Overview: We are a property and casualty insurance holding company headquartered in Clearwater, Florida and, through our insurance subsidiaries, we provide personal residential insurance for single-family homeowners and condominium owners, and rental property insurance in the states of Florida, Hawaii, North Carolina and South Carolina. We provide commercial residential insurance in Florida and are also licensed in the states of Georgia, Alabama and Mississippi. We are vertically integrated and control or manage substantially all aspects of insurance underwriting, customer service, actuarial analysis, distribution and claims processing and adjusting. We are led by an experienced senior management team with an average of 30 years of insurance industry experience. Heritage P&C and Zephyr are both currently rated “A” (“Exceptional”) or better by Demotech, Inc. (“Demotech”), a rating agency specializing in evaluating the financial stability of insurers.
We intend the discussion of our financial condition and results of operations that follows to provide information that will assist the reader in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles, policies and estimates affect our consolidated financial statements. This discussion should be read in conjunction with our consolidated financial statements and the related notes that appear elsewhere in this document.
Discussion of our business and overall financial results, and other highlights related to our results of operations for the periods presented.
There were 323,301 policies in-force at December 31, 2016, of which approximately 52.9% were assumed from Citizens, 22.7% were acquired in connection with the Zephyr acquisition, 6.0% were assumed from SSIC and 18.4% were from Heritage P&C voluntary sales
Gross premiums written of $626.7 million and total revenue of $439 million
Cash, cash equivalents and investments of $708.8 million, with total assets of $1 billion
Gross premiums earned. Gross premiums earned represent the total premiums earned during a period from policies assumed from Citizens, net of opt-outs, as well as policies acquired from SSIC, subsequent renewals of such policies and voluntary policies. Premiums associated with assumed policies are earned ratably over the remaining term of the policy and premiums associated with voluntary and renewed policies are earned ratably over the twelve-month term of the policy.
Net investment income. Net investment income represents interest earned from fixed maturity securities, short term securities and other investments, dividends on equity securities, and the gains or losses from the sale of investments.
Combined ratios. Our combined ratio on a gross basis represents the sum of ceded premiums, losses and loss adjustment expenses, policy acquisition costs and general and administrative expenses as a percentage of gross premiums earned. Our combined ratio on a net basis represents the sum of losses and loss adjustment expenses, policy acquisition costs and general and administrative expenses as a percentage of net premiums earned.
Net premiums earned increased to $411.7 million for the year ended December 31, 2016 from $376.3 million for the year ended December 31, 2015. The increase in net premiums earned in the comparable periods is primarily attributable to the increase in the number of policies in force during the year ended December 31, 2016 as compared to the year ended December 31, 2015, including the growth in policy count experienced in the second half of 2015 partially offset by increased ceded earned premiums.
Net investment income, inclusive of net realized investment gains and losses, increased to $10.9 million for the year ended December 31, 2016 from $8.9 million for the year ended December 31, 2015. The increase in net investment income is due to the increase in invested assets from $400.1 million at December 31, 2015 to $603 million at December 31, 2016. The increase resulted primarily from policy growth and the acquisition of Zephyr.
Ratios - Year Ended December 31, 2016 Compared to Year Ended December 31, 2015
Our ceded premium ratio increased to 35.7% for the year ended December 31, 2016 compared to 28.3% for the year ended December 31, 2015. The ceded premium ratio for the year ended December 30, 2015 benefited significantly from large Citizens depopulation activity in the fourth quarter of 2014 and first quarter of 2015, for which we incurred no additional reinsurance costs until June 1, 2015. Additionally, the 2016 reinsurance program, which was effective June 1, 2016, included coverage for an increase in commercial residential policies and the addition of Zephyr and Heritage wind only polices, all of which have a higher ceded premium ratio.
Results of Operations - Year Ended December 31, 2015 Compared to Year Ended December 31, 2014
Ceded premiums increased to $148.5 million for the year ended December 31, 2015 from $87.9 million for the year ended December 31, 2014. The increase in ceded premiums is primarily a result of the significant increase in the policies in force noted above, in particular the introduction of commercial residential business which has higher reinsurance costs as measured against gross earned premium than personal residential. The increase in ceded premiums was partially offset by lower reinsurance costs due to favorable reinsurance market conditions and the availability of lower cost reinsurance related to $477.5 million of catastrophe bonds issued by Citrus Re, and improved geographic spread of risk.
Net premiums earned increased to $376.3 million for the year ended December 31, 2015 from $223.6 million for the year ended December 31, 2014. The increase in net premiums earned in the comparable periods is primarily attributable to the increase in the number of policies in force during the year ended December 31, 2015 as compared to the year ended December 31, 2014, the growth in policy count experienced in the second half of 2014, partially offset by increased ceded earned premiums.
Total revenue increased to $394.8 million for the year ended December 31, 2015 from $233.8 million for the year ended December 31, 2014. The increase in total revenue was due primarily to the growth in net premiums earned resulting from the significant increase in the number of policies in force throughout the year ended December 31, 2015 as compared to the prior year.
