Homeowners Choice, Inc. is a property and casualty insurance holding company incorporated in Florida in 2006. Through our subsidiaries, we provide property and casualty homeowners’ insurance, condominium-owners’ insurance, and tenants’ insurance to individuals owning property in Florida. We offer these insurance products at competitive rates, while pursuing profitability using selective underwriting criteria. Our principal revenues are earned premiums, which are reported net of reinsurance costs, and investment income. We cede a substantial portion of our earned premiums to reinsurers to mitigate risks primarily associated with hurricanes and other catastrophic events. Our principal expenses are claims from policyholders, policy acquisition costs, and other underwriting expenses. As of December 31, 2010, we had total assets of $140.9 million and stockholders’ equity of $46.6 million. Our net income was approximately $5.4 million for the year ended December 31, 2010. Our book value per share increased to $7.51 as of December 31, 2010 compared to $7.03 as of December 31, 2009.
Effective December 7, 2010, Homeowners Choice Property & Casualty Insurance Company, Inc. assumed an additional 8,031 homeowners’ policies from Citizens.
On February 1, 2011, we filed Amendment No. 2 on Form S-3 with the Securities and Exchange Commission under which we offered for sale a minimum of 1,200,000 shares up to a maximum of 1,500,000 shares of our 7% Series A Cumulative Redeemable Preferred Stock (“Series A Preferred”). On March 25, 2011, the offering was completed with a total of 1,247,700 shares of Series A Preferred being issued by the Company for gross proceeds of approximately $12.5 million before deducting offering expenses, which are expected to total approximately $1.2 million including placement agent fees and expenses. The Company intends to use the net proceeds from this offering of approximately $11.3 million for general corporate purposes. Dividends on the Series A Preferred will be cumulative from the date of original issue and will accrue on the last day of each month at an annual rate of 7% of the $10.00 liquidation preference per share. Each share of the Series A Preferred will be convertible, at the holder’s option at any time, initially into one share of our common stock based upon an initial conversion price of $10.00 per share. The Company may terminate this conversion right on or after March 31, 2014, if, for at least twenty trading days within any period of thirty consecutive trading days, the market price of our common stock exceeds the conversion price of the Series A Preferred by more than 20% and our common stock is then traded on the New York Stock Exchange, the NASDAQ Global Select Market, the NASDAQ Global Market, the NASDAQ Capital Market, or the NYSE Amex. Shares of the Series A Preferred will have no voting rights except under limited circumstances.
On February 22, 2011, we announced our intention to enter the Alabama homeowners insurance market. We expect to satisfy Alabama regulatory requirements and begin operations in Alabama by the end of 2011.
The following table summarizes our results of operations for the years ended December 31, 2010 and 2009 (dollars in thousands, except per share amounts):
Gross Premiums Earned for the year ended December 31, 2010 were $119.8 million and reflect the revenue from policies assumed from Citizens in connection with the eight separate assumption transactions through December 2010 and the revenue on the renewal of these policies. Gross premiums earned for the year ended December 31, 2009 were $110.0 million and reflect the revenue from policies assumed from Citizens in connection with the seven separate assumption transactions through December 2009 and the revenue on the renewal of these policies.
Net Investment Income for the years ended December 31, 2010 and 2009 was $2.0 million and $1.8 million, respectively. There were no other than temporary impairments recorded during the years ended December 31, 2010 and 2009. The $0.2 million increase in total investment income is primarily due to interest income received from our available-for-sale investments, which were added to our investment portfolio beginning in the second quarter of 2009.
Other Income for the years ended December 31, 2010 and 2009 of $2.2 million and $1.2 million, respectively, primarily reflects the policy fee income we earn with respect to our issuance of renewal policies.
