For 2015 and 2014, we reclassified our presentation for costs related to acquisition and stock purchase agreements from non-operating expenses to other underwriting expenses, because these costs were incurred as a result of acquiring new businesses. The reclassification increased the combined ratio by 1.2% and 0.7% for the years ended December 31, 2015 and 2014, respectively.
For 2013, we reclassified our presentation for interest expense from other underwriting expenses to non-operating expenses. The reclassification reduced the combined ratio by 0.2% for the year ended December 31, 2013.
We are a financial services holding company incorporated under the laws of the Cayman Islands. Our core business is the underwriting of commercial automobile insurance policies, focusing on the “light” commercial automobile sector, which is carried out through our Insurance Subsidiaries. This sector includes taxi cabs, non-emergency para-transit, limousine, livery (including certain transportation network companies (“TNC”) drivers/operators) and business auto. Our goal is to always be the preferred specialty insurance business in any geographic areas where our value proposition delivers benefit to all stakeholders. We are licensed to write property and casualty (“P&C”) insurance in 49 states and the District of Columbia in the United States. The Insurance Subsidiaries distribute their products through a network of independent retail agents, and actively wrote insurance in 42 states and the District of Columbia during 2017. We embrace continuous improvement, analytics and technology as a means of building on the strong heritage our subsidiary companies cultivated in the niche markets we serve.
We believe that there is a positive correlation between the economy and commercial automobile insurance in general. Operators of “light” commercial automobiles may be less likely than other business segments within the commercial automobile insurance market to take vehicles out of service, as their businesses and business reputations rely heavily on availability. With respect to certain business lines such as the taxi line, there are also other factors such as the cost and limited supply of medallions, which may discourage a policyholder from taking vehicles out of service in the face of reduced demand for the use of the vehicle. The significant expansion of TNC has resulted in a reduction in taxi vehicles available to insure; however, we believe that the aforementioned factor relating to medallion values has mitigated the overall decline.
The other line of business is comprised of our surety program (currently in run off), Gateway’s truck and workers’ compensation programs (currently in run off), American Services’ non-standard personal lines business (currently in run off), Atlas’ workers’ compensation related to taxi, other liability, Global Liberty’s homeowners program (currently in run off) and assigned risk pool business.
In making these determinations, management makes subjective and complex judgments that frequently require estimates about matters that are inherently uncertain. Many of these policies, estimates and related judgments are common in the insurance and financial services industries; others are specific to our businesses and operations. It is reasonably likely that changes in these items could occur from period to period and result in a material impact on our consolidated financial statements.
For equity securities, the Company evaluates its ability to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Evidence considered to determine anticipated recovery are analysts’ reports on the near-term prospects of the issuer and the financial condition of the issuer or the industry, in addition to the length and extent of the market value decline. If an OTTI is identified, the equity security is adjusted to fair value through a charge to earnings. Refer to Note 5, ‘Investments’ to the Consolidated Financial Statements for further discussion of the other-than-temporary impairment on equity securities.
Atlas considers the impact of inflation when establishing adequate rates and estimating the provision for unpaid claims and claims adjustment expenses. We establish reserves to cover our estimated liability for the payment of claims and expenses related to the administration of claims incurred on the insurance policies we write. Inflation has a larger impact the longer the time between the issuance of the policy and the final settlement of claims. Greater than expected claims costs above the established reserves will require an increase in claims reserves and reduce the earnings in the period the deficiency was established. We consider the impact of inflation on these reserves when establishing policy rates.
Valuation of deferred tax assets - Deferred taxes are recognized using the asset and liability method of accounting. Under this method the future tax consequences attributable to temporary differences in the tax basis of assets, liabilities and items recognized directly in equity and the financial reporting basis of such items are recognized in the financial statements by recording deferred tax assets (“DTAs”) or deferred tax liabilities (“DTLs”).
In assessing the need for a valuation allowance, Atlas considers both positive and negative evidence related to the likelihood of realization of the deferred tax assets. Atlas performs an assessment of recoverability of its deferred tax assets on a quarterly basis. If, based on the weight of available evidence, it is more likely than not the deferred tax assets will not be realized, a valuation allowance is recognized in income in the period that such determination is made.
As of December 31, 2017, there was no valuation allowance recorded against the Company’s DTA, however there is no guarantee that a valuation allowance will not be required in the future.
The valuations are finalized within twelve months of the close of the acquisition. The changes upon finalization to the initial purchase price allocation and valuation of assets and liabilities may result in an adjustment to identifiable intangible assets and goodwill. Adjustments to the provisional amounts identified during the measurement period are recognized in the reporting period in which the adjustment amounts are determined. The effect of changes in depreciation, amortization, or other income effects, if any, as a result of the change to the provisional amounts, calculated as if the accounting had been completed at the acquisition date, are recorded in the financial statements and presented separately on the statements of income and comprehensive income in the reporting period in which the adjustment amounts are determined.
Reinsurance - As part of Atlas’ insurance risk management policies, portions of its insurance risk is ceded to reinsurers. Reinsurance premiums and claims adjustment expenses are accounted for on a basis consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums and claims and claims adjustment expenses ceded to other companies have been reported as a reduction of premium revenue and incurred claims. Commissions paid to Atlas by reinsurers on business ceded have been accounted for as a reduction of the related policy acquisition costs. Reinsurance recoverables are recorded for that portion of paid and unpaid claims and claims adjustment expenses that are ceded to other companies. Prepaid reinsurance premiums are recorded for unearned premiums that have been ceded to other companies.
2017 Full Year Financial Performance Summary (comparisons to 2016 unless otherwise noted):
In-force premium as of December 31, 2017 increased $43.9 million to $268.5 million
Total revenue for the year ended December 31, 2017 increased by 25.0% to $222.0 million
Book value per common share as of December 31, 2017 decreased $3.12 to $7.42
Return on equity was a negative 35.6% as compared to a positive 2.1%
3 - For 2015, we restated our presentation for preferred shares from within the permanent equity section to be included within the mezzanine equity section in accordance with Financial Accounting Standards Board (“FASB”) ASC Topic 480 - Distinguishing Liabilities from Equity. As a result, return on equity increased 0.4% as a result of this decrease in shareholders’ equity from the reclassification of preferred shares.
We derive our revenues primarily from premiums from our insurance policies and income from our investment portfolio. Our underwriting approach is to price our products to generate consistent underwriting profit for the insurance companies we own. As with all P&C insurance companies, the impact of price changes is reflected in our financial results over time. Price changes on our in-force policies occur as they are renewed. This cycle generally takes twelve months for our entire book of business and up to an additional twelve months to earn a full year of premium at the renewal rate.
Acquisition costs consist principally of brokerage and agent commissions and, to a lesser extent, premium taxes. The brokerage and agent commissions are reduced by ceding commissions received from assuming reinsurers that represent a percentage of the premiums on insurance policies and reinsurance contracts written and vary depending upon the amount and types of contracts written.
Other underwriting expenses consist primarily of personnel related expenses (including salaries, benefits and certain costs associated with awards under our equity compensation plans, such as share-based compensation expense) and other general operating expenses. We believe that because a portion of our personnel expenses are relatively fixed in nature, increased writings may improve our operating scale and may lead to reduced operating expense ratios.
The following table summarizes gross premiums written by line of business.
We continued our disciplined underwriting practices in the state of Michigan. We have raised prices incrementally, subject to regulatory rules, based on the challenging results seen in that state. As a result, we have seen fewer renewals of our Michigan business. Michigan insured vehicles represented approximately 1.4% and 3.9% of total insured vehicles in force as of December 31, 2017 and December 31, 2016, respectively.
