The following discussion should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this annual report on Form 10-K. Unless the context requires otherwise, as used in this Form 10-K, the terms “HCI,” “we,” “us,” “our,” “the Company,” “our company,” and similar references refer to Homeowners Choice, Inc. and its subsidiaries.
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, 2009, we had total assets of $137.9 million and stockholders’ equity of $45.4 million. Our net income was approximately $10.9 million for the year ended December 31, 2009. Our book value per share increased to $7.03 as of December 31, 2009 compared to $5.43 as of December 31, 2008.
We began operations in June of 2007 by participating in a “take-out program” through which we assumed insurance policies held by Citizens Property Insurance Corporation (“Citizens”), a Florida state-supported insurer. The take-out program is a legislatively mandated program designed to reduce the state risk exposure by encouraging private companies to assume policies from Citizens. We currently have approximately 70,000 property and casualty insurance policies in force. These policies were assumed in seven separate assumption transactions which took place in July and November 2007, February, June, October and December 2008, and December 2009, and account for substantially all of our premium revenue since inception. Of those policies assumed, approximately 86% are homeowners’ insurance policies, and the remaining 14% are a combination of policies written for condominium-owners and tenants. Our existing policies represent approximately $132.0 million in annualized premiums.
Citizens requires us to offer renewals on the policies we acquire for a period of three years subsequent to the initial expiration of the assumed policies. The policyholders have the option to renew with us or they may ask their agent to place their coverage with another insurance company. They may also elect to return to Citizens prior to the policy renewal date. We strive to retain these policies by offering competitive rates to our policyholders, which may be below the rates we initially charged in our take-out program.
Effective December 15, 2009, we assumed approximately 23,000 policies upon completion of our seventh assumption transaction with Citizens. Subsequent to December 31, 2009, policy level activity has reduced the assumed policy count to approximately 18,000 policies. Including this December 2009 assumption, our existing policies represent approximately $132.0 million in annualized premiums.
On March 2, 2010, we filed with the SEC a registration statement on Form S-3 for the proposed sale of our Series A preferred stock.
The following table summarizes our results of operations for the years ended December 31, 2009 and 2008 (dollars in thousands, except per share amounts):
Comparison of the Year Ended December 31, 2009 to the Year Ended December 31, 2008
Net Premiums Written during the years ended December 31, 2009 and 2008 totaled $66.6 million and $94.7 million, respectively. Net premiums written represent the premiums charged on policies issued during a fiscal period less any applicable reinsurance costs.
Our Losses and Loss Adjustment Expenses amounted to $35.2 million and $21.5 million, respectively, during the years ended December 31, 2009 and 2008. The $13.7 million increase during 2009 is primarily attributable to the increased claim activity resulting from the increase in policies in force. Our policies in force totaled 70,000 at December 31, 2009, which is approximately the same number of policies we had in force at December 31, 2008. However, between September 30, 2008 and December 31, 2008, we added approximately 50,000 policies as a result of the October and December 2008 assumption transactions. During 2009, we experienced some policy attrition, which was offset by the policies we assumed in December 2009. As a result, we had an additional 50,000 policies in force throughout most of the entire year in 2009, which has resulted in an increase in the number of reported losses for the 2009 accident year and an increase in the case reserves carried in our financial statements.
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 $14.8 million at December 31, 2008 to $19.2 million at December 31, 2009. The $4.4 million increase in our Reserves during 2009 is comprised of a $16.0 million increase specific to the year ended December 31, 2009 offset by a reduction of $11.1 million and $0.5 million in our Reserves for 2008 and 2007, respectively. The $16.0 million in Reserves established for 2009 claims is due to the increase in our policy volume, which resulted in an increase in the amount of reported losses in 2009. The decrease of $11.6 million specific to our 2008 and 2007 accident-year reserves is due to favorable development arising from lower than expected loss development during 2009 relative to expectations used to establish our Reserve estimates at the end of 2008. 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.
Policy Acquisition and Other Underwriting Expenses for the years ended December 31, 2009 and 2008 of $9.6 million and $3.1 million, respectively, primarily reflect the amortization of deferred acquisition costs, commissions payable to agents for production and renewal of policies, and premium taxes and policy fees. The increase in 2009 is primarily due to an increase in commissions during 2009 as compared to 2008, which is directly attributable to the increase in the number of policy renewals during 2009. In addition, the commission rate applicable to the policies assumed in December 2009 was 16% versus 6% applicable to the policies assumed in 2008. We also experienced increases in our premium taxes, payroll, and other underwriting expenses required to manage our policies in force as we have renewed significantly more policies in 2009 than in 2008.