Policy acquisition costs increased to $57.2 million for the year ended December 31, 2015 from $36.5 million for the year ended December 31, 2014. The increase is primarily attributable to the significant increase in new and renewed policies, which have associated commissions and administration fees paid to outside agents and administrators at the time of policy issuance, premium taxes and inspection fees, none of which are associated with policies assumed from Citizens prior to their renewal. This was partially offset by the fact that, $7.6 million of the $10 million SSIC policy acquisition fee was amortized during the year ended December 31, 2014, compared to only $2.4 million during the year ended December 31, 2015.
Provision for income taxes was $57.8 million and $27.2 million for the years ended December 31, 2015 and 2014, respectively. Our effective tax rates for the years ended December 31, 2015 and 2014 were 38.6% and 36.6%, respectively. The increase in the effective tax rate is a result of prior period adjustments and more favorable permanent differences in 2014.
For the year ended December 31, 2015 we generated net income of $92.5 million, or $3.05 earnings per diluted common share, compared to net income of $47.1 million, or $1.82 earnings per diluted common share, for the year ended December 31, 2014. The weighted average shares outstanding on a diluted basis increased from 25.8 million shares to 30.3 million shares as of December 31, 2015, primarily due to the issuance of IPO shares mid-year 2014 causing 2014 diluted shares to be lower.
Ratios - Year Ended December 31, 2015 Compared to Year Ended December 31, 2014
Our gross loss ratio decreased to 26.9% for the year ended December 31, 2015 from 28.7% for the year ended December 31, 2014, primarily due to the introduction of commercial residential business during the quarter ended December 31, 2014, which has a significantly lower loss ratio then personal residential. Commercial residential represented 18.5% of total gross earned premiums in 2015 compared to 6.1% in 2014.
Our net loss ratio decreased to 37.5% for the year ended December 31, 2015 from 40.1% for the year ended December 31, 2014, primarily as a result of the increase in commercial residential business in 2015.
As of December 31, 2016, we had $105.8 million of cash and cash equivalents, which primarily consisted of cash and money market accounts. We intend to hold substantial cash balances during hurricane season to meet seasonal liquidity needs and the collateral requirements of Osprey, our captive reinsurance company described below. We also had $20.9 million in restricted cash to meet our contractual obligations related to the Catastrophe bonds issued by Citrus Re.
Osprey is required to maintain a collateral trust account equal to the risk that it assumes from our insurance company affiliates, less amounts collateralized through a letter of credit. As of December 31, 2016, $12.8 million was held in Osprey’s trust account, $12.7 million was collateralized with a letter of credit, and there was a net premium receivable from Heritage P&C of $14.6 million which was paid on February 7, 2017. At December 31, 2016, Osprey provided $20 million excess $20 million of reinsurance coverage to Heritage P&C and Zephyr and $20 million excess $0 to Heritage P&C under two different reinsurance programs.
As of December 31, 2016, we had 28,840,443 shares of common stock outstanding, options to purchase 1,149,923 shares of common stock, at a weighted average price of $16.28 and 900,000 unvested shares of restricted common stock, reflecting total paid-in capital of $205.7 million as of such date.
On December 15, 2016, we issued Senior Notes in the aggregate principal amount of $79.5 million which consisted of a 7 year term note payable to 6 accredited investors. See Note 11 - “Note Payable” to our consolidated financial statements under Item 8 of this Annual Report on Form 10-K.
Net cash provided by operating activities for December 31, 2016 was $75.1 million as compared to $153.1 million cash provided during the year ended December 31, 2015. The decrease resulted primarily from the timing of assumed premium payments from Citizens, reinsurance premium payments, claim payments, and tax deposit payments.
In prior years we reported a deferred tax asset arising from the portion (20%) of unearned premiums that are otherwise recognized as taxable income in advance of being earned for financial reporting purposes. In 2016, there was a shift to a deferred tax liability. The deferred tax liability is created from purchase accounting for the Zephyr acquisition which created temporary differences due to the timing of tax deductions related to the purchased intangibles. In prior years we reported a net deferred tax asset which was driven primarily by the deferred tax asset arising from the portion (20%) of unearned premiums that are otherwise recognized as taxable income in advance of being earned for financial reporting purposes which was partially offset by deferred tax liabilities associated with policy acquisition costs deferred and amortized for financial statement purposes, but deducted currently for tax. In 2016, the Company reported a net deferred tax liability. The change from 2015 was primarily driven by an increase in deferred tax liabilities associated with Zephyr purchased intangibles for which the Company has no tax basis. Furthermore, the Company had recorded deferred tax liabilities associated with partnership investments for which the book basis is greater than the corresponding tax basis largely due to accelerated taxable losses being recorded in the current year. Our current year income taxes recoverable reflects excess estimated tax deposits over the tax to be remitted to the US Treasury. The excess payments are largely the result of the estimation process required by the Internal Revenue Service throughout the year to pay estimated quarterly deposits which indicated larger annualized tax liability than was actually realized at December 31. Our current year income taxes recoverable reflect this temporary difference between taxable income and earned income reported in our financial statements.