As illustrated by the table above, 36.0% of Atlas’ gross premiums written for the year ended December 31, 2017 came from New York and 64.2% came from the five states currently producing the most premium volume, as compared to 58.6% for the year ended December 31, 2016. Approximately 62.5% of the increase in New York gross premiums written for the year ended December 31, 2017 came from one new large limousine fleet account.
Ceded premiums written is equal to premium ceded under the terms of Atlas’ in force reinsurance treaties. Atlas generally purchases reinsurance in an effort to limit net exposure on any one claim to a maximum amount of $500,000 with respect to commercial automobile liability claims. Atlas also purchases reinsurance in an effort to protect against awards in excess of its policy limits. Effective July 1, 2014, Atlas implemented a quota share reinsurance agreement with Swiss Reinsurance America Corporation (“Swiss Re”) for its commercial auto and general liability lines of business (“Quota Share”) written by American Country, American Service and Gateway, or collectively “ASI Pool Subsidiaries.” This reinsurance agreement had an initial cession rate of 5%, which was increased to 15% effective April 1, 2015, and then was decreased to 5% effective July 1, 2016. The Quota Share provides the Company with financial flexibility to manage expected growth and the timing of potential future capital raising activities. For 2015, Global Liberty had a 20% quota share reinsurance agreement with SCOR Reinsurance Company (“SCOR Re”). In 2016, this contract was replaced by a 25% quota share reinsurance agreement with Swiss Re for its commercial auto and general liability lines of business (“Global Quota Share”). The cession rate of the Quota Share and Global Quota Share remained the same for 2017.
Net premiums written is equal to gross premiums written less the ceded premiums written under the terms of Atlas’ in-force reinsurance treaties. Net premiums written increased 28.4% to $231.1 million for the year ended December 31, 2017 compared with $180.1 million for the year ended December 31, 2016. These changes are attributed to the combined effects of the reasons cited in the ‘Gross Premiums Written’ and ‘Ceded Premiums Written’ sections above.
Premiums are earned ratably over the term of the underlying policy. Net premiums earned increased by $44.7 million to $215.8 million for the year ended December 31, 2017, a 26.1% increase compared with $171.1 million for the year ended December 31, 2016. The increase in net premiums earned is attributable to the combined effects of the reasons cited in the ‘Gross Premiums Written’ and ‘Ceded Premiums Written’ sections above.
Based on a ongoing analysis of the niche markets on which we focus, we believe that the total number of rides, and accordingly vehicle count, in these niche markets continues to grow. In 2016, we saw a decline in our taxi business as some passengers and drivers migrated to a TNC market. However, this was generally offset by corresponding growth in our limousine and livery business. Growth in vehicle count in our limousine and livery business is positively influenced by passengers and drivers increasingly participating in the TNC market, and we anticipate that it may outpace reductions in taxi business over time. Growth in our para-transit business is correlated with demographic trends in the U.S. We believe that our Insurance Subsidiaries can continue to grow these specialty products to within a market share of 20% without having a disproportionate share of the market. Atlas’ focus has been, and continues to be, utilizing our experience and strong value proposition to maximize underwriting profit. It is important to note that we continue to see favorable market trends within our niche and believe that increased opportunity to expand underwriting margin still exists. These projections are subject to change should the competitive environment reverse from current trends.
The loss ratio relating to the net claims incurred for the year ended December 31, 2017 was 94.5% compared to 78.8% for the year ended December 31, 2016. The loss ratio increase was primarily the result of the Company’s re-estimation of its unpaid claims liabilities on prior accident years, creating a 15.7% increase in loss ratio for the year ended December 31, 2017. Atlas experienced $75.4 million in unfavorable prior accident year development for the year ended December 31, 2017. The unfavorable development is primarily from our core commercial automobile liability line in the states of Louisiana, Michigan and New York, mostly from accident years 2015 and prior.
Remaining liability for non-New York Global Liberty business written prior to 2016 is expected to settle for greater amounts than previously expected.
Based on year end 2017 actuarial work, Atlas determined that this significant reserve increase was necessary to ensure sufficient IBNR levels to extinguish the remaining claims especially for older accident years.
Atlas intends to only write its products in states where it believes the Company can generate an above average underwriting profit. As a specialty insurer, Atlas puts a priority on addressing changes in our market in a nimble way. To this end, in recent years Atlas enhanced and initiated numerous underwriting and claim related processes designed to leverage our experience in the specialty light commercial auto sector, including the elevated use of predictive analytics. We have proactively compressed settlement time, particularly with respect to larger claims, providing earlier visibility into potentially changing claim trends. Atlas expects to continue to deliver improvements on more recent accident years by maintaining existing operating efficiency and further improving loss ratios through appropriate underwriting and pricing, disciplined claims handling as well as further leveraging the investments it has made in predictive analytics. However, credit for such improvement will not be recognized until it is reflected in future loss settlements.
Acquisition costs represent commissions and taxes incurred on net premiums earned offset by ceding commission on business reinsured. Acquisition costs were $27.9 million for the year ended December 31, 2017, or 12.9% of net premiums earned, as compared to $18.8 million, or 11.0%, for the year ended December 31, 2016.
The table below indicates the impact of the various components of acquisition costs on the combined ratio for the years ended December 31, 2017 and 2016:
While the Quota Share and Global Quota Share provide a ceding commission to offset underwriting expense, this commission reduces acquisition costs rather than other underwriting expenses on the statements of income and comprehensive income. With this in mind, acquisition costs, and other underwriting expenses should be examined either collectively as total underwriting expenses or independent of the effects of the Quota Share and Global Quota Share ceding commissions to understand operating efficiency.
The table below indicates the impact of the Quota Share and Global Quota Share on the various components of the combined ratio for the years ended December 31, 2017 and 2016:
1 - For 2017, net claims incurred, gross of the quota share, for the current accident year was $143.3 million with a combined ratio impact of 59.5%. For the prior accident years net claims incurred, gross of the quota share was $81.0 million with a combined ratio impact of 33.6%. For 2016, net claims incurred, gross of the quota share, for the current accident year was $115.2 million with a combined ratio impact of 56.5%. For the prior accident years net claims incurred, gross of the quota share was $36.7 million with a combined ratio impact of 17.9%.
Atlas recorded other income of $435,000 and $467,000 for the years ended December 31, 2017 and 2016, respectively. The decrease in other income resulted from lower income from premium financing offset by higher rental income.
Atlas generated a pre-tax loss of $44.2 million for the year ended December 31, 2017 compared to pre-tax income of $512,000 for year ended December 31, 2016. The causes of these changes are attributed to the combined effects of the reasons cited in the ‘Net Premiums Earned’, ‘Net Claims Incurred’, ‘Acquisition Costs and Other Underwriting Expenses’, ‘Net Investment Income’, ‘Interest Expense’, ‘Net Realized Investment Gains’, and ‘Other Income’ sections above.
Atlas recognized a tax benefit of $5.3 million for the year ended December 31, 2017 and $2.1 million for the year ended December 31, 2016. The following table reconciles the U.S. statutory marginal income tax rate of 35.0% to the effective tax rate for the years ended December 31, 2017 and 2016:
Upon the transaction forming Atlas on December 31, 2010, a yearly limitation as required by IRC Section 382 that applies to changes in ownership on the future utilization of Atlas’ net operating loss carryforwards was calculated. The Insurance Subsidiaries’ prior parent retained those tax assets previously attributed to the Insurance Subsidiaries that could not be utilized by Atlas as a result of this limitation. As a result, Atlas’ ability to recognize future tax benefits associated with a portion of its deferred tax assets generated during prior years have been permanently limited to the amount determined under IRC Section 382. The result is a maximum expected net deferred tax asset, which Atlas has available after the merger and believed more-likely-than-not to be utilized in the future, after consideration of valuation allowance.
yearly limitation as required by IRC Section 382 on net operating loss carryforwards generated prior to 2013.