Our losses and loss adjustment expense reserves (“Reserves”), which are more fully described below under “Critical Accounting Policies and Estimates,” are specific to homeowners insurance, which is our only line of business. These Reserves include both case reserves on reported claims and our reserves for incurred but not reported (“IBNR”) losses. At each period-end date, the balance of our Reserves is based on our best estimate of the ultimate cost of each claim for those known cases and the IBNR loss reserves are estimated based primarily on our historical experience. Our Reserves increased from $19.2 million at December 31, 2009 to $22.1 million at December 31, 2010. The $2.9 million increase in our Reserves during 2010 is comprised of $14.2 million in new reserves specific to the year ended December 31, 2010 offset by reductions of $9.9 million and $1.4 million in our Reserves for 2009 and 2008, respectively. The $14.2 million in Reserves established for 2010 claims is due to the increase in our policy exposure, which resulted in an increase in the amount of reported losses in 2010. The decrease of $11.3 million specific to our 2009 and 2008 accident-year reserves is due to favorable development arising from lower than expected loss development during 2010 relative to expectations used to establish our Reserve estimates at the end of 2009. Factors that are attributable to this favorable development may include a lower severity of claims than the severity of claims considered in establishing our Reserves and actual case development may be more favorable than originally anticipated.
Income Taxes for the years ended December 31, 2010 and 2009 were $3.2 million and $6.8 million, respectively, for state and federal income taxes resulting in an effective tax rate of 36.9% for 2010 and 38.5% for 2009.
The loss ratio applicable to the year ended December 31, 2010 (loss and loss adjustment expenses related to net premiums earned) was 60.3% compared to 53.9% for the year ended December 31, 2009. Our loss ratio was negatively impacted by a significant increase in our reinsurance costs during 2010, which reduced our net premiums earned.
We expect to experience increases in our losses and loss adjustment expenses during the period from June 1 through November 30 each year as this is typically the period during which hurricanes and other tropical storms may occur. As a result of such seasonal variations in our reported losses, we anticipate our operating profits during the period from June 1 through November 30 each year may be negatively impacted by an increase in losses and loss adjustment expenses.
We believe that we maintain sufficient liquidity to pay our insurance subsidiary’s claims and expenses, as well as satisfy commitments in the event of unforeseen events such as reinsurer insolvencies, inadequate premium rates, or reserve deficiencies. We maintain a comprehensive reinsurance program at levels management considers adequate to diversify risk and safeguard our financial position.
Net cash provided by operating activities for the year ended December 31, 2010 was approximately $16.1 million, which resulted primarily from the $19.5 million of premiums collected from Citizens offset by $10.6 million from reinsurance premiums prepaid in 2010 and $7.2 million cash received from net written premiums less cash disbursed for operating expenses and losses and loss adjustment expenses. Net cash used in investing activities was approximately $0.2 million of which $7.3 million was contributed from investment sales net of investment purchases offset by $7.5 million used to purchase property and equipment. Net cash used in financing activities totaled $4.5 million, which was primarily due to $3.6 million used to repurchase our shares and $1.9 million used to pay dividends offset by approximately $1.0 million from proceeds and tax benefits related to stock option exercises.
Net cash used in operating activities for the year ended December 31, 2009 was approximately $13.5 million, which resulted primarily from an increase of $19.5 million in uncollected premiums due from Citizens at December 31, 2009 from the December 2009 assumption transaction partially offset by cash received from net written premiums less cash disbursed for operating expenses and losses and loss adjustment expenses. Net cash used in investing activities of $21.0 million was primarily due to the $21.2 million net amount used to purchase various fixed maturity securities and short-term investments. Additionally, we used $314,000 to purchase property and equipment. These amounts were offset by our receipt of $450,000 upon repayment of a note receivable. Net cash used in financing activities totaled $3.1 million, which was primarily due to $3.2 million used to repurchase our shares and warrants offset by $49,000 from the exercise of common stock options.
As a smaller reporting company as defined by Rule 229.10(f)(1) of the Exchange Act, we are not required to provide the information under this item.
We maintain IBNR reserves to provide for already incurred claims that have not yet been reported and developments on reported claims. The IBNR reserve is determined by estimating our insurance company’s ultimate net liability for both reported and IBNR claims and then subtracting the case reserves and payments made to date for reported claims.
Description of Ultimate Loss Estimation Methods. The reported loss development method relies on the assumption that, at any given state of maturity, ultimate losses can be predicted by multiplying cumulative reported losses (paid losses plus case reserves) by a cumulative development factor. The validity of the results of this method depends on the stability of claim reporting and settlement rates, as well as the consistency of case reserve levels. Case reserves do not have to be adequately stated for this method to be effective; they only need to have a fairly consistent level of adequacy at all stages of maturity. Because of our limited loss experience, we select loss development factors based on industry data found in current A.M. Best’s Aggregates and Averages - Property/Casualty - United States & Canada. We assume that our loss development patterns will be reasonably consistent with industry averages, and use the selected factors to project the ultimate losses.