The following table summarizes our material contractual obligations and commitments as of December 31, 2016:
When we receive premium payments from policyholders prior to the effective date of the related policy, we record an advance premium liability. On the policy effective date, we reduce the advance premium liability and record the premiums as described above.
Our chief actuary evaluated the adequacy of our reserves as of December 31, 2016 and concluded that total reserves ranging from a low of $129.4 million to a high of 145.9 million would meet the requirements of the insurance laws of Florida, be consistent with reserves computed in accordance with accepted loss reserving standards and principles, and make a reasonable provision for all unpaid loss and loss adjustment expense obligations under the terms of our contracts and agreements. In addition to $56.5 million of recorded case reserves, we recorded $83.6 million of IBNR reserves as of December 31, 2016 to achieve overall gross reserves of $140.1 million.
The following table quantifies the pro forma impact of hypothetical changes in our loss reserves on our net income, stockholders’ equity and liquidity as of and for the year ended December 31, 2016 (in thousands).
Adjusted cash, cash equivalents and investments is intended to present a measure of future liquidity and consists of cash, cash equivalents and investments, less loss reserves, net of taxes, assuming a 38.575% tax rate.
We estimate uncollectible amounts receivable from reinsurers based on an assessment of factors including the creditworthiness of the reinsurers and the adequacy of collateral obtained, where applicable. We recorded no uncollectible amounts under our reinsurance program or bad debt expense related to reinsurance for the years ended December 31, 2016 and December 31, 2015.
The carrying amounts for the following financial instruments approximate their fair values at December 31, 2016 and December 31, 2015 because of their short-term nature: cash and cash equivalents, accrued investment income, premiums receivable, reinsurance payable, and accounts payable and accrued expenses.
are judgmental and highly sensitive in the determination of compensation expense. The fair value of restricted stock awards are estimated by the market price at the date of grant and amortized on a straight-line basis to expense over the period of vesting. We recorded $3.1 million, $2.6 million and $3.3 million of stock-based compensation in 2016, 2015 and 2014, respectively.
Long-term Debt and Debt issuance costs. On December 15, 2016, the Company entered into a Senior Secured Note (the “Notes”) with six accredited investors. The Notes has a total debt capacity of $80.0 million. The Company received net proceeds from the Note of $77.9 million. The Notes have a maturity date of December 15, 2023 and bear interest at a rate equal to a three-month average of LIBOR plus 8.75% per annum. The Company incurred 2% of gross proceeds in debt issuance costs or $1.6 million which consist of fees and expenses incurred in connection with the Note issuance, including legal, accounting and other related fees and a 6% one-time finders’ fee of $4.8 million. The debt issuance costs are amortized using the effective interest method over the terms of the debt issuance. The amortization expense is included in interest expense in the Company’s Consolidated Statements of Income and Comprehensive Income. Under the guidance of ASU No. 2015-03, the debt financing costs related to recognized debt liabilities is required to be presented on our balance sheet as a direct reduction, or contra liability, from the carrying value of the debt. At December 31, 2016, the Company has recorded on its balance sheet the net debt liability of $72.9 million. For the years ended December 31, 2016 and 2015, the Company capitalized $6.6 million and $0, in total capitalized debt insurance costs, respectively.
We record any income tax penalties and income tax-related interest as income tax expense in the period incurred. We did not incur any material tax penalties or income tax-related interest during the years ended December 31, 2016, 2015 and 2014.
In April 2015, the Financial Accounting Standards Board (“FASB”) issued guidance for Simplifying the Presentation of Debt Issuance Costs. This guidance requires debt issuance costs (deferred financing costs) related to a recognized debt liability to be presented on the balance sheet as a direct deduction from the related debt liability, similar to the presentation of debt discounts. The update is effective for fiscal years beginning after December 15, 2015 and interim periods within those fiscal years. Additionally, in August 2015, the FASB issued additional guidance, which provides further clarification on the same topic and states that the SEC would not object to the deferral and presentation of debt issuance costs as an asset and subsequent amortization of the deferred costs over the term of the line-of-credit arrangement, regardless of whether there are any outstanding borrowings on the line-of-credit arrangement. This guidance does not have a material effect on our consolidated financial statements as it results only in a reclassification on the Consolidated Statements of Assets and Liabilities. Accordingly, there was no impact on net asset value or net increase in net assets resulting from operations as a result of adoption of this guidance.
Consolidated Balance Sheets as of December 31, 2016 and December 31, 2015
Our primary products are personal and commercial residential insurance, which we currently offer in Florida, North Carolina, South Carolina, Georgia and through the Zephyr acquisition, Hawaii. We conduct our operations under a single reporting segment.
Certain prior year amounts have been reclassified to conform to current year presentation. Such classifications include goodwill and intangibles from other assets in the accompanying consolidated balance sheets.