Atlas had a net loss of $38.8 million for the year ended December 31, 2017 compared to net income of $2.6 million for the year ended December 31, 2016. After taking the impact of the liquidation preference of the preferred shares into consideration, the loss per common share diluted for the year ended December 31, 2017 was $3.22 versus earnings per common share diluted of $0.19 for the year ended December 31, 2016.
For the year ended December 31, 2016, gross premiums written from commercial automobile was $223.8 million, representing a 7.7% increase relative to the year ended December 31, 2015. This increase is attributable to Atlas’ continued geographic expansion as a positive response from both new and existing agents and insureds to Atlas’ value proposition. We wrote $75.8 million and $86.8 million of new gross premiums written business for the years ended December 31, 2016 and 2015, respectively. Of these amounts, Global Liberty, our most recent acquisition, contributed $19.3 million and $20.6 million in new premiums written for the years ended December 31, 2016 and 2015, respectively. With respect to our traditional commercial automobile, which excludes excess taxi, gross premiums written was $215.7 million, an increase of 10.4% versus the year ended December 31, 2015. As a percentage of the Insurance Subsidiaries’ overall book of business, commercial auto gross premiums written represented 99.4% of gross, and 99.9% of net, premiums written for the year ended December 31, 2016 compared to 99.3% and 99.4%, respectively, during the year ended December 31, 2015.
Ceded premiums written increased 13.7% to $45.0 million for the year ended December 31, 2016 compared with $39.6 million for the year ended December 31, 2015 primarily due to Atlas’ participation in the Quota Share and Global Quota Share, product mix and overall gross premium growth. Excluding the Quota Share and Global Quota Share, ceded premiums written were $13.4 million and $10.5 million for the years ended December 31, 2016 and 2015, respectively.
The loss ratio relating to the net claims incurred for the year ended December 31, 2016 was 78.8% compared to 59.2% for the year ended December 31, 2015. The loss ratio increase was primarily the result of the Company’s re-estimation of its unpaid claims liabilities on prior accident years, creating a 19.6% increase in loss ratio for the year ended December 31, 2016. Atlas experienced $32.6 million in unfavorable prior accident year development for the year ended December 31, 2016. The unfavorable development is primarily from our core commercial automobile liability line. Excluding pre-acquisition Global Liberty claims reserve development, the development of our core lines on prior accident years was $23.2 million for the year ended December 31, 2016. Michigan commercial automobile claims accounted for approximately 62.5% of this development.
The other underwriting expense ratio (including share-based compensation expenses and expenses incurred related to acquisitions and stock purchase agreements) was 13.1% for the year ended December 31, 2016 compared to 16.8% for the year ended December 31, 2015. Expenses recovered pursuant to stock purchase agreements lowered the other underwriting expense ratio by 3.7% for the year ended December 31, 2016. Bad debt expense totaled $2.4 million for the year ended December 31, 2016 compared to $622,000 for the year ended December 31, 2015. The increase resulted from the re-estimation of the allowance and the reserving for specific premium receivable accounts past due. Bad debt expense increased the other underwriting expense ratio by 1.4% for the year ended December 31, 2016. Changes in our Quota Share reinsurance during 2016 had an impact on the reported other underwriting expense ratio when comparing year to year. As shown in the table in the ‘Combined Ratio’ section, on a pro-forma basis, without the effect of the Quota Share, the other underwriting expense ratio would have been 11.0% for the year ended December 31, 2016 compared to 14.9% for the year ended December 31, 2015. The growth of our core lines and our increasing operational scale had a positive impact on this ratio.
Atlas’ combined ratio for the year ended December 31, 2016 was 102.9%, compared to 88.2% for the year ended December 31, 2015.
The table below indicates the impact of the Quota Share and Global Quota Share on the various components of the combined ratio for the years ended December 31, 2016 and 2015:
Interest expense was $1.0 million and $694,000 for the years ended December 31, 2016 and 2015, respectively. The increase in interest expense for the year ended December 31, 2016 primarily resulted from increased borrowings under the Loan Agreement and slight increases in the LIBOR.
Atlas recorded other income for the year ended December 31, 2016 of $467,000 compared to other income of $356,000 for the year ended December 31, 2015. The increase in other income resulted from rental income and the recovery of previously escheated funds.
Atlas generated pre-tax income of $512,000 for the year ended December 31, 2016 compared to pre-tax income of $22.0 million for year ended December 31, 2015. The causes of these changes are attributed to the combined effects of the reasons cited in the ‘Net Premiums Earned’, ‘Net Claims Incurred’, ‘Acquisition Costs and Other Underwriting Expenses’, ‘Net Investment Income’, ‘Interest Expense’, ‘Net Realized Investment Gains’, and ‘Other Income’ sections above.
The following chart illustrates Atlas’ potential dilutive common shares for the years ended December 31, 2016 and 2015:
Atlas held securities with a fair value of $166.4 million and $162.7 million as of December 31, 2017 and December 31, 2016, respectively, which were primarily comprised of fixed income securities. The securities held by the Insurance Subsidiaries must comply with applicable regulations that prescribe the type, quality and concentration of securities. These regulations in the various jurisdictions in which the Insurance Subsidiaries are domiciled permit investments in government, state, municipal and corporate bonds, preferred and common equities, and other high quality investments, within specified limits and subject to certain qualifications.
For the year ended December 31, 2017, total investment holdings increased to $197.9 million from $194.9 million as of December 31, 2016. This increase resulted from net purchases of fixed income securities and equities, positive changes in the market values of fixed income securities and equities and increases in Atlas’ share of the net book value of equity method investments offset by net sales of equity method investments.
As of December 31, 2017, 28.4% of the fixed income securities, including treasury bills, bankers’ acceptances, government bonds and corporate bonds had contractual maturities of five years or less, compared to 33.6% as of December 31, 2016. Actual maturities may differ from contractual maturities, because certain issuers have the right to call or prepay obligations with or without call or prepayment penalties. Atlas holds cash and high grade short-term assets, which, along with fixed income security maturities, management believes are sufficient for the payment of claims on a timely basis. In the event that additional cash is required to meet obligations to policyholders, Atlas believes that a high quality securities portfolio provides us with sufficient liquidity. As of December 31, 2017, the fixed income securities had a weighted average life of 4.9 years and a duration of 3.9 years, compared to a weighted average life of 4.1 years and a duration of 3.4 years, as of December 31, 2016. The increase in weighted average life of the fixed income securities portfolio was the result of the reinvestment of proceeds from the maturity and sales of fixed income securities with longer average lives. Changes in interest rates may have a modest market value impact on the Atlas portfolio relative to longer duration portfolios. Atlas can and typically does hold bonds to maturity by matching duration with the anticipated liquidity needs.
The following table summarizes the composition of the fair value of the fixed income securities portfolio, excluding cash and cash equivalents, as of the dates indicated, by ratings assigned by Fitch, S&P or Moody’s Investors Service. The fixed income securities portfolio consists of predominantly investment grade securities in corporate and government bonds with 99.3% rated ‘BBB’ or better as of December 31, 2017 compared to 99.2% as of December 31, 2016.
Atlas recognizes losses on securities for which a decline in market value was deemed to be other than temporary. Management performs a quarterly analysis of the securities holdings to determine if declines in market value are other than temporary. Atlas did not recognize any charges for securities impairments that were considered other than temporary for the years ended December 31, 2017, 2016, and 2015.
The total fair value of the securities in an unrealized loss position as of December 31, 2017 was $108.1 million compared to $91.9 million as of December 31, 2016. Unrealized losses as of December 31, 2017 were $1.4 million compared to $1.6 million as of December 31, 2016. This decrease in unrealized losses resulted primarily from increases in market values of our fixed income securities (see Note 5, ‘Investments’). Atlas has the ability and intent to hold the securities in an unrealized loss position until their fair value is recovered. Therefore, Atlas does not expect the market value loss position of these investments to be realized in the near term.
