Our historical consolidated balance sheet data as of December 31, 2011 and 2010 and our consolidated statement of operations data for the years ended December 31, 2011, 2010 and 2009 have been derived from our audited historical financial statements included elsewhere in this Form 10-K. The following table shows our selected historical financial data for the periods indicated (in thousands, except per share data). You should read our selected historical financial data, together with the notes thereto, in conjunction with the more detailed information contained in our financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in this Form 10-K.
We extended a senior unsecured loan to SWS Group, Inc .
We have prepared our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America, or GAAP, which requires us to make certain estimates and assumptions that affect the recorded amount of assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results may differ from these estimates. We have provided a summary of our significant accounting policies in Note 1 to the accompanying consolidated financial statements as of, and for the year ended, December 31, 2011. We have summarized below those accounting policies that require our most difficult, subjective or complex judgments and that have the most significant impact on our financial condition and results of operations. Our management evaluates these estimates on an ongoing basis. These estimates are based on information currently available to management and on various other assumptions management believes are reasonable.
The reserve analysis performed by our actuaries provides preliminary central estimates of the unpaid losses and LAE. At each quarter-end, the results of the reserve analysis are summarized and discussed with our senior management. The senior management group considers many factors in determining the amount of reserves to record for financial statement purposes. These factors include the extent and timing of any recent catastrophic events, historical pattern and volatility of the actuarial indications, the sensitivity of the actuarial indications to changes in paid and reported loss patterns, the consistency of claims handling processes, the consistency of case reserving practices, changes in our pricing and underwriting, and overall pricing and underwriting trends in the insurance market.
The underlying process of establishing our best estimate of the liability for unpaid losses and LAE require the use of estimates, actuarial judgment and management considerations and, therefore, is an inherently uncertain process. The recorded reserves for the companies’ liability for unpaid losses and LAE are estimates based on long term averages. Actual loss experience in any given year may differ from what is suggested by these averages. For some lines of business, the written premium volume is small and actual results are therefore subject to an exceptionally high degree of variability. While the recorded reserves are our best estimate as of a particular point in time, these reserves should be considered best estimates within a wide range of possible outcomes.
Investment Securities. At December 31, 2011, investment securities consist of U.S. Government, mortgage-backed, corporate debt and equity securities. Also included in our investment portfolio are other investments, which consist of a note receivable and warrants, held by the parent, HTH. We have the ability to categorize investments as trading, available-for-sale, and held-to-maturity. We classify our fixed maturities as either available-for-sale or held-to-maturity and equity securities as available-for-sale. Trading securities are bought and held principally for the purpose of selling them in the near term. As of December 31, 2011, all securities were classified as available-for-sale.
Trading and available-for-sale securities are recorded at fair value. Unrealized holding gains and losses on trading securities are included in earnings. Unrealized holding gains and losses, net of the related tax effect, on available-for-sale securities are excluded from earnings and are reported as a separate component of other comprehensive income until realized. Realized gains and losses from the sale of trading and available-for-sale securities are determined on a specific-identification basis.
· Level 2 - Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in inactive markets; or valuations based on models where the significant inputs are observable (e.g., interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.) or can be corroborated by observable market data. Based on management’s understanding of the methodologies used by our pricing service, all applicable investments have been valued in accordance with GAAP valuation principles.
· Level 3 - Valuations based on models where significant inputs are not observable. The unobservable inputs reflect the Company’s own assumptions about the assumptions that market participants would use.
The Company utilizes a pricing service to estimate fair value measurements for its fixed maturities. The pricing service utilizes market quotations for fixed maturity securities that have quoted prices in active markets. Since fixed maturities other than U.S. Treasury securities generally do not trade on a daily basis, the pricing service prepares estimates of fair value measurements for these securities using its proprietary pricing applications, which include available relevant market information, benchmark curves, benchmarking of like securities, sector groupings and matrix pricing.