As of December 31, 2016 and 2015, restricted cash was $20.9 million and $13.1 million, respectively. Heritage P&C holds approximately $19.3 million relating to a reinsurance agreement with an entity that issued catastrophe (“CAT”) bonds, as Heritage P&C is contractually required to deposit two installments of reinsurance premiums into a trust account.
Level 1-Assets and liabilities with values based on unadjusted quoted prices for identical assets or liabilities in an active market that the Company is able to access;
The Company estimates the fair value of its investments using the closing prices on the last business day of the reporting period, obtained from active markets such as the NYSE and NASDAQ. For securities for which quoted prices in active markets are unavailable, the Company uses observable inputs such as quoted prices in inactive markets, quoted prices in active markets for similar instruments, benchmark interest rates, broker quotes and other relevant inputs. The Company does not have any investments in its portfolio which require the use of unobservable inputs. The Company’s estimate of fair value reflects the interest rate environment that existed as of the close of business on December 31, 2016. Changes in interest rates subsequent to December 31, 2016 may affect the fair value of the Company’s investments.
The Company believes the carrying amounts of its cash and cash equivalents, accounts receivable, accounts payable, accrued expenses, and other current liabilities approximate their fair values at December 31, 2016 and December 31, 2015, due to the immediate or short term maturity of these instruments. The Company believes the carrying value of notes payable approximates fair value due to the recent nature of the transaction and its variable market rate of interest.
Premiums receivable represents amounts due from our policyholders for billed premiums and related policy fees. We perform a policy-level evaluation to determine the extent to which the balance of premiums receivable exceeds the balance of unearned premiums. We then age any resulting exposure based on the last date the policy was billed to the policyholder, and we establish an allowance for credit losses for any amounts outstanding for more than 90 days. When we receive payments on amounts previously charged off, we reduce bad debt expense in the period we receive the payment. Balances in premiums receivable and the associated allowance account are removed upon cancellation of the policy due to non-payment. We recorded no allowance for the years ended December 31, 2016 and 2015, respectively. Bad debt expense recovery related to uncollectible premiums was $0, $(250) thousand and $250 thousand for the years ended December 31, 2016, 2015 and 2014, respectively.
The application of the purchase method of accounting for business combinations requires the use of significant estimates and assumptions in determining the fair value of assets acquired and liabilities assumed in order to properly allocate the fair value of the acquired business. The estimates of the fair value of the assets acquired and liabilities assumed are based upon assumptions believed to be reasonable using established valuation techniques that consider a number of factors and when appropriate, valuations performed by independent third party appraisers. Assets acquired and liabilities assumed in connection with business combinations are recorded based on their respective fair values at the date of acquisition.
The Company assesses the recoverability of long-lived assets when events or circumstances indicate that the assets might have become impaired. The Company determines whether the assets can be recovered from undiscounted future cash flows and, if not recoverable, the Company recognizes impairment to reduce the carrying value to fair value. Recoverability of long lived assets is dependent upon, among other things, the Company’s ability to maintain profitability, so as to be able to meet its obligations when they become due. No impairment was recognized in any period presented.
The Company estimates its reserves for unpaid losses and loss adjustment expenses using individual case-based estimates for reported claims and actuarial estimates for IBNR losses. The Company continually reviews and adjusts its estimated losses as necessary based on industry development trends, the Company’s evolving claims experience and new information obtained. If the Company’s unpaid losses and loss adjustment expenses are considered to be deficient or redundant, the Company increases or decreases the liability in the period in which it identifies the difference and reflects the change in its current period results of operations. Though the Company’s estimate of the ultimate cost of settling all reported and unreported claims may change at any point in the future, a reasonable possibility exists that its estimate may vary significantly in the near term from the estimated amounts included in the Company’s consolidated financial statements.
In the event that the Company incurs losses recoverable under its reinsurance program, the Company records amounts recoverable from its reinsurers on paid losses plus an estimate of amounts recoverable on unpaid losses. The estimate of amounts recoverable on unpaid losses is a function of the Company’s liability for unpaid losses associated with the reinsured policies; therefore, the amount changes in conjunction with any changes to the estimate of unpaid losses. Given that an estimate of amounts recoverable from reinsurers on unpaid losses may change at any point in the future because of its relation to the Company’s reserves for unpaid losses, a reasonable possibility exists that an estimated recovery may change significantly from initial estimates.
Guaranty fund and other insurance-related assessments imposed upon the Company are recorded as policy acquisition costs in the period the regulatory agency imposes the assessment. To recover Florida Insurance Guaranty Association (“FIGA”)/Hawaii Insurance Guaranty Association (“HIGA”) assessments, the Company in turn submits a plan for recoupment to the Insurance Commissioner for approval and upon approval, begins collecting a policy surcharge that will allow it to collect the prior years assessments over a 12-month period, based on an estimate of the number of policies the Company expects to write. The Company then submits an information only filing, pursuant to Florida Statute 631.57(3)(h)/Hawaii Statute 431:16-115(b), to the insurance regulatory authority requesting formal approval of the policy FIGA/HIGA surcharge. The process may be repeated in successive 12-month periods until the Company recoups all assessments. The Company records the recoveries as revenue in the period that it collects the cash. While current regulations allow the Company to recover from policyholders the amount of assessments imposed upon the Company, the Company’s payment of the assessments and recoveries may not offset each other in the same year. There were no such assessments during the periods presented.
