We own the headquarters building and land at 1900 L. Don Dodson Drive in Bedford, Texas, which includes approximately 200,000 square feet of office space.
This discussion and analysis contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that are not historical facts, and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. See “Note on Forward-Looking Statements” in Part I of this report.
Our Lender Services segment generates premiums primarily from providing collateral protection insurance or CPI to our credit union, bank and specialty finance company clients. Lenders purchase CPI to provide coverage for automobiles or other vehicles of borrowers who do not uphold their obligation to insure the collateral underlying the loan. Our lender clients pay us directly for CPI and then add the cost of CPI to the borrower’s loan. Our CPI business is fully vertically integrated: we manage all aspects of the CPI business cycle, including sales and marketing, policy issuance, policy administration, underwriting and claims handling.
Effective January 1, 2017, the Company acquired 100% of the outstanding common shares of Fireman’s Fund Insurance Company of Ohio, an excess and surplus lines, or non-admitted, shell company. The company was subsequently renamed Independent Specialty Insurance Company (“ISIC”). The purpose of these acquisitions is to provide exclusive capacity for one of our programs.
Trending Market Opportunities. We believe that macroeconomic conditions will provide us with growth opportunities in each of our business segments. Increasing automobile sales should expand lenders’ loan portfolios to improve our Lender Services results. Over the past decade, alternative capital has been entering the reinsurance market at an accelerating pace. This influx of capital has had the effect of compressing rates for reinsurance, which in the past was primarily written to reinsure catastrophe-exposed property insurance. These lower reinsurance rates are now driving industry capital to seek opportunity in U.S. primary insurance markets for both property and casualty lines. These market dynamics should provide growth opportunities in our Program Services segment.
We believe that the increased role of capital market alternatives to reinsurance, including the capitalization of hedge fund-backed reinsurers and the availability of capital in the non-U.S. reinsurance market, is driving demand for our Program Services, as these firms typically do not have direct access to the U.S. insurance market. We are well positioned to meet this demand due to our highly rated and broadly licensed insurance subsidiaries in addition to our proven model to provide fronting for a fee.
Subchapter S Corporation Status. Prior to the completion of the private placement in 2014, we elected for our parent company to be taxed for federal income tax purposes as a “Subchapter S corporation” under the Internal Revenue Code and our subsidiaries (other than our insurance subsidiaries and intermediate holding company) to be pass-through entities for federal income tax purposes. As a result, prior to the completion of the private placement, the income for our parent company and pass-through subsidiaries was not subject to, and we did not pay, U.S. federal income taxes, and no provision or liability for federal or state income tax for our parent company and pass-through subsidiaries has been included in our consolidated financial statements. The tax provision, assets and liabilities that are reflected in our consolidated financial statements for periods prior to the completion of the private placement represent those for our insurance subsidiaries and their intermediate holding company, State National Intermediate Holdings, Inc. (“SNIH”), as those entities were “C” Corporations. Despite the Subchapter S corporation status, the impact of taxes on our parent company are included in the financial statements in that our shareholders were provided with the cash to pay the taxes that passed through to the shareholders. Prior to the completion of the private placement, we made periodic cash distributions to our shareholders that have included amounts necessary for them to pay their estimated personal U.S. federal income tax liabilities relating to the items of our income, gain, deductions and losses that pass through to them. Upon the completion of the private placement, our parent company’s status as a Subchapter S corporation terminated and our parent company became a “C” Corporation for U.S. tax purposes and became subject to a combined federal and state corporate income tax rate between 35% and 38%. We invest a portion of our investment portfolio in tax-exempt municipal securities, which investment may have the effect of lowering our effective tax rate.