Other Operating Expenses for the years ended December 31, 2009 and 2008 were $5.8 million and $4.1 million, respectively. Such expenses include administrative compensation and related benefits, corporate insurance, professional fees, office lease and related expenses, information system expense, and other general and administrative costs. The $1.7 million increase is primarily attributable to increases in 2009 for professional services fees, administrative compensation and related benefits, and net other operating expenses of $724,000, $612,000 and $328,000, respectively. The increase in professional fees primarily relates to our Sarbanes Oxley 404 compliance efforts as well as fees incurred with respect to regulatory filings. The increase attributable to compensation and related benefits relates primarily to new employees hired to manage the increase in our policy volume. As of December 31, 2009, we had 58 employees compared to 29 employees as of December 31, 2008.
Income Taxes for the years ended December 31, 2009 and 2008 were $6.8 million and $8.1 million, respectively, for state and federal income taxes resulting in an effective tax rate of 38.5% for 2009 and 39.1% for 2008.
The loss ratio applicable to the year ended December 31, 2009 (loss and loss adjustment expenses related to net premiums earned) was 53.9% compared to 45.6% for the year ended December 31, 2008. The increase in claims and related reserves is reflective of our increased policies in force and insured exposures described above under “Losses and Loss Adjustment Expenses.” In addition, our loss ratio was negatively impacted by a significant increase in our reinsurance costs, which reduced our net premiums earned.
The expense ratio applicable to the year ended December 31, 2009 (policy acquisition and other underwriting expenses related to net premiums earned plus compensation, employee benefits, and other operating expenses) was 23.6% compared to 15.3% for the year ended December 31, 2008. We have experienced an increase in our expense ratio due to increases in our premium taxes, payroll, and other underwriting expenses required to manage our policies in force as we have renewed significantly more policies in 2009 than in 2008.
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 period is typically the period during which hurricanes and other tropical storms 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 will be negatively impacted by an increase in losses and loss adjustment expenses. Conversely, we expect more favorable operating results during the period from December 1 through May 31 each year. Although 2009 and 2008 were fairly uneventful years for tropical storm development in Florida, our losses during the third quarter of 2008 included $262,000 specific to Tropical Storm Faye.
During our limited operating history, we have not experienced any material impact on revenues or our results of operations due to inflation or changing prices. However, our premiums are established before we know the amount of our losses and the related settlement expenses and before we know the extent to which inflation may impact our expenses. Consequently, we attempt to anticipate the future impact of inflation when establishing our rates, yet our ability to establish and increase rates is subject to regulatory approval and may be further constrained by competitive pressures. In the event we experience prolonged periods of inflation leading to material increases in our expenses without a corresponding increase in our premium rates, such an event could have a material adverse effect on our future results of operations.
The main objective of our investment policy is to maximize our after-tax investment income with a minimum of risk given the current financial market. We have historically invested substantially all of our excess cash primarily in money market accounts and certificates of deposit (i.e., CDs) that generally mature in no more than thirteen months.
Reserves for Losses and Loss Adjustment Expenses. We establish reserves for the estimated total unpaid costs of losses including loss adjustment expenses (LAE). Unless otherwise specified below, the term “loss reserves” shall encompass reserves for both losses and LAE. Loss reserves reflect management’s best estimate of the total cost of (i) claims that have been incurred, but not yet paid, and (ii) claims that have been “incurred but not yet reported” (“IBNR”). Loss reserves established by us are not an exact calculation of our liability. Rather, loss reserves represent management’s best estimate of our company’s liability based on application of actuarial techniques and other projection methodology and taking into consideration other facts and circumstances known at the balance sheet date. The process of establishing loss reserves is complex and necessarily imprecise, as it involves using judgment that is affected by many variables such as past loss experience, current claim trends and the prevailing social, economic and legal environments. The impact of both internal and external variables on ultimate loss and LAE costs is difficult to estimate. Our exposure is impacted by both the risk characteristics of the physical locations where we write policies, such as hurricane and tropical storm-related risks, as well as risks associated with varying social, judicial and legislative characteristics in Florida, the state in which we operate. In determining loss reserves, we give careful consideration to all available data and actuarial analyses, and this process involves significant judgment.
