We do not own any real property. We lease our corporate office space, which is located in Clearwater, Florida, from one of our directors pursuant to a lease agreement that commenced in July 2008. This lease covers 7,500 square feet of office and common area space and requires us to make monthly base rental payments of $12,500, which includes $2,500 for common area maintenance, throughout the initial term of the lease. The initial term of this agreement is for five years ending on July 15, 2013 and the lease may be extended for up to three additional five-year periods. In addition to this primary location, we lease a small office space in a building adjacent to our corporate office location. This six-month lease, which commenced in November 2009 and expires May 17, 2010, required us to prepay the entire base rental expense of approximately $12,000 prior to occupancy. Upon the end of the current lease term, we are permitted to holdover on a month-to-month basis with a 30-day notice requirement to terminate the month-to-month arrangement.
We face various challenges to implementing our operating and growth strategies. Since we write policies that cover Florida homeowners, condominium owners, and tenants, we cover losses that may arise from, among other things, catastrophes, which could have a significant effect on our business, results of operations, and financial condition. To mitigate our risk of such losses, we cede a portion of our exposure to other entities under catastrophe excess of loss reinsurance treaties. Even without catastrophic events, we may incur losses and loss adjustment expenses that deviate substantially from our estimates and that may exceed our reserves, in which case our net income and capital would decrease. Our operating and growth strategies may also be impacted by regulation and supervision of our business by the State of Florida, which must approve our policy forms and premium rates as well as monitor our insurance subsidiary’s ability to meet all requirements for regulatory compliance. Additionally, we compete with large, well-established insurance companies as well as other specialty insurers that, in most cases, possess greater financial resources, larger agency networks, and greater name recognition.
Our results of operations for the year ended December 31, 2009 reflect net income of $10.9 million, or $1.52 earnings per diluted share, compared to net income of $12.7 million, or $2.08 per diluted share, for the year ended December 31, 2008.
Premiums Ceded for the years ended December 31, 2009 and 2008 were $44.7 million and $14.7 million, respectively. Our premiums ceded represent amounts paid to reinsurers to cover losses from catastrophes that exceed the thresholds defined by our catastrophe excess of loss reinsurance treaties. Our reinsurance rates are based primarily on policy exposures reflected in gross premiums earned. Thus, the $30.0 million increase in premiums ceded during 2009 is primarily due to the increase in our policy exposure base. In addition, our reinsurers imposed a general rate increase of approximately seven percent effective June 1, 2009. Premiums ceded were 40.6% and 23.6% of gross premiums earned during the years ended December 31, 2009 and 2008, respectively.
The following is a reconciliation of our total Net Premiums Written to Net Premiums Earned for the years ended December 31, 2009 and 2008 (dollars in thousands):
Net Investment Income for the years ended December 31, 2009 and 2008 was $1,793,000 and $1,622,000, respectively. There were no other than temporary impairments recorded during the years ended December 31, 2009 and 2008. The $171,000 increase in total investment income is primarily due to interest income received from our investments in fixed maturity securities, which were added to our investment portfolio during 2009, offset by a reduction in interest income with respect to our short-term investments due to a decline in short-term interest rates.
Other Income for the years ended December 31, 2009 and 2008 of $1,248,000 and $645,000, respectively, primarily reflects the policy fee income we earn with respect to our issuance of renewal policies.
Since inception, our liquidity requirements have been met through issuance of our common stock and funds from operations. We expect our future liquidity requirements will be met by funds from operations, primarily the cash received by our insurance subsidiary from premiums written and investment income.
Our insurance subsidiary requires liquidity and adequate capital to meet ongoing obligations to policyholders and claimants and to fund operating expenses. In addition, we attempt to maintain adequate levels of liquidity and surplus to manage any differences between the duration of our liabilities and invested assets. In the insurance industry, cash collected for premiums from policies written is invested, interest and dividends are earned thereon, and loss and loss adjustment expenses are paid out over a period of years. This period of time varies by the circumstances surrounding each claim. A substantial portion of our losses and loss expenses are fully settled and paid within 90 days of the claim receipt date. Additional cash outflow occurs through payments of underwriting costs such as commissions, taxes, payroll, and general overhead expenses.