Premiums earned. Premiums earned are the earned portion of our net premiums written, which are predominately CPI premiums. As the CPI product is not a traditional insurance product, the premium recognition is likewise different. We do not record premiums until we collect them from our accounts since they have the right to waive the placement of insurance on any of their loans. There is a high level of policy cancellations since borrowers often purchase insurance at the traditional rates that provides protection for them in addition to their lender. Due to this high level of policy cancellations, we split the premium into two pieces: (1) an allowance for future cancellations and (2) premiums that we expect to earn, which we refer to as “stick premiums.” We earn stick premiums on a pro rata basis over the terms of the policies. The CPI premiums written as presented in this document reflect the effects of the allowance for policy cancellations including any adjustments related to re-estimation of the allowance. As such, our recorded CPI premiums written are those that we expect to earn while those that are expected to cancel are included in the allowance for policy cancellations. At the end of each reporting period, stick premium written that is not earned is classified as unearned premium, which is earned in subsequent periods over the remaining terms of the policies. Our policies typically have a term of one year, although the average duration of our CPI policies is typically less than six months due to policy cancellations.
Losses and loss adjustment expenses. Losses and loss adjustment expenses (“LAE”) include claims paid, estimates of future claim payments, changes in those estimates from prior reporting periods and costs associated with investigating, defending and servicing claims. We record loss and LAE related to estimates of future claim payments based on historical experience. We seek to establish all reserves at the most likely ultimate exposure based on our historical claims experience. We revise our estimates as we receive additional information about claims and the total costs of settlement.
Commissions. Substantially all commission expenses are related to our Lender Services segment. A significant portion of these amounts are paid to financial institutions as a means to reimburse the financial institution for costs associated with operating a CPI program. These commissions are partially offset by a 21% ceding commission received under our quota reinsurance agreement with CUNA Mutual and the reimbursement we received from CUNA Mutual for 30% of direct commissions and other reimbursable expenses paid to accounts. The ceding commission compensates us
for expenses, such as underwriting and policy acquisition expenses, that we incur in connection with the writing of the ceded business.
Stock-based compensation expense. Compensation expense for stock-based payments is recognized based on the measurement-date fair value for awards that will settle in shares. Compensation expense for restricted stock grants and stock option awards that contain a service condition are recognized on a straight line pro rata basis over the vesting period. For restricted stock awards that contain a performance condition, the expense is recognized based on the awards expected to vest and the cumulative expense is adjusted whenever the estimate of the number of awards to vest changes.
Net expense ratio. The net expense ratio is a component of our operational efficiency in administering our Lender Services segment. Expressed as a percentage, this is the ratio of net expenses (commissions, taxes, licenses, and fees and general and administrative) to net premiums earned. Our expense ratio is higher than that for most traditional insurance products due to the labor and systems intensive processes involved in monitoring the insurance statuses for the loan portfolios of our Lender Services clients. For the years ended December 31, 2016, 2015 and 2014, our net expense ratio was 39.5%, 41.0% and 47.3%, respectively.
Net combined ratio. The net combined ratio is a measure of the overall profitability of our Lender Services segment. This is the sum of the net loss ratio and the net expense ratio. For the years ended December 31, 2016, 2015 and 2014, our net combined ratio was 84.0%, 86.5% and 89.3%, respectively. Our objective is to price our products to achieve a net combined ratio between 85% to 90%.
Return on equity. One of the key financial measures that we use to evaluate our operating performance is return on equity. We calculate return on equity by dividing net income by the average GAAP equity. Our return on equity at December 31, 2016 was 17.5%. Our overall financial objective is to produce a return on equity of at least 15% over the long-term.
Financial leverage ratio. Our financial leverage ratio at December 31, 2016 was 14.8%, as compared to 16.6% at December 31, 2015. Our objective is to maintain a financial leverage ratio in the range of 20% to 40% over the long-term.
Our consolidated financial statements include amounts that, either by their nature or due to the requirements of GAAP, are determined using estimates and assumptions. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances. While we believe that the amounts included in our consolidated financial statements reflect our best judgment, actual amounts could ultimately materially differ from those currently presented. We believe the items that require the most subjective and complex estimates are: unpaid losses and LAE reserves, allowance for policy cancellations, unearned premium reserve, reinsurance recoverable, valuation of our investment portfolio, assessment of other-than-temporary impairments (“OTTI”) and minimum ceding fees.
While management believes the amounts included in the consolidated financial statements are adequate, such estimates may be more or less than the amounts ultimately refunded. The estimates are continually reviewed by management, and any changes are reflected in current operations.