Atlas purchases reinsurance from third parties in order to reduce its liability on individual risks and its exposure to large claims. Reinsurance is coverage purchased by one insurance company from another for part of the risk originally underwritten by the purchasing (ceding) insurance company. The practice of ceding insurance to reinsurers allows an insurance company to reduce its exposure to claims by size, geographic area, and type of risk or on a particular policy. An effect of ceding insurance is to permit an insurance company to write additional insurance for risks in greater number or in larger amounts than it would otherwise insure independently, based on its statutory capital, risk tolerance and other factors.
Atlas’ largest reinsurance partners are Great American Insurance Company (“Great American”), a subsidiary of American Financial Group, Inc., General Reinsurance Corporation (“Gen Re”), a subsidiary of Berkshire Hathaway, Inc., SCOR Re, a subsidiary of SCOR U.S. Corporation, Swiss Re, a subsidiary of Swiss Reinsurance Company Ltd. and White Rock Insurance (SAC) Ltd. (“White Rock”). Great American has a financial strength rating of A1 from Moody’s, Gen Re has a financial strength rating of AA+ from Fitch, SCOR Re has a financial strength rating of AA- from Fitch, Swiss Re has a financial strength rating of Aa3 from Moody’s, and White Rock is unrated. Gateway’s run-off workers’ compensation program was reinsured with White Rock. This reinsurance agreement was terminated during 2017.
Atlas has the following total net operating loss carryforwards as of December 31, 2017:
The provision for unpaid claims and claims adjustment expenses increased by 52.3% to $211.6 million as of December 31, 2017 compared to $139.0 million as of December 31, 2016. During the year ended December 31, 2017, case reserves increased by 20.4% compared to December 31, 2016, while IBNR reserves increased by 71.4%. The increase in case reserves resulted from the increase in current accident year claims due to business growth offset by a decrease in claims in older accident years due to the acceleration of claim payments for those years. Based on year end 2017 actuarial work Atlas determined that a significant IBNR increase was necessary to ensure levels are sufficient to extinguish the remaining claims, especially for older accident years.
Atlas experienced $75.4 million in unfavorable prior accident year development for the year ended December 31, 2017 as reflected as incurred related to prior years in the table above. The unfavorable development is primarily from our core commercial automobile liability line. Atlas previously identified that claim expenses in Michigan were significantly outpacing other states and took a significant charge. Although exposure in Michigan was reduced to approximately 1.4% of the Company’s insured vehicles inforce by year end 2017, payments for claims in this state continued to be disproportionate to historic premiums earned. In addition, the remaining liability for non-New York Global Liberty business written prior to 2016 is expected to settle for greater amounts than previously expected. Overall, the actuarially determined liability for remaining claims related to accident year 2015 and prior in general, across all jurisdictions, was indicated to be significantly higher than carried reserves.
The table below summarizes future payments under contractual obligations and estimated claims settlements for the year ended December 31, 2017:
On April 26, 2017, Atlas issued $25 million of five-year 6.625% senior unsecured notes. Total interest expense over the five years is expected to be $8.3 million. Interest on the senior unsecured notes is payable quarterly on each January 26, April 26, July 26 and October 26.
For the year ended December 31, 2017, the Company has restated the Consolidated Statements of Shareholders’ Equity to remove the preferred shares and related activity as previously stated for the periods as of January 1, 2015 and for the years ended December 31, 2015 and 2016. Although this impacted total equity for 2015, it had no impact on total equity as of December 31, 2016 due to the redemption and clawback of preferred shares previously issued. In addition, this change did not impact the Consolidated Statements of Financial Position, Consolidated Statements of Income (Loss) and Comprehensive Income (Loss), earnings per common share or the Consolidated Statements of Cash Flows. The Company has evaluated the effect of the incorrect presentation in the prior period, both qualitatively and quantitatively, and concluded that it did not have a material impact on, nor did it require amendment of, any previously filed annual or quarterly consolidated financial statements. See Note 20, ‘Change in Accounting Principle and Error Corrections’ for additional information regarding preferred shares.
During 2017, the 128,191 restricted voting common shares that were beneficially owned or controlled by Kingsway were sold to non-affiliates of Kingsway. The restricted voting common shares are entitled to vote at all meetings of shareholders, except at meetings of holders of a specific class that are entitled to vote separately as a class. The restricted voting common shares as a class shall not carry more than 30% of the aggregate votes eligible to be voted at a general meeting of common shareholders. The Kingsway-owned restricted voting common shares automatically converted to ordinary voting common shares upon their sale to non-affiliates of Kingsway. There are no restricted voting common shares outstanding as of December 31, 2017.
During the first quarter of 2015, the Company issued 4,000,000 preferred shares as a portion of the consideration related to the Anchor acquisition and an additional 940,500 preferred shares pursuant to the Gateway stock purchase agreement. During the first quarter of 2016, the Company canceled 401,940 preferred shares pursuant to the Gateway stock purchase agreement. During the third quarter of 2016, the Company redeemed all 2,538,560 of the remaining preferred shares issued to the former owner of Gateway. During the fourth quarter of 2016, the Company canceled the remaining 4,000,000 preferred shares pursuant to the Anchor stock purchase agreement. As of December 31, 2017 and December 31, 2016, there were no outstanding preferred shares. The preferred shares redeemed and canceled during 2016 and the preferred shares issued during the first quarter of 2015 pursuant to the Gateway stock purchase agreement have been recorded as a recovery of acquisition expense and additional acquisition expense, respectively, and not as an adjustment to goodwill, because the fair value of the contingent consideration was determined to be zero at the date of acquisition. In accordance with U.S. GAAP, such adjustments are reflected in the statements of income and comprehensive income in the period that the contingency is re-estimated. The Anchor cancellation was recorded as a recovery of acquisition expense.
On September 30, 2016, Atlas paid $409,000 in dividends earned on the preferred shares to the former owner of Gateway, the cumulative amount to which they were entitled through September 15, 2016, leaving no accrued and unpaid dividends owed to the former owner of Gateway. As of December 31, 2017 and December 31, 2016, Atlas has accrued $333,000 in dividends on the preferred shares for the former owner of Anchor, which remains unpaid. The paid claims development on Global Liberty’s pre-acquisition claims reserves was in excess of $4.0 million, and as a result, pursuant to the terms of the Anchor stock purchase agreement, dividends will no longer accrue to the former owner of Anchor. Although the re-issuance of preferred shares to the former owner of Anchor may be highly unlikely, the contingent consideration terms of the Anchor stock purchase agreement will remain in effect for a period of five years from the date of acquisition.
As a holding company, Atlas may derive cash from its subsidiaries generally in the form of dividends and in the future may charge management fees to the extent allowed by statute or other regulatory approval requirements to meet its obligations. The Insurance Subsidiaries fund their obligations primarily through premium and investment income and maturities in their securities portfolio. Refer also to the discussion in the MD&A’s ‘Investments Overview and Strategy’ section. The Insurance Subsidiaries require regulatory approval for the return of capital and, in certain circumstances, payment of dividends. In the event that dividends and management fees available to the holding company are inadequate to service its obligations, the holding company would need to raise capital, sell assets or incur debt obligations.
At December 31, 2016, American Acquisition was in compliance with the covenants of the Loan Agreement. In February 2017, American Acquisition filed its statutorily required financial statements for the year ended December 31, 2016, which are used to determine on-going compliance with the covenants contained in the Loan Agreement. As a result of the reserve strengthening and its effect on American Acquisition’s December 31, 2016 financial statements, American Acquisition was not in compliance with the Loan Agreements’ EBITDA Ratio covenant as of March 13, 2017. American Acquisition had a thirty day period to cure this covenant non-compliance, and the Company and American Acquisition agreed with the lender to a modification to the loan covenants to more specifically address the effects of reserve modifications and/or obtaining a waiver with respect to the existing non-compliance.