The Company holds investments in SWS as a note receivable and warrants, which are reported in other investments. The $60.4 million fair value of these investments at December 31, 2011 was disclosed in Level 3. The fair value estimate is determined based on recent filings, operating results, balance sheet stability, growth and other business and market sector fundamentals. Due to the significant unobservable inputs in these valuations, the Company includes the total fair value estimate for all of these investments at December 31, 2011 in the amount disclosed in Level 3.
Deferred Acquisition Costs. Costs of acquiring insurance vary with, and are related to, the production of new and renewal business, primarily consisting of commissions, premium taxes and underwriting expenses. These costs are deferred and amortized over the terms of the policies or reinsurance treaties to which they relate. Proceeds from reinsurance transactions that represent recovery of acquisition costs reduce applicable unamortized acquisition costs in a manner that net acquisition costs are capitalized and charged to expense in proportion to net revenue recognized. Future investment income is considered in determining the recoverability of deferred acquisition costs. The Company regularly reviews the categories of acquisition costs that are deferred and assesses the recoverability of this asset. A premium deficiency, and a corresponding charge to income, is recognized if the sum of the expected loss and loss adjustment expenses, unamortized acquisition costs, and maintenance costs exceed related unearned premiums and anticipated investment income. At December 31, 2011, there was no premium deficiency.
Deferred tax assets, including net operating loss and tax credit carry forwards, are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that any portion of these tax attributes will not be realized. Valuation allowances on deferred tax assets are established, if necessary, to reduce deferred tax assets to an amount expected to be recognized. In accordance with ASC 740, the Company considered all negative and positive evidence available including our cumulative pre-tax loss position since the quarter ending December 31, 2008, less any abnormal occurrences during that period,
From time to time, management must assess the need to accrue or disclose a possible loss contingency for proposed adjustments from various Federal, state and foreign tax authorities that regularly audit the company in the normal course of business. In making these assessments, management often must analyze complex tax laws of multiple jurisdictions.
Goodwill and Other Indefinite Lived Intangible Assets. HTH performs our annual goodwill impairment analysis for our reporting units during the fourth quarter of each year. Management determined that HTH has two reporting units, which are the Parent (the holding company) and NLASCO (the insurance company). Goodwill for HTH represents the excess of the cost over the fair value of the assets of NLASCO of $24.0 million. Goodwill is tested annually for impairment but is tested more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value.
The goodwill impairment analysis is subject to impact from uncertainties arising from such events as changes in economic or competitive conditions, the current general economic environment, material changes in the weather and hard and soft markets within the insurance industry that could positively or negatively impact anticipated future operating conditions and cash flows, and the impact of strategic decisions. If any of these factors were to material change it may require a reevaluation of our Goodwill.
Revenue. Revenue for the year ended December 31, 2011 was $152.5 million, compared to $131.7 million for the year ended 2010. This increase is due to net premiums earned of $134.0 for the year ended 2011, compared to $117.2 million for the year ended 2010, $10.8 million of net investment income for the year ended 2011 compared to $7.7 million for the year ended 2010, $6.8 million of other income for the year ended 2011 compared to $6.7 million in 2010 and $0.8 million in net realized investment gains for the year ended 2011 as compared to $0.1 million for the year ended 2010.
For the twelve months ended December 31, 2011 and 2010, the Company had incurred losses related to two 2008 catastrophes, Hurricane Ike and Hurricane Dolly. The Company also incurred losses in 2011 related to a catastrophic wind and hail storm in Arizona from October 2010. Gross losses incurred from these storms had favorable development of $7.0 million for the year ended December 31, 2011, compared to $28.9 million of development for the same period in 2010. The redundancy in 2011 is primarily due to decreases in ultimate losses for Hurricane Ike and Hurricane Dolly of $9.3 million and $1.0 million, respectively, which were offset by development on the Arizona storm of $3.3 million. The losses in the year ended December 31, 2010 relate primarily to lawsuits filed in response to the pending expiration of the statute of limitations. These losses have no effect on net loss and LAE incurred because the catastrophic events exceeded our retention and are fully recoverable. The primary financial effect is additional reinstatement premium payable to the affected reinsurers. For the year ended December 31, 2011 and 2010, the Company incurred reinstatement premiums of $0.1 million and $2.5 million, respectively.