The Company invests in convertible securities that have embedded derivatives. Derivatives embedded within non-derivative instruments, such as options embedded in convertible fixed maturity securities, are bifurcated from the host instrument when the embedded derivative meets the criteria for bifurcation. However, for reporting purposes, these embedded derivatives are presented together with the host contract and carried at estimated fair value. Changes in the estimated fair value of the embedded derivatives are reflected in “Realized net investment gains” in the consolidated statements of income, while changes in the estimated fair value of the underlying fixed maturity securities are reflected in “Unrealized holding gains (losses)” in the consolidated statements of comprehensive income.
Upon the completion of the private placement in 2014, our parent company’s status as a Subchapter S corporation terminated and our consolidated income became fully subject to U.S. federal income taxes. This adjustment represents estimated income taxes as if the Company had been treated as a C Corporation. The estimated tax was calculated assuming the Company’s blended statutory federal and state income tax rate of 37.5% for the period ended December 31, 2014.
Consolidated Results of Operations for the Year Ended December 31, 2016 compared to the Year Ended December 31, 2015
Ceding fees. Ceding fees increased by $5.3 million, or 7.9%, from $68.0 million for the year ended December 31, 2015 to $73.3 million for the year ended December 31, 2016, due to an increase in Program Services gross earned premium. Program Services gross earned premiums increased from $1.0 billion for the year ended December 31, 2015 to $1.2 billion for the year ended December 31, 2016, resulting in an increase in premium-related ceding fees of $8.3 million. Capacity fees decreased $3.0 million for the year ended December 31, 2016 compared to the year ended December 31, 2015, due to an increase in premium-related fees and a decrease in minimum contractual fees for 2016 compared to 2015.
Losses and loss adjustment expenses. Losses and LAE increased by $3.0 million, or 5.4%, from $55.8 million for the year ended December 31, 2015 to $58.8 million for the year ended December 31, 2016, which was primarily the result of increased exposure due to higher earned premiums. A strengthening economy, an aging automobile fleet, and easier access to credit have contributed to an increase in vehicle sales, resulting in higher loan balances which are the bases upon which we pay claims.
General and administrative expense. General and administrative expense increased by $7.0 million, or 11.2%, from $63.0 million for the year ended December 31, 2015 to $70.0 million for the year ended December 31, 2016, primarily due to investment in strategic growth, increased public company expenses, professional fees and stock-based compensation.
Income tax expense (benefit). Income tax expense increased by $2.8 million, or 11.4%, from $24.9 million for the year ended December 31, 2015 to $27.7 million for the year ended December 31, 2016, primarily resulting from the increase in income before income taxes. Our effective tax rate for financial reporting purposes was 36.1% and 35.8% for 2016 and 2015, respectively.
Investment income. Investment income increased by $3.1 million, from $4.8 million for the year ended December 31, 2014 to $7.9 million for the year ended December 31, 2015, in part due to an increase in investment holdings as a result of the net proceeds of the private placement and investing operating cash flows.
General and administrative expense. General and administrative expense increased by $4.1 million, or 6.9%, from $58.9 million for the year ended December 31, 2014 to $63.0 million for the year ended December 31, 2015, primarily due to stock-based compensation, employee group insurance and expenses associated with being a public company.
Offering-related expenses. We incurred $8.8 million of non-recurring offering-related expenses related to the private offering of the Company’s stock in 2014. We incurred no offering-related expenses in 2015.
Program Services Segment Results of Operations for the Year Ended December 31, 2016 compared to the Year Ended December 31, 2015
General and administrative expense. General and administrative expense increased by $2.2 million, or 17.3%, from $12.4 million for the year ended December 31, 2015 to $14.6 million for the year ended December 31, 2016. The increase was primarily due to investment in strategic growth and professional fees.
Ceding fees. Ceding fees increased by $22.3 million, or 48.6%, from $45.7 million for the year ended December 31, 2014 to $68.0 million for the year ended December 31, 2015, due to an increase in Program gross earned premium and
Premiums earned. Premiums earned increased by $11.6 million, or 9.8%, from $118.1 million for the year ended December 31, 2015 to $129.7 million for the year ended December 31, 2016. Factors contributing to this increase included new sales, active account management and growth in the loan portfolios of existing accounts driven by rising automobile sales and higher average auto loan balances.