Our cash flows from operating, investing and financing activities for the years ended December 31, 2009 and 2008 are summarized below.
Net cash provided by operating activities for the year ended December 31, 2008 was approximately $66.6 million, which consisted primarily of cash received from net written premiums less cash disbursed for operating expenses and losses and loss adjustment expenses. Net cash used in investing activities of $11.2 million was primarily the result of our purchase of short-term investments. Net cash provided by financing activities totaled approximately $9.9 million and consisted primarily of the net proceeds from the sale of our common stock through our initial public offering completed in July 2008.
With the exception of large national banks, it is our current policy not to maintain cash deposits of more than an aggregate of $5.5 million in any one bank at any time. In the future, we may alter our investment policy to include or increase investments in federal, state and municipal obligations, preferred and common equity securities and real estate mortgages, as permitted by applicable law, including insurance regulations.
As of December 31, 2009, we had no off-balance sheet arrangements as defined in Item 303(a)(4) of Regulation S-K.
Reserves are closely monitored and are recalculated periodically using the most recent information on reported claims and a variety of actuarial techniques. Specifically, claims management personnel complete weekly and ongoing reviews of existing reserves, new claims, changes to existing case reserves, and paid losses with
When a claim is reported to us, our claims personnel establish a “case reserve” for the estimated amount of the ultimate payment. This estimate reflects an informed judgment based upon general insurance reserving practices and on the experience and knowledge of the estimator. The individual estimating the reserve considers the nature and value of the specific claim, the severity of injury or damage, location, and the policy provisions relating to the type of loss. Case reserves are adjusted by us as more information becomes available. It is our policy to settle each claim as expeditiously as possible.
Finally, we employ the average outstanding and open claims method. We segregate our claims according to when we assumed them from Citizens and conduct a detailed review in order to estimate average future development of open claims and average projected loss on IBNR claims. We combine this estimate with our open claims in order to derive an estimate of expected unreported losses. Paid losses are added to this estimate in order to derive an estimate of ultimate losses. This method is based on the assumption that future IBNR claims and the average severity of open claims and IBNR claims can be reasonably estimated from the experience available.
Stock-Based Compensation. We account for our stock option plan under the fair value recognition provisions of Accounting Standards Codification Topic 718 (“ASC Topic 718”) - “Compensation - Stock Compensation,” which requires the measurement and recognition of compensation for all stock-based awards made to employees and directors including stock options and restricted stock issuances based on estimated fair values. Under the fair value recognition provisions of ASC Topic 718, we recognize stock-based compensation in the consolidated statements of earnings on a straight-line basis over the vesting period. We use the Black-Scholes option pricing model, which requires the following variables for input to calculate the fair value of each stock award on the option grant date: 1) expected volatility of our stock price, 2) the risk-free interest rate, 3) expected term of each award, 4) expected dividends, and 5) an expected forfeiture rate.
We have audited the accompanying consolidated balance sheets of Homeowners Choice, Inc. and Subsidiaries (the “Company”) as of December 31, 2009 and 2008, and the related consolidated statements of earnings, stockholders’ equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
Organization and Business. The accompanying consolidated financial statements include the accounts of Homeowners Choice, Inc. and its wholly-owned subsidiaries (collectively, the “Company”). All significant intercompany balances and transactions have been eliminated in consolidation.
Nearly all of the Company’s customers have been obtained through participation in a “takeout program” with Citizens Property Insurance Corporation (“Citizens”), a Florida state supported insurer. The customers were obtained in seven separate assumption transactions completed in July and November 2007, February, June, October and December 2008, and December 2009. The Company is required to offer renewals on the policies acquired for a period of three years subsequent to the initial expiration of the assumed policies. During the first full year after assumption, such renewals are required to have rates that are equivalent to or less than the rates charged by Citizens.
