We are an insurance holding company that markets and services our product offerings through specialty commercial and specialty personal insurance business lines. Our growth has been significant since our founding in 2009. Currently, we are authorized to write insurance as an excess and surplus lines carrier in 44 states, including the District of Columbia. We are licensed to write insurance in 42 states, including the District of Columbia, as an admitted carrier and we offer our insurance products in all 50 states.
Through our personal insurance lines, we offer homeowners insurance and dwelling fire insurance products to individuals in several states. Our specialty homeowners insurance line is primarily comprised of either wind-exposed homeowners insurance providing hurricane and wind coverage to underserved homeowners in Texas, Hawaii and Florida or low-value dwelling insurance tailored for owners of lower valued homes, which we offer in Illinois, Indiana, Louisiana and Texas. Due to certain Florida-based industry events, we have been de-emphasizing our Florida homeowners' business and reducing our exposures in that state. Otherwise, there has been little change in our approach to managing or evaluating these lines.
We identified the accounting estimates below as critical to the understanding of our financial position and results of operations. Critical accounting estimates are defined as those estimates that are both important to the portrayal of our financial condition and results of operations and which require us to exercise significant judgment. We use significant judgment concerning future results and developments in applying these critical accounting estimates and in preparing our consolidated financial statements. These judgments and estimates affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of material contingent assets and liabilities. Actual results may differ materially from the estimates and assumptions used in preparing the consolidated financial statements. We evaluate our estimates regularly using information that we believe to be relevant. See the Consolidated Financial Statements Note 1 - Summary of Significant Accounting Policies, for further details.
• Case reserves, which are unpaid loss and LAE amounts that have been reported; and
Case reserves are initially set by our claims personnel. When a claim is reported to us, our claims department completes a case-basis valuation and establishes a case reserve for the estimated amount of the probable ultimate losses and LAE associated with that claim. Our claims department updates their case-basis valuations upon receipt of additional information and reduces case reserves as claims are paid. The case reserve is based primarily upon an evaluation of the following factors:
• Analysis of other factors, such as variables in claims handling procedures, economic factors, and judicial and legislative trends and actions.
Our loss and LAE reserves do not represent an exact measurement of liability, but are estimates. The most significant assumptions affecting our IBNR reserve estimates are the loss development factors applied to paid losses and case reserves to develop IBNR by line of business and accident year. Although historical loss development provides us with an indication of future loss development, it typically varies from year to year. Thus, for each accident year within each line of business we select one loss development factor out of a range of historical factors.
The following table displays ultimate net loss and LAE and net loss and LAE reserves by accident year for the year ended December 31, 2017. We applied the sensitivity factors to each accident year amount and have calculated the amount of potential net loss and LAE reserve change and the impact on 2017 reported pre-tax income and on net income and shareholders’ equity at December 31, 2017. We believe it is not appropriate to sum the illustrated amounts as it is not reasonably likely that each accident year’s reserve estimate assumptions will vary simultaneously in the same direction to the full extent of the sensitivity factor. We also believe that such changes to our reserve balance would not have a material impact on our operating results, financial position, or liquidity. The net income and shareholders' equity amounts include an income tax rate assumption of 21%. The dollar amounts in the table are in thousands.
We consider a number of factors in assessing whether an impairment is other-than-temporary, including (1) the amount and percentage that current fair value is below cost or amortized cost, (2) the length of time that the fair value has been below cost or amortized cost and (3) recent corporate developments or other factors that may impact an issuer’s near term prospects. In addition, for debt securities, we consider the credit quality ratings for the securities, with a special emphasis on securities downgraded to below investment grade. We also consider our intent to sell available-for-sale debt securities in an unrealized loss position, and if it is more likely than not that we will be required to sell these securities before a recovery in fair value to their cost or amortized cost basis. For equity securities, we evaluate the near-term prospect of these investments in relation to the severity and duration of the impairment, and we consider our ability and intent to hold these investments until they recover their fair value.
We review fair value prices provided by our outside investment managers for reasonableness by comparing the fair values provided by the managers to those provided by our investment custodian. We also review and monitor changes in unrealized gains and losses. We obtain an understanding of the methods, models and inputs used by our investment managers and independent pricing services, and controls are in place to validate that prices provided represent fair values. Our control process includes initial and ongoing evaluation of the methodologies used, a review of specific securities and an assessment for proper classification within the fair value hierarchy.
On December 22, 2017, the U.S. federal government enacted H.R.1, “An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018” (the “Act”). The Act provides for significant changes to corporate taxation including the decrease of the corporate tax rate from 34% to 21%. We have completed an analysis of the impact of the Act and has followed the additional guidance provided by the Security and Exchange Commission's Staff Accounting Bulletin No. 118. We believe there are no material provisional balances as of December 31, 2017.