On December 15, 2016, the Company issued $79.5 million in Senior Secured Notes to six accredited investors. In connection with the issuance of debt the Company incurred $6.6 million in debt issuance costs. Debt issuance costs is reflected on the balance sheet as a net of note payable, and amortized using the effective interest method over the life of the underlying debt instrument.
The Company recognizes the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the more likely than not threshold, the amount recognized in the consolidated financial statements is the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement with the relevant taxing authority.
With regard to cash, the Company had $123.4 million and $243.7 million in excess of Federal Deposit Insurance Corporation (“FDIC”) insurance limits at December 31, 2016 and December 31, 2015, respectively. Deposits held in non- interest-bearing transaction accounts are combined with interest-bearing accounts and are insured up to $250 thousand.
On July 31, 2015, the Company acquired BRC Restoration Specialists, Inc., a Florida based provider of restoration services and emergency and recovery assistance for a purchase price in aggregate of $8 million in cash and common stock. The Company issued 79,850 shares of its common stock to BRC at a fair value of $2.0 million as part of the purchase price and paid in cash $6.0 million. For the purchase price allocation the Company utilized a third party to calculate the valuation. The purchase consideration for the BRC acquisition has been allocated to the estimated fair market value of the net assets acquired, including approximately $2.2 million in identifiable intangibles assets (brand, customer relations and non-compete), and a residual amount of goodwill of approximately $5.7 million.
On March 21, 2016, the Company acquired 100% of the outstanding stock of ZAC and its wholly-owned subsidiary, Zephyr, in exchange for approximately $110.3 million, net of cash acquired. Zephyr is a specialty property insurance provider that offers policies for residential customers in Hawaii that only cover the peril of windstorm-hurricane events.
The table below details the purchase consideration and allocation of assets and liabilities assumed for the ZAC acquisition:
At December 31, 2015, the Company recorded goodwill and intangibles, net in Other assets.
The following table (all amounts in thousands, except for per share data) provides supplemental unaudited pro forma consolidated information for the years ended December 31, 2016 and 2015, as if ZAC had been acquired as of January 1, 2015. The unaudited pro forma consolidated financial statements are presented solely for informational purposes and are not necessarily indicative of the consolidated results of operations that might have been achieved had the transaction been completed as of the date indicated, nor are they meant to be indicative of any anticipated consolidated future results of operations that the combined company will experience after the transaction.
the Company could recover its cost basis, and the Company also has the ability and the intent to hold these securities until the value equals or exceeds its cost.
As of December 31, 2016 and December 31, 2015 goodwill was $46.5 million and $8 million, respectively, and intangible assets were $26.5 million and $2.1 million, respectively. The Company has determined the useful life of the value of business acquired (see Note 2) to be one year. The Company has determined the useful life of the other intangible assets to range between 2-15 years. The Company has recorded $175 thousand relating to an insurance license and classified as an indefinite lived intangible which is subject to annual impairment testing.
Our intangible assets resulted primarily from the acquisition of Zephyr and consist of brand, agent relationships, renewal rights, customer relations, trade names, non-compete and insurance license. Finite-lived intangibles assets are amortized over their useful lives from one to fifteen years.
The tables below detail the finite-lived intangible assets, net as of December 31, 2016 and 2015, respectively (amounts in thousands):
Amortization expense of intangible assets was $7.4 million and $80 thousand for the year ended December 31, 2016 and 2015, respectively.
We believe the carrying amounts of our cash and cash equivalents, accounts receivable, accounts payable, accrued expenses, and other current liabilities approximate their fair values at December 31, 2016 and December 31, 2015, due to the immediate or short term maturity of these instruments. We believe the carrying value of notes payable approximates fair value due to the recent nature of the transaction and its variable market rate of interest.
alongside and above the FHCF layer, as well as aggregate reinsurance coverage. The following describes the various layers of the Company’s June 1, 2016 to May 31, 2017 reinsurance program.
Layers alongside the FHCF. The Florida reinsurance program includes third party layers alongside the FHCF. These include 2015 C and 2015 B series catastrophe bonds, which cover Florida only for the 2016 season, and 2016 D and 2016 E catastrophe bond series issued by Citrus Re, which total $377.5 million of coverage, as discussed below, as well as a traditional reinsurance layer providing $200 million of coverage. Through a reinstatement, the Company is able to reinstate the full amount of the $200 million of reinsurance one time. These 2016 catastrophe bonds and the traditional reinsurance layer provide coverage for both Florida and Hawaii catastrophe losses.