The Company reviews all securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such review. When the fair value of any investment is lower than its cost, an assessment is made to determine whether the decline is temporary or other-than-temporary. If the decline is determined to be other-than-temporary, the investment is written down to fair value and an impairment charge is recognized in earnings in the period in which the Company makes such determination. For a debt security that the Company does not intend to sell and it is not more likely than not that the Company will be required to sell before recovery of its amortized cost, only the credit loss component of the impairment is recognized in earnings, while the impairment related to all other factors is recognized in other comprehensive loss. The Company considers various factors in determining whether an individual security is other-than-temporarily impaired (see Note 3 - “Investments”).
Deferred policy acquisition costs. Deferred policy acquisition costs (“DAC”) primarily represent commissions paid to Citizens or outside agents at the time of collection of the policy premium, salaries and premium taxes and are amortized over the life of the related policy in relation to the amount of gross premiums earned. The method followed in computing DAC limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium earned, related investment income, unpaid loss and LAE and certain other costs expected to be incurred as the premium is earned.
Deferred income tax expense results from changes in deferred tax assets and liabilities between periods. Deferred tax assets are recognized if it is more likely than not, based on the technical merits, that the tax position will be realized or sustained upon examination. The term more likely than not means a likelihood of more than fifty percent; the terms examined and upon examination also include resolution of the related appeals or litigation processes, if any. A tax position that meets the more-likely-than-not recognition threshold is initially and subsequently measured as the largest amount of tax benefit that has a greater than fifty percent likelihood of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. The determination of whether or not a tax position has met the more-likely-than-not recognition threshold considers the facts, circumstances, and information available at the reporting date and is subject to management’s judgment. Deferred tax assets are reduced by a valuation allowance if, based on the weight of evidence available, it is more likely than not that some portion or all of a deferred tax asset will not be realized. As of December 31, 2009, management is not aware of any uncertain tax positions that would have a material effect on the Company’s consolidated financial statements.
Earnings Per Share. Basic earnings per share is computed on the basis of the weighted-average number of common shares outstanding. Diluted earnings per share is computed based on the weighted-average number of shares outstanding plus the effect of outstanding stock options and warrants, computed using the treasury stock method.
Accounting Standards Update No. 2009-13. In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2009-13 (“ASU 2009-13”), Revenue Recognition (Topic 605), Multiple-Deliverable Revenue Arrangements, a consensus of the FASB Emerging Issues Task Force. ASU 2009-13 addresses the accounting for multiple-deliverable arrangements to enable vendors to account for products or services separately rather than as a combined unit when those arrangements are within the scope of Subtopic 605-25. The amendments in this update establish a selling price hierarchy for determining a selling price of a deliverable. The amendments also require the vendor to determine its best estimate of selling price in a manner consistent with that used to determine the price to sell the deliverable on a standalone basis. This ASU significantly expands the disclosures related to a vendor’s multiple-deliverable revenue arrangements. The amendments in this update will be effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 with early adoption permitted. The adoption of this guidance will not have a material effect on the Company’s consolidated financial condition or results of operations.
Accounting Standards Update No. 2009-16. In December 2009, the FASB issued Accounting Standards Update No. 2009-16 (“ASU 2009-16”), Transfers and Servicing (Topic 860), Accounting for Transfers of Financial Assets. The amendments in ASU 2009-16 improve financial reporting by eliminating the exceptions for qualifying special-purpose entities from the consolidation guidance and the exception that permitted sale accounting for certain mortgage securitizations when a transferor has not surrendered control over the transferred assets. In addition, the amendments require enhanced disclosures about the risks that a transferor continues to be exposed to because of its continuing involvement in transferred financial assets and improves comparability and consistency in accounting for transferred financial assets through clarifications of the requirements for isolation and limitations on portions of financial assets that are eligible for sale accounting. ASU 2009-16 is effective as of the beginning of the first annual reporting period beginning after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. The adoption of this guidance will not have a material effect on the Company’s consolidated financial condition or results of operations.