Premiums. The property and casualty insurance industry is affected by soft and hard market business cycles. During a soft market, price competition tends to increase as insurers are willing to reduce premium rates in order to maintain growth in premium volume. The soft market makes it more difficult to attract new business, as well as retain exposures that are adequately priced. Although we recognize the need to remain competitive in the marketplace, the Company remains committed to its disciplined underwriting philosophy, accepting only risks that are appropriately priced, while declining risks which are under priced for the level of coverage provided.
Direct premiums written by major product line for the year ended December 31, 2011 and 2010 are presented in the table below (in thousands):
Net premiums written by major product line for the year ended December 31, 2011 and 2010 are presented in the table below (in thousands):
Total net premiums written increased for the year ended December 31, 2011 for all lines of business, except other, due to higher direct written premiums of $15.8 million, and a decrease in ceded premiums of $4.0 million. Ceded premiums decreased primarily as a result of lower reinstatement premiums of $2.4 million and lower reinsurance costs of $1.9 million in 2011 as compared to 2010. Reinsurance costs decreased in the year ended December 31, 2011, due to the Company increasing retention by $2.0 million.
Policy Acquisition and Other Underwriting Expenses. Policy acquisition and other underwriting expenses for the year ended December 31, 2011 and 2010 were as follows (in thousands):
Total policy acquisition and other underwriting expenses, less agency expenses, are up $3.5 million for the twelve months ended December 31, 2011, as compared to the same period in 2010, due to higher amortization of deferred policy acquisition costs (DAC). DAC increased during the year ended December 31, 2011 due to increases in direct written premiums, as compared to the year ended 2010.
Depreciation and Amortization Expense. Depreciation and amortization expense was $1.7 million for the year ended December 31, 2011, as compared to $1.8 million in 2010.
Income Taxes. The Company had a $5.0 million income tax benefit for the year ended December 31, 2011, compared to $1.0 million for 2010. The benefit increased in 2011 due to pre-tax losses of $11.5 million for the year ended December 31, 2011 as compared to $1.6 million loss for the same period in 2010. Also contributing to the benefit in 2011 was the release of the allowance for uncertain tax positions on the state tax receivable at the parent of $1.0 million. We allocate income taxes in accordance with ASC 740.
Preferred Stock Dividend. On March 11, 2010 and June 10, 2010, the HTH board of directors declared quarterly cash dividends of $0.5156 per share on each of the 5,000,000 outstanding shares of our Series A Preferred Stock, payable April 30, 2010 and July 30, 2010, amounting to $2.6 million on each disbursement date. On August 6, 2010, the Company called for redemption all of the outstanding shares of its Series A Preferred Stock. The Series A Preferred Stock was redeemed on September 6, 2010, at a cash redemption price of $25.2063 per share, representing the liquidation preference of $25.00 per share, plus accrued and unpaid dividends to, and including, the date of redemption. For the twelve months ended December 31, 2011, the dividend was $0.00 per share as compared to $1.2375 per share in the twelve months ended December 31, 2010.
Our combined ratio for the twelve months ended December 31, 2010 is 96.5%, as compared to 96.8% for the same period in 2009. The decrease in loss and LAE ratio in 2010 is due to lower average loss per claim, offset in part by the emergence of prior year claims in 2010. The higher loss and LAE ratio in 2009 is primarily due to the incurred losses related to non-catastophic claims, specifically the wind and hail losses, which tended to be more significant than current experience.
Loss and Loss Adjustment Expenses. Loss and LAE are recognized based on formula and case basis estimates for losses reported with respect to direct business, estimates of unreported losses based on past experience and deduction of amounts for reinsurance placed with reinsurers. The loss and LAE ratio is calculated by taking the ratio of incurred losses and LAE to net premiums earned. The loss and LAE ratio for the year ended December 31, 2010 and 2009 was 60.5% and 61.0%, respectively. The decrease in loss and LAE ratio in 2010 is due to lower average loss per claim for the 2010 accident year, offset in part by the emergence of prior year claims in 2010.