Cash used in investing activities during the year ended December 31, 2017 was due to the net purchases of fixed income and equity securities and the furnishings and improvements for the Company’s new headquarters offset by the net sales of other investments. Cash provided by investing activities during the year ended December 31, 2016 was due to the net sale of invested assets offset by the purchase of a building and land used for the Company’s headquarters. Cash used in investing activities during the year ended December 31, 2015 was due to the net purchase of invested assets and the acquisition of Anchor. For the year ended December 31, 2015, investing activities included $11.0 million in cash used in the Anchor acquisition net of the cash received.
Cash provided by financing activities during the year ended December 31, 2017 resulted from the proceeds of the issuance of the Company’s senior unsecured notes and options exercised partially offset by the repayment of the Revolver and Draw Amount. Cash used in financing activities during the year ended December 31, 2016 resulted from the buyback of preferred shares pursuant to the Gateway stock purchase agreement partially offset by the proceeds from the Revolver and Draw Amount. Cash provided by financing activities during the year ended December 31, 2015 resulted from proceeds from the Revolver and Draw Amount and the exercise of options.
Capital resources - The Company manages capital using both regulatory capital measures and internal metrics. The Company’s capital is primarily derived from common shareholders’ equity, retained deficit and accumulated other comprehensive income (loss).
We have audited Atlas Financial Holdings, Inc.’s (the “Company’s”) internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO criteria”). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated statements of financial position of the Company and subsidiaries as of December 31, 2017 and 2016, the related consolidated statements of income (loss) and comprehensive income (loss), shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2017, and the related notes and financial statement schedules listed in the accompanying index, and our report dated April 2, 2018 expressed an unqualified opinion thereon.
We have audited the accompanying consolidated statements of financial position of Atlas Financial Holdings, Inc. (the “Company”) and subsidiaries as of December 31, 2017 and 2016, the related consolidated statements of income (loss) and comprehensive income (loss), shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2017, and the related notes and financial statement schedules listed in the accompanying index (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company and subsidiaries at December 31, 2017 and 2016, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2017, in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company's internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) and our report dated April 2, 2018 expressed an unqualified opinion thereon.
r - Prior to the year ended December 31, 2017, the Company presented preferred shares issued as contingent consideration within the permanent equity section of the Consolidated Statements of Financial Position. In accordance with Financial Accounting Standards Board (“FASB”) ASC Topic 480 - Distinguishing Liabilities from Equity, contingent consideration issued as preferred shares wherein the number of shares to be issued is variable should be classified outside of permanent equity and reflected as mezzanine equity on the Consolidated Statements of Financial Position.
Estimates and assumptions - The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates and changes in estimates are recorded in the accounting period in which they are determined. The liability for unpaid claims and claims adjustment expenses and related amounts recoverable from reinsurers represents the most significant estimate in the accompanying financial statements, and differences between such estimates and actual results could be material. Significant estimates in the accompanying financial statements also include the fair values of investments, deferred policy acquisition cost recoverability, deferred tax asset valuation and business combinations.
Financial instruments - Financial instruments are recognized and unrecognized using trade date accounting, since that is the date Atlas contractually commits to the purchase or sale with the counterparty.
Available for sale - Investments in fixed income and equity securities are classified as available for sale. Securities are classified as available for sale when Atlas may decide to sell those securities due to changes in market interest rates, liquidity needs, changes in yields or alternative investments, and for other reasons. Available-for-sale securities are carried at fair value, with unrealized gains and losses, net of income taxes, included as a separate component of accumulated other comprehensive income (loss) in shareholders’ equity.
When anticipated claims, claims adjustment expenses, commissions and other acquisition costs exceed recorded unearned premium and any future installment premiums on existing policies, a premium deficiency reserve is recognized by recording a reduction to DPAC with a corresponding charge to operations. Atlas utilizes anticipated investment income as a factor in its premium deficiency calculation. Atlas concluded that no premium deficiency adjustments were necessary in any of the years ended December 31, 2017, 2016, and 2015.
When considering the extent of the valuation allowance on Atlas’ deferred tax asset, weight is given by management to both positive and negative evidence. U.S. GAAP states that a cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome in determining that a valuation allowance is not needed against deferred tax assets. However, the strength and trend of earnings, as well as other relevant factors are considered.
Reinsurance - As part of Atlas’ insurance risk management policies, portions of its insurance risk is ceded to reinsurers. Reinsurance premiums and claims expenses are accounted for on a basis consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums and claims ceded to other companies have been reported as a reduction of premium revenue and claims incurred. Commissions paid to Atlas by reinsurers on business ceded have been accounted for as a reduction of the related policy acquisition costs. Reinsurance recoverables are recorded for that portion of paid and unpaid claims and claims adjustment expenses that are ceded to other companies. Prepaid reinsurance premiums are recorded for unearned premiums that have been ceded to other companies.
Share-based compensation - Atlas has a share-based compensation plan that is described in Note 12, ‘Share-Based Compensation,’ to the Consolidated Financial Statements. Atlas uses the fair-value method of accounting to determine and account for equity settled transactions and to determine stock-based compensation for awards granted to employees and non-employees. For stock-based compensation for awards granted to employees and non-employees that include a performance provision, the Monte-Carlo simulation model is utilized to determine fair value. Stock-based compensation prior to 2015 was valued using the Black-Scholes option pricing model. Compensation expense is recognized over the period that the stock options vest, with a corresponding increase to additional paid in capital.
Reclassifications - Certain accounts in the prior years’ consolidated financial statement have been reclassified for comparative purposes to conform to the current year’s presentation.
Pertinent Accounting Standard Updates (“ASUs”) are issued from time to time by the FASB and are adopted by the Company as they become effective. All recently issued accounting pronouncements with effective dates prior to January 1, 2018 have been adopted by the Company.
In February 2018, the FASB issued ASU 2018-02, Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. This update provides guidance on the reclassification of stranded tax effects in accumulated other comprehensive income (“AOCI”) resulting from the Tax Cuts and Jobs Act of 2017 (the “Tax Act”). Companies will have the option to reclassify the effect of the change in the federal corporate tax rate on gross deferred tax items and related valuation allowances for item in AOCI. For public entities, this guidance is effective for years beginning after December 15, 2018, including interim periods within those years. Early adoption is permitted. This update can be applied retrospectively or at the beginning of the period of adoption. The Company elected to early adopt and will apply the change at the beginning of the period of adoption within the Consolidated Statements of Financial Position and Consolidated Statements of Shareholders’ Equity. The adoption of this ASU resulted in a increase to AOCI and an decrease in retained earnings of $7,000 for the year ended December 31, 2017 with no net effect on total shareholders’ equity.
In January 2017, the FASB issued ASU 2017-04, Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The provisions of this update simplify the subsequent measurement of goodwill by eliminating Step 2 from the quantitative analysis. For public entities, this guidance is effective for years beginning after December 15, 2019, including interim periods within those years. Early adoption is permitted after January 1, 2017. Atlas has goodwill associated with one of the insurance subsidiaries and is subject to annual goodwill impairment testing. Atlas early adopted this ASU beginning with the 2017 goodwill impairment testing. The adoption of this ASU did not have any required prior period adjustments and did not have an impact on the consolidated financial statements.
In March 2017, the FASB issued ASU 2017-08, Receivables-Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. This update shortens the amortization period for certain callable fixed income securities held at a premium to the earliest possible call date. For public entities, this guidance is effective for years beginning after December 15, 2018, including interim periods within those years. Early adoption is permitted. The Company plans on adopting the update on the required effective date using the prescribed modified retrospective approach. Atlas has a number of fixed income securities that are callable and held at a premium. The amount of the difference in amortization from current accounting treatment to the change prescribed in this ASU will be recorded upon adoption as an adjustment to retained earnings and treated as a change in accounting principle. Atlas is currently evaluating the potential impact of the ASU on these certain securities, which will change as securities mature, are sold, or are purchased.