Accounting Standards Update No. 2010-02. In January 2010, the FASB issued Accounting Standards Update No. 2010-02 (“ASU 2010-02”), Consolidation (Topic 810), Accounting and Reporting for Decreases in Ownership of a Subsidiary - a Scope Clarification. The amendments in ASU 2010-02 provide updates to Subtopic 810-10 and related guidance within U.S. GAAP to clarify the scope of the decrease in ownership provisions of the Subtopic and related guidance. The amendments in ASU 2010-02 also clarify that the decrease in ownership guidance does not apply to certain transactions even if they involve businesses. Because the Company had previously adopted FASB Statement 160 (Noncontrolling Interests in Consolidated Financial Statements - an amendment of ARB No. 51), ASU 2010-02 is effective beginning in the first interim or annual reporting period ending on or after December 15, 2009 with retrospective application. The adoption of this guidance had no effect on the Company’s consolidated financial condition or results of operations.
Accounting Standards Update No. 2010-05. In January 2010, the FASB issued Accounting Standards Update No. 2010-05 (“ASU 2010-05”), Compensation - Stock Compensation (Topic 718), Escrowed Share Arrangements and the Presumption of Compensation. The amendments in ASU 2010-05 codify Emerging Issues Task Force Topic D-110, Escrowed Share Arrangements and the Presumption of Compensation. The adoption of this guidance did not have a material effect on the Company’s consolidated financial condition or results of operations.
Accounting Standards Update No. 2010-06. In January 2010, the FASB issued Accounting Standards Update No. 2010-06 (“ASU 2010-06”), Fair Value Measurements and Disclosures (Topic 820), Improving Disclosures about Fair Value Measurements. The amendments in ASU 2010-06 require new disclosures about the different classes of assets and liabilities measured at fair value, the valuation techniques and inputs used, the activity in Level 3 fair value measurements, and the transfers between Levels 1, 2, and 3. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements, which are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The adoption of this guidance will not have a material effect on the Company’s consolidated financial condition or results of operations.
Accounting Standards Update No. 2010-08. In February 2010, the FASB issued Accounting Standards Update No. 2010-08 (“ASU 2010-08”), Technical Corrections to Various Topics. ASU 2010-08 was issued by the FASB primarily to eliminate inconsistencies and outdated provisions of U.S. GAAP. The changes resulting from this update are generally effective for the first reporting period beginning after issuance (including interim periods) and are generally nonsubstantive. Certain clarifications made to the guidance on embedded derivatives and hedging (Subtopic 815-15 of ASC) may cause a change in the application of that Subtopic and, thus, special transition provisions are provided for accounting changes related to that Subtopic. Since none of the provisions of ASU 2010-08 fundamentally change U.S. GAAP, adoption did not have a material effect on the Company’s consolidated financial condition or results of operations.
Accounting Standards Update No. 2010-09. In February 2010, the FASB issued Accounting Standards Update No. 2010-09 (“ASU 2010-09”), Subsequent Events (Topic 855), Amendments to Certain Recognition and Disclosure Requirements. ASU 2010-09 was issued by the FASB primarily to eliminate any potential conflicts with the Securities and Exchange Commission’s guidance with respect to disclosure of the date through which subsequent events have been evaluated. The changes resulting from this update are generally effective upon issuance. The adoption of this guidance did not have a material effect on the Company’s consolidated financial condition or results of operations.
During 2009, the Company made investments in fixed maturity securities comprised of corporate bonds. The amortized cost and estimated fair value of these investments, which were classified as held-to-maturity at December 31, 2009, are summarized as follows (in thousands):
During 2009, the Company added available-for-sale, fixed maturity securities to its investment portfolio comprised of U.S. Treasury notes and commercial mortgage-backed securities, all of which are carried at fair value. At December 31, 2009, the amortized cost, gross unrealized gains and losses, and fair value of the Company’s available-for-sale fixed maturity securities by security type were as follows (in thousands):
Securities with gross unrealized loss positions at December 31, 2009, aggregated by investment category and length of time the individual securities have been in a continuous loss position, are as follows (in thousands):
The Company believes there were no fundamental issues such as credit losses or other factors with respect to any of its securities. The unrealized losses on investment securities were caused by interest rate changes. It is expected that the securities would not be settled at a price less than the par value of the investments. Because the decline in fair value is attributable to changes in interest rates and not credit quality, and because the Company has the ability and intent to hold these investments until a market price recovery or maturity, the Company does not consider any of its investments in fixed maturity securities to be other-than-temporarily impaired at December 31, 2009.