Losses and loss adjustment expenses. Losses and LAE increased by $13.2 million, or 32.4%, from $40.6 million for the year ended December 31, 2014 to $53.8 million for the year ended December 31, 2015, which is partly the result of increased exposure due to higher earned premiums and an increase in claim frequency and severity. The net loss ratio increased from 42.0% to 45.5% for the years ended December 31, 2014 and December 31, 2015, respectively. A strengthening economy, an aging automobile fleet, and easier access to credit have contributed to an increase in vehicle sales, resulting in higher loan balances which are the bases upon which we pay claims.
General and administrative expense. General and administrative expense increased by $2.7 million, or 25.5%, from $10.7 million for the year ended December 31, 2015 to $13.4 million for the year ended December 31, 2016, primarily due to investment in strategic growth, professional fees and an increase in stock-based compensation.
Income tax expense (benefit). Income tax expense increased by $2.8 million, from $24.9 million for the year ended December 31, 2015 to $27.7 million for the year ended December 31, 2016, primarily resulting from the increase in income before income taxes. Our effective tax rate for financial reporting purposes was 36.1% and 35.8% for 2016 and 2015, respectively.
Our investment strategy emphasizes, first, the preservation of capital and, second, the generation of an appropriate risk-adjusted return. We seek to generate investment returns using investment guidelines that stress prudent allocation among cash and cash equivalents, fixed-maturity securities and, to a lesser extent, equity securities. Cash and cash equivalents include cash on deposit and short-term money market funds. As of December 31, 2016, the tax adjusted yield on our fixed maturity and equity securities was 2.7%. Convertible securities represent 13.9% of the portfolio at December 31, 2016. The average duration, excluding convertible securities, was 4 years and included obligations of the U.S. Treasury or U.S. government agencies, obligations of U.S. and Canadian corporations, mortgages guaranteed by the Federal National Mortgage Association, the Government National Mortgage Association, the Federal Home Loan Mortgage Corporation, Federal Farm Credit entities, and asset-backed securities and commercial mortgage obligations. Our equity securities include preferred stock and common stock of U.S. corporations. Our investment portfolio is managed by Asset Allocation & Management Company, LLC and AAM Advisors, Inc. (collectively, “AAM”). AAM operates under written investment guidelines approved by our board of directors. We pay AAM an investment management fee based on the market value of assets under management.
The table below summarizes the credit quality of our fixed-maturity securities as of December 31, 2016, as rated by Standard and Poor’s.
The tables below summarize the gross unrealized losses of fixed-maturity and preferred securities by the length of time the security had continuously been in an unrealized loss position for each year or shorter period specified below:
There were 270 and 237 securities at December 31, 2016 and December 31, 2015, respectively, that account for the gross unrealized loss, none of which we deemed to be other-than-temporarily impaired. Management believes that the temporary impairments are primarily the result of a combination of widening credit spreads and higher underlying Treasury rates, and that despite the wider credit spreads and higher rates, the securities are only temporarily impaired due to the strength of the issuing companies’ balance sheets, as well as their available liquidity options. For structured securities, future cash flow projections were used to determine potential impairment. For those securities where cash flow projections showed less than 100% principal recovery, a net present value test was done to determine any credit related losses. We do not intend to sell or believe we will be required to sell any of our temporarily-impaired fixed maturities before recovery of their amortized cost basis. Management has the intent and ability to hold the equity securities in an unrealized loss position until the recovery of their fair value. Therefore, Management does not consider these investments to be other-than-temporarily impaired.
We are required to maintain deposits in various states where the insurance subsidiaries are licensed to operate. These deposits are fixed maturity securities at fair values totaling $77.0 million and $53.5 million at December 31, 2016 and December 31, 2015, respectively. The increase in the amounts on deposit at December 31, 2016 is due to an increase in the required deposits for workers’ compensation business and required deposits acquired in the acquisition of CNIC.
terms or at all, we may be unable to support future growth or operating requirements and, as a result, our business, financial condition and results of operations could be adversely affected. We may generate liquidity through the issuance of debt or equity securities or financing through borrowings under credit facilities, or a combination thereof.