In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230). The provisions of this update address the diversity in practice of eight issues on the statement of cash flows. For public entities, this guidance is effective for years beginning after December 15, 2017, including interim periods within those years. Early adoption is permitted. The Company plans on adopting the update on the required effective date by retrospectively restating all required amounts for the periods presented in the consolidated financial statements. Atlas’ current presentation of its Consolidated Statements of Cash Flows is not expected to change as a result of this ASU. Atlas plans to elect the cumulative earnings approach for distributions from equity method investees upon adoption, which is consistent with current practice.
In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. One provision of this update requires that equity investments, except those accounted for under the equity method, be measured at fair value and changes in fair value recognized in net income. The provisions of this update are recognized as a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. For public entities, this guidance is effective for years beginning after December 15, 2017, including interim periods within those years. Early adoption is not permitted, except for certain provisions. The Company plans on adopting the update on the required effective date. The adoption of this ASU will result in the recognition of $377,000 of net after-tax unrealized gains on equity investments as a cumulative-effect adjustment to increase retained earnings and decrease AOCI.
On March 11, 2015, Atlas acquired Anchor Holdings Group, Inc., a privately owned insurance holding company, and its wholly owned subsidiary, Global Liberty, along with its affiliated entities, Anchor Management, and Plainview (collectively, “Anchor”), from an unaffiliated third party. Anchor provides specialized commercial insurance products, including commercial automobile insurance to niche markets such as taxi, black car and sedan service owners and operators primarily in the New York market. Atlas’ acquisition of Anchor expands our distribution channel for core commercial automobile lines and provides incremental licensure as well as important infrastructure in the large New York market. Global Liberty also wrote homeowners insurance in the northeast, which was put into runoff, subject to applicable regulatory requirements, prior to the transaction.
Under the terms of the stock purchase agreement, the purchase price was based on the combined U.S. GAAP book value of Anchor as of December 31, 2014. The total purchase price for the combined entities of Anchor was $23.2 million, consisting of a combination of cash and Atlas preferred shares, and was approximately 1.3 times combined U.S. GAAP book value. Consideration consisted of approximately $19.2 million in cash and $4.0 million of Atlas preferred shares (consisting of a total of 4,000,000 preferred shares at $1.00 per preferred share), subject to the future development of Global Liberty’s actual claims reserves for certain lines of business during the five year period after the acquisition. During the fourth quarter of 2016, Atlas canceled all 4,000,000 of the preferred shares pursuant to the terms of the Anchor stock purchase agreement due to the adverse development of Global Liberty’s pre-acquisition claims reserves.
From the date of acquisition through December 31, 2015, Anchor earned revenue of $27.5 million and net income of $2.4 million.
The acquisition of Gateway resulted in the recognition of intangible assets, comprised entirely of state insurance licenses valued at $740,000. The state insurance licenses are considered to have an indefinite life and will not be amortized, but will be evaluated for impairment at least annually. Thus, Atlas recognized no amortization expense during the years ended December 31, 2017, 2016, and 2015 related to intangible assets acquired in the Gateway transaction.
Earnings per ordinary voting common share, restricted voting common share, and participative restricted stock unit (“RSU”) (collectively, the “common shares”) for the years ended December 31, 2017, December 31, 2016, and December 31, 2015 are as follows ($ in ‘000s, except share and per share amounts):
Earnings per common share diluted is computed by dividing net income by the weighted average number of common shares outstanding for each period plus the incremental number of shares added as a result of converting dilutive potential ordinary voting common shares, calculated using the treasury stock method (or, in the case of the convertible preferred shares, using the “if-converted” method).
Atlas’ dilutive potential ordinary voting common shares consist of outstanding stock options to purchase ordinary voting common shares and, for the 2016 and 2015 computation, preferred shares potentially convertible to ordinary voting common shares at the option of the holder at any date after December 31, 2018 (2,538,560 preferred shares at the rate of 0.1270 ordinary voting common shares for each preferred share related to the Gateway acquisition, all of which were redeemed during the third quarter of 2016, are considered to have been redeemed on the last day of the third quarter of 2016) and after March 11, 2020 (4,000,000 preferred shares at the rate of 0.0500 ordinary voting common shares for each preferred share related to the Anchor acquisition, all of which were canceled as of December 31, 2016). Refer to Note 14, ‘Share Capital and Mezzanine Equity,’ to the Consolidated Financial Statements for further discussion regarding the redemption and cancellation of the preferred shares.
The cost or amortized cost, gross unrealized gains and losses and fair value for Atlas’ investments in fixed income securities and equities are as follows as of ($ in ‘000s):
The aging of unrealized losses on the Company’s investments in fixed income securities and equities is presented as follows ($ in ‘000s):
As of December 31, 2017, we held 346 and 2 individual fixed income and equity securities, respectively, that were in an unrealized loss position, of which 103 individual fixed income securities were in a continuous loss position for longer than 12 months. As of December 31, 2016, we held 316 individual fixed income securities that were in an unrealized loss position, of which 39 individual fixed income securities were in a continuous loss position for longer than 12 months. We did not recognize the unrealized losses in earnings on these fixed income securities for the years ended December 31, 2017 and 2016, because we neither intend to sell the securities nor do we believe that it is more likely than not that we will be required to sell these securities before recovery of their amortized costs.
The following table summarizes the components of net investment income for the years ended December 31, 2017, 2016, and 2015 ($ in ‘000s):
1 - The proceeds from sales and calls, gross realized investment gains and gross realized investment losses on fixed income securities for the years ended December 31, 2016 and 2015 were restated to include both voluntary and involuntary calls.
The following table summarizes investments in equity method investments by investment type as of December 31, 2017 and December 31, 2016 ($ in ‘000s):
1 - We recategorized the carrying value of one limited partnership that was valued at $283,000 as of December 31, 2016 from ‘Venture capital’ to ‘Real estate’ based on its operations.
The Company recognizes an impairment loss for equity method limited partnerships when evidence demonstrates that the loss is other-than-temporary. To determine if an other-than-temporary impairment has occurred, the Company evaluates whether or not the investee could sustain a level of earnings that would justify the carrying amount of the investment. Collateral loans are considered impaired when it is probable that the Company will not collect the contractual principal and interest. Valuation allowances are established for impaired loans equal to the fair value of the collateral less costs to sell or the present value of the loan’s expected future repayment cash flows discounted at the loan’s original effective interest rate. Valuation allowances are adjusted for subsequent changes in the fair value of the collateral less costs to sell or the present value of the loan’s expected future repayment cash flows. As of December 31, 2017 and as of December 31, 2016, the Company had no valuation allowances established for impaired loans.
As of December 31, 2017 and 2016, bonds, cash and cash equivalents with a fair value of $15.0 million and $15.1 million, respectively, were on deposit with state and provincial regulatory authorities. Also, from time to time, the Company pledges securities to and deposits cash with third parties to collateralize liabilities incurred under its policies of reinsurance assumed and other commitments made by the Company. As of December 31, 2017 and 2016, the amounts of such pledged securities were $12.2 million and $5.6 million, respectively. Collateral pledging transactions are conducted under terms that are common and customary to standard collateral pledging and are subject to the Company’s standard risk management controls. These assets and investment income related thereto remain the property of the Company while pledged. Neither the state and/or provincial regulatory authorities nor any other third party has the right to re-pledge or sell said securities held on deposit.
Fixed Income: Comprised of certain U.S. Treasury fixed income securities. Valuation is based on unadjusted quoted prices for identical assets in active markets that Atlas can access.