DAC considered recoverable could be reduced in the near term if the estimates of total revenues discussed above are reduced or permanently impaired as a result of the disposition of a line of business. The amount of amortization of DAC could be revised in the near term if any of the estimates discussed above are revised.
Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2010 and 2009
Notes to the Consolidated Financial Statements for the Years Ended December 31, 2010 and
We have audited the accompanying consolidated balance sheets of Homeowners Choice, Inc. and Subsidiaries (the “Company”) as of December 31, 2010 and 2009, and the related consolidated statements of earnings, stockholders’ equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company at December 31, 2010 and 2009, and the results of its operations and its cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.
Nearly all of the Company’s customers have been obtained through participation in a “takeout program” with Citizens Property Insurance Corporation (“Citizens”), a Florida state supported insurer. The customers were obtained in eight separate assumption transactions completed in July and November 2007, February, June, October and December 2008, December 2009, and December 2010. The Company is required to offer renewals on the policies acquired for a period of three years subsequent to the initial expiration of the assumed policies. During the first full year after assumption, such renewals are required to have rates that are equivalent to or less than the rates charged by Citizens.
Cash and Cash Equivalents. The Company considers all short-term highly liquid investments with original maturities of less than three months to be cash and cash equivalents. At December 31, 2010 and 2009, cash and cash equivalents consist of cash on deposit with financial institutions and securities brokerage firms.
Time Deposits. Time deposits consist of certificates of deposit with initial maturities ranging from one to five years.
Investments. Securities may be classified as either trading, held to maturity or available for sale. Held-to-maturity securities are reported at amortized cost. The Company’s available-for-sale securities are carried at fair value. Temporary changes in the fair value of available-for-sale securities are excluded from operations and reported in stockholders’ equity as a component of accumulated other comprehensive loss, net of deferred income taxes. Realized investment gains and losses are recorded on the trade date and are determined using the specific identification method. Investment income is recognized as earned and discounts or premiums arising from the purchase of securities are recognized in investment income using the interest method over the estimated remaining term of the security.
As part of the Company’s investment strategy, put and call options are purchased or sold on various equity securities the Company is willing to buy or sell. The premiums received are recorded as a liability until such time as the options are exercised or expire. Upon exercise, the value of the premium will adjust the basis of the underlying security bought or sold. Options that expire are recorded as income in the period they expire. With respect to these written option contracts, the Company includes the net gain or loss in the amount reported for realized investments gains in the Consolidated Statements of Earnings. In accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 815, “Derivatives and Hedging,” in the event the Company has open option contracts at the end of the reporting period, these options are marked to fair value through earnings. There were no option contracts outstanding at December 31, 2010 or 2009.
The Company reviews all securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such review. When the fair value of any investment is lower than its cost, an assessment is made to determine whether the decline is temporary or other-than-temporary. If the decline is determined to be other-than-temporary, the investment is written down to fair value and an impairment charge is recognized in earnings in the period in which the Company makes such determination. For a debt security that the Company does not intend to sell and it is not more likely than not that the Company will be required to sell before recovery of its amortized cost, only the credit loss component of the impairment is recognized in earnings, while the impairment related to all other factors is recognized in other comprehensive income. The Company considers various factors in determining whether an individual security is other-than-temporarily impaired (see Note 3 - “Investments”).
Losses and Loss Adjustment Expenses. Reserves for losses and loss adjustment expenses (“LAE”) are determined by establishing liabilities in amounts estimated to cover incurred losses and LAE. Such reserves are determined based on the assessment of claims reported and the development of pending claims. These reserves are based on individual case estimates for the reported losses and LAE and estimates of such amounts that are incurred but not reported. Changes in the estimated liability are charged or credited to earnings as the losses and LAE are settled.
Income Taxes. The Company accounts for income taxes in accordance with ASC Topic 740 - “Income Taxes” (“ASC 740”). ASC 740 results in two components of income tax expense: current and deferred. Current income tax expense reflects taxes to be paid or refunded for the current period by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues. The Company determines deferred income taxes using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax bases of assets and liabilities, and enacted changes in tax rates and laws are recognized in the period in which they occur.