The following time deposits and short-term investments exceeded 10% of consolidated stockholders’ equity at December 31, 2009 and 2008 (dollars in thousands):
Fair values of the Company’s available-for-sale fixed maturity securities are determined in accordance with ASC Topic 820, Fair Value Measurements and Disclosure, using valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. Fair values are generally measured using quoted prices in active markets for identical securities or other inputs that are observable either directly or indirectly, such as quoted prices for similar securities. In those instances where observable inputs are not available, fair values are measured using unobservable inputs. Unobservable inputs reflect the Company’s own assumptions about the assumptions that market participants would use in pricing the security and are developed based on the best information available in the circumstances. Fair value estimates derived from unobservable inputs are significantly affected by the assumptions used, including the discount rates and the estimated amounts and timing of future cash flows. The derived fair value estimates cannot be substantiated by comparison to independent markets and are not necessarily indicative of the amounts that would be realized in a current market exchange.
The following table presents information about the Company’s available-for-sale fixed maturity securities measured at fair value as of December 31, 2009, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value (dollars in thousands):
There were no financial instruments measured in accordance with ASC Topic 820 at December 31, 2008 or for the year then ended.
The Company has a lease for office space located in Clearwater, Florida. This lease commenced in July 2008 and requires the Company to make monthly rent payments of $12,500, which includes $2,500 for common area maintenance, to an entity owned by one of the Company’s directors. The initial term of this agreement is for five years ending on July 15, 2013 and the lease may be extended for up to three additional five-year periods. In addition to this primary location, the Company leases a small office space in a building adjacent to the corporate office location. This six-month lease, which commenced in November 2009 and expires May 17, 2010, required the Company to prepay the entire base rental expense of approximately $12,000 prior to occupancy. Upon the end of the current lease term, the Company is permitted to holdover on a month-to-month basis with a 30-day notice requirement to terminate the month-to-month arrangement. The Company previously had leases covering its former office facilities in Port St. Lucie and St. Petersburg, Florida. Rental expense under all facility leases was $181,000 and $136,000 during the years ended December 31, 2009 and 2008, respectively.
The Company has no uncertain tax positions or unrecognized tax benefits that, if recognized, would impact the effective income tax rate. The tax years ending December 31, 2008, 2007, and 2006 remain subject to examination by our major taxing jurisdictions. There have been no interest or penalties recognized for the years ended December 31, 2009 and 2008.
Significant components of our net deferred income tax asset are as follows (dollars in thousands):
On July 24, 2008, the Company completed the sale of 1,666,668 units consisting of one share of the Company’s common stock and one warrant. Two warrants may be exercised to acquire one share of common stock at an exercise price equal to $9.10 per share on or before July 30, 2013. In addition, the Company’s placement agents with respect to the offering received an aggregate of 166,666 warrants to purchase 166,666 shares of common stock at an exercise price of $9.10 per share. These placement agent warrants are exercisable beginning on January 27, 2009 through their expiration date of July 30, 2013. In December 2008, a total of 61,666 of the placement agent warrants were forfeited. In October 2009, a total of 33,000 placement agent warrants were repurchased by the Company. Thus, the Company has reserved 905,334 shares of common stock for issuance upon exercise of the warrants. At any time after January 30, 2009 and before the expiration of the warrants, the Company at its option may cancel the warrants in whole or in part, provided that the closing price per share of the Company’s common stock has exceeded $11.38 for at least ten trading days within any period of twenty consecutive trading days, including the last trading day of the period. The placement agents also have the option to effect a cashless exercise in which the warrants would be exchanged for the number of shares which is equal to the intrinsic value of the warrant divided by the current value of the underlying shares.