Though Atlas believes the valuation methods used in determining fair value are appropriate, different methodologies or assumptions could result in a different fair value as of December 31, 2017. Management does not believe that reasonable changes to the inputs to its valuation methodology would result in a significantly higher or lower fair value measurement.
On December 22, 2017, the Tax Act was signed into law. Among other things, beginning with the 2018 tax year, the Tax Act reduced the Company’s corporate federal tax rate from a marginal rate of 35% to a flat 21%, eliminated the corporate Alternative Minimum Tax (“AMT”), changed reserving and other aspects of the computation of taxable income for insurance companies, and modified the net operating loss carryback and carryforward provisions for all entities in the group except for those subject to tax as property and casualty companies. The modified net operating loss provisions no longer allow a carryback to prior years to recover past taxes, but now allow an indefinite carryforward period subject to a yearly utilization limit. As discussed above, any net operating losses with respect to the insurance entities taxed as property and casualty companies retain the current net operating loss carryback and carryover provisions, which are two years carryback and 20 years carryforward. As of December 31, 2016, the Company measured its deferred tax items at the enacted rate in effect of 35%. Due to the Tax Act’s enactment, the Company’s deferred tax assets and liabilities as of December 31, 2017 have been re-measured at the new enacted tax rate of 21%. For the year ended December 31, 2017, the Company recognized income tax expense of $10.5 million related to reduction in the net deferred tax asset a result of this re-measurement.
Atlas’ effective tax rate was 12.1%, (416.8)%, and 34.5% for the years ended December 31, 2017, 2016, and 2015, respectively. The table below reconciles the U.S. statutory marginal income tax rate to the effective tax rate ($ in ‘000s):
Income tax (benefit) expense consists of the following for the years ended December 31, 2017, 2016, and 2015 ($ in ‘000s):
Upon the transaction forming Atlas on December 31, 2010, a yearly limitation as required by U.S. Internal Revenue Code of 1986 (as amended, “IRC”) Section 382 that applies to changes in ownership on the future utilization of Atlas’ net operating loss carryforwards was calculated. The Insurance Subsidiaries’ prior parent retained those tax assets previously attributed to the Insurance Subsidiaries, which could not be utilized by Atlas as a result of this limitation. As a result, Atlas’ ability to recognize future tax benefits associated with a portion of its deferred tax assets generated during prior years has been permanently limited to the amount determined under IRC Section 382. The result is a maximum expected net deferred tax asset that Atlas has available after the merger, which is believed more-likely-than-not to be utilized in the future, after consideration of valuation allowance.
The components of net deferred income tax assets and liabilities as of December 31, 2017 and December 31, 2016 are as follows ($ in ‘000s):
Amounts and expiration dates of the operating loss carryforwards as of December 31, 2017 are as follows ($ in ‘000s):
NOLs and other carryforwards generated in 2015 and 2017 are not limited by IRC Section 382.
Atlas has not established a valuation allowance for its gross future deferred tax assets as of December 31, 2017 or as of December 31, 2016. Based on Atlas’ expectations of future taxable income, its ability to change its investment strategy, as well as reversing gross future tax liabilities, management believes it is more likely than not that Atlas will fully realize the net future tax assets. However, there can be no guarantee that a valuation allowance will not be required in the future.
Atlas accounts for uncertain tax positions in accordance with the income taxes accounting guidance. Atlas has analyzed filing positions in the federal and state jurisdictions where it is required to file tax returns, as well as the open tax years in these jurisdictions. Atlas believes that its federal and state income tax filing positions and deductions will be sustained on audit and does not anticipate any adjustments that will result in a material change to its financial position. Therefore, no reserves for uncertain federal and state income tax positions have been recorded. Atlas would recognize interest and penalties related to unrecognized tax benefits as a component of the provision for federal income taxes. Atlas did not incur any federal income tax related interest income, interest expense or penalties for the years ended December 31, 2017, 2016, and 2015. The Internal Revenue Service (“IRS”) completed its audit of tax year 2012 during the three month period ended March 31, 2016. No changes to tax year 2012 were made to our reported tax. Tax years 2014 and years thereafter are subject to examination by the IRS.
On May 22, 2012, Atlas closed the sale and leaseback of the former headquarters building to 150 Northwest Point, LLC, a Delaware limited liability company. Atlas recognized a gain on the sale of this property of $213,000, which was deferred and recognized over the initial five year lease term, which ended in May 2017. The deferred gain was completely recognized at the end of the second quarter. Atlas recognized $17,000 as an offset to rent expense for the year ended December 31, 2017 and $43,000 for each of the years ended December 31, 2016 and 2015. Total rental expense recognized on the former headquarters building was $740,000, $743,000 and $704,000 for the years ended December 31, 2017, 2016, and 2015, respectively.
The Company has entered into various contracts to renovate and furnish the building that was purchased in 2016 to serve as the Company’s new headquarters, which the Company moved into on October 27, 2017. As of December 31, 2017, the remaining contractual obligations related to the renovation and furnishing of Atlas’ new headquarters building are $1.2 million.
In addition, as a condition to the ability to conduct business in certain states (and within the jurisdiction of some local governments), insurance companies are subject to or required to participate in various premium or claims based insurance-related assessments, including non-voluntary assigned risk pools, underwriting associations, workers’ compensation second-injury funds, reinsurance funds and other state insurance facilities. Atlas’ proportionate share of these various premium or claims based insurance-related assessments, including non-voluntary assigned risk pools, underwriting associations, workers’ compensation second-injury funds, reinsurance funds and other state insurance facilities is not expected to be material.
Depreciation expense and amortization was $1.4 million, $1.0 million, and $966,000 for the years ended December 31, 2017, 2016, and 2015, respectively.
During the year ended December 31, 2016, Atlas purchased a building and land for $9.3 million to serve as its new corporate headquarters to replace its former leased office space. Atlas’ Chicago area staff moved into this space in late October 2017 and occupies approximately 70,000 square feet on the second and third floors of the building. An unrelated tenant occupies the remaining office space on the first floor of the building. Rental income related to this lease agreement for the years ended December 31, 2017 and 2016, was $415,000 and $69,000, respectively. Depreciation expense related to the building and its improvements was $171,000 for the year ended December 31, 2017. There was no depreciation expense related to the building and its improvements recorded for the year ended December 31, 2016.
Atlas experienced $75.4 million in unfavorable prior accident year development for the year ended December 31, 2017 as reflected as incurred related to prior years in the table above. The unfavorable development is primarily from our core commercial automobile liability line. Atlas previously identified that claim expenses in Michigan were significantly outpacing other states and took a significant charge. Although exposure in Michigan was reduced to approximately 1.4% of the Company’s insured vehicles inforce by year end 2017, payments for claims in this state continued to be disproportionate to historic premiums earned. In addition, the remaining liability for non-New York Global Liberty business written prior to 2016 is expected to settle for greater amounts than previously expected. Overall, the actuarially determined liability for remaining claims related to accident year 2015 and prior in general, across all jurisdictions, was indicated to be higher than carried reserves.
The reconciliation of the net incurred and paid claims and claims adjustment expenses development tables to the liability for claims and claims adjustment expenses in the consolidated statement of financial position as of December 31, 2017 is as follows ($ in ‘000s):
The following is supplementary information about the average annual percentage payout of incurred claims by age, net of amounts recoverable from reinsurers, for the year ended December 31, 2017 (amounts are unaudited).
Stock options - Stock option activity for the years ended December 31, 2017 and 2016 follows (prices in Canadian dollars designated with “C$” and United States dollars designated with “US$”):
Information about options outstanding as of December 31, 2017 is as follows:
There are 229,390 stock options that are exercisable as of December 31, 2017. The stock option grants outstanding have a weighted average remaining life of 6.26 years and have an intrinsic value of $2.2 million as of December 31, 2017.