Accounting Standards Update No. 2010-26. In October 2010, the FASB issued Accounting Standards Update No. 2010-26 (“ASU 2010-26”), Financial Services - Insurance (ASC Topic 944), Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. The objective of the amendments in ASU 2010-26 is to address diversity in practice regarding the interpretation of which costs relating to the acquisition of new or renewal insurance contracts qualify for deferral. The amendments in ASU 2010-26 specify which costs should be capitalized. The amendments in ASU 2010-26 are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011 and should be applied prospectively upon adoption. Retrospective application to all prior periods presented upon the date of adoption is permitted, but not required. Early adoption is permitted, but only at the beginning of an entity’s annual reporting period. Management is currently evaluating the impact of ASU 2010-26 and the effect adoption of this guidance will have on the Company’s consolidated financial statements.
Accounting Standards Update No. 2010-29. In December 2010, the FASB issued Accounting Standards Update No. 2010-29 (“ASU 2010-29”), Business Combinations (Topic 805), Disclosure of Supplementary Pro Forma Information for Business Combinations. The objective of ASU 2010-29 is to address diversity in practice about the interpretation of the pro forma revenue and earnings disclosure requirements for business combinations. The amendments in ASU 2010-29 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 in ASU 2010-29 are effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. Early adoption is permitted. The adoption of this guidance is not expected to have a material effect on the Company’s consolidated financial statements.
At December 31, 2009 the Company held investments in fixed maturity securities comprised of corporate bonds, which were classified as held-to-maturity. The amortized cost and estimated fair value of these investments at December 31, 2009 are summarized as follows (in thousands):
The scheduled maturities of fixed maturity securities at December 31, 2010 are as follows (in thousands):
Proceeds received, and the gross realized gains and losses from sales of available for sale securities, for the year ended December 31, 2010 were as follows (in thousands):
Securities with gross unrealized loss positions at December 31, 2010, aggregated by investment category and length of time the individual securities have been in a continuous loss position, are as follows (in thousands):
The Company believes there were no fundamental issues such as credit losses or other factors with respect to any of its available-for-sale securities. The unrealized losses on investments in fixed maturity securities were caused by interest rate changes. It is expected that the securities would not be settled at a price less than the par value of the investments. In determining whether equity securities are other than temporarily impaired, the Company considers its intent and ability to hold a security for a period of time sufficient to allow for the recovery of cost. Because the decline in fair value is attributable to changes in interest rates or market conditions and not credit quality, and because the Company has the ability and intent to hold its available-for-sale investments until a market price recovery or maturity, the Company does not consider any of its investments to be other-than-temporarily impaired at December 31, 2010.
At December 31, 2010, the Company also had one single investment in U.S. Treasury notes exceeding 10% of consolidated stockholders’ equity. This investment is carried at its $4.7 million fair value and included in investments in fixed maturity securities at December 31, 2010. There were no single investments exceeding 10% of consolidated stockholders’ equity at December 31, 2009.
In addition, at December 31, 2010 and 2009, cash and cash equivalents included $14.7 million and $21.6 million, respectively, on deposit at one national bank. At December 31, 2010, the Company also had an aggregate of $16.4 million in cash on deposit at two brokerage firms.
The fair values for fixed maturity securities that do not trade on a daily basis are determined by management, utilizing prices obtained from an independent pricing service and information provided by brokers. Management reviews the assumptions and methods utilized by the pricing service and then compares the relevant data and pricing to broker-provided data. The Company gains assurance of the overall reasonableness and consistent application of the assumptions and methodologies and compliance with accounting standards for fair value determination through ongoing monitoring of the reported fair values.
There were no transfers between Levels 1 or 2 during the years ended December 31, 2010 and 2009.
The Company cedes a portion of its homeowners insurance exposure to other entities under catastrophe excess of loss reinsurance treaties. The Company remains liable with respect to claims payments in the event that any of the reinsurers are unable to meet their obligations under the reinsurance agreements. The Company evaluates the financial condition of its reinsurers and monitors concentrations of credit risk arising from similar geographic regions, activities or economic characteristics of the reinsurers to minimize its exposure to significant losses from reinsurer insolvencies.
