The income statement data for the years ended December 31, 2016, 2015 and 2014 and the balance sheet data as of December 31, 2016 and 2015 are derived from our audited financial statements included elsewhere in this report. The income statement data for the years ended December 31, 2013 and 2012 and the balance sheet data as of December 31, 2014, 2013 and 2012 are derived from our audited financial statements that are not included in this report.
Upon the completion of the private placement in 2014, our parent company’s status as a Subchapter S corporation terminated and our consolidated income became fully subject to U.S. federal income taxes. This adjustment represents estimated income taxes as if the Company had been treated as a C Corporation for each period presented. The estimated tax was calculated assuming the Company’s blended statutory federal and state income tax rates of 37.5%, 38.1% and 37.2% for the years ended December 31, 2014, 2013 and 2012, respectively.
As a result of the Company’s conversion to a C Corporation, the deferred tax asset increased by approximately $14.3 million primarily due to the effects of eliminating deferred tax balances on the insurance subsidiaries related to intercompany transactions.
In connection with the 2014 amendment to the alliance agreement with CUNA Mutual, we paid CUNA Mutual $17.8 million.
Represents the tax effect of non-GAAP expense adjustments for founder special compensation, offering-related expenses, and contract modification expense for each period presented. The estimated tax was calculated assuming the Company’s blended statutory federal and state income tax rates of 37.5%, 38.1% and 37.2% for the years ended December 31, 2014, 2013 and 2012, respectively.
Our reinsurance recoverables are based on estimates, and our actual liabilities may exceed the amount that we are able to recover from our reinsurers or any collateral securing the liabilities. This could occur because the loss
experience based on the policy terms is higher than expected or due to litigation, regulatory or other extra-contractual liabilities. Our insurance subsidiaries remain liable for unearned premiums and unpaid losses and loss adjustment expenses with respect to reinsurance ceded should the reinsurer be unable to meet its obligations. Management considers the possibility of a reinsurer becoming unable to meet its obligations as remote due to the reinsurers’ financial stability, A.M. Best Company rating, size, security funds available, and other factors as appropriate.
We are a leading specialty provider of property and casualty insurance services operating in two niche markets across the United States. In our Program Services segment, we leverage our “A” (Excellent) A.M. Best rating, expansive licenses and reputation to provide access to the U.S. property and casualty insurance market in exchange for ceding fees. In our Lender Services segment, we specialize in providing collateral protection insurance (“CPI”), which insures personal automobiles and other vehicles held as collateral for loans made by credit unions, banks and specialty finance companies.
Our Program Services segment generates significant fee income, in the form of ceding fees, by offering issuing carrier (“fronting”) capacity to both specialty general agents and other producers (“GAs”), who sell, control, and administer books of insurance business that are supported by third parties that assume reinsurance risk. These reinsurers are domestic and foreign insurers and institutional risk investors (“capacity providers”) that want to access specific lines of U.S. property and casualty insurance business. Issuing carrier arrangements refer to our business in which we write insurance on behalf of a capacity provider and then reinsure the risk under these policies with the capacity provider in exchange for ceding fees. We reinsure substantially all of the underwriting risks in connection with our fronting arrangements to our capacity providers. As such, this segment generates very large gross premiums with no net
In our Lender Services business, we believe that organic growth from our existing lender clients will be driven by overall growth in lenders’ portfolios as a result of rising automobile sales, higher average auto loan balances and an aging U.S. automobile fleet. We also expect that new sales from our alliance with CUNA Mutual will produce additional premiums.
We currently have a significant program with Nephila Capital, Ltd. (“Nephila”) under which we granted Nephila the exclusive right to utilize the Company as issuing carrier for U.S. catastrophe exposed property insurance from 2015 through 2019. Nephila is a hedge fund with approximately $11 billion in assets under management that participates in the market for catastrophe exposed property business. In exchange for this exclusive right, Nephila has agreed to pay State National contractual minimum ceding fees totaling $51.5 million for 2016 through 2019. The minimum ceding fees are subject to State National maintaining its “A” A.M. Best rating and potential reductions to the extent that State National is unable to provide production year capacity or is otherwise constrained from writing premium. Also, under certain circumstances, Nephila may terminate the exclusivity, which would reduce the contractual minimum ceding fees to a total of $32.5 million for 2016 through 2019. In the event of such a termination, State National would have the ability to write the catastrophe exposed property business for other capacity providers. The timing and actual amount of gross premiums written for Nephila will impact the timing and amount of ceding fees earned each period under this program. See “-Principal Revenue and Expense Items-Minimum ceding fees.” In addition, State National and
Nephila have an alliance under which State National acquired City National Insurance Company (“CNIC”), an admitted property and casualty insurance shell company and ISIC, a non-admitted property and casualty insurance shell company, which will be used exclusively to write business produced by Nephila. Nephila will have a three year option to purchase these companies beginning three years after the shell companies first write premium. In the event that the option is exercised, contractual minimum payments to State National will extend for an additional two years.