respect to the current and prior year. In addition, a claims committee of our board of directors meets periodically to review any major claims. As we develop historical data regarding paid and incurred losses, we use this data to develop expected ultimate loss and loss adjustment expense ratios. We then apply these expected loss and loss adjustment expense ratios to earned premium to derive a reserve level for our homeowners line of business. In connection with the determination of these reserves, we will also consider other specific factors such as recent weather-related losses, trends in historical paid losses, and legal and judicial trends regarding liability. Most of our business was assumed from Citizens. Therefore, we use the loss ratio method, among other methods, to project an ultimate loss expectation, and then the related loss history must be regularly evaluated and loss expectations updated, with the possibility of variability from the initial estimate of ultimate losses.
The validity of the results from using a loss development approach can be affected by many conditions, such as internal claim department processing changes, a shift between single and multiple claim payments, legal changes, or variations in our mix of business from year to year. Also, since the percentage of losses paid for immature years is often low, development factors are volatile. A small variation in the number of claims paid can have a leveraging effect that can lead to significant changes in estimated ultimate losses. Therefore, ultimate values for immature accident years are often based on alternative estimation techniques.
The loss ratio method used by us relies on the assumption that remaining unreported losses are a function of the total expected losses rather than a function of currently reported losses. The expected loss ratio is multiplied by earned premium to produce ultimate losses. Paid losses are then subtracted from this estimate to produce expected unreported losses.
While the property and casualty industry has incurred substantial aggregate losses from claims related to asbestos-related illnesses, environmental remediation, product and mold, and other uncertain or environmental exposures, we have not experienced significant losses from these types of claims.
Our reported results, financial position and liquidity would be affected by likely changes in key assumptions that determine our net loss reserves. Management does not believe that any reasonably likely changes in the frequency of claims would affect our loss reserves. However, management believes that a reasonably likely increase or decrease in the severity of claims could impact our net loss reserves. The table below summarizes the effect on net loss reserves and equity in the event of reasonably likely changes in the severity of claims considered in establishing loss and loss adjustment expense reserves. The range of reasonably likely changes in the severity of our claims was established based on a review of changes in accident year development and applied to loss reserves as a whole. The selected range of changes does not indicate what could be the potential best or worst case or likely scenarios:
Income Taxes. We account 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. We determine 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. Valuation allowances are provided against assets that are not likely to be realized. We have elected to classify interest and penalties as income tax expense as permitted by current accounting standards.
Consolidated Statements of Earnings for the Years Ended December 31, 2009 and
Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2009 and
Consolidated Statements of Cash Flows for the Years Ended December 31, 2009 and
Notes to the Consolidated Financial Statements for the Years Ended December 31, 2009 and
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, 2009 and 2008, and the results of its operations and its cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.
Accounting Standards Codification. During 2009, the Company adopted the Financial Accounting Standards Board (“FASB”) Accounting Standards Update No. 2009-01 (“ASU 2009-01”), Topic 105 - Generally Accepted Accounting Principles amendments based on Statement of Financial Accounting Standards No. 168 - The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles (“ASC”). The ASC became the source of authoritative U.S. generally accepted accounting principles (“GAAP”) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. On the effective date of this Statement, the ASC supersedes all then-existing non-SEC accounting and reporting standards. All other non-grandfathered non-SEC accounting literature not included in the ASC will become non-authoritative. The adoption of the ASC and ASU 2009-01 did not change previous GAAP, but rather simplified user access to all authoritative literature related to a particular accounting topic in one place. Accordingly, the adoption did not have any effect on the Company’s consolidated financial condition or results of operations. All prior references to previous GAAP in the Company’s consolidated financial statements were updated for the new references under the ASC.
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, 2009 and 2008, cash and cash equivalents consist of cash on deposit with financial institutions.
The Company has elected to classify interest and penalties as income tax expense as permitted by current accounting standards.
Fair Value of Financial Instruments. The carrying amounts for the Company’s cash and cash equivalents and short-term investments approximate their fair values at December 31, 2009 and 2008 due to their short-term nature. The Company’s available-for-sale securities are carried at fair value as of the balance sheet date (see Note 3 - “Investments”).