The impact of the catastrophe excess of loss reinsurance treaties on premiums written and earned is as follows (in thousands):
The Company writes insurance in the state of Florida, which could be exposed to hurricanes or other natural catastrophes. Although the occurrence of a major catastrophe could have a significant effect on our monthly or quarterly results, the Company believes that such an event would not be so material as to disrupt the overall normal operations of the Company. However, the Company is unable to predict the frequency or severity of any such events that may occur in the near term or thereafter.
A valuation allowance is established if, based upon the relevant facts and circumstances, management believes any portion of the tax assets will not be realized. Although realization of deferred income tax assets is not certain, management believes it is more likely than not that deferred tax assets will be realized. As a result, the Company did not have a valuation allowance established as of December 31, 2010 or 2009.
A summary of the numerator and denominator of the basic and diluted earnings per share is presented below (dollars and shares in thousands, except per share amounts):
The warrants may be exercised at an exercise price equal to $9.10 per share on or before July 30, 2013. At any time after January 30, 2009 and before the expiration of the warrants, the Company at its option may cancel the warrants in whole or in part, provided that the closing price per share of the Company’s common stock has exceeded $11.38 for at least ten trading days within any period of twenty consecutive trading days, including the last trading day of the period. The placement agents also have the option to effect a cashless exercise in which the warrants would be exchanged for the number of shares which is equal to the intrinsic value of the warrant divided by the current value of the underlying shares.
At December 31, 2010, the Company is authorized to issue 20,000,000 shares of preferred stock, no par value. The authorized but unissued preferred stock may be issued in one or more series and the shares of each series shall have such rights as determined by the Company’s Board of Directors. See Note 17 - “Subsequent Events.”
The Company accounts for stock-based compensation under the fair value recognition provisions of ASC Topic 718 - “Compensation - Stock Compensation.”
The Company’s 2007 Stock Option and Incentive Plan (the “Plan”) provides for granting of stock options to employees, directors, consultants, and advisors of the Company. Under the Plan, options may be granted to purchase a total of 6,000,000 shares of the Company’s common stock. At December 31, 2010, options to purchase 4,850,000 shares are available for grant under the Plan. The options vest over periods ranging from immediately vested to five years and are exercisable over the contractual term of ten years.
There were no options granted during the years ended December 31, 2010 and 2009.
HCPC has qualified as a Limited Apportionment Company in Florida for a one-year period beginning in April 2010. This designation allows the Company to pay assessments from regulatory agencies as assessments from insureds are recouped rather than paying the assessment and then recouping from the insureds/ policyholders.
The Bermuda Monetary Authority requires Claddaugh to maintain minimum capital and surplus of $2.0 million. At December 31, 2010 and 2009, Claddaugh’s statutory capital and surplus was $4.5 million and $5.5 million, respectively. Claddaugh’s statutory net profit was $4.9 million and $3.5 million, respectively, for the years ended December 31, 2010 and 2009.
One of the Company’s directors receives a consulting fee and software license fees for development and use of the Company’s premium administration application software. Under this arrangement, the Company incurred fees of $359,000 and $352,000 for the years ended December 31, 2010 and 2009, respectively. Software license fees totaling $129,000 and $71,000 were unpaid at December 31, 2010 and 2009, respectively.
One of the Company’s directors is a partner at a law firm that manages certain of the Company’s corporate legal matters. Fees incurred with respect to this law firm for the years ended December 31, 2010 and 2009 were approximately $266,000 and $103,000, respectively.
Effective January 20, 2010, the Company repurchased and retired a total of 200,000 shares of the Company’s common stock at a price of $7.00 per share for a total cost of $1,400,000. Such shares were repurchased under a stock purchase agreement with one of the Company’s directors at a price below the $7.95 market value of the Company’s common stock on the date of the transaction. Such repurchases were not part of a publicly announced plan or program. In addition, the Company paid a $10,000 consulting fee during 2010 to this director for investment advisory services.
Condensed financial information of Homeowners Choice, Inc. is as follows (in thousands):
Note 16 - Condensed Financial Information of Homeowners Choice, Inc. (continued)