Minimum ceding fees. Minimum ceding fees are fees we receive pursuant to contractual minimum premium requirements for certain of our programs where either significant premium capacity is reserved for that program or where the expected premium volume is not reasonably assured. For those programs where a minimum applies, the ceding fees are considered as two distinct pieces (1) “premium-related fees,” which are earned as the associated gross written premium is earned, typically pro rata on an annual basis; and (2) “capacity fees,” which are determined based on the shortfall, if any, between the program’s contractual annual premium minimum and the amount of premium that we estimate will be written in the contract year, which fees are earned over the contract year.
General and administrative expense. General and administrative expense is composed of all other operating expenses, including various departmental salaries and benefits expense for employees. General and administrative expense also includes expenses related to our office space, postage, telephone and information technology charges, as well as legal and auditing fees and corporate travel. In addition, general and administrative expense includes those charges that are related to the amortization of tangible and intangible assets.
Adjusted net income. Adjusted net income is considered a non-GAAP financial measure because it reflects adjustments to net income, which is the most directly comparable measure calculated in accordance with GAAP for the pro forma provision for income taxes as if the Company had been treated as a C Corporation for each period presented and the exclusion of the increase in the Company’s deferred tax asset as a result of the conversion to the C Corporation status, for the amount of founder special compensation and the non-recurring offering-related expenses and contract modification expense related to the amendment to our alliance with CUNA Mutual, as applicable. Management believes this measure is helpful to investors because it provides comparability in evaluating core financial performance between periods before and after the completion of our private placement in June 2014. Management uses adjusted net income to evaluate core financial performance against historical results without the effect of these items.
For a reconciliation of these non-GAAP financial measures, see “Management’s Discussion and Analysis of Financial Condition and Results of Operation-Results of Operations-Consolidated Results of Operations.” These adjustments to the GAAP measures are only applicable to 2014 and prior periods.
Gross leverage. Gross leverage for the Company is the ratio of gross written premiums and gross liabilities to surplus. A significant portion of our capital is used to support the gross premium and insurance liabilities in our Program Services segment. Because we retain virtually no risk other than the credit risk of the capacity providers, and we maintain strict credit underwriting standards, broad indemnification agreements and collateral requirements, we are able to maintain significant ceded reinsurance business on a relatively small amount of capital compared to our peers. For the year ended December 31, 2016, our gross leverage ratio was 14.7 to 1. Our objective is to produce a total company gross leverage ratio of between 13 to 1 and 17 to 1.
Net loss ratio. The net loss ratio is a measure of the underwriting profitability of our Lender Services segment. Expressed as a percentage, this is the ratio of net losses and LAE incurred to net premiums earned. For the years ended December 31, 2016, 2015 and 2014, our net loss ratio was 44.5%, 45.5% and 42.0%, respectively. This decrease is primarily due to an increase in premiums earned, resulting in part from active account management on our CPI product.
In establishing these estimates, we make various assumptions regarding a number of factors, including frequency and severity of claims, the length of time needed to achieve ultimate settlement of claims, inflation of medical costs, insurance policy coverage interpretations, jury determinations and legislative changes. Due to the inherent uncertainty associated with these estimates, and the cost of incurred but unreported claims, our actual liabilities may be different from our original estimates. On a quarterly basis, we review our reserves for losses and LAE to determine whether further adjustments are required. Any resulting adjustments are included in the current period’s results. Additional information regarding the judgments and uncertainties surrounding our estimated reserves for losses and LAE can be found in “Business-Loss Reserves” in Item 1 of this report.
The Company evaluates its investment portfolio for impairments of individual securities that are deemed to be other-than-temporary. Fixed maturity securities that are determined to have other-than-temporary impairment and it is more likely than not the Company will sell before recovery of their amortized cost, are written down to fair value and the entire amount of the write-down is included in net income, net of realized investment gains. For all other impaired fixed-
maturity securities, the impairment loss is separated into the amount representing the credit loss and the amount representing all other factors. The amount of impairment loss that represents the credit loss is included in net income, net of realized investment gains. The amount of the impairment loss that relates to all other factors is included in other comprehensive income. Equity securities that are determined to have other-than-temporary impairment are recognized in net income, net of realized investment gains.
