated by the purchase and sale agreement with Crosswinds Investor and TransRe dated November 27, 2017. FNIC purchased Crosswinds Investor’s 42.4% Class A membership interest and 50% voting interest for $12.3 million, and TransRe’s 15.2% non-voting membership interest in Monarch Delaware for $4.4 million. The outstanding principal balance and interest due on the $5.0 million promissory note to TransRe was paid in full. Following the closing, Monarch Delaware and Monarch Holdings were merged into MNIC. With the completion of these transactions, FNIC owns 100% of MNIC.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2017 and 2016, the related consolidated statements of operations, comprehensive income (loss), changes in shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2017, and the related notes and the financial statement schedules listed in the index at Item 15 and our report dated March 13, 2018 expressed an unqualified opinion thereon.