Accounting Standards Update No. 2009-14. In October 2009, the FASB issued Accounting Standards Update No. 2009-14 (“ASU 2009-14”), Software (Topic 985), Certain Revenue Arrangements That Include Software Elements, a consensus of the FASB Emerging Issues Task Force. ASU 2009-14 changes the accounting model for revenue arrangements that include both tangible products and software elements. Tangible products that contain software components and non-software components that function together to deliver the tangible product’s essential functionality are no longer within the scope of the software revenue recognition guidance in Subtopic 985-605. The amendments in this update require that hardware components of a tangible product containing software components always be excluded from the software revenue guidance. Vendors impacted by the amendments in this update are required to provide disclosures that are included within the amendments in Update 2009-13. The amendments in this update will be effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 with early adoption permitted. The adoption of this guidance will not have a material effect on the Company’s consolidated financial condition or results of operations.
Accounting Standards Update No. 2009-17. In December 2009, the FASB issued Accounting Standards Update No. 2009-17 (“ASU 2009-17”), Consolidations (Topic 810), Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities. The amendments in ASU 2009-17 replace the quantitative-based risks and rewards calculation for determining which reporting entity, if any, has a controlling financial interest in a variable interest entity (“VIE”) with an approach focused on identifying which reporting entity has the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and either the obligation to absorb losses of the entity or the right to receive benefits from the entity. The amendments in ASU 2009-17 also require additional disclosures about a reporting entity’s involvement in VIEs. ASU 2009-17 is effective as of the beginning of the first annual reporting period beginning after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. The adoption of this guidance had no effect on the Company’s consolidated financial condition or results of operations.
Accounting Standards Update No. 2010-01. In January 2010, the FASB issued Accounting Standards Update No. 2010-01 (“ASU 2010-01”), Equity (Topic 505), Accounting for Distributions to Shareholders with Components of Stock and Cash, a consensus of the FASB Emerging Issues Task Force. The amendments in ASU 2010-01 clarify that the stock portion of a distribution to shareholders that allows them to elect to receive cash or stock with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance that is reflected in earnings per share prospectively and is not a stock dividend for purposes of applying Topics 505 and 206 (Equity and Earnings Per Share). ASU 2010-01 is effective for interim and annual reporting periods ending on or after December 15, 2009. The adoption of this guidance had no effect on the Company’s consolidated financial condition or results of operations.
Accounting Standards Update No. 2010-04. In January 2010, the FASB issued Accounting Standards Update No. 2010-04 (“ASU 2010-04”), Accounting for Various Topics, Technical Corrections to SEC Paragraphs. The amendments in ASU 2010-04 represent technical corrections effective January 15, 2010 to Securities and Exchange Commission guidance on various ASC Topics. The adoption of this guidance did not have a material effect on the Company’s consolidated financial condition or results of operations.
The scheduled maturities of fixed maturity securities at December 31, 2009 are as follows (in thousands):
In addition, at December 31, 2009 and 2008, cash and cash equivalents included $21.6 million and $73.8 million, respectively, on deposit at Bank of America.
In November 2008, the Company entered into a loan agreement under which the Company advanced $450,000 to a non-affiliated entity. The loan was payable on demand after September 1, 2009 and required quarterly interest payments to be made to the Company at a fixed annual rate of 7.0% beginning on January 1, 2009. The loan agreement was collateralized by a security interest in all of the noteholder’s property and rights, and title and interest in, its intellectual property, including without limitation money, accounts, stock, stock options, wages, documents, instruments, receivables, inventory, machinery, equipment, automobiles and the proceeds of any of the foregoing.
All scheduled interest payments were made to the Company during 2009. In September 2009, the Company received $451,143 representing the full amount of $450,000 in principal due plus the remaining $1,143 of accrued interest in full settlement of the note receivable.
During the year ended December 31, 2009, there were no recoveries pertaining to reinsurance contracts that were deducted from losses incurred and there were no such amounts recoverable at December 31, 2009. At December 31, 2009, prepaid reinsurance premiums related to 26 reinsurers. Thus, there were no concentrations of credit risk associated with reinsurance receivables and prepaid reinsurance premiums as of December 31, 2009. During the year ended December 31, 2008, the recoveries pertaining to reinsurance contracts that were deducted from losses incurred amounted to approximately $175,000 and related to one non-catastrophic event. At December 31, 2008, ceded reinsurance balances receivable of $157,000 were due from one reinsurer. At December 31, 2008, prepaid reinsurance premiums related to 30 reinsurers.