The process for identifying other-than-temporary declines in fair value involves the consideration of several factors, including, but not limited to, whether the issuer has been downgraded to below investment-grade, the length of time in which there has been a significant decline in value, the liquidity and overall financial condition of the issuer, the nature and performance of the collateral or other credit support backing the security, the significance of the decline in value, and whether the Company has the intent to sell the security or may be required to sell the security prior to its anticipated recovery. The Company reviews securities for other-than-temporary impairment internally and with its investment advisors.
Minimum ceding fees are fees the Company receives pursuant to contractual minimum premium requirements for certain programs where either significant premium capacity is reserved for that program or where the expected premium volume is not reasonably assured. For those programs where a minimum applies, the ceding fees are considered as two distinct pieces: (1) “premium-related fees,” which are earned as the associated gross written premium is earned, typically pro rata on an annual basis; and (2) “capacity fees,” which are determined based on the shortfall, if any, between the program’s contractual annual premium minimum and the amount of premium estimated to be written in the contract year, which fees are earned over the contract year.
In connection with the 2014 amendment to the alliance agreement with CUNA Mutual, we paid CUNA Mutual $17.8 million. As a result, we recorded non-recurring contract modification expense of $17.8 million.
Represents the tax effect of non-GAAP expense adjustments for founder special compensation, offering-related expenses, and contract modification expense. The estimated tax was calculated assuming the Company’s blended statutory federal and state income tax rate of 37.5% for the period ended December 31, 2014.
Premiums earned. Premiums earned increased by $11.6 million, or 9.8%, from $118.1 million for the year ended December 31, 2015 to $129.7 million for the year ended December 31, 2016. This increase was due to an increase in Lender Services premiums earned. Factors contributing to this increase are new sales, active account management and growth in the loan portfolios of existing accounts driven by rising automobile sales and higher average auto loan balances.
Ceding fees. Ceding fees increased by $22.3 million, or 48.6%, from $45.7 million for the year ended December 31, 2014 to $68.0 million for the year ended December 31, 2015, due to an increase in Program gross earned premium and capacity fees. Program Services gross earned premiums increased from $815.2 million for the year ended December 31, 2014 to $1.0 billion for the year ended December 31, 2015 resulting in an increase in premium-related ceding fees of $11.1 million. Capacity fees increased $11.2 million for the year ended December 31, 2015 compared to the year ended December 31, 2014.
Commissions. Commission expense increased by $1.6 million from $3.9 million for the year ended December 31, 2014 to $5.5 million for the year ended December 31, 2015, primarily due to the increase in Lender Services premiums earned and a reduction to ceding commissions as a result of the amendment to the CUNA Mutual alliance agreement.
Income tax expense (benefit). Income tax expense increased by $34.6 million, from a benefit of $9.7 million for the year ended December 31, 2014 to an expense of $24.9 million for the year ended December 31, 2015, primarily resulting from the conversion of the Company’s tax status from a Subchapter S Corporation to a C Corporation.
capacity fees. Program Services gross earned premiums increased from $815.2 million for the year ended December 31, 2014 to $1.0 billion for the year ended December 31, 2015 resulting in an increase in premium-related ceding fees of $11.1 million. Capacity fees increased $11.2 million for the year ended December 31, 2015 compared to the year ended December 31, 2014.
Lender Services Segment Results of Operations for the Year Ended December 31, 2016 compared to the Year Ended December 31, 2015
General and administrative expense. General and administrative expense increased by $2.2 million, or 5.4%, from $39.8 million for the year ended December 31, 2015 to $42.0 million for the year ended December 31, 2016, primarily due to investment in strategic growth and stock-based compensation.
General and administrative expense. General and administrative expense increased by $0.8 million, or 2.2%, from $39.0 million for the year ended December 31, 2014 to $39.8 million for the year ended December 31, 2015. The increase in general and administrative expenses was minimal in relation to our increased premium retention from the Alliance quota share agreement due to our ability to effectively leverage our fixed costs. This contributed to a decrease in our net expense ratio to 41.0% in 2015 compared to 47.3% in 2014.
Prior to the completion of the private placement in June 2014, we made special compensation payments to our co-founders in recognition of their service to our Company. We refer to these payments as “Founder special compensation.” Following the completion of the private placement, we ceased paying Founder special compensation.
Corporate Segment Results of Operations for the Year Ended December 31, 2016 compared to the Year Ended December 31, 2015
General and administrative expense. General and administrative expense increased by $1.7 million, from $9.0 million for the year ended December 31, 2014 to $10.7 million for the year ended December 31, 2015, primarily due to an increase in stock-based compensation.
The amortized cost and fair value of available-for-sale debt securities held as of December 31, 2016, by contractual maturity, are shown in the table below. Actual maturities may differ from contractual maturities because some borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Fair value of financial instruments. ASC 820, “Fair Value Measurements and Disclosures”, provides a definition of fair value, establishes a framework for measuring fair value, and requires expanded disclosures about fair value measurements. The standard applies when GAAP requires or allows assets or liabilities to be measured at fair value; therefore, it does not expand the use of fair value in any new circumstance. Investments measured at fair value on a recurring basis at December 31, 2016 and December 31, 2015 are all considered level 2 investments.