On March 12, 2015, the Board of Directors of Atlas granted equity awards of (i) 200,000 restricted stock grants for ordinary voting common shares of the Company and (ii) 200,000 options to acquire ordinary voting common shares to the executive officers of the Company as part of the Company’s annual compensation process. The awards were made under the Company’s Equity Incentive Plan. The awards vest in 5 equal annual installments of 20%, provided that an installment shall not vest unless an annual performance target based on specific book value growth rates linked to return on equity goals is met. In the event the performance target is not met in any year, the 20% installment for such year shall not vest, but such non-vested installment shall carry forward and can become vested in future years (up to the fifth year from the date of grant), subject to achievement in a future year of the applicable performance target for such year. For the year ended December 31, 2017, 40,000 shares of each of the restricted stock grants for ordinary voting common shares and the options to acquire ordinary voting common shares vested. For the year ended December 31, 2016, performance targets linked to these awards were not achieved, and therefore no vesting occurred.
In accordance with ASC 718 (Stock-Based Compensation), Atlas has recognized share-based compensation expense on a straight-line basis over the requisite service period of the last separately vesting portion of the award. Share-based compensation expense is a component of other underwriting expenses on the statements of income and comprehensive income. Atlas recognized $1.2 million, $1.6 million and $1.8 million in share-based compensation expense, including income tax expense, for the years ended December 31, 2017, 2016, and 2015, respectively. Total unearned share-based compensation expense was $660,000 related to all stock option grants and $1.4 million related to restricted stock grants for ordinary voting common shares and restricted share units as of December 31, 2017. This unearned share-based compensation expense will be amortized over the next 26 months.
Employee Stock Purchase Plan - The Atlas Employee Stock Purchase Plan (the “ESPP”) encourages employee interest in the operation, growth and development of Atlas and provides an additional investment opportunity to employees. Full time and permanent part time employees working more than 30 hours per week are allowed to invest up to 7.5% of adjusted salary in Atlas ordinary voting common shares. Atlas matches 100% of the employee contribution up to 2.5% of annual earnings, plus 50% of additional contributions up to 5% of annual earnings, for a total maximum expense of 5% of annual earnings per participant. Atlas’ matching contributions are discretionary. Atlas also pays all administrative costs related to this plan. For the years ended December 31, 2017, 2016, and 2015, Atlas’ costs incurred related to the matching portion of the ESPP were $212,000, $199,000, and $151,000, respectively. Share purchases pursuant to this plan are made in the open market.
There were 14,816 and 22,224 non-vested restricted stock units (“RSUs”) as of December 31, 2017 and December 31, 2016, respectively. These RSUs are participative and are included in the computations of earnings per common share and book value per common share for these periods.
On March 21, 2017, the Company’s Board of Directors approved a Share Repurchase Program of up to 650,000 shares of common stock. The repurchases may be made from time to time in open market transactions, privately-negotiated transactions, block purchases, or otherwise in accordance with securities laws at the discretion of the Company’s management until March 21, 2018. The Company’s decisions around the timing, volume, and nature of share repurchases, and the ultimate amount of shares repurchased, will be dependent on market conditions, applicable securities laws, and other factors. The share repurchase program and the Board’s authorization of the program may be modified, suspended, or discontinued at any time. During 2017, no shares were repurchased under this Share Repurchase Program.
Prior to the year ended December 31, 2017, the Company presented preferred shares issued as contingent consideration within the permanent equity section of the Consolidated Statements of Financial Position. In accordance with FASB ASC Topic 480 - Distinguishing Liabilities from Equity, contingent consideration issued as preferred shares wherein the number of shares to be issued is variable should be classified outside of permanent equity and reflected as mezzanine equity on the Consolidated Statements of Financial Position.
For the year ended December 31, 2017, the Company has restated the Consolidated Statements of Shareholders’ Equity to remove the preferred shares and related activity as previously stated for the periods as of January 1, 2015 and for the years ended December 31, 2015 and 2016. Although this impacted total equity for 2015, it had no impact on total equity as of December 31, 2016 due to the redemption and clawback of preferred shares previously issued. In addition, this change did not impact the Consolidated Statements of Financial Position, Consolidated Statements of Income (Loss) and Comprehensive Income (Loss), earnings per common share or the Consolidated Statements of Cash Flows. The Company has evaluated the effect of the incorrect presentation in the prior period, both qualitatively and quantitatively, and concluded that it did not have a material impact on, nor did it require amendment of, any previously filed annual or quarterly consolidated financial statements.
On September 30, 2016, Atlas paid $409,000 in dividends earned on the preferred shares to the former owner of Gateway, the cumulative amount to which they were entitled through September 15, 2016, leaving no accrued and unpaid dividends owed to the former owner of Gateway. As of December 31, 2017 and December 31, 2016, Atlas has accrued $333,000 in dividends on the preferred shares for the former owner of Anchor, which remains unpaid. The paid claims development on Global Liberty’s pre-acquisition claims reserves was in excess of $4.0 million, and as a result, pursuant to the terms of the Anchor stock purchase agreement, dividends will no longer accrue to the former owner of Anchor.
Deferred policy acquisition costs represent those costs that are incremental and directly related to the successful acquisition of new or renewal written premium. Such deferred policy acquisition costs generally include agent commissions, premium taxes and a portion of employee compensation and benefits directly related to time spent performing specific acquisition or renewal activities. The method followed in determining the deferred policy acquisition costs limits the deferral to its realizable value by giving consideration to estimated future claims and expenses to be incurred as premiums are earned. Changes in estimates, if any, are recorded in the accounting period in which they are determined. Anticipated investment income is included in determining the realizable value of the deferred policy acquisition costs. Atlas’ deferred policy acquisition costs are reported net of deferred ceding commissions.
During the periods presented, a portion of the Company’s investment portfolio, which is included in “Other Investments” on the Consolidated Statements of Financial Position, included investment vehicles that are considered related-party transactions. As of December 31, 2017 and December 31, 2016 these related-party transactions comprised 8.4% of our investment portfolio. In these transactions, one or more of the Company’s directors or entities affiliated with such directors may invest in and/or manage these vehicles. These related-party transactions are consistent with the Company’s investment guidelines and have been reviewed and approved by the Investment Committee of the Company’s Board of Directors. The Company believes that these transactions leverage investment resources that would otherwise not be available to the Company.
On March 9, 2015, American Insurance Acquisition, Inc. (“American Acquisition”), a wholly-owned direct subsidiary of Atlas, entered into a loan and security agreement (“Loan Agreement”) for a $35.0 million loan facility with Fifth Third Bank. On May 7, 2016, American Acquisition entered into a Modification of Loan Documents with Fifth Third Bank to amend its Loan Agreement. The Loan Agreement, as modified, included a $30.0 million line of credit (“Draw Amount”), which could have been drawn in increments at any time until December 31, 2016. The $30.0 million line of credit had a five year term and bore interest at one-month LIBOR plus 4.5%. The Loan Agreement also included a $5.0 million revolving line of credit (“Revolver”), which could have been drawn upon until May 7, 2018, that bore interest at one month LIBOR plus 2.75%.
Interest expense on notes payable was $1.8 million, $1.0 million, and $694,000 for the years ended December 31, 2017, 2016, and 2015, respectively.
The Company elected to early adopt ASU 2018-02, Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income, for the year ended December 31, 2017. This update provides guidance on the reclassification of stranded tax effects in AOCI resulting from the Tax Act. We reclassified the effect of the change in the federal corporate tax rate on gross deferred tax items and related valuation allowances for item in AOCI. The adoption of this ASU resulted in a increase to AOCI and an decrease in retained earnings of $7,000 for the year ended December 31, 2017 with no net effect on total shareholders’ equity.