As of December 31, 2017, we have federal and state income tax net operating loss (“NOL”) carryforwards of $43.6 million and $11 million, respectively, which will expire at various dates from 2029 through 2037. Of the federal NOL amount, $15.1 million are subject to limitations under Section 382 of the Internal Revenue Code. These net NOL carryforwards are limited in the amount that can be utilized in any one year and may expire before they are realized. At this time we do not expect that any of the remaining NOL carryforwards will expire before utilized.
Adjusted operating income (loss) and adjusted operating income (loss) per share are non-GAAP measures that represent net income allocable to common shareholders excluding net realized investment and other gains (losses), net of tax, the effects of tax reform, and the tax effect of changes in unrealized gains to the extent included in net income. The most directly comparable financial GAAP measures to adjusted operating income and adjusted operating income per share are net income and net income per share, respectively. Adjusted operating income and adjusted operating income per share are intended as supplemental information and are not meant to replace net income or net income per share. Adjusted operating income and adjusted operating income per share should be read in conjunction with the GAAP financial results. Our definition of adjusted operating income may be different from that used by other companies. The following is a reconciliation of net income to adjusted operating income (dollars in thousands), as well as net income per share to adjusted operating income per share:
In 2017, we continued to expand our commercial lines and reposition our personal lines of business. Our commercial lines gross written premiums grew by 4.4% in 2017, and personal line gross written premiums decreased by 16.9% in 2017, as compared to 2016.
In September 2017, we entered into an adverse development cover reinsurance agreement (the "ADC") to protect against loss development of up to $17.5 million in excess of stated reserves as of June 30, 2017. The agreement provides up to $17.5 million of reinsurance for adverse net loss reserve development for accident years 2005 through 2016. The agreement attaches when net losses exceed $1.4 million of the $36.6 million carried reserves at June 30, 2017, and extends to $19.5 million in coverage up to $57.5 million (inclusive of a 10% co-participation).
The 2017 results were mainly driven by adverse development on prior-year reserves which were incurred through September 30, 2017, the cost of the ADC, and losses from hurricanes Irma and Harvey.
Our expense ratio continues to improve as we have executed on rationalizing costs with growing earned premiums. In the fourth quarter of 2017, the expense ratio was 41.4%, down 4.2 percentage points from the fourth quarter of 2016.
Adjusted operating loss, a non-GAAP measure, was $22.8 million, or $2.90 per share, for the year ended December 31, 2017, compared to an adjusted operating loss of $9.5 million, or $1.26 per share, for the year ended December 31, 2016.
In the event there is additional adverse development that exceeds the cost of the ADC, that excess amount will be deemed a gain under retroactive reinsurance accounting rules and is required to be deferred and only recognized in earnings in proportion to the actual paid recoveries under the ADC. Over the life of the contract, the accounting benefit will align with economic benefit of the ADC, however we may be required to recognize losses in near-term future periods, only to recognize offsetting gains in periods further out.
Personal lines gross written premiums decreased $4.5 million, or 16.9%, to $22.2 million for the year ended December 31, 2017, as compared to $26.7 million for the same period in 2016. This was largely driven by a reduction in wind-exposed homeowners business in both Florida and Texas.
The tables below detail our losses and LAE and loss ratios for the years ended December 31, 2017 and 2016 (dollars in thousands).
Net losses and LAE increased by $14.9 million, or 25.3%, for the year ended December 31, 2017, as compared to the same period in 2016. The increase was due to a combination of $9.5 million of adverse reserve development from prior years and $5.4 million of net losses from Hurricanes Harvey and Irma. The calendar year loss ratios were 79.2% and 65.0% for the years ended December 31, 2017 and 2016, respectively. The hurricanes contributed 6.4 percentage points to the 2017 loss ratio. The ADC resulted in approximately a 1.5 percentage point increase in the loss ratio as slightly more premiums were ceded under the ADC than losses in 2017. The 14.2 percentage point increase in our loss ratio was primarily attributable to the reserve strengthening in our Florida homeowners, commercial automobile and commercial liability lines of business.
Overall reserve development on prior accident years for the year ended December 31, 2016, was unfavorable by $10.2 million, or 11.3 percentage points of the loss ratio. The development included $2.7 million of adverse development in both the wind-exposed homeowners and commercial auto lines of business as well as $2.6 million and $760,000 of adverse development in the hospitality line of business and personal auto lines of business, respectively.