We are organized as a holding company with four domestic insurance company subsidiaries, as well as a wholly-owned subsidiary that operates in an agency capacity. Our principal sources of operating funds are premiums, ceding fees, investment income and proceeds from sales and maturities of investments. Our primary uses of operating funds include payments of claims and operating expenses. We pay claims using cash flow from operations and invest our excess cash primarily in fixed-income securities. We expect that projected cash flows from operations and our revolving credit facility will provide us with sufficient liquidity to fund our anticipated growth and to pay claims and operating expenses, interest on debt facilities and other holding company expenses for the foreseeable future. However, if our growth attributable to potential acquisitions, internally generated growth, or a combination of these factors, exceeds our expectations, we may have to raise additional capital in the near term. If we cannot obtain adequate capital on favorable
Net cash provided by operating activities was $10.2 million higher for the year ended December 31, 2016 compared to the year ended December 31, 2015, primarily due to an increase in Lender Services and Program Services operating results.
Net cash used in in investing activities decreased $18.7 million for year ended December 31, 2015 to the year ended December 31, 2016, primarily due to the liquidation of investments related to the acquisition of CNIC and acquisition of ISIC in January 2017. These decreases were largely offset by the purchase of CNIC on September 30, 2016 in the amount of $17.4 million.
Net cash provided by operating activities was $37.8 million higher for the year ended December 31, 2015 compared to the year ended December 31, 2014. The increase is primarily due to nonrecurring cash expenditures for the year ended December 31, 2014 related to founder special compensation, amendment to the CUNA Mutual alliance agreement and offering-related expenses. Also, contributing to the increase is an increase in ceding fees and the change to the Company’s retention related to the CUNA Mutual Alliance agreement to 70% from 50%.
Accounts receivable from agents, net. This balance reflects ceding fees, premiums and premium taxes receivable. During the year ending December 31, 2016, accounts receivable from agents increased $12.1 million from December 31, 2015, primarily as a result of an increase in Program Services receivables. The increase primarily relates to one of our arrangements under which we are responsible to certain reinsurers for the collection and payment of premiums. As a result, the related premiums receivable and payable are reflected in our balance sheet. The remainder partially relates to an agreement with Nephila we entered into effective January 1, 2016. For Nephila, we will, at Nephila’s request, transfer certain exposures that are otherwise reinsured by Nephila’s quota share reinsurer to excess reinsurers. In instances where this agreement is utilized, State National enters into an agreement directly with excess reinsurers, and Nephila guarantees the obligation of those excess reinsurers and pays the premiums on our behalf on a quarterly basis in arrears. We purchased one excess reinsurance policy under this agreement during 2016.
Goodwill and intangible assets, net. As of December 31, 2016, goodwill and intangible assets increased $6.6 million compared to December 31, 2015, primarily due to an increase in indefinite-lived intangible assets of $7.4 million related to the CNIC acquisition.
Deferred income taxes, net. Deferred income taxes, net, increased $2.7 million compared to December 31, 2015, primarily due to increases in Deferred ceding fees and the Allowance for policy cancellations related to growth in Program Services and Lender Services revenues.
Allowance for policy cancellations. As of December 31, 2016, the allowance for policy cancellations increased by $6.8 million from December 31, 2015, primarily due to the volume and timing of CPI premiums (gross of cancellations) written in 2016 compared to 2015. The fourth quarter tends to generate the greatest amount of written premium, whereas the first quarter of the year tends to generate the least. On a quarterly basis, we review our estimates for allowance for policy cancellations to determine whether further adjustments are appropriate. Any resulting adjustments are included in
On March 31, 2016, the Company, through TBA, entered into a loan agreement, which provides for a secured revolving credit facility in an aggregate principal amount of $15 million. The credit agreement matures on April 30, 2018. Under the credit agreement, TBA may request advances up to the aggregate amount of the unused commitment under the credit facility, on a revolving basis, prior to the maturity of the credit agreement. Borrowings under the credit agreement will bear interest at a variable rate equal to LIBOR plus 1.85% per annum; provided, however, that LIBOR shall be subject to a floor of 0.15%. TBA shall also pay a commitment fee on the daily average unused commitment amount for the period running from the closing date to the maturity date at a rate of 0.125% per annum. The credit agreement contains customary representations, warranties, covenants, and events of default, as well as a financial covenant requiring TBA and the Company to maintain a consolidated tangible net worth of at least $150 million.