Our insurance subsidiaries are subject to statutory and regulatory restrictions imposed on insurance companies by their states of domicile which limit the amount of cash dividends or distributions that they may pay to us unless special permission is received from the insurance regulator of the relevant domiciliary state. The aggregate limit imposed by the various domiciliary states of our insurance subsidiaries was approximately $26.9 million and $23.0 million as of December 31, 2016 and 2015, respectively. In addition, we are able to generate substantial cash flow outside of our regulated insurance company subsidiaries through intercompany agency and management agreements between our insurance subsidiaries and our agency, TBA. TBA functions as a managing general agent for SNIC, NSIC and USIC in connection with the Lender Services segment. In addition, under the management agreement TBA provides business development, financial monitoring and other oversight functions to our insurance subsidiaries.
Net cash used in financing activities increased $2.4 million for the year ended December 13, 2016 compared to the year ended December 31, 2015, primarily due to the settlement of $3.9 million in stock repurchases in 2016.
Net cash used in in investing activities decreased $101 million from $128 million for year ended December 31, 2014 to $27 million for the year ended December 31, 2015. This decrease is primarily due to investing cash received from the private placement in 2014.
Net cash from financing activities decreased $94.3 million for the year ended December 31, 2015 compared to the year ended December 31, 2014. The decrease is primarily due to proceeds of $97 million received from the private
placement in 2014. Other activity impacting cashflows was a decrease in dividends paid of $10.5 million, $14.4 million stock repurchase in 2015 and $6.8 million subordinated debenture repurchase in 2014.
Reinsurance recoverables, unpaid losses and loss adjustment expenses and unearned premiums. As of December 31, 2016, we held $2.2 billion in collateral securing $1.7 billion in reinsurance recoverables. The remaining unsecured reinsurance recoverables of $664.6 are ceded to highly-rated, well capitalized reinsurers. During the year ended December 31, 2016, reinsurance recoverables increased $431.2 million from December 31, 2015, which was primarily a result of the increase in gross premiums written for Program Services business due to the addition of new programs and expansion of existing programs and gross loss development for prior year claims. These factors also caused an increase in the corresponding unearned premiums and the unpaid losses and loss adjustment expenses of $95.2 million and $338.9 million, respectively.
the current period’s operating results. The allowance for policy cancellations for the year ended December 31, 2016 and December 31, 2015 included upward revisions to prior year estimates of $1.4 million and $0.6 million, respectively. Because of the interplay between the allowance for policy cancellations and the related unearned premium reserve, changes in the allowance for policy cancellations are partially offset by related changes in the unearned premium reserve and amounts ceded to reinsurers. After taking into account the associated changes in unearned premium and amounts ceded to reinsurers, the net impact to the balance sheet and the corresponding reduction in net income from the revised estimates for the year ended December 31, 2016 and 2015 was approximately $0.6 million and $0.2 million, respectively.
The loss and LAE payments due by period in the table above are based upon the loss and LAE estimates as of December 31, 2016 and actuarial estimates of expected payout patterns and are not contractual liabilities with finite maturities. Our contractual liability is to provide benefits under the policy. As a result, our calculation of loss and LAE payments due by period is subject to the same uncertainties associated with determining the level of loss and LAE generally and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. For a discussion of our loss and LAE estimation process, see “Business-Loss Reserves” in Item 1 of this report. Actual payments of loss and LAE by period will vary, perhaps materially, from the table above to the extent that current estimates of loss and LAE vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns. See “Risk Factors-Risks Relating to Our Business-If we are unable to establish and maintain accurate loss reserves, our business, financial condition, results of operations and prospects may be materially and adversely affected” in Item
1A of this report for a discussion of the uncertainties associated with estimating loss and LAE.
The interest related to the debt by period as of December 31, 2016 was as follows: $2.2 million-less than 1 year, $4.5 million-1 - 3 years, $4.5 million-3 - 5 years and $ 26.3 million-more than 5 years.