Operating expenses consist primarily of employee compensation, information technology and occupancy costs, such as rent and utilities. Operating expenses as a percent of net earned premiums and other income was 18.6% and 19.4% for the years ended December 31, 2017 and 2016, respectively. Earned premium growth on a more fixed operating expense structure has helped to reduce the operating expense ratio, which is expected to continue to decline as our earned premium grows. In addition, there have been Company-wide efforts to reduce operating expenses even with growing earned premiums. Dampening the effects of the growth in earned premium and expense reductions was the impact of the ADC and reinstatement premiums. Before the impact of the ADC and reinstatement premiums, the operating expense ratio was 17.2% for the year and only 15.4% in the fourth quarter of 2017.
For the year ended December 31, 2017, the Company reported $16,000 of current federal income tax benefit and $12,000 of current state income tax benefit. The Company also reported a deferred tax benefit of $419,000 which was largely the
Personal lines gross written premiums increased $1.1 million, or 4.4%, to $26.7 million for the year ended December 31, 2016, as compared to $25.6 million for the same period in 2015. This was largely driven by favorable growth of 38% in the Company’s low-value dwelling product line, partially offset by reduction in gross written premiums in the Florida homeowners business as well as the personal automobile business which is in runoff.
The tables below detail our losses and LAE and loss ratios for the years ended December 31, 2016 and 2015 (dollars in thousands).
Net losses and LAE increased by $20.1 million, or 51.7%, for the year ended December 31, 2016, as compared to the same period in 2015. The increase was primarily due to a 34.2% increase in net earned premiums and $10.2 million of unfavorable reserve development from prior years. The calendar year loss ratios were 65.0% and 56.8% for the years ended December 31, 2016 and 2015, respectively. The 8.2 percentage point increase in our loss ratio was primarily attributable to the reserve strengthening in our Florida homeowners, commercial automobile and commercial liability lines of business.
Overall reserve development on prior accident years for the year ended December 31, 2016 was unfavorable by $10.2 million, or 11.3 percentage points of the loss ratio. For the year ended December 31, 2016, this was made up of $2.7 million of adverse development in both the wind-exposed homeowners and commercial auto lines of business as well as $2.6 million and $760,000 of adverse development in the hospitality line of business and personal auto lines of business, respectively.
Net investment income increased by $271,000, or 14.2%, to $2.2 million for the year ended December 31, 2016, as compared to $1.9 million for the year ended December 31, 2015. This increase was the result of growth of the investment portfolio and a change in the mix of investments. Average invested assets as of December 31, 2016 were $123.1 million as compared to $111.5 million at December 31, 2015, an increase of $11.6 million, or 10.4%. As of December 31, 2016, the average invested asset balance was comprised of 89.4% fixed maturities, 3.6% equity securities and 7.0% short-term investments, compared to the December 31, 2015 mix of 85.8% fixed maturities, 3.8% equity securities and 10.4% short term investments.
At December 31, 2017, we had $23.3 million in cash and short-term investments. Our principal sources of funds, excluding capital raises, are insurance premiums, investment income, proceeds from maturity and sale of invested assets and
installment fees. These funds are primarily used to pay claims, commissions, employee compensation, taxes and other operating expenses, and service debt.
We believe that our existing cash, short-term investments and investment securities balances will be adequate to meet our capital and liquidity needs and the needs of our subsidiaries on a short-term and long-term basis.
Operating Activities. Cash provided by operating activities for the year ended December 31, 2017, was $9.1 million as compared to cash used in operating activities of $6.2 million for the year ended December 31, 2016. The increase in cash provided by operations was attributable to the overall growth of the business.
Cash provided by operating activities for the year ended December 31, 2016, was $6.2 million as compared to cash used in operating activities of $3.1 million for December 31, 2015. The increase in cash provided by operations was attributable to the overall growth of the business.
Net cash used in investing activities for the year ended December 31, 2015, was $15.3 million and was primarily attributable to net investments into debt securities of $23.9 million, offset by the sale of short-term investments of $10.3 million.
We are a party to $30.0 million in subordinated notes, effective September 29, 2017. The notes have a maturity date of September 29, 2032, bear interest, payable quarterly at a fixed annual rate of 8.0%, and allows for up to four quarterly interest deferrals. On the fifth and tenth anniversary of the notes, the interest rate resets to 1,250 basis points and 1,500 basis points, respectively, above the 5-year mid-swap rate. The Notes include an issuer call option at par from July 31, 2018, through October 31, 2018, and at 105% of par any time after September 29, 2020. The carrying value of the Notes is offset
(2) Includes estimated future payments under the software license agreement relating to our policy issuance system. This agreement requires minimum monthly payments of $30,000, and is variable with premium volume. The future payment assumptions are based on the minimum monthly payments. The software license agreement expires on September 30, 2022.