At December 31, 2009, assumed reinsurance balances receivable of $19.5 million related to the December 2009 assumption of certain policies from Citizens. The entire balance outstanding at December 31, 2009 was collected in January 2010.
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, 2009 or 2008.
A summary of the numerator and denominator of the basic and fully diluted earnings per share is presented below (dollars and shares in thousands, except per share amounts):
For each of the years ended December 31, 2009 and 2008, 40,000 options to purchase 40,000 shares of common stock were excluded from the computation of diluted earnings per share because the exercise price of $7.00 exceeded the average market price of the Company’s common stock. For the years ended December 31, 2009 and 2008, 1,738,668 and 1,771,668 warrants, respectively, to purchase 945,334 and 978,334 shares of common stock, respectively, were excluded from the computation of diluted earnings per share because the exercise price of $9.10 exceeded the average market price of the Company’s common stock.
Effective March 18, 2009, the Company’s Board of Directors authorized a plan to repurchase up to $3.0 million (inclusive of commissions) of the Company’s common shares. The repurchase plan allowed the Company to repurchase shares from time to time through March 19, 2010. This repurchase plan was supplemented in December 2009 upon approval by the Board of Directors to extend the repurchase authority by an additional $3.0 million and continue until the repurchase plan is terminated by the Company or the maximum number of dollars has been expended. The shares may be purchased for cash in open market purchases, block transactions and privately negotiated transactions in accordance with applicable federal securities laws. The share repurchase plan may be modified, suspended, terminated or extended by the Company any time without prior notice. During the year ended December 31, 2009, the Company repurchased and retired a total of 452,033 shares at an average price of $6.83 per share and a total cost, inclusive of fees and commissions, of $3,111,000, or $6.88 per share. At December 31, 2009, a total of $2,889,000 is available in connection with this plan.
The components of comprehensive income are as follows (dollars in thousands):
At December 31, 2009 and 2008, there was approximately $185,000 and $668,000, respectively, of total unrecognized compensation expense related to nonvested stock-based compensation arrangements granted under the plan. The Company expects to recognize the remaining compensation expense over a weighted-average period of fifteen (15) months. During the years ended December 31, 2009 and 2008, a total of 16,000 and 44,000 options, respectively, were exercised. The total fair value of shares vesting and recognized as compensation expense was approximately $483,000 and $466,000, respectively, for the years ended December 31, 2009 and 2008 and the associated income tax benefit recognized was $164,000 and $157,000 respectively. The total intrinsic value of options exercised during the years ended December 31, 2009 and 2008 was $42,000 and $96,960, respectively, and the income tax benefit recognized was $9,000 and $26,000, respectively.
Claddaugh has been required since inception to maintain minimum capital and surplus of $2.0 million, which the Company funded with a $120,000 cash deposit and a $1,880,000 bank letter of credit. Claddaugh is the beneficiary of the letter of credit, which is collateralized by a $1,880,000 certificate of deposit.
Under Florida law, a domestic insurer may not pay any dividend or distribute cash or other property to its stockholders except out of that part of its available and accumulated capital and surplus funds which is derived from realized net operating profits on its business and net realized capital gains. A Florida domestic insurer may not make dividend payments or distributions to stockholders without prior approval of the Florida Office of Insurance Regulation (OIR) if the dividend or distribution would exceed the larger of (1) the lesser of (a) 10.0% of its capital surplus or (b) net income, not including realized capital gains, plus a two year carry forward, (2) 10.0% of capital surplus with dividends payable constrained to unassigned funds minus 25% of unrealized capital gains or (3) the lesser of (a) 10.0% of capital surplus or (b) net investment income plus a three year carry forward with dividends payable constrained to unassigned funds minus 25% of unrealized capital gains. At December 31, 2009 and 2008, no dividends are available to be paid by HCPC.
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 year ended December 31, 2009 were approximately $103,000. Fees incurred during the year ended December 31, 2008 amounted to $643,000 of which $607,000 related to the Company’s initial public offering.
Management has evaluated events occurring subsequent to the balance sheet date and has determined that, except for the above item, there are no events requiring additional disclosure in these consolidated financial statements.