2016 Class D and E Notes: During February 2016, Heritage P&C and Zephyr entered into two catastrophe reinsurance agreements with Citrus Re. The agreements provide for three years of coverage from catastrophic losses caused by named storms, including hurricanes, beginning on June 1, 2016. Heritage P&C and Zephyr pay a periodic premium to Citrus Re during this three-year risk period. Citrus Re issued an aggregate of $250 million of principal-at-risk variable notes due February 2019 to fund the reinsurance trust account and its obligations to Heritage P&C and Zephyr under the reinsurance agreements. The Class D notes provide $150 million of coverage and the Class E notes provide $100 million of coverage. The Class D and Class E notes provide reinsurance coverage for a sliver of the catastrophe coverage that had previously been provided by the FHCF. The limit of coverage is fully collateralized by a reinsurance trust account for the benefit of Heritage P&C and Zephyr. The maturity date of the notes may be extended up to two additional years to satisfy claims for catastrophic events occurring during the three-year term of the reinsurance agreements.
Aggregate Coverage. In addition to what is described above, much of the reinsurance is structured in a way to provide aggregate coverage. $682 million of limit is structured on this basis. To the extent that this coverage is not fully exhausted in the first catastrophic event, it provides coverage commencing at its reduced retention for second and subsequent events where underlying coverage has been previously exhausted. $460 million has a reinstatement, which is prepaid.
For a first catastrophic event striking Florida, our reinsurance program provides coverage for $1.9 billion of losses and loss adjustment expenses, including our retention, and we are responsible for all losses and loss adjustment expenses in excess of such amount. For a first catastrophic event striking Hawaii, our reinsurance program provides coverage for $1.1 billion of losses and loss adjustment expenses, including our retention, and we are responsible for all losses and loss adjustment expenses in excess of such amount. For subsequent catastrophic events, our total available coverage depends on the magnitude of the first event, as we may have coverage remaining from layers that were not previously fully exhausted. $860 million of limit purchased in 2016 includes a reinstatement, with $825 million being prepaid. In total, we have purchased $3 billion of potential reinsurance coverage, including our retention, for multiple catastrophic events. Our ability to access this coverage, however, will be subject to the severity and frequency of such events.
Layers Below FHCF. Immediately above the Company’s retention, the Company purchased $440 million of reinsurance from third party reinsurers. Through the payment of a reinstatement premium, the Company was able to reinstate the full amount of this reinsurance one time. To the extent that $440 million or a portion thereof was exhausted in a first catastrophic event, the Company had purchased reinstatement premium protection insurance to pay the required premium necessary for the reinstatement of this coverage. A portion of this coverage wrapped around the FHCF and provided coverage alongside and above the FHCF.
CAT Bond Layer alongside the FHCF. During April 2015 Heritage P&C entered into three catastrophe reinsurance agreements with Citrus Re. The agreements provided for three years of coverage from catastrophic losses caused by named storms, including hurricanes, beginning on June 1, 2015. Heritage P&C paid periodic premiums to Citrus Re during the three-year risk period. Citrus Re issued an aggregate of $277.5 million of principal-at-risk variable notes due April 2017 to fund the reinsurance trust account and its obligations to Heritage P&C under the reinsurance agreements. These notes were issued in three classes. The Class A notes provide $150 million of coverage for the layer immediately above the FHCF. The Class B notes provided $97.5 million of coverage, and the Class C notes provided $30 million of coverage. The Class B and Class C notes provided reinsurance coverage for a sliver of the catastrophe coverage that had previously been provided by the FHCF. The limit of coverage was fully collateralized by a reinsurance trust account for the benefit of Heritage P&C. The maturity date of the notes may be extended up to two additional years to satisfy claims for catastrophic events occurring during the three-year term of the reinsurance agreements.
FHCF Layer. The Company’s FHCF coverage included an estimated maximum provisional limit of 90% of $484 million, or $436 million, in excess of its retention and private reinsurance of $181 million. The limit and retention of the FHCF coverage was subject to upward or downward adjustment based on, among other things, submitted exposures to FHCF by all participants. The Company purchased coverage alongside from third party reinsurers. The layer alongside was in the amount of $48 million. To the extent the FHCF coverage was adjusted, this private reinsurance would adjust to fill in any gaps in coverage up to the reinsurers’ aggregate limits for this layer. The FHCF coverage could not be reinstated once exhausted, but it did provide coverage for multiple events.
CAT Bond Layer. Immediately above the FHCF layer was the coverage provided by the reinsurance agreements entered into with Citrus Re. The first contract with Citrus Re provided $150 million of coverage and the second contract provided an additional $50 million of coverage. Osprey provided $25 million of coverage alongside the second contract.
Aggregate Coverage. In addition to the layers described above, the Company purchased $105 million of aggregate reinsurance coverage for losses and loss adjustment expenses in excess of $825 million for a first catastrophic event. To the extent that this coverage was not fully exhausted in the first catastrophic event, it provided coverage commencing at its reduced retention levels for second and subsequent events and where underlying coverage had been previously exhausted. There was no reinstatement of the aggregate reinsurance coverage once exhausted, but it did provide coverage for multiple events. Osprey provided $20 million of protection in the layer above $940 million.