The Company’s net loss and LAE and the gross loss and LAE ratios for the year ended December 31, 2010 and 2009 are shown in the tables below (in thousands, except claim count figures):
As of December 31, 2011, we had $578.5 million in cash and cash equivalents, consisting of $533.4 million held by the parent company and $45.1 million held by NLASCO and its subsidiaries. At December 31, 2011, we had total investments of $224.2 million, consisting of investments in available-for-sale equities with a fair value of $19.0 million, $144.8 million in fair value of fixed maturities securities and other investments consisting of a note receivable and warrants with a combined fair value of $60.4 million. HTH held $10.1 million of the investments in available-for-sale equities and $60.4 million of other investments. NLASCO held $152.1 million in available-for-sale fixed maturity securities and $8.9 million in available-for-sale equity securities.
NLASCO’s liquidity requirements are met primarily by positive cash flow from operations and investment activity. Primary sources of cash from insurance operations are premiums and other considerations, net investment income and investment sales and maturities. Primary uses of cash include payments of claims, operating expenses and income taxes, funds to service $47.5 million of debt and purchases of investments. NLASCO’s insurance subsidiaries have regulatory restrictions on the amount of dividends they can declare.
Regulations of the Texas Department of Insurance require insurance companies to maintain minimum levels of statutory surplus to ensure their ability to meet their obligations to policyholders. At December 31, 2011, NLASCO’s insurance subsidiaries had statutory surplus in excess of the minimum required.
Also, the National Association of Insurance Commissioners, or NAIC, has adopted risk-based capital, or RBC, requirements for insurance companies that establish minimum capital requirements relating to insurance risk, credit risk, interest rate risk and business risk. The formula is used by the NAIC and certain state insurance regulators as an early warning tool to identify companies that require additional scrutiny or regulatory action. At December 31, 2011, the Company’s insurance subsidiaries’ RBC ratio exceeded the level at which regulatory action would be required.
We believe that restrictions on liquidity resulting from restrictions on the payments of dividends by our subsidiary companies will not have a material impact on our ability to carry out our normal business activities, including debt payments on our senior exchangeable notes.
Cash used in operations was $3.3 million in 2011, as compared to cash provided by operation of $9.9 million in 2010. The Company used $13.2 million more cash in 2011 due to higher loss from operations of $6.0 million, lower income tax receivable of $2.3 million, lower deferred income taxes of $5.4 million, changes in operating assets and liabilities of $9.1 million and lower loss and LAE reserves of $39.1 million. These negative operating results were offset by a decrease in reinsurance recoverables of $43.7 million, an increase in unearned premiums of $3.2 million, and a decrease in payable to related party of $3.4 million.
Cash used in investing activities was $60.7 million in 2011, as compared to $16.7 million in 2010. The increase in cash used by investing activities of $44.0 million was primarily due to purchases of available-for-sale securities and other investments of $11.5 million and $50.0 million, respectively, lower proceeds from sales of available-for-sale securities of $11.2 million, offset by proceeds from sales of held-to-maturity securities of $7.4 million.
Cash used in financing activities was $6.9 million in 2011, as compared with $133.8 million in 2010. The decrease in cash used in financing activities was primarily due to the redemption of preferred stock in 2010 of $125 million. The cash used in 2011 is related to the repurchase of the parent held senior exchangeable notes by NLASCO.
Cash provided by operations was $9.9 million in 2010, as compared to $18.9 million in 2009. Cash provided by operations decreased $9.0 million primarily due to increase in deferred acquisition costs of $1.7 million, decrease in cash received from income taxes of $20.2 million, decrease in payable to related party of $4.4 million, offset by decrease in net loss of $1.6 million, increase in deferred income taxes of $0.5 million, increase in unearned premiums of $5.0 million and changes in operating assets and liabilities of $10.2 million.
At December 31, 2011, we had $131.5 million of outstanding indebtedness. It consists of the following: $84 million, or 64%, of our total indebtedness is fixed rate and $47.5 million, or 36%, is variable rate. At December 31, 2011, we had the following indebtedness outstanding with the following repayment obligations (in thousands):
At December 31, 2011 the following table shows our outstanding commitments for leases (in thousands).