The Company’s 2007 Stock Option and Incentive Plan (the “Plan”) provides for granting of stock options to employees, directors, consultants, and advisors of the Company. Under the Plan, options may be granted to purchase a total of 6,000,000 shares of the Company’s common stock. At December 31, 2009, options to purchase 4,810,000 shares are available for grant under the Plan. The options vest over periods ranging from immediately vested to five years and are exercisable over the contractual term of ten years.
There were no options granted during the year ended December 31, 2009. The fair value of options granted during the year ended December 31, 2008 was estimated on the date of grant using the following assumptions and the Black-Scholes option pricing model:
The Company is party to claims and legal actions arising routinely in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the consolidated financial position or liquidity.
As a direct premium writer in the state of Florida, the Company is required to participate in certain insurer pools and associations under Florida statutes 631.57(3) (A). Participation in these pools is based on written premium by line of business to total premiums written statewide by all insurers. Participation may result in assessments against the Company. For the years ended December 31, 2009 and 2008, HCPC collected and paid assessments to the Florida Hurricane Catastrophe Fund (FHCF) amounting to $947,000 and $378,000, respectively. Additionally, HCPC collected and paid assessments to Citizens of $1,326,000 and $529,000, respectively, for the years ended December 31, 2009 and 2008. These assessments are recorded as a surcharge in premium billings to insureds. The surcharges are 1.0% of premium for the FHCF and 1.4% for Citizens.
HCPC has qualified as a Limited Apportionment Company in Florida for a one-year period beginning in April 2009. This designation allows the Company to pay assessments from regulatory agencies as assessments from insureds are recouped rather than paying the assessment and then recouping from the insureds/ policyholders.
The Florida Insurance Code (the “Code”) requires HCPC to maintain capital and surplus equal to the greater of 10% of its liabilities or a statutory minimum as defined in the Code. At December 31, 2009 and 2008, HCPC is required to maintain a minimum capital and surplus of $4.0 million. At December 31, 2009 and 2008, HCPC’s statutory capital and surplus was $24.1 million and $24.8 million, respectively. For the year ended December 31, 2009, HCPC had a statutory net loss of $0.6 million. For the year ended December 31, 2008, HCPC had a statutory net profit of $3.4 million. Statutory surplus differs from stockholders’ equity reported in accordance with generally accepted accounting principles primarily because policy acquisition costs are expensed when incurred. In addition, the recognition of deferred tax assets is based on different recoverability assumptions.
As of December 31, 2009 and 2008, HCPC had a cash deposit with the Insurance Commissioner of the state of Florida, in the amount of $300,000, to meet regulatory requirements. At December 31, 2009 and 2008, there were no material permitted statutory accounting practices utilized by HCPC.
The Bermuda Monetary Authority requires Claddaugh to maintain minimum capital and surplus of $2.0 million. At December 31, 2009 and 2008, Claddaugh’s statutory capital and surplus was $5.5 million and $2.3 million, respectively. Claddaugh’s statutory net profit was $3.5 million and $291,000, respectively, for the years ended December 31, 2009 and 2008.
One of the Company’s directors receives a consulting fee and software license fees for development and use of the Company’s premium administration application software. Under this arrangement, the Company incurred $352,000 and $400,000 for the years ended December 31, 2009 and 2008, respectively.
As discussed in Note 6, the Company leases office space under an operating lease agreement with one director. The lease requires annual base rental payments of approximately $150,000. Lease payments on this property for the years ended December 31, 2009 and 2008 totaled $160,000 and $96,000, respectively. In 2008, the Company also paid this landlord a refundable deposit of $13,000. Additionally, the Company paid $31,000 during 2008 to reimburse the landlord for tenant improvements.
Effective January 20, 2010, the Company repurchased and retired a total of 200,000 shares of the Company’s common stock at a price of $7.00 per share for a total cost of $1,400,000. Such shares were repurchased under a stock purchase agreement with one of the Company’s directors.