For a first catastrophic event, the Company’s 2014-2015 reinsurance program provided coverage for $990 million of losses and loss adjustment expenses, including its retention, and the Company was responsible for all losses and loss adjustment expenses in excess of such amount. For subsequent catastrophic events, the Company’s total available coverage depended on the magnitude of the first event, as the Company may have had coverage remaining from layers that were not previously fully exhausted. The Company purchased reinstatement premium protection insurance to provide an additional $185 million of coverage. The Company’s aggregate reinsurance layer also provided coverage for second and subsequent events to the extent not exhausted in prior events.
The Company writes insurance in the states of Florida, North Carolina, South Carolina, Hawaii and Georgia, 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, such an event is unlikely to be so material as to disrupt our overall normal operations. However, the Company is unable to predict the frequency or severity of any such events that may occur in the near term or thereafter. The Company believes that the reserve for unpaid losses reasonably represents the amount necessary to pay all claims and related expenses which may arise from incidents that have occurred as of the balance sheet date.
The following is information about incurred and paid claims development as of December 31, 2016, net of reinsurance, as well as cumulative claim frequency and the total of incurred-but-not-reported liabilities plus expected development on reported claims included within the net incurred claims amounts.
On December 15, 2016, we issued Senior Secured Notes (“Secured Notes”) in the aggregate amount of $79.5 million, 7-year term note payable to six accredited investors. The Secured Notes bears interest of 8.75% plus 0.95% of the three month average of LIBOR. Principal and interest is paid quarterly, interest payments commence on March 15, 2017, the quarterly principal payments commence on December 31, 2018. At December 31, 2016, we owed $72.9 million, net of issuance costs. In addition, the Company incurred approximately $6.6 million of debt issuance costs
Subject to replacement capital covenant, the Secured Notes may be redeemable, in whole or in part, at any time on or after December 15, 2018, based on the quarterly payment date, at the following redemption prices (as a percentage of outstanding principal amount of the notes to be redeemed) plus accrued and unpaid interest and principal of the Secured Notes: 2018 - 103%; 2019 - 102%; 2020 - 101% and thereafter at 100%. If there is a change in control offer that Holder has the right to require the Company to purchase such Holder’s Secured Notes based on the redemption terms stated above.
The effective interest rate, taking into account the stated interest expense and amortization of debt issuance costs, approximates 9.7%.
Expected annual principal payments due by Heritage Insurance under the Senior Secured Note agreement is as follows:
The following table sets forth the components of income before income taxes for the years ended December 31, 2016, 2015 and 2014 (in thousands):
The table below summarizes the significant components of our net deferred tax assets (liabilities):
The statute of limitations related to our federal and state income tax returns remains open from our first filings for 2013 through 2015. For the 2014 tax year, the federal income tax return was examined by the tax authority resulting no material adjustment. Currently, no taxing authorities are examining any of our federal or state income tax returns.
As of December 31, 2016, the Company had no uncertain tax positions or unrecognized tax benefits that, if recognized, would impact the effective income tax rate.
The Company’s insurance subsidiaries are required to file with state insurance regulatory authorities an “Annual Statement” which reports, among other items, net income and surplus as regards policyholders, which is called stockholder’s equity under GAAP. Combined results of the Company’s insurance subsidiaries reported statutory net income of $567 thousand and $45.6 million for the years ended December 31, 2016 and 2015, respectively. The Company’s insurance subsidiaries must maintain capital and surplus ratios or balances as determined by the regulatory authority of the states in which they are domiciled. Heritage P&C is required to maintain capital and surplus equal to the greater of $15 million or 10% of their respective liabilities. Zephyr is required to maintain a deposit of $750 thousand in a federally insured financial institution. The Company’s combined statutory surplus was $276 million and $216.6 million at December 31, 2016 and December 31, 2015, respectively. State law also requires the Company’s insurance subsidiaries to adhere to prescribed premium-to-capital surplus ratios, with which the Company is in compliance. At December 31, 2016, our insurance subsidiaries met the financial and regulatory requirements of the states in which they do business.
State law for Florida and Hawaii permits an insurer to pay dividends or make distributions out of that part of statutory surplus derived from net operating profit and net realized capital gains. The law further provides calculations to determine the amount of dividends or distributions that can be made without the prior approval of the insurance regulatory authority and the amount of dividends or distributions that would require prior approval of the insurance regulatory authority. Statutory risk-based capital requirements may further restrict our insurance subsidiaries ability to pay dividends or make distributions if the amount of the intended dividend or distribution would cause statutory surplus to fall below minimum risk-based capital requirements. However, the consent order authorizing our commencement of operations precludes us from paying dividends without the prior approval of FLOIR until July 31, 2017.
Florida law limits an insurer’s investment in equity instruments and also restricts investments in medium to low quality debt instruments. The Company was in compliance with all investment restrictions at December 31, 2016 and 2015.
Governmental agencies or certain quasi-governmental entities can also levy assessments upon policyholders, and the Company collects the amount of the assessments from policyholders as surcharges for the benefit of the assessing agency. There are currently no assessments to be collected from policyholders and remitted to any governmental or quasi-governmental entities. If an assessment becomes levied the Company would multiply the premium written on each policy by these assessment percentages to determine the additional amount that it will collect from the policyholder and remit to the assessing agencies.
The table below reconciles the Company’s consolidated GAAP net income to statutory net income of its insurance subsidiaries (in thousands):
The Company’s reinsurance subsidiary, Osprey, which was incorporated on April 23, 2013, is licensed as a Class 3a Insurer under The Bermuda Insurance Act 1978 and related regulations. Osprey is required to maintain statutory capital and surplus of at least $1.0 million and maintain liquid resources or have access to liquid resources equal to its maximum obligation for which it is responsible under the terms of any reinsurance arrangement to which it is a party. In May 2013, the Company contributed $1.7 million in cash to Osprey. Osprey secures its reinsurance obligations to our insurance subsidiaries with an irrevocable letter of credit in the amount of $12.7 million. These resources, in addition to premiums ceded to it by our insurance subsidiaries are sufficient to comply with regulatory requirements as of December 31, 2016. Bermuda’s standard for financial statement reporting is U.S. GAAP.
At December 31, 2016 and 2015, Other liabilities included approximately $0.2 million and $4.9 million related to amounts owed to Citizens for policies assumed by the Company, where the policyholder subsequently opted-out of the assumption program. Also, included in other liabilities for the years ended December 31, 2016 and 2015 was $6.2 million and $5.8 million for commission payables, $5.6 million and $3.9 million for accounts payable and other payables, and $6.9 million and $0 for payments in connection with the issuance of debt, $1.8 million and $1.6 million for dividends payable and $1 million and $1.2 million for unearned revenue, respectively.
The Company has been party to various related party transactions involving certain of its officers, directors and significant stockholders as set forth below. The Company has entered into these arrangements without obligation to continue its effect in the future and the associated expense was immaterial to its results of operations or financial position as of December 31, 2016, 2015 and 2014.
The total amount of authorized capital stock consists of 50,000,000 shares of common stock and 5,000,000 shares of preferred stock. As of December 31, 2016, the Company had 28,840,443 shares of common stock outstanding, 1,759,330 treasury shares of common stock and 900,000 unvested restricted common stock issued reflecting total paid-in capital of $205.7 million as of such date.
applicable to the common stock. All outstanding shares of the Company’s capital stock (excluding restricted stock) are fully paid and nonassessable.
On September 14, 2015, the Company announced that the Company’s Board of Directors, authorized a stock repurchase program authorizing the Company to repurchase up to $20 million of the Company’s common stock. On May 4, 2016, the Board of Directors authorized an additional stock repurchase of up to $50 million of the Company’s common stock through December 31, 2017. For the year ended December 31, 2016, the Company has purchased in aggregate 1,759,330 shares of common stock at a cost of $25.6 million through open market or private transactions.
On March 2, 2017, the Company’s Board of Directors declared a $0.06 per share quarterly dividend payable on April 4, 2017, to shareholders of record March 15, 2017.
Cash dividends declared on our outstanding weighted average number of basic common shares for the periods presented were approximately as follows:
At December 31, 2016 and 2015, there were 170,814 shares available for grant under the Plan.
option grant, which was $2.70 per option granted in 2014, was estimated on the date of grant using the Black-Scholes option-pricing model. The fair value of options vested during the year ended December 31, 2014 was $2.5 million.
On December 2, 2014, the Company granted options to purchase 1,326,923 shares to certain employees and directors. The employee options were awarded with the strike price set at the fair market value at the grant date, and vest at 50 percent upon grant and 50 percent on April 30, 2015 with an expiration date of December 2, 2017. The directors’ options were awarded with the strike price set at the fair market value at the grant date, and vest quarterly commencing on January 1, 2015 with an expiration date of December 2, 2017. The fair value of each option grant, which ranged from $3.07 to $3.54 per option granted in 2014, is estimated on the date of grant using the Black-Scholes option-pricing model. The fair value options that vested as of December 31, 2015 was $2.7 million.
No compensation expense was recognized for stock options granted above during the year December 31, 2016. The Company has recognized $1.9 million and $3.3 million of compensation expense during the years ended December 31, 2015 and 2014 relative to the stock options granted above.
The Company has also granted shares of its common stock subject to certain restrictions under the Plan. Restricted stock awards granted to employees vest in equal installments generally over a five year period from the grant date subject to the recipient’s continued employment. The fair value of restricted stock awards are estimated by the market price at the date of grant and amortized on a straight-line basis to expense over the period of vesting. Recipients of restricted stock awards have the right to receive dividends. No restricted stock was granted during the year ended December 31, 2016. Restricted stock activity during the year ended December 31, 2016 is as follows:
The following table summarizes information about deferred tax benefits recognized and tax benefits realized to restricted stock awards and related paid dividends, and the fair value of vested restricted stock for the year ended December 31, 2016 and 2015, respectively.
The following summarizes the major categories of Heritage Insurance Holdings, Inc.’s financial statements (in thousands, except share and per share data):